THE INSTITUTE OF CPA A2.1 STRATEGIC CORPORATE FINANCE Study Manual

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CPA
Certified Public Accountant Examination
Stage: Advanced Level 2 A2.1
Subject Title: Strategic Corporate Finance
Study Manual
LOSSARY
INSIDE COVER - BLANK
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omissions in relation to the contents of this book.
INSTITUTE OF
CERTIFIED PUBLIC ACCOUNTANTS
OF
RWANDA
Advanced Level 2
A2.1 STRATEGIC CORPORATE
FINANCE
First Edition 2012
This study manual has been fully revised and updated
in accordance with the current syllabus.
It has been developed in consultation with experienced lecturers.
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CONTENTS
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INTRODUCTION TO THE COURSE
Stage: Advanced Level 2
Subject Title: A2.1 Strategic Corporate Finance
Aim
The aim of this subject is to enable students to understand the key responsibilities and
financing decisions facing today’s strategic financial manager. Students should be able to
develop detailed business plans, to assess the potential financial risks and to advise on
suitable risk management strategies for entrepreneurial activities and established
organisations.
Strategic Corporate Finance as an Integral Part of the Syllabus
Strategic Corporate Finance develops the financial management skills acquired by students
in Managerial Finance (A1) and other disciplines acquired in the earlier examination stages.
Strategic Corporate Finance requires students to integrate and expand that knowledge so as
to provide a framework for strategic financial management analysis and decisions.
Learning Outcomes
On successful completion of this subject students should be able to:
Evaluate the financial objectives of an organisation, explain how they are determined
and interrelate with the non-financial objectives and stakeholder interests.
Discuss the legal regulations, the professional and ethical considerations facing
financial managers.
Value shares / businesses in the context of a proposed merger, acquisition or
management buyout.
Analyse reasons for and advise on actions to prevent corporate failure.
Evaluate and advise as to the optimum capital gearing structure, term structure and
dividend policy for an organisation.
Advise as to appropriate exchange risk and interest rate risk management strategies and
discuss the use of derivatives in long term risk management.
Discuss the relevance of portfolio theory and the Capital Asset Pricing Model to
financial managers.
Prepare a business plan for an organisation given prescribed information.
Evaluate the financial management of an organisation over a period of time and/or
relative to competitors / industry norms.
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Syllabus:
1. Financial Environment
Determining financial objectives within the strategic planning process.
Identify key stakeholders of organisations and the interests of each stakeholder
group.
Corporate Social Responsibility, its relationship to the objective of maximising
shareholder wealth.
Agency theory and its relevance to financial managers.
The professional, regulatory and legal framework relevant to financial management
including stock exchange requirements, money laundering, directors’
responsibilities.
Monetary regulation and its effect on Capital Markets.
The key activities undertaken by treasury managers.
Centralised treasury management and the arguments for and against.
The efficient market hypothesis.
2. Mergers and Acquisitions
Organic and acquisitive corporate growth.
Mergers and acquisitions, the arguments for and against.
Procedures to be complied with during an acquisition.
Valuation of an organisation in the context of a potential takeover using both the
earnings and assets based methodologies.
The significance of Value Gaps and the information efficiency of capital markets.
Methods of financing mergers and takeovers including cash, debt, equity and
hybrids.
Defence tactics used during a hostile takeover.
The role of legal and financial due diligence during a merger/acquisition.
The attractions and risks associated with Management Buy-outs (MBOs).
Sources of finance for MBOs.
The advantages and disadvantages of management buy-ins.
The arguments for and against a quoted company going private.
3. Corporate Failure
The symptoms and causes of corporate failure.
Avoidance of corporate failure.
The nature, scope and elements of working capital and the importance of effective
working capital management to corporate survival.
Overtrading- symptoms, causes and remedies.
Page 9
4. Sources of Finance
Equity and debt financing.
The attractions and risks associated with each.
Short, medium and long term funding.
Optimising the gearing structure of an organisation.
The optimum term structure of an organisation, taking into account strategic plans.
Dividend policy - key considerations. Including theories of Mogdalini & Miller and
Myers Pecking Order Hypothesis.
Advise on dividend policy.
Investment from overseas.
5. Financial Risk Management
The key financial risks facing an organisation.
Currency risk - transaction, translation and economic exposure.
The workings of the foreign exchange markets.
The relationship between foreign exchange rates and interest rates in different
countries.
Forward Exchange Contract and Money Market hedges.
Other forms of exchange rate risk management including, netting, leading and
lagging, currency swaps, currency futures and currency options.
Exchange risk management strategies.
Interest rate options, swaps, forwards, futures and swap options.
Interest rate risk management strategy.
6. Cost of Capital
Weighted Average Cost of Capital (WACC) - calculate and discuss its uses and
limitations
Portfolio diversification, estimate the risk and return of a portfolio
The relevance of portfolio theory to practical financial management.
The Capital Assets Pricing Model (CAPM) application and limitations.
7. Financial Analysis and Business Planning
Preparation of long-term business plans from prescribed information.
Appraise capital investment options using NPV, IRR and Payback criteria.
Evaluation of a business plan from the perspective of an equity investor or provider of
debt funding.
Assessment an organisation’s current financial position.
Comparison and evaluation of the financial management of an organisation with that
of competitors and industry norms.
Preparation, evaluation and discussion of key financial management indicators based
on the published financial statements of an organisation.
Benchmarking of selected financial KPIs against companies in the same industry
sector.
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8. International Managerial Finance
International capital markets
International money markets
Euro Markets, Euro Equity Markets, Euro Currency Markets
Foreign Bonds
International CDs
International Bond Markets
Project Finance
Currency Cocktails
Foreign financial intermediaries
International financial institutions
Bilateral, multilateral and regional financial institutions
Integration & Segmentation of financial markets
Hedging Instruments
Page 11
Study Unit 1
Objectives of Financial Management
Contents
A. Introduction
B. Agency Theory
C. Nationalised Industries/Public Sector
D. Corporate Social Responsibility (CSR)
E. Impact of Government on Activities
F. Composition of Shareholders
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A. INTRODUCTION
It is often assumed that the single objective of commercial entities is:
To Maximise the Value of the Firm
Or
To Maximise the Wealth of the Shareholders
In reality, firms have multiple, and often conflicting, objectives and will seek to optimise
among those. The modern corporation is a complex entity which is responsible not only to
shareholders but to all stakeholders.
The main stakeholders are:
1. Shareholders
2. Loan Creditorsseek security, repayment of loan interest and principal.
3. Employees seek fair wages, promotional opportunities, welfare & social facilities =>
improved motivation.
4. Management - job security; fair reward; job satisfaction.
5. Trade Creditors - payment within credit terms.
6. The Community - sponsorship; charities; install environmental measures.
7. The Government - payment of taxes, rates, provide employment.
8. Customers - provision of service/goods at fair price; quality; on time etc.
The relative importance of the various groups may differ, possibly depending on company
size and management style.
Management will be concerned with the value of the firm as it satisfies one of the important
stakeholders (shareholders). A low valuation may increase the possibility of an unwanted
takeover bid. Also, finance must be adequately rewarded and its market value maintained, so
that further finance is obtainable when required.
Non-financial objectives may conflict with financial objectives e.g. provision of staff
recreational facilities; modern, safe working environment etc.
B. AGENCY THEORY
The managers/directors act as agents for the shareholders (owners) in running the company.
This separation of ownership from control may lead to certain problems if managers are not
monitored or constrained - e.g. management working inefficiently; adopting risk averse
policies such as ‘safe’ short-term investments and low gearing; empire building for
power/status; rewarding themselves with high salaries and fringe benefits; increased leisure
time etc.
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Managers’ and shareholders’ interests can be aligned by a number of measures - introducing
profit-related remuneration for management; offering bonus shares; share option schemes;
scrutiny of performance by the board of directors and banks who provide finance etc.
However, care must be taken to ensure that management does not take action to boost
performance in the short-term to the detriment of the long-term wealth of the shareholders
(‘short-termism’).
C. NATIONALISED INDUSTRIES/PUBLIC SECTOR
The objectives of nationalised industries are likely to be strongly influenced by the
government and not primarily financial. These organisations exist to provide a service and to
ensure that social needs are satisfied and financial requirements may be seen as constraints
and not objectives. They are not usually profit maximising, although subsidiary objectives
may be concerned with earning an acceptable return on capital employed.
In the private sector the effects of investments (and associated financing and dividend
decisions) on share price and shareholder wealth will be considered. As there are no share
prices in a nationalised industry and investor wealth maximisation is not the assumed
objective, some private sector investment appraisal techniques will not be appropriate.
However, some private sector financial management techniques can be used in the public
sector - e.g. discounted cash flow is often used.
D. CORPORATE SOCIAL RESPONSIBILITY (CSR)
Corporate Social Responsibility (CSR) is often used to describe the actions of a private,
commercial organisation assuming a responsible view of its wider obligations to society.
Corporate Social Responsibility has been otherwise defined as:
“fulfilling a role wider than your strict economic role” or “acting as a good corporate citizen”.
The theory of business finance is that the prime objective of management of a listed company
is to maximise the wealth of its ordinary shareholders. Agency theory dictates that
management, as agents of the company’s owners, must act in their best interests and, thus,
strive to maximise shareholders wealth at all times. In their attempt to achieve this prime
objective management will set financial objectives, including:
Profit levels
Sales and profit growth
Margin improvement
Cost releasing efficiency savings
EPS growth
Page 14
Management will also set non-financial objectives, which should complement and support the
financial objectives. These may include:
Brand awareness levels
Research & development successes
New product development
New markets entered
Customer satisfaction levels
Employee motivation levels
Such objectives may also include the following:
Providing for the welfare of employees and management
Upholding responsibilities to customers and suppliers
Provision of a service.
Contributing to the welfare of society as a whole
Environmental protection
Which may be loosely described as acting in a socially responsible manner. This has led
to the development of the concept of Corporate Social Responsibility (CSR).
Examples of acting in a socially responsible manner may include:
Such as KPMG International’s policy of purchasing over 90% of its electricity from
renewable sources.
Junior Achievement Awards initiative.
Likewise, companies have been alleged to have acted in a less than socially responsible
manner. Examples include clothing and sports goods companies using sub-contractors who
employ child labour practices.
The extent to which organisations subscribe to CSR varies greatly both ideologically and in
practice. Recent research has shown that 90% of companies believed that CSR should be part
of a company’s DNA, yet only 30% thereof actually did anything about it.
Many organisations view CSR as a strategic investment and consider it necessary in order to
achieve the reputation that is gaining importance in attracting and retaining key staff and to
winning and retaining prestigious contracts and clients. Many such companies have moved
to operationalise CSR. This has been achieved in many ways including:
Incorporating CSR in their mission statements
Appointing a ‘champion’ of CSR
Formally incorporating CSR objectives into its strategic planning process
Dissemination of CSR targets and reporting of key performance indicators
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Retaining consultants to advise on existing performance and to recommend
improvements
Appointment of committees to implement and reviews CSR related policies.
Whilst, some organisations see social responsibility as a passing trend and are content to get
by with a bit of ‘lip service’ and tokenism, other organisations view CSR as the preserve of
multinationals and government. Part of the challenge in pursuing CSR related objectives lies
in the relative novelty of the concept. The critical debate is whether or not CSR detracts from
the objective of maximising shareholder wealth. As with all debates there are opposing views
including:
Arguments in favour of CSR include that it:
Creates positive Public Relations for the organisation, or, as a minimum avoids bad P.R.
Helps attract new and repeat custom
Improves staff recruitment, motivation and retention
Helps keep the organisation within the law,
All of which may be considered to support the drive to maximise profits.
However, there are many writers who vigorously oppose the notion that private organisations
should embrace social responsibility. Some of the main arguments against CSR are:
Market capitalism is the most equitable form of society that has ever appeared
The ethics of doing business are not those of wider society
Governments are responsible for the well- being of society
An organisation’s maximum requirement is to remain within the law, no more than this
is required.
Ultimately, they argue that business organisations are created and run in order to maximise
returns for their owners and that CSR detracts from the profit maximisation
Conclusion
The broad philosophical debate on the role of companies in society is still in its early days.
Depending on your viewpoint, CSR may be considered to support or detract from the
objective of maximising shareholder wealth. Neither viewpoint is definitive.
As the public debate on CSR and the changing role of business in society intensifies,
companies will need to determine their own view on CSR and adopt their own stance on the
subject. Ultimately, they will have to make policy decisions that are in the best interests of
the company and its owners, their shareholders.
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E. IMPACT OF GOVERNMENT ON ACTIVITIES
There are a number of areas where the Government plays a role in the financial arena:
Taxation - Corporate (Capital Allowances etc.) & Personal (Business Expansion
Scheme, etc.)
Monetary PolicyRates of Inflation, Interest Rates, Exchange Rates etc.
Investment Incentives Offered - Grants, etc.
Legislation - Monopolies, Competition, Environmental etc.
Wage Controls
Duties, Tariffs etc.
F. COMPOSITION OF SHAREHOLDERS
Is there anything to be gained from a company knowing the composition of its shareholders.
Generally, it is useful as it may assist the company in framing its policy/approach in a number
of areas e.g.
Dividend Policy
Attitude to Risk/Gearing
Unwelcome Bid - support critical
How Performance is Measured
Recent Shareholder Changes => Price Movements
Page 17
Study Unit 2
Corporate Governance
Contents
A. Introduction
B. Best Practice
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A. INTRODUCTION
Corporate Governance can be defined as the system by which organizations are directed and
controlled.
B. BEST PRACTICE
Financial aspects of corporate governance have introduced a “Code of Best Practice”
Some of the main recommendations are:
1. The roles of chairman and chief executive should generally be separate. Whether or not
the roles are combined, a senior non-executive director should be identified.
2. Non-executive directors should comprise at least one-third of the membership of the
board and the majority of non-executive directors should be independent.
3. Boards should establish a Remuneration Committee, made up of independent non-
executive directors, to develop policy on remuneration and devise remuneration
packages for individual executive directors.
4. Each company should establish an Audit Committee of at least three non-executive
directors, at least two of them independent. The audit committee should keep under
review the overall financial relationship between the company and its auditors, to
ensure a balance between the maintenance of objectivity and value for money.
5. Disclosure of directors’ total emoluments, including pension contributions and stock
options. Separate figures for salary and performance-related elements and the basis on
which performance is measured.
6. Directors should report on internal controls.
7. The accounts should contain a statement of how the company applies the corporate
governance principles and explain the policies, including any circumstances justifying
departure from best practice.
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Study Unit 3
Investment Appraisal - Introduction
Contents
A. Nature and Stages of Investment Appraisal
B. Investment Appraisal Techniques
______________________________________________________________
C. Relevant Cash Flows
Page 20
A. NATURE AND STAGES OF INVESTMENT APPRAISAL
Nature
Replacement Investment
Investment for Expansion
Product Improvement/Cost Reduction
New Ventures
Strategic Investment may satisfy overall objectives but might not satisfy normal
financial criteria.
Statutory Requirements/Employee or Community Welfare may not produce a positive
NPV but may be essential.
Stages
1. Identification.
Ideas may generate from all levels of the organisation. Initial screening may reject
those that are unsuitable - technically/too risky/cost/incompatible with company
objectives etc. The remainder are investigated in greater depth - assumptions required
regarding sales, costs etc./collect relevant data. Also consider alternative methods of
completing projects.
2. Evaluation
Identification of expected incremental cash flows. Measure against some agreed
criteria - Payback/Accounting Rate of Return/Net Present Value/Internal Rate of Return.
Consider effect of different assumptions - Sensitivity Analysis or other techniques.
Consultation with other interested parties (particularly if great organisational and/or
technological change) - accountants/production staff/marketing staff/trade unions etc.
3. Authorisation
Submit to appropriate management level for approval/rejection/modification. The
larger the expenditure, the higher the management level.. Reappraise investment -
reassess assumptions and cash flows (e.g. check for any "bias" in estimates)/evaluate
how investment fits within corporate strategy and capital constraints (if any). If
budgetary or other constraints exist rank as to how essential (financial and non-financial
considerations).
4. Monitor & Control
Regularly review to ascertain if any major variations from cash flow estimates. If
significant variations - consider continuation v abandonment. Post audits (one or two
years after implementation!) useful - encourage more realistic estimates at evaluation
stage/help to learn from past mistakes/basis for corrective action to existing
investments.
Page 21
B. INVESTMENT APPRAISAL TECHNIQUES
There are many techniques for evaluating investment proposals. These can be broadly
classified as:
Non-Discounting
Payback Period
Accounting Rate of Return (ARR)
Discounted Cash Flow
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period
Definition: The time taken in years for the project to recover the initial investment.
The shorter the payback, the more valuable the investment.
Example
An initial investment of RWF50,000 in a project is expected to yield the following cash
flows:
Cash Flow
Year 1 RWF20,000
Year 2 RWF15,000
Year 3 RWF10,000
Year 4 RWF10,000
Year 5 RWF8,000
Year 6 RWF5,000
The Payback Period is 3 1/2 years - the cash inflows for that period equal the initial outlay of
RWF50,000.
Is 3 1/2 years acceptable? - it must be compared to the target which management has set. For
example, if all projects are required to pay back within, say, 4 years this project is acceptable;
if the target payback is 3 years then it is not acceptable.
Although of limited use it is the most popular technique.
It is often used in conjunction with other techniques.
It may be used as an initial screening device.
Advantages
Calculation is simple.
It is easily understood
It gives an indication of liquidity.
It gives a measure of risk - later cash flows are more uncertain.
It considers cash flow rather than profit – profit is more easily manipulated.
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Disadvantages
Cash flows after the Payback Period are ignored.
It ignores the timing of the cash flows (“Time Value of Money”).
No clear decision is given in an accept/reject situation.
Accounting Rate of Return (ARR)
Definition:
ARR =
Average Annual Accounting Profits
= %
Initial Investment
(Alternative definitions may be used occasionally - e.g. ‘Average Investment’ may replace ‘Initial Investment’).
The Accounting Rate of Return is based upon accounting profits, not cash flows.
Example
A company is considering an investment of RWF100,000 in a project which is expected to
last for 4 years. Scrap value of RWF20,000 is estimated to be available at the end of the
project. Profits (before depreciation) are estimated at:
Year 1 RWF50,000
Year 2 RWF50,000
Year 3 RWF30,000
Year 4 RWF10,000
Find the Accounting Rate of Return
Total profits before
depreciation
RWF140,000
Less total depreciation
(RWF80,000)
Total accounting profits
RWF60,000
Average Annual Profits (4
years)
RWF60,000
= RWF15,000
4
ARR =
RWF15,000
= 15%
RWF100,000
To ascertain if the project is acceptable the ARR must be compared to the target rate which
management has set. If this target is less than 15% the project is acceptable; if greater than
15% the project is unacceptable.
Advantages
Calculation is simple.
It is based upon profits, which is what the shareholders see reported in the annual
accounts.
It provides a % measure, which is more easily understood by some people.
It looks at the entire life of the project.
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Disadvantages
It is a crude averaging method.
It does not take account of the timing of the profits.
It is based on accounting profit which can be manipulated by creative accounting.
Shareholders’ wealth is determined ultimately by cash.
Various definitions are used.
Discounted Cash Flow (DCF)
The main shortcomings of the non-discounting techniques of Investment Appraisal can be
summarised as:
they do not allow for the timing of the cash flows/accounting profits
they do not evaluate cash flows after the payback period
Discounted Cash Flow addresses these shortcomings, by allowing for the “time-value of
money” and looking at all cash flows. So what is discounting? Discounting can be regarded
as Compound Interest in reverse. To understand Compound Interest let us take a simple
example.
Example
If you invest RWF100 and are guaranteed a return of 10% per annum we can work out how
much your investment is worth at the end of each year.
Present Value
Future Value
End of Year 1 RWF100 x (1.10)
=
RWF110.00
End of Year 2 RWF100 x (1.10)(1.10)
=
RWF121.00
End of Year 3 RWF100 x
(1.10)(1.10)(1.10)
=
RWF133.10
For simplicity this can be re-written
End of Year 1 RWF10 x (1.10) 1
=
RWF110.00
End of Year 1 RWF10 x (1.10) 2
=
RWF121.00
End of Year 1 RWF10 x (1.10) 3
=
RWF133.10
In general terms we can express this as:
PV (1 + i) n = FV
Where: PV = Present Value
i = Rate of Interest
n = Number of Years/Periods
FV = Future Value
We are starting with a Present Value (RWF100) and depending on the rate of interest used
(10%) and the duration of the investment (n) we can find the Future Value, using Compound
Interest.
Page 24
As mentioned above, Discounting is Compound Interest in reverse. Thus, using the
statement
PV (1 + i) n = FV we can turn it around to get
FV 1
--------- = PV or FV x ------- = PV
(1 + i) n (1 + i) n
Again, taking the example above, if you are given the Future Value and asked to find the
Present Value
Future Value
Present Value
End of Year 1
RWF110.00 x
1
= RWF100
(1.10) 1
End of Year 2
RWF121.00 x
1
= RWF100
(1.10) 2
End of Year 3
RWF133.10 x
1
= RWF100
(1.10) 3
In effect, what you are doing is ascertaining the amount which must be invested now at 10%
per annum to accumulate to RWF110 in a years time (or RWF121.00 in two years; or
RWF133.10 in three years).
In converting the Future Value to a Present Value it is multiplied by a factor (Discount
Factor), which varies depending on the discount rate (i) selected and the number of
years/periods (n) into the future. Fortunately, it is not necessary to individually calculate each
factor, as these can be easily obtained from DISCOUNTING TABLES (attached). These
tables supply a factor for all % rates and periods.
The previous example is reproduced using the Discounting Tables, at 10%
Future Value
Present Value
End of Year 1
RWF110.00 x
0.909
=
RWF100
End of Year 2
RWF121.00 x
0.826
=
RWF100
End of Year 3
RWF133.10 x
0.751
=
RWF100
The compounding and discounting features shown above relate to single payments or receipts
at different points in time. Similar calculations can be done for a series of cash flows, where
a single present value can be calculated by aggregating the present value of several future
cash flows.
Page 25
ANNUITIES
An annuity is where there is a series of cash flows of the same amount over a number of
years.
The present value of an annuity can be found by discounting the cash flows individually (as
above).
Example
Using a discount rate of 10% find the present value of an annuity of RWF2,000 per annum
for the next four years, with the first payment due at the end of the first year.
Year Value
Cash Flow
Disc. Factor
Present
10%
1
RWF2,000
0.909
RWF1,819
2
RWF2,000
0.826
RWF1,653
3
RWF2,000
0.751
RWF1,502
4
RWF2,000
0.683
RWF1,366
Net Present
Value
RWF6,340
However, a much quicker approach is to multiply the annual cash flow by an annuity factor.
The annuity factor is simply the sum of the discount factors for each year of the annuity. In
this example the annuity factor is 3.17 (0.909 + 0.826 + 0.751 + 0.683). If you multiply the
RWF2,000 by the annuity factor of 3.17 you get RWF6,340, which is the same Net Present
Value as the longer approach adopted in the example. Annuity factors are available for all %
rates and periods in Annuity Tables (attached) and you will see the factor of 3.17 at period 4
under the 10% column.
In the above example the first receipt arose at the end of the first year. If this is not the case
you can still use the Annuity Tables but you must modify your approach. The present value
can be found by multiplying the annual cash flow by the annuity factor for the last date of the
annuity less the annuity factor for the year before the first payment.
Example
Using a discount rate of 10% find the present value of an annuity of RWF5,000 per annum,
which starts in year 5 and ends in year 10.
Annuity Factor Years 1 – 10
6.145
Annuity Factor Years 1 – 4
3.170
Annuity Factor Years 5 – 10
2.975
Therefore, the Present Value is RWF5,000 x 2.975 = RWF14,875.
Page 26
PERPETUITIES
A perpetuity is an annuity which continues forever. To find the present value of a perpetuity
which starts at year 1 you use the following simple formula:
PV =
a
i
Where: a = amount of the perpetuity
i = the discount rate
Example
The present value of a perpetuity of RWF1,000 per annum, which commences at the end of
year 1, at a discount rate of 10% is:
PV =
a
=
RWF1,000
= RWF10,000
i
0.10
If the perpetuity commences at a time other than year 1 a further calculation is required.
Example
Using a discount rate of 10% find the present value of a perpetuity of RWF1,000 per annum,
if it commences (a) end of year 1, or (b) end of year 6.
(a)
PV =
a
=
RWF1,000
= RWF10,000
i
0.10
(b) We can find this in two stages.
The PV in year 5 of a perpetuity of RWF1,000 from year 6 onwards is
PV =
a
=
RWF1,000
= RWF10,000
i
0.10
We must now convert this to a year 0 value, by discounting the RWF10,000 (year 5
value) at 10%.
PV = RWF10,000 x .621(Discount Factor for year 5 @ 10%) = RWF6,210
Net Present Value (NPV)
This technique converts future cash flows to a common point in time (Present Value), by
discounting them. The present values of the individual cash flows are aggregated to arrive at
the Net Present Value (NPV).
The NPV figure represents the change in shareholders' wealth from accepting the project. It
produces an absolute value (RWF) and therefore, the impact of the project is identified.
Page 27
For independent projects the decision rule is:
Accept if the NPV is positive
Reject if the NPV is negative
For mutually exclusive projects (where it is only possible to select one of many choices) -
calculate the NPV of each project and select the one with the highest NPV.
In calculating the NPV, the selection of a discount rate is vitally important. It is generally
taken as the cost to the business of long-term funds used to fund the project.
Example 1 - Independent Project
A company is considering a project, which is expected to last for 4 years, and requires an
immediate investment of RWF20,000 on plant. Inflows are estimated at RWF7,000 for each
of the first two years and RWF6,000 for each of the last two years. The company's cost of
capital is 10% and the plant would have zero scrap value at the end of the 4 years.
Calculate the NPV and recommend if the project should be accepted.
Year
Cash Flows
Disc. Factor 10%
Present Value
0
(20,000)
1.0
(20,000)
1
7,000
.909
6,364
2
7,000
.826
5,785
3
6,000
.751
4,508
4
6,000
.683
4,098
Net Present Value
+755
The project should be accepted as it produces a positive NPV. This indicates that the project
provides a return in excess of 10% (the discount rate used).
Example 2 - Mutually Exclusive Projects
A company has RWF100,000 to invest. It is considering two mutually exclusive projects
whose cash flows are estimated as follows:
Year
Project A
Project B
0
(100,000)
(100,000)
1
50,000
70,000
2
60,000
50,000
3
40,000
30,000
Which project should the company select if its cost of capital is 10%.
Page 28
Year
Disc Factor
10%
Pres Value
Pres.
Value
Project A
Project
B
0
1.0
(100,000)
(100,000
)
1
.909
45,450
63,630
2
.826
49,560
41,300
3
.751
30,040
22,530
Net Present Value
+ 25,050
+ 27,460
Project B should be selected as it has the higher NPV.
Advantages
Correctly accounts for the time value of money.
Uses all cash flows.
Is an absolute measure of the increase in wealth
Consistent with the idea of maximising shareholder wealth i.e. telling managers to
maximise NPV is equivalent to telling them to maximise shareholder wealth.
It can be used for benchmarking in post-audit review.
Disadvantages
Difficult to estimate cost of capital.
Not easily interpreted by management i.e. managers untrained in finance often have
difficulty in understanding the meaning of a NPV.
Internal Rate of Return (IRR)
The NPV method produces an absolute value (RWF). A positive NPV indicates that the
project earns more than the required rate of return and should be accepted; a negative NPV
indicates a return less than the required rate and rejection of the proposal.
The IRR is another discounted cash flow technique. It produces a percentage return or yield,
rather than an absolute value. It determines the discount rate at which the NPV would be zero
-where the present value of the outflows = present value of the inflows. It can, therefore, be
regarded as the expected earning rate of the investment.
If the IRR exceeds the company's target rate of return it should be accepted. If less than the
target rate of return it should be rejected.
The IRR can be estimated by a technique called 'Linear Interpolation’. This requires the
following steps:
1. Calculate two NPV's, using two different discount rates.
2. Any two rates can be used but, ideally, one calculation will produce a positive NPV and
the other a negative NPV.
Page 29
3. Choosing the discount rate is a 'shot in the dark.' However, if the first attempt produces
a positive NPV, generally a higher discount rate will be required to produce a negative
NPV and vice versa.
Example 3 - Internal Rate of Return
Using the cash flows from example 1, a discount rate of 10% produced a positive NPV of
RWF755. In an attempt to find a negative NPV try a higher rate of 15%.
Year
Cash Flows
Disc. Factor 15%
Present
Value
0
(20,000)
1.0
(20,000)
1
7,000
.869
6,083
2
7,000
.756
5,292
3
6,000
.658
3,948
4
6,000
.572
3,432
Net Present Value
- 1,245
We now know that the real rate of return is > 10% (+ NPV) but < 15% (- NPV). The IRR is
calculated by 'Linear Interpolation.' It will only be an approximation of the actual rate as it
assumes that the NPV falls in a straight line (linear) from + RWF755 at 10% to - RWF1,245
at 15%. The NPV, in fact, falls in a curved line but nevertheless the interpolation method is
accurate. In this example the IRR is:
10% +
755
x (15% - 10%) = 11.9%
755 + 1,245
Advantages
Often gives the same decision rule as NPV.
More easily understood than NPV.
Doesn’t require an exact definition of r in advance.
Considers the time value of money.
Considers all relevant cash flows over a projects life.
Disadvantages
Relative, not absolute return - ignores the relative size of investments.
If a change in the sign of the cash flow pattern, one can have multiple IRR’s.
NPV is much easier to use for benchmarking purposes in a post-audit situation then
IRR.
It looks at projects individually – the results cannot be aggregated.
It cannot cope with interest rate changes.
DCF Techniques V Non-DCF Techniques
Page 30
DCF techniques have advantages over non-DCF techniques:
1. They allow for the 'time value of money.'
2. They use cash flows, which result from an investment decision. The ARR technique is
affected by accounting conventions (e.g. depreciation, deferred expenditure etc.) and
can be susceptible to manipulation.
3. They take account of all cash flows. The Payback Period disregards cash flows after the
payback period.
4. Risk can be easily incorporated by adjusting the discount rate (NPV) or cut-off rate
(IRR).
Advantages of IRR Compared to NPV
It gives a percentage rate of return, which may be more easily understood by some.
To calculate the IRR it is not necessary to know in advance the required rate of return or
discount rate, as it would be to calculate the NPV.
Advantages of NPV Compared to IRR
It gives an absolute measure of profitability (RWF) and hence, shows immediately the change
in shareholders' wealth, this is consistent with the objective of shareholder wealth
maximisation. The IRR method, on the other hand, ignores the relative size of investments.
It always gives only one solution. The IRR can give multiple answers for projects with non-
conventional cash flows (a number of outflows occur at different times).
It always gives the correct ranking for mutually exclusive projects, whereas the IRR
technique may give conflicting rankings.
Changes in interest rates over time can easily be incorporated into NPV calculations but not
IRR calculations.
C. RELEVANT CASH FLOWS
In an examination question you will be given much information regarding the impact on the
organisation of a new investment proposal etc. Some of the information may not be relevant
to the decision and it is important that you are able to figure out which flows are relevant and
should be included in an investment appraisal calculation.
The following pointers and simple examples should assist in coping with the various items
which are presented to you in an examination:
1. CASH FLOWS v PROFITS
Shareholders’ wealth is based upon the movement of cash. Accounting policies and
conventions have no effect on the value of the firm and, thus, pure accounting or book
entries should be excluded from calculations. The most common of these is
depreciation, which should be excluded as it is a non-cash item.
Page 31
Example
A company is considering investing in a new project which requires the expenditure of
RWF12m immediately on plant. The project will last for 5 years and at the end of the
project the plant is expected to have a scrap value of RWF2m. The company normally
depreciates plant over 5 years using the straight-line method.
In this simple illustration the last sentence concerning depreciation can be ignored
completely as it does not affect the cash flows. It would be incorrect to show an
outflow of RWF2m. p.a. for depreciation. The relevant cash flows are the outflow of
RWF12m. on plant in year 0 and the inflow of RWF2m. as scrap in year 5.
2. CASH FLOWS SHOULD BE INCREMENTAL
The effect of a decision on the company’s overall cash flows must be considered in
order to determine correctly the changes in shareholders’ wealth.
Example
A company is considering a proposal which would require (amongst other cash flows)
the purchase of a new machine for RWF100,000. If it proceeds with the proposal it
could dispose of an existing machine which has a book written-down value of
RWF30,000. This machine could be sold immediately for RWF20,000 instead of
waiting for 5 years as planned and selling it for scrap value of RWF5,000.
Should the existing machine be taken into account in evaluating the new proposal ?
Undertaking the new proposal requires the purchase of a new machine which, in turn,
enables the existing machine to be sold, thereby generating an inflow for the
organisation. Thus, the cash flows associated with the existing machine are relevant in
evaluating the new proposal. The present written-down value of RWF30,000 is not
relevant as it is merely an accounting book entry. The sale proceeds of RWF20,000 is
obviously relevant as is the loss of RWF5,000 scrap value which the company would
have received in year 5 if the new proposal was not undertaken.
The relevant cash flows are:
Year
New Machine
Sale – Existing
Machine
Scrap
Foregone
Existing
Machine
Net Cash
Flows
0
(100,000)
20,000
(80,000)
1
2
3
4
5
(5,000)
(5,000)
3. OVERHEADS
Variable overheads will always be relevant in decision making. However, depending
on the situation fixed overheads may or may not be relevant. If fixed overheads are
Page 32
allocated on some arbitrary basis (e.g. on the basis of machine or labour hours) they are
not usually relevant. However, if the total fixed costs of the organisation are affected by
the proposal then they are relevant and should be incorporated as a cash flow.
Example
A company is considering the introduction of a new product to its existing range. Each
product will take two hours labour to manufacture. Fixed overheads are allocated
within the company on the basis of RWF1 per labour hour. Sales of the new product are
estimated at 12,000 units per annum. If the new product is manufactured the company
will have to employ an additional supervisor at a salary of RWF20,000 per annum.
The allocation of fixed overheads at the rate of RWF2 per unit has no effect on cash
flows and is not relevant. It is merely an accounting entry for costing or control
purposes.
The additional supervisory salary of RWF20,000 per annum is relevant, as it is incurred
solely as a result of the new proposal and must be taken into account.
Example
A company is considering the introduction of a new product to its existing range. It
currently rents a factory at an annual rental of RWF100,000. Only three-quarters of the
factory is used on production of its existing range of products and the remaining quarter
of the factory would be adequate in which to produce the new product. However, it will
be necessary to rent additional warehouse space at RWF20,000 per annum in order to
store the new production.
To produce the new product the organisation can utilise factory space which is currently
idle. No additional factory rental costs will be incurred by the company and it would
be incorrect to show an annual cash outflow of RWF25,000 (one-quarter) in respect of
rent when evaluating the new proposal.
On the other hand, the additional warehouse rent of RWF20,000 per annum is incurred
solely as a result of the new proposal and must be taken into account in the evaluation
process.
4. SUNK COSTS
Sunk costs (or past costs) are costs which have already been incurred. When making an
investment decision sunk costs can be ignored and you need only consider future
incremental cash flows.
Example
A company is considering the introduction of a new type of widget. Over the past two
years it has spent RWF100,000 on research and development work.
The RWF100,000 spent on research and development is a sunk cost and can be ignored
when evaluating the future inflows and outflows of the proposal. One way of looking at
it is that whether you decide to go ahead with the new proposal or not this will not alter
the position of the RWF100,000 - it has already been incurred.
Page 33
Example
A company uses a special raw material, named Nylon, in production. It currently has
5,000 tons in stock. The company is considering a once-off project which would use
2,000 tons of Nylon. The original cost of the Nylon in stock was RWF20 per ton; the
current purchase price is RWF17 per ton and its resale value is RWF10 per ton.
What is the relevant cost of the Nylon for the project if:
(a) It is regularly used by the company?
(b) It is no longer used and any remaining stock will be sold off immediately?
Solution:
(a) The original cost of RWF20 per ton is not relevant. The 2,000 tons used on this
project are taken out of stock and must be replaced at the current purchase price,
as the Nylon is regularly used by the company. Thus, current purchase price is
the relevant cost - 2,000 tons @ RWF17 = RWF34,000.
(b) Again, the original cost of RWF20 per ton is not relevant. If the company does
not use the existing stock in the new project the next best use is to dispose of it at
RWF10 per ton, as it is no longer used in production. Thus, current resale value
is the relevant cost - 2,000 tons @ RWF10 = RWF20,000.
5. OPPORTUNITY COSTS
The use of resources for a new project may divert them from existing projects, thereby
causing opportunity costs. These opportunity costs must be taken into account in
evaluating any new project.
Example
A company is considering the introduction of a new range of advanced personal
computer, which will be very competitively priced. While accepting that the new
machine is vital to remain competitive, the marketing manager has estimated that sales
of existing models will be reduced by 100 units per annum for the next three years as a
consequence. The existing model sells for RWF3,000 and variable costs are RWF1,750
per unit.
In evaluating the introduction of the new advanced machine, the lost contribution from
reduced sales of existing models must be included as an opportunity cost. In this case
the opportunity cost is RWF125,000 [100 units x (RWF3,000 - RWF1,750)] per annum
for the next three years.
6. INTEREST COSTS
In many examination questions you will be presented with all the costs of the proposed
project. These may be presented in the form of a standard Profit & Loss Account. One
of these costs may be ‘Interest.’ The figure for interest should not be included as a
Page 34
relevant cost because the cost of finance, no matter what its source, is encompassed
within the discount rate. Therefore, to include the annual interest charge as a relevant
cost and to also discount the cash flows would result in double counting.
7. WORKING CAPITAL
Where the project requires an investment of, say RWF50,000, for working capital it
should be remembered that working capital revolves around continuously in the project
(e.g. purchase of raw materials, which are used to manufacture goods, sold and
eventually generate cash to enable the purchase of more raw materials etc.. and
continuously repeat the cycle). Thus, the RWF50,000 flows back into the organisation
once the project ceases. In this example, if the project has a life of five years the cash
flows relating to working capital are:
Year Working Capital
0 (50,000)
5 50,000
Page 35
Study Unit 4
Investment Appraisal Impact of Taxation
Contents
A. Introduction
B. Corporation Tax
C. Capital Allowances
D. Timing of Taxation Effects
E. Worked Examples
Page 36
A. INTRODUCTION
To appraise fully an investment, management must take account of the impact of taxation, as
it is the after-tax cash flows that are relevant to decision making.
As a result of accepting a project tax payments or savings will, generally, be made by the
company. These relate to:
1. Corporation Tax payments on profits.
2. Tax benefits due to capital allowances granted on certain expenditure.
B. CORPORATION TAX
Annual cash inflows from a project will cause an increase in taxable profits and, hence, a tax
payment. Annual cash outflows (e.g. cost of materials, labour etc.) will reduce taxable profits
and yield tax savings. However, tax payments or savings can be based upon the net cash
inflows or outflows each year.
One can assume that an annual cash flow (inflow or outflow) will produce a similar change in
taxable profits, unless the exam question specifically indicates otherwise. For example, you
may be told that a particular item of expenditure (say, a contract termination payment of
RWF100,000) is not allowable for tax purposes. In this instance, the RWF100,000 must be
shown as an outflow of the project but it is ignored when calculating the taxation effect.
It is important to appreciate that the taxation payment or saving is the cash flow multiplied by
the rate of Corporation Tax. For example, if the net cash inflow in a particular year is
RWF50,000 and the rate of Corporation Tax is 40% an outflow of RWF20,000 (RWF50,000 x
40%) is shown in the taxation column.
C. CAPITAL ALLOWANCES
The Revenue does not allow depreciation charges as a deduction in calculating the tax
payable. However, it does grant capital allowances, which can be quite generous. These
allowances on capital items can be set-off against taxable profits to produce tax savings (i.e.
cash inflows).
The capital allowances can take various forms. The most common are:
1. 100% initial allowance, whereby an allowance equivalent to the full cost of the item is
available up-front.
2. A writing-down allowance of, say, 25% per annum on a straight line basis. This
means that the benefit of the allowance is spread equally over 4 years.
3. A writing-down allowance of, say, 25% per annum on a reducing balance basis. This
means that the allowance is spread over a number of years but on a reducing basis.
25% of the expenditure is allowable in the first year (as under number 2) and a reducing
allowance thereafter.
Page 37
Again, it is important to appreciate that the cash flow effect is the capital allowance
multiplied by the rate of Corporation Tax. For example, if the capital expenditure (which
qualifies for 100% allowances) in a particular year is RWF50,000 and the rate of Corporation
Tax is 40% then a saving of RWF20,000 (RWF50,000 x 40%) is shown in the taxation
column.
The eventual sale of capital items will usually cause a balancing charge or a balancing
allowance, which must also be taken into account in the project appraisal.
D. TIMING OF TAXATION EFFECTS
Unless specifically advised to the contrary in an examination, assume that there is a time lag
of one year between a cash flow and the corresponding taxation effect. Thus, expenditure on
a capital item in year 0 will usually be accompanied by a tax saving in year 1.
E. WORKED EXAMPLES
Example 1
A company is considering a new project. It must purchase plant and machinery for
RWF48,000, which qualifies for 100% initial allowance. The project will generate net cash
inflows of RWF20,000 per annum before tax for three years. Corporation Tax is 40% and the
company makes large taxable profits from its existing operations. The after-tax cost of
capital is 10%.
The phrase ‘...the company makes large taxable profits from its existing operations’ is very
significant as it is an indicator that the taxation advantage of the capital allowance can be
utilised at the earliest opportunity, by reducing the existing tax liability.
Year
Plant
Profits
Taxation
Net C
Flows
D.F. – 10%
Pres.
Value
0
(48,000)
(48,000)
1.00
(48,000)
1
20,000
19,200
39,200
0.909
35,633
2
20,000
(8,000)
12,000
0.826
9,912
3
20,000
(8,000)
12,000
0.751
9,012
4
(8,000)
(8,000)
0.683
(5,464)
1,093
As the project produces a positive NPV it should be accepted.
Page 38
Example 2
Using the same data as Example 1 but now due to the nature of the expenditure assume that
the company can only claim a 25% per annum writing down allowance on a straight line
basis.
Year
Plant
Profits
Taxation
Net C
Flows
D.F. – 10%
Pres.
Value
0
(48,000)
(48,000)
1.00
(48,000)
1
20,000
4,800
24,800
0.909
22,543
2
20,000
(3,200)
16,800
0.826
13,877
3
20,000
(3,200)
16,800
0.751
12,617
4
(3,200)
(3,200)
0.683
(2,186)
(1,149)
Note: The year 1 figure under the Taxation column is the first years capital allowance
(RWF48,000 x 25% = RWF12,000) at the tax rate of 40% = RWF4,800.
The figure for years 2-4 consists of profits of RWF20,000 less capital allowance
(RWF12,000) multiplied by the tax rate of 40% = RWF3,200 payment.
Now due to the delay in receiving the benefit of the capital allowances they are not as
valuable (“Time Value of Money) as in Example 1 and the project produces a negative NPV.
It should, therefore, be rejected.
Example 3
In Examples 1 and 2 we have assumed that the company is in a tax paying position and can
utilise the allowances as early as possible. However, if the company has tax losses or only
limited taxable profits from its existing operations this will affect the timing of the tax
savings.
A company is considering a project which will last for four years and produce annual net cash
inflows of RWF20,000. It must purchase a new machine for RWF45,000. The machine
qualifies for a 100% initial allowance and will have a scrap value of RWF8,000 at the end of
the project. Working capital of RWF12,000 is required. Corporation Tax is 40% and the
company earns no profits or losses from its other operations. The after-tax cost of capital is
10%.
While the machine qualifies for 100% allowances the company is unable to utilise this
initially as it is not currently in a tax paying position. As a result, it will have to spread the
advantage of the allowance by setting them off against the profits of the new project.
Page 39
The first task is to calculate the tax payments:
Year 1
Year 2
Year 3
Year
4
Cash Inflows
20,000
20,000
20,000
20,000
Capital Allowance
(20,000)
(20,000)
(5,000)
--
Scrap
8,000
Taxable
Nil
Nil
15,000
28,000
Tax @ 40%
6,000
11,200
Note: The capital allowances are set-off against the cash inflows of years 1 - 3.
As capital allowances are claimed in full over years 1-3, when the machine is sold for
RWF8,000 scrap in year 4 this generates a balancing charge.
The tax payments can now be incorporated in the main cash flow schedule.
Year
Machine
W.Cap
Profits
Taxation
Net C
Flows
D.F. –
10%
Pres.
Value
0
(45,000)
(12,000)
(57,000)
1.00
(57,000)
1
20,000
20,000
0.909
18,180
2
20,000
20,000
0.826
16,520
3
20,000
20,000
0.751
15,020
4
8,000
12,000
20,000
(6,000)
34,000
0.683
23,222
5
(11,200)
(11,200)
0.621
(6,955)
8,987
As the project produces a positive NPV it should be accepted.
Example 4
A company is considering a new project. It must purchase equipment for RWF80,000. Due
to the nature of the equipment it qualifies for a writing down allowance of 25% per annum on
a reducing balance basis. The project will generate net cash inflows of RWF35,000 per
annum for four years. Corporation Tax is 40% and the after-tax cost of capital is 10%. The
equipment will have no scrap value at the end of the project. Working capital of RWF10,000
is required.
Firstly, calculate the Capital Allowances available:
Year 1
Plant
80,000
Capital Allowance (80,000 x 25%)
20,000
Written Down Value
60,000
Year 2
Written Down Value
60,000
Capital Allowance (60,000 x 25%)
15,000
Written Down Value
45,000
Page 40
Year 3
Written Down Value
45,000
Capital Allowance (45,000 x 25%)
11,250
Written Down Value
33,750
Year 4
As the plant is disposed of in year 4 for zero value there is a Balancing Allowance of
RWF33,750 (written down value for tax purposes) available. Thus, over the four years,
allowances totalling RWF80,000 have been claimed.
Note
A quick method of calculating the capital allowances on a reducing balance basis is to take
the previous years capital allowance and multiply it by 75% (100% minus the rate at which
the allowance is available). Thus, in this example:
Year 1 Capital Allowance
20,000
Year 2 Allowance (20,000 x 75%)
15,000
Year 3 Allowance (15,000 x 75%)
11,250
Total Allowances Claimed Years 1-3
46,250
Year 4 Balancing Allowance (80,000 – 46,250)
33,750
Total Allowances Claimed
80,000
Secondly, calculate the tax payable as follows:
Year 1
Year 2
Year 3
Year 4
Cash Inflows
35,000
35,000
35,000
35,000
Capital Allowances
(20,000)
(15,000)
(11,250)
(33,750)
Taxable
15,000
20,000
23,750
1,250
Tax @ 40%
6,000
8,000
9,500
500
Thirdly, incorporate the tax payments in the main cash flow schedule:
Year
Machine
W.Cap
Profits
Taxation
Net C
Flows
D.F. –
10%
Pres.
Value
0
(80,000)
(10,000)
(90,000)
1.00
(90,000)
1
35,000
35,000
0.909
31,815
2
35,000
(6,000)
29,000
0.826
23,954
3
35,000
(8,000)
27,000
0.751
20,277
4
10,000
35,000
(9,500)
35,500
0.683
24,247
5
(500)
(500)
0.621
(310)
9,983
As the project produces a positive NPV it should be accepted.
Page 41
Study Unit 5
Investment Appraisal Impact of Inflation
Contents
A. Introduction
B. Real v Nominal/Money Discount Rates
C. Handling Different Rates of Inflation
D. General Considerations - Inflation
Page 42
A. INTRODUCTION
To illustrate how inflation should be handled in Investment Appraisal we shall take a simple
example, under two different scenarios an environment with no inflation and an
environment where inflation is present:
1. No Inflation suppose you are considering the purchase of a television for RWF1,000.
I am undertaking a simple one-year project and I require RWF1,000. I approach you
and guarantee you a return of 5% on your investment. Your investment will have grown
to RWF1,050 at the end of the year and, in theory, because there has been no inflation
the price of the television should still be RWF1,000. Thus, you have made RWF50 in
the process and also got your television. Therefore, you have achieved a real return of
5%.
2. Inflation (assume 20% per annum) using the same example as number 1. If you
had given me the RWF1,000 this would be worth RWF1,050 at the end of the year but
the price of the television would probably have risen to RWF1,200 (+20%) because of
inflation, so you would not be able to afford it. The value of your savings has been
eroded because of inflation you have got a return of 5% in money terms but inflation
has been running at 20%. Therefore, you have not got a real return of 5% - this is only
a nominal (or money) return. In this instance, with inflation of 20% you would
require a nominal (money) return of 26% in order to obtain a real return of 5%.
Obviously, there is a link between the nominal (or money) rate of return (26%), the real rate
of return (5%) and the rate of inflation (20%). This relationship may be expressed as
follows:
(1 + Real Rate) =
(1 + Nominal Rate)
(1 + Inflation Rate)
Using the figures in the above example:
1.26
= 1.05
1.20
If you have any two variables you can find the third. For example, if you require a real return
of 5% from an investment and you estimate inflation to be 20% you can work out the
required nominal return at 26% as follows:
(1 + Real Rate)
x
(1 + Inflation Rate)
=
(1 + Nominal Rate)
(1.05)
x
(1.20)
=
(1.26)
Page 43
B. REAL v NOMINAL (MONEY) DISCOUNT RATES
Now that you know the difference between a real and a nominal rate of return (or discount rate) which rate
should be used in discounting the cash flows of a project? This really depends on how the
cash flows are expressed. They can be stated either as:
1. Real Cash Flows – stated in today’s prices and exclude any allowance for inflation.
2. Nominal/Money Cash Flows these include an allowance for inflation and are stated
in the actual RWF’s receivable/payable.
As a very simple illustration, an examination question might state (amongst other things)
…….”materials for the project cost RWF10 per unit in terms of today’s prices. Inflation is
expected to run at the rate of 10% per annum and the project will last for three years.”
We can express the cash flows in either real or nominal terms:
Year
Real Cash Flows
Money Cash Flows
1
RWF10
RWF10 x (1.10)
=
RWF11.00
2
RWF10
RWF10 x (1.10) 2
=
RWF12.10
3
RWF10
RWF10 x (1.10) 3
=
RWF13.30
The rules for handling inflation are quite straightforward:
If the cash flows are expressed in real terms (today’s money), use the real discount rate.
If the cash flows are expressed in money terms (the actual number of RWF’s that will be
received/paid on the various future dates), use the nominal/money discount rate.
No matter which approach is used you should get the same result.
Example:
A company is considering a project which will last for three years. The initial cost is
RWF100,000 and cash inflows of RWF60,000, RWF50,000 and RWF40,000 respectively are
anticipated for the three years. These inflows are expressed in current values and do not
take account of any projected inflation. It is estimated that inflation will be 20% per annum
for the life of the project. The investment will have no residual value at the end of the
project. The company’s required rate of return in money terms is 26%.
First Approach – Real Cash Flows & Real Discount Rate
(1 + Real Rate) =
(1 + Nominal Rate)
(1 + Inflation Rate)
1.26
= 1.05
1.20
Page 44
Year
Real Cash Flows
Dis. Factor 5%
Present
Value
0
(100,000)
1.0
(100,000)
1
60,000
0.952
57,120
2
50,000
0.907
45,350
3
40,000
0.864
34,560
37,030
Second Approach – Money Cash Flows & Money Discount Rate
We already have a money rate (26%) but we need to re-express the cash flows in money
terms by inflating them at 20% per annum.
Year
Real Cash Flows
Money Flows
Dis. Factor
26%
Present
Value
0
(100,000)
(100,000)
1.0
(100,000)
1
60,000
x 1.20
= 72,000
0.794
57,168
2
50,000
x (1.20) 2
= 72,000
0.630
45,360
3
40,000
x (1.20) 3
= 69,120
0.499
34,491
37,019
Allowing for some rounding, the same answer is produced under each approach.
So which approach should be used? In most cases it is probably best to inflate the cash
flows to money cash flows and then discount at the money required rate of return. Among
the reasons for suggesting this are:
Different inflation rates may apply to different variables. For example, raw materials
may inflate at 5% per annum, labour at 3% per annum etc. Thus, in converting a money
rate to a real rate, which inflation rate do you divide by – 5% or 3% ?
When converting a money rate to a real rate you often end up with fractions. For
example, where the money rate of return is 15% and inflation is expected to be 5% per
annum, this translates to a real rate of 9.52%. This rate may be difficult to handle as
Discount Tables tend to be produced for whole numbers only.
When taxation is included in the appraisal capital allowances are based on original,
rather than replacement cost and do not change in line with changing prices. Therefore,
if the cash flows are left in terms of present day prices and discounted at the real
discount rate it would understate the company’s tax liability.
C. HANDLING DIFFERENT INFLATION RATES
Where different inputs inflate at different rates the best approach is to inflate each element by
the appropriate inflation rate and then to discount the net cash flows (which are now in
money terms) by the money rate of return.
Page 45
Example:
A company is considering a new project which would cost RWF60,000 now and last for four
years. Sales revenue is expected to be RWF50,000 per annum. Raw materials will cost
RWF10,000 in the first year and will rise thereafter by 5% per annum because of inflation.
Labour costs will be RWF15,000 in year 1 and agreement has just been concluded with the
trade union, whereby increases of 4% per annum will apply for the following three years. No
residual/scrap value will arise at the end of the project. Due to the current competitive
environment it will not be possible to increase selling prices.
The general rate of inflation is expected to be 8% per annum for the next few years. The
company’s required money rate of return is 15%. Should the project be undertaken?
Year
Investment
Sales
Material
Labour
Net
D.F
15%
Pres.
Value
(Fixed)
(+5%)
(+4%)
0
(60,000)
(60,000)
1.0
(60,000)
1
50,000
(10,000)
(15,000)
25,000
0.870
21,750
2
50,000
(10,500)
(15,600)
23,900
0.756
18,068
3
50,000
(11,025)
(16,224)
22,751
0.658
14,970
4
50,000
(11,576)
(16,873)
21,551
0.572
12,327
7,115
As the project produces a positive NPV it should be accepted.
D. GENERAL CONSIDERATIONS - INFLATION
Planning – more difficult
Project Appraisal – another complication
Interest Rates – higher nominal rates
Capitaladditional capital required
Borrowings – extra borrowings => increased financial risk for shareholders
Nature of Borrowings – long v short; fixed v floating; foreign borrowings?
Selling Prices – can costs be passed on???
Impact on Customers – delayed payment; bad debts; liquidations etc.
Page 46
BLANK
Page 47
Study Unit 6
Investment Appraisal Risk & Uncertainty
Contents
A. Introduction
B. Methods of Treating Risk & Uncertainty
Page 48
A. INTRODUCTION
Definition of Risk
(a) (i) Risk occurs where it is not known what the future outcome will be but where the
likelihood of various possible future outcomes may be assessed with some degree
of confidence, probably based on a knowledge of past or existing events. In other
words, probabilities of alternative outcomes can be estimated.
(ii) Uncertainty occurs where the future outcome cannot be predicted with a degree
of confidence from a knowledge of past or existing events, so that no probability
estimates are available.
Risk and uncertainty are the business risk of an investment.
(b) Business risk can be defined as the potential volatility of profits caused by the nature
and types of business operations.
There are three elements of business risk:
(i) The inherent risk of the industry or market itself
(ii) The stage of the product life-cycle
(iii) The proportion of fixed costs in total costs
B. METHODS OF TREATING RISK OR UNCERTAINTY
1. Adjust The Discount Rate
This method requires that risky projects should earn a higher return than that required
for ongoing operations. By adding a safety margin into the discount rate, what were
marginally profitable projects, i.e. the riskier projects, are less likely to have a positive
NPV.
If, for example, the companys cost of capital is 10% a premium of say, 5% might be
added for risk and the project evaluated using a discount rate of 15%. If the project still
produces a positive NPV at 15% it would be considered acceptable, even allowing for
its risk.
The main advantage of this method is that it recognises that risky projects should earn a
higher return to compensate for the additional risk.
The main drawback is in deciding the size of the premium to be added. Thus, it is
subjective and some may regard the method as unreliable.
Page 49
2. Payback Period Applying A Time Limit
In addition to requiring projects to yield a positive NPV when discounted at the cost of
capital, management may apply a payback period as a means of limiting risk. Thus,
projects may be required to:
Provide a positive NPV when discounted at, say 10%
and
Have a Payback Period of, say, 5 years or less
One of the drawbacks to this approach is that projects with very good long-term
prospects may be rejected because they do not offer the required return in the short-
term.
3. Sensitivity Analysis
The impact of changes in individual variables is measured to see the extent of the
leeway before a project would only just breakeven. What would have to happen to the
variable for the NPV to change to zero?
In this way the key variables are highlighted so that management is aware of the
dangers of incorrect estimating and can perhaps make contingency plans in the event of
this happening.
Example
Your company is considering a project with the following cash flows:
Year
Machinery
Running Costs
Savings
0
(11,000)
1
(2,000)
6,000
2
(3,000)
8,000
3
(4,000)
9,000
The cost of capital is 10%. You are asked if the project should be accepted and what is
the scope for error as some of the estimates of cash flow may be open to question.
Ignore taxation.
Firstly, work out the present value of the cash flows:
Year
PV -
Machinery
PV – Costs
PV – Savings
PV Cash
Flows
0
(11,000)
(11,000)
1
(1,818)
5,455
3,637
2
(2,479)
6,611
4,132
3
(3,005)
6,762
3,757
(11,000)
(7,302)
18,828
526
The project has a positive NPV and would appear to be acceptable.
Page 50
Secondly, check each of the variables (machinery, costs and savings) to see how
sensitive they are to change i.e. by how much can they alter before the NPV is just
zero. This can be done by relating the NPV to the present value of each of the
variables.
Machinery
526
= 4.8%
11,000
The cost of machinery could increase by 4.8%
Running Costs
526
= 7.2%
7,302
Running costs could increase by 7.2%
Savings
526
= 2.8%
18,828
Savings could reduce by 2.8%
If asked how sensitive the project is to changes in the cost of capital this can be found
by calculating the Internal Rate of Return (IRR). In the above example, the IRR is
12.5%. Thus, the cost of capital could increase by 25%, from the existing level of 10%,
before the NPV is just zero.
The conclusion is that savings are the most sensitive and particular attention must be
paid by management to the estimates of these as the margin for error is only 2.8%.
They could take measures in advance to ensure that they will be achieved e.g. by
insisting on fixed price contracts.
Some of the drawbacks to Sensitivity Analysis are:
It treats variables as if they are independent and does not consider the inter-
relationships that might exist between variables.
There is no measure of the probability of changes in any of the variables
occurring.
There is no automatic decision rule for managers. Managers do not know
whether their decisions should be altered because of the level of sensitivity of a
variable.
Page 51
4. Certainty Equivalent
The expected cash flows of the project are converted to riskless equivalent amounts.
The greater the risk of an expected cash flow, the smaller the certainty equivalent value
(for receipts) or the larger the certainty equivalent value (for payments).
Example:
Year
Cash
Flow
Certainty
Equivalent
D.F. 10%
Pres.
Value
0
(12,000)
(12,000)
1.0
(12,000)
1
7,000
x 90% =
6,300
0.909
5,727
2
5,000
x 80% =
4,000
0.826
3,304
3
5,000
x 70% =
3,500
0.751
2,629
(340)
The main drawback is that the adjustment to each cash flow is subjective.
5. Expected Values
Instead of just estimating individual cash flows for a project, probabilities could be
assigned to various outcomes and these could be used to find expected values.
Example
A company is considering the addition of a new product to its range. The marketing
manager has estimated sales for the next four years as:
Probability
Annual Sales (units)
.10
2,000
.30
4,000
.25
5,000
.20
7,000
.15
10,000
Once sales are established for the first year they will be maintained at that level.
Selling price and variable costs are estimated at RWF20 and RWF15 per unit
respectively. New machinery costing RWF70,000 must be purchased immediately and
this is expected to have a scrap value of RWF10,000 at the end of the project in four
years’ time. Additional fixed costs of RWF5,000 per annum will be incurred. The cost
of capital is 10%. Calculate the expected NPV.
Firstly, calculate the expected value of sales volume per annum.
Probability
Sales (units)
Expected Value (units)
.10
2,000
200
.30
4,000
1,200
.25
5,000
1,250
.20
7,000
1,400
.15
10,000
1,500
5,550
Page 52
Secondly, calculate the expected value of contribution => 5,550 units x (RWF20 -
RWF15)
= RWF27,750 per annum. Deducting fixed costs of RWF5,000 per annum gives net
cash flow of RWF22,750 per annum.
The expected value of NPV is:
Year
Cash Flow
D.F. 10%
Pres.
Value
0
(70,000)
1.000
(70,000)
1-4
22,750
3,170
72,118
4
10,000
0.683
6,830
8,948
The expected NPV is positive and the project would be acceptable.
The drawback to this technique is the difficulty in estimating probabilities of the
various outcomes for the key variables.
6. Standard Deviation of the NPV
It is unlikely that you will be expected to calculate the standard deviation of a project,
but you must be able to:
(a) Understand how a standard deviation might be used for risk analysis of individual
investment projects.
(b) Understand the relevance of standard deviations to risk measurement.
Example
Y Ltd is considering which of two mutually exclusive projects, A or B, to undertake.
There is some uncertainty about the running costs with each project and a probability
distribution of the NPV for each has been estimated as follows:
Project A
Project B
NPV
Probability
NPV
Probability
RWF’000
RWF’000
-20
0.15
+5
0.2
+10
0.20
+15
0.3
+20
0.35
+20
0.4
+40
0.30
+25
0.1
Which project should the company choose, if either?
Page 53
Begin by calculating the EV (Expected Value) of the NPV for each project.
Project A
Project B
NPV
Probability
EV
NPV
Probability
EV
RWF’00
0
RWF’000
RWF’000
RWF’000
-20
0.15
(3.0)
5
0.2
1.0
10
0.20
2.0
15
0.3
4.5
20
0.35
7.0
20
0.4
8.0
40
0.30
12.0
25
0.1
2.5
EV =
18.0
EV =
16.0
Project A has a higher EV of NPV, but what about the risk - i.e. the possible variations
in NPV above or below the EV that might occur? This can be measured by the standard
deviation.
The
σ
of the project NPV, S, can be calculated as:
S =
Σp (x x)
2
where
x
is the EV of the NPV.
Project A,
= 18.00
Project B,
= 16.00
x
P
x -
P(x -
)
2
x
P
x-
P(x -
)
2
RWF’000
RWF’000
RWF’000
RWF’0
00
-20
0.15
-38
216.6
5
0.2
-11
24.2
10
0.20
-8
12.8
15
0.3
-1
0.3
20
0.35
+2
1.4
20
0.4
+4
6.4
40
0.30
+22
145.2
25
0.1
+9
8.1
376.0
39.0
S
=
376
S
=
39.0
=
19.39
=
6.24
i.e. RWF19,390 approx
i.e. RWF6,240 approx
Although Project A has a higher EV of NPV, it also has a larger standard deviation of
NPV, and so has greater business risk associated with it.
Which project should therefore be selected? Clearly it depends on the attitude of the
company’s management to business risk.
7. Simulation
The Monte Carlo simulation technique is most appropriate for modelling cash flow
forecasting problems where there are several independent uncertain cash flows for
which discrete probability distributions can be estimated. The more independent cash
Page 54
flows there are, the more likely it is that simulation will be the only practical method
available to model the system.
Random numbers are allocated to the cash flows in proportion to their relative
probabilities. A stream of random numbers is then fed into the system to simulate
actual cash flows during a number of periods.
The numerical output from the application of simulation techniques is a range of
possible cash flow outcomes with an indication of the likelihood of each outcome i.e.
a probability distribution of possible outcomes. This can be used to assess the
probabilities of particular events occurring during the review period.
Page 55
Study Unit 7
Working Capital Management
Contents
A. Overview of Working Capital Management
B. Cash Management
C. The Management of Debtors
D. The Management of Creditors
E. The Management of Stocks
Page 56
A. OVERVIEW OF WORKING CAPITAL MANAGEMENT
Definition of Working Capital
Working Capital (Net Current Assets) = Excess of Current Assets over Current Liabilities.
Current Assets: Stock (Finished Goods, WIP and Raw Materials), Debtors, Marketable
Securities and Cash/Bank.
Current Liabilities: Creditors Due Within One Year, Trade Creditors, Tax Payable, Dividends
Payable, Short-term Loans and Long-term Loans Maturing Within The Year..
It may be regarded loosely as: STOCKS + DEBTORS - CREDITORS.
Working Capital Management is basically a trade- off between ensuring that the business
remains liquid while avoiding excessive conservatism, whereby the levels of Working Capital
held are too high with an ensuing large opportunity loss. Obviously, the levels of Working
Capital required depend to a large extent on the type of industry within which the company is
operating -> contrast service industries with manufacturing industries.
Matching Concept
Long-term assets must be financed by long-term funds (debt/equity). Short-term assets can
be financed with short-term funds (e.g. overdraft, creditors) but it may be prudent to finance
partly with long-term funds. Working capital policies can be identified as conservative,
aggressive or moderate:
1. Conservative financing working capital predominantly from long-term sources of
finance. Current assets are analysed into permanent and fluctuating; with long-term
finance used for permanent element and some of the fluctuating current assets. This
will increase the amount of lower risk finance, at the expense of increased interest
payments and lower profitability.
2. Aggressive short-term finance used for all fluctuating and most of the permanent
current assets. This will decrease interest costs and increase profitability but at the
expense of an increase in the amount of higher-risk finance used.
3. Moderate (or matching approach) short-term finance used for fluctuating current
assets and long-term finance used for permanent current assets.
Short-term finance is usually cheaper and more flexible than long-term finance. However,
the trade-off between the relative cheapness of short-term debt and its risks must be
considered. For example, it may need to be continually renegotiated as various facilities
expire and due to changed circumstances (e.g. a credit squeeze) the facility may not be
renewed. Also, the company will be exposed to fluctuations in short-term interest rates
(variable).
Overtrading/Undercapitalisation
This occurs where a company is attempting to expand rapidly but doesn’t have sufficient
long-term capital to finance the expansion. Through overtrading, a potentially profitable
business can quite easily go bankrupt because of insufficient cash.
Page 57
Output increases are often obtained by more intensive use of existing fixed assets and growth
is financed by more intensive use of working capital. Overtrading can lead to liquidity
problems that can cause serious difficulties if they are not dealt with promptly.
Overtrading companies are often unable/unwilling to raise long-term capital and rely more
heavily on short-term sources (e.g. creditors/overdraft). Debtors usually increase sharply as
credit is relaxed to win sales and while stocks increase as the company attempts to produce at
a faster rate ahead of increases in demand.
Symptoms of Overtrading
Turnover increases rapidly
The volume of current assets increases faster than sales (fixed assets may also increase)
Increase in stock days and debtor days
The increase in assets is financed by increases in short-term funds such as creditors and
bank overdrafts
The current and quick ratios decline dramatically and Current Assets will be far lower
than Current Liabilities
The cash flow position is heading in a disastrous direction.
Causes of Overtrading
Turnover is increased too rapidly without an adequate capital base (management may
be overly ambitious)
The long-term sources of finance are reduced
A period of high inflation may lead to an erosion of the capital base in real terms and
management may be unaware of this erosion
Management may be completely unaware of the absolute importance of cash flow
planning and so may get carried away with profitability to the detriment of this aspect
of their financial planning.
Possible means of alleviating overtrading are:
Postponing expansion plans
New injections of long-term finance either in terms of debt/equity or some combination
Better stock/debtor control
Maintaining/increasing proportion of long-term finance
Undertrading/Overcapitalisation
Here the organisation operates at a level lower than that for which it is structured. As a result
capital is inadequately rewarded. This can normally be identified by poor accounting ratios
(e.g. liquidity ratios too high or stock turnover periods too long).
Page 58
Assessment of Liquidity Position
The liquidity position of an organisation may be assessed using some key financial ratios:
Current Ratio =
Current Assets
Current Liabilities
Quick Ratio
=
Current Assets Stock
(“Acid Test”)
Current Liabilities
Debtors Collection Period =
Debtors
x 365 Days
Sales
Creditors Payment Period =
Creditors
x 365 Days
Purchases
Stock Period =
Stock
x 365 Days
Cost of Sales
Alternatively:
Stock Turnover Period =
Cost of Sales
= x times
Stock
Benchmarks often quoted are a Current Ratio of 2 : 1 and a Quick Ratio of 1 : 1 but these
should not be adopted rigidly as organisations have vastly different circumstances (operating
in different industries, seasonal trade etc.).
Page 59
Working Capital Cycle
Often referred to as the “Operating Cycle” or the “Cash Cycle” this indicates the total length
of time between investing cash in raw materials and its recovery at the end of the cycle when
it is collected from debtors. This can be shown diagrammatically:
The Working Capital Cycle can also be expressed as a period of time, by computing various
ratios:
Stock
Average Stock
x 365 =
A days
Cost of Sales
Debtors
Average Debtors
x 365 =
B days
Sales
Less: Creditors
Average Creditors
x 365 =
(C days)
Purchases
Working Capital Cycle (days)
D days
It is difficult to determine the optimum cycle. Attention will probably be focussed more on
individual components than on the total length of the cycle. Comparison with previous
periods or other organisations in the same industry may reveal areas for improvement.
(1) RAW
MATERIALS
(3) WORK
IN
PROGRESS
(4) FINISHED
GOODS
(2)
CREDITORS
(5)
DEBTORS
(6)
CASH
Page 60
B. CASH MANAGEMENT
Cash is an idle asset and the company should try to hold the minimum sufficient for its needs.
Three motives are suggested for holding liquid funds (cash, bank deposits, short-term
investments):
Transaction Motive - to meet payments in the ordinary course of business pay
employees, suppliers etc. Depends upon the type of business, seasonality of trade etc.
Precautionary Motive - to provide for unforeseen events e.g. fire at premises.
Depends upon management’s attitude to risk and availability of credit at short notice.
Speculative Motive - to keep funds available to take advantage of any unexpected
“bargain” purchases which may arise - e.g. acquisitions, bulk-buying etc.
Cash Budget
This is a very important aid in cash management. Most organisations, whether small,
unsophisticated or large , will prepare a Cash Budget at least once a year. It is usually
prepared on a monthly/quarterly basis to predict cash surpluses/shortages.
Example
A company’s sales are RWF100,000 for November and these are expected to grow at the rate
of 10% per month. All sales are on credit and it is estimated that 60% of customers will pay
in the month following sale; the remainder will pay two months after sale but on average 10%
of sales will turn out to be bad debts. The company has some investments on which income
of RWF20,000 will be received in February.
Materials must be purchased two months in advance of sale so that demand can be met.
Materials cost 50% of sales value. The supplier of the materials grants one month’s credit.
Wages and overheads are RWF30,000 and RWF15,000 respectively per month.
A new machine costing RWF48,000 will be purchased in February for cash. The estimated
life of the machine is 4 years and there will be no scrap value at the end of its life.
Depreciation will be at the rate of RWF12,000 per annum and this will be charged in the
monthly management accounts at RWF1,000 per month.
Rent on the companys factory is charged in the monthly management accounts at
RWF5,000. This is paid half-yearly in March and September.
The company’s fleet of cars will be replaced in January at a cost of RWF50,000.
At the 31st December the company expects to have a cash balance of RWF50,000.
Prepare a Cash Budget for the period January to March.
Page 61
(RWF’000)
Jan
Feb
Mar
Inflows
Sales Revenue:
November
100,000 x 30%
30
December
110,000 x 60%/30%
66
33
January
121,000 x 60%/30%
73
36
February
133,100 x 60%
80
Investment Income
20
96
126
116
Outflows
Materials:
February
133,100 x 50%
67
March
146,410 x 50%
73
April
161,051 x 50%
81
Wages
30
30
30
Overheads
15
15
15
Rent
30
Machine
48
Car Fleet
50
162
166
156
Opening Balance
50
(16)
(56)
Inflows Outflows
(66)
(40)
(40)
Closing Balance
(16)
(56)
(96)
The opening cash surplus of RWF50,000 turns into a negative figure from end of January
onwards, mainly due to capital expenditure, and peaks at (RWF96,000) in March. Thus, the
company will have to arrange an overdraft in advance to cover the shortfalls. Alternatively,
the company could take action to avoid the potential negative results. Some possibilities are:
Deferring replacement of fleet of cars.
Deferring purchase of machine - impact on production and sales must be considered.
Considering leasing cars/machine.
Negotiating more generous credit period from supplier.
Encouraging earlier payment by customers, possibly by offering a discount.
Chasing bad debts and reducing to below 10%.
Liquidating investments - consider yield etc.
Selling any non-essential assets
Rescheduling loan repayments
Reducing dividend payments
Page 62
Bank Overdraft
This is one of the most important sources of short-term finance. It is a very useful tool in
cash management, particularly for companies involved in seasonal trades.
The main advantages are:
Cost may be lower than other sources (generally, short-term finance is cheaper than
long-term).
Less security required than for term loans - overdraft can be recalled at short notice.
Repayment is easier as there are no structured repayments - funds are simply paid into
the account as they become available.
Interest is only charged on the amount outstanding on a particular day.
Extra flexibility is provided as all of the facility may not be used at any one time. The
unused balance represents additional credit which can be obtained quickly and without
formality.
The main disadvantages are:
Renewal is not guaranteed.
Technically, the advance is repayable on demand, which could lead to a strain on the
company’s cash flow.
Variable rate of interest the facility may be renewed on less favourable terms if
economic circumstances have deteriorated.
Term Loan
Finance is made available for a fixed term and usually, at a fixed rate of interest. Repayments
are in equal instalments over the term of the loan. Early repayment may result in penalties.
The main advantages are:
The term can be arranged to suit the borrowers needs.
The repayment profile may be negotiable to suit the expected cash flow profile of the
company (e.g. interest only basis to keep on-going repayments lower).
Known cash flows assist financial planning.
The interest rate is fixed, so the company is not exposed to increases in rates.
Cash Lodgement
It is important that cash is lodged as quickly as possible so that the organisation gets the
benefit through an increase in investments or a reduction in overdraft. However, apart from
the security risk of cash lying idle there are costs of making lodgements (bank, clerical,
transportation etc.) It becomes a “Balancing Actto minimise costs and maximise benefits
(interest).
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Example
A company always works off an overdraft which currently costs 15% p.a. Sales are
RWF600,000 per week (5 working days). Half the cash is received on Monday and Tuesday,
split equally between the two days. The remaining sales are split equally over the other three
days. At present all lodgements are made on Friday afternoon.
It is now proposed to lodge on Monday, Wednesday and Friday but this will increase
administration and bank costs by RWF200 per week. Should the company change policy?
Receipts(RWF’000)
Day Banked
Days
Saved
Overdraft Saving (RWF)
Monday
150
Monday
4
(150 x 4/365 x
15%) =
246
Tuesday
150
Wednesday
2
(150 x 2/365 x
15%) =
123
Wednesday
100
Wednesday
2
(100 x 2/365 x
15%) =
82
Thursday
100
Friday
0
0
Friday
100
Friday
0
0
600
451
Weekly saving of the new policy is (RWF451 - RWF200) = RWF251
Annual saving is RWF251 x 52 = RWF13,052.
The new proposal should be adopted.
Centralised Cash Management
If an organisation has decentralised operations e.g. multiple branches, there may be
advantages in centralising cash management at Head Office. These are:
Economies of Scale - by avoiding duplication of skills among divisions.
Expertise - specialist staff employed at Head Office.
Higher Yield - increased funds available may provide a greater return and reduce
transaction charges. Likewise, borrowings can be arranged in bulk at keener interest
rates than for smaller amounts.
Planning - a cash surplus in one division may be used to offset a deficit in another,
without recourse to short-term borrowings.
Bank Charges - should be lower as the carrying of both balances and overdrafts should
be eliminated.
Foreign Currency Risk - can be managed more effectively as the organisation’s total
exposure situation can be gauged.
Some disadvantages are:
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Slower decision making
Loss of local market knowledge
Demotivation of local staff
Computerised Cash Management
This allows companies via a computer terminal to get up-to-date information on cleared
balances on their bank accounts. Three basic services are provided:
Account Balances - information provided on all accounts within a group (domestic and
foreign). Details of un-cleared items which will clear the next day, forecast balances
and individual transactions are available.
Decision Support - current money market and foreign exchange rates provided.
Funds Transfer - some services offer a direct link to brokers/banks, permitting instant
deals to be made.
The service facilitates more efficient cash management as available cash balances are
identified and utilised to the maximum. Thus, overall cash flow planning is more accurate.
To obtain the full benefit cash management should be centralised. However, potential
benefits must be compared with the additional costs incurred.
Cash Management Models
A number of cash management models have been developed to determine the optimum
amount of cash that a company should hold. One approach is to use the Economic Order
Quantity (EOQ) Model, which is used in stock management (see Stock Management section
later). Another (and more sophisticated) approach is the Miller-Orr Model. This determines
a lower limit, an upper limit and a normal level on cash balances. If cash reaches the lower
limit the firm sells securities to bring the balance back to the normal level. On the other
hand, if the cash balance reaches the upper limit the firm should buy sufficient securities to
return to the normal level. The various limits are set by reference to the variance of cash
flows, transaction costs and interest rates.
(a) Baumol’s Model based on the EOQ
Assumes costs can be divided into fixed and variable elements
Total Cost =
Q x i
+
F x S
2
Q
S = cash required in each time period
F = fixed cost of new funds (e.g. cost of negotiating an overdraft)
i = opportunity interest cost of holding cash or near cash equivalents
Q = the total amount of cash to be raised
Like the EOQ, the optimum amount of new funds to raise (Q) =
i
FS 2
Suppose a company faces a fixed cost of RWF5,000 to obtain funds. Cash
requirements per annum are RWF40,000 for the foreseeable future. The opportunity
Page 65
interest cost is 5% per annum. How much should the company raise at each time and
how often will they have to raise it.
The Q level is {(2 x RWF5k x 40k)/.05} = RWF89k.
Therefore the company should raise RWF89k each time it raises cash. It will need to
raise cash once every 2¼ years approximately (RWF89k/RWF40k).
The difficulties of Baumol’s application of the EOQ to Cash Management are:
Difficulties in predicting cash needs
What if use of cash is ‘unsteady’
Ignores costs of running out of cash
Ignores the normal costs of holding cash which may increase in line with the
amounts held
Ignores inflation
(b) The Miller-Orr Model
Typically cash balances will vary considerably over time. The Miller-Orr model
imposes limits on the amount within which the cash balance is allowed to vary. When
the cash balance reaches an upper limit, the firm buys securities so that the cash balance
returns to its ‘normal’ level (the return point). When the cash balance reaches a lower
limit the firm sells securities in order to bring the balance back to the return point. The
upper/lower limits and the return point are based on the following factors:
The variance of cash flows (if high -> set wide limits)
The level of transaction costs (if high -> set high limits to reduce the level of
transactions)
Interest rates (if high -> set low limits to minimise interest costs and maximise
return on short-term investments
Steps in Using the Miller-Orr Model
1. Set lower limits for the cash balances (safety needs)
2. Estimate the variance of the cash flow over time
3. Calculate the transaction costs and interest rates applicable
4. Calculate the spread between upper and lower cash limits as follows:
1/3
3
RateInterest
FlowCash of Variance x Costsn Transactio x 3/4
5. Once you have the spread and the lower limit (LL), the return point is set as:
Page 66
Return Point = Lower Limit + (1/3 x Spread)
By keeping the return point at this level, you are helping to keep down the interest
costs of holding cash.
The Upper Limit (UL) = Lower Limit + Spread
When the cash flows reach the Upper/Lower limit you sell/buy securities to get to
the return point.
The Miller-Orr model, while reasonably sophisticated, is nevertheless quite
operational. While cash flows are more predictable in certain contexts than those
allowed by Miller-Orr, the model can save time and energy which would
otherwise be spent predicting these cash flows. The major difficulties are in
estimating the parameters of the model particularly the variance of the cash flows.
Investment of Short-Term Funds
In deciding the best approach consideration must be given to the quantity of funds; length of
time for which available; certainty of the funds; rate of return; risk and variability of return;
possibility and costs of early termination (liquidity).
Possible investments are:
Short-Term Deposits - return depends on the period and amount.
Certificates of Deposit (CD’s) - flexible as CD’s are negotiable.
Short Gilts/Treasury Bills - known, fixed return if held to maturity. Early disposal may
result in capital gain/loss.
Reduction in Overdraft
C. THE MANAGEMENT OF DEBTORS
Excess debtors are a wasted resource which should be avoided by careful management.
Managing means reducing it to the practical minimum, consistent with not damaging the
business. For example, it is no good simply refusing to give customers credit - they will go
elsewhere. A balanced approach is required which will reduce debtors to a minimum
acceptable level.
Debtors are often one of the largest items in a company’s Balance Sheet and also one of the
most unreliable assets, largely because company policies concerning them are often
inadequate or poorly defined and in the hands of untrained staff. Typically, a company could
have 20% - 25% of total assets as debtors.
Credit management is a problem of balancing profitability and liquidity. Credit terms can be
a sales attraction but higher debtors put a strain on liquidity. Management of debtors will be
concerned with achieving the optimum level of investment. This requires finding the correct
balance between:
Extending credit to increase sales and, therefore profits and
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The cost of investment in debtors (cost of finance, administration, bad debts etc.)
By setting the “terms of sale” the company can, to some extent, control the level of debtors.
However, the relative strengths of the credit-giver and the credit-taker are important.
Consideration must also be given to the industry norm.
The company has at least four factors to control debtors:
1. The customers to which it is prepared to sell.
2. The terms of credit offered.
3. Whether cash discounts will be offered?
4. The follow-up procedures for slow payment.
Evaluating Credit Risk
Before extending credit to new customers management will assess the risk of default in
payment/non-payment. This will be based upon experience and judgement but in addition,
the following sources may be used:
Trade References - from other suppliers (at least two).
Bank References - may be of limited use as banks are reluctant to supply adverse
references.
Credit Agency Reports - specialist agencies (e.g. Dun & Bradstreet) will provide
detailed reports on the history, creditworthiness, business etc. of individuals and
organisations on payment of a fee.
Published Information - annual accounts etc.
Own Salesmen - useful source but views may be biased (commission receivable?).
Newspapers and Trade Journals.
Other Credit Controllers - many trade associations where controllers meet regularly
to exchange information about the state of the industry generally and slow/bad payers
in particular.
Own Information - check old customer files to see if you have ever done business in
the past.
Trial Period - on a "cash -only" basis.
Credit Limit - fix at low level initially and only increase if payment record warrants.
Site Visits - an opinion on the operations can be formed by visiting the premises.
Credit Scoring - evaluate potential customer using credit scoring or other quantitative
techniques. Credit scores are risk indicators - the higher the score, the lower the risk.
Scores will be allocated based on the characteristics of the new customer (e.g. age,
occupation, length of service, married/single, home owner, size of family, income,
commitments etc.). Credit scoring is particularly suited to financial institutions and the
amount of credit offered, if any, will depend on whether the credit score is above a
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predetermined cut-off level. Computerised systems (“expert systems”) are especially
useful for this purpose.
Although terms and settlement discounts are often influenced by custom and practice within
an industry it is still possible to change them. Once defined, ensure that the customers are
aware of them - ideally, they should be informed when they order, when they are invoiced
and when they receive statements. Always try to enforce the specified discount policy.
Discounts
As extended credit facilities may be expensive to finance the firm may offer customers a
discount (cash/settlement discount) to encourage them to pay early. As with extended credit
discounts may also be used as a marketing tool in an effort to increase sales. To evaluate
whether it is financially worthwhile the cost of the discount should be compared with the
benefit of the reduced investment in debtors.
Example
A company offers its customers 40 days credit. On average they take 60 days to pay. To
encourage early payment the company now proposes to offer a 2 % discount for payment
within 10 days.
For each RWF100 of sales the cost is RWF2 and the company only receives a net RWF98. In
return the company receives payment 50 days earlier (day 60 - day 10). The annualised cost
of the discount is:
2
x
365
= 14.9% p.a.
98
50
The cost of 14.9% should be compared with other sources of finance. If, for example, the
cost of the company’s overdraft is 16% p.a. the discount would seem to be worthwhile. If, on
the other hand, the cost of the overdraft is only 10% p.a. the discount should not be offered as
it would be better to leave the debts outstanding and finance through the overdraft.
In industries that deal with both trade and retail customers (e.g. building supplies) it is usual
to offer trade discounts. This may reflect the economies of scale which derive from larger
orders and the greater bargaining power of the customer. Trade discounts are frequently
much larger than cash/settlement discounts and may be for as much as 25% of the quoted
price.
Debt Control
Good debt control can be summed up as ensuring that all sales are paid for within an agreed
period, without alienating customers, at the minimum cost to the company.
The company itself can take steps to “assist” the debtors to pay promptly:
1. Issue invoices and statements promptly.
2. Deal with customer queries/disputes immediately.
3. Issue credit notes as agreed.
4. Be flexible in billing arrangements to accommodate customers.
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There is no debt collection policy that is applicable to all companies. Policies will differ
according to the nature of the product and the degree of competition. A debt control system
will probably include:
1. Well trained credit personnel.
2. Measures to ensure that credit limits are not exceeded.
3. Formal set procedures for collecting overdue debts, which should be known by all staff
and applied according to an agreed time schedule. Care must be taken that the cost of
the debt collection does not exceed the amount of the debt, except where used as a
deterrent. Also over-zealous collection techniques may damage goodwill and lose
future sales.
4. Computerised monitoring systems to identify overdue accounts as early as possible.
For example, ratios, compared with the previous period to highlight trends in credit
levels and the incidence of overdue and bad debts; statistical data to identify causes of
default and the incidence of bad debts among different classes of customer and types of
trade. An “Aged Analysis of Debtors” is particularly useful in this regard.
Debtor
Total
Current
1-2 Months
2-3 Months
> 3 Months
xxxxx
RWF10,000
RWF5,000
RWF5,000
xxxxx
RWF20,000
RWF10,000
RWF5,000
RWF5,000
xxxxx
RWF50,000
RWF30,000
RWF20,000
xxxxx
RWF50,000
RWF10,000
RWF20,000
RWF20,000
xxxxx
RWF60,000
RWF30,000
RWF20,000
RWF10,000
xxxxx
RWF40,000
RWF10,000
RWF20,000
RWF10,000
xxxxx
RWF30,000
RWF10,000
RWF20,000
xxxxx
RWF50,000
RWF20,000
RWF20,000
RWF10,000
Total
310,000
95,000
65,000
85,000
65,000
%
31%
21%
27%
21%
Debt collection policies must not be regarded as completely inflexible and systems should be
modified as circumstances change.
Among the many debt collection techniques that can be used are:
1. Invoices - issued promptly following delivery of goods/service.
2. Statements - at monthly/other intervals to draw attention to unpaid debts.
3. Overdue Letters - carefully drafted to provoke an immediate response; individual
rather than obviously computer-produced; series of letters of varying degrees of
severity.
4. Telephone Calls these ensure that customer has received the letter(s) and gives him
an opportunity to raise any queries or advise of any difficulties which may cause a
change of approach to help him out.
5. Mail or Email Reminders.
6. Visits by Sales Staff.
7. Visits by Credit Control Staff.
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8. Use of External Agencies - debt collection agency; factoring company etc.
9. Threaten Withdrawal of Credit Facilities/Discounts.
10. Threaten To Withhold Future Supplies.
11. Solicitor’s Letter.
12. Legal Action - beware cost of action does not exceed debt.
In most cases some extra spending on debt collection will reduce the overall cost of the
investment in debtors (e.g. reduction in bad debts/average collection period etc.). However,
beyond a certain level extra spending is not usually cost effective.
Credit Policy
Example 1
Current sales are RWF500,000 p.a. - all on credit. On average customers take 60 days credit.
Bad debts are 1% of sales.
Marketing manager suggests that if credit is relaxed to 90 days sales will increase by 20%.
However, bad debts will increase to 2%. It is estimated that 75% of existing customers will
take the 90 days. Variable costs are 90% of sales value and the company uses an overdraft
costing 10% p.a.
Should the new proposal be adopted?
RWF
RWF
Increased Sales (20%)
100,000
Increased Contribution (10%)
10,000
Bad Debts
- Existing
500,000 x 1%
5,000
- Revised
600,000 x 2%
12,00
(7,000)
Debtors
- Existing
500,00 x 60/365
82,192
- New
500,000 x 75% x 90/365
92,466
500,000 x 25% x 60/365
20,548
100,000 x 90/365
24,658
137,672
Increase in Debtors
55,480
Cost of Increased Debtors @ 10%
p.a.
(5,548)
Net Cost
(2,548)
The New Policy is Not Worthwhile
Example 2
Current sales are RWF500,000 p.a. - all on credit. 60 days credit allowed but on average 90
days taken.
New credit terms of a 4% discount for payment by day 10 are being considered. It is
estimated that 60% of the customers will take the discount. The new terms will increase sales
by 20%. Variable costs are 85% of sales value and the company uses an overdraft costing
11% per annum. Should the discount be offered?
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RWF
RWF
Increased Sales (20%)
100,000
Increased Contribution (15%)
15,000
Cost of Discount
600,000 x 60% x 4%
(14,400)
Debtors
- Existing
500,000 x 90/365
123,287
- New
600,000 x 60% x 10/365
9,863
600,000 x 40% x 90/365
59,178
69,041
Reduction in Debtors
54,246
Saving Due to Reduced Debtors @ 11% p.a.
5,967
Net Benefit
6,567
The New Policy Is Worthwhile.
Factoring
This involves the sale of trade debts for immediate cash to a “factor” who charges
commission. Factoring companies are financial institutions often linked with banks. Unlike
an overdraft the level of funding is dependent, not upon the fixed assets of the company, but
on its success for as the company grows and sales increase the facility offered by the factor
grows, secured against the outstanding invoices due to the company. Three basic services are
offered, although a company need not use all of them:
1. Finance - instruction on invoices that payment is to be made to the factor, who is
responsible for collection of the debt. When the factor receives the invoices 80%
approx. of value is advanced. The balance (less charges, including interest) is paid,
either when the invoice is settled or after a specified period.
2. Sales Ledger Management - the factor takes the place of the client’s accounts
department. Duplicate invoices are sent to the factor who maintains a full sales ledger
for each client handles invoices, chases outstanding payments etc. Commission of 1% -
2% is charged.
3. Credit Insurance - in return for a commission the factor provides a guarantee against
bad debts.
Recourse Factoring - the factor will reclaim the money advanced on any uncollected debt so
the business will retain the risk of non-recovery and, depending on the contract terms,
perhaps the administration burden as well.
Non-Recourse (Full) Factoring - the factor runs credit checks on the companys customers
and agrees limits dependent on their creditworthiness. These can be adjusted in the light of
experience, once a pattern has been established. The factor will protect the client against bad
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debts on approved sales and will also take on all the administration burden. The balance
over the 80% advance is paid to the client an agreed number of days after the initial advance.
Recourse v Non-Recourse Factoring - with non-recourse factoring the business knows that it
will get paid, no matter what happens but protection only applies to credit-approved debts
and it is not always easy to get this approval for doubtful ones. Recourse factoring allows
more funding to be made available against less credit-worthy debtors and the business is in
control of when and how individual debts are to be pursued and collected.
The cost of finance through factoring is usually slightly above overdraft rates. The
administration charges vary, usually between 0.6% and 2.5% approx.
Advantages of Factoring
1. It is an alternative source of finance if other sources are fully utilised, particularly for a
company with a high level of debtors.
2. It is especially useful for growth companies where debtors are rising rapidly and funds
available from the factor will rise in tandem.
3. Security for the finance is the company’s debtors, leaving other assets free for
alternative forms of debt finance.
4. The factor may be able to manage the company’s sales ledger more efficiently by
employing specialist staff, leading to lower costs for the company and freeing
management to concentrate on growing the business.
5. Bad debts will be reduced or guaranteed by credit insurance.
6. Due to the greater guarantee of cash flow the company will have a better opportunity
for taking up cash discounts from suppliers.
7. The factor will be more efficient in collecting monies. Evidence suggests that, on
average, it takes over 75 days for an invoice to be paid, whereas the average debt turn
of companies using factoring is 60 days.
8. The company replaces a great many debtors with one - the factor - who is a prompt
payer.
Disadvantages of Factoring
1. It may be more expensive than other sources.
2. When fixing credit terms and limits the factor will be concerned with minimising risk
and, therefore, certain risky but potentially profitable business may be rejected.
3. The factor may be “pushy” when collecting debts. This may lead to ill-feeling by
customers.
4. Use of a factor might reflect adversely on a company’s financial stability in the eyes of
some people. Factoring is more acceptable nowadays but this problem could be
overcome by undisclosed factoring, which leaves the company to collect payment as
agent for the factor.
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Invoice Discounting
This is similar to factoring but only the finance service is used. Invoices are discounted (like
Bills Receivable) and immediate payment, less a charge, is received. The company still
collects the debt as agent for the financial institution and is also liable for bad debts. The
service tends to be used on an ad hoc basis and is provided by factors for clients who need
finance but not the administrative service or protection. Invoice Discounting is confidential
and solely a matter between the lender and borrower, unlike Factoring where the bank
assumes a direct and visible role between the company and its debtors. Also, the company
retains full control over the management of its debtors ledger, including credit control.
D. THE MANAGEMENT OF CREDITORS
Trade credit is an often used source of finance. The costs of this source of finance are the
costs of any discounts forgone and any interest charges which the creditor charges on overdue
bills. Of course, excessive use of this source may lead to poor relations with a supplier (or
even no relations) which can be damaging.
Credit from suppliers is a very important source of short-term finance.
The credit is mistakenly believed to be cost-free. The costs include the following:
1. Loss of Suppliers Goodwill - this is difficult to quantify. If the credit period is
regularly overdone suppliers may be put a low priority on the quality of service given;
further orders may be refused; cash on delivery or payment in advance demanded.
2. Higher Unit Costs - the supplier may try to recoup the cost of longer credit by
charging increased prices.
3. Loss of Cash Discounts - if the credit period is used then discounts are not being taken.
Thus, the cost of credit is the cost of not taking the discount.
Example
Your company normally pays within 45 days. The supplier offers a 2% discount for payment
within 10 days. If the company refuses the discount the implied cost of not taking the
discount is:
2
x
365
= 21.3% p.a.
98
35
The cost of not taking the discount (opportunity cost) is 21.3% p.a.
Despite the above costs trade credit is the largest source of short-term funds for companies.
Among the advantages are:
1. Obtaining credit is informal.
2. It is a flexible source of finance - but payment should not be delayed regularly.
3. It is a relatively stable source of finance - it is available continuously.
4. No security is required - unlike other forms of credit.
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E. THE MANAGEMENT OF STOCKS
In many organisations stock requires the commitment of a large amount of resources. The
classic conflict often arises:
The Production manager desires a large stock of raw materials so that production is
uninterrupted.
The Sales manager desires a large stock of finished goods so that no sales are lost.
The Finance manager desires a low level of all types of stock so that costs are
minimised.
Ordering and Holding Costs
High levels of stock can only be achieved at a cost. The total cost of stock-holding has many
elements:
Cost of financing
Storage (warehousing)
Handling
Insurance
Administration
Obsolescence
Deterioration
Pilferage
Sound stock control entails having the right product available in the right quantity, at the
right time and at the right cost.
Fast and frequent replenishment of sales will minimise stock-holding.
Overall, reducing stock is likely to increase profitability rather than decrease it. Reducing
stock is almost totally within the control of management - unlike reducing debtors or
increasing creditors, it does not rely on the co-operation of third parties.
Economic Order Quantity (EOQ)
Total stock-holding costs could be broadly classified as “Holding” costs and “Ordering”
costs. The EOQ model attempts to minimise total costs by balancing between holding and
ordering costs. If large batches are ordered, this will result in high holding costs and low
ordering costs. Conversely, if small batches are ordered this will result in low holding costs
and high ordering costs.
EOQ =
2 cd
h
Where: c = cost per order
d = annual demand for item of stock
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h = annual cost of holding a unit in stock
The EOQ Model makes a number of assumptions:
Order cost is constant regardless of the size of the order.
Use of the item of stock is constant.
No stock-outs occur.
Purchase price is constant.
Example:
A company has annual demand for 2,000 units. Each unit can be purchased for RWF20. The
cost of placing each order is RWF20 and the annual cost of holding an item in stock is RWF2.
Calculate the Economic Order Quantity.
EOQ =
2 x 20 x 2,000
= 200 units
2
Discounts
If the supplier offers a discount for larger orders this may alter the position. The discount will
offer two savings - a reduced purchase price and lower ordering costs because fewer orders
are placed. Using the above example, suppose that a discount of 2% is offered on orders of
400 or more.
Calculate the total costs with and without the discount. Total costs will now consist of
ordering costs + holding costs + purchase price.
200 Units
Ordering: RWF20 x
2,000
RWF200
200
Holding: RWF2 x
200
RWF200
2
Purchase:
2,000 x
RWF20
RWF40,000
RWF40,400
400 Units
Ordering: RWF20 x
2,000
RWF100
400
Holding: RWF2 x
400
RWF400
2
Purchase:
2,000 x
RWF19.60
RWF39,200
RWF39,700
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The discount is worthwhile
Just In Time Stock Management (JIT)
The main purpose of JIT purchasing is to ensure that delivery of supplies occurs immediately
prior to the requirement to use them in manufacture, assembly or resale. Close co-operation
between user and supplier is essential. The supplier is required to guarantee product quality
and reliability of delivery while the user offers the assurance of firmer long-term sales. Users
will purchase from fewer and perhaps, only a single supplier, thus enabling the latter to
achieve greater scale economies and efficiency in production planning. The user expects to
achieve savings in materials handling, inventory investment and store-keeping costs since
(ideally) supplies will now move directly from unloading bay to the production line. There
may also be benefits from bulk purchasing discounts or lower purchase costs.
With a JIT system there is little room for manoeuvre in the event of unforeseen delays e.g.
on delivery times. The buyer is also dependent on the supplier for the quality of materials, as
expensive downtime or a production standstill may arise, although guarantees and penalties
may be included in the contract as protection.
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Study Unit 8
Capital Markets
Contents
A. Introduction
B. Main Functions of Capital Markets
C. Capital Providers
D. Company Flotation
E. Going Private
F. Efficient Markets
Page 78
A. INTRODUCTION
Capital Markets are markets where long-term instruments are traded e.g. equities, preference
shares, debentures etc.
A good example of a Capital Market is the Stock Exchange.
B. MAIN FUNCTIONS
The main functions of the Stock Exchange are:
PRIMARY MARKET - used to raise new finance/issue new securities
SECONDARY MARKET - trade in second-hand securities. This is where most of the
day-to-day activity takes place.
COMPANY FLOTATION
SHARE SWAP - securities used as consideration in takeover of other companies
C. CAPITAL PROVIDERS
The main providers of capital are:
Pension Funds
Insurance Companies
Investment Trusts
Unit Trusts
Other Financial Institutions
Overseas Investors
Venture Capital Organisations
Business Expansion Scheme Funds
Individuals
D. COMPANY FLOTATION
There are many reasons why a company may be floated on the Stock Market (“Going
Public”). Chief among these is access to capital.
1. Advantages - Shareholders
1. Cash for some shares.
2. Wider market for remaining shares.
3. Shares perceived as less risky.
4. Ready share price available.
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2. Advantages - Company
1. Possibility of new funds.
2. Better credit-standing.
3. Ability to “swap shares” on a takeover.
4. Ability to issue shares more easily at a later date.
5. Reduced risk & greater marketability leads to lower cost of capital.
6. Extra status.
7. Possibility of share options for top employees.
3. Disadvantages
1. Costs can be quite high.
2. Compliance with stringent regulations.
3. Dilution of control.
4. Additional administration.
5. Extra scrutiny of profitability/performance.
E. GOING PRIVATE
Some company shareholder(s) take a company from public ownership back to private
ownership. This happens when the major shareholder and possibly founder finds compliance
with the rules governing public limited companies and reporting to shareholders expensive
and time-consuming. Also public ownership also confers a pressure to maintain share price
through short-term profits or dividends. Where the major shareholder is also chief executive
officer or managing director this can be a disincentive to public ownership.
F. EFFICIENT MARKETS
A market is generally regarded as efficient if the following are present:
Prices immediately reflect all relevant available information
No individual investor dominates the market
Transaction costs are not too high to discourage trading
Are the markets efficient? The Efficient Market Hypothesis (EMH) has been developed to
test different levels of efficiency. [Note: Hypothesis is defined as a supposition put forward
as a basis for reasoning or investigation.]
The Efficient Market Hypothesis tests three degrees of efficiency
1. Weak Form Efficiency
Prices reflect the information in past stock prices.
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2. Semi-strong Form Efficiency
Prices reflect past price information
Plus
All publicly available information.
3. Strong Form Efficiency
Prices reflect past price information
Plus
All publicly available information
Plus
Inside information
Most of the research suggests that capital markets are semi-strong-form efficient but not quite
strong-form efficient.
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Study Unit 9
Long-Term Sources of Finance
Contents
A. Introduction
B. Share Capital
C. Loan Capital
D. Warrants
E. Methods of Share Issues
F. Bank Lending
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A. INTRODUCTION
Example:
RWF’000
Average
Poor
Excellent
Profits
100
20
300
(i) Interest (200 x 10%)
20
20
20
80
0
280
Corporation Tax (20%)
16
0
56
Profits After Tax
64
0
224
(ii) Preference Dividend
10
0
10
(iii) Available for Equity
54
0
214
Note:
Comparing the Average with the Excellent performance it should be noted that while Profits
increase by 200%, the amount Available for Equity [at number (iii)] increases by more than
200%.
No matter what the level of performance, a fixed amount is paid to the Lenders and the
Preference Shareholders.
Interest on borrowings is allowable for Corporation Tax.
Note the ranking of the different providers of capital.
The Ordinary Shareholders (equity) are entitled to the “residue” after all others have been
rewarded.
B. SHARE CAPITAL
Ordinary Shares
The main features are:
Issued to the owners of the company (equity).
Nominal or “face” value (e.g. RWF1,000).
Market value moves with market’s view of the company’s performance/prospects.
Shareholders are not liable for the company’s debts on a winding-up (limited liability).
Carry voting rights
Ordinary shareholders are entitled to the residue after other parties have been rewarded.
This applies to both annual profits and capital on a winding-up.
Subscription privileges apply in the event of a new issue of shares (“pre-emptive
rights”).
Shareholders may be rewarded by dividends (income), or retained profits (capital gain)
which should be reflected in the market price of the shares. Some companies offer
concessions on their products to shareholders - e.g. discounts or vouchers.
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Some companies have different classes of ordinary shares. For example,
Non-Voting - similar to other shares in every respect, except holders cannot vote.
Advantages to the Company
No fixed annual charges are payable - no legal obligation to pay a dividend.
Do not have a maturity date and are not normally redeemable.
Usually more attractive to investors than fixed interest securities.
Might increase the creditworthiness of a company as they reduce gearing.
Disadvantages to the Company
Issue might reduce EPS, especially if the assets acquired do not produce immediate
earnings.
Extend voting rights to more shareholders.
Lower gearing as a result of the issue might result in a higher overall cost of capital
than is necessary.
Issues often involve substantial issue and underwriting costs.
Dividends are not a tax allowable expense.
Preference Shares
The main features are:
Holders are entitled to a fixed maximum dividend.
Dividends are only paid if sufficient profits are available.
Rank prior to ordinary shares (both dividends and capital on a winding-up).
Cumulative Preference Shares have the right to any arrears of dividend and these are
carried forward and must be paid before any dividend is paid to the ordinary
shareholders. Preference Shares are cumulative, unless expressly stated to be non-
cumulative.
Restricted voting rights - usually only available in a situation where the rights attaching
to the shares are being amended or if dividends are in arrears.
Some companies have different classes of preference shares. For example:
Redeemable - generally redeemable subject to sufficient profits being available or sufficient
cash being raised from a new issue.
Convertible - the right to convert to ordinary shares as per the terms of the issue.
Advantages to The Company
A fixed percentage dividend per year is payable no matter how well the company
performs, but only at the discretion of the companys directors.
Do not normally give full voting rights to holders.
Preference shares are mostly irredeemable.
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Disadvantages To The Company
Cumulative arrears of dividend are payable.
Dividends are not a tax allowable expense.
C. LOAN CAPITAL
The main types are Loan Stock and Debentures.
Loan Stock - long-term debt (usually > 10 years duration) on which a fixed rate of
interest (coupon rate) is paid. Generally unsecured.
Debentures - a form of loan stock, legally defined as a written acknowledgement of
debt. Usually secured. Trustees appointed to look after investors’ interests. Can be
redeemable or irredeemable.
Loan capital ranks prior to share capital (both interest and capital on a winding-up).
The ranking of individual debt will depend upon the specific conditions of each issue.
Restrictive covenants are often included in the lending agreement (e.g. restrictions on
further borrowings, the payment of dividends, or major changes in operations; the
maintenance of certain key ratios in the accounts etc.).
If security is provided the cost to the company may be cheaper. Security may be in the
form of a fixed or floating charge.
Interest payments are allowable for Corporation Tax.
If the net cost of debt is low why do companies not borrow more and more? Some of
the reasons are:
A high level of debt will increase the financial risk for the shareholders.
Interest charges at a particular point in time may be high.
The company may have insufficient security for new debt.
There may be restrictions on further debt - Articles of Association; restrictive
covenants; credit lines fully used etc.
Redemption of Loan Capital
Most redeemable stocks have an earliest and a latest date for redemption.
Redemption is at the company’s option anytime between these two dates.
When should the company redeem? Generally, if the coupon rate is below current
interest rates, delay to the later date and vice versa. However, the following factors
should be considered:
If internally generated funds are to be used, consider their availability.
If a further issue of debt is to be used, consider issue costs.
The trend in future interest rates.
If new equity is to be used, shares should be issued when the price is relatively
high.
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Convertible Loan Stock
This is debt paying a fixed rate of interest but also providing the option to convert to equity at
a pre-determined rate on pre-determined date(s).
The main features are:
Conversion is at the option of the holder.
Conversion terms usually vary over time.
Once stock is converted it cannot be converted back.
Advantages to the Company
It is cheaper than straight debt, due to the conversion rights. The lower coupon rate
may suit projects with low cash flows in the early years.
A high-risk company may have difficulty raising long-term finance no matter what
coupon rate is offered. Convertibles may attract investors due to the “upside potential”.
If conversion takes place the debt is self-liquidating. Conversion will reduce gearing
and enable further debt to be raised in the future.
Interest payments are tax deductible.
Convertibles are often not secured and have less restrictive covenants than straight
debentures.
The number of shares eventually issued on conversion will be smaller than if straight
equity is issued.
Advantages to the Investor
If the market value of the company’s shares falls the value of the convertibles will not
fall below the market value of straight debt with the same coupon.
If the market value of the company’s shares rises the value of the convertibles will rise
also.
Convertibles rank before shares on a winding-up.
If the company’s fortunes improve dramatically investors can share in this by
exercising their option.
Floating Rate Bonds
These are debt securities whose interest is not fixed but is re-fixed periodically by
reference to some independent interest rate index - e.g. a fixed margin over NBR
Interbank rate or LIBOR (London Interbank Offered Rate). These are commonly
referred to as Floating Rate Notes or FRNs. Coupons are re-fixed, and coupon
payments made, usually every six months.
When market interest rates fall the issuer (borrower) is not saddled with high fixed
coupon payments. Likewise, when interest rates rise the investor is not stuck with a
fixed income but will see his income rise in line with market rates.
The market value of such securities should be fairly stable as interest rates will rise/fall
in line with market interest rates.
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Deep Discount Bonds
These are debt securities which are issued at a large discount to their nominal value but will
generally be redeemable at par on maturity. To compensate for the fact that a large capital
gain accrues on maturity, the ongoing coupon rate is substantially lower than other types of
loan stock. An example might be:
2% Bond 2020, which was issued in 2010 at a price of RWF70 per cent
The price of the bond in the secondary market will gradually appreciate as the maturity
date approaches.
Many projects require funding up-front, but are unlikely to give rise to an income
stream to service interest costs for some period of time - e.g. a building project where
income from rentals or sale of the building would be received much later. A Deep
Discount Bond can be a useful source of funding for such a project as it helps to match
cash flows.
An attraction to the investor is the advantageous taxation treatment in certain countries
- e.g. the capital gain at maturity may be subject to Chargeable Gains Tax, which may
be at a lower rate than income tax, or the gain is taxed as income in one lump sum on
maturity or sale rather than as interest each year.
Zero Coupon Bonds
Zero Coupon Bonds are very similar to Deep Discount Bonds except that no interest is paid
during the life of the bond and are, therefore, issued at a large discount to their nominal value.
An example might be:
0% Bond 2021, which was issued in 2011 at a price of RWF50 per cent
Instead of interest payments the investor receives as a return the difference between the issue
price and the higher redemption proceeds.
D. WARRANTS
Holder has the right (but not the obligation) to purchase a stated number of shares, at a
specified price, anytime before a specified date.
If not exercised the warrants lapse.
Warrants are often issued as a “sweetener” to make a loan stock issue more attractive,
or to enable the company to pay a lower coupon rate.
The warrant-holder is not entitled to dividends/voting rights.
Unlike convertibles, new funds are generated for the company if the warrants are
exercised.
Generally, the warrant is detachable from the stock and can be traded separately.
The value of the warrant is dependent on the underlying share price.
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E. METHODS OF SHARE ISSUE
Offer For Sale
Public at Large
Fixed Price
Offer For Sale By Tender
Public at Large
Not a Fixed Price
Set a Minimum Price & Invite Tenders
Shares Issued at Highest Price where All Taken-up
Placing
Shares "Placed" with Target Audience generally institutions
Rights Issue
Shares Issued to Existing Shareholders
Pro-rata to Existing Shareholding (e.g. One for Five Issue)
Example: One for Five Issue
Company
Shareholder
10m
shares
1m
shares (10%
holding)
2m
new shares
0.2m
new shares
12m
1.2m
(10% holding)
Possible Choices:
Subscribe for new shares (exercise rights)
Sell "rights" to new shares
Exercise rights (part) & sell rights (part)
Do nothing
Example:
Shares currently trading at RWF2.00 (cum rights). Rights issue on a one-for-four basis at a
price of RWF1.50. Examine the consequences for a shareholder who currently owns 1,000
shares.
Firstly, calculate the "Theoretical Ex-Rights Price"
4 shares
@ RWF2.00 =
RWF8.00
1 share
@ RWF1.50 =
RWF1.50
5 shares
RWF9.50
Theoretical Ex-Rights Price = RWF9.50/5 = RWF1.90
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Secondly, calculate the Value of The Rights
Ex-Rights Price
RWF1.90
Issue Price
RWF1.50
Value of Rights
RWF0.40
(i) Exercise Rights
Value of Shares (1,000 + 250) @ RWF1.90
RWF2,375.00
Less Cost of Purchase (250 @ RWF1.50)
(RWF375.00)
RWF2,000.00
Current Wealth (1,000 @ RWF2.00)
RWF2,000.00
(ii) Sell Rights
Sale of Rights (250 @ RWF0.40)
RWF100.00
Value of Shares (1,000 @ RWF1.90)
RWF1,900.00
RWF2,000.00
Current Wealth (1,000 @ RWF2.00)
RWF2000.00
(iii) Exercise Half & Sell Half
Sale of Rights (125 @ RWF0.40)
RWF50.00
Value of Shares (1,000 + 125 @ RWF1.90)
RWF2,137.50
Less Cost of Purchase (125 @ RWF1.50)
(RWF187.50)
RWF2,000.00
Current Wealth (1,000 @ RWF2.00)
RWF2,000.00
(iv) Do Nothing
Value of Shares (1,000 @ RWF1.90)
RWF1,900.00
Current Wealth (1,000 @ RWF2.00)
RWF2,000.00
Loss of Wealth
(RWF100.00)
F. BANK LENDING
The main considerations by the bank before advancing a loan can be summarized by the
mnemonic PARTS.
P URPOSE
A MOUNT
R EPAYMENT
T ERM
S ECURITY
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Study Unit 10
Venture Capital
Contents
A. Introduction
B. Stages of Investment
C. Specialist Areas
D. Business Plan
E. Types of Financing Structure
F. Methods of Withdrawal by Venture Capitalist
G. Case Study
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A. INTRODUCTION
Many new business ventures are considered too risky for traditional bank lending (term loans,
overdrafts etc.) and it is this gap that Venture Capital usually fills.
Venture Capital could be described as a means of financing the start-up, expansion or
purchase of a company, whereby the venture capitalist acquires an agreed proportion of the
share capital (equity) of the company in return for providing the requisite funding. To look
after its interests the venture capitalist will usually want to have a representative appointed to
the board of the company.
The venture capitalist’s financing is not secured he takes the risk of failure just like other
shareholders. Thus, there is a high risk in providing capital in these circumstances and the
possibility of losing the entire investment is much greater than with other forms of lending.
The venture capitalist also participates in the success of the company by selling his
investment and realising a capital gain, or by the company achieving a flotation on the Stock
Market in usually five to seven years from making his investment. As a result, it will
generally take a long time before a return is received from the investment but to compensate
there is the prospect of a substantial return.
B. STAGES OF INVESTMENT
The various stages of investment by a venture capitalist can be defined as follows:
Seed Capital finance provided to enable a business concept to be developed, perhaps
involving production of prototypes and additional research, prior to bringing the
product to market.
Start-Up finance for product development and initial marketing. Companies may be
in the process of being set up or may have been in business for a short time but have not
sold their product commercially.
Expansion capital provided for the growth of a company which is breaking even or
possibly, trading profitably. Funds may be used to finance increased production
capacity, market or product development and/or provide additional working capital.
Capital for “turnaround” situations is also included in this category.
Management Buy Out (MBO) funds provided to enable current operating
management and investors to acquire an existing business.
Management Buy In (MBI) funds provided to enable a manager or group of
managers from outside the company to buy into the company.
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C. SPECIALIST AREAS
Venture Capitalists may specialise in areas in which they will invest. These may relate to:
Preferred Business Sectors e.g. consumer services, Information Technology,
property etc.
Stage of Investment many venture capitalists will finance expansions, MBO’s and
MBI’s but far fewer are interested in financing “Seed Capital,” start-ups and other early
stage companies, due to the additional risks and time/costs involved in refinancing
smaller deals as compared with the benefits.
National or Regional Preferences the preferred geographical location of the
investee.
Amount of Investment varies with the stage of the investment. Start-up and other
early stage investments are usually lesser in amount than expansion and MBO/MBI
investments.
D. BUSINESS PLAN
Before deciding whether an investment is worth backing the venture capitalist will expect to
see a Business Plan. This should cover the following:
Product/Service what is unique about the business idea? What are the strengths
compared to the competitors?
Management Team can the team run and grow a business successfully? What are
their relevant experience, qualifications, track record and motivation? How much is
invested in the company by the management team? Are there any non-executive
directors? Details of other key employees.
Industrywhat are the issues, concerns and risks affecting the business area?
Market Research – do people want to buy the idea?
Operations – how will the business work on a day-to-day basis?
Strategy – medium and long-term strategic plans.
Financial Projections are the assumptions realistic (sales, costs, cash flow etc.)?
Generally, a three or even a five year period should be covered. Alternative scenarios,
using different economic assumptions. Also state how much finance is required, what it
will be used for and how and when the venture capitalist can expect to recover his
investment?
Executive Summaryshould be included at the beginning of the Business Plan. This
is most important as it may well determine the amount of consideration the proposal
will receive.
E. TYPES OF FINANCING STRUCTURE
There are various ways in which a deal can be financed:
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Debt in Addition to Equity a proportion of the required finance is obtained from a
debt provider (e.g. Clearing Bank, Merchant Bank, Factor, Government sources etc.)
Mezzanine Debt loan finance which is half-way between equity and secured debt in
that it either takes a second charge on the company’s assets or is unsecured. Due to the
higher risk the lender requires a higher rate of interest.
Stage Financing the venture capitalist provides rounds of finance when certain
achievements are met e.g. product development, product launch, expansion of
manufacturing facilities etc.
Preference Sharesthese may include Redeemable/Convertible/Participating shares.
Ratchets these enable management to increase (or avoid a reduction in) their equity
holding when the company reaches specific financial stages in its business plan (e.g.
Preference Share redemption targets).
F. METHODS OF WITHDRAWAL BY VENTURE CAPITALIST
The various means by which an investment may be withdrawn after a number of years
include:
The company is acquired by another company (probably through an arranged deal).
A management buyout occurs and the venture capitalist’s shares are purchased by the
existing management team.
A management buy in occurs.
The investment is refinanced, possibly by another venture capitalist organisation.
The company obtains a listing on a Stock Market.
A minority equity stake is purchased in the company, possibly by a customer or other
company in the same industry. This is sometimes referred to as “Corporate Venturing.”
The company is liquidated.
G. CASE STUDY
Balderton Capital Management, with $19bn. in assets under management is one of Europe’s
largest. In March 2008 it made more than nine times its initial investment when it sold a
15.7% stake in Bebo to Time Warner for $140m. It had made the investment less than two
years earlier.
The following is from an interview with Barry Moloney, MD Balderton Capital Management
29.11.2009 The Sunday Times, England
Balderton sold a stake in MySQL, a software company, to Sun Microsystems for a hefty
multiple and then made ten times its original stake when Cisco Systems bought Scansafe, an
online security business. Yoox, an online fashion retailer and another Balderton investment,
will be the first IPO on the Milan bourse for 18 months. Next year Balderton could yield one
of its biggest ever paydays when the online betting exchange Betfair debuts on London’s
Stock Market.
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Balderton’s model is “labour intensive” investing in early-stage companies with a view to big
returns. The goal for every investment is nine or ten times return. Of ten investments we
would expect three or four to lose money and three or four to return twice or three times our
money. Then we would expect two of the ten to make a return of eight, nine or ten times.
It’s not a fool-proof formula, however. In the past two years Balderton had two spectacular
blowouts Payzone and Setanta Sports. Payzone is still a live investment but the company is
so burdened with debt that equity holders are likely to be wiped out in an upcoming
restructuring. A $75m - $80m. loss at Setanta Sports is balanced by an earlier $50m. gain
that Balderton made from NASN, the sports network that Setanta sold to ESPN. The risk did
not pay off but that’s par for the Venture Capital course if you are not prepared to take risk,
you shouldn’t be in the game.
Balderton has 67 investments, many of them in the “new economy” wonga.com, a loans
company; Bling Nation, a mobile payments company; figleaves.com, which sells lingerie and
LoveFilm, a movie rentals business. It has backed a disproportionately high number of Irish
companies, with almost a quarter of its total funds ($450m) invested in them.
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