F9 Smart Study Notes

CONTENT
1. Introduction to Financial Management 1
2. Investment Appraisal 4
3. Net Present Values (other issues) 16
4. Cost of Capital 26
5. Sources of Finance 42
6. Dividend Policy 48
7. Ratio Analysis 50
8. Business Valuation 54
9. Working Capital Management 59
10 Risk 75
FINANCIAL MANAGEMENT
HOW TO PASS F9
KNOWLEDGE
PRACTICE
TIME MANAGEMENT
Introduction to financial
management
Investment appraisal
Cost of capital
financial management
WORKING CAPITAL
Risk
Ratiosandvaluation
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Mob/WhatsApp: +923346853808 SMART STUDY ACCA & SKANS PESHAWAR
INTRODUCTION TO FINANCIAL MANAGEMENT CHAPTER 1
THREE KEY DECISIONS
INVESTMENT DECISION FINANCING DECISION DIVIDEND DECISION
FINANCIAL OBJECTIVES
 PROFIT MAXIMISATION
 WEALTH MAXIMISATION
 EPS – GROWTH
 SATISFICING
OBJECTIVES OF NOT FOR PROFIT ORGANISATIONS

Nonprofit organisations exist mainly to provide help or resources to a target audience
with a specific need. They usually serve a public purpose such as enriching the lives of
people in the community.
VALUE FOR MONEY (VFM) & 3Es
VFM can be defined as „achieving the desired level and quality of service at the most
economical cost‟.
Economy:
Minimising the costs of inputs required to achieve a defined level of output.
Efficiency:
Ratio of outputs to inputs – achieving a high level of output in relation to the resources put
in (input driven) or providing a particular level of service at reasonable input cost (output
driven)
Effectiveness:
Whether outputs are achieved that match the predetermined objectives.
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TYPES OF STAKEHOLDERS
 INTERNAL
 CONNECTED
 EXTERNAL
STAKE HOLDRE CONFLICTS
AGENCY THEORY & AGENCY COST Agency relationships occur when one or more people
employ one or more persons as agent. The persons who employ others are the principals and those who
work for them are called the agent.
1- Creative accounting.
2- Off balance sheet
finance. 3- Directors private
life .
4- Managerial reward schemes.
 Linked to profit .
 Linked to increase in sales.
 Share option scheme.
5- Corporate governance codes.
Goal Congruence
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PAST EXAM QUESTIONS (homework)
(1) Discuss how good corporate governance procedures can help to manage under-
performance in private sector companies. (5 marks)
(2) Discuss the factors that should be considered when deciding on a management
remuneration package that will encourage the directors of RZP Co to maximise the
wealth of shareholders, giving examples of management remuneration packages that
might be appropriate for RZP Co. (9 marks)
(3) Explain and compare the public sector objective of 'value for money' and the private
sector objective of 'maximisation of shareholder wealth'. (6 marks)
(4) Outline the economic problems caused by monopoly and explain the role of
government in maintaining competition between companies. (9 marks)
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CHAPTER 2
INVESTMENT APPRAISAL
INVESTMENT APPRAISAL
TECHNIQUES
BASIC ADVANCE
payback TIME VALUE OF MONEY
DISCOUNTING AND
COMPOUNDING
ARR/ ROCE
INTERNAL RATE OF
RETURN
ANNUITY
DISCOUNTED
PERPETUITY PAYBACK
NET PRESENT VALUE
TAXATOIN & CAPITAL

ALLOWANCES WORKING CAPITAL
MONEY VSREAL REPLACEMENT OF

ANALYSIS ASSET
CAPITAL RATIONING
LEASE Vs BUY
DISCOUNT RATE
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PAYBACK PERIOD
The payback period is the time a project will take to pay back the money spent on it. It is
based on expected cash flows and provides a measure of liquidity.
Decision rule:
 Choose the shorter payback period.
 Invest when payback is shorter than target payback period.
QUESTION 2.1
A project is expected to have the following cash flows:
Year Cash flow

$000
0 (1,900)
1 300
2 500
3 600
4 800
5 500
What is the expected payback period?
QUESTION 2.2 ( HOME WORK)
Calculate the payback period in years and months for the

following project:
Year Cash flow

$000
0 (3,100)
1 1,000
2 900
3 800
4 500
5 500
PAYBACK WHEN EQUAL CASHFLOW EVERY YEAR
We can use this formula to calculate payback when we have equal cashflows every
year.
initial investment
Payback period = –––––––––––––
annual cash flow
QUESTION 2.3
An expenditure of $2 million is expected to generate net cash inflows of $500,000 each year
for the next seven years.
What is the payback period for the project?
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QUESTION 2.4 (HOMEWORK)
A project will involve spending $1.8 million now. Annual cash flows from the project would
be $350,000.
What is the expected payback period?
ADVANTAGES DISADVANTAGES
• Simple to calculate andunderstand • Ignores time value of money.
• Useful in changing circumstances. • Ignores cashflows after payback period.
• Useful when investment conditions are • No definitive investment signal .
improving.(liquidty) • It ignores profitability.
• It could be used as a measure of risk.
• It uses cash rathar than profits. (Cashis
king)
ACCOUNTING RATE OF RETURN (ARR)

OR
RETURN OF CAPITAL EMPLOYED ( ROCE)

'Accounting Rate of Return - ARR' The amount of profit, or return, that an individual can expect
based on an investment made.
ARRand ROCEareusedinterchangeably forinvestmentappraisalpurpose in

exam but are slightly different conceptually.
ARR ROCE
• Inestment appraisal. •Performance appraisal.
•Average annual profit. •Last years profit .(PBIT)
•Future information. •Past information.
•Covers the whole life of the project.
•Formula = •Formula =
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ROCE/ARR - FORMULAE
Average annual profits before interest and tax

ROCE = ––––––––––––––––––––––––––––––––––– × 100%
Initial capital costs
OR
Average annual profits before interest and tax

ROCE = ––––––––––––––––––––––––––––––––––– × 100%
Average capital investment
Average capital investment = Initial investment + scrap value
Profit = Cashflow - Depreciation

Depreciation = Initial investment – Scrap value
Decision rule:
• If the expected ROCE for the investment is greater than the target or hurdle rate (as
decided by management) then the project should be accepted.
QUESTION 2.5
A project involves the immediate purchase of an item of plant costing $110,000. It would
generate annual cash flows of $24,400 for five years, starting in Year 1. The plant
purchased would have a scrap value of $10,000 in five years, when the project terminates.
Depreciation is on a straightline basis.
Determine the project's ROCE using:
(a) initial capital costs
(b) average capital investment
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A project requires an initial investment of $800,000 and then earns net cash inflows as
follows:
Year 1 2 3 4 5 6 7
Cash inflows ($000) 100 200 400 400 300 200 150
In addition, at the end of the seven year project the assets initially purchased will be sold for
$100,000.
Determine the project’s ROCE using:
(a) initial capital costs

(b) average capital investment.
PAST EXAM QUESTION (HOMEWORK )

(1) Explain why accounting profits may not be the best measure of a company‟s
achievements. (5 marks)
•Easy to understand and simple as it is •Ignores time value of money.
a percentage. •Ignores life of the project.
•Unlike payback It doesn‟t ignore profitability . •Ignores cash flows.
•Accountants can paly with profit figures.
•No definitive investment signal.
•. Using profits will include non relevant items such
as depreciation in our calculations also .
TIME VALUE OF MONEY
Money received today is worth more than the same sum received in the future, i.e. it has a
time value.
This occurs for three reasons:
• potential for earning interest/cost of finance
• impact of inflation
• effect of risk.
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Discounting
We use discounting technique to calculate present value from future value.
PV = FV
n = number of years
r = discount rate
QUESTION 2.7 Find present values of the following using discounting formula AND
discounting table :
1. Future value is $1000 in 10 years time and discount rate is 10%.

2. Future value is $250 in 5 years time and discount rate is 7.5%.
4. We are expecting $ 6000 after 3 years where discount rate is 9%.
5. We are expecting $9000 from year 1 to year 4 and discount rate is 2%.
6. We are expecting $4500 from today (year 0) to year 6 and discount rate is 5%
QUESTION 2.8 (HOME WORK)
Find present values of the following using discounting formula AND discounting table:

2. We are expecting to receive $5m in 5 years time while discount rate is 3%.
3. We expect to receive $6000 every year from coming year to year 6 and discount rate
is 8%.
4. We expect to receive $3500 from year 7 to 12 and discount rate is 2%.
5. We are expecting to receive $ 15000 from year 0 to year 2 and discount rate is 1%.
Compounding We use compounding technique to calculate future value from present

value.
FV = PV
n = number of years
r = discount rate

Recalculate future value from the answers( present values) of question 2.8 and match if you
get the same figure.
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ANNUITIES
Annuities are equal cashflow every year for certain period of time .
PV = FV
We can find out present value of an annuity using :
 Discounting formula.
 Using annuity formula.
 Using annuity table .
TYPES OF ANNUITIES
Normal annuity is annuity that starts

NORMAL fromyear1
ANNUITY
Formula=
Advance annuity is annuity that starts

beforeyear 1 ( i.e , year 0)
TYPES OF ADVANCE
ANNUITIES ANNUITY
Formula=
Delayed annuity is annuity that starts

afteryear 1.
DELAYED
ANNUITY
Formula=
QUESTION 2.10
Find present values of the the following using
 Discounting formula
 Annuity formula
 Annuity table
1- We expect to receive $10m every year from year 1 to 4 while discount rate is 5%.
2- We expect to receive $2000 every year from year 0 to 4 while discount rate is 8%.
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QUESTION 2.11 (HOME WORK)
Find present values of the the following using
 Discounting formula
 Annuity formula
 Annuity table
4- We expect to receive $8m every year from year 1 to 6 while discount rate is 8%.
Perpetuity
Perpetuities are equal cashflow every year for ever .
PV = FV
We can find out present value of perpetuities using the following formulae.
Normal perpetuity starts from year 1.

NORMAL
PERPETUITY
Formula=
Advance perpetuity starts before year 1

( i.e , year 0)
TYPES OF ADVANCE
PERPETUITIES PERPETUITY
Formula=
Delayed perpetuity starts after year 1.

DELAYED
PERPETUITY
Formula=
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QUESTION 2.12
Find present values of the the following
1-We expect to receive $10m every year from year 1 to infinity while discount rate is 5%.
2-We expect to receive $2000 every year from year 0 to infinity while discount rate is 8%.
Find present values of the the following
1- We expect to receive $100 every year from year 1 to infinity while discount rate is 7%.
2- We expect to receive $7000 every year from year 0 to infinity while discount rate is 14%.
COST OF CAPITAL
In the above discussions we referred to the rate of interest. There are a

number of alternative terms used to refer to the rate a firm should use to take
account of the time value of money:
• cost of capital
• discount rate
• required return.
Whatever term is used, the rate of interest used for discounting reflects the cost of the
finance that will be tied up in the investment.
Net Present Value (NPV)

Net Present Value (NPV) is the difference between the present value of cash inflows and the
present value of cash outflows.
Decision rule:
If net present value is positive , we accept the project .
QUESTION2.14
The cash flows for a project have been estimated as follows:
The cost of capital is 6%.
Year $
0 (25,000)
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1 6,000
2 10,000
3 8,000
4 7,000
Calculate the net present value (NPV) of the project to assess

whether it should be undertaken.

An organisation is considering a capital investment in new equipment. The estimated cash
flows are as follows.
Year Cash flow

$
0 (240,000)
1 80,000
2 120,000
3 70,000
4 40,000
5 20,000
The company‟s cost of capital is 9%.

Calculate the NPV of the project to assess whether it should be
undertaken.
• considers the time value of money

• is an absolute measure of return • It is difficult to explain to managers
• is based on cash flows not profits • It requiresknowledge of the cost of capital
• considers the whole life of the project • It is relatively complex.
• should lead to maximisation of shareholder
wealth.
Internal Rate Return (IRR)
The IRR is another project appraisal method using DCF techniques. The IRR represents the
discount rate at which the NPV of an investment is zero. As such it represents a breakeven
cost of capital.
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Decision rule:
• projects should be accepted if their IRR is greater than the cost of capital.
Calculating the IRR using linear interpolation
The steps in linear interpolation are:
(1) Calculate two NPVs for the project at two different costs of capital
(2) Use the following formula to find the IRR:
where:
L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest.
QUESTION 2.16The cash flows for a project have been estimated as follows:
Year $
0 (25,000)
1 6,000
2 10,000
3 8,000
4 7,000
The cost of capital is 6%.
Calculate the IRR of the project to assess whether it should be undertaken.
An organisation is considering a capital investment in new equipment. The estimated cash
flows are as follows.
Year Cash flow

$
0 (240,000)
1 80,000
2 120,000
3 70,000
4 40,000
5 20,000
The company‟s cost of capital is 9%.

Calculate the IRR of the project to assess whether it should be undertaken.
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• considers the time value of money • it isnot ameasureofabsoluteprofitability

• It is used for risk measurement. as it is a percentage.
• is a percentage and therefore easily • interpolation (formula) only provides an
understood estimate and is not accurate .
• uses cash flows not profits • It is fairly complicated to calculate.
• considers thewholelifeof theproject • Nonconventional cash flows may give rise to
• means a firm selecting projects where the multiple IRRs.
IRR exceeds the cost of capital should • IRR assumes reinvestment at the IRR ,which
increase shareholders' wealth. does not look logical.
• is a good way to compare projects of • mutually exclusive projects may give rise to
different scales. Consider the following two conflicting resultswith NPV.(If we faceit in
projects: exam we follow NPV ,considering it tobea
• Project A Project B superior measure for investment
appraisal.See graph below.
• Initial investment $20m $0.5m
• NPV $0.2m $0.1m
• IRR 2% 15%
NPV vs IRR for mutually exclusive projects . Which project will you choose ?
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CHAPTER 3
NET PRESENT VALUE ( OTHER ISSUES )
MONEY VS REAL ANALYSIS

This is about how we deal with inflation in NPV questions. As we already know that discount
rate consists of the following:
• potential for earning interest/cost of finance

• impact of inflation
• effect of risk.
There two ways of dealing with inflation:
1. Include inflation by inflating up the cash flows year on year and use money (nominal)
discount rate .Money discount rate includes all the three factors above.
2. Exclude inflation (and take the cash flows in year 0 terms) and use real discount
rate.Real discount rate does not include inflation in it .
EXAM TIP: We must use money discount rate when we have more than
one inflation rates given in the question . If we are given only one inflation rate, we
may use real discount rate.
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FISHER EFFECT
The relationship between real and money discount rate is :
(1 + m) = (1 + r) (1 + i)
Where
r = real discount rate
m = money discount rate
i = inflation rate
QUESTION 3.1
r = 8% i = 5%
Required:
What is the money rate of interest?
QUESTION 3.2
m = 10.6% i = 5%
Required:
What is the real rate of return?
QUESTION 3.3
A company has invested $50,000 in a project. The project generates net cash inflows of
$14,000 each year for 5 years in year 0 terms. The rate of return is 12% and inflation is
expected to be 3.6%
Required:
Calculate the NPV using both the money and real analyses.
QUESTION 3.4 ( exam standard )
Explain how inflation affects the rate of return required on an investment project, and
the distinction between a real and a nominal (or „money terms‟) approach to the
evaluation of an investment project under inflation.
QUESTION 3.5 (exam standard)
Explain the general problems associated with inflation (7 marks)
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QUESTION 3.6
A company is considering a cost saving project. This involves purchasing a machine costing
$7,000, which will result in annual savings (in real terms) on wage costs of $1,000 and on
material costs of $400. The following forecasts are made of the rates of inflation each year
for the next five years:
Wage costs 10%
Material costs 5%
General prices 6%
The cost of capital of the company, in real terms, is 8.5%.
Evaluate the project, assuming that the machine has a life of five
years and no scrap value.
TAXATION & TAX SAVING (due to capital allowances)
TAXPAYMENT
Tax payment is an outflow therefore needs to be dealt with in an NPV question. Be

careful though with the timings of the cashflow.
TAX SAVING (due to capital allowances)
Tax saving is a decrease in outflow therefore will be treated as an inflow.Capital

allowances decrease taxable profit which leads to lower tax payment in return.
QUESTION 3.7
What is the purpose of capital allowances ?
QUESTION 3.8
An asset is bought for $10,000 and will be used on a project for four years after which it will
be disposed of. Tax is payable at 30%, one year in arrears, and taxallowable depreciation is
available at 25% reducing balance.
Required:
(a) Calculate the taxallowable depreciation and hence the tax savings for each year if the
proceeds on disposal of the asset are $2,500.
(b) How would your answer change if the asset was sold for $5,000?
(c) If net trading income from the project is $8,000 pa, based on your answer to part (a)
and a cost of capital of 10%, calculate the NPV of the project.
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Incorporating working capital
Investment in a new project often requires an additional investment in working capital, i.e.
the difference between short term assets and liabilities.
The treatment of working capital is as follows:
 Initial investment is a cost at the start of the project . ( outflow)
 If the investment is increased during the project, the increase is a relevant cash
outflow. (normally examiner will link working capital to sales .e.g, 6% of sales.
 At the end of the project all the working capital is „released‟ and treated as a cash
inflow
QUESTION 3.9
A company expects sales for a new project to be $225,000 in the first year growing at 5%
pa. The project is expected to last for 4 years. Working capital equal to 10% of annual sales
is required and needs to be in place at the start of each year.
Calculate the working capital flows for incorporation into the NPV
calculation.
QUESTION 3.10
A company anticipates sales for the latest venture to be 100,000 units per year. The selling
price is expected to be $3 per unit in the first year, inflating by 8% pa over the threeyear
life of the project. Working capital equal to 10% of annual sales is required and needs to be
in place at the start of each year.
Calculate the working capital flows.
Lease versus buy( FINANCING decision)

Once the decision has been made to acquire an asset for an investment project, a decision
still needs to be made as to how to finance it. The choices that we will consider are:
Lease or Buy
 As we said that lease v buy decision is financing decision, we will ignore operating
cashflows.
The assumption is that buying requires the use of a bank loan (for the sake of
comparability). Therefore discount rate used for lease vs buy decision should be after
tax cost debt .
Post tax cost of debt= Cost of debt × (1 – Tax rate).
(Note: in some questions you may find that a company is not paying tax and so the pretax
rate would be appropriate.)
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BUY OPTION - relevant cash flows
• the purchase cost

• any residual value
• any associated tax implications due to tax allowable depreciation.
LEASE OPTION – relevant cash flows
 the lease payments

 tax relief on the lease payments.
QUESTION 3.16
A firm has decided to acquire a new machine to neutralise the toxic waste produced by its
refining plant. The machine would cost $6.4 million and would have an economic life of five
years.
Tax allowable depreciation of 25% pa on a reducing balance basis is available for the
investment. Taxation of 30% is payable on operating cash flows, one year in arrears.
The firm intends to finance the new plant by means of a fiveyear fixed interest loan at a
pretax cost of 11.4% pa, principal repayable in five years‟ time.
As an alternative, a leasing company has proposed a finance lease over five years at
$1.42 million pa payable in advance. Scrap value of the machine under each financing
alternative will be zero.
Evaluate the two options for acquiring the machine and advise the company on the
best alternative
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Asset Replacement decisions
Once the decision has been made to acquire an asset for a long term project, it is quite
likely that the asset will need to be replaced periodically throughout the life of the
project. The decision we are concerned with here is – how often should the asset be
replaced?
Equivalent annual costs (EACs)

In order to deal with the different timescales, the NPV of each option is converted into
an annuity or an EAC.
The optimum replacement period (cycle) will be the period that has the lowest EAC,
although in practice other factors may influence the final decision.
Key assumptions
 Cash inflows from trading are ignored since they will be similar regardless of the
replacement decision. In practice using an older asset may result in lower
quality, which in turn could affect sales.
 The operating efficiency of machines will be similar with differing machines or
with machines of differing ages.
 The assets will be replaced in perpetuity or at least into the foreseeable future.
 Price change of asset due to inflation are ignored.
 Tax saving on capital allowances on the purchase of new asset is ignored.
 As with all NPV calculations nonfinancial aspects such as pollution .
Limitations of replacement analysis
• changing technology
• inflation
• changes in production plans.
Question 38 Calvic Co
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Capital rationing
Shareholder wealth is maximised if a company undertakes all possible positive NPV
projects. Capital rationing is where there are insufficient funds to do so. This implies that
where investment capital is rationed, shareholder wealth is not being maximised.
Two types of capital rationing
1- Hard capital rationing

Externally imposed Due to:
1. Wider economic factors (e.g. a credit crunch)
2. Company specific factors
(a) Lack of asset security
(b) No track record
(c) Poor management team.
2- Soft capital rationing

Internally imposed by senior management.
Issue: Contrary to the rational aim of a business which is to maximise shareholders’

wealth (i.e. to take all projects with a positive NPV)
Reasons:
1. Lack of management skill
2. Wish to concentrate on relatively few projects
3. Unwillingness to take on external funds
4. Only a willingness to concentrate on strongly profitable projects.
Multi period capital rationing

A more complex environment where there is a shortage of funds in more than one period. This
makes the analysis more complicated because we have multiple constraints and multiple outputs.
Linear programming would have to be employed.
Single period capital rationing
There is a shortage of funds in the present period which will not arise in following
periods. Note that the rationing in this situation is very similar to the limiting factor
decision that we know from decision making. In that situation we maximise the
contribution per unit of limiting factor.
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divisible projects
non divisble
projects
Four exam
situations
synergy between
two projects
Mutually
exclusive projects
QUESTION CAPITAL RATIONING
QUESTION BASRIL
QUESTION 3.22
Projects C and E are mutually exclusive (divisible projects). Other information is below.
A company has $100,000 available for investment and has identified the following 5
investments in which to invest. All investments must be started now (Yr 0).
Project Initial investment NPV PI

(Yr 0) $000 $000
C 40 20 0.5
D 100 35 0.35
E 50 24 0.48
F 60 18 0.3
G 50 (10) not worth while
Required:
Determine the optimal project selection
QUESTION CAPITAL RATIONING

QUESTION BASRIL
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Sensitivity Analysis
A sensitivity analysis is a technique used to determine how different values of an

independent variable (e.g. sales) will impact a particular dependent variable (e.g. NPV)
under a given set of assumptions. It is also called what if analysis.
Sensitivity analysis is a way to predict the outcome of a decision if a situation turns out
to be different compared to the key prediction(s).
NPV
Sensitivity margin = ––––––––––––––––––– × 100%
Present value (PV) of flow
under consideration
QUESTION 3.23
An investment of $40,000 today is expected to give rise to annual contribution of

$25,000. This is based on selling one product, with a sales volume of 10,000 units,
selling price of $12.50 and variable costs per unit of $10. Annual fixed cost of $10,000
will be incurred for the next four years; the discount rate is 10%.
Required:
(a) Calculate the NPV of this investment.
(b) Calculate the sensitivity of your calculation to the following:
(i) initial investment
(ii) selling price per unit
(iii) variable cost per unit
(iv) sales volume
(v) fixed costs
(vi) discount rate
Advantages of sensitivity analysis

• simple
• provides more information to allow management to make subjective judgments
• identifies critical estimates
Disadvantages of sensitivity analysis
• assumes variables change independently of each other.(To include the effect variables
effecting each other we can use Simulation model such as monte carlo simulation.)
• does not assess the likelihood of a variable changing

• does not directly identify a correct decision.
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PROBABILITY ANALYSIS
When there are several possible outcomes for a decision and probabilities can be
assigned to each, a probability distribution of expected cash flows can often be
estimated, recognising there are several possible outcomes, not just one. This could
then be used to calculate Expected value and measure risk.
Calculating an EV
The formula for calculating an EV is:
EV =Σpx
Where
p = the probability of an outcome
x = the value of an outcome.
QUESTION 3.24
A firm has to choose between three mutually exclusive projects, the outcomes of which
depend on the state of the economy. The following estimates have been made:
State of the economy Recession Stable Growing

Probability 0.5 0.4 0.1
NPV NPV NPV
($000) ($000) ($000)
Project A 100 200 1,400
Project B 0 500 600
Project C 180 190 200
Determine which project should be selected on the basis of expected market
values.
QUESTION ZSE
STRENGHTS OF PROBABILITY ANALYSIS
• Deals with multiple outcomes.

• Quantifies probabilities.
• Relatively simple calculation.
• Assists decision making.
WEAKNESSES OF PROBABILITY ANALYSIS
• Subjective probabilities.
• Answer is only a long run average.
• Ignores variability of outcomes.
•Used for risk neutral decision, i.e. ignores investor‟s attitude to risk.
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CHAPTER 4 COST OF CAPITAL
COST OF CAPITAL
A fundamental calculation for all companies is to establish its financing costs, both
individually for each component of finance and in total terms. These will be of use
both in terms of assessing the financing of the business and as a cost of capital for
use in investment appraisal.
COST OF EQUITY (Ke)‒ the Dividend Valuation Model(DVM)
Cost of equity is the requiredrate of return by the share holders .The valuation of the share
in terms of the cash returns of dividends into the future.The cash inflow is normally an
perpetuity to reflect the permanent nature of the share capital.
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Asuumption :
• Future income stream is the dividends paid out by the company

• Dividends will be paid in perpetuity
• Dividends will be constant or growing at a fixed rate.
QUESTION- 4.1
A company has paid a dividend of 30c for many years. The company expects to
continue paying dividends at this level in the future. The company‟s current share price
is $1.50.
Calculate the cost of equity.
DIVIDEND GROTH
Although in reality a firm‟s dividends will vary year on year, a practical assumption is to
assume a constant growth rate in perpetuity. The share valuation formula then
becomes:
Do(1+g) D1
Po = ––––––– = –––––
ke – g Ke – g
where:
g = constant rate of growth in dividends, expressed as a decimal
D1 = dividend to be received in one year – i.e. at T1
Do(1+g) = dividend just paid, adjusted for one year‟s growth.
Therefore to find the cost of equity the formula can be rearranged to:
Do(1+g) D1
Ke = ––––––– + g = ––––– + g
Po Po
QUESTION 4.2
P Co has just paid a dividend of 10c. Shareholders expect dividends to grow at 7% pa.
P Co‟s current share price is $2.05.
Calculate the cost of equity of P Co.
QUESTION 4.3
The current share price is 140c and a dividend of 8c is due to be paid shortly.
Calculate the value of Po, the exdiv share price.
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ESTEMATING GROWTH
AVERAGING GORDON‟S
METHOD GROWTH MODEL
g= g=
Where : where :
dn= dividend n years ago r=return on reinvested
funds
do= dividend this year b= retention rate
QUESTION 4.4
A company has paid the following dividends per share over the last five
years.
20Y0 10.0c
20Y1 11.0c
20Y2 12.5c
20Y3 13.6c
20Y4 14.5c
Calculate the average annual historical growth rate.
QUESTION 4.5
company is about to pay an ordinary dividend of 16c a share. The share price is 200c.
The accounting rate of return on equity is 12.5% and 20% of earnings are paid out as
dividends.
Calculate the cost of equity for the company.
Weaknesses of the DVM
The DVM has a sound basic concept. The weaknesses occur because:
• the input data used may be inaccurate:
– current market price
– future dividend patterns
• the growth in earnings is ignored.(capital gain)
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COST OF PREFRENCE SHARE (Kp)
Preference shares usually have a constant dividend. So the same approach

can be used as we saw with estimating the cost of equity with no growth in
dividends.
D D
Kp = ––– Po = –––
Po Kp
where:
D = the constant annual preference dividend
Po = ex div MV of the share
Kp = cost of the preference share.
QUESTION 4.6
A company has 50,000 8% preference shares in issue, nominal value $1. The current ex div
MV is $1.20/share.
What is the cost of the preference shares?
COST OF DEBT (Kd)
Irredeemable
Traded
Redeemable
Convertable
Debt
Non-traded Bank loan
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QUESTION 4.7
A company has in issue 10% irredeemable debt quoted at $80 ex interest. The corporation tax
rateis 30%
(a) What is thereturn requiredby thedebt providers (thepretaxcost of debt)?
(b) Whatis theposttaxcost of debtto thecompany?
QUESTION 4.8
A company has in issue 12% redeemable debt with 5 years to redemption. Redemption is at par.
The current market value of the debt is $107.59. The corporation tax rate is 30%.
What is the return required by the debt providers (pretax cost of debt)?
QUESTION 4.9
A company has in issue 12% redeemable debt with 5 years to redemption. Redemption is at par.
The current market value of the debt is $107.59. The corporation tax rate is 30%.
What is the cost of debt to the company (post tax cost of debt)?
QUESTION 4.10
A company has issued convertible loan notes which are due to be redeemed at a 5% premium
in five year's time. The coupon rate is 8% and the current MV is $85. Alternatively, the investor
can choose to convert each loan note into 20 shares in five year's time.
The company pays tax at 30% per annum. The company‟s shares are currently worth $4 and
their value is expected togrowat arateof 7% pa.
Find the post tax cost of the convertible debt to the company.
QUESTION 4.11 (i)
Afirm hasafixed ratebank loanof $1million. It ischarged 11%pa.Thecorporation taxrate is

30%.
What is the post tax cost of the loan?
QUESTION 4.11(ii)
Butch Co has $1 million loan notes in issue, quoted at $50 per $100 of nominal value
(also equal to their book value); $625,000 preference shares of $1 each quoted at 40c
(book value 30c per share) and 5 million ordinary $1 shares quoted at 25c (book value
20c per share). The cost of capital of these securities is 9%, 12% and 18% respectively.
This capital structure is to be maintained.
(a) Calculate the weighted average cost of capital using market values
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(b) Calculate the weighted average cost of capital using book values and
comment on the difference to your answer from part (i)
QUESTION 4.12(home work)
B Co has 10 million 25c ordinary shares in issue with a current price of 155c cum div.
An annual dividend of 9c has just been proposed. The company earns an accounting
rate of return to equity (ROE) of 10% and pays out 40% of the return as dividends. The
company also has 13% redeemable loan notes with a nominal value of $7 million,
trading at $105. They are due to be redeemed at par in five years‟ time.
If the rate of corporation tax is 33%, what is the company’s WACC?
When to use the weighted average cost of capital
The WACC calculation is based upon the firm‟s current costs of equity and debt. It is
therefore appropriate for use in investment appraisal provided:
• the historic proportions of debt and equity are not to be changed

• the operating risk of the firm will not be changed
• the finance is not project specific, i.e. projects are financed from a pool of funds.
OR
• the project is small in relation to the company so any changes are
COST OF EQUITY (Ke) ‒ the Capital Asset Pricing Model (CAPM)
The CAPM model considers risk and return approach to calculate cost of equity. The relationship
between risk and return is easy to see, the higher the risk, the higher is the return.
Ke= Rf + β (Rm – Rf)
Where :
Ke = cost of equity.
Rf = risk free rate of return.
Rm= the expected average return on the market.
(Rm– Rf) = equity risk premium (sometimes referred to as average market risk premium)
β = systematic risk of investment compared to the market and therefore amount of the
premium needed.
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Portfolio Theory
Investor may reduce risk with no impact on return as a result of holding a mix of investments.
Do not put all your eggs in one basket.
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Systematic and non-systematic risk
If we start constructing a portfolio with one share and gradually add other shares to it we
will tend to find that the total risk of the portfolio reduces as follows:
Initially substantial reductions in total risk are possible; however, as the portfolio
becomes increasingly diversified, risk reduction slows down and eventually stops.
The risk that can be eliminated by diversification is referred to as unsystematic risk.
This risk is related to factors that affect the returns of individual investments in unique
ways, this may be described as company specific risk.
The risk that cannot be eliminated by diversification is referred to as systematic risk. To
some extent the fortunes of all companies move together with the economy. This may
be described as economy wide risk.
The relevant risk of an individual security is its systematic risk and it is on this basis
that we should judge investments. Non systematic risk can be eliminated and is of no
consequence to the well-diversified investor.
Investment Options
1. If an investor wants to avoid risk altogether, he must invest in a portfolio consisting
entirely of risk-free securities such as government debt.
2. If the investor holds only an undiversified portfolio of shares he will suffer
unsystematic risk as well as systematic risk.
3. If an investor holds a ‘balanced portfolio’ of all the stocks and shares on the
stock market, he will suffer systematic risk which is the same as the average
systematic risk in the market.
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 (beta) factor
The method adopted by CAPM to measure systematic risk is an index . The  factor is
the measure of a share’s volatility in terms of market risk The  factor of the market as
a whole is 1. Market risk makes market returns volatile and the  factor is simply a
yardstick against which the risk of other investments can be measured.
For example, suppose that it has been assessed statistically that the returns on shares
in XYZ plc tend to vary twice as much as returns from the market as a whole, so that if
market returns went up by 6%, XYZ’s returns would go up by 12% and if market returns
fell by 4% then XYZ’s returns would fall by 8%, XYZ would be said to have a  factor of
2.
If an investment is riskier than average (i.e. the returns more volatile than the average
market returns) then the β > 1.
If an investment is less risky than average (i.e. the returns less volatile than the average
market returns) then the β < 1.
If an investment is risk free then β = 0.
Criticisms of the CAPM

1. CAPM is a single period model, this means that the values calculated are only valid
for a finite period of time and will need to be recalculated or updated at regular intervals.
2. CAPM assumes no transaction costs associated with trading securities
3. Any eta value calculated will be based on historic data which may not be
appropriate currently. This is particularly so if the company has changed the
capital structure of the business or the type of business they are trading in.
4. CAPM assumes an efficient investment market where it is possible to diversify away
risk. This is not necessarily the case meaning that some unsystematic risk may remain.
5. CAPM assumes all stocks relate to going concerns, this may not be the case.
Advantages:
• works well in practice
• focuses on systematic risk
• is useful for appraising specific projects.
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Question Burse Co
CAPM IN PROJECT APPRAISAL

In project appraisal we use a cost of capital for a discount rate. Normally we can use the WACC
providing that risk has not changed.
If project risk differs to the company’s risk profile we need another way to calculate a discount
rate.
The CAPM provides a means by which a project’s risk can be considered in relation to market
risk.
Different types of betas
β Asset (βa) reflects purely the systematic risk of the business area.
β Equity (βe) reflects the systematic risk of the business area and the company specific financial
structure.
(βa) = β Asset – ungeared beta
(βe) = β Equity - geared beta

E = Equity
D = Debt
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QUESTION 4.13
B Co is a hot air balloon manufacturer whose equity:debt ratio is 5:2. The corporate debt, which
is assumed to be riskfree, has a gross redemption yield of 11%. The beta value of the company’s
equity is 1.1. The average return on the stock market is 16%. The corporation tax rate
is 30%. The company is considering a water bed manufacturing project. S Co is a water bed
manufacturing company. It has an equity beta of 1.59 and an equity:debt ratio of 2:1. B Co
maintains its existing capital structure after the implementation of the new project.
What would be a suitable risk adjusted cost of equity to apply to the project?
QUESTION 4.14( homework )
Hubbard, a food manufacturing firm, is about to embark upon a major diversification in the
consumer electronics industry. Its current equity beta is 1.2, whilst the average equity ß of
electronics firms is 1.6. Gearing in the electronics industry averages 30% debt, 70% equity.
Corporate debt is considered to be risk free.
Rm = 25%, Rf = 10%, corporation tax rate = 30%
What would be a suitable risk adjusted cost of equity for the new investment if Hubbard were to
be financed in each of the following ways?
(a) By 30% debt and 70% equity
(b) Entirely by equity.
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(c) By 20% debt and 80% equity.
(d) By 40% debt and 60% equity.
Capital structure and risk adjusted WACC

Does the capital structure have a bearing on shareholders’ wealth?
Key relationship
Aim :
Reduce WACC to maximise market value.
Impact of debt financing on the WACC
Substitution effect of debt finance
As debt is cheaper ( Less risky to investor and Tax efficient) therefore Kd < Ke. Increasing debt
finance will lead to reduction in overall WACC.
Financial risk effect of Debt finance
Debt is risky for the company and the risk associated with debt Financing is born by the
shareholders.The shareholders in return require higher return for taking higher risk. Which
increases Ke and this leads to an increase in WACC.
GEARING THEORIES
Traditional theory
 Modigliani and Miller (M&M) – no tax
 Modigliani and Miller (M&M) – with tax
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Traditional theory
Cost of equity:
At relatively low levels of gearing the increase in gearing will have relatively low impact
on Ke. As gearing rises the impact will increase Ke at an increasing rate.
Cost of debt:
There is no impact on the cost of debt until the level of gearing is prohibitively high.
When this level is reached the cost of debt rises.(e.g. unsecured loan is introduced)
Key point
There is an optimal level of gearing at which the WACC is minimized and the value of the
company is maximized.This is the point where substation effect of debt financing is strongest
compared to the financial risk effect of debt finance .
Question :Find optimal level of gearing in the diagram above .
Question : Why is Kd increased at high level of gearing ?
Implication for finance
Company should gear up until it reaches optimal point and then raise a mix of finance to
maintain this level of gearing.
Problem
There is no method, apart from trial and error, available to locate the optimal point.
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Naveed ur rehman
Modigliani and Miller (M&M) – no tax
Cost of equity:
Ke rises at a constant rate to reflect the level of increase in risk associated with gearing.
Cost of debt:
There is no impact on the cost of debt (Kd) .
Key point
The substitution effect of debt financing is equal to financial risk effect of debt finance .It means
that the change in the level of gearing will not affect WACC . The only way to increase the
market value of the company is to increase future cash flows.
Assumptions
- Perfect capital market exist where individuals and companies can borrow unlimited amounts at
the same rate of interest.
- There are no taxes or transaction costs.
- Personal borrowing is a perfect substitute for corporate borrowing.
- Firms exist with the same business risk.
- Debt is risk free.
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Modigliani and Miller (M&M) – with tax
Cost of equity:
Ke rises at a constant rate to reflect the level of increase in risk associated with gearing.
Cost of debt:
Kd decreases as the level of debt increases as more and more debt will lead to more and more tax
savings i.e Kd (1-t)
Key point
The substitution effect of debt financing is greater than financial risk effect of debt finance .It
means that increasing debt finance will decrease WACC and increase market value .
Assumptions
- Perfect capital market exist where individuals and companies can borrow unlimited amounts at
the same rate of interest.
- There are no transaction costs.
- Personal borrowing is a perfect substitute for corporate borrowing.
- Firms exist with the same business risk.
- Debt is risk free.
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problems of high gearing
In practice firms are rarely found with very high levels of gearing. This is
because of:
• bankruptcy risk
• agency costs
• tax exhaustion
• the impact on borrowing/debt capacity
• differences in risk tolerance levels between shareholders and directors
• restrictions in the articles of association
• increases in the cost of borrowing as gearing increases.
As a result of these market imperfections, companies will often follow the industry average
gearing.
Pecking order theory
Firms follow a line of least resistance that establishes the capital structure.
• internally generated funds
• debt
• new issue of equity.
•
QUESTION - FAQ (BPP)
QUESTION - IML Co
QUESTION - YGV
QUESTION - Droxfol Co
QUESTION - Zigto Co
QUESTION - BKB Co
QUESTION - AQR Co
QUESTION - Li Co
QUESTION - AMH
QUESTION – DD Co
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CHAPTER 5 ( SOURCES OF FINANCE )
SOURCES
OF FINANCE
SHORT ISLAMIC
LONG TERM
TERM FINANCE
Criteria for choosing between sources of finance
A firm must consider the following factors:
Factor Issue to consider
Cost Debt usually cheaper than equity.

Duration Long term finance more expensive but secure.
Firms usually match duration to assets purchased.
Term structure Relationship between interest and loan duration –
of interest rate usually short term is cheaper – but not always!
Gearing Using mainly debt is cheaper but high gearing is risky.

Accessibility Not all sources are available to all firms.
Short term sources of finance
Will be discussed later, working capital is usually funded using short term sources of
finance.
Sources of short term finance include:
• bank overdrafts
• bank loans
• better management of working capital
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• squeezing trade credit
• leasing
• sale and leaseback
Long term sources of finance
Equity finance
There are three main sources of equity finance:

• internally generated funds – retained earnings
• rights issues
• new external share issues – placing, offer for sale, etc.
Internally generated funds – retained earnings
Points to consider :-
 Less formal
 No transaction cost
 Less risk
 Power is not diluted
Rights issues
Points to consider :-
 Rarely fails (share holders may lose control if they don‟t invest .)
 Share holders perception about the rights issue is very important.
 Theoretical exright price may be different than actual exright price.
 Cheaper than new issue .
 it is made at the discretion of the directors, without consent of the shareholders
or the Stock Exchange.
Theoretical ex-rights price (TERP)
The new share price after the issue is known as the theoretical ex-rights price and
is calculated by finding the weighted average of the existing market price and the
issue price, weighted by the number of shares ex-rights.
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QUESTION 5.1
Babbel Co, which has an issued capital of 2 million shares, having a current market
value of $2.70 each, makes a rights issue of one new share for every two existing
shares at a price of $2.10.
Required:
Calculate the TERP.
QUESTION 5.2
ABC Co announces a 2 for 5 rights issue at $2 per share. There are currently 10 million shares in
issue, and the current market price of the shares is $2.70.
Required:
Calculate the TERP
Value of a right
Value of a right = theoretical ex rights price – issue (subscription) price
Shareholders’ options
The shareholder‟s options with a rights issue are to:

(1) take up his rights by buying the specified proportion at the price offered
(2) renounce his rights and sell them in the market
(3) renounce part of his rights and take up the remainder
(4) do nothin
 QUESTION TIRWEN CO BPP (12/04)
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Choosing between sources of equity
When choosing between sources of equity finance, account must be taken of factors
such as:
(1) the accessibility of the finance
(2) the amount of finance
(3) costs of the issue procedure
(4) pricing of the issue
(5) control
(6) dividend policy – using retained earnings to pay dividends could impact the share
price
Characteristics of loan notes and other long term debt
Advantages:
From the viewpoint of the investor From the viewpoint of the company
• is low risk. • is cheap

• has predictable flows
• does not dilute control.
Disadvantages:
From the viewpoint of the investor From the viewpoint of the company
• has no voting rights. • is inflexible

• increases risk at high levels of gearing
• must (normally) be repaid.
Hybrids – Convertibles
Covered in the previous chapter
Hybrids – loan notes with warrants
Warrants give the holder the right to subscribe at a fixed future date for a certain
number of ordinary shares at a predetermined price.
Note: If warrants are issued with loan notes, the loan notes are not converted into
equity. Instead bond holders:
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• make a cash payment for the shares
• retain the loan notes until redemption.
Often used as sweeteners on debt issues:
• interest rate on the loan is low and loan may be unsecured

• right to buy equity set at an attractive price.
• bond holders can sell the warrants after buying the loan notes, thereby decreasing the
cost of buying the loan notes
Attractions for the company ( convertibles and warrants)
1- Because of the conversion option, the loans can be raised at below normal interest
rates or with less security.
2- Where companies wish to raise equity finance, but share prices are currently
depressed, convertibles offer a „backdoor‟ share issue method.
3-Where loans are converted into shares, the problem of repayment disappears.
Venture Capital
 High risk/ high return.
 Close relationship between VC and the company being offered finance.(to make
sure that the company struggling is able to get return for the venture capitalist)
 Medium term (5–7 years).
 Exit strategy.
Other sources of long term finance
 Finance lease
 Business Angels
 Government grants
 Mortgage -which is a special type of loan for buying property where monthly
payments are spread over a number of years.
Islamic finance
Islamic finance has the same purpose as other forms of business finance except that it
operates in accordance with the principles of Islamic law (Sharia).
Therefore, ethical and moral investing is encouraged. Instead of interest being charged,
returns are earned by channeling funds into an underlying investment activity, which will
earn profit. The investor is rewarded by a share in that profit, after a management fee is
deducted by the bank.
The basic principles covered by Islamic finance include:
• Sharing of profits and losses.
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• No interest (riba) allowed.
• Finance is restricted to Islamically accepted transactions. i.e. No investment in alcohol,
gambling etc.
The main sources of finance within the Islamic banking model include:
• Murabaha (trade credit)
• Ijara (lease finance)
• Sukuk (debt finance)
• Mudaraba (equity finance)
• Musharaka (venture capital)
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CHAPTER 6 (Dividend policy)
Dividend irrelevancy theory
1. It doesn‟t matter if the level dividend is more or less .Less dividend means more
retained earnings and higher share price .(leads to capital gain )
2. We can pay any level of dividend we wish for . Shortfall can be met through a
new equity issue.
Assumption:
Investment opportunities are available.

Perfect capital market - Modigliani & Miller (M&M) - (no taxation, no transaction costs, no
market imperfections)
Residual theory
1- After spending on all positive NPV projects we should spend the remains on dividend
payments.
2- Timing of thedividend payment is not important. So there is nopoint in retaining profits
for the year of lowprofits.
Dividend relevance
Practical influences, including market imperfections, mean that changes in dividend

policy, particularly reductions in dividends paid, can have an adverse effect on
shareholder wealth:
• reductions in dividend can convey „bad news‟ to shareholders (dividend signalling)
• changes in dividend policy, particularly reductions, may conflict with investor liquidity
requirements
• changes in dividend policy may upset investor tax planning (clientele effect).
As a result companies tend to adopt a stable dividend policy and keep shareholders
informed of any changes.
Practical constraint
Bond and loan agreements may contain covenants that restrict the amount of dividends
a firm can pay.
Alternatives to cash dividends
1- Share repurchase- consider using cash to buy back shares as an alternative to a

dividend, particularly if surplus cash available would distort normal dividend
policy.
2- Special dividend- Pay one off special dividend if surplus cash is available .
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3- Scrip dividends- A scrip dividend is where a company allows its shareholders to
take their dividends in the form of new shares rather than cash. The advantage to
the company is that it does not have to find the cash to pay a dividend.
QUESTION BAR Co-BPP
QUESTION ECHO BEACH Co BPP
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CHAPTER 7 (Ratio Analysis )
PROFITABILITY RATIOS :
Return on Capital Employed (ROCE)
A measure of the underlying performance of the business before finance. It considers

the overall return before financing. It is not affected by gearing.
Return on Equity (ROE)
A measure of return to the shareholders. It is calculated after taxation and before

dividends have been paid out. It will be affected by gearing.
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Asset turnover
Asset turnover is a financial ratio that measures the efficiency of a

company's use of its assets in generating sales revenue
Revenues
Asset Turnover = -------------------
Total Assets
Gross profit margin
Shows how much of revenue earned by the company is translated into gross profits.
Gross profit
Gross profit margin = -------------------
Revenue
Net profit margin
Shows how much of revenue earned by the company is translated into net profits.
Net profit
Net profit margin = -------------------
Revenue
Operating profit margin
Shows how much of revenue earned by the company is translated into operating profits.
PBIT
Operating profit margin = -------------------
Revenue
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INVESTORS RATIOS or STOCK MARKET RATIOS :
Earnings per share

Earnings per share (EPS) is the portion of a company's profit that is allocated to each
outstanding share .
Price Earnings Ratio (P/E Ratio)
The P/E ratio is a measure of future earnings growth, it compares the market value
to the current earnings.
Dividend Cover
The relationship between the dividend paid and the funds available to pay the dividend
ie the attributable profit (PAT or EPS)
1. The industry type
2. Shareholder expectations
3. The investment opportunities
4. Tax
5. Dividend policy.
Dividend Yield
The cash return from holding a share. It is theoretically irrelevant because it only
considers part of the return available to the shareholder (the other part being the capital
gain or increase in share price).
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GEARING RATIOS :
Equity gearing
Total or Capital gearing
INTEREST COVER
An income statement measure that considers the ability of the business to cover the
interest payments as they fall due.
QUESTION TFR Co
-QUESTION ARWIN
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CHAPTER 8 (Business valuations and market efficiency)
Dividend valuation model
The value of the company/share is the present value of the expected future dividends
discounted at the cost of equity.
Total MV = Share price x Total number of shares.
Advantages
1. Considers the time value of money and has an acceptable theoretical basis.
2. Particularly useful when valuing a minority stake of a business.
Disadvantages
1. Difficulty estimating an appropriate growth rate.

2. The model is sensitive to key variables.
3. The growth rate is unlikely to be constant in practice.
4. There are different ways to calculate growth rate.( giving different results)
Asset based valuations
A type of business valuation that focuses on a company's net asset value, or the fair-
market value of its total assets minus its total liabilities. The asset-based approach
basically asks what it would cost to recreate the business. There is some room for
interpretation in the asset approach in terms of deciding which of the company's assets
and liabilities to include in the valuation, and how to measure the worth of each.
Types of asset based measures
Book value
There is never a circumstance where book value is an appropriate valuation base.

It may however be used as a stepping stone towards identifying another measure.(e.g,
minimum price )
Net realisable value
Only used to establish a minimum value for an asset, it may be difficult to find an
appropriate value over the short term. Used for a company when being broken up
or asset stripped.
Replacement cost
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May be used to be find the maximum value for an asset. Used for a company as a going
concern.
QUESTION 8.1 Fagan Ltd

Below is a balance sheet of Fagan Ltd,
$
Non-current assets (carrying value) 625,000
Net current assets 160,000
785,000
50c ordinary shares 300,000

Reserves 285,000
6% debentures 200,000
785,000
Notes:
1- loan notes are redeemable at a premium of 5%
2- The premises have a market value that is $50,000 higher than the book value
3- all other assets are estimated to be realisable at their book value.
Required:
Value a 60% holding of ordinary shares on an assets basis.
Income / earnings based methods
Income / earnings based methods are of particular use when valuing a majority
shareholding:
1. As majority shareholders, the owners can influence the future earnings of the
company.
2. The dividend policy of a company is less of an issue when control is held, the
level of dividends can be manipulated to what you want.
PE ratio method or Earning yield method
Value of company = Total earnings x P/E ratio

OR
Value of company = Total earnings x ( 1 / Earning yield )
Using PE method for unquoted companies
Value per share = EPS × P/E ratio

Value of company = value per share x number of shares
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Using an adjusted P/E from a similar quoted company (or industry average).PE will be
adjusted by 10% per difference – but in exam amounts are less important than the
explanation.
QUESTION CLOSE Co (12/11)
Present value of Free cashflows (FCF)
Buyer of a business will calculate operating or „free‟ cash flows per annum.
The value of the business is:
PV of future cash flows
A discount rate reflecting the systematic risk of the flows should be used.
Method:
1. Identify relevant „free‟ cash flows
 operating cash flows
 investment per annum.
 revenue from sale of assets
 tax payable(ignore time delay in tax payment)
 tax relief
 synergies from merger (if any)
2. Select a suitable time horizon.( it can be limited or unlimited)
3. Identify a suitable discount rate
4. Calculate the present value over the time horizon.
Advantages
 The best method on a theoretical basis.

 May value a part of the company.
Disadvantages
 It relies on estimates of both cash flows and discount rates – may be

unavailable.
 Difficulty in choosing a time horizon.
 Difficulty in valuing a company‟s worth beyond this period.
 Assumes that the discount rate and tax rates are constant through the period.
QUESTION MCQ
QUESTION PHOBIS Co (12/07)
QUESTION BOLUJE Co (12/08)
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EFFICIENT MARKET HYPOTHESIS (EMH)
A market is efficient if
The prices of securities traded in that market reflect all the relevant information
accurately and rapidly, and are available to both buyers and sellers.
No individual dominates the market.
Transaction costs of buying and selling are not so high as to discourage trading
significantly.
Market efficiency from the perspective of the EMH relates to the efficiency of
information, the better the information received by investors, the better and more
informed the decisions they make will be.
Degree or forms of efficiency
For the purpose of testing, EMH is usually broken down into 3 forms as follows:
1. Weak form
Weak form hypothesis states that current share prices reflect all relevant information
about the past price movements and their implications. If this is true, then it should be
impossible to predict future share price movements from historic information or pattern.
Share prices only changes when new information about a company and its profits have
become available. Since new information arrives unexpectedly, changes in share prices
should occur in a random fashion, hence weak form can be referred to as random walk
hypothesis.
2. Semi- strong form
Semi-strong form hypothesis state that current share prices reflects both
(i) all relevant information about past price movement and their implications;
and
(ii) publicly available information about the company.
Any new publicly accessible information whether comments in the financial press,
annual reports or brokers investment advisory services, should be accurately and
immediately reflected in current share prices, so investment strategies based on such
public information should not enable the investor to earn abnormal profit because these
will have already been discounted by the market.
3. Strong form
The strong form hypothesis states that current share prices reflect all relevant
information available from
past price changes
public knowledge; and
insider knowledge available to specialists or experts such as investment
managers.
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Implications of EMH for financial managers
If capital markets are efficient, the main implications for financial managers are:
1. The timing of issues of debt or equity is not critical, as the prices quoted in the market
are „fair‟. That is price will always reflect the true worth of the company, no over or under
valuation at any point.
2. An entity cannot mislead the markets by adopting creative accounting techniques.
3. The entity‟s share price will reflect the net present value of its future cash flows, so
managers must only ensure that all investments are expected to exceed the company‟s
cost of capital.
4. Large quantities of new shares can be sold without depressing the share price.
5. The market will decide what level of return it requires for the risk involved in making
an investment in the company. It is pointless for the company to try to change the
market‟s view by issuing different types of capital instrument.
6. Mergers and takeovers. If shares are correctly priced this means that the rationale
behind mergers and takeovers may be questioned. If companies are acquired at their
current market valuation then the purchasers will only gain if they can generate
synergies . In an efficient market these synergies would be known, and therefore
already incorporated into the price demanded by the target company shareholders.
The more efficient the market is, the less the opportunity to make a speculative
profit because it become impossible to consistently out-perform the market.
Evidence so far collected suggests that stock markets show efficiency that is at
least weak form, but tending more towards a semi-strong form. In other words, current
share prices reflect all or most publicly available information about companies and their
securities.
QUESTION MCQ
QUESTION 8. 2
The following information has been taken from the statement of profit or loss and
statement of financial position of B Co:
Revenue $350m
Production expenses $210m
Administrative expenses $24m
Tax allowable depreciation $31m
Capital investment in year $48m
Corporate debt $14m trading at 130%
Corporation tax is 30%.
The WACC is 16.6%. Inflation is 6%.
These cash flows are expected to continue every year for the foreseeable future.
Required:
Calculate the value of equity.
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CHAPTER 9 Working capital management
THE TREASURY FUNCTION
A function devoted to all aspects of cash within a company.

This includes:
1. Investment
2. Raising finance
3. Banking and exchange
4. Cash and currency management
5. Risk
6. Insurance.
Role
„Treasury management is the corporate handling of all financial matters, the generation
of external and internal funds for business. The management of currencies and cash
flows, and complex strategies, policies and procedures of corporate finance.‟
The role being summarised under 5 headings:
1. Corporate objectives
2. Liquidity management
3. Investment management
4. Funding management
5. Currency management.
Centralisation vs. decentralisation
In a large organisation there is the opportunity to have a single head office treasury
department or to have individual treasury departments in each of the divisions. Modern
practice would suggest the decentralised route where there is little or no head office
intervention in the workings of an autonomous division. This runs contrary to treasury
practice where large companies tend to have a centralized function.
Advantages of centralisation
1. Avoid duplication of skills of treasury across each division. A centralised team will
enable the use of specialist employees in each of the roles of the department.
2. Borrowing can be made „in bulk‟ taking advantage of better terms in the form of lower
interest rates and less imposing conditions.
3. Pooled investments will similarly take advantage of higher rates of return than smaller
amounts.
4. Pooling of cash resources will allow cash-rich parts of the company to fund other
parts of the business in need of cash.
5. Closer management of the foreign currency risk of the business.
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Advantages of decentralisation
1. Greater autonomy of action by individual treasury departments to reflect local

requirements and problems.
2. Closer attention to the importance of cash by each division.
Profit centre vs. cost centre
Should the treasury department be run as a cost centre or a profit centre?

Cost centre – A function to which costs are accumulated.
Profit centre – A function to which both costs and revenues are accounted for.
Advantages of using a profit centre
1. The use of the treasury department is given „a value‟ which limits the use of the
service by the divisions.
2. The prices charged by the treasury department measure the relative efficiency of that
internal service and may be compared to external provision.
3. The treasury department may undertake part of the hedging risk of a trade thereby
saving the company as a whole money.
4. The department may gain other business if there is surplus capacity within the
department.
5. Speculative positions may be taken that net substantial returns to the business.
Disadvantages of using a profit centre
1. Additional costs of monitoring. The treasury function is likely to be very different to the
rest of the business and hence require specialist oversight if run as a profit making
venture.
2. The treasury function is unlikely to be of sufficient size in most companies to make a
profit function viable.
3. The company may be taking a substantial risk by speculation that it cannot readily
quantify. In the event of a position going wrong the company may be dragged down as
a result of a single transaction.
Short-term sources of finance
Factoring
The outsourcing of the credit control department to a third party. The debts of the
company are effectively sold to a factor. The factor takes on the responsibility to collect
the debt for a fee. The factor offers three services:
1. Debt collection
2. Financing
3. Credit insurance.
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The factor is often more successful at enforcing credit terms leading a lower level of
debts outstanding. Factoring is therefore not only a source of short-term finance but
also an external means of controlling or reducing the level of debtors.
Invoice discounting / Debtor finance / Recievable finance
A service also provided by a factoring company. Selected invoices are used as security
against which the company may borrow funds. This is a temporary source of finance
repayable when the debt is cleared. The key advantage of invoice discounting is that it
is a confidential service, the customer need not know about it.The higher risk (i.e more
bad debts) taken by the invoice discounter (i.e the factoring company)the more
expensive will be cost of finance for the company .
Trade credit
The delay of payment to suppliers is effectively a source of finance.By paying on credit

terms the company is able to „fund‟ its stock of the material at the expense of its
suppliers.
Overdrafts
A source of short-term funding which is used to fund fluctuating working capital

requirements. Its great advantage is that you only pay for that part of the finance that
you need. The overdraft facility (total limit) is negotiated with the bank on a regular basis
(maybe annually). For a company with a healthy trading record it is normal for the
overdraft facility to be „rolled over‟ from one year to the next although theoretically
it is „repayable on demand‟.
Bank loans
Bank loans or term loans are loans over between one and three years which have
become increasingly popular over the past ten to fifteen years „as a bridge‟ between
overdraft financing and more permanent funding.
Bills of exchange
A means of payment whereby by a „promissory note‟ is exchanged for goods.The bill of

exchange is simply an agreement to pay a certain amount at a certain date in the future.
No interest is payable on the note but is implicit (suggested though not directly
expressed) in the terms of the bill.
Asset specific sources of finance
Some sources of finance are used to purchase individual assets using the asset as
security against which the funds are borrowed.
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Hire purchase
The purchase of an asset by means of a structured financial agreement.Instead of

having to pay the full amount immediately, the company is able to spread the payment
over a period of typically between two and five years.
Finance lease
A type of asset financing that appears initially very similar to hire purchase. Again the
asset is paid for over between two and five years (typically) and again there is a deposit
(initial rental) and regular monthly payments or rentals.
The key difference is that at the end of the lease agreement the title to the asset does
not pass to the company (lessee) but is retained by the leasing company (lessor). This
has important potential tax advantages.
Operating lease
In this situation the company does not buy the asset (in part or in full) but instead rents
the asset. The operating lease is often used where the asset is only required for a short
period of time .
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Liquidity vs Profitability
Level of working capital (factors to consider)
1. The nature of the business( service industry vs manufacturing industry)

2. Certainty in supplier deliveries,(high uncertainty means high working capital)
3. The level of activity of the business,(higher production and sales leads to high
working capital)
4. The company‟s credit policy.(tight credit policy means lower working capital
Funding the working capital requirement
Short-term sources of Long-term sources of

Finance finance
Examples
Bank overdraft Equity
Trade creditors Long-term debt
Advantages
1. Flexible – only borrow 1. Secure – no need to
what is needed . constantly replenish.
2. Cheaper – liquidity 2. Lower financing risk.
Preference.
3. Easier to source . 3. Matching funding to need.
The attitude of management to risk: aggressive, conservative and matching

funding policies – See diagram below
There is no ideal funding package, but three approaches may be identified.
• Aggressive – finance most current assets, including „permanent‟ ones, with shortterm
finance. Risky but profitable.
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• Conservative – longterm finance is used for most current assets, including a
proportion of fluctuating current assets. Stable but expensive.
• Matching – the duration of the finance is matched to the duration of the investment.
Liquidity ratios
Current assets may be financed by current liabilities or by long-term funds. The “ideal”
current ratio is 2:1. This would mean that half of the current assets are financed by
current liabilities and therefore half by long-term funds. Similarly the ideal quick ratio is
1:1.
Current ratio
A simple measure of how much of the total current assets are financed by current
liabilities. A safe measure is considered to be 2:1 or greater meaning that only a limited
amount of the assets are funded by the current liabilities.
Current Assets
Current Ratio = --------------------------
Current Liabilities
Quick ratio
A measure of how well current liabilities are covered by liquid assets. A safe measure is
considered to be 1:1 meaning that we are able to meet our existing liabilities if they all
fall due at once.
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Current Assets minus Stock
Quick Ratio = ---------------------------------------
(or acid test) Current Liabilities
Operating cycle
Also known as the cash cycle or trading cycle. The operating cycle is the length of time
between the company‟s outlay on raw materials, wages and other expenditures and the
inflow of cash from the sale of goods.
QUESTION 9.1
Profit and loss account extract $

Turnover 250,000
Gross profit 90,000
Balance Sheet extract $ $

Current Assets
Inventory 30,000
Debtors 60,000
180,000
Current Liabilities
Creditors 50,000
Required:
Prepare the operating cycle.
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OVERTRADING
Overtrading is the term applied to a company which rapidly increase its turnover without
having sufficient capital backing, hence the alternative term “undercapitalisation”.
Output increase are often obtained by more intensive utilisation of existing fixed assets,
and growth tends to be financed by more intensive use of working capital.
Overtrading companies are often unable or unwilling to raise long-term capital and thus
tend to rely more heavily on short-term sources such as overdraft and trade creditors.
Debtors usually increase sharply as the company follows a more generous trade credit
policy in order to win sales, while stock tend to increase as the company attempts to
produce at a faster rate ahead of increase demand. Overtrading is thus characterised
by rising borrowings and a declining liquidity position in terms of the quick ratio, if not
always according to the current ratio.
Symptoms of overtrading
1. Rapid increase in turnover

2. Fall in liquidity ratio or current liabilities exceed current assets
3. Sharp increase in the sales-to-fixed assets ratio
4. Increase in the trade payables period
5. Increase in short term borrowing and a decline in cash balance
6. Fall in profit margins.
Overtrading is risky because short-term finance may be withdrawn relatively quickly if

creditors lose confidence in the business, or if there is general tightening of credit in the
economy resulting to liquidity problems and even bankruptcy, even though the firm is
profitable.
The fundamental solution to overtrading is to replace short-term finance with longterm
finance such as term loan or equity funds.
MANAGING RECEIVABLES
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Credit management
There are three aspects to credit management

1. Assessing credit status
2. Terms
3. Day to day management.
1- Assessing credit status
The creditworthiness of all new customers must be assessed before credit is offered, it
is a privilege and not a right. Existing customers must also be reassessed on a regular
basis. The following may be used to assess credit status of a company
1. Bank References
2. Trade References
3. Published accounts
4. Credit rating agencies
5. Company‟s own Sales Record.
2-Terms
Given that we are willing to offer credit to a company, we must know consider the
limits to the agreement.
This may include:
1. Credit limit value
2. Number of days credit
3. Discount on early payment
4. Interest on overdue account.
3- Day to day management.
The credit policy is dependent on the credit controllers implementing a set of simple but
rigorous procedures. If the system is not rigorous, those debtors who don‟t want to pay
will find ways not to pay. A process may be like the following
Time line Action

After 30 days Send statement of account
+7 days Reminder letter
+7 days 2nd reminder
+7 days Legal action threat
+7 days Take action to recover funds
COST OF FINANCING RECEIVABLES
The receivables balance needs to be financed. Any change to the receivables balance
will lead to a change in the financing cost of the business.
Interest cost = Receivables balance × Interest r
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Receivables days
Receivables balance = Sales × ------------------------
365
QUESTION 9.2
Shankly Limited has sales of $40m for the previous year, receivables at the year
end were $8m. The cost of financing debtors is covered by an overdraft at the
interest rate of 14%.
Required:
(a) What are the receivables days for Shankly?

(b) Calculate the cost of financing receivables.
Discounts for early payment
Cash discounts are given to encourage early payment by customers. The cost of the
discount is balanced against the savings the company receives from a lower balance
and a shorter average collecting period.
QUESTION 9.3
Shankly as above but a discount of 2% is offered for payment within 10 days.

Required:
Should the company introduce the discount given that 50% of the customers take up the
discount?
Advantages
1. Early payment reducing the debtor balance and hence the interest charge.
2. May reduce the bad debts arising.
Disadvantages
1. Difficulty in setting the terms.

2. Greater uncertainty as to when cash receipts will be received.
3. May not reduce bad debt in practice.
4. Customers may pay over normal terms but still take the cash discount.
Factoring
There are three main types of factoring service available:

1. Debt Collection And Administration
2. Credit Insurance. (incase of debt going bad ,factor is to suffer)
3. Financing.(e.g by invoice discounting)
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QUESTION 9.4
Shankly again but a factor has offered a debt collection service which should shorten
the debtor collection period on average to 50 days. It charges 1.6% of turnover but
should reduce administration costs to the company by $175,000.
Required:
Should the company use the factoring facility?
Advantages
1. Saving in internal administration costs.

2. Reduction in the need for day to day management control.
3. Particularly useful for small and fast growing businesses where the credit control
department may not be able to keep pace with volume growth.
Disadvantages
1. Should be more costly than an efficiently run internal credit control department.
2. Factoring has a bad reputation associated with failing companies, using a factor may
suggest your company has money worries.
3. Customers may not wish to deal with a factor.(Reputation risk)
4. Once you start factoring it is difficult to revert easily to an internal credit control.
5. The company may give up the opportunity to decide to whom credit may be given.
(a) Identify the reasons for the sharp decline in Ewden‟s liquidity and assess the
extent to which the company can be said to be exhibiting the problem of
„overtrading‟.
Illustrate your answer by reference to key performance and liquidity ratios
computed from Ewden‟s accounts. (13 marks)
(b) Determine the relative costs and benefits of the two methods of
reducing debtors, and recommend an appropriate policy. (7 marks)
MANAGING INVENTORY
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Material costs
Material costs are a major part of a company‟s costs and need to be carefully controlled.
There are 4 types of cost associated with stock:
1. ordering costs,
2. holding costs,
3. stockout costs,
4. purchase cost.
Ordering costs
The clerical, administrative and accounting costs of placing an order. They are usually
assumed to be independent of the size of the order.
Holding costs
Holding costs include items such as:
1. Opportunity cost of the investment in stock.(Money tied up in stock)
2. Storage costs
3. Insurance costs
4. Deterioration.
Stockout costs
1. Lost contribution through loss of sale;
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2. Lost future contribution through loss of customer;
3. The cost of emergency orders of materials;
4. The cost of production stoppages.
Economic order quantity
When the reorder quantity is chosen so that the total cost of holding and ordering is
minimized, it is known as the economic order quantity or EOQ. As the size of the order
increases, the average stock held increases and holding costs will also tend to increase.
Similarly as the order size increases the number of orders needed decreases and so
the ordering costs fall. The EOQ determines the optimum combination.
QUESTION 9.6
A company requires 10,000 units of material X per month. The cost per order is
$30 regardless of the size of the order. The holding costs are $20 per unit per
annum. It is only possible to buy the stock in quantities of 400, 500, 600 or 700
units at one time.
Required:
(a) What is the cheapest option?

(b) Calculate the economic order quantity using the formula.
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Bulk purchase discounts
Now there are two possible points of minima. The sum of the holding and ordering costs
are minimised at the EOQ. There will however be savings in the purchase cost when
the bulk discount volume is taken.
QUESTION 9.7
Annual demand is 120,000 units. Ordering costs are $30 per order and holding costs
are $20/unit/annum. The material can normally be purchased for $10/unit, but if 1,000
units are bought at one time they can be bought for $9,800. If 5,000 units are bought at
one time, they can be bought for $47,500.
Required:
What reorder quantity would minimize the total cost?
Criticism of EOQ
 EOQ does not calculate stock out cost and bulk purchase discount.
 Lead time is assumed to be constant.
 Assumes constant annual demad.
CASH MANAGEMENT
There are three areas associated with managing cash:

1. The Miller-Orr Model
2. The Baumol Model
3. The Cash Budget.
The Miller-Orr model
A model that considers the level of cash that should be held by a company in an
environment of uncertainty. The decision rules are simplified to two control levels in
order that the management of the cash balance can be delegated to a junior manager.
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The model allows us to calculate the spread. Given that we have the spread all key
control levels can be calculated.
Minimum level will be given in the question

Maximum level = minimum level + spread
Return point = minimum level + 1/3 spread
QUESTION 9.8
The minimum level of cash is $25,000. The variance of the cash flows is $250,000.
The transaction cost for both investing and en-cashing funds is $50. The interest rate
per day is 0.05%.
Required:
Calculate the:
(a) spread
(b) maximum level
(c) return point.
Criticism of Miller – Orr model
 Transaction cost is the same for all transactions (investing cash and injecting
cash)
 Variance of cash is calculated on the basis of variance in the past , assuming it to
be the same every year.
 Interest rate is assumed to be constant .
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The Baumol model
The use of the EOQ model to manage cash.
QUESTION 9.9
A company generates $5,000 per month excess cash. The interest rate it can expect to
earn on its investment is 6% per annum. The transaction costs associated with each
separate investment of funds is constant at $50.
Required:
(a) What is the optimum amount of cash to be invested in each transaction?
(b) How many transactions will arise each year?
(c) What is the cost of making those transactions per annum?
Cash budget
A budget prepared on a monthly basis (at least) to ensure that the company has an
understanding of its cash position going forward. There are 3 considerations:
Inflow and outflows of cash

Ignore non cash flows
Pro forma led
QUESTION CASH BUDGET
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CHAPTER 10
RISK
Foreign currency risk
Unlike when trading domestically, foreign currency risk arises for companies that trade
internationally. The risk that the exchange rate may move up or down in relation to other
currencies. It will have a major impact on the profitability of any company that buys or
sells to other countries.
Currency Pair
The value of a currency is determined by its comparison to another currency. The

currency pair shows how much of the quote currency is needed to purchase one unit of
the base currency.
Spot rate
A prevailing rate at a point in time (say today)

e.g. $:£ 1.9500
Spot rate with spread
The bank expects a margin to transact funds. As a result the rate is often expressed in
terms of a bid/offer spread. Remember the bank will always win!
e.g. $:£ 1.9150 – 1.9850 or $:£ 1.9500 +/- 0.0350
QUESTION 10.1
The US$ rate per £ is quoted as 1.4325 – 1.4330.

1-Company A wants to buy $100,000 in exchange for sterling.
2-Company B wants to sell $200,000 in exchange for sterling.
What rate will the bank offer each company?
EXCHANGE RATE SYSTEMS
Exchange rates are a key measure for governments to attempt to control. They will
have direct bearing on the economic performance of the country.
Fixed (or pegged) rate systems
Where a currency is fixed in relation to the dominant world currency ($) or alternatively
against a basket of currencies . The „peg‟ may be changed from time to time to reflect the
relative movement in underlying value.
This form of currency management is effective at giving a stable exchange platform for
trade. It will however lead to a parallel or unofficial market for currency if out of step with
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perceived value and normally requires strict exchange control to operate.
Floating rate systems
Where the exchange rate is allowed to be determined without any government

intervention. It is determined by supply and demand. This is rare, currency value is
normally considered too important a measure to be left solely to the market.
The market has a tendency to be volatile to the adverse effect of trade and wider
government policy. This volatility can adversely affect the ability to trade between
currencies.
Managed or ‘dirty’ float
Where the market is allowed to determine the exchange rate but with government
intervention to reduce the adverse impacts of a freely floated rate.
The government may intervene by:
1- Using reserves to buy or sell currency the government can artificially stimulate
demand or supply and keep the currency within a trading range reducing volatility.
2- Using interest rates, by increasing the interest rate within the economy the
government makes the currency more attractive to investors in government debt and
will attract speculative funds.
TYPES OF FOREIGN CURRENCY RISK
There are three risks associated with foreign currency:

1. Transaction risk.
2. Economic risk.
3. Translation risk.
Transaction risk
The risk associated with short-term cash flow transactions.

This may include:
Commercial trade – this is normally reflected by the sale of goods in a foreign currency
but with a delay in payment. The receipt will have an uncertain value in the home
currency.
Borrowing or lending in another currency
Subsequent cash flows relating to interest payments would be uncertain in the home
currency.These transactions may be hedged relatively easily either using internal or
external hedging tools.
Economic risk
Long-term cash flow effects associated with asset investment in a foreign country or
alternatively loans taken out or made in a foreign currency and the subsequent capital
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repayments.
Economic risk is more difficult to hedge given the longer term nature of the risk (possibly
over 10 or more years). A simple technique would be to adopt a portfolio approach to
investments by currency to spread the risk.
Translation risk
Risk associated with the reporting of foreign currency assets and liabilities within
financial statements.There is no cash flow impact of this type of risk. However, the
impact on the financial statements can be severe.
Translation risk may be hedged by matching the assets and liabilities within each
country. Any increase or decrease in value would cancel out on consolidation.
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WHAT MAKES EXCHANGE RATES FLUCTUATE?
Balance of payments
The inflows and outflows from trade reflect demand for and supply of the home
currency. If there is a consistent deficit or surplus there will be a continuing excess
supply or demand for the currency that would be reflected in weakness or strength
in the currency.For major traded currencies this effect is relatively small.
Capital movements between countries
Of far more importance for major currencies are the flows of speculative capital from
one currency to another. This makes the level of relative interest rates of critical
importance for these currencies. An increase in the interest rate of one currency will
lead to a one-off increase of demand for that currency increasing its value.
It is difficult to predict future rates based on this measure.
Purchasing power parity theory (PPPT)
Based on the law of one price in economic theory. This would suggest that the price of
the same product is the same in all currencies.
To extend the principle further this would suggest that a relative change in prices
(inflation) would have a direct effect on the exchange rate.
PPPT is an unbiased but poor predictor of future exchange rates.
Illustration
A product is currently being sold in the UK for £2,000 and in the US for $4,000.
This would infer that the current exchange rate is $:£ 2.0000. What would we expect
the exchange rate to be in 1 year if the inflation rates are 4% and 7% respectively?
Year UK US
0 £2,000 $4,000
Inflation × 1.04 × 1.07
1 £2,080 $4,280
The predicted exchange rate would be $4,280/£2,080 = $:£ 2.0577.

To calculate the impact of PPPT use the following formula:
(1+ic)
S1 = S0 × ––––––
(1+ib)
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Where:
S0 = Current spot
S1 = Expected future spot
ib = Inflation rate in country for which the spot is quoted (base currency)
ic = Inflation rate in the other country. (counter currency)
Problems with PPPT

 PPPT assumes that economic condition (inflation rate ) are not changing .
 There are market imperfections such as taxation and tariffs that reduce the
impact of PPPT.
 Only a small proportion of trade relates to traded goods ,greater portion relates to
speculative transactions.
 Demand and supply of that particular product traded is ignored .(e.g pair of jeans
may have higher demand in the US)
Interest Rate Parity Theory (IRPT)
The IRPT claims that the difference between the spot and the forward exchange rates is
equal to the differential between interest rates available in the two currencies.
IRPT is an unbiased but poor predictor of future exchange rates.
Illustration
It is possible to invest £1m in short-dated govt bonds in the UK at 6.08% or
alternatively in US treasury bills at 9.14%. The current exchange rate is $:£2.0000
Year UK US
0 £1m ×2= $2m
Interest × 1.0608 × 1.0914
1 £1.0608m $2.1828m
The predicted exchange rate would be $2.1828m/£1.0608m = $:£ 2.0577.

(1+ic)
F0 = S0 × ––––––
(1+ib)
Where:
S0 = Current spot
F0 = Forward rate
ib = interest rate for base currency
ic = interest rate for counter currency
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Disadvantages
1- Interest rates are not regarded as a particularly good predictor of exchange rates
– inflation rates are regarded as better. That is why in the exam (and on the
formula sheet) we use inflation rates to forecast exchange rates (when needed).
In theory, inflation rates and interest rates move together which is why (in the
exam) we would use interest rates if inflation rates were not available
2- In practice lots of things affect exchange rates, and it is therefore impossible to
forecast them accurately – it is just that relative interest rates (and inflation rates)
are things we can actually measure.
3- Forward rates quoted by the bank are not the banks prediction – they base them
solely on relative interest rates (the reason being that the bank itself is using
money market hedging on the money – they as a result cannot lose out!)
The international Fisher effect
The assumption that all currencies must offer the same real interest rate. This links
PPPT to IRPT. It is based upon the Fisher effect.
The international Fisher effect has a strong theoretical basis but is a poor predictor
of future exchange rates.
Remember the Fisher effect
(1 + m) = (1 + r)(1 + i)
Illustration
(using values from previous illustrations for PPPT and IRPT)
YR PPPT IRPT
0 2.0000 2.0000
× 1.07/1.04 ×1.0914/1.0608
1 2.0577 2.0577
Real rate of return (using fisher formula)
UK
= 1.0608/1.04 – 1 = 2%
US
= 1.0914/1.07 –1 = 2%
The reason for both PPP and IRP having the same prediction is because the
international Fisher effect holds true.
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Expectations theory
The expectations theory claims that the current forward rate is an unbiased
predictor of the spot rate at that point in the future.
If a trader takes the view that the forward rate is lower than the expected future
spot price, there is an incentive to buy forward. The buying pressure on the
forward raises the price, until the forward price equals the market consensus
view on the expected future spot price.
In practice, it is a poor unbiased predictor - sometimes it is wide of the mark in
one direction and sometimes wide of the mark in the other.
Four-way equivalence
The four theories can be pulled together to show the overall relationship between
spot rates, interest rates, inflation rates and the forward and expected future spot
rates. As shown above, these relationships can be used to forecast exchange
rates.
Managing foreign currency risk
Practical approaches to managing foreign currency risk include:
 Dealing in your home currency

 Doing nothing
 Leading
 Lagging
 Matching receipts and payments
 Foreign currency bank accounts
 Matching assets and liabilities
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Deal in home currency
Insist all customers pay in your own home currency and pay for all imports in home
currency.
This method:
 transfers risk to the other party
 may not be commercially acceptable.
Do nothing
In the long run, the company would 'win some, lose some'.
This method:
 works for small occasional transactions
 saves in transaction costs
 is dangerous!
Leading
If an exporter expects that the currency it is due to receive will depreciate over the next
few months it may try to obtain payment immediately.
This may be achieved by offering a discount for immediate payment.
Lagging
If an importer expects that the currency it is due to pay will depreciate, it may attempt to
delay payment.
This may be achieved by agreement or by exceeding credit terms.
Note: If the importer expects that the currency will in fact appreciate, then it should
settle the liability as soon as possible(leading). Or, if an exporter expects the currency to
appreciate, it may try to delay the receipt of payment by offering longer credit terms
(lagging).
Note_ Strictly this is not hedging _ it is speculation ( the company only benefits if it
correctly anticipates the exchange rate movement)
Matching payments and receipts
When a company has receipts and payments in the same foreign currency due at the
same time, it can simply match them against each other. It is then only necessary to
deal on the foreign exchange (forex) markets for the unmatched portion of the total
transactions.
Foreign currency bank accounts
Where a firm has regular receipts and payments in the same currency, it may choose to
operate a foreign currency bank account.
This operates as a permanent matching process.
The exposure to exchange risk is limited to the net balance on the account.
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Matching assets and liabilities (asset and liability management)
A company which expects to receive a significant amount of income in a foreign

currency will want to hedge against the risk of this currency weakening. It can do this by
borrowing in the foreign currency and using the foreign receipts to repay the loan. For
example, Euro receivables can be hedged by taking out a Euro overdraft. In the same
way, Euro trade payables can be matched against a Euro bank account which is used
to pay the suppliers.
A company which has a long-term foreign investment, for example an overseas
subsidiary, will similarly try to match its foreign assets(property, plant etc) by a long-term
loan in the foreign currency.
EXTERNAL HEDGING TECHNIQUES
Forward contract
Features
1. An agreement with the bank to exchange currency for a specific amount at a future
date.
2. It is an obligation that must be completed once entered into.
3. The transaction may take place over a limited range of dates if option dated. It is an
over the counter (OTC) product which means that it is tailored to the specific value and
date required.
4. The forward rate offers a perfect hedge because it is for the exact amount required by
the transaction on the appropriate date and the future rate is known with certainty.
5. The underlying theory behind the setting of the future rate is IRPT.
Illustration
The current spot rate is $:£2.1132 ± 0.0046. The company is expecting to receive
$400,000 in three months. The forward is quoted at a discount of 0.32 – 0.36 in
cents in three months.
Forward rule
The forward rate may be given as an adjustment to the prevailing spot rate, if so:
Add a discount, subtract a premium
$ $
Spot rate 2.1086 2.1178
Add discount 0.0032 0.0036
Forward rate 2.1118 2.1214
(buy rate ) (sell rate)
Receipt in £= $400,000/ 2.1214 = £188,555
QUESTION 10.2
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A US corporation is looking to hedge its foreign exchange. The current spot rate is
$:€ 1.6578 ± 0.0032. The company is expecting to pay €350,000 in one month.
The forward is quoted at a premium of 0.13 – 0.11 in cents in one months.
Required:
What is the value of the payment in $s?
Advantages
1- flexibility with regard to the amount to be covered, should lead to a perfect hedge in
terms of amount and date
2- relatively straightforward to organise.
Disadvantages
2- contractual commitment that must be completed on the due date, if the underlying
transaction is in anyway doubtful this may be problem
3- the rate is fixed with no opportunity to benefit from favourable movements in
exchange rates
Money market hedge
Use of the short-term money markets to borrow or deposit funds. This gives the
company the opportunity to exchange currency today at the current spot rate.
Steps
1. Borrow – borrow funds in the currency in which you need the money.
2. Translate – exchange the funds today avoiding exposure to fluctuations in the rate.
3. Deposit – deposit the funds in the currency in which you eventually want the funds
until such time as you will need them.
QUESTION 10.3
Liverpool plc must make a payment of US $450,000 in 3 months' time. The company
treasurer has determined the following:
Spot rate $1.7000 _ $1.7040
3-months forward $1.6902 _ $1.6944

6-months forward $1.6764 _ $1.6809
Decide whether a forward contract hedge or a money market hedge should be

undertaken.
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Advantages
 There is some flexibility regarding the date at which the transaction takes place.
 May be available in currencies for which a forward rate is not available.
Disadvantages
 Complex.
 May be difficult to borrow/ deposit in some currencies at a risk-free rate.
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Currency Futures
The „fixing‟ of the exchange rate today for a future trade in a similar manner to the
forward contract. The Future is an exchange traded instrument that can be bought
or sold on an exchange e.g. London International Financial Futures and Options
Exchange (LIFFE).
The future is a standardised financial instrument in terms of amount and date. This
may lead to a hedge that is less than perfect because the amount of the trade may
differ.
Currency Futures works in the following way :
1. A futures contract betting on the exchange rate rising or falling, and
2. An underlying transaction that may fall or rise in terms of the home currency.
The linking of the two cancels out the movement of the exchange rate and leads to
the hedge.
Currency options
Options have the benefit of being a one sided bet. You can protect the downside risk of
the currency moving against you but still take advantage of the upside potential. The
option writer therefore only has a downside risk (as we take the upside). The option
writer needs compensating for this risk and is paid a premium over and above
transaction costs.
QUESTION NEDWEN
Nedwen Co is a UK-based company which has the following expected transactions.

One month: Expected receipt of $40,000
One month: Expected payment of $140,000
Three months: Expected receipts of $300,000
The finance manager has collected the following information:

Spot rate ($ per £): 1.7820 ± 0.0002
One month forward rate ($ per £): 1.7829 ± 0.0003
Three months forward rate ($ per £): 1.7846 ±
0.0004 Money market rates for Nedwen Co:
Borrowing Deposit
One year sterling interest rate: 4.9% 4.6%
One year dollar interest rate: 5.4% 5.1%
Assume that it is now 1 April.
Required:
(a) Discuss the differences between transaction risk, translation risk and economic risk.
(6 marks)
(b) Explain how inflation rates can be used to forecast exchange rates. (6 marks)
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(c) Calculate the expected sterling receipts in one month and in three months using the
forward market. (3 marks)
(d) Calculate the expected sterling receipts in three months using a money-market
hedge and recommend whether a forward market hedge or a money market hedge
should be used. (5 marks)
(e) Discuss how sterling currency futures contracts could be used to hedge the three-
month dollar receipt. (5 marks
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INTEREST RATE RISK
The risk that interest rates will rise or fall in the future. Interest rates are normally
less volatile that exchange rates, changing at most on a monthly basis. They may
even be constant over long periods of time.
The exposure to interest rates however is more long lasting for companies on the
basis that any form of existing borrowing or investing will be affected by a change
in interest rates.
A company has a basic choice between borrowing fixed rate or variable (floating)
rate. Both present a risk, the variable rate represents a cash flow risk and the fixed
rate an opportunity cost.
Reasons for fluctuations in interest rates
Interest rates or base rates( interest rate which the Central Bank lend money to commercial
banks at) are a key economic tool for government. They may be changed for the following
reasons:
1- To control inflation_ higher interest rates will reduce demand for funds, aggregate
demand and hence inflationary pressure.
2- To protect the currency _ an increase in the interest rates will attract new funds
and increase the value of the economy.
3- To „kick-start‟ the economy, a reduction in interest rates can stimulate economic

activity by encouraging borrowing and discouraging savings.
The yield curve (term structure of interest rates)
There are three main types of yield curve shapes: normal, inverted and flat (or humped):
 normal yield curve - longer maturity bonds have a higher yield compared with
shorter-term bonds due to the risks associated with time
 inverted yield curve - the shorter-term yields are higher than the longer-term
yields, which can be a sign of upcoming recession
 flat (or humped) yield curve - the shorter- and longer-term yields are very close to
each other, which is also a predictor of an economic transition.
The slope of the yield curve is also seen as important: the greater the slope, the greater
the gap between short- and long-term rates.
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What explains the shape of the yield curve?
The shape of the yield curve at any point in time is the result of the three following
theories acting together:
 liquidity preference theory

 expectations theory
 market segmentation theory.
Liquidity preference theory
Investors have a natural preference for holding cash rather than other investments,
even low-risk ones such as government securities.They therefore need to be
compensated with a higher yield for being deprived of their cash for a longer period of
time. The normal shape of the curve as being upwards sloping can be explained by
liquidity preference theory.
Expectations theory
This theory states that the shape of the yield curve varies according to investors'
expectations of future interest rates.
A curve that rises steeply from left to right indicates that rates of interest are expected to
rise in the future. There is more demand for short-term securities than long-term
securities since investors' expectation is that they will be able to secure higher interest
rates in the future so there is no point in buying long-term assets now. The price of
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short-term assets will rise , the price of long-term assets will fall, so the yields on short-
term and long-term assets will consequently fall and rise.
A falling yield curve (also called an inverted curve, since it represents the opposite of
the usual situation) implies that interest rates are expected to fall.
A flat yield curve indicates expectations that interest rates are not expected to change
materially in the future.
Market segmentation theory
The market segmentation theory suggests that there are different players in the short-
term end of the market and the long-term end of the market. If there is an increased
supply in the long-term end of the market because the government needs to borrow
more, this may cause the price to fall and the yield to rise and may result in an upward
sloping yield curve
HEDGING INTEREST RATE RISK
We may hedge interest rate risk over the short or the long-term
Short term hedging Long-term hedging
Forward rate agreements Swaps

Interest rate guarantee
Interest rate futures
Interest rate options
Forward rate agreements (FRA)
The fixing of the interest rate today in relation to a future short-term loan. It is an
obligation that must be taken once entered into. It is OTC and tailored to a specific
loan in terms of:
1. Date
2. Amount, and
3. Term
and offers a „perfect hedge‟. The FRA is wholly separate to the underlying loan.
It will give certainty as regards the interest paid but there is a downside risk that
interest rates may fall and we have already fixed at a higher rate.
Interest rate guarantee (IRG)
Similar to a FRA but an option rather than on obligation. In the event that interest
rates move against the company (eg rise in the event of a loan) the option would
be exercised. If the rates move in our favour then the option is allowed to lapse.
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There is a premium to pay to compensate the IRG writer for accepting the downside
risk.
Interest rate futures
An exchange traded instrument that works in a similar manner to a FRA. By

trading on the exchange the Future can „fix‟ the rate today for a future loan.
Exchange traded interest rate options
Similar to an IRG but exchange traded, the option gives protection against the
downside for the payment of a premium.
LONG-TERM HEDGING – SWAPS
A company will borrow either using a variable or a fixed rate. If it wishes to change
its borrowing type it could redeem its present debt and re-issue in the appropriate
form. There are risks and costs involved in doing so.
A swap allows the company to change the exposure (fixed to variable or vice versa)
without having to redeem existing debt.
To prepare a swap we need the following steps
1. Identify a counter-party, either another company or bank willing to be the „other side‟
of the transaction. If we want to swap fixed for variable they will want the opposite
2. Agree the terms of the swap to ensure that at the outset both parties are in a neutral
position
3. On a regular basis (perhaps annually) transfer net amounts between the parties to
reflect any movement in the prevailing exchange rates
Characteristics
An interest rate swap is an agreement whereby the parties agree to swap a floating
stream of interest payments for a fixed stream of interest payments and via versa.
There is no exchange of principal:
 The companies involved are termed 'counter-parties'.

 Swaps can run for up to 30 years.
 Swaps can be used to hedge against an adverse movement in interest rates. Say
a company has a $200m floating loan and the treasurer believes that interest
rates are likely to rise over the next five years. He could enter into a five-year
swap with a counter party to swap into a fixed rate of interest for the next five
years. From year six onwards, the company will once again pay a floating rate of
interest.
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A swap can be used to obtain cheaper finance. A swap should result in a
company being able to borrow what they want at a better rate under a swap
arrangement, than borrowing it directly themselves.
Advantages of swaps
Allows a change in interest rate exposure at relatively low cost and risk.
May allow access to a debt type that is otherwise unavailable to the company.
May reduce the overall cost of financing in certain circumstances.
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CONTENT

1. Introduction to Financial Management 1

3. Net Present Values (other issues) 16

9. Working Capital Management 59

THREE KEY DECISIONS

INVESTMENT DECISION FINANCING DECISION DIVIDEND DECISION

OBJECTIVES OF NOT FOR PROFIT ORGANISATIONS

VALUE FOR MONEY (VFM) & 3Es

STAKE HOLDRE CONFLICTS

payback TIME VALUE OF MONEY

NET PRESENT VALUE

TAXATOIN & CAPITAL

MONEY VSREAL REPLACEMENT OF

Year Cash flow

QUESTION 2.2 ( HOME WORK)

Calculate the payback period in years and months for the

Year Cash flow

PAYBACK WHEN EQUAL CASHFLOW EVERY YEAR

ACCOUNTING RATE OF RETURN (ARR)

RETURN OF CAPITAL EMPLOYED ( ROCE)

ARRand ROCEareusedinterchangeably forinvestmentappraisalpurpose in

Average annual profits before interest and tax

Average annual profits before interest and tax

Average capital investment = Initial investment + scrap value

Profit = Cashflow - Depreciation

Determine the project's ROCE using:

(a) initial capital costs

(b) average capital investment

(a) initial capital costs

PAST EXAM QUESTION (HOMEWORK )

TIME VALUE OF MONEY

1. Future value is $1000 in 10 years time and discount rate is 10%.

QUESTION 2.8 (HOME WORK)

1. Future value is $10000 in 20 years time and discount rate is 4%.

Compounding We use compounding technique to calculate future value from present

QUESTION 2.9 (HOMEWORK)

We can find out present value of an annuity using :

Normal annuity is annuity that starts

Advance annuity is annuity that starts

Delayed annuity is annuity that starts

Find present values of the the following using

Find present values of the the following using

Perpetuities are equal cashflow every year for ever .

Normal perpetuity starts from year 1.

Advance perpetuity starts before year 1

Delayed perpetuity starts after year 1.

Find present values of the the following

QUESTION 2.13 (HOMEWORK)

Find present values of the the following

In the above discussions we referred to the rate of interest. There are a

Net Present Value (NPV)

Calculate the net present value (NPV) of the project to assess

QUESTION 2.15 (HOMEWORK)

Year Cash flow

The company‟s cost of capital is 9%.

• considers the time value of money

Internal Rate Return (IRR)

Year Cash flow

The company‟s cost of capital is 9%.

• considers the time value of money • it isnot ameasureofabsoluteprofitability

NET PRESENT VALUE ( OTHER ISSUES )

MONEY VS REAL ANALYSIS

• potential for earning interest/cost of finance