Study Notes First Intuition Acca
Study Notes First Intuition Acca
Course Notes
ACCA
Financial Management (FM)
Exams from September 2019
Tutor details
ii I n t ro d u c t i on A C C A FM
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Fi No part of this publication may be reproduced, stored in a retrieval system
or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording or otherwise, without the prior written permission
of First Intuition Ltd.
A C C A FM I n t ro d u c t i on iii
Contents
Page
Introduction i
1 Welcome v
2 Your exam vi
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1 The nature, elements and importance of working capital
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2 Techniques for managing inventory 19
3 Techniques for managing accounts receivable 21
4 Techniques for managing accounts payable
5 Techniques for managing cash balances ntu ght 24
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6 Determining working capital needs and funding strategies
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4: Investment appraisal
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5: Business finance 63
6: Business valuations 91
iv I n t ro d u c t i on A C C A FM
Chapter 1 121
Chapter 2 122
Chapter 3 122
Chapter 4 125
Chapter 5 130
Chapter 6 133
Chapter 7 134
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A C C A FM I n t ro d u c t i on v
1 Welcome
To begin your course, log in using the information provided in your joining instructions e mail.
The Financial Management (FM) course is based around these course notes and the related question
bank. You should have had a physical copy of both these notes and the question bank delivered to
your address. A PDF of the course notes and question bank is included at the end of the online course,
should you wish to download a soft copy.
The FM course
On phase 1 of your course, your online tutor works through these notes in a series of online lectures.
You will see the notes on the screen and hear your tutor explaining the relevant points and working
through the lecture examples. You will get the most out of these lectures if you have your own course
notes in front of you as you listen. You can annotate your own notes as you wish. Lectures can be
paused at any point so you can make your own notes, or you can replay the video to go back over
something that wasn’t clear the first time you heard it. You should work through the chapters and
lectures in order.
Once you have listened to the lectures in a particular chapter, try the questions associated with that
chapter. You have the same questions both online and in your physical copy of the question bank. We
recommend that you practise the section A and B questions online as you will need to be used to an
online question environment for your real exam. Try questions without looking at the answers: only
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look at the answers after you have tried the question for yourself. Certain questions have been
debriefed by your online tutor. Watch these debriefs only after you have tried the question concerned.
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once in phase 1 of your studies and once again as you revise in phase 2 of your studies.
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When you have completed all the chapters on the course, revisit any areas where you felt weak and
try the questions related to those chapters again. If you are unsure of any points listen to the related
lectures again. There is then a course exam for you to attempt. This will give you a good indication of
how well you are progressing
Finally you should work through the ACCA specimen exam and example questions. The link to these is
provided on your course and it is vital that you work through these to familiarise yourself with the
ACCA software.
Once you have completed the above, you are ready to move to phase 2 of your studies, which is the
revision phase.
If you need help at any point, please contact your tutor. Details of your tutor are included on your
joining instructions e mail.
Good Luck!
vi I n t ro d u c t i on A C C A FM
2 Your exam
You will sit your exam on a computer. *
*In some locations of the world paper based exams may be available, please check locally.
Your exam
You will have three hours and 20 minutes for the exam PLUS you may have up to 10 minutes to read
the exam instructions.
The exam is in three parts:
All questions are compulsory and may contain computational and discursive elements. Some
questions will adopt a scenario/case study approach.
Section A: 15 objective test questions of 2 marks each.
Section B: 3 × 10 mark case-based questions. Each case has 5 objective test questions of 2 marks
each.
Section C: 2 x 20 mark questions.
The two 20-mark questions will mainly come from the working capital management, investment
appraisal and business finance areas of the syllabus. The section A and section B questions can cover
any areas of the syllabus. Candidates are provided with a formulae sheet and tables of discount and
annuity factors
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The section A and section B questions can cover any areas of the syllabus.
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Seeded questions
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There are extra questions in the exam. The extra questions are known as ‘seeded questions’ and do
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not contribute to your result but are added to your test by the ACCA to ensure all exams are fair and
equal.
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As a result, your exam will contain 110 marks of exam content:
Fi (ii) 10 marks of seeded content which will not contribute to your overall mark
The 10 marks of seeded content is either randomly distributed within section A of the exam, five single
OT questions, or within section B of the exam, five OT questions around a single scenario.
You will not be able to determine which questions are the seeded content and all questions are quality
assured and set to the same standard.
Financial management
function
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1 The nature and purpose of financial management
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1.1 Financial management tio
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Financial management involves identifying the financial objectives of an organisation and then
ensuring that these are achieved.
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In order to achieve the financial objectives set out by an organisation the financial managers within
the organisation have to make effective decisions in three key areas:
Investment (covered in Chapters 3 and 4)
Financing (covered in Chapter 5)
Dividend (covered in Chapter 6)
These decisions form the Financial Strategy of the organisation).
Examples of interdependence of the three key decision areas:
– Companies raise capital either in the form of equity or debt (the financing decision) which
they invest in different projects (the investment decision) in order to generate returns
which are either reinvested or paid out to the shareholders (the dividend decision).
– If a company increases its dividends (the dividend decision), this will reduce the level of
retained cash and increase the need for external finance (the financing decision) in order
to fund capital investment projects (the investment decision).
– An increase in capital investment expenditure (the investment decision) would also
increase the need for finance (the financing decision) which may be internally generated
by reducing dividends (the dividend decision).
2 1: Fi n an c i al man ag e me n t f u n ct i o n A C C A FM
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achieving its overall mission and goal(s). These objectives cover the whole organisation and include:
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Commercial objectives (e.g. market share, growth, customer satisfaction)
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Financial objectives (objectives which can be expressed in financial terms - see below).
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Corporate strategy is the course of action required to achieve the corporate objectives and includes
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key business decisions such as how the business will grow (organic vs. acquisition) and in which
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markets to operate.
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2.2 Identify and describe a variety of financial objectives
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Fi 2.2.1 Shareholder wealth maximisation
As a general rule the prime financial objective of profit making organisations is to maximise
shareholder wealth. Wealth is delivered to shareholders through the payment of dividends and the
increase in share price. So this combination needs to be maximised.
A C C A FM 1: Fi n an c i al man ag e me n t f u n ct i o n 3
Definitions:
PBIT = Profit before interest & tax, PAT = Profit after tax and preference dividends (also known
as ‘earnings’)
TALCL = Total assets less current liabilities
Shareholder funds = Ordinary share capital + Share premium + Reserves
Asset turnover
Revenue
Revenue st I pyri goods sold
Measure how efficiently a company uses its assets
TALCL
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Growth in Revenue,
PBIT, PAT
Year on year, or geometric
growth itioTo what extent is turnover growth leading to profit
growth? How good is cost control?
4 1: Fi n an c i al man ag e me n t f u n ct i o n A C C A FM
The following financial data is available for Diamond Co which has issued 2.1 million shares which are
currently priced at $7.20 per share (they were priced at $7 at the end of the prior year).
Extracts from the financial statements:
$000
Income statement
Revenue 14,687
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Profit from operations before interest and tax
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Profit from operations after interest and tax
2,159
1,260
Dividends
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Statement of financial position
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Non-current assets
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Current assets
7,340
3,562
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Current liabilities 3,070
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Long-term liabilities
Shareholders’ funds
2,876
4,956
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Industry average figures
ROCE
Return on Equity
27.5%
25.5%
EPS $0.42
Dividend per share $0.15
Calculate the ROCE, Return on Equity, EPS, Dividend per Share, P/E ratio and total shareholder return
for Diamond Co and comment on your figures.
A C C A FM 1: Fi n an c i al man ag e me n t f u n ct i o n 5
SOLUTION
ROCE
Return on
Equity
EPS
Dividend
per share
P/E ratio
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TSR
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3.2 Stakeholders and their objectives 019
A stakeholder is an individual or group of individuals with an interest in the organisation.
Stakeholder Objectives
Shareholder Share price maximisation, dividend maximisation, earnings growth,
maintenance of control
Lenders Certainty of payment, security of capital, further loans
Directors/Senior managers Maximise remuneration, Security of tenure, maximisation of power and
influence
Employees Maximise remuneration, security of tenure, career development , training
Customers VFM, high quality, reliable service, innovation
Suppliers Certainty of payment, further business
Government Creation of employment, payment of taxes
Community Environmental improvements, creation of wealth
6 1: Fi n an c i al man ag e me n t f u n ct i o n A C C A FM
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The Agency Problem refers to the situation where the directors may be tempted to act in their own
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best interests rather than the shareholders.
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The agency problem may be addressed by using a mixture of appropriate managerial reward schemes
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3.5 How to encourage the achievement of stakeholder objectives
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3.5.1 Managerial reward schemes such as share options and performance-related pay
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Directors can be encouraged to act in the best interests of shareholders if their objectives are aligned
with those of the shareholders.
Fi This can be achieved by rewarding them partly in share options in the company. Hence, if the share
price of the company rises over the long term, the value of the options will increase (and this should
encourage the directors to target long term growth and performance).
Alternatively, the director’s remuneration can be linked to the increase in the company’s share price,
profits or earnings.
However, both of these approaches may still lead to poor performance being rewarded (as the move
in share price may not be due to the actions of the directors).
3.5.2 Regulatory requirements such as corporate governance codes of best practice and
stock exchange listing regulations
In the UK the UK Corporate Governance Code (September 2012) sets out what is accepted as best practice
as to the ways in which directors should behave in running a company. All listed companies must make a
statement on the appliance and compliance of the Code when they publish their financial statements.
The Code recommends certain measures to curb the power of the executive directors, such as the
appointment of non-executive directors and nomination and remuneration committees.
The Stock Exchange Listing Regulations contain the eligibility criteria for listing, the duties of sponsors
and continuing obligations of listed companies. These regulations apply to all companies listed on the
Main Market, but are particularly pertinent to those obtaining a listing for the first time.
A C C A FM 1: Fi n an c i al man ag e me n t f u n ct i o n 7
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Appointing regulators/experts to monitor performance Co
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Comparing actual performance to appropriate financial targets
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8 1: Fi n an c i al man ag e me n t f u n ct i o n A C C A FM
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Financial management
environment
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1 The economic environment for business
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1.1 The main macroeconomic policy targetstio
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Different governments will put a different emphasis on individual policies and use different measures
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to achieve these policies, but in general governments try to achieve the following macroeconomic
targets:
Strengthening business to make the economy more competitive
Protecting the environment
Increasing employment opportunities
Ensuring fairness for families and communities
Delivering macroeconomic stability to encourage long term planning and investment
10 2: Fi n an c i al man ag e me n t e n v i ro n me n t A C C A FM
Central banks can also increase the supply of money by repurchasing Government debt
from banks (known as quantitative easing)
Increasing the supply of money (by reducing interest rates or quantitative easing) should
make borrowing cheaper and hence increase demand
Exchange rate policy describes Government’s attempts to influence exchange rates:
Current policy in the UK is to allow a free or floating exchange rate (where demand and
supply is allowed to set the exchange rate)
Alternatives include managed and fixed exchange rate policies.
However, exchange rates are one of the factors taken into account by the Bank of
England when setting interest rates.
A higher exchange rate (1 unit of domestic currency buys a large quantity of a foreign
currency) will make imports and costs of production cheaper (hence leading to a
reduction in inflation) and make exports more expensive (reducing demand for exports)
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Exchange rates if importing or exporting or competing with those that do
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Government economic policy affects all of the above and so interacts with planning and decision-
making in business.
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1.3.2 Competition policy
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Without a competition policy which prevents anti-competitive behaviour such as price fixing,
and market dominance; business could abuse its power and consumers would suffer.
Thus when business is making plans especially for things such as mergers and takeovers, but
also with regards to general competition it will be influenced by relevant competition policy.
A C C A FM 2: Fi n an c i al man ag e me n t e n v i ro n me n t 11
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companies to manage their capital structure efficiently.
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Both Money and Capital markets consist of a primary market through which initial issues take
place and a secondary market where the securities are traded once they have been issued.
borrowing markets).
Certificates of Deposit A time deposit with a bank (≥$100k) 3 months - 5 years Fixed rate
Repo (sale & repurchase Short term loan secured on specific Usually < 1 year Fixed rate
agreement) assets (lender actually takes possession
of secured assets)
Treasury Bills Short-term securities issued by 1 / 3 / 6 month Redeem at par, so
Governments at a discount (sold in effectively a fixed
denominations of $1k) rate
Commercial Paper Short-term debt issued by companies / Usually < 270 days Redeem at par, so
banks (usually issued at a discount) effectively a fixed
rate
Eurocurrency Market Short - medium term deposits / loans (often bank - bank) in currencies of
(International Money countries other than that of the bank (e.g. USD deposit at bank in London)
Market) Most money market instruments are available on the Eurocurrency market
(though typically only in major currencies)
12 2: Fi n an c i al man ag e me n t e n v i ro n me n t A C C A FM
Allowing an organisation to manage its exposure to foreign currency risk and interest rate risk
One way an organisation can manage its exposure to foreign currency risk is by using a money market
hedge (Chapter 7), which involves short term lending and borrowing which is facilitated by the money
markets. An organisation can also manage its exposure to foreign currency risk and interest rate risk is
by using derivatives (Chapter 7), which also involves short term lending and borrowing which is
facilitated by the money markets.
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/ banks (usually issued at par) years)
Fixed rate coupon,
with redemption at
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Longer-term debt issued by Any Fixed rate coupon,
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Ordinary Shares
governments (usually issued at par)
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Capital growth (shares may rise in value based on performance of the company)
F Eurobond Market Longer term debt (bonds) issued to investors (probably international) and
denominated in a currency other than the domestic currency of the issuer
Often issued via investment banks, normally in the major currencies (USD, EUR,
CHF, GBP)
A C C A FM 2: Fi n an c i al man ag e me n t e n v i ro n me n t 13
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2.4 Explain the role of banks and other financial institutions in the
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operation of the money markets
Banks and other financial institutions form the core of the money market as the vast majority of
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transactions consist of interbank lending where banks borrow and lend to each other.
14 2: Fi n an c i al man ag e me n t e n v i ro n me n t A C C A FM
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1 The nature, elements and importance of working capital
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1.1 The nature of working capital and its elements
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Working capital is the cash invested in current assets less current liabilities. Current assets will consist
of inventories (raw materials, work in progress and finished goods), receivables and cash. Current
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liabilities will consist of trade and other payables, short term loans and overdrafts.
16 3: W o rki n g c ap i t al man ag e me nt A C C A FM
h tand leasing
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–
–
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A decreases in the current ratio
A decrease in the quick ratio
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Note: The measures (e.g. receivables days) mentioned above are covered in section 2 below.
Both ‘overtrading’ and ‘undercapitalisation’ are opposite sides of the same coin and the financial
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manager should always ensure that any project undertaken by an organisation (such as a growth in
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sales) is beneficial to the shareholders and that the appropriate funding is also available.
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Thus the successful management of working capital is central to a company achieving its financial
objectives.
1.4 The cash operating cycle and the role of accounts payable / receivable
The cash operating cycle is the time difference between cash being paid out for production costs and
cash being received for goods sold. This can be calculated as follows:
Days
Average time raw materials are in stock X
Average time work in progress is in production X
Average time finished goods are in stock X
Average collection period X
Less: (Average payable period) (X)
Cash operating cycle X
Thus the cash operating cycle will become smaller either as accounts payable increase and/or as
accounts receivable reduce.
A C C A FM 3: W o rki n g c a p i t al man ag e me nt 17
1.5.2 Inventory turnover ratio, average collection period and average payable period
Cost of sales
Inventory turnover ratio =
Average inventory
This ratio looks at how many times the inventory is used each year. Year-end inventory can also
be used to measure this ratio.
A higher ratio indicates a more efficient management of inventory, however the relatively low
levels of inventory could also increase the risk of stock-outs, which could damage an
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organisations reputation. It may also discourage customers from trading with the organisation
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as there could be a lack of choice or a delay in receiving delivery.
By inverting this ratio and multiplying by 365 it is possible to calculate the inventory days as
follows
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Average inventory period =
Average inventory
Cost of sales
× 365 days
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This ratio looks at the average time inventory stays in the warehouse. Again year-end inventory
can also be used. A short period has the same implications as a high inventory turnover ratio.
This ratio looks at the average time it takes to collect money from customers. Again year end
trade receivables can also be used. A short period is good for liquidity but may discourage
customers from trading with the organisation.
Average trade payables
Average payable period = × 365 days
Credit purchases or cost of sales
This ratio looks at the average time it takes to pay money to suppliers. Again year end trade
payables can also be used. A long period is good for liquidity but may discourage suppliers from
trading with the organisation.
This ratio looks at the overall working capital of the organisation compared to its sales. It is very
difficult to compare absolute levels of working capital as even organisations involved in the
same business will vary in size.
This ratio allows the overall working capital efficiency management to be compared, both over
time and against competitors. If this ratio is low, this would suggest inefficiency, however if it is
high the organisation may be losing business due to being too tough with customers.
18 3: W o rki n g c ap i t al man ag e me nt A C C A FM
Current ratio
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Quick ratio
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Inventory turnover ratio
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A C C A FM 3: W o rki n g c a p i t al man ag e me nt 19
Where
Co = Cost of placing one order
D
Ch
= Demand per annum
= Cost of holding one unit for one year
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And the total annual cost (TAC) is:
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Annual order cost + Annual holding cost
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TAC = C o
D
Q
+ Ch
Q
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Where n2
Q = Reorder quantity (EOQ)
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LECTURE EXAMPLE 3.2
Paton Co uses components at the rate of 500 units per month, which are bought in at a cost of $1.20
each from the supplier. It costs $20 each time an order is placed, regardless of the quantity ordered.
The total holding cost is 20% per annum of the value of stock held.
What are the EOQ and TAC?
SOLUTION
20 3: W o rki n g c ap i t al man ag e me nt A C C A FM
The EOQ model assumes both constant known levels of demand and lead times, which are
unlikely in practice.
One way of overcoming this issue is to hold a buffer stock (so if the level of demand is higher
than expected or the lead time longer, the buffer can be used and stock-outs will be avoided)
On average the buffer stock will not be used and so the inventory levels are simply increased by
the quantity of buffer stock and so are the holding costs. The level of buffer stock needs to be
balanced against the cost of stock-outs.
If a buffer stock of B units is held, the total annual inventory cost will be
D
+ Ch B +
Q
TAC = C o
Q 2
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The point at which the total annual cost is lowest is the best order quantity.
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LECTURE EXAMPLE 3.2 REVISITED
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Paton Co has now been offered a 0.5% discount if it orders at least 1,500 units at a time.
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How many units should Paton order?
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The EOQ model uses relevant costing principles and so ignores committed costs such as the fixed costs
associated with the warehouse. However, if inventory is removed completely, then these costs also
become relevant and so there is potential for significant savings.
A C C A FM 3: W o rki n g c a p i t al man ag e me nt 21
Fir Co
However, this also worsens the liquidity of the organisation and if the debt went bad, could result in
no benefit what so ever from the sale. This is a significant drawback and can be dealt with as follows.
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confidence that they will meet their debts as and when they fall due. There is no single correct way of
assessing credit worthiness, but common elements include obtaining:
A bank reference
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At least one trade references
A credit rating agency report
Financial statements
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Any media coverage
Views of a member of staff who has visited the potential customer
22 3: W o rki n g c ap i t al man ag e me nt A C C A FM
Consider the cost of financing accounts receivable before and after the discount
Treat the accounts receivable balance like a permanently overdrawn balance
Early Bird Co currently has annual credit sales of $4,450,000. On average trade receivables take
55 days to pay and 8% of credit sales go bad. Early Bird is considering introducing an early settlement
discount whereby all customers who pay in less than 30 days will receive a 5% discount. It is expected
that 80% of customers will take advantage of the scheme and that bad debts will fall to 5%. The
average trade receivables are expected to fall to 30 days. Early Bird currently pays 12% pa on its
overdraft.
Is the proposed early settlement discount scheme economically viable for Early Bird Co?
SOLUTION
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A C C A FM 3: W o rki n g c a p i t al man ag e me nt 23
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3.6 Managing foreign accounts receivable
Managing foreign accounts receivable is the same as managing home accounts receivable but three
points in particular need to be borne in mind:
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(1)
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Credit periods tend to be longer due to the extra time taken for goods to be physically
transported and the extra associated paperwork. These delays in foreign trade mean that
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exporters often build up large investments in inventories and accounts receivable. These
working capital investments have to be financed somehow.
(2) 019
The bad debt risk is generally higher and so the credit worthiness checks become even more
important. If a foreign customer refuses to pay a debt, the exporter must pursue the debt in the
debtor's own country, where procedures will be subject to the laws of that country.
(3) If the debts are denoted in a foreign currency, their value will vary as the exchange rates vary.
Potential solutions to this problem are covered in Chapter 7.
The first two issues above can be managed and reduced as follows:
24 3: W o rki n g c ap i t al man ag e me nt A C C A FM
Export factoring
The exporter pays for the specialist expertise of the factor in order to reduce bad debts and the
amount of investment in foreign accounts receivable.
Countertrade
A means of financing trade in which goods are exchanged for other goods.
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4 Techniques for managing accounts payable
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4.1 Using trade credit effectively
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Trade credit helps to reduce the cash operating cycle and so the amount should be maximised,
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however care must be taken not to abuse suppliers as this can result in future credit being stopped.
As relationships with suppliers develop, the amount of credit should be extended
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4.2 Evaluating the benefits of discounts for early settlement and bulk
Fi purchase
In exactly the same way organisations offer their customers early settlement discounts (as discussed
above), they may be offered early settlement discounts themselves. Before taking such discounts it is
important to ensure that the benefits outweigh the costs (calculations very similar to lecture example
3.3 above).
A C C A FM 3: W o rki n g c a p i t al man ag e me nt 25
Flow Co started in business in June, making children’s ride on toy Jeeps. The following information is
June.
Fir Co
available for the first few months of trading. $50,000 of capital was put into the business at the start of
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Forecast sales volumes for the first four months are as follows:
Month
June ntu ght Sales (Jeeps)
500
July
August itio 1,200
1,500
September
n2 1,900
An initial selling price of $90 has been set
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Normal trading terms are for customers to pay within one month of end of month of sale but a more
realistic pattern of receipts is as follows:
26 3: W o rki n g c ap i t al man ag e me nt A C C A FM
Supporting notes:
(1) Direct materials. All materials needed in the production process will be purchased in the month
of production and paid for one month later. It is policy not to hold any inventory for materials.
(2) Direct labour. All paid for in the month production occurs.
(3) Variable production overheads. 50% is paid in the month of production and 50% a month later.
(4) Fixed production overheads. The absorption rate used has been based on expected annual
overheads of $180,000 and expected annual sales of 18,000 units. Fixed overheads are
expected to be paid in equal instalments each month.
Prepare a detailed monthly cash budget for June, July and August.
SOLUTION
June July August
$ $ $
Receipts
From customers (W1)
Capital
Payments
Materials (W3)
Labour (W4)
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Variable overheads (W5)
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Fixed overheads (W6)
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Net cash flow
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Opening balance
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Closing balance
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(W1) Cash receipts from customers
June July August
Sales
A C C A FM 3: W o rki n g c a p i t al man ag e me nt 27
(W2) Production
In order to work out our costs we need to establish the production volumes each month. This
can be done by taking the sales volumes for a month, adding closing inventory and deducting
opening inventory.
June July August
Sales volume
Add: closing inventory
Less: opening inventory
Production
Now we know this we can calculate the cash flows for the variable costs:
(W3) Materials
June July August
Production (W2)
Material cost (@ $15 each)
Cash payment
(W4) Labour
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June July August
Production (W2)
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Labour cost (@ $20 each)
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Cash payment
28 3: W o rki n g c ap i t al man ag e me nt A C C A FM
2FS
Q=
I
h t 9
F
S
r g 0 1
= Cost of obtaining funds
i
= Amount of cash required per annum
2
I
y
= Cost of holding $1 for one year
p ion
o
And the total annual cost (TAC) is:
C uit
Annual order cost + Annual holding cost
I n t S Q
rs tTAC = F
Q
+I
2
Fi
ILLUSTRATION 3.1
Reddies Co uses cash at the rate of $500 per month. It costs $20 each time cash is raised. The interest
rate is 24% per annum.
What are the amounts of cash to be raised and the total annual cost?
SOLUTION
F = $20
S = $500 × 12months = $6,000
I = $1.00 @ 24% = $0.24
2×20×6,000
Q = � = $1,000
0.24
6,000 1,000
TAC = 20 × 1,000 + 0.24 × 2
= $120 + $120 = 240
By raising $1,000 of cash whenever Reddies needs cash, the total annual variable costs are minimised
at $240.
A C C A FM 3: W o rki n g c a p i t al man ag e me nt 29
Cash
balance
Upper limit
The firm
buys securities
Spread
Return point
Lower limit
st I pyri Time
30 3: W o rki n g c ap i t al man ag e me nt A C C A FM
Oscillate Co has an overdraft limit of $40,000 which it does not want to exceed. The variance of its
daily cash flows is $400,000,000. The transaction cost of investing and raising funds is $575 and the
interest rate is 0.03% per day.
What are the spread, return point and upper limit for Oscillate Co using the Miller-Orr model?
SOLUTION
h
Investing short-term t 9
r i g 2 0 1
If an organisation has a short-term surplus, this can be used to:
y
p ion
Offer more generous credit terms to customers
o
C uit Reduce short term borrowing (e.g. overdrafts)
Put on deposit on the money markets
I n t
r s t
6 Determining working capital needs and funding strategies
F i 6.1 The level of working capital investment and key factors determining
this level
The level of working capital investment in current assets is the monetary value of inventories and
receivables. You may, for instance, be provided with the average receivables collection period and
thus have to calculate the trade receivables by rearranging the average collection formula (from
section 1.5)
The level of working capital investment in current assets will be determined by the following key
factors:
6.1.1 The length of the working capital cycle and terms of trade
The working capital (or cash operating) cycle depends in part upon the level of current assets;
the higher the current assets, the longer the cash operating cycle and so the more cash there
will be invested in working capital.
The more generous the terms of trade offered to customers, the higher receivables will be and
so once again the more cash there will be invested in working capital.
A C C A FM 3: W o rki n g c a p i t al man ag e me nt 31
Fir Co
6.2.1 The distinction between permanent and fluctuating current assets
st I pyri
The overall level of current assets is likely to vary over time; this is particularly obvious if we
think of a seasonal business. The level of current assets will fluctuate between a minimum and
maximum level.
ntu ght
itio
The minimum level represents a permanent long-term requirement from a funding point of
view; whereas the range between the minimum and maximum represent a temporary short-
term requirement.
n2
019
6.2.2 The relative cost and risk of short-term and long-term finance and the matching
principle
Long term funding is relatively expensive but is lower risk, as once it is raised, assuming there is
no breach of any terms, it may be kept for the long term whether or not it is required.
Short-term funding is relatively cheap (due to liquidity preference theory, see Chapter 7) but is
higher risk, as once it is repaid there is no guarantee that it will be replaced even if it is required.
The matching principle states that long term investments should be financed with long term
finance e.g. people buy their homes with 25-year mortgages; and short term investments
should be financed with short term finance e.g. if you don’t have enough money to last until
your next pay day, you use an overdraft.
32 3: W o rki n g c ap i t al man ag e me nt A C C A FM
Long-
Non-current assets term
funds
h t 9
Time
r i g 2 0 1
y
p ion
o
C uit
The conservative approach
I n t
Alternatively, long-term finance could be used to fund all of your current assets, this would be more
expensive, but the organisation will know that it will not run out of funding and so is safe.
r s t
Consequently, this is referred to as the conservative funding policy.
Total
assets
Long-
term
Permanent current assets funds
Long-
Non-current assets term
funds
A C C A FM 3: W o rki n g c a p i t al man ag e me nt 33
Long-
Non-current assets term
funds
Fir Co
st I pyri
6.2.3 Management attitudes to risk, previous funding decisions and organisation size
ntu ght
If management are high risk takers they are likely to adopt the aggressive funding policy and if
itio
they are risk averse they are likely to adopt the conservative funding policy. In practice most
managers will be somewhere in between these two extremes and so the matching funding
policy is very popular.
n2
019
Previous funding decisions for current assets will also influence the current decision as if these
are seen as having been successful they are more likely to be repeated.
Finally, larger organisations are able to raise funds relatively easily and so the risks of the
aggressive funding policy may not in fact be that high.
Smaller organisations find fund raising significantly harder and find raising long-term finance
even harder than short term-finance and so, ironically, may be forced into the aggressive
funding policy despite the high risks involved.
34 3: W o rki n g c ap i t al man ag e me nt A C C A FM
h t 9
r i g 2 0 1
y
p ion
o
C uit
I n t
rs t
Fi
35
Investment appraisal
Fir Co
1 Investment appraisal techniques
st I pyri
1.1 Relevant cash flows
ntu ght
itio
In investment projects it is important that the appraisal is based upon the correct information.
The correct financial figures are the relevant costs. A relevant cost is defined as a future incremental
n2
cash flow. In other words for a figure to be relevant it must pass three tests:
(1) Future
–
019
A decision being made today cannot change the past and so only future costs are
considered.
– Past costs are sometimes referred to as sunk costs and are not relevant and so are
ignored e.g. the price paid for something which is already owned.
(2) Incremental
– Only those costs that are affected by the decision are incremental and therefore
relevant.
– Costs that are sometimes referred to as committed costs and are not relevant and so are
ignored e.g. unavoidable fixed costs.
– Businesses need to consider lost opportunity costs (revenue / contribution lost from
diverting resources away from an alternative use), which are also relevant.
– Businesses also need to consider the deprival value (the relevant cost of using capital
items on a new project instead of continuing with their current use). A useful diagram for
determining the deprival value for capital items is shown below:
36 4: I n v e s t me nt a p p ra i s a l A C C A FM
Lower of
Higher of
Replacement cost
Net Realisable Value Value in Use
Proposal Co is considering investing in a new project. The following details have been obtained:
The project requires 1,200 kg of raw material. Proposal Co has 2,000 kg in inventory, bought two years
ago for $1.50 per kg, but no longer used for any of the firms' products. The current market price for
the material is $2.00 per kg, but Proposal Co could only sell it for $0.80 per kg.
100 hours of labour will be used on this project. There are 300 hours’ worth of spare labour capacity.
There is a union agreement that staff cannot be laid-off. The workers are paid $6.50 per hour.
h t 9
The variable overheads will total $34,564 and the fixed overhead rent $42,500.
r i g 0 1
The project will require a machine which was bought four years ago for $20,000. This machine could
2
y
be scrapped now for $12,000. If it is kept it will generate $15,000. An identical machine can currently
p ion
o
be purchased for $14,000.
C uit
What are the relevant costs of this project?
SOLUTION
I n t
rs t
Fi
A C C A FM 4: I n v e s t me nt a p p ra i s a l 37
Horizon Co is considering a project that will require an investment in machinery of $80,000 and which
will generate a net income of $15,000 in the first year, increasing by $5,000 each subsequent year. The
project is expected to last for five years and the machinery is not expected to have any residual value.
Calculate the payback period of this project.
SOLUTION
Annual cash flow Cumulative cash flow
$ $
Investment
First year
Second year
Third year
Fourth year
Fir Co
st I pyri
ntu ght
itio
n2
The usefulness of payback as an investment appraisal method is: 019
It is simple to calculate
It is easy to understand, especially for non-accountants
It uses relevant cash flows
It can be used as an initial screening tool on projects before undertaking a more detailed review
It (rather crudely) allows for risk
Where:
(Total net cash flows – Total depreciation)
Average annual profit of the project =
Length of project
(Initial investment + Scrap value)
Average investment = 2
This measures the return made by the project from the amount of capital invested and so gives an
indication as to how efficient the project is at generating profits from its capital investment.
38 4: I n v e s t me nt a p p ra i s a l A C C A FM
h t
The ROCE usefulness as an investment appraisal method is:
9
r i g 2 0 1
It is simple to calculate
As a percentage the measure is familiar to non-accountants
y
p ion
It looks at the entire project
o
C uit
It reflects the way external investors judge the organisation
I n t
1.4 Present Valuing
rs t
When money is borrowed or invested, the amounts grow larger over time as interest is added,
however when appraising investments we want to know what they are worth to the organisation now,
Fi
so that we can directly compare different potential investments. Thus we need to calculate present
values.
To calculate the present value of a future value we can use the following formula:
Where:
FV = future value
r = period interest rate expressed as a decimal
n = number of periods
As the present value is lower than the future value, the multiplier is called the discount factor.
A C C A FM 4: I n v e s t me nt a p p ra i s a l 39
Money Bags is expecting to receive $16,751 in six years. Interest rates will be 5% for the whole six
years.
Calculate the present value of Money Bags’ receipt.
SOLUTION
1.4.1 Annuities
Some investments generate a constant return, this is called an annuity. The present value of an
annuity can be calculated by using the following formula:
Where:
PV = present value ntu ght
A
r
= constant return (starting in one year’s time)
= period interest rate expressed as a decimal itio
n = number of periods
n2
LECTURE EXAMPLE 4.4 019
Henry Stanley is going to receive $150 every year for 12 years. The annual interest rate is 6%.
Calculate the present value of Henry Stanley’s annuity.
SOLUTION
40 4: I n v e s t me nt a p p ra i s a l A C C A FM
Money Bags is expecting to receive $16,751 in six years. Interest rates will be 5% for the whole six
years.
Calculate the present value of Money Bags’ receipt using the discount tables.
SOLUTION
Henry Stanley is going to receive $150 every year for 12 years, starting in one year’s time. The annual
interest rate is 6%.
Calculate the present value of Henry Stanley’s annuity using the discount tables.
SOLUTION
h t 9
r i g 2 0 1
y
p ion
o
C uit
I n t
rs t
1.4.2 Delayed Annuities
Fi The annuity formula and annuity factors from the annuity table assume that the first cashflow will
occur in one year’s time.
If that is not the case, then the annuity formula / annuity factors should be used to calculate the value
as at one year before the start of the annuity. Then a discount factor may be used to find the present
value.
Henry Stanley is going to receive $150 every year for 12 years, starting in four years’ time. The annual
interest rate is 6%.
Calculate the present value of Henry Stanley’s annuity.
SOLUTION
A C C A FM 4: I n v e s t me nt a p p ra i s a l 41
1.4.3 Perpetuities
Some annuities last forever, these are called a perpetuities. The present value of a perpetuity can be
calculated by using the following formula:
1
PV = A × r
Where:
PV = present value
A = constant return (starting in one year’s time)
r = period interest rate expressed as a decimal
Victoria is expecting to receive $2,000 a year for ever, starting in one year’s time. Interest rates are
expected to remain constant at 5%.
Calculate the present value of Victoria’s perpetuity.
SOLUTION
Fir Co
st I pyri
1.4.4 Net Present Value
Most investments will involve a series of cash outflows and inflows at different points in time.
ntu ght
If we calculate the present value of each cash flow and then add all the present values together,
itio
we can calculate the Net Present Value (NPV) of the investment.
A positive NPV represents the present value of the excess return of the project over and above
n2
the cost of capital, hence investments with a positive NPV should be undertaken (as the return
on the project beats the cost of financing the project)
Projects with a negative NPV should not be undertaken 019
LECTURE EXAMPLE 4.2 CONTINUED (PART 3)
42 4: I n v e s t me nt a p p ra i s a l A C C A FM
NPV
0 %
–
h t 9
r i g 2 0 1 IRR
y
p ion
o
C uit
I n t
Due to this curved relationship, finding the precise IRR would be very time consuming, so instead we
find an approximate IRR by finding two points on the curve and then assuming that there is a straight
rs t
line between them:
Fi NPV
NPV L ≈IRR
H
0 %
L
NPV H
_– IRR
A C C A FM 4: I n v e s t me nt a p p ra i s a l 43
We can then use the following formula to find this approximate IRR:
NPVL
IRR ≈ L + × (H – L)
NPVL−NPVH
Where:
L = lower discount factor
H = higher discount factor
st I pyri $11,155
ntu ght
itio
n2
The internal rate of return’s usefulness as an investment appraisal method is:019
It does not require the exact cost of funds to be known
As a percentage the measure is familiar to non-accountants
It looks at the entire project
It provides a relative measure of performance
44 4: I n v e s t me nt a p p ra i s a l A C C A FM
h t
ignoring inflation return is called the real interest rate, as it shows how much better off you
9
r i g
really are.
2 0 1
y
The relationship between real and nominal interest rates is:
p ion
o
FORMULA GIVEN IN EXAM
C uit
I n t
(1 + i) = (1 + r) × (1 + h)
Where:
rs t
Fi
i = nominal interest rate
r = real rate
h = general inflation rate
So there are two different rates;
Real rate (excludes inflation, compensates the lender for the time value of money)
Nominal rate (includes inflation, compensates the lender for TVM and inflation)
In choosing which rate to use we must be consistent:
If the cash flows exclude inflation (‘real’ cashflows) then so must the discount factor
(‘real’ rate)
If the cash flows include inflation (‘nominal’ or ‘money’ cashflows) then so must the
discount factor (‘nominal’ rate)
A C C A FM 4: I n v e s t me nt a p p ra i s a l 45
ILLUSTRATION 4.1
Rise Co is considering a project that will require an investment in machinery of $50,000 and which will
generate net income of $18,000 in the first year, $24,000 in the second year and $33,000 in the third
and final year. The cost of funds is 12%. None of these figures include inflation.
Calculate the NPV for Rise Co.
SOLUTION
Timing Cash flow Discount Factor Present Value
$ 12% $
0 (50,000) 1.000 (50,000)
1 18,000 0.893 16,074
2 24,000 0.797 19,128
3 33,000 0.712 23,496
NPV = $8,698
Fir Co
Inflation is currently 7% and is expected to remain at this level for at least the next three years in the
country where Rise Co operates.
Calculate the NPV for Rise Co including inflation. st I pyri
SOLUTION ntu ght
To include inflation in the cost of funds we use the formula:
itio
(1 + i) = (1 + r) × (1 + h)
n2
(1 + i) = (1 + 0.12) × (1 + 0.07)
(1 + i) = 1.1984
019
i = 0.1984 or 19.84%
Real cash Nominal Discount Present
Timing flow Inflation cash flow Factor Value
$ 7% $ 19.84% $
0 (50,000) 1.00 (50,000) 1.000 (50,000)
1 18,000 1.07 19,260 0.834 16,063
2 24,000 1.072 27,478 0.696 19,125
3 33,000 1.073 40,426 0.581 23,488
NPV = $8,676
Note. The small differences are due to rounding of discount factors to 3 d.p.
46 4: I n v e s t me nt a p p ra i s a l A C C A FM
ILLUSTRATION 4.2
Penalty Co is considering a project that will require an investment in machinery of $40,000 and which
will generate revenue of $27,000 in the first year, $37,000 in the second year and $49,000 in the third
and final year. The direct costs will equal 35% of the revenue and relevant overheads will be $9,000
each year. It is thought that the machinery will be sold for $19,000 at the end of the project.
Penalty Co pays 30% corporation tax on its net operating cash flows and can claim capital allowances
on the machinery at 25% on a reducing balance basis, with a balancing allowance or charge in the final
year. All tax is paid or saved at the end of year in which the cash flows arise. The cost of funds is 9%.
h t
Calculate the NPV for Penalty Co.
9
SOLUTION
r i g 2 0 1
Time
y
p ion
0 1 2 3
o
$ $ $ $
C uit
Revenue
Direct costs @ 35%
27,000
(9,450)
37,000
(12,950)
49,000
(17,150)
Overheads
I n t
Net operating cash flows
(9,000)
8,550
(9,000)
15,050
(9,000)
22,850
rs t
Tax @ 30% (2,565) (4,515) (6,855)
Fi
Machinery (40,000) 19,000
Capital allowance savings (W1) 3,000 2,250 1,050
Net cash flow (40,000) 8,985 12,785 36,045
Discount Factor @ 9% 1.000 0.917 0.842 0.772
Present Value (40,000) 8,239 10,765 27,827
NPV = $6,831
Workings:
Capital Allowances (W1)
Time 1 2 3
Opening value of equipment 40,000 30,000 22,500
Closing value of equipment 30,000 22,500 19,000
Capital Allowances 25% reducing balance 10,000 7,500 3,500
Tax Saving at 30% 3,000 2,250 1,050
A C C A FM 4: I n v e s t me nt a p p ra i s a l 47
ILLUSTRATION 4.3
A company plans to make sales of £100,000 in year 1, increasing by 5% per annum until year 3 when
the project ends. Working capital equal to 15% of annual sales is required at the start of each year.
What are the working capital cash flows for the NPV calculation?
Fir Co
st I pyri
SOLUTION
Time 0 1 2 3
019
48 4: I n v e s t me nt a p p ra i s a l A C C A FM
Time 0 1 2 3 4 5
Revenue 0 250 220 200 190 170
Variable Costs 0 (100) (88) (80) (76) (68)
Contribution 0 150 132 120 114 102
Incremental Fixed Costs 0 (20) (20) (20) (20) (20)
Net Operating Cashflow 0 130 112 100 94 82
Tax @ 30% (if same year) 0 (39) (34) (30) (28) (25)
Capital cashflows
h t 9
r i g 2 0 1
Net Present Value $7k
y
p ion
o
C uit
2.4.2 Capital allowance workings
Fi
Closing value of equipment 300 225 169 127 100
Capital Allowances 25% reducing balance 100 75 56 42 27
Tax Saving at 30% (included in lead schedule) 30 23 17 13 8
A C C A FM 4: I n v e s t me nt a p p ra i s a l 49
Funtime Co, a toy company, has developed a new game, ‘Zoom’, which it plans to launch in time for
the school summer holidays. Sales of the new game are expected to be very strong, following a
favourable review by a national newspaper. Sales and production volumes and selling prices for ‘Zoom’
over its four-year life are expected to be as follows:
Year 1 2 3 4
Sales and production (no. of games) 150,000 70,000 60,000 60,000
Selling price (per game) $25 $24 $23 $22
Financial information on ‘Zoom’ in current prices is as follows:
Direct material cost $5.40 per game
Other variable production cost $6.00 per game
Apportioned fixed costs $4.00 per game
Advertising costs to stimulate demand are expected to be $650,000 in the first year of production and
$100,000 in the second year of production. No advertising costs are expected in the third and fourth
years’ of production. ‘Zoom’ will be produced on a new production machine costing $800,000. Capital
allowances can be claimed at 20% on a straight-line basis, with a balancing allowance or balancing
charge in the final year. It is expected that the machine will be sold for $150,000 at the end of the
project.
Fir Co
Funtime Co pays tax on cash flows at the rate of 30% per year and tax liabilities are settled at the end
of the year in which they arise. Inflation at 3% pa is expected to apply to the production costs for the
duration of the project.
st I pyri
ntu ght
If the new game is launched then sales of another game ‘Skip’ would be reduced due to lack of
resources to devote to this other game. This reduction in sales would amount to 10,000 units per year.
itio
‘Skip’ currently earns a contribution of $15 per game and this would be expected to remain constant
over the next four years.
n2
Working capital equal to 10% of the annual sales revenue is needed at the start of each year. All
working capital will be released at the end of the project.
Required 019
Calculate the net present value of the proposed investment using an after tax nominal discount rate of
15%.
SOLUTION
50 4: I n v e s t me nt a p p ra i s a l A C C A FM
h t 9
r i g 2 0 1
y
p ion
o
C uit
I n t
rs t
Fi
A C C A FM 4: I n v e s t me nt a p p ra i s a l 51
When calculating the sensitivity to the cost of capital, the following formula is used:
IRR - Cost of capital
Cost of capital
× 100%
ntu ght
ILLUSTRATION 4.2 (PART 2) itio
n2
019
How sensitive is Penalty Co’s decision to invest in new machinery to changes in the sales volume,
overheads and cost of capital?
52 4: I n v e s t me nt a p p ra i s a l A C C A FM
h t 9
r i g 2 0 1
y
p ion
o
The usefulness of sensitivity analysis in assisting investment decisions is:
rs t
Fi
3.3 Probability analysis and expected values (risk)
If it is possible to identify the possible outcomes (x) and their associated probabilities (p). By
multiplying each outcome by its probability and adding all of the results together (∑px), an
expected value (probability-weighted average result) can be calculated.
This expected value can then be used in investment appraisal.
A C C A FM 4: I n v e s t me nt a p p ra i s a l 53
(a) Calculate the expected net present value of the project being considered by Possibly Co.
(b) What is the probability that the total revenue exceeds $1,600,000?
SOLUTION
(a)
Time 0 1 2 3
$ $ $ $
Expected revenue (W1)
Direct costs @ 60%
Overheads
Net operating cash flows
Tax @ 35%
Equipment (W2)
Net cash flow
Discount Factor @ 13%
Present Value
st I pyri
Workings:
ntu ght
itio
n2
019
54 4: I n v e s t me nt a p p ra i s a l A C C A FM
Probability analysis can also be used to incorporate risk into investment decision making by using joint
probability tables.
ILLUSTRATION 4.3
Year
h t PV of
9
Y1 prob
PV of
Y2 prob
Total
PV joint prob PV x JP NPV
r i g 2 0 1 CF
$000
CF
$000 $000 $000 $000
y
p ion
PV of cash flow 1 455 0·55 826 0·4 1,281 0·22 281.8 (469)
o
C uit
PV of cash flow 2 909 0·45
1,652
826
1,652
0·6
0·4
0·6
2,107
1,735
2,561
0·33
0·18
0·27
695.3
312.3
691.5
357
(15)
811
I n t Sum of PV
Investment
1980.9
(1,750.0)
F i Workings
Year 1 DF 10% PV 2 DF 10% PV
Cash flow 1 500 0.909 455 1,000 0.826 826
Cash flow 2 1,000 0.909 909 2,000 0.826 1,652
(i) Mean (expected) NPV = $230.9 (in $000)
The mean (expected) NPV is positive and so it might be thought that the proposed investment is
financially acceptable. However, the mean (expected) NPV is not a value expected to occur
because of undertaking the proposed investment, but a mean value from undertaking the
proposed investment many times. There is no clear decision rule associated with the mean
(expected) NPV.
(i) Probability of a negative NPV = 0.22+0.18 = 0.4
A decision on financial acceptability must also consider the risk (probability) of a negative NPV
being generated by the investment. At 40%, this might appear too high a risk to be acceptable.
(i) Most likely outcome ($000) = $357
This outcome has a 33% probability of occurring.
A C C A FM 4: I n v e s t me nt a p p ra i s a l 55
itio
different combinations of values for the different variables (using random numbers and
computers to select values for each of the variables).
n2
The results then show the expected NPV and the distribution of possible NPV values.
56 4: I n v e s t me nt a p p ra i s a l A C C A FM
Horizon Co now realises that the payback period it has already calculated is too simplistic and so it is
considering using an adjusted payback by discounting the cash flows to reflect the risk in these
forecasts, using its cost of funds.
Calculate the adjusted payback period of this project.
SOLUTION
Time Cash flow Discount factor Present value Cumulative PV
$ 10% $ $
0 (80,000) 1.000 (80,000)
1 15,000 0.909 13,635
2 20,000 0.826 16,520
3 25,000 0.751 18,775
4 30,000 0.683 20,490
5 35,000 0.621 21,735
This is more appropriate than using undiscounted cashflows, as it factors in the time value of
money and uncertainty surrounding later cashflows.
However, the adjusted payback method still suffers from the same shortcomings as the
h t
standard payback period (e.g. no consideration of cashflows later than the payback date, the
9
r i g 2 0 1
need for a target payback period to compare to).
p y n
o
C uit
4 Specific investment i o
decisions
I n t
4.1 Lease vs. buy
r s t
F i Once an organisation has decided to acquire an asset it then needs to decide how it is going to
finance this acquisition. The two alternatives we are going to compare here are leasing the asset
or borrowing the required funds and buying the asset.
The most significant difference between these two alternatives is that with a lease, the
organisation (lessee) is not the legal owner; whereas if the asset is purchased then the
organisation is the legal owner.
Legal ownership is particularly important when considering taxation. Only the legal owner can
claim capital allowances, however the lease payments are assumed to be fully tax allowable.
Any disposal proceeds are also only received by the legal owner and so are also a relevant cash
flow.
To evaluate these two alternatives we discount the relevant cash flows and see which option is
cheapest. We can discount the cash flows using any discount factor, however it is
recommended to use the cost of borrowing.
The reason for this is that we can then avoid calculating and including the loan repayments and
interest and instead just put in the amount borrowed e.g. If you borrow $1,000 for one year at
10% interest, in one year you will have to repay $1,100. If you discount this at 10%, the present
value is $1,000 i.e. the amount borrowed.
A C C A FM 4: I n v e s t me nt a p p ra i s a l 57
So despite paying $100 of interest, Interest Co after tax earnings are only $70 lower than No Interest
Co. Hence the after-tax cost is:
10% (1 – 0.30) = 7%
Or in more general terms:
Before-tax rate (1 – tax rate) = After-tax rate
If we are discounting post-tax cashflows, then we need to use a post-tax discount rate.
Fir Co
Therefore, if tax is included in the cash flows in a lease vs buy calculation the cash flows
st I pyri
should be discounted at an after- tax cost of borrowing.
The examiner may provide you with a discount rate which is already post tax – hence it’s
very important to read the question
ntu ght
ILLUSTRATION 4.2 (PART 3)
itio
n2
Penalty Co has decided that it would like a machine costing $40,000. It can either borrow the money
019
from its bank at an interest rate of 13% or a leasing company has offered to lease the machine to
Penalty Co for three years at an annual cost of $11,300. It is thought that the machine can be sold in
three years’ time for $19,000.
Would it be better for Penalty to lease or borrow and buy this machine?
SOLUTION
Lease:
Timing Cash flow Discount Factor Present Value
$ 13% $
1–3 (11,300) 2.361 (26,679)
Borrowing and buy:
Timing Cash flow Discount Factor Present Value
$ 13% $
0 (40,000) 1.000 (40,000)
3 19,000 0.693 13,167
$(26,833)
The two alternatives are very close, but the lease is marginally cheaper.
In the previous example we ignored tax. As we earlier, tax reduces the cost of debt and brings in tax on
the operating cash flows and capital allowances.
58 4: I n v e s t me nt a p p ra i s a l A C C A FM
Would it be better for Penalty to lease or borrow and buy this machine after allowing for tax?
SOLUTION
The after tax cost of borrowing = 13% (1 – 0.30) = 9%
Lease:
Time 0 1 2 3
$ $ $ $
Payments (11,300) (11,300) (11,300)
Net operating cash flows (11,300) (11,300) (11,300)
Tax saved @ 30% 3,390 3,390 3,390
Net cash flow (7,910) (7,910) (7,910)
Discount Factor @ 9% 0.917 0.842 0.772
Present Value (7,253) (6,660) (6,107)
NPV = $(20,020)
Borrow and buy:
Time
h t 9
0
$
1
$
2
$
3
$
Borrow
r i g 2 0 1 (40,000)
Machinery
y
p ion
Capital allowance savings (W1 from 3,000 2,250
19,000
1,050
o
illustration 4.2 part 1)
C uit
Net cash flow (40,000) 3,000 2,250 20,050
t
Discount Factor @ 9% 1.000 0.917 0.842 0.772
t I n
Present Value (40,000) 2,751 1,894 15,479
Fi rs NPV = $(19,876)
The two alternatives are still very close, but now borrow and buy is marginally cheaper.
The EAC represents a constant annual cashflow that has the same present value as the actual
cashflows arising under each proposal. The proposal with the lowest EAC should be chosen.
We are assuming that the replacement will keep happening forever.
A C C A FM 4: I n v e s t me nt a p p ra i s a l 59
Mobile Co is trying to decide whether to replace its grinding machines every one, two or three years.
Each machine costs $7,000. Mobile Ltd has a cost of capital of 12%. Costs and scrap value data is as
follows:
Year 1 2 3
$ $ $
Maintenance costs 500 1,000 1,500
Running costs 2,500 3,000 3,250
Year-end scrap value 5,000 3,500 2,500
What is the optimum replacement cycle for the machines?
Fir Co
st I pyri
ntu ght
itio
n2
019
60 4: I n v e s t me nt a p p ra i s a l A C C A FM
ILLUSTRATION 4.4
Short Co is trying to choose between four projects, all of which have positive NPV’s, however Short
only has $1,000,000 to invest. Details of the four projects are as follows:
Project: A B C D
$ $ $ $
Initial investment (300,000) (370,000) (143,000) (1,000,000)
h t
PV of future cash flows
9
445,000 500,000 200,000 1,340,000
g
NPV 145,000 130,000 57,000 340,000
y r i 2 0 1
All four of the projects are divisible.
o p ion
What is the optimum investment policy for Short Co?
C uit
SOLUTION
I n
Project:
t A
$
B
$
C
$
D
$
Fi
Initial investment 300,000 370,000 143,000 1,000,000
Profitability Index 0.48 0.35 0.40 0.34
Ranking 1st 3rd 2nd 4th
A C C A FM 4: I n v e s t me nt a p p ra i s a l 61
Fir
Capital rationing can be caused by two different reasons: Co
(1)
st I pyri
The organisation would like to raise more funds, but no stakeholder is prepared to invest. This is
known as hard capital rationing and may result from the potential returns not being high
enough to compensate for the perceived risks involved.
ntu ght
(2)
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The organisation could raise more funds, but has internally decided not to. This is known as soft
capital rationing and may result from a concern that the available finance is too expensive or
may result in a loss of control.
n2
019
62 4: I n v e s t me nt a p p ra i s a l A C C A FM
h t 9
r i g 2 0 1
y
p ion
o
C uit
I n t
rs t
Fi
63
Business finance
Fir Co
1 Sources of and raising business finance
st I pyri
ntu ght
1.1 Identify and discuss the range of short-term sources of finance
available to businesses
itio
1.1.1 Overdraft
n2
019
An overdraft is an overdrawn balance on a current account and is the most common form of bank
funding. This is due to their flexibility and ease of operation; a facility letter is all that is required to
initiate this facility. In the UK overdrafts are strictly repayable on demand. Interest which is variable
and calculated daily tends to be at a higher rate than other short-term sources of finance.
64 5: B u s i n e ss fi n an c e A C C A FM
for doing so. This is consequently very similar to renting an asset and due to the security provided by
the asset, operating leases are often available to organisations that may find it difficult to obtain other
sources of finance because of their poor credit rating.
1.2 Identify and discuss the range of long-term sources of finance available
to businesses
1.2.1 Equity finance
Equity finance normally takes the form of ordinary shares and these denote ownership of the
business. This is the primary risk capital as if the business fails, it is the last to be paid, conversely
however if the business is a success it will receive the greatest benefit in the form of increasing
dividends and share prices.
Preference shares also exist, but these tend not to denote ownership and receive a fixed return in the
form of a set dividend. As the Preference dividend is paid before the Ordinary dividend, Preference
shares are also sometimes referred to as prior charge capital.
Issuing equity finance will reduce the level of gearing and assuming the business expansion results in
increased profits, interest coverage would also improve and financial risk would fall.
h t
organisations assets and receives regular interest payments. Thus compared to equity finance, debt
9
g
finance is relatively low risk and so receives a commensurately low return. Debt is also referred to as
y r i 0 1
debentures, bonds, loan stock and loan notes.
2
o p ion
1.2.3 Lease finance
C uit
Long-term lease finance is in the form of a finance lease where a lessee selects an asset which the
I n t
lessor purchases and then leases to the lessee. Substantially all of the risks and rewards of ownership
are transferred to lessee. Thus this is very similar to debt finance however the finance is provided for a
t
specific (long term) asset.
rs
Fi 1.2.4 Venture capital
Venture capital refers to higher risk finance provided by venture capitalist companies. This will
normally take the form of an investment in ordinary shares and unsecured debt in an unlisted
company for a period of around five years at the end of which time the venture capitalist will look for
an exit route either by listing or selling the company. In this way they can realise their investment. The
venture capitalist will normally insist on Board representation.
A C C A FM 5: B u s i n e ss fi n an c e 65
Fir Co
st I pyri
White Spirit Co currently has 10m shares in issue (valued at a current share price of $2.40) and
generated profits after tax of $2m in the last year.
ntu ght
White Spirit intends to raise $4.288m for a new investment opportunity via a rights issuance at a
discount of 25% to the current share price. The issue costs are expected to be $212,000.
itio
The board member proposing the project insists that the project will increase White Spirit’s profits
n2
after tax by 15% and will not affect the price-earnings ratio of White Spirit (which is expected to
remain constant).
(a)
(b)
What is the theoretical ex rights price?
What is the value of one right?
019
(c) Calculate whether the proposed use of the rights issuance funds will be financially acceptable to
the shareholders of White Spirit Co
SOLUTION
66 5: B u s i n e ss fi n an c e A C C A FM
h t
issuance may be underwritten (by an investment bank) in order to reduce the risk to the
9
r i g 2 0 1
company of less than full subscription.
y
Offer for sale by tender: This is where shares are offered to the public, but no fixed price is set.
p ion
Instead, potential investors bid for shares with a striking price set based on demand. These
o
issuances are often via an issuing house (investment bank) which will also underwrite the
C uit
issuance and are rarer than fixed price offers.
I n t
1.3.4 Stock exchange listing
rs t
A stock exchange listing is where a company has its shares listed on a recognised stock exchange by
Fi
fulfilling certain criteria:
In the UK in order to obtain a listing on the main market a company must have at least a three year trading
history, be worth at least £700,000 and at least 25% of the shares must be in the hands of the public.
Such shares have a secondary market i.e. they can be traded between individual shareholders, and this
makes it considerably easier to issue further shares. It is common for companies to simultaneously
obtain a listing and issue more shares – this is called an initial public offer (IPO)
1.4.1 Matching
A fundamental principle of financing is that the type/source of funds used should match the use of
those funds. Matching can cover the following variables:
Duration – long term funds (e.g. mortgage) used to fund long term acquisitions (e.g. house purchase)
and shorter term funds (e.g. three-year loan) used to finance shorter term items (e.g. car). A short
term shortfall in day to day spending could be financed with an overdraft.
A C C A FM 5: B u s i n e ss fi n an c e 67
Currency – An investment in a foreign asset could be funded with a foreign source (e.g. currency loan,
Eurobond issue, equity issue in foreign currency), which will reduce exposure to foreign exchange rate
movements (covered in Chapter 7).
Pattern of cash flows – try to mirror the pattern of receipts from projects with the pattern of
payments made on the finance. High risk projects where the potential returns are high but by no
means certain, may be more suited to being financed with equity where returns are not obligatory.
Projects with regular steady income may be able to support the use of debt finance.
1.4.2 Cost
Cost covers many areas and is an important factor when looking into raising finance. It is sensible to
split this into issue costs and on-going servicing costs.
Issue costs will include the following:
Arrangement fees
Underwriting fees
Prospectus printing costs
Advisers’ fees (e.g. merchant bankers, accountants, lawyers)
In general it is much cheaper to issue debt than shares in terms of the above issue costs.
The on-going servicing costs will include dividends with equity and interest payments with debt.
Generally, required returns on equity will be higher than those on debt due to equity being the highest
st I pyri
Tax (interest is tax deductible for the company whereas dividends are not). This makes debt
finance attractive.
ntu ght
Reporting/Information provision required. If raising debt finance the banks/investors may well
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require regular information (e.g. monthly detailed accounts).
68 5: B u s i n e ss fi n an c e A C C A FM
The concept of “Riba” (interest) and how returns are made by Islamic financial securities
(calculations are not required)
The word “Riba” means excess, increase or addition and in the form of interest is forbidden by
the Qur’an.
Conventional banks aim to profit by accepting money deposits in return for the payment of
interest and then lending money out in return for the payment of a higher level of interest.
Islamic finance does not allow the use of interest - returns are made by sharing the profits and
losses of the business with the finance providers. Islamic financial instruments include:
r i g 0 1
payments not interest payments i.e. the asset is being rented from its owner.
2
y
p ion
1.5.3 Debt finance (Sukuk)
o
C uit
A Sukuk transaction is where a business asset with a life of three to five years is bought and paid
t
for by a third party or parties. The business then uses this asset to earn profits which it then
t I n
shares with the third party or parties (i.e. there is no interest).
rs
If the asset makes a loss, this is also shared with the third party or parties.
A C C A FM 5: B u s i n e ss fi n an c e 69
Such funds are described as retained earnings. These should not be confused with retained profits, as
you can only invest the cash that retained profits generate!
itio
seem to be consistent with the concept of trying to maximise shareholder wealth but can lead
to an erratic dividend.
(2) Irrelevancy theory n2
019
American economists Modigliani & Miller stated that the pattern of dividends paid by a
company is irrelevant in a tax-free world, based on the following logic:
A company will always invest in positive NPV projects.
If the company can’t invest in a certain project out of its retained earnings (due to a
dividend having been paid out), then it will need to raise funds from other sources (which
M&M assume will always be possible for positive NPV projects).
This will potentially lead to existing shareholders receiving proportionately less of the
returns from the new project, but this loss will be offset by the dividend they are
receiving now.
Hence, the ultimate pattern of dividend payments is irrelevant.
Modigliani and Miller stated that if a firm’s dividend policy was not to the taste of shareholders,
the shareholders could take action:
If the dividend is lower than desired, simply sell a few shares to create some extra
income to replicate an increased dividend (a ‘manufactured dividend’)
If the dividend is higher than desired, simply use the ‘excess’ dividend to buy some
additional shares.
In reality, tax and transaction cost implications means this logic is flawed.
70 5: B u s i n e ss fi n an c e A C C A FM
2.2.2 Signalling
In Chapter 6 you will see how investors do not have perfect information and capital markets are, at
best, semi-strong efficient. Hence, investors will look for information contained in dividend
h t
announcements and react to it, causing share price movements:
9
r g 0 1
If a company cuts its dividend, investors may interpret this as a sign of bad news and seek to sell
i
their shares, leading to a reduction in share price
2
y
p ion
If a company increases its dividend, investors may interpret this as a sign of improved future
o
prospects and purchase shares in the company, increasing the share price.
C uit
I n t
2.2.3 Legal constraints
t
Legally a dividend can only be paid from accumulated profits. A dividend can exceed this year’s profit
rs
only if the company has sufficient retained profit from previous years.
Fi 2.2.4 Liquidity
The dividend is an optional cash outflow, which by definition reduces the liquidity of the company. Thus a
dividend should only be paid if the company is left with or has access to sufficient cash to remain solvent.
A C C A FM 5: B u s i n e ss fi n an c e 71
There are also disadvantages of scrip dividends. Assuming that dividend per share is maintained
or increased, the total cash paid as a dividend will increase in the future. Scrip dividends may
also be seen as a negative signal by the market i.e. the company is experiencing cash flow
issues.
(b) Share repurchase
The company pays cash to the shareholders in return for a proportion of their shares. This could
be used to change the capital structure of the company (see later in this chapter).
(c) Concessions
Shareholders are given concessions if they use the company’s products or services e.g. Original
Eurotunnel shareholders could travel at reduced fares.
Fir
model and the capital asset pricing model.
itio
value of a stream of constantly growing dividends (valuing them as a growing perpetuity discounted at
the cost of equity).
Share prices can be quoted Cum div, meaning the current price includes the right to the
upcoming dividend i.e. the dividend is about to be paid, and Ex div, meaning the current price
excludes the right to the upcoming dividend i.e. the dividend has just been paid.
72 5: B u s i n e ss fi n an c e A C C A FM
Lano Co has just paid a dividend of 25 cents on its ordinary shares which have a market value of $3.75.
The constant dividend growth rate is 9%.
What is the cost of equity for Lano Co?
SOLUTION
Estimating growth
Often, the growth rate (g) is not provided so we can use one of two methods to estimate this:
(1) Annualising growth as a geometric average of the historical dividend stream
(2)
h t 9
The earnings retention method
r i g 2 0 1
y
FORMULA GIVEN IN EXAM
p ion
o
C uit
g = bre
Where:
b
I n t
= The proportion of earnings retained and reinvested
re
rs t
= The % return earned on those investments
Fi
ILLUSTRATION 5.1
Growth Co has just paid a dividend of 25c per share from earnings per share of $1.00. The dividend has
grown from 18c four years ago. The company has a target return on capital of 12%. Its share price is
currently $2.50. Calculate the Cost of Equity (Ke) using both methods.
SOLUTION
(a) We assume that there has been compound growth over the four-year period:
18 × (1+g)4 = 25 ∴ g =8.56%
25 ( 1.0856 )
ke = + 0.0856 = 19.4%
250
(b) If a dividend of 25c has been paid from earnings of $1.00, then b = 0.75/1.00 = 75% and r = 12%
growth = 75% × 12% = 9% p.a.
25 ( 1.09 )
ke = + 0.09 = 19.9%
250
A C C A FM 5: B u s i n e ss fi n an c e 73
Fir
increased by e.g. operational gearing and is measured by β (see later).
st I pyri
The main assumption of CAPM is that shareholders in a company own a portfolio of shares in
uncorrelated companies and that due to this their exposure to specific risk has been diversified away
ntu ght
(as if one of their shareholdings performs worse than expected due to specific risk factors, it will be
offset by another shareholding performing better than expected).
itio
Because of this, the shareholders are only concerned by the impact of a new investment on their
n2
exposure to systematic risk, as measured by a β factor (calculated by comparing the change in the
019
return on an individual share to the change in return on a stock market index in the same period).
This β factor for a company, individual investment or project is then used in the CAPM formula to give
a measure of the shareholders’ required return (the cost of equity) to compensate them only for the
systematic risk they are facing.
Where:
E (ri) = Expected return on a share called ‘i’ or the cost of equity of share ‘i’
Rf = Risk free rate of return, often taken as the return on short term Government Bonds
βi = Beta, which is a measure of the systematic risk in share ’i’
E(rm) = Expected return on the market portfolio (e.g. the return on stock indices like FTSE100)
(E(rm) – Rf) = Equity risk premium
CAPM calculates the required return by starting with the risk free return which can be obtained
without being exposed to any risk at all.
This is then increased by the systematic risk premium based upon the excess of the market
return over the risk free return. In other words:
Required return = Risk free return + Premium for the risk being taken
74 5: B u s i n e ss fi n an c e A C C A FM
Drewboy Co has a beta value of 1.5. The average return on the market is currently 17% and risk free
investments are paying a return of 5%.
What is the cost of equity for Drewboy Co?
SOLUTION
h t 9
r i g 2 0 1
y
p ion
Advantages and disadvantages of the CAPM
o
C uit
The advantages of CAPM are:
t
It directly links risk and return
I n
rs t It can be used to calculate the cost of equity when the dividends are not growing constantly
Fi
The disadvantages of CAPM are:
It can only be used when the investors are diversified
It assumes that all of the components will remain constant and the same as they have been
historically
It assumes that investors can invest and borrow at the risk free rate
It assumes that the capital markets are perfect i.e. no transaction costs, no tax and no dominant
investor
It assumes that the risk of all macroeconomic variables can be grouped into one measure
We will see later on that the β factor used will need to be adjusted if there are changes in:
Business risk
Gearing (financial risk)
A C C A FM 5: B u s i n e ss fi n an c e 75
If we are given the market value of the debt, then we can re-arrange the formula to solve for the cost
of debt:
I(1–T)
Kd = Po
Where:
Fir Co
st I pyri
Kd = Cost of debt
I = Interest
T
Po
= Corporation tax rate
= Current ex-interest debt price ntu ght
LECTURE EXAMPLE 5.4 itio
n2
of 84% ex-interest. The corporation tax rate is 30%.
What is the cost of debt for Hammered Co?
019
Hammered Co has some $100 nominal value 6% irredeemable debt which currently has a market value
SOLUTION
76 5: B u s i n e ss fi n an c e A C C A FM
Plastered Co has some $100 nominal value 4% redeemable debt which currently has a market value of
75% ex-interest. This debt will be redeemed in seven years’ time at a 12% premium and the
corporation tax rate is 35%.
h t
What is the cost of redeemable debt for Plastered Co?
9
SOLUTION
r i g 2 0 1
y
p ion
o
C uit
I n t
rs t
Fi
A C C A FM 5: B u s i n e ss fi n an c e 77
ILLUSTRATION 5.2
Sozzled Co has some $100 nominal value 6% convertible debt which currently has a market value of
88% ex-interest. This debt will be redeemed in four years’ time at par or converted into 20 ordinary
shares. A financial expert has forecast that Sozzled’s shares will be worth $5.10 in four years’ time.
The corporation tax rate is 40%.
Fir
What is the cost of the convertible debt for Sozzled Co? Co
SOLUTION
st I pyri
ntu ght
So in four years’ time the debt can either be redeemed for $100 or converted into shares which will be
worth 20 × $5.10 = $102 and so the debt will be converted.
I = $6 itio
T
Po
= 0.40
= $88 n2
Rv = $102
Timing Cash flow Discount factor
019
Present value Discount factor Present value
$ 10% $ 5% $
0 (88) 1.000 (88) 1.000 (88)
1–4 6(1 – 0.40) 3.170 11.41 3.546 12.77
4 102 0.683 69.67 0.823 83.95
$(6.92) $8.72
8.72
IRR ≈ 0.05 + 8.72−(6.92) × (0.10 − 0.05)
= 0.08
So the cost of convertible debt for Sozzled Co is 8%.
78 5: B u s i n e ss fi n an c e A C C A FM
Razzled Co has just paid a dividend of 20 cents on its preference shares which have a market value of
$1.90.
What is the cost of preference share capital for Razzled Co?
SOLUTION
h t 9
r i g 2 0 1
y
p ion
o
C uit
4.5 Bank debt
I n t
Unlike other forms of debt finance, bank loans have a variable rate of interest, which means that the
t
market value always equals the nominal value and the cost of bank debt capital can be calculated by
rs
Fi
using the following formula:
I(1–T)
Kb = Po
Blotto Co has a bank loan that is currently charging 8% interest and the corporation tax rate is 25%.
What is the cost of bank debt capital for Blotto Co?
SOLUTION
A C C A FM 5: B u s i n e ss fi n an c e 79
Where:
Ve = Total value of the equity
Vd = Total value of the debt
Ke = Equity cost of capital
Kd = Debt cost of capital
T = Corporation tax rate
Note. The total equity and debt values can either be calculated using book values or market values,
though market values give a better indication of the current cost of capital.
Fir Co
Note. This formula assumes that tax has been ignored in calculating Kd, however as tax has to be
included when calculating the cost of redeemable debt, it is much easier to always include tax when
st I pyri
calculating the cost of debt and then ignoring it when using this formula.
This formula also assumes that the organisation only has two sources of finance; if it has more the
ntu ght
formula can be extended by adding the extra source and its market value. So if an organisation was
financed with ordinary shares, preference shares and debt; the formula would look as follows:
WACC = �V
Ve
� Ke + �
Vp
� Kp + �
Vd itio� Kd (1–T)
e+Vp +Vd Ve+Vp+Vd Ve+Vp+Vd
n2
LECTURE EXAMPLE 5.8 019
SCS Co is financed with a mixture of equity and debt. It has just paid a dividend of 45 cents on its
4.5 million ordinary shares which have a market value of $5.25. The constant dividend growth rate is
6%. The 7% irredeemable debt currently has a market value of 83% cum-interest. The corporation tax
rate is 35%. An extract from SCS’s statement of financial position shows the following:
$
Debt 10,000,000
Shareholders’ funds 19,450,000
What is the WACC using book value and market value weightings for SCS Co?
SOLUTION
80 5: B u s i n e ss fi n an c e A C C A FM
h t 9
Risk and return are connected; as the risk rises so the required return increases and so the relative
costs rise.
r i g 2 0 1
y
Equity is the primary risk capital and, hence, the most expensive source of capital, as:
p ion
o
If the business fails, it is the last to be paid
C uit
The returns it receives (dividends) are also uncertain (as they are discretionary).
n t
Debt is a less risky and hence cheaper source of capital, as:
I
rs t It is generally secured
Fi
The returns it receives are more certain (interest is not discretionary)
It may be redeemable
Debtholders are the first to be paid should the business fail
Finally, tax makes the debt even cheaper from the businesses point of view (per Chapter 4)
6.2 The creditor hierarchy (and its impact on risk and return)
The creditor hierarchy refers to the order creditors are paid when a business becomes insolvent and is
as follows:
(1) Secured Creditors e.g. fixed charge over a non-current asset
(2) Preferential Creditors e.g. pension schemes and employees
(3) Floating Charge Holders e.g. charge over the current assets
(4) Unsecured Creditors e.g. trade payables and the Crown
(5) Preference Shareholders
(6) Ordinary Shareholders
As a creditor moves down the above list they are exposed to greater risk and so require a
commensurately greater return. Hence the cost of the source of finance increases.
A C C A FM 5: B u s i n e ss fi n an c e 81
itio
cost of equity is relatively small compared to the benefit of the increase in cheap debt.
n2
However as the level of debt increases further, the cost of equity starts to rise faster,
outweighing the benefit of the extra cheap debt, resulting in the WACC also rising.
Note: At very high levels of gearing, even the cost of debt starts to rise.
The traditional view can be depicted graphically as follows:
019
Cost of Ke
Capital
WACC
Kd
Gearing
Optimum Vd
Ve + Vd
82 5: B u s i n e ss fi n an c e A C C A FM
It can be seen from the above graph that the traditional view suggests that there is an optimum capital
structure where the WACC is at a minimum.
The traditional view makes the following assumptions:
Operating profits are constant
There are no transaction costs on issuing finance
Business risk is constant
All earnings are paid out as dividends
Unfortunately, the traditional theory doesn’t tell us where the optimum WACC is reached. Hence trial
and error must be used to find the this point
7.3 Modigliani & Miller’s view of capital structure 1958 (no tax)
The economists Modigliani & Miller made the following assumptions in their initial view of capital
structure:
Capital markets are perfect
Investors are rational and risk averse
There are no transaction costs
Debt is always risk free
There is no taxation
The no taxation assumption is particularly important as this removes the tax benefit of paying interest
and means that the total payments to investors will be the same for equivalent companies with and
without debt:
h t 9
r i g 2 0 1 No Interest Co Interest Co
Year
y
p ion
1
$
2
$
3
$
1
$
2
$
3
$
o
C uit
Earnings
Interest
800
nil
1,600
nil
400
nil
800
(100)
1,600
(100)
400
(100)
I n t
After tax earnings 800 1,600 400 700 1,500 300
rs t
Debt holders’ return nil nil nil 100 100 100
Fi
Equity holders’ return 800 1,600 400 700 1,500 300
Total investors’ return 800 1,600 400 800 1,600 400
This in turn means that these comparable companies must also have the same total market value and
hence the same WACC.
M&M’s initial views can be summarised as:
As debt is introduced, the cost of equity rises
Without any tax saving on interest payments, the benefit of the extra cheap debt is only enough
to offset the increased cost of equity
Hence the WACC remains unchanged and there is no optimal capital structure
A C C A FM 5: B u s i n e ss fi n an c e 83
The Miller and Modigliani view without corporate taxation can be depicted graphically as follows:
Cost of Ke
Capital
WACC
Kd
Gearing
Vd
Ve + Vd
Fir Co
st I pyri
This view was criticised because the no taxation assumption is unrealistic.
ntu ght
7.4 Modigliani & Miller’s view of capital structure 1963 (with tax)
itio
If the no taxation assumption is removed then the tax benefit of paying interest is reintroduced and
this means that the total payments to investors will be higher for the equivalent company with debt:
No Interest Co
n2 Interest Co
Year
Earnings
1
$
800
2
$
1,600
3
$
400
019 1
$
800
2
$
1,600
3
$
400
Interest nil nil nil (100) (100) (100)
800 1,600 400 700 1,500 300
Tax @ 30% (240) (480) (120) (210) (450) (90)
After tax earnings 560 1,120 280 490 1,050 210
This in turn means that the company with debt must also have a higher total market value and hence a
lower WACC.
84 5: B u s i n e ss fi n an c e A C C A FM
The Miller and Modigliani view with corporate taxation can be depicted graphically as follows:
Cost of Ke
Capital
WACC
Kd
Gearing
Vd
Ve + Vd
h t 9
r i g 2 0 1
7.5 Capital market imperfections and their impact on M&M
y
In the real world capital markets are not perfect and suffer from the following imperfections:
p ion
o
Companies cannot always raise finance when required (hard capital rationing) and so there is a
C uit
risk of bankruptcy. This risk increases as the level of gearing increases and so this deters
I t
companies from having high levels of debt.
n
Debt is not always risk free, especially at high gearing levels and so the cost of debt will rise as
rs t debt increases and so the WACC will stop falling and start to rise at some point. (Traditional
Fi
view!)
The tax saving on interest payments only exists while the company has sufficient pre-interest
profits. Once the interest payment exceeds pre-interest profit (known as tax exhaustion), there
is no longer any benefit from increasing the level of debt finance.
A C C A FM 5: B u s i n e ss fi n an c e 85
Ve+Vd (1-T)
βe = βa � Ve
�
(2) Calculate the new βe for the company (based on the new debt to equity ratio given)
Ve+Vd (1-T)
βe = βa � Ve
�
(3) Use the CAPM formula with the new βe to calculate the new cost of equity
(4) Use the new cost of equity and new debt to equity ratio to find a new WACC
(5) Use this new WACC to evaluate new projects
86 5: B u s i n e ss fi n an c e A C C A FM
(5) Use the new equity beta and the CAPM formula to calculate a project specific cost of equity.
(6) Use this cost of equity to calculate a new project-specific WACC.
h t
Millie Mo Co produces bread and is financed with 43% debt. It is now appraising a new project which
9
will involve producing cakes and will be financed from its existing capital. It has obtained beta factors
r i g 0 1
for a number of different companies as follows:
2
Name
y
p ion Business Debt finance Beta
o
Millie Mo Co
C uit
Huckleberry Co
Fletch Co
Bread
Jam
Cakes
43%
28%
32%
1.34
1.30
1.36
I n
Jo Jo Co
t Bread 28% 1.12
rs t
Sally Co
Thumb Co
Currents
Jam
43%
35%
1.52
1.40
Fi The average return on the market is currently 18% and risk free investments are paying a return of 4%.
Tax is 30%.
What is the cost of equity that should be used in a WACC calculation to identify a project specific
discount rate for Millie Mo’s new project?
SOLUTION
A C C A FM 5: B u s i n e ss fi n an c e 87
019
leads to a general loss of confidence and accompanying fall in share price of the company.
88 5: B u s i n e ss fi n an c e A C C A FM
h t 9
be successful and grow significantly. They will normally want significant
r i g 2 0 1 influence over the business and a potential exit route in around five years,
y
Supply chain financing
p ion
Introduced in 2012, this scheme allows SME’s to potentially access finance
(usually in the form of an advance by a bank) when a large organisation
o
C uit
which is a customer of the SME has vouched for the income of the SME.
The bank accepts the credit rating of the large organisation as evidence
I n t
Crowdfunding
that the SME’s sales invoice will be paid.
This involves raising finance from a large number of investors who each
rs t only have to provide a small portion of the finance. This has become
Fi
popular as websites and social media make it possible to access many
potential investors quickly.
Peer-to-peer financing This involves borrowing and lending between unrelated individuals (peers)
without using a traditional financial intermediary. This is usually organised
via a peer-to-peer company’s website.
A C C A FM 5: B u s i n e ss fi n an c e 89
Fir Co
outsiders who invest in the ordinary shares of unquoted companies.
st I pyri
Venture Capital Trusts (VCT) offers tax relief’s to investors when the
trusts invest a large proportion of their assets in unquoted
companies.
ntu ght
These are just some of the features of a select number of schemes.
itio
n2
019
90 5: B u s i n e ss fi n an c e A C C A FM
h t 9
r i g 2 0 1
y
p ion
o
C uit
I n t
rs t
Fi
91
Business valuations
Fir Co
st I pyri
1 Nature and purpose of the valuation of business and financial assets
1.1 Reasons for valuing businesses and financial assets
ntu ght
itio
There are several reasons for valuing businesses and financial assets as follows:
n2
For tax reasons – inheritance, capital gains and income taxes can all require business and
financial asset values.
019
For legal purposes – if business and financial asset are being used as loan collateral or as part of
an estate valuation in matrimonial disputes
For commercial reasons – if business and financial asset are being bought or sold or if a business
is being floated on a stock market. This is the mostly likely reason for performing a valuation in
this paper.
92 6: B u s i n e ss v al u at io n s A C C A FM
h t
replacement cost or
realisable value?
9
• Earnings yield • Dividend yield
• Dividend growth
r i g 2 0 1 model
y
p ion
In addition, the quickest way to value a business is if given a share price for a company and then its
o
C uit
market capitalisation can be calculated as share price × no of shares (often overlooked by students
making them look rather foolish!).
n t
The following illustration will be used throughout this section to demonstrate the above valuation
I
rs t
techniques. A typical exam question may require you to do a valuation of a company or demonstrate a
detailed understanding of the benefits and drawbacks of all of the valuation techniques.
Fi
LECTURE EXAMPLE 6.1
AJB is an IT consultancy based in Asia that trades globally. It was established 10 years ago. The four
founding shareholders own 25% of the issued share capital each and are also executive directors of the
entity. The shareholders are considering a flotation of AJB on an Asian stock exchange and have
started discussing the process and a value for the entity with financial advisors. The four founding
shareholders, and many of the entity’s employees, are technical experts in their field; however they
are not financial experts.
Assume you are one of AJB’s financial advisors. You have been asked to estimate a value for the entity
and explain your calculations and approach to the directors. You have obtained the following
information.
A C C A FM 6: B u s i n e ss v al u at io n s 93
Summary financial data for the past three years and forecast revenue and costs for the next two years
is as follows.
Statement of profit or loss for the years ended 31 December
Actual Forecast
20X1 20X2 20X3 20X4 20X5
$m $m $m $m $m
Revenue 85.0 92.5 102.0 115.0 130.0
Less:
Cash costs 29.8 32.4 35.7 40.3 45.5
Depreciation 22.5 35.0 35.0 35.0 35.0
Pre-tax profits 32.7 25.1 31.3 39.7 49.5
Tax 9.8 7.5 9.4 11.9 14.9
PAT 22.9 17.6 21.9 27.8 34.6
Dividends 10.0 10.6 11.2 11.9 12.6
Retained profits 12.9 7.0 10.7 15.9 22.0
st I pyri
135 155 170
Other information/assumptions
Growth in after tax cash flows for 20X6 and beyond (assume indefinitely) is expected to be 2% per
annum.
Cash operating costs can be assumed to remain at the same percentage of revenue as in previous years.
Depreciation can be assumed to equal capital allowances and to remain constant from 20X6 onwards
at the 20X5 level. Capital expenditure can be assumed to equal depreciation.
Tax has been payable at 30% per annum for the last three years. This rate is expected to continue for
the foreseeable future and tax will be payable in the year in which the liability arises.
A comparable company to AJB which is already listed has a current share price of $7.50 based on
earnings per share of $0.50 for the year ended 31st December 20X3.
An estimated cost of equity capital for the industry is 11% after tax.
Required:
Calculate a range of values for AJB, in total and per share, using methods of valuation that you
consider appropriate.
94 6: B u s i n e ss v al u at io n s A C C A FM
Net Assets
Replacement
Book value Realisable value
cost
To get an estimate of the minimum potential valuation, the net asset value as it appears on the
statement of financial position can be a quick and easy starting point. Care needs to be taken to
identify the correct net assets figure (strictly this is non-current assets plus net current assets less any
long-term liabilities).
Important points to note:
Statement of financial position book values are likely to be stated at historic cost and therefore
h t 9
not representative of current market values (important if there is a large property/land element
i g 1
that has not been revalued).
r 2 0
y
A realisable value would give a better indication of price if there was a sell off or asset stripping
p ion
o
intention. However, realisable values would need to be given in the question and would
C uit
generally be lower than market values since the reason for sale would probably be known (e.g.
football clubs in financial trouble selling off key players for less than their true worth).
I n t
Using the replacement cost of the assets may be more appropriate if you are trying to duplicate
rs t an existing business. You would need to be given the replacement cost of the assets in the
question.
Fi
LECTURE EXAMPLE 6.1 (a)
Calculate the asset based valuation for AJB and briefly comment on your answer.
A C C A FM 6: B u s i n e ss v al u at io n s 95
A P/E ratio gives an indication of the market’s perception of the future growth potential of a business.
By applying a suitable P/E ratio to the current earnings the valuation of a business can be estimated as:
𝑃𝑃
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑣𝑣𝑀𝑀𝑣𝑣𝑣𝑣𝑀𝑀 𝑜𝑜𝑜𝑜 𝑀𝑀𝑣𝑣𝑣𝑣 𝑜𝑜𝑀𝑀𝑜𝑜𝑜𝑜𝑜𝑜𝑀𝑀𝑀𝑀𝑜𝑜 𝑠𝑠ℎ𝑀𝑀𝑀𝑀𝑀𝑀𝑠𝑠 = 𝑀𝑀𝑀𝑀𝑀𝑀𝑜𝑜𝑜𝑜 × 𝑐𝑐𝑣𝑣𝑀𝑀𝑀𝑀𝑀𝑀𝑜𝑜𝑀𝑀 𝑀𝑀𝑀𝑀𝑀𝑀𝑜𝑜𝑜𝑜𝑜𝑜𝑒𝑒𝑠𝑠 (𝑃𝑃𝑃𝑃𝑃𝑃 𝑣𝑣𝑠𝑠𝑣𝑣𝑀𝑀𝑣𝑣𝑣𝑣𝑜𝑜)
Co
𝑃𝑃
𝑆𝑆ℎ𝑀𝑀𝑀𝑀𝑀𝑀 𝑝𝑝𝑀𝑀𝑜𝑜𝑐𝑐𝑀𝑀 = 𝐸𝐸 𝑀𝑀𝑀𝑀𝑀𝑀𝑜𝑜𝑜𝑜 × 𝐸𝐸𝑃𝑃𝑆𝑆
st I pyri
Important points to note:
ntu ght
itio
The P/E ratio used should reflect as closely as possible the potential growth of the business in the
question. This may require a P/E ratio of a similar business to be used and then adjusted to reflect
n2
any differences in likely growth (e.g. expected growth, strength of team, quoted or unquoted status,
R&D capability…).
019
The earnings figure used should be the sustainable earnings available to the ordinary shareholders,
typically this is the profit after tax (PAT) but some adjustments may be necessary if the current
earnings figure is distorted by any one-off factors (e.g. restructuring costs, salaries).
P/E ratios are only available for quoted (listed) companies so if valuing an unquoted (non-listed)
business a P/E ratio for a similar quoted business must be used (& adjusted if necessary).
Calculate a valuation on a P/E basis for AJB and briefly comment on your answer.
SOLUTION
96 6: B u s i n e ss v al u at io n s A C C A FM
This can then be used to value a company (often by using a listed company’s earnings yield:
h t 9 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 (𝑃𝑃𝑃𝑃𝑃𝑃)
r i g 2 0 1
𝑀𝑀𝑀𝑀 𝑜𝑜𝑜𝑜 𝑀𝑀𝑣𝑣𝑣𝑣 𝑠𝑠ℎ𝑀𝑀𝑀𝑀𝑀𝑀𝑠𝑠 =
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑦𝑦𝐸𝐸𝑎𝑎𝑦𝑦𝑦𝑦
y
𝑆𝑆ℎ𝑀𝑀𝑀𝑀𝑀𝑀 𝑝𝑝𝑀𝑀𝑜𝑜𝑐𝑐𝑀𝑀 =
p ion
𝐸𝐸𝑃𝑃𝐸𝐸
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 𝑦𝑦𝐸𝐸𝑎𝑎𝑦𝑦𝑦𝑦
o
C uit
2.4 Cash flow based valuations
n t
Cash based methods are also useful for valuing the on-going business, with DCF appropriate for
I
rs t
controlling interests and dividend based methods more suitable for smaller (i.e. minority)
shareholdings since they are only valuing the entitlement to a future stream of dividends.
COMPANY
VALUE
Future Cost of
cashflows capital
A C C A FM 6: B u s i n e ss v al u at io n s 97
Calculate the discounted cash flow valuation of AJB and briefly comment on your answer.
SOLUTION
Fir Co
st I pyri
ntu ght
itio
n2
019
98 6: B u s i n e ss v al u at io n s A C C A FM
h t
will have to use the dividend yield of a similar listed company and make some adjustments to
9
your valuation (similar idea to P/E adjustments in the P/E valuation in that for a non-listed
r i g 0 1
company the valuation needs to be scaled down potentially).
2
y
p ion
o
2.4.3 Dividend growth model
C uit
We have already seen the dividend growth model used to estimate a company’s cost of equity.
I n t
A rearranged version of that formula can be used to estimate the value of the equity in the business
(providing a figure for ke can be identified).
rs t
This views the cash flows that the shareholder actually might receive rather than the overall cash flows
Fi the company generates and as such it is better suited to valuing minority shareholdings.
A C C A FM 6: B u s i n e ss v al u at io n s 99
Calculate a dividend valuation for AJB and briefly comment on your answer.
SOLUTION
Fir Co
st I pyri
Advantages and disadvantages
ntu ght
Advantages
Considers future cash flows to shareholder. itio
Disadvantages
Assumes dividends grow at a constant rate forever.
Relevant for minority interests.
n2
Requires a cost of equity to be estimated.
019
Spurious results arise for businesses that don’t pay
dividends (zero value) or where growth (g) > cost of
equity (ke) (negative value).
Where:
Po = Current ex-interest debt value
I = Interest
rd = Required return of the debt holders
100 6: B u s i n e ss v al u at io n s A C C A FM
ILLUSTRATION 6.1
Hammered Co has some $100 nominal value 6% irredeemable debt. Hammered’s debt holders have a
required return of 7%.
What is the value of Hammered Co debt?
SOLUTION
I = $6
rd = 0.07
6
So Po = 0.07 = $86
ILLUSTRATION 6.2
h t 9
r i g 0 1
Plastered Co has some $100 nominal value 4% redeemable debt. This debt will be redeemed in seven
2
y
years’ time at a 12% premium. The debt holders’ required return is 10%. What is the value of Plastered
p ion
Co redeemable debt?
o
C uit
SOLUTION
I
Rv
= $4
I n t
= $112
rd
rs t = 10%
Fi
Timing Cash flow Discount Factor Present Value
$ 10% $
1–7 4 4.868 19.47
7 112 0.513 57.46
76.93
A C C A FM 6: B u s i n e ss v al u at io n s 101
ILLUSTRATION 6.3
Sozzled Co has some $100 nominal value 6% convertible debt. This debt will be redeemed in four
years’ time at par or converted into 20 ordinary shares. A financial expert has forecast that Sozzled’s
shares, which are currently valued at $3.48, will be worth $5.10 in four years’ time. The convertible
debt holders required return is 10%. What is the market value of Sozzled Co convertible debt?
SOLUTION
So in four years’ time the debt can either be redeemed for $100 or converted into shares which will be
worth 20 × $5.10 = $102 and so the debt will be converted.
I = $6
Rv = $102
rd = 10%
Timing Cash flow Discount Factor Present Value
$ 10% $
1–4
4 102
6
Fir Co 3.170
0.683
19.02
69.67
st I pyri $88.69
Finally we can also calculate the conversion premium, which is the difference between the current
market value of the convertible debt and the current conversion value of the shares. This is the extra
value in holding the convertible debt rather than the equivalent shares.
102 6: B u s i n e ss v al u at io n s A C C A FM
ILLUSTRATION 6.4
Razzled Co has just paid a dividend of 20 cents on its preference shares. The preference shareholders
h t
required return is 11%. What is the value of Razzled Co preference share capital?
9
SOLUTION
r i g 2 0 1
Do
Kp y
= $0.20
p ion
= 0.11
So o
C uit
0.20
Po = 0.11
So
I n t
Po = $1.82
t
So the value of Razzled Co preference share capital is $1.82.
rs
F i
4 Efficient Market Hypothesis (EMH) and practical considerations in the
valuation of shares
4.1 Market Efficiency
An efficient market is one where:
No individual dominates the market
Transaction costs are not significant
Share prices change ‘quickly’ to reflect information about a company
There are different degrees of efficiency which reflect different interpretations of the word ‘quickly’:
A C C A FM 6: B u s i n e ss v al u at io n s 103
Hence, the market cannot be beaten by technical analysis (the study of past share price
movements), as share prices already reflect the information that technical analysis uses to
predict share prices.
Fir Co
The main difference between private and listed company shares is that listed company shares are far
st I pyri
more marketable and hence the shares are more liquid. This feature makes listed company shares
more valuable.
n2
information, the less risk there will be. Reducing the risks increases the value.
104 6: B u s i n e ss v al u at io n s A C C A FM
h t 9
r i g 2 0 1
y
p ion
o
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I n t
rs t
Fi
105
Risk management
Fir Co
1 Managing interest rate risk
st I pyri
1.1 Causes of interest rate risk
ntu ght
itio
Interest rate risk refers to the sensitivity of a company’s profits and cashflows to changes in interest
rates.
n2
For example, a company with variable rate debt will face increases in interest payments if interest
rates rise.
106 7: R i s k man ag e me nt A C C A FM
Rate
% Normal yield curve
(upward sloping)
h t 9
1.2.1 Liquidity preference theory
r i g 0 1
Liquidity preference theory states that as investors prefer instant access to their funds, the
2
y
longer the funds are borrowed for, the higher the cost will be.
p ion
o
This would result in the normal yield curve shown above.
C uit
I t
1.2.2 Expectations theory
n
Expectations theory states that the shape of the yield curve reflects investors’ expectations of
rs t
future interest rates.
Fi Hence, if lenders expected interest rates to fall in the future, then they would be prepared to
accept lower interest rates on borrowing spanning future periods. This would result in short
term interest rates being higher than long term interest rates, resulting in the inverted yield
curve shown above.
A C C A FM 7: R i s k man ag e me nt 107
Matching
This is where a company has investments and loans of the same value earning and paying the same
rate of interest at the same dates. Thus if interest rates change the effects self-cancel. This technique
is most commonly used by financial institutions and for the majority of institutions is a noble long-term
goal that is practically very difficult to achieve.
Smoothing
This is where a company maintains a balance between fixed rate and variable rate borrowing to
reduce the impact of any interest rate rises.
one net settlement at the start of the borrowing period.
ntu ght
FRAs settle on the start date of the underlying loan as one net payment or receipt (but no
amounts are actually lent as part of the FRA).
itio
n2
The net impact (across the FRA and the actual borrowing) is that the borrower will pay the FRA
fixed rate.
Terminology: 019
– A spot interest rate of 5.65-5.61 means that you can borrow at 5.65% and deposit at
5.61% (remember, you always get the worst rate!).
– A 3-6 FRA starts in 3 months’ time and lasts for 3 months
– A FRA fixed rate of 5.75-5.70 means you can fix a rate to borrow at 5.75%, and to deposit
at 5.70%
Advantages of FRAs
They fix an interest rate, hedging away any downside risk
They are tailored to the investor (so they won’t be under/over hedged)
Disadvantages of FRAs
They are usually only available on loans > £500k & < 1yr maturity
They remove any upside potential (i.e. if interest rates were to fall)
They cannot be cancelled (e.g. if the borrowing requirement changes)
108 7: R i s k man ag e me nt A C C A FM
ILLUSTRATION 7.1
In 3 months’ time Paton Co will be borrowing $2.5m for 3 months from a bank and wants to hedge
uncertainty over its borrowing costs using a forward rate agreement. The quote for a 3-6 forward rate
agreement is currently 2.60-1.35.
Show the effect if in 3 months’ time the spot rate of interest is 3%.
Answer:
As our borrowing period will start in 3 months’ time and last for 3 months, we will need to buy a
3-6 FRA with notional value $2.5m
In 3 months’ time we will pay the FRA fixed rate (2.6%) and receive the spot rate
The cashflow on the FRA = (3% - 2.6%) × $2.5m × 3/12 = $2,500 receipt
We will then borrow $2.5m at spot and pay interest = $2.5m × 3% × 3/12 = $18,750
Net payment = $18,750 - $2,500 = $16,250
Hence, the effective interest rate = ($16,250/$2,500,000) × 12/3 = 2.6% (= the FRA rate)
h t
A derivative is something which derives its value from something else; in this context it will be interest
9
r i g 2 0 1
rates. There are three main types of interest rate derivative:
y
Interest Rate Futures
p ion
o
These are similar to forward rate agreements, but futures are of a standardised contract size,
C uit
standardised maturity date and are traded on organised exchanges.
t
Settlements take place in three-monthly cycles ending in March, June, September and December.
I n
rs t
Borrowers will sell futures now and buy the same number of futures contracts when their
borrowing starts. This will lead to a net cash payment or receipt based on the difference
Fi
between the price sold at and the price purchased at.
However, the futures do not facilitate the borrowing – we will still have to borrow at spot.
Being traded on an exchange means that they can be closed out i.e. by purchasing an equal and
opposite investment in the same underlying currency, prior to maturity. This makes futures
more flexible than forward contracts.
The futures price will change as the spot price changes and this allows any gain or loss on the
actual borrowing (due to interest rate movements) to be offset by losses/ gains on the futures.
Advantages of futures
They fix an interest rate, hedging away any downside risk
They may be closed out early (and are hence more flexible than FRAs)
Disadvantages of futures
They are standardised and hence may lead to over / under hedging (if maturity dates and
contract sizes don’t fit with borrowing requirements)
They remove any upside potential (i.e. if interest rates were to fall)
Futures prices will differ to the spot rate until you reach the maturity date of the future
and this will lead to the hedge not being 100% effective if the borrowing date doesn’t
equal the futures maturity date (this is known as ‘basis risk’)
A C C A FM 7: R i s k man ag e me nt 109
Options
Over the counter (OTC) interest rate options can be purchased from major banks and allow the
borrower to have the right, but not the obligation to borrow at a set fixed rate (strike price) in the
future.
The borrower would have to pay a premium now to buy the option contract and would then
wait to see how interest rates move before deciding whether to exercise the option or not.
If interest rate rise between now and the borrowing date, the borrower would exercise the
option and borrow at the pre-determined fixed rate specified in the option
If interest rates fall between now and the borrowing date, the borrower would let the option
lapse and borrow at the spot rate.
Advantage of options
They only hedge away the downside risk, leaving the borrower the ability to benefit from
the upside (rates falling) – this is in contrast to FRAs and futures.
Disadvantage of options
They are expensive and the premium must be paid up front.
Swaps
Interest rate swaps involve two counterparties swapping interest rate payments on a set notional
borrowing amount for a set period of time.
Fir Co
st I pyri
The swap would be based on one party having fixed rate debt, but actually desiring variable rate
interest payments and another party wanting fixed rate interest payments but having variable rate
debt.
ntu ght
By swapping interest payments, the two parties get the type of interest rate exposure that they desire,
without having to renegotiate the terms of their debt / refinance.
itio
2 Managing foreign exchange risk n2
2.1 Different types of foreign currency risk
019
2.1.1 Transaction risk
Transaction risk refers to the risk a business is exposed to when it enters into a short term
transaction involving credit in a non-native currency - e.g. a UK based exporter making a sale on
1-month credit with payment in Euros.
By the time the transaction is actually settled the exchange rate may have moved adversely
(e.g. Euros weakening against the Pound) and the value of the receipt will have reduced.
110 7: R i s k man ag e me nt A C C A FM
h 9
r i g 0 1
I.e. an investor should be indifferent between buying Dollars using a forward contract OR
borrowing Pounds to buy Dollars at spot and investing Dollars in a deposit account.
2
y
p ion
Assumptions: spot price represents equilibrium price (demand = supply)
o
C uit
FORMULA GIVEN IN EXAM
I n t
(1 + ic )
rs t
F 0 = S0 ×
(1 + ib )
Fi Where:
F0 = Current forward exchange rate
S0 = Current spot exchange rate
ic = interest rate in foreign country
ib = interest rate in home country
A C C A FM 7: R i s k man ag e me nt 111
ILLUSTRATION 7.2
The current exchange rate between the USA and the UK is $1.9854:£1. Interest rates in the USA are
forecast to be 8% for the next year and UK interest rates are forecast to be 6%.
What should the current one year forward rate be (using interest rate parity)?
SOLUTION
S0 = 1.9854
ic = 0.08
ib = 0.06
(1+0.08)
So the forward rate for the first year is: F0 = 1.9854 × (1+0.06)
F0 = 2.0229
Dollars and buying the same goods in Dollars
Fir Co
st I pyri
If it is cheaper to buy goods in the US (due to higher inflation in the UK), the exchange rate will
adjust to make Dollars more expensive as more people buy Dollars - bringing the equivalent
future Pound and Dollar prices back in line.
ntu ght
I.e. the country with higher inflation will see its currency weaken (depreciate).
itio
Problems: inflation rates are estimates; PPPT works better in the long run as it is hampered by
government intervention (monetary policy).
n2
FORMULA GIVEN IN EXAM
(1 + hc )
019
S1 = S0 ×
(1 + hb )
Where:
S1 = Expected future spot rate
S0 = Current spot exchange rate
hc = inflation rate in foreign country
hb = inflation rate in home country
112 7: R i s k man ag e me nt A C C A FM
The current exchange rate between the USA and the UK is $1.9854:£1. Inflation in the USA is forecast
to be 5% for the next year and UK inflation is forecast to be 3%.
What is the forecast exchange rate in one year’s time using purchasing power parity?
SOLUTION
2 0 1
y
Expectations theory
p ion
o
Following on, the current forward rate should therefore be an unbiased predictor of the future
C uit
spot rate
I n t
These theories are summarised in the diagram below:
rs t
Difference in (nominal)
interest rates
Fisher Effect Expected difference in
inflation rates
Fi
(1 + 𝑜𝑜𝑝𝑝 ) (1 + ℎ𝑝𝑝 )
(1 + 𝑜𝑜𝑏𝑏 ) (1 + ℎ𝑏𝑏 )
International
Fisher Effect PPPT
IRPT
A C C A FM 7: R i s k man ag e me nt 113
Currency of invoice
Fir Co
By ensuring that the currency of invoice is the same as the domestic currency, the transaction risk is
st I pyri
removed entirely in a cheap and effective way. The risk is in fact transferred to the other party
involved in the transaction and so this will not always be a viable solution.
114 7: R i s k man ag e me nt A C C A FM
Exportit Co is a UK based organisation which sells some goods on three months’ credit to a US
customer for $90,000. The current exchange rate is $1.9851-$1.9857:£1 and the bank has offered
Exportit a forward contract at a rate of $2.0117-$2.0123.
Using a forward contract, how much sterling will Exportit receive in three months’ time?
SOLUTION
h t
Calculating a forward rate
9
i g 1
Instead of being given the forward rate, you may be asked to calculate it. For example, you may
r 2 0
y
be given the spot rate spread and the necessary adjustments to the spot rate to calculate the
p ion
forward rate.
o
C uit
The forward rate adjustment is quoted as a premium or discount on the spot rate.
If the forward rate is at a discount, it means the foreign currency is expected to depreciate in
n t
relation to the home currency. Thus the home currency will be worth more under the forward
I
rs t
rate than it is currently.
It may seem illogical but therefore you need to ADD a discount, but DEDUCT a premium as the
Fi
ILLUSTRATION 7.3
exchange rate tells us what the home currency is worth.
Spot rate £/$1.9730 – 1.9738 (i.e. £1 = 1.973 dollars). The 2 month forward adjustment is given as
0.9 to 0.58 cents premium for £/$.
To calculate the 2 month forward rate spread :
£/$ Spread
Spot (£/$) 1.9730 – 1.9738 0.0008
2 month adjt (premium) 0.0090 – 0.0058
2 month forward rate 1.9640 – 1.9680 0.0040
Three things to note here:
(1) A “premium” will ALWAYS mean that you DEDUCT the adjustment
(2) The forward adjustment is usually quoted in the smallest unit of currency, so 0.9 cents =
$0.0090
(3) The spread for a forward contract is ALWAYS greater than the spread for the spot
A C C A FM 7: R i s k man ag e me nt 115
st I pyri
MM hedges are effectively do-it-yourself forward contracts, however the interest rates obtained by
ntu ght
companies in the money markets are unlikely to be as good as those obtained by banks and so these
are not that widely used (and may prove more difficult to arrange and expensive than forward
contracts).
itio
MM Hedge step-by-step guide:
n2
To hedge future payment in Euros:
Borrow in $ now 019
To hedge future receipt in Euros:
Borrow in € now
Convert to € at spot Convert to $ at spot
Deposit €, earn interest Deposit $, earn interest
On payment date, settle payment out of € deposit account On receipt date, use receipt to pay back € loan
Pay back $ loan + interest. Withdraw $ from deposit
116 7: R i s k man ag e me nt A C C A FM
Importit Co is a UK based organisation which buys some goods on three months credit from a US
supplier for $90,000. The current exchange rate is $1.9851-$1.9857:£1 and the money market interest
rates are as follows:
Borrowing Depositing
One year sterling interest rate: 6.0% 5.7%
One year dollar interest rate: 8.3% 8.0%
Using a money market hedge, how much sterling will Importit pay in three months’ time?
SOLUTION
h t 9
r i g 2 0 1
y
p ion
o
C uit
I n t
rs t
Fi
A C C A FM 7: R i s k man ag e me nt 117
Trading Co is a UK based organisation which sells some goods on six months credit to a European
customer for €120,000. The current exchange rate is €1.1446-€1.1452:£1 and the money market
interest rates are as follows:
Borrowing Depositing
One year sterling interest rate: 6.0% 5.7%
One year euro interest rate: 4.0% 3.7%
Using a money market hedge, how much sterling will Trading receive in six months’ time?
SOLUTION
Fir Co
st I pyri
ntu ght
itio
n2
019
118 7: R i s k man ag e me nt A C C A FM
FX Futures
These are similar to forward contracts, but FX futures are of a standardised contract size, standardised
maturity date and are traded on organised exchanges.
Settlements take place in three-monthly cycles ending in March, June, September and
December.
E.g. a US company expecting to receive Euros in 3 months’ time will sell Euro futures now (to
lock in a Dollar price at which they can sell the Euros).
They will then buy the same number of Euro futures contracts when on the date they receive
the Euros.
This will lead to a net cash payment or receipt in Dollars based on the difference between the
price sold at and the price purchased at.
However, the futures do not facilitate the sale of the Euros – we will still have to sell our Euros
at the spot rate to a buyer.
Being traded on an exchange means that they can be closed out i.e. by purchasing an equal and
opposite investment in the same underlying currency, prior to maturity. This makes futures
h t
more flexible than forward contracts.
9
i g 1
The futures price will change as the spot price changes and this allows any gain or loss on the
r 2 0
y
actual business transaction to be offset by losses or gains on the futures.
p ion
o
Advantages of futures
C uit
They fix an exchange rate, hedging away any downside risk
I n t They may be closed out early (and are hence more flexible than forwards)
Disadvantages of futures
rs t
They are standardised and hence may lead to over / under hedging (if maturity dates and
Fi
contract sizes don’t fit with the user’s requirements)
They remove any upside potential (i.e. in the above example if the Euro strengthens vs
the Dollar)
Futures prices will differ to the spot rate until you reach the maturity date of the future
and this will lead to the hedge not being 100% effective if the transaction date doesn’t
equal the futures maturity date (this is known as ‘basis risk’)
A C C A FM 7: R i s k man ag e me nt 119
FX Options
Over the counter (OTC) currency options can be purchased from major banks and allow the user to
have the right, but not the obligation to e.g. sell Euros at a set Dollar price (strike price) in the future
(this would be a ‘put’ option – the right to sell, ‘call’ options are the right to buy).
We would have to pay a premium now to buy the option contract and would then wait to see
how exchange rates move before deciding whether to exercise the option or not.
If Euros weaken vs. the Dollar between now and the receipt date, we would exercise the option
and sell the Euros at the pre-determined fixed Dollar price specified in the option
If Euros strengthen vs. the Dollar between now and the receipt date, we would would let the
option lapse and sell the Euros at the spot rate.
Advantage of options
They only hedge away the downside risk, leaving the borrower the ability to benefit from
the upside (rates falling) – this is in contrast to forwards and futures.
Disadvantage of options
They are expensive and the premium must be paid upfront.
Currency Swaps
Currency swaps involve two counterparties swapping principal and interest rate payments on
borrowings in two different currencies.
Fir Co
st I pyri
For example, a US based company might have arranged existing debt finance in Dollars but are
using the debt to finance an investment in operations in the Eurozone.
ntu ght
Meanwhile, a French company has existing debt in Euros which it is using to finance operations
in the US.
itio
A currency swap would allow the two parties to swap interest payments and notionals on their
n2
debt to better facilitate asset and liability management (see earlier), without the pain of having
to refinance (especially useful if either of the two companies are unable to borrow in their
desired currency).
019
120 7: R i s k man ag e me nt A C C A FM
h t 9
r i g 2 0 1
y
p ion
o
C uit
I n t
rs t
Fi
121
Solutions to
Class lecture examples
Fir Co
st I pyri
Chapter 1
ntu ght
Lecture example 1.1 itio
ROCE 2,159
× 100 = n2 28%
Return on Equity
7,340 + 3,562 – 3,070
1,260
× 100 =
019 25%
4,956
EPS 1,260 $0.60
=
2,100
Dividend per share 525 $0.25
=
2,100
P/E ratio 7.20 12
=
0.60
TSR 0.25 + (7.20 − 7) 6.4%
=
7
These figures give us very little indication as to whether or not Diamond Co is achieving its own
corporate objectives, however if we knew what its corporate objectives were and what ROCE, Return
on Equity, EPS and Dividend per Share had been achieved in previous years, we would then be better
placed to reach a conclusion.
122 So l u t i o n s t o Cl as s l e c t u re e xamp l e s A C C A FM
However we are able to compare these figures with the industry averages, though care needs to be taken:
(1) ROCE: Diamond is marginally outperforming the industry average.
(2) Return on Equity: The fact that this slightly lower than the industry average, but the ROCE is
higher, suggests that the debt holders are doing relatively well.
(3) EPS: The industry average comparison is almost certainly meaningless as this figure depends
upon the nominal value of the shares and this can be any figure the company chooses. If
Diamond had twice as many shares with half their current nominal value, the total nominal
value of the shares would be the same, but the EPS would be halved to $0.30.
(4) Dividend per share: Again comparing with the industry average is dangerous as the significance
of the absolute dividend depends upon what was paid for the shares and the risks being faced
by shareholders.
(5) Total shareholder return: to conclude on whether this is a sufficient return for shareholders we
would need to compare it to either an industry average or an estimated cost of equity for
Diamond Co (see chapter 5).
Chapter 2
No lecture examples
Chapter 3
h t 9
r i g
Lecture example 3.1
2 0 1
y
p ion
o
Current ratio
C uit
936 + 2,626
1,296 + 537 + 1,237
=
1.2
I n t
Quick ratio 2,626
1,296 + 537 + 1,237
=
0.9
rs t
Inventory turnover ratio 14,687– 4,386 11 times
Fi
=
936
Average collection period 2,626 65 days
× 365 =
14,687
Average payable period 1,296 46 days
× 365 =
14,687– 4,386
Sales revenue/net working capital ratio 14,687 29.9
=
492
By ordering 1,000 units of inventory whenever Paton places an order, the total annual variable
inventory costs are minimised at $240.
A C C A FM So l u t i o n s t o Cl a s s l e c t u re e xa mp l e s 123
The total annual cost of ordering 1,500 units including the purchase price is:
6,000 1,500
�20 × 1,500� + �0.24 × 0.995 × 2
� + (6,000 × 1.20 × 0.995) = $80 + $179 + $7,164 = $7,423
st I pyri
So as the costs are greater than the benefits this particular scheme is not economically worthwhile.
54,576
100,845
100,845
Payments
Materials (W3) 12,000 19,125
Labour (W4) 16,000 25,500 32,000
Variable overheads (W5) 2,000 5,188 7,187
Fixed overheads (W6) 15,000 15,000 15,000
33,000 57,688 73,312
Net cash flow 30,365 (3,112) 27,533
Opening balance 0 30,365 27,253
Closing balance $30,365 $27,253 $54,786
Workings
(W1) Cash receipts from customers
June July August
Sales $45,000 $108,000 $135,000
Received in month of sale (30% × 99% × sales in mth) $13,365 $32,076 $40,095
Received 1 mth later (50% × previous mth sales) – $22,500 $54,000
Received 2 mths later (15% × sales 2 mths ago) – – $6,750
TOTAL $13,365 $54,576 $100,845
124 So l u t i o n s t o Cl as s l e c t u re e xamp l e s A C C A FM
(W2) Production
In order to work out our costs we need to establish the production volumes each month. This
can be done by taking the sales volumes for a month, adding closing inventory and deducting
opening inventory.
June July August September
Sales volume 500 1,200 1,500 1,900
Add: closing inventory (25% of next
month’s sales) 300 375 475
Less: opening inventory nil 300 375
Production 800 1,275 1,600
Now we know this we can calculate the cash flows for the variable costs:
(W3) Materials
June July August
Production (W2) 800 1,275
Material cost (@ $15 each) $12,000 $19,125
Cash payment (1 month later) nil $12,000 $19,125
(W4) Labour
June July August
Production (W2) 800 1,275 1,600
Labour cost (@ $20 each) $16,000 $25,500 $32,000
h t
Cash payment (same month)
9
$16,000 $25,500 $32,000
i g
(W5) Variable overheads
r 2 0 1
y
p ion
Production (W2)
June
800
July
1,275
August
1,600
o
C uit
Variable overhead cost (@ $5 each)
Cash payment ( 50% same month)
$4,000
$2,000
$6,375
$3,188
$8,000
$4,000
rs t
(W6) Fixed overheads
A C C A FM So l u t i o n s t o Cl a s s l e c t u re e xa mp l e s 125
Chapter 4
Lecture example 4.1
Materials: The relevant cost is $0.80 × 1,200kg = $960, which is the benefit forgone from the
next best alternative use of the material.
Labour: The relevant cost is nil as there is no incremental cost.
Overheads: The relevant cost is $34,564. The fixed overhead will not change and so is not
incremental.
Machine: The original purchase price of $20,000 is not relevant as this is a sunk cost. Ignoring
the new opportunity, Proposal Co would keep the machine as it will earn more
money ($15,000) than its scrap value ($12,000).
If the machine is used on the new project, the final question to ask is, will Proposal
Co replace it? The answer is yes as the replacement cost ($14,000) is less than the
money it will earn ($15,000).
So the relevant cost is $14,000.
Investment
Fir
$
(80,000) Co $
(80,000)
First year
Second year
15,000
20,000 st I pyri (65,000)
(45,000)
Third year
Fourth year
25,000
30,000 ntu ght (20,000)
10,000
itio
So the payback period is 4 years or if we assume that the cash flows come in evenly throughout each
year:
20,000
3 + 30,000 = 323 years n2
Lecture example 4.2 (part 2)
019
(($15,000 + $20,000 + $25,000 + $30,000 + $35,000) − $80,000)
Average profit = 5
= $9,000
$9,000
ROCE = $40,000 × 100 = 22.5%
126 So l u t i o n s t o Cl as s l e c t u re e xamp l e s A C C A FM
o
C uit
1
So PV = 2,000 × 0.05 = $40,000
n t
Lecture example 4.2 (part 3)
I
rs t
Timing Cash flow Discount Factor Present Value
Fi
$ 10% $
0 (80,000) 1.000 (80,000)
1 15,000 0.909 13,635
2 20,000 0.826 16,520
3 25,000 0.751 18,775
4 30,000 0.683 20,490
5 35,000 0.621 21,735
NPV = $11,155
A C C A FM So l u t i o n s t o Cl a s s l e c t u re e xa mp l e s 127
11,155
IRR ≈ 0.10 + 11,155−(10,620) × (0.20 − 0.10)
= 0.15 or 15%
Co
Present Value (1,175) 946 367 258 351
Fir
st I pyri
Net Present Value $747
As the net present value is positive, the proposed investment should be accepted as it will increase the
shareholders’ wealth by $747k.
ntu ght
(W1) Tax saved on Capital Allowances
itio
n2
Time Tax Tax Saved Cash Flow
$000 $000
0
1
Purchase
CA @ 20% 019 800
(160)
640
@30% 48
128 So l u t i o n s t o Cl as s l e c t u re e xamp l e s A C C A FM
2
y
rate of return (the actual % return on the project). For instance, the NPV at 20% =
p ion
Time
o
C uit
0
$
1
$
2
$
3
$
I n t
Net cash flow
Discount Factor @ 20%
(40,000)
1.000
8,985
0.833
12,785
0.694
36,045
0.579
rs t
Present Value (40,000) 7,485 8,873 20,870
Fi NPV = $(2,772)
6,831
IRR ≈ 0.09 + × (0.20 − 0.09)
6,831−(2,772)
= 16.8%
16.8%−9%
× 100 = 87%
9%
Thus the new machine is most sensitive to the revenue estimate.
A C C A FM So l u t i o n s t o Cl a s s l e c t u re e xa mp l e s 129
Fir Co
st I pyri
Third Year Probability Forecast Sales
High 0.25 $600,000 $150,000
Medium 0.60 $500,000 $300,000
Low 0.15
ntu ght $400,000
Expected Sales Value =
$60,000
$510,000
(b) For the revenue to exceed $1,600,000, as the first year’s sales are $480,00, the second year’s
sales would need to be high ($650,000) and the third year’s sales would need to be either high
or medium ($600,000 or $500,000). So the probability of this is:
(0.55 × 0.25) + (0.55 × 0.60) = 0.1375 + 0.33 = 0.4675
130 So l u t i o n s t o Cl as s l e c t u re e xamp l e s A C C A FM
h t 9
2,500 0.712 1,780
(14,469) 2.402 (6,024)
r i g 2 0 1
y
So Mobile Co should replace their grinding machines every year.
p ion
Chapter 5 o
C uit
I n t
Lecture example 5.1
r s t(a) White Spirit Co needs to raise enough funds for the new investment opportunity and the issue
A C C A FM So l u t i o n s t o Cl a s s l e c t u re e xa mp l e s 131
re = 0.16 or 16%
So Kd =
6(1−0.30)
= 0.05
Fir Co
st I pyri
84
= 0.09
So the cost of redeemable debt for Plastered Co is 9%.
132 So l u t i o n s t o Cl as s l e c t u re e xamp l e s A C C A FM
Kb = 0.06
So the cost of bank debt capital for Blotto Co is 6%.
re = 0.15
I = $7
T = 0.35
Po = $83 – $7 = $76
So Kd =
7(1−0.35)
76
h t = 0.06
9
r i g 0 1
So the WACC using book values is:
2
y
p ion
19,450,000 10,000,000
WACC = �19,450,000+10,000,000� 0.15 + �19,450,000+10,000,000� 0.06
o
C uit = 0.12 or 12%
I n t
To calculate the WACC using market values we first need to calculate the total market value of the
equity and debt:
= 0.13 or 13%
βa = 1.02
57
1.02 = 57+43(1−0.30) × βe
1.02 = 0.654 × βe
A C C A FM So l u t i o n s t o Cl a s s l e c t u re e xa mp l e s 133
1.02
βe = 0.654 = 1.56
Rf = 0.04
E(rm) = 0.18
So the project specific discount rate for Millie Mo’s new project is 25.8%.
Chapter 6
Lecture example 6.1
(a) Calculate the asset based valuation for AJB
The most recent net asset value from the statement of financial position is $133m. This could be
expressed as a value per share of $133m/40m shares = $3.325. The limitations of this value here
are that:
No account is taken of any intangible value which in an IT consultancy might be assumed to be a
significant amount (see later valuation of intangibles/intellectual property).
Whilst we are told that book values reflect realisable values there is no indication as to when
things like the non-current assets were last revalued.
(b) Earnings based valuation for AJB
Fir
The P/E ratio for the similar listed company = $7.5/$0.5 = 15 Co
st I pyri
Applying a P/E valuation to the most recent (i.e. 2013) earnings (PAT) gives:
15 x $21.9m = $328.5m = MVe
ntu ght
itio
Hence, the value of one share = $328.5m / 40m = $8.21
However, adjustments would have to be made for differences between the two companies:
n2
AJB is not listed, hence it might have a lower P/E ratio (due to investors paying a
019
premium for shares in a listed company due to increased liquidity / marketability
hence we may need to revise the valuation down (say by 25-30%?)
What are the growth projections in each company?
How does the gearing of each company compare?
All of these differences could cause the P/E valuation to be inaccurate.
(c) Cash flow valuation of AJB
The free cash flow can be estimated as follows for the future cash flows starting in one year’s
time
1 2 3 Thereafter
PAT 27.8 34.6
Add: depreciation 35.0 35.0
Less: CAPEX 35.0 35.0
Free cash flow 27.8 34.6 35.3 Growing at 2%pa
A PV calculation can then be performed on the future cash flows.
Step 1 – Work out the value as at 2015 of the growing perpetuity from 2016 onwards:
1 1
𝑀𝑀𝑀𝑀𝑣𝑣𝑣𝑣𝑀𝑀 𝑀𝑀𝑀𝑀 20𝑋𝑋5 = 20𝑋𝑋6 𝑐𝑐𝑀𝑀𝑠𝑠ℎ𝑜𝑜𝑣𝑣𝑜𝑜𝑓𝑓 × = 35.3 × 0.11−0.02 = $𝟑𝟑𝟑𝟑𝟑𝟑𝟑𝟑
𝐸𝐸−𝐸𝐸
134 So l u t i o n s t o Cl as s l e c t u re e xamp l e s A C C A FM
h t
Remember to question the assumptions about constant growth and a constant cost of equity
9
Chapter 7 r i g 2 0 1
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Lecture example 7.1
S0
I
hc
n t = 1.9854
= 0.05
r s thb = 0.03
F i S1
S1
= 1.9854 ×
= 2.0240
(1+0.05)
(1+0.03)
A C C A FM So l u t i o n s t o Cl a s s l e c t u re e xa mp l e s 135
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136 So l u t i o n s t o Cl as s l e c t u re e xamp l e s A C C A FM
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137
Formulae sheets
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138 Fo rmu l ae s h e e t s A C C A FM
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A C C A FM Fo rmu l ae s h e e t s 139
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140 Fo rmu l ae s h e e t s A C C A FM
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