ACCA F9 Passcard

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ACCA Passcards
Paper F9
Financial Management
Passcards for exams
up to June 2015
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Page i
Fundamentals Paper F9
Financial Management
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First edition 2007, Eighth edition May 2014

ISBN 9781 4727 1128 1
e ISBN 9781 4727 1184 7
British Library Cataloguing-in-Publication Data
A catalogue record for this book is available from the
British Library
Published by
BPP Learning Media Ltd,
BPP House, Aldine Place,
142-144 Uxbridge Road,
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Your learning materials, published by BPP Learning

Media Ltd, are printed on paper obtained from traceable
sustainable sources.
Page ii
All rights reserved. No part of this publication may be

reproduced, stored in a retrieval system or transmitted, in
any form or by any means, electronic, mechanical,
photocopying, recording or otherwise, without the prior
written permission of BPP Learning Media.
BPP Learning Media Ltd

2014
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Page iii
Preface
Contents
Welcome to BPPs Learning Medias new syllabus ACCA Passcards for Paper F9 Financial Management.
They focus on your exam and save you time.
They incorporate diagrams to kick start your memory.
They follow the overall structure of the BPP Learning Medias Study Texts, but BPP Learning Medias ACCA
Passcards are not just a condensed book. Each card has been separately designed for clear presentation.
Topics are self contained and can be grasped visually.
ACCA Passcards are still just the right size for pockets, briefcases and bags.
Run through the Passcards as often as you can during your final revision period. The day before the exam, try
to go through the Passcards again! You will then be well on your way to passing your exams.
Good luck!
Page iii
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Page iv
Preface
Page
1
2-3
4
5
6
7
8
9
10
11
12
13
14
Financial management and financial

objectives
1
Financial management environment
9
Working capital
15
Managing working capital
19
Working capital finance
27
Investment decisions
35
Investment appraisal using DCF methods 39
Allowing for inflation and taxation
45
Project appraisal and risk
49
Specific investment decisions
53
Sources of finance
59
Dividend policy
67
Gearing and capital structure
71
15
16
17
18
19
20
The cost of capital

Capital structure
Business valuations
Market efficiency
Foreign currency risk
Interest rate risk
Contents
Page
75
83
89
95
99
107
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Page 1
1: Financial management and financial

objectives
Topic List
Financial management
Objectives
Stakeholders
Measuring achievement of objectives
Encouraging achievement of objectives
Not-for-profit organisations
This chapter provides a definition of financial management

and objectives and provides the background for your study
of this subject.
You must be able to choose appropriate measures and
indicators of an organisations situation and discuss
whether objectives have been achieved.
Financial
management
Objectives
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Stakeholders
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Page 2
Measuring achievement
of objectives
Encouraging
achievement of objectives
Financial accounting
Provides externallyused information
Management accounting
Provides internallyused information
Financial management
Financial management decisions
Not-for-profit
organisations
Historic picture of past operations
Used to aid management to record, plan and control

activities and help the decision-making process
Financial planning making sure funds available
Financial control objectives being met and assets being
used efficiently
Financing, taking more credit, profit retention, issuing shares
Dividends
Investing, to maximise companys value
Financial
management
Objectives
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Stakeholders
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Page 3
of objectives
Encouraging
Not-for-profit
organisations
Strategy is a course of action to achieve an objective. Corporate strategy is concerned with

the overall purpose and scope of the organisation
Corporate objectives are relevant for the organisation as a whole, relating to key factors for
business success
Non-financial objectives
Financial objectives
Shareholder wealth maximisation
Profit maximisation
Earnings per share growth
Page 3

Welfare of employees
Welfare of management, perks, benefits
Welfare of society, eg green policies
Provision of certain level of service
Responsibilities towards customers/suppliers
1: Financial management and financial objectives
Financial
management
Objectives
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Stakeholders
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of objectives
Stakeholders
are groups whose interests are directly
affected by activities of the organisation.
Internal
Connected
External

Page 4
Managers
Employees
Directors
Shareholders
Lenders
Customers
Suppliers
Competitors
Government
Pressure groups
Local communities
Encouraging
Not-for-profit
organisations
Stakeholder objectives
Ordinary shareholders want to maximise
their wealth
Suppliers want to be paid full amount at
due date and to continue trading
relationship
Banks want to receive interest and
minimise default risk
Employees want to maximise rewards and
ensure employment continuity
Managers want to maximise their own
rewards
Government wants sustained economic
growth and high levels of employment
Financial
management
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Objectives
Stakeholders
Return on capital employed

(ROCE)
PBIT
_______________
Capital employed
Return on equity
Page 5
of objectives
Encouraging
Not-for-profit
organisations
Dividends
Returns to shareholders
Profitability
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Capital gains from increases in market value
Profit margin
Asset turnover
= ____________
PBIT
Sales revenue
Sales revenue
______________
Capital employed
= _________________________________
Profit available to ordinary shareholders
Shareholders equity
PBIT = profit before interest and tax

Page 5
Financial
management
Objectives
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Stakeholders
Dividend yield
Dividend per share
________________________
100%
Ex-div market price per share
Dividend cover
________________________________
Actual dividend
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Page 6
of objectives
Encouraging
Price earnings ratio

Market price of share
__________________
EPS
P/E ratio reflects markets appraisal of
shares future prospects.
Earnings per share (EPS)

________________________________
Weighted average number
of ordinary shares
Not-for-profit
organisations
Financial
management
Objectives
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Stakeholders
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of objectives
Encouraging
Not-for-profit
organisations
Agency relationship
Managers act as agents for the shareholders using delegated powers to run the company in shareholders
best interests.
Encouraging the achievement of stakeholder objectives

Regulatory requirements
Managerial reward schemes
Performance-related pay
Rewarding managers with shares
Share option schemes
Page 7
Corporate governance
The system by which organisations
are directed and controlled
Involves risk management, internal
controls, accountability to
stakeholders, conducting business
in an ethical and effective way
Stock exchange listing

regulations
Rules and regulations
to ensure the stock
market operates fairly
and efficiently
Financial
management
Objectives
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Stakeholders
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of objectives
Encouraging
Not-for-profit
organisations
Not-for-profit organisation
is an organisation whose attainment of its prime goal is not assessed by economic measures.
Value for money

is getting the best
possible combination of
services from the least
resources.
Efficiency Relationship between inputs and outputs

(getting out as much as possible for what goes in)
Effectiveness Relationship between outputs and
objectives (getting done what was supposed to be done)
Economy Obtaining the right quality and quantity of
inputs at lowest cost (being frugal)
Problems of measuring VFM
Multiple objectives
Meaningful measurement of outputs
Subjective assessment
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23: Financial management environment
Topic List
Macroeconomic policy
Government intervention
Financial intermediaries and markets
Rates of interest and rates of return
Businesses must operate in an economy in which the

government is trying to achieve its objectives. The
economic environment will impact on a businesss
activities and future plans.
Financing of a business takes place through financial
markets and institutions.
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Macroeconomic
policy
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Government
intervention
Financial intermediaries
and markets
Rates of interest
and rates of return
Macroeconomic policy targets

Economic growth
Control of inflation
Balance of
payments stability
High level of
employment
Policy tools
Fiscal policy
Monetary policy
Exchange rate policy
involves using government

spending and collecting taxes.
is regulation of the economy

through control of money
supply/interest rates.
is controlling the value of the

currency to manage the prices of
imports and exports.
Each policy will affect businesses through changes in demand, relative prices of goods and services,
borrowing costs, tax on profits, etc.
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Macroeconomic
policy
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Government
intervention
and markets
Rates of interest
and rates of return
Regulation
is any form of state intervention with the operation of the free market.
Competition policy

To reduce a companys domination of a market

Controls on prices or profits
Investigation of mergers
Investigation of restrictive practices
Government assistance for business

Official aid schemes eg grants for depressed areas
Severely restricted by EU policies to prevent distortion of
free market competition
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Green policies
Polluter pays principle eg levy a tax
Subsidies to reduce pollution
Legislation eg waste disposal
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Macroeconomic
policy
Government
intervention
Euromarkets
Rates of interest
and rates of return
are operated by banks/financial institutions and provide

means of trading, lending and borrowing in the shortterm. Markets include primary, Interbank, Eurocurrency
and certificate of deposit.
Functions
Examples
Commercial banks
Finance houses
Mutual societies
Institutional investors
and markets
Money markets
bring together lenders and borrowers of finance.

Page 12

Means of lending/investing
Source of borrowing
Package amounts lent by savers
Pool risk
Provide maturity transformation
are international markets for larger companies to raise finance in

a foreign currency. (Not necessarily the euro or Europe.)
Capital markets
are markets for trading in long-term
financial instruments, equities and
bonds. They enable organisations to
raise new finance and investors to
realise investments. Principal UK
markets are the Stock Exchange and
Alternative Investment Market.
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Money market instruments

(traded over the counter between institutions)
Interest-bearing
instruments
Discount
instruments
Money market
deposits
Treasury bill
Bankers
acceptance
Certificate of
deposit
Repurchase
agreement
Page 13
Commercial paper
Derivatives

Future
Forward
Swap
Option
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Macroeconomic
policy
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Government
intervention
and markets
Rates of interest
and rates of return
Factors affecting interest rates
The risk-return trade-off
Various interest rates are available;

they depend on risk, duration, size of
loan, likely capital gain.
Investors in riskier assets expect to be

compensated for the risk.
General factors affecting

all rates

Need for a real return

Inflation/expectations
Liquidity preference
Balance of payments policy
Monetary policy
Foreign interest rates
Risk

Government bonds
Company loan notes
Preference shares
Ordinary shares
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4: Working capital
Topic List
Working capital management is a crucial part of the

syllabus and essential for a successful business.
The ratios covered in this chapter are essential to learn.
Working capital
Liquidity ratios
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Working capital
Liquidity ratios
Working capital = current assets current liabilities
Working capital management

Minimise risk of insolvency
Maximise return on assets
Cash operating cycle

is the period of time between the outflow of cash to pay for raw materials and the inflow of cash from
customers.
The average time raw materials remain in inventory
less: The period of credit taken from suppliers
plus: The time taken to produce the goods
plus: The time taken by customers to pay for the goods
The optimal length of the cycle depends on the industry.
X
X
X
X
X
The longer the cycle,

the more money is
tied up.
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Working capital
Liquidity ratios
Liquidity ratios
help to indicate whether a company is over-capitalised, with excessive working capital, or if a business is
likely to fail.
Current ratio =
Current assets
Current liabilitie s
Acid test/quick ratio =
Receivables payment period

=
Trade receivables
Credit sales
Inventory days
Average inventory
Cost of sales
365 days
365 days
Current assets
(excluding inventory)
Current liabilitie s
Payables payment period =

Inventory turnover =
Trade payables
Purchases
365 days
Cost of sales
Average inventory
Sales revenue/net working capital can be used to forecast the level of working capital needed for a projected
level of sales.
Page 17
4: Working capital
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Working capital
Liquidity ratios
Overtrading
is when a business is trying to support too large a volume of trade with the capital resources at its disposal.
Symptoms

revenue
current assets
non-current assets
Asset increases financed by trade
payables/bank overdraft
Little/no in proprietors capital

current/quick ratios
Liquidity deficit
Solutions
Finance from share
issues/retained profits
Better inventory/receivables
control
Postpone expansion plans
Maintain/increase proportion
of long-term finance
Low liquidity ratios can

provide indications of
impending bankruptcy.
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5: Managing working capital
Topic List
Managing inventories
Managing accounts receivable
Managing accounts payable
The management of inventories, accounts receivable and

accounts payable are key aspects of working capital
control. Questions may be set on the financial effect of
changing policies and longer questions will probably
require a discussion as well as a calculation.
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Managing
inventories
Inventory costs
Holding costs
Procuring costs
Shortage costs

Cost of capital
Warehouse/handling costs
Deterioration/obsolescence
Insurance
Pilferage
Ordering costs
Delivery costs
Contribution from lost sales

Emergency inventory
Stock-out costs
Re-order level = maximum usage maximum lead time

Purchase cost
Managing
accounts receivable
Economic order quantity (EOQ)

is the optimal ordering quantity
for an item of inventory which will
minimise costs.
EOQ =
D
CO
CH
Q
re-order amount
2
2COD
(Given in exam)
CH
= Usage in units (demand)

= Cost of placing one order
= Holding cost
= Reorder quantity
Buffer safety inventory = re-order level (average usage average lead time)
Average inventory = buffer safety inventory +
Managing
accounts payable
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Bulk discounts
Just-in-time (JIT)
Total cost will be minimised:
describes a policy of obtaining goods from suppliers at the

latest possible time, avoiding the need to carry
materials/component inventory.
At pre-discount EOQ level, so that

discount not worthwhile or
At minimum order size necessary to earn
discount
Calculate: Purchasing costs + Holding costs +
Ordering costs
Page 21
Benefits of JIT
Inventory holding costs
Manufacturing lead
times

Labour productivity
Labour/scrap/warranty
costs
Material purchase costs
(discounts)
Number of transactions
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Managing
inventories
Cost of offering credit =
Managing
accounts receivable
Managing
accounts payable
Value of interest charged on an overdraft to fund the period of credit

or
Interest lost on cash not received and deposited in the bank
Managing receivables involves:

A credit analysis system

Trade references
Bank references
Credit rating agency
A credit control system

Decide on credit limit to be offered

Review regularly
A debt collection system

Efficient administration
Aged listing of receivables
Regular statements and reminders
Clear procedures for taking legal action or charging interest
Consider the use of a debt factor
Analyse whether to use cash discounts to encourage early payment
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The benefits of action to collect debts must be greater than the costs incurred.
Discounts for early settlement
Factoring
Calculate:
Profits foregone by offering discount
Interest charge changes because customer paid at
different times and sales change
is debt collection by factor company which advances

proportion of money due.
Invoice discounting
similar to factoring, this is when a company sells specific
trade debts to another company, at a discount. Invoice
discounting helps to improve cash flow at times of
temporary cash shortage.
Page 23
Advantages
Saving in staff time/

admin costs
New source of finance
to help liquidity
Frees up management
time
Supports a business
when sales are rising
Disdvantages
Can be expensive
Loss of direct
customer contact
and goodwill
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Managing
inventories
Problems with foreign trade

Delays due to paperwork
Transport problems
Bad debt risks
Managing
accounts receivable
Managing
accounts payable
Methods of control
Letters of credit. The customers bank guarantees
it will pay the invoice after delivery of the goods
Bills of exchange. An IOU signed by the
customer, can be sold
Export factoring
Countertrade. A form of barter with goods
exchanged for other goods
Larger inventories and accounts receivable
Export credit insurance
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Managing
inventories
Management of
trade payables
Cost of lost cash
discounts
365
100
100 d
Managing
accounts receivable
Managing
accounts payable
Obtaining satisfactory credit terms

Extending credit if cash short
Maintain good relations
Foreign accounts payable

are subject to exchange rate risk. Depreciation of
a domestic currency will make the cost of supplies
more expensive.
where d is % discount
t is reduction in payment
period in days necessary to
obtain early discount
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Notes
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Page 27
6: Working capital finance
Topic List
The management of cash is the final part of working

capital management.
Cash flow
The cash needs of an organisation can be determined

using a cash flow forecast and this will allow a business
to plan how to deal with expected cash flow surpluses or
shortages.
Treasury management
Cash management models
Investing surplus cash
Working capital funding strategies
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Cash flow
9:51 PM
Treasury
management
Cash flow forecast

A detailed forecast of cash inflows and
outflows incorporating revenue and capital

items
Clearly laid out with references to workings

Depreciation is not a cash item
Page 28
Cash management
models
Investing surplus
cash
Working capital
funding strategies
Cash forecast
Cash receipts
Sales receipts (W1)
Share issue
Cash payments
Purchases (W2)
Dividends
Taxes
Purchase of
non-current assets
Wages
Net surplus/deficit
Opening cash balance
Closing cash balance
Jan
X
___
X
___
X
X
X
X
___
X
___
(X)
X
___
(X)
___
___
Feb
X
X
X
___
X
___
March
X
X
X
___
X
___
X
X
___
X
___
___
X
___
X
___
X
X
___
X
___
___
___
X
___
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Reasons for holding cash

Transactions motive to meet regular
commitments
Precautionary motive to maintain a buffer for
unforeseen contingencies
Speculative motive to make money from a rise in
interest rates
Losses
Asset replacement
Growth support
Seasonal business
One-off expenditure
Page 29
Easing cash flow problems

Postponing capital expenditure

Accelerating cash inflows
Selling non-essential assets
Longer credit
Rescheduling loan repayments
Deferring corporation tax
Reducing dividend payments
Cash flow problems

Cash flow
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Treasury
management
Page 30
Cash management
models
Investing surplus
cash
Working capital
funding strategies
Treasury management
Treasury departments are set up to manage cash funds and currency efficiently, and make the best use of
corporate finance markets.
The main advantages of centralised treasury management are avoiding a mix of surpluses and overdrafts, and
being able to obtain favourable rates on bulk borrowing/investment.
Centralised treasury management

Improve exchange risk management

Employ experts
Smaller precautionary balances required
Focus on profit centre
Decentralised treasury management

Finance matches local assets

Greater autonomy for subsidiaries
More responsive to operating units
No opportunities for large sum speculation
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Cash flow
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Treasury
management
Baumol model
seeks to minimise cash holding
costs by calculating optimal
amount of new funds to raise.
Page 31
Cash management
models
Miller-Orr model
Investing surplus
cash
Working capital
funding strategies
When cash balance reaches upper limit,

firms buys securities to return cash
balance to return point (normal level)
When cash balance reaches lower limit
sell securities to return to return point
Return point = lower limit + (1/3 spread)
Q=
2CS
i
where S is the amount of

cash used in period
C is the fixed cost of
obtaining new funds
i
is the interest cost of

holding cash
May be difficult to
Q is the total amount
predict amounts
to be raised to
required and no buffer
provide for S
cash is allowed for.
Page 31
transaction cost
Spread = 3 3 cash flow variance
4 interest rate
1
/3
Set lower limit

for cash balance
Ascertain interest rate

and transaction cost
Estimate variance
of cash flow
Compute upper limit

and return point
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Cash flow
Investing
surplus
cash
9:51 PM
Treasury
management
Page 32
Cash management
models
Considerations
Liquidity
Profitability
Safety
Long-term cash surpluses may be

used to fund
Investing surplus
cash
Working capital
funding strategies
Instruments

Treasury bills
Term deposits
Certificates of deposit
Sterling commercial paper
Investments (new projects or acquisitions)

Financing (repay debt, buy back shares)
Dividends
Cash flow
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Treasury
management
Page 33
Cash management
models
Working capital
funding strategies
Investing surplus
cash
Conservative approach

Moderate approach
Aggressive approach
Working capital
investment policy

Page 33
High levels of working capital

High financing cost
Reduced risk of system breakdown
Possible inventory obsolesence and lack of flexibility to customer
demand
Low levels of working capital

Aim to increase profitability by reducing financing cost
Increased risk of system breakdown and loss of goodwill
Easier with modern manufacturing techniques
Cash flow
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Treasury
management
Page 34
Cash management
models
Investing surplus
cash
Assets
($)
Fluctuating
current assets
A
C
Permanent
current assets
Non-current assets
Time
Working capital
funding strategies
In A (conservative) all
permanent and some
fluctuating current assets
financed out of long-term
sources; may be surplus cash
for investment.
In B (aggressive) all fluctuating
and some permanent current
assets financed out of shortterm sources, possible liquidity
problems.
In C long-term sources finance
permanent assets, short-term
sources finance
non-permanent assets.
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7: Investment decisions
Topic List
The investment decision is a major topic in F9 and this

chapter introduces the basic techniques.
Investment
As well as carrying out payback and ROCE calculations,

you will also be expected to know their drawbacks.
Payback
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Investment
Investment
Revenue expenditure
Capital expenditure
Payback
Return on capital
employed
For purpose of trade

To maintain assets existing earnings

Acquisition of non-current assets

Improvement in earnings capacity
Bigger outlay
Accrue over time period
The investment decision-making process

1
Origination of proposals
Project screening
Analysis and acceptance
Monitoring and review
Relevant cash flows

Future
Incremental
Cash
No: central overheads, sunk costs, depreciation
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Investment
Payback
Return on capital
employed
Example
is the time taken for the cash inflows from

a capital investment project to equal the
cash outflows, usually expressed in years.
It is used as a minimum target/first screening
method.
$000
P
Q
Investment
60
60
Yr 1 profits
20
50
Yr 2 profits
30
20
Yr 3 profits
50
5
Q pays back first, but ultimately Ps profits are higher on
the same amount of investment.
Disadvantages
Advantages
Simple to calculate and understand

Concentrates on short-term, less risky flows
Can identify quick cash generators
Page 37
Payback

Ignores timing of flows after payback period

Ignores total project return
Ignores time value of money
Arbitrary choice of cut-off
7: Investment decisions
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Investment

Also known as accounting rate of return or
return on investment.
Can be used to rank projects taking place
over a number of years (using average profits
and investment).
Can also rank mutually exclusive projects.
Return on capital
employed
Method of calculation
Estimated average profits
100%
Estimated average investment
Initial outlay + scrap value
2
Profit is after depreciation but before interest and tax
Where average investment =
Disadvantages
Advantages
Quick and simple calculation

Easy to understand % return
Looks at entire project life
Payback

Takes no account of timing

Based on accounting profits, not cash flows
Relative, not absolute, measure
Ignores time value of money
Takes no account of project length
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8: Investment appraisal using DCF methods
Topic List
Discounted cash flow
NPV
IRR
This is an absolutely critical chapter, as questions

requiring the use of NPV and IRR will come up frequently
not just in F9, but also in later papers.
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Discounted
cash flow
NPV
IRR
Discounted cash flow analysis applies discounting arithmetic to the costs and benefits of an
investment project, reducing value of future cash flows to present value equivalent.
Conventions of DCF analysis
Cash flows incurred at beginning of project
occur in year 0
Cash flows occurring during time period
assumed to occur at period-end
Cash flows occurring at beginning of period
assumed to occur at end of previous period
PV of cash flows in perpetuity

$1/r, r is cost of capital
Discounting
Present value of 1 =
1
(1 + r)n
Annuity
Present value of annuity of 1 =
r = Discount rate
n = number of periods
1 (1 + r)
r
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Discounted
cash flow
Net present value (NPV)
NPV
IRR
Features of NPV
is the value obtained by discounting all cash flows of

project by target rate of return/cost of capital. If NPV is
positive, the project will be accepted, if negative it will
be rejected.
Uses all cash flows related to project

Allows timing of cash flows
Can be calculated using generally
accepted method
Rules of NPV calculations

Include
Effect of tax allowances

After-tax incremental cash flows
Working capital requirements
Opportunity costs
Page 41
Exclude

Depreciation
Dividend/interest payments
Sunk costs
Allocated costs and overheads
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Discounted
cash flow
IRR
NPV
The IRR (internal rate of return) method calculates the rate of return at which the NPV is zero.
Calculate net present value using rate for cost

of capital which
a
Is whole number
May give NPV close to zero
Calculate second NPV using a different rate

a
If first NPV is positive, use second rate

greater than first rate
If first NPV is negative, use second rate

less than first rate
Use two NPV values to calculate IRR
Formula to learn
NPVa
NPV NPV
a
b
IRR = a +
(b a) %
where
a
is lower of two rates of return
used
b
is higher of two rates of return
used
NPVa is NPV obtained using rate a
NPVb is NPV obtained using rate b
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Advantages of DCF methods

NPV
Simpler to calculate
Better for ranking mutually
exclusive projects
Easy to incorporate different
discount rates
Page 43
Take into account time value of money

Take account of all projects cash flows
Allow for timing of cash flows
Universally accepted methods
NPV and IRR

comparison
For conventional cash
flows both methods give
the same decision.
IRR

More easily understood

Can be confused with ROCE
Ignores relative size of investments
May be several IRRs if cash flows
not conventional
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Notes
5/13/2014
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Page 45
9: Allowing for inflation and taxation
Topic List
Inflation
Taxation
NPV layout
Tax complications are likely to be introduced frequently

into NPV calculations. As well as bringing inflation and
tax into calculations, in longer questions you could be
asked to explain the difference between real and nominal
rates of return.
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Inflation
Nominal rate of return measures

return in terms of the (falling in value)
currency.
Real rate of return measures return in
constant price level terms.
Real rate or nominal rate?

If cash flows in terms of actual dollars
received/paid in various future dates, use the
nominal rate
If cash flows in terms of value of dollar at time 0
(constant price levels) use the real rate
For DCF calculations, use end of year
money values.
Taxation
NPV layout
Formula (given in exam)

(1 + nominal rate) = (1 + real rate) (1 + inflation rate)
(1 + i)
=
(1 + r)
(1 + h)
If all costs and benefits rise at same inflation
rate, real values are the same as current day
values and no adjustments are needed.
If some costs/revenues inflate at different rates,
apply inflation rates to real cash flows and
discount at nominal rates.
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Taxation
Inflation
Working capital
Increases in working capital reduce the net
cash flow of period
Taxation
Follow the instructions given in the question re
timing and rates.
Relevant cash flows are the incremental cash

flows from one years requirement to next
Assumed to be recovered at end of project
outflows = inflows
Page 47
NPV layout
Total tax cash flow

Tax benefits from tax
allowable depreciation
Tax payments (benefits)

on operating profit
(losses)
Calculate amount of capital allowance

claimed in each year
Dont forget balancing adjustment in year of

sale
Calculate tax saved

9: Allowing for inflation and taxation
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Inflation
Sales receipts
Costs
Sales less Costs
Taxation on profits
Capital expenditure
Scrap value
Working capital
Tax benefit of
tax depreciation
Discount factors @
post-tax cost of capital
Present value
Year
0
___
Year
1
X
(X)
___
X
(X)
Year
2
X
(X)
___
X
(X)
Taxation
Year
3
X
(X)
___
X
(X)
NPV layout
Year
4
___
(X)
(X)
X
X
(X)
___
(X)
X
___
X
X
___
X
X
___
X
X
___
(X)
X
___
(X)
___
___
X
___
X
___
___
X
___
X
___
___
X
___
X
___
___
X
___
(X)
___
___
NPV is the sum

of present values
5/13/2014
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10: Project appraisal and risk
Topic List
Risk and uncertainty
Sensitivity analysis
Probability analysis
Another complication that can be introduced into DCF

calculations is uncertainty. You may be asked in the exam
to carry out sensitivity analysis on a number of variables
or use probabilities when calculating NPV.
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Risk and
uncertainty
Sensitivity
analysis
The probabilities of a projects outcomes are:
Predictable and quantifiable
Not predictable and not

quantifiable
RISK
UNCERTAINTY
Expected values
Risk adjusted discount factor
Adjusted payback
Simulation
Probability
analysis
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Sensitivity
analysis
Risk and
uncertainty
assesses how responsive a projects NPV is to
changes in the variables used to calculate the NPV.
Weaknesses

Only considers one variable at a time

Changes in variables often interdependent
Takes no account of probabilities
Critical factors possibly not controllable
Doesnt provide decision rule
Page 51
Probability
analysis
Variables

Selling price
Sales volume
Cost of capital
Initial cost
Operating costs
Benefits
Sensitivity =
NPV
PV of variable
10: Project appraisal and risk
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Risk and
uncertainty
Sensitivity
analysis
Probability
analysis
Probability analysis
Which project should be selected?
Calculate expected value of NPV
Measure risk by one of following methods

Calculate worst possible outcome and
its probability
Calculate probability that project fails to
achieve positive NPV
If projects are mutually exclusive and carry different

levels of risk, with the less risky project having a
lower expected NPV, which project is selected will
depend on how risk-averse management are.
Problems with expected values
Investment may be one-off, and expected value

not possible outcome
Assigning probabilities may be subjective
Expected values do not indicate range of
outcomes
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11: Specific investment decisions
Topic List
Lease or buy
Asset replacement
Capital rationing
Specific investment decisions use DCF techniques to

evaluate different options.
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Lease or buy
Asset
replacement
Capital
rationing
Operating leases
Finance leases
Lessor bears most of risk and rewards

Lessor responsible for servicing and
maintenance
Period of lease short, less than useful economic
life of asset
Asset not shown on lessees statement of
financial position
Lessee bears most of risks and rewards

Lessee responsible for servicing and maintenance
Primary period of lease for assets useful
economic life, secondary (low-rent) period
afterwards
Asset shown on lessees statement of financial
position
Advantages of leasing

Supplier paid in full

Lessor receives (taxable) income and tax depreciation
Help lessees cash flow
Cheaper than bank loan?
Sale and leaseback

is when a business agrees to sell one
of its assets to a financial institution and
leases it back.
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Steps in lease or buy decision for tax-paying organisation

1
Calculate the costs of leasing (lease payments, lost capital allowances, lost scrap revenue)
Calculate the benefits of leasing (saved outlay on purchase, tax on lease payments)
Discount at the post-tax cost of debt
Calculate the NPV (if positive, lease is cheaper than post-tax cost of loan)
An alternative method is to evaluate the NPV of the cost of the loan and the NPV of the lease separately and
choose the cheapest option.
Page 55
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Page 56
Lease or buy
Asset
replacement
Capital
rationing
Equivalent annual cost method

When an asset is being replaced with an identical asset, the equivalent annual cost method can be
used to calculate an optimum replacement cycle.
Calculate present value of costs for each replacement cycle over one cycle only
Turn present value of costs for each replacement cycle into equivalent annual cost:
PV over one replacement cycle
____________________________
Cumulative PV factor for number
of years in one cycle
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Lease or buy
Capital rationing
is where a company has a limited amount of money
to invest and investments have to be compared in
order to allocate monies most effectively.
Joint ventures
Licensing/franchising
Contracting out
Other sources of finance
Page 57
Capital
rationing
Soft capital rationing

Internal factors

Relaxation of capital constraints

Asset
replacement
Reluctance to surrender control

Wish only to use retain earnings
Reluctance to dilute EPS
Reluctance to pay more interest
Capital expenditure budgets
Hard capital rationing
External factors

Depressed stock market

Restrictions on bank lending
Conservative lending policies
Issue costs
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Lease or buy
Profitability index
Asset
replacement
Capital
rationing
Assumptions
PV future cash flows (excluding capital investment)

PI = _________________________________________
PV capital investment
Example
Project A has investment of $10,000, present value cash
inflows of $11,240
Project B has investment of $40,000, present value of cash
inflows $43,801
Project B has higher NPV ($3,801 compared with $1,240)
Project A has higher PI (1.12 compared with 1.10)
Opportunity to undertake project lost if

not taken during capital rationing period
Compare uncertainty about project
outcomes

Projects are divisible

Ignore strategic value
Ignore cash flow patterns
Ignore project sizes
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Page 59
12: Sources of finance
Topic List
Short-term sources of finance
Debt finance
Venture capital
Equity finance
Islamic finance
This chapter covers a range of sources of short and

long-term finance. Section B questions may require a
discussion of sources of finance.
5/13/2014
Short-term
sources of finance
Debt finance
Overdrafts

9:48 PM
Designed for day to day help

Only pay interest when overdrawn
Bank has flexibility to review
Can be renewed
Wont affect gearing calculation
Trade credit
An interest-free short-term loan

Risks loss of supplier goodwill
Cost is loss of early payment discounts
Page 60
Venture capital
Overdrafts
v
loans
Equity finance
Islamic finance
Loans

Medium-term purposes
Interest and repayments set in advance
Bank wont withdraw at short notice
Shouldnt exceed asset life
Can have loan-overdraft mix
Loan interest rate usually lower than o/d
rate
Operating leases
A contract between the lessor and the

lessee for the hire
Lessor responsible for servicing and
maintenance
5/13/2014
Short-term
sources of finance
Debt finance
Debt finance

9:48 PM
Availability depends on size of business

Duration of required finance
Fixed or floating rate?
Security and covenants?
Page 61
Venture capital
Equity finance
Islamic finance
Deep discount bonds

are issued at a large discount to the nominal value of the
bonds.
Zero coupon bonds

are issued at a discount, with no interest paid on them.
Redemption
Convertible bonds
is the repayment of bonds at maturity.
give the holder the right to convert to other securities, normally ordinary shares, at a pre-determined price/rate
and time.
Conversion premium = Current market value of bonds Conversion value of bonds
Page 61
5/13/2014
Short-term
sources of finance
9:48 PM
Debt finance
Venture capital
is risk capital normally provided in return for an
equity stake and possibly board representation.
Page 62
Venture capital

Equity finance
Islamic finance
Business startups
Development of new products/markets
Management buyouts
Realisation of investments
Very significant amounts
Very high growth potential
Very high returns
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Short-term
sources of finance
9:48 PM
Debt finance
Page 63
Equity finance
Venture capital
Islamic finance
Equity finance
is raised through the sale of ordinary shares to investors via a new issue or a rights issue.
Stock
market
listing
Page 63
Access to wider pool of equity finance

Higher public profile
Higher investor confidence due to
greater scrutiny
Allows owners to realise some of their
investment
Allows use of share issues for incentive
schemes and takeovers.
Disadvantages of obtaining
listing

Loss of control
Vulnerability to takeover
More scrutiny
Greater restrictions on directors
Compliance costs
5/13/2014
Short-term
sources of finance
9:48 PM
Debt finance
Page 64
Venture capital
Equity finance
Islamic finance
Initial public offer (IPO)
Placing
The company sells shares to the public at large for

the first time. Offer for sale by tender means allotting
shares at the highest price they will be taken up.
Placing means arranging for most of an issue to be

bought by a small number of institutional investors. It
is cheaper than an IPO.
Costs of share issues
Pricing share issues
Underwriting costs
Stock Exchange listing fees
Issuing house, solicitors, auditors, public
relation fees
Printing and distribution costs
Advertising

Price of similar companies

Current market conditions
Future trading prospects
Premium on launch
Price growth after launch
Higher price means fewer shares and less
earnings dilution
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Rights issue
Offer price will be

lower than current
market price of
is an offer to existing shareholders
existing shares
enabling them to buy new shares.
Advantages of rights issue
Lower issue costs than IPO

Shareholders acquire more shares
at discount
Relative voting rights unaffected
Value of rights
Theoretical ex-rights price Issue price
TERP example
4 shares @ $2.00
1_ share @ $1.50
5__
Page 65
$
8.00
1.50
____
9.50
____
____
TERP =
9.50
5
= $1.90
5/13/2014
Short-term
sources of finance
9:48 PM
Debt finance
Page 66
Venture capital
Equity finance
Islamic finance
Islamic finance
transaction
Similar to
Murabaha
Trade credit/loan
Musharaka
Venture capital
Profits shared according to a pre-agreed contract. No dividends paid.

Losses shared according to capital contribution.
Mudaraba
Equity
Profits shared according to a pre-agreed contract. No dividends paid.

Losses solely attributable to the provider of the capital.
Ijara
Leasing
Whether operating or finance transaction, in ijara the lessor still owns

the asset and incurrs the risk of ownership. The lessor is responsible
for major maintenance and insurance.
Sukuk
Bonds
There is an underlying tangible asset that the sukuk holder shares in

the risk and rewards of ownerships. This gives the sukuk properties of
equity finance as well as debt finance.
Differences
Pre-agreed mark up to be paid, in recognition of convenience of
paying later, for an asset transferred now. No interest charged.
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13: Dividend policy
Topic List
Dividend policy
Dividend policy is an important part of a companys

relations with its equity shareholders.
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Page 68
Dividend policy
Sufficient funds available

Law on distributable profits
Loan agreements
Investors want dividend/capital gains
Dividend policy
Funds for asset replacement
Preferred gearing level

Other sources of finance
Consistency
Avoid large falls/rises
Retain earnings
No payment to finance providers
Enables directors to invest without asking for
approval by finance providers
Avoids new share issue and change of control
and issue costs
Pay dividends
Signal of good prospects
Ensures share price stability
Shareholders want regular income
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Young company
Mature company
Zero/low dividend
High growth/investment needs
Wants to minimise debt
High, stable dividend

Lower growth
Able and willing to take on debt
Scrip dividend
Share repurchase
is a dividend payment in the form of

new shares, not cash.
is a use for surplus cash, increases

EPS and increases gearing. It may
prevent a takeover or enable a
quoted company to withdraw from
the stock market.
Scrip issue
is an issue of new shares to current
shareholders, by converting equity
reserves.
Page 69
13: Dividend policy
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Page 70
Notes
5/13/2014
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Page 71
14: Gearing and capital structure
Topic List
Gearing
SMEs
This chapter looks at the effects of sources of finance on

the financial position and financial risk of a company. It
also considers the particular financing needs and
problems of small and medium-sized entities.
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Gearing
SMEs
Gearing
is the amount of debt finance a company uses relative to its equity finance.
Financial gearing
Operational gearing
Interest coverage
Market value of debt

____________________
Market value of equity
+ Market value of debt
Contribution
____________
PBIT
PBIT
_______
Interest
Business confidence
Inflation
Interest rate expectations
Level of
gearing
Lender attitudes to increased

debt levels
Shareholder attitudes to
increased debt levels
Restrictions in articles/trust deeds

Gearing increases variability of shareholder earnings and risk of financial failure.
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Gearing
Small and medium-sized enterprises (SMEs)

have three main characteristics:
Unquoted private entities
Ownership restricted to a few individuals
Not just micro-businesses that exist to
employ just owner
SMEs
Funding gap
High failure rate so hard to raise
external finance
Few shareholders so hard to
raise internal finance
Maturity gap
Hard to obtain medium
term loans due to
mismatching of
maturity of assets and
liabilities.
Financing problems
Inadequate security
making banks reluctant to lend.
Page 73
14: Gearing and capital structure
5/13/2014
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Page 74
Gearing
Sources of finance

Owner financing
Overdraft financing
Bank loans
Trade credit
Equity finance
Business angel financing
Venture capital
Leasing
Factoring
Government aid
SMEs
Equity finance
is hard to obtain (equity gap). Major problem is lack of exit
route for external investor.
Business angels
are wealthy individuals who invest directly in small
businesses.
Informal market
May be difficult to arrange
Business angels generally have industry knowledge
includes the Enterprise Finance Guarantee, grants and

Enterprise Capital Funds.
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15: The cost of capital
Topic List
The cost of capital
Dividend growth model
CAPM
Cost of debt
WACC
The cost of capital is used as a discount rate in NPV

calculations. This chapter looks at how the cost of capital
is calculated.
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The cost
of capital
9:47 PM
Dividend growth
model
Page 76
Cost of debt
CAPM
WACC
The cost of capital

is the rate of return that the enterprise must pay to satisfy the providers of funds and it reflects the riskiness of
providing funds.
Risk free rate of return +
Premium for business risk +
Premium for financial risk
COST OF CAPITAL
Creditor hierarchy
Increasing risk
Creditors with a fixed charge
Creditors with a floating charge
Unsecured creditors
Preference shareholders
Ordinary shareholders
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9:47 PM
Dividend growth
model
The cost
of capital
Cost of capital if constant dividends paid

k
Exam formula
P
0
where P0 is price at time 0
D is dividend
ke is cost of equity or preference capital
The growth model

D (1 + g)
+g
k = 0
e
P
0
Page 77
CAPM
P
0
Exam formula
WACC
Estimating growth rate

Use formula (Gordons growth model):
g = br
Exam formula
where r is accounting return on capital employed

b is proportion of earnings retained
Or historic growth:
g = n
1 +g
Cost of debt
dividend in year x
dividend in year x n
where D0 is dividend at time 0

D1 is dividend at time 1
g is dividend growth rate
Page 77
The cost
of capital
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Page 78
Dividend growth
model
CAPM
Cost of debt
WACC
The capital asset pricing model (CAPM)

can be used to calculate the cost of equity and incorporate risk.
Unsystematic risk
Systematic risk
Specific to the company

Can be reduced or
eliminated by
diversification
Due to variations in
market activity
Cannot be
diversified away
Beta factor ()
measures the systematic risk of
a security relative to the market.
It is the average fall in the return
on a share each time there is a
1% fall in the stockmarket as a
whole.
Increasing risk
Beta < 1.0
Share < average risk
Ke < average
Beta = 1.0
Share = average risk
Ke = average
Beta > 1.0

Share > average risk
Ke > average
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The CAPM formula

E(ri) = Rf + i (E (rm) Rf)
Problems with CAPM

Exam formula
where E(ri) is cost of equity capital/expected equity

return
Rf is risk-free rate of return
E(rm) is return from market
i is beta factor of security
Market risk premium/equity risk premium

E(rm) Rf The extra return required from a share to
compensate for its risk compared with average
market risk.
Page 79
Assumptions unrealistic?

Zero insolvency costs

Investment market efficient
Investors hold well-diversified portfolios
Perfect capital market
Required estimates difficult to make

Excess return
Risk-free rate (govt. securities rates vary with
lending terms)
factors difficult to calculate
5/13/2014
The cost
of capital
9:47 PM
Dividend growth
model
After tax cost of irredeemable debt capital

kdnet =
i (1 T )
P
0
Formula to learn
where kdnet is the after-tax cost of the debt capital
i
P0
is the annual interest payment

is the current market price of the debt
capital ex-interest
is the rate of tax
Cost of convertible debt

Use the IRR method as for cost of redeemable debt,
but redemption value = conversion value.
Conversion value = P0 (1+ g)n R Formula to learn
Page 80
Cost of debt
CAPM
WACC
Cost of redeemable debt

Year
Cash flow
DFa
PVa
0
Market value
1
(X)
1 n Interest less tax X
X
n
Redemption value X
X
Kd = a +
NPVa
(b a)
DFb
PVb
1
X
X
(X)
X
X
NPVa NPVb
P0 is current ex-dividend ordinary share price
g is the expected annual growth of the ordinary
share price
n is the number of years to conversion
R is the number of shares received on conversion
5/13/2014
The cost
of capital
WACC =
9:47 PM
Page 81
Dividend growth
model
[ ] [ ]
Ve
Ve + Vd
ke +
ke is cost of equity
kd is cost of debt
Vd
Ve + Vd
WACC
Cost of debt
CAPM
Exam formula
kd (1 T)
Ve is market value of equity

Vd is market value of debt
Use market values rather than book values unless market values unavailable (unquoted company)
Assumptions of WACC
Problems with WACC
Project small relative to company and has same

business risk as company
WACC reflects companys long-term future
capital structure and costs
New investments financed by new funds
Cost of capital reflects marginal cost
New investments may have different business

risk
New finance may change capital structure and
perceived financial risk
Cost of floating rate capital not easy to calculate
Page 81
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Notes
5/28/2014
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Page 83
16: Capital structure
Topic List
Capital structure theories look at the impact of a company

changing its gearing.
Capital structure theories
Geared betas can be used to obtain an appropriate

required return from projects with differing business and
financial risks.
Impact of cost of capital on

investments
5/28/2014
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Page 84
Capital structure
theories
Traditional theory
Is there an optimal capital structure?

Modigliani and Miller
There is an optimal capital mix at which the weighted

average cost of capital is minimised. Shareholders
demand increased returns to compensate for greater risk
as gearing rises (due to increased financial risk). At high
gearing debtholders also require higher returns.
The weighted average cost of capital is

not influenced by changes in capital
structure. The benefits of issuing debt are
counterbalanced by the increased cost of
equity.
Pecking order theory

Increasing
issue
costs
Impact of cost of
capital on investments
Use internal funds if available
Use debt
Issue new equity
5/28/2014
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Page 85
Traditional theory
keg
Cost of
capital
WACC
kd
Po
keg
is the cost of equity in the

geared company
kd
is the cost of debt
WACC
is the weighted average cost

of capital
Po
is the optimal capital structure

where WACC is lowest
Level of gearing
Assumptions
Page 85
All earnings paid out as dividends

Earnings and business risk constant
No issue costs
Tax ignored
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Page 86
Capital structure
theories
M&M ignoring taxation
Impact of cost of
M&M with corporate taxation
Cost of
capital
Cost of
capital
Keg
Keg
WACC
Kd
WACC
Kd
Gearing
Gearing
5/28/2014
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Page 87
Capital structure
theories
Impact of cost of
The lower a companys WACC, the higher the NPV of its future cash flows and the higher its market
value.
Cost of capital
Calculate using
WACC
Marginal cost of capital (using CAPM)
Projects must be small relative to company

Same financial risk from existing capital
structure
Project has a different business risk

Finance used to fund investment changes capital
structure
Project has same business risk as company
Use geared betas
Page 87
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Page 88
Capital structure
theories
Impact of cost of
Calculating a marginal cost of capital

1
Find a companys beta in the new business area
Ungear their beta for their debt, then regear it for your companys debt
Use this project-specific geared beta and CAPM to calculate an appropriate cost of capital
Ve
e
(Ve Vd (1 T))
a = Ungeared (asset) beta
Vd (1 T )
Ve Vd (1 T)
Exam formula
e = Geared (equity) beta
Vd = Market value of debt capital

Ve = Market value of equity
d = Beta factor of debt
T = Rate of corporate tax
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Page 89
17: Business valuations
Topic List
There are a number of methods of valuing businesses

and acquisitions are a key investment decision.
Asset valuation
If a business pays too much for a target, it can damage

shareholders wealth.
Income based valuation

Cash flow valuation
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Asset valuation
Range of values
Max
Min
Income based
valuation
Cash flow
valuation
Uses of net asset valuation method
Value the cashflows or earnings under

new ownership
Value the dividends under the existing
management
Value the assets
Possible bases of valuation
As measure of security in a share valuation

As measure of comparison in scheme of
merger
As floor value in business that is up for sale
Doesn't value the business as a going
concern
Problems in valuation
Historic
basis
(unlikely to
be realistic)
Replacement
basis
(asset used
on ongoing
basis)
Realisable
basis
(asset sold/
business
broken up)

Need for professional valuation

Realisation of assets
Contingent liabilities
Market for assets
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Asset valuation
Price-earnings ratio
Market value
EPS
Market value = EPS P/E ratio
P/E ratio =
Shows the
current profitability
of the company
Shows the markets view of

the growth prospects/risk of
a company
May be affected by
one-off transactions
Which P/E ratio to use?

Adjust downwards if
valuing an unquoted
company
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Income based
valuation
Cash flow
valuation
Have to decide suitable P/E ratio.

Factors to consider:
Industry
Status
Marketability
Shareholders
Asset backing and liquidity
Nature of assets
Gearing
Earnings yield valuation model

Market value =
Earnings
Earnings yield
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Asset valuation
Dividend valuation model

P0 =
Cash flow
valuation
Assumptions
Dividends from new projects of same risk type as
D
ke
existing operations
Where P0 is price at time 0

D is dividend (constant)
ke is cost of equity
P0 =
Income based
valuation
D 0 (1 + g)
ke g
Where D0 is dividend in current year

g is dividend growth rate

No increase in cost of capital

Perfect information
Shareholders have same marginal capital cost
Ignore tax and issue expenses
Problems
Companies that dont pay dividends dont have
zero values
Need enough profitable projects to maintain

dividends
Dividend policy likely to change on takeover
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Discounted cash flows method

Value investment using expected after-tax cash
flows of investment and appropriate cost of capital.
Problems
Difficult to select appropriate cost of capital
Unreliable estimates of future cash flows
Not best method for minority interests who lack
influence on cash flows
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Irredeemable debt
P0 =
i
kd
or
i (1 T )
k dnet
with taxation
Redeemable debt
P0 = (interest earnings annuity factor) +
(Redemption value Discounted cash flow factor)
Convertible debt
P0 = (1 + g)n R
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Notes
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18: Market efficiency
Topic List
Efficient market hypothesis
Valuation of shares
Share prices are determined by the stock market and

should provide a reasonably accurate business valuation
if the market is at least semi-strong form efficient.
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Efficient market
hypothesis
The efficient market hypothesis

provides a rationale for explaining how share
prices react to new information about a company
and when any such reaction occurs
Features of efficient
markets
Prices reflect all relevant
information
No individual dominates
market
Transaction costs insignificant
Valuation of
shares
Weak-form efficiency suggests prices reflect all

relevant information about past price movements
and their implications.
Semi strong-form efficiency suggests prices are
also influenced by publicly available knowledge.
Strong-form efficiency suggests prices are also
influenced by inside information.
Implications
The share price of a company is the best basis for a takeover bid
A company should concentrate on maximising NPV of investments
There is no point in attempting to mislead the market
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Efficient market
hypothesis
Fundamental analysis
Chartists/technical analysts
is based on the theory that share

prices can be derived from an
analysis of future dividends.
Availability and sources of

information
Efficiency in a market relates to
how quickly and accurately prices
adjust to new information.
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Valuation of
shares
attempt to predict share prices by

assuming that past price patterns
will be repeated.
Practical
considerations
Liquidity
is the ease of dealing in shares.
Large companies have better
liquidity and greater marketability
than small companies.
18: Market efficiency
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Efficient market
hypothesis
Valuation of
shares
Practical considerations
Market imperfections and price anomalies
support the view that irrationality often drives the
stock market eg seasonal effects, short-run
overreactions.
Market capitalisation
is the market value of a companys shares
multiplied by the number of issued shares. The
return from investing in smaller companies is
greater in the long run.
Behavioural finance
attempts to explain the market implications of the
psychological factors behind investor decisions and
suggests that irrational investor behaviour may
cause overreactions in prices.
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19: Foreign currency risk
Topic List
Foreign currency risk
Causes of exchange rate fluctuations
Foreign currency risk management
Derivatives
You need to be able to explain the risks associated with

exchange rate movements and suggest and calculate
appropriate hedging methods.
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Foreign currency
risk
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Causes of exchange
rate fluctuations
Foreign currency
risk management
Spot rate
is the exchange rate currently offered on a particular currency.
Forward rate
is an exchange rate set for currencies to be exchanged at a
specified future date.
Economic risk
is the risk that the present value of a companys future
cash flows might be reduced by adverse exchange rate
movements.
Transaction risk
is the risk of adverse exchange rate movements between
the date the price is agreed and the date cash is
received/paid, arising during normal international trade.
Derivatives
Remember!
Company sells
buys
base currency
base currency
LOW
HIGH
For example, if UK company is buying and selling

pounds, selling (offer) price may be 1.45 $/,
buying (bid) price may be 1.47 $/.
Translation risk
is the risk that the organisation will make
exchange losses when the accounting results of
its foreign branches or subsidiaries are translated
into the home currency.
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Foreign currency
risk
Influences on exchange rates

Interest rates
Inflation rates
Balance of payments
Market sentiment/speculation
Government policy
Purchasing power parity

predicts exchange rate fluctuations based on
differences in inflation rates in two countries.
(1 + hc )
Exam formula
S1 = S 0
(1 + hb )
hc = inflation rate in country c
hb = inflation rate in country b
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Page 101
Causes of exchange
rate fluctuations
Foreign currency
risk management
Derivatives
Fisher effect
looks at the relationship between interest rates and expected
rates of inflation
[1 + nominal rate] = [1 + real interest rate] [1 + inflation rate]
Interest rate parity

predicts foreign exchange rate fluctuations based on
differences in interest rates in two countries.
(1 + ic)
F0 = S0
Exam formula
(1 + ib)
Where F0
S0
ic
ib
=
=
=
=
forward rate
current spot rate
interest rate in country c
interest rate in country b
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Foreign currency
risk
Page 102
Causes of exchange
rate fluctuations
Foreign currency
risk management
Four-way equivalence
links interest rates, inflation, the expected forward rate and the expected spot rate.
Derivatives
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Foreign currency
risk
Internal methods include:
Page 103
Causes of exchange
rate fluctuations
Foreign currency
risk management
Derivatives
Matching
Creating $ costs
Currency of invoice
Invoice foreign
customers in their
currency
Page 103
Leading
$ Revenue
Accelerating
receipts/payments
Netting
Lagging
Against $ costs from

other divisions
Delaying
payments/receipts
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Foreign currency
risk
Page 104
Causes of exchange
rate fluctuations
Foreign currency
risk management
Forward exchange contract

A firm and binding contract between a bank and its customer

For the purchase/sale of a specified quantity of a stated foreign currency
At a rate fixed at the time the contract is made
For performance at a future time agreed when contract is made
Advantages
Simple
Available for many currencies

Normally available for more than a year ahead
Disadvantages
Fixed date agreements

Rate quoted may be unattractive
Derivatives
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Money market hedging

Future foreign currency payment
1 Borrow now in home currency
2 Convert home currency loan to foreign currency
3 Put foreign currency on deposit
4 When have to make payment
(a) Make payment from deposit
(b) Repay home currency borrowing
Advantages
May be cheaper if an exporter with a cash flow
deficit
May be cheaper if an importer with a cash flow
surplus
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Future foreign currency receipt

1 Borrow now in foreign currency
2 Convert foreign currency loan to home currency
3 Put home currency on deposit
4 When cash received
(a) Take cash from deposit
(b) Repay foreign currency borrowing
Disadvantages
More time consuming than forward contract

and normally no cheaper
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Foreign currency
risk
Page 106
Causes of exchange
rate fluctuations
Foreign currency
risk management
Derivatives
Currency futures
are standardised contracts for the sale or purchase at a set future date of a set quantity of currency.
Disadvantages of futures
Advantages of futures
Flexible dates ie a September futures can be

used on any day up to the end of September
Only available in large contract sizes

Deposit needs to be topped up on a daily basis if
the contract is incurring losses
Currency options
are the right to buy (call) or sell (put) a foreign currency at a specific exchange rate at a future date.
Advantages of options
Disadvantages of options
Flexible dates (like a future)

Allow a company to take advantage of favourable movements in
Only available in large contract
Expensive
exchange rates. Options are the only form of hedging that does this
Useful for uncertain transactions, can be sold if needed
sizes
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20: Interest rate risk
Topic List
Interest rate risk
Risk management
Interest rate fluctuations are a source of risk for a business

and can be managed using financial instruments.
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Interest
rate risk
Risk
management
Types of interest rate risk

Higher costs on existing loans
If loans are at a variable or floating rate
Higher costs on planned loans
Even if fixed interest finance is used
Basis risk
Interest bearing liabilities and interest bearing assets

may not move perfectly in line with each other
Gap exposure
Interest rates on interest bearing liabilities and interest

bearing assets may be revised at different time periods
Structure of interest rates

Risk
Higher risk borrowers pay higher rates
Size of loan
Larger deposits attract higher rates than smaller deposits
Duration of lending
The longer the term of an asset to maturity, the higher the rate of interest paid
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% rate
of interest
Normal yield curve
Explanation of yield curve

Expectations theory
Liquidity preference theory
Market segmentation theory
Page 109
Years to maturity
Interest rates are expected to rise in the future (if expected to fall, yield curve
is less steep or downward sloping)
Investors require compensation for sacrificing liquidity on long-dated bonds,
hence generally upward sloping
Banks prefer short-dated bonds and pension funds prefer long-dated bonds
ie, there are different markets and investors will not switch segment even if
forecast of future interest rates changes, hence often kinked or discontinuous
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Interest
rate risk
Risk
management
Internal methods
Matching
is where assets and liabilities with a common
interest rate are matched. Used by banks.
Forward rate agreements
Smoothing
is where a company keeps a balance between its
fixed rate and floating rate borrowing.
External methods
hedge interest rate risk by fixing the rate on the future borrowing.
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Interest rate futures
Hedge against interest rate movements. The terms,

amounts and periods are standardised.
The futures prices will vary with changes in

interest rates
Outlay to buy futures is less than buying the

financial instrument
Interest rate swaps
are agreements where parties exchange interest

rate commitments.
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Page 111
Interest rate option
Grants the buyer the right to deal at an agreed interest

rate at a future maturity date.
If a company needs to hedge borrowing,
purchase put options.
If a company needs to hedge lending, purchase
call options.
Interest rate cap sets an interest rate ceiling.
Interest rate floor sets lower limit to interest
rates.
Which instruments to use?
Consider:
Cost
Flexibility
Expectations
Ability to benefit from favourable interest rate
movements
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Notes
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Notes
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Notes
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Notes
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Notes
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Notes
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Notes
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Notes
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Notes
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Notes
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Notes
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Notes
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Notes

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First edition 2007, Eighth edition May 2014

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All rights reserved. No part of this publication may be

BPP Learning Media Ltd

Financial management and financial

The cost of capital

1: Financial management and financial

This chapter provides a definition of financial management

Provides externallyused information

Provides internallyused information

Historic picture of past operations

Used to aid management to record, plan and control

Strategy is a course of action to achieve an objective. Corporate strategy is concerned with

Return on capital employed

Capital gains from increases in market value

PBIT = profit before interest and tax

1: Financial management and financial objectives

Price earnings ratio

Earnings per share (EPS)

Encouraging the achievement of stakeholder objectives

Stock exchange listing

1: Financial management and financial objectives

Value for money

Efficiency Relationship between inputs and outputs

23: Financial management environment

Businesses must operate in an economy in which the

Macroeconomic policy targets

Exchange rate policy

involves using government

is regulation of the economy

is controlling the value of the

To reduce a companys domination of a market

Government assistance for business

are operated by banks/financial institutions and provide

bring together lenders and borrowers of finance.

are international markets for larger companies to raise finance in

Money market instruments

23: Financial management environment

Factors affecting interest rates

The risk-return trade-off

Various interest rates are available;

Investors in riskier assets expect to be

General factors affecting

Need for a real return

Working capital management is a crucial part of the

Working capital = current assets current liabilities

Working capital management

Maximise return on assets

Cash operating cycle

The longer the cycle,

Acid test/quick ratio =

Receivables payment period

Payables payment period =

Little/no in proprietors capital

Low liquidity ratios can

5: Managing working capital

The management of inventories, accounts receivable and

Contribution from lost sales

Re-order level = maximum usage maximum lead time

Effect of tax allowances