Express Notes ACCA F9
Express Notes ACCA F9
ACCA Paper F9
Financial Management
For exams in 2011
theexpgroup.com
ExPress Notes
ACCA F9 Financial Management
Contents
About ExPress Notes
1. 2. 3. 4. 5. 6. 7. Financial Management Function Working Capital Management Investment Appraisal Business Finance Cost of Capital Business Valuations Risk Management
3
7 11 19 37 43 51 56
Page | 2
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
ACCA F9 Financial Management
ExP classroom course students will also have access to various online support materials, including: The unique ExP & Me e-portal, which amongst other things allows view again of the classroom course that was actually attended. ExPand, our online learning tool and questions and answers database
Page | 3
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Everybody in the World has free access to ACCAs own database of past exam questions, answers, syllabus, study guide and examiners commentaries on past sittings. This can be an invaluable resource. You can find links to the most useful pages of the ACCA database that are relevant to your study on ExPand at www.theexpgroup.com.
HowtogetthemostfromtheseExPressnotes
For people on a classroom course, this is how we recommend that you use the suite of learning materials that we provide. This depends where you are in terms of your exam preparation for each paper.
Your stage in study for each paper Prior to study, e.g. deciding which optional papers to take These ExPress notes ExP recommended course notes, or ExPedite notes Dont use yet ExP recommended exam kit Dont use yet ACCA online past exams
Skim through the ExPress notes to get a feel for whats in the syllabus, the size of the paper and how much it appeals to you. Work through each chapter of the ExPress notes in detail before you then work through your course notes. Dont try to feel that you have to understand everything just get an idea for what you are about to study. Dont make any annotations on the ExPress notes at this stage.
Have a quick look at the two most recent real ACCA exam papers to get a feel for examiners style. Dont use at this stage.
Work through in detail. Review each chapter after class at least once. Make sure that you understand each area reasonably well, but also make sure that you can recall key definitions, concepts, approaches to exam questions, mnemonics, etc.
Nobody passes an exam by what they have studied we pass exams by being efficient in being able to prove what we know. In other words, you need to have effectively input the knowledge and be effective in the output of what you know. Exam practice is key to this. Try to do at least one past exam question on the learning phase for each major chapter.
Page | 4
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Your stage in study for each paper Practice phase These ExPress notes ExP recommended course notes, or ExPedite notes Avoid reading through your notes again. Try to focus on doing past exam questions first and then go back to your course notes/ ExPress notes if theres something in an answer that you dont understand. ExP recommended exam kit This is your most important tool at this stage. You should aim to have worked through and understood at least two or three questions on each major area of the syllabus. You pass real exams by passing mock exams. Dont be tempted to fall into passive revision at this stage (e.g. reading notes or listening to CDs). Passive revision tends to be a waste of time. Dont touch it! ACCA online past exams ACCA F9 Financial Management
Work through the ExPress notes again, this time annotating to explain bits that you think are easy and be brave enough to cross out the bits that you are confident youll remember without reviewing them.
Download the two most recent real exam questions and answers. Read through the technical articles written by the examiner. Read through the two most recent examiners reports in detail. Read through some other older ones. Try to see if there are any recurring criticisms he or she makes. You must avoid these! Do a final review of the two most recent examiners reports for the paper you will be taking tomorrow.
Read through the ExPress notes in full. Highlight the bits that you think are important but you think you are most likely to forget.
Unless there are specific bits that you feel you must revise, avoid looking at your course notes. Give up on any areas that you still dont understand. Its too late now. Avoid looking at them in detail, especially if the notes are very big. It will scare you.
Read quickly through the full set of ExPress notes, focusing on areas youve highlighted, key workings, approaches to exam questions, etc.
Leave at home.
Leave at home.
Page | 5
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Our ExPress notes fit into our portfolio of materials as follows:
ACCA F9 Financial Management
Notes
Provide a base understanding of the most important areas of the syllabus only.
Notes
Provide a comprehensive coverage of the syllabus and accompany our face to face professional exam courses
Notes
Provide detailed coverage of particular technical areas and are used on our Professional Development and Executive Programmes.
To maximise your chances of success in the exam we recommend you visit www.theexpgroup.com where you will be able to access additional free resources to help you in your studies.
As well as courses for ACCA and other professional qualifications, our portfolio of expertise covers all areas of financial training ranging from introductory financial awareness courses for non-financial staff to high level corporate finance and banking courses for senior executives.
Our expert team has worked with many different audiences around the world ranging from graduate recruits through to senior board level positions. Full details about us can be found at www.theexpgroup.com and for any specific enquiries please contact us at [email protected].
Page | 6
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Chapter 1
ACCA F9 Financial Management
KEYKNOWLEDGE TheNatureandPurposeofFinancialManagement
The main purpose of financial strategy is to ensure that financial resources are available to the organization in support of its overall corporate objectives, which include financial objectives. Management accounting is a set of tools and disciplines measuring corporate performance and to facilitate decision-making; it is designed and implemented in coordination with the companys strategy. Financial accounting is concerned with maintaining the records of the transactions of the firm and preparing financial statements for the benefit of shareholders (and other external audiences) in conformity with established accounting standards.
Page | 7
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
ACCA F9 Financial Management
In pursuing its financial objectives, the firm must ensure that those objectives are congruent i.e. consistent with its overall corporate strategy.
KEYKNOWLEDGE StakeholdersandImpactonCorporateObjectives
Stakeholder groups Shareholders: As owners of the business, they rank supreme, as reflected in US/UK models of corporate governance; Lenders: Important if the business relies heavily on providers of loan capital (banks, bondholders); Directors: The executive directors or senior management of the business are central since they have hands-on power and can serve their own interests (giving rise to agency risk); Employees: Often referred to as a companys most valuable asset; they must be motivated and adequately compensated; Customers: No customers, no business! How influential they are or how carefully management needs to listen to their concerns depends on the type of business activity and the competitive environment; Suppliers: Good and reliable suppliers can be critical to corporate success; Government: They have two major interests: (a) they receive revenue via taxes and (b) benefit indirectly when firms create employment. Environmental and other regulatory concerns are also within the scope of the governments interest; Public: The general public, its opinions and ability to exert pressure through lobby groups are all relevant factor for businesses that pollute, are involved in nuclear power, or carry out other activities that may be controversial (e.g. abortion clinics).
Page | 8
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Conflicting stakeholder interests Conflicting interests can exist between various stakeholder groups. Management must examine the degrees of stakeholder influence and actively manage the relationship with relevant stakeholders. Agency theory Agency theory addresses the risk that management will not act in the best interest of the shareholders, but will make decisions that will serve its own interests. Examples of self-serving management behavior could include: (a) artificially boosting corporate profits in the short-term in order to earn bonuses; (b) paying too much to acquire another company for reasons of prestige or in order to build empires; (c) rejecting opportunities, such as takeover bids, or restructuring initiatives, that might jeopardize their positions (an orientation to maintaining the status quo). Influencing managerial behavior In order to cause managers to behave in a way consistent with stakeholder interests, rewards and bonus schemes need to be carefully designed. This can be seen as the internal dimension to corporate governance. The other dimension -- external comes in the form of regulation.
ACCA F9 Financial Management
Profit and Not-for-profit organisations Profit-seeking organizations exist ultimately to create wealth for their owners. Non-profit (or not-for-profit) organizations are created to accomplish a pre-defined mission, such as the delivery of a service; they are expected to do so in an economical manner.
Page | 9
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
ACCA F9 Financial Management
KEYKNOWLEDGE FinancialManagementEnvironment
1. The economic environment for business The general economic environment, and in particular the influence of governments through its monetary and fiscal policies has a far-reaching impact on most businesses. 2. The nature and role of financial markets and institutions Financial markets and institutions have achieved such a degree of global integration that shocks in one part as shown with the onset of the financial crisis in 2008 can have systematic implications across all markets.
Page | 10
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Chapter 2
ACCA F9 Financial Management
2. Management of inventories, accounts receivables, accounts payable and cash These elements are linked through the Cash conversion cycle, also known as the Cash Operating Cycle.
Page | 11
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Raw materials received Receipt of cash Payment to supplier
ACCA F9 Financial Management
Sale of goods
The above diagram shows the operating cash flows for a typical manufacturing company converting raw materials into finished goods for sale. The company needs its own cash to pay the supplier and can only recover this from the sale of the finished goods. The cash invested in inventories and receivables represents a cost to the company. This is most directly obvious in opportunity cost terms: the cash could be earning interest, reducing interest-bearing debt, or ultimately find its way into shareholders pockets as a dividend payment. The presence of payables indicates that cash payments (outflows) are delayed; this is beneficial to the company as long as it is not overdue on its payments, as late payment could lead to penalties or damage to the companys reputation (creditworthiness). Managing the individual parts of working capital means managing the whole picture in an optimal way; doing this well can give a firm a significant competitive advantage over its competitors. Ratio Analysis
Liquidity ratios
The relationship between current assets and current liabilities is used as a measure of liquidity in the firm: Current ratio = Current assets Current liabilities Quick ratio = Current assets - Inventories Current liabilities
Page | 12
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
ACCA F9 Financial Management
Turnover ratios
(1) Trade debtors (receivables) Trade Debtors x 365 Sales (2) Inventory turnover Inventory x 365 COGS (3) Trade creditors (payables) Trade Payables x 365 COGS Economic Order Quantity (EOQ) Within a company, there is a natural temptation to accumulate buffer stocks (raw materials and semi-finished goods) so that production is never interrupted. Similarly, in order to avoid stock-outs, sales managers will insist on maintaining a plentiful level of finished goods. All of this costs money. The EOQ is a method which seeks to minimize the costs associated with holding inventory. To determine the total costs, the following data is required: Q = order quantity D = quantity of product demanded annually P = purchase cost for one unit C = fixed cost per order (not incl. the purchase price) H = cost of holding one unit for one year
Page | 13
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
The total cost function is as follows: Total cost = Purchase cost + Ordering cost + Holding cost which can be expressed algebraically as follows: TC = PxD + C x D/Q + H x Q/2
ACCA F9 Financial Management
It is this total cost function which must be minimized. Recognizing that: PD does not vary; Ordering costs rise the more frequently one places (during the year); and Holding costs rise the fewer times one places orders (due to larger quantities being ordered each time),
It follows that there is a trade-off between the Ordering and the Holding costs. The optimal order quantity (Q*) is found where the Ordering and Holding costs equal each other, i.e. C x D/Q = H x Q/2 Rearranging the above and solving for Q results in
EXAMPLE
A trucking company uses disposable carburetor units with the following details: Weekly demand Purchase price Ordering cost Holding cost 500 units USD 15 / unit USD 40 / order 7% of the purchase price
Page | 14
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Assessing the creditworthiness of customers When assessing the creditworthiness of (potential) clients, companies can use the approach typically employed by banks, referred to (originally) as the 3 Cs of credit, later expanded to the 5 Cs. They are (1) Character: Focuses on the reputation of the principals/decision makers at a company; credit checking agencies and bank references assist to this end; (2) Capacity: Examines the companys cash flow generation in the context of managements ability to perform competently and reliably in meeting their obligations, based on an examination of their track record (either directly or via the experiences of others). Financial statement analysis is a major part of the exercise here (and in the next point); (3) Capital: Identifies and assesses the financial staying power and resources of the business; how much of a capital cushion do they have to withstand losses and how much do they have committed at risk in a proposed transaction that incentivizes them to succeed (one can refer to this as the pain factor); (4) Collateral: Assesses what (if any) security the company is willing to provide in support of the intended transaction. Banks refer to this as providing additional exits (ways out) from a transaction. (5) Conditions: This is a general review of the economic environment to appreciate to what extent a customer may be affected by a decline in general business conditions (business cycle influences).
ACCA F9 Financial Management
EXAMPLE
A downturn in housing construction will affect a range of other businesses, from plumbers to building material producers and companies leasing earth-moving equipment. Anyone selling to such businesses needs to keep the big picture in mind so as not to be over-exposed to secondary influences.
Settlement discounts The objective of granting a settlement discount is to give customers a financial incentive to pay their bills more quickly (before the standard due date).
Page | 15
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
A company granting settlement discounts must ensure that the benefits of doing so will outweigh the costs.
ACCA F9 Financial Management
EXAMPLE
Redwood Co. currently gives payment terms of 3 months to its customers. If it shortens this to one month by offering a 2% settlement discount, calculate what the impact will be if sales of USD 5m remain unchanged and all customers elect to take advantage of the discount. The companys cost of capital is 15%.
Cost of financing receivables for 3 months: 5,000,000 x 3/12 x 15% Cost of financing receivables for 1 month: 5,000,000 x 1/12 x 15% Savings in financing costs Cost of settlement discount: 5,000,000 x 2% = 100,000 = = 62,500 125,000 = 187,500
The discount is worth implementing as the company achieves a net benefit of USD 25,000. Collection of debts A company must have in place a clear policy on the collection of debts. Even if a good screening/assessment procedure is in place for accepting and reviewing customers, late payments are a fact of life and must be handled pro-actively. Much time can be spent in chasing late payments and if this process is not well-organized, management may come to the conclusion that it is not worthwhile. This is especially true in cases where a company is growing very quickly and celebrates the signing of contracts and issuance of invoices as signs of success. If, however, these invoices are not collected in due time (or at all), then the company is throwing away the rewards of success.
Page | 16
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Deductions Another phenomenon which results in significant write-offs of receivable is the practice of deductions in which a customer pays less than the full amount of the invoice, giving a reason for withholding the difference. This amounts to a renegotiation of the original invoice and is often accepted as a fait accompli by the supplier. A company managing its receivables diligently will have the following: (1) A monitoring system that clearly flags late payers, known as an aging system. This includes identifying properly the practice of deductions mentioned above; (2) A follow-up system that assigns responsibility to specific staff doing the follow-up; this includes an elevating of difficult cases to more senior and/or more experienced staff to handle; (3) Training for staff involved in handing follow-ups, whether performed by phone, mail or personal visits; (4) A policy determining when to involve refer the case to lawyers (preferably in-house, for cost reasons) in preparation of follow-up letters. An external lawyer may carry more weight, but is also more costly; (5) Use of a collection agent to chase the receivable. Here again, a company must calculate the costs and benefits of involving an external agent. In such an analysis, the savings of management time (opportunity cost) is the most difficult to estimate. Financial implications of different credit policies Evaluating a change in a credit policy requires the identification of relevant cash flows structured as before (the change) and after scenarios.
ACCA F9 Financial Management
EXAMPLE
A company has current annual sales of USD 3,000,000 of which 50% is cash and 50% on 2 month credit terms. The contribution on credit sales is 25% of the selling price. The company is considering reducing its credit terms to 1 month and expects all (credit) customers to accept it with a 2% discount. No change in sales volume is anticipated. The company uses a 15% cost of capital.
Page | 17
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Analysis: Contribution USD - Before modification of terms: 375,000 (25% x 1.5m) - After modification: 345,000 (23% x 1.5m) Net change: (30,000) Receivables USD - Financing cost before modification: 37,500 (1.5m x 2/12 x .15) - After modification: 18,750 (1.5m x 1/12 x .15) Net change: 18,750 The change is not worthwhile.
ACCA F9 Financial Management
3. Determining working capital needs and funding strategies The level of working capital required in a business depends on the industry it operates in, the length of its working capital cycle and the range of funding options open to it. Retaining flexibility is a key requirement. While overdraft financing is expensive, it does permit spontaneous drawdowns and rapid repayments.
Page | 18
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Chapter 3
ACCA F9 Financial Management
Investment Appraisal
Page | 19
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
What are the advantages and disadvantages of this method?
ACCA F9 Financial Management
Advantages
It is easy to understand and to use. It focuses on the time needed to cover the investment (in money terms) and no more; it can be considered a minimalists approach (psychologically). If you invest in a Central American country where you expect a coup in the next 2 years, the payback method may be for you! But remember, the net (money) returns start only after that point!
Disadvantages
It is a crude measure. It does not take opportunity costs or expected returns on money invested into account. Accounting Rate of Return ARR is an accounting-based measure of return on investment. Its definition varies. Here are some: 5 year project Initial Investment (20% p.a. depreciation) Avg. Investment
40,000 20,000 Profit Before Depreciation 10,000 13,000 18,000 20,000 12,000 Profit After Depreciation 2,000 5,000 10,000 12,000 4,000 6,600
Year 1 Year 2 Year 3 Year 4 Year 5 Avg. profit (p.a.) (1) ARR =
6,600 20,000
33%
Page | 20
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
(2) ARR = Avg. profits Total Investment Total profits Total Investment = 6,600 40,000 = 16.5%
ACCA F9 Financial Management
(3)
ARR =
= 33,000 40,000
82.5%
Note: Always use the accounting profit after deduction of depreciation In the case where the asset has a residual value of 5,000, then the calculation is: 5 year project Initial Investment (20% p.a. depreciation) Residual value Avg. Investment Total profit before Depreciation Total depreciation Total profit after Depreciation Avg. Profit (1) ARR = 40,000 5,000 22,500 73,000 35,000 38,000 7,600 Avg. profits Avg. Investment Avg. profits Total Investment Total profits Total Investment = 7,600 22,500 7,600 40,000 = 33.8%
(2)
ARR =
19%
(3)
ARR =
= 38,000 40,000
95%
Whats wrong with this measure? 1) It is using an accounting measure of profit (not cash) 2) It does not take the timing of cash flows into consideration.
Page | 21
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
3. Discounted cash flow (DCF) techniques The preeminence of cash Cash, both its receipt and possession, lies at the basis of economic value. Cash is used to pay the bills and bonuses. It is a better indicator of wealth when compared with measures defined by accounting conventions, such as accounting profit. Timing and value Tracking and measuring cash flows on a time-adjusted basis is critical: cash received quickly can be used to repay debt (avoiding interest costs) or invested (earning interest). Cash paid with a delay can reduce costs (as long as penalties are not incurred). It follows that the longer one waits for a receipt of cash, the less that cash is worth in todays terms. Among other factors, its purchasing value may diminish due to the effects of inflation. Instead of receiving USD 100 today, assume it will be received after one year. To compensate for the delay, what should the value be after one year?
ACCA F9 Financial Management
As opportunity cost: what we sacrifice by not having it now. As risk-adjusted rate: representing the riskiness of not getting the money back. As cost of capital rate: representing the return that capital providers expect
From a companys point of view, this is the rate of return that the business must generate for its capital providers (shareholders and lenders). If a company has to raise the necessary cash for its activities, then this is the rate it must pay. It reflects the opportunity cost to the investors (what investment alternatives they have) on a risk-adjusted basis.
Page | 22
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Discounting The above relationship between PV and FV: can be re-arranged to: with r representing the discount rate. The above refers to one-period discounting, with r corresponding to the period. If discounting is done over more than one period, then the discounting effect will be: PV = FV (1+r)n where n refers to the number of periods. Thus, 100 received after two years, discounted at 10% p.a. will be PV = 100 = 82.6 (1.10)2 This reflects that the uncertainty of getting money back increases with time. This allows one to discount future values into present values and can be applied to a series of cash flows: Year: Future Values: 1 100 2 100 3 125 4 105 5 140 PV x (1+r) = FV PV = FV (1+r)
ACCA F9 Financial Management
If discounted at r = 10%, then the above cash flows can be restated at their present values: FV discounted: PV: 100 1.10 90.9 100 (1.10)2 82.6 125 (1.10)3 93.9 105 (1.10)4 71.7 140 (1.10)5 86.9
Page | 23
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Reducing future cash flows of different timings and amounts to one PV is a powerful tool. Refer to Present Value tables. Note: If all the cash flows had been equal say 100 then the PV calculation would have been simplified: FV discounted: PV: 100 1.10 90.9 100 (1.10)2 82.6 100 (1.10)3 75.1 100 (1.10)4 68.3 100 (1.10)5 62.1
Net Present Value (NPV) To add meaning to the future cash flows, we can include the amount invested (which gives rise to the FVs): Year: 0 1 2 3 4 5
Investment: (200) FV: PV: (200) 100 90.9 100 82.6 125 93.9 105 71.7 140 86.9
Year 0 amounts denote the present and are automatically = PV. The NPV of the above cash flows is therefore = 226.
Page | 24
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Discounted Payback We can apply the concept of discounting to the Payback method in order to capture the time value of money element. Year: 0 1 2 3 4 5
ACCA F9 Financial Management
Investment: (200) FV: PV: (200) 100 90.9 100 82.6 125 93.9 105 71.7 140 86.9
In the table above, the (simple) payback period is in Year 2; The Discounted Payback period is longer (Year 3). Relevant Cash Flows When evaluating projects, cash flow projections must meet the criteria of relevance. Relevance refers to cash flows that are relevant to the decision whether to accept a project or not. Cash flows that are created (or discontinued) as a result of taking the decision (to undertake the project) are relevant; these are also called incremental cash flows. Included in relevant cash flows would be any investments in equipment and working capital required by the project. More subtle, but no less important, are any opportunity costs incurred as a result of accepting the project. Cash flows which occur whether the project goes ahead or not are not relevant. Also not relevant are: Sunk costs; Committed costs; Allocated (overhead) costs; Non-cash expenses
Depreciation is an example of a non-cash expense. One may need to work with depreciation, however, if they are related to a calculation of taxes due. Any change in the amount of taxes paid is a very relevant cash flow!
Page | 25
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Internal rate of Return (IRR) The internal rate of return (IRR) is defined as the discount rate (r) at which the net present value (NPV) of a stream of cash flows will be equal to zero. In other words, If, at a discount rate r, NPV = 0, then IRR = r The IRR includes among its assumptions the following: any cash flows generated in the course of a project being evaluated are calculated as being reinvested at the IRR rate. This is illustrated thus: Time 0 1 2 Cash flows (20,000) 5,000 30,000
ACCA F9 Financial Management
The IRR of the above cash flows (using interpolation or calculator) is 35.61%. The above cash flows is equivalent to re-investing the 5,000 (Year 1) at the IRR rate (35.61%) to maturity (Year 2). Time 0 1 2 Cash flows (A) (20,000) 5,000 30,000 Cash flows (B) (20,000) 0 36,780.5 (30,000 + 6,780.5*)
* 5,000 x 1.3561 = 6,780.5 The IRR of the cash flows shown in Column (B) is 35.61% -- exactly the same as in Column (A). Note: Column (B) cash flows resemble that of a zero-coupon bond, with investment at time 0 and no cash returns until the final year. This calculation confirms that interim cash flows are re-invested at the IRR rate. This assumption has been criticized for being unrealistic, since cash paid out of a project (returned to the investors, for example) is unlikely to obtain the same rate if invested elsewhere: they may be higher (i.e. interest rates may have risen in the meantime), or lower (placed in the bank to earn deposit interest).
Page | 26
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Comparison of NPV and IRR methods The following decision rules apply to appraisal methods: NPV: Positive NPV projects are acceptable; the higher the better. IRR: An IRR in excess of a hurdle rate (set by the company) indicates acceptability; the higher (the IRR) the better.
ACCA F9 Financial Management
EXAMPLE
Year A B 0 -5,000 -7,500 1 6,000 8,850 IRR 20% 18% NPV: 10% 454 545 14% 263 263 16% 172 129
Intuitively, IRR should be preferable, as it relates return to amount invested. Equal investment amounts do not necessarily remove the ambiguity.
EXAMPLE
Year A B 0 -500 -500 1 100 500 2 600 155 IRR 20% 25% NPV (9%) 97 89
Page | 27
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
4. Allowing for inflation and taxation in DCF Inflation Price increases reduce the purchasing power of money. If inflation is 7% p.a., then the same amount of goods can be purchased with: USD 100 (today) or USD 107 (in one year)
ACCA F9 Financial Management
We can express the same idea the other way around: USD 100 received in one year will buy as much as USD 93.46 does today.
EXAMPLE
An investor considers the following investment. Her return threshold is 10% p.a. Years 0 1 2 Cash flows -200 115 125 DF (10%) 1.0 0.909 0.826 PV -200 105 103 +7.6
The investment looks acceptable. Assumption: 10% as a real rate of return Now, suppose that the investor had wanted a 10% p.a. real rate of return and inflation is expected to be 5% p.a. The cash flows shown above are money (or nominal) cash flows. We can re-state these cash flows in real terms by adjusting for inflation: Nominal Cash flows -200 115 125 Real Cash Flows -200 109.5 113.4
Years 0 1 2
Page | 28
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Next, we discount the real cash flows at the desired real 10% p.a.: Years 0 1 2 Nominal Cash flows -200 115 125 DF (5%) 1.0 0.952 0.907 Real Cash Flows -200 109.5 113.4 DF (10%) 1.0 0.909 0.826 PV -200 99.5 93.7 -6.8
ACCA F9 Financial Management
The investment does not meet the return requirements. We could have avoided the re-statement of cash flows into real terms by working with only nominal amounts. In this case, we would need to discount by a nominal rate which incorporates both the inflation rate and the required (real) rate of return. The nominal rate is calculated according to the Fisher formula which is used to convert real interest rates to nominal rates (and vice versa): (1 + Nominal rate) = (1+ Inflation rate) x (1+ Real rate) In our example, Nominal rate = (1.05) x (1.10) 1 = 15.5 % Discounting the nominal cash flows at this (nominal) rate produces the following: Nominal Cash flows -200 115 125 DF (15.5%) 1.0 0.866 0.750 PV -200 99.6 93.7 -6.7
Years 0 1 2
The investment remains unacceptable, of course; we have simply used a second method of discounting to confirm the same NPV result. It is conceptually more straightforward to use nominal values when forecasting cash flows, particularly if there are differential inflation rates applying to the future cash flows, i.e. if there is no uniform (single) price change for revenues and various cost categories (materials, labor, etc.).
Page | 29
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Years Wages Growth: 4% p.a. Raw materials Growth: 7% p.a. 0 4,000 6,000 1 4,160 6,420 2 4,326 6,869 3 4,500 7,350
ACCA F9 Financial Management
The numbers above are discounted at nominal discount rates. Alternatively, a 20-year utility project may make long-term projections in real rates:
EXAMPLE
Customer tariffs (revenues) are projected to be USD 6,000,000 p.a. in real terms for the next 20 years. To arrive at a PV, USD 6,000,000 would have to be discounted at the companys cost of capital expressed in real terms.
Taxation
Taxes represent another cash outflow when projecting cash flows. Care must be taken to calculate the tax impact correctly. A company can reduce its taxable income if it can make use of tax allowances on its fixed assets. This will reduce taxes.
EXAMPLE
Operating profit (before tax): 30,000 Tax @35% (10,500) Net profit: 19,500 If an allowance of 5,000 can be taken for writing down fixed assets, then the profit would be adjusted as follows: Operating profit: Allowance: Taxable income: Tax @35% Net profit: 30,000 (5,000) 25,000 ( 8,750) 16,250
Page | 30
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
The cash benefit attributable to tax saving is 1,750 (10,500-8,750). This can also be calculated as Allowance x Tax rate = 5,000 x 0.35 = 1,750. Alternatively, taxable income can increase as a result of a cost-saving measure!
ACCA F9 Financial Management
EXAMPLE
The investment in a new process costing 4,000 will bring annual savings of 3,000 p.a. over 2 years. The cost of capital is 10% and the tax rate is 35%. Is the investment worthwhile? Investment Year 0 Year 1 Year 2 (4,000) 3,000 3,000 (1,050) (1,050) Savings Tax on Savings Net cash flow (4,000) 1,950 1,950 Present Value (4,000) 1,773 1,612 NPV: -615 5. Adjusting for risk and uncertainty in investment appraisal Risk and Uncertainty These are commonly used interchangeably, but there is a formal distinction. Risk: whichever way it is defined, is a quantification of probability. In other words, it is susceptible to measurement, statistically or mathematically. Risk may be viewed as relating to objective probabilities. Uncertainty: in contrast to risk, is not capable of being quantified. It has also been referred to as subjective probability (or unmeasurable uncertainty). Sensitivity Analysis This asks the following question: What happens to the NPV of a project if certain key variables are altered. It is a one-dimensional approach as it isolates and alters each (key) variable in turn in order to measure the impact.
Page | 31
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
ACCA F9 Financial Management
EXAMPLE
The following cash flows have been projected for a business. Years Investment 0 1 2 (12,000) 36,000 36,000 (26,400) (26,400) Cash sales Variable costs Net Cash Flows (12,000) 9,600 9,600 DF (12%) PV
We can perform the following sensitivities: Investment: Would need to increase by 35% (by 4,224 to 16,4224) to reduce the NPV to zero; The cost of capital would have to rise to 38%;
Sales price and sales volume sensitivities are a bit more complex to calculate: Taking sales, we can ask the following question: How much do sales have to drop in order to make the NPV = 0. The same can be applied to the other variables. Alternatively, one can work within likely ranges of variable movements (i.e. sales not likely to drop by more than 10%; costs not likely to vary beyond a certain level; interest rates are likely to stay stable +/- 1.0% within the next 12 months. Scenario Analysis One can also go beyond determining project sensitivity to one variable and define scenarios, in which several variables move simultaneously (as outlined in the previous paragraph). Based on these scenarios, the NPV outcomes can be evaluated.
Page | 32
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Discounted Payback We can apply the concept of discounting to the Payback method in order to capture the time value of money element.
ACCA F9 Financial Management
Year:
Investment: (200) FV: PV: 86.9 In the table above, the (simple) payback period is in Year 2; The Discounted Payback period is longer (Year 3). 6. Specific investment decisions (Lease or buy; asset replacement; capital rationing) Leasing Leasing is a form of fixed asset financing, in which a lessor, as owner of an asset, makes it available to, and for the use of, a lessee in return for a stream of payments over a period of time. Operating leases These are generally short-term rental contracts in which the lessor services and insures the asset. They are usually cancelable during the lease period at the choice of the lessee. Finance leases These are also known as capital leases and are in substance similar to the use of a secured bank loan to acquire and use an asset. Main features include: Lease term covering most of the assets economic useful life; The lessee assumes responsibility for servicing the asset; Any cancellation clause would require the lessee to cover the lessor for any losses; (200) 100 90.9 100 82.6 125 93.9 105 71.7 140
Page | 33
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Lessee will usually have an option to buy the asset at the termination of the lease (note: the transfer of ownership, if any, outside and after the end of the lease contract); The lessee must show the lease asset and liability on its balance sheet.
ACCA F9 Financial Management
Attractiveness of Leasing Leasing has been attractive to lessees (the users of the asset) for a several possible reasons: Conservation of cash flow: If a bank loan cannot be arranged, then leasing provides a way of financing the asset; Cost reasons: The leasing costs may be more competitive than a bank loan; From the lessors perspective, leasing can be attractive for tax reasons, where the tax benefits of ownership are useful to the lessor.
Asset replacement decisions Consider the following situation: A skating rink operator has an ice-cleaning machine costing USD 20,000 with the following data: Year 1 2 3 4 Operating costs 2,000 2,500 3,000 3,500 Resale value 14,500 8,000 7,000 6,000
The company wishes to determine how often to replace the machine. Its cost of capital is 10%. The best method to use is to convert all the cash flows into a single figure! Look at how to do this: 1. The NPV of replacing the machine after 1 year Year 0 1 Purchase price Operating costs Resale value USD 20,000 2,000 (14,500) PV (10%) 20,000 1,818 (13,181) 8,637
/0.909 = 9501
Page | 34
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
2. The NPV of replacing the machine after 2 year Year 0 1 2 Purchase price Operating costs Operating costs Resale value USD 20,000 2,000 2,500 (8,000) PV (10%) 20,000 1,818 2,066 (6,612) 17,272 /1.736 = 9949
ACCA F9 Financial Management
3. The NPV of replacing the machine after 3 years Year 0 1 2 3 Purchase price Operating costs Operating costs Operating costs Resale value USD 20,000 2,000 2,500 3,000 (7,000) PV (10%) 20,000 1,818 2,066 2,253 (5,259) 20,878
/2.487 = 8394
Applying the profitability index to single-period, divisible projects For projects that require single period investments and where projects are divisible, the Profitability Index can be applied. Profitability Index (PI) = PV of cash flows Investment Rule: If PI > 1; If < 1, Reject
EXAMPLE
Investment Angola Burundi Chad Djibouti (30,000) (20,000) (15,000) (10,000) PV of Inflows 40,000 29,000 21,000 16,000 NPV 10,000 9,000 6,000 6,000 PI 0.33 0.45 0.40 0.60 Ranking 4 2 3 1
Page | 35
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Investment limit: 25,000. Under conditions of: (a) Divisible projects (b) Non-divisible projects
ACCA F9 Financial Management
What is capital rationing? Ideally, a company should like to pursue all projects that generate a return in excess of its cost of capital. This may not be practically possible, as funding sources may be limited, in which case the company is forced to employ its scarce capital resources optimally according to a clear decision rule. Soft rationing This refers to internal, self-imposed, limitations on projects undertaken by a corporation. These limits may have the effect of frustrating consideration of projects that would otherwise be NPV-positive. The limits may be practical, such as scarce management time or lack of specialist skills. Hard rationing This exists when the market imposes constraints on a companys access to capital in cases where projects would otherwise be NPV-positive. The implication is that the market suffers from imperfections. This is rare, however, in highly sophisticated markets.
Page | 36
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Chapter 4
ACCA F9 Financial Management
Business Finance
Page | 37
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Non-Equity Shares Preference shares Preference shares (or pref shares) This is often referred to as a form of non-equity capital. Preference shareholders rank preferentially to common shareholders; Pref shares may be redeemable or irredeemable; Dividends are not tax deductible; The dividend rate is usually fixed (as a percentage of the par value of the issue); The dividend rate can be participating, i.e. share in some of the excess profits; Voting rights: may or may not be accorded preference shares; Prefs may be cumulative, where dividends not paid in one year are carried forward and have to be paid before a common dividend payment resumes; Prefs may be convertible into common shares
ACCA F9 Financial Management
Debt
In contrast to equity, debt: Is a liability of the business; Pays interest which is tax deductible; Does not represent ownership in the firm
Debt comes in many forms. Straight long-term debt (also called loan capital avoid confusion!) includes: Bonds: Secured by a mortgage on tangible assets of the firm Debentures: Unsecured corporate debt
Note: The term bonds is commonly used for both categories above. In the event of default, debt holders with a security interest over assets enjoy a prior claim in the event such assets are sold. Debenture holders can be paid only after (secured) bondholders have been repaid.
Page | 38
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Convertible debt: This is debt which is convertible (at the option of the convertible debt holder) into equity, based on pre-defined conversion conditions; Subordinated loans: Refers to any kind of debt which ranks inferior to more senior debt; it cannot be repaid until more senior-ranked creditors have been repaid; Warrants: A security giving the holder the option to buy common shares from a company for a pre-set price valid for a period of time. These are usually tradable in a secondary market and therefore have a market price; Deep discount bonds: Debt issued with a very low or no (zero) coupon, so that the issue price will be far below the par value of the bond. Such instruments with no coupom are also called pure-discount or zero bonds. Junk (high yield) bond: A speculative debt instrument that either carries no rating or a low rating by the rating agencies (below investment grade);
ACCA F9 Financial Management
Hybrid securities Companies are imaginative in creating hybrid securities as debt in order to achieve tax deductibility but with conditions that avoid bankruptcy costs (i.e. payouts contingent only on the achievement of profits).
Rights issues When a company issues new shares, it is usually obliged to first offer these to its shareholders in proportion to their existing shareholdings. Such pre-emption rights protect shareholders against dilution of their holdings, provided they have the cash to subscribe.
EXAMPLE
A company has a capital of 300,000 shares with a market price of USD 10. It plans to raise additional capital by making a rights issue of 100,000 shares at a price of USD 7. (i) Procedurally, the company issues 300,000 rights to the existing shares, so that 3 existing shares possess (3) rights to one new share.
Page | 39
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
(ii) (iii) (iv) (v) 3 rights plus USD 7 will buy one new share. A shareholder with 3 existing shares has an initial portfolio value of USD 30 (3 x 10) Using his 3 rights, he can acquire an additional share for USD 7. After the rights offer, his portfolio will be 4 shares at a value of USD 37. The value per share after the rights issue is USD 9.25.
ACCA F9 Financial Management
The value of a right is therefore the difference in the share prices: Old price New price (of a share) = USD 0.75 (10 9.25) Alternatively, this can be calculated as: New price Subscription price = 9.25 - 7 = USD 0.75 No. of rights for a share 3 Placing The companys shares are offered to a selected base of institutional investors (chosen by the company). Raising capital in this way is less costly and the company retains greater freedom. The restricted range of shareholders means that the liquidity of the shares will be lower. Initial public offering (IPO) In an IPO, an adviser is retained by the company to offer shares to private and/or institutional investors. The offer may be underwritten, meaning the adviser, usually an investment bank, will commit to buy shares that do not find a buyer. An IPO is an important way to increase the liquidity of the companys shares; it is also the most costly method. It is used by larger companies or those looking for substantial amounts of capital.
There are several ways for a company to list its shares: 1) An offer for sale, which is a public invitation by a sponsoring intermediary such as an investment bank. An offer for sale refers to the sale of existing shares. 2) An offer for subscription (or direct offer), which is a public invitation by the issuing company itself in which new shares are issued.
Page | 40
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
The offer can be made at a price that is: (i) fixed in advance; or (ii) by tender, in which investors state the price they are prepared to pay. After all bids are received, the lowest clearing price (strike price) is set which is charged to all investors. 3. Islamic finance Islamic finance refers to financial practices and instruments which are consistent with Islamic law (Sharia). Sharia prohibits the payment or acceptance of interest (riba, literally meaning excess or addition) on loans of money at pre-set terms. It also prohibits investments in businesses that provide goods or services that are contrary to its principles (e.g. gambling, pork processing). Prohibited activities or practices are referred to as haraam (forbidden). Short and long term Islamic financial instruments available to businesses include: i) ii) iii) iv) Trade credit (murabahah); Lease finance (ijara); Equity finance (mudaraba); Debt finance (sukuk)
ACCA F9 Financial Management
4. Internal sources of finances and dividend policy Internally generated sources of long-term finance As a matter of practicality, managers usually choose to finance new projects or investments by making use of the following sources in the order shown: (i) (ii) (iii) Internally-generated funds Debt Equity
The above sequence is referred to as the pecking order theory and is based on observations of business behavior. The first choice is a natural one: positive operating cash flows are already at the disposal of the company without involving costs or formalities. They are not considered to be a free (costless) form of finance, however; they are available for distribution to the shareholders and as long as they are not paid out by the firm, management is expected to earn a cost of equity return on such funds.
Page | 41
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
5. Gearing and capital structure considerations Choosing between ordinary shares, preference shares and loan capital is based on financial strategic decisions taken by a corporation regarding capital structure. Debt and Equity The amounts of debt and equity appropriate at a company depends mainly on the industry in which the company operates, and also its internal policies and attitudes toward financial risk. The industry in which the company operates has an important impact on: Revenue volatility; and Operating leverage (cost structure)
ACCA F9 Financial Management
A company cannot use too much debt for fear of encountering bankruptcy when economic conditions decline. The reasons for issuing different kinds of debt (loan capital). Companies need to take a variety of factors into consideration when deliberating the use of debt: Capital structure constraints: Is there enough equity underpinning? Term of borrowing: This must be determined in relation to the use to which the proceeds will be put. Cash flow projections and repayment provisions must be analyzed (bullet repayment or amortizing schedule). Currency and interest rate base (fixed/floating): What are the companys views on currency and interest rate market risks? What hedging possibilities exist? Security: What tangible security is available to support borrowings?
6. Finance for SMEs Working capital management Small businesses are handicapped by their lack of scale. The reality is that many small businesses are chronically under-capitalized. They often neglect to plan for growth, and risk falling into the overtrading trap. The result can be negative working capital, permanent overdrafts and, eventually, insolvency.
Page | 42
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Chapter 5
ACCA F9 Financial Management
Cost of Capital
Page | 43
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
2. Estimating the cost of equity Cost of Equity The cost of equity provides the link between the price of a share and its future dividend stream. According to the Dividend Discount Model: Po = D1 + D2 + D3 + + Dn 2 3 (1+k) (1+k) (1+k) (1+k)n Assuming the dividends above are constant, the formula can be reduced to: Po = D1 k If we factor in a constant growth rate (g) for dividends, then: Po = D1 k-g which can be re-arranged to arrive at: k = D1 + g Po Remember that P0 is the current share price, while D1 is the anticipated dividend. Note: Do not confuse the most recent dividend D0 with D1 ; D1 = D0 x (1+g) The growth rate g can be determined by extrapolating their recent growth.
ACCA F9 Financial Management
EXAMPLE
The dividend history of Ajax Corp. is as follows: Year Year Year Year 1: 2: 3: 4: 2.30 2.48 2.68 2.89
Page | 44
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
The compounded growth rate based on the above data is: g = (2.89/2.30)1/3 - 1 = 7.9% The cost of equity is: k = 2.89 (1.079) + 0.079 23 = 21.5% Capital Asset Pricing Model There is another way to derive the cost of equity, which we will now denote as ke. Ke is derived from statistical measures of the risk of investing in equities; when investing in an asset class, such as equities, an investor can eliminate non-systematic risks through diversification: as shares of different kinds are added to a portfolio, the good performers offset the losers and non-systematic risk declines. What cannot be diversified away is the systematic risk due to general economic and market fluctuations. This risk is measurable by a factor called beta: reflects the sensitivity of an individual stocks price to price movements in the stock market (index) as a whole. It is derived by (empirical) statistical observations of market data and figures prominently in the Capital Asset Pricing Model (CAPM): ke = rf + (rm - rf) x e Where: ke = cost of equity rf = risk-free rate
ACCA F9 Financial Management
rm = expected rate of return on the (equity) market portfolio If = 1, then ke = rm ; If > 1, then ke > rm ; If < 1, then ke < rm
Page | 45
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
ACCA F9 Financial Management
EXERCISE
If: rf = 2%; rm = 16%; e = 1.3 Then: ke = 2% + (16% - 2%) x 1.3 = 20.2% 3. Estimating the cost of debt and other capital instruments Cost of preference shares If the preference share is irredeemable, then we can use the perpetuity formula: kp = Dp Po kp = return on preference shares Dp = dividend on the preference share Po = market price of the preference share If the preference shares are redeemable, then they can be modeled thus: + Dp + + Dn + Pn Po = Dp + Dp (1+kp) (1+kp)2 (1+kp)3 (1+kp)n Where: n = no. of years until redemption Pn = redemption (nominal) value of the preference shares As all the terms above, except for kp , are known, then kp can be derived by calculator or manually (trial-and-error).
Page | 46
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Cost of loan capital (debt) Specific debt issues, with contractually repayable dates (e.g. bonds), are handled in a similar way to redeemable preference shares: Po = Where: kd = return on debt i = nominal interest rate i + i + i + + i + Pn (1+kd)n (1+kd) (1+kd)2 (1+kd)3
ACCA F9 Financial Management
Po = market price of debt Note: kd refers to the rate of return required by debt providers. If irredeemable debt is evaluated, then this will be done with the perpetuity formula: Kd = i / Po Where: Kd = return on debt i = nominal interest rate
Po = market price of debt Note: kd refers to the rate of return required by debt providers. Impact of taxes In the cases above, we have not mentioned taxation. As interest on debt is tax deductible, we need to look at the cost of debt from two perspectives, making a distinction between: 1) The rate of return on debt required by debt providers (as above); and 2) The effective cost of that same debt to the borrowing company
Page | 47
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
ACCA F9 Financial Management
EXAMPLE
A company issues a bond with a nominal (face) value of USD 100m in perpetuity with a coupon (nominal interest rate) of 4%. The bond is now trading at 95% of its nominal value. The corporate tax rate is 35%. 1) The rate of return to an investor buying this bond is: 4 / 95 = 4.21% 2) The cost of the debt to the company is: 4 x (1 0.35) 95 = 2.74% i (1 t)
Because of the tax deductibility of interest, companys after-tax cost of debt is: Where: t = corporate tax rate The application of tax also applies to redeemable debt, but care must be taken.
EXAMPLE
The following bond was issued: Face value: USD 100m; Coupon: 5% Redemption in 3 years at 100% Current market yield: 6% (required by lenders) Corporate tax rate: 30%
Page | 48
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Years 1 2 3 3 Interest Interest Interest Interest Cash flow 5,000,000 5,000,000 5,000,000 100,000,000 DF (6%) 0.943 0.890 0.840 0.840 PV 4,716,981 4,449,982 4,198,096 83,961,928 97,326,988
ACCA F9 Financial Management
From the companys point of view, its cost of debt will be 4.47% (the IRR of its cash flows): Years 0 1 2 3 3 Market value Interest (after tax) Interest (after tax) Interest (after tax) Interest Cash flow (97,326,988) 3,500,000 3,500,000 3,500,000 100,000,000 DF (4.47%) 1.0 0.957 0.916 0.877 0.877 PV (97,326,988) 3,350,244 3,206,896 3,069,681 87,705,174 approx. 0
4. Estimating the overall cost of capital Average and Marginal Cost of Capital The different types of financing a company can avail itself of can be combined in an average cost of capital (as in the weighted average cost of capital WACC see next section). If the cost of capital reflects a current market rate, then it can be regarded as a marginal cost of capital, i.e. it expresses what the cost is to the company of borrowing additional capital. Weighted average cost of capital (WACC) The WACC is the formula that is used to calculate a companys overall cost of capital, incorporating the costs of equity: ke; and debt: kd (1 - t), in proportion to the amount of equity and debt is in the capital structure of the company:
WACC = Where:
Page | 49
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Assumptions underlying the use of WACC in investment decision making Use of a companys WACC when appraising a project is appropriate if business and financial risks do not change. 5. Capital structure theories and practical considerations The traditional view of capital structure has it that as the debt-to-equity (gearing) ratio rises, the cheaper debt reduces WACC until an optimal point; after that point the costs of financial distress (risk of bankruptcy) cancel the benefits of further debt and WACC begins to rise. Modigliani and Miller (MM) developed a theory which suggested that financial gearing does not matter. WACC stays the same as (cheaper) cost of debt is offset by rising cost of equity. Their theory at this stage ignored taxes. They further concluded (in MM Proposition 1) that the enterprise value of a company remains the same, regardless of its capital structure. Furthermore (MM Proposition 2) the addition of debt introduces financial risk, which causes the cost of equity to rise. WACC remains unchanged. The drawback of MM theory is that it ignores the tax deductibility of interest payments. When this possibility is introduced (tax relief on debt), MM observed that the WACC will decline in linear fashion. MM concluded that on this basis, a company should (theoretically) borrow as much as possible! Another conclusion of MM is that the value of a leveraged company will exceed the value of the same company unleveraged by the value of its tax shields. 6. Impact of cost of capital on investments The cost of capital is the discount rate used to evaluate the acceptability of investments.
ACCA F9 Financial Management
Page | 50
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Chapter 6
ACCA F9 Financial Management
Business Valuations
Page | 51
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
For small, unlisted companies, a goodwill factor can be added to the tangible asset value. For large companies, brand value can be determined through separate, specialist valuations. Market-relative methods Price-Earnings ratio Limitation of the P/E multiple: It assumes that the companies being compared are similar in terms of (i) business risk; (ii) finance risk; and (iii) prospective growth. By choosing a peer group of similar companies with care, one can improve the relevance of such market-relative data. (i) (ii) Business risk: means companies in the same industry relevance is assured; Financial risk: companies in the same industry can have different levels of gearing, which affects the earnings (net profits) of the companies chosen; therefore, the peer group of similar companies must take similar gearing ratios into account; Growth rates: If two companies in the same industry, serving the same markets and with the same gearing have different growth rates, then one must try to isolate the reasons that explain the difference. If the reason is superior management (at the higher growth company), for example, then that company would deserve an upward adjustment to its P/E ratio relative to the other.
ACCA F9 Financial Management
(iii)
Other methods: Earnings Yield The reciprocal (inverse) of the P/E ratio expresses the yield, or the level of earnings one would expect to generate from investment in the equity of the company. This yield can then be applied to similar companies to determine whether it is fairly priced. Cash flow-based methods (1) Dividend Value Method It is important to be confident in using the basic dividend model: Po = D1 ke g
Page | 52
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
In which: Po shares); D1 ke g is the value of the equity of the company (one share or all the is the expected dividend; is the return shareholders expect (cost of equity); and is the growth rate in the dividend
ACCA F9 Financial Management
(2) Free Cash Flow (FCF) This has been referred to earlier in the discussion of discounting future cash flows of a project. If we view a company as a never-ending project, then we would seek to discount its cash flows into perpetuity. The preferred method indicated is to discount future Free Cash Flows to all Capital Providers, as this avoids the complexity of forecasting financial cash flows, such as debt drawdowns/repayments as well as interest payments. Since the resulting FCFs are available to debt and equity holders, the appropriate discount rate is derived from the weighted average cost of capital. The forecasting of FCFs is typically in two chronological segments: (i) Forecast horizon
The forecast horizon is a manageable period of time, typically 5 years, during which the company can explicitly model its expected revenues, costs and investment (both capital expenditures capex and working capital). This is the unique part of the modeling, as it reflects factors particular to the company being valued: for example, they may include a new product launch at the company, or a new strategic departure, with investment spending carefully timed and quantified, and expected revenue growth and margins projected based on market research or experience. (ii) Terminal (Continuing) value
This is the residual value into perpetuity of the firm. Since it is impossible to explicitly model cash flows 20 years into the future (unless one were valuing a utility,
Page | 53
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
for example), then it is common practice to make a continuing value assumption based on a realistic sustainable growth rate of the FCF into the future. The FCFs derived above are discounted at the WACC. The resulting Present Value of the FCFs will represent the Enterprise Value of the company. Think of the Enterprise Value as being the value of all the assets of the company. If the company is leveraged (i.e. has debt in its capital structure) then the Debt has to be subtracted from the Enterprise value to arrive at the value belonging to the shareholders, i.e. the Equity value. Consider the following FCFs: ------------------------Forecast Horizon------------------------------ TV 1 2 3 4 5 5+ 1,000 1,200 1,350 1,300 1,370 FCF5+
ACCA F9 Financial Management
Years FCF
The FCF in Year 5+ has to be modeled with care as it represents all future FCFs and must therefore be an average future FCF, rather than specific to Year 6. If we establish, based on average future cash flows, that the Year 5+ is, say, 1,350, with a continuing growth rate of 2% p.a., then the present value of all the FCFs above, at a WACC of 10%, will be: Forecast Horizon value: PV (Years 1-5) = 4,654 Terminal value: PV (1,350 / WACC-g) Enterprise value (EV) = 10,478 = 15,132
The Terminal (Continuing) Value has been calculated using the Gordon growth formula and has been discounted back to t=0! Dont be surprised by its high value (as a proportion of overall EV). Finally, EV minus the (market) value of Debt = Equity value
Page | 54
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Limitations of the valuation methods The major limitation in the more sophisticated share valuation models those based on projected cash flows is that the future resists precise measurement and that outlooks differ. This, of course, is what creates opportunities for investors. A share that is considered over-valued by an analyst, therefore, should be sold (by her); however, the share may continue to rise for a period of time as a result of general sentiment, even if the fundamentals suggest otherwise. The main difference therefore lies in timing.
ACCA F9 Financial Management
3. The valuation of debt and other financial assets Redeemable debt can be valued using the net present value technique. If debt is irredeemable, then a perpetuity formula can be used. Convertible debt and preference shares likewise can be valued as above. 4. The Efficient Market Hypothesis and practical considerations in the valuation of shares This theory maintains that financial markets are efficient with respect to information; in other words, that the prices of traded assets embody all known information and that they adjust to new pieces of information becoming known. It is therefore practically impossible to outperform the market, at least systematically. Main forms of market efficiency (1) Strong efficiency Share price incorporates all information, public or private; this means even inside information, so that an insider trader would not derive an advantage. (2) Semi strong form: reflect all information known at present about the company, including analysis, opinions and anticipated news; prices adjust quickly to such information, so that little advantage can be taken of them; (3) Weak-form: share prices reflect only to facts or accomplished actions by the company and therefore have little value for the future.
Page | 55
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Chapter 7
ACCA F9 Financial Management
Risk Management
(ii)
Page | 56
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Losses here are not necessarily realized in cash, but are reported as accounting losses due to exchange rate differences.
ACCA F9 Financial Management
Interest rate gap exposure The risk of interest-bearing assets and liabilities having different periods and re-set dates, so that a rise or fall in interest rates causes their values to change to differing degrees; the result is a gain or loss on the net position. Basis risk The risk of the prices of interest-bearing assets and liabilities not moving in line with each other over time; this can occur when imperfect hedges are employed.
2. Causes of exchange rate differences and interest rate fluctuations Balance of Payments A measure of the payments flow in and out of a country relative to the rest of the world. If the country spends more than it earns, then its currency will come under pressure to devalue relative to foreign currencies. Purchasing power parity (PPP) The exchange rate at which the same good in two countries are priced at the same level. Interest rate parity theory (IRP) The theory (and mechanism) by which forward foreign exchange rates reflect the differences in interest rates of two currencies. Four-way equivalence This model ties together four concepts: (i) (ii) (iii) (iv) PPP (as above); Fisher formula (the link between real and nominal interest rates); IRP (as above); Expectations: all relevant information is reflected in market prices.
Page | 57
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
The Fisher formula is: 1+Nominal rate = (1+Real rate)(1+Expected inflation rate). A countrys exchange rate will adjust to offset the inflationary impact on prices. The four theories (above) combine consistently to explain foreign exchange rates (spot and forward) and the link to interest rates. Exchange rate forecasting Using purchasing power parity:
The Big Mac costs USD 3.57 in the US and EUR 3.31 in Europe. PPP suggests that the EURUSD should be 1.08 (3.57/3.31). Any rate above (below) this means that the EUR is over (under)-valued. Using interest rate parity:
EURUSD spot rate is 1.3300; the EUR 1 year interest rate is 4% p.a.; the USD 1 year rate is 2% p.a. The implied EURUSD 1-year forward rate will be: 1.33 x (1.02/1.04) = 1.3044. Interest rates These are the prices borrowers and investors pay, resp. receive, for funds in the money and capital markets. Interest rate curves are normally upwardly sloping, showing that rates are higher the longer the maturity date. The difference in rates along the maturity curve can be explained by the:
1) Expectations theory: Investors expect higher interest rates in the future, if only to
offset inflation;
2) Liquidity preference: investors have to be compensated for not having the use of
meeting different investor preferences. Borrowers can move between these different markets for their funding.
3. Hedging techniques for foreign currency risk There are a number of methods by which a company can protect (hedge) itself against adverse movement in exchange rates.
Page | 58
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
(a) Currency of invoice: A firm can invoice in its home currency, thus avoiding forex risk altogether; (b) Netting and matching: A firm can systematically match and offset foreign currency payables and receivables when planning its forex purchase and sales; also identifying a liability (such as a cost) denominated in the same currency as an asset. (c) Leading and lagging: Timing the receipts and payments of foreign currencies so as to collect depreciating currencies more quickly and to slow payments of such currencies; (d) Forward exchange contracts: Buying and selling currencies on a forward basis with banks; (e) Money market hedging: See example below; (f) Asset and liability management: Firms can actively adjust their assets and liabilities according to the currencies in which they are denominated so as to limit forex risk. Money market hedge: A firm will receive GBP 1m in 6 months. It fears a decline in the value of the GBP. Spot rate: GBPUSD 1.4800 10 GBP 6-month interest rates: 4 7/8 - 5 % p.a. USD 6-month rates: 2 - 2 % p.a. 1. Borrow GBP 975,610 for 6 months at 5%; 2. Sell GBP 975,610 and buy USD at 1.4800 (= USD 1,443,903); 3. Place USD 1,443,903 for 6 months at 2%; 4. At maturity, receive GBP 1m and repay the loan of GBP 1m (principal plus interest). Net position in GBP: 0; 5. Receive USD maturing deposit (USD 1,458,342) The net result is that GBP has been sold in advance for USD at GBPUSD 1.4583. Other types of derivatives include: Futures
ACCA F9 Financial Management
Page | 59
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
A contract, transacted over an exchange, representing a standard amount of currency which can be bought or sold with a specified future settlement (delivery) date, at a rate denominated in a counter-currency. Options The right to buy or sell a currency at an agreed price set in advance (called the strike price). Calls A call option on EUR (vs. USD) at 1.4000 guarantees a holder (of the option) the right to buy EUR at USD 1.4000. If, at the end of the option period, the market price is EURUSD 1.5000, then the holder will exercise the option and buy the EUR at 1.4000 (profit is USD 0.10); If the market price had been EURUSD 1.3500, then the holder can buy EUR at 1.35 (market) and let the option lapse (expire unused). Puts In the example above, the firm receiving GBP 1m could have bought an option to sell GBP. Swaps A company can use swaps to borrow a foreign currency without foreign exchange risk by fixing the exchange rate corresponding to the maturity date of the loan. 4. Hedging techniques for interest rate risk There are various methods used to manage interest rate risk: (a) Matching and smoothing: This is the process of matching assets and liabilities with similar interest rate conditions (fixed/floating) so as to smooth, or minimize, the impact of rate fluctuation; (b) Asset and liability management (ALM): This is the active management of interest rate risk by actively adjusting the combination of the fixed/floating interest rate profile of a firm, using also external hedging instruments to this end; (c) Forward rate agreements (FRA): A contract which allows buyers and sellers to fix an interest rate in advance for a specified currency, amount and settlement date.
Page | 60
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
ACCA F9 Financial Management
EXAMPLE
(months)
0 1 2 3 4 5
A borrower planning to take a loan in 2 months (see diagram) can buy an FRA today (t=0) to protect against a rise in rates. The FRA contract rate is agreed at e.g. 3% (t=0). This becomes an 2x5 FRA at a price of 3% (2x5 means 2-by-5 and refers to the 2 and 3 month periods shown in the diagram above) If rates rise to e.g. 5% when the loan is taken (t=2), then the borrower gets 2% (53); If rates had dropped below 3% at t=2, then the borrower would have paid the difference
Other derivatives exist to hedge interest rate risk: Futures A borrower sells futures contracts to protect (hedge) against a rise in rates: 1. Sell futures contracts at 3% (t=0 in the diagram above) 2. At t=2, the future must be settled; if: (i) Interest rates rise to e.g. 5%, then borrower makes a profit on the future (an increase in interest rates reduces the value of futures); The profit on the future offsets the higher rates. Effective borrowing cost: 3%.
Rates decline to e.g. 2%, then the borrower makes a loss on the future (a decrease in rates increases the value of the futures); The loss on the future offsets the lower rates. Effective borrowing cost: 3%. In this way, the future allows the borrower to fix the loan rate in advance.
(ii)
Page | 61
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com
ExPress Notes
Options A borrowers option is a call option hedging against rising interest rates. In the diagram above: The buyer of a call option at a guaranteed rate of 3% (purchased at t=0) can: (i) Use the option (at t=2) if rates have gone up, e.g. to 5%. The borrowing takes place at 3%. Let the option lapse (i.e. not use it) if rates fall to 2% (at t=2). The borrowing takes place at this lower rate (2%).
ACCA F9 Financial Management
(ii)
The borrower using an option to hedge avoids higher interest rates, but benefits from lower rates. An option allows you to having your cake and eat it. Swaps An interest rate swap allows a company to change a fixed rate into floating rate (and vice versa) on a loan without altering the loan contract itself. If a borrower has a floating (variable) rate debt and expects interest rates to rise, it can avoid this rise by swapping its floating rate commitment into fixed rate.
Page | 62
2011 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
theexpgroup.com