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Financial Management
Study Manual
For Exams until June 2021


British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library


ISBN 978-1-78480-775-7

Third Edition 2020

© 2020 InterActive World Wide Limited

London School of Business & Finance and the LSBF logo are trademarks or registered
trademarks of London School of Business & Finance (UK) Limited in the UK and in
other countries and are used under license. All used brand names or typeface names
are trademarks or registered trademarks of their respective holders.
We are grateful to the Association of Chartered Certified Accountants (ACCA) for
permission to reproduce syllabuses, study guides and pilot/specimen papers.
We are grateful to the Chartered Institute of Management Accountants (only where
applicable) and the Institute of Chartered Accountants in England and Wales (only
where applicable) for permission to reproduce past exam questions. The answers
have been prepared by InterActive World Wide.
All our rights reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording or otherwise, without the prior written permission of
InterActive World Wide.


Getting Started on Financial Management�������������������������������������������������������������������� 5

Chapter 1 - Financial Management: an Introduction�������������������������������������������������� 37
Chapter 2 - Investment Appraisal Techniques������������������������������������������������������������� 65
Chapter 3 - Advanced Discounted Cash Flow Techniques������������������������������������������� 95
Chapter 4 - Long-term Sources of Finance���������������������������������������������������������������� 131
Chapter 5 - Cost of Capital����������������������������������������������������������������������������������������� 153
Chapter 6 - Capital Structure and Risk Adjusted WACC��������������������������������������������� 185
Chapter 7 - Ratio Analysis������������������������������������������������������������������������������������������ 205
Chapter 8 - Raising Equity Finance���������������������������������������������������������������������������� 223
Chapter 9 - Working Capital Management���������������������������������������������������������������� 237
Chapter 10 - Efficient Market Hypothesis������������������������������������������������������������������ 287
Chapter 11 - Valuation����������������������������������������������������������������������������������������������� 295
Chapter 12 - Risk�������������������������������������������������������������������������������������������������������� 317
Question bank����������������������������������������������������������������������������������������������������������� 351
Index�������������������������������������������������������������������������������������������������������������������������� 381


Getting Started on
Financial Management


Aim of the paper

To develop knowledge and skills expected of a financial manager, in relation to
investment, financing and dividend policy decisions.

Outline of the syllabus

A. Financial management function
B. Financial management environment
C. Working capital management
D. Investment appraisal
E. Business finance
F. Business valuations
G. Risk management

Format of the exam paper

The syllabus is assessed by a three-hour computer-based examination.
All questions are compulsory. The exam will contain both computational and
discursive elements. Some questions will adopt a scenario/case study approach. Prior
to the start of the exam candidates are given an extra 10 minutes to read the exam
Section A of the computer-based exam comprises 15 objective test questions of
2 marks each.
Section B of the computer-based exam comprises three questions each containing
five objective test questions.
Section C of the exam comprises two 20 mark constructed response questions. The
two 20-mark questions will mainly come from the working capital management,
investment appraisal and business finance areas of the syllabus. The section A and
section B questions can cover any areas of the syllabus.


Efficient and effective studying with us

1. Study in a good environment
There are so many potential distractions you need to avoid. Your studies require
you to gain enough depth of knowledge. E-mail, mobile phones, social networking
sites act as threats to you. For example, seeing that you have a new e-mail in your
Inbox distracts you and it is hard not to respond to its existence, even if it is only
spam e-mail. Get away from all of these and you’ll have a far better retention of the
knowledge you have gained. You’ll stay alert if you sit at a desk so long as you don’t
have your PC/Mac on!
2. Get an overview of the subject early
Knowing the big picture of the subject you are about to study is a great way to study
efficiently. This is hard for you to gain without knowledge of the subject, so use the
knowledge of your provider of material for the exam, like the Overview given in this
Study Manual.
3. Study when best for you in the day
Many people can double their reading speed and improve their concentration by
studying early in the day. Also it has been shown that revision in the evening without
major distractions afterwards (avoid late-night parties, for example!) allows your brain
to work on the material once you are asleep and can significantly improve your memory.
4. Skim the chapter first for the main ideas
Read the Chapter Context and scan the structure of the main chapter sections. You’ll
improve your reading speed and comprehension if you understand the structure of
the chapter first.
5. Form a question or questions
Boost your reading comprehension, reading speed, and concentration by formulating
your own questions (write them down if it helps) and/or using the ones that we have
provided. Read the chapter to obtain the answers. Your reading speed improves by
doing this, and you become far more focused on your material so you will retain
more. Use the following questions – what, when, why, who, which, where, how –
and the main section titles in the chapter.
6. Take notes
Improve your overall study effectiveness by jotting brief notes immediately after
reading each section of the chapter. Linking your points together, using a mind map
for example, helps memory. Refer back to your notes later to test your understanding
(and see point 7 below).
7. But avoid highlighting
Although some readers believe that highlighting in yellow (or any other colour, for
that matter) improves their reading speed and comprehension, the reverse is actually
true. Highlighting simply means they don’t bother learning the material right now.


The result: they end up reading the material twice, and possibly not understanding
or remembering it either time! Similarly, using material that has been highlighted by
the publisher is ineffective for your learning.
8. Repetition, repetition, repetition
We learn by repeating. It can be shown that if you don’t repeat knowledge almost
immediately then you have no chance of remembering it. We also need to repeat
that knowledge again within the next 90 to 120 minutes or we will forget it. So build
in time to your studies to do this, it will be very effective for you. How do we learn?
9. What’s the story?
At the end of each chapter, try to generate your own story for what you have just
been reading. Use the Questions at the start of the Chapter and the Key Learning
Points at the end of the Chapter to help here. Making your own story is a very
powerful way of helping you remember. It can have a start a middle and an end, just
like a normal story!


Our material – how we help you

99 Our authors are all experienced at producing targeted material for your exam.
So you will gain from that wealth of knowledge, for example by understanding
the Overview of the syllabus at the start of your studies and reviewing your
knowledge in line with it as you progress.
99 Our material is based on knowledge of how your brain works to help you
study better.
99 We pose you questions at the start of each chapter to assist your learning and
boost your interest and retention. Look for the ‘3 Questions’ that we have at
the start of each chapter. These help you become engaged with the material
and will mean you can answer the three questions better as well as the other
material in the chapter. For example:

1. Can you describe each of the key three decisions?


2. What aim in a company is ‘a fundamental aim’ and hence key to this paper?
3. What types of government policy can come into conflict?

99 You will be advised where you should stop and spend time learning/
memorising key facts or knowledge. Look out for the ‘Learn’s to help your
repetition of important knowledge.

G Learn
99 Similarly if you have to be familiar with the principles behind a few paragraphs
(such as a calculation) then we will prompt you with ‘Principle’ plus guidance
on what to go back for. Take time to stop yourself and check that you are
happy with these, they are key for the exam. For example:

P Principle
Learn the steps above so you can apply them in the exam

99 You will find when a formula or other information is given in the exam. Look
out for the ‘Given’s.

ü Given
99 We want you to build up a ‘story’ based on the material to help you remember
it better. When you see the ‘What’s the Story’ at the end of each chapter, take
time to link the chapter together and also link to any relevant previous chapters.


What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).

99 Importantly, we don’t bloat our material with extra unneeded features (for
example in the margins of the page, which are inefficient for students to learn
from). All the reminders to learn are in the centre of the page.
99 We are interested in your feedback – please complete the Feedback Form at
the end of studying this paper and have the chance to win a prize!


This ACCA paper, Financial Management, helps you to understand the need for
financial management as well as learn and apply the techniques and ideas that will
help you understand financial management from a business’s view. These can also
help you personally.
The syllabus states that the aim of the paper is ‘to develop the knowledge and skills
expected of a finance manager, in relation to investment, financing, and dividend
policy decisions’.
Let’s see how this is reflected in this Study Manual and its chapters. There are
chapters on aims of financial management and the main parts of the syllabus which
are the investment decisions, financing decisions and dividend decisions that a
business makes. We also will look at the shorter term financing of the business, via
its working capital and see how all these decisions impact on a business’s accounts via
ratio analysis. We will also look at the risks that a business face, in particular exchange
rate and interest rate risks and look at how a business can try to reduce these.

Investment decisions
We cover Financial Management: an Introduction (Chapter 1) to get an overall view
of the syllabus. This then leads into one of the big decisions for the exam, Investment
Appraisal Techniques (Chapter 2), which looks at how businesses can decide if they
are spending their money wisely, by comparing the outlays they have on projects
against the return they receive. There are various techniques amongst which those
looking at assessing cashflows are the most useful. Advanced Discounted Cash Flow
Techniques (Chapter 3) takes this knowledge further to extend your knowledge of
these techniques further. You will return later on to see Efficient Market Hypothesis
(Chapter 10), which considers, if you are investing in the shares of a quoted
company, how much information gets reflected in the company’s share price. This
is useful when we move onto Valuation (Chapter 11) which looks at how companies
as a whole can be valued. This is useful if you are working for a company that is
considering buying another company, and is thinking how much to pay. It may also be
interesting for you if you ever consider investing in a company’s shares.

Financing decisions
Long-term Sources of Finance (Chapter 4) looks at where the money that finances a
company comes from. In simple terms the finance is either debt (money borrowed)
or equity (money invested by shareholders). There is a cost to the finance ie the
company must pay the providers of finance, interest or dividends, and how to work
out this cost is covered in Cost of Capital (Chapter 5). Capital Structure and Risk
Adjusted WACC (Chapter 6) looks at how the cost of the finance changes depending
on the balance between debt and equity. Companies will try to find the optimal,
cheapest balance of finance. Raising Equity Finance (Chapter 8) requires you to be
familiar with the methods to raise share capital.


Finally, looking at the shorter term you will see Working Capital Management
(Chapter 9), which looks at the short term assets and liabilities of a business to see
the best way to manage these

Ratio Analysis and Risk

Lastly we look at two chapters that develop from the previous chapters. Ratio
Analysis (Chapter 7) looks at how the financial statements vary with different
businesses, depending on their type of business, the way they are financed, the
working capital policies they use. Risk (Chapter 12) looks at how issues like changing
exchange rates can affect the cashflows of a business and how variable interest rates
will affect the cost of capital. This chapter looks at ways to reduce the risks that a
business faces.

Financial Management

Investment Financing Dividend

Decisions Decisions Decisions

Investment Appraisal Long Term Sources

Techniques Raising Equity Finance

Advanced Discounted
Cash Flows
Cost of Capital

Efficient Market Capital Structure and

Hypothesis Risk Adjusted WACC

Working Capital Management

Ratio Analysis


You can see the diagram covers the overall aims of financial management first. This
sets the scene for the three main decisions in the exam, the investment, financing
and dividend decisions. Most of the detail in the exam is concerned with the
investment and financing decisions. Once those subjects have been understood the
ratio analysis and risk chapter follow from that knowledge.
Learn this diagram so that you can see where the subjects you have learnt fits in. It
will be useful to come back to so that you can see the ‘big picture’ for the paper.
Finally look around at businesses or other organisations that you are involved with,
or look at the business pages in the newspapers so that you can put your learning in
context. You will see many examples of this material in real life, such as companies
raising finance, buying other companies or taking on new projects. If you can see
your studies coming to life in this way it will help your learning considerably and
make the subject both more interesting and useful for the rest of your life.

Syllabus and Study Guide







1. Intellectual levels
2. Learning hours and educational recognition
3. The structure of the ACCA Qualification
4. Guide to ACCA examination structure and delivery mode
5. Guide to ACCA examination assessment


6. Relational diagram linking Financial Management with other exams
7. Approach to examining the syllabus
8. Introduction to the syllabus
9. Main capabilities
10. The syllabus


11. Detailed study guide
12. Summary of changes to Financial Management (FM)

The syllabus is designed to progressively broaden and deepen the knowledge, skills
and professional values demonstrated by the student on their way through the
The specific capabilities within the detailed syllabuses and study guides are assessed
at one of three intellectual or cognitive levels:

Level 1: Knowledge and comprehension

Level 2: Application and analysis
Level 3: Synthesis and evaluation

Syllabus and Study Guide

Very broadly, these intellectual levels relate to the three cognitive levels at which the
Applied Knowledge, the Applied Skills and the Strategic Professional exams are assessed.
Each subject area in the detailed study guide included in this document is given a 1,
2, or 3 superscript, denoting intellectual level, marked at the end of each relevant
learning outcome. This gives an indication of the intellectual depth at which an area
could be assessed within the examination. However, while level 1 broadly equates
with Applied Knowledge, level 2 equates to Applied Skills and level 3 to Strategic
Professional, some lower level skills can continue to be assessed as the student
progresses through each level. This reflects that at each stage of study there will
be a requirement to broaden, as well as deepen capabilities. It is also possible that
occasionally some higher level capabilities may be assessed at lower levels.


The ACCA qualification does not prescribe or recommend any particular number of
learning hours for examinations because study and learning patterns and styles vary
greatly between people and organisations. This also recognises the wide diversity
of personal, professional and educational circumstances in which ACCA students
find themselves.
As a member of the International Federation of Accountants, ACCA seeks to enhance
the education recognition of its qualification on both national and international
education frameworks, and with educational authorities and partners globally. In doing
so, ACCA aims to ensure that its qualification is recognised and valued by governments,
regulatory authorities and employers across all sectors. To this end, ACCA qualification
is currently recognised on the education frameworks in several countries. Please refer
to your national education framework regulator for further information.
Each syllabus is organised into main subject area headings which are further broken
down to provide greater detail on each area.



ACCA member
Strategic Professional
Essentials Options (Pick 2)
Strategic Business Advanced Audit and Advanced Performance
Leader Assurance Management Requirement
Strategic Business Advanced Financial Advanced As well as
Reporting Management Taxation completing
exams and
the Ethics and
Ethics and Professional Skills module (EPSM) Professional Skills
EPSM prepares you for the Strategic Professional exams as well as module, you
providing you with the skills needed to become a trusted finance need to complete
professional in today’s digital world. three years’
relevant work
Applied Skills experience.
Performance Audit and
Management Assurance
Corporate and Financial Financial
Business Law Reporting Management

Applied Knowledge
Accountant Financial Management
in Business Accounting Accounting

Find out more about ACCA’s Foundation level qualification at

*See accaglobal.com for details


The structure and delivery mode of examinations varies.
Applied Knowledge
The Applied Knowledge examinations contain 100% compulsory questions to
encourage candidates to study across the breadth of each syllabus. These are
assessed by a two-hour computer based examination.

Syllabus and Study Guide

Applied Skills
The Corporate and Business Law exam is a two-hour computer-based objective test
examination for English and Global. For the format and structure of the Corporate
and Business Law or Taxation variant exams, refer to the ‘Approach to examining
the syllabus’ in section 9 of the relevant syllabus and study guide. For the format
and structure of the variant exams, refer to the ‘Approach to examining the syllabus’
section below.
The other Applied Skills examinations (PM, TX-UK, FR, AA, and FM) contain a mix of
objective and longer type questions with a duration of three hours for 100 marks.
These are assessed by a three hour computer-based exam. Prior to the start of
each exam there will be time allocated for students to be informed of the exam
The longer (constructed response) question types used in the Applied Skills exams
(excluding Corporate and Business Law) require students to effectively mimic
what they do in the workplace. Students will need to use a range of digital skills
and demonstrate their ability to use spread sheets and word processing tools
in producing their answers, just as they would use these tools in the workplace.
These assessment methods allow ACCA to focus on testing students’ technical
and application skills, rather than, for example, their ability to perform simple
Strategic Professional
Strategic Business Leader is ACCA’s case study examination at Strategic Professional
and is examined as a closed book exam of four hours, including reading, planning
and reflection time which can be used flexibly within the examination. There is no
pre-seen information and all exam related material, including case information
and exhibits are available within the examination. Strategic Business Leader is an
exam based on one main business scenario which involves candidates completing
several tasks within which additional material may be introduced. All questions are
compulsory and each examination will contain a total of 80 technical marks and 20
Professional Skills marks.
The other Strategic Professional exams are all of three hours and 15 minutes
duration. All contain two sections and all questions are compulsory. These exams all
contain four professional marks.
From March 2020, Strategic Professional exams will become available by computer
based examination. More detail regarding what is available in your market will be on
the ACCA global website.
With Applied Knowledge and Applied Skills exams now assessed by computer based
exam, ACCA is committed to continuing on its journey to assess all exams within the
ACCA Qualification using this delivery mode.
The question types used at Strategic Professional again require students to effectively
mimic what they would do in the workplace and, with the move to CBE, these
exams again offer ACCA the opportunity to focus on the application of knowledge to


scenarios, using a range of tools – spread sheets, word processing and presentations
- not only enabling students to demonstrate their technical and professional skills but
also their use of the technology available to today’s accountants.
ACCA encourages students to take time to read questions carefully and to plan
answers but once the exam time has started, there are no additional restrictions as
to when candidates may start producing their answer.
Time should be taken to ensure that all the information and exam requirements are
properly read and understood.
The pass mark for all ACCA Qualification examinations is 50%.


ACCA reserves the right to examine any learning outcome contained within the
study guide. This includes knowledge, techniques, principles, theories, and concepts
as specified. For the financial accounting, audit and assurance, law and tax exams
except where indicated otherwise, ACCA will publish examinable documents once a
year to indicate exactly what regulations and legislation could potentially be assessed
within identified examination sessions.
For most examinations (not tax), regulations issued or legislation passed on or before
31 August annually, will be examinable from 1 September of the following year to 31
August of the year after that. Please refer to the examinable documents for the exam
(where relevant) for further information.
Regulation issued or legislation passed in accordance with the above dates may be
examinable even if the effective date is in the future.
The term issued or passed relates to when regulation or legislation has been
formally approved.
The term effective relates to when regulation or legislation must be applied to an
entity transactions and business practices.
The study guide offers more detailed guidance on the depth and level at which the
examinable documents will be examined. The study guide should therefore be read
in conjunction with the examinable documents list.
For UK tax exams, examinations falling within the period 1 June to 31 March will
generally examine the Finance Act which was passed in the previous year. Therefore,
exams falling in the period 1 June 2020 to 31 March 2021 will examine the Finance
Act 2019 and any examinable legislation which is passed outside the Finance Act
before 31 May 2019.
In addition, for exams in the period 1 June 2020 to 31 March 2021, all questions will
assume that the UK remains in the European Union.
For additional guidance on the examinability of specific tax rules and the depth in
which they are likely to be examined, reference should be made to the relevant
Finance Act article written by the examining team and published on the ACCA website.

Syllabus and Study Guide

None of the current or impending devolved taxes for Scotland, Wales, and Northern
Ireland is, or will be, examinable.


This diagram shows links between this exam and other exams preceding or following
it. Some exams are directly underpinned by other exams such as Advanced Financial
Management with Financial Management. This diagram indicates where students are
expected to have underpinning knowledge and where it would be useful to review
previous learning before undertaking study.

Strategic Business Advanced Financial

Leader (SBL) Management (AFM)

Management (FM)

Accounting (MA)


The syllabus is assessed by a three-hour computer based examination.
All questions are compulsory. The exam will contain both computational and
discursive elements.
Some questions will adopt a scenario/case study approach.
Prior to the start of the exam candidates are given an extra 10 minutes to read the
exam instructions.
Candidates are provided with a formulae sheet and tables of discount and
annuity factors.
Section A
Section A of the computer-based exam comprises 15 objective test questions of 2
marks each plus additional content as per below.
Section B
Section B of the computer-based exam comprises three questions each containing
five objective test questions plus additional content as per below.

Section C
Section C of the exam comprises two 20-mark constructed response questions. The
two 20-mark questions will mainly come from the working capital management,
investment appraisal and business finance areas of the syllabus. The section A and
section B questions can cover any areas of the syllabus.
Total 100 marks


The aim of the syllabus is to develop the knowledge and skills expected of a finance
manager, in relation to investment, financing, and dividend policy decisions.
The syllabus for Financial Management is designed to equip candidates with the skills
that would be expected from a finance manager responsible for the finance function
of a business. It prepares candidates for more advanced and specialist study in
Advanced Financial Management.
The syllabus, therefore, starts by introducing the role and purpose of the financial
management function within a business. Before looking at the three key financial
management decisions of investing, financing, and dividend policy, the syllabus
explores the economic environment in which such decisions are made.
The next section of the syllabus is the introduction of investing decisions. This is
done in two stages - investment in (and the management of) working capital and the
appraisal of long-term investments.
The next area introduced is financing decisions. This section of the syllabus starts
by examining the various sources of business finance, including dividend policy and
how much finance can be raised from within the business. It also looks at the cost of
capital and other factors that influence the choice of the type of capital a business
will raise. The principles underlying the valuation of business and financial assets,
including the impact of cost of capital on the value of business, is covered next.
The syllabus finishes with an introduction to, and examination of, risk and the main
techniques employed in managing such risk.

On successful completion of this exam, candidates should be able to:
A. Discuss the role and purpose of the financial management function
B. Assess and discuss the impact of the economic environment on
financial management
C. Discuss and apply working capital management techniques
D. Carry out effective investment appraisal
E. Identify and evaluate alternative sources of business finance

Syllabus and Study Guide

F. Discuss and apply principles of business and asset valuations

G. Explain and apply risk management techniques in business.

Financial management function (A)

Financial management environment (B)

Working capital
management (C)

Investment appraisal (D)

Business finance (E) Business valuations (F)

Risk management (G)

This diagram illustrates the flows and links between the main capabilities of
the syllabus and should be used as an aid to planning teaching and learning in a
structured way.


A. Financial management function
1. The nature and purpose of financial management
2. Financial objectives and relationship with corporate strategy
3. Stakeholders and impact on corporate objectives
4. Financial and other objectives in not-for-profit organisations
B. Financial management environment
1. The economic environment for business
2. The nature and role of financial markets and institutions
3. The nature and role of money markets
C. Working capital management
1. The nature, elements and importance of working capital
2. Management of inventories, accounts receivable, accounts payable and cash
3. Determining working capital needs and funding strategies


D. Investment appraisal
1. Investment appraisal techniques
2. Allowing for inflation and taxation in DCF
3. Adjusting for risk and uncertainty in investment appraisal
4. Specific investment decisions (lease or buy, asset replacement, capital rationing)
E. Business finance
1. Sources of, and raising, business finance
2. Estimating the cost of capital
3. Sources of finance and their relative costs
4. Capital structure theories and practical considerations
5. Finance for small- and medium-sized entities (SMEs)
F. Business valuations
1. Nature and purpose of the valuation of business and financial assets
2. Models for the valuation of shares
3. The valuation of debt and other financial assets
4. Efficient market hypothesis (EMH) and practical considerations in the
valuation of shares
G. Risk management
1. The nature and types of risk and approaches to risk management
2. Causes of exchange rate differences and interest rate fluctuations
3. Hedging techniques for foreign currency risk
4. Hedging techniques for interest rate risk


A. Financial management function
1. The nature and purpose of financial management
(a) Explain the nature and purpose of financial management.[1]
(b) Explain the relationship between financial management and financial and
management accounting.[1]
2. Financial objectives and the relationship with corporate strategy
(a) Discuss the relationship between financial objectives, corporate objectives and
corporate strategy.[2]
(b) Identify and describe a variety of financial objectives, including: [2]
(i) shareholder wealth maximisation
(ii) profit maximisation
(iii) earnings per share growth.

Syllabus and Study Guide

3. Stakeholders and impact on corporate objectives

(a) Identify the range of stakeholders and their objectives.[2]
(b) Discuss the possible conflict between stakeholder objectives.[2]
(c) Discuss the role of management in meeting stakeholder objectives, including the
application of agency theory.[2]
(d) Describe and apply ways of measuring achievement of corporate objectives
i) ratio analysis, using appropriate ratios such as return on capital employed,
return on equity, earnings per share and dividend per share
ii) changes in dividends and share prices as part of total shareholder return.
(e) Explain ways to encourage the achievement of stakeholder objectives,
(i) managerial reward schemes such as share options and
performance-related pay.
(ii) regulatory requirements such as corporate governance codes of best
practice and stock exchange listing regulations.
4. Financial and other objectives in not-for-profit organisations
(a) Discuss the impact of not-for-profit status on financial and other objectives.[2]
(b) Discuss the nature and importance of Value for Money as an objective in not-for-
profit organisations.[2]
(c) Discuss ways of measuring the achievement of objectives in not-for-profit
B. Financial management environment
1. The economic environment for business
(a) Identify and explain the main macroeconomic policy targets.[1]
(b) Define and discuss the role of fiscal, monetary, interest rate and exchange rate
policies in achieving macroeconomic policy targets.[1]
(c) Explain how government economic policy interacts with planning and decision-
making in business.[2]
(d) Explain the need for, and the interaction with, planning and decision-making
in business of:
(i) competition policy [1]
(ii) government assistance for business [1]
(iii) green policies [1]
(iv) corporate governance regulation.[2]


2. The nature and role of financial markets and institutions

(a) Identify the nature and role of money and capital markets, both nationally and
(b) Explain the role of financial intermediaries.[1]
(c) Explain the functions of a stock market and a corporate bond market.[2]
(d) Explain the nature and features of different securities in relation to the risk/
return trade-off.[2]
3. The nature and role of money markets
(a) Describe the role of the money markets in:[1]
(i) providing short-term liquidity to the private sector and the public sector
(ii) providing short-term trade finance
(iii) allowing an organisation to manage its exposure to foreign currency risk
and interest rate risk.
(b) Explain the role of banks and other financial institutions in the operation of the
money markets.[2]
(c) Explain and apply the characteristics and role of the principal money market
(i) interest-bearing instruments
(ii) discount instruments
(iii) derivative products.
C. Working capital management
1. The nature, elements and importance of working capital
(a) Describe the nature of working capital and identify its elements.[1]
(b) Identify the objectives of working capital management in terms of liquidity and
profitability, and discuss the conflict between them.[2]
(c) Discuss the central role of working capital management in financial management.[2]
2. Management of inventories, accounts receivable, accounts payable and cash
(a) Explain the cash operating cycle and the role of accounts payable and accounts
(b) Explain and apply relevant accounting ratios, including: [2]
(i) current ratio and quick ratio
(ii) inventory turnover ratio, average collection period and average
payable period
(iii) sales revenue/net working capital ratio.

Syllabus and Study Guide

(c) Discuss, apply and evaluate the use of relevant techniques in managing
inventory, including the Economic Order Quantity model and Just-in-Time
(d) Discuss, apply and evaluate the use of relevant techniques in managing accounts
receivable, including:
(i) assessing creditworthiness [1]
(ii) managing accounts receivable [1]
(iii) collecting amounts owing [1]
(iv) offering early settlement discounts [2]
(v) using factoring and invoice discounting [2]
(vi) managing foreign accounts receivable.[2]
(e) Discuss and apply the use of relevant techniques in managing accounts
payable, including:
(i) using trade credit effectively [1]
(ii) evaluating the benefits of early settlement and bulk purchase discounts [2]
(iii) managing foreign accounts payable.[1]
(f) Explain the various reasons for holding cash, and discuss and apply the use of
relevant techniques in managing cash, including:[2]
(i) preparing cash flow forecasts to determine future cash flows and
cash balances
(ii) assessing the benefits of centralised treasury management and cash control
(iii) cash management models, such as the Baumol model and the
Miller-Orr model
(iv) investing short-term.
3. Determining working capital needs and funding strategies
(a) Calculate the level of working capital investment in current assets and discuss
the key factors determining this level, including:[2]
(i) the length of the working capital cycle and terms of trade
(ii) an organisation’s policy on the level of investment in current assets
(iii) the industry in which the organisation operates.


(b) Describe and discuss the key factors in determining working capital funding
strategies, including:
(i) the distinction between permanent and fluctuating current assets [2]
(ii) the relative cost and risk of short-term and long-term finance [2]
(iii) the matching principle [2]
(iv) the relative costs and benefits of aggressive, conservative and matching
funding policies [2]
(v) management attitudes to risk, previous funding decisions and
organisation size.[1]
D. Investment appraisal
1. Investment appraisal techniques
(a) Identify and calculate relevant cash flows for investment projects.[2]
(b) Calculate payback period and discuss its usefulness as an investment
appraisal method.[2]
(c) Calculate discounted payback and discuss its usefulness as an investment
appraisal method.[2]
(d) Calculate return on capital employed (accounting rate of return) and discuss its
usefulness as an investment appraisal method.[2]
(e) Calculate net present value and discuss its usefulness as an investment
appraisal method.[2]
(f) Calculate internal rate of return and discuss its usefulness as an investment
appraisal method.[2]
(g) Discuss the superiority of discounted cash flow (DCF) methods over non-
DCF methods.[2]
(h) Discuss the relative merits of NPV and IRR.[2]
2. Allowing for inflation and taxation in DCF
(a) Apply and discuss the real-terms and nominal-terms approaches to investment
(b) Calculate the taxation effects of relevant cash flows, including the tax benefits of
tax-allowable depreciation and the tax liabilities of taxable profit.[2]
(c) Calculate and apply before- and after-tax discount rates.[2]

Syllabus and Study Guide

3. Adjusting for risk and uncertainty in investment appraisal

(a) Describe and discuss the difference between risk and uncertainty in relation to
probabilities and increasing project life.[2]
(b) Apply sensitivity analysis to investment projects and discuss the usefulness of
sensitivity analysis in assisting investment decisions.[2]
(c) Apply probability analysis to investment projects and discuss the usefulness of
probability analysis in assisting investment decisions.[2]
(d) Apply and discuss other techniques of adjusting for risk and uncertainty in
investment appraisal, including:
i) simulation [1]
ii) adjusted payback [1]
iii) risk-adjusted discount rates. [2]
4. Specific investment decisions (Lease or buy, asset replacement, capital rationing)
(a) Evaluate leasing and borrowing to buy using the before- and after-tax costs of debt.[2]
(b) Evaluate asset replacement decisions using equivalent annual cost and
equivalent annual benefit.[2]
(c) Evaluate investment decisions under single-period capital rationing, including:[2]
i) the calculation of profitability indexes for divisible investment projects
ii) the calculation of the NPV of combinations of non-divisible
investment projects
iii) a discussion of the reasons for capital rationing.
E. Business finance
1. Sources of, and raising, business finance
(a) Identify and discuss the range of short-term sources of finance available to
businesses, including:[2]
i) overdraft
ii) short-term loan
iii) trade credit
iv) lease finance.
(b) Identify and discuss the range of long-term sources of finance available to
businesses, including:[2]
i) equity finance
ii) debt finance
iii) lease finance
iv) venture capital.


(c) Identify and discuss methods of raising equity finance, including:[2]

i) rights issue
ii) placing
iii) public offer
iv) stock exchange listing.
(d) Identify and discuss methods of raising short- and long-term Islamic finance,
i) major differences between Islamic finance and the other forms of
business finance.
ii) the concept of riba (interest) and how returns are made by Islamic
financial securities.
iii) Islamic financial instruments available to businesses including:
i) murabaha (trade credit)
ii) ijara (lease finance)
iii) mudaraba (equity finance)
iv) sukuk (debt finance)
v) musharaka (venture capital).
(note: calculations are not required)
(e) Identify and discuss internal sources of finance, including:[2]
i) retained earnings
ii) increasing working capital management efficiency
iii) the relationship between dividend policy and the financing decision
iv) the theoretical approaches to, and the practical influences on, the dividend
decision, including legal constraints, liquidity, shareholder expectations
and alternatives to cash dividends.
2. Estimating the cost of capital
(a) Estimate the cost of equity including:[2]
i) application of the dividend growth model, its assumptions, advantages and
ii) explanation and discussion of systematic and unsystematic risk
iii) relationship between portfolio theory and the capital asset
pricing model (CAPM)
iv) application of the CAPM, its assumptions, advantages and disadvantages.

Syllabus and Study Guide

(b) Estimating the cost of debt:[2]

i) irredeemable debt
ii) redeemable debt
iii) convertible debt
iv) preference shares
v) bank debt.
(c) Estimating the overall cost of capital including:[2]
i) distinguishing between average and marginal cost of capital
ii) calculating the weighted average cost of capital (WACC) using book value
and market value weightings.
3. Sources of finance and their relative costs
(a) Describe the relative risk-return relationship and the relative costs of
equity and debt.[2]
(b) Describe the creditor hierarchy and its connection with the relative costs of
sources of finance.[2]
(c) Identify and discuss the problem of high levels of gearing.[2]
(d) Assess the impact of sources of finance on financial position, financial risk and
shareholder wealth using appropriate measures, including:[2]
i) ratio analysis using statement of financial position gearing, operational and
financial gearing, interest coverage ratio and other relevant ratios
ii) cash flow forecasting
iii) leasing or borrowing to buy.
(e) Impact of cost of capital on investments including:[2]
i) the relationship between company value and cost of capital.
ii) the circumstances under which WACC can be used in investment appraisal
iii) the advantages of the CAPM over WACC in determining a project-specific
cost of capital.
iv) the application of the CAPM in calculating a project-specific discount rate.
4. Capital structure theories and practical considerations
(a) Describe the traditional view of capital structure and its assumptions.[2]
(b) Describe the views of Miller and Modigliani on capital structure, both without
and with corporate taxation, and their assumptions.[2]
(c) Identify a range of capital market imperfections and describe their impact on the
views of Miller and Modigliani on capital structure.[2]
(d) Explain the relevance of pecking order theory to the selection of sources
of finance.[1]


5. Finance for small and medium sized entities (SMEs)

(a) Describe the financing needs of small businesses.[2]
(b) Describe the nature of the financing problem for small businesses in terms of the
funding gap, the maturity gap and inadequate security.[2]
(c) Explain measures that may be taken to ease the financing problems of SMEs,
including the responses of government departments and financial institutions.[1]
(d) Identify and evaluate the financial impact of sources of finance for SMEs,
including sources already referred to in syllabus section E1 and also [2]
i) Business angel financing
ii) Government assistance
iii) Supply chain financing
iv) Crowdfunding / peer-to-peer funding.
F. Business valuations
1. Nature and purpose of the valuation of business and financial assets
(a) Identify and discuss reasons for valuing businesses and financial assets.[2]
(b) Identify information requirements for valuation and discuss the limitations of
different types of information.[2]
2. Models for the valuation of shares
(a) Discuss and apply asset-based valuation models, including:[2]
i) net book value (statement of financial position) basis
ii) net realisable value basis
iii) net replacement cost basis.
(b) Discuss and apply income-based valuation models, including:[2]
i) price/earnings ratio method
ii) earnings yield method.
(c) Discuss and apply cash flow-based valuation models, including:[2]
i) dividend valuation model and the dividend growth model
ii) discounted cash flow basis.
3. The valuation of debt and other financial assets
(a) Discuss and apply appropriate valuation methods to:[2]
i) irredeemable debt
ii) redeemable debt
iii) convertible debt
iv) preference shares.

Syllabus and Study Guide

4. Efficient Market Hypothesis (EMH) and practical considerations in the

valuation of shares
(a) Distinguish between and discuss weak form efficiency, semi-strong form
efficiency and strong form efficiency.[2]
(b) Discuss practical considerations in the valuation of shares and businesses,
i) marketability and liquidity of shares
ii) availability and sources of information
iii) market imperfections and pricing anomalies
iv) market capitalisation.
(c) Describe the significance of investor speculation and the explanations of investor
decisions offered by behavioural finance.[1]
G. Risk Management
1. The nature and types of risk and approaches to risk management
(a) Describe and discuss different types of foreign currency risk:[2]
i) translation risk
ii) transaction risk
iii) economic risk.
(b) Describe and discuss different types of interest rate risk:[1]
i) gap exposure
ii) basis risk.
2. Causes of exchange rate differences and interest rate fluctuations
(a) Describe the causes of exchange rate fluctuations, including:
i) balance of payments [1]
ii) purchasing power parity theory [2]
iii) interest rate parity theory [2]
iv) four-way equivalence.[2]
(b) Forecast exchange rates using:[2]
i) purchasing power parity
ii) interest rate parity.


(c) Describe the causes of interest rate fluctuations, including: [2]

i) structure of interest rates and yield curves
ii) expectations theory
iii) liquidity preference theory
iv) market segmentation.
3. Hedging techniques for foreign currency risk
(a) Discuss and apply traditional and basic methods of foreign currency risk
management, including:
i) currency of invoice [1]
ii) netting and matching [2]
iii) leading and lagging [2]
iv) forward exchange contracts [2]
v) money market hedging [2]
vi) asset and liability management.[1]
(b) Compare and evaluate traditional methods of foreign currency risk management.[2]
(c) Identify the main types of foreign currency derivatives used to hedge foreign
currency risk and explain how they are used in hedging.[1]
(No numerical questions will be set on this topic)
4. Hedging techniques for interest rate risk
(a) Discuss and apply traditional and basic methods of interest rate risk
management, including:
i) matching and smoothing [1]
ii) asset and liability management [1]
iii) forward rate agreements.[2]
(b) Identify the main types of interest rate derivatives used to hedge interest rate
risk and explain how they are used in hedging.[1]
(No numerical questions will be set on this topic)


ACCA periodically reviews its qualification syllabuses so that they fully meet the
needs of stakeholders such as employers, students, regulatory and advisory bodies
and learning providers.

Syllabus and Study Guide

Amendments to FM

Section and subject area Syllabus content

B3c) The nature and role of Apply has been added to the
money markets learning outcome to make it clear
that calculations can be tested
D1b) Investment appraisal techniques Wording changed for consistency
with other learning outcomes
E2a)i) Estimating the cost of capital Wording changed for consistency
with other learning outcomes

There have been no deletions to the FM study guide from the 2019 - 2020 study guide.


Financial Management: an

Financial management is concerned with the management of all matters associated
with the cash flow of an organisation, both short-term and long-term.
This chapter introduces the broad principles of financial management and the key
decisions that financial management addresses.
One way of looking at financial management is to link it with the accounting equation.
The left hand side of the equation shows how the company uses its funds, typically
by purchasing non-current assets and funding its working capital (current assets less
current liabilities). The right hand side of the equation shows where the funds came
from, typically from the shareholders (equity) or by borrowing money from third
parties (loans/debt).
We will look at how an organisation obtains funds as efficiently (and cheaply) as
possible and how the organisation can use these funds to make money. These ways
include operating its existing business, taking on new projects (for example a new
product that it wishes to sell) and buying other businesses and running them.

1. Can you describe each of the key three decisions?


2. What aim in a company is ‘a fundamental aim’ and hence key to this paper?
3. What types of government policy can come into conflict?

Financial Management: an Introduction

1.1 Financial management

Financial management covers dealing with the monetary resources of an
organisation. It looks at where the money comes from (financing) and where it goes
to (investments). It differs from management accounting, where internal records
of the activities of an organisation are kept and financial accounting, where the
results of an organisation are reported externally. It is more immediate, dealing with
planning, controlling and directing the money within an organisation.

1.2 The three key decisions

Financial management is often described in terms of the three basic
decisions to be made:
• the investment decision
• the financial decision
• the dividend decision
Each of these decisions will be looked at in far greater detail in later chapters but we
will look at the basic considerations.

1.2.1 The investment decision

The investment decision looks at where a company’s money is going. A company may
invest its money in one of three basic areas:
1. Capital assets

Capital assets (also referred to as non-current assets) are assets that the business
acquires with a view to using that asset to generate a profit (also referred to as a ‘return’).

The asset may be a machine, a complete business that has been sold by its
owners or even a brand name – anything that can be used to generate a return.
2. Working capital

Working capital is the net amount of current assets less current liabilities.

It is the amount of funds that a business uses for the day-to-day operating of the
business. It typically comprises:
• Inventory (stock)
• Receivables (debtors)
• Cash
• Payables (creditors)

G Learn


3. Financial assets

Financial assets are investments made by the business with funds that are not used in
either of the above two areas.

Financial assets may be investment in the shares of other companies, investments in

Government bills or bonds (known as gilt-edged securities or ‘gilts’) or simply cash
invested in a bank account to earn interest.

Investing in capital assets

The investment in capital assets is a critical decision because of the strategic
implications of most investments. The decision includes the following financial
1. Return

The return on an investment is, broadly speaking, the ‘profit’ that is generated by the
assets acquired.

The ‘profit’ may be calculated in several ways, the two most common being:
The financial accounting profit, or
The Net Present Value, which is a measure of the surplus cash received less the
cash paid out over the life of the product, expressed in terms of the current value
of the cash flows. This is an important topic and is the subject of later chapters.
2. Risk

Risk is the chance that the actual return will be different to the expected return. It is
capable of quantitative measurement by a ‘standard deviation’. Thus risk is not just a
feeling that something might occur – it is a quantified assessment of what might occur.

For example, if a business is considering an acquisition that is predicted to yield

revenues of £1m per annum, it would be possible to assess the risk associated
with that prediction. Market research, for example, could be carried out to
determine what consumers might spend on the products and the likelihood
(probability) of those outcomes can be assessed. This would enable us to assess
the risk of the acquisition.

Financial Management: an Introduction

3. Short-term profitability
Whilst the evaluation of whether an investment should be acquired depends
mainly on the total profitability of the project over its complete life. When
assessing the project the business must keep an eye on the short-term
profitability of the project. If too little profit is made in the early years, the
business may struggle to keep on financing the project for the longer term.
4. Liquidity
The investment in the project must include an amount for the increased working
capital requirement that the business will face. Buying a new machine, for
example, which will expand the business’s overall activity and size will require
more inventory, more receivables and more cash (to take care of the additional
strain on cash that new project requires). This additional cost must be built into
the cost of the project just as the cost of the new machine must be, to make
sure that the business does not run out of cash as it tries to operate what may
otherwise be a profitable project.
Note that of the above four considerations, numbers 1 and 2 (risk and return)
are the two main points that influence a decision (subject to the other two being
satisfactory). The greater the risk, the greater the return required by the business.

Working capital
There are two considerations with working capital that have to be balanced to
ensure the maximum benefit for the business.
1. Solvency
Working capital is the cash resource available to the business on a day-to-day
basis and used to fund current assets such as inventory and receivables. It is
referred to as the ‘lifeblood of the business’. It is this cash that allows a business
to buy inventory and finance receivables. Without this working capital the
business would simply run out of cash and become insolvent.
2. Profitability
The trouble with working capital is that is doesn’t directly give a return – the return
comes from using the capital assets which depend on the working capital. The
business therefore has to have as little working capital as is consistent with it being
solvent. Too much and the cost of having money tied up in working capital increases
and reduces profitability. Too little and the business risks becoming insolvent.
The key to identifying the level of investment in working capital is to balance the risk
of insolvency against the cost of funding.


Financial assets
The ownership of financial assets (such as owning company shares or government
debt) is not a core area of this paper. We tend to focus on financing from the
perspective of a company rather than an individual that is investing in financial assets.
1. Short-term investment
The main financial investment to consider is short-term saving. In this
circumstance the key considerations are, in order:
– Risk
– Liquidity
– Return
Given that the investment is short term then the return is not so important
– a slightly higher percentage yield over a few months does not make a great
deal of difference. However risk is vital – if a business puts aside an amount of
money that it needs to use in a couple of months’ time then risk is the main
consideration – the business needs to be sure that the money will be there
when it need the money. Liquidity is tied to this – the business needs to ensure
that the investments it makes are liquid ie, can easily be converted into cash.
2. Long-term investment
In the long term the order of the considerations is
– Return
– Risk
– Liquidity
If a business is investing for a long period then it needs to make sure that the
investment will be as profitable as possible, subject to satisfactory risk. It’s no
good tying money up in a long-term investment if it is not performing well. Risk
is important but in the long term risk tends to even out, particularly if you have a
portfolio of different investments. Stock markets go up and down and sometimes
an investment will do well, sometimes not so well. Overall risk should be acceptable
providing the business doesn’t choose all explicitly high risk investments.
Liquidity is not as important in the long term. The business doesn’t need the cash
immediately and so can afford less liquid investments – particularly at the start
of the period.

P Principle
Factors involved in the decisions

Financial Management: an Introduction

IE Illustrative example 1.1

For a rail company, providing rail services for passengers between cities in the UK,
there are a range of investment decisions that they will have to make. Let’s consider
what some of these will be.
A rail company will have to decide a variety of investment decisions. Remember that
these decisions affect a number of future periods of time. Examples include:
1. investing in new rail carriages to carry more customers or to provide a better
service to those customers (with improved comfort or canteen facilities)
2. improving the company's website to make booking tickets quicker or providing
better marketing information back to the company
3. staff training to improve the safety of the trains and service provided
4. property upgrades to improve the stations that the customers use
There are many other possible investment decisions. For each investment
decision the company will have to consider the net cash flows that will be gained
over time and weigh them against the initial cost of the investment (which
can often be large). There are various techniques which you will see to help
determine whether an investment is worthwhile.

1.2.2 The financing decision

When looking at the financing of a business (where its cash comes from) there are
four basic questions to consider:
1. total financing required
2. internally generated vs. externally sourced
3. debt or equity
4. long-term or short-term debt


Total financing required

The financing requirement will be determined by assessing the funds required and
the funds available. The funds required are calculated as follows:

Existing assets (These include capital assets
and working capital)
Add New investments (These are new projects to be
undertaken or possible new
financial investments)
Less Disposal of investments
Add/less Changes in working capital Working capital will change
in proportion to the level
of activity – the greater the
turnover, the greater the
working capital requirement
Total requirement for the

The funds available are calculated as follows:

Existing financing This will be the total of the existing
debt and equity
Add/ Retained earnings/
less losses
Add/ New equity raised or This will be via an issue of shares, or
less reduced could be a reduction in share capital
Add/ New loans or
less redemption of
existing loans
Total financing for
the year

The aim is to ensure that the total financing requirement equals the financing
available. Too much financing is inefficient – the company is bearing the cost of
the excess funds it holds, either by paying interest to loan holders or dividends to
shareholders. Too little financing and the company will either struggle to reach the
desired level of activity or in serious cases risk insolvency.

Financial Management: an Introduction

Internally vs externally generated funds

A company may be able to fund business growth via internally generated funds such
as retained earnings. If those funds are limited or the company wishes to grow at a
faster rate, then external sources of funding must be tapped.
Debt or equity
The balance between debt (borrowings) and equity (shareholders’ interest in a
company) is called the ‘gearing decision’. This is a critical issue in terms of risk and
cost of funding. Equity is more expensive for a company so companies will normally
want to finance themselves by cheaper debt. However, having too much debt is risky
so a balance between debt and equity must be decided.
Short-term or long-term debt
The consideration here is focused on the financing of working capital. In this context,
short-term funding may have benefits of flexibility and lower cost but is inherently
risky. For example, a bank overdraft is relatively cheap and easy to set up, but the
overdraft facility can typically be withdrawn by the bank at any time, increasing the
risk that the company may be left short of cash.
However we also have to consider the use to which the funds raised will be put
rather than just considering working capital. For example, if the funds are to be
raised to finance a long-term project then it is good to try and match the date of the
maturity of the debt with the length of the project.

P Principle
The sources of funding

IE Illustrative example 1.2

Some companies are quoted on a stock market, some are not. Let’s compare the
likely sources of finance and the costs of servicing that finance between quoted and
unquoted companies.
In general we would expect that a quoted company will have more sources of
finance. This is due to obvious reasons, such as a quoted company will be able to
obtain money from the investors in the stock market it is quoted on, whereas an
unquoted company cannot. Also quoted companies are likely to be larger and have a
bigger public profile (you are likely to be able to give examples of quoted companies
easily, less so for giving examples of unquoted companies). Quoted companies can
use these two features to obtain finance, for example, from the bond markets, which
unquoted companies cannot as easily.
Quoted companies are likely to be able to obtain cheaper finance as well due to their
size and reputation. Investors are likely to be attracted by the apparent safety of the
quoted company which is likely to increase its bargaining power to reduce the costs
of financing.


However the quoted company's shareholders may expect them to pay dividends
each year. Unquoted companies are less likely to have this expectation.

1.2.3 The dividend decision

The dividend decision looks at the cash to be paid to shareholders. The level of
dividend paid will be determined by the following:

Profitability You can only pay dividends out of profits (current or

retained). Hence the business has to be profitable to be
able to pay dividends.
Liquidity Paying a dividend involves paying out cash. The company
must therefore have sufficient liquidity to be able to
pay the dividend. Remember that profitability is not the
same as liquidity – think back to the cash flow statements
of your financial reporting studies and recall how a
profit made in a year can nevertheless result in the
company ending the year with less cash than it started
the year. Investments, increases in stock or debtors and
redemption of loans can all reduce cash.
Growth If a company wants to grow it usually has to find
additional funds to enable that growth to take place,
whether to finance the acquisition of an asset or the
extra working capital. It makes no sense for a company to
pay a large dividend and then have to go to the market to
raise more funds, either debt or equity. That is expensive
and inefficient. It is much better to pay smaller dividends
in the short term with the prospect of paying the
shareholders larger dividends in the future.
Investor expectations This is crucial. Investors don’t like to have too much
volatility in the dividends they receive. Many of the
shareholders are pension funds or perhaps individuals
who rely on the dividends to provide a flow of income.
It is very difficult for them to plan for the future if the
dividends paid are volatile in size. Stability is generally
what shareholders require.
Legal requirements There are sometimes legal restrictions on the way in
which a company can pay dividends.

G Learn

Financial Management: an Introduction

EG Learning example 1.1

A quoted power company is under pressure to pay a dividend from one of its main
investors. However the company has a project to invest in that will make a positive
return. The stock market doesn't know about this project yet but will respond well to
the benefits it will bring.
To finance the project the company will have to refrain from paying a dividend this
year. Given the pressure the power company is under can this decision to invest in
the project be justified?

1.3 Corporate strategy and financial management

The role of the financial manager is to align the aims of financial management team
with those of the wider corporate strategy. The wider strategy of the business is
usually separated into corporate, business and operational objectives. Financial
managers should be attempting to help to fulfil those objectives.
The nature of financial management means that it is fundamental to help in the
translation of strategic aims into financial objectives.

1.4 Financial objectives

The financial objectives of an organisation usually follow from the overall corporate
strategy and corporate objectives that the organisation has.
The corporate strategy says where the organisation is heading overall (ie which
products it is going to sell and to which markets). Corporate objectives follow from
the strategy but may also include other objectives such as corporate responsibility
ones, looking after employees or the environment. Financial objectives follow from
these and show the financial effects of the corporate strategy and objectives.
Financial objectives of commercial companies may include:
1. Maximising shareholders’ wealth
2. Maximising profits
3. Satisficing
4. Earnings per share growth

1.4.1 Maximising shareholders’ wealth

A fundamental aim within financial management is to create and sustain
shareholders’ wealth. Shareholders’ wealth comes primarily from the value of the
company’s shares – if the directors manage the business so that the share price is
maximised then they have maximised their shareholders’ wealth. You should add to
this the idea that if you took a long-term view of the business and the shareholders’
wealth over a long period of time, then you might add the dividends that the
company has paid to get the total wealth created over time.


The time period is important and it is possible that the time horizon of shareholders
(ie the period in which they would like to see their shares reach a certain value) may
differ between the shareholders themselves and indeed from the management of
the business. Some shareholders may be looking for a quick return (short-termism);
they don’t want to build a business for the long term but rather want to get in and
out quickly. Others may be in for the long haul. There is no right and wrong about
this, but you must realise that these conflicts about the desired outcome can arise.
Risk is also important. A high share price may be quickly achieved if the directors
pursue a risky strategy. This may be a strategy that will go badly wrong, resulting in a
collapse of the share price, and the share market will probably mark down the value
of these shares to take account of the risk. But do all the shareholders realise that
this is the strategy being pursued and do they agree with it? It is clearly valid to ask
whether pursuing a high risk/high return strategy is pursuing a suitable objective for
all the shareholders.
Of course, in practice, if shareholders don’t like the time horizon that the directors
are pursuing to produce the wealth or don’t like the risk/return profile of the
business, then they can sell their shares. However the point being made here is that
the directors should be aware of these issues to ensure that their objectives really
are those of the shareholders.
We shall now look at the other objectives that managers may pursue but note that
in all the chapters that follow the assumption is that we are trying to maximise
shareholders’ wealth (ie the share price) and not any of the other possible objectives
that we are going to consider.

1.4.2 Maximising profits

Within organisations it is normal to reward management on some measure of
profit such as ROI (Return on Investment). In simple terms we would expect a close
relationship between profit and shareholders’ wealth. There are, however, ways in
which they may conflict such as:
1. Short-termism
2. Cash vs profit (accruals)
3. Risk
A profit target is normally calculated over one year. It is relatively easy to manipulate
profit over that period to enhance rewards at the expense of future years. This may
result in high rewards for the mangers but may not be in the long term interest of the
Cash vs profit
As we will see later, wealth is calculated on a cash basis and not on profit. Thus
accruals, for example, are ignored. A usual method used is calculating the net present
value of a project/business by discounting the cash flows rather than the profit.

Financial Management: an Introduction

As we have seen, a manager may be inclined to accept very risky projects in order to
achieve profit targets which in turn would adversely affect the value of the business.

1.4.3 Satisficing
Many organisations do not profit maximise but instead aim to satisfice. This means that
they attempt to generate an acceptable level of profit with a minimum of risk. It reflects
the fact that many organisations are more concerned with surviving than growth.
It is important to consider the objectives of the people that are involved in
organisations. The people, and hence their objectives, will change dependent on the
type of organisation we are considering. These organisations include not-for-profit
organisations, such as charities, and for-profit organisations, such as companies. We
will see that a key concept is that of stakeholders.

1.4.4 Earnings per share growth

Quoted companies are likely to want to show increases year-on-year of their earnings
per share. This may well help to boost their share price and hence the wealth of their

1.4.5 Achieving corporate objectives

Other more complex measures apply for judging the achievement of corporate
objectives. These include looking at appropriate ratios to see if they have been
met, such as return on capital employed (ROCE), return on equity, earnings and
dividends per share.
In a quoted company measures like the change in dividends and share prices are
important for the shareholders and hence are usually built into the corporate
objectives of the company.

1.5 Objectives of not-for-profit organisations

These organisations are established to pursue non-financial aims and exist to provide
services to the community eg a charity. Such organisations, like profit-seeking
companies, need funds to finance their operations. Their major constraint is the amount
of funds that they would be able to raise. As a result not-for-profit organisations should
seek to use the limited funds they have available to obtain value for money.

1.5.1 Value for money

Value for money means providing a service in a way which is economical, efficient
and effective. It simply means getting the best possible service at the least possible
cost. Public services, for example, are funded by taxpayers. In seeking value for
money the needs of the taxpayer are being served, insofar as resources are being
used in the best manner to provide essential services.


Value for money

Economy Effectiveness Efficiency

‘Economy’ means resourcing and purchasing the inputs at minimum cost consistent
with the required quality of the output.
‘Effectiveness’ means doing the right thing. It measures the extent to which the
output meets its declared objectives; is the output the required quality, the right
specification etc?
‘Efficiency’ means doing the right thing well. It relates to the level of output
generated by a given input. Reducing the input:output ratio is an indication of
increased efficiency.

G Learn

IE Illustrative example 1.3

Consider the example of a refuse collection service.
The service will be economic if it is able to minimise the cost of weekly collection and
not suffer from wasted use of resources.
It will be effective if it meets its target of weekly collections.
It will be efficient if it is able to raise the number of collections per vehicle per week.

1.6 Stakeholders
We tend to focus on the shareholder as the owner and key stakeholder in a business.
A more comprehensive view would be to consider a wider range of interested parties
or stakeholders.
Stakeholders are any party that has
• an interest in the company
• a relationship of some sort with the company
• can exert influence over the company

Financial Management: an Introduction

The main stakeholders of a company can be listed as follows:

• Shareholders
• Employees and unions
• HM Revenue and Customs
• Local council
• Local people living close to the business
• Customers
• Debtholders
The basic idea is that the organisation has a responsibility to balance the
requirements of all stakeholder groups in relation to the relative economic power or
influence of each stakeholder.
This can be illustrated diagrammatically below, with a larger area indicating
more influence:

Local council

HM Revenue
and Customs

Employees and unions

Depending on the degree of influence which each stakeholder possesses, the

company must deliver to the various stakeholders the return that the stakeholder
is seeking. The various stakeholders may all expect a different sort of return. We
have seen that shareholders require an increase in wealth – that is their return.
But this does not mean that all the stakeholders have the same requirement. HM
Revenue and Customs, for example, want to be paid tax and National Insurance
and also require that the company abides by the various legislative requirements.
The neighbours of a company may be more concerned with issues about noise and
pollution and they may require assurances and action on these issues.

1.7 Conflict between stakeholder groups

The very nature of looking at stakeholders is that the level of ‘return’ is finite within
an organisation. There is a need to balance the needs of all groups in relation to their
relative strength.


For example, a company may not be able to meet all the labour union’s demands
regarding working conditions or a shorter working week and retain the profitability
to satisfy the expectations of the shareholders. The issue then becomes a question of
who exerts the greater influence – the unions or the shareholders. Often this leads to
protracted negotiation as unions have considerable power and influence.
On the other hand, if the company is in dispute with neighbours regarding planning
or pollution issues, providing the company stays within the law and does not break
pollution targets then the neighbours may not succeed in influencing the company,
as their power will typically be limited.
The needs of customers can be in conflict with employees. It may be simply that
the costs of employment (salary, pensions etc) are so large that prices are forced up
against the customers’ wishes. On the other hand the need to keep a shop open for
24 hours every day suits the customers but not the employees.
The debtholders may be in conflict with the shareholders. The debtholders have
the benefit of a guaranteed return no matter what the profitability of the company.
This can significantly reduce dividends when profits are low and works against the
interests of the shareholders. On the other hand the shareholders may demand large
dividends which can weaken the company’s asset base and jeopardise the capital of
the debt even if it is secured against the company’s assets.

1.8 Agency theory



Agency relationships occur when one or more people employ one or more persons
as agent. The persons who employ others are called the ‘principals’ and those who
work for them are called the ‘agents’. The reasons why agents are employed will
vary but generally an agent may be employed because of the special skills offered, or
information the agent possesses or to release the principal from the time committed
to the business. In an agency situation, the principal delegates some decision-
making powers to the agent. This type of relationship is common in business life. For
example shareholders of a company (the principals) delegate a stewardship function
to the directors of that company (the agents).

Financial Management: an Introduction

This delegation in the corporate context is referred to as the divorce of ownership

and control and leads to what is referred to as the ‘agency problem’.

The agency problem refers to the fact that the managers of the business do not
necessarily maximise shareholders’ wealth, so the agents don’t act in the best
interests of the principals.

We have seen that the main objective of financial management is (put simply) to
maximise the share price and thereby maximise the shareholders’ wealth. However
we have seen earlier that managers may have other objectives that conflict with
this objective. These include satisficing (seeking a sufficient profit rather than the
maximum profit); perhaps trying to maximise revenue and market share (not with
a view to eventually maximising shareholders wealth but rather with a view to
controlling a large, impressive company which may satisfy the directors’ need for
prestige rather than the shareholders’ need for wealth) perhaps pursuing reckless
risky strategies that are at odds with shareholders requirements.
One of the problems with the divorce of ownership and control is that very often the
shareholders simply do not know what some of the managers’ decisions are. This
lack of information allows the agency problem to persist.

1.9 Goal congruence

Goal congruence is defined as the state which leads individuals or groups to take
actions which are in their self-interest and also in the best interest of the entity.

For an organisation to function properly, it is essential to achieve goal congruence

at all levels. All the components of the organisation should have the same overall
objectives, and act cohesively in pursuit of those objectives.
This relates to the agency problem that we referred to above.
In order to achieve goal congruence, there should be introduction of a careful
designed remuneration packages for managers and the workforce which would
motivate them to take decisions which will be consistent with the objectives of the
shareholders. Two examples are:
• Share options. One important way in which goal congruence can be achieved is
the inclusion of share options as part of the managers’ remuneration package.
The strength of this is that it incentivises the managers to try and maximise the
share price as this will maximise the capital gains they will achieve. It will also at
the same time satisfy the shareholders.


• Performance related pay. This is another important way in which managers and
employees can be incentivised to maximise shareholders’ wealth. Objectives and
targets are set at all levels of the business depending on the various functions
of the respective departments. For example the warehouse may be set targets
regarding the avoidance of stock-outs; the sales departments may be set targets
regarding market share and sales revenue; and the managers may in addition
be set targets regarding the share price. If the targets are met then bonuses are
paid in accordance with an agreed formula.
There is some discussion about how effective this approach is. Much depends on
how the targets are set; are they clear and quantified? Are the employees really able
to control and influence the targets and measures on which their bonuses depend?
Is money a good motivator; does it take more than just money to motivate staff to
perform, eg recognition, appreciation, good working conditions, etc? Research has
shown that money is not a single motivator or even the prime motivator.

P Principle
Remuneration packages for promoting goal congruence

The agency problem refers to the fact that the managers of the business do not
necessarily maximise shareholders’ wealth.

EG Learning example 1.2

Identify three key areas of conflict between directors and shareholders.

1.10 The economic environment

We will now look at another aspect of this paper, knowing about the wider
economic environment. This influences the financial management of a company. The
government will have an effect on the economy.

1.10.1 Macroeconomic policy targets

Macroeconomic policy targets are the targets that are typically set for the economy
taken as a whole. Four macroeconomic economic policy targets are usually identified
for an economy by the government:
• Growth
• Control of inflation
• Full employment
• External balance – usually referred to as the balance of payments
Note that reference will be made to ‘goods’ ie physical things sold which should be
taken to include ‘services’, intangible ways to make money. Also, the discussion is
with reference to the UK economy, although the principles apply to all economies.

Financial Management: an Introduction

Growth is important to an economy because it is the engine that drives the standard
of living of the population. Two measures of growth are possible:
• Growth in monetary terms which will include the effect of inflation; and
• Growth in real terms where inflation has been removed from the figures.
The most useful measure is growth in real terms because that is the true measure
of how much more real goods and services the economy produced, which can be
shared among and consumed by the population.
One can also distinguish between:
• Total growth of the whole economy
• Growth per head of population.
Growth in real terms per head of population is the measure of the increase in the
standard of living of the population.

Control of inflation

Inflation is a rise in price of a good that is not caused by any change to the good itself
eg is not caused by some enhancement.

A small amount of inflation is considered beneficial to the economy. The general

population is comfortable with low inflation. The fact that their salaries increase
makes them feel good even though the prices of the final goods that they consume
will also have increased. Similarly business benefit from a low inflation rate. The fact
that prices are increasing will encourage consumers to buy now rather than defer
their purchases to the future. In addition inflation means that producers can sell
goods at higher price levels compared to the price levels which applied to the costs
that they incurred in the production of the goods.
However, a high rate of inflation is undesirable for two reasons:
• It will typically cause a wage/price spiral as consumers demand higher wages to
compensate for the higher prices, and business then demands higher prices to
compensate for the higher wages.
• The economy will find it increasingly difficult to sell goods overseas at the higher
price levels. This will cause the price of Sterling on the foreign exchanges to fall.

Full employment

Full employment means that all those able and seeking work are in work, save for
those who are in between jobs.


Full employment is important for several reasons.

• People need jobs both for personal satisfaction and to improve their
standard of living
• The economy’s output and the total wealth generated will only reach its
maximum if as many people as possible are working
• People who are unemployed are supported by the remainder of the population
who are employed, so it is good to reduce this burden

External balance
The external balance or balance of payments refers to the relationship between
the UK economy and the rest of the world.
The value of Sterling (ie the price at which Sterling can be bought and sold on the
foreign exchange markets) is determined by the supply and demand for Sterling,
or, put more simply, it is determined by the amount of Sterling that is bought or
sold. The rest of the world buys Sterling from the markets so that it can purchase
UK goods and sells Sterling to the markets in order to purchase the currencies
and goods of other countries. If the value of Sterling is set at a rate where the
UK economy can sell its exports and buy its imports in ‘balanced amounts’ then
Sterling will have a stable value and the balance of payments will not cause
difficulties for the economy.
If, however, the rest of the world does not want to purchase UK goods at the
going rate, then the UK will be importing more goods than it is exporting and the
balance will be lost.

1.10.2 Government policies to achieve policy targets

The government has four main policies which it can employ to achieve its economic
targets: fiscal policy, monetary policy, interest rate policy and exchange rate policy.

Fiscal policy

Fiscal policy is the decisions the government takes regarding taxation and public

The government can

• Spend as much as it receives in taxation – called a balanced budget
• Spend more than it receives in taxation – called a budget deficit
• Spend less than it receives in taxation – called a budget surplus.
Allied to this is the Public Sector Borrowing Requirement. This is the amount of
money that the government has to borrow if it has a budget deficit in any one year.
Effect of fiscal policy on economic targets
We can summarise the effects of the government running a deficit in the context of
the four policy targets we looked at above. In practice the four policies interact and
matters can be complicated but the basic ideas are the important things to grasp. We

Financial Management: an Introduction

shall look at the effect of a government running a deficit and borrowing money to
make up the difference. A surplus will have the opposite effect.
• Growth. A budget deficit will have an expansionary (or reflationary) effect on
the economy. By spending more money than it has taken out in taxation, the
government will be putting additional purchasing power into the economy.
Businesses will therefore sell more, employ more people and the economy will
grow. However we have to consider the inflationary pressures this can cause.
• Inflation. A budget deficit will be inflationary if there is no spare capacity in the
economy. The additional money being spent by the government will push up the
prices of the existing goods available. If there is spare capacity in the economy
then there will be growth without inflation. This is referred to as NICE (non-
inflationary continuous expansion) and is an ideal condition for an economy.
• Employment. A budget deficit will create additional employment if there is spare
capacity in the economy. If there is no spare capacity then wages will be bid
upwards as employers try to attract workers to their businesses.
• Balance of payments. A budget deficit will cause the balance of payments to
worsen if there is no spare capacity. The extra money being spent and the extra
demand that this creates may be spent on imports. If there is spare capacity,
then there will be little effect on imports and the balance of payments will not be
affected as much.

Monetary policy

Monetary policy is the decisions that the government makes regarding the rate of
interest and the supply of money to the economy.

• The rate of interest. Technically the rate of interest is controlled by the Bank
of England rather than by the government. Since the Bank of England was
made independent of the government in 1997, the Monetary Policy Committee
(MPC) has set interest rates for the economy. The brief of the MPC is to control
inflation, and interest rates are the means by which this is done.
Raising interest rates will tend to slow economic activity. Credit is made more
expensive so that individuals and companies are reluctant to borrow. This reduces
the demand in the economy for both consumer goods and investment goods.
In addition as we shall see below, an increase in interest rates will strengthen
Sterling. This will make the UK’s exports more expensive to the rest of the world
which will reduce demand for exports. Similarly, the strong Pound will lower the
price of imports so that more goods will be imported, replacing the demand for
UK produced goods and lowering demand and activity in the UK economy.
• The supply of money. The supply of money to the economy (usually referred to
as the ‘money supply’ can be determined by the government.


The money supply is broadly speaking the amount of notes, coins and bank deposits
in the economy. There are several measures of the money supply but the definition
above is sufficient for our purposes.

Bank deposits means the money deposited with the banks by companies and
individuals, and available to be spent by those groups. The government can
increase or decrease the money supply by various means. We shall discuss here
an increase but a decrease is simply the reverse process. One way that the
government increases the money supply is for the Bank of England to buy from
the banks securities that the banks own.
Traditionally the securities bought will be government securities. When the
Bank of England buys securities from the banks it pays money to the banks in
exchange for the securities. The banks can then lend this money to individuals or
companies. In fact, because the banks can lend several times the amount of the
new money, the money supply is increased by several times the cash injection.
The newest form of this process is called ‘quantitative easing’. The mechanism
is as described above but the government buys commercial paper (ie corporate
debt owed to the banks) as well as government debt.
• Interest rates and the money supply
Interest rates and the money supply are connected. High interest rates will tend
to reduce the money supply and vice versa. This is because high interest rates
will deter people from borrowing and this lack of demand for money will cause
people to both reduce the amount of new money that they borrow from the
banks and also pay back some of their earlier borrowings.
Effect of monetary policy on economic targets
• Growth. Lower interest rates and the higher money supply will encourage
economic growth. There will be more demand from individuals and companies. As
with fiscal policy however there may be inflationary pressures as described below.
• Inflation. The lower interest rates and the increased money supply will increase
demand in the economy which will cause inflationary pressures if there is no
spare capacity in the economy. If there is spare capacity inflationary pressures
will be reduced.
• Employment. As you may now be able to work out for yourselves, the lower
rates and higher money supply will increase demand in the economy which
will increase employment if there is spare capacity, but will cause inflationary
pressures in the labour market if there is no spare capacity.
• Balance of payments. As we noted above, higher interest rates will cause
Sterling to rise in value on the foreign exchange markets and this will cause
exports to be more expensive and imports to be cheaper. This will tend to reduce
exports and increase imports, thereby worsening the balance of payments.

Financial Management: an Introduction

IE Illustrative example 1.4

In 2008 interest rates were reduced substantially in many countries such as the
UK. Governments and the banking authorities were concerned about their weak
economies so they reduced interest rates to make the cost of finance cheaper and
encourage spending, particularly on investments. This helped boost their economies.

Exchange rate policies

Independent from the EMU
The UK government’s policy on the exchange rate is governed by its decision to
retain Sterling as an independent currency and not join the European Economic and
Monetary Union (EMU). The cornerstone of EMU is the common European currency,
the Euro. Adopting the Euro as a country’s currency has consequences that are far
more important than the fact that the coins and notes of the country are Euros
rather than their own historic currency. Joining EMU entails being subject to the
control of the European Central Bank. This bank exercises the following functions:
• Issues a common currency
• Sets interest rates and determines monetary policy for the whole of Europe
• Acts as the central bank for the whole of Europe and in particular is the lender of
last resort and has the power to create money ie, can increase the money supply
to the European countries.
• Very importantly, the bank manages the exchange rate for the Euro in the foreign
exchange markets.
Clearly, the implications for the individual economies are significant. In particular
they lose the ability to manage their own interest and exchange rates.
We have seen above how the UK can alter its interest rates to affect growth,
employment, inflation and also the exchange rate. Such flexibility is denied to those
who are part of the EMU.
UK policy
Exchange rate policy in the UK is the managing of the exchange rate to respond to
an imbalance between imports and exports. If imports are too high and exports
too low, the rate of interest can be lowered to reduce the value of Sterling on the
markets. This will cause imports to be more expensive (and will therefore be reduced
in quantity), and exports to be cheaper (and will therefore be increased in quantity).
Whilst exchange rate policy seems to be an easy response to the problem and
certainly is a very useful weapon in maintaining the balance of payments it is not
without cost to the economy. It entails a loss of real wealth for the economy because
the UK is effectively being forced to sell its goods more cheaply and buy the rest of
the world’s goods at higher cost.


1.10.3 Conflicts of government policies

One of the problems with government policies is that the different policies will come
into conflict.
If we consider the broad aim of promoting steady, non-inflationary growth at near
full employment with the balance of payments stable, the problems will quickly
become apparent.
• Steady growth requires increasing demand in the economy for domestically
produced goods. However it is not possible to pursue protectionist policies
and therefore total aggregate demand for all goods whether produced in the
UK economy or imported from overseas will need to increase to promote the
desired growth.
• The imported goods may cause the balance of payments to deteriorate,
particularly as the economy begins to approach full employment causing
bottlenecks in production that has to be filled with imports.
• The deteriorating balance of payments will cause the value of Sterling to fall.
In addition there will be the inflationary pressures as the economy approaches
full employment.
• These two changes will cause the Monetary Policy Committee to raise interest
rates in order to protect against inflation. The rise in interest rates will deter
businesses from investing and cause the economy to begin to contract. In
addition, the rise in interest rates will also cause the value of Sterling to rise
thereby making exports more expensive and thereby reducing growth in the
export industries.
Clearly, the government treads a fine line and history is littered with examples of
‘boom and bust’ as the economy expands, overheats and then contracts.

Interaction between government policy and planning and decision-

making of companies
Companies are affected by the actions and policies pursued by governments. Of
particular interest to companies are
• The level of demand in the economy – the greater the demand the more likely
that the company’s products will sell.
• The rate of economic growth – the faster the growth, the more likely that the
company’s sales will grow in the future.
• The level of inflation – the higher the rate of inflation, the easier it will be to raise
prices, but costs will also rise.
• The level of employment – an economy that is near to full employment will pose
problems for companies. Good workers will be hard to find and expensive to employ.
• The rate of interest – high interest rates make borrowing expensive pushing
up the costs of any overdrafts and also increasing the cost of borrowing for
major investments.
• The foreign currency exchange rate – if the rate is too high, exporters will
struggle to compete overseas as their overseas prices will be high.

Financial Management: an Introduction

A company must consider all the above factors when making decisions about
investment, pricing, levels of employment and the type of markets that should be
targeted, in particular whether to invest in overseas markets.

G Learn
Interaction between government regulation and planning and
decision-making of companies
Competition policy
The Competition Commission is the body charged with regulating competition in the
UK economy. There are several reasons why this is necessary:
• To ensure that there are no monopoly providers unless there are good
commercial or strategic reasons why they exist. Monopoly providers tend to
maximise profits by charging prices that are higher than a competitive market
and do not respond well to consumers’ preferences.
• To ensure that the competitive forces in the economy operate to optimise the
allocation of resources and are responsive to the choices of consumers.
• To ensure that the full social costs of production and distribution are reflected in
the price charged to consumers. For example, production processes that pollute
the environment should bear the cost of clearing up such pollution so that the
cost is reflected in the selling price.
A company must bear in mind the powers and interests of the Commission when
planning future investments or marketing strategies. The company must ensure that
any proposed activity will not fall foul of the legislation, or if it is likely to attract the
interest of the Commission that there is a good chance that the activity will be allowed.
Government assistance for business
The government and the European Union both assist businesses and regions by a
variety of measures.
The assistance may take the form of:
• General improvements to an area’s infrastructure (eg new roads or rail links) to
enable that area to improve its business and employment prospects
• Specific assistance for a particular industry in an area where the area is
dependent on that industry
• Specific assistance for green policies that the government wants to promote eg
renewable energy or domestic insulation
Companies should be aware of the assistance available and be flexible in their
planning to be able to take advantage of it.
Green policies
Green policies may present companies with opportunities as noted above or may
be aimed at preventing abuses.


Legislation that governs the disposal of waste products or the control of

pollution tends to be expensive and have a negative impact on a company’s
profitability. Companies must clearly take these matters into account.
However there is a positive side to this as the requirements of the legislation
provide opportunities for businesses to produce systems and products that
satisfy the legal requirements regarding such matters as pollution or insulation.
Businesses can produce and sell these as products in their own right and one
can expect very large industries to be created to satisfy the demand for green
products and technology.

IE Illustrative example 1.5

The amount of government intervention depends on the political party in power.
Some governments are less likely to intervene whilst other governments are more
likely to intervene. However all governments will be involved with their economies
to some extent.
Corporate governance
Corporate governance has acquired much greater prominence in recent years
because of several large and well-publicised company failures. In most cases
the failures that attracted the authorities’ attention were in companies where
fundamental principles of managing a company in a legal, fair and competent way
were disregarded. Powerful chief executives who dominated a weak board of
directors; weak non-executive directors; too much power vested with too few people
with little overview by the stakeholders (not even the shareholders).
In many cases there was a failure to manage risk, poor internal controls, a culture
that ignored ethical considerations and insufficient audit supervision.
The main objectives of good corporate governance are
• The establishment of systems and management structures that will lead to good
governance, ie it is not just good individuals but good systems that will satisfy
the objectives
• Risk management
• Ethical culture and performance
• Supervision of performance in all areas which should follow best practice
• Transparency and accountability

Financial Management: an Introduction

Several different codes of practice have been devised by different regulatory

authorities in different countries to achieve the above objectives, but the main
elements are as follows:
• A nomination committee will supervise board appointments
• There must be a mix of skills on the board
• The roles of chief executive and chairman must be separate
• The remuneration of directors to be set by a remuneration committee
• The board of directors has the responsibility for internal control and risk
management and must review these annually and report their findings in the
financial report. An audit committee of non-executive directors must oversee
this, effectively supervising the external and internal auditors

Æ Key Learning Points

• Learn the three key decisions that a company has to make (the investment,
financing and dividend decisions) as these are the basis of the whole of financial
management. (A1a, A1b)
• Understand the financial objectives of the company are at the heart of the
company’s strategy and underpin how the company operates. (A2a, A2b, A4a– A4c)
• Be aware of the stakeholders in a company, including shareholders, employees,
customers and suppliers and reasons for stakeholder conflicts. (A3a–A3e)
• Learn about the economic environment and how it affects the operation of a
company. (B1a–B1d)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).


Learning example solutions

EG Solution 1.1
Making the decision to take on a profitable project is justifiable. Once the project
is known about then the stock market that the company is quoted on is likely to
respond favourably and the company's share price will rise.
The major investor may have to forgo the dividend that it wants but will have more
valuable shares. If it needs the cash in the short term it can sell some of its shares.

EG Solution 1.2
Three possible answers are:
• High salaries of employees not necessarily in the interests of the shareholders
• Covenants imposed by debtholders and agreed by the directors that restrict the
activities that a company can undertake.
• Senior managers may be in strategic conflict with the shareholders if they decide
to operate the company in a manner that does not maximise shareholder wealth

Investment Appraisal

Investment appraisal is one of the most important types of decisions that a company
makes. It involves deciding if an investment (eg a new machine or buying another
company) is worthwhile.
Investment appraisal is the single most important topic in this exam. At least one
question and possibly one and a half questions will be asked on this topic. In addition
it includes techniques that will assist you in other areas of the syllabus.

1. Do you know (at least) two advantages and two disadvantages of payback period?

2. Does the NPV technique use net present or net future values?
3. Do you know what to do to calculate NPV and then compare it to IRR?

Investment Appraisal Techniques

2.1 Investment appraisal and capital budgeting

Investment appraisal is of particular importance because of the following:
1. It is long term. The investment is made now but it will last well into the future,
maybe 10 or 15 years. The company must be confident that the investment will
be good. It is usually not easy to divest (ie sell the investment) and if you do
succeed in divesting it will often be at a loss.
2. Investments are often on a large size, both in absolute terms and in relation to
the overall business’s size. The sort of investments considered are not financial
investments (eg shares of other companies) which can often be relatively small
and probably quite easy to dispose of. Instead they are very large investments,
such as diversifying into a new area of business that requires new premises and
new expensive machinery plus a significant amount of working capital.
3. Investments involve uncertainty. While the cash outflows to make the
investment are relatively certain because they are being made in the present,
the inflows will stretch into the future for many years and are therefore
uncertain. Economies go through cycles of business activity and a downturn
of economic activity or a recession will damage the profitability of nearly all
companies no matter how well managed.
Payback period, return on capital employed (ROCE), net present value (NPV) and
internal rate of return (IRR) are the important investment appraisal techniques.
Payback period and ROCE are basic techniques. They are pretty straightforward but
the examiner examines them very regularly and you must be able to pick up the easy
marks offered to you.
Net present value and internal rate of return are referred to as DCF (discounted cash
flow) techniques and involve the concept of the ‘time value of money’. These are the
most important part of this chapter.
We shall use the following examples to illustrate how each method is calculated.


IE Illustrative example 2.1

Reina Ltd has the opportunity to invest in two mutually exclusive investments with the
following initial costs and returns:

Initial investment (100)
Cash flows Yr 1 50 
Yr 2 40 
Yr 3 30 
Yr 4 25 
Yr 5 20 
Residual value Yr 5 5 

The cost of capital is 10%.

We shall use this example in the chapter to calculate the various ways that the
investment can be assessed:
Payback period

2.2 Payback period

Payback period is the length of time it takes for cash inflows from trading to pay back
the initial investment.

G Learn

Investment Appraisal Techniques

IE Illustrative example 2.2

From the data given, let us calculate the payback period of the proposed investment.

Initial investment (100)
Net cash flows (£) Periodic Cumulative 
Yr 1 50 50 
Yr 2 40 90 
Yr 3 30 120 
Yr 4 25 145 

The payback period is somewhere between 2 and 3 years.

If we assume that the cash flows accrue evenly throughout the years, then we can
calculate the payback period more exactly as follows
In year 3 the business needs to generate an additional £10 to breakeven, and in fact
generates £30 in the whole year. The total payback period is therefore,
2 years + 10/30 of year 3 = 2⅓ years
Notes on the solution
1. Note that the question refers to the ‘cost of capital’. This is something that
affects the two DCF techniques but is not relevant to payback.
2. We have not attempted to calculate the profitability or the return on the
investment. All we have calculated is how quickly we get our cash back.
3. Most importantly we need to ask why we have calculated the payback period.
The answer has two considerations
(a) We are talking about the business’s cash and liquidity, and it should always
be the case that the quicker the business can recover its cash the better
(b) We referred earlier to the uncertainty that surrounds the economy in
general, and we might add that the uncertainty that faces any individual
sector of the economy or any individual business can only add to that
uncertainty. No-one can predict how stable consumer demand for a product
will be. An economic downturn or just a new aggressive competitor in the
business’s market can cause significant falls in demand and revenue.
Thus the general conclusion is that the payback period is vital because it gives
management an idea of the length of time they are exposed before they get
their cash back.
1. We haven’t ventured an opinion on whether the above payback is good or bad.
In the exam you shouldn’t do so either. If the examiner tells you that there is a


required payback (say 3 years) then you can say whether the solution you have
calculated falls within this (in this case it does).
2. Finally note that we didn’t consider all the cash flows in the investment, only the
first three years. This may be seen as a weakness of the method if it was the only
method you used to evaluate the investment.

EG Learning example 2.1

The examiner may give you a question like this where the inflows are all the
same each year.

Investment $60,000
Net cash inflow per annum $25,000

Calculate the payback period.
The examiner may ask you to list or discuss the advantages or disadvantages of
payback – make sure that you don’t miss these easy marks.

1. It is simple to use (calculate) and easy to understand
2. It is a measure of risk, where rapid payback minimises risk
3. It is a particularly useful approach for ranking projects where a company faces
liquidity constraints and requires a fast repayment of investment
4. It is appropriate in situations where risky investments are made in uncertain
market that are subject to fast design and product changes or where future cash
flows are particularly difficult to predict
5. Unlike the other traditional methods payback uses cash flows, rather than
accounting profits, and so is less likely to produce an unduly optimistic figure
distorted by assorted accounting conventions
6. It is based on cash flows so that it is easier to understand by managers who may
not be accountants

1. It ignores the time value of money
2. It does not measure the return on the investment. This is a major flaw as
managers and shareholders like to know what percentage return they are getting
3. It does not use all the cash flows of the investment, ie those that occur after the
payback date. This makes it impossible to evaluate the whole investment in any
meaningful way

G Learn

Investment Appraisal Techniques

Payback is a good indicator of risk and liquidity of a proposed investment, but it

generally needs to be used in conjunction with other methods to give a fuller more
reliable picture.

2.3 Return on capital employed (ROCE)

Return on capital employed (ROCE) is a measure that considers the impact of the
investment on accounting profit. It is calculated as the average annual profit divided
by the average investment expressed as a percentage. It is also called the accounting
rate of return (ARR).

Estimated average annual profit

ROCE = × 100
Average investment

G Learn
Difference between investment appraisal and performance appraisal
Investment appraisal is different to performance appraisal. The key differences are:

Investment appraisal Performance appraisal

Time period Over the life of the project A single year
When? Future Past
Use Decision-making Appraisal and reward

You will already have studied ROCE in your financial or management accounting
studies. In those contexts you would have been looking at performance appraisal –
expressing profit as a percentage of capital employed to see how well or badly the
division or company performed.
The formula for performance appraisal would have been something like
Profit before interest and tax
Capital employed  debt + equitty 

The difference with investment appraisal is summarised in the table above. Note that:
(a) Investment appraisal is looking at the results over the whole life of the project –
not just one year. You wouldn’t invest in a project if it had just one good year and
the remainder were poor.
(b) Investment appraisal is looking to the future – performance appraisal looks back
over the past.
(c) Investment appraisal is performed in the context of making a decision – the
investment will be accepted if it meets the company’s required return. Performance
appraisal is a part of the assessment and reward structure of the company.


Converting cash flow to profit

In investment appraisal questions the examiner very often gives the company’s
expected results in terms of cash, but the formula is based on profits and not cash.
Thus you need to be able to convert profit into cash and vice versa.
In this paper it is done in a very simple way. The only adjustment you have to make is
for depreciation, as follows:
Cash – Depreciation = Profit
For example, if you are told that in one year the cash inflows of a business were
£50,000 and depreciation was £5,000, then the profit would be calculated as:

Cash inflows 50,000
Less depreciation 5,000
Profit 45,000

IE Illustrative example 2.3

Going back to the example Reina that we saw at the start of the chapter, you are
required to calculate the return on capital employed (ROCE) to appraise the investment.

Average annual profit
Cash flows 50 + 40 + 30 + 25 + 20 165 
Depreciation 100 – 5 (95)
Net cash flows 70 
÷ number of years 5 
= average profit 14 

Average investment
Initial investment 100 
Plus residual value 5 
Total 105 
Dividing by 2 105/2 
Equals average investment 52.5 
ARR 14/52.5 = 26.67 

Investment Appraisal Techniques

1. You have to adjust the cash into profit by deducting depreciation.
2. You have to calculate the average profit and capital employed.
Decision criteria
There is no right or wrong ROCE percentage in itself. The investment will be accepted
or rejected depending on the target the company has set for new projects. If the
ROCE exceeds the target the investment will be accepted, if it is lower than the target
the investment will be rejected.

1. ROCE is widely used. This is an advantage because its wide use means that it is
accepted as a reliable measure and that managers and shareholders are familiar
with it. Managers may be happy in expressing project acceptability in broadly
the same terms in which their performance will be reported to shareholders, and
according to which they will be evaluated and rewarded.
2. It is easy to understand and easy to calculate. Trained accountants often think
that simplicity of calculations is a poor reason for preferring an important
decision-making tool. Good accountants recognise the behavioural aspects of
decision-making, and in particular that many managers and shareholders will
be better disposed to the company and buy into its decisions if they understand
what is happening.
3. ROCE can be calculated from available accounting data. This is only partly true in
that the ROCE is based on future profits that are not part of the accounting data,
but it is true in the sense that it uses the conceptual approach from the accounts
and is familiar in that way.
4. ROCE is based on the return of the investment. It gives us a measure of the
impact that the investment will have on the company’s accounting profit.

1. It fails to take account of the project life or the timing of cash flows and time
value of money within that life. This is a critical failure.
2. It uses accounting profit, hence it is subject to various accounting conventions
and subjective judgements. In addition, profit includes items that are not
relevant costs, ie cost that are not relevant to a decision.
3. There is no definite investment signal. The decision to invest or not remains
subjective in view of the lack of an objectively set target ROCE. Who is to say that
the target ROCE is the correct one? Who decided what the target was? How do
we know that it is a measure of absolute gain in wealth for the business owners?
4. The ROCE can be expressed in a variety of ways and is therefore susceptible to


G Learn

EG Learning example 2.2

Andy Limited is a division of Stevie plc which requires each of its divisions to achieve
a rate of return on capital employed of at least 10 per cent per annum. For this
purpose, capital employed is defined as fixed capital and investment in inventory.
This rate of return is also applied as a hurdle rate for new investment projects.
Divisions have limited borrowing powers and all capital projects are centrally funded.
The following is an extract from Andy’s divisional accounts.
Profit and loss account for the year ended 31 December 20X4

Turnover 120 
Cost of sales (100)
Operating profit 20 
Assets employed as at 31 December 20X4
£m  £m 
Fixed assets (net) 75 
Current assets (including inventory £25m) 45 
Current liabilities (32)
Net capital employed 88 

Andy’s production engineers wish to invest in a new computer-controlled press. The

equipment cost is £14 million. The residual value is expected to be £2 million after four
years operation, when the equipment will be shipped to a customer in South America.
The new machine is capable of improving the quality of the existing product and
also of producing a higher volume. The firm’s marketing team is confident of selling
the increased volume by extending the credit period. The expected additional sales
are as follows.

Investment Appraisal Techniques

Year 1 2,000,000 units

Year 2 1,800,000 units
Year 3 1,600,000 units
Year 4 1,600,000 units

Sales volume is expected to fall over time because of emerging competitive

pressures. Competition will also necessitate a reduction in price by £0.5 each year
from the £5 per unit proposed in the first year. Operating costs are expected to be
steady at £1 per unit, and allocation of overheads (none of which are affected by the
new project) by the central finance department is set at £0.75 per unit.
Higher production levels will require additional investment in stocks of £0.5 million,
which would be held at this level until the final stages of operation of the project.
Customers at present settle accounts after 90 days on average.
Determine whether the proposed capital investment is attractive to Andy, using the
average rate of return on capital employed method, defined as average profit to
average capital employed, ignoring debtors and creditors.
Note: Ignore taxes.

2.4 Discounted cash flow

Discounted cash flow (DCF) is an investment appraisal technique that takes into the
timing of a project’s cash flows and discounts these to the present time.

The technique is based on the idea that there is a time value of money. What this
means is that money received today will have more worth than the same amount
received at some point in the future.
Would you rather have £100 now rather than in one year’s time? The answer is
invariably that you would rather have the £100 now. Even if you didn’t want to spend
it immediately, most people would want to know that they had safely got the money.
They could invest the money for a year and earn interest until they wanted to spend it.
The question could be changed to ask ‘how much would you have to be offered in
one year’s time to be prepared to accept the money in one year rather than now?’.

Year 0 Year 1
£100 £100?


IE Illustrative example 2.4

Let’s say that you will need to be offered £108 in a year’s time to defer the cash until
then. The £8 is the ‘reward’ you need to defer the cash – and it can be expressed as a
percentage (£8/£100) × 100 = 8%. In other words, you need an 8% premium to defer
the receipt of the cash (and consumption) for a year.
What are the reasons for needing a premium for delaying the receipt of the
cash? They are:
1. Inflation
2. Risk
3. Opportunity cost of capital
Let’s look at these in more detail:
1. Inflation. You are aware that inflation will make the £100 less valuable in a year’s
time. Prices will have risen and you will be able to buy less with the money in a
year’s time. You therefore need a bit extra to make it worth your while to defer
receiving for a year.
2. Risk. There is a risk to waiting a year for the cash – you may never get it. Some
unforeseen occurrence may intervene and circumstances may change. You
therefore need a bit extra to compensate you for this risk.
3. Opportunity cost of capital. If you’ve got the money today you can make
decisions about what you do with it. Even if there was no inflation and no risk you
would still need a bit extra to compensate you for deferring the cash for a year.
You could for example invest it to earn interest of say 8% and end up with £108
in a year’s time.
Most people prefer the cash now because of the opportunity cost of capital.
There is a cost of not having the cash now – the £8 interest.

2.5 Compound interest

IE Illustrative example 2.5

If we invest £1,000 now (Yr 0) what will the value of that investment be in 1, 2, 3
or 4 years at a compound rate of 10%? Calculate this by taking the £1,000 now and
multiplying by (1 + 10%) for each year invested.
First of all you need to remember that 10% = 10/100 = 0.1 when it is expressed
as a decimal.
After 1 year
We can now work out the value of £1,000 at the end of year 1 with interest added for
that one year as follows:
£1,000 + (£1,000 × 0.1) = £1,000 (1 + 0.1) = £1,000 × 1.1

Investment Appraisal Techniques

After 2 years
After two years, the 10% interest is added to both the original £1,000 and to the
interest added in the first year – the interest is added to the whole balance at the
end of year 1 which was (£1,000 × 1.1) as calculated above.
So, the balance at the end of the second year will be (£1,000 × 1.1) × 1.1
We can express all these results for the four years as follows:

End of year Calculation Future value

1 £1,000 × 1.1 £1,100
2 £1,000 × 1.1 × 1.1 £1,210
3 £1,000 × 1.1 × 1.1 × 1.1 £1,331
4 £1,000 × 1.1 × 1.1 × 1.1 £1,464
× 1.1

Therefore we are able to express the Future Values of an initial amount of money
using the following formula:
FV = PV × (1 + r)n
PV = Present value (ie the initial amount of capital at the start of year 1).
FV = Future value (ie the amount of money at the end of a year).
R = the rate of interest or cost of capital.
N = the number of periods (years).
So, in the above example we can express the Future Value as
FV = £1,000 × (1.1)4 = £1,464
Using the calculator:
Make sure that you can calculate 1.14 using your calculator. Calculators differ in how
they do this, but typically you have to
1. enter 1.1
2. followed by a key labelled something like xy
3. followed by the number 4
4. followed by the = sign
We have used the terms ‘present value’ and ‘future value’. Let’s see what they mean.

The present value of an amount of money is the value of that money at the
present moment.


In investment appraisal it is usually the day you acquire the investment or the start
of the project. The start of the project is referred to as ‘Year 0’. We will see how to
calculate present value later.

The future value of an amount of money is the value of that money at the end of a
specified period of time. This includes the compounded interest that the money has
earned. The future value is also sometimes referred to as the terminal value.

EG Learning example 2.3

Calculate the future value of
(a) £1,000 invested at compound interest of 7% for 6 years.
(b) £2,000 invested at compound interest of 4.5% for 11 years.

2.6 Discounting

Discounting is the opposite of compounding whereby the future value of an amount
of money is calculated and expressed as its present value.

Year 0 Year n


We have already shown the relationship between the future value and present value
of an amount of money, namely
FV = PV (1 + r)n
This can be rearranged as follows:
PV = n
1 + r 
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Investment Appraisal Techniques

IE Illustrative example 2.6

In Illustrative example 2.5 we calculated the future value of £1,000 at 10% compound
interest after 1 to 4 years. We can now calculate this in reverse, calculating the
present value of the year 4 future value of £1,464.
Using the formula
PV =
1+r  n
We get PV = 1,464/(1.1)4 = 999.99, ie £1,000 allowing for rounding errors.
Using tables to calculate present values
Rather than have to divide by (1 + r)n each time we want to calculate a present value,
tables have been prepared which do this for you. You are given these discount factor
tables with the formula sheet for this paper.
Present value of 1 ie (1 + r)-n
r = discount rate
n = number of periods until payment
Discount rate (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

The number for 10% for 4 years (0.683) is the discount factor to convert a future
value at 10% after 4 years to a present value:
1/1.1n = 0.683
If we use these tables to deal Illustrative example 2.6, then instead of dividing £1.464
by 1.14, we simply multiply £1,464 by the factor 0.683
1,464 × 0.683 = 999.91 ie £1,000 allowing for rounding errors.


EG Learning example 2.4

Use discount factor tables to calculate the present values of Learning example 2.3.
Look for the figure for 10% and 4 years and then multiply it by the Year 4 future value
to get the same answer as Learning example 2.3.

2.7 Net present value (NPV)

The net present value (NPV) is the key investment appraisal method. It incorporates
the time value of money in calculating an absolute value of the project. It is called the
net present value because there will be a range of outflows and inflows in the typical
investment and we will take the net of the present values of the outflows and inflows.
We accept projects with a positive NPV and reject projects with a negative NPV.
Layout of an NPV calculation

Year 0 1 2 3 4
Cash flows (x) x x x x
Discount factor 1 DF1 DF2 DF3 DF4
Present value (x) a b c d

The net present value is the sum of all the present values on the final row.

EG Learning example 2.5

Refer back to the data for Reina in Illustrative example 2.1 and calculate the NPV
of the project.

Net present value is the net of all the positive and negative present values of the cash
flows resulting from an investment over the whole life of the investment.

It may therefore be seen as the net amount of cash that the investment generates
expressed in terms of the present value of that cash. The project undertaken by
Reina, which lasts for 5 years, has the same expected impact on the investors as if
they had been given £33,610 cash now, ie ‘year 0’ at the start of the investment.
They are therefore £33,610 better off as a result of the investment and this is a
measure of their increase in wealth.
Decision criteria
If the investment has a positive NPV then the project should be accepted (if negative
it should be rejected). A positive NPV means that the project will expect to increase
the wealth of the company by the amount of the NPV at the current cost of capital.

Investment Appraisal Techniques

1. A project with a positive NPV increases the wealth of the company, and thus
maximise the shareholders’ wealth.
2. NPV takes into account the time value of money and therefore the cost of capital.
3. The discount rate can be adjusted to take account of different levels of risk
inherent in different projects.
4. Unlike the payback period, the NPV takes into account events throughout the life
of the project.
5. The NPV is better than the ROCE because it focuses on cash flows rather than profit.
6. The NPV technique can be combined with sensitivity analysis to quantify the risk
of the project’s result.
7. It can be used to determine the optimum policy for asset replacement.

1. NPV assumes that firms pursue an objective of maximising the wealth of their
2. Determination of the correct discount rate can be difficult.
3. Non-financial managers may have difficulty understanding the concept.
4. The speed of repayment of the original investment is not highlighted.
5. The cash flow figures are estimates and may turn out to be incorrect.
6. NPV assumes cash flows occur at the beginning or end of the year, and it is not a
technique that is easily used when complicated, mid-period cash flows are present.

G Learn


2.8 Internal rate of return (IRR)

The internal rate of return (IRR) is the rate of return at which the NPV equals zero.



Cost of capital

Shape of the IRR curve

Note that as the cost of capital increases the NPV decreases. It will typically be
positive at lower costs of capital, but will become negative as the cost of capital
increases. This is an important point to understand, and is based on the opportunity
cost of capital.
Consider £100 to be received in, say, 3 years’ time. The higher the rate of interest the
less you would need now to have £100 in three years’ time because you could invest a
smaller amount of money at a higher rate of interest – so the present value is smaller.
The internal rate of return (IRR) is simply the point on the curve where the NPV
is zero. The IRR is expressed as a percentage (like any rate of return), and if you
discounted the cash flows of the investment at the IRR percentage discount factors,
the NPV would be zero.

Investment Appraisal Techniques



12% Cost of capital

5% 8%


Decision criteria
If the IRR is greater than the cost of capital the project should be accepted. Thus in
the diagram above, the IRR is 8% and at 5% the project has a positive NPV – so if the
cost of capital was 5% the project should be accepted.
Linear interpolation
The IRR is calculated by using a method called linear interpolation. This involves
choosing two discount rates and calculating the two NPVs using these rates. The
rates should ideally be chosen such that one of the NPVs is positive and the other
negative. The IRR is then calculated by using the formula:
Interpolated IRR = L +   × H - L 
 NL - NH 
L = Lower discount rate
H = Higher discount rate
NL = NPV at lower discount rate
NH = NPV at higher discount rate


IE Illustrative example 2.7

The following data refers to a project:

A (£000s)
Initial investment (125)
Cash flows Year 1 50 
Year 2 40 
Year 3 30 
Year 4 25 
Year 5 20 
Residual value Year 5 5 

Calculate the IRR of the project. To achieve this calculate the NPVs at 5% and 20%
and then use these results in the IRR formula.

Year Cash flow  Discount NPV @ 5%  Discount NPV @ 20% 

factor (5%) factor (20%)
0 (125) 1.000 (125.00) 1.000 (125.00)
1 50  .952 47.60  .833 41.65 
2 40  .907 36.28  .694 27.76 
3 30  .864 25.92  .579 17.37 
4 25  .823 20.57  .482 12.05 
5 25  .784 19.60  .402 10.05 
24.97  (16.12)

Applying the interpolation formula:

IRR = 0.05 +  ×  0.20 - 0.05  = 0.1411
  24.97 + 16.12  

Thus the IRR is 14.11 %.

1. Like the NPV method, IRR recognises the time value of money.
2. IRR is based on cash flows, not accounting profits.
3. The IRR is more easily understood than the NPV by non-accountants, being a
percentage return on investment.
4. For accept/reject decisions on individual projects, the IRR method will reach the
same decision as the NPV method.

Investment Appraisal Techniques

1. The IRR does not indicate the size of the investment, thus the risk involved in
the investment.
2. The IRR assumes that earnings throughout the period of the investment are
re-invested at the same rate of return (ie at the internal rate of return).
3. It can give conflicting signals with mutually exclusive projects.
4. If a project has irregular cash flows there can be more than one IRR for that
project (multiple IRRs).
5. IRR can be confused with Accounting Rate of Return.

2.9 NPV and IRR compared

2.9.1 Single investment decision
If there is only one project to be appraised, then the NPV and IRR will give a
consistent appraisal. This means that if the project has a positive NPV it will also have
an IRR that is larger than the cost of capital. Similarly, if the project has a negative
NPV, the IRR will be smaller than the cost of capital.

2.9.2 Mutually exclusive projects

Two projects are mutually exclusive if only one of the projects can be undertaken. In
this circumstance the NPV and IRR may give conflicting recommendations.
For example, consider a situation where project A and project B are being appraised.
It is possible that the results of the NPV and IRR methods are as follows:

Project A Project B
NPV (£000) 1,567 1,200
IRR (%) 14% 16%

Project A has the larger NPV, but the smaller IRR. If both projects could be undertaken
then they would both be accepted. However if only one can be undertaken then the
two methods conflict. In this situation the NPV method is preferred.
The reasons for the differences in ranking are:
1. NPV is an absolute measure but the IRR is a relative measure of a project’s viability.
2. Reinvestment assumption. The two methods are based on different assumptions
about the rate at which funds generated by the project are reinvested.
NPV assumes reinvestment at the company’s cost of capital, IRR assumes
reinvestment at the IRR.


2.10 Annuities

An annuity is an investment that gives a return in the form of a series of equal cash flows.

IE Illustrative example 2.8

Year Cash flow 

0 (500)
1 140 
2 140 
3 140 

The cost of capital is 8%.

The NPV of this investment can be calculated in two ways:
(a) by using the present value tables we have been considering to date (an
excerpt is given below)
Present value table
Present value of 1 ie (1 + r)−n
r = discount rate
n = number of periods until payment
Discount rate (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

(b) by using the Annuity present value tables (and an excerpt of these
is given below)
Annuity table
Present value of an annuity of 1 ie

Investment Appraisal Techniques

r = discount rate
n = number of periods until payment
Discount rate (r)

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5

There is very simple connection between the tables. The annuity tables are simply
the relevant parts of the present value tables added up. We will see this by working
through the above example.
Part (a)

Year Cash flow (£000s) Present value factor NPV (000s)

0 (500) 1.000 (500.00)
1 140  0.926 129.64 
2 140  0.857 119.98 
3 140  0.794 111.16 

The NPV is −£139.22

Part (b)
If you think about what we have done in part (a), it is clear that we could do it quicker
by simply adding up the three discount factors (0.926, 0.857 and 0.794 = 2.577) and
multiplying £140 by 2.577. If you look at the annuity discount factors at 8% for three
years you will see that this is what the table do.
The calculations may therefore be presented as follows

Year Cash flow (£000s) Present value factor NPV (000s)

0 (500) 1.000 (500.00)
1–3 140  2.577 360.78 

The NPV is the same as before −£139.22.


EG Learning example 2.6

A project costing £2,000 has returns expected to be £1,000 each year for 3 years.
Agger uses a discount rate of 10% to assess projects.
Calculate the NPV:
(a) using present value tables
(b) using annuity tables

2.10.1 PV of annuities that do not start in year 1

There are situations where the annuity will not start in year 1, for example

Year 0 1 2 3 4 5 6 7 8 9 10
Cash 50 50 50 50 50 50 50 50

The cost of capital is 10%.

The present value of these cash flows is calculated in two steps as follows.
A. Calculate the ‘present value’ as normal using the annuity tables. (We shall see
below why the ‘present value’ is put in quotes.)

PV of annuity = £50 × 8 year annuity factor at 10%

= £50 × 5.335 = £266.75

B. The present value was put in quotes because the cash flows start in year 3 and
you are actually calculating the ‘year 2 value’ of the annuities.
The way the tables work is that when you discount an amount of money by using
the, say, 1 year factor, you are actually discounting it back by one year which will
not necessarily be to year 0. Thus a year 1 amount is discounted to year 0, a year
3 amount is discounted to year 2 etc. A year 99 amount is discounted to year 98.
So if you use the eight-year annuity factor you are discounting to the year before
the annuity starts.
Therefore the £266.75 is the year 2 value of the whole annuity series and must
be discounted back using the present value tables for a further 2 years to give
the true year 0 present value:
£266.75 × 0.826 = £220.34

Investment Appraisal Techniques

2.10.2 PV of perpetuities

A perpetuity is an annuity that lasts forever.
In this situation the calculation of the present value of the future cash flows is very
straightforward. This is of particular importance when considering cost of capital later.

Annual cash flow

PV of perpetuity =
Cost of capital

IE Illustrative example 2.9

A company expects to receive £1,000 each year in perpetuity. The current
discount rate is 9%.
(a) What is the present value of the perpetuity?
PV of perpetuity = £1,000/0.09 = £11,111.11
(b) What is the value if the perpetuity starts in year 5?
If the perpetuity starts in year 5, the above value is the year 4 value of the
perpetuity. It must therefore be discounted back a further 4 years at 9% to give the
year 0 present value:
£11,111.11 × 0.708 = £7,866.67

2.11 Discounted (adjusted) payback period

Discounted (adjusted) payback period takes the payback period we saw earlier and
recalculates it by discounting any future cash flows. This gives a similar answer to
the payback period, that is, a number of years that it takes to pay back the initial
investment. However future cash flows (which are often inflows) are discounted
and hence reduced in size, meaning that discounted payback period is likely to be
longer. If discounted payback period is used consistently it can be a good measure
of comparing projects. It takes into account that future cash flows are not worth as
much as current ones. However it does require more calculation and hence effort
plus it ignores cash flows after the payback period.

EG Learning example 2.7

Sanogo Ltd spends £120,000 on a project and expects to receive £50,000 each year
in return. What is the discounted payback period to the nearest year? Sanogo Ltd's
cost of capital is 10%.


Æ Key Learning Points

• Be able to calculate and comment on a range of investment appraisal techniques:
– Payback period
– Return on capital employed (ROCE)
– Net present value (NPV) (D1b, D1d, D1e)
• Payback period is a simple technique that focuses on the length of time it takes
to recover the cash spent on the initial investment. (D1b, D1c)
• ROCE considers the impact of the investment on accounting profit and is
calculated as the average annual profit divided by the average investment
expressed as a percentage. (D1d)
• NPV is the net of all the positive and negative present values of the cash flows
resulting from an investment over the whole life of the investment. (D1a, D1e)
• Internal rate of return (IRR) is the rate of return at which the net present value
is zero. (D1f)
• Learn the advantages and disadvantages of the different techniques and be able
to list them in the exam. (D1g, D1h)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).

Investment Appraisal Techniques

Learning example solutions

EG Solution 2.1
Where cash flows are the same each year you can use the following simple formula
to calculate the payback period.
Initial investment
Payback period =
Annual inflow
In this case = 60,000/25,000 = 2.4 years
Decision criteria
Accept the project in the event that the time period is within the acceptable time
period (as given in the exam).

EG Solution 2.2

Yr 1  Yr 2  Yr 3  Yr 4  Total 
Volume (000s) 2,000  1,800  1,600  1,600 
Selling Price $5.00  $4.50  $4.00  $3.50 
Operating costs ($1.00) ($1.00) ($1.00) ($1.00)
Allocated overheads ($0.75) ($0.75) ($0.75) ($0.75)
Margin $3.25  $2.75  $2.25  $1.75 
Total Margin ($000s) 6,500  4,950  3,600  2,800  17,850 
Less Depreciation ($14m − $2m) (12,000)
Total profit 5,850 
Average profit (÷4 yrs) 1,462.5 

Average investment
CAPEX ($14m+$2m) ÷2 8,000
Working capital 500
ROCE $1,462.5 ÷ $8,500 = 17.2%

Based on the ROCE method this project would be acceptable because the predicted
ROCE is greater than the target of 10%, suggesting that accounting profit will increase
as a result of taking on the project.


EG Solution 2.3
(a) The expression you have to plug into your calculator is
£1,000 × (1.07)6 = £1,500.73
Remember that 7% = 7/100 = 0.07.
(b) £2,000 × (1.045)11 = £3,245.71
Remember that 4.5% = 4.5/100 = 0.045

EG Solution 2.4

Year Future Value Discount factor Present Value

(£) (from tables) (£)
at 10%
1 1,100 0.909 1,000
2 1,210 0.826 1,000
3 1,331 0.751 1,000
4 1,464 0.683 1,000

As we expect, allowing for rounding errors, the £1,000 present values are restored.

EG Solution 2.5

Year Project A  Discount factor NPV 

(£000s) @ 10% (£000s)
0 (100) 1.000 (100.00)
1 50  0.909 45.45 
2 40  0.826 33.04 
3 30  0.751 22.53 
4 25  0.683 17.07 
5 25*  0.621 15.52 
* Amount includes the residual value

Investment Appraisal Techniques

EG Solution 2.6

(a) Year Cash flow  Present value NPV 

(£000s) factor (10%) (£000s)
0 (2,000) 1.000 (2,000)
1 1,000  0.909 909 
2 1,000  0.826 826 
3 1,000  0.751 751 

The NPV is positive £486

(b) Year Cash flow  Present value NPV 

(£000s) factor (10%) (£000s)
0 (2,000) 1.000 (2,000)
1–3 1,000  2.487 2,487 

The NPV is positive £487. Note that there are rounding errors in the tables.

EG Solution 2.7
Applying a cost of capital of 10% we get
£50,000 × 0.909 = £45,450
£50,000 × 0.826 = £41,300
£50,000 × 0.750 = £37,500
Taking the sum of these three we get £124,250, so the discounted payback period is
3 years (or just under if we were to calculate to the nearest day rather than to the
nearest year).


Advanced Discounted Cash
Flow Techniques

This chapter covers a series of techniques that build on the material studied in the
previous chapter. They are the more practical issues that companies face in the real
world when making investment decisions.
Discounted cash flows (DCF) and taxation and DCF and inflation are both enormously
important in practice and will be part of most calculations using DCF techniques.
The topics in this chapter are regularly examined and can be virtually guaranteed
to form a significant part of any exam. You have to be able to cope easily with DCF,
inflation and taxation.

1. Do you know what are relevant or irrelevant cash flows eg is a sunk cost relevant?

2. How do you decide in the exam to use real or money costs of capital?
3. Do you know the cash flows that apply to a finance lease?

Advanced Discounted Cash Flow Techniques

3.1 Decision-making theory

Investment appraisal is a form of decision-making. As such, it uses decision-making
theory. A key idea in decision-making is that the costs included in the calculations for
the decision must be based on relevant costs.

3.1.2 Relevant costs

Relevant costs are costs that are incurred as a result of a decision.

There are three criteria that determine whether a cost is relevant:

• It must arise in the future, after the decision has been made. Thus any costs
that have already been incurred prior to the decision cannot be included in
the decision-making process. In the exam, the sort of thing that the examiner
includes in the list of costs for you to consider is a survey that has already
been carried out to gauge customer reactions if the decision goes ahead. This
cannot affect the decision because the money has already been spent and is not
therefore dependent on the decision.
• It must be a cash flow. Because we are dealing with DCF, all non-cash flows are
excluded from the decision.
• It must arise as a direct consequence of the decision.

3.1.3 Examples of relevant costs

• Opportunity cost

An opportunity cost is the cost of the best alternative foregone. For example, if
deciding to produce product A means that product B cannot be produced then the
profit attributable to product B should be included as a cost of product A.

• Variable costs are the costs that vary with output. They should be contrasted
with fixed costs which don’t change with output.
• Incremental costs are the additional costs caused by the decision.

3.1.4 Examples of non-relevant costs

• Sunk costs. Sunk costs are costs that the business has already incurred and the
business is committed to whether the decision is made or not. For example,
a business has commissioned research into the viability of the proposed
investment before the decision to invest. This is not relevant.
• Committed costs. These are costs that have not yet been incurred but the
business is committed to them whether the decision is taken or not. For
example, if a business rents a factory on a long lease and cannot sublet or
surrender the lease then the cost is incurred whether the decision is made or not
and so is not relevant.


• Overhead absorbed arbitrarily. These are fixed costs that are absorbed into
products’ cost for accounting purposes. They are not relevant as the decision
has not caused them to be incurred. For example, the rent paid subject to a long
lease and absorbed into product is not relevant because the business incurs the
rent regardless of a particular decision.
• Non-cash flows (eg depreciation). These are not relevant to DCF calculations.

P Principle
Be able to decide which costs are relevant or not

3.1.5 Working capital

Working capital is a relevant cash flow as the additional requirement is only
necessary if we proceed with the project under consideration.
Key assumptions:
1. The initial requirement is a cash outflow at the start of the project (Year 0)
2. Any changes to the working capital requirement during the life of the project will
be relevant with an increase being a cash outflow and a decrease a cash inflow.
Only the incremental amount is recorded in the NPV.
3. At the end of the projects life, any remaining working capital will be released and
is thus a cash inflow.

IE Illustrative example 3.1

A company has estimated that the following working capital amounts are required
and must be in place at the start of each year. Any remaining working capital will be
released at the end of the projects life.

Year Cash flows (£)

1 45,000
2 48,000
3 52,000
4 36,000

Advanced Discounted Cash Flow Techniques

The relevant cash flows included in the NPV each year would be as follows:

Year Working capital  Working

0 (45,000) 0 – 45,000
1 (3,000) 45,000 – 48,000
2 (4,000) 48,000 – 52,000
3 16,000  52,000-36,000
4 36,000  36,000 -0

3.2 Inflation and DCF

Inflation is a naturally occurring phenomenon in most countries. It means that the
price of goods rise. This could be due to a range of factors, including strong demand
for a product, poor weather causing a shortage of an agricultural product or general
economic conditions. In order to understand the calculations it is important to
understand real and money cash flows.

3.2.1 Real and money cash flows

Real cash flows are cash flows which have had the effects of inflation removed.

Money cash flows are cash flows that have not had the effect of inflation removed.
They are the cash flows that actually occur–the cash that is actually received or paid out.

There are two ways of dealing with inflation:

• Deal with the money cash flows, ie include inflation by inflating up the cash flows
year on year.
• Exclude inflation and take the cash flows in real terms, ie year 0 terms.

3.2.2 Real and money rates of return

The rate of return used in calculating a present value must match the cash
flows being used.
If real cash flows are being used, then the rate of return must be the real rate of
return, ie the rate that excludes inflation.


If money cash flows are being used, then the rate of return must be the money rate
of return that includes inflation.

Include inflation Exclude inflation

(money analysis) (real analysis)
Inflate cash flows by the inflation rates Leave cash flows in year 0 terms
And And
Use a money rate of return Use a real rate of return
Exam tip Exam tip
Include inflation where there is more Exclude inflation where a single inflation
than one inflationrate in the question rate is given

The rate of return is the interest rate or discount rate that is used in the DCF

3.2.3 The Fisher effect

When discounting with inflation involved, the Fisher effect allows us to make sure
that the rate of return used is consistent with the cash flows discounted.
The relationship between real and money interest is given as:
1 + m 
(1 + m) = (1 + r) (1 + i) or 1 + r  =
1 + i 
G Learn
r = real discount rate
m = money discount rate
i = inflation rate

IE Illustrative example 3.2

If r = 6% and i = 3%, what is the money rate of interest?
It is calculated as follows:
1 + m = 1.06 × 1.03 = 1.0918
Therefore, m = 1.0918 – 1 = 0.0918 = 9.18%

EG Learning example 3.1

If m = 7% and i = 4% what is the real rate of return?

Advanced Discounted Cash Flow Techniques

IE Illustrative example 3.3

A company expects the following cash flows from a project in year 0 values (ie
in real terms)

Year Cash flows (£)

0 (10,000)
1 5,000 
2 3,000 
3 2,000 
4 1,000 

The inflation rate is expected to be 4.8% for costs and revenues and the money cost
of capital is expected to be 10%
Let us calculate the NPV of the project, making sure that the cashflows and interest
rate are consistent.

Year Real cash flows (£) Discount factor PV 

(see below)
0 (10,000) 1 (10,000)
1 5,000  0.952 4,760 
2 3,000  0.907 2,721 
3 2,000  0.864 1,728 
4 1,000  0.823 823 
Net present value 32 

Calculation of real cost of capital

(1 + r) = (1 + m)/(1 + i)
= 1.1/1.048 = 1.049
r = 4.9% = say 5%

EG Learning example 3.2

Peter Plc is contemplating investment in an additional production line to produce its
range of computer memory discs. A market research study, undertaken by a well-
known firm of consultants, has revealed scope to sell an additional output of 400,000
units per annum. The study cost £80,000 but the account has not yet been settled.


The price and cost structure of a typical disc is as follows:

£ £
Price per unit 12.00
Costs per unit of output
Material cost per unit 1.50
Direct labour cost per unit 0.50
Variable overhead cost per unit 0.50
Fixed overhead cost per unit 1.50
Profit 8.00

The fixed overhead represents an apportionment of central administrative and

marketing costs. These are expected to rise in total by £500,000 per annum as a
result of undertaking this project. The production line is expected to operate for
five years and to require a total cash outlay of £11 million, including £0.5 million of
materials stocks. The equipment will have a residual value of £2 million. The working
capital balance will remain constant after allowing for inflation of materials. The
production line will be accommodated in a presently empty building for which an
offer of £2 million has recently been received from another company. If the building
is retained, it is expected that property price inflation will increase its value to
£3 million after five years. While the precise rates of price and cost inflation are
uncertain, economists in Peter’s corporate planning department make the following
forecasts for the average annual rates of inflation relevant to the project (per annum):

Retail price index 6 per cent

Disc prices 5 per cent
Material prices 3 per cent
Direct labour wage rates 7 per cent
Variable overhead costs 7 per cent
Other overhead costs 5 per cent

Note: You may ignore taxes and capital allowances in this question
Given that Peter’s shareholders require a real return of 8.5 per cent for projects of
this degree of risk, assess the financial viability of this proposal
(10 marks)
Tips: Look out for sunk costs. Plan your approach given there are several rates
of inflation.

Advanced Discounted Cash Flow Techniques

3.3 Taxation and DCF

3.3.1 The complications that tax causes
Tax causes two main complications in DCF questions:
1. We have to calculate the writing down allowances (WDA) that the company
receives because it has made a capital investment. In the exam you may assume
that the WDA will be at 25%, and that this is the only tax relief available.
2. The timing of the tax relief can be complicated. There are two issues here:
– The question will generally say that tax is payable 1 year in arrears. This
means that the tax cash flows will extend for 1 extra year beyond the
revenues and costs of the project.
– It also allows a potentially nasty little complication about the timing of the
WDAs depending on the precise wording of the question about when the
investment in the project was actually made.

IE Illustrative example 3.4

A company purchases a machine on 1 January 20X6 for £50,000. The company has a
31 December year end. WDA are given at 25% and tax is payable one year in arrears
at a rate of 30%.
The cash profits in years 1 and 2 of the project are £20,000
Let us calculate the cash flows for year 1 and 2 of the project.
The main point to understand here is the difference between the timing of the initial
acquisition of the capital asset and the timing of the tax relief (the WDA) for that asset.
The asset was purchased on 1 January 20X6. This is Year 0 (strictly speaking year 0
was 31 December 20X5, but this is only one day different, and in PV terms one day
of discounting makes no real difference to the PV calculation. An asset bought on 31
December 20X5 and 1 January 20X6 has the same year 0 value.)
However for tax purposes it means that it was purchased in year 1 because it falls in
the calendar year to 31 December 20X6, and the tax relief will not be received until
the tax is payable one year in arrears at the end of year 2

Year 0  1  2 
Cash profits 20,000  20,000 
Tax on profits (6,000) (6,000)
Tax relief (WDA)(W) 3,750  2,813 
Capital outlay (50,000)
Net cash flow (50,000) 17,750  (16,813)



Tax Allowance Tax saving Year of relief

year (25%) (30%)
1 Investment 50,000
WDA 12,500 3,750 year 2
WDV 37,500
2 WDA 9,375 2,813 year 3
WDV 28,125

3.3.2 Key proforma

The layout for these questions can be best laid out as follows. The first two lines relate
to the trading cash inflows and the tax on these. The next three lines relate to the
capital expenditure, the WDA relief and any residual value at the end of the project.
1. Net trading revenue – The inflows and outflows from trading
2. Tax payable – The net trading revenue × tax rate
3. Tax allowance – separate working for the capital allowances
4. Investment
5. Residual value

G Learn

EG Learning example 3.3

An asset is bought on the first day of the year for £20,000 and will be used for four
years after which it will be disposed of (on the final day of year 4) for £5,000. Tax is
payable at 30% one year in arrears.
Calculate the writing down allowance and hence the tax savings for each year.

EG Learning example 3.4

Continuing from learning example 3.3, we are further told that net cash from trading
is £8,000 per annum from trading. The cost of capital is 10%.
Calculate the net present value (NPV).

Advanced Discounted Cash Flow Techniques

EG Learning example 3.5

A company invests £30,000 in a project that will yield cash flows of £10,000 per annum
for 3 years before tax. WDAs are given at 25% and corporation tax is 30%. The cost of
capital is 8%. The residual value at the end of the project is expected to be £10,000.
Calculate the NPV of the project.

EG Learning example 3.6

Barry plc, a manufacturer of speciality chemicals, has been reported to the anti-
pollution authorities on several occasions in recent years, and fined substantial
amounts for making excessive toxic discharges into local rivers. Both the
environmental lobby and Barry’s shareholders demand that it clean up its operations
It is estimated that the total fines it may incur over the next four years can be
summarised by the following probability distribution (all figures are expressed in
present values)

Level of fine Probability

£0.5m 0.3
£1.4m 0.5
£2.0m 0.2

Filta & Strayne Limited (FSL), a firm of environmental consultants, has advised
that new equipment costing £1 million can be installed to virtually eliminate illegal
discharges. Unlike fines, expenditure on pollution control equipment is tax-allowable
via a 25 per cent writing-down allowance (reducing balance). The rate of corporate
tax is 33 per cent, paid with a one-year delay. The equipment will have no resale
value after its expected four-year working life, but can be in full working order
immediately after Barry’s next financial year
A European Union Common Pollution Policy grant of 25 per cent of gross expenditure
is available, but with payment delayed by a year. Immediately on receipt of the grant
from the EU, Barry will pay 20 per cent of the grant to FSL as commission. These
transactions have no tax implications for Barry.
A disadvantage of the new equipment is that it will raise production costs by £30 per
tonne over its operating life. Current production is 10,000 tonnes per annum, but is
expected to grow by 5 per cent per annum compound. It can be assumed that other
production costs and product price are constant over the next four years. No change
in working capital is envisaged.
Barry applies a discount rate of 12 per cent after all taxes to investment projects of
this nature. All cash inflows and outflows occur at year ends.


Calculate the expected net present value of the investment assuming a four-year
operating period. Briefly comment on your results.

3.4 Asset replacement

The situation under consideration here is that a decision has been made to replace
an asset. What is now being decided is how often to replace the asset in order to
minimise the costs of the new asset. The costs we are considering are not just the
initial capital costs of the asset but all the costs of the asset over its entire life.
The key in all questions of this type is the lifecycle of the asset in years. You will be given
various lifecycles (eg 3 years, 4 years) and have to work out the cheapest cost per year.
The key ideas/assumptions are:
1. Cash inflows from trading are not normally considered in this type of question. The
assumption is made that they will be similar regardless of the replacement decision
2. The operating efficiency of machines will be similar with differing machines
or with machines of differing ages. The implication of this assumption is that
the different machines that we could buy will not affect the direct costs of
production (labour, materials etc.) although the machines may well have
different running costs that need to be taken into consideration
3. The assets will be replaced in perpetuity or at least into the foreseeable future.
This does not mean that the machine that is bought will last into perpetuity. It
does mean that production will be in perpetuity and we may have to purchase a
new machine every few years to keep production going.

P Principle
Know which cash flows are and are not included

Advanced Discounted Cash Flow Techniques

IE Illustrative example 3.5

A company is considering the replacement of an asset with the following two machines:

(£000s) (£000s)
Investment cost 60 30
Life 3 years 2 years
Running costs 10 p.a. Yr 1: 20
Yr 2: 15
Residual value 5 nil

Let us determine which machine should be bought using a NPV analysis at a cost of
capital of 10%, ignoring the differing lives of the two machines.

Year Cash flow Discount Present value

(£000s) (£000s) (£000s) (£000s)
0 60 30 1.000 60.00 30.00
1 10 20 0.909 9.09 18.18
2 10 15 0.826 8.26 12.39
3 (10 – 5) 5 0 0.751 3.76 0
NPV = 81.11 60.57

So far this is a very familiar calculation–we have calculated the PV of the machine
costs for the two possible replacement machines. We now have to decide which
the cheaper option is. However, remember that this production is to continue
indefinitely and the machines will have to be replaced every three years in the case
of machine P and every two years in the case of machine H.
The NPV from the above calculations can be thought of as the single amount
that summarises as a PV all the costs of the two machines over one life cycle. We
therefore have the following stream of PVs:


Year NPV of P (000’s) NPV of H (000’s)

0 81.11 60.57
2 60.57
3 81.11
4 60.57
6 81.11 60.57
8 60.57

We clearly can’t make the decision on the NPVs shown above as this represents the
costs of the two machines over a different number of years.
Similarly we cannot calculate the annual cost of each machine simply by dividing the NPV
by three for P and two for H, because that will ignore the time value of money. The cash
flows of the two machines occur at different times so a simple average will not work.
In order to decide which is the cheaper in PV terms we need to understand the
‘equivalent annual cost’.

3.4.1 Equivalent annual cost or benefit (EAC or EAB)

In order to decide which machine has the lower annual cost (referred to in this context
as the equivalent annual cost), we recall the way we calculated the PV of an annuity
PV of an annuity = Annuity × (PV annuity factor)
This can be reworked to fit the current problem by replacing the annuity in the
formula by the equivalent annual cost that we are looking for:
PV of annuity of machine cost for 1 cycle = equivalent annual cost × (PV annuity factor)
NPV of machine's costs over one cyclle
Equivalent annual cost =
PV annuity factor

G Learn
The annuity factor is found from the annuity tables as before, at 10% for the number
of years for the machine we are calculating the EAC.

Advanced Discounted Cash Flow Techniques

In other words, for machine P (which has an NPV of 81.11 in Illustrative example 3.4)

Equivalent annual cost = 81.11/Annuity factor at 10% for 3 years

= 81.11/2.487
= £32.61

For machine H (which has an NPV of 60.57 in Illustrative example 3.4)

Equivalent annual cost = 60.57/Annuity factor at 10% for 2 years

= 60.57/1.736
= £34.89

We therefore choose machine P because it is the cheaper option.

We could have a situation where there is a benefit overall, for example buying a
property and saving on rent, in which case we would use the same calculation but
calculate an overall equivalent annual benefit (EAB).

3.4.2 Criticisms of equivalent annual cost

The assumptions are unrealistic:
• The assumption that direct production costs will not be affected by the choice
of machine is unrealistic. A machine with a longer life cycle will mean that the
company is working with older machines for most of the time. These older
machines may have reliability issues, may be inefficient and may produce work of
poorer quality.
• Technological change may mean that in a very short time, the replacement
machines will be nothing like the machines that they replace, making the
calculations meaningless.

EG Learning example 3.7

A company is considering replacing an asset with the following two machines:

Machine A Machine B
Investment cost £25,000 £40,000
Life 3 years 5 years
Running costs £2,000 pa £3,000 pa
Residual value £5,000 £7,000

Calculate which machine should be bought using NPV analysis with a cost of
capital of 10%.


3.5 Capital rationing

This topic explores what happens if there is a limit on the level of funding available to
a business, there are two types:

3.5.1 Hard capital rationing

This refers to capital rationing imposed externally by banks or other lenders.
This can be caused by
1. Wider economic factors (eg a credit crunch)
2. Company specific factors
(i) Lack of asset security
(ii) No track record
(iii) Poor management team

3.5.2 Soft capital rationing

This is imposed internally by senior management.
This seems to be contrary to the overall aim of DCF which is to maximise
shareholders’ wealth (ie to take all projects with a positive NPV).
However there may be good reasons:
1. Lack of management skill.
2. Wishing to concentrate on relatively few projects.
3. Unwillingness to take on external funds.
4. Only a willingness to concentrate on strongly profitable projects.

3.5.3 Multi-period capital rationing

Multi-period capital rationing means that capital is rationed over many periods. It
assumes that when considering projects, the projects require capital over many
periods and not just in year 0, which is what we are used to.
This can become a very complicated and requires linear programming to solve. It can
also be fairly complicated linear programming if there are several projects with different
capital requirements over several years and capital restrictions over several years.
You are unlikely to get a difficult question in this area and you just need to know the
broad technique.

3.5.4 Single period capital rationing

This assumes 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 you have met in management accounting. In that
situation we maximise the contribution per unit of limiting factor.

Advanced Discounted Cash Flow Techniques

There are several scenarios:

• The projects are divisible, ie the projects can be divided into parts with only
a part or the whole of projects taken. In the case that you take only part of a
project (eg 60%) you will receive the same proportion of the return (ie 60%).
Here you should work out the NPV per £ invested and take on projects with the
highest NPV per £ invested until you use up all the money available.
• Projects are indivisible, ie you can either take all of a project or none of it. If you
are faced with this you should use trial and error to find the best combination that
uses up all of the funds available (or as much as possible) to give the best total NPV.
• The situation can be complicated if the examiner includes mutually exclusive
projects, ie projects that cannot both be undertaken at the same time. In this
situation you have to experiment to find the best combination.

P Principle
Why capital rationing occurs and the types

IE Illustrative example 3.6

A company is considering 4 possible investments. The funds available for investment are
£200,000. All investments must be started now (Yr 0):

Project Initial investment (Yr 0) (£000s) NPV (£000s)

A 100 25
B 200 35
C 80 21
D 75 10

Which project(s) should we invest in to maximise the return to the business?

(a) If all the projects are divisible, ie each project can be taken in part and the
returns (NPV) will be proportionate to the amount of investment. Work out
the NPV per £ invested and choose the highest ones in order.
The key point to realise here is that this is simply calculating the return per limiting factor.
In this context we calculate the profitability index (PI) which is defined as follows:


PI = NPV/Investment

Project Working PI Ranking

A 25/100 0.250 2
B 35/200 0.175 3
C 21/80 0.263 1
D 10/75 0.133 4

The projects will therefore be undertaken in the order: C, A, B, D.

We now list them until all the available funds are used:

Project Funds used NPV (000s)

undertaken (000s)
C (80) 21
A (100) 25
B (20) 35 × (20/200) = 3.5
Total NPV 49.5

(b) If the projects are not divisible. Use trial and error–what is the best
combination to spend £200,000 of funds?
Projects are non-divisible, so they are taken as a whole or not at all.
In order to solve this we have to use a fairly unsophisticated technique-we just have
to list all the possible mixes of projects and calculate the returns from the various
mixes. We then choose the most profitable mix.

Project mix Funds used NPV

B 200 35
A, C 100 + 80 = 180 25 + 21 = 46
A, D 100 + 75 = 175 25 + 10 = 35
C, D 80 + 75 = 155 21 + 10 = 31

We would therefore choose the combination A and C.

Advanced Discounted Cash Flow Techniques

Unused funds
You need to note that there is a problem with the unused funds (20,000). It may
be that these are funds that the company cannot simply pay back and has to invest
them-perhaps this £20,000 was part of the proceeds of an issue of loan notes and
cannot be repaid. It is possible that any alternative investment of this surplus may
yield a return less than the cost of the loan notes and if this happens you would in
practice have to deduct any loss from the NPV of the chosen mix.
In general, if the alternative return from surplus funds is less than the cost of capital,
then this will reduce the NPV of the mix chosen.
(c) If the projects are divisible but projects A and C are mutually exclusive (as (a)
but experiment to see if A or B should be included).
Projects are divisible, and A and C are mutually exclusive.
We can take any part of a project and the return is proportionate to the investment,
and taking project A precludes the taking of project C.
There are three possible ways of dealing with the mutually exclusive projects A and C.
Option 1: Take project A and the mix of other projects excluding C depending on their PI
Option 2: Take project C and the mix of other projects excluding A depending on their PI
Option 3: Do neither A nor C
Bearing in mind that A and C are the projects with the largest PIs we will want to
include one of them, so option 3 above is not realistic.
There are therefore two possible mixes.
1. Take project A followed by B, followed by D.

Project Funds used (000s) NPV (000s)

A 200  25
B 50% 100  50% × 35 = 17.5
Total NPV 42.5


2. Take project C followed by B, followed by D.

Project Funds used (000s) NPV (000s)

C 200  21
B 60% 100  60% × 35 = 21
Total NPV 42

Therefore the decision is to take 100% of project A, followed by 50% of project B.

3.6 Risk
3.6.1 Risk and uncertainty
The difference between risk and uncertainty is that
• Risk can be quantified. We can assess the risk mathematically by using
techniques such as probability distributions. For example, if considering sales
volumes we can carry out market research and assess the likelihood of the
company selling different volumes of the product. This can be expressed as a
probability distribution and even as a ‘standard deviation’ – the calculation of
which is beyond the scope of this syllabus.
• Uncertainty is not quantified. We know that there is the possibility of
something changing.
Assessment of risk is particularly important when performing investment
appraisal due to:
• Long timescale. The length of the timescale is important because the project
commits the company to a course of action that is going to affect its results
for many years.
• Large size in relation to the size of the company. Capital projects tend to be large
relative to the other decisions that a company makes. This makes these decisions
very important.
• Outflow today, inflow in the future. The fact that we commit to the project now
but do not get the return until maybe many years in the future is an obvious risk.
• Strategic nature of the decision. Capital decisions tend to affect the core
activities of the company and determine the routes that the company will take
for many years to come.

Advanced Discounted Cash Flow Techniques

Techniques to deal with risk are:

1. Sensitivity analysis
2. Expected values
3. Adjusted discount rates
4. Adjusted payback
5. Simulation

3.6.2 Sensitivity analysis

The profitability of a project is sensitive to many factors, mainly for our purposes the
inputs and the sales figures. Other factors such as, for example, the general state of
the economy are not as relevant for this exam.

Sensitivity analysis is a technique that considers a single variable at a time and
identifies by how much that variable has to change for the decision to change (from
accepting the project to rejecting the project).

The variables that we need to consider are

• Selling price
• Sales volume
• Variable costs
• Fixed costs
• Discount rate
• The cost of the investment itself
• The term of the investment
A change in any of these can cause the project to change from being an ‘accept’
decision to a ‘reject’ decision.
A key calculation in all these questions is the sensitivity margin
NPV of project
Sensitivity margin =
PV of the cash flow of the variable under consideration

G Learn

IE Illustrative example 3.7

An investment of £50,000 in year 0 is expected to give rise to inflows of £22,000
for each of years 1 to 3. The discount rate is 10%. The inflow p.a. is after deducting
fixed costs per annum of £8,000. Selling price is £10/unit and variable cost is £7/unit.
Volume is estimated at 10,000 units.
(a) Should we accept or reject the investment based on NPV analysis?


NPV of project

Yr Cash flow  DF at 10% PV 

0 (50,000) 1.000 (50,000)
1–3 22,000  2.487 54,714 
NPV  +4,714 

The NPV is positive, therefore, the project should be accepted.

(b) By how much would the values have to change for the decision to alter for:
(i) Initial investment
(ii) Cash inflows (sales price, sales volume and fixed costs respectively),
(iii) Discount factor?
(i) Initial investment
To calculate the sensitivity margin we need to divide the NPV of the project by the PV
of the cash flow under consideration.
In this case the PV of the cash flow of the initial investment is the initial investment
itself because it is in year 0.
NPV of project
Sensitivity margin =
PV of the cash flow of the variable under consideration
SM = 4,714/50,000 = 9.43%
This means that the NPV of the project equals 9.43% of the PV of the capital investment.
Thus, if the capital investment rose by 9.43% (ie 9.43% × 50,000 = 4,714), the NPV of
the project would be nil.
(ii) Sales price
To calculate the sensitivity margin in this case we have to realise that that the PV
of the cash flow under consideration is the PV of the sales revenue, which is (£10 ×
10,000 × 2.487). Therefore:
SM = 4,714/(£10 × 10,000 × 2.487) = 1.9%
Thus the price has to fall by 1.9% for the NPV to fall to zero.
Note how sensitive this makes the project to the sales price. It only has to change by
1.9% × £10 = £0.19 for the project to be rejected.
Sales volume
To calculate the sensitivity margin of the sales volume, note that the cash flow under
consideration is not the sales volume but the contribution from sales. This is because
the change in volume does not just change the revenue but also changes the variable
costs. Thus the cash flow under consideration is the contribution =

Advanced Discounted Cash Flow Techniques

(£10 − £7) × 10,000 × 2.487

SM = £4,714/((£10 − £7) × 10,000 × 2.487) = 6.32%
Thus volume may fall by 6.32% before NPV falls to zero.
Fixed costs
This is more straightforward. The cash flow under consideration is the fixed costs
of £8,000 pa.
SM = £4,714/£8,000 × 2.487 = 23.69%
Thus fixed costs may rise by 23.69% before NPV falls to zero.
(iii) Change in discount rate
Remember the original calculation

Yr Cash flow  DF at 10% PV 

0 (50,000) 1.000 (50,000)
1-3 22,000  2.487 54,714 
NPV +4,714 

If the discount rate changes the only thing that will change in the above calculation is
the annuity factor 2.487. Clearly if this was smaller, the PV of the annual cash inflows
would be smaller. We have to calculate what the new figure should be to make the NPV
of the cash inflows equal to £50,000 so that the NPV of the whole project equals zero.
We can say:
Annuity × required annuity factor = initial investment
Required annuity factor = initial investment/annuity
Required annuity factor = £50,000/£22,000 = 2.273
If we look up the annuity tables, we look for the number 2.273 for a three year
annuity. The number 2.273 falls between 15% and 16%.
Thus we can say that if the discount rate rises to 15% (say), the decision will change.
What we have actually calculated is of course the IRR–the discount rate that gives a zero
NPV for the project. We can only use the short cut if we are dealing with an annuity.


EG Learning example 3.8

A company is planning an investment of £40,000 which is expected to give rise
to cash inflows of £15,000 per annum for 4 years. The sales price is £20 per unit;
variable costs are £10 per unit; number of units sold is 2,500 per annum and fixed
costs are £10,000 per annum. The cost of capital is 10%.
(a) Should the project be accepted or rejected?
(b) By how much would the values have to change for the decision to alter for
(i) Sales price
(ii) Sales volume
(iii) Cost of capital?

3.7 Expected values

Expected values are used where there are a range of possible outcomes which can
be identified and a probability distribution can be attached to those values. In this
situation we may use a variety of techniques to establish some sort of ‘average’
return. The measure of average return is then assumed to be the expected value of
the project that we should use when deciding whether to accept or reject.
The expected value is the arithmetic mean of the outcomes as expressed below:
EV = Σ Px
Where P = the probability of an outcome
x = the value of an outcome

IE Illustrative example 3.8

A new project is being launched. There are four possible outcomes with profits/
losses expressed in £m, and the management team attached the best estimate of
probability to these outcomes:

Outcome Profit/Loss (x) Probability (P) Working

Strong success £25m 0.10
Reasonable success £10m 0.25
Weak success £3m 0.35
Failure (£20m) 0.30
Expected value

Advanced Discounted Cash Flow Techniques

Let us calculate the expected value of the project.

Outcome Profit/Loss (x) Probability (P) Working (Px)

Strong success £25m 0.10 £2.5m
Reasonable success £10m 0.25 £2.5m
Weak success £3m 0.35 £1.05m
Failure (£20m) 0.30 (£6.0m)
Total £0.05m

The result is a very small positive expected value. The worrying thing however is the
range of possible outcomes, from +£25m to −£20m.
Expected values have several advantages:
• They are simple to use.
• They give a reasonable estimate of the outcome of projects if the project were
to be repeated many times. They are an averaging method, and this implies that
they are an average of many different outcomes.
• They are a weighted average and are therefore not accurate for any one outcome.
• They ignore the individual expected outcomes and therefore detail is lost. The
company may want to know the extreme values that are possible.
• They are not a reliable guide to the outcome of a one-off project. They only give a
reasonable guide to the likely result if the project were to be repeated many times.

3.8 Risk-adjusted discount rates

The discount rate we have assumed so far reflects the cost of capital of the business.
In simple terms this means that the rate reflects either the cost of borrowing funds in
the form of a loan rate or it may reflect the underlying return of the business (ie the
return required by the shareholder), or a mix of both.
An individual investment or project under consideration may be perceived to be
more risky than existing investments. In this situation the increased risk could be
used as a reason to adjust the discount rate up to reflect the additional risk.

3.9 Adjusted payback period

As discussed earlier in the notes payback period gives a simple measure of risk. The
shorter the payback period, the lower the risk.

Before- and after-tax discount rates

Normally the cash flows that will be given in the exam will be adjusted for the tax
effects of those cash flows, meaning the cash flows will be after-tax. For consistency
the discount rate used will also be after-tax. It makes sense that tax should be taken


into account in both cash flows and discount rate. An alternative is to take a before-
tax rate and apply to before-tax.

IE Illustrative example 3.9

Calculate the net present value of £1,000 per annum received before tax into infinity
at a before-tax rate of 10%. Tax is at 40%,
We will demonstrate the effect on the cash flows, discount rate and net present value.
With before-tax figures, the net present value is £1,000 divided by 10%, to calculate
the value of a perpetuity, which comes to £10,000.
After tax of 40% the cash flows are £600 per annum and the discount rate is 10%
times (1-0.40) so 6%. The net present value is £600 divided by 6%, so £10,000.
In this simple example the effect of the tax on the cash flow and the discount rate is
the same, so the net present value is unchanged.
If the cash flows and discount rate are simple then we can get the same answer for
our NPV calculation. However the tax system means that cash flows are likely to
move out of line from this simple situation. For example, the cost of a machine is
included in a project's cash flows at time 0. Capital allowances are given to reflect
this cost and they are received over time, hence the tax effect and the cash flows are
not moving together. Similarly tax losses will distort when tax relief is received.
Hence in practice it is unusual to get the same result before and after tax. Hence, to
reflect the real-life situation, it is best to take actual after-tax cash flows and discount
with an after-tax rate.

Simulation is a method to try to take into account risk and uncertainty by considering
the variables that are involved in the project and the chances of those variables
occurring. Once these have been estimated then usually, due to the complexities of
the data, a computer will be used to look at the likely outcomes and the chances that
the project will be successful.
For the exam you may be required to mention this as a possible method but won't
be able to take it any further. A popular method in practice is called Monte Carlo
simulation. However any method used is only as good as the estimates of the future
outcomes and probabilities. Predicting the future is difficult (or we would all be
lottery winners!).

3.10 Lease or buy

This is not an investment decision technique. It is a financing decision. The decision
has already been made to accept a project – the only decision now is to decide how
to finance the project.

Advanced Discounted Cash Flow Techniques

We shall see that the issue is really about the different tax treatments for leased or
bought assets.
The decision is between
• Leasing the asset on a finance lease
This means that the company will not actually own the asset.
The tax implication of this is that the company cannot claim capital allowances for
tax purposes on the capital amount it would have spent had it bought the asset.
However the annual lease payments are fully deductible for tax purposes.
• Buying the asset with a bank loan
The company does get capital allowances on the purchase cost of the asset.

3.10.1 Key information to be calculated

• Discount rate
The discount rate we use is the post-tax cost of borrowing. The rate is given by
the rate on the bank loan in the question. If the rate given is pre-tax then the
rate must be adjusted for tax. If the loan rate is 10% pre-tax and corporation tax
is 30% then the post-tax rate will be 10% × (1 – 0.3) = 7%.
• Cash flows
The following cash flows apply to these decisions:

Bank loan Finance lease

1. Cost of the investment 1. Lease rental
- These are paid in advance
- They are always annuities
2. WDA tax relief on investment 2. Tax relief on rental
3. Residual value

Finally note that the examiner will generally say that there is a one-year delay in the
payment of tax.

G Learn
To calculate the correct answer, work out the cashflows under the bank loan and
discount them at the post-tax rate of capital. After that, calculate the present value
of the cash flows of the finance lease at the post-tax cost of capital. Choose the
cheapest method of financing by taking the lowest present value.


IE Illustrative example 3.10

Smicer plc is considering how to finance a new project that has been accepted by its
investment appraisal process.
For the four year life of the project the company can either arrange a bank loan at an
interest rate of 15% before corporation tax relief. The loan is for £100,000 and would
be taken out immediately prior to the year end. The residual value of the equipment
is £10,000 at the end of the fourth year.
An alternative would be to lease the asset over four years at a rental of £30,000 per
annum payable in advance.
Tax is payable at 33% one year in arrears. Capital allowances are available at 25% on
the written down value of the asset.
Should the company lease or buy the equipment?
Cost of buying (with a bank loan)

Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
($000s) ($000s) ($000s) ($000s) ($000s) ($000s)
Capex (100)
Residual value 10
Tax relief (W1) 8.3 6.2 4.7 13.9 
Cash flow (100) 8.3 6.2 14.7 13.9 
DF at 10% (W2) 1.000  0.909 0.826 0.751 0.683 0.621 
PV (100) 6.9 4.7 10.0 8.6 
NPV (69.8)

W1: WDA Tax Relief

Year Allowance Relief (at 33%) Timing

($000s) ($000s) (1 yr in arrears)
1 Capex 100 
WDA 25% (25) 8.3 Yr 2
2 WDV 75 
WDA 25% (18.8) 6.2 Yr 3
3 WDV 56.2 
WDA 25% (14.1) 4.7 Yr 4
4 WDV 42.1 
Proceeds (10)
BA 32.1  13.9 Yr 5

Advanced Discounted Cash Flow Techniques

W2: Post tax cost of borrowing

15% × (1 – 0.33) = 10%
Cost of leasing

Yr Cash flow  DF at 10% (W2) PV 

0-3 Rental  (30.0) 3.487  (104.6)
2-5 Tax relief  9.9  2.886  28.6 
(30 × 0.33)
NPV  (76)

The asset should be purchased with a bank loan in preference to leasing as this
would be cheaper. There is however some issue with the residual value as it is
possible that the residual value passes to the company (lessee).

4 Residual value 10.0 0.683 6.8

If the residual value passes to the lessee the cost of leasing falls to (76 – 6.8) $69,200
which makes it marginally cheaper than buying.

3.10.2 Other considerations

1. Who receives the residual value in the lease agreement? It is possible that
the residual value may be received wholly by the lessor or almost completely
by the lessee.
2. There may be restrictions associated with the taking on of leased equipment.
The agreements tend to be much more restrictive than bank loans.
3. Are there any additional benefits associated with lease agreement? Many
lease agreements will include within the payments some maintenance or other
support services.


Æ Key Learning Points

• Learn the additional calculations needed for DCF and taxation, looking at how
the cash flows of a project are affected by taxation. (D2b)
• Learn how cash flows are affected by inflation over time and be able to deal with
this in an NPV calculation. (D2a)
• Understand cash flows and discount rates before and after tax and be able to
identify which to use. (D2b)
• Learn about asset replacement (in particular the calculation of equivalent annual
cost), which indicates the best cycle to replace assets on. (D4b)
• Understand capital rationing and be able to identify which project amongst
many a company should choose when short of money. (D4c)
• Understand capital rationing and be able to identify which project amongst
many a company should choose when short of money. (D3a–D3d)
• Understand capital rationing and be able to identify which project amongst
many a company should choose when short of money. (D4a)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).

Advanced Discounted Cash Flow Techniques

Learning example solutions

EG Solution 3.1
1 + r = (1 + m)/(1 + i) = 1.07/1.04 = 1.0288
Therefore, r = 1.0288 − 1 = 0.0288 = 2.88%

EG Solution 3.2

NPV analysis Yr 0  Yr 1  Yr 2  Yr 3  Yr 4  Yr 5 
($000s) ($000s) ($000s) ($000s) ($000s) ($000s)
Net trading revenue
Revenue 5,040  5,292  5,557  5,834  6,126 
$12 : Inflation 5%
Material (618) (637) (656) (675) (696)
$1.5 : Inflation 3%
Labour (214) (229) (245) (262) (281)
$0.5 : Inflation 7%
Variable overhead (214) (229) (245) (262) (281)
$0.5 : Inflation 7%
Fixed overhead (525) (551) (579) (608) (638)
$500K : Inflation 5%
Sub-total 3,469  3,646  3,832  4,027  4,230 
Capex (excl. W.C.) (10,500)
Residual value 2,000 
Opportunity cost (2,000)
Opportunity benefit 3,000 
Working Capital (500) 500 
Cash flow (13,000) 3,469  3,646  3,832  4,027  9,730 
D.F. @ 15% (W1) 1.000  0.870  0.756  0.658  0.572  0.497 
Present Values (13,000) 3,018  2,756  2,521  2,303  4,836 
N.P.V. +2,434 

Accept the project as the NPV is positive and this would suggest that the project will
increase shareholder’s wealth by this amount today if the project is accepted.
W1: To calculate the nominal (money) rate of return we need to use the Fisher
(1 + m) = (1 + r) (1 + i) Therefore m = 1.085 × 1.06 – 1 = 15%


EG Solution 3.3

Year Allowance  Tax saving Timing

(25%) (30%)
1 Investment 20,000 
W.D.A. (5,000) 1,500 Year 2
2 W.D.V. 15,000 
W.D.A. (3,750) 1,125 Year 3
3 W.D.V. 11,250 
W.D.A. (2,813) 844 Year 4
4 W.D.V 8,437 
Proceeds (5,000)
BA/BC 3,437  1,031 Year 5

EG Solution 3.4

Year 0  1 2  3  4  5 
NTR 8,000 8,000  8,000  8,000 
Tax payable (2,400) (2,400) (2,400) (2,400)
CAPEX (20,000)
Residual 5,000 
Tax relief 1,500  1,125  844  1,031 
Cash flow (20,000) 8,000 7,100  6,725  11,444  (1,369)
Disc factor 1.000  0.909 `0.826  0.751  0.683  0.621 
PV (20,000) 7,272 5,865  5,050  7,816  (850)

NPV = +5,153
Therefore, accept the project as the NPV is positive.

Advanced Discounted Cash Flow Techniques

EG Solution 3.5
Step 1 – calculate the tax savings caused by the WDAs

Tax year Allowance Tax saving Year of relief

(25%) (30%)
1 Investment 30,000
WDA 7,500 2,250 Year 2
WDV 22,500
2 WDA 5,625 1,688 Year 3
WDV 16,875
3 Residual value 10,000
Balancing allowance 6,875 2,063 Year 4

Step 2 – calculate the NPV of the project

0  1 2  3  4 
Net cash 10,000 10,000  10,000 
Tax payable (3,000) (3,000) (3,000)
CAPEX (30,000)
Residual value 10,000  10,000 
Tax relief 2,250  1,688  2,063 
Cash flow (30,000) 10,000 9,250  18,688  (937)
Disc factor 1.000  0.926 0.857  0.794  0.735 
PV (30,000) 9,260 7,927  14,838  (689)

NPV = +1,336
Therefore accept the project.

EG Solution 3.6
Note: This question is slightly out of the ordinary because there is no benefit
associated with the investment. Instead the impact of the investment is to increase
operating costs and hence reduce operating profit. This will have the result of
reducing the amount of tax paid. The fines are ignored in the NPV analysis to simplify
matters and only included once the NPV was calculated.


Yr 0  Yr 1  Yr 2  Yr 3  Yr 4  Yr 5 
($000s) ($000s) ($000s) ($000s) ($000s) ($000s)
NTR (Inc. Prodn (315) (331) (347) (365)
Cost) $30/tonne : 5%
Tax saving 104  109  115  120 
Capex (1,000)
Residual value 0 
Tax relief (W1) 83  62  47  139 
Grant 250 
1,000 × 25%
Commission (50)
Cash flow (1,000) (115) (144) (176) (203) 259 
DF at 12% 1.000  0.893  0.797  0.712  0.636  0.567 
PV (1,000) (103) (115) (125) (129) 147 
NPV (1,325)

The EV of the PV of the fines is as follows:

$0.5m × 0.3 + $1.4m × 0.5 + $2.0m × 0.2 = $1.25m
On purely financial grounds the company should not make the investment because
the cost of cleaning up is less than the expected value of the fines.
W1: WDA tax relief

Year Allowance  Relief (at 33%) Timing

($000s) ($000s) (1 yr in arrears)
1 Capex 1,000  83 Yr 2
WDA 25% (250)
2 WDV 750  62 Yr 3
WDA 25% (188)
3 WDV 562  47 Yr 4
WDA 25% (141)
4 WDV 421 
Proceeds 0 
BA 421  139 Yr 5

Advanced Discounted Cash Flow Techniques

EG Solution 3.7
Step 1 – calculate the NPV of the two machines over 1 cycle.

Year Cash flow (000s) Discount Present values (000s)

A  B  A  B 
0 25  40  1.000 25.00  40.00 
1 2  3  0.909 1.82  2.73 
2 2  3  0.826 1.65  2.48 
3 (5 – 2) = (3) 3  0.751 (2.25) 2.25 
4 3  0.683 0  2.05 
5 (7 – 3) = (4) 0.621 0  (2.48)
NPV 26.22  47.03 

Step 2 – calculate the EAC for the two machines.

NPV of machine's costs over one cyycle
Equivalent annual cost =
PV annuity factor
Machine A
EAC = £26,220/annuity factor 3 years at 10% = £26,220/2.487 = £10,543
Machine B
EAC = £47,030/annuity factor for 5 years at 10% = £47,030/3.791 = £12,406
Therefore, choose machine A.


EG Solution 3.8
(a) NPV of project

Yr Cash DF at 10% PV
flow (£)
0 (40,000) 1.000 (40,000)
1-4 15,000  3.170 47,550 
NPV +7,550 

Positive NPV therefore accept the project.

NPV of project
Sensitivity margin =
PV of the cash flow of the variable under consideration
(i) Sales price
The PV of the cash flow under consideration is the PV of the sales revenue,
which is (£20 × 2,500 × 3.170). Therefore:
SM = 7,550/(£20 × 2,500 × 3.170) = 4.8%
Thus the price may fall by 4.8% for the NPV to fall to zero.
Thus the sales price has to fall by £20 × 0.048 = £0.96 for the decision to change.
(ii) Sales volume
The cash flow under consideration is the contribution =
(£20 − £10) × 2,500 × 3.170
SM = £7,550/((£20 − £10) × 2,500 × 3.170) = 9.5%
Thus volume may fall by 9.5% before NPV falls to zero.
(iii) Change in discount rate
If the discount rate changes the only thing that will change in the original
calculation is the annuity factor 3.170. It has to fall to a value that will make
the PV of the inflows equal to £40,000.
Required annuity factor = £40,000/£15,000 = 2.667
If we look up the annuity tables, we look for the number 2.667 for a four
year annuity. The number 2.667 falls between 18% and 19%.
It is nearer to 18%, so we can say that if the discount rate rises to 18%, the
decision will change.

Long-term Sources of Finance

Long-term finance is essential for all companies. Equally important is the choice of
what sort of finance should be raised and what mix of finance should be chosen to
maximise the company’s profits and provide stable finances for the company. The
problems of raising finance and the best way of avoiding those problems should be
clearly understood by companies.
We will look at the markets that are involved with company finance and then explore
the types of finance and the problems facing small and medium entities (SMEs).
There are generally a few marks for this part of the syllabus on every paper. You
need to be able to discuss the advantages and disadvantages of the various forms
of finance and explain how the different types can be combined to suit a company’s
funding requirements. You also need to be aware that businesses have different
requirements depending on their size-from SME to much larger companies.
There are a variety of financing options, such as leasing, that a company can
choose. Understanding of the advantages and disadvantages of the options is
important for the exam.

1. Can you name two markets that a company obtains money from?

2. Can you describe the difference between equity and debt?

3. What is an SME and what types of finance can an SME access?

Long-term Sources of Finance

4.1 Financial markets and institutions

4.1.1 Money
Money in economic terms is defined as having several properties. It is:
• A medium of exchange, ie it can be exchanged for other assets
• A store of wealth, ie it can be used for savings
• A unit of value, ie assets can be valued as an amount of money.
In general terms money is anything that is generally accepted as payment for goods
and services or repayment of debts.
In a developed economy money has two main components:
• Notes and coins
• Bank deposits
Bank deposits are money because they are the money that has been deposited with
the bank by its customers and can be paid out by the customers either by cheque,
debit card etc.
Money can also be created by the banks. A bank can simply agree to lend a customer
say £10,000 and credit the customer’s account with £10,000. The customer can
now spend that money. This is not money that the bank has already borrowed or
has on deposit from another customer–it is new money (new spending power in
the economy). Of course the bank needs reserves if it does this. If it lent too much
money to too many customers in this way and all the customers wanted to withdraw
it or pay cheques to third parties at the same time the bank would not be able to pay
them all. This is called a ‘run on the bank’, possibly resulting in the bank failing.

4.1.2 Capital markets

Capital markets are markets where financial instruments are traded.

There are two types of instruments traded on two separate markets:

• Shares of companies (representing ownership rights of the company itself),
traded on the stock market. Companies issue shares, each one of which
represent a fraction of the ownership of the company.
• Bonds, traded on the bond market. Bonds are debt securities in which the issuer
(eg, the company borrowing the money) issues the bond to the lender (the bond
holder, ie, the person lending the money). It is a contract that specifies the rate
of interest and the repayment terms etc.
In addition, each of the above two markets has two separate operations:
• The primary market – the market where new issues are traded, and
• The secondary market – the market where existing stocks or bonds are traded.


The two markets depend on each other – the secondary market is the ‘exit route’
for persons who have bought securities in the primary market. The primary market
would not be so successful if people buying the securities did not have a means of
selling them if they wanted an exit.

4.1.3 Money market

The money market is a market for short-term borrowing and lending, and trades
financial instruments such as Treasury Bills, short term gilts (government bonds) and
commercial paper (bonds issued by companies).

The money market allows a company, also known as a private sector organisation,
(or equally public sector organisations such as government departments or local
authorities) to obtain short-term liquidity, obtain trade finance (allowing it to buy
goods more easily through a financial institution providing the required money (or
guarantee, such as a letter of credit, in the short term) and manage its exposure to
foreign currency and interest rate risks, by the methods that it can obtain finance
from the money markets.
Banks and other financial institutions are financial 'intermediaries', helping out by
providing places for companies to deposit excess cash and for other companies to
borrow that cash. The interest rates that the banks and financial institutions offer will
depend on the amount of cash available and that required. If they haven't enough
money to lend then they will offer higher rates to depositors.
The following are a series of money market instruments available:
1. Interest bearing instruments that allow depositors to get a return and lenders to
be charged for their borrowing. For banks to make a profit, depositors will get a
lower return than the cost to investors. Instruments have different lengths of life
and different interest rates. For example:
– A $100 nominal 1-year 4% pa instrument will pay $4 interest when it matures
after a year.
– A $100 nominal 3-month 6% pa instrument will pay $1.50 interest when it
matures at the end of its three month life.
Note that in the second example the interest rate is 6% pa, but this applies over only
three months. The interest rate on all instruments is always quoted as an annual
rate as this allows easier comparison between different instruments’ returns.
2. Discount instruments-these offer no explicit rate of interest but instead require a
company to pay back more than they borrowed. For example, they may borrow
£97,000 and have to pay back £100,000 in three months' time. The extra amount
that is paid is effectively an interest charge. That is equivalent to a three month

Long-term Sources of Finance

rate of interest 3/97 = 0.0309 = 3.09% and is equivalent to an annual cost of

12.36% (ie 3.09 x 4)
3. Derivative products derive their value from other some separate index or
instrument. Hence, they may have an interest rate that is linked to a separate
benchmark interest rate. An example of a derivative is an interest rate future.
This is a product whose value depends on LIBOR, the London Inter-bank Offered
Rate, which is the reference rate of interest used by banks to borrow and lend
between themselves. The value of futures can be thought as depending on 100
– LIBOR. Just think of futures as stocks and shares that can be bought and sold.
If LIBOR is 5% the value of the future is 95 (ie 100 – 5); if LIBOR falls to 4%, the
value of the future will be 96 (ie 100 – 4). This behaviour can be used to help
borrowers and lenders protect themselves against interest rate fluctuations. For
example, if you deposit money in a variable rate account when interest rates are
5%, you would be disappointed if interest rates then fell to only 4%. However, if
you had bought some futures at 95 when you made the deposit, if interest rates
fall to 4% your futures would rise in price to 96 and you can sell the futures to
make a gain to compensate you for the loss of interest.

4.1.4 Global markets

The above markets are global markets. All developed countries will use them and
government and companies trade freely between them. Individual countries have
their own ‘stock market’ or ‘financial centre’ where the financial activity takes place,
and the various firms that operate in these centres trade between each other.
London is one of the world’s largest financial centres–partly due to London’s position
in the world’s time zones. Sitting geographically between the centres in the Far East
and USA, it is able to trade with both during its working day (the Far East in the
morning and the USA in the evening).

4.1.5 Financial intermediation

Financial intermediation is a system whereby a person or more usually a financial
institution ‘mediates’ between two other people or institutions in order to facilitate
a transaction.

Its most normal form is exemplified when a bank acts as an intermediary between
borrowers and lenders. On the one hand there may be many lenders who all wish to
lend different relatively small amounts of money for different periods of time. On the
other hand there may be a few borrowers who want to borrow large sums of money
for a fixed period of time. The bank acts as an intermediary by borrowing all the money
from the small lenders and ‘repackaging’ it so that it suits the needs of the borrowers.
A financial intermediary can thus be seen to perform the following functions:


• Borrow varying amounts of money from lenders and reform them into an
amount suitable for the final borrower.
• Borrow various amount of money with different maturity dates and reform them
into an amount with a maturity suitable for the final borrower.
In order to do this the financial intermediary must borrow from numerous lenders
with many different maturity dates so that reformed packages can be lent on to
final borrowers.
The advantages of financial intermediaries in an economy are that:
• Lenders do not have to search the markets for suitable borrowers, a task that
would be beyond the average individual.
• Similarly, borrowers do not have to search for lenders.
• Risk is reduced for lenders because if a borrower defaults, the risk has been
borne by the intermediary (remember, it is the intermediary who lends his
own (albeit borrowed) money to the final borrowers, and it the intermediary
therefore who bears the risk. The intermediary will pass on the costs of such
risks to the lender as part of the fee charged for services tendered; hence the
loss is spread across all the lenders.
• The system allows for flexibility and individual lenders may be able to vary the
terms on which they have lent to the intermediary (perhaps by early redemption)
without the intermediary or final borrower being disadvantaged. This is possible
because the intermediary keeps reserves of cash or liquid investments that can
be used in the event of a potential shortfall.

4.2 Business finance

4.2.1 The risk-return trade-off
Each type of financial instrument has a different level of risk, depending on how safe
it is for the investor. The greater the risk the higher the return that the investor will
require. Look out for this as you progress through the types of finance.

4.2.2 Equity
Equity refers to the ownership rights to the business. The shareholders own the
business and the equity of the business refers to the value of the business that
belongs to the shareholders.
We shall be looking at how a business raises equity later, and shall concentrate here
on describing equity’s main features. These are:
• Owning an equity share in a business confers part ownership of the business on
the owner of the shares. The shareholders have certain rights and control over
the running of their company. In particular the shares they hold will have voting
rights attached and they can exercise limited control by raising resolutions at
the company’s meetings and voting at those meetings if they want a particular
course of action to be taken. In reality a small shareholder’s influence over the
way the company is run is very limited.

Long-term Sources of Finance

• Equity shares are high risk investments offering returns that are higher than
safer non-equity investments. If the company is very profitable the shareholders
will share in that profitability. If on the other hand the business fails, the
shareholders may lose all their investment in the company.
• The finance raised by the equity holders is the permanent finance of the business
and with very few exceptions cannot be removed from the business. Unlike debt,
where lenders lend money to the business for a limited period of time, there is
no time limit to the period for which the equity is available to the business.
• The shareholders are entitled to dividends – regular, typically annual payments
out of profits. The directors of the company decide how much the company can
pay each year and this will be the dividend.
• The dividend is paid out of post-tax profits. To this extent it is not tax efficient. If
one contrasts this with the payment of debt interest by the company, the debt
interest is allowed to be set against the taxable profits thereby reducing the tax
charge for the year. This means that the true cost of debt finance is the post-tax
cost of the debt interest. No such treatment is available for equity.
• Equity shares are often marketable on capital markets – a stock exchange. We
have referred above to the secondary markets and this marketability of the
shares is an important feature. If shareholders did not have a ready ‘exit’ from
the shares they would be less willing to subscribe for the shares in the first place.

Advantages of equity
These include:
• The company is not obliged to pay a dividend if it cannot afford to do so.
Contrast this with interest payments on debt which has to be paid.
• The company does not have to repay the equity holders.
• Equity carries a higher return than loan finance. From the shareholders’ point
of view the fact that equity finance carries a higher return that non-equity
investments will be seen as an advantage. But from the company’s point of view,
this is a disadvantage as it increases its cost of capital. We shall see later in this
text how shareholders effectively try to get the best of both worlds: owning
equity and a share of the business with the high returns that that implies, but
financing any new investments with debt as that is cheaper finance and will
increase the return on their equity.
• Shares in listed companies can be easily disposed of at a fair value.

Disadvantages of equity
These include:
• Issuing equity finance can be expensive in the case of a public issue.
• There is a problem that if new shares are issued, there may be a dilution of
ownership of the existing shareholders.
• Dividends are not tax-deductible.
• A high proportion of equity can increase the overall cost of capital for the company.


• Shares in unlisted companies are difficult to value and sell.

P Principle
Understand what equity is and why good and bad
aspects arise

IE Illustrative example 4.1

A quoted supermarket has been advised by its financial advisors to raise money for
its new project, an expansion setting up a new chain of stores overseas, by equity.
Why might the company have been advised this?
The reasons that the supermarket may have been advised to raise equity for an
expansion overseas include:
1. There is a lot of risk associated with the expansion, many supermarket
expansions overseas fail.
2. The company may have high gearing (debt) already, meaning the company may
find it difficult to raise more debt.
3. Interest rates may be high.
4. The company is quoted, meaning it has access to equity finance.
5. There may not be many investment opportunities in the UK for stock market
investors, meaning that they may be interested in taking on overseas investments.

4.2.3 Preference shares

Preference shares are shares that attract a fixed dividend.

They have some of the features of both equity and debt. They are relatively
rare in practice.
• Preference shares receive a fixed dividend and they receive it in preference to
the dividends that may be paid to equity shares. Thus if the profits are poor
preference dividends may be paid even though equity dividends are not.
• However, the dividend is not guaranteed and may not be paid if profits are
• Because they receive a fixed dividend, preference shares do not participate in
the growth of the company and their value does not increase in line with profits.
• They are not secured on any of the assets of the company and their value may
therefore be lost if the company fails, although they rank before ordinary shares
in the order of payment in a liquidation.

Long-term Sources of Finance

• Preference shares are sometimes convertible into equity. The idea behind this
is that new preference capital may be raised more cheaply because the new
preference holders have the option of converting into full equity participation
with all the upside of value and dividends that that carries. They will therefore
require a lower return in the startup phase.

Dividend policy (and internal sources of finance)

Over time a company will hope to make profits and be able to use the cash
generated in its business. Retained earnings are an example of an internal source of
finance. If successful, a company will be able to fund its own future without raising
external finance. There are ways that the company can improve this situation further,
such as managing its working capital position. If it is able to reduce its inventories
or receivables without damaging its business then this will release money for other
purposes. Similarly, if a company has surplus non-current assets these can be sold
and the money reused in the business.
Most shareholders will want to receive a return on the money that they have
invested in a company. Dividends are one way in which this can happen. If dividends
are paid out this will mean that the company has less money available to reinvest
in the business. So initially it appears that paying dividends will not help a company
expand. However, shareholders will be more likely to reinvest in a company that is
successful and pays a return. Hence paying dividends can be beneficial overall to a
company's financial situation.

Dividend policy–theoretical approaches

The main theoretical view is sensible–if there are no projects that a company has
that will generate a positive net present value the company should pay any surplus
cash as dividends. Alternatively if there are projects with a positive NPV then the
company should retain the money and reinvest in those projects. Effectively the
company can generate better returns than its investors require so it should use its
money internally on those projects. Shareholders will be rewarded with a higher
value for their company in time. Dividends are a residual amount after all positive
NPV projects have been taken on. This theory is referred to as residual theory.
An alternative theory is that of Modigliani and Miller who say that division of
retained earnings between new investment and dividends does not influence the
value of a company. It is the investment pattern and consequently the earnings
of the company which affect the share price or the value of the company. This is
called dividend irrelevancy theory as shareholders are indifferent between receiving
dividends and paying in new capital to the business through share issues. If there are
profitable opportunities then the shareholders will be interested in pursuing them.
The increase in the wealth of the shareholders will be offset by the decrease due to
the new capital raising.


Dividend policy–practical issues

The theoretical approaches should be considered along with practical influences on
dividend policy. These include:
1. Legal constraints on paying dividends. If a company does not have positive
retained earnings it is unable by law to pay out dividends. Hence this will
constrain a company.
2. Liquidity. If a company does not have the cash available it can't pay out a
dividend. This may be due to timing differences, for example if a large customer
hasn't paid what it owes at the time the dividend is due to be paid.
3. Shareholder expectations. For quoted companies the shareholders may
expect to receive dividends on a regular basis. For example one major type
of shareholder for many large companies is likely to be pension funds. These
pension funds need to pay out money to pensioners on a regular basis, meaning
that they require dividend payments from the companies they invest in. Once
the expectations of dividends is present a failure to meet that expectation can
mean that the company's share price is adversely affected and this can harm the
chances of the company raising equity finance in the future.
4. Alternatives to cash dividends. For example, a company can consider if
shareholders would accept a scrip dividend. This means that a company
issues extra shares to shareholders in place of paying them cash. This sounds
attractive but may mean that the shareholders end up with more shares each,
but at a lower value per share, with the same overall value of the company and
shareholder wealth.

4.3 Debt

Debt is the loan of funds to a business without any ownership rights.

Debt finance has the following features:

• The debt is lent to a company by the ‘debtholder’.
• The debtholder will normally require security for the debt so that in the event of
default, the debtholder will be able to take assets in exchange for the debt.
• Covenants. The debtholders may demand certain covenants be attached to the loan
which will restrict the company’s flexibility. Such covenants will typically include:
– Limits on the total debt that the company can amass
– Limits on the amount of dividends that can be paid
• The interest on the loan is paid out as an expense of the business and is
allowed against tax.

Long-term Sources of Finance

• There is the risk of default if interest and principal payments are not met. This
may result in the debtholder taking charge of the assets that were pledged as
security and realising these assets to pay off the debt.

P Principle
Know what debt is and its features

4.3.1 Types of debt

Debt may be raised from two general sources, banks or investors.

Bank finance
For companies that are unlisted and for many listed companies the first port of call
for borrowing money is the banks. These could be the high street banks or more
likely for larger companies the large number of merchant banks concentrating on
‘securitised lending’. Bank finance for large acquisitions will be sought to assist in a
leveraged acquisition where the purchaser can only provide a relatively small amount
of the purchase price.
Banks will also be asked to provide medium sized loans where the amount to be
raised does not justify the cost of arranging a more complicated issue of loan notes
or similar instruments for sale to investors.

Bonds–loans from investors

A bond is a generic term that covers any debt issued by a company for sale to investors.

These will typically be debt instruments sold by the company, through a broker,
to investors.
Typical features may include:
• The debt is denominated in units of £100, this is called the nominal or par value
and is the value at which the debt is subsequently redeemed.
• Interest is paid at a fixed rate on the nominal or par value.
• The debt has a lower risk than ordinary shares. It is protected by charges
and covenants.


IE Illustrative example 4.2

A football club usually receives a lot of money, via the sale of season tickets, at the
start of a season. For one mid-ranking club there are a variety of matters that require
spending money. These include:
1. Payment to a supplier before the season ticket money is received
2. Building a new stadium, using its existing stadium to sell off to a property developer
3. Investing in new players that will boost the team to higher levels in the league
the team plays in.
What type of finance would be recommended for each situation, with reasons?
The football club is likely to use the following sources of finance for each situation:
1. Payment to a supplier is a short-term situation that will require short-term
finance such as a bank loan or short term borrowings.
2. Building a new stadium will often be financed by debt, with the future receipts
from the stadium used to secure the finance as well as the land from the old
stadium. However equity could be used, if available.
3. Investing in new players is often done by the owners of the team via equity.
There is a degree of risk and speculation in this situation that most banks, for
example, are unlikely to want to invest in.

4.4 Types of bonds

4.4.1 Debentures
The financial instrument that is sold by the company to the debtholder is usually
referred to as a ‘debenture’. Remember that there are in fact two elements to the
debenture-the loan itself and the charge securing the loan.
Debt secured with a charge against assets (either fixed or floating) is low risk debt
offering the lowest return of commercially issued debt.

4.4.2 Unsecured loans

Unsecured lending is lending that is not backed by any security. It is relatively rare
and represents a very high risk. This type of loan is more expensive.

4.4.3 Mezzanine finance

Mezzanine finance is a broad name for a variety of financial instruments. They are all
typically unsecured, and may be subordinated to other loans (secured or unsecured)
so they are less likely to be repaid if the company fails. The mezzanine debt may
be being issued by a company with a poor track record such that any investment
is inherently risky. The mezzanine debt may also be sold by means of a placing, ie
placed with an individual or fund that takes on the debt with all its lack of security

Long-term Sources of Finance

and uncertainty. These are very high risk and rank just below the ordinary share
capital in terms of risk.

4.4.4 Zero coupon bonds

Bonds that are issued with no coupon, ie do not pay a rate of interest. The investor
makes a profit because the bonds are sold at a discount to the redemption price.
The advantage for the company is that it does not pay interest and only needs to find
the cash to redeem the bonds when they mature. This it can do by issuing another
tranche of similar bonds.

4.4.5 Warrants
Warrants are an option to buy shares at a specified point in the future for a specified
(exercise) price.
The warrant offers a potential capital gain where the share price may rise above the
exercise price.
The holder has the option to buy the share on a future date at a pre-determined price.
The main use of a warrant is to encourage potential lenders where the proposed
investment is highly risky or where the company wants to offer a low coupon to
minimise the costs of the debt. By offering lenders the option of converting the debt
to equity with the attraction of much higher returns, the company hopes that the
offer will be taken up.

4.4.6 Convertible loan stock

Convertible loan stock is very similar to warrants. It is a debt instrument that may,
at the option of the debtholder, be converted into shares. The terms are determined
when the debt is issued and lay down the rate of conversion (debt: shares) and the
date or range of dates at which conversion can take place.
The convertible is offered at a price and terms that will encourage investors to take
up the debt instrument. The conversion offers a possible capital gain if the value of
shares exceeds the value of the debt.
The holder has the option to buy the share on a future date at a pre-determined price.

P Principle
Be able to describe each type of finance

EG Learning example 4.1

Explain how the banks fulfil their role as financial intermediaries.


4.5 Other sources of long-term finance

4.5.1 Sale and leaseback
Sale and leaseback involves the sale of good quality fixed assets such as high street
buildings and leasing them back over many (25+) years.
The purpose is to release funds without any loss of use of the assets.
A disadvantage is that any future capital gain on assets is forgone.

4.5.2 Grants
Grants are often given by the government for the purpose of regional assistance, job
creation or for high-tech companies.
Grants can be very important to small and medium sized businesses (ie unlisted) for
the obvious reasons that they allow investment in assets without any loss of cash and
the grants do not have to be paid back.
The EU is a major provider of loans and grants.

4.5.3 Retained earnings

The single most important source of finance, for most businesses is the use of
retained earnings as the core basis of their funding.

4.5.4 Venture capital

Venture capital is the name given to a particular source finance provided by (usually)
very large funds who seek out high risk investment opportunities. The funds will
normally require an equity stake and will typically take a fairly hands on approach which
at the very least will be the requirement that they have a director on the board, but
may extend to a more day-to-day involvement with business strategy and operation.

Venture capitalists will invest in promising looking start-ups where the current
owners need significant funds and possibly expertise in the chosen market.
They will also seek out opportunities with existing, well established but
possibly underperforming companies where they consider that a restructuring
would be beneficial.

4.6 Small and medium-sized entities (SMEs)

Small and medium-sized entities (SMEs) are defined rather loosely as businesses
owned by a few shareholders, often with family connections, employing under 250
employees. They are typically unquoted and will probably have a low asset base.

Long-term Sources of Finance

4.6.1 Financial needs of SMEs

SMEs tend to be relatively unsophisticated companies, whose size and low asset base
means that the directors may have difficulty accessing the normal equity and bond
markets that are available to larger companies. This is partly due to the inexperience
of the directors and partly the inability of the company to offer the sort of security
that the markets are looking for.
In order to grow, the SME will require additional financing for the following purposes:
• Working capital–many businesses fail because they expand too fast and cannot
fund the working capital they need. Debtors pay slowly, creditors chase the small
companies hard and cash can be a problem. This is called ‘overtrading’ and the
SME has to find the cash to fill the gap.
• Investment in expansion. Expansion requires investment, both of a capital and
revenue nature. New premises and machinery require typically large amounts
of finance. Marketing campaigns, new marketing and sales personnel, new IT
systems and additional working capital all require cash.

4.6.2 Funding gap

The funding gap is simply the difference between the SME’s requirement for funds as
described in the above paragraph, and the funds available.

The funds available in the start-up phase may just be the funds paid into the
business by the owners, sometimes with mortgages on their homes if any
borrowings have been made.
It is not always possible for SMEs to attract capital from external parties for
several reasons:
• the new business may not have a proven track record of solid profits over
several years.
• the new managers may not be experienced and may not have extensive
commercial experience. The managers may not be ‘stars’ of the City who can
attract money because of past successes.

4.6.3 Inadequate security

SMEs may have a low asset base which deters would-be lenders.

4.6.4 Maturity gap

A related problem to the above is the maturity gap.

The maturity gap is the difference between the maturity of assets and the maturity of
liabilities in the portfolio.


It is a fundamental policy of good funding management that the maturity of loans

should match the length of life of the assets for which the loan was arranged. If the
life of the loan is shorter than the life of the asset the business may have a problem
when the loan has to be repaid. A new loan may be difficult and expensive to
arrange-the worst case being that it may be impossible to arrange a new loan and
the company could be forced into liquidation.
If, on the other hand, the loan matures after the life of the asset, this may cause a
problem if there are early redemption penalties and the business did not want to
replace the asset (eg if the loan was on a property bought by the company and the
directors wanted to sell the property and work out of rented accommodation).
The general problem is that the loans that carry low rates of interest will be longer
term loans secured against fixed assets and SMEs do not always want this sort of loan.

4.6.5 Sources of finance for SMEs

The following are the most normal sources of finance for SMEs:
A. Bank overdraft. Most businesses have a bank overdraft and SMEs are no exception,
particularly in the early stages. Bank overdrafts have two main problems:
– they are expensive
– they may be withdrawn with no notice
As such they are an unreliable source of finance for anything other than short
term, and ideally temporary, shortages of funds.
B. Bank loans. These are very common for SMEs. They will generally be secured on
either the assets of the business (if the business has sufficient quality assets for
the purpose) or against the private assets of the owners (eg the family home).
The loans have several problems:
– Because they may be secured against the private assets of the owners, the
owner’s personal possessions are at risk.
– The loans will probably carry a high interest rate even though they are
secured reflecting the general poor quality of the business from the financial
point of view.
– The bank will be fairly intrusive into the operation of the business, typically
requiring regular reports on the financial situation, cash flow projections etc.
C. Business angels. These are wealthy individuals who seek out small businesses
with good ideas and good management which they feel they can support and
make money out of. To attract an angel, the business idea and plan has to be
good, and the owners who will be running the business need to be sound and
the sort of people that the angels will be able to work with.
The problem with the angels is that they will typically require a large share of the
equity in exchange for their participation. They do not lend money to businesses-
they want high equity returns and accept the high risk as part of the deal.

Long-term Sources of Finance

D. Venture capital. Venture capitalists look to invest in growing businesses. This

type of finance may not be appropriate for many SMEs as the amounts required
by the SME may be too small for venture capital to become involved.
E. Working capital management. Note that the business can improve its financial
position by such means as:
– Factoring debts–ie selling the debts to obtain cash immediately, rather than
wait one or two months.
– Trade credit–paying creditors as late as possible to keep cash in the business.
F. Supply chain financing. Supply chain financing relates to financing specific goods
and/or products as they move from origin to destination along the supply chain
ie as one company makes something and sells it to another, creating accounts
receivable and payable balances. There are a range of technologies and financial
business practices that allow for discounting of accounts receivable and financing
of companies' confirmed accounts payable. Some companies specialise in gathering
information on supply chains and providing this type of financing, at a cost.
G. Crowd funding and peer-to-peer financing. Crowd funding is a way of raising
finance by asking a large number of people each for a small amount of money.
This allows new business ideas to be funded without any one provider of finance
supplying too much and becoming dependent on the success of the venture. It
allows for diversification of investments for the suppliers of finance.
The internet is a great way for this to happen as investors can see investment
opportunities online and offer finance. The investors can share the knowledge of
the opportunity with friends.
A fee is charged to the business with the idea seeking funding, say 5%, and to the
providers of finance, say through an online payment organisation such as PayPal.
The finance can be equity funding or debt funding (often called peer-to-
peer funding).

G Learn
4.6.6 Government assistance for SMEs
There are many initiatives by Government to help the SME sector. The following lists
the more important. Note that the exam will not require details of the UK provision,
but the following will give you a flavour of the sort of help that is available.
Government assistance for SMEs is the responsibility of the Department for Business,
Enterprise and Regulatory Reform (BERR).
The Government has launched a Real Help for Business campaign to assist
small businesses.
• Enterprise finance guarantee. For businesses with turnover up to £25m to
enable businesses to secure loans between £1,000 to £1m.
• Working capital guarantee scheme. The purpose of this is to secure lending by
the banks so that banks can lend additional amounts to business.


• Capital for enterprise fund. The fund allows companies with viable business
models to sell debt in exchange for an equity stake in the business-up to
£250,000 equity for businesses with turnover up to £50m.
• Enterprise capital funds (ECFs)-This provides up to £2m for businesses that
fall within the ‘equity gap’– ie more than business angels and less than venture
capital would supply.

EG Learning example 4.2

Give reasons why an SME may have difficulty raising finance at low rates of interest.

4.7 Leasing
Leasing is a possibility for a business to obtain finance. A lease is an obligation to pay
a leasing company amounts of money over time in return for the use of an asset. The
use of the assets will be over a period of time. If this period is for a short term the
lease will be referred to as an operating lease, which is similar to renting the asset.
If the asset is leased over a long term and is such that a transfer of risks and rewards
relating to that asset occurs at the inception of the lease then the lease is called a
finance lease.
Finance leases are similar to the company purchasing the asset by borrowing. The
company will use the asset similar to if it had purchased the asset and will repay the
cost of the asset plus extra amounts, which effectively are interest payments. Often
the company will have the option to purchase the asset at the end of the lease term.

4.8 Islamic finance

A form of finance that specifically follows the teachings of the Qur’an. The teachings
of the Qur’an are the basis of Islamic Law or Sharia. Sharia Law is however not
codified and as such the application of both Sharia Law and by implication Islamic
Finance is open to more than one interpretation.
Any interpretation of Sharia will require a legal opinion or Fatwa provided by a
religious scholar or Mufti. The Mufti will belong to one of five major juristic schools,
and as such, and because of their individual interpretation, opinions may differ on
compliance to Sharia Law.
An Islamic bank will have a specific Sharia Committee devoted to ensuring that
transactions conform to Sharia Law made up of senior officers and scholars.

Long-term Sources of Finance

4.8.1 Prohibited activities

In Sharia Law there are some activities that are not allowed and as such must not be
provided by an Islamic financial institution, these include:
1. Gambling (Maisir)–Futures and options are highly speculative and hence would
not be allowed.
2. Uncertainty in contracts (Gharar)–no contract may include ambiguities or
unclear passages. This excludes a contract that may give a person any option to
buy an asset in the future.
3. Prohibited activities (Haram)–Any financial transaction associated with the
provision or service linked to wider prohibitions will also be a prohibited activity
(eg pork, alcohol, pornography and gambling services).

G Learn
4.8.2 Riba
Interest in normal financing relates to the monetary unit and is based on the
principle of time value of money. Sharia Law does not allow for the earning
of interest on money. It considers the charging of interest to be usury or the
‘compensation without due consideration’. This is called riba and underpins all
aspects of Islamic financing.
Instead of interest a return may be charged against the underlying asset or
investment to which the finance is related. This is in the form of a premium being
paid for a deferred payment when compared to the existing value.
There is a specific link between the charging of interest and the risk and earnings of
the underlying assets. Another way of describing it is as the sharing of profits arising
from an asset between lender and user of the asset.

G Learn
4.8.3 Forms of Sharia-compliant finance
There are some specific types of finance that are deemed compliant and allow
Islamic finance to offer similar financial products to those offered in normal
financing, these include:
• Murabaha–trade credit
• Ijara–lease finance
• Mudaraba–equity finance
• Sukuk–debt finance
• Musharaka–venture capital
Murabaha–trade credit
The delay in payment of the goods by the customer leads to the title being held
for longer by the supplier. The effective rental of the goods to the customer during
the period of credit can be seen as the basis as to why there is a profit charge to be
earned by the supplier.


Ijara–lease finance
A lease allows for the use of an asset by a lessee or user without necessarily any
commitment to ownership in the future.
Ijara identifies the transactions to be acceptable because they relate to an underlying
asset and the use of that asset. As such the concept of riba does not apply because
any rental covers the costs of the asset and shares the profits generated by the asset.
Mudaraba–equity finance
A form of equity finance that adheres to Sharia Law, it allows one party to entrust
money to another in exchange for a share of the profits. It requires the following:
• Division of profits on a pre-agreed basis
• Loss limited to principal invested by investor
• Loss limited to time and effort of financial intermediary
Sukuk–debt finance
A form of debt finance acceptable to Sharia Law. Sukuks must be backed by physical
assets to be tradeable. The sukuk links the purchase of an asset to a lease agreement.
This means that the asset is transferred from the borrower to the bank in exchange
for funds. The bank then enters into a lease agreement with the borrower where the
borrower leases the asset back in exchange for rental payments
Musharaka–venture capital
A form of finance that allows for investors to share profits and risks of an investment
in proportion to their investment. The investment may be in the form of funding or
alternatively other participation.

P Principle
Be able to explain the differences between the
types of finance

Long-term Sources of Finance

Æ Key Learning Points

• Know the capital and money markets and be able to describe their
differences. (B2a, B2d)
• Learn the concept of financial intermediation and how a financial institution (eg a
bank) helps lenders and borrowers find others to lend to or borrow from. (B2b)
• Know the different types of equity and debt finance available to companies and
be able to list their advantages and disadvantages. (B2a)
• Learn about dividend policy, which helps decide whether dividends should be
paid or not, its theories and practical issues. (E1e)
• Learn about gearing and capital structure issues, the theories and practical
considerations. (E3c, E3d))
• Know the particular problems facing small and medium entities (SMEs) when
raising finance. (E5a–E5d)
• Know the methods of raising money through Islamic finance, the principles and
issues involved. (E1d)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).


Learning example solutions

EG Solution 4.1
Financial intermediaries have three main functions and banks fulfil these in the
following ways:
• Matching the amounts that lenders and borrowers are willing to deal in, by
accepting the typically small amounts that the banks customers’ supply as
deposits and pooling them into larger amounts required by the banks borrowers.
• Matching the different maturity requirements of the banks customers by
accepting customers’ deposits as short term deposits and lending to borrowers
for the long term.
• Effectively insuring the customers deposits against default by the bank’s
borrowers by spreading the risk aver all deposits.

EG Solution 4.2
An SME may have difficulty raising finance at low rates of interest as follows:
• The directors may not be aware of the sorts of finance available.
• The SME may not have sufficient good quality assets to act as security.
• The directors may be unwilling to pledge their personal assets as security.
• The SME and its directors may not have a proven track record of profitability
and achievement.
• Given that so many small businesses fail within a few years of starting, the SME
may not have a good enough product or business plan to attract finance.

Cost of Capital

A fundamental calculation for all companies is to establish financing costs, both
individually and in total terms. These will be of use both in terms of assessing the
appropriateness of the company’s financial structure and as a cost of capital for use
in investment appraisal. This is a vital chapter for your exam preparation and you
should expect there to be a question on this in every exam.
The calculations are most important but you should also understand the concepts
that underlie the calculations (such as risk and return) as there may well be a few
marks in the exam for being able to discuss these topics.

1. Which finance would have a bigger risk premium for a company–loans or shares?
2. Do you know two methods of calculating dividend growth and where this

dividend growth rate fits into the cost of equity calculation?

3. Do you know where the cost of equity and the cost of debt fit into the
weighted average cost of capital (WACC)?

Cost of Capital

5.1 Risk and return

We have already looked at the relationship between risk and return. The higher the
risk of an investment, the higher will be the return required by the providers of the
capital that funds the investment. The relationship is important as it impacts on
the cost of capital for a company. Put simply, if a company only invested in ‘safe’
projects or offered the providers of capital the guaranteed return of their capital,
then the cost of such capital to the company would be low. Conversely, for higher
risk investments the cost of capital to the company will be high to compensate the
investors for the additional risk.

5.1.1 The elements of return

A combination of two elements determines the return required by an investor for a
given financial instrument.
1. Risk-free return–the level of return expected of an investment with zero risk to
the investor.
2. Risk premium–the amount of return required above and beyond the risk-free
rate for an investor to be willing to invest in the company.

Risk-free return
The risk-free rate is normally equated to the return offered by short-dated
government bonds or treasury bills (gilts). The government is not expected to default
on either interest payments or capital repayments.
The risk-free rate is determined by the market pricing the gilts at a price which
reflects prevailing interest and inflation rates and general market conditions.

5.1.2 Degree of risk

In the previous chapter we looked at the various types of finance that companies
typically raise. There is a whole spectrum of risk associated with these different
instruments, as shown in the diagram below. The risk increases the further to
the right we go.

Risk free High risk

return investments

Secured Mezzanine
Loan Notes Finance

Government Unsecured Ordinary

Debt Loan Notes Shares


• Government debt is the least risky as it will always be repaid. The reason
why short term debt is generally regarded as risk-free rather than long term
government debt is that although the long term debt will also be repaid,
investors could lose out on the return and the capital value of the long debt if
economic conditions changed materially. Government debt carries fixed interest
so when an investor buys debt, he is tied into that return. If interest rates rose,
the investor would not benefit from the higher rates and to make matters worse
the capital value of the debt would decrease.
• Secured loan notes are company debt that is bought by investors and is
secured on the company’s assets with either a fixed charge (on specific assets)
or a floating charge (over all the assets). They are sometimes referred to as
debentures. A debenture is strictly speaking the charge over the assets and so you
need to be clear that what is called a debenture really has two components-the
loan itself that the investor makes to the company and the charge on the assets.
• Unsecured loan notes. This is debt that the company sells without any security. It
is therefore not protected and carries significant risk.
• Mezzanine finance is a broad name for a variety of financial instruments. They
are all typically unsecured, and may be subordinated to other loans (secured
or unsecured) so they are less likely to be repaid if the company fails. The
mezzanine debt may be being issued by a company with a poor track record such
that any investment is inherently risky. The mezzanine debt may also be sold by
means of a placing, ie placed with an individual or fund that takes on the debt
with all its lack of security and certainty. These are very high risk and rank just
below ordinary share capital in terms of risk.
• Ordinary shares are the most risky investments. They rank last in their holders
receiving an annual return (dividend) and the return of their capital in the event
that the company fails.

P Principle
Know which type of finance carries most risk and how
that affects return

5.2 Cost of equity

The cost of equity is the rate of return required by a shareholder.

This may be calculated in one of two ways:

1. Dividend valuation model (DVM).
2. Capital asset pricing model (CAPM).

Cost of Capital

5.2.1 Dividend valuation model

To understand how to calculate the cost of equity, we start with the closely related
calculation of the company’s share price. The calculation is known as the dividend
valuation model because it equates the share price to the present value of the
dividends received by the shareholders. The cash inflow from the dividends is
normally a perpetuity to reflect the permanent nature of the share capital.

Perpetuity formula
Cash inflow p.a.
PV of a perpetuity =
Rate of return
Using the terminology of shares in this formula we get:
Dividend p.a. Dividend p.a.
Shareprice = =
Return required by shareholders Cost of equity
This is expressed as
P0 =

Where Ke = cost of equity

d = is a constant dividend pa
P0 = the ex-div market price of the share at year 0. (Note
that the price is the ex-div price, ie the price of the share
when the share is not entitled to the next dividend. This
is the price when a dividend has just been paid.)

We can rearrange the formula to show the cost of equity with the dividend
valuation model:

The meaning of ex-div

Ex-div means ‘without the dividend’.


An equity share is entitled to a dividend if the directors of the company decide that a
dividend should be paid.
The process of paying a dividend is straightforward.
A. The directors declare a dividend. This simply means that the directors decide and
announce that the company will pay a dividend. A dividend is typically paid once
or twice a year.
If the company pays a dividend twice a year, the first dividend is known as an
interim dividend, and the second dividend is known as the final dividend. The
interim dividend will be paid after the interim results are produced at the half
year, and the final dividend will be paid once the full year results are known after
the year end.
If the company only pays one dividend a year that dividend is referred to as a final
dividend-ie it is again paid when the full year results are known after the year end.
When the directors have decided to pay a dividend they ‘declare’ the dividend
ie they simply:
– announce that a dividend will be paid;
– the date of the payment; and
– the amount of the dividend payment.
Importantly, they also declare a date when the shares will go ex-div. This means
that up to that date the shares are ‘cum-div’ ie the dividend is attached to them
and will be paid to the persons who own the shares on that date. After that
date the shares are ‘ex-div’, ie the shares no longer carry the entitlement to the
dividend. Thus if you own the shares before a dividend is paid you are entitled
to the dividend (the shares are priced cum-div). But if you didn’t own the shares
at that date but bought them after the date you are not entitled to the dividend
(the shares are priced ex-div).
B. The company pays the dividend at the date specified in the declaration of the
dividend – usually a few weeks after the declaration.

Notes regarding dividends in the exam

A. In the exam and in the calculations and formulae we use, it is assumed that the
company only pays a dividend once a year and that the dividend is actually paid
at the year end.
B. The examiner will indicate whether the shares are cum-div or ex-div in the
question. He will either simply say that they are cum- or ex-div, or he may say
something like ‘the shares are priced at £2 per share and a dividend of 20p is
about to be paid’. This means that the share price of £2 is the cum-div share price.

Cost of Capital

IE Illustrative example 5.1

The ordinary shares of Kewell Ltd are quoted at $5 per share ex-div. A dividend of 40c
per share has just been paid and there is expected to be no growth in dividends.
What is the cost of equity?
Cost of equity = $0.40/$5 = 0.08 = 8%
Note that we can do this in cents.
Cost of equity = 40c/500 = 0.08 = 8%

EG Learning example 5.1

The ordinary shares of Gerrard Ltd are quoted at $2 per share. A dividend of 15¢ has
just been paid. There is expected to be no growth in dividends.
What is the cost of equity?

5.2.2 Introducing growth of dividends

So far we have considered the cost of equity with constant dividends.
We now look at the situation when there is a constant growth of the dividends.
The dividend valuation model now gives the cost of equity as:
d1 d (1 + g)
Ke = or Ke = 0 +g
P0 P0

Where g = a constant rate of growth in dividends

d0 = current dividend
Ke = The ex-div share price
P0 = The current date when the shares are
being priced.

G Learn
A very important point to note is that the dividend used as the numerator in this
formula is not the current dividend but the dividend that is going to be paid at the
end of the following year.


IE Illustrative example 5.2

Alonso Ltd has a share price of $4.00 ex-div and has recently paid out a dividend 20¢.
Dividends are expected to grow at an annual rate of 5%. What is the cost of equity?
Ke = 1 + g
20¢ ×1.05
Ke = + 0.05 = 10.25%

EG Learning example 5.2

X Ltd is planning to pay a dividend of 30¢ per share. The share price is $3.50 cum-div.
Dividends are expected to grow by 5% per annum.
Calculate the cost of equity.

5.2.3 Assumptions, advantages and disadvantages of the

dividend growth model
• g is constant.
• The company pays dividends or is expected to in the future.
• There is a reliable, fairly stable share price.
• A simple calculation.
• Often applicable to listed companies as they have a readily available share price
and many try to have a stable dividend policy.
• Not useful for unlisted companies because there is no readily available,
agreed share price
• Not applicable if the share price is very volatile. Share prices are subject to many
random buffeting influences and the cost of capital will be affected similarly.

Cost of Capital

5.2.4 Estimating growth of dividends

There are two main methods of determining growth:
1. The averaging method
g= n 0

Where do = current dividend

dn = dividend n years ago

G Learn
You need to know how this formula is derived.
If do is the current dividend and d3 was the dividend three years ago (note that d3
comes three years before do in this notation), then assuming constant growth,
we can say that
do = d3 × (1 + g)3, where g is the annual rate of dividend growth.
(1 + g)3 = do/d3; and
1 +g  3 d0 / d3
g  3 d0 / d3  1

Note that instead of g  3 d0 / d3  1


we can write 1
 do /d3  3 -1

The advantage of this is that your calculator will calculate the nth root of a
number by raising that number to the power 1/n.


IE Illustrative example 5.3

Sissoko Ltd paid a dividend of 20¢ per share 4 years ago, and the current dividend is
33¢. The current share price is $6 ex-div.
(a) Estimate the rate of growth in dividends.

g=n -1
g = (33/20)1/4 - 1 = 1.333 - 1 = 0.1333
(b) Calculate the cost of equity.
Ke = 1

Remember that d1 is the dividend for the following year, so we have to add a year’s
growth to the current dividend of 33¢. We therefore get:
Ke = ((33 × 1.1333)/600) + 0.1333 = 19.56%

EG Learning example 5.3

Mascherano Ltd paid a dividend of 6p per share 8 years ago, and the current dividend
is 11¢. The current share price is $2.58 ex-div.
Calculate the cost of equity.

EG Learning example 5.4

Z Ltd paid a dividend of 10¢ five years ago and the current dividend is 22¢.
The current share price is $8 cum-div.
Calculate the cost of equity.
2. Gordon’s growth model
Gordon’s growth model is another way of estimating the growth of dividends.
There are two ways of writing the formula for this model which both mean exactly
the same thing.
A. g = rb
r = return on reinvested funds
b = proportion of funds retained

Cost of Capital

B. In the exam formula sheet the examiner gives you a slightly different version.
g = bre,
re = the return to equity
b = proportion of funds retained

ü Given
The rationale behind the model is that the growth of dividends only occurs if a
company retains some of its earnings to reinvest in the business. If a company paid
out all its earnings as dividends there would be no growth as there would be no new
investments or projects which would generate the additional profits. Thus profits
would be the same and therefore dividends would also be the same every year.
Of course a company might be lucky and reap the benefit of some random change
in its fortunes. But Gordon’s model is looking at companies in general and in general
companies do not regularly get lucky is that way.
Similarly you might say that companies could seek further share capital and make
new investments to boost dividends. That is true, but in general the additional
dividends would be the reward to the new shares and not really be an increase in the
dividends to the existing shares.
The equation does therefore seem to be intuitively sound-dividend growth does
depend on the amount of earnings retained and the rate of return on those earnings.
And although the equation appears to be very rough and ready it does in practice
provide a very accurate measure of the growth of dividends.

EG Learning example 5.5

The ordinary shares of Torres Ltd are quoted at $5.00 cum-div. A dividend of 40¢ is
just about to be paid. The company has an annual accounting rate of return of 12%
and each year pays out 30% of its profits after tax as dividends.
Estimate the cost of equity.

5.3 Capital asset pricing model

The capital asset pricing model (CAPM) is a model that calculates the return required
on a share. In order to do this it requires a measure of the risk of the share against the
risk of the overall market in all shares, called a beta factor. It can also be applied to
financial instruments other than shares.

The basic idea behind this theory of pricing capital assets, ie assets that are used
to generate returns, is that there is a relationship between risk and return. If


we concentrate on shares, it is logical to think that there is a general risk/return

relationship that covers the entire stock market for shares. Thus all investors in
the market will have a general idea of the trade-offs that they collectively expect
between risk and return for all shares. The CAPM is simply based on the idea that
if we can understand/ quantify what this general relationship between risk and
return is for the whole market then by knowing the risks and returns associated
with a particular share we can say what its return should be if the investors in the
market are acting rationally. By acting rationally we mean that investors require an
adjustment to the return on a particular share to reflect the increased or decreased
risk associated with that share.
There are two stages to the full explanation of the CAPM:
A. Systematic and unsystematic risk
B. The CAPM formula

5.3.1 Systematic and unsystematic risk

Systematic risk is the risk affecting all the company shares in the market (the
stock market).

It is a risk that is caused by economy wide considerations and is not caused by factors
specific to particular shares. Thus an increase in interest rates will tend to depress all
share prices. Similarly, a recession will also depress all share prices. These risks are
nothing to do with the individual companies (how well or badly they are run; whether
their business model is suspect etc.).

Unsystematic risk is the risk associated with an individual company. These risks are
company specific, such as a strike by its workforce only.

5.3.2 Diversifying away 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. For example, if
you buy shares in ice cream producers and sun glasses producers, you could also buy
shares in umbrella manufacturers so that you balance (and therefore reduce) the
risks posed by the weather. You have reduced the company specific risks associated
with the products of these types of companies. You can repeat this process, adding
similarly complementary groups of shares that balance and eliminate the risks.
In theory if you bought all the shares on the market in proportion to their market
capitalisations, you would have what is referred to as the ‘market portfolio’ and you
would have diversified away all the company specific (unsystematic) risks.

Cost of Capital

The important point to grasp is that the risk that can be eliminated by diversification
is called unsystematic risk. As we have just seen, this risk is related to factors that
affect the returns of individual investments in unique ways.
However, even if you have a very well diversified portfolio such that you have
diversified away all the unsystematic risk you will still be left with systematic risk.
If the economy goes into recession ice cream and umbrella makers will all feel
the downturn and cannot avoid the risk. The risk that cannot be eliminated by
diversification is called systematic risk.

Risk of
(σ) Unsystematic


Number of shares in portfolio

The above diagram illustrates this. Most of the unsystematic risk is eliminated with a
portfolio of about 30 different shares.

P Principle
The difference between systematic and unsystematic risk

For a well-diversified investor, the risk that is relevant when considering the risks
(and therefore the returns) that a share offers is its systematic risk because this
cannot be diversified away. Unsystematic risk can be eliminated and is of no
consequence to the well-diversified investor.

5.3.3 Implications
If an investor wants to try to avoid risk altogether, he/she must invest in a portfolio
consisting entirely of risk-free securities such as government debt.
If the investor holds only an undiversified portfolio of shares he/she will suffer
unsystematic risk as well as systematic risk.


If an investor holds a ‘balanced portfolio’ of all the stocks and shares on the stock
market, he/she will suffer systematic risk which is the same as the average systematic
risk in the market.
Individual shares will have systematic risk characteristics which are different to this
market average. Their risk will be determined by the industry sector and gearing.
Some shares will be more risky and some less.

5.3.4 ß (Beta) factors

You are familiar with the idea that risk and return are connected-the greater the risk
the greater the return, and vice versa. Thus measuring the risk of a share will also
give a measure of the required return.
The ß factor was devised as a means of measure the systematic risk of a single
company share or a portfolio.
The market portfolio (remember, this is the portfolio of all the shares in the market
weighted by capitalisation) is taken to be the benchmark and is given a ß factor of 1.
All other shares or portfolios will have a ß factor greater or smaller than 1 depending
on their systematic risk, which is measured by considering their required returns.
If a share or portfolio has a ß factor of 0.5 it will move in line with the market
movements but only half as much. If the share or portfolio has a ß factor of 2, it will
again move in line with the market but twice as much.
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 ß factor of 2.
The ß factor is thus the measure of a share’s volatility in terms of the market’s
systematic risk.
Finally, let’s consider how ß factors are calculated. For any given market movement, one
can calculate the change in the returns available for the whole market portfolio and the
change in the returns for a particular share. This tells us how the return of an individual
share reacts compared to how the market reacts. This process results in the ß factor for
a particular share, and it can be applied to all the individual shares in the market.

5.3.5 Calculations involving CAPM

The above explanation of what a ß factor is results in a mathematical formula for the
required return for a particular share:

Cost of Capital

(Ke − Rf) = ß (Rm − Rf)

where Ke = required (expected) return from individual security

ß = Beta factor of individual security
Rf = risk-free rate of interest
Rm = return on market portfolio

ü Given
This means that the expected excess return of the particular share over the risk free
rate equals the share’s ß times the expected excess return of the whole market over
the risk-free rate. This is consistent with the broad idea behind the CAPM described
above, namely that the return of a particular share is the share’s ß times the return
required on the market.
There are several things to note here.
• The risk free rate is not the same as the market portfolio rate. The market
portfolio (which has diversified away all unsystematic risk) still has systematic
risk. The risk free rate is the rate on short term gilts which are effectively risk free.
• The important thing that determines prices is the expected returns on the
various shares and portfolios. It is this expectation that causes investors to invest
at certain prices.
This equation can be written as:
Ke = Rf + (Rm − Rf) ß
And this is the more usual presentation of the formula.

5.3.6 The market risk premium

The difference between the return on the market portfolio and the risk free return (Rm
– Rf) is referred to as the market risk premium or the equity risk premium (ERP).

As we saw above, the difference between the expected return on a security and the
risk free return equals ß times the market risk premium.


5.3.7 The securities market line





1.0 βe Risk ( )
The securities market line illustrates the formula for the CAPM that we have
already looked at.
Ke = Rf + ß (Rm − Rf)
This is the equation of a straight line and simply shows graphically the relationship
between the return on any share and the share’s ß. It simple serves to emphasise
that as ß increases for a share so the expected return will also increase.
It also illustrates that the return and ß of a share can be higher or lower than the
market return and market ß.

Cost of Capital

5.3.8 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 beta 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. The market return may change considerably over short periods of time.
5. 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.
6. The idea that all unsystematic risk is diversified away will not hold true if stocks
change in terms of volatility. As stocks change over time it is very likely that the
portfolio becomes less than optimal.

G Learn

EG Learning example 5.6

The market return is 15%. Kuyt Ltd has a beta of 1.2 and the risk free return is 8%.
What is the cost of capital?

EG Learning example 5.7

The risk-free rate of return is 8%
The market risk premium is 6%
The beta factor for Crouch plc is 0.8
What would be the expected annual return?


EG Learning example 5.8

The return required by the shareholders of Y Ltd is 15%. The return on the market
portfolio is 12% and the risk free rate is 9%.
(a) Calculate the equity risk premium of Y Ltd’s shares.
(b) Calculate the ß of Y Ltd.

5.4 The cost of debt

The cost of debt is the cost to the company of funds that debtholders provide to a
company. We would expect this to be lower than the cost of equity because the risk
is lower than the risk associated with equity. In addition, interest attracts tax relief,
reducing this cost of debt.
The market value of debt is assumed to be the present value of its future cash flows.
In other words, to calculate the market value of debt, you have to determine all the
cash flows associated with the debt (typically the interest payments and the final
value at which the debt will be redeemed) and this can then be discounted at an
appropriate rate to give the present value of the debt (the present value being the
current market value).

5.4.1 Terminology
1. Loan notes, bonds and debentures are all types of debt issued by a company.
Gilts and treasury bills are debt issued by a government.
2. Traded debt is always quoted in $100 nominal units or blocks
3. Interest paid on the debt is stated as a percentage of nominal value ($100 as
stated). This is known as the coupon rate. It is not the same as the cost of debt.
4. Debt can be:
(i) irredeemable–never paid back
(ii) redeemable at par (nominal value)
(iii) redeemable at a premium or discount (for more or less than par value
5. Interest can be either fixed or floating (variable). All questions are likely to give
fixed rate debt.

5.4.2 Difference between coupon rate and return on debt

This is an important point to understand.
The debt will normally carry a coupon rate of interest and we shall assume for
simplicity in this example that this is fixed at 10% of the nominal value of $100 and
that the debt is irredeemable. As interest rates in the economy change (in the UK this
will be a function of the bank rate set by the Bank of England) then the market value
of this debt will also change. If we ignore the effect that risk and taxation will have on

Cost of Capital

the debt’s value then the following calculation will illustrate how the market value of
the debt changes with the economy’s rate of interest.

Economy’s interest rate 10% 5%

Nominal value of debt $100 $100
Market value of debt $100 $200 (W)
Yield on debt (ignoring risk and tax) 10% 5%

The point to grasp is that the debt pays 10% no matter what the economy rate of
interest is. Thus $100 of debt pays $10 per annum.
If the economy rate of interest is 5% then you would have to invest $200 to receive
$10 per annum ($200 × 5% = $10). The market will push up the price of this debt to
$200. (If the price of this debt stayed at $100, then its yield would remain at 10%
and all rational investors (faced with 5% yield elsewhere) would try to buy this debt,
pushing up its price to the equilibrium price of $200).
This is simply an example of the PV of a perpetuity.
PV of perpetuity = perpetuity/rate of interest (discount rate)
PV of debt when interest rates are 5% = $10/0.05 = $200
Note therefore, that while the coupon rate on the debt is still 10%, the yield on the
debt has fallen to 5% because of the rise in price.

Important points to note

• The market value of the debt decreases as interest rates increase, and vice versa.
• The coupon rate of interest of the debt does not change, but the price of the
debt and therefore its yield does change.
• The illustration is very theoretical (irredeemable debt with no final redemption
value, and ignoring the effects of tax and risk), but it does illustrate the very
important point of how the market value of debt is dependent on the economy’s
interest rates.
• The price calculated will be the ex-interest price. The ex-interest price excludes
and interest at time 0. This is because the calculation is the PV of a perpetuity,
ie the year 0 value of a perpetuity. A perpetuity assumes that the first interest
receipt is in year 1-hence the value calculated is the ex-interest value.


5.4.3 Irredeemable debt with tax

The calculation is based on the PV of a perpetuity as above, but here we are
calculating the return on the debt for a given market price.
i 1 - T 
Kd =

Where i= interest paid

T= marginal rate of tax
P0 = Ex-interest (similar to ex-div) market price of the loan stock.

IE Illustrative example 5.4

The 10% irredeemable loan notes of Rafa plc are quoted at £120 ex-int. Corporation
tax is payable at 30%.
What is the cost of debt net of tax?
Kd = (10% × $100) × (1 – 0.30)/$120 = 5.83%
Note that the interest is calculated on the standard nominal value of $100.

5.4.4 Cost of redeemable debt with tax

The Kd for redeemable debt is given by the IRR of the relevant cash flows. The
relevant cash flows would be:

Year Cash flow

0 Market value of the loan note P0
1 to n Annual interest payments i(1 − T)
N Redemption value of loan RV

G Learn

EG Learning example 5.9

Warnock Ltd has 10% loan notes quoted at $102 ex-interest redeemable in 5 years’
time at par. Corporation tax is paid at 30%.
What is the cost of debt net of tax?

Cost of Capital

5.4.5 Cost of redeemable debt with tax when redemption value

is same as market value
In most cases we use the technique outlined above but if the current market value
and the redemption value are the same the irredeemable debt formula can be used.

EG Learning example 5.10

The 10% loan notes of Rafa plc are quoted at $120 ex-int. Corporation tax is payable
at 30%. They will be redeemed at a premium of $20 over par in 4 years’ time
What is the net of tax cost of debt:
(a) Using the redeemable debt calculation?
(b) Using the irredeemable debt calculation?

5.4.6 Convertible debt

Convertible debt is a loan note with an option to convert the debt into shares at a
future date with a predetermined price. In this situation the holder of the debt has
the option to convert or not, and if the investor acts logically will choose the option
which provides the greater value:
1. the share value on conversion, or
2. the cash redemption value if not converted.

EG Learning example 5.11

Dudek has convertible loan notes in issue that may be redeemed at a 10% premium
to par value in 4 years. The coupon rate is 10%, the current market value is $95 and
the corporation tax rate is 30%.
Alternatively the loan notes may be converted at that date into 25 ordinary shares.
The current value of the shares is $4 and they are expected to appreciate in value by
6% per annum.
What is the cost of the convertible debt?

5.4.7 Bank debt (non-tradeable debt)

A substantial proportion of the debt of companies is not traded. Bank loans and
other non-traded loans have a cost of debt equal to the coupon rate adjusted for tax.
Kd = Interest (coupon) rate × (1 – T)


EG Learning example 5.12

Traore has a loan from the bank at 12% per annum. Corporation tax is charged at 30%
What is the cost of debt?

5.4.8 Preference shares

A preference share is a fixed rate charge to the company in the form of a dividend
rather than in terms of interest. Preference shares are normally treated as debt rather
than equity but they are not tax deductible therefore we do not deduct the tax in
calculating the cost to the company. They can be treated using the dividend valuation
model with no growth:

Kp =

IE Illustrative example 5.5

Hamann’s 9% preference shares ($1) are currently trading at $1.4 ex-div.
What is the cost of the preference shares?
Kp = 0.09/1.40 = 0.064 = 6.4%

EG Learning example 5.13

Saunders Ltd has convertible loan notes in issue that may be redeemed at a 7%
premium to par value in 5 years. The coupon is 8% and the current market value is $103.
Alternatively the loan notes may be converted at that date into 18 ordinary shares.
The current value of the shares was $2 six years ago and is $4 today and is expected
to grow at the same rate in the future.
What is the cost of the convertible debt?

5.5 Weighted average cost of capital (WACC)

The weighted average cost of capital (WACC) is the average of cost of the company’s
finance (equity, loan notes, bank loans, preference shares) weighted according to the
proportion each element bears to the total pool of funds.

G Learn

Cost of Capital

If a company is financed by debt and equity then the WACC formula is:
 Vg   Vd 
WACC =   Kg +   Kd 1-T 
 Vg +V d   Vg +V d 

ü Given

EG Learning example 5.14

Baros Plc has 20m ordinary 25c shares quoted at $3, and $8m of loan notes
quoted at $85.
The cost of equity has already been calculated at 15% and the cost of debt (net of
tax) is 7.6%.
Calculate the weighted average cost of capital.

5.5.1 Use of the WACC

A company’s WACC can be regarded as its overall cost of capital, and this cost
of capital can be used to evaluate the company’s investment projects if certain
conditions apply.
The main thing to be considered is whether the average cost of capital or the
marginal cost of capital is appropriate to use as the cost of capital when evaluating
the company’s projects.
1. the WACC is appropriate if the company adopts a ‘pooled funds’ approach to
financing its projects and:
(i) The company will maintain its existing capital structure in the long run (ie
same financial risk);
(ii) The project has the same degree of systematic (business) risk as the
company has now.
2. The WACC is also appropriate if the project is insignificant relative to the size
of the company.
However, if funds are to be raised specifically for a project with the funds raised
matched to the project, then the marginal cost of capital may be more appropriate.

Æ Key Learning Points

• Understand the relationship between risk and return and why this is
fundamental to the syllabus, whether looking at investment appraisal or
financing. (E3a, E3b)
• Be able to calculate the cost of equity finance using the dividend valuation model
and the capital asset pricing model. (E2a)
• Be able to calculate the debt finance. (E2b)
• Be able to calculate the overall cost of finance (WACC). (E2c)


What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).

Cost of Capital

Learning example solutions

EG Solution 5.1
Cost of equity = $0.15/$2 = 0.075 = 7.5%

EG Solution 5.2
Ke = +g
0.30 × 1.50
Ke = + 0.05 = 0.1484 = 14.8%
(3.50 - 0.30)

EG Solution 5.3
a) g = n d0 - 1
g = (11/6) - 1 = 1.0787 - 1 = 0.0787
b) K e = 1 + g
Remember that d1 is the dividend for the following year, so we have to add a year’s
growth to the current dividend of 11¢. We therefore get:
Ke = ((11 × 1.0787)/258) + 0.0787 = 12.5%

EG Solution 5.4
g = (22/10)1/5 − 1 = 1.1708 – 1 = 0.1708
Ke = ((0.22 × 1.1708)/(8.00 – 0.22) + 0.1708 = 0.2039 = 20.4%


EG Solution 5.5
First calculate the growth rate of dividends
g = rb = 0.12 × (1 – 0.3) = 0.084
Now use that growth rate in the formula
Ke = (d1/P0) + g
Ke = ((40¢ × 1.084)/(500¢ – 40¢)) + 0.084 = 17.8%
1. The dividend you use in the equation when there is dividend growth is the
dividend of the following year, not the current year-you have to increase the
current dividend by one year’s growth.
2. The share price you use is the ex-div share price – if you’re given the share price
cum-div you have to take the dividend away.

EG Solution 5.6
Ke = Rf + ß Rm - Rf 

Ke = 0.08 + 1.2 (0.15 – 0.08) = 0.164 = 16.4%

EG Solution 5.7
Ke = Rf + ß Rm - Rf 

Ke = 0.08 + 0.8 (Rm − Rf)

Note in this question you are given the risk premium which is the amount in the
brackets (Rm – Rf) = 0.06
Ke = 0.08 + 0.8 × 0.06 = 0.128 = 12.8%

EG Solution 5.8
(a) Equity risk premium = (Rm – Rf) = 12% – 9% = 3%
Ke = Rf + ß Rm - Rf 
0.15 = 0.09 + (ß × 0.03)
Therefore, ß = (0.15 − 0.09)/0.03 = 2

Cost of Capital

EG Solution 5.9
1. Columnar approach
2. Identify the cash flows
3. Discount at 5% and 10%
4. Use the IRR formula.

Year Cash Discount factor NPV at 5%  Discount factor NPV at 10% 
flow  (5%) (10%)
0 (MV) (102) 1.000 (102.00) 1.000 (102.00)
1–5 (Interest) 7  4.329 30.30  3.791 26.54 
5 (Redemption 100  0.784 78.40  0.621 62.10 
NPV + 6.7  (13.36)

Applying the interpolation formula:

Interpolated IRR = L +   × H - L 
 NL - NH 
IRR = 0.05 +  ×  0.10 - 0.05  = 0.067 = 6.7%
Thus the IRR is 6.7% and this is therefore the cost of the redeemable debt.


EG Solution 5.10
Note that there is a bit of a trick here. You are asked to do this question two ways,
partly to get more practice at calculating the IRR but mainly to show you a trick
which we shall explain further in part (b).

Year Cash  Discount NPV at 5%  Discount NPV at 10% 

flow  factor (5%) factor (10%)
0 (MV) (120) 1.000 (120.00) 1.000 (102.00)
1–4 (Interest) 7  3.546 24.82  3.170 22.19 
4 (Redemption 120  0.823 98.76  0.683 81.96 
NPV +3.58  (15.85)

Applying the interpolation formula:

Interpolated IRR = L +   × H - L 
 NL - NH 
IRR = 0.05 +  ×  0.10-0.05 = 0.0592 = 5.92%
  3.58 + 15.85  
Thus the IRR is 5.92% and this is therefore the cost of the redeemable debt.
(b) If the redemption value is the same as the market value, then there is a simple
trick that will save you all the trouble of doing the IRR calculation.
You can instead simply use the perpetuity approach we looked at earlier. We
assume that the interest is not just for 4 years but is an irredeemable perpetuity.
The IRR is therefore calculated as:
Kd = 7/120 = 5.83%
This is so much easier and is really just a mathematical trick. You needn’t
worry why it works but the answer is more accurate than the answer using the
interpolated IRR.
Note that it only works in the unusual circumstance that the redemption value
and the market value are the same.

Cost of Capital

EG Solution 5.11

Step 1 Calculate the conversion and redemption value of the debt.

Conversion value = 25 × $4 × 1.064 = $126.25
Redemption value = $100 × 1.1 = $110
The debtholder will therefore choose to convert to shares.
Step 2 Use the IRR technique to calculate the cost of capital for the
convertible debt.

Year Cash flow  Discount NPV at 5%  Discount NPV at

factor (5%) factor 10% 10%
0 (MV) (95) 1.000 (95.00) 1.000 (95.00)
1–4 (Int) 7  3.546 24.82  3.170 22.19 
126.25  0.823 103.90  0.683 86.23 
NPV + 33.72  +13.42 

They are both positive. This is a problem for the interpolation formula as it only really
works accurately if you have one positive and one negative – but in the exam you don’t
have the time to worry about this – so just carry on (but be careful about the signs).
Applying the interpolation formula:

Interpolated IRR = L +   × H - L 
 NL - NH 
IRR = 0.05 +  ×  0.10 - 0.05  = 0.1331 = 13.31%
  33.72 - 13.42  

Thus the IRR is 13.31% and this is therefore the cost of the convertible debt.

EG Solution 5.12
The calculation is simply as follows:
Kd = 12% × (1 – 0.3) = 8.4%
There is no need for any PV calculation.


EG Solution 5.13

Step 1 Calculate the growth rate of the ordinary shares.

g = ($4/$2)1/6-1 = 1.1225 − 1 = 0.1225 = 12.25%
Step 2 Calculate the conversion and redemption value of the debt
Conversion value in 5 years = 18 × $4 × 1.12255 = $128.31
Redemption value = $100 × 1.07 = £107
The debtholder will therefore choose to convert to shares.
Step 3 Use the IRR technique to calculate the cost of capital for the
convertible debt.

Year Cash Discount NPV at Discount NPV at 10% 

flow factor (5%) 5%  factor
0 (MV) (103) 1.000 (103.00) 1.000 (103.00)
1–5 (Interest) 5.6  4.329 24.24  3.791 21.23 
(8 × 0.7)
4 (conversion 128.31  0.784 100.60  0.621 79.68 
NPV +21.84  (2.09)

Interpolated IRR = L +   × (H - L)
 NL - NH 
IRR = 0.05 +  ×  0.10 - 0.05 = 0.0956 = 9.56%
 21.84 + 2.09  
Thus the IRR is 9.56% and this is therefore the cost of the convertible debt.

Cost of Capital

EG Solution 5.14
The formula sheet gives the formula for the WACC as follows:

 Ve   Vd 
WACC = Ke ×   + Kd ×  
  Ve +Vd     Ve +Vd  
This can be simplified as:
Ke Ve Kd Vd
WACC = +
 Ve +Vd   Ve +Vd 
This is easy to calculate if there are only two sources of debt, but if there are more it
can be complicated. The following tabular approach keeps it all simple.

Equity (20m × $3) $60m 0.15 $9.0m
Debt ($8m 185/100) $6.8m 0.076 $0.517m
$66.8m $9.517m

WACC = 9.517/66.8 = 14.25%


Capital Structure and Risk
Adjusted WACC

The amount of debt and equity and in particular the ratio of debt and equity in a
company’s statement of financial position will affect the risk that the shareholders of
a company face. This in turn affects the return that they require and the company’s
cost of capital. For the most part you can expect a written question on the first
part of the chapter dealing with the theories about the WACC. The second part of
the chapter deals with a particular technique which the examiner may test with a
calculation question.

1. Can you describe how the WACC changes with increased gearing under the
traditional theory?

2. Can you give the M+M assumptions and say how this theory is different to the
traditional theory?
3. Do you know the difference (if any) between an asset, ungeared and geared beta?

Capital Structure and Risk Adjusted WACC

6.1 Capital structure and cost of capital

6.1.1 Cost of capital and shareholder wealth
There is a very simple relationship between the overall cost of capital and
shareholder wealth.
Future cash flows
Market value =
If the overall cost of capital increases, the market value, and therefore shareholders’
wealth will become smaller. If the cost of capital decreases, the market value and
shareholders’ wealth will increase.
We have seen in earlier chapters how the different types of financial instruments
have a different risk/return profile. Equity has the greatest risk and the greatest
return and debt a lower risk and return.
The question that this chapter addresses is the extent to which the different
combinations of equity and debt can affect the WACC and increase or decrease
shareholder wealth.

6.1.2 Impact of debt financing on the WACC

We can consider if the introduction of debt increases or decreases the WACC.
Probably more importantly, we can think if there is an optimal mix of debt and equity
that will minimise the WACC and maximise shareholders’ wealth.
The following table summarises the main trade-offs that interact when debt is
introduced into the funding of a company.

Reduction in WACC Increase in WACC

Because Kd is less than Ke, an Debt introduces financial risk which
increase in debt funding should lead increases Ke, and should lead to an
to a fall in WACC. increase in WACC.
Debt finance is cheaper because it is: The risk associated with debt financing
1. less risky to investor is borne by the shareholders.
2. tax efficient

P Principle
How debt funding affects WACC


Hence we can see that:

• Debt is a cheaper form of finance than equity because it is less risky and is also
tax efficient. The debtholders will generally have a charge on the company assets
so that if the company fails they can sell the assets and regain their investment.
• However, when debt is introduced into the statement of financial position, the
risk to equity increases, and if the risk to equity increases the return to equity
(affecting the cost of equity) also increases.
• The risk increases for two reasons:
(i) the risk to dividends being paid. Debtholders have to be paid their annual
interest before dividends. If profits are reduced in a year for any reason, this
debt payment can reduce or eliminate the payment of dividends.
(ii) the risk to the equity capital. As we noted above, the debtholders will have
a charge on the assets and this is a threat to the survival of the company if it
fails to pay interest (or breaches any other of the terms of the debt issue).
• On the one hand, introducing debt should lower the WACC because of the
cheaper debt. On the other hand, introducing debt may cause the cost of equity
to rise, thereby increasing the WACC.
In order to understand how a company can maximise shareholders’ wealth by issuing
debt, we need to look at the various theories that address this problem.

6.2 Gearing theories

6.2.1 The traditional view of capital structure
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.
The thinking behind this is that when the level of gearing is low, there is no great
risk to equity. Dividends are not threatened and the amount of debt is not sufficient
to threaten the company itself. Thus the cost of equity will not increase very much
because the risk has not increased.
However as the level of gearing rises, the risks to equity increase and the return
required by the shareholders also rises-pushing up the cost of equity.

Cost of debt
At low levels of gearing, there is no risk to debt as the debtholders have
sufficient asset cover.
However if the level of gearing rises, the debtholders may perceive increasing risk
both to the payment of the debt interest and to the asset cover. While in theory the
debtholders are safe, in practice there are numerous examples of companies failing
with insufficient assets to repay the debtholders. Thus the cost of debt will increase.
This is illustrated in the following diagram.

Capital Structure and Risk Adjusted WACC

Cost of



Gearing (D/E)
The cost of equity rises at an increasing rate.
The cost of debt is flat at first and then rises.
The WACC dips at first and then rises, giving an optimal WACC at the lowest point
of the curve. (Note that the WACC is not just the average of the two costs-it is the
weighted average. The x-axis is the gearing ratio and indicates that, as more debt is
added, the extra cheap debt initially brings down the WACC until the debt and equity
become more expensive).

G Learn
Summary of traditional view
You can describe the interaction of the cost of equity and debt above by thinking in
terms of a ‘substitution effect’ and a ‘financial risk effect’.
• The substitution effect describes the effect of substituting equity by cheaper
debt-lowering the WACC.
• The financial risk effect describes the effect of the debtholders perceiving
an increased risk as the level of debt increases and requiring a higher return,
thereby increasing the cost of debt and the WACC.
These two effect work against each other, resulting in the shape of the WACC. In the
case of the traditional theory, the trade-off results in an optimal level of gearing at
which the WACC is minimised and the value of the company is maximised.


6.3 Modigliani and Miller (M&M)

Modigliani and Miller (M and M) were two economists who studied the equity
markets to develop a theory of how prices were established. They set up a
theoretical model of the market with a series of assumptions.

6.3.1 Assumptions
Their theory was based on the premise of a perfect capital market in which:
1. The market is perfect, meaning that individuals and companies can both borrow
unlimited amounts at the same rate of interest as each other.
2. Personal borrowing is a perfect substitute for corporate borrowing.
3. There are no taxes or transaction costs.
4. Firms exist with the same business or systematic risk but different levels of gearing.
5. All projects and cash flows relating thereto are perpetual and any debt
borrowing is also perpetual.
6. All earnings are paid out as dividend.
7. Debt is risk free.

G Learn
6.3.2 M&M theory without tax
M&M suggested that the cost of equity rises at a fixed rate to reflect the level of
increase in risk associated with gearing.
They also suggested that the cost of debt would be constant at all likely levels of
gearing. Only at very high levels of gearing will the cost of debt rise.
Note how this differs from the traditional view where the cost of equity rose at an
increasing rate, and the cost of debt increased even at relatively low levels of gearing.
The key premise of the theory is that as the level of gearing rises, the increase in the
cost of equity is exactly compensated for by the increase in cheaper debt, in such a
way that the WACC is constant. Note how this differs from the traditional view. The
traditional theory also predicted that as the level of gearing increased there would
be an increase in the cost of equity but this would not be exactly compensated for by
an increase in cheaper debt so that the WACC would not be constant.
M&M’s WACC can be shown in the following diagram.

Capital Structure and Risk Adjusted WACC

Cost of Ke



Gearing (D/E)

G Learn
If the weighted average cost of capital is to remain constant at all levels of gearing, it
follows that any benefit from the use of cheaper debt finance must be exactly offset
by the increase in the cost of equity.
The conclusion of this theory is that capital structure is irrelevant to a company.
Its weighted average cost of capital (and hence, its financing cost) stays the same
regardless of the balance of debt and equity.

6.3.3 M&M theory with tax

Due to criticisms of their first theory, M&M modified their model to include the impact
of tax. Debt has the advantage that interest paid is allowable for tax so that the cost to
the company is the after-tax cost. The effective cost of debt will be lower as a result.
The result of this is that as the level of gearing rises the overall WACC falls. The
company will benefit from having the highest level of debt possible (subject to the
cost of debt eventually rising at very high levels of gearing).


Cost of



Gearing (D/E)

G Learn

EG Learning example 6.1

(a) Summarise the relationship between WACC and market value.
(b) Summarise the meaning of, and interaction between, the substitution effect and
the financial risk effect.
(c) Summarise the way the three theories we have studied describe the effect that
the level of gearing has on the WACC.

6.3.4 Capital market imperfections and their effect on

Modigliani and Miller
There are a series of practical reasons why the theories of Modigliani and Miller
are unlikely to work exactly in practice. Their assumptions are that capital markets
are perfect.
These imperfections include:
1. Transaction costs – to buy or sell shares investors have to pay a transaction
cost to the stock market and/or dealer they are buying the shares through.
This breaks one of their assumptions and means that investors are less likely to
take the rational actions of buying or selling shares if their value changes that
Modigliani and Miller expect.

Capital Structure and Risk Adjusted WACC

2. Taxes – similarly if governments charge tax on share transactions (such as stamp

duty) this will discourage investors buying and selling shares. Also, if the tax regime
doesn't give tax relief on all interest paid that would make debt less attractive.
3. Costs of financial distress – if a company has very high levels of gearing (causing
financial distress) investors will sell their shares. Modigliani and Miller expect
high gearing to be good news due to the tax savings that high gearing brings. In
real life though high gearing is a bad thing and investors will sell shares in highly
geared companies, reducing their share price and increasing their cost of capital.

6.3.5 Problems with a high level of gearing

It is rare to find companies who seek to have very high gearing. This is due to
problems such as:
• bankruptcy. At very high debt levels the company may not be able to service the
debt interest and may be forced into bankruptcy by the debtholders.
• tax exhaustion. The debt interest is allowable against tax, but it is possible
that at very high levels of debt there will be insufficient profits to utilise all the
available interest.
• loss of borrowing capacity. It may be impossible to find additional lenders to lend
ever-increasing amounts of debt.
• risk attitude of current and potential investors. The existing equity investors may
be put off by the debt levels and dispose of their shares causing the share price
to fall and making any future equity fund raising expensive. Similarly prospective
investors may not wish to subscribe for new issues of shares.
We can compare these problems with having high borrowings/gearing as an
individual. It may be tempting to borrow a lot of money to finance spending.
However, an individual would then be at risk if their income dips or interest rates rise.

6.3.6 Effect on financial position and financial risk

In order to see the financial impact of different sources of finance it is useful to
look at the statement of profit or loss and statement of financial position to see
how the ratios and cash flows change as gearing changes. The ratios that should be
considered include:
1. The ratio of debt to equity (financial gearing)
2. Operational gearing (how many fixed costs there are in a company)
3. Interest cover
It is useful to look at the interplay of some of these as well. The ratios all look at the
level of risk in the company.
There will be an effect on shareholder wealth of the variation in these measures. As
the risks in the business are higher, then the value of the company will be expected to
reduce. Risks can be negative (if volumes sold and revenues drop then this affects the
value of the company) but also may be positive-if volumes rise then profits will be higher.


IE Illustrative example 6.1

In order to see the effect of differing gearing levels on a company let's consider
the following:
Statement of profit or loss for DTE Limited

Revenue 100m
Variable costs 30m
Contribution 70m
Fixed costs 40m
Profit before interest and tax 30m
Interest 20m
Profit before tax 10m
Taxation 3m
Earnings for shareholders 7m

Statement of financial position

Shareholders’ equity 150m
Debt 100m

We need to calculate the ratio of debt to equity (financial gearing), the operational
gearing and the interest cover to see how these factors affect a company.
The solutions and their implications are as follows:
1. Debt to equity (financial gearing) is £100m/£150m so 67%. This could be
calculated as debt to total of debt and equity, ie £100m/(£100m + £150m) hence
40%. The implications of this is that there is a lot of debt for each £ of equity.
However this may well be sustainable for the company (we can look at its past
record to see if it has been able to maintain this level successfully). We can look
at the other ratios to get a clearer view.
2. Operational gearing looks at the level of fixed costs in the statement of profit
or loss over the contribution of the company. The higher this is the more the
company is at risk of losses if the volumes that it sells, and hence its contribution,
falls. Here we have a ratio of £40m/£70m which is 57%. This is an amount that
has to be paid each year (similar to interest payments) so this increases the
risk of the company to falls in volumes sold and revenues. A drop of £30m in
contribution would mean the company has no profits and not be able to cover its
interest payments.

Capital Structure and Risk Adjusted WACC

3. The interest cover looks at how much profit before interest and tax covers the
interest payment. Currently this is £30m/£20m which is 1.5 times. Hence a 33%
drop in profit before interest and tax would mean that the interest payment is
only just covered.
If we look at this company we can see that there is some financial gearing on the
statement of financial position but it is easier to see that there are two factors
that demonstrate the true risks to the company on the statement of profit or
loss. Any drop in volumes and revenue will affect the profits of the business and
the possibility of it paying out dividends-if there are no profits the company is
unlikely to pay out dividends. The operational gearing and interest cover show
how much the volume changes would have to be to reduce the profit to zero.

6.4 Pecking order theory

A theory that funding of companies does not follow theoretical rules but instead
often follows the ‘path of least resistance’.
A suggested order is as follows:

1st Retained earnings. All companies start off with equity and retained
earnings and it is natural to utilise these before seeking debt finance.
2nd Bank debt. An easy and obvious option-probably starting with an
overdraft and then a bank loan.
3rd Other loan instruments such as loan stock, convertibles and preference
shares. The company will use these if it believes that these will reduce
the WACC, trying to gain the benefits of cheap long term debt finance.
4th Issue of equity. A company will use this if its debt is excessive or it wants
to expand its equity base.

The point about pecking order theory is that the company is not consciously
calculating the optimal mix of equity and debt–it is rather following a fairly
unscientific, common sense approach.

6.5 CAPM in project appraisal

6.5.1 Using the WACC
We saw that a company’s WACC can be regarded as its cost of capital, and this cost
of capital can be used to evaluate the company’s investment projects if certain
conditions apply.


The key conditions are:

• The company adopts a ‘pooled funds’ approach to financing its projects;
• The company will maintain its existing capital structure in the long run (ie
keeping the same financial risk);
• The proposed project has the same degree of systematic (business) risk as the
company, ie the company’s systematic risk does not change.

6.5.2 Using the project specific cost of capital

We also noted briefly that sometimes the company may use not the WACC but the
marginal cost of capital. This is often referred to as a project specific cost of capital.
The overall average cost of capital to the company takes into account all the activities
and risks of a company so is unlikely to be appropriate to a specific project. A
marginal cost of capital looks at the extra risks that are involved with a project, which
may be higher or lower than average.
The main reason why a company may use a project specific cost of capital is if a
project’s risk differs to the company’s risk profile. In this case we use a cost of capital
based on the CAPM.
The assumptions underpinning the CAPM must hold:
• shareholders are rational
• shareholders are well diversified
• the project is an investment in its own right.
The key thing to understand is that the project is assessed on its ability to earn a
return in relation to its own level of risk, not in relation to the weighted average of all
the company’s project risks.

6.5.3 Advantages of using a cost of capital based on the CAPM

• It is possible to assess all projects providing the level of risk (beta) can be
determined. This can be difficult for some projects. If we were talking about
an investment is shares rather than a new commercial project, then calculating
the ß is relatively easy as we have seen. However if we are investing in a new
commercial project then calculating the ß can be very difficult.
• By considering only systematic risk we have a better theoretical basis for setting
a discount rate.
• It reflects the position of large companies whose investors are likely to be
well diversified.

6.5.4 Disadvantages of using cost of capital based on the CAPM

• The ß of the project can be difficult to calculate
• The CAPM is a single period technique–it only strictly applies to projects lasting
one year. One can use it for other longer projects but that requires viewing the
project as a series of single year projects which is difficult.

Capital Structure and Risk Adjusted WACC

IE Illustrative example 6.2

Toshack plc is an all equity company and has a cost of capital of 17% pa.
A new project has arisen with an estimated beta of 1.3. r f = 10% and rm = 20%.
(a) What is the required return of the project?
Ke = Rf + ß (Rm − Rf)
Ke(project) = 10% + 1.3 (20% − 10%) = 10% + 13% = 23%
This is different from the company’s cost of capital of 17%. The reason for this is
straightforward-it is different because the project has a different risk from the rest
of the company’s investments and hence the project specific cost of capital is used.
(b) What relationship does this have to the cost of capital to the company?
The new cost of capital does not really have any relationship to the existing cost
of capital of the company. As noted above the difference in risk is the cause of
the different return that is required from the project.

EG Learning example 6.2

Johnson plc is an all equity company with a beta of 0.6. It is considering a single year
project which requires an outlay now of $2,000 and will generate cash in one year
with an expected value of $2,500. The project has a beta of 1.3. r f = 10%, rm = 18%.
(a) What is the Johnson’s cost of equity capital?
(b) What is the required return of the project?
(c) Is the project worthwhile?

EG Learning example 6.3

Mears Ltd is an all equity company with a ß of 0.9. It is considering a project which
has a ß of 1.2. The risk free rate is 7% and the equity risk premium if 6%. Calculate
the project specific cost of capital.

6.6 Introducing debt finance into the CAPM

6.6.1 Complications that debt introduces to beta factors
The CAPM can be extended to take debt/gearing into account.
The type of scenario that is relevant here is the situation where a company (the
investing company) is planning to diversify into a different sector of the economy
(the sector). The risks of the sector will be different from the risks of the investing
company. In addition, the company may well use a different balance of debt and


equity to finance the project. In this situation, the investing company has to calculate
a cost of capital that reflects the different risk.

6.6.2 Asset, equity and geared betas

In general a geared company faces two sorts of risk:
• The business risks of the investment (ie the sort of investment it is, which will be
influenced by the sector it is in) plus;
• The financial risks which depend on the amount of debt that the company has
taken on and which will increase the cost of equity.
The definitions of different betas reflect these different risks.

The asset beta (ßa) is an ungeared beta. This is the beta of an all-equity financed
company that has no debt and therefore no financial risk. The ungeared beta is a
function of the business risk only.

The equity beta (ße) is a geared beta. It is the beta of a geared company which
includes the business risks and the finance risks caused by the debt.

The beta factor of debt (ßd) is generally very small and in the exam is largely ignored.
If we follow M and M then they assumed that debt is risk free and hence a debt beta is
equal to zero.

G Learn
6.6.3 Converting a geared beta of the sector into the geared beta
of the investing company
The specific problem we face is as follows:
• The investing company can know the geared beta of the companies in the new
sector into which the company plans to diversify, and this would be sensible to
use as the beta to evaluate the investment.
• However, it is unlikely to be the best beta to use because the investing company
is likely to use a different geared beta that reflects its own gearing risk.
In order to convert the geared beta of the sector to the geared beta of the investing
company you have to learn how to use the formula given in the exam and the two
steps needed to make the conversion.
The formula given in the exam–the asset (ungeared) beta formula

Capital Structure and Risk Adjusted WACC

 Ve   Vd 1 - t  
 a =   e  +   d 
 Ve + Vd 1 - t    Ve + Vd 1 - t  
This can be simplified because the debt beta is usually given as nil (you will be told
that the debt is risk free), so the formula can be reduced to

ü Given
a = 
Ve + Vd 1 - t  e

Where ßa = the asset beta (ungeared beta)

ße = the equity beta (geared beta)
ßd = the debt beta (taken to be nil)
Ve = the market value of equity (or the proportion of equity)
Vd = the market value of debt (or the proportion of debt)
t = the tax rate.

Steps needed to make the conversion

1. Convert the geared beta of the sector company to the ungeared beta of the
sector company by removing the gearing risk.
You have the formula for doing this in the exam (this is the simplified formula
given above when ßd = 0)
a = 
Ve + Vd 1 - t  e
Note, very importantly, the data for performing this conversion is taken from the
sector company, not the investing company, because the investment is currently
in the sector and we are stripping out the sector gearing effect.
2. Convert the ungeared beta above into the geared beta of the investing company.
The formula for doing this is easily derived from the formula above:
a = 
Ve + Vd 1 - t  e
3. Simply rearrange the formula so that ße is on the left and the remainder of the
formula on the right:
 a  Ve + Vd 1 - t  
e =
Note that the data for doing this is taken from the investing company, because it
is this company’s gearing that causes the gearing risk now.


IE Illustrative example 6.3

A Ltd is planning to diversify by investing into a different market sector.
This market sector has an average geared beta of 1.8 and average debt/equity
ratio of 2:3.
A Ltd has a geared beta of 1.4 and a debt equity ratio of 1:3.
The tax rate is 30%.
Let us calculate the geared beta that A Ltd should use when calculating the cost of
capital for this project.

Step 1 Convert the geared beta of the sector company to the ungeared beta
of the sector company by removing the gearing risk.
ßa = ße Ve/(Ve + Vd(1 – T))
ßa = (3 × 1.8)/(3 + 2(1 – 0.3)) = 5.4/4.4 = 1.23
Step 2 Convert the ungeared beta above (1.23) into the geared beta of the
investing company.
 a  Ve + Vd 1 - T  
e =
ße = 1.23(3 + 1(1 – 0.30))/3 = 1.52

EG Learning example 6.4

Voronin plc is a matruska doll manufacturer with an equity: debt ratio of 5:3. The
corporate debt, which is assumed to be risk free, has a gross redemption yield of
10%. The beta value of the company’s equity is 1.2. The average return on the stock
market is 16%. The corporation tax rate is 30%.
The company is considering a rag doll manufacturing project. K plc is a rag doll
manufacturing company. It has an equity beta of 1.86 and an equity to debt ratio of
3:1. Voronin plc maintains its existing capital structure after the implementation of
the new project.
What would be a suitable cost of capital to apply to the project?

Capital Structure and Risk Adjusted WACC

Æ Key Learning Points

• Learn how companies may vary the balance of debt and equity finance they use
and be able to calculate the weighted average cost of capital (WACC) and the
traditional theory. (E2c)
• Learn Modigliani and Miller’s theory of calculating the WACC, with and without
tax, and learn the assumptions it is based upon. (E4a–E4d)
• Know the capital asset pricing model (CAPM) and how to use the CAPM to
produce a project specific cost of capital. (E3e)
• Understand the impact of gearing on the CAPM cost of capital. (E3e)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).


Learning example solutions

EG Solution 6.1
Future cash flows
Market value =
There is an inverse relationship between the market value of a share and the
WACC. If the WACC increases the market value decreases and vice versa.
(b) The substitution effect describes the effect of substituting equity by cheaper
debt. This will lower the WACC.
The financial risk effect describes the effect of the debt-holders perceiving an
increased risk as the level of debt increases. They require a higher return which
tends to increase the WACC.
These two effect work against each other, resulting in the shape of the WACC.

Theory WACC
Traditional Minimised at a specific level of gearing in
the normal range
MM (no tax) No impact-WACC constant
MM (with tax) WACC on a continuous downward trend-
only rises at a high level of gearing, probably
outside a normal range

Capital Structure and Risk Adjusted WACC

EG Solution 6.2
(a) Ke(Johnson) = Rf + β (Rm − Rf)
Ke(Johnson) = 10% + 0.6(18% − 10%) = 14.8%
(b) Ke(Johnson) = 10% + 1.3 (18% − 10%) = 20.4%
Note for parts (a) and (b) that the Ke we are calculating is different in the sense
that one is for the company and the other is for the project.
(c) The project is a single period project so the cash flows can be written as follows:

Year 0 ($2,000)
Year 1 $2,500 

The IRR of this is (2,500/2,000) – 1 = 0.25 = 25%

As this is greater than the cost of capital of the project (20.4%), then the project
is worthwhile. Note that the cost of capital of the company is irrelevant.

EG Solution 6.3
Ke(project) = Rf + β (Rm − Rf),
Where (Rm − Rf) is the market risk premium
Ke(project) = 7% + (1.2 × 6%) = 7% + 7.2% = 14.2%
Note that the company ß is irrelevant in this question.


EG Solution 6.4
Voronin plc
1. Identify proxy company
K plc
Equity beta (ße) 1.86
Gearing Equity: Debt 3:1
2. De-gear (ße to ßa) ßa
Equity 3
Debt (1 − t) 0.7 (1 × 0.7)
Sum 3.7
Ve 3
a = e = 1.86 × = 1.51
Ve +Vd 1 - t  3.7

3. Re-gear (ßa to ße)

Equity 5
Debt (1-t) 2.1 (3 × 0.7)
Sum 7.1
Ve +Vd (1 - t) 7.1
βe = βa = 1.51 × = 2.14
Ve 5

4. Use CAPM formula

Ke = Rf + Rm - Rf ² = 10%+ 16% - 10%  2.14 = 22.84%

Ratio Analysis

Ratios are a way of assessing key indicators about a company’s performance. This
chapter looks at profitability ratios very briefly and then goes on to look at gearing
ratios and investment ratios (sometimes called stock market ratios). These ratios are
the ratios that financial managers are really interested in–they are the ratios that
are affected by the capital structure of the company and the dividend policies of
the company. These are important because, among other things, they influence the
company’s cost of capital.
The examiner will be particularly interested in the gearing and investment ratios. Be
very careful when commenting on the meaning of a ratio. An individual ratio means
very little unless it is compared with the same ratio for another company, an industry
average or the same ratio of the same company for a different period. Also be clear
that the ratios are to an extent linked, and what may appear to be a ratio that is a
cause for concern may simply indicate a particular corporate strategy.

1. Can you write down and calculate two profitability ratios?

2. Do you know the similarity and the difference between financial and

operational gearing?
3. What is the P/E ratio a measure of?

Ratio Analysis

7.1 Profitability ratios

Profitability is the main aim of a company.
There are two basic measures:
• Return on capital employed (ROCE).
• Return on equity.
Before looking at these two measures we shall look at a proforma statement of profit
or loss to identify the key headings that affect these ratios.

Less interest (x)
Less tax (x)
Less dividends (x)
Retained earnings x

The PBIT (profit before interest and tax) and the PAT (profit after interest and tax) are
two key figures that are used when assessing the profitability of a company.

7.1.1 Return on capital employed

ROCE = × 100
Capital employed
This is a measure of the underlying performance of the business before finance.
What this means is that the PBIT is an operational measure of how the business has
performed, it is not affected by the company’s capital structure. It considers the
overall return before financing and is not affected by gearing.

PBIT is the profit before interest and tax. It is also known as operating profit.

Capital employed is the total funds invested in the business. It includes equity and
long-term debt.


7.1.2 Return on equity

The formula is:
Profit after tax
ROE = × 100
Equity is the sum of the share capital and all the reserves (share premium account,
retained earnings, etc.).

IE Illustrative example 7.1

A company has the following excerpts from its statement of financial position and
statement of profit or loss.
Statement of financial position excerpts

Share capital 50
Share premium 20
Revenue reserves 40
Debentures 15

Statement of profit or loss excerpts

Less interest 5
PBT 15
Less tax 5
PAT 10

Calculate the ROCE and the ROE.

ROCE = (PBIT/capital employed) × 100

= (20/(50 + 20 + 40 + 15)) × 100 = 16%
ROE = (PAT/equity) × 100
= 10/(50 + 20 + 40) × 100 = 9.1%

Ratio Analysis

EG Learning example 7.1

A company is considering a number of funding options for a new project. The new
project may be funded by £20m of equity or debt. Below are the financial statements
given the project has been funded in either manner.
Statement of financial position extract

Equity Finance Debt Finance

(£m) (£m)
Debentures (10%) 0.0 20.0
Share capital (50p) 22.0 14.5
Share premium 17.0 4.5
Reserves 3.0 3.0
42.0 22.0

Statement of profit or loss extract

Turnover 200.0 
Gross profit 40.0 
less expenses (excluding interest) (30.0)
Operating profit 10.0 

Corporation tax is charged at 30%.

Calculate profitability ratios and compare the financial performance of the company
under both equity and debt funding.

7.2 Gearing
Should we finance the business using debt or equity?
There are two basic considerations:
1. Cost.
2. Risk.

7.2.1 Cost of finance

Any finance will incur servicing costs; debt will require interest payments and equity
will require payment of dividends and/or capital growth. On the basis of the cost of


servicing we would always choose debt over equity. Debt should be less expensive
for two reasons:
• Taxation
Debt is tax deductible because the debtholders are not owners of the business.
Equity however will receive a return after tax because they receive an
appropriation of profits. Debt saves tax and is hence cheaper.
• Risk
The debtholder is in a less risky position than the shareholder. If there is lower
risk then the debtholder should be willing to expect a lower return. The lower
risk is due to two factors:
1. Priority of payout-there is a legal obligation to pay interest.
2. Security-debt is secured by charges or covenants against assets.

7.2.2 Risk from the point of view of the company

Risk may be split into two elements:
1. Business risk.
2. Financial risk.
• Business risk is inherent to the business and relates to the environment in which
the business operates. Factors include:
– Competition-the more competition, the greater the risk to profit.
– Market-some markets are more reliable than others. Food retailing is a fairly
safe market-people always need to eat. Tourism or house building are more
volatile and will contract if the economy contracts.
– Legislation may change and damage the businesses in certain sectors.
– Economic conditions may change and although some markets will be harder
hit than others, all will be affected.
• Financial risk is the risk associated with debt financing. If the company is
financed using equity, it carries no financial risk. This is because it has no need to
pay shareholders a return (dividend) in the event of a poor trading year.
If however the company finances itself using debt as well as equity then it must
generate sufficient cash flow to pay interest payments as they fall due. The
greater the level of debt, the greater the interest payments falling due and hence
the higher the risk of default. This is financial risk.

7.2.3 Two types of risk associated with gearing

Operational gearing is the risk associated with the level of fixed costs within a business.
The higher the fixed cost, the more volatile the profit. The level of fixed cost is
normally determined by the type of industry and can rarely be changed.
Operational gearing =

Ratio Analysis

Consider two businesses. Company A has high fixed costs and company B has low fixed
costs. We shall contrast the effect of a 10% fall in contribution in both companies.

Original contribution  Reduced contribution 

(£000) (£000)
Company A
Contribution 60  (60 × 0.9) 54 
Fixed costs 50  50 
PBIT 10  4 
Company B
(£000) (£000)
Contribution 60  (60 × 0.9) 54 
Fixed costs 20  20 
PBIT 40  34 

The PBIT of company A has fallen by (6/10 × 100) = 60%

The PBIT of company B has fallen by (6/40 × 100) = 15%
Hence having high fixed costs (which have to be paid) increases the volatility of
profits. Conversely if contribution rises then a company with high fixed costs will see
a stronger rise in its profits.

7.2.4 Financial gearing

Financial gearing is the mix of debt to equity within a firm’s permanent capital.
There are two measures:
1. Capital gearing – a statement of financial position measure. This measures the
ratio of the debt to equity in the statement of financial position, and is therefore
a direct measure of the amount of debt relative to equity.
2. Interest cover – a statement of profit or loss measure that measures the ability of
the company to pay the interest on its debt out of the profits that are paid to equity.

7.2.5 Capital gearing

Equity gearing
Gearing = × 100
Total or capital gearing
Gearing = × 100
Debt + Equity

G Learn


We need to define clearly what is meant by debt and what is meant by equity. These
are to some extent ‘controversial’ definitions. Although equity is clear enough,
different people will argue that different sorts of debt should or shouldn’t be included.
• Debt
All permanent capital charging a fixed interest may be considered debt.
1. Debentures and loans, these are clearly debt.
2. Bank overdraft-this is more contentious but the examiner sees this as debt
if it is significant. It is money borrowed, even if sometimes only briefly (the
inconsistency here is perhaps that trade creditors are not considered debt).
3. Preference share capital-this is share capital but it carries a fixed interest
charge and to that extent behaves like debt.
• Equity
Equity is comprised of:
1. Ordinary share capital
2. Share premium
3. Reserves.

EG Learning example 7.2

Statement of financial position for Redknapp Ltd

(£m) (£m)
Fixed assets (total) 20.0 
Current assets (total) 12.0
Current liabilities
Trade creditors 4.0
Bank overdraft 5.0
Long-term liabilities
Debenture 10% (8.0)

Ratio Analysis

Ordinary share capital 8.0
Share premium 4.0
Preference share capital 1.0
Reserves 2.0

Calculate the financial gearing of the business using both methods.

7.2.6 Interest cover

Interest cover is a statement of profit or loss measure that considers the ability of the
business to cover the interest payments as they fall due.

Interest cover =

IE Illustrative example 7.2

Collymore statement of profit or loss extract is as follows:

Operating profit 20.0 
Interest (4.5)
Profit before tax 15.5 
Tax at 30% (4.65)
Profit after tax 10.85 

(a) Calculate the interest cover.

Interest cover = £20m/£4.5m = 4.4
(b) Is this level of cover safe?
It is difficult to comment on how safe 4.4 interest cover is. It seems good enough, but
to be absolutely confident we would have to know the following:
• How volatile are the profits?
• Where we are in the business cycle-near the peak or trough?


• Is the company well diversified-are the profits derived from investments that are
secure in their lifecycle, or are they coming to the end of their lifecycle and likely
to generate reducing profits?

EG Learning example 7.3

Extracts from the statement of financial position of Company Z Ltd are as follows:

Trade creditors 25
Overdraft 5
Long-term loans
6% debentures 30
Share capital
Ordinary shares 40
5% Preference shares 10
Share premium account 5
Revenue reserves 25

Calculate the following:
(i) Equity gearing ratio
(ii) Capital (total) gearing ratio.

7.3 Stock market ratios

7.3.1 Earnings per share
PAT less preference dividend
Number of ordinary sharess in issue
• In the numerator, the preference dividends are deducted from the profit after
tax because these dividends are paid in preference to the ordinary dividends and
are therefore not available to the ordinary shareholders.
• In the denominator, it is only the ordinary shares that count. If there are
preference shares they are not included as they are classed as debt.
• The number of ordinary shares is the weighted average of the ordinary shares in
issue during the year.
Thus, if a company starts the year on the 1st of January with 5m shares in issue and
issues another 2m on the 1st of July, the number of shares in issue will be:
((5m × 6) + (7m × 6))/12 = 72m/12 = 6m shares

Ratio Analysis

EG Learning example 7.4

The Hyypia Co. earned profits after tax of £14m and has a preference dividend of
£2m. There are 6 million ordinary shares in circulation.
What is the EPS?

7.3.2 Price earnings ratio (P/E ratio)

The P/E ratio is the ratio of the current shares price divided by the EPS (where
earnings are the profit after tax – PAT).

It can be calculated either for an individual share or for the total company.
Individual share Total company
Current share pricee Total market value (MV)
PE Ratio= or
EPS Profit after tax

G Learn
Importance and interpretation of P/E ratio
Broadly speaking, the P/E ratio is a function of the current share price divided by the
current earnings per share. But remember the current share price depends on the
future dividends (earnings).
Let us compare two companies (A and B) with the same number of shares and the
same current earnings and dividends, but with A anticipating faster growth than
B. A’s share price will be higher than B’s because of the faster future growth and
therefore A’s P/E ratio will be bigger.
The P/E ratio is therefore a measure of the future earnings and dividend growth
of a company.


EG Learning example 7.5

Danny Stephan
Share price 200 pence 80 pence
EPS 10 pence 8 pence
Dividend per share 2 pence 8 pence
Number of shares 2 million 4 million

Which company is seen to have a better future by the market?

7.3.3 Dividend cover

Dividend cover is the number of times the dividend is covered by the earnings.

Individual share Total company

Earnings per share Profit after tax
Dividend cover = or
Dividennd per share Total dividend ds

G Learn

EG Learning example 7.6

Using Learning example 7.5, what is the dividend cover for each company?

7.3.4 Dividend yield

The dividend yield is the cash return from holding a share expressed as a percentage.

Dividend per share

Dividend yield = × 100
Price per share

Ratio Analysis

IE Illustrative example 7.3

Using Learning example 7.5, let us calculate the dividend yield.

Danny Stephan
Dividend yield (2p/200p) × 100 = 1% 8p/80p = 100 × 10%

The importance and interpretation of dividend yield

The dividend yield adds to our understanding of the company’s position. Stephan
is a very good investment for investors looking for high returns in the short term. It
appears to have a policy of returning as much of its earnings as it can to investors
thereby giving them a high yield on their investment. This results in lower dividend
cover and lower growth potential which lowers the P/E ratio. Danny offers a poorer
short-term return as measured by dividend yield, but offers higher mid- to long-term
prospects as its dividend retention policy offers higher future growth and therefore
capital gains.

Dividend irrelevancy theory

The above ideas lead to what is known as dividend irrelevancy theory-the idea of the
dividend yield is irrelevant because what matters is the earnings. The earnings can
either be paid out as a dividend with little growth prospects, or can be retained to
offer high growth.
If the individual investor wants dividends and the company is offering high growth,
the investor can sell a few shares to provide the required cash flow. If the investor
wants growth rather than dividends, he can take the dividends and reinvest to
achieve the longer term growth.
However, it is not as simple as that because:
• Investors tend to like some form of steady dividend.
• Tax influences the decision because dividends are taxed as income (which may
be 40% for investors), and capital growth attracts capital gains tax which can be
about 20% depending on annual allowances, etc.

7.3.5 Total Shareholder Return (TSR)

The TSR is the total return received by investor in return from holding a single share. It
constitutes both a realisable (cash) and unrealisable element (increase in share price)
and reflects the total wealth created for the investor.
TSR = Dividend per share + Capital gain per share / Share price at the start of the year


EG Learning example 7.7

The following information is taken for the accounts of A Ltd and B Ltd.

A Ltd B Ltd
Ordinary share price 100 pence 60 pence
Number of ordinary shares 1 million 3 million
Ordinary dividend per 3 pence 7 pence
Preference share dividend 5 pence 6 pence
Number of preference 800,000 600,000
PAT £200,000 £300,000

Calculate for A Ltd and B Ltd the following:
(a) Earnings per share
(b) P/E ratio
(c) Dividend cover
(d) Dividend yield

Æ Key Learning Points

• Learn the profitability ratios, which are useful to assess a company and compare
to its investment returns. (D1d)
• Learn the gearing ratios as they are important to help see the level of gearing a
company has and judge how high that level is. (E3c)
• Learn the investment ratios as they are important to assess the impact of the
company’s performance on financial position and financial risk. (E3d)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).

Ratio Analysis

Learning example solutions

EG Solution 7.1
The profit after interest will fall from £10m to £8.6m after deducting interest (£2m
less 30% tax saved), though we are not told how much any dividends paid amount to.
This will reduce the profit margin slightly.
More significantly though, the profit on capital employed will change from 10/42 =
24% to 8.6/22 = 39%.
Hence there is a significant benefit to the shareholders of using debt financing, they
are able to liberate their capital to invest in other companies. There are some risks if
the profits drop, as interest will still need to be paid.
Overall though it appears that it is beneficial for the shareholders to obtain debt
finance and especially so if profits rise as the increase will go to the shareholders.

EG Solution 7.2

Debt Bank overdraft 5
Debenture 8
Preference shares 1
Equity Ordinary shares 8
Share premium 4
Reserves 2

Equity gearing = Debt/Equity = 14/14 × 100 = 100%

Capital gearing = Debt/(Debt + Equity) = 14/(14 + 14) = 50%
1. The two measures mean the same thing even though one is 100% and the other
50%. This emphasises the importance in the exam of calculating the one that the
examiner asks for-read the question carefully.
2. You cannot say whether the 100% or 50% are good or bad unless you have some
comparator to set them against. The examiner may give you the industry average
for example-in that case you will be able to make some comment.


EG Solution 7.3

Debt Overdraft 5
6% debentures 30
5% preference shares 10
Total debt 45
Equity Ordinary shares 40
Share premium account 5
Revenue reserves 25
Total equity 70

(a) Equity gearing ratio

Debt/equity = (45/70) × 100 = 64%
(b) Total gearing ratio
Debt/debt + equity = (45/115) × 100 = 39%

EG Solution 7.4
EPS = £m (14 – 2)/6m = £2 per share

EG Solution 7.5

Danny Stephan
P/E ratio 200p/10p = 20x 80p/8p = 10x

The market must believe that Danny will grow its earnings faster than Stephan and
has therefore bid up its share to the higher level.

EG Solution 7.6

Danny Stephan
Dividend cover 10p/2p = 5x 8p/8p = 1x

The importance and interpretation of dividend cover

In the above example, Danny has the dividend covered 5 times and is only paying out
20% of its earnings as dividends. Stephan on the other hand has its dividend covered
only once and is paying out 100% of its earnings.

Ratio Analysis

Dividend cover can reveal two distinct things about a company:

• The company may be struggling to pay the dividend. We cannot tell this just from
the dividend cover, but it certainly may be the case that Stephan is struggling.
We need further information before we can make a decision on this (and the P/E
ratio and dividend yield may help here).
• The company may on the other hand simply have a different dividend
policy. Stephan may judge that there are insufficient alternative investment
opportunities available and that it should therefore pay as much money as it can
back to the shareholders so that they can make their own alternative investment
decisions. Danny may think otherwise and have sound investment plans for the
money it retains.
If you look back to the P/E ratio, the market certainly seems to interpret Danny’s
strategy in this way. The market expects Danny to reinvest the retained earnings and
this is where Danny’s extra growth comes from. The market expects Danny to grow
because it is retaining earnings; it does not expect Stephan to grow because it is not
retaining earnings.

EG Solution 7.7
Earnings per share = (PAT – Preference dividend)/Number of ordinary shares

A Ltd B Ltd
(a) (£200,000 − £40,000)/1,000,000 £0.16
(£300,000 − £36,000)/3,000,000 £0.09
(b) P/E ratio = current share price/EPS
(100p/16p) 6.25
(60p/9p) 6.66
(c) Dividend cover = EPS/ord dividend per share
(16p/3p) 5.33
(9p/7p) 1.29
(d) Dividend yield = dividend per share/current
price per share
(3p/100p) × 100 3%
(7p/60p) × 100 11.67%


Raising Equity Finance

This chapter concentrates on the methods of raising equity finance. Equity finance is
the permanent long-term finance of the company.
The examiner has asked a full question on this and closely related areas of the
syllabus so you need to be aware of the contents of this chapter and how equity
finance fits into the finance options of a company.

1. Can you describe the difference between a public offer and a placing?

2. How does a rights issue protect the existing shareholders?

3. Can you write down the formula for the TERP?

Raising Equity Finance

8.1 The meaning of equity finance

Equity finance is the finance of the company that represents the owners’ interest in
the company. The equity capital of the company is not restricted to the share capital
but includes funds, such as retained earnings, that also belong to the owners.

8.2 Source of equity finance for SMEs and unquoted companies

8.2.1 Providers of finance for SMEs and unquoted companies
Equity finance for ‘small and medium sized enterprises’ (SMEs) and unquoted
companies is provided typically by the following groups of people:
1. Personal funds of the founding owners
2. Retained earnings
3. Funds advanced by friends and family of the founding owners
4. Venture capital
The main features of venture capital (as seen earlier in this text) are:
– High risk/ high return. Venture capitalists are attracted to good, sound
new businesses because they offer the prospects of a high return albeit
with a high risk.
– Close relationship between VC and the company being offered finance.
Venture capitalists like to keep a close eye on the businesses they have
invested in. They will usually have a member on the board and will require
regular financial and operational reports on the progress of the business.
– Their involvement will be for about 5 or 7 years after which time they will
want to exit the company by selling their shares.
– In order to be able to exit the company at the time of their choice they will
agree the exit strategy with the company at the time of their investment.
Particular attention will be paid to the method of valuing their shares at the
time of exit because the company will be unlisted and there will therefore be
no market price.
5. Business angels. These are similar to venture capitalists except that
the amounts of capital they will provide is smaller. There will be similar
considerations about their exit.

8.2.2 Method of issuing and trading unquoted shares

Unquoted shares are shares that do not have a full listing on the UK Stock Exchange.

These unquoted shares may be traded on other markets for shares such as the
Alternative Investment Market (AIM).


Issuing unquoted shares

Unquoted shares can be issued with the minimum of regulation other than the
requirements of the company law of the relevant country. These requirements will
usually govern such things as the
• registration of the company and
• filing the company’s accounts

Trading shares of unquoted companies

Unquoted shares may be traded as follows in the UK. Other countries will have
similar arrangements.
• They may be shares of private companies. These will typically be the shares
of family companies whose shareholders are members of the family which
collectively owns the company. Such shares will be bound by terms which will
restrict the ability of the owner to sell them to anyone other than a restricted
group of people, eg members of the family.
• Alternatively unquoted shares may be traded on a market that is not the main stock
market. In the UK this would be the Alternative Investment Market (AIM) or OFEX.
• These markets do have regulations for companies that wish to trade shares
on them, but such regulations are considerably simpler than the regulations
governing shares with a full listing on the main Stock Exchange.
• In addition, the shares can be traded through private equity deals ie private
arrangements between wealthy individuals or institutions who specialise in the
trading of these types of shares.

8.3 Issuing and trading quoted shares

A quoted share is a share that has a full listing on the UK Stock Exchange.

8.3.1 Public offer

Quoted shares for a new company are sold to members of the public or institutions by
way of an Initial Public Offering (IPO). This is referred to as ‘going public’ or a ‘flotation’.
The procedure has the following stages:
• The company issues a prospectus which outlines the financial position of the
company, its strategy and the terms of the shares on offer.
• The company’s shares or a large part of them are acquired by an issuing house.
An issuing house is a merchant bank which specialises in this work.
• The issuing house, or other specialist firm, may underwrite the offer so that in
the event that the offer is not fully subscribed (ie not all the shares are bought),
the underwriter will purchase the unsold shares itself thereby ensuring that the
company receives the full proceeds from the offer.

Raising Equity Finance

• The issuing house offers the shares to the public (and institutions) and the
shares are sold.

8.3.2 Advantages of a listing

A listing gives companies significant advantages. In the UK a listing on the Stock
Exchange has the following advantages:
• Access. The market allows easy access to new funds and offers investors a ready
market for their shares.
• Prestige. The Stock Exchange is well regarded round the world and a company
that obtains a listing is seen to be a reliable company.
• Growth. The company can grow by acquisition by using its own paper to buy
other companies. It does this by issuing its own shares to the shareholders in the
bought company in exchange for their existing shares in the bought company.
Thus, no cash is required.
• Visibility. The company receives marketing advantages for its shares and brand/
image by being listed.
• Accountability. The shareholders have confidence that the company is
accountable to the Stock Exchange regulations.
• Responsibility. The company has to act in a responsible way which creates
confidence in the investing public.
• Regulation. The company has to abide by the rules of the Stock Exchange.

8.3.3 A placing

A placing is a method of raising equity finance by approaching a restricted number of
institutional investors, pension funds or individuals of high net worth and selling large
packages of shares to these persons. The placing will generally be undertaken by a
merchant or investment bank who will act as the intermediary and broker the deals.

It has the advantage that it is a relatively inexpensive process and avoids much of the
paperwork and regulation that applies to other forms of financing.
Such shares can be listed on the Stock Exchange with all the benefits described above.
The placing has the advantage that it is simpler and cheaper than the IPO and there
are fewer regulations governing how the placing should be managed.


8.3.4 Stock exchange introduction

An introduction is the process of obtaining a listing for a company’s existing shares.
The shares may already be quoted on the main stock market of another country, but
the company may seek the advantages of trading on the UK Stock Exchange.

P Principle
Be able to describe the differences between the different
ways of publicly raising equity

8.4 Rights issue

A rights issue is the right of existing shareholders to subscribe to new share issues
in proportion to their existing holdings. This is to protect the ownership rights of
each investor.

These are known as pre-emptive rights because the company is prevented in

law from offering new shares to non-shareholders unless it has offered them to
existing shareholders first. The reason for this is that it would be unfair on existing
shareholders who had perhaps funded a risky start-up to have their share of the
company diluted by new shareholders who buy into a stable, profitable concern.

8.4.1 Procedure of a rights issue

• The issuing company may issue a prospectus (not necessary in all cases) to the
existing shareholders offering them new shares in proportion to their existing
holdings. For example, a ‘1 for 3’ rights issue would mean that a shareholder
could purchase one new share for every three they currently hold.
• The shares are acquired by an issuing house who sells them to the shareholders
who wish to take up the rights. The issuing house may underwrite the issue.
• The issue price will generally be priced below the current price as an incentive to
shareholders to take up the issue.

8.4.2 Advantages of a rights issue

• Low cost. It is much cheaper to make a rights issue than an IPO.
• The rights issue protects the ownership rights of existing shareholders.
• Rights issues rarely fail if they are priced correctly.

G Learn

Raising Equity Finance

8.4.3 Theoretical ex-rights price (TERP)

Cum-rights is a phrase that refers to the price of the shares when the rights issue has
been announced-it means ‘with rights’.

Ex-rights refers to the price of the shares after the rights have been issued and traded
– it means ‘without rights’.

When the rights issue is announced the share price may rise or fall depending on
market sentiment and whether the existing shareholders think that the raising of new
equity is a good thing and likely to boost future profits and the future share price.
Similarly the actual share price after the issue (the ex-rights price) will rise or fall for
similar reasons of shareholder sentiment. (Note that general increases or decreases
in share prices across the market as a whole will also affect prices). However if
sentiment is neutral one might expect the ex-rights price to fall simply because the
new shares have been issued at a discount.
We can calculate a theoretical ex-rights price. This is not a projection of what we
think the share price might be after the issue. It is simply a mathematical calculation
of the effect of the additional cash and additional shares on the existing share price.
It is calculated using the following formula:
MV of shares (cum-rights) + Proceeds of rights issue
Theoretical ex-rights price =
Number of shares (ex-rights)

IE Illustrative example 8.1

Marcus plc, which has an issued capital of 4,000,000 shares, having a current market
value of £2.80 each, makes a rights issue of one new share for every three existing
shares at a price of £2.00.
Let us calculate the TERP.
TERP = ((4m × £2.80) + (4m × 1/3 × £2.00))/(4m × 4/3) = £2.60 per share
An alternative calculation for this is as follows:

Value of 3 existing shares = 3 × 2.80 = £8.40

Value of 1 new rights share = 1 × 2.00 £2.00
Total of 4 shares £10.40
Theoretical ex-rights price per share = £10.40/4 = £2.60


8.4.4 Value of a right

The new shares are issued at a discount to the existing market value, and this gives
the rights themselves some value. The value of the right is the difference between
the TERP and the issue price of the new shares.
Value of a right = Theoretical ex-rights price – Issue price

G Learn

EG Learning example 8.1

Using the information from Illustrative example 8.1, calculate the value of the rights.

8.4.5 Shareholder options

1. Take up (buy) the rights
2. Sell the rights
3. A bit of both
4. Do nothing.

IE Illustrative example 8.2

A shareholder had 10,000 shares in Marcus plc before the rights offer.
Let us calculate the effect on his net wealth of each of the following options:
(a) Take up the shares,
(b) Sell the rights,
(c) Do nothing.
We shall compare the shareholder’s wealth before and after he/she takes his action
by considering what he/she has put into the transaction and what he/she gets out of
the transaction.
(a) Takes up rights

Puts into the transaction Gets out of the transaction

Shares 10,000 × £2.80 = £28,000 Shares 10,000 × 4/3 × £34,666
£2.60 =
Cash 10,000 × 1/3 × £2.00 = £6,666
Total £34,666

There is no gain or loss for the shareholder.

Raising Equity Finance

(b) Sells the rights

Puts into the transaction Gets out of the transaction

Shares 10,000 × £2.80 = £28,000 Shares 10,000 × £2.60 = £26,000
Cash 10,000 × 1/3 × £0.60 = £2,000
Total £28,000

Again there is no gain or loss for the shareholder.

(c) He/she would lose the rights value of the shares, although if the company
managed to sell them the company would send him/her the proceeds so
that he again made no gain or loss.
Provided the shareholder sells the rights or takes up the rights his/her wealth
will not change.

EG Learning example 8.2

A company has issued capital of 2,000,000 shares with a current market value of
£2.00 per share. It makes a rights issue of 1 for 4 at an issue price of £1.50.
(a) Calculate the TERP.
(b) Demonstrate that a shareholder with 5,000 shares is no better off before and
after the rights issue if he or she takes up all his rights.

8.4.6 Actual share price after rights issue

A rights issue is made for a variety of reasons, one of which will be to invest the
proceeds in a new project that will create new earnings for the company. It is
important for the exam that you can calculate the actual share price after a rights
issue given certain information by the examiner and compare this to the theoretical
ex-rights price. We have seen that the shareholder is no better off if you compare
his/her wealth before and immediately after the rights transaction. However that
calculation is based on the theoretical ex-rights price. In practice, shareholders
would hope that the new cash raised could be invested in a way that will increase the
profitability of the company and leave them better off in terms of their net wealth.
A standard technique is to use the P/E ratio together with details of expected
growth of earnings after a rights issue to decide if the shareholders will have a net
increase in wealth.


EG Learning example 8.3

PE Promotions Ltd is planning a new investment that will cost £1,000,000.
It is planning to raise this amount by means of a 1 for 4 rights issue. The current share
price is £3.25 and the rights issue price will be £2.50.
The company’s P/E ratio is 8 and is not expected to change.
It is expected that the total earnings after the investment will be £900,000 per annum.
(a) Calculate the theoretical ex-rights price immediately after the rights issue
(before the new investment)
(b) Calculate the change in the share price after the new investment has been made.

EG Learning example 8.4

A business currently has earnings of £200,000 per annum.
It is proposing a rights issue of 1 for 3 to raise £500,000 at an issue price of £1 per
share which will yield additional earnings of £50,000 per annum. The expansion will
enable the existing business to grow at 5% per annum.
The P/E ratio is 9 and is expected to remain stable.
Calculate the share price after the investment has been made.

Æ Key Learning Points

• Learn how unquoted companies and small and medium enterprises (SMEs) can
raise equity. (E2b)
• Learn the various methods by which quoted companies can raise equity. (E1c)
• Know the advantages of a listing. (E1c)
• Be able to explain the procedures and advantages of a rights issue. (E1c)
• Be able to calculate the potential gains to shareholders from a rights issue. (E1c)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).

Raising Equity Finance

Learning example solutions

EG Solution 8.1
The value of the right = £2.60 − £2.00 = £0.60
Thus a third party would pay:

Value of rights per share £0.60

Issue price of new shares £2.00
Total paid £2.60

As this is the theoretical ex-rights price, the new shareholder has broken even.

EG Solution 8.2

(a) Value of 4 shares £2.00 × 4 = £8.00

Value of 1 rights share £1.50
Total value of 5 shares £9.50
TERP £9.50/5 = £1.90

Alternative calculation
TERP = ((2,000,000 × £2.00) + (500,000 × £1.50))/2,500,000 = £1.90

(b) Puts in the transaction Gets out of the transaction

Shares 5,000 × £2.00 = Shares 5,000 × 5/4 × £1.90 = £11,875
Cash (5,000/4) × £1.50 =
Total £11,875 Total £11,875


EG Solution 8.3

(a) Value of four shares = £3.25 × 4 = £13.00

Value of 1 rights issue share = £2.50
Total value of 5 shares = £15.50
Theoretical ex-rights price = £15.50/5 = £3.10

(b) Tutorial note. Before setting out on this part of the answer, stop and think
where you are going and how you are going to get there. You are asked for the
change in the share price after the investment has been made. You have already
calculated the starting share price (the TERP) so you have to calculate the final
share price. The examiner can give you all sorts of information that you have to
sort out to get this, but he is most likely to give you the P/E ratio (in fact the ‘P/E
ratio method’ is a standard way of doing this).
To use the’ P/E ratio method’ the examiner will give you the P/E ratio (or the
means of calculating it), and the earnings (or the means of calculating them).
From these two you can calculate the required price.

Step 1 Calculate the earnings

In this case the question gives this to you = £900,000
Step 2 Calculate the earnings per share
Number of new shares issued = amount to be raised/issue price
= £1,000,000/£2.50 = 400,000 shares
Existing number of shares = 400,000 × 4 = 1,600,000 shares
Total number of shares in issue after rights = 2,000,000
Therefore EPS = £900,000/2,000,000 = £0.45
Step 3 Calculate the share price after the investment
The question gives you the P/E ratio = 8
EPS = £0.45
Therefore the share price = 8 × £0.45 = £3.60
Step 4 Calculate the change in the share price
Note that this is the difference between the TERP and the
final share price.
Difference = £3.60 − £3.10 = £0.50
Therefore the rights issue has been worthwhile for the investors.

Raising Equity Finance

EG Solution 8.4

Step 1 Calculate the earnings

Earnings from existing business = £210,000
£200,000 × 1.05 =
New earnings £50,000
Total earnings £260,000
Step 2 Calculate the total number of shares
New shares issued = £500,000/£1 = 500,000 shares
Existing shares = 500,000 × 3 1,500,000 shares
Total shares = 2,000,000 shares
Step 3 Calculate earnings per share
Total earnings = £260,000
Number of shares = 2,000,000
EPS = £260,000/2,000,000 = £0.13
Step 4 Calculate the new share price
New share price = EPS × P/E ratio =
£0.13 × 9 = £1.17


Working Capital Management

Working capital (including receivables, inventory and payables) management is a vital
element in the planning of a business’s finances, affecting the liquidity of a business.
Having working capital enables the production and sales function to operate but it
also represents net assets tied up, which costs the company money. The aim when
considering the amount of working capital that a business should have is to balance
the need for working capital against the cost.
Overtrading is a problem that affects some companies and shows how profitability is not
enough for survival – liquidity is also important. In addition companies have to consider
how working capital should be financed, and the sorts of debt that should be taken on.
The treasury function is an important part of most larger companies. This function
allows companies to control their short-and long-term liquidity as well as other risks
in their business.
Working capital management is a topic that is divided into several separate elements.
They are all governed by the company’s overall strategy but in the exam they tend to
be examined separately.

1. Can you give two advantages and disadvantages of running a treasury

department as a profit centre?

2. Do you know the parts of the operating cycle and how to calculate their length?
3. Can you use the EOQ model, and do you know which cash management model
it is most similar to?

Working Capital Management

9.1 The treasury function

The treasury department/function is often a separate department in many large
companies that allows those companies to:
1. Obtain short-term finance via the money markets
2. Control risks such as foreign exchange and interest rates
3. Access longer-term finance via the capital markets.

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 the strategies, policies and procedures of corporate finance.

The treasury department is often set up to provide these services to the whole of
a group of companies. Alternatively the treasury department might be set up on a
company or divisional level. However a lot of expertise is needed in this department so
a careful decision is needed on which level of a group to best set it up, balancing the
cost of the department against the knowledge of the group companies that is needed.
The aims of the treasury department include:
1. Maximising liquidity
2. Mitigating operational, financial and reputational risks
And may have various specialist parts, such as a money markets desk, a foreign
currency desk and an equities and/or bonds desk, if these are required.

9.2 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 much treasury practice where large companies tend to have a centralised function.
Setting the treasury department up at a group level can have benefits for control of
cash. One division within a group may have excess cash whilst another may require
cash. If there are separate treasury departments in each division the opportunity
of using the excess cash may not be apparent and hence the company may lose the
chance to offset the cash balances.


9.2.1 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
keener interest rates and less onerous 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 risk. One such area is the foreign currency risk of the
business. If there is a division that is selling to the US in dollars and another buying
from the US in dollars then it makes sense that the control of the dollar accounts
falls under one central function thereby reducing exposure to risk in this area.

9.2.2 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.

9.3 Profit centre vs cost centre

Should the treasury department be run as a cost centre or a profit centre?

A cost centre is a function to which costs are accumulated.

A profit centre is a function to which both costs and revenues are accounted for.

9.3.1 Advantages of using a profit centre

1. The treasury department is given ‘a value’ which charges the use of the service
to the divisions, thereby making them recognise its value as well as its cost and
therefore controlling the use that the divisions make of it.
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 made
by an operations department of the company, thereby saving the company money.
4. The department may gain other business from external companies if there is
surplus capacity within the department–but this is very rare and only applies to
very large companies.
5. Speculative positions may be taken that gain substantial returns to the business–but
this can be a very dangerous operation as it is outside the core business operations.

Working Capital Management

9.3.2 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.

9.4 Working capital management – an overview

9.4.1 The purpose of working capital
Working capital is the net of current assets minus current liabilities.

Current assets Inventory x

Receivables x
Cash/bank x
Current liabilities Payables x
Bank overdraft x
Working capital X

G Learn
9.4.2 The conflict between liquidity and profitability
The aim of working capital management is to achieve a balance between having
sufficient working capital to ensure that the business is liquid, but not so much that
the level of working capital reduces profitability due to the extra cost of financing the
working capital.

By liquid we mean primarily that the business has sufficient stock and cash so that it
can trade without worrying about running out or stock or cash.

However, note that whilst we are used to the idea that current assets (like any assets)
are ‘good’ and liabilities are ‘bad’, when considering the profitability of the company
this is not the true picture. Current assets cost the company money in the sense


that they represent cash tied up, which has an opportunity cost of the interest lost.
Similarly current liabilities are good (eg trade credit) because they are an interest
free way of financing the business.

The balance
Thus we have to try to:
• minimise current assets, ensuring that they are sufficient for the
business’s needs, and
• maximise current liabilities or rather the trade payables as a free source of
finance (an overdraft costs money). However, when maximising trade payables
great care must be taken to ensure that creditors are not disadvantaged in the
sense that we must try to adhere to their terms of trade, particularly the timing
of payments. Paying late is a dangerous way of minimising working capital.
The various elements of working capital are managed individually.
• In general terms we minimise the sum of (inventory + receivables – payables).
• Cash is effectively the balancing figure which we can always invest if the balance
is sufficiently greater than our working capital needs.
The balance can be expressed as:

Keep the
Have sufficient working requirement
capital to avoid to a minimum
running out to avoid the
of cash financing cost

9.4.3 Influences on the level of working capital

1. The nature of the business. Different industry types require different levels of
working capital.
– Service industries need very little, if any
– Retailers need more, but depending on the retailer (perishable goods or
non-perishable goods for example) their inventory requirements will vary
– Manufacturers will probably require more because they need raw material
stocks, work in progress and final goods.

Working Capital Management

There are ways of minimising inventory costs.

– Retailers may sell mainly for cash and so have few receivables
– Producers may have trade customers and will have receivables
2. Certainty in supplier deliveries. If there is uncertainty in supply, the level of
inventory will be greater.
3. Level of activity. If the level of activity increases (ie if sales increase), one would
expect receivables and payables to increase in line with the sales. Similarly
inventory would probably also increase. Thus the overall level of working capital
would increase.
4. The company’s operating cycle is important to understand for a business.

9.5 The working capital (operating) 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. It is also known as the cash cycle or trading cycle.

Purchases Sales Receipt

Inventory Receivables

Operating cycle


9.5.1 Calculating the number of days in the operating cycle

The operating cycle illustrated above is made up of three elements:
• The inventory turnover period (also called inventory days)
• The average collection period (also called receivables days)
• The average payable period (also called payable days)


We can then say that the operating cycle = inventory days + receivable days
− payable days

G Learn
The idea behind these three periods is to calculate the length of time (measured in
days) that the statement of financial position item (inventory) lasts, until it is used up.
Clearly that depends on how fast the business sells it, and this information is given to
us by the statement of profit or loss item, sales.
In general, the calculation is as follows
Statement of financial position amount
Days = × 365
Statement of profit or loss amount
We shall see why this is the case in the following example.

9.5.2 Receivables turnover period

Consider the following information taken from a company’s statements

Statement of profit or loss (SPL) Statement of financial position (SFP)

Sales $600,000 Receivables $100,000
Gross profit $200,000 Inventory $80,000
Payables $120,000

We shall first calculate the receivables turnover period using the above formula.
Statement of financial position amount
Days = × 365
Statement of profit or loss amount
Statment of financial poosition amount
Days = × 365
Statement of profit or loss amount
Dayss = × 365
= × 365
= 60.8 daays
You may understand this better if you consider that what we are doing is calculating
the sales per day ($600,000/365 = $1,643) and then dividing that into the receivables
balance ($100,000). This tells us how many days sales make up this balance, which
tells us how long on average it has taken the debtors to pay (60.8 days).

Working Capital Management

9.5.3 Inventory turnover period

Days = × 365
Cost of sales (or purchases)
Note the cost of sales = sales – gross profit = $600,000 – 200,000 = $400,000
Therefore inventory days = ($80,000/$400,000) × 365 = 73 days

9.5.4 Average payable period

Days = × 365
Cost of sales (or purchases)
Therefore payable period = ($120,000/$400,000) × 365 = 109.5 days
The operating cycle will therefore be (61 + 73 – 110) = 24 days
This is the length of time it takes from paying our suppliers to receiving the money
from our debtors.
Note that in the above calculation of payable days we could have used the purchases
rather than the cost of sales. However we are seldom given the purchases figure in
the exam and the cost of sales will have to be used.

9.5.5 The importance of the operating cycle

The operating cycle is important because it determines the amount of working
capital a business needs. If you can halve the operating cycle you will halve the
working capital requirement of the business.
Many companies will try to reduce their operating cycle as the smaller the net
current assets they have the less financing they require. The less financing the
cheaper the cost of financing (eg interest cost) for the business.
However, most companies will be subject to the type of industry that they operate
in. A supermarket, for example, will have to hold stock on a day-to-day basis in order
to satisfy its customers. However the supermarket could use the fact that they are
large relative to their suppliers to increase the payables days in order to reduce the
length of the operating cycle.
For other organisations they may decide to take a more or less aggressive attitude to
the amount of current assets they hold. An aggressive approach means holding less
current assets. This will often be affected by the industry characteristics though.
If the organisation can obtain more of the current assets quickly then they are likely
to be more aggressive so hold fewer current assets.


IE Illustrative example 9.1

The following are extracts for A Ltd:

Statement of profit or loss extract $

Turnover 250,000
Gross profit 90,000

Statement of financial position extract $ $

Current assets 30,000
Inventory 60,000
Current liabilities 90,000
Payables 50,000

Let us prepare the operating cycle.

Receivable days = (60,000/250,000) × 365 = 88 

Inventory days = (30,000/160,000) × 365 = 68 
Payable days = (50,000/160,000) × 365 = (114)
Total days 42 

Note – the cost of sales = $(250,000 – 90,000) = $160,000

Working Capital Management

EG Learning example 9.1

Extracts from X Ltd accounts are as follows:
Statement of profit or loss

Turnover 100
Cost of sales 50

Statement of financial position

Inventory 10
Receivables 15
Payables 12

Prepare the operating cycle.

9.6 Overtrading (under-capitalisation)

Overtrading is the term applied to a company which rapidly increases its turnover
without having sufficient capital backing, hence the alternative term ‘under-

We can describe overtrading by saying that:

• the permanent funding of the business is less than the funding needs
• the business is unable to pay its suppliers as they fall due.
Overtrading has two main reasons:
• Fast growth of sales–this can develop into a problem.
• Loss of permanent finance. This may be caused by a bank withdrawing a loan
set up to finance the startup of the company, or perhaps a loan has come up
for renewal and the company has insufficient funds to redeem the original loan
because it is short of funds.


9.6.1 Overtrading caused by fast sales growth

It seems paradoxical that fast sales growth should be the cause of the problem but
overtrading tends to follow a fairly standard pattern of expansion and declining liquidity:
• Output increases 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 increased 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.

9.6.2 Measures of overtrading – 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 out of the very liquid current assets (ie
excluding stock which is not very liquid).
Current ratio Current assets minus stock

 or acid test  Current liabilities

• Bank balance
A fairly obvious sign of overtrading is the change in the bank balance from a
surplus to a deficit. A bank overdraft is not in itself a problem but an increasing
overdraft is and the bank may withdraw the overdraft with little notice.
• Payable days
If payable days (the time taken to pay suppliers) are getting longer, that suggests
that the cash position is worsening.
Similarly, if the payable days are longer than the industry average, which
suggests that the company may be exceeding the supplier’s terms of trade and
the supplier may cut off supplies.

Working Capital Management

• Changes in level of activity

If the level of activity rises sharply then this is an obvious indicator that
overtrading may be taking place, particularly in a new business.

P Principle
Know why these measures reflect overtrading

9.6.3 Summary
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 in liquidity problems and even bankruptcy.
Note that the problem of overtrading is not that the company is unprofitable.
The company may be making good profits. The problem is that the company has
run out of cash.
The fundamental solution to overtrading is to replace short-term finance with long-
term finance such as a term loan or equity funds.


9.7 Funding working capital

Short-term sources of Long-term sources of

finance finance
Examples Bank overdraft Equity
Trade payables Long-term debt

9.7.1 Advantages of short-term finance

• Cheaper. Short-term finance is cheaper than long term because lenders need to
be compensated for having their money tied up in a loan for a long period. This
is referred to as ‘liquidity preference’ and simply reflects the fact that investors
prefer to be liquid.
• Flexible. An overdraft offers a very significant benefit to a business seeking to
finance its working capital. The amount of finance needed will typically fluctuate
considerably over the operating cycle. If bulk purchases have been made from
a supplier, there may be an increased demand when the payment for these
purchases is due. Similarly, the receipt of a large sum from a debtor can reduce
the pressure on the funding requirement. If the funding is provided by a fixed
loan, then the business is paying a fixed amount of interest even though all of
the loan is not being utilised. On the other hand, if an overdraft is being used, the
business will only pay interest on the amount of the overdraft.
• Easy to arrange. An overdraft is simple to arrange compared with a formal sale of
loan stock on the markets. It is also normally unsecured on the company’s assets
and does not need any of the formality of organising charges on these assets.

9.7.2 Advantages of long-term finance

• The funds are permanent and will run for the full term of the loan. One of the
main disadvantages of the overdraft is that it is repayable on demand, a fact that
could seriously damage the company.
• There is no need to continually have to renew the finance. Equity is of course
genuinely permanent and will not normally be repaid.

9.7.3 Permanent and fluctuating current assets

Permanent current assets

Permanent current assets are the normal level of stock and debtors that the
company needs in order to keep the business going. The company will always need
a certain amount of stock to sell, and having sold it, it will always have the level of
debtors that results from those levels of sales. These are not individual assets that will
never change, ie we do not mean inventory that the business cannot sell.

Working Capital Management

Fluctuating current assets

Fluctuating current assets are the levels of current assets (stock and receivables) that
fluctuate with the seasonal nature of the business, or with the unpredictable large
purchase or sale of inventory.

The effect of these two types of current asset can be illustrated in the following diagram.
Non-current assets have been added to the diagram to give the complete picture of
the funding requirement of the business.


Permanent funds or
current assets Long-term

Non-current Long-term
assets funds


9.7.4 Matching funding to the type of asset (the matching principle)

The general principle is that the term of the funding should match the long- or short-
term nature of the assets being funded.
A. Non-current assets
These will always be funded by debt or equity. The assets are permanent
and their cost is fixed at the date of acquisition so there is no question of any
fluctuation in their value.
B. Permanent current assets
These may be financed with either short- or long-term funding


Aggressive funding policy is to use short-term funds to finance the permanent
working capital. This is cheaper but high risk because short term funds such as bank
overdrafts can be recalled on demand, and even 1 or 2 year loans need regular
renewal, which also carries risk.

Conservative funding policy is to use long term funding for the permanent
working capital.

C. Fluctuating working capital

This will generally be financed by short term funding – typically a bank overdraft.

P Principle
Know why particular assets are financed as they are

Factors to determine working capital funding strategies

The factors that are likely to affect working capital funding strategies are as follows:
1. Management attitude to risk – are they willing to use more short-term funds and
take the risk that they will sometimes have to suffer higher interest costs?
2. Previous funding decisions – have they got a good track record on determining
the right level of funding? Alternatively, once bitten, twice shy!
3. The size of the organisation – are they big enough to suffer any extra costs
reasonably easily or could their business be fundamentally affected by a
wrong decision?

9.8 Short-term sources of finance

9.8.1 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.

9.8.2 Invoice discounting

Invoice discounting is a service 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.

Working Capital Management

9.8.3 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.

9.8.4 Overdrafts
A source of short-term funding which is used to fund fluctuating working capital
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’.

9.8.5 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.

9.8.6 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 in the terms of the bill.

9.9 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.

9.9.1 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.

9.9.2 Finance lease

A type of asset financing that appears initially very similar to hire purchase. Again
the asset is paid for over a period of 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.


9.9.3 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 such as plant hire. Alternatively, assets that the company uses in the long
term may be leased if the company would prefer not to own those sorts of assets, eg
a company vehicle or photocopier.

9.10 Managing receivables

Offering credit is a balancing act.
The benefit is the fact that credit encourages customers to do business with us. Most
other companies will offer credit and companies have to follow the industry norm.
The disadvantage of offering credit is that there are costs associated with it:
• Bad debts
• Slow payers that increase our working capital
• The administration of the sales ledger and debt collection

Offering credit
Offering credit introduces risk of
encourages default, defers
customers inflow of cash
to take up and needs
our goods managing

There are three aspects to credit management:

1. Assessing credit status
2. Deciding the terms on which credit will be offered
3. Day-to-day management.

G Learn

Working Capital Management

9.10.1 Assessing credit status

The creditworthiness of all new customers must be assessed before credit is offered.
Existing customers must also be re-assessed on a regular basis. The following may be
used to assess credit status of a company:
1. Bank references. The bank is always the first port of call. It will be able to
comment on whether the potential customer is sound for the terms that the
company proposes to offer. The bank reference will typically be guarded and will
not make any explicit assertions, but will be based on its experience of how the
potential customer has managed its account.
2. Trade references. Also very important. Again they will typically be carefully
worded but will alert the company to any problems that the referee company
may have experienced.
3. Published accounts. Very useful to be able to see how well the customer is
capitalised and whether its level of working capital is causing stress to its finances.
4. Credit rating agencies. Only really applicable to larger companies.
5. Company’s own sales records. This is not useful for a new customer but will be
invaluable when reassessing whether a customer should continue to receive credit.

9.10.2 Terms of trade

Given that we are willing to offer credit to a company, we must now consider the
limits to the agreement.
This may include:
1. Credit limit value. For a new customer this credit limit should be set to a
relatively low amount. As time passes, if the customer has not missed payments
or posed other problems then the limit can be increased.
2. Number of days’ credit. This is very important. Again, it should be set fairly
tightly for a new customer so that any problems will be recognised quickly.
3. Discount for early payment. This is a very good way of encouraging payment and
reducing outstanding debtors. However there are two main problems with it:
– Customers frequently abuse the system – paying late and still taking the
discount – the process has to be well policed and care taken not to upset
customers by over-aggressive chasing of relatively small amounts.
– The cost has to be carefully monitored. Too high a level of discount will cost
more than the cost of the working capital finance.
4. Interest on overdue accounts. Another useful encouragement but not widely
used. The amounts involved are typically fairly small; customers frequently pay the
amount of the original invoice without the added interest and the cost of chasing
these small amounts is expensive and corrodes the relationship with the customer.


9.10.3 Day-to-day management of collecting amounts owing

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 as follows:

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

• The important consideration in all the above is to remember that the aim is to
recover the money and keep the customer.
• Some companies will have a policy of telephoning the debtor at some point in
the process to enquire about any problems.
• Letters should always ask for the reasons for non-payment. Perhaps the goods
were returned or faulty and no one has told the accounts department.
• Communication is the key.

9.11 Cost of financing receivables

9.11.1 The total cost for a year
The receivables balance needs to be financed and it is important that a company
knows how much the receivables are costing it in the course of a year. The interest
rate to be applied to receivables will usually be the overdraft rate that is financing
the working capital. Any change to the receivables balance will lead to a change in
the financing cost of the business.
Interest cost = Receivables balance × Interest rate
It may also be useful to be able to calculate the receivables balance from the sales
and receivables days (it depends on the information given in the question).
We have already seen the formula for calculating receivables days
Receivables balance
Receivables days = × 365
Therefore, rearranging
Receivables days × Sales
Receivables balance =

G Learn

Working Capital Management

EG Learning example 9.2

Consider the following data for A Ltd.

Sales $10m
Receivables $3m
Interest rate 6%

(a) The receivables days
(b) The cost of financing receivables.

9.11.2 Discounts for early settlement

Early settlement 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 receivables balance and a shorter average collecting period.

IE Illustrative example 9.2

A Ltd (from Learning example 9.2) offers a 0.5% discount to customers who pay after
30 days (ie they pay at 30 days after the sale) rather than the current average of
109.5 days. 40% of customers are expected to take up the offer.
What is the cost of financing the receivables?

Step 1 Calculate the receivables balance for those who continue with the
existing terms (60% of customers).
Receivables balance = ($10m × 60% × (109.5/365)) = $1,800,000
(Alternative calculation of receivables balance for this part of the
question would have been $3m × 60% = $1,800,000. However note
that this will not work for the customers who pay after 30 days.)
Step 2 Calculate the receivables balance for those who pay after 30 days.
Receivables balance = ($10m × 40% × (30/365)) = $328,767
Step 3 Calculate the interest cost of these to A Ltd.
($1,800,000 × 0.06) + ($328,767 × 0.06) =
$108,000 + $19,726 = $127,726
Step 4 Calculate the cost of the discount.
$10m × 40% × 0.5% = $20,000
Therefore total cost of finance = $127,726 + $20,000 = $147,726


EG Learning example 9.3

Shankley Limited has sales of $40m for the previous year and receivables at the
year-end were $8m. The cost of financing debtors is covered by an overdraft at an
interest rate of 14%.
(a) What are the receivables days for Shankley?
(b) Calculate the cost of financing receivables.

EG Learning example 9.4

Shankley (from Learning example 9.3) is considering offering a discount of 2% for
payment within 10 days.
Should the company introduce the discount given that 50% of the customers take up
the discount?

9.11.3 Advantages and disadvantages of early settlement discounts

1. Early payment reduces the debtor balance and hence the interest charge.
2. May reduce the bad debts arising.

1. Difficulty in setting the terms. Set too high and too many customers take the
discount costing too much – set too low and not enough customers take it and it
is ineffective.
2. Greater uncertainty as to when cash receipts will be received. The company
cannot know how many people will pay early or stay with the current terms.
3. May not reduce bad debts in practice.
4. Customers may pay over normal terms but still take the cash discount.

Working Capital Management

9.12 Factoring
There are three main types of factoring service available:
1. Debt collection and administration
Factors offers a wide range of different services to companies.
– Collection of debts with the company being paid a certain amount in
advance of the monies being collected.
– Monies collected only being paid to the company after collection.
– Taking over all or part of the client’s sales ledger, from the actual invoicing itself
to the collection of the debts, and all the administration of the entire process.
2. Credit insurance
Factors will offer a whole range of insurance options, ranging from insuring all
the debts to insuring only sections of debts as agreed with the company. There is
an important bit of terminology in this context:
The factoring may be with recourse or without recourse.
– With recourse factoring means that the factor does not insure the debts and
any bad debts will be borne by the company,
– Without recourse factoring means that the factor takes on the risk of non-
payment and therefore insures the debt.
3. Financing
One of the main benefits of factoring is that it should not only enable the
company to receive the money from debtors more quickly, but the factor should
also be able to save the company money when considering the costs of the
whole process. There are typically three types of costs that are relevant here:
– The reduced cost of the receivables caused by quicker collection
– The factor’s fee
– The reduced cost of the company’s administration.
An example will illustrate this.

G Learn

IE Illustrative example 9.3

Continuing our example using A Ltd. Rather than offer a discount, the company has
been offered a contract by a factor whereby the factor offers to collect the debts for
a fee of 0.75% of turnover. They believe they can collect the debts in 80 days. Admin
savings of $20,000 are expected.


Should A Ltd accept the offer?

Interest cost = $10m × 80/365 × 0.06 = 131,507 

Fee = $10m × 0.0075 = 75,000 
Admin saving (20,000)

This is more expensive so the offer should be refused on financial grounds.

9.12.1 Advantages of factoring

• The company benefits from improved cash flow as it effectively receives
immediate payment, less the fee.
• Saving in internal administration costs will be made.
• Particularly useful for small and fast growing businesses where the credit control
department may not be able to keep pace with volume growth.
• Reduction in the need for day to day management control. The whole
administration of debt collection is taken away from the company, allowing
managers more time to run the business.
• 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.

9.12.2 Disadvantages of factoring

• Should be more costly than an efficiently run internal credit control department.
• Factoring has a bad reputation, sometimes being associated with failing
companies. The company’s customers may be concerned that the company has
cash flow problems and be wary of dealing with the company – if they are looking
for a secure source of supply they may be worried that the company may fail.
• Customers do not like dealing with a factor. The general perception of customers
is generally negative towards factors – customers like to think that their suppliers
can manage their own affairs.
• Once you start factoring it is difficult to revert easily to an internal credit control.
• The company may give up the opportunity to decide to whom credit may be given.
• Factors are generally more aggressive towards the company’s customers
because their job is to collect debts and not worry too much about customer
care. This is particularly the case if the factoring is without recourse, as the
factor will bear any bad debts.

G Learn

Working Capital Management

EG Learning example 9.5

X Limited has sales of $30m for the year and receivables at the year-end were $7m.
The cost of financing debtors is covered by an overdraft at an interest rate of 9%.
A factor has offered to take over the debt collection for a fee of 0.6% of turnover. It
will collect the debts in 60 days and pay the cash collected to X Ltd at that time. The
administrative saving for X Ltd will be $120,000.
(a) Receivables days for X Ltd without the factor
(b) The cost of financing the debtors without the factor
(c) The cost of financing the debtors with the factor
(d) The considerations X Ltd should take into account when deciding whether to
accept the offer

EG Learning example 9.6

Justin plc is a company producing a range of plumbing products which it sells
to distributors. Its revenues have begun to rise quickly following a boost to the
economy as a whole. Despite that Justin plc is concerned about its liquidity and is
thinking of ways of improving its cashflow. Justin’s accounts for recent years are
summarised below.
Statement of profit or loss for the year ended 31 December

20X2  20X3 
(£000) (£000)
Sales 12,000  16,000 
Cost of sales 7,000  9,150 
Operating profit 5,000  6,850 
Interest 200  250 
Profit before tax 4,800  6,600 
Taxation (after capital allowances) 1,000  1,600 
Profit after tax 3,800  5,000 
Dividends 1,500  2,000 
Retained profit 2,300  3,000 


Statement of financial position as at 31 December

20X2  20X3 
(£000) (£000) (£000) (£000)
Fixed assets (net) 9,000  12,000 
Current assets
Stock 1,400  2,200 
Debtors 1,600  2,600 
Cash 1,500  100 
4,500  4,900 
Current liabilities
Overdraft –  200 
Trade creditors 1,500  2,000 
Other creditors 500  200 
(2,000) (2,400)
10% loan stock (2,000) (2,000)
Net assets 9,500  12,500 
Capital and reserves
Ordinary shares (50p) 3,000  3,000 
Profit and loss account 6,500  9,500 
9,500  12,500 

In order to speed up collection from debtors, Justin is considering two alternative

policies. One option is to offer a 2 per cent discount to customers who settle within
10 days of dispatch of invoices rather than the normal 30 days offered. It is estimated
that 50 per cent of customers would take advantage of this offer. Alternatively Justin
can utilise the services of a factor. The factor will operate on a service-only basis,
administering and collecting payment from Justin’s customers. This is expected to
generate administrative savings of £100,000 per annum and, it is hoped, will also
shorten the debtor days to an average of 45. The factor will make a service charge
of 1.5 per cent of Justin’s turnover. Justin can borrow from its bankers at an interest
rate of 18 per cent per annum.

Working Capital Management

(a) Why has Justin’s liquidity declined? Can the company can be said to be
Calculate key performance and liquidity ratios computed from Justin’s accounts
to demonstrate.
(b) Show the costs and benefits of the suggested methods of reducing debtors, and
recommend a policy.

9.13 Managing foreign accounts receivable

When a company trades with an overseas customer there is need to try to make sure
that the company gets paid and also that the value of the receivable doesn't drop
due to currency fluctuations. There are a series of different techniques that might be
used to manage these issues:
1. Hedging against currency fluctuations, using a forward contract or a derivatives
contract, such as a futures contracts. Any loss on the receivable would be offset
by a gain on the forward or derivatives contract.
2. Employing overseas debt collectors to ensure payment
3. Entering into a factoring arrangement so that the debt factor is responsible for
collecting the receivable, at a cost to the company.
Each of these can be effective but the cost of each needs to be weighed up against the
risk of the customer not paying and the magnitude of the exchange rate risks involved.
For foreign currency payables the issue on currency fluctuations also applies, as does the
potential to take out a method of hedging that risk, such as a forward or futures contract.

9.14 Managing inventory

There is a balance to be struck between the benefits and cost of holding stock. The
benefits of holding stock are that is allows the business to sell a range of goods which are
immediately available to customers. The costs are given below. The balance is as follows:


Holding stock is necessary

for operations, in terms Holding stock incurs costs,
of finished goods it in particular there is the
offers greater choice to opportunity cost of money
customers tied up in stock

9.14.1 Costs of purchasing and holding materials

Material costs are a major part of a company’s costs and need to be carefully
controlled. There are four types of cost associated with stock:
1. Ordering costs
2. Holding costs
3. Stockout costs
4. Purchase costs.

G Learn
Ordering costs

Ordering costs are the costs relating to the placing of orders. These relate to the
clerical, administrative and accounting costs of placing an order. The ordering costs do
not include the costs of the materials ordered.

The costs include

• obtaining a quote from the supplier
• raising the purchase order
• all the accounting entries and payment procedures for the order.
The costs are usually assumed to be independent of the size of the order.

Holding costs

The holding cost is the total annual cost of holding orders, ie the warehousing and related
costs of storing or holding stock. It does not include the cost of the materials purchased.

Working Capital Management

Holding costs include items such as:

• Opportunity cost of the investment in stock. This is the cost of the working
capital tied up in the stock and is equal to the cost of the stock × the cost of
capital (possibly the rate charged on the bank overdraft)
• Storage costs. These include the rent of the warehouse, cost of
warehouse employees
• Insurance costs
• Deterioration in stock which will clearly vary depending on the nature of the stock.

Stockout costs
Stockout costs are the costs involved with running out of stock. They include:
• Lost contribution through loss of sales;
• Lost future contribution through loss of customers;
• The cost of emergency orders of materials;
• The cost of production stoppages.
Note that for the calculation of the economic order quantity, it is assumed that
stockout costs do not occur.

Purchase costs
The purchase costs are simply the cost of what is bought. For the purpose of the
following analysis, we initially assume that the purchase costs of goods is constant,
eg there are no quantity discounts.

9.15 Economic order quantity

The economic order quantity is the reorder quantity which minimises the total cost
of holding and ordering materials over a given time period (usually a year).

The essential point to grasp is that the size of the order placed will affect the total
holding costs and ordering costs over the year (remember the stockout costs are
assumed to be zero and the purchase costs per unit are assumed to be constant no
matter how many units are ordered)
• If the company has a policy of placing large orders rather than small orders, the
total annual holding costs will increase. A bigger warehouse will be needed,
insurance costs will be higher, more staff will be employed in the warehouse etc.
• However, as the order size increases the number of orders needed to satisfy the
year’s sales will decrease and so the total annual cost of placing the orders will fall.
Conversely, placing smaller orders will reduce holding costs but increase the total
cost of placing orders.
The EOQ determines the optimum combination and these two costs and is shown in
the diagram below:


Total cost

Holding Costs

Ordering Costs

EOQ Reorder

9.15.1 Tabular approach

We shall first of all look at an example that calculates the EOQ in a tabular way
before studying the EOQ formula.

IE Illustrative example 9.4

A company requires 1,000 kg of material × per month. The cost of placing an order is
$30 regardless of the size of the order. The holding costs are $2 per unit per annum. It
is only possible to buy the stock in quantities of 400, 500, 600 or 700 units at one time.
Which order quantity minimises the costs?
Note that the question plays a trick. It gives you the demand per month (1,000 kg)
and the holding costs per annum. When dealing with this you must make sure that
you use the same time period of a year.

Annual demand 12,000 kg Order quantity (kg)

400 500 600 700
Average stock 200 250 300 350
Number of orders p.a. 30 24 20 17.14
Total annual holding cost = average stock 400 500 600 700
× $2
Total annual ordering cost = no. of orders 900 720 600 514.2
× $30
Total annual costs 1,300 1,220 1,200 1,214.2

The EOQ that minimises total annual costs is 600 units.

Working Capital Management

Notes on the table:

• The average stock assumes that the stock is used evenly over the year and that
the stock runs out to zero before the next order arrives in the warehouse.

Therefore average stock = (opening stock – closing stock)/2

= (opening stock – 0)/2
= order quantity/2

• The number of orders = total annual demand/order quantity.

9.15.2 The EOQ formula

In the exam you are given the EOQ formula

2Co .D
Q = the EOQ
CO = Cost per order
D = Annual demand
CH = Cost of holding one unit for one year

ü Given
We shall now calculate the EOQ for the above example using the formula.

IE Illustrative example 9.5

Taking data from Illustrative example 9.4, calculate economic order quantity using
the formula given.

2Co .D
Q = (2 × 30 × 12,000/2)1/2 = 600 units

9.16 Bulk order discounts

If a bulk discount is offered there are two possible order quantities that will minimise
total annual costs
• The EOQ as before because this minimises the sum of the holding and
ordering costs; or
• The alternative is the quantity at which the bulk discount is available. The effect
of the savings made by taking the bulk discount may outweigh the increased
order and holding costs by not using the EOQ.


EG Learning example 9.7

Details are the same as for Illustrative example 9.4. Annual demand is 12,000 kg.
Ordering costs are $30 per order and holding costs are $2/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.
What reorder quantity would minimise the total cost?

9.17 Just in time (JIT) stock ordering

Just in time (JIT) is referred to as a ‘holistic’ approach to ordering. The basic aim is to
eliminate or minimise inventory.
The theory suggests that stock is only needed because of inefficiencies in the
production process.
• Some businesses need stock because they cannot schedule the work accurately.
They are never certain about how long something may take and when the next
delivery is needed.
• Some need stock because of quality problems. For example, wastage in
the production process may need additional stock on hand, for example to
fulfil an order.
• Inflexible work practices that means that a production delay may occur because
some workers are off sick and others are not able to do their job.
The idea behind JIT is that if you can eliminate the inefficiencies and can plan and
deliver production processes to a fixed time schedule then inventory is either
unnecessary or at least minimised.
However, it is one thing for the company to organise its own factory and procedures
in this way, but clearly the suppliers must also be JIT suppliers. The JIT factory only
works without stock if the supply of parts that are needed to fit into the production
process are available when they are supposed to be available.
Thus when we say that JIT is a holistic concept, the work ethic that enables JIT
to operate in the company’s own factory must also operate in some way in the
suppliers’ factories.
The company therefore has to have a JIT contract with their suppliers.

9.17.1 The JIT contract

The contract must specify the following:
• Reliability of supply – if the supplier does not supply exactly when required, the
factory will come to a standstill
• Quality assurances – the goods supplied must meet the agreed standard,
otherwise production will have to stop

Working Capital Management

• Single supply status – the company will typically have fewer suppliers with whom
it develops close ties
• Product development – the company must keep suppliers up to date with new
product ideas so that the suppliers can deliver the required parts when needed
• Close system links to integrate the company’s and suppliers’ communication and

EG Learning example 9.8

A company requires 20,000 kg of a raw material per annum. The cost of placing an order
is $40 regardless of the size of the order. The holding costs are $0.5 per unit per month.
Calculate the EOQ.

9.18 Managing cash

Managing cash is another balancing act between the need to have cash to be able
to run the business, while at the same time trying to keep the cash to a minimum in
order to minimise the cost of the cash balances. This balance can be illustrated as:

Cash is an idle asset

Holding cash is necessary that costs money to
to be able to pay the bills fund but generates little
and maintain liquidity or no return

There are three approaches associated with managing cash:

1. The Miller-Orr model
2. The Baumol model
3. The cash budget.

9.18.1 The Miller-Orr model

The Miller-Orr model 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.
The diagram illustrates the typical fluctuations of cash in a business – fairly
unpredictable daily movements of the cash balance.


The diagram also illustrates the key features of the Miller-Orr model:

Cash Maximum level



Return point

Minimum level


The lower and upper limits

By studying the cash movements over a period of time the business can get a good
idea of how its cash fluctuates with no controls in place. The business will then set
lower and upper limits. These limits are not simply the lowest and highest points that
the cash ever reaches; they are control limits. We shall see how these limits are set.
If the cash in the business falls below the lower limit, more cash is needed in order to
be able to operate.
If the cash exceeds the upper limit, the excess cash should be invested, probably in
short term securities.
The difference between the lower and upper limits is called the spread.
• Setting the lower limit
This is always given to you in the exam.
• Calculating the spread
You are given the formula for the spread in the exam.
 3 Transaction cost × Variance of cashflows  3
Spread =  3× × 
 4 Interrest rate 

ü Given
Definitions in the spread calculation
The transaction cost is the cost of investing or realising cash as the
limits are reached.

Working Capital Management

The variance is a measure of uncertainty or dispersion. It is the square of the

standard deviation of the observed cash balances and is a measure of the
fluctuation in the cash balance.
The interest rate is the rate of interest per day (remember that the Miller–Orr
model is used to control the daily fluctuations of cash).
The calculations are:
• Setting the upper limit
The upper limit is simply the lower limit plus the spread.
• Calculating the return point
The business then determines the ‘return point’. The return point is set 1/3 of
the spread above the lower limit.
Return point = lower limit + 1/3 of the spread.

9.18.2 Controlling cash balances with the Miller-Orr model

Remember that purpose of this calculation is to control cash balances so that they
are neither too high nor too low.
The control is exercised as follows:
• If cash reaches the upper limit, sufficient cash is invested in order to return the
cash balance to the return point.
• If cash reaches the lower limit, sufficient cash is realised to return the cash to the
return point.

P Principle
Be able to draw the Miller-Orr

EG Learning example 9.9

The minimum level of cash for a company is set at $25,000. The variance of the cash
flows is $250,000. The transaction cost for both investing and encashing funds is $50.
The interest rate per day is 0.05%.
Calculate the:
(a) spread
(b) maximum level
(c) return point.


9.18.3 Interpreting Miller-Orr

If you look again at the Miller-Orr equation for the spread, you should notice
several things:
• The model is based on uncertainty of the cash flows. Hence the introduction of
the variance into the formula.
• The model is designed to offer a way of controlling cash balances on a day-to-day
basis. Hence the interest rate used is the interest rate for one day.
• If the transaction cost increases, the spread increases and vice versa. It is
important to see the reason for this. If the transaction cost increases, this makes
the control action of investing or realising cash more expensive and hence the
spread is made larger to give a little extra leeway before having to act.
• Similarly, if the interest rate increases the spread decreases and vice versa. This
is because the opportunity cost of holding cash increases with the rate increase
thereby making holding cash more expensive and so the spread is reduced to
encourage investment of surplus cash.

9.19 Baumol model

The Baumol model uses the EOQ model to manage cash.
We use the same formula as for controlling the reorder level for stock. In that
situation we were minimising the total annual cost of reordering goods, and the key
to that calculation was the recognition that as we increased the amount reordered
we increased the annual holding cost but decreased the annual reorder costs.
Here, the same basic idea applies, but in this case we are trying to minimise the total
cost of investing surplus funds (we assume the business is a net generator of funds).
Note that it is surplus funds we are concerned about, that is the funds that are
surplus to our working capital requirements. Now one might instinctively think that
the more frequently we could invest the surplus funds the better because they would
be lying idle for a shorter period of time. However as with stock, we have to bear in
mind that the transaction cost of investing the funds frequently may outweigh the
extra interest earned by not having cash idle.

Q = Amount invested per transaction
CO = Transaction cost of investing/encashing a security
D = Excess cash available to invest in short-term securities
CH = Opportunity cost of holding cash

G Learn

Working Capital Management

EG Learning example 9.10

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.
(a) What is the optimum amount of cash to be invested in each transaction?
(b) How many transactions will arise each year?

9.20 Cash budgets

A cash budget is a statement of all the inflows and outflows of cash for a given period.

The cash budget is 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:
• We are only concerned with the inflow and outflows of cash
• It follows that non-cash flows, such as depreciation, are ignored
• There are standard proformas that should be followed.

9.20.1 Calculating the cash flows for credit sales

Credit sales will be given to you in the exam in a way that will indicate when the
cash from the credit sales is received. The important thing is to be able to pick up
the information quickly and put it in the standard proforma layout. An example will
illustrate this.

IE Illustrative example 9.6

X Ltd makes sales on credit in the first four months of the year as follows:

January 50
February 60
March 40
April 50

Cash is received from debtors as follows. 60% after 1 month; 30% after 2 months and
10% after 3 months. The opening cash balance at 1 January was $10,000.


Let us calculate the cash flow for the first four months of the year and show the cash
balance at the beginning and end of each month.

Jan  Feb  March  April 

($000) ($000) ($000) ($000)
Jan sales (W) 30  15  5 
Feb sales 36  18 
March 24 
30  51  47 
Opening cash 10  10  40  91 
Closing cash cf 10  40  91  138 

Workings and notes

1. The cash from January sales is calculated as follows ($000)
In February: $50 × 60% = $30
In March: $50 × 30% = $15
In April: $50 × 10% = $5
2. Note the calculation at the end of the statement giving the opening and closing
balances – this is a standard presentation.
3. Note that the question tells you about the April sales but they do not feature in
the cash from sales. This is typical as the information for sales will probably have
a bearing on the calculation of purchases as we shall soon see.

9.20.2 Calculating the cash flows for purchases

In exam questions, the question may be set where the company manufactures the
goods it sells. This is a bit more complicated than the simpler scenario where the
company simply buys in the finished goods it then sells.
We shall expand the above example to see how the figure for purchases may
be calculated.

Working Capital Management

IE Illustrative example 9.7

Continuing the example of X Ltd. X Ltd manufactures the goods that it sells. The costs
of one unit of the product is made up as follows:

Raw materials 5
Labour 3
Fixed overhead 9

It is company policy to have closing stocks of finished goods at the end of each month
equal to the following month’s sales. The selling price of the finished product is $20.
There is only one raw material in the production process. The company’s policy is
to purchase sufficient raw materials each month so that the closing stock of the raw
material at the end of each month is equal to 75% of the following month’s production.
The company pays the supplier of the raw material one month after the end of the
month in which it was purchased.
We calculate the materials purchased for the first two months of the year, indicating
in which month the cash is paid.

Step 1 Calculate the sales quantities for each month. We use the information
about sales revenue and the unit price of sales to calculate the units sold.
Jan Feb March April
Revenue ($000) 50 60 40 50
Units sold (Rev/$20) 2,500 3,000 2,000 2,500

Step 2 Calculate the completed units produced in each month. Start with the
units sold and adjust for changes in stock. The closing stock of a month
equals the sales of the following month, therefore the opening stock of a
month equals the sales of the month.
Units sold Jan  Feb  March  April
Plus closing stock 2,500  3,000  2,000  2,500
Less opening 3,000  2,000  2,500 
Production (2,500) (3,000) (2,000)
3,000  2,000  2,500 


Note how we cannot calculate the closing stock for April because we do not have
sales figures for May.

Step 3 Calculate the amount and cost of raw materials purchased for each of
the first three months. Start with the month’s production and convert
this into the cost of raw material used in that production. Then adjust for
stock. Finally decide in which month the cash is paid.
Jan  Feb  March April
Production (units) 3,000  2,000  2,500
$  $  $
Raw material (× $5) 15,000  10,000  12,500
Plus closing stock (W1) 7,500  9,375 
Less opening stock (W2) (11,250) (7,500)
Materials purchased  11,250  11,875 
Cash paid  11,250  11,875

Workings and comment for step 3

(W1) Closing stock of raw materials for = February production × 75% × $5

= 2,000 × 0.75 × $5 = 7,500
(W2) Opening stock of raw materials for = January production × 75% × $5
= 3,000 × 0.75 × $5 = 11,250

Note how we cannot calculate the closing stock for March because we do not have
the production figure for April.

Working Capital Management

EG Learning example 9.11

In the near future a company will purchase a manufacturing business for £315,000,
this price to include goodwill (£150,000), equipment and fittings (£120,000), and
stock of raw materials and finished goods (£45,000). A delivery van will be purchased
for £15,000 as soon as the business purchase is completed. The delivery van will be
paid for in the second month of operations.
The following forecasts have been made for the business following purchase:
(i) Sales (before discounts) of the business’s single product, at a mark-up of 60%
on production cost will be:

Month 1 2 3 4 5 6
(£000) 96 96 92 96 100 104

25% of sales will be for cash; the remainder will be on credit, for settlement in
the month following that of sale. A discount of 10% will be given to selected
credit customers, who represent 25% of gross sales.
(ii) Production cost will be £5.00 per unit. The production cost will be made up of:

Raw materials £2.50

Direct labour £1.50
Fixed overhead £1.00


(iii) Production will be arranged so that closing stock at the end of any month
is sufficient to meet sales requirements in the following month. A value
of £30,000 is placed on the stock of finished goods which was acquired
on purchase of the business. This valuation is based on the forecast of
production cost per unit given in (ii) above.
(iv) The single raw material will be purchased so that stock at the end of a month
is sufficient to meet half of the following month’s production requirements.
Raw material stock acquired on purchase of the business (£15,000) is valued
at the cost per unit which is forecast as given in (ii) above. Raw materials will
be purchased on one month’s credit.
(v) Costs of direct labour will be met as they are incurred in production.
(vi) The fixed production overhead rate of £1.00 per unit is based upon a forecast
of the first year’s production of 150,000 units. This rate includes depreciation
of equipment and fittings on a straight-line basis over the next five years.
(vii) Selling and administration overheads are all fixed, and will be £208,000
in the first year. These overheads include depreciation of the delivery van
at 30% per annum on a reducing balance basis. All fixed overheads will be
incurred on a regular basis, with the exception of rent and rates. £25,000 is
payable for the year ahead in month one for rent and rates.
Prepare a monthly cash budget. You should include the business purchase and the
first four months of operations following purchase.

Æ Key Learning Points

• Know how the treasury function works and how it can be set up. (B3a–B3c)
• Learn about working capital and the balance between profitability and liquidity.
Know the importance of avoiding overtrading. (C1a–C1c)
• Be able to calculate the operating cycle and ratios. (C2a, C2b)
• Know the issues on funding working capital and short-term finance. (C3a, C3b)
• Know the issues and approaches relating to the control of receivables and
payables, including factoring. (C2d, C2e)
• Learn the problems and calculations on control of inventory. (C2c)
• Also know how to control cash and the key models here, Miller-Orr and
Baumol. (C2f)
• Be able to produce cash budgets and describe what they tell us. (C2f)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).

Working Capital Management

Learning example solutions

EG Solution 9.1

Receivable days = (15,000/100,000) × 365 = 54.75 

Inventory days = (10,000/50,000) × 365 = 73.00 
Payable days = (12,000/50,000) × 365 = (87.60)
Total days 40.15 

EG Solution 9.2
(a) Receivables days = ($3m/$10m) × 365 = 109.5 days
(b) Cost of financing receivables = $3m × 0.06 = $180,000

EG Solution 9.3
(a) Receivables days = ($8m/$40m) × 365 = 73 days
(b) Cost of financing debtors = $8m × 0.14 = $1,120,000

EG Solution 9.4

Step 1 Calculate the cost of receivables for those who continue with
the current terms (note that this step and step 2 combines
the calculation of the receivables balance with the calculation
of the interest on that balance)
$40m × 50% × 73/365 × 0.14 = $560,000
Step 2 Calculate the cost of the receivables for those who take the
early settlement discount
$40m × 50% × 10/365 × 0.14 = $76,712
Step 3 Calculate the cost of the discount
$40m × 50% × 2% = $400,000
Step 4 Calculate the total cost of finance $(560,000 + 76,712 +
400,000) = $1,036,712.This is cheaper than the previous cost
of $1,120,000, therefore the new offer is cost effective.

EG Solution 9.5
(a) Receivables days = ($7m/$30m) × 365 = 85 days
(b) Cost of financing debtors = $7m × 0.09 = $630,000


(c) Cost of finance with the factor

Interest cost = $30m × 60/365 × 0.09 = 443,835 
Fee = $30m × 0.006 = 180,000 
Admin saving (120,000)

(d) The offer is acceptable on financial grounds.

X Ltd should however consider the effect that employing the factor will have on
its customers:
‐ It is quite a large company and probably should be able to manage its own
debtors better than a receivables period of 85 days.
‐ Its customers will probably be uncomfortable with the factor. They will
worry that X Ltd is perhaps short of funds.
‐ They should also be aware that the factor may treat its customers in a way
that will reduce customer goodwill

EG Solution 9.6
(a) Reasons for the sharp decline in Justin’s liquidity
(i) Non-current assets
During the year the company has invested in excess of $3m in non-current
assets, the value of the increase being the change in the net book value plus
any depreciation charged during the year.
(ii) Inventory/Stock
The level of inventory has increased by $800,000 during the year. This will tie
up cash in inventory that would otherwise be available.
(iii) Receivables/Debtors
The level of receivables has increased by $1m during the year. This increase
has led to an increase in the amount of deferred cash inflow.
(iv) Dividends
The dividend paid during the year will be last year’s dividend of $1.5m. This
appears a substantial discretionary cash outflow to incur by a company that
is growing quickly and is suffering pressure on its cash resources.
Is Justin overtrading?
Overtrading is where there is an imbalance between the permanent funding of
the business and the need for funds to cover investment in working capital and

Working Capital Management

non-current assets. It will lead to the company running out of cash and possibly
becoming insolvent.
Growth and permanent funding
The company has grown by 33% in terms of sales. As a result the company is at
risk of overtrading because increases in activity are likely to require an increase
in the need for cash resources.
The company has not increased its level of permanent funding during the period
as there is no new debt issued or share capital raised.
The combination of both of these issues it to increase the likelihood of over-trading
as the company is funding its growth solely by cash generated from trading.
Liquidity ratios
The current ratio has fallen from 2.25 to 2.04 which suggests that the company is
relying more on short-term funds such as payables and overdraft to fund operations.
The quick ratio (trade payables only) has fallen dramatically from 1.55 to 1.13
which suggests a dramatic fall in liquidity. The level however is still above 1.0
which suggests that the company can cover its debts if they fell due in the short
term as its liquid assets are greater than its current liabilities.
Payable days
The payable days have barely changed during the year (78 to 80 days), which
suggests that the company is having no additional difficulty in paying its suppliers.
The term of nearly three months may suggest that the company is abusing its
credit terms given a normal credit term of 30 days.
Cash position
The cash position of the company has fallen from a $1.5m cash balance to a net
overdraft of $0.1m.
This illustrates that the reinvestment of surplus funds in the business, as a
company would not normally want to hold such a large balance of an idle asset.
The company is now operating a modest overdraft given its relative size and
financial health.
Although the company has grown very quickly during the year it is not at present



Existing cost of financing receivables $ 

Interest cost 468,000 
$2.6m × 18%
Cash discount
Interest cost
Normal terms – 50% 234,000 
$2.6m × 0.5 × 18%
Discounted terms – 50% 39,452 
$16m × 0.5 × 10/365 × 18%
Cost of discount 160,000 
$16m × 0.5 × 2%
Total 433,452 
Debt factor
Admin savings (100,000)
Interest cost 355,068 
$16m × 45/365 × 18%
Service charge 240,000 
$16m × 1.5%
Total 495,068 

The cost of using the cash discount is lowest.

EG Solution 9.7
Note two important points:
1. There are only two possible order quantities as we noted above, the EOQ and the
bulk discount quantity.
2. In this table we have to add a row for the actual cost of the purchases. In the
previous example we only had to consider the cost of ordering and the holding
cost because we assumed that the purchase cost of a unit was constant no
matter how many were ordered. In this example we have to consider the change
in the unit cost as the bulk discount takes effect.

Working Capital Management

Annual demand: 12,000 kg EOQ Bulk

(600 kg) discount
(1,000 kg)
Average stock (Q/2) 300 500
Number of orders (D/Q) 20 12
Total annual holding cost = Average stock × $2 600 1,000
Total average ordering cost = No. of orders × $30 600 360
Total annual purchasing cost of materials ($10 or 120,000 117,600
$9.8) × 12,000
Total annual costs 121,200 118,960

Therefore the effect of taking the bulk discount outweighs the fact that we are no
longer using the EOQ to minimise the order and holding costs.

EG Solution 9.8
2C0 .D
Q = (2 × 40 × 20,000/6)1/2 = 516.4 units

EG Solution 9.9
(Note before we start that the variance has been given as $250,000. Another way the
examiner may have given this information would have been to say that the standard
deviation was $500.
Variance = Standard deviation squared = $5002 = $250,000)
(a) Spread
Spread = 3 × ((3/4 × $50 × $250,000)/0.0005))⅓ = $7,970
(b) Maximum level = $25,000 + $7,970 = $32,970
(c) Return point = $25,000 + (1/3 × $7,970) = $27,657

EG Solution 9.10
(a) Q = ((2 × $50 × $60,000)/0.06)1/2 = $10,000
As with the inventory control formula – make sure everything is in terms of the
annual value.
(b) Number of transactions = D/Q = $60,000/$10,000 = 6


EG Solution 9.11

(all '000s)
Sales units (÷ SP 12 12 11.5 12 12.5 13
of $8)
Add CS 12 11.5 12 12.5 13 0
Minus OS 6 12 11.5 12 12.5 13
Production units 18 11.5 12 12.5 13
Mat cost (× Mat $45.00 $28.75 $30.00 $31.25 $32.50
cost of $2.5)
Add CS $14.38 $15.00 $15.63 $16.25 -
Minus OS $15.00 $14.38 $15.00 $15.63 $16.25 -
Material purchases $44.38 $29.38 $30.63 $31.88
Payment (month $44.38 $29.38 $30.63 $31.88
+ 1)
Direct labour $27.00 $17.25 $18.00 $18.75

Working papers Months

1 2 3 4 5 6
Sales (000s) $96.00 $96.00 $92.00 $96.00 $100.00 $104.00
Re- 25% $24.00 $24.00 $23.00 $24.00 $25.00 $26.00
ceipts current
75% $72.00 $72.00 $69.00 $72.00 $75.00
Discount 10% −$2.40 −$2.40 −$2.30 −$2.40 −$2.50
$24.00 $93.60 $92.60 $90.70 $94.60 $98.50

Working Capital Management

Fixed production o/h 150

less depreciation −24
Total p.a. 126
Per month (÷ 12) 10.5
Selling and distribution o/h 208
less depreciation −4.5
less rent and rates −25
Total p.a. 178.5
Per month (÷ 12) 14.875


Efficient Market Hypothesis

The Efficient Market Hypothesis is a theory that states that in a free financial market
comprising many buyers and sellers will set an ‘accurate’ price for the commodities
(shares, bonds) being sold provided that the information available to the buyers and
sellers is perfect. It is important for financial management because the implication
is that it is impossible to outperform the market using information that is already
known to the market other than by luck or random events. It is also important to
consider practical issues in the valuation of shares, including speculation and the
behavioural aspects of valuations.
The question will probably relate to a scenario rather than a purely theoretical
question and as such you must answer accordingly. If asked to comment on the
effect of the situation presented in the scenario make sure you start with the weak
form and the effects of information efficiency in general before moving on to discuss
the semi-strong and strong forms and their effect on the scenario.

1. Can you describe the three forms of the efficient market hypothesis?

2. How would you describe informational efficiency?

3. What are the implications of different efficiencies for financial managers?

Efficient Market Hypothesis

10.1 Efficient market hypothesis (EMH)

A market (for example, a stock market like the London Stock Exchange) 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
• There is information efficiency. 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.

10.2 Degree or forms of efficiency

The EMH is generally presented as having three forms. The difference between these
three forms is the amount of information available to the market (referred to as the
degree of information efficiency). The reason for these distinctions is that prices do
change for a variety of reasons and this may seem to suggest that EMH is not a reliable
guide to correct prices because information changes and prices therefore also change.
The three forms attempt to explain the different sorts of information available to the
market and the confidence that one can therefore place in the prices. The first form
of the EMH is the weak form.

10.2.1 Weak form

The weak form of the EMH assumes that all past information about the share price
movements and its implications is available and reflected in the share price.

• Weak form hypothesis states that current share prices reflect all relevant
information about the past price movements and their implications. Share
prices only changes when new information about a company and its profits have
become available.
• If this is true, then it should be impossible to predict future share price
movements from historic information or patterns. Since new information arrives
unexpectedly, changes in share prices should occur in a random fashion. Good
news about the company will cause its share price to rise, bad news (perhaps the
CEO resigns) may cause its price to fall. Hence weak form is sometimes referred
to as the random walk hypothesis.
• There is a paradox with the weak form of the EMH. No matter how much
investors analyse the past results, they will not be able to predict the future of the
share price. Hence it is unlikely that the weak form of the EMH applies in real life.


10.2.2 Semi-strong form

The semi-strong form hypothesis state that current share prices reflects:
• all relevant information about past price movement and their implications; and
• 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.

10.2.3 Strong form

The strong form hypothesis states that current share prices reflect all relevant
information available from
• past price changes
• public knowledge; and
• all unpublished information about the company. This unpublished information
will be insider knowledge available to specialists or experts such as investment
managers who have discovered information that is not in the public domain.
The strong form of the EMH gives the ‘best’ guide to the true share value of the
company because it reflects all information – whether that information is in the
public domain or not. If this form of EMH is applicable to a company’s shares then it
will not be possible for any person to outperform the market – there are no surprises
as all available information is reflected in the share price.

P Principle
Be able to explain the different types of market efficiency

10.3 Implications of EMH for financial managers

If capital markets are efficient the main implications for financial managers are listed
below. Note that it depends on how efficient the market is when considering the
extent to which the following can be relied on. In particular it depends whether the
market is strong form efficient or semi-strong form efficient and in the following list
reference is made to the difference that this can make.

Efficient Market Hypothesis

1. The timing of issues of debt or equity

If a market is strong form efficient, timing is not critical, as the prices quoted in
the market are ‘fair’. The share price will always reflect the true worth of the
company including any future events that are not yet in the public domain, so
there can be no over- or under-valuation at any point. Thus large quantities of
new shares or debt can be sold without depressing the share price.
However, if the market is only semi-strong efficient then a sudden future sale of
debt or equity may not be factored into the current share price. Hence such a
sale will cause the share price to change.
2. Window dressing
If strong form efficient, an entity cannot mislead the markets by adopting
creative accounting techniques. If a semi-strong market then a change in share
price will depend on the nature and materiality of the manipulation.
3. Market value of shares will be based on DCF
In general it makes no difference whether the market is strong or semi strong.
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 to avoid any sudden changes in the share price. This
is providing there was no sudden and unexpected major raising of capital, in
particular debt, which may not be factored into the share price.
4. Market assessment of risk and return
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.
5. 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
(operating economies or rationalisation). In a strong efficient market these
synergies would be known, and therefore already incorporated into the price
demanded by the target company shareholders. In a semi-strong market, not all
the details of the merger/ takeover may be known so that the share price may
not reflect this.
The more efficient the market is, the less the opportunity to make a speculative
profit because it becomes impossible to consistently outperform 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.


IE Illustrative example 10.1

Assuming that a stock market is semi-strong form efficient, which type of news
about a company is more likely to be released, good news or bad news? Is this a good
approach for the company long term?
It is more tempting for a company to release good news about the company as this
will boost the company's share price. Bad news will affect the share price adversely
so companies are more likely to want to hide this from the market.
However this isn't necessarily a good idea. A company will lose the confidence of the
stock market if bad news is found out a later date.

10.4 Practical issues in the valuation of shares

There are a number of practical issues that we should consider in the valuation of
shares. These include:
1. The marketability and liquidity of shares. Shares that are quoted on a stock
market and can be sold quickly are likely to be valued higher than shares in an
unquoted company, where it would require time and effort to find a buyer or
buyers. Thus marketability of shares is attractive. However even if shares are
quoted on a stock market if there aren't many shares available due to poor
liquidity then this will affect the value of the shares downwards.
2. Availability and sources of information. Quoted shares are likely to have more
information available as they are usually required to file financial statements and
other information by the stock exchange. More information available and the
quality of that information gives confidence that the company is more likely to
be correctly valued. The sources of information can bring confidence, eg reports
by reputed share analysts based on their research of the market.
3. Market imperfections and pricing anomalies. Markets are in theory perfect,
valuing shares correctly and rationally based on the views of buyers and sellers.
However many markets may not value the shares quoted on it correctly due
to situations such as stock market booms and crashes or due to asymmetry in
the information available to buyers and sellers (ie they have different levels of
4. Market capitalisation. Companies with larger market capitalisations are likely to
be more correctly valued than those with smaller capitalisations. This is in part
due to the extra attention larger companies have on them as well, as well as the
riskiness of smaller companies (both positively and negatively as their shares
may shoot upwards in value as well as plummet).

Efficient Market Hypothesis

10.5 Investor speculation and behavioural finance issues

The actions of investors in a company's shares will affect the short-term valuations of
shares. Investor speculation is a necessary part of the functioning of a stock market.
Speculators bring liquidity into a stock market and this is useful as it means that all
investors have more parties to buy shares from or sell them to. On the other hand
investor speculation is often regarded negatively as it is associated with stock market
booms and crashes. This may be true, particularly if the investors are behaving
on limited information and following the herd, ie copying the behaviour of other
investors without sound reasons for doing so.
There are a series of behavioural finance issues that affect how investors behave on a
stock market. These include:
1. Anchoring – investors are likely to look at the current share price and believe
the true price is close and will remain close to this. This looks fine on the face of
it but there may be strong reasons that the price will change that the investor is
not taking into account, such as contractions and expansions in the economy as a
whole and economic cycles. Investors will anchor on the current share price. This
phenomenon holds in other situations, such as when people negotiate. The first
person to venture a price has a greater chance of the final price being close to
that initial price.
2. Priming – investors are primed by the situation they are in. This means they are
affected by what they are seeing, such as confident predictions that the stock
market will rise by someone in authority, even if this has no basis in reality. It
has even been shown that events such as a win in a cricket match can affect the
stock market positively.
These behavioural issues can affect the value of shares though in the longer term one
would expect that supply and demand for the shares would be the key determinant
of the share price.


Æ Key Learning Points

• Learn the three forms of market efficiency. (F4a)
• Know the concept of information efficiency. (F4a)
• Be able to describe the effects of the different forms of efficiency on the share price
and the possibility of outperforming the market, plus practical issues. (F4b, F4c)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).


Asset valuation is a very important part of accounting. Whether you are valuing
assets for the financial statements or with a view to a company bidding to acquire
another company, you need a sound understanding of the principles that underlie
the various valuation techniques.
You also need to understand the reasons for valuing assets and the information
The chapter covers a range of techniques any one of which could be the basis of a
question in the exam. The basic equity dividend and earnings valuation models are very
important as is the calculation based on free cash flows. The calculation of debt is more
straightforward, with the valuation of convertible debt an important area. You cannot
afford to go into the exam without a sound understanding of any of these topics.

1. Can you distinguish asset, dividend and earnings valuation methods?


2. What are free cash flows and how are they used for valuation?
3. Which cash flows are used to value debt?


11.1 Business and asset valuation

11.1.1 Reasons for valuing businesses and financial assets
There are many situations that it is necessary to value businesses and financial
assets. For example, if a company is quoted on a stock market there are investors
that will want to buy or sell shares in that company. If the investor needs the money
for some reason then they will want to realise the value in the shares. Similarly other
investors may believe that the company will be successful and would like to gain
from that expectation by buying the shares now and receiving dividends over time
and then selling the shares for more than they were purchased for. Hence a market in
the company's shares is formed.
Even for companies that are not quoted it is often necessary for their value to be
estimated. Companies are often bought or sold outside stock markets, there may
need to be a valuation for inheritance tax purposes (on the death of the owner) or
a company may need to borrow money and show that the company is valuable by
obtaining a business valuation.
This also applies for other financial assets, such as property, loans and so on.
Their valuation can be important to help their owners realise the assets or use the
valuation to use as security, to calculate tax or prove the owner's wealth.

11.1.2 Information requirements for valuations

There is a lot of information that can be taken into account in the valuation of a
company. Past information, such as the last statement of financial position and
statement of profit or loss, can be used for financial information as well as other
information about a company such as its management team, the markets it operates
in and the growth that the company has experienced in past years will all be used
commonly in a valuation.
However the future is important for the valuation of companies. If they were to
become insolvent or to lose their major customer tomorrow then the past record over
many years may be irrelevant. So there will always be some prediction involved with a
business valuation. Past information may help with this, for example past growth rates
may be an indicator of future growth rates. Current trends and new events should
also be monitored and taken into account. For example if a retail company, which has
a series of shops in locations around the UK, is being valued then knowing the effect
of its competitors' future actions could be valuable (knowing that a competitor is
going to aggressively expand in the company's main locations) as well as the growth of
new businesses, such as Internet sites that are selling the same products.
In practice a range of information will be obtained and there are limitations on all the
information. Past information may not apply in the future and estimates of what may
happen involve some guesswork and luck. In valuations it is difficult, if not impossible,
to account for rare and unexpected events, eg earthquakes, new technologies that
would affect the valuation of the company if you had known them today.


When we talk about valuing assets or businesses, we are for the purpose of this
exam talking about valuing the shares or debt of a company. There are three main
methods of valuing these sorts of assets.
• Asset basis.
The asset basis is used where there is some question about the viability of the
company – issues about whether it is a going concern. In this situation, we
cannot value its earnings potential because it may not have a future where it can
produce future earnings. Hence we effectively value the break-up value of the
assets. This gives us a minimum price – the owners will presumably not sell for a
price below the asset value.
• Dividend valuation model.
We have already used the dividend valuation model when we calculated the
cost of capital. In that situation, we knew the dividend and the share price and
calculated the cost of capital.
We now are going to do things the other way round. We know the dividend and
the cost of capital and are trying to calculate the share price.
• Income/earnings basis.
There are two broad ways of doing this.
– by using the P/E ratio
– by calculating the present value of the free cash flows.

11.2 Asset-based valuations

Asset-based valuations are relatively rare, unless the company is being broken up
and is therefore no longer a going concern.
Investors do not normally buy a company for the value of its assets, but for the
earnings/cash flows that the sum of its assets can produce in the future.

11.3 Uses for asset-based valuations

There are two main uses for an asset-based valuation:
• asset stripping, where the company is worth more broken up than as a
going concern
• to identify a minimum price in a takeover

11.4 Types of asset-based measures

11.4.1 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.
The book value ignores intangible assets. It is very possible that intangible assets,
such as goodwill or intellectual property, are more valuable than the statement of
financial position assets.


11.4.2 Net realisable value

If we are going to dispose of the company and its assets, then we use the net
realisable value of the assets.
This is only used to establish a minimum value for an asset, and it may be difficult to
find an appropriate value over the short term. This method is used for a company
being broken up or asset stripped.

11.4.3 Replacement cost

If the company is a going concern, we are looking to use the assets into the future
and the replacement cost would be the appropriate value.

Advantages of asset-based valuation

4. This method provides an insight into what the business would cost to build from
scratch, when calculated on a replacement cost basis.
5. It indicates a recoverable value if the business were to cease trading.

Disadvantages of asset-based valuation

It fails to provide the genuine value of a business as it ignores the items that create
value such as the brand.

P Principle
Know which form of asset valuation should be used
when and be able to discuss the advantages and
disadvantages of each

IE Illustrative example 11.1

Below is a statement of financial position of Fagan Ltd.

Non-current assets (carrying value) 625,000
Net current assets 160,000
Represented by
50c ordinary shares 300,000
Reserves 285,000
6% debentures 20X1 200,000


• Loan notes are redeemable at a premium of 5%.
• The premises have a market value that is $50,000 higher than the book value.
• All other assets are estimated to be realisable at their book value.
Let us value a 60% holding of ordinary shares on an assets basis.
The net assets of the business at their realisable value are as follows:

Non-current assets (625,000 + 50,000) 675,000 
Net current assets 160,000 
Debentures (200,000 × 1.05) (210,000)
Total realisable value 625,000 
Therefore 60% = $375,000

11.5 Dividend valuation model

Dividends are deemed to be a perpetuity (this assumes they continue forever) and
the value of the company may be calculated as the present value of the dividends
(with growth of dividends built into the calculation).
The value of the company/share is the present value of the expected future
dividends discounted at the cost of equity.

d0 1 + g 
P0 =
ke - g
P0 = the ex-div share price
d0 = the current dividend that has just been paid.
(Remember that d0(1+g) = d1 which is next year’s dividend)
g = dividend growth
ke = the cost of capital

The DVM can either be used to calculate the total MV of a company or the
value of a share.

ü Given
11.5.1 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. This is important.
A minority shareholder does not control any aspect of the company’s operation.


They do not control the assets or the earnings. They can do nothing about
increasing investment in the company to achieve greater future growth of
earnings. The only thing that the minority holders get out of the company is the
dividends. Hence the value of the company from their point of view is the value
of the dividends.

11.5.2 Disadvantages
1. Difficulty estimating an appropriate growth rate.
2. The model is sensitive to key variables and will vary with the cost of capital.
3. The growth rate is unlikely to be constant in practice.

G Learn
The total market value (MV) of a company = Share price per share × Total
number of shares.

EG Learning example 11.1

A company has the following information:
• Share capital in issue is 2m ordinary shares (25¢)
• Current dividend per share (ex-div): 4¢
• Dividend two years ago: 3.3¢
• Current equity beta: 0.6
Market information:
• Equity risk premium: 10%
• Risk-free rate: 5%
What is the market value of the company?

11.5.3 Limitations of the model

Note that this model does not give an accurate value of the company. It is a valuation
in the sense that it is based on assumptions about what elements prospective buyers
and sellers value about the company and assumptions about what the value of those
elements are. If a prospective buyer values dividends and if the buyer agrees that
dividends will follow the assumption about growth in the model, then that buyer
would pay something like the value arrived at. There are of course a number of caveats
that a buyer may have that will increase or decrease his valuation of the company.
If we assume that it is dividends that the buyer requires and that they agree with the
broad thrust of the valuation, it may nevertheless be the case that the buyer would
like to see more diversification in the product offering that the company makes. This
would give him more confidence about the sustainability of the dividend growth
and he/she may mark his valuation down accordingly. Now there is no real way that


we can build this into the model. Just note that the model gives a very simple and
therefore limited guide to the valuation that may be finally agreed.
Note that this applies to the valuation of any company no matter which valuation
method is adopted.
We can also use the Capital Asset Pricing Model (CAPM) to calculate the cost of
capital in the model.

EG Learning example 11.2

A company has the following information:
• Ordinary share capital (1m par value 50c)
• Current dividend (ex-div): 16¢
• The dividend is expected to grow at 8% per annum in the future
• Current equity beta: 0.9
• Current market return: 11%
• Risk-free rate: 6%
Find the market capitalisation of the company.

11.6 Income/Earnings based methods

This is of particular use when valuing a majority shareholding. The majority
shareholders control the earnings of the company. They can decide whether to
distribute the earnings as dividends or retain them for further investment in the
company which should increase future profitability.

11.6.1 Price/Earnings (PE) method of valuation

PE ratios are quoted for all listed companies. When valuing an unquoted company,
we use an appropriate ratio taken from a similar quoted company as the basis of
the valuation.
First of all let us recall what the PE ratio and the earnings per share (EPS) are:

EPS = PAT less preference dividends/number of ordinary

shares in issue
PE ratio = Current share price/EPS; or, for the whole company,
Market value of company/PAT


Value per share = EPS × P/E ratio

Value of company = PAT × P/E ratio


11.6.2 Using the PE ratio in practice

When using the PE ratio to value shares of a target company (ie a company that is
being bought), we use the:
• PAT of the target company, and the
• PE ratio of the buying company or a proxy company.
The choice of the PE ratio needs a little attention. You will remember from earlier
chapters that the PE ratio that applies to a company will depend on the future
growth of earnings of that company. A high PE will indicate a company that the
market expects to grow quickly; a low PE indicates an expectation of slower growth.
Part of the reason for buying a company may be that the buying company thinks
that it can improve on the performance of the target company. This need not be the
case of course. The buying company may be buying the target for strategic reasons
eg a simple diversification. But in general if there are no special reasons for the
acquisition other than the desire for greater profitability, then there is little point
buying a well-run company at a full price if the buying company doesn’t think it can
do better with the target company and create more value out of it.
Thus, assuming that the target company is in the same industry as the buyer, the
buying company will use its own PE as this is the PE it believes it can achieve with the
earnings of the target company. Of course this will increase the price of the target
company so what we are calculating here is the maximum amount that the buying
company will pay – not its opening bid in the negotiations!
If the target company is in a different industry sector from the buyer, the buyer will
use a PE that is typical of that sector – perhaps an industry average.
You may also want to adjust any PE for risk. You may be uncertain about quality of
the earnings you are buying, or if the company is unlisted you may decide to mark
down the PE to be used.
Similarly, we may adjust the PAT of the target to reflect the changes the buyer may
make to the operation – cost savings are an obvious change, whether it is cheaper
sourcing of raw materials perhaps through better buying power or simply removing
some of the target’s senior management. Remember the cost saving adjustments
must be made net of tax.


EG Learning example 11.3

A company is valuing a target company. The following information is relevant

Buyer Target
PAT $20m $1.2m
Share price $3 $4
EPS 20c 50c

Value the target company

11.6.3 Earnings yield

The earnings yield is the inverse of the PE ratio:
Earnings yield =
Price per share
It can therefore be used to value the shares or market capitalisation of a company in
exactly the same way as the PE ratio:
Price per share = EPS/earnings yield; or for whole company
Value of company = PAT/earnings yield
In discussing the earnings yield model, similar issues apply as for the P/E model above.

EG Learning example 11.4

Dalglish Ltd has earnings of $420,500. A similar listed company has a PE ratio of 7.
Find the market capitalisation of Dalglish.

11.7 Present value of free cash flows

This technique combines the use of the time value of money with a version of the
earnings of the company. The dividend yield method took the dividend flow and
used a formula based on the PV of a perpetuity to calculate the PV and therefore
the market value of those dividend flows. The ‘earnings’ we use as the basis for the
calculation here is what is referred to as the ‘free cash flows’, and it is these that we
will use to calculate an NPV and therefore a market price.
A discount rate reflecting the systematic risk of the flows should be used.


11.7.1 Method of using free cash flow technique

1. Identify relevant ‘free’ cash flows. The broad idea here is to produce a set of
cash flows for each year of the investment. This may not be as ‘scientific’ as the
cash flows that were produced when dealing with the basic DCF calculations.
There may be a certain amount of assumption and approximation going on here
as we try to ascertain what the cash flows for the company look like year on year.
The free cash flows will typically include:
– operating cash flows eg, inflows from sales, outflows such as materials
and labour etc.
– capital expenditure per annum
– tax relief
– tax payable
– synergies from merger (if any)
2. Select a suitable time horizon. The question may specify the time horizon of say
10 years, or it could be a perpetuity.
3. Identify a suitable discount rate. The discount rate may have to be calculated eg,
WACC or use of CAPM.
4. Finally we can calculate the present value of the free cash flows over the time
horizon less the value of any debt in the statement of financial position.

G Learn

EG Learning example 11.5

The following information has been taken from the statement of profit or loss and
statement of financial position of Paisley Ltd:

Revenue $400m
Production expenses $150m
Administrative expenses $36m
Tax allowable depreciation $28m
Capital investment $60m
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.
Calculate the value of the company based upon its free cash flows.


11.7.2 Advantages of free cash flows

• It is the best method on a theoretical basis, because it values expected cash
flows rather than profits
• It may be used to value a part of the company.

11.7.3 Disadvantages of free cash flows

• It relies on estimates of both cash flows and discount rates which may
be unavailable.
• There is difficulty in choosing a time horizon.
• There is difficulty in valuing a company’s worth beyond the time horizon.
• It assumes that the discount rate and tax rates are constant through the period.

11.8 Valuation of debt

When valuing debt we assume that:
1. The market price will be the present value of the cash flows associated with
owning the debt. Depending on the type of debt, these will include
– Interest received by the investor
– Any redemption value for redeemable debt, or other capital amounts (such
as shares for convertible debt).
2. The interest and other benefits received by the investor will be the gross amount
rather than the post-tax amount. The reason for this is that we do not know the
tax circumstances of the investors and therefore we calculate using the gross
values. Individual investors who are faced with buying the debt will have to take
their own circumstances into account when deciding on the benefits of investing
in one type of debt rather than another.
Be prepared to discuss the uncertainties around the figures used eg how the current
rate of interest in the economy affects the required return and how that affects the
valuation (the higher the current interest rate the lower the valuation).


11.9 Irredeemable debt

With redeemable debt, the company does not intend to repay the principal but to
pay interest forever (the interest is paid in perpetuity).
The formula for valuing a debenture is therefore:
MV =

I = annual interest starting in one year’s time 

MV = market price of the debenture now (year 0)
r = debtholders’ required return, expressed as a decimal. 

If you are given details of taxation then the formula would be:
I 1  T 
Where T is the investors’ relevant rate of tax.

G Learn

EG Learning example 11.6

A company has issued irredeemable loan notes with a coupon rate of 9%. The
required return of investors in this category of debt is 6%.
Calculate the current market value of the debt.


11.10 Redeemable debt

The market value of redeemable debt is the present value of the future cash flows.
These normally include:
1. Interest payments for the years in issue
2. Redemption value.

IE Illustrative example 11.2

A company has 10% debt redeemable in 5 years. Redemption will be at par value.
The investors require a return of 7% (gross).
Let us calculate the market value of the debt.

Year Cash flow DF @ 7% PV

1–5 Interest $10 4.100 41.0
5 Redemption value $100 0.713 71.3
Total 112.3

EG Learning example 11.7

A company has in issue 9% redeemable debt with 10 years to redemption.
Redemption will be at par. The investors require a return of 16%. What is the market
value of the debt?

11.11 Convertible debt

• With convertible debt, the holder has the option at the conversion date of either
– Converting to shares according to the terms of the offer; or
– Retaining the debt until redemption.
• The value of a convertible is the higher of its value as debt and its converted
value. This is known as the formula value.
• Note that the conversion date may not be the same as the redemption date. It
may be that you can convert in 4 years’ time and if you choose not to convert,
redeem in 6 years’ time. You must read the question carefully to see what the
examiner has asked.
• The floor value is the price of the debt assuming that the holder does not
convert and holds the debt to redemption. It equals the PV of the interest plus
redemption monies.


• The actual price of the debt on the markets will vary in accordance with the
fluctuations in interest rates and the market expectation about the value of the
conversion rights. Leaving aside interest rate fluctuations for the moment, if the
market expects the share price to be attractive at the conversion date then the
price of the debt will increase above the floor value to reflect the value of the
conversion rights. Conversely, if the market does not expect an attractive share
price at conversion, then the price of debt will fall to its floor value with no value
attached to the conversion rights.
For discussion purposes in the exam make sure you have learn the above issues as
well as the uncertainties around the figures used in the calculations.

IE Illustrative example 11.3

A company has 11% convertible debt redeemed at par in 5 years’ time. They may be
converted into 20 shares in five years with a current price of $4.40 per share. Shares
are expected to grow in value by 7% per annum. Kd(gross) = 8%
(a) Calculate the market value on conversion.

Step 1 Calculate the conversion value

20 shares × $4.4 × 1.075 = $123.42
Step 2 Decide whether to convert or redeem
In this case it is easy – the conversion value is higher than the
redemption value which is par ie $100. Therefore the decision
is to convert.

Year Cash flow DF @ 8% PV

1–5 Interest $11 3.993 43.92
5 Conversion value $123.42 0.681 84.05
Total 127.97

Therefore the market value is $127.97


(b) The floor value can be calculated by extending the above table to include a
line for the redemption value.

Year Cash flow DF@8% PV

1–5 Interest $11 3.993 43.92
5 Conversion value $123.42 0.681 84.05
TOTAL 127.97
5 Redemption value $100 0.681 68.1

The floor value is the PV of the interest plus the PV of the redemption
monies = $43.92 + $68.1 = $112.02

EG Learning example 11.8

9% convertible loan stock is redeemable in 4 years’ time at a premium of 5%. The
return on debt is 6%. The loan stock is convertible into 20 ordinary shares at the
redemption date.
(i) Calculate the floor value of the loan stock
(ii) What does the floor value represent?
(iii) Should a holder of loan stock convert or redeem their holding if the
expected share price at the time of redemption is $6.
(iv) Calculate the market value of the stock given that the holders will convert.

11.12 Preference shares

You will recall that the cost of capital of preference shares
Kp =
We can manipulate this formula to give the formula for the market value
P0 =


Similar to irredeemable debt, the income stream is the fixed percentage dividend
received in perpetuity. Thus the market value is the perpetuity divided by the
required return, where:

d = the constant annual preference dividend

P0 = ex-div market value of the share

Kp = cost of the preference share.

G Learn

EG Learning example 11.9

A firm has in issue 8% preference shares with a nominal value of $1. The required
return of preference shareholders is 9%.
What is the value of a preference share for this firm?
For discussion purposes in the exam, note that preference shares appear far less
regularly in most companies’ accounts. However the issues are similar to the
valuation of ordinary shares with respect to the risks involved, the accuracy of the
required return and any other values given.

Æ Key Learning Points

• Learn the reasons for business valuations. (F1a)
• Know the ways of valuing the equity in businesses, the first model being the
asset valuation model. (F2a)
• Secondly, learn the dividend valuation model and be able to do the
calculations. (F2c)
• Learn the earnings valuation models and understand the meaning and use of the
PE ratio. (F2b)
• Finally, be able to use your discounting knowledge to calculate the PV of free
cash flows. (F2c)
• Be able to calculate the value of debt, including convertible debt. (F3a)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).


Learning example solutions

EG Solution 11.1

Step 1 Calculate the value of d0. This is given in the question as 4¢

Step 2 Calculate the value of Ke
Ke = Rf + ß (Rm – Rf) = 0.05 + (0.6 × 10%) = 11%
Step 3 Calculate the growth rate g
g = (d0/d1)1/n – 1 = (4/3.3)1/2 – 1 = 10%
Substitute the amounts calculated above into the formula
P0 = 4(1 + 0.1)/(0.11 – 0.1) = 440¢
Therefore value of company = $4.4 × 2m = $8.8m

EG Solution 11.2

Step 1 The value of do is given in the question as 16¢

Step 2 Calculate the value of Ke
Ke = Rf + ß (Rm – Rf) = 0.06 + 0.9(0.11 – 0.06) = 10.5%
Step 3 The growth rate g is given as 8%
Substitute the amounts calculated above into the formula
P0 = 16(1 + 0.08)/(0.105 – 0.08) = 691.2¢
Therefore value of company = $6.91 × 1m = $6.91m

EG Solution 11.3
The value of the company = PAT × P/E ratio
The relevant PAT is the PAT of the target company = $1.2m
The PE ratio is the PE of the buyer company = $3/$0.20 = 15
Therefore the market value = $1.2m × 15 = $18m


EG Solution 11.4
Value of company = PAT/Earnings yield
PAT = $420,500
Earnings yield = 1/PE = 1/7 = 14.3%
Therefore value of company = $420,500/0.143 = $2.94m
(Just to avoid any confusion, you could have done this using the PE ratio as we did
before. Market value = PAT × PE = $420,500 × 7 = $2.94m)

EG Solution 11.5
Free cash flows ($m)

Trading cash flows per annum (400 − 150 − 36) 214 

Tax payable (214 × 0.3) (64.2)
Tax relief (28 × 0.3) 8.4 
Capital expenditure p.a. (60)
FCF 98.2 
Time horizon is a perpetuity
Use the dividend growth model for a growing perpetuity
P0 = d0(1 + g)/Ke − g = 98.2 × 1.06/0.166 – 0.06 = $982m 

g = inflation rate
d = FCF

EG Solution 11.6
We are valuing debt with a nominal value of $100.
We have seen the formula we have to use above - MV =
I = $100 × 9% = $9
r = 6%
MV = $9/0.06 = $150


The important point to grasp here is that when we are calculating the market value
of debt we are calculating the amount that the investor will pay for the debt. The
crucial thing to note is that the market value of the debt depends on the relationship
between the coupon on the debt and the investors’ required return (which in simple
terms we can think of as being a function of the rates of interest available in the
economy as a whole).
• As the economy interest rate increases, the price of the debt goes down.
• As the economy interest rate decreases, the price of the debt goes up.
Same debt, same coupon, the issuing company does nothing – but if interest rates
change, the price of the debt will change.
So, if the economy interest rate rose to 12%, the price of our company’s debt would
fall to $9/0.12 = $75.

EG Solution 11.7

Year Cash flow DF @ 7% PV

1 – 10 Interest $9 4.833 43.50
10 Redemption value $100 0.227 22.7
TOTAL 66.2

EG Solution 11.8
(a) Floor value

Year Cash flow DF @ 6% PV

1–4 Interest $9 3.465 31.19
4 Redemption value $105 0.792 83.16
Floor value 114.35

(b) The floor value is the value of the loan stock assuming that the stock has no
conversion value.
(c) The conversion value = 20 × $6 = $120
The redemption value = $100 × 1.05 = $105
Therefore the holder should convert to ordinary shares.


(d) Market value of stock

Year Cash flow DF @ 6% PV

1–4 Interest $9 3.465 31.19
4 Conversion value $120 0.792 95.04
Market value 126.23

EG Solution 11.9
The value of a preference share is:
P0 =

Therefore the price = 8¢/0.09 = 88.9¢



This chapter looks at the risk to a company from:
• foreign currency and
• interest rates.
Many companies use foreign currency for some or all of their transactions. We study
the types of risk that a company faces if part of its transactions are in a foreign
currency, the most obvious risk being that the exchange rate of the foreign currency
will move in a way that loses the company money.
Companies also face interest rate risk when they say borrow money at one rate of
interest and that rate rises such that the borrowing becomes more expensive. We
shall be looking at the underlying causes of the various risks and the ways that a
company can protect itself from these risks.
The most important part of this chapter is the exchange rate risk. The forward
contract and money market hedge are the areas that will most likely be the source of
However all parts of the chapter may provide scope for written questions of the
topics covered.

1. What are the types of exchange rate risk and how are they managed
by governments?

2. Do you know the difference between internal and external hedging methods?
3. Can you describe the different methods of hedging interest rate risk?


12.1 Foreign currency risk

When studying exchange rate risk (which is also called foreign currency risk) we
examine four areas
• What types of risk a company faces, for example the risk that the exchange rate
may move up or down in relation to other currencies. This will have a major
impact on the profitability of any company that buys or sells to other countries.
• The underlying systems that determine how exchange rates operate in the
financial markets
• Reasons why exchange rates move
• The way a company can hedge or reduce its exposure to exchange rate risks. This
latter point is by far the most important from the computational point of view
and is most likely to form the basis of an exam question.

12.2 Types of foreign currency risk

There are three risks associated with foreign currency:
1. Transaction risk
2. Translation risk
3. Economic risk

12.3 Transaction risk

Transaction risk is the risk associated with short-term cash flow transactions with a
company where a transaction is carried out in a foreign currency.

One example of this is the sale of goods at a certain exchange rate where we shall
not be paid for some time and during which time the rate may change.
The risk is not limited to trade however and a very similar risk is present if the
company borrows money in a foreign currency and will have to repay the capital or
interest with a disadvantageous exchange rate.
The important thing about this for the exam is that this is a risk that we want to
reduce (hedge) and this scenario is therefore a fertile source of exam questions.
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.


12.4 Translation risk

Translation risk is the risk associated with the reporting of foreign currency assets and
liabilities within financial statements.

The issue here is nothing to do with the current operations of the company or its
transactions but rather the value of the assets and liabilities as presented in the
statement of financial position at the year end. This has more to do with financial
reporting than financial management and as such we do not study this in much detail.
An important point to make in the exam is that there is no cash flow involved with
this risk even though the implications for the financial statements can be severe.
Many companies do not try to hedge this risk, but if they do want some protection
translation risk may be hedged by matching the assets and liabilities for each currency.
This means there would be a smaller net balance that the company is exposed to.

12.5 Economic risk

Economic risk refers to the 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 repayments.

Economic risk is more difficult to hedge given the longer term nature of the risk
(possibly over 10 or more years). The type of risk we are talking about is the risk
associated with buying a foreign subsidiary and comparing its value at the time of
acquisition with its value in say 10 years’ time. It is possible that if the exchange rates
have worked against us or local costs in the foreign country have caused the business
to be less competitive in world markets, then the value of the business in 10 years
may be greatly reduced.
There is also a risk for companies who manufacture in one country and sell
substantially in another. The problem here is that the costs are denominated in one
currency (say Euros) and the sales in another (say dollars). If the dollar were to fall
against the euro, the business would be faced with a fall in contribution as the value
of sales fell and costs remained high.
A simple technique to protect against this risk would be to adopt a portfolio
approach to investments to spread the risk. Owning different business in different
countries and selling also in different countries will spread the risk both regarding the
costs of supply and the revenues from sales such that the total risks will be reduced.


P Principle
Be able to describe the differences between the three risks

12.6 Exchange rate systems

12.6.1 Determination of exchange rates
Exchange rates are a key measure for governments to attempt to control. They will
have direct bearing on the economic performance of the country.
The exchange rate is determined by the buying and selling of a currency on the
foreign exchange markets.
Some of these transactions are performed by speculators who will try to anticipate
the rise or fall of a currency and then buy or sell as appropriate to take advantage of
the eventual changes in the rate.
However, the underlying exchange rate is determined by real economic factors. (We
shall refer to Sterling as an example, but other currencies operate in the same way.
We shall also refer to ‘goods’ which is to be taken to include ‘services’.)
• The demand for sterling is driven by the demand for goods produced in the UK.
These are the UK’s exports and have to be paid for in sterling.
• There is also a large demand for sterling caused by the sale of government debt,
and this too has to be paid for in sterling.
• The supply of sterling is driven by the demand for goods produced outside the
UK. These are the UK’s imports: sterling is supplied to the market in exchange for
foreign currency which is used to buy the overseas produced goods.
The supply and demand determines the exchange rate.
We shall now look at how the exchange rate can be managed by governments.

12.6.2 Fixed (or pegged) rate systems

In a fixed (or pegged) rate system, exchange rates are fixed when a currency is fixed
in relation to the dominant world currency ($) or alternatively against a basket of
currencies, the Exchange Rate Mechanism (ERM).
This fixed rate (or ‘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. Buyers and sellers know the foreign currency price of goods
that they are planning to buy or sell.
• A country has to keep its domestic economy under control otherwise the rate at
which its currency is fixed will become unsustainable.


• For example, excessive inflation will tend to put downward pressure on the
currency. This will cause people to sell the currency which reduces the country’s
foreign reserves. The government will have to take action to support the
currency in the short term (by the sale of foreign reserves and by raising interest
rates) and correct the inflation in the longer term.

• The remedial action referred to above causes the domestic economy to contract
and is one of the causes of ‘boom and bust’.
• The overall economy is unstable and growth and profitability of
companies is reduced.

12.6.3 Floating rate systems

Rates are said to float when the exchange rate is allowed to be determined by the
free operation of the market without any government intervention.
As always, the rate is determined by supply and demand.
A pure floating rate system is rare as the exchange rate is too important to be left
entirely to the markets.

• There is no need to use domestic policy to correct an imbalance. This can
remove the threat of ‘boom and bust’.
• For the most part, there is no threat to the foreign exchange reserves.
• The system is in theory self-correcting. If sterling is bid down on the markets
such that imports are more expensive and exports cheaper, the adverse balance
of supply and demand for the currency will be reversed because exports will
increase and imports will be reduced.

• Although the system is self-correcting, this may only take effect when sterling
has fallen to an uncomfortably low level, where inflation is very high and
imported goods very expensive.
• The market has a tendency to be volatile with an adverse effect on trade and
wider government policy. Buyers and sellers cannot be certain of the prices of
goods. This volatility can adversely affect the ability to trade between currencies.

G Learn
12.6.4 Managed (or dirty) float

A managed float is where the market is allowed to determine the exchange rate but
with government intervention to reduce the adverse impacts of a freely floating rate.


The basic aim is to ‘dampen’ the volatility by intervening or being prepared to

intervene to maintain the value within a ‘trading range’.
A government may further attempt to influence the ongoing value of the currency.
However, if this is materially at odds with the markets’ perception of the value of the
currency, the government’s attempts are rarely successful in the long run. Examples
of this failing include the pound falling out of the ERM or the collapse in the value of
the Argentinian Peso.
The government may intervene:
• 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.
• Increasing the interest rate within the economy so that the currency becomes
more attractive to investors and so attract speculative funds.

12.7 Causes of exchange rate fluctuations

12.7.1 Balance of payments

The balance of payments is the balance of all the sales and purchases of a currency
on the foreign exchange markets over a period of time (typically a month or year).

The different causes of purchases and sales of a currency are outlined below:
• International trade in goods and services. The inflows and outflows from trade
reflect demand for and supply of the goods produced by the economy which is
translated into the demand and supply of the 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.
• Speculative transactions from one currency to another are very important
for major currencies particularly when the markets scent a weakness. These
transactions can result in very large trades of the currency, causing large
movements in its value.
• Sales and purchases of government debt will also affect the demand and supply
of the currency.
• Changes in domestic interest rates will make the currency more or less attractive
to investors eg, an increase in interest rates will cause investors to buy sterling
thereby increasing its value.

12.7.2 Purchasing power parity theory (PPPT)

1 + inf 11st
Current spot rate × = expected spot rate in one year
1 + inf 12nd

ü Given


This theory explains the underlying cause of the exchange rate by stating that the
exchange rate is in equilibrium when any given good costs the same in any country or
currency (ie the purchasing power of the currency is the same).
This is 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.
This is an attractive theory that seems to be plausible, because if a good cost a
different amount in different currencies then it would be possible to buy goods in
one country and sell them in another making a profit on the exchange difference.
If this was done often enough the effect would be to realign the currencies so that
it was not possible to make the exchange profitable – the equilibrium rate of the
currencies would have become the rate at which the goods did cost the same, and no
exchange profits were possible. This process is referred to as arbitrage.
To extend the principle further this would suggest that a relative change in prices
(inflation) would have a direct effect on the exchange rate.
The problems with the theory are
• Transport costs
• Transaction costs of buying and selling the currency
• Tariffs and taxation that artificially increase the cost of goods in a country
• Local taste and differences in disposable income
However, while the theory does not explain absolute exchange rates for the reasons
given above, it does help to explain changes in exchange rates. We can illustrate this
by considering the effects of inflation.

P Principle
Be able to explain the theory

IE Illustrative example 12.1

A product is currently being sold in the UK for £2,000 and in the US for $4,000. The
exchange rate is in equilibrium at $2 = £1 (or $:£ 2.0000) – Note that in this latter
presentation of the exchange rate the rate is given to four decimal places.
What would we expect the exchange rate to be in 1 year if the inflation rates are 4%
and 7% respectively?


(a) We can calculate this by simply working out the year 1 inflated prices of the
goods and deriving the exchange rate from these.

Year UK US
0 £2,000 $4,000
Inflation x 1.04 x 1.07
1 £2,080 $4,280

The predicted exchange rate would be $4,280/£2,080 = $:£ 2.0577.

(b) Alternatively, to calculate the impact of PPP we can use the following formula:
1 + inf 11st
Current spot rate x = expected spot rate in one year's time.
1 + inf 12nd

Remember the original exchange rate was given as

$:£ 2.0000 ie there are 2 dollars to 1 pound
In this formula, the 1st exchange rate means the currency that is quoted first ($)
and the 2nd exchange rate is the currency that is quoted second (£).
Therefore $:£ = 2.0 × 1.07/1.04 = 2.0577

EG Learning example 12.1

The current exchange rate is $:€ 1.4000. Inflation rates for the two currency zones
are as follows:
Eurozone 2%
US 4%
What is the predicted exchange rate in one year?

12.7.3 Summary of PPPT

The PPP theory does provide a limited prediction of future exchange rates when using
comparative expected inflation rates as the driving cause of exchange rate changes.


EG Learning example 12.2

The current exchange rate is $:£ 1.8000. Inflation rates for the two currency zones
are as follows:
UK 3.5%
US 2%
What is the predicted exchange rate in one year?

12.8 Interest rate parity theory (IRPT)

F0 = S0 ×
1 + i 

1 + ib 
ü Given
The theory states that there is a no net gain relating to investing in government
bonds in differing countries, because any benefit in additional interest is eliminated
by a compensating adverse movement in exchange rates. If this wasn’t the case and
the forward exchange rate did not adjust, then profits could be made by investing in
bonds and switching currencies at an advantageous rate.
IRPT is an unbiased but poor predictor of future exchange rates.

G Learn

IE Illustrative example 12.2

It is possible to invest £1m in short-dated government bonds in the US at 6.08% or
alternatively in EU bonds at 4.04%. The current exchange rate is $:€ 1.4000. Let us
calculate the forward rate.
1 + inf i1st
Current spot rate x = forward rate in one year's time.
1 + inf i2nd

Therefore forward rate = 1.4000 × 1.0608/1.0404 = 1.4275

In practice the relationship between interest and exchange rates is not perfect and
certainly not simultaneous. It is possible that the exchange rate does not move in line
with interest rates for long periods, but will then correct over a short period of time.


EG Learning example 12.3

The current exchange rate is £:€0.7865. Interest rates for the two currency zones
are as follows:
Eurozone 4%
UK 5.5%
What is the predicted exchange rate in one year?

12.9 The International Fisher effect

The International Fisher effect states that all currencies must offer the same real
interest rate. This links PPPT to IRPT.

The relative real interest rates should be the same due to the principles of supply
and demand. If a country offers a higher real interest rate investors will invest in that
currency and push up the price of the currency bringing the real rate back to equilibrium.
The International Fisher effect has a strong theoretical basis but is a poor predictor of
future exchange rates.
Remember the Fisher effect from our dealings with DCF and inflation

(1 + m) = (1 + r)(1 + i)
We can recast this as (1 + r) = (1 + m)/(1 + i)
Or r = ((1 + m)/(1 + i)) − 1

ü Given

IE Illustrative example 12.3

We are going to take the figures from Learning example 1 and Illustrative example 2 and
examine whether the real rate of interest (r) is the same for the US and the Eurozone.
To summarise the relevant information from those questions
Inflation rates for the two currency zones are:
Eurozone 2%
US 4%
Interest rates for the two zones are:


Eurozone 4.04%
US 6.08%
We can calculate the real interest rates as follows.
US r = (1.0608/1.04) – 1 = 0.02 = 2%
Euro r = (1.0404/1.02) – 1 = 0.02 = 2%
Therefore the International Fisher effect holds true.

EG Learning example 12.4

The following interest and inflation rates are known for the pound and the euro:

Inflation rates Interest rates

UK £ 5.5% 7%
Eurozone € 4% 5%

The current exchange rate is €1.2 to the £1.

What are the predicted exchange rates in one year using:
(a) PPPT?
(b) IRPT?
(c) Does the International Fisher effect (IFE) hold true?

12.10 Four-way equivalence

In dealing with PPPT, IRPT and the International Fisher effect above, we have looked
at a rather confusing range of variables.
• PPPT looked at the link between
– inflation rates and
– movements in the spot exchange rate
• IRPT looked at the link between
– monetary interest rates on government bonds and
– differences between spot and forward exchange rates
• The International Fisher effect looked at the link between
– inflation rates
– monetary interest rates, and
– real interest rates (which demonstrates that real interest rates across all
countries are the same because of the linkages between inflation, interest
rates and exchange rates).


The four-way equivalence model identifies how these can all be brought together
in a way that shows how equalities link them all. The arrows indicate that the items
joined by the arrows are equal.

Difference in Fisher Expected difference

interest rates in inflation rates


Difference between
Expected change in
spot and forward
Expectation spot rates
exchange rates
You probably don’t need to know too much about this other than to appreciate that
there is an interconnections between interest rates, inflation rates and exchange rates.

12.11 Hedging exchange rate risk

Hedging is the process of reducing or eliminating risk. It may be achieved by using
internal or external measures.

12.11.1 Why hedge at all?

It is difficult to hedge in the long term, ie for more than year. In the short term it is
difficult to predict how exchange rates are going to move (IRPT, for example, is a poor
predictor) and an argument is that we may as well take the ‘rough with the smooth’
and not hedge
As a result you save on hedging costs, the downside being that the exposure to
exchange rates is present in the short-term and companies feel that they can reduce
their exposure by hedging.

12.11.2 Internal or external hedging

Internal measures comprise for the most part good control of the treasury function.
They have the advantage of being essentially cost free but at the same time are
unlikely to completely eliminate the risk.


External measures involve the banks or financial markets. They will incur cost but
may totally eliminate the risk.
In reality a company will use both internal of external hedging.

12.11.3 Obligation or option

There is a conceptual choice to be made between using
• an obligation to hedge the risk (eg a forward contract whereby the company
has to purchase the required foreign exchange at an agreed price). This has the
advantage of certainty as the company knows what it will cost.
• an option (eg an option to purchase the required foreign currency at a given
price). This has the advantage that the company only has to take up the option if
the foreign exchange rate has moved against the company. However an option
comes with a cost.
The choice will depend on how much risk can be avoided and at what cost.

12.11.4 Over The Counter (OTC) or exchange traded derivatives

• Over The Counter (OTC) instruments are set up by a bank to suit a company’s
particular needs. These have the advantage that they are made to measure
for the exact amount for the exact date and should eliminate all risk. The
disadvantage is that they are inflexible and cannot be changed or sold on.
• The alternative is to use derivatives. These are standardised instruments that
are packages by finance houses. They come in standard amounts of money at
standard dates. They are cheaper but the company may end up purchasing more
or less than they really need and for the wrong date. However they are flexible in
the sense that they can be sold at any time, as there is an active market for them.

12.12 Internal hedging techniques

12.12.1 Invoice in own currency
By invoicing in your own currency (or if the contract is for a purchase, be invoiced in
your own currency), the risk does not disappear but is transferred to the other party.
The question is whether the other party will accept the risk.
There are several options here if the other party will not accept the risk:
• Agree the exchange rate at which the contract is invoiced. This avoids
uncertainty and removes the risk.
• It may be possible to avoid the risk by sourcing supplies for the completion of
the contract with suppliers in the foreign country, thereby effectively netting off
most of the risk.


12.12.2 Lead payments

By paying early, or encouraging a customer to pay early, the risk relating to an
individual transaction is reduced or eliminated. The earlier the cash flow, the lower
the likely exposure to exchange rate movements.

12.12.3 Matching or netting

• Matching is possible if a company makes a number of transactions in both
directions (ie, sales and purchases). These may not be in relation to the same
contract, and the larger the company the more possible it is to match in this way.
Ideally, it has to arrange that the receipts will be received on the same day that
the payments are due.
The company needs a bank account in the foreign country denominated in the
foreign currency. It will then be able to net off those transactions relating to the
same dates. By doing this a company can materially reduce the overall exposure,
but is unlikely to eliminate it.
• Netting is entirely different and applies mainly to large companies with several
overseas subsidiaries or divisions which all engage in buying and selling in
foreign currency. These will have receivables and payables balances in the same
currencies which can simply be netted off by intercompany transfers.

G Learn
12.12.4 Asset and liability management
If a company has assets and liabilities in a foreign currency then the overall risk of
currency losses on either of them are reduced. As we account in sterling we have
to translate foreign currency assets and liabilities into sterling at the exchange rate
at the date of the Statement of Financial Position. If we just have foreign currency
assets there would be the chance for the exchange rate to change and these assets
to drop in value and make a loss (or alternatively to rise and make a profit). If these
foreign currency assets are matched with corresponding foreign currency liabilities
then any loss will be offset with a profit on the liabilities (and vice versa).

12.13 External hedging techniques

12.13.1 Introduction:
We shall look at these by distinguishing between:
• Hedging techniques that use the services of a bank
– Forward contracts
– Money market hedge
• Derivatives
– Currency futures
– Options


For the most part, the forward contract and the money market hedge will involve
calculations and the derivatives will require discussion.

12.13.2 Forward exchange contract

A forward contract is an agreement with the bank to exchange currency for a specific
amount at a future date at an agreed rate.

The mechanism for this is quite simple – our bank will agree to buy or sell an agreed
amount of a foreign currency for a rate agreed at the time we make the contract
with the bank. If we are selling in a foreign currency, the bank will agree to buy the
currency off us at the agreed rate on the agreed day. If we are buying in a foreign
currency, the bank will agree to sell the foreign currency to us at the agreed rate on
the agreed day.

G Learn
1. It is an obligation that must be completed once entered into. This is important
because we may regret having entered into the agreement if on the day the
money is needed, the spot rate is better than the rate we have agreed with the
bank. That is just unlucky and unpredictable. The advantage of the forward
contract is that at least we have certainty and are shielded from losses if the spot
rate had moved against us.
2. The underlying theory behind the setting of the forward rate is IRPT. This is a
poor predictor because interest rates are unpredictable, and hence we may
expect that 50% of the time the forward rate will move against us, and 50% of
the time it will move in our favour. If we had to do lots of these contracts then
we may start to think about bearing the risk ourselves. The banks do hundreds of
these contracts and therefore bear little overall risk so they are able to offer good
rates for this service that dissuade most businesses from doing it themselves.
3. 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.

12.13.3 What if the customer cannot complete the contract

It may happen that our company cannot complete the contract with the bank
because, for example, the company’s customer does not pay for the goods supplied
on the agreed date. The company had entered into the forward agreement with the
bank whereby the bank had agreed to buy the foreign currency proceeds from the


customer on the due date at the forward rate. The bank will insist that the company
fulfils this contract and will:
• Sell the required foreign currency at the spot rate on the day to the company, and
• As required by the forward contract, buy this currency back from the company at
the agreed forward rate.
The reverse happens if the contract was for the bank to sell foreign currency at the
forward rate.
Before we move on to look at an example of this we need to study the basic ideas of
exchange rates and how we convert, and buy and sell, currencies.

12.13.4 Calculations involving the spot rate with spread

Before moving on to further consideration of a forward contract, it will be useful to
consider calculations involving the spot rate with spread. A spread is the difference
between the buying rate and the selling rate.
• Consider a spot rate without the spread $:€1.4000
This means that $1.4000 are worth €1.0000
Note that the rate is expressed as an amount of dollars for 1 euro.
Note also some very important terminology – If the dollar sign comes first
($:€), and the dollar is referred to as the first currency and the euro as the
second currency.
• Now consider the spot rate with spread $:€1.4000± 0.0010
This means that the value is $:€1.3990 – 1.4010
The purpose of the spread is that it gives the bank its margin when it buys and
sells currency. We are going to illustrate this by talking about the company
buying or selling dollars (if it were buying or selling euros it would be reversed).
The rate quoted with spread means that:
– the bank will sell $1.3990 for €1.0000
– the bank will buy $1.4010 for €1.000
• Note how this spread is how the bank makes its profit. Let’s look at an example:
1. A bank sells you dollars for euros
2. you give the bank €1, the bank gives you $1.3990
3. the bank buys back the dollars for euros
4. the bank gives you €1, you have to give the bank back $1.4010
The bank has made a profit, being the spread.
We can see this in a diagram which shows the rate at which the company buys
and sells and emphasises the point that if the company is buying, the bank is
selling and vice versa – don’t get this confused.


$: € 1.3990 1.4010
Bank sells dollars Bank buys dollars
Company buys dollars Company sells dollars

G Learn
12.13.5 Converting and buying currency
In order to be able to buy a currency we have to convert one currency to the other.
There are some simple rules that you need to follow, and the following diagram will
assist with this. We are repeating the above table with an added divide and multiply
sign above the currencies and just noting the rate that applies when the company
buys or sells.

÷ x
$: € 1.3990 1.4010
Company buys dollars Company sells dollars

(a) Do we multiply or divide to convert – the conversion rule

When converting one currency to the other we have to be clear whether we are
dividing or multiplying by the rate. The exchange rate has been given dollars to euros
($:€), where the $ is referred to as the first currency and the € the second currency.
– If we are converting the first currency to the second, we divide the 1st
currency by the rate to calculate the second, and
– If we are converting the second currency to the first, we multiply the 2nd
currency by the rate to calculate the first.
We therefore have to ask the key question, ‘Are we converting the first or
second currency?’

Conversion rule ÷ 1st currency to calculate the 2nd

× 2nd currency to calculate the 1st

(b) Which rate do we use – the buying or selling rate?

We then have to decide whether the company is buying or selling the first
currency (dollars).
– If the company is buying the first currency (dollars) we use the low rate
– If the company is selling the first currency (dollars) we use the high rate.


We therefore have to ask another key question, ‘Are we buying or selling the
first currency?’

Flow rule (when looking at the 1st currency use the ‘Bart Simpson’ rule)
Bart (buy 1st currency at the low rate)
Simpson (sell 1st currency at the high rate)

G Learn

IE Illustrative example 12.4

A company is to make a $100,000 payment to a supplier. It is planning to sell euros to
buy the dollars.
The rate is quoted as $:€1.4000 ± 0.0010
How will the number of euros be calculated?
Note very importantly that the rate puts $ as the first currency – vital that you get this.

Step 1 Are we converting the first or second currency? 

The amount to be converted is quoted in dollars ($100,000)
Therefore we have to divide the dollars to get the amount of euros 
Step 2 Are we buying or selling the first currency? 
We are buying dollars, so we use the buy rate (1.3990)
Therefore we have $100,000/1.3990 = €71,480 

EG Learning example 12.5

A company is to make a €100,000 payment to a supplier. It is planning to sell dollars
to buy the euros.
The rate is quoted as $:€1.4000 ± 0.0010
How will the number of dollars be calculated?

12.13.6 Returning to the forward contract

IE Illustrative example 12.5

A company is expecting to receive €300,000 from a customer in one month and is
due to make a €200,000 payment in three months.
The 1 month forward rate is $:€1.4150 ± 0.0012


The 3 month forward rate is $:€1.4430 ± 0.0015

The company’s own currency is in dollars and it therefore decides to arrange a
forward contract to hedge the risk.
We need to determine the dollar amounts that the bank will guarantee to exchange
the currency for at the relevant dates.
(a) Consider first the €300,000 receipt in one month.

Step 1 Do we multiply or divide to convert the currency to dollars? 

The amount is quoted in euros which is the second currency, so we
have to multiply
Step 2 Do we use the buy or sell rate? 
We are going to receive euros and we need to buy dollars to deposit
into the bank. Dollars are the first currency so we use the buy rate
which is the lower rate (1.4150 – 0.0012 = 1.4138)
1 month forward = €300,000 × 1.4138 = $424,140 

(b) Consider now the €200,000 payment in three months.

Step 1 Do we multiply or divide to convert the currency to dollars? 

The amount is quoted in euros which is the second currency, so we
have to multiply.
Step 2 Do we use the buy or sell rate? 
We are going to pay in euros and we need to sell dollars to buy the
euros to make the payment. Dollars are the first currency so we use
the sell rate which is the higher rate (1.4430 + 0.0015 = 1.4445)
The 3 month forward = €200,000 × 1.4445 = $288,900. 

EG Learning example 12.6

A UK company is to make a €200,000 payment to a supplier. It is planning to sell
pounds to buy the euros. The rate is quoted as €:£ 1.1000 ± 0.0005
How will the number of pounds be calculated?

EG Learning example 12.7

A US company is to receive €300,000 from a customer.
The rate is quoted as $:€ 1.6000 ± 0.0010


Determine the dollar amounts that the bank will guarantee to exchange the currency
for at the relevant date.

12.13.7 Calculating the forward rate of exchange

The forward rate may be given as an adjustment to the prevailing spot rate, if
so the rule is:
Add any discount given, subtract any premium given

IE Illustrative example 12.6

The spot rate is $:£ 2.1132 ± 0.0046 giving the spread $:£ 2.1086 – 2.1178
The forward discount is 0.0032 – 0.0036
You are required to calculate the value of a receipt of $400,000 at the forward rate.

Step 1 Calculate the forward rate

The forward rate can be calculated as follows:
$ $
Spot rate 2.1086 2.1178
Add discount 0.0032 0.0036
Forward rate 2.1118 2.1214
Step 2 Decide whether to multiply or divide.
The receipt is in dollars which is the first currency –
therefore divide
Step 3 Decide which rate to use
We are receiving dollars (the first currency) so we
are selling dollars to the bank to obtain pounds. We
therefore use the higher rate 2.1214
Receipt in £ = $400,000/2.1214 = £188,555.

• There is flexibility with regard to the amount to be covered. This should lead to a
perfect hedge in terms of amount and date
• Relatively straightforward both to comprehend and to organise.

• Contractual commitment that must be completed on the due date, if the
underlying transaction is in anyway doubtful this may be problem;
• The rate is fixed with no opportunity to benefit from favourable movements in
exchange rates.


12.14 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 prevailing spot rate.

12.14.1 Steps
We shall assume that the scenario is that you need to pay an invoice for $4m in three
months’ time. Your own currency is the euro.
1. Borrow funds in the currency in which you need the money – euros.
2. Exchange the euros today into dollars at the spot rate avoiding exposure to
fluctuations in the rate.
3. Deposit the dollars in a dollar bank account. The amount you borrow, exchange
and deposit has to be enough to be worth $4m dollars in three months’ time
including the interest earned in the dollar account.
4. In three months’ time you can pay the $4m dollar invoice and will be left with a
euro debt equal to the original amount borrowed in euros plus interest.

G Learn

EG Learning example 12.8

Arbeloa is a UK company trading extensively in the US. The current exchange rate is
$:£ 1.9750 ± 0.003.
We wish to do the following transactions:
$ Receipt of $500,000 in 1 month.
$ Payment of $300,000 in 3 months.
The money markets provide the following interest rates for next year (pa)

Loan rate 6.0% 7.5%
Deposit rate 4.0% 5.0%

Forward rates
1 month discount 0.0012 – 0.0017
3 month discount 0.0034 – 0.0038

Calculate the £ receipt and payments using both money markets and forward markets.


12.14.2 Comparison with a forward contract

• There is some flexibility regarding the date at which the transaction takes place
than a forward contract.
• May be more available in currencies for which a forward rate is not available.
• Will produce a similar amount to a forward contract

• More complex than a forward contract.
• May be difficult to borrow/ deposit in some currencies at a risk-free rate.

12.15 Other currency hedging techniques

12.15.1 Introduction
You need to know and understand the main types of foreign currency derivatives
used to hedge foreign currency risk, though note that no numerical questions will be
set on this topic.
We therefore look at the two most common derivatives.

12.15.2 Currency futures

A currency future is an exchange traded contract to buy or sell a fixed quantity of a
specific currency at a set rate at a set future date.

The main points to note are that:

• The futures contract is for a standard amount of currency for example $125,000
or €150,000 depending on what contracts are being offered.
• The date when the contract will have to be delivered is called the settlement
date or delivery date (ie the date when you will have to buy or sell the currency).
This date is fixed – it is usually the last day of a quarter (eg 31 March).
• The rate at which you will have to buy or sell on the closing date is also fixed at
the time of buying the contract.
• You can sell the contract before the closing date because there is an active
market in futures contracts. Note that the market price of the contract will
increase or decrease throughout its life as exchange rates vary.
• The future contract is not a bespoke instrument. As we have seen, it is for
standard amounts for a fixed period. If you want a larger amount you have to
purchase more than one contract. If you want a smaller amount you cannot
divide a contract so you are hedging more than you need.
The fixed time period is not such a problem because you can sell at any time. This
gives more flexibility on timing than a forward contract.


12.15.3 How the futures contract provides a hedge

The way a futures contract works as a hedge is that the company effectively has two
transactions whose prices complement each other and are designed to cancel out
any movement in the exchange rate.
1. The commercial contract that has resulted in the company needing to, say, pay
$150,000 in one month’s time. It wants the hedge to protect against any adverse
exchange rate movement.
2. A futures contract that effectively bets on the exchange rate movement.
The linking of the two is designed to cancel out the movement of the exchange rate
and leads to the hedge.

G Learn
12.15.4 Currency options

A currency option is simply a right (or option) to buy a currency at a set rate at a
set future date.

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.
Currency options may be exchange traded or over-the-counter (OTC).
Exchange traded options are standard options in certain currencies that are can be
bought from an options exchange. They are limited in type and inflexible.
OTC options are bought from a bank and can be specifically for a particular trade.

12.15.5 How currency options provide a hedge

The currency option works because it is an option. The buying company does not
have to take up the option if the rates have moved against it.
Consider a company with a domestic currency in euros and needing to pay $150,000 in
three months’ time. The current spot rate is $:€ 2.0000. The company wants to hedge
the risk so that in three months’ time it will be exchanging at the same rate ($:€ 2.0000).
To do this it can simply purchase a currency option to buy $150,000 at that rate.
• If the market moves against the company, it will exercise the option and buy at
the $:€ 2.0000 rate.
• If the market moves in favour of the company such that it is cheaper to buy on
the open market, it will simply not exercise the option and buy on the open
market instead.


P Principle
The difference between an option and a forward or
futures contract

12.16 Interest rate risk

Interest rate risk is the risk that interest rates will rise or fall in the future.

There are two types of interest rate risk:

• Gap exposure. This is the risk that a company faces when its interest bearing
assets and liabilities mature and need to be refinanced. The risk is that they will be
refinanced at rates that are disadvantageous to the company. The risk is generally
assessed for assets and liabilities that carry fixed rates or are very rate sensitive.
The main risk is when assets and liabilities have similar maturity dates and the
liabilities that mature at those dates exceed the assets.
• Basis risk. This is a risk where a company has matched its assets and liabilities
at the relevant maturity dates but may have the interest rates on its assets and
liabilities set by reference to different benchmark rates. Rates are typically based
in the UK on the Bank of England’s base rate and the LIBOR (London Inter-Bank
Offered Rate). However with global companies borrowing and lending in many
different financial centres, there are many rates that companies may have their
borrowing and lending tied to. European rates and US rates differ markedly from
UK rates and companies increasingly look to these for finance.
The risk is that the borrowing and lending rates may move by different amounts
if they are based on different benchmark rates which can cause a significant
increase in the company’s cost of finance and cash flow.
Interest rates are normally less volatile than 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 enduring 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 (ie the company may have been able to borrow at a cheaper
variable rate).


12.17 Reasons for interest rate fluctuations

12.17.1 Government policy
Interest rates or base rates are a key economic tool for government. They may be
changed for the following reasons:
• To control inflation. Higher interest rates reduce the demand for money in the
economy and this leads to a reduction in aggregate demand. The reduction in
demand leads to lower inflation.
• To protect the currency. An increase in the interest rates will have a one-off
effect of attracting speculative funds and increasing the value of the currency.
• To ‘kick-start’ the economy. A reduction in interest rates can stimulate economic
activity by encouraging borrowing and investment.

12.17.2 Term structure of interest rate – The yield curve

The following diagram shows the relationship between the gross redemption yield
of a debt investment and its term to maturity. As the maturity (the term) of the debt
increases the yield of the debt increases.


Term to maturity

G Learn
There are three elements which cause this relationship:
1. Liquidity preference
2. Expectations theory
3. Market segmentation.


12.17.3 Liquidity preference

Investors prefer to hold cash rather than debt. They would prefer to spend the
money now rather than later and need to be compensated for lending. This applies
to any lending (long or short term) and it is the rate of interest (or yield) that is the
compensation they seek.
Long term debt requires a higher yield partly because the lender requires greater
compensation for not having access to the money for longer and partly because of
the greater risk involved.
Thus long term bonds have a higher yield that short term bonds.

12.17.4 Market expectations

If interest rates were expected to fall over time, long term rates would be lower than
short term rates. The yield curve would therefore slope downwards.
Thus the shape of the curve is a good indicator of how the markets expect rates to move.

12.17.5 Market segmentation

Differing parts of the market (short-term vs long-term debt markets) may react
to differing economic information meaning that the yield curve is not smooth but
suffers discontinuities.

12.18 Hedging interest rate risks

We may hedge interest rate risk over the short or the long-term using the
following instruments:

Short-term hedging Long-term hedging

Forward rate agreements Swaps
Interest rate guarantee
Interest rate futures

G Learn
12.18.1 Short-term hedging
A. Matching and smoothing
These are internal hedging techniques that a company can perform by organising
its internal borrowing and lending in a way that will reduce risks.
– Matching. A company matches liabilities and assets that have the same
interest rate characteristics. For example, a company may decide to arrange
that one company in the group borrows money at LIBOR and another invests


at LIBOR. The advantage is that although the company will suffer the LIBOR
spread the borrowing and lending rates will not dramatically diverge.
Note that matching does not mean that the loans are netted off in the books
– each separate company keeps its own books.
Also, matching does not mean that the borrowing and lending are cancelled,
the proceeds of the lending paying off the cost of the borrowing. Firstly that
may not be possible depending on the loan agreements. Secondly, it may not
be desirable as the company which has the surplus cash which it has loaned
on the market may itself have plans to invest that cash in a longer term
project at some time in the near future.
– Smoothing. A company is said to smooth its borrowing if it keeps a balance
between fixed and variable rate borrowing. This will smooth the changes
in the interest cost because if, for example, a company held the balance at
50:50 and rates increased, the change in interest cost would only be half of
what it would have been if all the debt had been variable.
B. Asset and liability management
One example of asset and liability management has been alluded to when
looking at gap exposure and basis risk above. The assets and liabilities referred
to are financial assets and liabilities that bear interest and we saw the risks that
were present due to different maturities and different interest bases.
The gap risk is managed by ensuring that the maturities of the debt portfolio are
such that liabilities do not exceed assets in any maturity group.
The basis risk is managed by the smoothing techniques we have just looked at.
C. Forward rate agreements

A forward rate agreement (FRA) is an agreement entered into with a bank whereby
the bank fixes the interest rate for a loan to be taken out in the future for a given
period of time.

The agreement specifies:

1. the date when the loan will commence
2. the ‘term’ of the loan, ie the period for which the loan will last. In practice this
will tend to be fairly short and probably not more than one year.
3. the amount of the loan. The agreement will usually be for fairly large sums.
The FRA works as follows
• The bank offers a loan at a fixed rate of interest – say 5%
• If the actual rate of interest at the time the loan is taken out is 6%, the bank
charges the client 6% with repayment of 1% making a net cost of 5%.
• If the actual rate of interest at the time the loan is taken out is 4%, the bank
charges the client 4% plus 1% making a net cost of 5%


The net effect of this is that the FRA is the perfect hedge. There is no upside for the
client but the client will not have to pay more than the agreed rate.
Important points to note
– The FRA is wholly separate from the underlying loan.
– It is an obligation that must be taken once entered into.
– It is OTC and tailored to a specific loan
– It will give certainty as regards the interest paid but there is a downside risk
that interest rates may fall and the client is tied into a higher rate.
D. Interest rate guarantee (IRG)
An IRG is similar to a FRA but this is 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.
There is a premium to pay to compensate the IRG writer for accepting the
downside risk.
E. 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.

12.19 Long-term hedging – swaps

An interest rate swap is an agreement between two parties, both of whom have
interest bearing loans, whereby the first party agrees to pay the interest of the second
party, and the second party agrees to pay the interest of the first.

The reasons why companies would consider this are various. It may be that they have
a very different perception of how interest rates will move. However the main reason
in practice is that the two parties have a different type of loan – one fixed interest
and the other variable, and they want to swap the type of interest paid.
The companies could simply redeem the present debt and refinance in the
appropriate form. However 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.

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.

G Learn

Æ Key Learning Points

• Know the types of foreign currency risk. (G1a)
• Learn how exchange rates are determined. (G2a)
• Study the causes of rate fluctuations particularly the purchasing power parity
theory, the interest rate parity theory and the International Fisher Effect. (G2b, G2c)
• Learn the approaches to hedging exchange rate risk, particularly forward
contracts and the money market hedge. (G3a–G3c)
• Similarly, know how to hedge interest rate risk and discuss the main methods of
hedging these risks. (G4a, G4b)

What's the story?

Stop and think through the 'story' of this chapter and how it links with other
chapters (use the Overview to help).


Learning example solutions

EG Solution 12.1
$:€ = 1.4000 × 1.04/1.02 = 1.4275
The dollar has depreciated against the euro. We can get more dollars for a euro after
1 year when the dollar inflated faster than the euro.

EG Solution 12.2
1.8000 × 1.02/1.035 = 1.7739
The dollar is the first currency, so (1 + the dollar’s inflation rate) is the numerator.

EG Solution 12.3
0.7865 × 1.055/1.04 = 0.7978
The pound is the first currency, therefore (1 + the pound’s interest rate) is the numerator.

EG Solution 12.4
(a) The predicted exchange rate using PPPT is €1.2 × (1.04/1.055) = €1.1829
(b) The predicted rate using IRPT is €1.2 × (1.05/1.07) = €1.1776
Hence it is unlikely that the real rates in each currency zone are the same, given
these solutions are different.
For the Eurozone, using (1 + m) = (1 + r)(1 + i) we see that r = 1.05/1.04 − 1= 0.96%
For the UK we see that r = 1.07/1.055 − 1= 1.42%
As these two rates aren’t the same we can see the IFE doesn’t hold true in this case.

EG Solution 12.5
Note very importantly that the rate puts $ as the first currency – vital that you get
this (again!).

Step 1 Are we converting the first or second currency? 

The amount to be converted is quoted in euros (€100,000)
Therefore we have to multiply the euros to get the amount of dollars 
Step 2 Are we buying or selling the first currency? 
We are selling dollars, so we use the sell rate (1.4010)
Therefore we have €100,000 × 1.4010 = $140,100 


EG Solution 12.6
Note very importantly that the rate puts € as the first currency.

Step 1 Are we converting the first or second currency? 

The amount to be converted is quoted in euros (€200,000)
Therefore we have to divide the euros to get the amount of pounds 
Step 2 Are we buying or selling the first currency? 
We are selling pounds and buying euros (the first currency), so we use
the buy rate (1.1000 – 0.0005 = 1.0995)
Therefore we have €200,000/1.0995 = £181,901 

EG Solution 12.7
Note that the rate puts $ as the first currency.

Step 1 Are we converting the first or second currency? 

The amount to be converted is quoted in euros (€300,000) the
second currency.
Therefore we have to multiply the euros to get the amount of dollars. 
Step 2 Are we buying or selling the first currency? 
We are selling euros and buying dollars (the first currency), so we
use the buy rate
(1.6000 – 0.0010 = 1.5990)
Therefore we have €300,000 × 1.5990 = $479,700 


EG Solution 12.8
Firstly, taking the $ receipt of $500,000 in 1 month.
Using the money market, borrow $s now at 7.5% pa. For one month the rate will
be 7.5%/12 = 0.625%. The amount borrowed is $500,000/1.00625 = $496,894, so
that the $500,000 receipt will repay this in one month’s time once interest is added.
Converting the $496,894 to £s we get $496,894/1.9780 = £251,210 now. Invested at
4% per annum of 4/12 = 0.33% per month we get £251,210 × 1.0033 = £252,039 in
one month’s time.
Using the forward market we get $500,000/1.9797 = £252, 563 in a month’s time.
Note that we add on any discount given to find the forward rate (and deduct
premiums). Here we take the higher exchange rate to mean the receipt gets us less £s.
Secondly, taking the $ payment of $300,000 in 3 months.
Using the money market, lend $s now at 5.0% pa. For three months the rate will be
5.0%/4 = 1.25%. The amount lent is $300,000/1.0125 = $296,296, so that this will
grow to $300,000 in three months’ time and be used to make the payment. To get
the $296,296 now we need to have £s to convert to $s. $296,296/1.9720 (the spot
rate) = £150,225 now.
Using the forward market we need $300,000/1.9754 = £151,868 in three months’ time.
Note that we add on any discount given to find the forward rate (and deduct premiums).
Here we take the lower exchange rate, meaning that the payment costs us more £s.


Question bank

Specimen Exam applicable from September 2016

Section A – ALL 15 questions are compulsory and MUST be attempted

Please use the grid provided on page two of the Candidate Answer Booklet to record
your answers to each multiple choice question. Do not write out the answers to the
MCQs on the lined pages of the answer booklet.
Each question is worth 2 marks.
1. The home currency of ACB Co is the dollar ($) and it trades with a company in
a foreign country whose home currency is the Dinar. The following information
is available:

Home country Foreign country

Spot rate 20·00 Dinar per $
Interest rate 3% per year 7% per year
Inflation rate 2% per year 5% per year

What is the six-month forward exchange rate?

A. 20·39 Dinar per $
B. 20·30 Dinar per $
C. 20·59 Dinar per $
D. 20·78 Dinar per $

2. The following financial information relates to an investment project:

Present value of sales revenue 50,025
Present value of variable costs 25,475
Present value of contribution 24,550
Present value of fixed costs 18,250
Present value of operating income 6,300
Initial investment 5,000
Net present value 1,300

What is the sensitivity of the net present value of the investment project to a
change in sales volume?
A. 7·1%
B. 2·6%
C. 5·1%
D. 5·3%

Question bank

3. Gurdip plots the historic movements of share prices and uses this analysis to
make her investment decisions.
To what extent does Gurdip believe capital markets to be efficient?
A. Not efficient at all
B. Weak form efficient
C. Semi-strong form efficient
D. Strong form efficient

4. Which of the following statements concerning capital structure theory is correct?

A. In the traditional view, there is a linear relationship between the cost of equity
and financial risk
B. Modigliani and Miller said that, in the absence of tax, the cost of equity would
remain constant
C. Pecking order theory indicates that preference shares are preferred to
convertible debt as a source of finance
D. Business risk is assumed to be constant as the capital structure changes

5. Which of the following actions is LEAST likely to increase shareholder wealth?

A. The weighted average cost of capital is decreased by a recent financing decision
B. The financial rewards of directors are linked to increasing earnings per share
C. The board of directors decides to invest in a project with a positive NPV
D. The annual report declares full compliance with the corporate governance code

6. Which of the following statements are features of money market instruments?

1. A negotiable security can be sold before maturity
2. The yield on commercial paper is usually lower than that on treasury bills
3. Discount instruments trade at less than face value

A. 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3

7. The following are extracts from the statement of profit or loss of CQB Co:

Sales income 60,000
Cost of sales 50,000
Profit before interest and tax 10,000


Interest 4,000
Profit before tax 6,000
Tax 4,500
Profit after tax 1,500

60% of the cost of sales is variables costs.

What is the operational gearing of CQB Co?
A. 5·0 times
B. 2·0 times
C. 0·5 times
D. 3·0 times

8. The management of XYZ Co has annual credit sales of $20 million and accounts
receivable of $4 million. Working capital is financed by an overdraft at 12%
interest per year. Assume 365 days in a year.
What is the annual finance cost saving if the management reduces the
collection period to 60 days?
A. $85,479
B. $394,521
C. $78,904
D. $68,384

9. Which of the following statements concerning financial management are correct?

1. It is concerned with investment decisions, financing decisions and
dividend decisions
2. It is concerned with financial planning and financial control
3. It considers the management of risk

A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3

10. SKV Co has paid the following dividends per share in recent years:

Year 20X4 20X3 20X2 20X1

Dividend ($ 0·360 0·338 0·328 0·311
per share)

The dividend for 20X4 has just been paid and SKV Co has a cost of equity of 12%.
Using the geometric average historical dividend growth rate and the dividend
growth model, what is the market price of SKV Co shares on an ex dividend basis?

Question bank

A. $4·67
B. $5·14
C. $5·40
D. $6·97

11. ‘There is a risk that the value of our foreign currency-denominated assets and
liabilities will change when we prepare our accounts’
To which risk does the above statement refer?
A. Translation risk
B. Economic risk
C. Transaction risk
D. Interest rate risk

12. The following information has been calculated for A Co:

Trade receivables collection period: 52 days

Raw material inventory turnover period: 42 days
Work in progress inventory turnover period: 30 days
Trade payables payment period: 66 days
Finished goods inventory turnover period: 45 days

What is the length of the working capital cycle?

A. 103 days
B. 131 days
C. 235 days
D. 31 days

13. Which of the following is/are usually seen as benefits of financial

1. Interest rate fixing
2. Risk pooling
3. Maturity transformation

A. 1 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3


14. Which of the following statements concerning working capital

management are correct?
1. The twin objectives of working capital management are profitability and liquidity
2. A conservative approach to working capital investment will increase
3. Working capital management is a key factor in a company’s long-term success

A. 1 and 2 only
B. 1 and 3 only
C. 2 and 3 only
D. 1, 2 and 3

15. Governments have a number of economic targets as part of their monetary policy.
Which of the following targets relate predominantly to monetary policy?
1. Increasing tax revenue
2. Controlling the growth in the size of the money supply
3. Reducing public expenditure
4. Keeping interest rates low

A. 1 only
B. 1 and 3
C. 2 and 4 only
D. 2, 3 and 4

(30 marks)

Question bank

Section B – ALL 15 questions are compulsory and MUST be attempted

Please use the grid provided on page two of the Candidate Answer Booklet to record
your answers to each multiple choice question. Do not write out the answers to the
MCQs on the lined pages of the answer booklet.
Each question is worth 2 marks.
The following scenario relates to questions 16-20.
Par Co currently has the following long-term capital structure:

$m $m
Equity finance
Ordinary shares 30·0
Reserves 38·4
Non-current liabilities
Bank loans 15·0
8% convertible loan notes 40·0
5% redeemable preference shares 15·0
Total equity and liabilities 138·4

The 8% loan notes are convertible into eight ordinary shares per loan note in seven
years’ time. If not converted, the loan notes can be redeemed on the same future
date at their nominal value of $100. Par Co has a cost of debt of 9% per year.
The ordinary shares of Par Co have a nominal value of $1 per share. The current ex
dividend share price of the company is $10·90 per share and share prices are expected
to grow by 6% per year for the foreseeable future. The equity beta of Par Co is 1·2.
16. The loan notes are secured on non-current assets of Par Co and the bank loan is
secured by a floating charge on the current assets of the company.
In terms of risk to the investor, what are the riskiest and least risky sources of
finance for Par Co?

Riskiest Least risky

A Redeemable preference shares Bank loan
B Ordinary shares Bank loan
C Bank loan Loan notes
D Ordinary shares Loan notes


17. What is the conversion value of the 8% loan notes of Par Co after seven years?
A. $16·39
B. $111·98
C. $131·12
D. $71·72

18. Assuming the conversion value after seven years is $126·15, what is the current
market value of the 8% loan notes of Par Co?
A. $115·20
B. $109·26
C. $94·93
D. $69·00

19. Which of the following statements relating to the capital asset pricing
model is correct?
A. The equity beta of Par Co considers only business risk
B. The capital asset pricing model considers systematic risk and unsystematic risk
C. The equity beta of Par Co indicates that the company is more risky than the
market as a whole
D. The debt beta of Par Co is zero

20. Which of the following statements are problems in using the price/earnings
ratio method to value a company?
1. It is the reciprocal of the earnings yield
2. It combines stock market information and corporate information
3. It is difficult to select a suitable price/earnings ratio
4. The ratio is more suited to valuing the shares of listed companies

A. 1 and 2 only
B. 3 and 4 only
C. 1, 3 and 4 only
D. 1, 2, 3 and 4

Question bank

The following scenario relates to questions 21-25

ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan
several years ago when peso interest rates were relatively cheap compared to dollar
interest rates. ZPS Co does not have any income in pesos. Economic difficulties have now
increased peso interest rates while dollar interest rates have remained relatively stable.
ZPS Co must pay interest on the dates set by the bank. A payment of 5,000,000 pesos
is due in six months’ time. The following information is available:

Spot rate 12·500–12·582 pesos per $

Six-month forward rate 12·805-12·889 pesos per $

Interest rates which can be used by ZPS Co:

Borrow Deposit
Peso interest rates 10·0% per year 7·5% per year
Dollar interest rates 4·5% per year 3·5% per year

21. What is the dollar cost of a forward market hedge?

A. $390,472
B. $387,928
C. $400,000
D. $397,393

22. Which of the following statements relate to purchasing power parity theory?
1. The theory holds in the long term rather than the short term
2. The exchange rate reflects the different cost of living in two countries
3. The forward rate can be found by multiplying the spot rate by the ratio of
the interest rates of the two countries

A. 1, 2 and 3
B. 1 and 2 only
C. 1 and 3 only
D. 2 only

23. What are the appropriate six-month interest rates for ZPS Co to use if the
company hedges the peso payment using a money market hedge?

Deposit rate Borrowing rate

A 7·5% 4·5%
B 1·75% 5·0%
C 3·75% 2·25%
D 3·5% 10·0%


24. Which of the following methods are possible ways for ZPS Co to hedge its
existing foreign currency risk?
1. Matching receipts and payments
2. Currency swaps
3. Leading or lagging
4. Currency futures

A. 1, 2, 3 and 4
B. 1 and 3 only
C. 2 and 4 only
D. 2, 3 and 4 only

25. ZPS Co also trades with companies in Europe which use the Euro as their home
currency. In three months’ time ZPS Co will receive €300,000 from a customer.
Which of the following is the correct procedure for hedging this receipt using a
money market hedge?

A Step 1 Borrow an appropriate amount in Euro now

Step 2 Convert the Euro amount into dollars
Step 3 Place the dollars on deposit
Step 4 Use the customer payment to repay the loan
B Step 1 Borrow an appropriate amount in dollars now
Step 2 Place the dollars on deposit now
Step 3 Convert the dollars into Euro in three months’ time
Step 4 Use the customer payment to repay the loan
C Step 1 Borrow an appropriate amount in dollars now
Step 2 Convert the dollar amount into Euro
Step 3 Place the Euro on deposit
Step 4 Use the customer payment to repay the loan
D Step 1 Borrow an appropriate amount in Euro now
Step 2 Place the Euro on deposit now
Step 3 Convert the Euro into dollars in three months’ time
Step 4 Use the customer payment to repay the loan

Question bank

The following scenario relates to questions 26-30

Ridag Co operates in an industry which has recently been deregulated as the
government seeks to increase competition in the industry.
Ridag Co plans to replace an existing machine and must choose between two
machines. Machine 1 has an initial cost of $200,000 and will have a scrap value of
$25,000 after four years. Machine 2 has an initial cost of $225,000 and will have
a scrap value of $50,000 after three years. Annual maintenance costs of the two
machines are as follows:

Year 1 2 3 4
Machine 1 ($ per year) 25,000 29,000 32,000 35,000
Machine 2 ($ per year) 15,000 20,000 25,000

Where relevant, all information relating to this project has already been adjusted to
include expected future inflation. Taxation and tax allowable depreciation must be
ignored in relation to Machine 1 and Machine 2.
Ridag Co has a nominal before-tax weighted average cost of capital of 12% and a
nominal after-tax weighted average cost of capital of 7%.
26. In relation to Ridag Co, which of the following statements about competition
and deregulation are true?
1. Increased competition should encourage Ridag Co to reduce costs
2. Deregulation will lead to an increase in administrative and compliance
costs for Ridag Co
3. Deregulation should mean an increase in economies of scale for Ridag Co
4. Deregulation could lead to a decrease in the quality of Ridag Co’s products

A. 1 and 4
B. 2 and 3
C. 1 and 3
D. 2 and 4

27. What is the equivalent annual cost of Machine 1?

A. $90,412
B. $68,646
C. $83,388
D. $70,609


28. Which of the following statements about Ridag Co using the equivalent annual
cost method are true?
1. Ridag Co cannot use the equivalent annual cost method to compare Machine
1 and Machine 2 because they have different useful lives
2. The machine which has the lowest total present value of costs should be
selected by Ridag Co

A. 1 only
B. Both 1 and 2
C. 2 only
D. Neither 1 nor 2

29. Doubt has been cast over the accuracy of the year 2 and year 3 maintenance
costs for Machine 2. On further investigation it was found that the following
potential cash flows are now predicted:

Year Cash flow Probability

2 18,000 0·3
2 25,000 0·7
3 23,000 0·2
3 24,000 0·35
3 30,000 0·45

What is the expected present value of the maintenance costs for year 3?
A. $26,500
B. $18,868
C. $21,624
D. $35,173

30. Ridag Co is appraising a different project, with a positive NPV. It is concerned

about the risk and uncertainty associated with this other project.
Which of the following statements about risk, uncertainty and the project is true?
A. Sensitivity analysis takes into account the interrelationship between project variables
B. Probability analysis can be used to assess the uncertainty associated with the project
C. Uncertainty can be said to increase with project life, while risk increases with the
variability of returns
D. A discount rate of 5% could be used to lessen the effect of later cash flows
on the decision

(30 marks)

Question bank

Section C – BOTH questions are compulsory and MUST be attempted

Please write your answers to all parts of these questions on the lined pages within
the Candidate Answer Booklet.
31. PV Co, a large stock-exchange-listed company, is evaluating an investment
proposal to manufacture Product W33, which has performed well in test
marketing trials conducted recently by the company’s research and development
division. Product W33 will be manufactured using a fully-automated process
which would significantly increase noise levels from PV Co’s factory. The following
information relating to this investment proposal has now been prepared:

Initial investment $2 million

Selling price (current price terms) $20 per unit
Expected selling price inflation 3% per year
Variable operating costs (current price terms) $8 per unit
Fixed operating costs (current price terms) $170,000 per
Expected operating cost inflation 4% per year

The research and development division has prepared the following demand
forecast as a result of its test marketing trials. The forecast reflects expected
technological change and its effect on the anticipated life-cycle of Product W33.

Year 1 2 3 4
Demand (units) 60,000 70,000 120,000 45,000

It is expected that all units of Product W33 produced will be sold, in line with the
company’s policy of keeping no inventory of finished goods. No terminal value or
machinery scrap value is expected at the end of four years, when production of
Product W33 is planned to end. For investment appraisal purposes, PV Co uses
a nominal (money) discount rate of 10% per year and a target return on capital
employed of 30% per year. Ignore taxation.


(a) Calculate the following values for the investment proposal:
(i) net present value; (5 marks)
(ii) internal rate of return; and (3 marks)
(iii) return on capital employed (accounting rate of return) based on average
investment. (3 marks)

(b) Briefly discuss your findings in each section of (a) above and advise whether
the investment proposal is financially acceptable. (4 marks)
(c) Discuss how the objectives of PV Co’s stakeholders may be in conflict if the
project is undertaken. (5 marks)

(20 marks)
32. DD Co has a dividend payout ratio of 40% and has maintained this payout ratio
for several years. The current dividend per share of the company is $0·50 per
share and it expects that its next dividend per share, payable in one year’s time,
will be $0·52 per share.
The capital structure of the company is as follows:

$m $m
Ordinary shares (nominal value $1 per share) 25
Reserves 35
Bond A (nominal value $100) 20
Bond B (nominal value $100) 10

Bond A will be redeemed at nominal in ten years’ time and pays annual interest
of 9%. The cost of debt of this bond is 9·83% per year. The current ex interest
market price of the bond is $95·08.
Bond B will be redeemed at nominal in four years’ time and pays annual interest
of 8%. The cost of debt of this bond is 7·82% per year. The current ex interest
market price of the bond is $102·01.
DD Co has a cost of equity of 12·4%. Ignore taxation.

Question bank

(a) Calculate the following values for DD Co:
(i) ex dividend share price, using the dividend growth model; (3 marks)
(ii) capital gearing (debt divided by debt plus equity) using market values;
and (2 marks)
(iii) market value weighted average cost of capital. (2 marks)

(b) Discuss whether a change in dividend policy will affect the share price of DD
Co. (8 marks)
(c) Explain why DD Co’s capital instruments have different levels of risk and
return. (5 marks)

(20 marks)


Formulae Sheet
Economic order quantity

Miller-Orr Model
Return point = Lower limit +   spread 
3 3
 4  transaction cost  variance of cash flows 
Spread = 3  
 intt erest rate 

The Capital Asset Pricing Model

E(ri) = Rf + ßi(E(rm)) – Rf)

The asset beta formula

 Ve   Vd 1  T  
a =  e  +  d 
  Ve + Vd 1  T      Ve + Vd 1  T   

The Growth Model

D0  1 + g 
P0 =
re  g

Gordon’s growth approximation

g = bre

The weighted average cost of capital

 Ve   Vd 
WACC =   ke +   k d 1  T 
 Ve + Vd   Ve + Vd 

The Fisher formula

(1 + i) = (1 + r)(1 + h)

Purchasing power parity and interest rate parity

1 + hc  1 + ic 
S1 = S 0  F0 = S 0 
1 + hb  1 + ib 

Question bank

Present Value Table

Present value of 1 i.e. (1 + r)–n

Where r = discount rate

n = number of periods until payment

Discount rate (r)

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826 2
3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751 3
4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683 4
5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621 5
6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564 6
7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513 7
8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467 8
9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424 9
10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386 10
11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350 11
12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319 12
13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290 13
14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263 14
15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694 2
3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579 3
4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482 4
5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402 5
6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335 6
7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279 7
8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233 8
9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194 9
10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162 10
11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135 11


Discount rate (r)

12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112 12
13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093 13
14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078 14
15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065 15

Annuity Table
1  1 + r 

Present value of an annuity of 1 i.e.


Where r = discount rate

n = number of periods

Discount rate (r)

Periods 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 1
2 1·970 1·942 1·913 1·886 1·859 1·833 1·808 1·783 1·759 1·736 2
3 2·941 2·884 2·829 2·775 2·723 2·673 2·624 2·577 2·531 2·487 3
4 3·902 3·808 3·717 3·630 3·546 3·465 3·387 3·312 3·240 3·170 4
5 4·853 4·713 4·580 4·452 4·329 4·212 4·100 3·993 3·890 3·791 5
6 5·795 5·601 5·417 5·242 5·076 4·917 4·767 4·623 4·486 4·355 6
7 6·728 6·472 6·230 6·002 5·786 5·582 5·389 5·206 5·033 4·868 7
8 7·652 7·325 7·020 6·733 6·463 6·210 5·971 5·747 5·535 5·335 8
9 8·566 8·162 7·786 7·435 7·108 6·802 6·515 6·247 5·995 5·759 9
10 9·471 8·983 8·530 8·111 7·722 7·360 7·024 6·710 6·418 6·145 10
11 10·368 9·787 9·253 8·760 8·306 7·887 7·499 7·139 6·805 6·495 11
12 11·255 10·575 9·954 9·385 8·863 8·384 7·943 7·536 7·161 6·814 12
13 12·134 11·348 10·635 9·986 9·394 8·853 8·358 7·904 7·487 7·103 13
14 13·004 12·106 11·296 10·563 9·899 9·295 8·745 8·244 7·786 7·367 14
15 13·865 12·849 11·938 11·118 10·380 9·712 9·108 8·559 8·061 7·606 15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 1
2 1·713 1·690 1·668 1·647 1·626 1·605 1·585 1·566 1·547 1·528 2
3 2·444 2·402 2·361 2·322 2·283 2·246 2·210 2·174 2·140 2·106 3
4 3·102 3·037 2·974 2·914 2·855 2·798 2·743 2·690 2·639 2·589 4
5 3·696 3·605 3·517 3·433 3·352 3·274 3·199 3·127 3·058 2·991 5
6 4·231 4·111 3·998 3·889 3·784 3·685 3·589 3·498 3·410 3·326 6

Question bank

Discount rate (r)

7 4·712 4·564 4·423 4·288 4·160 4·039 3·922 3·812 3·706 3·605 7
8 5·146 4·968 4·799 4·639 4·487 4·344 4·207 4·078 3·954 3·837 8
9 5·537 5·328 5·132 4·946 4·772 4·607 4·451 4·303 4·163 4·031 9
10 5·889 5·650 5·426 5·216 5·019 4·833 4·659 4·494 4·339 4·192 10
11 6·207 5·938 5·687 5·453 5·234 5·029 4·836 4·656 4·486 4·327 11
12 6·492 6·194 5·918 5·660 5·421 5·197 4·988 4·793 4·611 4·439 12
13 6·750 6·424 6·122 5·842 5·583 5·342 5·118 4·910 4·715 4·533 13
14 6·982 6·628 6·302 6·002 5·724 5·468 5·229 5·008 4·802 4·611 14
15 7·191 6·811 6·462 6·142 5·847 5·575 5·324 5·092 4·876 4·675 15


Specimen Exam Answers

Section A
1. A
20 x (1·035/1·015) = 20·39 Dinar per $
2. D
Sensitivity to a change in sales volume = 100 x 1,300/24,550 = 5·3%
3. A
Gurdip is basing her investment decisions on technical analysis, which means that she
believes the stock market is not efficient at all, not even weak form efficient.
4. D
The statement about business risk is correct.
5. B
Increases in shareholder wealth will depend on increases in cash flow, rather than
increases in earnings per share, i.e. increases in profit. If the financial rewards
of directors are linked to increasing earnings per share, for example, through a
performance-related reward scheme, there is an incentive to increasing short-term
profit at the expense of longer growth in cash flows and hence shareholder wealth.
6. B
Both statements 1 and 3 are correct.
7. D
Operational gearing = Contribution/PBIT = [60,000 – (50,000 x 0·6)]/10m = 3 times
8. A
Finance cost saving = 13/365 x $20m x 0·12 = $85,479
9. D
All three statements concerning financial management are correct.
10. C
The geometric average dividend growth rate is (36·0/31·1)1/3 – 1 = 5%
The ex div share price = (36·0 x 1·05)/(0·12 – 0·05) = $5·40
11. A
The statement refers to translation risk.
12. A
The length of the operating cycle is 52 + 42 + 30 – 66 + 45 = 103 days.

Question bank

13. C
Risk pooling and maturity transformation are always included in a list of benefits of
financial intermediation.
14. B
Both statements 1 and 3 are correct.
15. C
The two targets relating predominantly to monetary policy are controlling the
growth in the size of the money supply and keeping interest rates low (2 and 4).


Section B
16. D
The secured loan notes are safer than the bank loan, which is secured on a floating
charge. The redeemable preference shares are above debt in the creditor hierarchy.
Ordinary shares are higher in the creditor hierarchy than preference shares.
17. C
Future share price after seven years = 10·90 x 1·067 = $16·39 per share
Conversion value of each loan note = 16·39 x 8 = $131·12 per loan note
18. B
Market value of each loan note = (8 x 5·033) + (126·15 x 0·547) = 40·26 + 69·00 = $109·26
19. C
An equity beta of greater than 1 indicates that the investment is more risky than the
market as a whole.
20. B
It is correct that the price/earnings ratio is more suited to valuing the shares of listed
companies, and it is also true that it is difficult to find a suitable price earnings ratio
for the valuation.
21. A
Interest payment = 5,000,000 pesos
Six-month forward rate for buying pesos = 12·805 pesos per $
Dollar cost of peso interest using forward market = 5,000,000/12·805 = $390,472
22. B
Exchange rates reflecting the different cost of living between two countries is stated
by the theory of purchasing power parity.
The theory holds in the long term rather than the short term.
The forward rate is found by multiplying the spot rate by the ratio of the inflation
rates of the two countries.
23. C
Dollars will be borrowed now for six months at 4·5 x 6/12 = 2·25%
Pesos will be deposited now for six months at 7·5 x 6/12 = 3·75%
24. C
Currency futures and swaps could both be used. As payment must be made on
the date set by the bank, leading or lagging are not appropriate. Matching is also
inappropriate as there are no peso income streams.

Question bank

25. A
The correct procedure is to: Borrow euro now, convert the euro into dollars and
place the dollars on deposit for three months, use the customer receipt to pay back
the euro loan.
26. A
Deregulation to increase competition should mean managers act to reduce costs
in order to be competitive. The need to reduce costs may mean that quality of
products declines.
27. A
Since taxation and capital allowances are to be ignored, and where relevant all
information relating to project 2 has already been adjusted to include future
inflation, the correct discount rate to use here is the nominal before-tax weighted
average cost of capital of 12%.

0  1  2  3  4 
Maintenance costs (25,000) (29,000) (32,000) (35,000)
Investment and (200,000) 25,000 
Net cash flow (200,000) (25,000) (29,000) (32,000) 10,000 
Discount at 12% 1·000  0·893  0·797  0·712  0·636 
Present values (200,000) (22,325) (23,113) (22,784) (6,360)

Present value of cash flows ($274,582)

Cumulative present value factor 3·037
Equivalent annual cost = 274,582/3·037 = $90,412
28. D
Both statements are false. The machine with the lowest equivalent annual cost
should be purchased not the present value of future cash flows alone.
The lives of the two machines are different and the equivalent annual cost method
allows this to be taken into consideration.
29. B
EV of year 3 cash flow = (23,000 x 0·2) + (24,000 x 0·35) + (30,000 x 0·45) = 26,500
PV discounted at 12% = 26,500 x 0·712 = 18,868
30. C
The statement about uncertainty increasing with project life is true.


Section C
(i) Calculation of NPV

Year 0  1 2 3 4
$  $ $ $ $
Investment (2,000,000)

Income 1,236,000 1,485,400 2,622,000 1,012,950

Operating costs 676,000 789,372 1,271,227 620,076
Net cash flow (2,000,000) 560,000 696,028 1,350,773 392,874
Discount at 10% 1·000  0·909 0·826 0·751 0·683
Present values (2,000,000) 509,040 574,919 1,014,430 268,333
Net present value: $366,722 

Calculation of income

Year 1 2 3 4
Inflated selling 20·60 21·22 21·85 22·51
price ($/unit)
Demand 60,000 70,000 120,000 45,000
Income ($/year) 1,236,000 1,485,400 2,622,000 1,012,950

Calculation of operating costs

Year 1 2 3 4
Inflated variable 8·32 8·65 9·00 9·36
cost ($/unit)
Demand (units/year) 60,000 70,000 120,000 45,000
Variable costs ($/year) 499,200 605,500 1,080,000 421,200
Inflated fixed costs ($/ 176,800 183,872 191,227 198,876
Operating costs ($/year) 676,000 789,372 1,271,227 620,076

Question bank

Alternative calculation of operating costs

Year 1 2 3 4
Variable cost ($/unit) 8 8 8 8
Demand (units/year) 60,000 70,000 120,000 45,000
Variable costs ($/year) 480,000 560,000 960,000 360,000
Fixed costs ($/year) 170,000 170,000 170,000 170,000
Operating costs ($/year) 650,000 730,000 1,130,000 530,000
Inflated costs ($/year) 676,000 789,568 1,271,096 620,025

(ii) Calculation of internal rate of return

Year 0  1 2 3 4
$  $ $ $ $
Net cash flow (2,000,000) 560,000 696,028 1,350,773 392,874
Discount at 20% 1·000  0·833 0·694 0·579 0·482
Present values (2,000,000) 466,480 483,043 782,098 189,365

Net present value: ($79,014)

Internal rate of return = 10 + ((20 – 10) x 366,722)/(366,722 + 79,014) = 10
+ 8·2 = 18·2%
(iii) Calculation of return on capital employed
Total cash inflow = 560,000 + 696,028 + 1,350,773 + 392,874 = $2,999,675
Total depreciation and initial investment are same, as there is no scrap value.
Total accounting profit = 2,999,675 – 2,000,000 = $999,675
Average annual accounting profit = 999,675/4 = $249,919
Average investment = 2,000,000/2 = $1,000,000
Return on capital employed = 100 x 249,919/1,000,000 = 25%
(b) The investment proposal has a positive net present value (NPV) of $366,722 and
is therefore financially acceptable. The results of the other investment appraisal
methods do not alter this financial acceptability, as the NPV decision rule will
always offer the correct investment advice.
The internal rate of return (IRR) method also recommends accepting the
investment proposal, since the IRR of 18·2% is greater than the 10% return required
by PV Co. If the advice offered by the IRR method differed from that offered by the
NPV method, the advice offered by the NPV method would be preferred.


The calculated return on capital employed of 25% is less than the target return
of 30%, but as indicated earlier, the investment proposal is financially acceptable
as it has a positive NPV. The reason why PV Co has a target return on capital
employed of 30% should be investigated. This may be an out-of-date hurdle rate
which has not been updated for changed economic circumstances.
(c) As a large listed company, PV Co’s primary financial objective is assumed to be
the maximisation of shareholder wealth. In order to pursue this objective, PV
Co should undertake projects, such as this one, which have a positive NPV and
generate additional value for shareholders.
However, not all of PV Co’s stakeholders have the same objectives and the
acceptance of this project may create conflict between the different objectives.
Due to Product W33 being produced using an automated production process,
it will not meet employees’ objectives of continuity or security in their
employment. It could also mean employees will be paid less than they currently
earn. If this move is part of a longer-term move away from manual processes,
it could also conflict with government objectives of having a low rate of
The additional noise created by the production of Product W33 will affect the
local community and may conflict with objectives relating to healthy living.
This may also conflict with objectives from environmental pressure groups and
government standards on noise levels as well.
(i) Dividend growth rate = 100 x ((52/50) – 1) = 100 x (1·04 – 1) = 4% per year
Share price using DGM = (50 x 1·04)/(0·124 – 0·04) = 52/0·84 = 619c or $6·19
(ii) Number of ordinary shares = 25 million
Market value of equity = 25m x 6·19 = $154·75 million
Market value of Bond A issue = 20m x 95·08/100 = $19·016m
Market value of Bond B issue = 10m x 102·01/100 = $10·201m
Market value of debt = $29·217m
Market value of capital employed = 154·75m + 29·217m = $183·967m
Capital gearing = 100 x 29·217/183·967 = 15·9%
(iii) WACC = ((12·4 x 154·75) + (9·83 x 19·016) + (7·82 x 10·201))/183·967 = 11·9%
(b) Miller and Modigliani showed that, in a perfect capital market, the value of a
company depended on its investment decision alone, and not on its dividend
or financing decisions. In such a market, a change in dividend policy by DD Co
would not affect its share price or its market capitalisation. They showed that
the value of a company was maximised if it invested in all projects with a positive

Question bank

net present value (its optimal investment schedule). The company could pay any
level of dividend and if it had insufficient finance, make up the shortfall by issuing
new equity. Since investors had perfect information, they were indifferent
between dividends and capital gains. Shareholders who were unhappy with the
level of dividend declared by a company could gain a ‘home-made dividend’ by
selling some of their shares. This was possible since there are no transaction
costs in a perfect capital market.
Against this view are several arguments for a link between dividend policy
and share prices. For example, it has been argued that investors prefer certain
dividends now rather than uncertain capital gains in the future (the ‘bird-in-the-
hand’ argument).
It has also been argued that real-world capital markets are not perfect, but
semi-strong form efficient. Since perfect information is therefore not available,
it is possible for information asymmetry to exist between shareholders and the
managers of a company. Dividend announcements may give new information
to shareholders and as a result, in a semi-strong form efficient market, share
prices may change. The size and direction of the share price change will depend
on the difference between the dividend announcement and the expectations of
shareholders. This is referred to as the ‘signalling properties of dividends’.
It has been found that shareholders are attracted to particular companies as
a result of being satisfied by their dividend policies. This is referred to as the
‘clientele effect’. A company with an established dividend policy is therefore likely
to have an established dividend clientele. The existence of this dividend clientele
implies that the share price may change if there is a change in the dividend policy
of the company, as shareholders sell their shares in order to reinvest in another
company with a more satisfactory dividend policy. In a perfect capital market,
the existence of dividend clienteles is irrelevant, since substituting one company
for another will not incur any transaction costs. Since real-world capital markets
are not perfect, however, the existence of dividend clienteles suggests that if DD
Co changes its dividend policy, its share price could be affected.
(c) There is a trade-off between risk and return on DD’s capital instruments.
Investors in riskier assets require a higher return in compensation for this
additional risk. In the case of ordinary shares, investors rank behind all other
sources of finance in the event of a liquidation so are the most risky capital
instrument to invest in. This is partly why DD Co’s cost of equity is more
expensive than its debt financing.
Similarly for debt financing, higher-risk borrowers must pay higher rates of
interest on their borrowing to compensate lenders for the greater risk involved.
DD Co has two bonds, with Bond A having the higher interest rate and therefore
the higher risk. Since both bonds were issued at the same time, business risk is
not a factor in the higher level of risk.


Instead, this additional risk is likely to be due to the fact that Bond A has a
greater time until maturity, meaning that its cash flows are more uncertain than
Bond B. In particular where interest rates are expected to increase in the future,
longer-term debt will have a higher rate of interest to compensate investors for
investing for a longer period.
A further factor is that the total nominal value (book value) of Bond A is twice as
large as Bond B and therefore may be perceived to be riskier.

Question bank

Specimen Exam Marking Scheme

Section A
1-20 Two marks per question 30
Section B
16-30 Two marks per question 30
Section C Maximum Marks
marks awarded
31 (a) Inflated income 2
Inflated operating costs 2
Net present value 1
Internal rate of return 3
Return on capital employed 3
(b) Discussion of investment 3
appraisal findings
Advice on acceptability of project 1
(c) Maximisation of 2
shareholder wealth
Conflict from automation of 2
production process
Conflict from additional noise 1
32 (a) Dividend growth rate 1
Share price using dividend 2
growth model
Capital gearing 2
Weighted average cost of capital 2
(b) Dividend irrelevance 4
Dividend relevance 4
(c) Discussion of equity 1


Debt and recognising business 1
risk is not relevant
Time until maturity of bonds 1
Different value of bonds 1
Other relevant discussion 1


Earnings yield 304

Index Economic environment

Economic Order Quantity
Economic risk
Economy 50
A Effectiveness 50
Efficiency 50
Agency problem 53 Efficient Market Hypothesis (EMH) 289
Agency theory 52 Equity beta 198
Asset-based valuations 298 Equity finance 225
Asset beta 198 Equivalent annual cost (EAC) 108
Asset replacement 106 Exchange rate policies 59
Asset valuation 296 Exchange rate systems 321
Ex div 157
B External hedging techniques 331
Baumol model 272 F
Bonds 141
Factoring 259
C Financial gearing 211
Financial intermediation 135
Capital Asset Pricing Model (CAPM) 163
Financial management 38
Capital gearing 211
Financial objectives 47
Capital markets 133
Financing decision 43
Cash budget 273
Fiscal policy 56
Competition policy 61
Fisher effect 100
Convertible debt 173
Fluctuating current assets 251
Cost centre 240
Foreign currency risk 319
Cost of debt 170
Forward exchange contract 332
Cost of equity 156
Forward rate agreements 344
Currency futures 339
Full employment 55
Currency options 340
Funding gap 145
D Future value 78

Debentures 142 G
Debt 140
Goal congruence 53
Discounted (adjusted) payback period 89
Gordon’s growth model 162
Discounted cash flow (DCF) 75
Discounting 78 H
Dividend cover 216
Dividend decision 46 Hedging exchange rate risk 329
Dividend policy 139
Dividend valuation model 157 I
Dividend yield 216
Inflation 55
E Interest cover 213
Interest rate futures 345
Earnings per share 214 Interest rate guarantee (IRG) 345


Interest Rate Parity Theory (IRP) 326 Preference shares 138

Interest rate risk 341 Present value 77
Interest rate swap 345 Present Value of Free Cash Flows 304
Internal hedging techniques 330 Price/Earnings (PE) method 302
Internal rate of return (IRR) 82 Price earnings ratio (P/E ratio) 215
International Fisher Effect 327 Profit centre 240
Investment appraisal 66 Purchasing power parity theory (PPP) 323
Investment decision 39
Islamic Finance 148 Q
J Quoted shares 226

Just in time (JIT) stock ordering 268 R

L Ratios 206
Real cash flows 99
Lease or Buy 120 Relevant costs 97
Long-term finance 132 Return on capital employed (ROCE) 71
Riba 149
M Rights issue 228
Risk 40
Market risk premium 167
Risk-adjusted discount rates 119
Maturity gap 145
Risk-free return 155
Maximising shareholders’ wealth 47
Miller-Orr model 269 S
Modigliani and Miller (M&M) 190
Monetary policy 57 Satisficing 49
Money cash flows 99 Sensitivity analysis 115
Money market 134 Sharia Law 148
Money market hedge 338 Simulation 120
Money supply 58 Single period capital rationing 110
Small- and medium-sized entities (SMEs) 144
N Stakeholders 50
Stock Exchange introduction 228
Net present value (NPV) 80
Systematic risk 164
Operating cycle 243
Theoretical Ex-Rights Price (TERP) 229
Operational gearing 210
Three key decisions 39
Opportunity cost 97
Traditional view of capital structure 188
Opportunity cost of capital 76
Transaction risk 319
Overtrading 247
Translation risk 320
P Treasury management 239
Types of debt 141
Payback period 68
Pecking Order Theory 195 U
Permanent current assets 250
Unquoted shares 225
Perpetuity 89


Unsystematic risk 164

Valuation of debt 306
Venture capital 144

Weighted Average Cost of Capital (WACC) 174
Working capital 238

Yield curve 342