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FINANCIAL
MANAGEMENT I
Assoc Prof Dr Yusnidah Ibrahim
Faudziah Zainal Abidin
Norlida Abd Manab
Rusmawati Ismail
Zaemah Zainuddin
Project Directors: Prof Dr Mansor Fadzil
Assoc Prof Dr Wardah Mohamad
Open University Malaysia
Answers 325
Attachments 377
COURSE GUIDE
COURSE GUIDE xi
INTRODUCTION
BBPW3103 Financial Management I is one of the courses offered by the Faculty of
Business and Management at Open University Malaysia (OUM). This course is
worth 3 credit hours and should be covered over 8 to 15 weeks.
COURSE AUDIENCE
This course is offered to all students taking the Bachelor of Business
Administration programme. This module aims to impart an overview of
currency risk in international economic activities.
As an open and distance learner, you should be able to learn independently and
optimise the learning modes and environment available to you. Before you begin
this course, please confirm the course material, the course requirements and how
the course is conducted.
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
xii COURSE GUIDE
Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussion 3
Study the module 60
COURSE OUTCOMES
By the end of this course, you should be able to:
1. Explain the concepts and theories in key areas of finance;
2. Analyse financial information and enhance conceptual understanding of the
financial decision making process;
3. Examine the financial tools used by financial managers and investors in
analysis and decision making;
4. Analyse the interrelationships among the areas of finance in allowing firms,
financial managers and investors to achieve their investment and financing
goals efficiently; and
5. Apply the strategies of working capital management in managing short-term
obligations.
COURSE SYNOPSIS
This course is divided into 10 topics. The synopsis for each topic is presented
below:
Topic 1 introduces the topic of finance, the role of the finance manager in
companies as well as the main objective of companies to maximise the
shareholders' wealth. Besides that, the types of business entities, agency
problems and financial institutions will also be discussed. This topic also
discusses the main financial market, that is the money market and capital market.
COURSE GUIDE xiii
Topic 2 discusses the usage of financial ratio analysis such as the liquidity ratio,
asset management, leverage, profitability, and market value ratio. Besides that,
this topic also discusses on the DuPont analysis and the overall financial analysis.
Topic 3 exposes students to the basic concept for time value of money, which is
the concept of present value and future value. You will learn the application and
formula for the time value of money for single cash flow and net cash flow,
annuity, perpetuity and derivation cash flow. The discussion will also include
compounding and discounting methods that occur more than once a year and
compounding and discounting that occurs continuously.
Topic 4 discusses the valuation of bonds and the valuation of ordinary shares.
The topic of discussion will touch on the characteristics of bonds, ratings of
bonds, types of bonds, valuation of bonds, yield upon maturity and the
connection between the value and yield upon maturity. The discussion topic will
also focus on characteristics of ordinary shares, dividend valuation models in
ordinary shares, characteristics of preference shares and valuation of preferences
shares.
Topic 5 introduces you to the relationship between the risk and return from the
financial theories perspective. The discussion comprises the definition of risk and
return from the investors' perspective, the usage of statistics in ascertaining the
level of risk and return and the measurement of risk and return. The basic
principles of systematic and unsystematic risks and the CAPM Model (model
that explains the relationship between risk and return) are also discussed.
Topic 6 discusses the four techniques of capital budgeting, which are the payback
period, net present value, profitability index and internal rate of return.
Topic 7 explains how the cash flow for capital budget is estimated and applied in
decision making for long-term investments. The calculation of initial outlay,
operating cash flow and terminal cash flow are also explained.
Topic 8 discusses the cost of capital. The discussion topic touches on the
definition for cost of capital, cost of long-term debt, cost of ordinary shares, cost
of preference shares and weighted average cost of capital.
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.
COURSE GUIDE xv
Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
PRIOR KNOWLEDGE
Learners of this course are required to pass BBAW2103 Financial Accounting
course.
ASSESSMENT METHOD
Please refer to myVLE.
REFERENCES
Emery, D. R., Finnerty, J. D., & Stone, J. D. (1997). Principles of financial management
(1st ed.). Upper Saddle River, NJ: Prentice Hall Inc.
Lasher, W. R. (2008). Practical financial management (5th ed.). Mason, Ohio: South-
Western Thomson Learning.
Martin, J. D., Petty, J. W., Scott, D. F. Jr., & Keown, A. J. (1998). Basic financial
management (8th ed.). New Jersey: Prentice Hall Inc.
xvi COURSE GUIDE
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Identify the areas of finance and its importance to businesses;
2. Explain the four main activities of finance managers in a company;
3. Discuss the main objective of financial management, that is to
maximise the wealth of the shareholders;
4. Examine the relationship in agency problems;
5. Elaborate on the three types of business organisations, which are the
sole proprietors, partnerships and companies; and
6. Explain the characteristics of financial market.
INTRODUCTION
This topic introduces the area of finance and discusses the role of finance
managers in companies. Besides that, the main objective and mission of the
company in maximising the wealth of the shareholders as well as the different
types of business entities will also be discussed. The next subject will enable you
to discover problems that might affect the agencies due to the existence of two
different parties that is the manager and the owner in achieving their separate
objectives. At the end of this topic, the financial institutions will be discussed in
general.
2 TOPIC 1 INTRODUCTION TO FINANCE
1.1 FINANCE
As you have known, nearly all rational individuals and organisations will try to
obtain profit or money and thereafter, spend or invest the money for specific
purposes. Finance is closely related to these processes, institution, market and
instruments that are involved in the transfer of money between individuals and
businesses.
Businesses are involved in numerous dealings and each day, the finance manager
will face a variety of questions such as:
(a) Should the company carry out the project?
(b) Will the investment be successful?
(c) How to fund the investment?
(d) Which is the best funding decision? Getting a loan from a bank or issuing
shares?
(e) Does the company have enough cash to fulfil its daily operations?
(f) What is the level of inventory that needs to be kept?
(g) To which customer should the company offer credit?
(h) What is the optimal dividend policy?
(i) Should the takeover be continued?
ACTIVITY 1.1
SELF-CHECK 1.1
If you were assigned as a finance manager, what are the main
responsibilities that you will face in straightening the financial position
of your organisation?
SELF-CHECK 1.2
The companys profit is measured by the earnings per share, that is the profit of
each ordinary share. The earning per share is obtained by dividing the net profit
with the number of ordinary shares issued.
Net Profit
Earnings Per Share
Ordinary Shares Issued (Units)
6 TOPIC 1 INTRODUCTION TO FINANCE
This does not illustrate the cash flow obtained during that period. To obtain
a true picture of the companys return, items that do not involve cash flow,
especially depreciation, bad debts and loss on assets disposal must be
added again to the net profit.
Project Profits
Year 1 Year 2
Project A RM100,000 0
Project B 0 RM 100,000
Both the projects show the same profit. If we follow the objective of
maximising profits, both projects are equally good. However, this is
incorrect. In actual fact, Project A is the better project as the returns or the
amount of RM100,000 is received earlier compared to Project B. Thereafter,
this amount can be invested to obtain additional returns. For example, if
we deposit RM100,000 received through Project A in a bank that gives an
interest rate of 5 percent, this amount will become RM105,000 after one year
(RM100,000 1.05). This shows that this amount will exceed the RM100,000
that is obtained through Project B.
(c) Risks
The objective of maximising profits also disregards risks. Risk is defined as
the probability of a result being different from what is expected. One basic
concept in finance states that there exists a relationship between risks and
returns. High returns can only be achieved by bearing higher risk.
TOPIC 1 INTRODUCTION TO FINANCE 7
Companies that balance the profits and risks can be seen as consistent with
the objective in maximising the shareholders wealth. By defining the
companys objective in the aspect of the shares market value, it will reflect
the managements efforts in optimising between risks and profits. The
manager should find the combination between profits and risks that can
maximise shareholders wealth.
ACTIVITY 1.2
In your opinion, besides investing money, what are the roles and
responsibilities of shareholders in the company's operations? Are they
only interested in profit taking or in having absolute authority in the
companys operations?
EXERCISE 1.1
The separation of ownership and control has caused managers to pursue their
own selfish objectives. They would no longer maximise the owners objective but
instead, the manager adopts a self-sufficient attitude or only attempt to obtain a
moderate level of achievement, and at the same time, tries to maximise their own
interest. They are more focused on their own position and job security. They will
try to limit or minimise the risks borne by the company as unsatisfactory
outcome might result in them being terminated or the company becoming
bankrupt.
To avoid or minimise agency problems, the companys owners will have to bear
the costs of agency and to control the actions of the managers. The company will
offer various incentives to motivate the managers to act in the best interest of the
shareholders. Among steps that can be taken include provide compensation or
incentives based on the companys achievement, threats of termination and
threats of company takeover by another company due to administrative
weaknesses.
10 TOPIC 1 INTRODUCTION TO FINANCE
SELF-CHECK 1.3
State the differences that might exist between the objectives of the
companys managers with the board of directors or shareholders.
SELF-CHECK 1.4
A business incorporated can be in the form of sole proprietor,
partnership or company. If you plan to start a business, which type of
business would you choose? Why?
The capital resources are normally acquired from the owners savings,
loans from family members and friends or from the bank. The owner owns
all the assets and bears all the business liabilities. The liabilities of a sole
proprietor are unlimited. This means that if the business fails to pay its
debts to its creditors, the owner will have to use its own property to settle
the business debts.
TOPIC 1 INTRODUCTION TO FINANCE 11
Advantages Disadvantages
Business is simple to establish. Rather difficult for organisations of
Cost to establish the business is low. sole proprietors to obtain huge
capital.
Business is not governed by several
regulations. Business owners have unlimited
liabilities on the business debts.
Profit of the business is not taxable.
Income is only subject to personal The existence of sole proprietors is
tax. not permanent. It will end upon the
death of the business owner.
The financial status can be kept
confidential.
(b) Partnership
Partnership is a business operated by two or more partners. The
partnership can be made in writing or verbally. If the partnership is made
verbally, the Partnership Act 1961 will be relevant.
Advantages Disadvantages
A partnership is easily formed and Partnership can be dissolved
the cost of formation is low. upon the death, withdrawal or
More capital can be acquired bankruptcy of one of the partners.
compared to the sole proprietor The decision making process will
business. be rather difficult compared to the
Profits from business will only be sole proprietor as it must be
subject to personal tax. referred with consent obtained
from the other partners.
Partnership combines a variety of
expertise and skills of the partners. Partners have unlimited liabilities.
Personal assets can be claimed by
Businesss risks and liabilities can creditors to settle business debts.
be shared among the partners.
Business risks must be borne by
all partners. A mistake made by
one partner will bind the other
partners.
(c) Company
Company is a business entity that exists separately from its owners. Under
the Companies Act 1965, a company is a legal entity under the aspect of the
law, can own assets, bear liabilities, have authority to sue other parties and
can be sued by other parties. To incorporate a company, registration must
be made with the Registrar of Companies and is governed by the
companies act, such as the preparation of Memorandum of Understanding
and Articles of Association documents.
TOPIC 1 INTRODUCTION TO FINANCE 13
Advantages Disadvantages
EXERCISE 1.2
SELF-CHECK 1.5
What do you understand by the term financial market? Provide two
types of the main financial markets in the country and explain their
respective functions.
Financial market is the intermediary that connects the capital depositors with
borrowers in the economy. There are two main financial markets:
Money market; and
Capital market.
The main characteristic that differentiates the money market from the capital
market is the maturity period of the traded securities.
These long-term securities are traded in two types of markets, the main
market and the ACE market.
All trade debts exceeding the All trade debts exceeding the
normal credit period and all non- normal credit period and all
trade debts, owning by the non-trade debts, owning by
interested persons to the the interested persons to the
company or its subsidiary company or its subsidiary
companies must be fully settled companies must be fully
prior to listing settled prior to listing
* Companies with MSC status, BioNexus status and companies with predominantly
foreign-based operations are exempted from the Bumiputera equity requirement.
ACTIVITY 1.3
EXERCISE 1.3
4. Assume you own IBM shares, but you are not allowed to enter the
companys headquarter at any time you feel like doing so. If then, in
what sense are you considered an owner of the IBM Company?
A financial manager must be smart and be able to obtain and use the funds to
enable the value of the company to be maximised to attract investors.
The agency problems that occur due to the separation of internal controls of
the company show that there are differences in objectives between the
manager and the companys actual objective and this can interfere with the
administration of the company.
The owner must find alternatives to control the managers actions by offering
various incentives and reimbursements. This internal problem arises without
taking into consideration whether the organisation is a sole proprietor,
partnership or company.
The financial market, which are the money market and the capital market had
set up a forum or platform where the funds suppliers and funds borrowers
can conduct financial assets transactions. It is the medium that connects the
capital depositors with the borrowers in the economy.
22 TOPIC 1 INTRODUCTION TO FINANCE
INTRODUCTION
Financial statement is a data summary on asset, liability and equity as well as
income and expenditure of a business for a specific period. Financial statement is
used by financial managers to evaluate the companys status and for planning
the companys future.
In this topic, you will learn about the four main financial statements, which are
the income statement, balance sheet, statement of retained earnings and cash
flow statement. In the beginning, you will be exposed to the basic format of each
financial statement. Subsequently, you will learn how to prepare each of the
financial statement. Understanding of the financial statements is important as
these financial statements will assist in evaluating the companys performance.
24 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Finance manager use the financial analysis for the companys future planning.
For example, shareholders and potential investors are interested in the level of
returns and risks of the company. Creditors are interested in the short-term
liquidity level and the ability of the company to settle its interests and debts.
They will also emphasise on the profitability of the company as they want to
ensure that the companys performance is good and will be successful. Therefore,
the finance manager must know the entire aspects of the financial analysis that
are being focused by several parties having their own interests in evaluating the
company.
Beside the finance manager, the management also uses the financial analysis to
monitor the companys achievement from time to time. Any unexpected changes
will be examined to identify the problems that need to be dealt with.
SELF-CHECK 2.1
Companies are required to report their business financial status at the end of
each accounting period in the annual report.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 25
Annual reports usually contain messages from the chairman, financial statements
and notes explaining the practices and policies adopted in reporting the
companys accounts (see Figure 2.1).
There are two types of information in an annual report. The first section is the
message from the chairman. It reports the companys achievement throughout
that year and discusses on new developments that will affect the companys
future operations. The second section will report on the basic financial statements
such as the income statement, balance sheet, statement of retained earnings and
cash flow statement.
(a) Internal users include the managers and other officers that operate the
business. They are responsible in planning the strategies and operations of
the company. Therefore, they use the financial statements to obtain
information on the overall companys performance.
(b) External users of the company are not directly involved in the operations of
the company. They comprise of users who have direct interest in the
company (such as shareholders, investors and creditors) and users who
have indirect interest in the company (such as customers, tax agent and
labour organisations).
The Companies Act 1965 stipulates that at least four of the following financial
statements must to be included in the annual reports, which are:
(a) Income statements;
(b) Balance sheet;
(c) Statement of retained earnings; and
(d) Cash flow statement.
Let us look at these financial statements and the relationship between each of
them based on the financial statements of Company FAZ as an example.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 27
SELF-CHECK 2.2
Monthly statements are also prepared for the usage of the management who
required more frequent information to enable more prudent decisions to be made.
Yearly quarter statements are also prepared for shareholders of public companies.
(a) Sales figure can be compared with the firms sales for the previous year and
the expected sales in the future. This information can be used for the firms
future planning.
(b) Gross profit/gross loss can be compared with the sales figure to show
profit from the products/services sold.
(c) Firm expenditures can be compared with the firms expenditures for the
previous year to see which policy can be adopted to reduce costs.
Table 2.1 is the income statement of Company FAZ for year ended 31 December
2012. This statement starts with sales revenue that is the sales value in ringgit
throughout the accounting period. Cost of goods sold is deducted from the sales
revenue to obtain gross profit of RM70,000. This total is the amount obtained
from sales to cover the financial operating costs and tax.
28 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Company FAZ
Income Statement
for the Year Ended 31 December 2012
RM
Sales 170,000
Less: Cost of goods sold 100,000
Gross profit 70,000
Less: Operating expenditure
Sales expenses 8,000
Administrative and general expenses 15,000
Depreciation expenses 10,000
Total operating expenditure 33,000
Profit before interest and tax 37,000
Interest 7,000
Profit before tax 30,000
Tax (40%) 12,000
Profit after tax 18,000
Less: Dividend for preference shares 1,000
Net profit (or profit available for ordinary shareholders) 17,000
Earnings per share = Net profit/Total ordinary shares 0.17
All the operating expenditures such as sales expenses, general and administrative
expenses and depreciation expenses will be listed and totalled to obtain the total
operating expenditure. This total will then be deducted from the gross profit to
obtain profit from operations of RM37,000. Profit from operations is the profit
obtained from activities of manufacturing and selling of products; it does not
take into account the financial costs and tax. Profit from operations is also known
as profit before interest and tax.
Thereafter, the financial cost that is the interest expenses of RM7,000 will be
deducted from the profit from operations to obtain the profit before tax of
RM30,000. After deducting tax, we will obtain profit after tax (or profit before
preference shares) of RM18,000.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 29
Any dividends for preference shares must be deducted from the profit after tax
to obtain net profit. This total is also known as profit available to the ordinary
shareholders and is the total obtained by the company on behalf of ordinary
shareholders throughout the specific period. Normally, reports on earnings per
share are provided at the last section of the income statement. Earnings per share
show the total obtained by the company throughout the specific period for each
ordinary share. In year 2012, Company FAZ obtained RM17,000 for the ordinary
shareholders or RM0.17 for each share issued (total ordinary shares is 100,000).
Earnings per share are often referred as the bottom line to show that earnings
per share are the most important item in the income statement compared to the
other items (see Figure 2.3).
Figure 2.3: Companys objectives are to increase earnings and maximise profit
SELF-CHECK 2.3
If you are one of the preference shareholders in Company FAZ, how
would the information contained in the companys financial statements
be useful to you?
30 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
SELF-CHECK 2.4
Company FAZ
Balance Sheet
As at 31 December 2011 and 2012
31-12-2012 31-12-2011
RM RM
Assets
Current assets
Cash 40,000 30,000
Marketable securities 60,000 20,000
Account receivables 40,000 50,000
Inventory 60,000 90,000
Total current assets 200,000 190,000
Long-term assets
Land and building 120,000 105,000
Machines and equipment 85,000 80,000
Fixtures and fittings 30,000 22,000
Vehicles 10,000 8,000
Others (including lease) 5,000 5,000
Total fixed assets 250,000 220,000
Less: Accumulated depreciation 130,000 120,000
Fixed assets, net 120,000 100,000
TOTAL ASSETS 320,000 290,000
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 31
2.3.1 Assets
Assets are valuable economic resources owned by the business. It can be used
in several activities such as manufacturing, usage and exchange. Assets have
service potential or will bring economic benefit in the future. Assets have the
capability to provide services or generate benefit to the business entity that owns
it. In businesses, services or economic benefit will generate cash inflow (receiving
cash) to the business.
Assets can be categorised into current assets and long-term assets. Assets are listed
in the balance sheet according to its liquidity level from the most liquid to the less
liquid. Therefore, current assets are arranged first, followed by fixed assets.
Other current assets which are not in Company FAZs balance sheet are
prepaid expenses (prepayment). Prepaid expenses are expenses that have
been paid in advance by cash but the benefits from the expenses have not
been received. Examples of prepaid expenses are prepaid rental, prepaid
insurance and office supplies.
Fixed assets are land and buildings, machines and equipment, fixtures and
fittings and vehicles. Usually, a company will report the total fixed asset
that is the original cost of all the fixed assets owned by the company. From
that total, the company will deduct the accumulated depreciation for all
fixed assets to obtain net fixed assets. All fixed assets must be depreciated
except for land. This is because the value of land will always increase, while
the values of other fixed assets such as machines and equipment, as well as
vehicles will decrease when the life span of the asset increases.
Besides current assets and fixed assets, a business might show intangible
assets in its balance sheet. Intangible assets are long-term assets that cannot
be physically seen and usually provide a competitive advantage to the firm.
Examples of intangible assets are patents, franchise licences, licences,
trademarks, copyrights and goodwill. Although these assets cannot be
physically seen, it is recorded using the same method as the other fixed
assets. This means that the assets will be recorded at its original cost and
this cost will be amortised throughout its lifetime. Among the intangible
assets that are famous are the patent of Polaroid, the franchise of
McDonalds and the trademark of Colonel Sanders Kentucky Fried Chicken.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 33
ACTIVITY 2.1
2.3.2 Liabilities
Most businesses have been in situations where they need to take loans to finance
the businesss assets or to buy assets such as raw materials on credit. Liabilities
are claims made by creditors on the company assets. In other words, liabilities
are debts and obligations of a company. Liabilities comprise of current liabilities
and long-term liabilities.
If a situation occurs where the company is unable to pay its business liabilities,
the creditors can force the company to be liquidated. In this situation, the
creditors claims must be settled first before the company can settle the claims of
the shareholders.
Other current liability that is not in the balance sheet of Company FAZ is
deferred income. Deferred income is cash that had been received from
customers but the services or products paid had not been provided.
Examples of deferred income are deferred rental and deposit from
customers.
34 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Bonds are a type of fixed income securities that are issued by companies.
Notes payables are a type of credit transaction that involves a written
agreement between the company and creditors. Mortgage loans are long-
term loan that use the assets (such as land and buildings) as a mortgage for
the loan. Notes payable can also be mortgaged with the other assets as a
security for the loan. A lease is a contractual agreement between the lessor
and the lessee. The lessor gives the right to the lessee to use the asset for a
specific period and will impose charges for usage of the asset.
(a) Preference shares are securities that provide fixed return dividend to its
holders. Preference shareholders do not have ownership in the company.
(b) Ordinary shares are securities that reflect the ownership of the company.
Ordinary shareholders are the real owners of the company. They will
receive returns in dividends that will be paid to them in cash or shares
(bonus issues).
(c) There will be situations where the par value (stated value) is not equal to
the market price of the ordinary shares at the time of issue. Cash earnings
from the issuance of shares might be equal, more or less than the par value.
When this situation occurs, the company will record the issuance of shares
at the par value in the Ordinary Shares account and the difference between
the par value and the shares selling price (surplus earnings) will be
recorded in a separate account known as Paid-up Capital Above Par.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 35
(d) Retained earnings are the total accumulated earnings since incorporation
that had not been distributed to the shareholders as dividend but was re-
invested into the company. It is important to remember that retained
earnings are not cash but are earnings that have been used to finance the
companys assets.
The equation above is known as the summary of basic accounting where the total
assets must be equal to the total liabilities plus owners equity. Owners equity is
equal to total assets less total liabilities. This is because the assets of a business
are financed by either the creditors or the owner. To determine the owners
portion (owners equity), we must deduct the creditors portion (liabilities) from
the assets. The balance will be the claim of the owner on the businesss assets. As
the creditors claims would be given priority over the owners claims upon
liquidation, the owners claims are also known as residual equity.
ACTIVITY 2.2
EXERCISE 2.1
3. Fixed assets are items that cannot be converted into cash within a
period of one year.
(a) True (b) False
5. Which is FALSE?
A. Assets = Liabilities + Owners Equity
B. Assets Liabilities = Owners Equity
C. Assets + Liabilities = Owners Equity
D. Assets Owners Equity = Liabilities
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 37
(b) In column (2), state whether the account is a current asset (CA),
fixed asset (FA), current liabilities (CL), long term liabilities (LTL),
shareholders equity (SE), income (I) or expenditure (EX).
7. Use the relevant items listed below to prepare the income statement for
Company PC for period ending 31 December 2011.
8. Use the relevant items from the list below to prepare the balance sheet
for Company ODC as at 31 December 2011.
The statement shows that the company started with a retained earnings of
RM50,000 on 31 December 2011 or 1 January 2012 and profit after tax of
RM18,000 (data obtained from the income statement). From this total, the
company had paid dividends of RM1,000 for preference shares and dividends of
RM7,000 for ordinary shares. Therefore, the retained earnings had increased by
RM10,000 from RM50,000 as at 1 January 2012 to RM60,000 as at 31 December
2012.
Company FAZ
Statement of Retained Earnings
for the Year Ended 31 December 2012
Evaluate the companys capability to settle debts, pay dividends and provide
loans.
ACTIVITY 2.3
Step 2 List the data according to the arrangement in Table 2.4. All resources
and net profit including depreciation are positive cash flow, which is
the cash flowing in; while all usages, any losses and dividends payable
are negative cash flow, which is the cash flowing out. Obtain the total
for the items in each component.
Step 3 Add the total from each component to obtain the increase (or decrease)
of net cash and marketable securities. To check whether you had
prepared the statement correctly, ensure that the value is equal to the
changes in cash and marketable securities for the relevant year by
looking at the opening and closing balances of cash and marketable
securities in the balance sheet.
Table 2.4: Components and Data Sources that Must be Included into the
Cash Flow Statement
RM
Cash Flow from Operating Activities
Net profit (Net loss) IS
Depreciation and other non-cash charges IS
Changes in all current assets BS
(except cash and marketable securities)
Changes in all current liabilities BS
(except notes payable)
Cash flow from operating activities xx
Data Sources
BS = Balance Sheet
IS = Income Statement
42 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Company FAZ
Cash Flow Statement
as at 31 December 2012
RM RM
Cash Flow from Operating Activities
Net Profit 18,000
Depreciation 10,000
Decrease in account receivable 10,000
Decrease in inventory 30,000
Increase in account payable 20,000
Decrease in tax accrual (10,000)
Cash flow from operating services 78,000
Several issues can help you to classify between cash resources and usage as
shown in Table 2.6.
(a) Decrease in the asset account is a cash inflow resource while increase in the
asset account is a cash usage or cash outflow.
Company bought new assets with cash. Therefore, any increase in the asset
items between the two dates of the balance sheets will indicate that cash
outflow had occurred. Any decrease in the asset items will indicate cash
inflow as the company had sold the assets to obtain cash.
(b) Increase in the liability account and owners equity is a cash inflow resource
and a decrease in the liability account is cash usage.
The company might use cash to settle its liability and claims on the assets.
Therefore, any decrease in the liability items, preference shares or ordinary
shares between the two dates of balance sheets indicates cash outflow. To
obtain additional cash, the company can take loans. Hence, any increase in
the liability items, preference shares or ordinary shares indicates cash
inflow.
(d) Direct changes in the retained earnings are not included in the cash flow
statement as these items affect the retained earnings and are shown as
profit after tax (or loss after tax) and cash dividends.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 45
Table 2.7 shows changes in the balance sheet items of Company FAZ between
31 December 2011 and 31 December 2012.
Company FAZ
Changes in the Balance Sheet Items between 31 December 2011
and 31 December 2012
Classification
31-12-11 31-12-12 Changes Resource Usage
Assets
RM RM RM RM RM
Cash 30,000 40,000 +10,000 10,000
Marketable 20,000 60,000 +40,000 40,000
securities
Account 50,000 40,000 10,000 10,000
receivable
Inventory 90,000 60,000 30,000 30,000
Total fixed assets 220,000 250,000 +30,000 30,000
Less: (120,000) (130,000) 10,000 10,000
Accumulated
depreciation
Liabilities
Account payable 50,000 70,000 +20,000 20,000
Notes payable 70,000 60,000 10,000 10,000
Tax accrual 20,000 10,000 10,000 10,000
Long-term loan 40,000 60,000 +20,000 20,000
Equities
Preference shares 10,000 10,000 0
Original shares at 12,000 12,000 0
par
Paid-up capital 38,000 38,000 0
Retained earnings 50,000 60,000 +10,000 10,000
TOTAL 100,000 100,000
46 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
(c) Total fixed assets increased by RM30,000 and this is considered as cash
usage as the company uses the cash to buy fixed assets.
(e) Notes payable and tax accrual decreased by RM10,000 and this is
considered as cash usage as the cash is used to settle debts to the creditors
and tax to the government.
These types of classifications (based on Table 2.6) are made on every item in the
balance sheet. The result of these classifications will be totalled to obtain the total
cash resources and total cash usage. If these classifications are done correctly, the
total cash resources will be equal to the total cash usages.
ACTIVITY 2.4
All sorts of support and loan assistance had been provided by the
government through organisations such as Perbadanan Usahawan
Nasional Berhad (PUNB) to encourage the participation of Bumiputeras
in the field of entrepreneurship. Many have grabbed this opportunity to
be involved in their own businesses covering various economic sectors
but not all of them succeeded. What is your opinion on this matter?
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 47
EXERCISE 2.2
1. In the Cash Flow Statement, you will see that both interest expenses
and dividends paid are in the section of financing activities.
(a) True (b) False
3. Profit from the sale of fixed assets will be deducted from the net
profit to ascertain the cash flow from operating activities.
(a) True (b) False
8. Profit after tax of year 2011 for Company Ceria is RM186,000. The
closing balance for retained earnings for year 2011 and 2010 were
RM812,000 and RM736,000 accordingly. How much dividend did
the company pay in the year 2010?
9. Classify each of the following items as funds resource (R), usage (U),
or neither one (N).
10. Use the data from the balance sheet and several items from the
income statement of Suresh Corporation to prepare the Cash Flow
Statement for year ended 31 December 2011.
Suresh Corporation
Balance Sheet
as at 31 December 2011
Assets RM RM
Cash 15,000 10,000
Marketable securities 18,000 12,000
Account receivable 20,000 18,000
Inventory 29,000 28,000
Total current assets 82,000 68,000
Total fixed assets 295,000 281,000
Less: Accumulated depreciation 147,000 131,000
Net fixed assets 148,000 150,000
Total Assets 230,000 218,000
Liabilities
Current liabilities
Account payable 16,000 15,000
Notes payable 28,000 22,000
Wages accrual 2,000 3,000
Total current liabilities 46,000 40,000
Long-term loans 50,000 50,000
Owners Equities
Ordinary shares 100,000 100,000
Retained earnings 34,000 28,000
Total shareholders equity 134,000 128,000
Total liabilities and
shareholders equities 230,000 218,000
SELF-CHECK 2.5
Financial ratio analysis involves the calculation of several ratios that will enable
the manager to evaluate the performance and financial status of the company by
comparing its financial ratios with the financial ratios of other companies. These
ratios are divided into five groups or categories, which are:
Within the short-term period, liquidity, asset management and profitability ratios
are important to the management of the company as these ratios provide critical
information on the companys short-term operations. If a business is unable to
sustain within the short-term period, it would be pointless to discuss its long-
term prospects.
Before preparing the ratio analysis, the finance manager must consider the
following issues:
(a) One ratio is unable to give complete information on the status of the
company. This means that several categories of ratios must be looked at
simultaneously before any conclusion can be made.
(b) Comparisons between the financial ratios of one company with other
companies in the industry must be made at the same point of time. Industry
average is not a figure that must be achieved by a company. There are
many companies that had been managed efficiently but the performance of
their financial ratios is much higher or lower than the performance of the
industry average. The obvious difference between the financial ratios of the
company and the industry average is an indication to the analysts to check
on the ratio further.
(c) Use the financial statements that have been audited. This will show the
actual status of the company.
(d) Use the same method to evaluate items in the financial statement that will
be compared. For example, to record inventory, a company might use
different accounting methods such as the first-in-first-out, first-in-last-out
or moving average method. Choose only one of these methods for
comparison purposes. Different methods will provide different ratio values.
Therefore, actual evaluation cannot be done.
52 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Financial statements of the company are the main input for the manager who
intend to prepare the ratio analysis for its company. Each example of the ratios
that will be discussed in the next section will be based on the financial
information extracted from the income statement and balance sheet of Company
ABC (refer to Table 2.8 and Table 2.9).
Company ABC
Income Statement
for the Year Ended 31 December 2011 and 2010
2011 2010
RM RM
Sales 307,400 256,700
Less: Cost of goods sold 208,800 171,000
Gross profit 98,600 85,700
Less: Operating expenses
Sales expenses 10,000 10,800
Administrative and general expenses 19,400 18,700
Lease expenses 3,500 3,500
Depreciation expenses 23,900 22,300
Total operating expenses 56,800 55,300
Profit before interest and tax (operating profit) 41,800 30,400
Less: Interest expense 9,300 9,100
Profit before tax 32,500 21,300
Less: Tax (29%) 9,425 6,177
Profit after tax 23,075 15,123
Less: Preference shares dividend 1,000 1,000
Profit available for ordinary shareholders 22,075 14,123
Company ABC
Balance Sheet
as at 31 December 2011 and 31 December 2010
2011 2010
RM RM
Assets
Current Assets
Cash 36,300 28,800
Marketable securities 6,800 5,100
Account receivable 50,300 36,500
Inventory 28,900 30,000
Total current assets 122,300 100,400
Net Fixed Assets 237,400 226,600
Total Assets 359,700 327,000
Equities
Preference shares 20,000 20,000
Ordinary shares, RM2.50 par value, 19,100 19,000
100,000 shares issued 2011: 76,262;
2010: 76,244
Net working capital of Company ABC for the year 2011 is calculated as follows:
Based on the calculation above, the net working capital of Company ABC is
higher than the industry average. This shows that Company ABC is able to settle
its short-term debts and has higher surplus funds than the other companies in the
industry to manage its daily operations.
Current ratio is obtained by dividing the current assets with the current
liabilities. The current ratio of Company ABC (year 2011) is as follows:
Current Assets
Current ratio
Current Liabilities
RM122,300
(2.2)
RM62,000
1.97
Industry average 2.05
56 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
The current ratio of Company ABC is 1.97 which is lower compared to the
industry average of 2.05. This shows that for every ringgit of current liability, the
company only has RM1.97 current assets for its payment compared to the other
companies in the industry that has RM2.05 to settle their current liabilities.
However, the current ratio of the company is not too low for concern.
Current ratio of 2.0 times is acceptable; however, this acceptance depends on the
type of industry. For example, current ratio of 1.0 is satisfactory for industries
such as utilities that have a rather stable business but it is unsatisfactory for
industries like the manufacturing line due to their business volatility.
Quick ratio is obtained when the most liquid current assets (cash, marketable
securities and account receivables) are divided with current liabilities. The higher
the quick asset ratio compared with the current liabilities, the better the liquidity
level of the company to settle its short-term loans quickly.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 57
The calculation of quick ratio for Company ABC (year 2011) is as follows:
The quick ratio of Company ABC is 1.51 times, it is higher compared to the
industry average of 1.43 times. This means that the liquidity level of the company
is better compared to the other companies in the industry. For every ringgit of
current liability, the company has RM1.51 cash and assets that can be easily
converted into cash to pay its short-term debts immediately. This is better
compared to other companies in the industry that only has RM1.43 to pay their
short-term debts immediately.
EXERCISE 2.3
2009 2008
Sales RM640,000 RM560,000
Cost of sold goods 380,000 360,000
Cash 30,000 26,000
Marketable securities 40,000 52,000
Account receivable 70,000 62,000
Inventory 150,000 140,000
Prepayment items 10,000 10,000
Net fixed assets 300,000 260,000
Current liabilities 120,000 140,000
Based on the data above, calculate the following liquidity ratios for the
years 2008 and 2009:
(a) Net working capital
(b) Current ratio
(c) Quick ratio
58 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Ratios that can be used to measure the efficiency in asset management are shown
in Figure 2.5.
Account receivable turnover is the net credit sales revenue (if unavailable,
use the total sales) divided by the account receivables (or average account
receivable).
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 59
Credit sales
Account receivable turnover
Account receivable
RM307,400
(2.4)
RM50,300
6.11 times
Industry average 8.24 times
360
Account receivable turnover
360
(2.5)
6.11
58.92 days
Industry average 44.3 days
If the credit period for Company ABC is 30 days, the average collection period of
58.2 days is unsatisfactory. This means, on average, the customers did not settle
their payments within the period specified. This could also indicate that the
credit management or credit department is inefficient or both. If the collection
60 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
period extends for several years without changes to the credit policy, the
company must take action to expedite the collection of account receivables.
However, if the companys credit period is 60 days and the average collection
period is 58.92 days, this shows a practical collection period.
The average collection period can also be calculated using formula 2.6.
Account receivables
Average collection period
Yearly sales/360
RM50,300
(2.6)
RM307,400/360
58.92 days
Inventory turnover is obtained by dividing the cost of goods sold with inventory.
The calculation of inventory turnover for Company ABC is shown as follows:
If the company holds a high inventory, the funds that could be invested
elsewhere would be held by the inventory. Furthermore, the transportation and
holding cost of the inventory will be high and the company is at risk of goods
becoming damaged or obsolete. However, the company might lose sales if it is
unable to fulfil the customers demands due to low inventory keeping. Therefore,
the manager must be efficient in managing its inventory.
(a) Notice that the cost of goods sold and not sales (as might be done by some
companies) is used as the numeric figure as inventory is recorded at cost.
(b) The usage of sales as the numeric figure is not appropriate as it will
increase the value of inventory turnover.
(c) Remember that for comparison, the company must ensure that the method
of inventory recording must be similar between the company and the
industry.
(d) The inventory turnover can be changed into number of days when it is
divided by 360 days (average number of days a year). This ratio is known
as the average inventory sales period as discussed in the next section.
For Company ABC, the average inventory sales period is 50 days as calculated
below:
360
Inventory turnover
360
(2.8)
7.22
49.86 days
Industry average 55.30 days
62 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
The average inventory sales period for Company ABC of 49.86 days is better
compared to the industrial performance of 55.30 days. This indicates that the
company takes shorter time to sell its inventory compared to the other companies
in the industry.
Inventory
Cost of goods sold/360
RM28,900
(2.9)
RM208,800/360
49.83 days
Industry average 55.30 days
This ratio is obtained when the sales is divided by the net fixed assets. The
calculation of fixed asset turnover for Company ABC is as follows:
Sales
Fixed asset turnover
Net Fixed Assets
RM307,400
(2.10)
RM237,400
1.29 times
Industry average 1.35 times
The fixed asset turnover ratio for Company ABC is lower compared to the other
companies in the industry indicating that the asset management of the company
in generating sales is less efficient compared to the other companies. This might
be because the company has lots of fixed assets or unsatisfactory sales.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 63
Sales
Total assets
RM307,400
(2.11)
RM359,700
0.85 times
Industry average 0.75 times
Some companies may have old assets or new assets. Therefore, it might not be
appropriate to compare the fixed asset ratio. Companies that owned new fixed
assets normally will show lower fixed asset turnover. Therefore, the difference in
the performance of the asset turnover might be due to the costs of the assets and
not the efficiency of the managements operations.
ACTIVITY 2.5
The economic and technology status of the country will influence the
operations of a business. To ensure that the company stays competitive
and is expanding, what effective actions can be taken?
64 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
EXERCISE 2.4
The following data was taken from the financial statements of Fazrul
Company. Based on the data below, calculate the asset management
ratios for the years 2008 and 2009. Assume that there are 365 days in a
year.
2009 2008
Sales RM640,000 RM560,000
Cost of goods sold 380,000 360,000
Cash 30,000 26,000
Marketable securities 40,000 52,000
Account receivables 70,000 62,000
Inventory 150,000 140,000
Prepayment items 10,000 10,000
Net fixed assets 300,000 260,000
Current liabilities 120,000 140,000
Leverage occurs when a company is being funded by debt. Debt include all
current liabilities and long-term liabilities. Debt is also one of the main sources of
funding. It provides tax advantage as interest is a tax deductible item. The costs
of debt transactions are also lower as debts are easier to obtain compared to the
issuance of shares. Usually, the more debt in relation to total assets, the higher
the financial leverage of the company.
(a) Ratios to evaluate the debt level used by the company such as debt ratio,
debt-equity ratio and equity multiplier; and
(b) Ratios to see the ability of the company in fulfilling its claims or obligations
to the creditors such as interest coverage ratio.
Normally, analysts would focus their attention on the long-term loans as the
company is bound by interest payments for a longer period and at the end of that
period, the company must repay the principal amount of the loan. As creditors
claims must be settled first before any earnings can be distributed to the
shareholders, potential shareholders will usually look at the debt level and the
ability of the company to repay the companys debts.
66 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Creditors will also focus on the leverage ratios as the higher the debt level, the
higher the probability of the company being unable to settle the debts of all its
creditors. Therefore, the management of the company must prioritise on the
leverage ratio as it attracts attention from several parties that are concerned with
the debt level of the company.
Total liabilities
Debt ratio 100
Total assets
RM164,300
100
RM359,700
45.7%
Industry average 40.0%
The debt ratio of the company is 45.7% and this is higher than the industry
average of 40%. Potential creditors might be reluctant to provide additional loans
to the company as they worry that the company would not be able to settle the
interest and principal payment, due to its rather high debt ratio.
Long-term liabilities
Debt-equity ratio
Shareholders equity
RM102,300
100 (2.13)
RM195,400
52.4%
Industry average 50%
The debt-equity ratio of the company is higher compared to the industry average.
This shows that the percentage of long-term debt relative to the amount of equity
of the company is higher compared to the industry average. The higher the ratio
indicates that the company relies on long-term creditor-supplied funds than
owner-supplied funds.
From this information, we know that the company is being funded by 60%
equity. Equity multiplier is 100/60 = 1.67 times. Therefore, when the debt ratio of
Company ABC is 45.7%, thus the equity multiplier is 100/54.3 = 1.84 times.
In general,
1
Equity multiplier
1-Debt ratio
Total asset
Total equity (2.14)
RM359,700
RM195,400
Industry average 1.67 times
68 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Interest coverage ratio of 4.49 times is more satisfactory compared to the industry
average performance of 4.3 times. This indicates the interest expenses margin
with current income.
Interest coverage ratio can also be calculated by using the following formula:
EXERCISE 2.5
Adiy Corporation
Balance Sheet Income Statement
Assets: Sales (all credit) RM6,000,000
Cash RM150,000 Cost of goods sold 3,000,000
Account receivable 450,000 Operating expenses 750,000
Inventory 600,000 Interest expenses 750,000
Net fixed assets 1,800,000 Tax 420,000
Net Profit 1,080,000
Liabilities and Equities:
Account payable 150,000
Notes payable 150,000
Long-term liabilities 1,200,000
Equities 1,500,000
Gross profit margin can be obtained by dividing the gross profit with sales. It
shows the balance percentage for each ringgit of sales after the company had
paid all the costs of goods.
Gross Profit
Gross Profit Margin 100
Sales
RM98,600
100 (2.17)
RM307,400
32.1%
Industry average 30%
Gross profit margin of 32.1% is higher compared to the industry average of 30%.
This shows that the purchasing management and cost of the company are better
compared to the industry average. The company generates 32.1 cents gross profit
after deducting all costs of goods for each ringgit of sale.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 71
Net profit margin is calculated by dividing the profit after tax with sales. Hence,
the net profit margin of Company ABC is as follows:
The net profit margin for the company of 7.5% is higher compared to the
industrys performance of 6.4%. This shows that the management of purchasing
and related purchasing costs are better compared to the industry average. The
company had managed to generate 7.5 cents net profit for each ringgit of sale
compared to the industry average that only managed to generate 6.4 cents for
each ringgit of sale.
Operating Profit
Operating Profit Margin 100
Sales
RM41,800
100 (2.19)
RM307,400
13.6%
Industry average 10%
72 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
The operating profit margin of company ABC is better compared to the industry
average. This shows that the company is more efficient in its operations and
control of its operating expenditures to generate higher earnings before interest
and tax.
Return on assets of the company is better compared to the industry average that
only contributes 4.8%. This shows that the company is better in managing its
assets to generate profit compared to the other companies in the industry.
Return on equity of the company is 11.8% and this is more satisfactory compared
to 8% for the industry average. This shows that the management of the company
is more efficient compared to the industry average. The calculation of return on
equity will be discussed further when we discuss the DuPont analysis.
Earnings per share is obtained by dividing the net profit with the number of
shares issued.
The company obtained RM0.29 for each unit of shares issued compared to the
industry average of only RM0.26. The value of this difference is small and in
practice, this value represents the actual amount that will be distributed to the
shareholders.
SELF-CHECK 2.6
Provide the differences between price earnings ratio and dividend yield
ratio.
74 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Market value ratio measures the ability of the company to generate market
values in excess of its investment costs. This aspect is very important as these
market value ratios are directly related to the objective of the company, that is to
maximise shareholders wealth and value of the company. Therefore, it can be
said that the value of market value ratio influences the markets reaction and
investors confidence towards the ability of the companys management in
generating profit efficiently and effectively.
Price earnings ratio can be obtained when the market price per share is divided
by the earnings per share. To calculate the price earnings of Company ABC, we
assumed that the market price for the companys share is RM3.23.
The ratio shows that the degree of confidence of the investors towards
the company is significantly higher compared to the industry average as the
investors are willing to pay 11.1 times more for each companys share compared
to 1.25 for each share in the industry average.
You can see this price earning ratio in share prices section in the newspaper.
However, newspapers provide current price ratio instead of the latest profits.
Investors prioritise more on the price relative to future earnings.
A lot of companies try to maintain paying a stable dividend and, if possible, they
will try to increase the dividends so that investors will receive more returns from
their share holdings. There are companies that pay small dividends and there are
those that do not pay any dividends to their shareholders. This is because they
put in more effort to expand their businesses by retaining and reinvesting the
profit obtained.
EXERCISE 2.6
4. EXERCISE 2.6
Inventory turnover is obtained by dividing _________ by _________.
X-Cell N-Hance
Total assets RM3,000,000 RM1,600,000
Total liabilities 1,800,000 960,000
Total equities 1,200,000 640,000
Net sales 3,700,000 1,880,000
Interest expenses 90,000 38,000
Tax expenses 240,000 100,000
Net profit 380,000 180,000
Earnings per share 5.60 2.10
Market price per share of ordinary shares 35.00 26.50
Dividends per share for ordinary shares 2.40 0.50
X-Cell N-Hance
(a) Return on assets _______________ _______________
(b) Return on equity _______________ _______________
(c) Net profit margin _______________ _______________
(d) Total asset turnover _______________ _______________
(e) Debt ratio _______________ _______________
(f) Equity multiplier _______________ _______________
(g) Interest coverage ratio _______________ _______________
(h) Price earnings ratio _______________ _______________
(i) Dividend yield ratio _______________ _______________
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 77
(a) DuPont Analysis looks at the main sections that contribute to the
companys financial performance.
(b) Summary of financial ratio analysis looks at all the financial aspects of the
company to identify sections that require further investigations or
improvements.
In the DuPont formula, the net profit margin measures the profitability of sales,
while the total asset turnover shows the efficiency of management in using assets
to generate sales.
The value of return on asset is calculated by using the DuPont formula is the
same as the value of return on assets calculated directly parting section 2.10.4.
However, the DuPont formula allows the company to evaluate its return on asset
by separating it into two different components that is the profit on sales and
efficiency in asset management.
The second step in DuPont analysis is to connect the return on asset with return
on equity. This relationship is shown below.
When the values for return on asset and equity multiplier are replaced in the
formula above, the result is 11.8%, the same as calculated directly in topic 2.10.5.
However, the DuPont analysis has the advantage of allowing the manager to
evaluate the return on equity by looking at three separate components, which are:
(a) Profit on sales;
(b) Efficiency of asset management; and
(c) Effect of using debts in funding assets.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 79
If the DuPont analysis is extended, the return to the owner can be evaluated by
looking at each important dimension as shown in Figure 2.9.
From Figure 2.9, we found that the return on equity for Company ABC (11.8%) is
higher compared to the industry average (8%). This higher return on equity is
influenced by the companys higher return on asset compared to the industry
and less influenced by the pattern of funding as illustrated by the equity
multiplier. (Return on asset of the company is 6.41%, while the return on asset
of the industry is only 4.8%. The difference in equity multiplier between the
company and the industry is quite marginal, 1.84 times for the company and
1.67 times for the industry).
The difference in returns between the company and the industry is influenced by
the difference in net profit margin compared to the difference in total assets
turnover. The difference in profit margin between the company and industry is
significant (7.5% for the company and 6.4% for the industry) compared to the
difference in total assets turnover (0.85 times for the company and 0.75 times for
the industry).
80 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Net profit margin of the company is influenced by the higher operating profit
margin compared to the gross profit margin. Therefore, the higher return on
equity for the company is due to the management efficiency in managing its
operations.
The companys financial ratios can be compared with the ratios of other
equivalent companies, or with the industry average at one point of time. These
comparisons provide explanations on the relative financial status and
performance of the company compared to the relative performance of its
competitors. This analysis uses industry average as a benchmark or standard of
comparison.
When the industry average cannot be obtained, comparisons are usually made
with other companies in the same industry. This benchmark is assumed to be the
suitable value for a company in the same industry. The assumption here is for the
companies in the same industry to have an almost identical financial ratio. If the
ratio of a company shows a significant difference with the standard ratio, then
further investigation must to be done to find the cause of that difference.
Table 2.10 summarises the comparison between Company ABCs financial ratios
with the industry average for the year 2011.
Table 2.10: Summary of Ratio Analysis for Company ABC Compared with the
Industry Average for Year 2011
Leverage Ratio
Debt ratio 45.7% 40.0% US
Debt-equity ratio 52.4% 50% S
Interest coverage ratio 4.49 times 4.3 times S
Profitability Ratio
Gross profit margin 32.1% 30% S
Net profit margin 7.5% 6.4% S
Return on assets 6.42% 4.8% S
Return on equity 11.80% 8.0% S
Earnings per share RM0.29 RM0.26 S
*S = Satisfactory US = Unsatisfactory
82 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
(a) Liquidity
The companys achievement in current ratio and quick ratio are much
different compared with the industry. Overall, the companys liquidity is
rather satisfactory.
(c) Leverage
The level of the companys debts is higher than that of the industry average.
However, the ability of the company to pay interests is better compared to
the industry.
(d) Profitability
Profitability, relative to the investors (as seen in the return on asset and
return on equity ratios) of the company is better compared to the industry.
This is the same with the gross profit margin and net profit margin.
(a) The accuracy of the financial ratio depends on the accuracy of the data
found in the financial statements.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 83
(b) In using the financial ratio for industrial comparison purposes, the users
must take into consideration that the industry ratio is only a rough
estimate. This is due to the difficulty to obtain the entire similar firms in the
same industry.
(c) Financial ratio is a relative measurement and does not show the actual size
of the firm.
(d) Financial ratio is used to measure the status of the firm but it cannot show
the issues that had caused the situation.
ACTIVITY 2.6
http://www.ppkm.net/
Description: Persatuan Pasaran Kewangan Malaysia was established
with the objective to provide an organisation for individuals who are
actively engaged in the foreign exchange and financial markets in
Malaysia.
http://www.finpipe.com/equity/finratan.htm
Description: Introduction to Financial Ratio Analysis
http://www.investopedia.com/university/ratios/
Description: Steps and explanations on the calculations of Financial
Ratio Analysis
http://www.credit-to-cash-advisor.com/Document.asp?lid=120
Description: Detailed explanation on DuPont Analysis. It also includes a
convenient web calculator.
84 TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
EXERCISE 2.7
Lily Corporation
Balance Sheet as at 31 December 2010
RM RM
Cash 1,000 Account payable 9,000
Account receivable 8,900 Accrual account 6,675
Inventory 4,350
Total current liabilities 15,675 Total current asset 14,250
Total fixed asset 35,000 Long-term loans 4,125
Accumulated
Depreciation 13,250
Net fixed asset 21,750
Total liabilities 19,800
Ordinary shares 1,000
Retained earnings 15,200
Total equity 16,200
Total asset 36,000 Total liability and equity 36,000
RM
Sales 100,000
Cost of goods sold 87,000
Gross profit 13,000
Operating expenditure 11,000
Operating profit 2,000
Interest expenses 500
Profit before tax 1,500
Tax 420
Net Profit 1,080
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 87
Company Amri
Balance Sheet
RM RM
Assets Liability and Owners Equity
Current asset Current liabilities
Cash 8,005 Account payable 28,800
Marketable securities Notes payable
Account receivable Accruals 18,800
Inventory Total current liabilities
Total current assets 159,565
Long-term liabilities
Total fixed assets Total liabilities
Accumulated depreciation 50,000
Net fixed asset Shareholders equity
Preference shares 2,451
Ordinary shares 30,000
Paid-up capital 6,400
Retained earnings 90,800
Total assets Total equity
Total liabilities and equity
Liquidity ratios such as net working capital, current ratio and quick ratio
enables the measurement of the companys ability to fulfil its short-term
maturity claims.
Asset management ratios measure the companys efficacy in using the assets.
Examples of this ratio include account receivable turnover, average collection
period, inventory turnover, average inventory sales period, fixed asset
turnover and total asset turnover.
TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS 89
Leverage ratio measures the level a company is being funded by debt or the
ability of a company to fulfil its financial claims such as interest claims.
Market value ratio such as price earnings ratio and dividend yield ratio,
measures the ability of a company to create values in the market exceeding its
investment costs. This aspect is very important as these ratios are directly
connected with the companys objective that is to maximise shareholders
wealth and value of the company.
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Apply the concept of compounding and discounting in determining
future value and present value of money;
2. Differentiate between an ordinary annuity and an annuity due;
3. Calculate the present value of a perpetuity; and
4. Calculate the future and present value of money for non-annual
compounding periods.
INTRODUCTION
The public generally assume time as very precious and must be managed
efficiently. They place the value of time on par with various valuable objects and
one of the globally accepted proverb is time is money. From the financial
management perspective, this proverb is a phrase that can be measured and
proven quantitatively by using financial mathematics. In fact, this quantitative
proof has been developed as one of the basic principles in financial decisions
known as the concept of time value of money.
TOPIC 3 TIME VALUE OF MONEY 91
SELF-CHECK 3.1
Rationally, you will certainly choose the offer at the beginning of the year as
the value of money makes this alternative more profitable. The concept of
compounding is one of the main concepts of time value of money. The concept of
compounding, in brief, explains that RM1 today is more valuable than RM1 in
the future. This is because RM1 today can be invested to generate interest and
subsequently multiply to become more than RM1 at the end of the investment
year.
Among the reasons why time value of money makes this alternative more
valuable are:
(a) In general, individuals are more interested in the present usage than
postponing the usage to the future.
Example 3.1
If you had invested RM100 in the savings account in a bank with the interest
rates of 10% per year, how much returns will you receive at the end of the first
year? Roughly, you will obtain RM110. These returns can be calculated as
follows:
If the stated returns are not withdrawn from the savings account, and the banks
interest rates for the second and third year remained unchanged, how much
return will you receive at the end of the second and third year?
TOPIC 3 TIME VALUE OF MONEY 93
F2 = P (1+i)2
= F1 (1+i)
= RM100 (1 + 0.1)2
= 121
F3 = RM121 + RM12.10
= RM133.10 that is
= F2 +F2 (i)
= F2 (1+i)
= P2 (1+i)2 (1+i)
= P (1+i)3
When the savings period is extended to tn, the total amount in period (n) is:
Fn = P (1+i)n (3.1)
The complete time line for savings of RM100 at an interest rate of 10% per year is
as follows:
EXERCISE 3.1
1. Salmah deposits RM100 in the savings account at Affin Bank with
an interest rate of 5% per year for 5 years. How much would Salmah
have in the savings account at the end of the 5-year period?
2. Assume that Ah Seng deposits RM5,000 in the savings account at
CIMB at the interest rate of 10% per year for 2 years. How much
would Ah Seng have in the savings account at the end of the second
year?
94 TOPIC 3 TIME VALUE OF MONEY
Equation 3.2 shows that the future value (FVn) is equivalent to the principal at
the point of time equal to 0 or the original principal amount (PV0) multiply with
the future value factor stated in the schedule of Future Value Interest Factor
(FVIFi,n). This schedule is enclosed in Attachment A.
As a basic guide on the usage of the financial schedule, please refer to the extract
on the schedule of Future Value Interest Factor (FVIFi,n) in Table 3.1 to solve
examples 3.2 and 3.3.
Example 3.2
You deposited RM2,000 in the savings account in a bank at a yearly interest rate
of 5% for the period of one year. Upon the completion of one year, how much
will you receive?
Example 3.3
Assume you deposited RM2,000 in the savings account in your bank at a yearly
interest rate of 5% for the period of four years. Upon the completion of four
years, how much will you receive?
Table 3.1: Extract from the Future Value Interest Factor (FVIF i, n) Schedule
EXERCISE 3.2
To show how the interest rate influences the future value of an investment, we
must assume that the principal and the time period are constant. Therefore, any
changes to the future value are caused only by the interest rates. For example,
you intend to deposit RM100 at Bank A, B and C that offer different interest rates
of 8%, 10% and 12%. Compounded annually how much will the future value of
your deposit be in 3 years from now?
FVn=PV0(FVIFi,n)
The future value of deposit in Bank A that offers an interest rate of 8% is:
FV0.083 = RM100(FVIF8%,3)
= RM100(1.26)
= RM126.00
The future value of deposit in Bank B that offers an interest rate of 10% is:
FV0.13 = RM100(FVIF10%,3)
= RM100(1.331)
= RM133.10
Meanwhile, the future value of deposit in Bank C that offers an interest rate of
12% is:
FV0.123 = RM100(FVIF12%,3)
= RM100(1.405)
= RM140.50
TOPIC 3 TIME VALUE OF MONEY 97
The examples above can also be applied on either the principal value or the time
period by assuming that the other variables are constant. You will discover that
the future value has a positive correlation with the time period (n) and the
interest rate (i) as shown in Figure 3.2.
Figure 3.2: Relationship among interest rate, time period and future value for RM100
ACTIVITY 3.1
SELF-CHECK 3.2
The second concept that is related with the time value of money is the concept of
cash flow discounting. This concept is used to ascertain the present value (PV0)
or principal value for a sum of money in the future (FV0) that is discounted at an
interest rate known as rate of return (i) for the valuation period (t).
The process to determine the present value is the reverse process of determining
the future value. The relationship between these two processes is illustrated in
the time line as shown in Figure 3.3.
Example 3.4
Assume you expect to receive RM2,500 a year from now. How much is the
present value for RM2,500 if the discount rate or rate of return is 8% per year?
RM2,314.81 RM2,500
How much must you invest if you expect to receive of RM2,500 in the period (a)
2 years and (b) 3 years at a discount rate of 8% per year?
If the discounting period is extended to tn, the principal amount that must be
invested is
FVn
PV0 = (3.3)
(1+i)n
100 TOPIC 3 TIME VALUE OF MONEY
Or
EXERCISE 3.3
1. You want RM1,100 in your account a year from now. How much
investment must you make now if the interest rate offered by the
bank is 10%?
2. Seri Sdn Bhd offers a low risk security that promises a payment of
RM3,000 at the end of 2 years period with an offer of 15% interest
rate per year. What is the present value for RM3,000?
As a basic guide on the use of the financial schedule, please refer to the extract on
the schedule of Present Value Interest Factor (PVIFi,n) in Table 3.2 to solve
examples 3.5 and 3.6.
Example 3.5
Assume you expect to receive RM3,999 in 3 years time. How much is the present
value for RM3,999 if the discount rate or rate of return is 9% per year?
Example 3.6
You intend to accumulate RM5,713 in a bank savings account in 4 years. How
much savings must you deposit now if the interest rate offered by the bank is
10% per year?
EXERCISE 3.4
Use the schedule of present value interest factor to help you solve the
questions below:
1. Assume that you are given the opportunity to purchase a low risk
security that promised a payment of RM127.63 at the end of 5 years
with an interest rate of 5% per year. How much is the present value
for RM127.63?
2. You plan to accumulate RM6,213 in a bank savings account 5 years
from now. How much savings must you deposit now if the interest
rate offered by the bank is 12% per year?
102 TOPIC 3 TIME VALUE OF MONEY
Example 3.7
You intend to obtain a return of RM1,000 within 3 years in banks A, B and C that
offer different compounding interest rates of 8%, 10% and 12%. What is the
principal value that you should make?
The principal value for Bank A that offers an interest rate of 8% is:
The principal value for Bank B that offers an interest rate of 10% is:
The principal value for Bank C that offers an interest rate of 12% is:
The examples above can also be applied either in the future value or time period
by assuming that the other variables are constant. You will find that the present
value has a negative relationship both with the time period (n) and interest rates
(i) as shown in Figure 3.4. This graph explains that the principal value of
RM1,000 that will be received in the future will decrease when the acceptance
period is extended. The rate of decrease for present value is higher with the
increase in discount rates or interest rates.
TOPIC 3 TIME VALUE OF MONEY 103
Figure 3.4: Relationship between interest rate, time period and future value for RM100
The examples stated clearly show that the future value of an amount of single
cash flow invested presently will increase from time to time with the existence of
specific interest rates. In reverse, a sum value of single cash flow that has been
determined in the future will decrease when time approaches zero (see Figure 3.5).
Figure 3.5: Single Cash Flow: Future value and present value
104 TOPIC 3 TIME VALUE OF MONEY
A series of cash flow means that there are a series of receiving or payments of
cash that occur throughout the valuation period. There are several categories of
series cash flow which are annuity, derivation cash flow and perpetuity.
3.4.1 Annuity
Annuity is a series of payment or receiving of the same amount at the same
intervals throughout the period of valuation. Therefore, a cash flow of RM5 each
month for one year is an annuity. While a cash flow of RM5 that is swap
alternately with a cash flow of RM10 each month for a year is not an annuity.
Annuity has a clearly stated starting point and an ending, in other words,
annuity cash flow would not be indefinite. Normally, annuity occurs at the end
of each period and this annuity is known as ordinary annuity. However, in some
cases, annuity occurs at the beginning of the period and this type of annuity is
called annuity due.
The finance manager often makes future planning for the company but he
usually does not know how much investment or savings that must be saved
continuously to accumulate the sum of money required in the future. The
future value of annuity is the number of annuity payments at a specific
amount (n) that will increase at a specific period based on a specific interest
rate (i).
Example 3.8
You had deposited RM100 at the end of each year for 3 years continuously
in the account that pays a yearly interest of 10%. How much is the future
value of this annuity?
First step: Calculate the future value for t1, t2 and t3.
Second step: Total the three future values to get the future value annuity
(FVA).
First step:
F1 = RM100(1+0.1)1
= RM100 (1.1)
= RM110
F2 = RM100(1+0.1)2
= RM100 (1.21)
= RM121
F3 = RM100 (no increase in the future value as the deposit was made at
the end of the third year).
106 TOPIC 3 TIME VALUE OF MONEY
Second step:
FVA3 = F1 + F2 + F3
= RM110 + RM121 + RM100
= RM331
The steps shown in the example above takes time to do even though it is a
simple example. In cases where the calculation for future value of annuities
are for a period of 20 or 30 years, it will be slow with complicated
calculations. Therefore, we can simplify the calculations by using the
following formula:
(1+i)n 1
FVA n =A (3.5)
i
Equation 3.5 is used to solve the future value problems that involve
ordinary annuity is by manual calculation. While equation 3.6 is the
solution formula for ordinary annuity using schedule. Annuity future value
schedule can be obtained in Attachment C.
Example 3.9
Danon Company deposited RM5,000 at the end of each year for a period of
3 years consecutively in an account that pays a yearly interest of 10%. What
is the future value of this annuity?
A [ (1 + i)n 1]
FVA n
i
RM5, 000 [(1 + 0.10)3 1]
0.10
RM16, 550
TOPIC 3 TIME VALUE OF MONEY 107
FVA n = A (FVIFA i, n )
= RM5, 000
= RM5, 000 (3.310)
= RM16, 550
The time line for future value of ordinary annuity of RM5,000 for 3 years at
a rate of 10% per year is as follows:
The equation of annuity due can be formulated with a little alteration to the
ordinary annuity equation that is by multiplying the equation of ordinary
annuity with (1 + i). This alteration is made because the cash flow for
annuity due occurs at the beginning of a period.
(1 + i) n 1
FVA n A (1 + i) (3.7)
i
Example 3.10
Danon Company deposited RM5,000 at the beginning of each period for 3
years consecutively in the account that pays yearly interest of 10%. How
much is the future value for that annuity?
(1 + i)n 1
FVA n A (1 + i)
i
[1 + 0.10)3 1] (1 + 0.10)
RM5, 000
0.10
RM18, 205
FVA n A (FVIFAi, n ) (1 + i)
RM5,000 (3.310) (1.10)
RM18,205
TOPIC 3 TIME VALUE OF MONEY 109
The time line for future value annuity due of RM5,000 for 3 years at an
interest rate of 10% per year is as follows:
t1
t0 t2 t3
RM18,205
From the solution above, we found that the future value for annuity due
(RM18,205 in example 3.10) is higher compared to the future value for
ordinary annuity (RM16,550 in example 3.9). This is because for annuity
due, the deposit is deposited in the beginning of the period and therefore
generates more interest compared to the ordinary annuity where the
deposit is deposited at the end of the period.
EXERCISE 3.5
Solve the questions below by using the manual formula or schedule
(FVIFAi,n).
1. Assume that you deposit RM100 into the bank at the beginning of
the year for 3 years in the savings account that gives 5% interest
rate. How much can be obtained at the end of the third year?
2. Mr Yeoh deposits RM10,000 into the bank on 31 December each year
for 5 years at an interest rate of 10%. How much can he obtain at the
end of the fifth year?
The present value of ordinary annuity (PVAn) can be obtained by using the
manual equation (equation 3.9) or by using the financial schedule in
Attachment D (equation 3.10). Both the equations below refer to the present
value annuity (PVA n) equivalent to the annuity cash flow multiply by the
present value annuity factor.
[ 1 [1/(1 + i)n ]
PVA n = A (3.9)
i
Example 3.11
Taming Company expects to receive RM3,000 at the end of each year for
3 consecutive years. How much is the present value of this annuity if it is
discounted at the rate of 6% per year?
[1[1 / (1+i)n ]
PVA n =A
i
[1 [1 / (1+i)3 ]
=RM3,000
0.06
=RM8,019.04
PVAn = A (PVIFAi, n)
= RM3,000 (PVIFA6%,3)
= RM3,000 (2.673)
= RM8,019
TOPIC 3 TIME VALUE OF MONEY 111
The time line for present value ordinary annuity of RM3,000 for 3 years at a
discounted rate of 6% per year is as follows:
t0 i = 6% t1 t2 t3
RM8,019.04
@
RM8,019.00
1 [1/(1 + i)n
PVA n = A (1 + i) (3.11)
i
Example 3.12 can help you to differentiate between ordinary annuity with
the annuity due for present value.
Example 3.12
Taming Company expects to receive RM3,000 at the beginning of each year
for 3 consecutive years. How much is the present value of this annuity if it
is discounted at the rate of 6% per year?
[ 1 [1/(1 + 0.063)3 ]
RM3,000 (1 + 0.06)
0.06
RM8,500.18
112 TOPIC 3 TIME VALUE OF MONEY
The time line for present value annuity due of RM3,000 for 3 years at a
discounted rate of 6% per year is as follows:
t0 i = 6% t1 t2 t3
RM8,500.18
@
RM8,500.14
As per the difference between ordinary annuity and annuity due for
future value, the solution for present value of annuity due (RM8,500 in
example 3.12) is also higher compared to the present value of ordinary
annuity (RM8,019 in example 3.11). This is because in annuity due, the
deposit is deposited in the beginning of the period and therefore generates
interest longer compared to ordinary annuity.
EXERCISE 3.6
You are offered an annuity payment of RM100 at the end of each year
for 3 years and is deposited into the bank. The interest rate offered is 5%
per year. How much is the present value of that annuity payment?
Exponent is used in this formula because the last cash flow happens at the
end of the last period. Therefore, interest is not obtained for it. The sigma
symbol ( ) is the mathematical symbol for a total of a series of value.
n
FVn Pt (1 + i)nt
(3.12)
t 1
If solution by using the schedule is chosen, you can use the formula in 3.2,
3.6 or 3.8 according to the suitability of the cash flow. This is because the
calculation of future value of irregular cash flow is a combination concept
of determining the value of money for single cash flow and also annuity.
Example 3.13
Bikin Fulus Company made a decision to deposit RM2,000 at the end of the
first and second year, withdrawing RM3,000 at the end of the third year
and depositing RM4,000 again at the end of the fourth year. How much is
the future value of these cash flows at the end of the fourth year if the
annual interest rate is 10% per year?
Step 1:
Find the future value of annuity for RM2,000 for 2 years (end of second
year).
Step 2:
Find the future value of RM4,200 at the end of fourth year.
Step 3:
Find the future value at the end of fourth year for the withdrawal of
RM3,000 that occurred at the end of third year.
Step 4:
The present value cash flow is obtained by adding the result of Steps 2
and 3 with the final cash flow of RM4,000. As RM4,000 occurs at the
last period, there is no interest earnings from it.
Manual equation:
n
PV0 Pt [1/(1 + i)t ] (3.13)
t 1
If solution by using the schedule is chosen, you can use the formula in
present value of single cash flow, present value of ordinary annuity or
present value of annuity in advance according to the suitability of the type
of cash flow stated in the problem.
Example 3.14
Buat Pitih Company expects to receive RM1,000 at the end of the first and
second year, RM2,000 at the end of the third year and RM4,000 at the end of
the fourth year. How much is the present value of the cash flow if the
yearly interest rate is 10% per year?
n
PV0 Pt (1 + i)t
t 1
[RM1,000][1/(1.10)1 ] [RM1,000][1/(1.10)2 ]
[RM2,000][1/(1.10)3 ] [RM4,000][1/(1.10)4 ]
RM5,970.22
116 TOPIC 3 TIME VALUE OF MONEY
The time line for example 3.14; present value for derivation cash flow is as
follows:
t0 i = 10% t1 t2 t3 t4
RM909.99
RM826.45
RM1,502.632 RM5,970.22
RM2,732.05
Step 1:
Find the present value for annuity of RM1,000 for 2 years.
Step 2:
Find the present value for RM2,000 that occurs at the end of third year.
Step 3:
Find the present value for RM4,000 that occurs at the end of fourth year.
Step 4:
The present value cash flow is obtained by adding all the previous results
earlier (figure bolded).
3.4.3 Perpetuity
Perpetuity is a series of cash flow that involves the same amount for each period
continuously. In other words, perpetuity is an annuity that has an infinity period.
An example of perpetuity is the payment of dividends for preference shares.
The concept for future value of perpetuity is illogical and cannot be used in
making financial decisions as the concept do not predict the period ending point
while future value is something that can be expected. Instead, the concept for
present value of perpetuity can be applied in making financial decisions. For
example, the use of this concept to determine the present value for preference
shares and present value for pensions.
[ 1 [1/(1 + i)n ]
PVA n = A (3.14)
i
Try to imagine what will happen if the value of n increases. The value of (1 + i)n
will also increase. This will cause 1/(1 + i)n to become smaller. When (n)
approaches infinity, the value of (1 + i)n will become extremely big, while the
value of 1/(1 + i)n will approach zero.
PV p = P/i (3.15)
t0 i% t1 t2 t60 t=
PVp P P P
Example 3.15
Sukehati Company issued securities that promised a payment of RM100 per year
at the yearly interest rate of 8% to the holders of that security. How much is the
present value for this cash flow?
PVp = P/i
= RM100/0.08
= RM1,250
The financial schedule does not provide the factor for present value of perpetuity
because perpetuity involves an infinity period. Therefore, the solution for
perpetuity cases can only depend on manual calculations.
EXERCISE 3.7
Consider the perpetuity that pays RM100 per year, with an interest rate
of 10%. How much is the present value of this perpetuity?
FV = PV (1 + i/m)nm (3.16)
FV = Future value
PV = Present value
i = Interest rate
m = Frequency of compounding or discounting in a year
n = Number of years
Example 3.16
The future value of RM1 now after 6 years, using the interest rate of 10% per year
with different compounding frequencies.
Example 3.17
The present value of RM1 received in 6 years from now, discounted at the
interest rate of 10% per year with different discounting frequencies.
The conclusion that can be made based on examples 3.16 and 3.17 are:
(a) The higher the frequency of compounding, the higher the future value of
cash flow; and
(b) Higher the frequency of discounting, the lower the present value of cash
flow.
The new formula for future value and present value that is compounded and
discounted continuously is as follows.
The estimate number for the symbol e in equation 3.18 and 3.19 is 2.72 (or more
accurately, 2.71828183).
TOPIC 3 TIME VALUE OF MONEY 121
Example 3.18
What is the future value for RM100 that is invested now for 6 years with an
interest rate of 8% per year and compounded continuously?
Manual solution:
Example 3.19
What is the present value of RM161.61 that will be received in 6 years from now
that is discounted continuously at an interest rate of 8% per year?
PVn = FVn (ein)
= 161.61 (2.72 (0.08)(6)
= RM100
EXERCISE 3.8
1. What is the future value for RM260 that is invested now for 3 years
at the interest rate of 10 % per year and compounded continuously?
2. What is the present value for RM200 that will be received 5 years
from now and discounted continuously at the interest rate of 6% per
year?
6. You have just won a puzzle contest where you were offered
two choice of prizes that is whether to accept RM60,000 today or
RM12,000 at the end of each year for 5 consecutive years. If the cash
flow is discounted at a yearly rate of 12% and compounded twice a
year, which prize would you choose?
7. Mrs Aimi plans to get a loan for a total of RM6,000 at the interest
rate of 10% from a kind-hearted money lender. The money lender
agrees to receive a sum of payment for the same amount at the end
of each year for 4 years. What is the size of payment that Mrs Aimi
must give to the money lender each year?
8. What is the present value for RM400 that will be received in 7 years
from now and discounted continuously at the interest rate of 10%
per year?
TOPIC 3 TIME VALUE OF MONEY 123
This topic explains the key conceptual and computational aspects of the time
value of money. It is important to understand the role of time value of money
when assessing the value of the expected cash flow streams associated with
investment alternatives either based on compounding to find future value or
discounting to find present value.
What you have learned in this topic will enhance your understanding in
various areas of financial management including the valuation of bonds and
shares as well as determining the value of a new project.
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Define the term value as used in different context;
2. Describe the characteristics and types of bonds;
3. Calculate the value of a bond and yield to maturity of a bond;
4. Assess the relationships that exist in bond valuation; and
5. Calculate the value of ordinary shares based on zero growth,
constant growth rate and differential divided growth.
INTRODUCTION
Valuation is a very important concept in finance. The process of valuation takes
into consideration specific factors that can influence the value. This topic
discusses the general concept of valuation and the process of bonds valuation.
The topic of discussion will touch on the characteristics of bonds, rating of bonds,
types of bonds, evaluation of bonds, rate of yield upon maturity and the
correlation between value and rate of yield upon maturity.
In Topic 4, you will be exposed to the basic concept of valuation. In this topic, we
will discuss the intrinsic value or economic value that has been identified as
present value of cash flow that is expected to be generated in the future by an
investment or asset.
TOPIC 4 VALUATION OF SECURITIES 125
4.1 VALUATION
SELF-CHECK 4.1
(b) Timing
To estimate cash flow, you must know the timing for each cash flow. For
example, you will make an investment after you expect that you will obtain
RM2,000 in year 1, RM4,000 in year 2 and RM5,000 in year 3.
Figure 4.1 shows the basic factors to determine the value of assets.
In the earlier topic you have learnt, that the present value is obtained from the
following formula:
F
Pn 1 n
(1 i)n
by replacing:
(a) Pn1 to Vn1;
(b) Fn to CFt; and
(c) i to k;
CFt
Vt 1
(1 k)t
If the valuation period is more than a year (t > 1), the formula above can be
expanded as follows:
Where:
CFt = Cash flow expected to be received at time t.
V0 = Intrinsic value/present value of asset that will generate cash flow from
period 1 to n.
k = Required rate of return (rate of discount)
n = Period cash flow is expected to be received.
Formula 4.1a measures the present value for future cash flow and it is the basis
for the valuation process. It is very important as all the formulas in this unit are
based on this equation.
ACTIVITY 4.1
If you intend to buy land in Putrajaya, what is the value that you will
use? Why do you use that value?
EXERCISE 4.1
4.2 BONDS
Bonds are long-term guarantee notes issued by borrowers. The bondholders will
receive interest at a fixed rate for a determined period. On the maturity date, the
bondholder will receive the interest and principal amount. The payment of fixed
interest on each period is the basic concept of annuity that we had discussed in
the earlier topic.
Figure 4.2 shows the concept of bonds in graphics. Based on the example in
Figure 4.2, these bonds have a maturity period of 5 years. It pays interest of
RM100 each year and has a face value of RM1,000.
130 TOPIC 4 VALUATION OF SECURITIES
(d) Indenture
Indenture is a legal contract between the trustees who represents the
bondholders with the company that issued the bond. Indenture specifies
the terms and conditions related to the issuance of the bonds.
TOPIC 4 VALUATION OF SECURITIES 131
In Malaysia, there are two rating agencies, which are the Rating Agency Malaysia
Berhad (RAM) and the Malaysian Rating Corporation Berhad (MARC). Both
these agencies play important roles in the ratings of all bonds and commercial
notes issued, especially in the private debt security market.
The valuations by RAM are stated in alphabet symbols. For long-term loans that
is more than a year, the valuation of AAA indicates a high level of credit trust
while loans level between AA and BBB is generally regarded as a prudent
investment grade. Long-term loans rated as BB or lower are classified as
speculative grade.
The valuations by MARC are stated in symbols and symbols with numerical. For
long-term loans, its valuation is within the range of AAA D. For short-term
loans, its valuation is within the range of MARC-1 MARC-4.
Ratings are done via the financial ratio analysis and cash flow analysis by looking
at the capability of the company to fulfil its specific obligations in bonds. Besides
that, other factors will also provide positive effects on the ratings of bonds. For
example, the level of funding with equity, operations that are profitable, low
level of variables in previous returns and the size of the company.
Valuation given on a bond will influence the returns required by the investors.
The lower the ratings of the bond, the higher the rate of return that is required for
the bond and vice versa. Therefore, the finance manager must be aware of the
ratings given as it will have an effect on the rate of return that must be paid to the
investors.
ACTIVITY 4.2
Visit the websites of RAM at http://www.ram.com.my and MARC at
http://www.marc.com.my and see how the financial securities are
rated by both these agencies.
132 TOPIC 4 VALUATION OF SECURITIES
(b) Debentures
Debentures refer to the long-term loans that are not secured with assets but
depend on the ability of the company that issued the bonds to obtain earnings.
This type of bond has a higher risk to the investors compared to secured
bonds. Therefore, the rate of return that is required by the investors is also
higher. This type of bond provides an advantage to the issuing company as no
property is charged. This enables the company that issued the bonds to
maintain its opportunity to borrow additional loans in the future.
ACTIVITY 4.3
SELF-CHECK 4.2
List the types of bonds and its characteristics.
(a) Amount and Timing of Cash Flow that Will be Received by Investors
This refers to the payment of annual interest and face value or principal
amount.
SELF-CHECK 4.3
What are the three important elements that influence the valuation
process of bonds? Explain.
We also know that bond has a maturity date and it also pays interest at a rate that
is constant for a fixed period. Therefore, the formula for valuation of bonds is
obtained by modifying the formula above to be as follows:
i i i i M
Vb 1
2
3
... n
(4.2)
(1 k b ) (1 k b ) (1 k b ) (1 k b ) (1 k b )n
Or
n
I M
Vb (4.2a)
t=1 (1 k b ) t
(1 k b )n
As bond pays interest at a fixed rate for a fixed period, we can also use the
schedule for present value interest factor of annuity (PVIFA) to calculate the
value of bonds. The formula for valuation of bonds using the PVIFA schedule is
obtained by modifying the basic formula of present value annuity. The following
is the formula for valuation of bonds using the PVIFA schedule.
Where:
Vb = Intrinsic value or present price of bond
I = Coupon payment
n = Period of bond till maturity
kb = Rate of return required for the bond
M = Par value or face value of bond
PVIF = Interest factor of present value
PVIFA = Interest factor of present value annuity
Example 4.1
Bond A has 10 years maturity period. The coupon rate is 10% per year and the
interest is paid every year. The par value of bond is RM1,000. The returns
required for the bond is 8% per year. What is the value of this bond?
Step 2: Determine the rate of return required to evaluate the cash flow risk of
the bond in the future. Assume that the rate of return required is 10%.
136 TOPIC 4 VALUATION OF SECURITIES
Step 3: Calculate the intrinsic value of the bond that is the present value of
interest that is expected to be received in the future and the payment
of the principal on date of maturity, discounted at the rate of return
required by the investors.
Or
(Note: The difference between the answers that are calculated using
the formula and schedule PVIFA is small and is caused by the decimal
point. Both the answers are acceptable.)
Figure 4.4: Calculating the value of bond using the time line
(a) Changes in the economic situation that causes the cost of long-term funds
to change as well; or
The increase in the long-term funds cost or risk will increase the required rate of
return. Instead, the decrease in long-term funds cost or risk will reduce the
required rate of return.
There are three different situations that can be used to show the relationship
between the required rate of return and the value of the bond.
(a) Required Rate of Return is Larger than the Coupon Interest Rate (kb> i)
Example 4.2
Bond A has a maturity period of 10 years with the coupon interest rate of
10% per year and interest payable every year. The face value is RM1,000.
The required return for this bond is 12% per year.
138 TOPIC 4 VALUATION OF SECURITIES
In this situation, the value of the bond (Vb) is smaller than par value,
M (Vb < M). If this bond is traded, its transaction will be at a price lower
than par value. Therefore, it can be called a transaction at a discounted
price.
(b) Required Rate of Return is Lower than the Coupon Interest Rate (kb< i)
Example 4.3
Bond A has a maturity period of 10 years with the coupon interest rate of
10% per year and interest payable every year. The face value is RM1,000.
The required return for this bond is 8% per year.
In this situation, the value of bond (Vb) is larger than par value (Vb > M). If
this bond is traded, its transaction will be at a price higher than par value.
Therefore, it can be called a transaction at a premium price.
TOPIC 4 VALUATION OF SECURITIES 139
(c) Required Rate of Return is Same Value with Coupon Interest Rate (kb = i)
Example 4.4
Bond A has a maturity period of 10 years with the coupon interest rate of
10% per year and interest payable every year. The face value is RM1,000.
The required return for this bond is 10% per year.
In this situation, the value of bond (Vb) is the same with the par value (Vb=M). If
this bond is sold or purchased, its transaction is at the same price with the par
value. Therefore, it can be called a transaction at par value.
Table 4.1 shows the conclusion on the relationship between the values of bond
with the required rates of return. The value of bond has a inverse relationship
with the required rate of return that is, if the investors require higher returns, the
value of the bond will decline.
The current interest rate is used as the basis to the rate of return required by the
investors. Therefore, it has a inverse relationship with value or price of bond.
140 TOPIC 4 VALUATION OF SECURITIES
The formula for interest compounded more than once a year is as follows:
FV
PV=
(1+i/m)nm
In the formula:
PV = Present value
FV = Future value
i = Interest rate
m = Frequency of compounding or discounting
n = Period
(a) Change the annual interest (I) to interest twice a year by dividing (I) with 2;
(c) Change annual required rate of return, kb, to each half yearly by dividing
kb into 2 (kb/2).
Therefore, the valuation formula for bonds with coupon payments of twice a
year is:
2n
I/2 M
Vb (4.3)
t 1 (1 k b /2)
t
(1 k b /2)2n
or
Where:
I = Coupon rate Par value
n = Period
kb = Required rate of return
Example 4.5
Maya Enterprise Company had issued bonds that have a maturity period of 8
years with a coupon rate of 8% that is payable every 6 months. The par value of
the bond is RM1,000. If the required rate of return is 10%, what is the value of the
bond?
I
Vb (PVIFA kb/2,2N ) M(PVIFkb/2,2N )
2
RM80
(PVIFA10%/2,82 ) RM1,000(PVIF10%/2,82 )
2
RM40(PVIFA 5%,16 ) M(PVIF5%,16 )
RM40 (10.8378) RM1,000 (0.4581)
RM891.61
ACTIVITY 4.4
Do not invest your money until you have fully understood all the
information related to investment. Give your opinion on this
statement.
142 TOPIC 4 VALUATION OF SECURITIES
EXERCISE 4.2
3. How do coupon payments of more than once a year affect the value
of the bond?
Yield to maturity or YTM is the rate or return that will be obtained by the
investors if the bond is hold until maturity. This expected rate of return is also
known as yield to maturity if the investors hold the bonds until its maturity
period. Therefore, when we refer to bonds, the terms expected rate of return and
yield to maturity are used interchangeably.
Yield to maturity is the discount rate that equals the present value for all interest
payments and principal payment of bond with the present value of bond. It can
be calculated using the basic formula for valuation of bonds (formula 4.3b).
This discount rate can also be calculated using the PVIF schedule by a method of
trial and error. Through this trial and error method, different discount rates, k,
will be applied in the formula for valuation of bonds until the present value of
the bond cash flow is similar to market value. If this rate is located between the
rates found in the schedule, the interpolation method will be used to obtain the
exact value. To explain this concept in detail, let us look at Example 4.6.
Example 4.6
Orlid Bhd issued bonds that have a par value of RM1,000 with a coupon rate of
10% per year and a maturity period of 10 years. The present price of the bond is
RM1,080. As the price of the bond is higher than the par value (P0 > M), then the
rate of yield to maturity is smaller than the coupon interest rate (k < I). This
shows that the rate that must be found must be lower than 10%. To begin the
process of looking for the discount rate, the rate of 9% will be used.
When we use the discount rate of 9%, the value of bond obtained, that is
RM1,064.17, is lower than the market value, that is RM1,080. To increase the
value we are searching for, the rate of discount must be decreased to 8%.
When we use 8% as the discount rate, the value of bond obtained is more than its
market value. This shows that the rate of yield to maturity is between 8% and 9%
as illustrated in Table 4.2.
Table 4.2: Searching for the Value of Bond by Using the Trial-and-Error Method
Rate Value
8% RM1,134.21
YTM RM1,080.00
9% RM1,064.17
144 TOPIC 4 VALUATION OF SECURITIES
Next, use the interpolation method to obtain the rate of yield to maturity more
accurately.
Step 1: Calculate the difference between the value of bond at the rate of 8%
and 9%.
Step 2: Calculate the difference between the value required that is the rate of
yield to maturity with the value of the bond at a discount rate that is
lower, that is 8% (disregard the symbol of minus or plus).
Step 3: Divide the value obtained in Step 2 with the result obtained in Step 1.
Step 4: Add to the value calculated with the rate of discount that is lower and
multiply it with the gap in discount rate to obtain the rate of yield to
maturity.
54.21
YTM 8% (9% 8%)
70.04
8% (0.774 1%)
8.774%
TOPIC 4 VALUATION OF SECURITIES 145
Besides the interpolation method, you can also use the estimation method to
calculate the rate of yield to maturity by using the following formula:
M P0
i
YTM n (4.4)
M P0
2
Where:
i = Coupon rate
M = Par value
P0 = Market value of bond
n = Number of years for bond until maturity
Furthermore, by using equation 4.4, you can obtain the rate of yield to maturity
as follows:
1,000 1,080
100
YTM 10
1,000 1,080
2
0.0885
8.85%
Through this estimation method, we find that the rate of yield to maturity is
8.85%. This answer is not as accurate as when we use the trial-and-error method
and interpolation method that is 8.774%.
EXERCISE 4.3
Bond A has a par value of RM1,000 and pays interest of RM82 per year.
The maturity period for Bond A is 5 years and the present market price
is RM720. How much is the yield to maturity for Bond A? Use the trial-
and-error method as well as the estimation method to obtain the yield
to maturity.
146 TOPIC 4 VALUATION OF SECURITIES
Figure 4.5 shows the movement of the bond value based on the calculation from
Table 4.1. The required rates of return of 12%, 10% and 8% are assumed constant
throughout the 10 years for bond maturity and the par value is assumed the
same that is RM1,000.
(a) When the required rate of return is the same as the coupon rate of the bond,
that is 10%, the value of bond and is remain constant or maturity period,
that is RM1,000.
(b) When the required rate of return is 12%, value of the bond increases from
RM887 to RM1,000 when time passes and approaches the maturity period.
(c) Finally, when the required rate of return is 8%, the premium value of the
bond decreases from RM1,134.21 to RM1,000 on maturity period.
This shows that when the required rate of return is assumed constant until
maturity, the value of the bond will reach par value of RM1,000 on maturity date.
Therefore, the bondholders are always aware of the increase in interest rate. The
shorter the maturity period of the bond, the lower the response of market value
on the changes to the required rate of return. In summary, a shorter maturity
period will have lower interest rate risk compared to long-term bonds with the
assumption that the coupon rate, par value and frequency of interest payment
are the same.
Table 4.3 shows the value of the bond with different required rate of return and
different maturity period (summary of examples 4.2 and 4.3).
(a) When the required rate of return decreased from 10% to 8%, the value of
bond with a maturity period of 10 years will increase by RM134.21,
meanwhile the value of bond with a period of maturity of 5 years will only
increase by RM79.87.
(b) When the required rate of return increased from 10% to 12%, the value of
the bond with a period of maturity of 10 years will decrease by RM113.
Meanwhile, the value of the bond for 5 years will decrease by RM72.18.
Table 4.3: Effect of Bonds Maturity Period on Different Required Rate of Return
Based on the table and explanation above, it is clear that the changes to interest
rate has a bigger effect on the bonds with a longer maturity period compared to
bonds that have shorter maturity period.
148 TOPIC 4 VALUATION OF SECURITIES
EXERCISE 4.4
3. Bonds were sold at _________ when the interest rate (coupon) is more
than the required rate of return; sold at _________ when the interest
rate is lower than the required rate of return; and were sold at
_________ when the interest rate is the same with the required rate of
return.
A. premium; discount; same with par value
B. premium; same with par value; discount
C. discount; premium; same with par value
D. same with par value; premium; discount
TOPIC 4 VALUATION OF SECURITIES 149
6. How much is the value of a bond with a par value of RM1,000, pays
interest of RM80 per year and matures in a period of 11 years? Assume
that the required rate of return is 12%.
7. Indah Air Berhad issued bonds that will mature in a period of 10 years.
These bonds pay interest twice a year at a rate of 8% and the par value of
the bond is RM1,000. If the yearly required rate of return each year by
investors is 6%, what is the present market value of the said bond?
150 TOPIC 4 VALUATION OF SECURITIES
10. Company X has issued bonds with a par value of RM1,000 and a
maturity period of 3 years. The yearly coupon rate offered is 10%.
Rating Agency Malaysia Berhad (RAM) has given a rating of AAA to
the bonds of Company X.
(a) If the required rate of return is 13%, what is the market value of
this bond?
(b) If the bonds were sold at the price of RM975.98, what is its yield
to maturity (YTM)?
12. As a risk averse investor, would you choose, the long-term bonds or
short-term bonds to protect the effect of interest rate on bonds?
Ordinary shares do not have maturity period; it will remain forever as long as the
company is still in operation. It is the same from the aspect of dividend payment,
it is unlimited. Before dividends are paid, it must be announced earlier by the
companys board of directors. If the company goes bankrupt, the ordinary
shareholders, who are the owners of the company, cannot make any claims on
the assets before the claims by the creditors (including bondholders) and
preference shareholders are fulfilled.
The voting procedures involve two methods, which are majority voting and
collective voting. Majority voting is the voting where each share owned
grants one right to vote to the shareholder and each position in the board of
directors will be voted separately. Therefore, the majority shareholders
have the opportunity to select all the members of the board of directors.
Through collective voting, each share grants a voting right equivalent to the
number of positions contested. Shareholders can choose to use all their
rights to vote a particular candidate or divide it among several selected
candidates. This method gives a chance to the minority shareholders to
appoint members of the board of directors who will represent them.
SELF-CHECK 4.4
SELF-CHECK 4.5
Similar to how bonds are valued, the value of ordinary shares is also equivalent
to the present value of all cash flow that will be received by shareholders.
However, ordinary shareholders are not promised with fixed income or specific
payment upon maturity period such as bonds and preference shares. Ordinary
shareholders will receive returns in two forms, which are:
(b) Capital gain the difference between the selling price and the purchase
price of shares.
Dividends receivable depend on the profit of the company and the decision of
management to pay dividends or to retain earnings for the purpose of
reinvestment. The amount of dividend receivable is also not the same; it depends
on the companys profit and the rate of growth.
In general, the growth of the company has direct implication on the dividends
payable and the value of shares. The growth of the company can be achieved
through various ways. For example, through loans, issuance of new shares or by
merger with companies that are bigger and more solid. Normally, a company
will experience growth by the using new funding such as the issuance of bonds
and ordinary shares.
The growth of the company can also be achieved by internal growth; by retaining
a portion or all of the companys profit for the purpose of reinvestment.
Retaining profit is a form of investment by the existing ordinary shareholders.
154 TOPIC 4 VALUATION OF SECURITIES
To illustrate more clearly on the internal growth, assume that the return on
equity of Meru Company is 18%. If the management decides to pay all the profits
as dividends to the shareholders, this means that there will be no internal growth
for the company. If the company retains all its profits, then the shareholders
investments in the company will grow in the same amount of profit retained,
which is 18%. If the company only retains 50% of its profits for investment
purposes, then the growth of the company will also be half that is 9%. In general,
this relationship can be concluded as follows:
g = ROE r
(4.5)
Where:
g = Rate of growth of earnings in the future and internal growth of
shareholders investment in the company
ROE = Return on equity (profit after tax/total equity)
r = Percentage of profit retained by company
Therefore, if the company retains 25% of its profit, then the value of shares will
increase to 4.5%.
g = 0.18 0.25
= 0.045 or 4.5%
Step 1: Assume the cash flow that is expected to be received in the future,
which is the amount of dividend and the selling price of the shares at
the end of the period;
Step 3: Discount the dividend that is expected to be received and the price of
shares at the end of the period at the present value with the rate of
return required by the investors.
Example 4.7
Assume an investor plans to buy shares in Meru Company. It expects that the
dividend payable will be RM0.15 at the end of the year. It believes that the shares
can be sold at the price of RM2.40 after one year of holding. What is the value of
Merus shares if the required rate of return is 12%?
By using the basic formula of present value and following the steps above, the
value of the shares is:
Fn
P
(1 i)n
RM0.15 RM2.40
1
(1 0.12) (1 0.12)1
RM0.13 RM2.14
RM2.27
156 TOPIC 4 VALUATION OF SECURITIES
Where:
Vcs = Present value of ordinary shares
D1 = Cash dividend that is expected to be received at the end of the period
P1 = Price of shares that is expected at the end of the period
Kcs = Required rate of return for the shares
If the holding period is more than one or infinity, with a little modification to
formula 4.2, the valuation model of ordinary share is as follows:
D1 D2 Dn D
Vcs ...
(1 k cs ) (1 k cs )
1 2
(1 k cs ) n
(1 k cs )
Dt
(1 k
t 1 cs )
t
(4.7)
TOPIC 4 VALUATION OF SECURITIES 157
Dividends are a part of the companys earnings. When the earnings of a company
fluctuate throughout its period of operations, the risk will increase and this will
then influence the price of the companys shares. To reduce the risk assumed by
investors, the company normally pays dividends based on the long-term growth
of the company. The valuation model for ordinary shares above can be applied in
three levels of growth, which are:
D1 D2 Dn
Vcs ... (4.8)
(1 k cs ) (1 k cs )
1 2
(1 k cs )n
When D1 = D2 = = Dn, this shows that the cash flow is perpetuity as the
cash flow obtained is the same amount for an uncertain period.
With zero growth, the value of ordinary shares is the same with the present
value of perpetuity for D1. By using the basic formula of perpetuity as a
guide, equation 4.8 can be summarised as follows:
D1
Vcs = (4.9)
k cs
Example 4.8
Rias Company has been operating for a long time in the fast food industry.
Lately, the company had paid dividends of RM0.20 per share to its ordinary
shareholders. Based on the sales and current earnings of the company, the
management expects the dividends to maintain in the future. If the required
rate of return is 12%, what is the value of shares for Rias Company?
D1
Vcs
k cs
RM0.20
0.12
RM1.67
158 TOPIC 4 VALUATION OF SECURITIES
Where:
Dt = Dividend for period t
Dt1 = Dividend that was paid in the previous year
g = Dividends rate of growth
By using formula 4.10, we can find the dividend for any given year.
D1 = D0 (1+g)
D2 = D1 (1+g)
= D0 (1+g) (1+g)
= D0 (1+g)2
D3 = D2 (1+g)
= D0 (1+g)2 (1+g)
= D0 (1+g)3
D4 = D3 (1+g)
= D0 (1+g)3 (1+g)
= D0 (1+g)4
TOPIC 4 VALUATION OF SECURITIES 159
By using the basic method to estimate the dividends in the future, we can
obtain the present value of the shares (Vcs) by using formula 4.6.
Step 1: Find the cash flow that is expected to be received in the future
(dividend);
Step 2: Calculate the present value for all dividend payments; and
present value of dividends that are expected to be received in
the future.
D 0 (1 g) D0 (1 g)2 D 0 (1 g)t
Vcs ... (4.11)
(1 k cs ) (1 k cs )2 (1 k cs )t
D1
Vcs = (4.12)
k cs g
Formula 4.12 is better known as the Gordon Model, named after Myron J.
Gordon, the person who created and popularised the formula. Formula 4.12
is used to find the present value of ordinary shares that experience a
constant rate of growth. In theory, the required rate of return (kcs) must be
bigger than the value of the rate of dividend growth (g). If the required rate
of return is lower than the rate of dividend growth, you will obtain a
negative dividend and the value of the shares cannot be determined. In a
real situation, if the investor expects the dividend will increase at a higher
rate, then the required rate of return will also be higher than the rate of
dividend growth.
Example 4.9
BBB Company paid dividends of RM0.20 at the end of last year and is
expected to pay cash dividends every year starting from now until forever.
The rate of growth for each year is 10% while the rate of return is 15%.
Figure 4.6 shows the dividend for a company that experienced inconstant
growth. Dividends are expected to increase by 25% for the first three
years, after which, the growth rate is expected to fall to 6% a year for a
rather long period. The value of shares for this company is the same with
the present value of the dividends that are expected in the future, as shown
in equation 4.6. It also involves three steps:
(i) Calculate the present value of dividends for the entire period of
inconstant growth;
(ii) Calculate the share price at the end of the inconstant period of
growth, which is at the point it changes to constant growth, next
discount this price at present value; and
(iii) Add the present value obtained from step 1 and step 2 to obtain the
intrinsic value, Vcs.
Example 4.10
By using the illustration in Figure 4.6, calculate the present value of
ordinary shares that experienced inconstant growth. Assume the following
five information are given:
Kcs = Rate of return required by investors (12%)
n = Period of inconstant growth (3 years)
gs = Rate of dividend growth throughout the period of inconstant growth
(25%)
gn = Fixed rate (6%)
D0 = Amount of the last final paid by the company (RM0.20 per share)
Calculations:
D1 = D0 (1+g)
= RM0.20 (1+0.25)
= RM0.25
162 TOPIC 4 VALUATION OF SECURITIES
D2 = RM0.25 (1+0.25)
= RM0.3125
D3 = RM0.3125 (1+0.25)
= RM0.3906
Step 2: The price of shares is the present value of dividend from year 1
to infinity; therefore, it is required to obtain the value of
dividend at year 4, D4, by using the constant growth rate of
gn = 6%.
D4 = RM0.3906 (1+0.06)
= RM0.414
Next, we use the formula for constant growth rate to find the
price at year 3 that is the present value of dividend from year 4
to infinity.
D4
P3
k cs g n
RM0.414
0.12 0.06
RM6.90
Step 3: Discount the cash flow for year 1 to 3 and the present value of
dividend at year 4 at the required rate of return, kcs = 12%, to
obtain the intrinsic value for ordinary shares.
The valuation process above can be shown by using a time line as seen
in Figure 4.7.
The value of RM6.90 stated in Figure 4.7 is the second cash flow
at year 3. The shareholders can sell it at year 3 at the price of
RM6.90 or in other words, it is the present value of dividend
cash flow from year 4 to infinity.
The rate of return is calculated based on the value or price of shares and
dividends that are received. The equation of share valuation can still be used to
estimate the expected rate of return for ordinary shares. However, this equation
must be modified as the value required is the required rate of return or the rate of
return used to discount cash flow.
164 TOPIC 4 VALUATION OF SECURITIES
The expected rate of return is also shown for the three aspects of growth:
D
Vcs (4.13)
k cs
As we are looking for the value for the rate of return, the formula above can
be modified as follows:
D
K cs (4.14)
Vcs
Example 4.11
Cergas Maju Company has just sold its ordinary shares at the price of
RM2.30 per share. Last year, the company paid dividends of RM0.25. Based
on the economic situation and the current developments in the company,
the management expects that the company will not experience growth for a
long period of time. What is the expected rate of return for the shares of
Cergas Maju Company?
D
K cs
Vcs
RM0.25
RM2.30
10.87%
D1
Vcs (4.15)
K cs g
TOPIC 4 VALUATION OF SECURITIES 165
As we are looking for the value for the required rate of return, the formula
above can be modified as follows:
D1
K cs g (4.16)
Vcs
From the equation above, the required rate of return for ordinary
shareholders is equivalent to the rate of return for dividend added with the
growth factor. Even though the rate of growth (g) is applied to the rate of
growth for dividend of the company, assume that the value of shares is also
expected to increase at the same rate. This is because (g) represents the
percentage of annual rate of growth for the value of shares. In other words,
the rate of return required by investors is determined by dividends received
including capital gain, as reflected by the expected percentage rate of
growth in the share price.
Example 4.12
The ordinary shares for Maju Jaya Company were recently sold at the price
of RM3.38. The company has just paid dividends of RM0.30 per share and is
expected to experience constant growth of 8.5%. If you purchase these
shares in the market, what are the returns that you would expect to receive?
D1
K cs g
Vcs
RM0.30 (1 0.085)
0.085
RM3.38
0.1813 or 18.13%
ACTIVITY 4.5
Based on the formula g = ROE r, what are the factors that influence
the value of ordinary shares?
166 TOPIC 4 VALUATION OF SECURITIES
EXERCISE 4.5
1. What are the two forms of returns that will be obtained by ordinary
shareholders on their investments?
5. Ordinary shares of Mesra Company had just been sold at the price of
RM2.30 per share. The company expects to experience a constant
growth rate of 10.5% and the dividend at the end of the year is
expected to be RM0.25.
(a) What is the expected rate of return for the shares of Mesra
Company?
(b) If the required rate of return is 17%, will you buy those shares?
TOPIC 4 VALUATION OF SECURITIES 167
SELF-CHECK 4.6
Preference shares are also known as hybrid securities as they have characteristics
of bonds and ordinary shares. Table 4.4 lists down the similarities and differences
between preference shares with ordinary shares and bonds.
There are two methods for the redemption of preference shares that are
normally used, these are:
ACTIVITY 4.6
SELF-CHECK 4.7
Preference shares enable its holders to receive fixed dividends. How
are fixed dividends paid?
170 TOPIC 4 VALUATION OF SECURITIES
(a) Assume the amount and timing of the cash flow that will be received from
the investment of the preference shares;
(b) Calculate the risk level of cash flow that is expected to be received and then
determine the rate of return required by the investors; and
(c) Calculate the intrinsic value of preference shares by discounting all the cash
flow that is expected to be received by using the required rate of return.
As preference shares do not have maturity period, the dividends are expected to
be received continuously until infinity. Therefore, the formula to calculate the
value of preference shares is as follows:
Annual Dividends
Value of Shares =
Required Rate of Return
(4.17)
D
Vps =
k ps
Example 4.13
The annual dividend that is expected to be received is RM0.36 per share. The rate
of return required by investors is 7%. Calculate the value of these preference
shares.
RM0.36
Vps
0.07
RM5.14
TOPIC 4 VALUATION OF SECURITIES 171
D
k ps (4.18)
Vps
Example 4.14
Cher Mate Company sold its preference shares at the price of RM5.50 and pays
dividends of RM0.25 per share. What is the expected rate of return if you
purchase the shares at market price?
D
k ps
Vps
RM0.25
RM5.50
4.54%
ACTIVITY 4.7
EXERCISE 4.6
7. What is the value of preference shares if the dividend rate is 16% of its
par value of RM10? The required rate of return is 12%.
9. Maju Company had just paid dividends of RM1.32. If the growth rate
is expected at 7% perpetually and the rate of return required by
investors is 11%, what is the price of Maju Companys shares?
10. Chips Computer Sdn. Bhd. had just paid dividends for ordinary
shares of RM1.15. For the next two years, the company is expected to
experience high growth as high as 15% and 13% for the third year
and consequently with a fixed rate of 6%. The required rate of return
for the companys shares is 12%. Calculate the value of shares for
Chips Computer Sdn. Bhd.
11. Recently, Tenun Company had just issued its ordinary shares at the
price of RM4.05 per share. Dividend of RM0.24 per share is expected
to be paid at the end of this year and is expected to experience a fixed
growth rate of 7% per year. What is the required rate of return for
these shares?
12. Last year, Primax Company paid dividend of RM0.40, and this year
the dividend is expected to experience a growth rate of 10%. The
company had just paid dividend of RM0.44. Through a new
technique in producing its products, Primax expects to obtain high
achievement in the short term that is, at 25% per year for the first 3
years. After this, the growth is expected to return to normal for a
long period, that is 10% perpetually. If investors required 15% rate of
return, what is the price of the company's shares today?
13. If Cabin Company pays dividends as much as RM1 per year for its
preference shares and the required rate of return is 12%, what is the
value of these preference shares?
14. What is the rate of return required for preference shares if the
dividends payable every year is RM0.15 with a par value of RM4.00?
These shares had just been sold at the price of RM5.
TOPIC 4 VALUATION OF SECURITIES 175
Understanding the concept of value and having skills in valuations are very
important to assist the manager in making financial decisions for the
company. It is in accordance with the objective of the company to maximise
the shareholders wealth.
In the valuation of bonds, you will obtain the intrinsic value, which is the
actual value or true value of an asset and this value is emphasised in finance.
This value will then be compared to the selling price of the bonds in the
market.
If the selling price of the bond in the market is higher than the intrinsic value,
the bond is said to be overvalued and if the reverse occurs, the bond is said to
be undervalued.
Ordinary shares is a more important source of funding and the usage is wider
than preference shares.
176 TOPIC 4 VALUATION OF SECURITIES
The objective of valuating ordinary shares and preference shares is the same
with the objective of valuating bonds, that is to find the intrinsic value or true
value of shares to assist in the decision making on funding or investing.
The rate of return that is expected concerns the returns to be received from
the investment in ordinary shares and preference shares. Knowing the
expected rate of return receivable is also important as it influences the
funding and investment of the company.
INTRODUCTION
The modern portfolio theory was introduced by Harry Markowitz in the year
1952. According to this theory, risk and return cannot be separated. The higher
the risk the higher the expected return. In 1964, this theory analysis has been
further developed by William F. Sharpe to form another theory that is very useful
in the field of finance that is, the Capital Asset Pricing Model (CAPM).
In this topic, you will learn the risk and return from the perspective of capital
contributors or shareholders. According to the research on the habits of investors
that were conducted by Markowitz, capital contributors will make valuation on
returns before making investment. Subsequently, they will make analysis on the
changes in returns as a measurement of risk.
178 TOPIC 5 RISK ANALYSIS
SELF-CHECK 5.1
Explain the relationship of risk and return in investments.
(c) The value 0 shows the probability of a specific occurrence that definitely
would not occur;
(d) The value 0.1 shows the probability of a specific occurrence occurring is
10%; and
(e) The value 1 shows the probability of a specific occurrence that would
definitely occur.
Example 5.1
Nusa Company is currently considering two alternative investments, which are
the project to rear fish (PRF) and project to rear sheep (PRS). The following are
the discrete probability distribution of returns for both investment alternatives:
Figure 5.1: Discrete probability distribution for the prediction of returns for PRF and PRS
Figure 5.2: Continuous probability distribution for the prediction of returns for
PRF and PRS
182 TOPIC 5 RISK ANALYSIS
From the aspect of its concept, the steeper the probability distributions graph on
investment return, the riskier the said investment. A steep graph shows that the
probability distribution gap of return is bigger. The probability distribution gap
is the difference or variation between the estimated highest return and the
estimated lowest return. The smaller the differences in value, the lower the
estimated risk and on the other hand, the higher the gap the higher the risk of an
investment.
Figure 5.1 shows that the probability distribution gap of return for PRS is bigger
(RM18,000 RM2,000 = RM16,000) compared to PRF (RM12,000 RM8,000 =
RM4,000). Meanwhile, Figure 5.2 shows that the probability distribution of return
for PRS is flatter compared to the probability distribution of return for PRF.
Therefore, you can conclude that PRS is riskier compared to PRF.
n
X X t Pt (5.1)
t1
or
n
r rt Pt (5.2)
t1
Where:
Variance:
n
2 (ri r )2 Pi (5.3)
i=1
n
(ri r)2 Pi (5.4)
i=1
Where:
2 = Variance
= Standard deviation
It is used if a situation arises where the financial asset of A produces return that
is higher than the financial asset of B but at the same time, the financial asset of A
has higher risk compared to the financial asset of B. The higher the value of CV,
the higher it will be for the level of risk for each unit of return.
CV (5.5)
r
184 TOPIC 5 RISK ANALYSIS
5.2.6 Covariance
The use of covariance can explain to you the relationship of returns among the
financial assets that can be compared. In other words, covariance measures how
far two random variables are different from each other.
(a) The value of positive covariance shows that one of the random variables
states a value of more than mean, while the other random variable is also
inclined towards the value of more than mean.
(b) The value of negative covariance shows that one of the random variables
states a value of more than the mean, while the other random variable will
incline towards the value of less than mean.
(c) The value of zero covariance shows that no pattern had been formed
between the two variables. The covariance for the two random variables (r1,
r2) is usually written as Cov (r1,r2) of sr1r2.
n
Cov (r1 , r2 ) Pi (ri1 r1 ) (ri2 r2 ) (5.6)
i=1
Cov (r1 , r2 )
Corr (r1 , r2 ) (5.7)
r1 , r2
Example 5.2
A B
Weak 0.20 12% 6%
Moderate 0.50 14% 14%
Strong 0.30 16% 19%
Financial Asset A
Financial Asset B
(b) Variance
Financial Asset A
Financial Asset B
Financial Asset A
Financial Asset B
EXERCISE 5.1
Unsystematic risk or risk that can be diversified is a risk that only has effect on
the financial assets of specific companies or group of related companies. This risk
is unique or different among the companies (depends on the nature of the
business). It comprises of business risk (operations) of the company and financial
risk of the company. These risks can be distributed or reduced by diversification
in investments.
SELF-CHECK 5.2
What is the principle of systematic and unsystematic risk?
TOPIC 5 RISK ANALYSIS 189
n
rport w1 r1 w 2 r 2 w n rn (5.8)
i=1
Where:
rport1. = Expected rate of return for portfolio.
The portfolio risk refers to the variability of expected returns or average returns
from investments in the portfolio. The effects from diversification caused the
portfolio risk to become smaller compared to the risk of individual assets
(portfolio components). The total reduction of risk (through diversification)
depends on the correlation of an asset return with other assets return in the
portfolio that is measured with the coefficient correlation.
portf.
n
P n (rportf. in a specific economic situation rportf. for all securities in the portf.)2
i=1
(5.9)
190 TOPIC 5 RISK ANALYSIS
For data based on time series, the portfolio formula for standard deviation is
modified as follows:
Example 5.3
Investment portfolio is made up of 50% of Financial Asset A, 25% of Financial
Asset of B and the remaining 25% of Financial Asset C.
Financial Asset B
Financial Asset C
= 9.8%
TOPIC 5 RISK ANALYSIS 191
(c) Variance
Expected portfolio return during a strong economic situation:
= 11.026 + 9.02
= 4.477%
EXERCISE 5.2
Calculate:
(a) Expected return for each share.
(b) Expected return for investment portfolio of share X, Y and Z.
(c) Standard deviation for the investment portfolio.
192 TOPIC 5 RISK ANALYSIS
In the capital market, there are many combinations of assets that have uncertain
risk-return levels. Therefore, investors have a chance to choose and diversify the
investment combinations or portfolio that consist of risky and non-risky assets.
Non-risky asset refers to asset that has a standard deviation equals to zero. In
other words, the actual return is the same as the expected return. In reality, there
would not be any asset that is totally free from risk. However, there are assets
with very low risks. For example, treasury bills issued by the government.
Although these treasury bills are not totally risk-free but because their returns are
guaranteed by the government, they are categorised as non-risky assets.
This graph explains the connection between the value of rate of return and
standard deviation. At Y axis, the straight line is known as CML, starting from
the point marked rf, which is the return of risk-free asset and subsequently, it
touches the efficient frontier curve (that is the market portfolio known as M).
TOPIC 5 RISK ANALYSIS 193
The market portfolio is the portfolio that contains all securities in the market. The
overall unsystematic risks in the market portfolio has been distributed or
reduced to the lowest level. The balance is the systematic risks. The possibility of
these systematic risks to be distributed is very slim or in theory it is categorised
as risks that cannot be distributed. M is the risky portfolio that is the best to be
chosen compared to the other risky portfolios in the efficient frontier curve but in
reality it is not possible for you to own a portfolio containing all the securities in
the market.
The entire portfolio along the CML is a combination of risk-free assets and risky
portfolio that will produce the same risk and return in investments if made in
risk-free assets and market portfolio M. When CML is formed, it is up to the
investors to choose any combination of investments on the CML. This is because
based on the gradient of the CML, any of the combinations will provide the same
risk-return.
The gradient of the CML can measure the amount of expected return for a unit of
total risky investment. The formula is as stated in equation 5.10.
rm rf
Gradient of CML (5.10)
Each of these risky assets has a combination of systematic and unsystematic risks.
Therefore, when this portfolio is formed, the unsystematic risk can be fully
distributed. The result, the only systematic risk left accumulated is due to the
combination of systematic risk from each of the risky assets of A, B, C and D.
194 TOPIC 5 RISK ANALYSIS
You can measure the systematic risk by using the coefficient beta () that is the
relative shares diversifiable index. The following are the indicators that are used
to interpret the results of beta multiplier:
(b) = 0.5: The level of securities risk is half of the market risk.
(c) = 1.0: Securities have the same level of risk as the average market
risk.
(d) = 2.0: The level of securities risk is twice the average market risk.
The systematic risk for each risky asset portfolio is the total risk that contributes
to the risky market portfolio. Therefore, the systematic risk of the asset influences
the return that is expected in the market. However, how do you know how much
is the return payable on the willingness to receive a certain amount of systematic
assets risk?
Total expected return for a unit of risk that is stated above actually can be
measured by the CML gradient that had been learned previously. Therefore, you
are able to determine the risk premium for a risky asset, for example asset A
using equation 5.11.
rm rf
{[Corr (A, M)] A } (5.11)
m
Equation 5.11 above can be modified to determine the beta for asset A
(equation 5.12)
Cov(A, M)
A (5.12)
M2
After each of the beta multiplier for the risky assets portfolio had been calculated,
you will determine the beta for the entire investment portfolio. Your calculation
is based on equation 5.13.
n
portf. Wi Bi (5.13)
i =1
TOPIC 5 RISK ANALYSIS 195
Example 5.4
Assume you have determined the beta multiplier including the weighted
investment for each of the risky financial assets. Based on this information, you
can then calculate the portfolio beta multiplier for the investment of assets X, Y
and Z.
Equation 5.14 is the basic formula for CAPM where the expected return for risky
asset A is the sum return for risk-free assets and risk premium for risky assets A.
This equation shows how SML connects the expected returns for risky asset A
with the beta of risky asset A.
rA rf (rm rf )A (5.14)
Assume that there is an investment portfolio that comprised of all the securities
in the market. This type of portfolio is known as market portfolio where the
expected return for this portfolio is stated as rm. As this portfolio represents all
the securities in the market, then it is certain that this portfolio has an average
systematic risk that is bm = 1.0. The SML gradient for market portfolio is:
rm rf rm rf
rm rf (5.15)
m 1
Example 5.5
First Portfolio
Assume the portfolio comprised of investments in security X (where its beta is 1.5
and the expected return is 18%) and risk-free security (where rf is 7%). 30% of
the investment is invested in security X, while 70% is invested in the risk-free
security.
Therefore,
rx rf
SML gradient =
x
TOPIC 5 RISK ANALYSIS 197
(18 7)
For security X, the reward to risk ratio is =
1.5
= 7.33%
Example 5.6
Second Portfolio
Assume the portfolio comprised of investments in security Y (where its beta is 1.1
and the expected return is 14%) and risk-free security (where rf is 7%). 30% of
the investment is invested in security Y, while 70% is invested in the risk-free
security.
Therefore,
(14 7)
=
1.1
= 6.36%
(meaning the security has a reward to risk ratio of 6.36% which is less than the
7.33% offered by security X)
198 TOPIC 5 RISK ANALYSIS
Figure 5.6 shows the graph position that draw the combination points of expected
returns and beta for security X that is higher compared to security Y. This situation
explains that the return offered by the first portfolio is higher compared to the
return offered in the second portfolio at any level of systematic risk that is
measured by beta.
SELF-CHECK 5.3
EXERCISE 5.3
0.25 25 0.20 20
0.25 15 0.20 30
0.30 20 0.50 25
(a) Draw a bar chart for the shares in Company A and Company
B.
(b) Calculate the range of probability distribution for the return
of shares in Company A and Company B.
(c) Determine which of the shares is riskier.
2.
Economic Situation Probability Estimated Return (%)
Shares X Shares Y
Strong 0.6 14 7
Moderate 0.4 6 12
50 percent from the total capital was invested in shares X and the
remaining 50 percent was invested in shares Y.
(a) Calculate the expected return for each security.
(b) Calculate the expected portfolio return for shares X and shares
Y.
(c) Calculate the standard deviation for the portfolio of shares X
and shares Y.
200 TOPIC 5 RISK ANALYSIS
5. What is the risk status for a share if the beta for this share is less
than 1.0?
The following are the estimated returns for all the three types of
financial assets:
7. The estimated beta for the shares in Emas Company is 1.3. The risk-
free rate is 8 percent and the estimated market return is 16 percent.
(a) Based on the CAPM formula, what is the required rate of
return for investors who invest in the shares of Emas
Company?
(b) What is the premium value of the market risk?
10. Share A has a beta of 1.2 and expected return of 20%. Meanwhile,
share B has a beta of 0.80 and expected return of 13%. If the risk-
free rate is 5% and the market premium risk is 12%, which share is
said to be overpriced or underpriced?
In this topic, you have been exposed to the basic knowledge on risk and
return from the perspective of an investor. Based on this knowledge, it is
hoped that you will be able to apply it to ascertain the risk and return of an
investment in a security as well as in a portfolio.
The importance of return and risk can also be analysed from the viewpoints
of financial managers and financial markets.
They assess the return and risk of all major decisions to make sure that the
best return is being earned for a given level of risk or that risk is being
minimised for a given level of return which is also known as efficient
portfolio.
TOPIC 5 RISK ANALYSIS 203
Beta Portfolio
Capital asset pricing model (CAPM) Return
Capital market line Risk
Coefficient of variation Risk-free assets
Correlation coefficient Security market line
Covariance Standard deviation
Diversification Systematic risk
Expected return Unexpected return
Market risk Variance
Topic Criteria of
6 Capital
Budgeting
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Determine the acceptability of a new project based on the payback
period, net present value, the profitability index and the internal rate
of return; and
2. Explain the advantages and disadvantages of each capital budgeting
technique.
INTRODUCTION
Capital budgeting is a process where firms plan the investments in long-term
assets or activities that have long-term financial implications. It involves a
substantial cash withdrawal and the cash inflow is for a long period in the future.
Just like other decisions making process, capital budgeting involves the
considerations and valuation of available alternatives. Among the important
matters that must be given attention in the valuation process of capital budgeting
projects are the appropriate use of techniques and accurate estimation of cash
flow as inputs to the techniques that will be used.
TOPIC 6 CRITERIA OF CAPITAL BUDGETING 205
SELF-CHECK 6.1
Example 6.1
Project A has the following cash flow. What is the PBP of this project?
The negative cash flow of RM100,000 at year 0 equals the total that was invested,
or the cash outflow as the money has been spent on this project. Observe that in
year 4, the cumulative cash inflow is RM100,000, matching the cash outflow
(initial capital) at year 0. Therefore, the PBP for Project A is 4 years, that is the
time where the total sum obtained matches the total sum withdrawn.
Example 6.2
When PBP is between two different time periods, we can assume that the
distribution of cash flow is uniform. In this situation, we can use the linear
interpolation to estimate the PBP for the project assessed.
Based on the above cash flow, the PBP for this project is found to be within
3 years to 4 years because to achieve PBP, the cash inflow must be equal to the
cash outflow at the beginning of this project that is RM200,000. At the third year,
the cumulative cash inflow of RM170,000 is still short of RM30,000 (RM200,000
RM170,000) to achieve the PBP. By estimating that the cash flow distribution is
uniform, the calculation of PBP for the project of purchasing a grinding machine
is as follows:
RM30,000
PBP 3 years
70, 000
PBP 3.43 years
For projects that generate cash flow in the form of annuity, you can use
formula 6.1 to calculate the PBP.
IO
PBP (6.1)
ACF
IO = Initial Outlay
ACF = Annual Cash Flow
Example 6.3
Suppose there is a project that involves a cash outflow of RM700,000 and it is
expected to produce a cash inflow of RM200,000 every year throughout the
lifetime of the project, which is 5 years. By using formula 6.1, the PBP of this
project is:
RM700,000
PBP
RM200, 000
3.5 years
208 TOPIC 6 CRITERIA OF CAPITAL BUDGETING
By using the cash flow schedule, we can also obtain the same answer, which is
PBP = 3.5 years.
If a comparison is made between two projects with different PBP, the project
with the lower PBP value is better as the company will regain its invested capital
faster. Therefore, the company will have the opportunity to use that cash for
other investing purposes. Besides that, a shorter PBP shows that the period
where the company is exposed to investment risks is also shorter.
In deciding whether to accept or reject a project, the company must compare the
PBP of the project with the targeted PBP set by the company. This technique
proposed that a project will be rejected if the PBP of that project is longer than the
targeted PBP and vice versa, that is, the project should be accepted if the PBP of
that project is less than the targeted PBP.
By referring to example 6.1, if the company involved had set the targeted PBP for
the project at 3 years, the PBP technique proposed that project A to be rejected as
the PBP of project A of 4 years exceeded the targeted PBP of 3 years.
TOPIC 6 CRITERIA OF CAPITAL BUDGETING 209
What is important is to evaluate whether the PBP of the project is less or more
than the targeted PBP. The manager need to calculate the PBP of the project
accurately as it is important to ensure whether the PBP of the project is higher or
lower than the targeted PBP. To evaluate whether the PBP of the project is higher
or lower than the targeted PBP, we only need to determine whether the
cumulative cash inflow of the targeted PBP is higher or lower than the initial cash
outflow.
Example 6.4
Suppose that the targeted PBP for the project in example 6.2 is 4 years. Should the
company purchase the grinding machine?
Solution
The cumulative cash inflow at year 4, which is at the targeted PBP, is RM240,000.
As this total is more than the initial cash outflow of RM200,000, therefore it can
be concluded that the PBP of the grinding machine is higher than the targeted
PBP. Based on the PBP technique, the grinding machine should be purchased.
EXERCISE 6.1
Project A
Requires an initial investment of RM250,000 and this project will
generate cash inflow of RM100,000 at the end of the second and
third year and RM150,000 at the end of the fourth year.
Project B
Requires an initial investment of RM400,000 and this project will
produce cash inflow of RM125,000 every year for five years.
2. Calculate the payback period for a project that involves the initial
cash outflow of RM1 million and an annual cash inflow of RM100,000
for the first five years and RM200,000 for the next five years.
210 TOPIC 6 CRITERIA OF CAPITAL BUDGETING
(b) PBP uses the cash flows and not accounting profits as the basis of
calculation. The use of cash flow as the basis of calculation is more accurate
as it shows the income and cost involved and also clearly shows the time
when the cash flow occurs.
(c) The criteria of PBP is an indication of the liquidity for the project. A shorter
PBP shows that the period where the funds are tied to a project is shorter.
(d) The criteria of PBP also takes into account the risk of a project. A cash flow
that is distant has higher uncertainties. Therefore, the company should
focus on a lower PBP to reduce risk that may be faced by the company.
SELF-CHECK 6.2
However, the PBP technique has two main disadvantages, which are:
(a) PBP Does Not Take into Account the Concept of Time Value of Money
The cumulative cash inflow is obtained by totalling the cash flow at
different times without making any adjustments to the time value of
money. An analysis that does not take into account the time value of money
concept, implicitly assumes that the opportunity cost of the funds is 0.
Further explanation on this disadvantage is shown in the following
example.
Example 6.5
Referring to the above schedule, both these projects have the same PBP that
is in the second year. This means that both these projects should be given
the same priority if PBP is applied.
(b) PBP Does Not Take into Account the Cash Flows After the Payback Period
One of the disadvantages of the PBP technique is that it disregards the cash
flow after the payback period. Thus, long-term projects cannot be valued
accurately. This disadvantage can be shown in the example.
Example 6.6
Based on PBP, project A is better than project B because the PBP for project A is
shorter than project B (2 years compared to 4 years). If the targeted PBP is not
more than 2 years, the PBP technique would accept project A and reject project B
even though project B generates cash flow after the targeted PBP. By not taking
into account the cash flow after the payback period, the company may disregard
another better and more profitable investment merely because it does not fulfil
the targeted PBP.
EXERCISE 6.2
1. Most companies use the payback period as a guideline for making
decisions in capital investments because of the following reasons
except:
A. It provides implicit consideration on the timing of cash flow.
B. Identifies cash flow that will be obtained after the payback
period.
C. Measures the exposure to risks.
D. Simple calculation.
E. A and C.
Where:
I0 = Initial cash flow
CFt = Cash flow for period t
k = Cost of capital
n = Project lifetime
The cost of capital is the required rate of return for a firm, from a particular new
capital budgeting project in order to maintain the value of the firm.
Example 6.7
A project has a cost of capital of 15% and the cash flow is as follows:
Calculation:
1
As can also be written as PVIF15%,n, the formula above can also be
(1 0.15)n
solved using the present value schedule.
NPV = 40,000 (0.870) + 80,000 (0.756) + 100,000 (0.658) + 100,000 (0.572) 200,000
= RM34,800 + RM60,480 + RM65,800 + RM57,200 RM200,000
= RM18,280
Example 6.8
If a project has a cash inflow that is in the form of annuity, the calculation for
NPV is easier and simpler as you can use the present value factor annuity in your
calculations.
(a) If the projects that are evaluated are independent projects, accept the
projects that have NPV 0.
(b) If the projects that are evaluated are mutually exclusive projects, accept the
projects that have the highest NPV and NPV 0
216 TOPIC 6 CRITERIA OF CAPITAL BUDGETING
(b) It takes into account the timing of cash flow by using the discounted cash
flow or the concept of time value of money.
(c) It takes into account all the cash flows of the project.
(d) The criteria of NPV is in accordance with the concept of owners wealth
where, in theory, NPV of a project represents the explicit measurement of
the increase or decrease of a firms value and owners wealth. Therefore,
the NPV technique is the best technique in the perspective of financial
theory.
(b) The calculation of NPV requires information on the cost of capital for the
project that is sometimes difficult to ascertain.
ACTIVITY 6.1
EXERCISE 6.3
1. You are required to evaluate three projects that have a cash flow
estimation as shown in the table below.
If the cost of capital for these projects is 10%, should you make
investments in these projects if you use the NPV technique?
3. When the cost of capital increases, the NPV of the project will
________________.
218 TOPIC 6 CRITERIA OF CAPITAL BUDGETING
n CFt
t 1 (1 k)
t
PI (6.2)
I0
(c) If PI = 0, the project will have no effect on the wealth of the company.
Therefore, the acceptance or rejection of the project will not have any effect
on the company.
It also has an advantage where it is used together with the NPV to make
decisions in situations where the investment capital of the firm is limited.
EXERCISE 6.4
SELF-CHECK 6.3
If the NPV for a project at a discount rate of 15% is (RM350,000), the IRR
for this project is more than 15%. Is this statement true or false?
This technique uses the criteria known as the internal rate of return as the
evaluation basis in capital budgeting project.
220 TOPIC 6 CRITERIA OF CAPITAL BUDGETING
n CFt
NPVIRR I0 0
t 1 (1 IRR)
t
The manual calculation of IRR involves a process of trial and error and linear
interpolation. Example 6.9 shows the calculations involved in using the above
equation.
Example 6.9
Two projects have the following cash flows:
Manually, you would have to use the trial-and-error method, where you would
include a discount rate (k) and determine whether NPV is equal to 0 or not. You
might have to do this process several times until you obtain k when NPV is equal
to 0. (Whenever possible, you should try until you obtain a positive number and
a negative number). There is a bigger possibility that it would involve a linear
interpolation where the IRR is not a whole number. Calculators and certain
computer packages can be used to help calculate the IRR that is not a whole
number.
Based on this NPV value, and the inverse relationship between k and NPV, it is
clear that you should try a discount rate higher than 14%. Suppose you tried 15%.
As the NPVA,14% is positive and NPVA,15% is negative, we know that the IRR is
between 14% and 15%.
To get the estimated IRR for Project A, you can perform the linear interpolation
as follow:
780
14% 15% 14%
780 800
14% 0.49%
14.49%
222 TOPIC 6 CRITERIA OF CAPITAL BUDGETING
For project B, the calculation of IRR is easier because you can use the function of
present value annuity to simplify your calculations. This is because the cash
inflow for years 1 to 5 is uniform that is at RM 250,000.
NPVB,IRR 0
250,000 (PVIFAIRR,5 ) 1,000,000 0
1,000,000
PVIFAIRR,5
250,000
4
Refer to the schedule of present value annuity (see row period 5) you will get 8%.
Through the trial-and-error method, you will find that the IRR for Project B is
between 7% and 8% as shown in the following table.
To obtain the estimated IRR, you can perform the linear interpolation as follows:
25,000
= 7% + (8% 7%)
(25,000 + 1,750)
= 7% + 0.94%
= 7.94%
The calculation of IRR is much easier if you use a financial calculator. There are
special functions to calculate the IRR and you only have to enter the information
into the schedule above.
TOPIC 6 CRITERIA OF CAPITAL BUDGETING 223
In summary, the criteria for acceptance and rejection of a project based on the
IRR are as follows:
(a) If the projects evaluated are independent projects, accept the project that
have IRR cost of capital.
(b) If the projects evaluated are mutually exclusive projects, accept the project
with the highest IRR and between the projects that have at least an IRR
equal to the cost of capital.
Referring to the projects in example 6.9, if the cost of capital is 14%, project A will
be accepted while project B will be rejected.
EXERCISE 6.5
1. When the net present value is negative, the internal rate of return is
_____________ the cost of capital.
A. bigger than
B. bigger than or equal to
C. less than
D. equal to
E. cannot be identified without cash flow
(a) Just like the criteria of PBP and NPV, IRR uses the cash flow and not
accounting profits as the basis for calculations.
(b) Just like the criteria of NPV, the IRR takes into account the time value of
money in its calculations.
TOPIC 6 CRITERIA OF CAPITAL BUDGETING 225
(c) In a lot of situations, the IRR technique provides a solution that is parallel
with the NPV technique. The IRR technique is acknowledged to be the best
technique in the perspective of financial theory. This is because when a
project has IRR more than k, its NPV is also more than 0.
(b) The calculation of IRR requires information on the cost of capital of the
project which is rather difficult to ascertain.
(c) Decisions are difficult to make when IRR is multiple, which is a situation
where the solution of the mathematical equation for IRR gives more than
one answer. This situation will be faced in the consideration of projects that
are unconventional. Conventional projects are defined as projects where the
cash outflow only happens in the beginning of the project, while in the
following years, the project will generate cash inflows. The signal for this
cash flow has the following pattern: + + + + +. For projects that are
unconventional, the cash outflow can occur in the middle of a series of cash
inflows, for example, projects that have the following cash flow pattern: +
+ - + + - + +. The number of IRR for such projects is the same with the
number of the cash flow direction change, in this example, its number is 5.
226 TOPIC 6 CRITERIA OF CAPITAL BUDGETING
EXERCISE 6.6
4. A project has the initial cash outflow of RM10,000 and produces cash
inflow of RM3,000 at the end of the first year, RM5,000 at the end of
the second year and RM7,500 at the end of the third year. If the cost
of capital is equal to 12%, calculate the:
(a) Payback period
(b) Net present value
(c) Profitability index
(d) Internal rate of return
6. List one advantage and one disadvantage that is unique for each of
the following capital budgeting evaluation techniques:
(a) Payback period
(b) Net present value
(c) Internal rate of return
228 TOPIC 6 CRITERIA OF CAPITAL BUDGETING
There are four main types of techniques in capital budgeting, which are PBP
technique, NPV technique, PI technique and IRR technique.
The payback period (PBP) is the number of years required to regain the
project costs. By using this technique, the project will be accepted if its PBP is
less than the targeted PBP.
The net present value (NPV) is the difference between the present value of
cash inflows with the present value of cash outflow. By using this NPV
technique, the project will be accepted if its NPV is more than 0.
The NPV technique is the best technique in the perspective of financial theory
because NPV measures the increase in the firms value and the owners
wealth that is affected by the evaluated project.
The profitability index (PI) is the ratio of present value of cash inflows
throughout the project with the initial outflow. Based on the PI technique,
this project will be accepted if the PI is more than 1.
The internal rate of return is the rate of discount where the NPV is equal to
zero. Based on the IRR technique, a project will be accepted if its IRR is more
than k.
One of the main disadvantages of IRR is the problem of multiple IRR, which
is a situation where the solution of the mathematical equation gives more
than one answer.
The techniques of NPV, PI and IRR are categorised as discounted cash flow
techniques (DCF techniques).
INTRODUCTION
Several main techniques for capital budgeting discussed in Topic 6 required an
estimated cash flow in its calculations. Without the estimated cash flow, we
cannot apply these techniques. Therefore, it is important for us to understand
that a wrongly estimated capital budgeting cash flow will produce an inaccurate
decision that may result in a decrease in the owners wealth instead of increasing
the owners wealth.
This topic will discuss the estimation for cash flow of capital budgeting by
looking at three types of cash flow during the time it occurs. You will then find
that this separation is appropriate due to the uniqueness of the cash flows
involved at that time. Subsequently, we will analyse the items that must be taken
into account in estimating each type of these cash flows. Finally, we will apply
what we had learned in the decision making of capital budgeting.
230 TOPIC 7 CASH FLOW OF CAPITAL BUDGETING
SELF-CHECK 7.1
State several guidelines that assist in estimating the cash flow for
capital budgeting.
Several other guidelines that can assist in the estimation for cash flow of capital
budgeting are:
Figure 7.1 shows the three cash flows based on time line.
Figure 7.1: Time line showing the types of cash flow for capital budgeting
SELF-CHECK 7.2
Initial outlay (IO) of a capital budget project refers to the total cash outflow that
is expected to occur at the beginning of an investment to enable an asset or
project to operate smoothly. As shown in Figure 7.1, IO is the cash flow at time 0.
The acronym IO is often used to represent initial outlay.
Among the main items that are involved in the estimation of IO are:
(a) Cost of purchasing, installing and transporting the new assets;
(b) Changes to the net working capital of the firm due to the investment made;
and
(c) Sale revenue after tax for the old assets that must be sold if the project is
accepted.
TOPIC 7 CASH FLOW OF CAPITAL BUDGETING 233
These increases that are not balanced between the current assets and
current liabilities will cause the level of net working capital to change,
whether to increase or decrease. In summary, the changes in NWC are
represented by the following equation:
In the above example, the changes in the level of net working capital are
calculated as follows:
The level of net working capital has increased by RM600,000. The level
of NWC will decrease if NWC has a negative value. Observe that the
negative symbol is used for the increase in current liabilities and its the
same when there is a decrease in the current assets.
As the increase in net working capital involves a sum of cash that is tied
to the firm, it is assumed as the cash outflow while the decrease in net
working capital involves the release of cash and is considered as cash
inflow.
In some taxation systems, capital gain, which is the profit obtained from selling
the capital assets, will be taxed. Meanwhile, the losses that occurred from the sale
of capital assets will be tax savings. Therefore, we must take into account the
effect of taxation in the calculation of IO via the calculations of the revenue from
sales, after tax.
Tax is imposed on the components of disposal gains only and not the entire
revenue from the sale of the assets; and
Disposal gain is the surplus of selling asset new its book value.
The following equations will help us to understand and calculate the sales
revenue of the old assets after tax:
Now we will look at how the sales revenue of the assets after tax and the changes
in net working capital are handled via examples 7.1 and 7.2.
Example 7.1
Project A involves the replacement of an old grinding machine with a new
grinding machine. The old grinding machine was bought at a price of RM250,000
three years ago and has a lifetime of 5 years. What is the sales revenue of the
asset after tax if this old machine can be sold at a price of RM120,000 now and the
marginal tax rate is 30%?
Solution:
* Assumption:
The following calculation can also be used to obtain the book value of the old
machine:
= RM20,000 0.3
= RM6,000
Step 4: Calculate the sales revenue after tax for the old machine
Observe that in cases of capital losses, we will obtain a tax saving, where to
calculate the assets sales revenue after tax, we must add the tax saving to the
selling price of the asset.
In summary, the formula for sales revenue of asset after tax is as follows:
Example 7.2
Teguh Company plans to purchase a new cement mixing machine to replace the
old machine. The old machine was purchased 6 years ago at a price of RM200,000
and was depreciated using the straight line method to the scrap value equivalent
to zero, throughout its lifetime of 10 years.
If the company plans to replace this old machine, it can be sold at a price of
RM120,000. The price of the new machine is RM300,000 while the transportation
cost is RM20,000 and the installation cost is RM10,000. To meet this new level of
productivity, the raw materials inventory must be increased by RM20,000 and
the account payable will increase by RM10,000. The marginal tax rate of the
company is 30%. Based on this information, calculate the initial outlay.
TOPIC 7 CASH FLOW OF CAPITAL BUDGETING 237
Solution:
ACTIVITY 7.1
Observe in Example 7.2, the sales revenue of the old machine after tax
had been deducted in the process of obtaining the initial outlay. Why?
EXERCISE 7.1
Among the items that must be taken into account in the estimation of OCF are as
follows:
(a) Change in sales revenue;
(b) Change in cash operating costs; and
(c) Change in taxation.
A capital budgeting project can cause changes to any one of the items above or all
of them at once. A development project, for example, has a higher possibility of
involving the changes to all the items above, while a manufacturing automation
project has a higher possibility of only involving a reduction in the cash
operation cost and taxation. The increase in revenue is a cash inflow while the
increase in cost and taxation are cash outflows. Generally, OCF can be stated in
the following equation:
OCF n = S n E n T n (7.2)
Where:
S n = Increase in the sales revenue for year n
E n = Increase in the cash expenditure for year n
T n = Increase in taxation for year n
There are several formulas to calculate OCF. By using formula 7.2, we can expand
that formula as follows:
OCFm = Sn En Tn
= Sn En t (Sn En Dn)
= (Sn En) (1+t) + t(Dn) (7.3a)
= (Sn En Dn) (1 t) +Dn (7.3b)
= NIn + Dn (7.3c)
Where:
Sn = Increase in the sales revenue for year n
Dn = Increase in depreciation for year n
En = Increase in cash expenditure for year n
Tn = Increase in taxation for year n
NIn = Increase in net income for year n
t = Tax rate
Dn is calculated as follows:
The equation 7.3b states that the cash flow for year n is equivalent to the increase
in net income (NI) plus the increase in depreciation. This can be explained quite
easily; because the calculation of net income (NI) involves the deduction of
depreciation (D), a non-cash cost, therefore to calculate OCF, this depreciation is
added back. You will see how these equations are used via Example 7.3.
240 TOPIC 7 CASH FLOW OF CAPITAL BUDGETING
Example 7.3
We return to the project that is being considered by Teguh Company in Example
7.2. To estimate the operating cash flow of this project, we need to obtain the
information for the effect of this project on the level of sales, operating
expenditure and also the depreciation expenses.
(a) The new machine will be used for 4 years and is depreciated using straight
line to the scrap value of zero.
(b) At the end of year 4, this machine is expected to be sold at the price of
RM70,000. With this replacement, the company expects to increase the sales
revenue by RM50,000 per year.
(c) At the same time, the cash expenditure will reduce by RM5,000 per year.
Based on the information above and the information provided in Example 7.2,
calculate the OCF for this project.
Solution:
S = RM50,000
E = RM5,000
EXERCISE 7.2
The purchase price of a new machine is RM35,000, the delivery cost
is RM3,000 and the installation cost is RM3,000. The lifetime of this
machine is 5 years. The old machine was bought at the price of
RM15,000 and can be sold at the price of RM17,000. This machine has a
book value of RM10,000.
The usage of this new machine will reduce the wages cost by RM9,000,
Employees benefit by RM1,000 per year, the defect cost reduced from
RM8,000 to RM3,000. However, the maintenance cost will increase by
RM4,000 per year. The depreciation of the old machine is RM2,000 per
year. Assume that the taxation rate is 30%, how much is the annual
additional cash flow after tax?
What are the items involved at the time a project is terminated? One of it is the
disposal price for the assets. The following are among the several important
items that form the TCF:
Observe that for asset with its salvage value of zero, the following formula
can be used:
Suppose in the beginning of the project, the level of net working capital has
increase to RM200,000. You need to take into account the regaining of this level
that will involve a cash inflow of RM200,000 in estimating the terminal cash flow.
TOPIC 7 CASH FLOW OF CAPITAL BUDGETING 243
Look at Example 7.4 to understand the terminal cash flow more clearly.
Example 7.4
Use the example of Teguh Company (Example 7.2) that is evaluating the
replacement of an old grinding machine with a new grinding machine. To assist
this company in making a decision whether or not this replacement should be
made, we need to calculate the TCF of this project. No other information will be
given besides those that had already been included in Examples 7.2 and 7.3.
TCF is:
ACTIVITY 7.2
Explain the differences that exist among the concept of initial outlay,
operating cash flow and terminal cash flow.
Example 7.5
We want to make a decision on whether the project of replacing a grinding
machine that is being considered by Teguh Company in Examples 7.2, 7.3 and 7.4
should be accepted or not. State your decision based on the PBP and NPV
techniques if the cost of capital used is 12% and the targeted PBP is 3 years.
Solution:
Estimation for cash flow of capital budgeting can be obtained as follows:
IO = RM232,000
OCF = RM48,250
TCF = RM94,000
The cumulative cash flow for year three is RM144,750. As this total is less
than the initial cash outlay, which is RM232,000, it can be summarised that
the PBP of this project is higher than the targeted PBP. Based on the PBP
technique, this project should be rejected.
TOPIC 7 CASH FLOW OF CAPITAL BUDGETING 245
CF CF2 CFn
NPV ... I0
1K 1K
1 2
1K n
RM48,250 PVIFA12%,4 RM94,000 PVIF12%,4 RM232,000
RM206,319 RM232,000
RM25,680.75
The NPV value of this project is RM25,680.75. The negative NPV value will
decrease the value of the firm. Therefore, this project should be rejected.
EXERCISE 7.3
The cost of capital for Koska is 14% while the marginal tax rate is
20%. Which model should be chosen based on the information
above?
246 TOPIC 7 CASH FLOW OF CAPITAL BUDGETING
Additional information:
Depreciation using the straight line method
Corporate tax is 20%
Cost of capital is 10%
(b) Should the company replace the old machine with the new
machine?
TOPIC 7 CASH FLOW OF CAPITAL BUDGETING 247
4. You are considering whether or not to replace the current meter with
a new meter. The old meter can be sold at the price of RM500. It
involves a cost of RM300 per year to operate. The new meter costs
RM4,000 and has a lifetime of 10 years. It also involves a cost of
RM140 per year to operate. If the cost of capital is 12% with taxation
disregarded, should the old machine be replaced?
Estimating the cash flows is one of the most important process and the most
complicated in decision making on capital budgeting.
The concept of additional cash flow after tax is used to ascertain the cash flow
of capital budgeting.
Among the important issues that can be used as a guide in estimating the
cash flow for capital budgeting are the sunk cost, opportunity cost and side
effects.
Increase in NWC must be taken into account in the calculation of initial cash
outlay and in the calculation of terminal cash flow.
Cash flow for capital budgeting can be classified into three, which are initial
outlay (IO), operating cash flow (OCF) and terminal cash flow (TCF).
Among the main items that are involved in the estimation of initial outlay are
the purchasing cost, installation and transportation cost incurred by new
assets, changes to the net working capital level of the firm and sales revenue
after tax of the old assets that must be sold if the project is accepted.
Among the main items that must be taken into account in the estimation of
operating cash flow are the changes to sales revenue, changes to cash
operating cost and changes in taxation. Operating cash flow can be seen as an
increase in the net income plus the increase in depreciation.
Among several important items that form the terminal cash flow is the sales
revenue after tax of the new asset, other expenses related to the termination
of the project and regaining the original level of net working capital.
INTRODUCTION
In Topics 4 and 5, we have discussed the relationship between the rate of return
with the risk in a security and the valuation process of bonds and shares. Next,
we will discuss cost of capital. Cost of capital is connected with the financing
decision and investment decision. It is the rate that must be achieved in an
investment before the shareholders wealth can be increased. The cost of capital
is often used interchangeably with the required rate of return by a company, the
rate of discount to evaluate new investments and opportunity cost of funds. Even
though its name is different, the concept remains the same.
In this topic, we will discuss the principle in determining the cost of capital of a
company and its rationale from the aspect of its usage and calculation. To obtain
the overall cost of the company or the weighted average cost of capital, we must
first obtain the cost for each capital resources, which are the cost of debts, cost of
preference shares and cost of ordinary shares.
250 TOPIC 8 COST OF CAPITAL
The rate of return required by investors is defined as the minimum rate of return
required to attract the interest of investors to buy or hold a security. The rate of
return is the return from the investment that pays the cost of capital and is also
an incentive to attract investors.
There are two factors that differentiate between the rate of return with the cost of
capital, which are taxation and the types of transactions involved. When a
company borrows funds for the purpose of buying assets, the interest expenses is
deducted from the earnings before tax. This means that the cost of debt of the
company will reduce. The second factor that differentiates the cost of capital with
the required rate of return is the cost of transaction involved when the company
increases its funds by issuing securities. The cost of this transaction is known as
the floatation cost and this cost increases the companys overall costs.
SELF-CHECK 8.1
The cost of capital, which is the combined cost of all the company's financing
resources (debt and equity) is known as the weighted average cost of capital. It is
the average cost after tax for each capital resources that is used by the company
to finance its project. Weight refers to the percentage of usage for each resources
from the total overall financing. Most companies will make an effort to maintain
the optimal financing combination of debt and equity or better known as the
target capital structure.
SELF-CHECK 8.2
SELF-CHECK 8.3
How do you think total cost of capital for the company is computed?
There are three important steps in the calculation for cost of debt, which are:
Step 1: Calculate the net value of debt (NPb) by taking into account the floatation
cost.
Step 2: Calculate the rate of return for debt that is required by investors. The
rate of debt return can be obtained by using the trial-and-error method or the
estimation method as explained in section 4.4, Topic 4.
By using the trial-and-error method, the different rates of discount kb, will be
applied in the following formula (Formula 4.2b in Topic 4):
The formula to calculate the rate of return by using the estimation method is as
follows:
M NPb
i
kb n
M NPb
2
Step 3: Calculate the cost of capital by taking into account the effect of taxation.
Example 8.1
Indah Company has sold bonds that have a maturity period of 20 years with a
coupon rate of 9%. The par value is RM1,000. The bond is sold at the price of
RM980 with a floatation cost of 2% based on the par value (2% x 1,000). What is
the cost of debt for Indah Company?
Calculation:
(b) Second Step, Calculate the Rate of Return for the Bond
You can use the trial and error method or the estimation method to obtain
the required rate of return.
From the calculations above, we find that the share value at the rate of
10% is RM915.26. This means that the cost of capital is between 9%
and 10%.
40.00
k b 9% (10% 9%)
84.74
9.47%
M NPb
i
kb n
M NPb
2
RM1, 000 RM960
90
20
RM1, 000 RM960
2
9.4%
(c) Calculate the capital cost of debt by taking into account the effect of
taxation. Assume that corporate tax is 34% per year.
The estimation method gives the answer of 6.2% while the trial-and-
error method gives a more accurate answer of 6.25%.
TOPIC 8 COST OF CAPITAL 255
EXERCISE 8.1
Maju Indah Company plans to issue bonds that have a maturity period
of 10 years with a par value of RM1,000 and pays an interest of RM55
every 6 months. These bonds are sold at the net amount of RM840.68
after taking into account the additional costs involved. If the rate of
corporate tax is 25%, what is the cost of debt after tax?
The cost of preference shares (kps) is the rate of return for preference shares,
which is the ratio of dividends for preference shares (Dps) compared to the net
earnings from sales of preference shares (Nps). Net earnings are the selling price
of preference shares minus the floatation cost.
To obtain the cost of preference shares (kps), we can use the formula (Formula 4.18
in Topic 4) as follows:
D ps
k ps
NPps
As the dividends of preference shares are paid from the cash flow after tax,
therefore the adjustment on tax is not required.
256 TOPIC 8 COST OF CAPITAL
Example 8.2
Calculate the cost of preference shares for Indah Company based on the
information as follows:
Calculation
RM0.87
(b) Kps =
RM8.20
= 10.6%
EXERCISE 8.2
(b) Second, there are two sources of financing for ordinary shares, which are
the retained earnings and the issuance of new ordinary shares. Both these
sources are different from the aspect of floatation cost. The use of retained
earnings does not involve floatation cost while the sale of new ordinary
shares involves floatation cost.
There are two methods that you can use to determine the cost of retained
earnings or the rate of return that is required by ordinary shareholders, which are:
D1
P0
k cs g
Where:
P0 = Value of ordinary shares
D1 = Current dividends
kcs = Required rate of return
g = Rate of dividend growth
To find the cost of ordinary shares or the rate of return for ordinary shares,
the formula above can be modified as follows:
D1
K cs g
P0
As the dividends of ordinary shares are paid from earnings after tax,
therefore there is no adjustment on tax.
258 TOPIC 8 COST OF CAPITAL
Example 8.3
The following is the financial information on Tuah Company.
Where:
kcs = Cost of ordinary shares for security j
krf = Risk-free rate
km = Rate of market returns
j = Beta of security j
Based on the equation above, we can estimate the use cost for retained
earnings as one of the components of capital as shown in example 8.4.
Example 8.4
Assume that the risk-free rate of Indah Company is 7%, the rate of market
return is 11% and the ordinary shares for the company have a beta of 1.5.
What is the cost of retained earnings?
D1
k cs g
NPcs
The cost of issuing new ordinary shares is usually higher than the cost of
existing shares and is usually higher than any other types of long term
financing cost. As the dividend is paid from the cash flow after tax, there
will be no adjustment for tax.
Example 8.5
Based on the financial information of Indah Company below, calculate the
cost of issuing new ordinary shares.
Solution:
RM0.40
K cs 0.05
RM4.45
0.14 or 14%
ACTIVITY 8.1
Why must we calculate all the costs for capital resources before
calculating the overall cost of capital?
260 TOPIC 8 COST OF CAPITAL
EXERCISE 8.3
3. What is the cost that can be connected with the internal equity of the
company?
4. Explain two approaches that can be used in the calculation for the
cost of ordinary shares.
(a) Calculate the cost for each capital resource (cost of debt, cost of preference
shares and cost of ordinary shares);
(b) Calculate the combined financing or capital structure that is the weight of
each resource that is used from the overall total financing of the company
(the capital structure is usually predetermined by the company); and
Where:
Wb = Weightage of debt
Kb = Cost of debt after tax
Wps = Weightage of preference shares
Kps = Cost of preference shares
Wcs = Weightage of ordinary shares
Kcs = Cost of ordinary shares
Example 8.6
Based on the financial information of Indah Company, calculate the WACC.
Therefore, the weighted average cost of capital (WACC), if the company uses the
retained earnings is:
If the company issues new ordinary shares, then the weighted average cost of
capital is:
262 TOPIC 8 COST OF CAPITAL
EXERCISE 8.4
The company can issue bonds that have a maturity period of 20 years
with a face value of RM1,000. The coupon rate for the bonds is 9%
and is sold at the price of RM980. The cost of issuing the bonds is 2%
from the face value of the bonds.
Preference Shares:
The company found that it can issue preference shares at the price of
RM6.50 per share with the annual dividend payment of RM0.80. The
cost involved in issuing and selling shares is RM0.30 per share.
Ordinary Shares:
The ordinary shares of the company are sold at the present price of
RM4 per share. The dividend that is expected to be paid at the end of
next year is RM0.50. The growth rate of dividends is constant, that
is at 8% every year. The company must pay the floatation cost of
RM0.10 per share.
3. The information below is the total financing for each capital resource
of Jati Company.
The cost of debt before tax is 9.37%, the cost of preference shares is
10%, the cost of ordinary shares is 13% and the marginal cost of tax is
34%. What is the weighted average cost of capital (WACC) for the
company?
4. How does the tax rate of the company affect the cost of capital?
The cost of capital is also known as the rate of return that is required by the
company.
The rate of discount and the opportunity cost of fund is the minimum rate of
return required by the company for its investments. Usually, it comprised of
three main components of capital resources, which are debt, preference
shares and the ordinary equities of the company that consist of retained
earnings and new ordinary shares.
To obtain the cost of capital for the entire financing of the company, firstly
you must determine the cost of capital for each component of the capital
resources, which are cost of debt, cost of preference shares and cost of
ordinary equity. Next, determine the overall cost of capital or the weighted
average cost of capital, which is the combination of all financing resources by
taking into account the financing combination.
TOPIC 8 COST OF CAPITAL 265
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the importance of cash budget and pro forma income
statement in financial management; and
2. Prepare cash budget and pro forma income statement.
INTRODUCTION
Topic 9 discusses the importance of financial planning, preparation of cash budget
and preparation of pro forma income statement. This topic also discusses the
importance of working capital management and the types of short-term financing.
Besides that, this topic will focus on the basis of cash management. It explains the
cash conversion cycle and its components, and the types of marketable securities
that are found in the market. It also touches on the management of account
receivable that is a part of the current asset of the company or the working capital
of the company. Finally, it discusses the management of current asset with the
lowest level of liquidity, which is the inventory.
SELF-CHECK 9.1
Financial planning that is practical and effective is very important in the
operations of a company. Who is responsible to plan and implement
these guidelines? Is it the responsibility of one individual or through
collective discussions?
TOPIC 9 FINANCIAL PLANNING 267
Before understanding the income statements even further, we need to look at the
guidelines for preparing the financial planning correctly. Generally, a financial
plan that is correct and complete should have the following criteria:
(a) Objective, strategy and operational plans that are clear;
(b) Assumptions that are used in the preparation of financial plans;
(c) Budgets that are classified according to the period and type;
(d) Projects financing that are classified according to the type and time period;
and
(e) Pro forma financial statement throughout the planning period.
After having some image on the initial steps of preparing a financial plan, the
next step is to understand the method of preparing a cash budget.
SELF-CHECK 9.2
Cash budget is a summary of the receipt and payment of cash that is expected for
a short period of time. Normally, it is prepared for a planning period of six
months or one year. It can show how the cash flow is planned for a specific time,
whether it is a cash inflow or cash outflow.
Besides that, cash budget is very important to the company as the sales and profit
obtained cannot ensure that the company will have enough cash to fulfil its
financial obligations. Instead, the cash budget can assist the company to know
the cash status of the company in the effort to ensure that the cash flow of the
company is strong and stimulating. The following are several terms that are often
used in cash budget.
268 TOPIC 9 FINANCIAL PLANNING
Example 9.1
The example below shows how a cash budget is prepared. The following are
several information and assumptions for preparing the cash budget of Nuri
Company.
(a) Cash budget will be prepared for the months of March, April and May. The
information required are as follows:
(ii) Sales forecast for the months of March, April and May.
(iii) Cash sales are 25% and the balance are credit sales. For credit sales,
80% of it will be collected in the next month and 20% will be collected
two months after the sale.
(b) The purchase of raw materials is predicted at 60% of sales and the payment
will be made a month later.
(e) The company will pay insurance premiums of RM2,800 in the month of
March.
(f) The purchase of a new asset involving a cost of RM25,000 will be made in
the month of March.
(h) The cash balance that the company intends to hold every month is
RM10,000.
270 TOPIC 9 FINANCIAL PLANNING
Solution
Step 1: Complete the schedule of cash received for the months of March to May.
Collections:
Cash sales (25%) 15,000 22,500 21,250
80% from last months sales 39,000 36,000 54,000
20% from last two months sales 6,750 9,750 9,000
Total cash inflow 60,750 68,250 84,250
Step 2: Complete the schedule of cash payment for the months of March to May
Next, we will make the following financial forecast for the purpose of forming a
series of pro forma financial statements:
(a) The company can estimate the level of account receivables, inventory,
account payable and other accounts in the future to fulfil the requirement
for loans and expected profits.
(b) The finance officer can make detail evaluation on the actual financial
statements that had been planned and from thereon make adjustments.
(c) The finance manager and creditors can evaluate in advance the level of the
companys profitability and the overall achievement of the company.
ACTIVITY 9.1
Budget is a forecast and forecast is often not accurate. What is the way
to ensure that the forecast in the estimation of the companys cash flow
achieves the objective without any contradiction or error?
EXERCISE 9.1
(i) 80% are credit sales; 80% of credit sales will be collected in the
next month; 15% will be collected 60 days after sales and 4%
more will be collected 90 days after sales. The company had to
bear 1% of credit sales as uncollectible debt (bad debt).
(ii) Purchases made every month are 65% of sales forecasted for
the next month. Payment for these purchases will only be
made one month after purchase.
(viii) Labour expenses are 10% of sales for the next month.
(xi) Sales forecast for the first seven months in the year 2011 is as
follows:
(i) Any sales trend expected for the company which will be repeated in
the coming years; and
(ii) Any factor or occurrence that may have a significant effect on the
sales trend of the company.
274 TOPIC 9 FINANCIAL PLANNING
Generally, these variables should change according to the changes in sales. For
example, if sales increase, then surely its expenditure, especially the costs will
change; will increase with the increase in sales. Assets must also be increased as
more assets, whether current assets or fixed assets, are needed to support the
increase in sales and those financial variables.
Step 1
Prepare the sales forecast.
TOPIC 9 FINANCIAL PLANNING 275
Step 2
Determine the production schedule and requirements for materials, labour and
expenditure.
Step 3
Calculate other expenditures
(a) Administration and general expenses
(b) Interest expenses
276 TOPIC 9 FINANCIAL PLANNING
Step 4
Prepare the pro forma income statement
Example 9.2
By using the information in Example 9.1, prepare a pro forma income statement
for Nuri Company for the month of May. The following are the additional
information:
Nuri Company
Pro forma Income Statement
for the month of May
(RM) (RM)
Sales revenue 85,000
Cost of goods sold
Opening inventory 20,000
Purchases (60% 85,000) 51,000
71,000
Closing inventory (40,000)
Cost of goods sold (31,000)
Gross profit 54,000
Operating expenditure
Office and warehouse rental expenses 4,500
Wages expenses 5,000
Operating expenditure (9,500)
Operating profit before interest and tax 44,500
Tax (13,350)
Earnings after tax 31,150
ACTIVITY 9.2
An auditor has detected an obvious difference in the net cash flow from
the accounting files of your company for the last two years period.
There is a possibility that it might be due to a recording error or there is
discrepancy by the companys employees. What action should be
taken?
278 TOPIC 9 FINANCIAL PLANNING
EXERCISE 9.2
You have been exposed to the importance of financial planning via the
preparation of pro forma income statement and cash budget in Topic 9.
Companies can make evaluations and detailed adjustments to maximise
profit through the comparisons of cash inflow with cash outflow.
Cash budget is a summary of the receipt and payment of cash that is expected
for a short period of time.
A pro forma income statement provides the forecast on the total profitability
that can be obtained by the company throughout a specific time period.
TOPIC 9 FINANCIAL PLANNING 279
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe the importance and strategies of working capital
management;
2. Explain the types and sources of short-term financing;
3. Evaluate the efficiency of a firms management of its working
capital based on cash conversion cycle;
4. Elaborate on the importance of marketable securities;
5. Assess the factors that influence the management of accounts
receivable; and
6. Identify costs that are related to inventory and explain how
inventory management decisions are made.
INTRODUCTION
Working capital management refers to the management of current assets and
current liabilities that are required for the daily operations of the company. It
involves the determination of working capital policy and the implementation of
this policy in the daily operations.
Working capital policy comprised of the working capital level and how the
working capital should be financed. For example, a firm needs to make a decision
on how much cash that needs to be kept in the accounts and the inventory level
that needs to be maintained. Besides that, a firm also needs to make decisions on
whether to finance its current assets with short-term fund, long-term funds or a
combination of both.
TOPIC 10 WORKING CAPITAL MANAGEMENT 281
SELF-CHECK 10.1
Working capital is required for the daily operations of the company. Efficient
working capital management is important to ensure that the firm does not have
any liquidity problems that will effect the operations of the company. At the
same time, efficient working capital management also means that the company
was successful in conducting its business without too much funds being tied up
in the form of current assets.
Current assets and current liabilities are the main items in the daily operations.
Most of the managements time is focused on the working capital management
such as:
(a) Controlling the cash inflows and outflows;
(b) Preparing credit facilities to customers; and
(c) Always ensuring adequate stock.
Example 10.1
Based on the above summary balance sheet of Endah Company Sdn. Bhd., the
net working capital for Endah Company Sdn Bhd is:
This shows that Endah Company has the ability to fulfil its short-term financial
claims whenever required. In other words, the net working capital can be used as
a measurement of the companys liquidity.
(a) Cash
Money in hand or bank.
(d) Inventory
Commercial goods that will be sold to customers.
For example, when the festive season is approaching, companies that sell clothes
will increase their inventory to fulfil the demand that will normally increase. This
increase in inventory is only temporary because after the festival, the inventory
level will return to its normal level.
After the current assets had been categorised into permanent current assets and
temporary current assets, the next question will be related to the sources of
capital financing that are used to finance the investment in these assets. To match
the financing with the investments, the sources of financing also have to be
categorised into permanent financing source and temporary financing source.
284 TOPIC 10 WORKING CAPITAL MANAGEMENT
ACTIVITY 10.1
Try to obtain the annual reports of several companies and refer to their
balance sheets. Calculate the average percentage of current assets
compared to the total assets of the companies. What can you summarise
from the results of your calculations?
SELF-CHECK 10.2
The net working capital management is especially drawn-up to explain the level
of investments that are suitable for current assets. Working capital management
involves financial decisions making that are simultaneously and interrelated with
investments in current assets together with the financing of these assets. One of
the methods used in working capital management is the matching of the assets
lifetime with the financing period used. This method is known as the hedging
principle. The hedging principle is also known as the matching principle or the
principle of self-liquidating debt.
The hedging principle matches the cash flow characteristics of an asset with the
maturity period of financial source that is used to finance that asset. How is this
hedging principle implemented? There are three approaches that can be used to
implement this principle, which are:
(a) Moderate approach;
(b) Aggressive approach; and
(c) Conservative approach.
TOPIC 10 WORKING CAPITAL MANAGEMENT 285
EXERCISE 10.1
1. What are the main components of current assets and why are these
components also known as liquid assets?
2. How are the assets and liabilities of a company classified for the
purpose of capital management?
SELF-CHECK 10.3
Example 10.2
Endah Company Sdn Bhd has made a purchase on credit from the supplier
for RM800 on the terms of 3/10 net 30. If the company made the payment
within 10 days, it will pay only RM776 because the cash discount of RM24
would be deducted from the invoice.
In summary, the company is assumed to have made a loan of RM776 for the
period of 20 days with the interest payment of RM24. Therefore, with the
assumption of 365 days a year, the annual cost borne by Endah Company
Sdn Bhd as a result of foregoing the discount offered can be estimated as
follows:
RM24 365
Annual cost
RM776 20
0.564 or 56.5%
Based on the calculation above, Syarikat Endah Sdn Bhd had to bear the
annual cost of 56.4% if it did not accept the discount offer of 3/10 net 30.
(b) Accruals
Accruals exist when there is a delay in payment. For example, the
employees salaries will only be paid at the end of each month and also the
employees salaries deduction (EPF and SOCSO) by the employer will only
be made on the 20th of the month. Financing sources through accruals do
not involve any costs. It is free to the company as long as it does not affect
the credibility of the company.
TOPIC 10 WORKING CAPITAL MANAGEMENT 289
(a) Overdraft
Overdraft is a credit facility provided by banks to its customers. It is
channelled through the customers current accounts, where the customer is
allowed to withdraw money in excess of the balance in its current account.
However, there is a limit set on the withdrawal. For example, Endah
Company Sdn. Bhd. received an overdraft facility for RM50,000. This means
that the company can use the funds provided by the bank until the balance
in its account reaches RM50,000.
Overdraft facilities are very useful to a company that wishes to take the
cash discount offered by the supplier. The cost that needs to be borne by the
customer who uses the overdraft service is the interest that is applied based
on the negative balance of the customers current account.
Example 10.3
Endah Company Sdn Bhd has obtained a bank loan of RM200,000 for a
period of 3 months at the rate of 15% per year. At the end of the period,
Endah Company Sdn Bhd repaid the principal together with its interest.
Before making calculations for the effective cost of the loan, the interest
amount must be ascertained in advance.
RM7,500
Effective cost
RM200,000 1
4
0.15 or 15%
290 TOPIC 10 WORKING CAPITAL MANAGEMENT
If you look at the example, the effective cost of 15% is the same with the rate
of the bank loan. However, there are two characteristics in the cost of short-
term loan that will make its value higher than the nominal interest rate.
These characteristics are the compensating balance and the discounted
interest.
To obtain the effective cost of this loan, we need to obtain the value for:
Interest amount;
Compensating balance; and
Value of net loan
RM7,500
Effective cost
RM180,000 1
4
0.1667 or 16.7%
Based on the calculation above, the effective cost of the loan is higher
compared to the value before there was a compensating balance.
TOPIC 10 WORKING CAPITAL MANAGEMENT 291
By using Example 10.3, the calculation of interest, net amount and the
effective cost for Endah Company Sdn Bhd are as follows:
Commercial papers are issued at a discounted price where the selling price
is the face value after deducting interest. The cost involved in the issuance
of commercial papers comprised of all the expenditures that are directly
involved in the issuance of this security. For example, a company that
issues commercial papers will obtain the services of a merchant bank to sell
it to the investors. All these expenditure must be taken into account in
estimating the effective cost of financing through commercial papers.
292 TOPIC 10 WORKING CAPITAL MANAGEMENT
Example 10.4
Endah Company Sdn Bhd will issue commercial papers that have a value of
RM20 million with a maturity period of 6 months. The interest rate for these
commercial papers is 10%. The cost involved in issuing these commercial
papers is RM50,000.
RM1.05
Effective cost =
RM19 million 1 2
= 0.1105 or 11%
(d) Factoring
Factoring is a transaction that involves the purchase of account receivables
or the invoices from supplier companies by the factoring companies.
Financial institutions that conduct these factoring activities are known as
factor. It comprised of takeover and administration of account receivables
as well as the activity of collecting debt.
The cost of financing that is counted by factoring is the total financing and
expenditure involved such as the factoring fee (1% to 3% from the invoice
value), interest on deposit and reserves (a small percentage that is held by
factor). The balance value of the invoice payable by factor will only be
settled to the company when the entire account receivables have been
collected.
TOPIC 10 WORKING CAPITAL MANAGEMENT 293
Example 10.5
Endah Company Sdn Bhd has factorised the account receivable totalling
RM200,000. The credit period of the company is 60 days. The factoring fee is
3.5% of the invoice value while the reserves are at 7.5%. The interest rate
that is charged on the deposit is 12% per year. When the deposit is received,
the fees and interest must be settled. Based on previous practice of the
company, it will give cash deposit of 60% of the invoice value.
RM7,000 RM1,960
Effective cost =
RM96,040 2 12
= 0.5598 or 55.98%
Based on the calculation above, the effective cost of this financing is 55.98%
and the company obtains a deposit of RM96,040 for the period of 2 months
at the cost of RM8,960 (fees and interest). If all the account receivable can
be collected successfully, the balance of RM80,000 including reserves of
RM15,000 will be given by the factor to Endah Company Sdn Bhd.
ACTIVITY 10.2
EXERCISE 10.2
2. Z-tron Company has obtained a loan from the bank for RM10,000
for a period of 90 days at the interest rate of 15% payable on the
maturity date of the loan. Assume that there are 360 days in a year.
(a) How much is the total interest (in Ringgit) that must be paid
by Z-tron Company for this loan?
(b) Calculate the effective cost for this loan.
TOPIC 10 WORKING CAPITAL MANAGEMENT 295
SELF-CHECK 10.4
What will happen if the cash conversion cycle exceeds the period that
had been set?
296 TOPIC 10 WORKING CAPITAL MANAGEMENT
The cash conversion cycle refers to the time period taken from the payment for the
purchase of raw materials to the receipt of cash from the sale of goods. Figure 10.4
shows the three main components in the cash conversion cycle, which are:
Example 10.6
Now, we will look at an example on how the calculation for cash conversion
cycle is made. Jaya Jati Company manufactures office fittings such as tables and
chairs. The following are the cash dealings of the company:
(a) Purchase of raw materials on credit for the production of tables and chairs
and the company is given a period of 30 days to make payment.
(b) Employees will be paid at the end of the month (that is after 30 working
days).
(c) The customers of the company will purchase the goods on credit.
Therefore, the account receivables will exist when sales are made.
(d) The payment for raw materials and wages must be made at the date
promised. As the cash from the credit sales have not been received, the
company has to finance the cash flow with short-term loans.
(e) The cash cycle will be complete when cash from the credit sales are
received. Subsequently, the cash will be used to pay the short-term loans
that were taken to pay for the raw materials and wages of employees.
TOPIC 10 WORKING CAPITAL MANAGEMENT 297
Sales of Jaya Jati Company are RM1,500,000, while the average inventory is
RM350,000. Account receivables are RM85,750. Assume that there are 360 days in
a year.
Based on the information, the cash conversion cycle for Jaya Jati Company can be
calculated as follows:
Inventory
Inventory conversion period
Sales/360
RM350,000
RM1,500,000/360
84 days
Account receivable
Account receivable
Sales/360
RM85,750
conversion period
RM1,500,000/360
21 days
(a) Requires 84 days to convert the raw materials into finished goods (office
chairs and tables);
(b) Has 21 days to obtain cash from the sales made on credit; and
(c) Has 30 days to make payment on the purchase of raw materials and
utilisation of labour.
298 TOPIC 10 WORKING CAPITAL MANAGEMENT
Therefore, the time period between the withdrawal of cash (payments that were
made for the purchase of raw materials and utilisation labour) and the receiving
of cash from the sales is 75 days.
EXERCISE 10.3
Sales RM 450,000
Average inventory RM 50,000
Account receivables RM 15,000
SELF-CHECK 10.5
The companies owners would sometimes use the surplus funds of the
company to insert in marketable securities to obtain some returns. Is
this a wise action?
TOPIC 10 WORKING CAPITAL MANAGEMENT 299
Companies that have surplus funds can temporarily invest these funds in
marketable securities. By doing this, the company can convert the securities into
cash in a short period of time and obtain some return from the investment.
(b) Liquidity/Marketability
Liquidity/marketability refer to the ability of the security to be converted
into cash in a short period of time.
(c) Taxation
Interest that is obtained from the marketable security which is not financed
by the federal government will be taxed.
(d) Returns
The criteria of returns involve evaluation of risk and interest for each factor
stated above.
EXERCISE 10.4
SELF-CHECK 10.6
Cash management involves a balance between risk and rate of return. Cash that
is insufficient will cause the risk of liquidity or insolvency to the company such
as the failure to fulfil liabilities at the predetermined time. A cash holding that is
too high will reduce the companys returns as cash is an asset that does not have
any return.
Therefore, the management must look at the effect of risk and rate of return of
the company in determining the optimal holding level of cash and marketable
securities. Decisions on the level of risk that will be taken by the company depends
on the decision that has been determined by the companys management.
(a) Company has sufficient cash to fulfil the requirements of its transactions;
and
(b) Cash surplus must be at the minimum level as cash does not have any return.
ACTIVITY 10.3
EXERCISE 10.5
Give the definition for the following terms:
(a) Liquid assets
(b) Cash
(c) Marketable securities
The total account receivable for a company at a specific time is determined by the
following two factors:
(a) Credit sales level of the company; and
(b) Average collection time.
Changes in any one of these factors will cause a change in the total account
receivable for the company. Therefore, the account receivable for a company at a
specific time can be determined as follows:
Example 10.7
Rania Company is a company that manufactures plastic goods. It has an annual
sales of RM250,000 per year. All sales were made on credit and the credit terms is
2/15 net 30. Based on previous experience, 60% of the companys customers will
take the discount and pay on the 15th day. In the meantime, the other 40% will
make payments on the 30th day. Assuming that there are 360 days in a year,
calculate the total account receivable for Rania Company.
This means that the average account receivable for Rania Company at a specific
time is RM14,583.33.
EXERCISE 10.6
Assuming the credit terms of 2/10 net 30. This means that customers will
get a 2% discount from the invoice price if payment is made within 10 days
of the invoice date. Customers who do not take this discount will have to
make payment within 30 days.
You can refer to Figure 10.5 to get a graphical illustration of credit terms.
304 TOPIC 10 WORKING CAPITAL MANAGEMENT
There are two things that form the credit term, which are:
Example 10.8 can help you to understand the credit terms of a company
more clearly.
Example 10.8
On 2 February 2001, U-Pen Company made credit sales amounting to
RM85,000 based on the terms 3/15 net 30. If the customers pay within the
period of 15 days, which is until 17 February, they will get a discount of 3%.
Customers who do not take the discount are given 30 days to settle the
payment at the invoice price of RM85,000.
The application of the credit standards can be seen via an analysis of the
customers credit applications conducted by companies via the 5C system.
This system is a subjective value measurement method that is widely used
among credit managers.
This method measures the credit quality that comprised of five main
sections, which are:
(i) Capacity/Capability
The capacity factor refers to the capacity or capability of the customer
to make payments as predetermined. Valuation can be made based
on the consideration of business practice including the customers
previous records, especially those related to the pattern and trend of
payments.
(iii) Capital
The capital factor refers to the overall financial status of the
customers. For the purpose of credit evaluations, emphasis is made on
the ratio related to the customers ownership status such as the debt
equity ratio, liquidity ratio and interest coverage ratio.
(iv) Character
Character refers to the enthusiasm shown by the customers in
fulfilling their promise to make payments as mutually agreed.
(v) Collateral
Collateral refers to any fixed assets that are pledged for the credit
facilities. Finance managers will evaluate the collateral based on the
value and the marketability of the asset pledged.
TOPIC 10 WORKING CAPITAL MANAGEMENT 307
The following are the methods normally used to collect account receivable
that had exceeded the payment period set:
(i) Sending reminder letters.
(ii) Making telephone calls.
(iii) Personal visits.
(iv) Forwarding the accounts to collection agency.
(v) Legal action.
(vi) Including those accounts as bad debt account.
EXERCISE 10.7
3. List five factors that are evaluated in the usage of the 5C system.
Example 10.9
E-Zet Company sells goods on credit with the terms of 2/15 net 40. Based
on previous experience, customers who will take the discount and make
payments on the 15th day are 70% and the rest will pay on the 40th day.
The credit sales of the company are RM80,000. Assume that there are
360 days in a year.
If the annual sales are RM80,000, therefore the average credit sales per day
are as follows:
RM80,000
Average credit sales per day =
360
= RM222.22
Example 10.10 shows how the ageing schedule assists the management in
controlling the companys account receivables. Both company NZJ and company
ZBZ had offered credit terms of 4/15 net 30 days to customers who deal on
credit. The total account receivables for both of these companies are RM4,000,000.
The following is the ageing schedule for both companies:
TOPIC 10 WORKING CAPITAL MANAGEMENT 309
Example 10.10
The ageing schedule above shows that 15% of the customers from NZJ Company
had exceeded the credit period that has been set while 35% of customers from
Company ZBZ had failed to pay within the period set.
Both these companies need to look at the credit policy that was set to identify the
problems faced in credit management of the company.
The management of account receivable starts from the decision on whether the
company should sell by credit or not. In relation to this, the company will set
specific policies in managing the account receivable which is normally known as
companys credit.
A loose credit policy normally will increase sales and this will bring a higher rate
of return. However at the same time, this policy will also increase the risk of bad
debts for the company. The increase in this risk will have a negative effect on the
rate of return for the company.
310 TOPIC 10 WORKING CAPITAL MANAGEMENT
On the other hand, a strict credit policy will reduce the sales of the company.
However, this policy will reduce the risk of bad debts and will indirectly have a
positive effect on the rate of return for the company. Therefore, in choosing a
specific credit policy, the management of the company must take into account the
effect of the credit policy on the overall risk level and the rate of return of the
company.
ACTIVITY 10.4
You were shocked to receive a tax claim of RM2 million for the business
period of the last three years. Before this, you had expected your
business to be given tax exemption by the government but you do not
have any written documents regarding this matter. This tax must be
settled in full without any instalment payments and you must inform
this issue to the members of the board of directors. What will be your
next course of action?
EXERCISE 10.8
1. Biru Company offers the term of 3/10 net 30 to all the customers
who purchase its goods. Assume that 60% of its customers take
the discount while the rest pays on the 30th day. The annual sales
of Biru Company is RM500,000. Calculate the average account
receivables of Biru Company with the assumption that there are
360 days in a year.
3. Mrs Latifah buys supplies for her bakery for RM3,500 from Zarina
Supplier Company with the credit term of 2/15 net 30 on 15 June
2011. What is the payment amount made by Mrs Latifah if she
makes payment on 27 June 2011?
TOPIC 10 WORKING CAPITAL MANAGEMENT 311
(b) Supplies
Supplies are goods that are used in the manufacturing process or the
operations of a business. However, supplies are not the main items in
finished goods. It is the supplementary items that are used in the
production of final product.
SELF-CHECK 10.7
2. Supplies ______________________
The carrying cost of inventory has a direct connection with the average
inventory. This means that the carrying cost of inventory will increase with
the increase in the average inventory held.
The formula and Figure 10.7 assumed that when inventory is ordered, the total
inventory kept is equal to 0 (all inventory ordered had been completely sold).
Example 10.11:
Intoll Company sells 150,000 (S) units of computer per year. The inventory is
ordered four times per year (N) and each order (Q) is 37,500 units. The purchase
price (P) is RM3.50 per unit. The cost of capital to finance the inventory is 10%
of the average inventory value. Warehouse cost is RM3,500 insurance cost is
RM1,000, and depreciation cost is RM500.
Average inventory A
37, 500
=
2
18,750
314 TOPIC 10 WORKING CAPITAL MANAGEMENT
By using the information that the inventory purchasing price is RM3.50 per unit,
the average value of inventory is:
The next step is to identify the costs involved in holding the inventory. Based on
the information given, the costs involved are financing costs, warehousing costs,
insurance costs and depreciation costs.
The ordering cost of inventory is a constant cost. Ordering cost is fixed for
specific order without taking into account the size of the order made. The
total ordering cost can be calculated as follows:
Where:
F = Fixed cost for an order
S = Sales unit per year
A = Average inventory
Example 10.12
If S = 150,000 units, A = 18,750 units and F = RM500, what is the total
ordering costs?
150,000
Total ordering cost (TOC) 500
2(18,750)
RM2,000
Based on the previous calculation example, the total inventory cost can be
calculated as follows:
The Economic Order Quantity Model which is also known as EOQ Model is the
method used to ascertain the optimal order quantity of inventory for a company.
Figure 10.8 shows the EOQ Model graphically.
Figure 10.8 shows that the cost of carrying inventory increases with the increase
in average inventory (please refer to the TCC line; Total Carrying Cost). This
means that a high order quantity will increase the carrying cost of inventory
that must be borne by the company. Therefore, costs that are related with this
inventory activity such as insurance, tax and storage will increase with the
increase in average inventory.
The ordering cost will decrease when the order quantity of inventory increases.
This is because a bigger order size will reduce the frequency of the orders. This
can be seen in the figure above which shows that the TOC (Total Ordering Cost)
curve will decrease when the order quantity increases.
TOPIC 10 WORKING CAPITAL MANAGEMENT 317
The total carrying cost and ordering cost are the total inventory cost (please refer to
the TIC curve; Total Inventory Cost). The minimum level at the TIC curve (as shown
by the dotted line) is the EOQ level which is the optimal order quantity of inventory
for the company. In Figure 10.8, we found that the TCC curve (total carrying cost
curve) and the TOC curve (total ordering cost curve) also crosses at this level. This
shows that at EOQ level, the total carrying cost and the total ordering cost are the
same. Therefore, also at this level, the total inventory cost is at the minimum level.
2(F)(S)
EOQ =
(C)(P)
Where:
EOQ = Economic order quantity
F = Fixed cost in ordering
S = Annual sales (units)
C = Carrying cost (percentage of inventory value)
P = Purchase price per unit of inventory
Example 10.13
The sales of Zulia Company is 50,000 units per year. The percentage of storage
cost is 20% of inventory value. The purchase price is RM15 per unit and the
ordering cost for each order is RM1,500. Based on the information given, the
EOQ level is as follows:
S = 50,000 units per year
C = 20% or 0.2
P = RM15
F = RM1,500
318 TOPIC 10 WORKING CAPITAL MANAGEMENT
2(1,500) (50,000)
EOQ
(0.2)(15)
7,071 units
This means that Zulia Company will order 7,071 units each time an order is
made. Therefore, the orders will be made seven times per year (50,000/7,071).
The total cost involved with the order level of 7,071 units are:
Therefore, the total inventory cost at EOQ quantity is RM21,212 and the total
carrying cost (TCC) and ordering cost (TOC) is the same at RM10,606.
The appropriate time to reorder inventory is known as the reorder point. The
reorder point refers to the inventory level where the next order needs to be made.
The determination of the reorder level is important to avoid problems in shortage of
inventory or depleted inventory. Three factors that influence the reorder point are:
Figure 10.10: Effect of lead time and safety stock on the reorder point
Sales
Reorder point lead time
52 weeks
320 TOPIC 10 WORKING CAPITAL MANAGEMENT
Example 10.14
D-Dee Company sells 130,000 units of inventory per year. Assume that the sales
are constant throughout the year. Therefore, the usage of inventory per week is
2,500 units (assume that there are 52 weeks in a year). If the lead time is 3 weeks,
the calculation of the reorder point is as follows:
Sales
Reorder point lead time Goods in Transit
52 weeks
Figure 10.11: Effect of safety stock, lead time and goods in transit on the reorder
point
TOPIC 10 WORKING CAPITAL MANAGEMENT 321
Example 10.15
Assume that a company takes 3 weeks to wait for a new order to be received and
the weekly usage is 2,500 units. The order quantity is 2,000 units and the time
between orders is 2 weeks. The inventory level when new orders must be made
is as follows:
In the example above, the company needs to reorder inventory at the level
of 5,500 units after taking into account the stock lead time for the order of
7,500 units to be received and the goods in transit of 2,000 units that would
arrive.
EXERCISE 10.9
3. Explain the assumptions that are made to enable the usage of the
EOQ Model.
The next example that will be discussed will show how the holding level of the
companys inventory will affect the risk and the rate of return of the company. A
grocery store must make investments in inventory. It cannot operate if there is
absolutely no inventory to sell. Therefore, the store owner must make estimation
on the level and type of inventory that will be sold in its store. The risk that may
be faced by the store owner is the risk of losing its customers. For example,
holding inventory that is too low will cause the store to be always out of stock
and regular customers will have to go to another store.
ACTIVITY 10.5
EXERCISE 10.10
Account receivables exist when sales are made on credit. Account receivables
at a specific period are influenced by the credit sales level of the company
and the time period required in collecting cash from those credit sales.
Inventory management involves a balance between risk and the rate of
return.
Answers
TOPIC 1: INTRODUCTION TO FINANCE
Exercise 1.1
1. wealth; price
2. Maximising profit
3. D
4. D
Exercise 1.2
1. taxed twice; dividends
2. withdraws; dies or becomes bankrupt
3. Dividend
4. A
5. B
Exercise 1.3
1. C
2. D
3. B
4. Separation of ownership and management means that you cannot be
interacting with the manager whenever you want. However, you are the co-
owner of the company; you share the success or failure of the company via
dividends payment by the company and the price of the shares traded; you
can vote in the election of the board of directors who control and appoint the
management.
326 ANSWERS
(b) Minimising cost might also be against the objective of maximising the
value of the company. For example, assume that the company accepts a
large order for its product. The company must be willing to pay wages
for overtime and bear the additional costs to fulfil that order only if it
can sell the additional product at a price in excess of these costs.
(c) Lowering prices to compete with rivals may result in the company
selling the goods at a price lower than the price needed to maximise
shareholders wealth. Again, in certain situations, this strategy can be
accepted but it must not be regarded as the ultimate objective of the
company. It must be valued by taking into consideration its effect on
the value of the company.
6. (a) Fixed salary means that compensation (in the short term) does not
depend on the achievement of the company.
(b) Salary that is related to the profit of the company will bind the
managers compensation with the success of the company. However,
profitability is not the appropriate method to measure a companys
success. We had already discussed earlier that the objective to maximise
profit is only a short-term objective that does not look at the long-term
prospects of the company.
(c) Salary that is partially paid by company shares means that the manager
will obtain the highest returns when the shareholders wealth are
maximised. Therefore, this compensation will lead the manager to act in
accordance with the interest of the owners.
ANSWERS 327
(1) (2)
Account
Statement Type of Account
Account payable BS CL
Account receivable BS CA
Accrual BS CL
Building BS FA
General expenses IS EX
Interest expenses IS EX
Sales expenses IS EX
Operating expenses IS EX
Administrative expenses IS EX
Tax IS EX
Preference shares dividends IS EX
Sales revenue IS R
Long-term loans BS LTL
Inventory BS CA
Cost of goods sold IS EX
Paid-up capital above par BS SE
Notes payable BS CL or LTL
Retained earnings BS SE
Equipments BS FA
Ordinary shares BS SE
Preference shares BS SE
Marketable securities BS CA
Depreciation IS EX
Accumulated depreciation BS FA (contra account)
Land BS FA
Cash BS CA
328 ANSWERS
7.
Company PC
Income Statement
for the Year Ended 31 December 2011
Sales RM5,250,000
Less: Cost of goods sold 2,850,000
Gross profit RM2,400,000
Less Operating expenditure
Sales expenses RM350,000
Administrative and general expenses 600,000
Depreciation expenses 550,000
Total operating costs RM1,500,000
Profit before interest and tax RM900,000
Interest expenses 250,000
Profit before tax RM650,000
Tax (30%) 195,000
Profit after tax RM455,000
Less: Preference shares dividend 100,000
Net profit (or profit available for ordinary
shareholders) RM355,000
Earnings per share RM 0.17
ANSWERS 329
8.
Company ODC
Balance Sheet
as at 31 December 2011
Assets
Current assets
Cash RM2,150,000
Marketable securities 750,000
Account receivable 4,500,000
Inventory 3,750,000
Total current assets RM11,150,000
Fixed assets
Land RM2,000,000
Building RM2,250,000
Machines 4,200,000
Equipments 2,350,000
Total fixed assets RM10,800,000
Less: Accumulated depreciation 2,650,000
Fixed assets, net 8,150,000
Total Assets RM19,300,000
Equities
Preference shares RM1,000,000
Ordinary shares 900,000
Paid up capital 3,600,000
Retained earnings 2,100,000
Total equities RM7,600,000
Total liabilities and equities RM19,300,00
330 ANSWERS
Exercise 2.2
1. (b) False
2. (b) False
3. (a) True
4. (b) False
5. C
6. D
7. (a)
Hugo Enterprise
Statement of Retained Earnings
for the year ended 31 December 2010
RM37,700 RM4,700
(b) Earnings per share = = RM2.36
14,000
RM21,000
(c) Dividends per share = = RM2.36
14,000
ANSWERS 331
9.
Changes
Items Cash Flow
(RM)
Cash +1,000 U
Account payable 10,000 U
Notes payable +5,000 R
Long-term loans 20,000 U
Inventory +20,000 U
Fixed assets +4,000 U
Account receivable 7,000 R
Net profit +6,000 R
Depreciation +1,000 R
Share buyback +6,000 U
Cash dividend +8,000 U
Sale of Share +10,000 R
332 ANSWERS
10.
Suresh Corporation
Changes in balance sheet items
between 31 December 2011 and 31 December 2012
Assets
Cash 15,000 10,000 +5,000 5,000
Marketable securities 18,000 12,000 +6,000 6,000
Account receivable 20,000 18,000 +2,000 2,000
Inventory 29,000 28,000 +1,000 1,000
Total fixed assets 295,000 281,000 +14,000 14,000
Less: Accumulated depreciation 147,000 131,000 (16,000) 16,000
Liabilities
Account payable 16,000 15,000 +1,000 1,000
Notes payable 28,000 22,000 +6,000 6,000
Wages accrual 2,000 3,000 1,000
Long-term loans 50,000 50,000 0
Equities
Preference shares 100,000 100,000 0
Retained earnings 14,000 28,000 +6,000 6,000 1,000
TOTAL RM29,000 RM29,000
ANSWERS 333
Suresh Corporation
Cash Flow Statement
For the Year Ended 31 December 2012
Exercise 2.3
1. Fazrul Company
2009 2008
(a) Net working capital RM180,000 RM150,000
(b) Current ratio 2.5 times 2.07 times
(c) Quick ratio 1.17 times 1 time
334 ANSWERS
Exercise 2.4
Fazrul Company
2009 2008
(a) Account receivable turnover 9.14 times 9.03 times
(b) Average collection period 39.9 days 40.4 days
(c) Inventory turnover 2.54 times 2.57 times
(d) Average inventory sales period 144.27 days 142.02 days
= 144 days = 142 days
(e) Fixed asset turnover 2.13 times 2.15 times
(f) Total asset turnover 1.07 times 1.02 times
Exercise 2.5
(a) Debt ratio = 50%
(b) Interest coverage ratio = 3 times
(c) Return on asset = 36%
(d) Average collection period = 27 days
(e) Total asset turnover = 2 times
Exercise 2.6
1. Liquidity
2. current asset; current liability
3. Inventory
4. cost of goods sold; inventory
5. total asset
6. net profit; owners equity
7. share price; earnings
ANSWERS 335
8.
X-Cell N-Hance
(a) Return on assets 12.67% 11.25%
(b) Return on equity 31.67% 28.13%
(c) Net profit margin 10.27% 9.57%
(d) Total asset turnover 1.23 times 1.18 times
(e) Debt ratio 60% 60%
(f) Equity multiplier 2.5 times 2.5 times
(g) Interest coverage ratio 7.89 times 8.37 times
(h) Price earnings ratio 6.25 12.62
(i) Dividend yield ratio 6.86% 1.89%
Exercise 2.7
1. (a) True
2. (b) False
3. D
4. C
7. Fima Corporation
(a) Current ratio increased.
(b) Return on equity decreased.
(c) Debt ratio increased.
(d) Dividend yield increased.
(e) Account receivables turnover decreased.
(f) Return on asset decreased.
336 ANSWERS
8. Lily Corporation
(a) Current ratio = 0.91 times
(b) Quick ratio = 0.63 times
(c) Average collection period = 32.5 days
(d) Inventory turnover = 20 times
(e) Fixed asset turnover = 4.60 times
(f) Total asset turnover = 2.8 times
(g) Debt ratio = 55%
(h) Interest coverage ratio = 4.0 times
(i) Gross profit margin = 13%
(j) Operating profit margin = 2%
(k) Net profit margin = 1.08%
(l) Return on asset = 3%
(m) Return on equity = 6.7%
9. Amri Company
Marketable securities = RM16,000
Account receivable = RM62,000
Inventory = RM73,560
Total fixed asset = RM146,663
Net fixed asset = RM96,663
Total asset = RM256,228
Notes payable = RM20,300
Total current liabilities = RM67,900
Long-term liabilities = RM58,677
Total liabilities = RM126,577
Total equity = RM129,651
Total liabilities and equity = RM256,228
ANSWERS 337
Exercise 3.2
1. RM11,171.10
2. RM4,974.55
Exercise 3.3
1. RM1,000
2. RM2,268.43
Exercise 3.4
1. RM100.06
2. RM3,522.77
Exercise 3.5
1. RM330.96
2. RM61,050
Exercise 3.6
RM272.30
Exercise 3.7
RM1,000
338 ANSWERS
Exercise 3.8
1. RM346.06
2. RM149.4
Therefore, Mas Joko Company should not continue with its investment.
7. PMTA = PVA/(PVIFA10%,4)
= RM6,000/3.170
= RM1,892.74
Exercise 4.2
1. Vb = 80 (PVIFA13%,12) + 1000 (PVIF13%,12)
= 80 (5.918) + 1000 (0.231)
= 473.44 + 231
= RM704.44
3. The value of bond will be higher as the time period (t) for the payment is
shorter and the present value of the bond will increase. Therefore, the value
of the bond will also increase.
340 ANSWERS
Exercise 4.3
Trial-and-error method = 16.96% @ 17%
Estimation method = 16.01%
Exercise 4.4
1. B
2. B
3. A
4. B
5. C
11. The rate of discount that equalise the present value for all interest and
capital payment for the bonds with the present value of the bond.
Exercise 4.5
1. (a) dividends
(b) capital gains
0.18
2. VCS =
0.11 0.05
= RM3.00
Yes, the shares will be sold as the actual value of these shares is lower than
the market price and it will be profitable.
342 ANSWERS
0.79
P3 = 9.875
0.12 0.04
0.25
5. (a) Kcs = + 0.105
2.30
= 0.2137
= 21.37%
(b) Yes. As the expected return (21.36%) is higher than 17%, therefore the
shares should be bought.
Exercise 4.6
1. A
2. A
3. A
4. B
5. B
0.16
7. VPS = = RM1.33
0.12
ANSWERS 343
0.35
8. (a) K ps = 9.09%
3.85
(b) Sell as the expected rate of return is lower than the required rate of
return.
D
9. VCS =
K cs g
1.32
=
0.11 0.07
= RM33
10. D1 = D0 (1 + g)
= 1.15 (1 + 0.15)
= 1.32
D2 = 1.32 (1 + 0.15)
= 1.52
D3 = 1.52 (1 + 0.13)
= 1.72
D4 = 1.72 (1 + 0.06)
= 1.82
1.82
P3 =
0.12 0.06
= RM30.33
D
11. KCS = +g
P0
0.25
= + 0.07
4.05
= 0.1317
= 13.17%
D2 = 0.55 (1 + 0.25)
= 0.688
D3 = 0.688 (1 + 0.25)
= 0.859
D4 = 0.859 (1 + 0.1)
= 0.945
0.945
P4 =
0.15 0.10
= RM18.90
D
13. VCS =
P0
D
=
kp
D2 = RM8.33
1
14. kP =
0.12
0.15
=
5
D2 = 3%
Exercise 5.2
(a) Value of expected return for shares x = 10%
Shares y = 10.32%
Shares z = 10.12%
Exercise 5.3
1. (a) Shares of Company A Shares of Company B
(c) Shares A are riskier as it has a bigger range of return and it also shows a
flatter probability distribution.
5. These shares have a lower level of risk than the average securities risk in the
capital market.
ANSWERS 347
Variance of shares W = 1
w = 1 = 1%
Project A should be rejected as the cumulative cash inflow at the end of the
third year, which is at the targeted payback period is less than the initial cash
outflow showing that this projects PBP is more than 3 years.
ANSWERS 349
PBP = RM400,000/RM125,000
= 3.2 years
Project B should also be rejected as its PBP is more than 3 years, which is the
targeted PBP.
2. The cumulative cash flow for this project at the end of the fifth year is
RM500,000. To regain the capital of another RM500,000, the time period that
will be taken is calculated as follows:
Exercise 6.2
1. B
2. D
Exercise 6.3
1. The NPV for project A is calculated as follows:
3. When the cost of capital increases, the NPV for the project will decrease.
ANSWERS 351
Exercise 6.4
PIA = 24,578/26,000
= 0.945
PIB = 629,192/500,000
= 1.258
PIC = 108,773/100,000
= 1.088
Exercise 6.5
1. C
2. B
3. C
4. C
Exercise 6.6
1. D
(c) PI = (RM16,650/0.893)/RM10,000
= RM14,866/RM10,000
= 1.49
352 ANSWERS
Therefore,
IRR = (16,650/10,000) 1
= 1.67 1
= 0.67
= 67%
Therefore,
4. (a) It is clear that PBP is between two and three years because the
cumulative cash inflow in the second year is RM8,000 while the
cumulative cash inflow for the third year is RM15,500.
PBP = 2 + (RM2,000/RM7,500)
= 2.26 years
ANSWERS 353
(c) PI = 12,004
= 10,000
= 1.2004
In question 3(b), when we use the discount rate of 12%, the NPV is
RM2,004. This means that the IRR is higher than 12%.
311.50
IRR 20% (24% 20%)
311.50 402.00
21.75%
PBP for Sik is more than 4 years because the cumulative cash inflow at
the end of year 4 is RM130 million less than the initial investment.
Based on the PBP technique, the Mergong project will be accepted while
the Sik project is rejected.
Based on the PI technique, the Mergong project will be accepted because its
PI is more than 1 while the Sik project will be rejected because its PI is less than
1.
Exercise 7.2
The additional annual cash flow after tax = (Sm Em Dm ) (1 t) +Dm
Sm = 0
Em:
Dm:
Therefore,
Exercise 7.3
1. NPV190-4 = RM87,000 (PVIFA14%,4) RM190,000
= RM87,000 (2.91) RM190,000
= RM253,170 RM190,000
= RM63,170
The model that should be chosen is Model 360-6 because its NPV is higher
than the NPV for Model 190-4. However, you will learn that the analysis
based on NPV is not accurate in this case because the comparison made
involved assets with different lifetime. The EAA technique will be
recommended in cases such as this.
358 ANSWERS
Sm = RM54,000 RM18,000
= RM36,000
Em :
D m
Depreciation of new machine
[(RM 135,000 + RM 5,000)/3 years] RM46,667
Depreciation of old machine RM20,000
[RM 100,000/5 years]
D m RM26,667
t = 40%
ANSWERS 359
Therefore,
(b) Yes, the company should replace the old machine with the new
machine because the NPV of this replacement is positive.
4. To make a decision on whether to replace the old meter with the new meter,
we need to calculate the NPV for this replacement project. The steps that
need to be taken are as follows:
As the NPV value is negative, the decision that should be made is to not
make the said replacement.
5. This statement is false because although the depreciation in itself is not cash
but as a tax deductible expense, it affects the tax for the capital budget
project. Tax is a cash flow item.
ANSWERS 361
k=72 = 14%
Exercise 8.2
Cost of preference shares = RM0.35 = 18.42%
= RM1.90
Exercise 8.3
0.18
K 0.09 0.126
1. (a) 5
12.6%
0.18
K 0.09 0.13
(b) 4.50
13%
362 ANSWERS
3. Opportunity cost.
Exercise 8.4
1. (d)
2. (f)
3. (e)
4. (b)
5. (a)
6. (c)
2. (a) Debt:
Interpolation:
980 960
= 9
980 914.8
= 9 + 0.307
= 9.307%
ANSWERS 363
Preference shares:
RM 8
Kp = 3%
RM 65
Ordinary shares:
5.07
Ks = 0.08
40 1
= 12.69%
4. Interest is a tax deduction item. Therefore, the cost of debt becomes lower
because it takes into account the taxes.
5. The floatation cost will cause the cost of capital for each capital component
that is issued to become higher.
Exercise 9.2
1. Pro forma financial income statement is used by the finance manager and the
creditors to make initial evaluation on the level of the companys overall
profitability and achievements.
Tulip Company
Pro forma Income Statement
For the year ended 31 December 2010
Sales RM10,000,000
Cost of goods sold 6,000,000
Gross profit RM4,000,000
Depreciation expenses 1,680,000
Administration and sale expenses 1,200,000
Operating profit (EBIT)
Interest expenses RM1,120,000
Profit before tax 120,000
Tax (34%) RM1,000,000
Net income 340,000
Less Dividend RM660,000
Increase in retained earnings 330,000
RM330,000
368 ANSWERS
2. For working capital management, assets are divided into permanent assets
and temporary assets. While liabilities are categorised into permanent
financing, temporary financing and spontaneous financing. This classification
is suitable to apply the principle of interest protection in the working capital
management.
3. The principle of interest protection matches the cash flow generation aspect
of an asset with the maturity period of the financing source that was used to
obtain the asset.
Exercise 10.2
1. (a) Average loans = [(RM12,000 + RM13,000 + RM9,000 + RM8,000 +
RM9,000 + RM7,000 + RM6,000 + RM5,000 +
RM6,000 + RM5,000 + RM7,000 + RM9,000)/12)]
= RM96,000/12 = RM8,000
(b) Annual cost of loans = RM8,000 0.15 = RM1,200
4. (a)
Account book value RM100,000
Less; Reserves (10% RM100,000) 10,000
Less: Fees (2% RM100,000) 2,000
Total available for advance RM88,000
Exercise 10.3
1. The cash conversion cycle refers to the time period taken from the time
payment is made on the purchase of raw materials to the time cash is
received from the sales made.
(a) The cash conversion period is the time period taken to convert raw
materials into finished goods which will be sold.
(b) The account receivable collection period refers to the average time
period taken to convert account receivable into cash.
(c) Deferred payment period refers to the average time taken beginning
from the purchase of raw materials and labour until the payment of
cash is made on the purchase of raw materials and labour.
RM50,000
RM450,000/360
40 days
370 ANSWERS
Exercise 10.4
1. Four criteria that are taken into account in choosing the marketable securities
are:
(a) Default risk
(b) Marketability or liquidity risk
(c) Tax
(d) Returns
Exercise 10.5
1. (a) Liquid Assets
Assets that can be converted into cash in a short period of time (less
than a year). For example, cash and marketable securities.
(b) Cash
Banknotes and coins that are owned by a company in its petty cash,
cash register or in its bank accounts.
ANSWERS 371
Exercise 10.6
1. Account receivable is the account that is formed when sales are made on
credit where it is a promise from the customer to make payment on the
purchase within an agreed time period.
2. The two factors that influence the total of account receivable are:
(a) The credit sales level of a company; and
(b) Average collection time.
Exercise 10.7
1. The three components of credit policy.
(a) Credit terms
(b) Credit standards
(c) Collection policies
2. Credit term 3/15 net 40 means that the customer who pays within the first
15 days are eligible to get a discount of 3%, while customers who do not take
this discount will have a period of 40 days to make payment.
3. The five factors that are evaluated in the usage of the 5C system:
(a) Character
(b) Capacity
(c) Capital
(d) Collateral
(e) Conditions
372 ANSWERS
Exercise 10.8
1. Average account receivables for Biru Company
= Average collection period Daily sales
= {(0.6) (10) + (0.4) (30)} (RM500,000/360)
= 18 days RM 1,389
= RM25,002
Exercise 10.9
1. Generally, inventory management is for the purpose of preparing sufficient
inventory for the operations of the company and to control the costs related
to inventory to be at the minimum level.
2. The EOQ Model is a method that is used to determine the order quantity that
is optimal for a company. This level is also the level where the inventory cost
is at the minimum level.
3. Assumptions that are made to enable the usage of the EOQ Model:
(a) Sales are constant throughout the year
(b) Sales can be forecasted accurately
(c) Orders made will be received on schedule
(d) Carrying cost and receiving cost are constant
ANSWERS 373
Exercise 10.10
1. (a) Economic Order Quantity for Bertam Company
S = 20,000 units
C = 0.15
P = RM1.50
O = RM5
= 942.809 ~ 943
(b) Total inventory cost for Bertam Company at the EOQ level
Total inventory cost = Total carrying cost and Total ordering cost
= (C) (P) (Q/2) + (O) (S/Q)
= (0.15) (RM1.50) (943/2) +
(RM5) (20,000/943)
= 106.088 + 106.045
= 212.133
Period
ATTACHMENTS
377
378
ATTACHMENT B
Financial Schedule for Present Value Interest Factor {PV0 = FVn (PVIFi,n)}
ATTACHMENTS
ATTACHMENT C
Financial table for Future Value Interest Factor Annuity{FVAn = A (FVIFAn)}
Period
ATTACHMENTS
379
380
ATTACHMENT D
Financial Table for Present Value Interest Factor Annuity {PVAn = A (PVIFAi,n)}
ATTACHMENTS
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