BDPW3103 Introductory Finance - Vapr20

BDPW3103
Introductory Finance
Copyright © Open University Malaysia (OUM)

BDPW3103
INTRODUCTORY
FINANCE
Loo Sin Chun

Project Directors: Prof Dr Widad Othman
Prof Dr Shamsul Nahar Abdullah
Open University Malaysia
Module Writer: Loo Sin Chun
Moderators: Dr Shaari Abd Hamid

Lilian Kek Siew Yick
Ratna Khuzaimah Mohamad

Enhancer: Farhana Aini Omar
Developed by: Centre for Instructional Design and Technology

First Edition, November 2008

Second Edition, December 2012
Third Edition, July 2019
Fourth Edition, April 2020 (MREP)
Copyright © Open University Malaysia (OUM), April 2020, BDPW3103
All rights reserved. No part of this work may be reproduced in any form or by any means without
the written permission of the President, Open University Malaysia (OUM).
Table of Contents
Course Guide ix–xiii
Topic 1 Introduction to Financial Management 1

1.1 The Difference between Accounting and Finance 2
1.2 Financial Management 3
1.3 The Objectives of the Firm 3
1.3.1 Maximise Profit 4
1.3.2 Maximise the Wealth of a Firm or Shareholders 5
1.3.3 Maximise the ManagerÊs Utility 5
1.3.4 Uplift the Standards and Welfare of Workers 6
1.3.5 Carry Out Social Responsibility 6
1.3.6 Maintain Continuous Existence 6
1.4 The Roles of the Financial Manager 7
1.4.1 To Prepare the FirmÊs Financial Planning 7
1.4.2 To Do Financial Analysis 7
1.4.3 To Advise the Management Regarding Investment 7
and Financing
1.5 Types of Business Organisations 9
1.5.1 Sole Proprietorship 9
1.5.2 Partnership 10
1.5.3 Company 11
1.6 The Challenge of Financial Management 13
Summary 15
Key Terms 16
Topic 2 Financial Environment 17

2.1 Financial Market 18
2.1.1 Money Market 19
2.1.2 Capital Market 21
2.2 Interest Rates 23
2.2.1 Factors that Influence Interest Rates 24
2.2.2 The Effect of Interest Rates on the Profits of a Firm 25
Summary 27
Key Terms 28
iv  TABLE OF CONTENTS
Topic 3 Financial Statements and Financial Ratio Analysis 29

3.1 Financial Statements 30
3.1.1 Balance Sheet 30
3.1.2 Income Statement 33
3.1.3 Cash Flow Statement 35
3.2 Financial Statements Analysis 37
3.2.1 Ratio Analysis 38
3.2.2 Liquidity Ratios 39
3.2.3 Asset Management Ratios 40
3.2.4 Debt Management Ratios 43
3.2.5 Profitability Ratios 45
3.2.6 Market Value Ratios 46
3.2.7 Uses of Financial Ratios 49
3.2.8 Limitations of Financial Ratio Analysis 50
Summary 52
Key Terms 54
Topic 4 Financial Mathematics 55

4.1 Present Value and Future Value 56
4.1.1 Compounding 56
4.1.2 Discounting 59
4.2 Annuity 63
4.2.1 Future Value Annuity 63
4.2.2 Present Value Annuity 65
4.3 Loan Amortisation 69
4.3.1 Calculating Loan Amortisation 70
4.3.2 Table of Loan Amortisation 71
4.4 Nominal Interest Rate and Effective Interest Rate 72
Summary 73
Key Terms 74
Topic 5 Capital Budgeting and Cash Flow Projection 75

5.1 Capital Budgeting 76
5.1.1 The Importance of Capital Budgeting 77
5.1.2 Evaluation of a Capital Budgeting Project 78
5.1.3 Steps in Evaluating a Capital Budgeting Project 79
5.1.4 Methods in Evaluating a Proposed Project 80
5.2 Guidelines on Cash Flow Estimation 93
5.2.1 Based on Cash Flow and Not on Accounting Profit 94
5.2.2 Only Relevant Additional Cash Flow is 94
Considered
TABLE OF CONTENTS  v
5.3 Making Decisions on Expansion Projects and 95

Replacement Projects
5.4 Cash Flow Estimation and Risk 96
5.5 Cash Flow Estimation and Inflation 96
Summary 97
Key Terms 97
Topic 6 Cost of Capital and Capital Structure 98

6.1 Cost of Capital 99
6.1.1 Factors Influencing Cost of Capital 99
6.1.2 The Importance of Cost of Capital 100
6.1.3 Types of Capital Components 100
6.2 Capital Structure 101
6.3 Weighted Average Cost of Capital 101
6.3.1 Cost of Debt 104
6.3.2 Cost of Preference Shares 105
6.3.3 Cost of Common Equity 106
6.4 Importance of Capital Structure to the Firm 108
6.5 Optimum Capital Structure 110
6.5.1 Target of Capital Structure 110
6.5.2 Risk 110
6.6 Leverage 111
6.6.1 Break-even Point 111
6.6.2 Contribution Margin 112
6.6.3 Earnings Before Interest and Tax 114
6.6.4 Operating Leverage 114
6.6.5 Financial Leverage 117
6.6.6 Combination of Operating Leverage and 120
Financial Leverage
6.6.7 Implication 124
6.7 Restructuring Capital and Leverage 124
Summary 125
Key Terms 125
Topic 7 Working Capital Management 126

7.1 Definition of Working Capital Management 127
7.2 Working Capital 127
7.2.1 Current Assets 128
7.2.2 Current Liabilities 128
7.2.3 Gross Working Capital and Net Working Capital 129
7.2.4 Correlation between Working Capital and 130
Liquidity
7.2.5 Correlation between Liquidity and Returns 133
vi  TABLE OF CONTENTS
7.3 Zero Working Capital 133

7.4 Factors Influencing the Sum of Working Capital 135
Summary 136
Key Terms 137
Topic 8 Cash and Marketable Securities Management 138

8.1 Cash 139
8.1.1 A FirmÊs Motives in Holding Cash 139
8.1.2 Cash Budget 141
8.1.3 Cash Management Techniques 143
8.2 Marketable Securities 146
Summary 148
Key Terms 148
Topic 9 Accounts Receivable Management 149

9.1 Accounts Receivable 150
9.1.1 Credit Policy and Collection 151
9.2 Important Notes on Accounts Receivable 153
Summary 154
Key Terms 154
Topic 10 Inventory Management 155

10.1 Inventory 156
10.2 The Importance of Inventory Management 157
10.3 Important Factors in Inventory Management 159
10.3.1 Economic Order Quantity (EOQ) Model 159
10.3.2 Safety Stocks 163
10.3.3 Discount Quantity and Economic Order Quantity 164
Model
10.3.4 Inflation and the Economic Quantity Model 165
10.3.5 Risks 166
Summary 166
Key Terms 167
Answers 168
COURSE GUIDE  ix
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.
INTRODUCTION
BDPW3103 Introductory Finance is one of the courses offered at Open
University Malaysia (OUM). This course is worth three credit hours and should
be covered over 8 to 15 weeks.
The subject matter aims to equip learners with basic understanding of several
concepts that are important in corporate finance. These include capital
budgeting, working capital management, accounts receivable and inventory
management.
COURSE AUDIENCE
This is a core course for students taking the Diploma in Management, Diploma in
Accounting and Diploma in Human Resource Management programmes.
As an open distance learner, you should be acquainted with learning

independently and being able to optimise the learning modes and environment
available to you. Before you begin this course, please confirm the course
material, the course requirements and how the course is conducted.
x  COURSE GUIDE
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.
Table 1: Estimation of Time Accumulation of Study Hours
Study
Study Activities
Hours
Briefly go through the course content and participate in initial discussions 3
Study the module 60
Attend 3 tutorial sessions 6
Online participation 16
Revision 15
Assignment(s), Tests and Examination(s) 20
TOTAL STUDY HOURS ACCUMULATED 120
COURSE LEARNING OUTCOMES

By the end of this course, you should be able to:
1. Explain the basic terms and concepts related to finance;
2. Apply the principles learnt in making financial decisions; and
3. Analyse various aspects of finance including financial statements,

investment, financing and planning to achieve financial goals.
COURSE SYNOPSIS
This course is divided into 10 topics. The synopsis for each topic can be listed as
follows:
Topic 1 begins with differentiating between accounting and finance.
Topic 2 introduces learners to the financial environment. It also introduces the

concept of interest rates, including influencing factors and the effects of interest
rates on the firmÊs profit.
COURSE GUIDE  xi
Topic 3 explains the importance of the financial statement and its analysis.
Topic 4 discusses financial mathematics or the concept of the value of money

over time.
Topic 5 discusses capital budgeting and cash flow projection to better

comprehend the technique of project evaluation.
Topic 6 discusses cost and capital structures.
Topic 7 explains the concepts of current assets and current liabilities as well as
their management.
Topic 8 discusses the management of every current asset in further detail. This
includes cash management, inventory management and accounts receivable
management.
Topic 9 discusses accounts receivable management in further detail.
Topic 10 discusses the importance of inventory management, which differs

according to different types of business.
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise
your study of this course in a more objective and effective way. Generally, the
text arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
Self-Check: This component of the module is inserted at strategic locations

throughout the module. It may be inserted after one subtopic or a few subtopics.
It usually comes in the form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the subtopic(s). Most of the time, the answers to the questions can be
found directly from the module itself.
xii  COURSE GUIDE
Activity: Like Self-Check, the Activity component is also placed at various

locations or junctures throughout the module. This component may require you
to solve questions, explore short case studies, or conduct an observation or
research. It may even require you to evaluate a given scenario. When you come
across an Activity, you should try to reflect on what you have gathered from the
module and apply it to real situations. You should, at the same time, engage
yourself in higher order thinking where you might be required to analyse,
synthesise and evaluate instead of only having to recall and define.
Summary: You will find this component at the end of each topic. This
component helps you to recap the whole topic. By going through the
summary, you should be able to gauge your knowledge retention level.
Should you find points in the summary that you do not fully understand, it
would be a good idea for you to revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should
go through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
References: The References section is where a list of relevant and useful

textbooks, journals, articles, electronic contents or sources can be found. The list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read or refer to the suggested sources to obtain the additional
information needed and to enhance your overall understanding of the course.
PRIOR KNOWLEDGE
This is an introduction course. No prior knowledge required.
ASSESSMENT METHOD
Please refer to myINSPIRE.
COURSE GUIDE  xiii
REFERENCES
Brigham, E. F., & Houstan, J. F. (2019). Fundamentals of financial management
(15th ed.). Mason, OH: Cengage Learning.
Keown, A. J., Martin, J. D., & Petty, J. W. (2016). Foundation of finance (9th ed.).
Boston, MA: Pearson.
TAN SRI DR ABDULLAH SANUSI (TSDAS)

DIGITAL LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for
the use of OUM learners. This comprehensive digital library, which is accessible
through the OUM portal, provides access to more than 30 online databases
comprising e-journals, e-theses, e-books and more. Examples of databases
available are EBSCOhost, ProQuest, SpringerLink, Books247, InfoSci Books,
Emerald Management Plus and Ebrary Electronic Books. As an OUM learner,
you are encouraged to make full use of the resources available through this
library.
viii  TABLE OF CONTENTS
Topic  Introduction to
Financial
1 Management
LEARNING OUTCOMES
By the end of this topic, you should be able to:
Differentiate between accounting and finance;
Explain the importance of financial management;
Identify the objectives of a firm;
Discuss the role of financial managers in a firm;
Elaborate on the characteristics, advantages and disadvantages of the different
types of business organisations; and
Discuss the challenges of financial management in the future.
 INTRODUCTION
We always relate the word „finance‰ with money. This is because both are
closely related. For a firm or a business organisation, any money spent for
business purposes or production is regarded as cost. A business organisation gets
profit from its production or business activities.
However, a business organisation may not always have sufficient funds for
expenses purposes. For example, a business firm wishes to invest but it does not
have sufficient funds; or when a government wants to undertake an infrastructure
project but its funds are insufficient. Where can the business organisation and the
government get funds to pay for the expenses? The answer lies in the existence of
the money market and capital market in the field of finance. Another issue related
to finance is the making of investment decisions. If a firm is given several
proposals for investment projects, how does it decide which project to choose?
2  TOPIC 1 INTRODUCTION TO FINANCIAL MANAGEMENT
Research regarding finance is divided into three fields as follows:
(a) Money market and capital market;
(b) Investment; and
(c) Financial management.
This topic provides an overview of financial management. We will discuss the

differences between finance and accounting, the meaning of financial
management, forms of business organisations and the challenge of financial
management. These matters are important to provide a whole description to
anyone who wishes to be involved in the field of finance.
ACTIVITY 1.1
Based on your prior knowledge and understanding, explain the differences

between accounting and finance. Share your answers on the myINSPIRE online
learning platform.
1.1 THE DIFFERENCE BETWEEN

ACCOUNTING AND FINANCE
Accounting is a record-keeping system that was invented to reflect the
financial operation of a firm. This involves the process of identifying,
measuring and organising the information in such a way that it can be used in
the process of decision-making. This record can be used periodically to produce
financial statements such as the balance sheet, income statement and cash
flow statement.
These statements reflect the firmÊs financial standing and performance. The
management, investors and banks can use the information attained from these
statements to help them in making decisions.
Finance consists of three important aspects, namely the money market and
capital market, investment and financial management. Although accounting and
finance do not involve the same aspects, they are closely related. To have good
financial management, a lot of accounting information is required such as
financial statements and the financial ratio analysis. These will be reviewed in
Topic 3.
TOPIC 1 INTRODUCTION TO FINANCIAL MANAGEMENT  3
1.2 FINANCIAL MANAGEMENT
Source: https://www.picpedia.org/clipboard/images/financial-management.jpg
Financial management refers to how we manage money to get maximum return

from investments. This encompasses activities such as financial analysis,
financial planning and capital budgeting. Financial planning and financial
management are important for all organisations – big and small, as well as
private firms and government bodies. Good financial planning and management
increases the value of a firm. Hence, the important task of a financial manager is
to utilise methods of collecting and using funds to maximise the wealth of the
firm and uplift the standards and welfare of its workers, as well as increase
consumersÊ satisfaction.
1.3 THE OBJECTIVES OF THE FIRM

ACTIVITY 1.2
In your opinion, what are the main objectives of a firm? Share and compare
your answers with your coursemates on myINSPIRE.
To measure whether a firm is being managed well, we first need to establish our
goals or objectives, which serve as a guide to our decision-making process. To
make an effective financial decision, we have to understand the goals or
objectives of a firm.
The objectives of a firm are shown in Figure 1.1:
Figure 1.1: The objectives of a firm
1.3.1 Maximise Profit

In economic theory, the objective of a firm is to maximise profit. This objective
can be achieved by producing goods where marginal cost is the same as marginal
revenue. In practice, it is not so easy to use this objective as a guideline in
making decisions. This is because firms do not operate in an environment of
perfect, complete information. Conditions of the environment such as changes in
demand, supply and technology also make it difficult to use this objective in
making the firmÊs decisions. Nevertheless, amongst economists, maximising
profit is still regarded as the main objective of the firm.
In financial management, we need to establish the firmÊs objective so that we

know which direction we want to go and also understand the implications of a
financial decision based on the objective. In financial management, the main
objective of a firm is to maximise the value of a company or the wealth of its
shareholders.
1.3.2 Maximise the Wealth of a Firm or Shareholders

Ownership and management are two different groups in a limited company. The
company owners are shareholders who hope to get financial returns from the
share investments they own. Shareholders have the right to vote and choose a
board of directors to oversee the companyÊs management. The management of
the company is done by a manager who is an employee of the company. Thus,
managers follow the policies that have been underlined by the shareholders.
These shareholders are the owners of the company who are interested in
maximising the wealth of the company and with that, increase its stock value.
The wealth of a company can be measured by its stock market price.
The goal of maximising the wealth of shareholders necessitates the management

of a firm to maximise the present value of a future return that is expected by
shareholders. This objective of maximising wealth is a rational objective because
it takes into account the different risks and times in terms of the acceptance of
returns and expenditure cost. Since the wealth of a shareholder is measured in
terms of the value of a stock, we can measure the firmÊs performance in
achieving this objective.
1.3.3 Maximise the Manager’s Utility

Since ownership and management are separated, a manager also has the
additional objective of maximising his or her own personal utility. As a manager
who receives a salary for the job done, he also needs to have additional benefits
to maximise his or her utility, such as better working conditions, higher prestige
etc. A manager also has personal interest apart from attaining satisfactory profits
for the shareholders.
1.3.4 Uplift the Standards and Welfare of Workers

Workers are important assets to a firm. To give encouragement to workers, a
company should give due emphasis to its salary scheme, as well as additional
benefits and suitable training programmes that would increase the workersÊ
skills. A firm should also motivate its workers to increase productivity.
1.3.5 Carry Out Social Responsibility

Although a company may have prime responsibilities to its shareholders, it
cannot neglect its workers as well as the society. As noted before, a company
does not consist of shareholders only. Rather, it is a combination of shareholders,
workers and clients. Hence, apart from its responsibility to shareholders and
workers, a company also needs to be responsible to its clients and society as a
whole. Social responsibility can be in the form of giving donations to welfare
organisations, taking steps to clean and beautify the environment, etc. The
purpose of social responsibility is to establish an ongoing relationship between
the company and society, which will in turn improve the companyÊs image
amongst the people.
1.3.6 Maintain Continuous Existence

Although a firm has several objectives, it is important that it continues to exist.
Other objectives are useless if the firm cannot continue to exist. For the purpose
of continuous existence, a firm should be able to position itself within an
environment that encompasses related issues such as competition, clients,
workers, management, technology, etc.
The study of economics emphasises the objective of profit maximisation, whereas

in the study of finance, more emphasis is given to maximising the wealth of the
company or increasing the price of shares. In the following topics, we shall
discuss this objective in further detail as well as how it is used as a guide to make
financial decisions.
SELF-CHECK 1.1
Even though maximising the wealth of a company is the main aim in making
the firmÊs financial decisions, there are other objectives that are determined
by the firm. State four additional objectives that can be the secondary
purposes of a firm.
1.4 THE ROLES OF THE FINANCIAL MANAGER

ACTIVITY 1.3
Assume the role of a financial manager. Describe your main responsibilities to

enhance your companyÊs financial standing. Share your descriptions on
myINSPIRE and review each otherÊs answers.
Finance is the cornerstone of a firm. Whether a firm can continue its business or
not is dependent on its financial situation. Most financial decisions are dependent
on the financial manager. Let us take a look at some of the roles of the financial
manager.
1.4.1 To Prepare the Firm’s Financial Planning

A financial manager plays the important role of planning the firmÊs finances
because without good financial management, a firm may go bankrupt. In the task
of predicting and preparing the firmÊs financial planning, a financial manager
needs to have information from other departments to ensure that the economic
probabilities used by all departments are consistent and make sense.
1.4.2 To Do Financial Analysis

All matters involving finance need to be analysed by the financial manager to
ensure that they help to achieve the firmÊs objective in maximising its wealth.
1.4.3 To Advise the Management Regarding

Investment and Financing
The firmÊs management needs to make various decisions such as the kind of
investments to be done, establishing the price of a product, cost control, types of
advertisements, dividend policy, workers policy, and so on. Hence, they may not
have the time to reflect all of these matters in detail and their implications to the
firmÊs finances. Besides that, in the management itself, there might be people
who are not adept in the field of finance. Thus, the financial manager should
lessen the managementÊs burden by preparing a working paper or report
regarding suitable types of investments from a financial perspective, as well as
suggesting compatible prices for its products to give the firm a reasonable margin
of profit.
In short, it can be said that the role of a financial manager and members of his
staff are to manage and control all matters related to the finance of the firm,
which would help in achieving the firmÊs objective to maximise its wealth.
ACTIVITY 1.4
Prepare a list of the work scope of a financial manager. Share your list on
myINSPIRE and review your coursematesÊ answers. Is there anything crucial
that you may have missed?
SELF-CHECK 1.2
Indicate TRUE (T) or FALSE (F) for each of the following statements
Finance is the same as accounting.
In the study of economics, all firms have the objective of maximising the
wealth of a firm.
Maximising the wealth of a company can also be regarded as increasing the

price of its shares.
The role of a financial manager includes helping to make decisions regarding

the price of products, dividend policy and workers policy.
Good financial management is important to an organisation in order to avoid

bankruptcy.
1.5 TYPES OF BUSINESS ORGANISATIONS

ACTIVITY 1.5
Discuss with your coursemates the meaning of sole proprietorship, partnership

and company. Focus on the need to have these different categories of
ownership.
There are three types of business organisations:
(a) Sole proprietorship;
(b) Partnership; and
(c) Company.
Let us take a look at each type in detail.
1.5.1 Sole Proprietorship

A sole proprietorship is a form of business that has only one owner and it is
usually small. This type of business organisation is simple to form. The
capital resource is usually attained from the ownerÊs savings or loans from
friends or banks. The proprietor owns all of its assets and also bears all of the
business liability. The liability of a sole proprietorship is unlimited – this
means that if the business is in debt to others, the proprietor must sell his own
personal assets such as houses, land or automobiles to pay off his debts. Profit
gained from the business is regarded as the ownerÊs revenue, and taxes are
based on individual income tax. Examples of sole proprietorship are small
sundry shops, restaurants, salons, pet shops, etc.
The advantages and disadvantages of this type of business are elaborated in

Table 1.1.
Table 1.1: The Advantages and Disadvantages of Sole Proprietorship
Advantages Disadvantages
 Easy to set up. • Unlimited liability.
 The management is flexible. The • The capital is small. Difficult to
proprietor can manage the business expand because of small
any way he sees fit. capital.
 Easy to control because all business • The existence of a sole
decisions are made by the proprietor. proprietorship is temporary. It
dissolves with the death of the
 Profits are taxed according to
owner.
individual taxation.
1.5.2 Partnership
A partnership can be formed when there are two or more partners who wish to
run a business. The agreement between partners can either be formal or
informal. This type of business is easy to form. Like sole proprietorship, a
general partnership also has unlimited liability – that is, when the business is
in debt to others, all its business partners who are the owners of the business
must pay the debt with their own personal assets.
The liability obligation may be in the form of percentage owned by the partners
concerned. Sometimes, limited partnership may be formed as a limited
partnership liability. In this type of partnership, there must be at least a partner
who is willing to be burdened with unlimited liability. A partner with limited
liability may only provide capital but he does not manage the business.
In terms of taxes, the profits of a partnership are taxable based on individual

income tax. A partnership can be deregistered if one of the partners pulls out
or passes away, there is misunderstanding amongst the partners or the
partners agree to separate.
The advantages and disadvantages of partnership are elaborated in Table 1.2.
Table 1.2: The Advantages and Disadvantages of Partnership
• Easy to form. • Unlimited liability.
• With two or more partners, owners • The existence of the partnership is
are able to raise a bigger sum of not continuous. It can be
capital compared to sole deregistered if one of the partners
proprietorship. Partners can discuss pulls out or passes away, there are
and work together, lessening the differences among the partners or
burden of work. they deregister the partnership.
• Profits are taxable based on personal
income tax.
1.5.3 Company
A company is a business entity that is different from its owners. The Company
Act 1965 states that a company is a legal body under the law, which can own
assets, has liability obligations, and has the power to sue others, as well as the
ability to be sued by others. To form a company, registration must be done with
the Registrar of Companies. Company rules need to be followed, such as
preparing documents on Memorandum and Articles of Association.
A company can either be formed as a private limited company or a limited

company. For a private limited company, the number of shareholders is limited to
50 people whereas the number of shareholders of a limited company is unlimited.
A limited company can be listed in the stock exchange if it complies with the
requirements and rules of the Securities Commission (SC) and is allowed to do so
by Bursa Malaysia.
The liability of a companyÊs shareholders or owners are limited. If the company

experiences losses, the liability of the owners is limited to the sum of capital
invested in the company.
Shareholders have the right to vote and choose a board of directors who will
oversee the companyÊs management. There is separation between the owners and
the management in a limited company. Company owners are shareholders but the
management of the company is done by employees who are paid by the company.
The advantages and disadvantages of this type of business are elaborated in

Table 1.3.
Table 1.3: The Advantages and Disadvantages of the Company
 Limited Liability • Difficult to Form
If there are losses, the liability of the Compared to sole proprietorship and
owners or shareholders is limited to partnership, the formation of a
the sum of capital invested in the company is more complex and
business. This can reduce the risk held difficult. A company must prepare a
by investors. Memorandum of Association and
Articles of Association before it can
 Transfer of Ownership be registered with the Registrar of
The ownership of the company is in Companies. This takes a longer time
the form of shares and these shares can and involves higher cost.
be bought and sold with ease,
especially if they are listed in the stock • Double Taxation
exchange. Hence, transfer of The proceeds of the company are
ownership is easy and this liquidity taxable twice – first, taxes on the
characteristic attracts investors. profits of the company and secondly,
taxes on dividends received by
 The Continuous Existence of shareholders.
the Company
Companies may continue to
function even though a shareholder
passes away or the ownership of
the company is transferred. This is
different from sole proprietorship
or partnership where the death of
its owner or one of the partners will
result in the deregistration of the
business.
 Ease of Getting Capital

The advantage of limited liability and
its continuous existence as well as
easy transfer of ownership will attract
many investors, which makes it easier
for the company to collect capital.
ACTIVITY 1.6
Give several examples of businesses for each type of organisation discussed.

Explain why they are suitable. Share your answers on myINSPIRE.
1.6 THE CHALLENGE OF FINANCIAL

MANAGEMENT
ACTIVITY 1.7
Give examples of the challenges faced by financial managers in a globalised

business environment. Share them in the myINSPIRE forum.
Financial management is a wide and complex field. As time goes on, it has
experienced many changes and this is a challenge for financial managers. This
challenge is due to the changes in financial environment, such as the state of the
economy, both within the country and outside. Apart from that, the increased
usage of information technology and globalisation have made the financial
management of firms even more difficult.
The increasing trend towards wider usage of information technology such as e-

business needs big financing. A lot of money is needed to buy the tools of
information technology, provide workersÊ training, etc. All these involve
investments such as doing financial analysis, project evaluation, as well as
finding financial resources.
The trend towards globalisation means that firms will face greater competition.
Financial managers must ensure that all departments of a firm operate efficiently
to reduce costs and are able to compete so that the business will continue
operating.
ACTIVITY 1.8
Fill in the schedule given below by writing down the characteristics of a
partnership and a limited company. Discuss with your coursemates and
compare the characteristics of each firm:
Types of
Organisation/ Sole Proprietorship Partnership Company
Characteristics
Number of owners One person only
Capital resource OwnerÊs savings and

loans from friends and
banks
Liability Unlimited
Taxation Based on personal

income tax
Control and Flexible management
management and easy to control
The existence of the Not continuous
business
Formation Easy to form
SELF-CHECK 1.3
Fill in the Blanks

In financial management, the main objective of a firm is to
.
The liability of a sole proprietor is whereas the liability of a company is .

plays an important role in the operation of firms to ensure allocation and
efficient use of financing.
One of the disadvantages of a company is .
Financial management faces many challenges because of the increased usage

of and .
• Accounting is a record-keeping system which reflects how a firm had been

managed, whereas financial management involves the technique of managing
money to gain maximum return from investments.
• Financial management refers to how we use money to gain maximum return

from investments. The activities of financial management include financial
analysis, financial planning and capital budgeting.
• A firm needs objectives to help financial managers plan the direction of the
firm and to make effective decisions. The usual objectives of a firm are to:
– Maximise profit;
– Maximise the wealth of a firm (which is the objective of financial

management);
– Maximise the utility of the manager;
– Uplift the standards and welfare of workers;
– Carry out social responsibility; and
– Maintain continuous existence.
• The responsibilities of a financial manager are to: prepare a firmÊs financial

planning; do financial analysis; and advise the management regarding the
suitable types of investment for the firm and the best method of financing.
• The most common forms of business organisation are sole proprietorship,

partnership and company (private limited and limited). The type of business
organisation chosen has important business implications in terms of financial
resources, liability and taxation.
• Challenges to financial management exist because of:
– Changes to the financial environment factors;
– Trends towards the increase usage of information technology; and
– Globalisation.
Accounting Limited company

Finance Partnership
Financial management Private limited company
Financial manager Sole proprietorship
Topic  Financial
Environment
2
LEARNING OUTCOMES
Explain the importance of the financial market;
Differentiate between money market and capital market;
Discuss the factors that influence interest rates; and
Analyse the effects of changes in interest rates on a firmÊs profits.
 INTRODUCTION
The financial environment can affect a financial managerÊs decisions and
actions. It is important that a financial manager understands the firmÊs financial
environment. In this topic, we shall the endeavour to understand the financial
environment, which will include discussion on the money market and capital
market, as well as the institutions in these markets. You will also be introduced to
interest rates, the factors that influence them and their effects on a firmÊs profits.
18  TOPIC 2 FINANCIAL ENVIRONMENT
2.1 FINANCIAL MARKET

Individuals, business organisations and governments need sufficient capital to
undertake a business or project. If there is insufficient capital, they will need
financing from outside sources. The financial market is an important source of
capital financing.
Figure 2.1: A ticker board used to indicate financial market prices
What are financial markets all about? A financial market is an intermediary

between those who have surplus funds with those who are in need of funds. It
facilitates savings and loan transactions. Those with surplus funds can deposit
them in the financial institutions from which those in need can have access to
them. Therefore, a financial market is an intermediary that can disburse funds
more efficiently in the economy.
In general, there are two main types of financial markets, namely the money
market and capital market. These markets can be further split according to the
types of instruments traded (see Figure 2.2), which we shall cover in this
subtopic.
TOPIC 2 FINANCIAL ENVIRONMENT  19
Figure 2.2: Types of financial markets
2.1.1 Money Market

A money market is a market that manages the buying and selling of short-term
securities that have a maturity period of less than one year. These securities are
very liquid, which means it can easily be converted into cash without loss of
value. The role of the money market is important for the banking and business
sectors, the government, as well as the economy as a whole.
A developing and progressive money market facilitates the allocation of

short- term funds through which those with surplus funds can invest, and
from which those in need of short-term funds can borrow. As such, the
money market can be regarded as an intermediary between surplus units and
deficit units. Those with surplus funds have the opportunity to invest in the
money market to attain returns. If excess money is deposited in a safe or in a
bank current account, they will not yield any return. On the other hand, those
who are in need of short-term funds can access them from the money market.
Apart from its role as a financial intermediary, the money market can play an
important role in the implementation of the governmentÊs financial policy to
achieve its macroeconomics objectives such as stabilising the state of the
economy. The following are some major instruments that are traded in the money
market:
(a) Treasury Bills

Treasury bills are short-term securities issued by the government, which
have maturity periods of either 3 months, 6 months, 9 months or 12 months.
When the government issues treasury bills, this means that the government
intends to borrow money from those who buy the treasury bills. In short,
treasury bills are government debts to the buyers of the bills. Here, the
objective of the government is to have funds to finance its operations or
projects. The selling of treasury bills is done through tenders whereby
interested buyers state the price they are willing to pay for those treasury
bills, which have a specific nominal value. For example, an investor is
willing to pay RM950 to get a one-year treasury bill with a nominal value
of RM1,000. This means that the bill is sold at a discount and the rate of
return gained by the investor is known as the discount rate, that is 50/950 =
5.26%. This transaction is called discounting.
(b) Commercial Paper

A commercial paper is a note issued by a well-known, creditworthy
company with a strong financial standing for the purpose of borrowing
money from investors for a short period of time. This is a kind of short-term
financial source for a large firm.
(c) Negotiable Certificates of Deposit

Although it has similarities to the fixed deposit in a bank, negotiable
certificates of deposit can be bought and sold in the money market whereas
ordinary fixed deposits cannot be traded. Since this certificate can be
traded, it is an alternative short-term investment for a large firm that has
short-term surplus funds. For example, a company that saves money to pay
off its taxes can make use of the opportunity to attain returns by investing in
negotiable certificates of deposit until the taxes are due.
ACTIVITY 2.1
Have you ever dealt with any money market instrument? Explain what you did
or used the instrument for. Share your experience with your coursemates on
the myINSPIRE online learning platform.
SELF-CHECK 2.1
Match the Correct Answers
1. A short-term financing resource  Money market

for a large firm.
2. An alternative investment for  Commercial paper
large firms that have surplus
funds.
3. The government issues them to  Negotiable certificates
finance its operational of deposit
expenditures.
4. The market that manages the  Treasury bills
trading of short-term securities.
2.1.2 Capital Market

A capital market is a market for securities that have maturity periods of more
than one year. Examples of instruments in this market are bonds, preference
shares and ordinary shares. These securities are traded in two types of markets:
(a) Primary Market

This is where a company sells new securities to get capital for the first time.
Trade is done directly between investors and the company that issues those
securities. A company wishing to offer its stocks in public can publish a
prospectus, which is a document that gives information on the company to
enable investors to decide whether to buy or not to buy the companyÊs
stocks. Once the securities are traded, they become part of the secondary
market.
(b) Secondary Market

This is a market for stocks that had been issued and are traded between
investors. An example of a secondary market is Bursa Saham Kuala
Lumpur (BSKL), which was established in 1964 as Bursa Saham Malaysia.
In 1973, it was transferred to a new BSKL company. Presently, the BSKL
is known as Bursa Malaysia.
The main reason why a company is listed in the stock exchange is to gather
funds more effectively. Companies listed in the stock exchange can attain
large sums of capital more easily because investors have more confidence
in listed companies. This is because listed companies in the stock exchange
have a higher profile and the stocks can be traded with ease, thus increasing
liquidity of these types of investments. Companies that wish to be listed in
the stock exchange must follow certain procedures like making application
to the Securities Commission Malaysia, getting the permission of Bursa
Malaysia, and so on.
There are three listing boards in Bursa Malaysia, i.e. the Main Market, ACE
Market and LEAP Market. Companies going for listing must observe the
listing requirements of that particular board, for example the sum of
minimum paid-up capital, the sum of public share holdings, the history of
profit achievement, etc.
A stock exchange is regarded as a secondary market because companiesÊ

shares issued in it are traded between investors. Although the trading of
shares in the stock market do not result in either the in-flow or out-flow of
the companiesÊ funds, financial managers must still give attention to the
trading of shares because the price of the stocks, which are determined by
the market, influences the value of a limited company.
For further reading, you may visit Bursa Malaysia website at

www.bursamalaysia.com.
ACTIVITY 2.2
Create a table to identify the differences between the following:
Money market and capital market; and
Primary market and secondary market.
Share your answers with your coursemates on myINSPIRE and review each
otherÊs work.
2.2 INTEREST RATES

ACTIVITY 2.3
What do you understand about interest rates? Discuss with a coursemate and
post your conclusion on myINSPIRE.
The interest rate is the price for the capital that had been borrowed. In a free
enterprise economic system, capital such as goods and services are allocated
through a price system determined by the forces of demand and supply.
Explanations regarding this matter are as follows:
The demand for capital is influenced by existing opportunities of investment

and the expected rate of return to be gained from the capital invested. The
higher the rate of return, the higher is the interest rate willingly offered by the
debtor to the party offering the fund.
The supply of capital is influenced by consumersÊ priorities towards current

and future consumption. If you have surplus funds but need the money now,
you will not use the funds for investments. On the other hand, if you currently
do not need the money, you will use it for investments. Hence, capital is
offered even though the interest rate may not be attractive.
Figure 2.3: Factors which influence interest rates

2.2.1 Factors that Influence Interest Rates

Apart from the demand and supply of capital, interest rates are also influenced by
the factors shown in Figure 2.3. Explanations regarding these factors are as
follows:
(a) Inflation Rate

Inflation is related to the increase of the price of goods and services. The
higher the expected rate of inflation, the higher the demanded rate of
returns. Hence, the capital provider must be offered a higher interest rate
to encourage him to provide loans.
(b) Rate of Risk

Risk happens due to the existence of uncertainty. The higher the rate of
risk, the higher the demanded rate of returns. Increased risk will lead to
an increased interest rate.
(c) Government Policy

To influence aggregate demand and economic activities, the government
can use monetary policy and a suitable budgetary policy for a specific
economic condition. But what are monetary and budgetary policies? The
following descriptions provide some clarity:
(i) Monetary Policy – This policy controls the levels of aggregate

demand through the financial system. The Central Bank, i.e. Bank
Negara Malaysia (BNM) controls total credit and the usage of various
types of credits through interest rates.
For example, in an inflationary situation, the BNM can adopt a tight

monetary policy, which will cause the interest rates to rise in the
economy and reduce aggregate demand. On the other hand, if there
is an economic recession, the BNM will adopt an accommodative
monetary policy, which will result in the decrease of interest rates in
the market.
(ii) Budgetary Policy – This policy, also known as a fiscal policy, uses
the tax system and government spending to achieve price stabilisation,
high employment and economic growth. If there is an economic
recession, the government can adopt a deficit budget policy where
spending exceeds returns. When this happens, the government will
need to borrow to make up for the spending deficit. The demand for
funds will increase, which in turn, will cause interest rates to rise.
ACTIVITY 2.4
List the factors that increase the interest rate in the economy.
Discuss the effects of interest rate movements on the profits of a firm.
Share your answers on myINSPIRE.
2.2.2 The Effect of Interest Rates on the Profits of a

Firm
The interest rate is the cost a firm has to pay on capital borrowed. For this reason,
interest rates can have several effects to a firmÊs profits. Two of the effects are:
(a) Interest rates are costs to a firm. For this reason, a high interest rate will
result in the rise of a firmÊs costs and jeopardise its profit.
(b) Interest rates can influence economic activity and in turn, influence a
firmÊs profits. When interest rates are high, sales will decrease because
buyers will be more careful in their spending especially for expensive goods
such as electrical appliances and housing. This will result in the cost of
debts to increase due to the increase in interest rates.
In making a financial decision, a financial manager must opt for either short-term
or long-term methods of financing. Changes in interest rates will affect the cost
of a project and if a financial manager wrongly decides on the type of financing
for the project, this will jeopardise the performance of the firm and its profits. For
this reason, a financial manager must use a combination of both short-term and
long- term methods of financing – both of which exist in the financial market – to
ensure that the firm is able to solve any financial difficulty that may arise due to
changes in interest rates.
SELF-CHECK 2.2
Multiple-Choice Questions
1. Which of the following is NOT an example of a money market?

A. Treasury bills issued by the government.
B. Government bonds with a maturity period of 10 years.
C. Commercial papers issued by an established company.
2. A primary market encompasses .

A. companies that sell new securities through a prospectus
B. companies listed in Bursa Malaysia
C. companies whose stocks are traded by investors
3. When interest rates go up .

A. capital becomes cheap
B. the demand for capital rises
C. the cost of capital rises
4. Monetary and budgetary policies are used for .

A. influencing aggregate demand
B. encouraging more people to borrow capital
C. decreasing interest rates
5. The profits of firms are affected whenever interest rates go up

because .
A. the cost of debts becomes high
B. firms are more careful in sales
C. firms have insufficient capital
 The financial market is an intermediary for those who have surplus funds and
those who are in need of funds. This plays an important role in the
distribution of funds in the economy.
 The financial market consists of the money market, capital market, primary
market and secondary market.
 A money market is a market that manages the buying and selling of

short-term securities with a maturity period of less than a year. The
instruments that exist in a money market are treasury bills, commercial
paper and negotiable certificate of deposit.
 A capital market is a market for securities with a maturity period of more

than one year. The instruments that exist in the capital market are bonds,
preference shares and ordinary shares.
 A primary market is a market that manages the sale of new securities, while
a secondary market is a market for securities that have been issued and can
be traded between investors. For example, Bursa Malaysia.
 The interest rate is the price for capital that had been loaned, and it can be
determined by the demand and supply of capital. Other factors that
influence interest rates include rate of inflation, rate of risk and
government policies, i.e. monetary policy and budgetary policy.
 Interest rate is an important factor in a financial environment. The following

are the main effects of interest rates on the profits of a firm:
– Interest rates can influence the costs of a firm and this affects the firmÊs
profits.
– Interest rates can influence economic activities such as the sales and
profits of a firm.
 Financial managers must give attention to the movements and changes of

interest rates because this can affect the decision regarding project financing
as well as the performance of a firm.
 Financial managers should combine short-term and long-term methods of

financing to avoid financial problems that may arise due to changes in interest
rates.
Capital market Money market

Financial market Primary market
Interest rate Secondary market
Topic  Financial
Statements and
3 Financial
Ratio Analysis
LEARNING OUTCOMES
Explain the importance of financial statements;
Analyse financial statements;
Calculate and interpret financial ratios;
Apply financial ratio analysis in making decisions; and
Discuss the limitations of financial ratio analysis.
 INTRODUCTION
The financial statement and its analysis are vital to an organisation and external
parties. The internal management of a company requires information obtained
from a financial statement to assist them in planning, controlling and decision
making. Meanwhile, external parties such as business creditors need to know the
liquidity position of a firm and its ability to pay their claims. Bondholders also
need to know the firmÊs ability to pay interest and its principal when the bond
matures. Before investing in a company, shareholders need to know its profit and
performance.
30  TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS
Therefore, whether you are a financial manager, creditor or investor, the

understanding of the financial statements and their analysis is important.
Figure 3.1 shows the typical groups who are interested in financial statements.
Figure 3.1: Typical users of financial statements
In this topic, you will be learning three types of basic financial statements and
their components. You will also be introduced to financial ratio analysis, which
can be used to gain important practical information for the benefit of certain
parties.
3.1 FINANCIAL STATEMENTS

There are three types of basic financial statements as follows:
(a) Balance sheet;
(b) Income statement; and
(c) Cash flow statement.
3.1.1 Balance Sheet

A balance sheet is a statement of the firmÊs financial position at a specific point
in time. The balance sheet of a firm may change daily because inventories may
increase or decrease each day, and non-current assets such as equipment can be
added or depreciate in value. A financial statement (example in Figure 3.2) can
be divided into two parts:
TOPIC 3 FINANCIAL STATEMENTS AND FINANCIAL RATIO ANALYSIS  31
(a) Assets
An asset is a resource owned by a firm. Assets can be separated into
current assets and non-current assets. Current assets can be converted
into cash in a period of less than one year. Examples of current assets are
cash, marketable securities, accounts receivable and inventories. On the
other hand, non-current assets include properties, equipment and plants.
Assets are arranged in order based on liquidity, that is, the time needed to
convert the assets into cash.
(b) Liabilities and Equity

A liability is a claim against the firmÊs assets. Accounts payable, notes
payable and accrued expenses are current liabilities that will mature in less
than one year. Bonds and bank loans, which are the firmÊs debts to other
parties, are categorised as non-current liabilities as they will mature in a
period of more than one year. Equity is a claim of shareholders on the
firmÊs assets, which may be in the form of preference shares, ordinary
shares or retained earnings.
Figure 3.2: Balance sheet of Emas Limited Company

Normally, assets are noted on the left side of a balance sheet while liabilities and
equity are noted on the right side of a horizontal balance sheet format. In a
vertical format, assets are noted at the top while liabilities and equity are noted at
the bottom of the balance sheet.
In accounting, all the firmÊs assets belong to creditors and owners of the firm.
Thus, there is an equation such as shown below:
Asset = Liability + Equity
ACTIVITY 3.1
Draw a chart to show where the following information are found in a balance
sheet:
(a) Current assets; (d) Non-current liabilities; and
(b) Non-current assets; (e) Equity.

(c) Current liabilities;
In general, a balance sheet gives information regarding the financing and

investment activities of a firm. Liabilities and ownerÊs equity present a view of
the related firmÊs capital structure. We can see the part of the total capital that
includes equity and the portion financed by debt. Segregation of the total
liabilities into current liabilities and non-current liabilities are also shown in the
balance sheet. This information is important to analyse the firmÊs financial
position. From the balance sheet, we can also calculate the working capital.
Working capital is the difference between current assets and current liabilities.
Working Capital = Current assets – Current liabilities
Working capital can be obtained by subtracting current liabilities from current

assets. Information on working capital is important to evaluate a firmÊs liquidity
and its ability to pay back short-term claims on it. A firmÊs liquidity is important
because the business is likely to fail if it is unable to pay interest or pay back debt
when it matures.
The balance sheet also shows a firmÊs combined assets, or the ratio of current
assets to non-current assets. If a firm holds too much non-current assets
compared to current assets, the firmÊs capital will be tied up and this may lead to
cash flow problems and financial failure. This is caused by the difficulty in
converting non-current assets into cash compared to current assets.
SELF-CHECK 3.1
Based on Figure 3.2, calculate the working capital of Emas Limited Company
for the years 2017 and 2018.
3.1.2 Income Statement

An income statement (like the one shown in Figure 3.3) is a statement that gives
information regarding the revenues and expenditures of a firm in a specific
period of time. Sales revenue is shown in every income statement and this is
followed by expenditures or costs and taxes. In brief, an income statement
indicates a firmÊs profit or loss in a specific period of time – normally one year.
Profit is important to a firmÊs owner, employees and suppliers because without
profit, the firm will not continue to exist.
Figure 3.3: Income statement of Emas Limited Company

The income statement, also known as profit and loss statement, gives information
to measure the firmÊs performance. To measure the performance of a firm, the
following aspects of an organisation must be considered:
(a) Sales figure – Can be compared with the firmÊs sales in the previous year
and expected future sales. This information can be used for the purpose of
planning the firmÊs future.
(b) Gross profit – Can be compared to the sales figure to show profit earnings
from goods sold.
Gross Profit = Sales – Cost of goods sold
(c) FirmÊs expenses – Can be compared with the firmÊs expenses in the previous
year to formulate policies to decrease cost.
(d) Net profit – Can be compared to sales. Normally, there are variations
between profitability and sales volumes. When a firmÊs sales volume is
high, it may receive a lower percentage of net profit. However, the ratio of
net sales-profit is influenced by the type of business undertaken by the firm
concerned.
Net profit = Gross profit – Sales and administrative expenses

– Depreciation and amortisation
SELF-CHECK 3.2
With reference to the income statement in Figure 3.3, differentiate between

gross profit and net profit.
3.1.3 Cash Flow Statement

A cash flow statement refers to the statement that records the effects of a firmÊs
activities – such as operating, investment and financing – on its cash flow for a
specific period. Net cash flow is the total cash attained by a business in a specific
period, for example, one year. But the cash flow attained by a firm may not
necessarily be the total cash stated in the „cash‰ item on the balance sheet,
because the cash may be used to pay dividends, finance accounts receivable,
invest in non-current assets, increase inventories, etc. Therefore, the available
total cash in a balance sheet may be influenced by factors such as cash flow,
changes in working capital, changes in non-current assets, companyÊs
transactions such as buying and selling of shares and bonds, dividend payment
and so on. These factors will be reflected in the cash flow statement, which
shows changes in the cash position of the firm.
A cash flow statement (example in Figure 3.4) can be divided into three parts
according to its activities:
(a) Operating activity;
(b) Investment activity; and
(c) Financing activity.
The cash flow statement is important to a financial manager because it gives

information regarding the firmÊs ability to generate sufficient cash to:
(a) Finance or purchase new assets for the firmÊs expansion; and
(b) Pay back its debts.

Figure 3.4: Cash flow statement for Emas Limited Company

SELF-CHECK 3.3
Depreciation expenses is an item that is added to the net profit to determine

cash flow from a firmÊs operating activities.
Interest expenses are items of investment activities in a cash flow statement.
Any increase in accounts receivable and accounts payable will be added to

net profit in determining cash flow from operating activities.
Purchase of non-current assets for the companyÊs use will be deducted to

determine cash flow from investment activities.
3.2 FINANCIAL STATEMENTS ANALYSIS

The analysis of financial statements involves:
(a) Comparison between the firmÊs performance with other firms in the same
industry; and
(b) Evaluation of the firmÊs financial position from time to time.
These analyses can be used by:
(a) A financial manager to identify the firmÊs weaknesses and take steps to
improve the firmÊs performance; and
(b) Investors to evaluate the firmÊs current financial standing.

3.2.1 Ratio Analysis

Information obtained from the financial statement will assist investors and
financial managers to forecast the firmÊs future performance. The firmÊs
management can also use the information gained to forecast the situation and
plan for the future. A basic method to obtain useful information from financial
statements is through financial ratio analysis.
There are five categories of financial ratios. Each type of financial ratio has its
own role to the management and owner of the firm. Financial ratios consist of
(refer to Table 3.1):
Table 3.1: Types of Financial Ratios
Type Ratio
Liquidity Ratios  Current ratio
 Quick ratio (Acid test ratio)
Asset Management Ratios • Inventory turnover ratio
• Non-current assets turnover ratio
 Total assets turnover ratio
Debt Management Ratios • Debt ratio
 Times interest earned ratio
Profitability Ratios • Net sales profit
 Returns of common equity
Market Value Ratios • Price/earnings ratio
• Book per share ratio
 Market/book ratio
ACTIVITY 3.2
What do you understand by the term liquid assets? Explain and share with your
coursemates on myINSPIRE.
3.2.2 Liquidity Ratios

Liquidity ratios are used to show the correlation between cash and a firmÊs
current assets with its current liabilities. Liquid assets can easily be converted
into cash without decreasing much of its value. A firmÊs liquidity standing can
answer questions as to whether a firm can afford or has the ability to pay off its
debts when the date is due.
(a) Current Ratio

This ratio shows the frequency that current liabilities are covered by
current assets and this is calculated by dividing current assets with current
liabilities. Current assets include cash, marketable securities, accounts
receivable and inventories. Meanwhile, current liabilities include accounts
payable, short-term notes payable, tax accrued and other expenses such as
employeesÊ wages.
The current ratio can be expressed as follows:
Current assets
Current Ratio = Current liabilities
According to the example of Emas Limited Company, the current ratio is

calculated as follows:
Current Ratio:
Year 2017: 24,300 

3.68
6,600 30,00 
Year 0
2018: 3.2
9,300 3
Therefore, the current ratio in 2017 is 3.68 and for the year 2018 is 3.23.
(b) Quick Ratio

Also known as an acid test ratio, the quick ratio measures the firmÊs ability
to pay short-term debts without having to sell inventory. Inventory is
deducted from current assets because it is the least liquid asset. Should the
firm be dissolved, inventory might be the asset that could incur losses.
Prepaid expenses are also deducted from the total current assets since these
are expenses that are paid in advance.
A firmÊs quick ratio can be shown by the following formula:
Current assets  Inventory  Prepaid expenses

Quick Ratio =Currentliabilities
Based on the example of Emas Limited Company, the quick ratio is as

follows:
Quick Ratio:
24,300  12,450  0
Year 2017 = 
6,600 1.80
30,000  18,450 

Year 2018 = 0
1.24
9,300
Thus, quick ratio for the year 2017 is 1.80 and for the year 2018 is 1.24. It
shows that the firm is able to pay its short-term debts better in the year 2017.
SELF-CHECK 3.4
Compare the current ratio and quick ratio for Emas Limited Company for the
years 2017 and 2018. What is your opinion regarding the liquidity position of
this company?
3.2.3 Asset Management Ratios

An asset management ratio measures the firmÊs efficiency in managing its assets.
The information from the asset management ratio can determine whether there is
too much or too little of each type of asset reported in the Balance Sheet, based
on the frequency of current or forecasted sales. If a firm has too many assets, its
capital is tied in the assets, which will involve a high cost of capital. As a
consequence, profits will decrease. On the other hand, if a firm saves too little on
assets, especially inventory, this will result in the loss of clients because of there
is not enough stocks to fulfil the demand.
(a) Inventory Turnover Ratio

This ratio can be expressed as follows:
Cost of goods sold

Inventory Turnover Ratio =Inventory
A high inventory turnover ratio indicates that sales are good and inventory
turnover is quick. The implication is that the firm can run its business
without having to tie its capital in inventory. This is because holding
inventory involves costs such as capital cost, storing cost, and insurance
cost. Therefore, the higher the inventory turnover ratio, the better the
situation for the firm.
Based on the example of Emas Limited Company, the calculation for

inventory turnover ratio is as follows:
Inventory Turnover Ratio:
Year 2017 = 71,110  5.71

12,450
Y ear2018 = 74,846  4.06

18,450
Thus, Emas Limited CompanyÊs inventory turnover ratio for the year 2017 is
5.71 and for the year 2018 is 4.06. This means that the firmÊs position was
better in the year 2017.
(b) Non-current Asset Turnover Ratio

This ratio measures the firmÊs efficiency in using non-current assets such
as buildings and equipment to generate profits. The formula for non-current
asset turnover ratio is expressed as follows:
Sales
Non-current Assets Turnover Ratio = Net non-current assets
Based on the example of Emas Limited Company, its non-current asset

turnover ratio is:
Inventory Turnover Ratio:
Year 2017 = 85,500  3.28

26,100
Year 2018 = 90,000  3.00

30,000
Thus, the non-current asset turnover ratio is 3.28 for the year 2017 and 3.00
for the year 2018. This means that the firmÊs efficiency in managing its
non-current assets had decreased in the year 2018.
(c) Total Asset Turnover Ratio

This can be calculated using the following formula:
Sales
Total Asset Turnover Ratio = Total assets
Normally, it is preferable to have high ratios of non-current asset turnover

and total asset turnover. This is because a high ratio indicates that assets
are used more effectively to generate sales. Based on the example of Emas
Limited Company, the total asset turnover ratio is:
Total Asset Turnover Ratio:
Year 2017 = 85,500  1.70

50,400
Year 2018 = 90,000  1.50

60,000
Therefore, total asset turnover ratio is 1.70 in the year 2017 and 1.50 for the
year 2018. This means that the total asset turnover ratio for the year 2017 is
higher.
ACTIVITY 3.3
Based on the asset management ratios for the Emas Limited Company for the
years 2017 and 2018, in which year was the company more efficiently
managing its assets? Give reasons to support your answer. Share and
crosscheck your answers on myINSPIRE.
3.2.4 Debt Management Ratios

Total debts used by a firm is known as financial leverage. The implications of using
debts as capital are:
(a) Shareholders can continue controlling a firm by obtaining funds through

debts;
(b) Creditors use equity to provide security margins. If shareholders have a

small total of financial ratio, the firmÊs risk will be borne by creditors; and
(c) If firms attain higher returns than what has been paid as interest on debts,
the returns on ownerÊs capital will be higher.
There are two types of debt management ratios:
(a) Debt Ratio

This measures the percentage of funds provided by creditors. The debt ratio
can be calculated using the following formula:
Total debt
Debt Ratio = Total assets
Total debt includes current liabilities and non-current liabilities. Creditors

prefer a low debt ratio as it is more advantagous when a company is
dissolved. For shareholders, they prefer a high debt ratio because it will
enlarge the expected earnings.
Based on the example of Emas Limited Company, the calculation of debt

ratio is as follows:
Debt Ratio:
Year 2017 = 24,000  0.48  48%

50,400
Year 2018 = 31,920  0.53  53%

60,000
Thus, the debt ratio is 48% in the year 2017 and 53% for the year 2018.
This means that the debt ratio has increased in the year 2018. The firm
relies more on its creditors to finance its total assets for the year 2018.
(b) Times Interest Earned Ratio

This ratio is used to measure the firmÊs ability to pay its annual interest
payment. If a firm is unable to pay off its interest charges, creditors have the
right to take legal proceedings against it and this might cause the company
to become bankrupt. From the creditorÊs point of view, it is better for the
firm to have a high times interest earned ratio, because that shows the
firmÊs ability to pay interest annually. Hence, the creditorÊs risk is smaller.
The times interest earned ratio is calculated using the following formula:
Earnings before interest and tax

Times Interest Earned Ratio =Interest expenses
Based on the example of Emas Limited Company, its times interest earned
ratio is as follows:
Times Interest Earned Ratio:
Year 2017 = 7,890  4.38

1,800
Year 2018 = 8,514  3.23

2,640
Thus, the times interest earned ratio is higher in the year 2017. This shows
the firmÊs ability to pay annual interest declined in the year 2018.
ACTIVITY 3.4
State the importance of debt management ratio to the following parties:

Shareholders; and
Creditors
Share and crosscheck your answers with your coursemates on myINSPIRE.
3.2.5 Profitability Ratios

Profitability ratios indicate the combined effects of liquidity, asset management
and debts decision on the firmÊs operations. In short, the profitability ratio is
the effect of various policies and decisions of the company. The two types of
profitability ratios are net profit margin and return on equity (ROE).
(a) Net Profit Margin

This ratio measures income from every ringgit of sales. Net profit margin
can be shown by the following formula:
Net Profit Margin = Net profit available for ordinary shareholders

Sales
Based on the example of Emas Limited Company, the net profit margin is:
Net Profit Margin:
Year 2017 = 3,540  0.041  4.1%

85,500
Year 2018 = 3,405  0.038  3.8%

90,000
The net profit margin for the year 2017 is 4.1% and in the year 2018 is
3.8%. This indicates that the firmÊs net profit margin in year 2017 is higher
than 2018. This margin went down in year 2018.
(b) Return on Equity (ROE)

This ratio measures the rate of returns earned on the investment of ordinary
shareholders. Return on equity is calculated using the following formula:
Return on Equity = Net profit available for ordinary shareholders

Ordinary shares equity
Based on the example of Emas Limited Company, the return on common

equity is as follows:
Return on Equity (ROE):
Year 2017 = 3,540  0.13409  13.41%

26,400
Year 2018 = 3,405  0.12126  12.13%

28,080
Therefore, the return on equity is 13.41% for the year 2017 is and 12.13%
for the year 2018. So, it shows that return on equity for the year 2017 is
higher.
3.2.6 Market Value Ratios

Market value ratios comprise ratios that correlates the firmÊs stock price to the
earnings per share based on book value. This ratio gives information to the
management regarding the investorsÊ view on the firmÊs past performance as
well as future prospects. The three types of market value ratios are as follows:
(a) Price Earnings (P/E) Ratio

This ratio shows how much investors are willing to pay for each ringgit of
the profit reported. This ratio can be expressed as follows:
Market price per share

Price Earnings Ratio =Earnings per share
(b) Book Value Per Share

This ratio is calculated using the following formula:
Common equity
Book Value Per Share = Outstanding shares
(c) Market to Book Ratio

This can be expressed as follows:
Market price per share

Market to Book Ratio = Book value per share
In using financial ratios, it is important for a financial manager to compare the

firmÊs performance in different time periods or make comparisons of firms in the
same industry to get a comprehensive view of the firmÊs performance. This is
known as flow analyses of financial ratios.
Table 3.2 summarises the formulas of financial ratios that we have discussed in
this subtopic.
Table 3.2: Formulas of Financial Ratios
Type of Financial Ratios Formula

Liquidity ratios Current ratio
Current assets
Current liabilities
Quick ratio
Current assets  Prepaid expenses

Current liability
Asset management ratios Inventory turnover ratio
Cost of goods sold

Inventory
Non-current assets turnover ratio
Sales
Net non-current assets
Total assets turnover ratio
Sales
Total assets
Debt management ratios Debt ratio
Total debt
Total assets
Times interest earned ratio
Earnings before interest and tax

Interest expenses
Profitability ratios Net profit margin
Net profit available for ordinary shareholders

Sales
Return on equity
Net profit available for ordinary shareholders

Ordinary shares equity
Market value ratios Price earnings ratio
Market price per

share Earnings
Common
per share
equity Book value per share
Outstanding
shares
Market to book ratio
Market price per

share Book
value per share
3.2.7 Uses of Financial Ratios

ACTIVITY 3.5
Team up with a coursemate for this activity. Based on your collective

knowledge of financial ratios, discuss how they assist organisations in making
decisions. Share the conclusions of your discussion with others on myINSPIRE.
Financial ratios can be used to interpret financial information in a way that is

easily understood. Compared to the figures in financial statements, financial
ratios can give a more comprehensive reflection of the firmÊs performance. For
example, if a financial manager wishes to know a firmÊs liquidity standing, he
can refer to the liquidity ratios, namely the current ratio and quick ratio. For an
investor who wishes to know the firmÊs profitability, he can refer to profitability
ratios such as net profit margin and return on common stock equity. If financial
ratios can be collected for several years, comparison can be made by showing
their flows in the form of graphs, thus making the information easily understood.
Financial ratios can be used to construct a firmÊs financial profiles. It can

evaluate various aspects of firmÊs financial performance and standing. This
information can be used in the decision-making process by the firmÊs
management team, suppliers, investors, banks and so on.
Financial ratios (especially if flow analyses or comparisons are made) can

measure the firmÊs financial health and give an „early warning‰ sign on the
difficulties it may be facing. Therefore, a financial manager may propose
appropriate steps to solve the problem before it becomes too acute.
ACTIVITY 3.6
Prepare a list of financial ratios that you might scrutinise before purchasing
shares of a firm. Explain your choices and share your answer on myINSPIRE.
3.2.8 Limitations of Financial Ratio Analysis

Although financial ratios are a useful and quick way to analyse the status and
performance of a business, it has some limitations, which should be considered
by a financial manager when using financial ratios. Among the limitations are as
follows:
(a) Financial ratios rely on data obtained from financial statements. Thus,
whether the resulting calculations can be trusted or not depends on the
quality of the financial statements. Weaknesses in the financial statement
will be reflected in the financial ratios and interpreting information from
these ratios is useless because the financial data is inaccurate. Apart from
that, one of the important factors that needs to be taken into consideration
when preparing the financial statements is the effect of inflation, which may
misrepresent the value of non-current assets such as properties, profit and
loss figures, etc.
(b) Financial ratios measure the firmÊs relative standing and performance
and do not take into account its absolute size. Sometimes, real figures can
give a better overall reflection when we make a comparison of the firmÊs
performance between two different time periods or between two different
firms.
(c) Normally, a firmÊs financial ratios are compared with industry averages,
where basic signs are used to look at the firmÊs standing and performance
compared to other firms. It should be reminded that this comparison might
not be appropriate because it is difficult to find two firms with the same
kind of business. Even though there may exist two firms in the same
industry, one of the firms might have miscellaneous activities in other types
of business. In addition, the accounting policies, financial policies, and
financial years may differ, and this will complicate the comparison thus
weakening the use of financial ratios.
(d) Financial ratios that are based on a balance sheet might not give accurate
information because a balance sheet only gives a reflection of the firm at a
certain point in time. Thus, a financial ratio calculated based on the data
of a balance sheet statement does not represent the firmÊs standing and
performance for the whole year. These weaknesses are even more obvious
in seasonal businesses.
(e) Although financial ratios are used to analyse a firmÊs strengths and
weaknesses, they cannot identify the factors that had brought it to that
position. A more detailed investigation into the firmÊs practices and
business records is still needed to identify those factors.
SELF-CHECK 3.5
Debt financing is also known as equity financing.
Interest expenses are subtracted before tax levied.
Profitability ratios indicate the combined effects of liquidity, assets

management and debt on operational decisions.
The current ratio is a stricter liquidity measurement compared to quick ratio.

 There are three important financial statements, which are the balance sheet,
income statement and cash flow statement. Information can be obtained from
each of the financial statements to calculate certain financial ratios to measure
the liquidity, asset management, debt management, profit and the firmÊs
market value.
 A balance sheet is a statement that shows a firmÊs financial standing at a

certain point in time. The balance sheet can be divided into two parts:
– Assets (current assets + non-current asset); and
– Liabilities (current liabilities + non-current liabilities) and equity

(preferences shares, common shares and retained earnings).
 Information that could be obtained from a balance sheet are:
– The capital structure of the company; and
– The working capital
 The income statement shows:
– A firmÊs revenues and expenditures at a certain point in time; and
– A firmÊs profit and loss for a certain period of time, normally one year.
 The cash flow statement indicates the effects of the firmÊs activities on cash
flows of the firm for a certain period of time. The firmÊs activities are:
– Operating activity;
– Investment activity; and
– Financing activity.
 Analysis of financial statements involves two main tasks: comparison of the

firmÊs performance with other firms in the same industry; and evaluation of
the flow of the firmÊs standing between certain time periods.
 Financial ratios include:
– Liquidity ratios (current ratio, quick ratio);
– Asset management ratios (inventory turnover ratio, non-current asset

turnover ratio, total asset turnover ratio);
– Debt management ratios (debt ratio, times interest earned ratio);
– Profitability ratios (net profit margin, return on equity); and
– Market value ratios (price earnings ratio, book value per share ratio,
market to book value ratio).
 Financial ratios can be used for:
– Interpreting financial information into a form that is easily understood;

Constructing a firmÊs financial profile; and
– Measuring the firmÊs financial health and give an „early warning‰ sign
on difficulties it may be facing.
 Even though financial ratios can be used to interpret financial information

into a format that could be easily understood, and to measure the firmÊs
health as well as construct the firmÊs profile, we cannot rely entirely on ratio
analysis in making our decision because there are several limitations that need
to be considered.
 The limitations of financial ratio analysis are as follows:
– If the financial data is inaccurate, this will influence the quality and
accuracy of the financial ratios;
– Financial ratios measure the firmÊs relative standing and performance

without taking into consideration its absolute size;
– Comparing the financial ratio of a firm with other firms in the same
industry might not be suitable if there are firms that run miscellaneous
types of business activities;
– The economic situation always changes but financial ratios are calculated
based on financial statements at a certain point in time, for example
balance sheets; and
– A firmÊs financial standing can be affected by many factors.

Asset management ratio Financial terms

Debt management ratio Liquidity ratio
Financial ratios Market value ratio
Financial ratio analysis Profitability ratio
Financial statement
Topic  Financial
Mathematics
4
LEARNING OUTCOMES
Explain the concepts of compounding and discounting;
Calculate a firmÊs future value and present value;
Differentiate between ordinary annuity and annuity due;
Construct a schedule of loan amortisation; and
Discuss the differences between nominal and effective interest rates.
 INTRODUCTION
If you were given RM1,000 today or RM1,000 in a year from now, which one
would you choose? Why?
To know whether you have made a wise choice, you need to understand the
concept of the value of money or financial mathematics. The value of one ringgit
you have today is higher than the one ringgit you may receive in the future. This
is because the ringgit you receive today can be invested and earn returns in the
form of interest.
56  TOPIC 4 FINANCIAL MATHEMATICS
4.1 PRESENT VALUE AND FUTURE VALUE

A timeline is a very important tool in calculating the time value of money. To
illustrate this, let us look at the following example.
Gemilang Company has RM1,000 in the current year. Interest rate per annum is
10%. If Gemilang Company invested the money, how much is its future value at
the end of the third year? This example can be simplified as the following:
Year 0 1 2 3
10% RM1,000 Future value at the

Cash flow end of year 3 = ?
(a) Time shown at the point above the line: Year 0 to 3.
(b) The numeral 10% shows the interest rate.
(c) Cash flow shown at the point below the line.
4.1.1 Compounding
Compounding refers to the process of adding interest each year to the initial
amount of money. The compounding process is related to the calculation of the
future value of the money we have today.
Future value (FV) or compounding can be calculated by using the following

equation:
FVn  PV(1  i)n

TOPIC 4 FINANCIAL MATHEMATICS  57
Where:
FV = Future value
PV = Present value or initial amount of money
i = Interest rate
n = Period/year
Now, take a look at the following example.
Example 4.1
Based on the concept of timeline, we want to know what is the value of RM1,000
after a period of three years at 10% interest rate. The answer can be obtained
by calculating the future value or by compounding the RM1,000 by using the
following equation:
FV3 = RM1,000(1 + 0.10)3
The answer for the example given is:

FV3 = RM1,000(1 + 0.10)3
= RM1,000(1.331)
= RM1,331
Calculation for future value can also be done by using the following equation:
FV = PV(FVIFi,n)
FV3 = PV(FVIF10%,3)
FVIF can be obtained by referring to the future value table as can be seen in
Figure 4.1 where the columns in the table indicate interest rate while rows
indicate time period in years. From the table, FVIF 10%, 3, is 1.331. Therefore,
the solution is:
FV3 = RM1,000(FVIF10%,3)
= RM1,000(1.331)
= RM1,331
Figure 4.1: Future value table

Source: http://highered.mcgraw-
hill.com/sites/dl/free/0072994029/291202/4eFutureValueof1_table1.pdf
SELF-CHECK 4.1
Calculate the future value of:

RM500 after two years at an interest rate of 5%.
RM2,000 after five years at an interest rate of 8%.
ACTIVITY 4.1
Based on your prior knowledge, can you explain what discounting is?
Crosscheck your answer with your coursemates on myINSPIRE.
4.1.2 Discounting
Discounting refers to the process whereby future cash flow value changes to the
present value. The process of discounting is related to the calculation of the
present value of money that will be received in the future. Each ringgit received
in the future has a lower value compared to the value of one ringgit in the current
year. This can be explained by referring to the example of compounding. If we
want to have RM1,331 three years from now, we only have to keep RM1,000 in
the current year if the interest rate is 10%.
Discounting is the opposite of compounding. Knowledge on the concept of

present value is important to financial managers in making investment decisions
that relate to cash inflow that occurs after one year (more on this will be covered
in Topic 5).
The equation for the present value (PV) or discounting is as follows:
PV FVn
 (1 
i)n
Now, take a look at Example 4.2:
Example 4.2
You expect to receive RM1,000, three years from now and need to know the present
value if the interest rate is 10%.
The answer involves the concept of PV or discounting. It is the opposite of

compounding.
Pv 
RM1,000
(1  0.10)3
RM1,000
 (1.331)
 RM751.31
Referring to Example 4.1 given to explain future value, we can calculate the PV for
RM1,331 discounted for three years at an interest rate of 10%.
The calculation of present value is as follows:

RM1,331
PV 
(1  0.10)3
RM1,331
 (1.331)
 RM1,000
The PV equation can also be written as the following:
n
FV (1)  1
PV  n FVn 

 1
(1 
i)n  i

Or
PV  FVn (PVIFi,n )
Calculation of future value and present value can be done with the use of the
calculator or by referring to their respective tables.
In the present value table (refer to Figure 4.2), the first column shows the period
in years, whereas the row above shows the interest rate. To find the value of
RM1,000 to be received three years from now at an interest rate or discount rate
= 10%, please refer to period 3 and the row above which shows 10%. The value
displayed is 0.7513. Multiply this value by RM1,000 to get the amount of
RM751.30.
Figure 4.2: Present value table

hill.com/sites/dl/free/0072994029/291202/4ePresentValueof1_table2.pdf
SELF-CHECK 4.2
Explain the differences between compounding and discounting.
Calculate the present value for:

RM1,500 to be received two years from now at a discount rate of 5%.
RM10,000 to be received four years from now at a discount rate of 8%.
ACTIVITY 4.2
Compare the calculation of the previous exercises (in Self-Checks 4.1 and 4.2)
by using:
A calculator; and
Future value and present value tables.
Are your answers the same despite using two different methods of calculation?
If your answer is „yes‰, congratulations, because you have understood the
concepts. If your answer is „no‰, please check your answer again.
Table 4.1 shows the present value of RM5,000 at a discount rate of 5% which
will be received one year, two years, three years, four years and five years from
now.
Table 4.1: Present Value
Year Present Value (RM)

1 RM4,761.90
2 RM4,535.15
3 RM4,319.19
4 RM4,113.51
5 RM3,917.63
What can you conclude from Table 4.1? The table shows that the present value of
money received in the future decreases during the payment period.
Now assume that RM5,000 will be received one year from now but with a
different discount rate. Table 4.2 shows the present value with the discount rates
of 5%, 8%, 10% and 15%. Observe that the higher the discount rate used, the
lower the present value will be.
Table 4.2: Present Value According to Discount Rate
Discount Rate (%) Present Value (RM)

5 RM4,761.90
8 RM4,629.63
10 RM4,545.45
15 RM4,347.83
SELF-CHECK 4.3
Underline the correct answer. Based on Table 4.2, the implication of the
relationship between the current value and the discount rate is that when the
discount rate is (higher/lower), the current value will (decrease/ increase) for
a sum of RM5,000 which will be received one year from now.
4.2 ANNUITY
Annuity is a series of uniform payments made at fixed intervals in a stipulated
period. Types of annuity depend on whether payment is made during the
beginning or end of the period:
(a) Ordinary annuity is an annuity payment made at the end of the period. It
is also known as deferred annuity.
(b) Annuity due is an annuity paid during the early period. For example, early
of the month or early of the year.
4.2.1 Future Value Annuity

Future value annuity (FVA) is the sum received at the end of the annuity
period if all payments are invested at the same interest rate and held until the
end of the annuity period.
The formula for FVA is as follows:
PVAn  P(1  i)n-t

t=1
 P(FVIFAi,n )
PVIFA = Future value of interest factor for an ordinary annuity; and

P = Principal
Now, look at Example 4.3 for the method of calculating ordinary annuity.
Example 4.3
Say that a payment of RM1,000 is made at the end of every year for three years at
an interest rate of 10%. How much is the future value of this annuity? Refer to
the future value annuity table in Figure 4.3 for the following calculation:
FVA3 = RM1,000 (3.3100)
= RM3,310
Therefore, the future value of RM1,000 for three years at an interest rate of 10%
is RM3,310.
Figure 4.3: Future value annuity table

Source: http://highered.mcgraw-hill.com/sites/dl/free/0072994029/291202/
4eFutureValueOrdinaryAnnuityof1_table3.pdf
Look at Example 4.4 for the calculation of an annuity due.
Example 4.4
If a payment of RM1,000 is made at the start of every year for three years at a
rate
of 10%, this is categorised as an annuity due and its calculation is as follows:
FVAn (Annuity Due) = P(FVIFAi,n)(1 + i)
= RM1,000(3.3100)(1 + 0.10)
= RM1,000(3.641)
= RM3,641
4.2.2 Present Value Annuity

Present value annuity (PVA) is payment made today that is equivalent to
annuity payment assigned throughout the annuity period. If a sum of money is
given today, how much can be withdrawn for each withdrawal with the
assumption that the amount of money withdrawn is uniform? Types of
annuity depend on the time of withdrawal i.e. whether at the start of the
annuity period or at its end:
(a) Ordinary annuity refers to an annuity with withdrawal at the end of the
period.
(b) Annuity due refers to an annuity with withdrawal at the start of the period.
The following is the equation of present value annuity for ordinary annuity
(PVAn):
n
PVA nP1/(1
  i)
t

t1
 P(PVIFAin
, )
The equation of present value for annuity due is as follows:
PVAn  P(PVIFAi,n )(1  i)

Now, look at Example 4.5 for the calculation of present value of ordinary annuity
and annuity due.
Example 4.5
Calculate the present value of an annuity for the sum of RM1,000 a year for three
years at a rate of 12%. The present value annuity table is shown in Figure 4.4.
PVA3 = RM1,000(2.4018)
= RM2,401.80
Figure 4.4: Present value annuity table

hill.com/sites/dl/free/0072994029/291202/4ePresentValueOrdinaryAnnuityof1_tabl
e4.pdf
Based on the example given, the present value of an annuity due (whose payment
is made at the start of the annuity period) is calculated as follows:
PVA3 (Annuity Due) = P(PVIFAi,n)(1 + i)
= RM1,000(2.4018)(1 + 0.12)
= RM1,000(2.6900)
= RM2,690
Now, let us learn about perpetual annuity. What is perpetual annuity?

An annuity of which the period is variable is called perpetual annuity. Its equation
is as follows:
PV (Perpetual Annuity)  Principal

Interest rate

P
I
Look at Example 4.6 for the calculation of a perpetual annuity.
Example 4.6
If interest rate = 10%, perpetual annuity for the sum of RM1,000 per year will
have a present value of:
RM1,000
PV (Perpetual Annuity) 
0.10
 RM10,000
SELF-CHECK 4.4
Calculate the current value of the perpetual annuity for RM500 per year at an
interest rate of 8%.
Calculate the future value of a yearly instalment of RM500 for a period of five
years at 8% interest rate.
Based on Question 2, calculate the future value of an annuity due.
Let us have a look at point of future value and present value for varying incomes.
Most financial decisions need varying cash flow analyses. In such a situation:
(a) Future value of a series of varying incomes is the addition of all future
value of each income stream; and
(b) Present value of a series of varying incomes is the addition of all present
value of each income stream.
Now, look at Examples 4.7 and 4.8 to calculate the future value and present value
of a series of varying incomes:
Example 4.7
Future Value of a Series of Varying Incomes

You save RM1,000 at the end of year 1, RM2,000 at the end of year 2 and
RM3,000 at the end of year 3. Calculate the future value of these series of
incomes at an interest rate of 10% at the end of year 3.
FVn = 1,000(1 + 0.1)2 + 2,000(1 + 0.1)1 + 3,000(1)

= 1210 + 2200 + 3000
= RM6,410
Example 4.8
Assume a project will give revenue as shown in the schedule below:
Year End
Year 1 RM 6,000
Year 2 RM 8,000
Year 3 RM 9,000
How much is the present value of the cash flow of this project if the discount rate
is 10%?
PVn = 6,000(0.9091) + 8,000(0.8264) + 9,000(0.7513)

= 5,454.60 + 6,611.20 + 6,761.70
= RM18,827.50
SELF-CHECK 4.5
Sally keeps RM500 at the end of year 1, RM800 at the end of year 2, RM1,000
at the end of year 3 and RM1,200 at the end of year 4. Calculate the future
value of this series of income at an interest rate of 8%.
In-flow of cash flow expected from a project is RM5,000 for year 1, RM7,000
for year 2, RM5,000 for year 3 and RM3,000 for year 4. If the discount rate is
8%, how much is the total present value of cash flow that enters this project?
4.3 LOAN AMORTISATION

Knowledge of financial mathematics, especially on the concept of present value
annuity (PVA), is an important aspect in understanding and calculating loan
amortisation. Loan amortisation occurs when the principal of a loan is paid in
instalments throughout the payment period. Examples of loan amortisation can be
seen in housing, car and business loans, whereby payment is made monthly
through fixed sum instalments to amortise the loan.
Every instalment payment can be divided into two categories:
(a) Payment of interest on loan yet unpaid; and
(b) Payment to reduce the principal of the loan.
At the beginning of the loan period, the interest rate due is higher because interest
payment is set on the total outstanding balance for the month. For the next
instalment payment, interest due will be reduced because part of the principal of
the loan has already been paid. Thus, the subsequent instalment payments will
consist of a larger ratio of the principal of the loan but a smaller ratio of interest
payments.
4.3.1 Calculating Loan Amortisation

To better understand loan amortisation, we shall refer to Examples 4.9 and 4.10.
Example 4.9
Sulaiman borrowed RM45,000 for five years at an interest rate of 12%,
compounded monthly. Payments are made by monthly instalments. Based on the
information given, how much is his monthly loan payment?
Loan compounded monthly is, therefore,

n = 5 years  12 = 60 months
i = 12%/12 =1%
PVA = B(PVIFA )
i=1%, n=60
45000 = B(44.9550)
B = RM1,001
Example 4.10
Assume you wish to buy a computer and are willing to pay a monthly
instalment of RM100. If the bank offers a loan with payment to be made
within three years at an interest rate of 12% compounded monthly, how much
of the loan are you eligible for?
n = 3 years  12 = 36 months
i = 12%/12 =1%
PVA = 100(PVIFAi=1%, n=36)
= 100(30.1075)
= RM3,010.75
SELF-CHECK 4.6
Johan borrowed RM200,000 from ABC Bank to start a business. The loan period
is five years at an interest rate of 9% compounded monthly. Calculate the
monthly instalment needed to amortise this loan.
4.3.2 Table of Loan Amortisation

As mentioned previously, every instalment payment of loan is divided into
interest payment and payback payment for the principal. To illustrate this, we use
a table of loan amortisation to show the division of each instalment for interest
payment and payback payment for the principal (see Self-Check 4.7).
SELF-CHECK 4.7
Based on Example 4.10, we can construct a loan amortisation table as

shown here.
(a)Fill in the table for periods 5 to 8.
(2) (5) = (3) – (4)

(3)
(1) Balance (4) = 1%  (2) Principal (6) = (2) – (5)
Payment
Period Brought Interest 1% Loan Final Balance
(RM)
Forward (RM) Reduction
1 3,010.75 100 30.10 69.89 2,940.86
2 2,940.86 100 29.41 70.59 2,870.27
3 2,870.27 100 28.70 71.30 2,798.96
4 2,798.96 100 27.99 72.01 2,726.96
5
. . . . . .
. . . . . .
. . . . . .
36 . . . . .
(b)With reference to columns 3, 4 and 5, what do you observe

regarding the content of interest payment and reduction of principal loan as
the period of payment increases?
4.4 NOMINAL INTEREST RATE AND

EFFECTIVE INTEREST RATE
Interest rates play a vital role in finance mathematics because changes in interest
rate will affect calculation. As seen in this topic, interest can be compounded
daily, monthly, every three months, every six months or yearly. For the purpose
of valuating an investment involving different compounding techniques, we must
change each base to one base type. Therefore, it is crucial that we distinguish
between the nominal interest rate and effective interest rate.
Nominal interest rate is the interest rate that is declared, whereas effective interest
rate is the actual interest rate.
Effective interest rate equation is as follows:
m = the sum of compounding period
0 1 2 3 years
RM1,000 RM1,194.10
Effective Interest Rate

m

EIR  1  i nom 
  m  1

The timeline above shows savings value of RM1,000 for three years at an interest
rate of 6% compounded yearly.
If compounding is done on a six-month basis, the effective interest rate is:

EIR = [1 + 0.06/2]2 – 1.0
= (1.03)2 – 1.0
= 1.0609 – 1
= 0.0609  100%
= 6.09%
If compounding is done every three months, the effective interest rate is:
EIR = [1 + 0.06/4]4 – 1.0
= (1.015)4 – 1.0
= 1.0614 – 1.0
= 0.0614
= 6.14%
SELF-CHECK 4.8
The process of discounting is associated with calculating the future value of

the money that we presently have.
Loan amortisation involves variable payments throughout the whole debt

period.
Ordinary annuity is an annuity paid at the end of a period.
The present value of RM1,000 received after five years is less if discounted at
a rate of 5% compared to a discount rate of 10%.
The effective interest rate is the actual interest rate.
 Timeline is an important tool in the calculation of the value of money over time.
 Compounding shows the calculation of the future value of a present sum

of money, at a certain interest rate.
 Present value involves the discounting of a sum of money to be received in

the future to the present value.
 Annuity is a series of uniform payments paid at fixed intervals in a specified

time period.
 Types of annuity are as follows:
– Ordinary annuity (payment made at the end of the period);
– Annuity due (payment made at the beginning of the period); and
– Perpetual annuity (annuity in which the period is variable).
 Future value annuity (FVA) is the sum to be received at the end of an

annuity period if every payment is invested at the same interest rate and is
held until the end of the annuity period.
 Present value annuity (PVA) is payment made today that is equivalent to

annuity payment allocated throughout the annuity period.
 Loan amortisation happens when the principal of the loan is paid back in
instalments throughout the debt period.
 A loan amortisation table is a schedule that shows division of each instalment

payment, the interest rate as well as the debt principal payment.
 Nominal interest rate is the interest stated on loans or savings. Effective

interest is the actual interest rate.
Annuity due Loan amortisation

Compounding Nominal interest rate
Discounting Ordinary annuity
Effective interest rate Present value
Future value Timeline
Topic  Capital
Budgeting and
5 Cash Flow
Projection
LEARNING OUTCOMES
Explain the importance of capital budgeting;
Identify the steps in evaluating a capital budgeting project;
Apply capital budgeting techniques;
Discuss the advantages and disadvantages of each budgeting technique; and
Analyse the relationship between cash flow estimation and risk, as well as
inflation.
 INTRODUCTION
Your company wants to do several projects. As a financial manager, you are
assigned to evaluate these projects and submit a report to the board of directors.
How will you evaluate these projects to determine their feasibility? To better
comprehend the technique of project evaluation, it is vital that you, as a financial
manager, understand the meaning of capital budgeting.
In this topic, you will also see how the concept of financial mathematics learnt in
Topic 4 is applied in the evaluation of a financial project.
76  TOPIC 5 CAPITAL BUDGETING AND CASH FLOW PROJECTION
Estimation of cash flow is a significant part in capital budgeting. As explained

earlier, capital budgeting is the process of planning the asset spending – that is,
the cash flow – expected to be received after a year. Proposals of projects are
evaluated to determine their suitability in achieving the firmÊs objective. This
can be done by using techniques such as accounting rate of return, payback
period, discounted payback period, net present value and internal rate of return.
The accurate calculation of cash flow is important because it greatly influences

the decision to accept or reject a proposed project. Numerous variables and many
workers will be involved in the process of capital budgeting. Projections are not
made only by the finance department. Other departments such as the marketing
department, production department and human resources department also make
their projections. The finance department compiles all data provided by other
departments to make an estimation of cash flow in the capital budgeting process.
Hence, it can be seen how difficult it is to prepare cash flow estimation. It
involves numerous variables, cooperation from many people and accurate
prediction.
A few guidelines on cash flow will be discussed in this topic to help financial
managers make a more accurate cash flow projection.
5.1 CAPITAL BUDGETING

ACTIVITY 5.1
Based on your prior experience, explain the importance of cash flow in capital
budgeting. Crosscheck your answer with your coursemates on myINSPIRE.
Capital budgeting is the process of planning asset spending, which is the receipt
of cash flow, expected after a year. In capital budgeting decisions, a company
places funds in various types of projects, such as firm expansion, production
diversification, improving cost efficiency, security and so on.
TOPIC 5 CAPITAL BUDGETING AND CASH FLOW PROJECTION  77
Every decision made regarding capital budgeting has significant implications to

both the cash flow expected to be received by the firm and to the cash flow risk.
This is because capital budgeting involves the investment of assets over more
than one year. For instance, a company wishes to invest in a project that has a life
expectancy of five years. Having invested in that project, it is difficult for a firm
to pull out within this five-year period. There may be changes in demand,
competition and so on. These factors can influence the cash flow expected to be
received and will affect the firmÊs financial performance. Therefore, it is
important for a financial manager to analyse long-term investment proposals in
detail in order to make the best decision for the firm.
As mentioned in Topic 1, one of the significant objectives of a firm is to

maximise its wealth. Capital budgeting is one of the steps to achieve this
objective. Thus, capital budgeting is part of a strategic management process.
5.1.1 The Importance of Capital Budgeting

Capital budgeting involves investment of assets that have a life expectancy of
more than a year. If a project has a life expectancy of eight years, it means that a
firm will be tied up with that project for eight years. Therefore, it is important
that a firm makes an accurate projection of the expected return. A mistake in
these projections, whether in terms of asset requirement or expected return, will
have a serious impact on the firmÊs performance. For example, a firm projects
that sales will increase in the future. To fulfil the increase in demand, the firm
must invest in new machines and expand its factory now so that the asset is
available when it is needed. If the projection is correct, the firm will attain profit
because it is ready with the capacity to increase production and fulfil the increase
in demand. But if there are mistakes in the projection, such as demand does not
increase as projected, the firm will experience the problem of reckless spending
due to the excessive capacity. This will incur a loss to the firm and if the loss is
great, this could lead the firm to bankruptcy.
Capital budgeting is part of the process of strategic management. Decisions

regarding capital budgeting reflect the strategic direction of the firm. Regardless
whether a firm embarks on a replacement project, expansion project or
environmental project, all of these projects need capital budgeting.
The timing of an investment project is important. Effective capital budgeting

must take into consideration the time the project is implemented and the quality
of assets invested. If a project takes place when the economy is in inflation, the
capital cost would be higher due to the high interest rate. This will influence the
discount rate used in the analysis of the projectÊs proposal.
ACTIVITY 5.2
Discuss with a coursemate to determine the three most important reasons for
doing capital budgeting. Justify your choices and share your list on myINSPIRE.
5.1.2 Evaluation of a Capital Budgeting Project

ACTIVITY 5.3
Why is a detailed analysis required for an expansion project compared to a

replacement project? Discuss with a coursemate and share your conclusions
with others on myINSPIRE.
Assessing a capital budgeting project proposal involves expenditure. For this

reason, a financial manager may classify projects into various categories to
determine the level of analysis needed – such as replacement project, expansion
project, security project, environmental project, etc.
Normally, a more detailed analysis is required for an expansion project compared

to a replacement project. A large-scale project that requires a huge budget will be
evaluated more thoroughly than a small-scale project.
5.1.3 Steps in Evaluating a Capital Budgeting Project

Evaluation of a capital budgeting project proposal involves a number of steps as
shown in Figure 5.1.
Figure 5.1: Steps in evaluating a capital budgeting project
Let us take a look at each step outlined in Figure 5.1 in further detail.
(a) Determining Cost of Project

Cost of project is the average rate of payment for the use of capital fund for
the operation of that particular capital budgeting project. Cost of project can
be influenced by factors such as financing policy and types of investment.
Whether a capital budgeting project is accepted or rejected depends mostly
on the discount rate used and this discount rate can be regarded as capital
cost. Capital cost will be discussed in detail in Topic 6.
(b) Cash Flow Forecasting

Estimation of cash flow is an important step in analysing a capital
budgeting project. To make a correct decision, accurate estimation of cash
flow is crucial. Estimation of cash flow is a complicated and difficult step to
make due to the existence of various factors that can influence a projectÊs
cash flow.
This step requires a financial manager to refer to a number of guidelines on

cash flow estimation in ensuring that only relevant additional cash flow is
taken into account before making a capital budgeting decision. Guidelines
regarding the estimation of cash flow shall be discussed in depth later in
this topic.
(c) Determining Risk

Risk plays a vital role in capital budgeting. Ignoring risk in the analysis
of proposed projects may lead to a wrong decision in capital budgeting,
which will erode the firmÊs profits.
(d) Choosing a Suitable Capital Cost

Based on cash flow risk, a suitable capital cost will be adopted for the
discounting of cash flow expected to be received.
(e) Present Value Acquisition

Cash flow is discounted at present value to get an expected value of the
asset to the firm.
(f) Comparing of Cash

The proposed project shall be accepted if present value of cash inflow is
more than cash outflow. On the contrary, the proposed project will be
rejected if present value of cash inflow is less than cash outflow.
5.1.4 Methods in Evaluating a Proposed Project

There are a number of evaluation techniques that can be used to determine
whether a project can be accepted or rejected. The evaluation techniques are as
follows:
(a) Accounting Rate of Return

This is a traditional method to evaluate a proposed project in capital
budgeting. The equation for accounting rate of return (ARR) is as follows:
Equation 5.1
ARR(%)  Net Average Income 

Average Investment Book Value 100
Equation 5.2
ARR(%)  Net Average Income 

Sum of Average Investment Value 100
Net average income refers to income after depreciation and tax expenditure.
Now, let us look at Example 5.1 that shows how to calculate the accounting
rate of return and use the figures to determine whether to accept or reject
the two projects proposed.
Example 5.1
Table 5.1 shows information regarding two projects, A and B. The book
value for both projects are RM30,000.
Table 5.1: Projects A and B Book Value

Year 1 Year 2 Year 3 Average
(RM) (RM) (RM) (RM)
Net income of Project A 8,000 12,000 16,000 12,000
(after depreciation and tax)
Net income of Project B 16,000 12,000 8,000 12,000
(after depreciation and tax)
Book value 1st January 30,000 20,000 10,000 –
31st December 20,000 10,000 0 –
Average 25,000 15,000 5,000 15,000
By using Equation 5.1, the accounting rate of return (ARR) for each
project is:
Project A Project B
12,000 12,000
ARR%   100 ARR%   100
15,000 15,000
 80%  80%
By using Equation 5.2, the accounting rate of return (ARR) for each
project is:
Project A Project B
12,000 12,000
ARR%   100 ARR%   100
30,000 30,000
 40%  40%
To determine whether to accept or reject a proposed project, compare the

accounting rate of return with the minimum rate of return required:
(i) Accept a project if ARR is higher than the minimum rate of return
required; and
(ii) Reject a project if ARR is lower than the minimum rate of return
required.
If projects compete with one another or overlap each other, we will choose
a project that will give the highest rate of return as long as the project gives
a higher accounting return rate than the required minimum rate of return.
In Example 5.1, both projects A and B are attractive because their

accounting rate of return are 80% (by using Equation 5.1) and 40% (by
using Equation 5.2) respectively. Both projects A and B will be accepted if
the required minimum rate of return is less than 40%.
Based on Example 5.1, project B gives a higher return in year 1 compared

to project A, which gives a higher return in year 3. If we take into
consideration the present value of money, project B will become more
attractive as compared to project A, even though both projects give the
same ARR.
One of the advantages of using ARR is, it is easy to understand and to be

used. The concept of income, book value and rate of return is a simple
concept to understand by managers.
The following however, are the disadvantages of using ARR:
(i) It does not take into account the present value of money as seen in
Example 5.1;
(ii) It uses accounting measurement and not cash flow; and
(iii) Different methods of calculation may cause different decisions to be

made. By using equation 1, the project may be accepted but by using
equation 2 it may be rejected.
(b) Payback Period

This is a very simple technique whereby we only have to determine the
period required in order to get back the sum of money invested in the
project. The firmÊs management will decide on a payback period; the
decision to accept or reject a proposal depends on whether the payback
period is longer or shorter than the period set by the management. The
principles for payback period are as follows:
(i) Accept the project if the payback period is less than or the same as the
period decided by the management; and
(ii) Reject the project if the payback period is more than the period
decided by the management.
Now, look at Example 5.2 which shows the method of choosing a project
based on payback period.
Example 5.2
Hebat Company is evaluating whether to accept Project A. The investment
required is RM12,000. The total cash inflow expected for Project A is as
shown in Table 5.2:
Table 5.2: Project A Cash Inflow

Cash Inflow
Year
(RM)
1 3,000
2 3,000
3 5,000
4 5,000
5 5,000
If Hebat Company sets the payback period to three years, Project A will be
rejected because the investment payback period exceeds the period set by
the management. After three years, this project will only give a return of
RM3,000 + RM3,000 + RM5,000 = RM11,000 whereas the cost of
investment is RM12,000.
If Hebat Company sets a payback period of four years, will this project be
accepted? Yes, Project A will be accepted because the payback period is
less than the period set. After three years, the firm will receive a return of
RM11,000. Therefore, it still needs RM1,000 to tally the cost of investment
of RM12,000. Assuming that cash flow is constant, Hebat Company will
take a time of (1,000  5,000) 0.2 years to get back the balance of
RM1,000. Therefore, the payback period is 3.2 years compared to the set
period of four years.
(12,000  11,000)
3,000 + 3,000 + 5,000 (3 years) +  3.2 years
5,000
SELF-CHECK 5.1
Pasti Jaya Company has a project proposal that requires an investment

of RM100,000. The schedule of cash inflow is as follows:
Year Cash Inflow (RM)

1 30,000
2 30,000
3 30,000
4 30,000
Calculate the payback period for this project.
If the management of Pasti Jaya Company has decided on a payback period of

three years, will this project be accepted?
Now let us look at Example 5.3.
Example 5.3
Hebat Company has two investment project proposals: Project A and
Project B. The information on these projects is in Table 5.3.
Table 5.3: Comparison of Projects A and B
Project A Project B
Investment RM12,000 RM12,000
Year Cash inflow

1 RM3,000 RM3,000
2 RM3,000 RM4,000
3 RM5,000 RM5,000
4 RM5,000 0
5 RM5,000 0
Assume that Hebat Company sets the payback period to be three years.
Based on the technique of payback period, Hebat Company will accept
Project B and reject Project A. But is this a good decision?
In the payback period technique, Hebat Company does not take into account
the cash inflow after the decided payback period. Although Project B is able
to yield a return on the investment in year 3, it will not be able to give any
returns after that. On the contrary, Project A may take a longer period to
yield a return but it will still produce a cash inflow of RM5,000 in year 4
and year 5.
The advantages of using the payback period technique are as follows:
(i) This is a very easy technique to evaluate projects. The calculation is

simple and the time needed for making evaluation is short. Thus, the
cost of using this technique is low.
(ii) Since this technique is simple and involves low cost, the management
can use this technique to screen several project proposals and to reject
projects that are unattractive in terms of payback period return. After
that, a detailed evaluation can be undertaken on the existing project
proposal. With this, the management can save the time and cost of
evaluating proposed projects.
(iii) Projecting cash flow in the long term is difficult because of the
elements of uncertainty. Hence, the payback period technique is a
useful risk evaluation method.
Based on Examples 5.2 and 5.3, the disadvantages of the payback period
technique are as follows:
(i) This technique emphasises cash inflow in the early years. What
happens if the payback period is ignored?
(ii) This technique fails to consider the present value of money because
it does not discount cash flow received to present value. Normally,
investment involves cash outflow at present and acquisition of
revenue in the future. As explained in Topic 4, one ringgit received
now is of higher value than one ringgit received in the future. If cash
inflow is not discounted to the present value, the decision made
may be incorrect.
To overcome these disadvantages, the discounted payback period technique

can be used. This technique will still determine the period needed to get
back the sum of money invested, but the cash inflow is discounted to
present value before the decision to accept or reject the project is made.
(c) Discounted Payback Period

To overcome the disadvantages of the payback period technique, discounted
payback period can be used. This technique still determines the period
needed to get back the sum of money invested but the cash inflow is
discounted to present value before the decision to accept or reject the
project is made.
Example 5.4 shows how the technique of discounted payback period is
used. Example 5.4

Referring to Example 5.2 and assuming that the discount rate is 10%, a
discounted payback period schedule can be constructed as shown in
Table 5.4.
Table 5.4: Discounted Payback Schedule
PVIF Discounted Cash

Year Cash Inflow (RM) i=10% Inflow (RM)
1 3,000 0.9091 2,727.30
2 3,000 0.8264 2,479.20
3 5,000 0.7513 3,756.50
4 5,000 0.6830 3,415.00
5 5,000 0.6209 3,104.50
Referring to the last column in the table, it shows that the total cash flow
collected for the first three years is RM8,963 (RM2,727.30 + RM2,479.20 +
RM3,756.50). For the first four years, the total cash flow collected is
RM12,378 (RM8,963 + RM3,415). Since the project investment cost is
RM12,000, the discounted payback period is three to four years. Therefore,
we still need RM3,037 from year 4. Thus, the discounted payback period is:
3  3,037
 3.89 years
3,415
Discounted payback period = 3.89 years

Even though this technique takes into consideration the time value of
money, it still does not take into account the cash flow after the payback
period.
(d) Net Present Value

Net present value of a project is the difference of the present value of all
cash inflow minus the present value of all cash outflow. Figure 5.2
describes a decision-making process based on net present value.
Figure 5.2: Decision-making process based on net present value
Based on the information in Example 5.2 for Hebat Company, let us now
look at Example 5.5 and Table 5.5.
Example 5.5
Table 5.5: Hebat Company Project Cash Inflow
Year Cash Inflow (RM) Present Value of Cash Inflow (RM)

1 3,000 0.9091  3,000 = 2,727.30
2 3,000 0.8264  3,000 = 2,479.20
3 5,000 0.7513  5,000 = 3,756.50
4 5,000 0.6830  5,000 = 3,415.00
5 5,000 0.6209  5,000 = 3,104.50
Total 15,482.40
Investment required = RM12,000

No discounting is required on the cost of investment because this sum of

money is presently withdrawn.
Discount Rate Used = 10%

Net Present Value = The sum of present value of cash inflow – Investment
cost
= RM15,482.40 – RM12,000
= RM3,482.40
Hebat Company accepts this project because the net present value (NPV) is
positive.
Advantages of using the net present value (NPV) technique are as follows:
(i) It takes into consideration the present value of money because it

discounts cash flow to present value; and
(ii) This technique takes into consideration all money flow for the life
expectancy of the project.
Disadvantages of using the net present value (NPV) technique are as follows:
(i) Different discount rates are used in determining a suitable discount

rate. These will affect the present value of returns and as such, will
influence the managementÊs decision on a particular project. This can
be seen in Topic 4, that is, if a higher discount rate is used, the present
value of a sum of money will become smaller. Therefore, choosing a
suitable discount rate is quite important for this type of evaluation.
(ii) Since this technique takes into consideration all cash flow of the life
expectancy of the project, projection of cash flow must be accurate. If
the projection is not accurate, this can cause a project to be accepted
even though it ought to be rejected.
ACTIVITY 5.4
If the discount rate given is 10%, use the technique of NPV to evaluate the
proposed project in Self-Check 5.1 (Pasti Jaya Company). Would you accept or
reject the project? Justify your answer.
(e) Internal Rate of Return

In the internal rate of return technique, we try to find the interest rate that
equals the present value of the total cash flow with investment cost. The
management will decide on a required rate of return from a particular
project. Accepting or rejecting a project depends on the internal rate of
return (IRR).
We will accept a project if the IRR is higher or the same as the rate of
return set by the management. We will also reject a project if the IRR is
lower than the rate of return set by management.
Now, look at Example 5.6 which shows how the internal rate of return
technique is used.
Example 5.6
Megah Company is evaluating whether to accept or reject Project X. The
investment needed is RM18,000. Project X is expected to have a life
expectancy of three years and is expected to give a cash inflow of RM8,000
per year for three years. The management has set a desired 10% rate of
return.
Based on the information, try to find an interest rate that equals the
investment cost with the present value on all cash flow for Project X.
18,000  8,000
8,000 8,000

(1  i) (1  i)
1 2 
(1  i)3
Since the cash flow for every year is the same for three years, we can use
the annuity concept to solve this problem. (Refer to Topic 4 for an
explanation of the annuity concept).
18,000  8,000 (PVIFAi=?, n=3 )

18,000/8000  PVIFA i=?, n=3
2.25  PVIFAi=?, n=3
Referring to the PVIFA table for the period of three years, it shows that:
(a) PVIFA at an interest rate = 15% is 2.2832; and
(b) PVIFA at an interest rate = 16% is 2.2459

Therefore, internal rate of return acquired can be said to be between 15% to

16%. Compare the internal rate of return acquired (15% – 16%) with the
interest rate set by the management (12%). The project can be accepted
because the internal rate of return received is more than the interest rate set
by the management.
Example 5.7
Syarikat Boleh Jaya (SBJ) is evaluating whether to accept or reject Project
S. The investment required is RM800,000. Project S is expected to have a
life expectancy of four years and will give cash inflow as shown in Table
5.6.
Table 5.6: Cash Flow for Project S
Year Cash Inflow (RM)

1 350,000
2 300,000
3 250,000
4 150,000
The management requires a 12% minimum rate of return for this type of
project. Based on the information provided, calculate the rate of return for
Project S.
Answer:
For varying cash flow, we have to use the trial and error technique. This
means that we will use one discount rate to determine the net present value
of the project. If the net present value is not equivalent to zero, we will try a
new discount rate to determine the net present value.
For a start, we can use the discount rate (i) = 12% (same as capital cost).
With this rate, the projectÊs net present value can be determined as
shown in Table 5.7.
Table 5.7: Determining NPV (at 12% Discount Rate)
(1) (2) (3) = (1)  (2)

Year
Cash Flow (RM) PVIFi=12%, n=4 Present Value
1 350,000 0.8929 312,515
2 300,000 0.7972 239,160
3 250,000 0.7118 177,950
4 150,000 0.6355 95,325
824,950
Net Present Value = RM824,950 – RM800,000

= RM24,950
Due to the net present value being positive, the discount rate must be
increased. Now, we try with i = 14% (Table 5.8).
(1) (2) (3) = (1)  (2)

Year
1 350,000 0.8772 307,020
2 300,000 0.7695 230,850
3 250,000 0.6750 168,750
4 150,000 0.5921 88,815
795,435

= –(RM4,565)
Due to the net present value being negative, the discount rate must be
reduced. Now, we try with i = 13% (Table 5.9).
(1) (2) (3) = (1)  (2)

Year
1 350,000 0.8850 309,750
2 300,000 0.7831 234,930
3 250,000 0.6931 173,275
4 150,000 0.6133 91,995
809,950

= RM9,950
Summary
Discount rate (i) Net Present Value
12% RM24,950
13% RM9,950
IRR = ? RM0
14% RM4,565
This means that zero net present value must be between the discount rates
of 13% and 14%. The projectÊs internal rate of return is the same as 13%
but less than 14%.
Please note that you must repeat the trial-and-error calculation (i.e. try a
number of different discount rates) until you arrive at two ranges of net
present value (one positive and another negative). This ensures that net
present value equals to zero can be determined. IRR is the discount rate that
makes the net present value becomes zero:
Advantages of using the internal rate of return technique are as follows:
(i) This technique measures the rate of return on investment. It is concept

that is easily understood by the management; and
(ii) This technique takes into account the present value of money as net
present value technique.
Disadvantages of using the internal rate of return technique are as follows:
(i) With regard to certain cash flow, there probably is more than one
internal rate of return. This will confuse the management in making
decisions;
(ii) For competing projects, management may be required to choose only

one project, for instance, in a power station project, management has a
choice between hydroelectric, nuclear or coal. The internal rate of
return technique may give priority to the wrong project; and
(iii) The calculation of this technique is quite difficult if there are different
returns during the life of the project.
5.2 GUIDELINES ON CASH FLOW ESTIMATION

ACTIVITY 5.5
Based on the project evaluation methods mentioned before, what is the best
method to employ if you are a project manager? What are the characteristics you
will consider? Share your thoughts on myINSPIRE.
SELF-CHECK 5.2
Based on the information available in Self-Check 5.1 (Pasti Jaya Company),

calculate the internal rate of return for that project.
Will you accept or reject the project if the management sets the required rate of
return at 15%? Give your reasons.
As a financial manager, what is the guideline that you will use for the estimation
of cash flow in your organisation?
A financial manager has to consider several important guidelines for a more

accurate cash flow projection. This in turn improves the accuracy of capital
budget decisions. We will discuss these guidelines in the next subtopic.
5.2.1 Based on Cash Flow and Not on Accounting

Profit
Profit is based on accrued concept. For instance, this yearÊs sale is considered
done and this yearÊs profit can take into consideration those sales. But, even if
sales happen this year, collection does not necessarily happen in this year too.
Therefore, we cannot regard those sales as cash inflow. Without this cash inflow,
the firmÊs project may be impeded due to financial difficulties. This applies to
any payment made by the company. Sometimes, the firm needs to make a certain
payment to another party next year and in the calculation of accounting profit, the
payment is this yearÊs cost because service has been given or merchandise has
been supplied by the party concerned. But since payment need not be paid this
year, cash outflow does not happen and with that, this cash flow will not be
shown this year.
5.2.2 Only Relevant Additional Cash Flow is

Considered
Additional cash flow is the net cash flow that is related to the investment project.
This cash flow will happen only if we accept the project. In determining
additional cash flow, a few doubts may arise, for instance, sunk cost, opportunity
cost and externality. Are these items included as part of additional cash flow?
(a) Sunk Cost

Sunk cost refers to the total cost spent and is not collectable whether a
project is accepted or not. Therefore, sunk cost cannot be included in the
analysis. For instance, the fee paid to a consultant for conducting market
research. Consultant fees cannot be included in a project analysis because
this cost has been spent. Regardless of whether the project is accepted or
not, the cost cannot be returned.
(b) Opportunity Cost

Opportunity cost refers to the return that can be acquired from an asset if
the asset is utilised for another purpose. For instance, ABC Company
has an office that can either be used as a new branch office, or be rented
to other people for RM36,000 per year. If ABC Company opens a
branch, it will lose the opportunity of having a yearÊs rent of
RM36,000. This opportunity cost must be included in the analysis.
(c) Externality
Externality refers to the impact of the project on other departments in the
firm or to the firmÊs existing production. For instance, if the firm
introduces a new product, this may affect the sale of an existing product. A
financial manager should take into account external impacts when
estimating an investment projectÊs cash flow.
ACTIVITY 5.6
Give one example to describe each of the following items:
Sunk cost;
Opportunity cost; and
Externality.
Crosscheck your answers with your coursemates on myINSPIRE.
5.3 MAKING DECISIONS ON EXPANSION

PROJECTS AND REPLACEMENT PROJECTS
Why is an expansion project more complicated and needs a more detailed
analysis compared to a replacement project? In capital budgeting, two types of
decisions are usually made, which are decisions concerning the following
analyses:
(a) Replacement project analysis; and
(b) Expansion project analysis.

Usually, analysis of expansion project is more difficult and complex compared to

analysis of replacement project. Analysis of expansion project involves
investment in new assets for the purpose of increasing sales and expanding
market share. Meanwhile, analysis of replacement projects involve investment to
replace equipment or old assets.
For expansion projects, all cash outflow (cost) and all cash inflow (revenue) need
to be considered. When evaluating an expansion project, a financial manager
must consider the degree of risk as well as the inflation rate relating to the
project. Evaluating techniques such as payback period, net present value and rate
of return discussed in this topic can be used to analyse the project.
For replacement projects, additional cash flow such as cash received from sale of
old assets or used assets must be calculated. Besides this, the impact of savings
on taxes also needs to be considered.
5.4 CASH FLOW ESTIMATION AND RISK

What is the relationship between cash flow estimation and risk? Risk measures
the variance between real outcome and expected outcome. In capital budgeting,
every period is a random variable and cash flow projection may not be accurate.
The bigger the variance between projection of cash flow and real cash flow, the
higher the risk will be. In order to make a more accurate analysis, a financial
manager needs to include the degree of risk.
5.5 CASH FLOW ESTIMATION AND INFLATION

What is the relationship between cash flow projection and inflation? Inflation
refers to an increase in the general prices of goods and services. When inflation
rate increases, the value of money decreases. If expected inflation rate is not
calculated into the analysis of cash flow projection, the value received is
inaccurate. As a result, the capital budgeting decision made will not be accurate
and may affect the firmÊs financial standing. Due to this, capital budgeting
analysis must consider the effects of inflation on cash flow projection to get a
more accurate decision.
The inflation rate expected must be included in the analysis of net present value
to ensure that capital cost takes into consideration the inflation rate. If inflation
rate is found to be higher, the discount rate used should be raised. If the inflation
rate is low, the discounted rate must be lowered. Please refer to Topic 4 on
Financial Mathematics to revise on discount rate and present value. You should
be able to understand the relationship between cash flow estimation and inflation
more clearly after having revised Topic 4.
SELF-CHECK 5.3
Fill in the Blanks
The difference between cash flow projection with true cash flow, the its risk.
In cash flow projection analysis, when the inflation rate is

, the discount rate used must be increased. When inflation rate is , the
discount rate used must be lowered.
 Capital budgeting is an essential process for any firm. It involves the planning
and evaluation of a long-term project.
• There are several methods of evaluating projects, such as accounting rate of

return, payback period, discounted payback, net present value and internal
rate of return. Each method or technique has its own advantages and
disadvantages.
• Cash flow projection is important in the analysis of a proposed investment

project. There are a number of guidelines on cash flow projection that can be
used to make decisions on what to include in the cost.
• The projectÊs degree of risk and the inflation rate need to be considered when
evaluating a project.
Accounting rate of return Internal rate of return

Budgeting technique Net present value
Cash flow Opportunity cost
Capital budgeting Payback period
Discounted payback period Sunk cost
Topic  Cost of Capital
and Capital
6 Structure
LEARNING OUTCOMES
Discuss cost of capital and its importance in financial management;
Identify the factors that influence cost of capital;
Calculate the cost of capital for each type of capital component, as well as the
weighted average cost of capital;
Differentiate between business risk and financial risk, as well as operating
leverage and financial leverage; and
Calculate the degree of financial leverage and its effect on earnings per share.
 INTRODUCTION
In Topic 5, we discussed a number of techniques to evaluate investment
proposals. Acceptance of a project depends on the expected rate of return and
capital cost for the project. In the net present value technique, a particular project
will be accepted if there is a positive sign of net present value. Meanwhile, in the
internal rate of return technique, a project will be accepted if the internal rate of
return is higher than the cost of capital.
In Topic 5, you also learnt that cash flow projection is very important in the
capital budgeting process because any mistakes in cash flow projection will
influence the investment decision as well as the companyÊs performance and
profit. Comparison between cash flow and cost of capital in the capital budgeting
process means that the cost of capital must also be projected accurately in making
a sound decision. In this topic, we will discuss the meaning of cost of capital and
how to calculate it for a particular firm.
TOPIC 6 COST OF CAPITAL AND CAPITAL STRUCTURE  99
We will discuss capital structure briefly in Topic 10. Capital structure is

defined as a combination of capital components such as debt, preference shares
and ordinary shares that are used by a particular company. We will see how to
calculate the weighted average cost of capital by using the capital structure,
which consists of various components of capital. A discussion on cost of capital
will show a direct relationship between a firmÊs asset structures with a firmÊs
financial structures. Areas covered under capital structure often include the
following:
(a) Optimal capital structure;
(b) The relationship between capital structure and risks;
(c) The relationship between capital structure and returns; and
(d) The relationship between capital structure and the value of the companyÊs
wealth.
6.1 COST OF CAPITAL

Cost of capital can be defined as the average payment rate for the use of capital
funds by a firm. Cost of capital is influenced by financing policy and its
investment. In determining capital budget, acceptance of a project depends on the
discount rate used and this discount rate can be considered as the cost of capital.
6.1.1 Factors Influencing Cost of Capital

There are a number of factors that may influence cost of capital:
(a) The Type of Capital Used by the Firm

Each type of capital is different in terms of cost because the risk associated
with each type of capital is different. If the risk of an investment is high,
it makes sense that the investor will need a higher return as compensation
and with that, the cost of capital to the company is higher. For instance, the
risks associated with ordinary shares are greater than preference shares.
Therefore, investors of ordinary shares will require a higher return
compared to investors of preference shares. Consequently, the cost of
ordinary shares is higher compared to preference shares.
100  TOPIC 6 COST OF CAPITAL AND CAPITAL STRUCTURE
(b) Dividend Policy

The dividend policy will determine the amount of total earnings that will be
distributed to ordinary shareholders and the amount to be held as retained
earnings. If more is distributed as dividends to shareholders, retained
earnings will decrease and the opposite occurs if dividend payment is
reduced. Thus, a firmÊs dividend policy will indirectly influence its cost of
capital.
(c) Interest Rate in the Economy

If the interest rate decreases, this will lower the cost of loans and interest
rates payable to the bondholders. On the contrary, if the interest rate in the
economy increases, bondholders will need to see a higher interest rate to
encourage them to invest in the companyÊs bonds. Hence, cost of capital
will increase.
(d) Government Tax Policy

Government tax rate will influence capital components such as debt
because interest payment can get tax shelter.
6.1.2 The Importance of Cost of Capital

Understanding cost of capital is important to financial managers in making
various types of financial decisions such as the following:
(a) Decisions related to capital budgeting. Cost of capital is important in capital

budgeting analysis and will influence decisions on whether to accept or
reject a particular project.
(b) Decisions regarding the type of capital component that should be used by
the firm, i.e. debt or equity capital.
6.1.3 Types of Capital Components

Capital can be raised through various sources:
(a) Debts
Loans from financial institutions such as banks, or through the sale of bonds.
(b) Preference Shares

Revenue acquired from the sales of preference shares.
(c) Common Equity

Consist of sales from ordinary shares and amount of retained earnings.
ACTIVITY 6.1
State two reasons where cost of capital is important to a financial manager

and explain why. Share and crosscheck your answers with your coursemates on
the myINSPIRE online learning platform.
6.2 CAPITAL STRUCTURE

Capital structure refers to the combination of capital components – which are
debt, preferences shares and common equity – that are used by a company. The
combination of capital structure is normally represented in percentages. What is
the combination of capital components for an optimum capital structure? Capital
structures vary according to the firmÊs type of business, industry and objectives.
Based on the firmÊs objective of maximising wealth, an optimum capital

structure can be defined as a combination (in percentage) of debts, preference
shares and common equities that can maximise its wealth or stock price. After
determining the optimum capital structure, the firm will use this as a guide to
ensure its actions work towards achieving the target.
ACTIVITY 6.2
Discuss the following with a coursemate. Post your answers on myINSPIRE and
compare them with other submissions:
What is the relationship between capital components and capital structure?
Give reasons why debt cost is lower compared to the cost of ordinary shares.
6.3 WEIGHTED AVERAGE COST OF CAPITAL

As we have previously discussed, a company may have various types of capital
components, which consist of debt, preference shares and common equities. For
each type of capital component, the cost is different. In finance, there is the
principle of exchange between risk and return, that is, if a risk is higher, the
expected return must also be higher to attract investors to take that higher risk.
Therefore, when a firm has different capital costs due to the different usage of
capital components, it is appropriate to use a weighted average cost of capital
to determine the cost of capital. Hence, weighted average cost of capital is the
weighted average cost of capital components, which is weighted depending on
the sum of each type of capital component used.
Let us take a look at Example 6.1, which shows a general example because the
cost of each capital component is calculated based on nominal cost. For a more
accurate calculation, we need to use the effective cost or real cost for each of
these capital components. This will be explained in three of the following
divisions, which are debt cost, preference shares cost and common equity cost.
Subsequently, the weighted average cost of capital is calculated based on these
costs.
Example 6.1
Table 6.1 shows the capital structure of Cemerlang Company Limited.
Table 6.1: Capital Structure of Cemerlang Company Limited
Capital Components Total Value (RM) Cost of Capital

Debt 75,000 8%
Preference shares 55,000 10%
Ordinary shares 120,000 15%
Total 250,000
First Step:
Calculate the weight for each capital component.
RM75,000
Debt: RM250,000  0.3
RM55,000
Preference shares:
RM250,000  0.22
RM120,000
Ordinary shares:  0.48
RM250,000
Second Step:
Multiply the weight with the cost for each capital component (see Table 6.2).
Table 6.2: Calculation for the Weighted Average Cost of Capital
Capital Component Weight Cost of Capital

Debt 0.30 0.30  8% = 2.40%
Preference shares 0.22 0.22  10% = 2.2%
Ordinary shares 0.48 0.48  15% = 7.20%
Total 1.00 11.80%
Third Step:
Add up the cost of capital for each capital component to obtain the weighted
average cost of capital.
Now let us try the following exercise:
SELF-CHECK 6.1
The following table shows the capital components of Double Eight

Company.
Capital Component Total Value (RM) Cost of Capital

Debt 150,000 7%
Preference Shares 80,000 8%
Ordinary Shares 270,000 12%
Total 500,000
Calculate the weighted average cost of capital for Double Eight Company.
6.3.1 Cost of Debt

A suitable cost of debt is the cost of debt after tax. Interest rate on debt is I D minus
tax savings because interest is eligible for tax relief.
After Tax Cost of Debt = Interest rate on debt  Tax savings

 ID  I D T
 ID (1 
T)
When T = Marginal tax rate.
For instance, Cemerlang Company acquired capital of RM75,000 through

borrowing at a cost of 8%. If marginal tax rate = 30%, therefore cost after tax is:
T = Tax rate
ID(1  T)  8%(1  0.30)
 8%(0.70)
 5.6%
ACTIVITY 6.3
Why is cost of debt (after tax) used? Post your explanation on myINSPIRE and
crosscheck your answer with your coursemates.
SELF-CHECK 6.2
Based on Double Eight Company in Self-Check 6.1, if marginal tax rate is 30%,
what is the cost of debt after tax?
6.3.2 Cost of Preference Shares

The rate of return required by investors on preference shares C PS of a firm is
calculated as dividends of preference shares divided by the net issue price of
shares PPS.
The net issue price of preference shares PPS is the price of preference shares
minus floating cost.
Cost of Preference Shares = DPS

CPS 
PPS
When DPS = Preference shares dividend; and

PPS = Price of preference shares.
For instance, Cemerlang Company acquired a capital of RM55,000 from the sale
of preference shares at a price of RM100 per share. Floating cost is 2% from
Cemerlang CompanyÊs share price, paying a dividend of 10% or RM10 for every
unit of preference share.
10 10
Cost of Preference Shares =   10.2%
100  2 98
SELF-CHECK 6.3
In Self-Check 6.1, Double Eight Company acquired capital of RM80,000 from

the sales of preference stock. Assume value per share is RM100 and floating
cost is 3% from the share price.
Based on a dividend rate of 8%, calculate the cost of preference stock for
Double Eight Company.
6.3.3 Cost of Common Equity

Cost of common equity is the rate of return required by shareholders. Cost
allocation is on retained earnings because it involves opportunity cost. Earnings
after tax are owned by ordinary shareholders. Bondholders are paid interest
and preference shareholders are paid preferred dividend. Balance of earnings –
that is, income after interest and tax – are allocated to ordinary shareholders
as compensation for investing in the company. Management can distribute this
income to shareholders or retain it for the purpose of reinvesting in the firm for
growth. Therefore, the firm should attain income of at least the same amount that
is received by shareholders in alternative investments with the same risk as these
retained earnings.
C E D1 
P0
g
When D1 = 1st year dividend;

P0 = Share price; and
g = Growth rate.
Now, let us refer to Example 6.2.
Example 6.2
Information on Cemerlang Company Limited.
Expected dividend = RM0.25

Expected growth rate = 6% a year
Share price = RM5.00
0.25
C=  0.06
E
5.00
= 0.05 + 0.06
= 0.11
= 11%
If common stock (ordinary share) has just been issued to collect funds, floating cost
should be included in the model to illustrate the actual capital cost.
CE  D1

g P0 (1  F)
When F = Floating cost.
Based on the example of Cemerlang Company, assuming floating cost is 20%,

therefore capital cost for the new issue of common stock is:
CE  0.25
 0.06
5.00(1 
0.20)
0.25
  0.06
4.00
 0.1225
 12.25%
Now, you can try the following calculation exercise:
SELF-CHECK 6.4
Information regarding the ordinary shares of Double Eight Company is

as follows:
Expected dividend= RM0.20 Expected growth rate = 5%
Price per share = RM3.00
Calculate the cost of common equity.
If Double Eight Company issues shares for the first time, and the floating cost
is 20%, how much is the equity cost?
The weighted average cost of capital is calculated based on debt, preference

shares and ordinary shares including cost of capital of each of these components.
Based on Cemerlang Company LimitedÊs information in Example 6.2 (with the
assumption that there is 20% floating cost for new issues of ordinary shares), the
weighted average cost of capital will be calculated as in Table 6.3.
Table 6.3: Calculation of Cemerlang CompanyÊs Weighted Average Cost of Capital
Capital Components Weight Cost Weighted Cost

Debt 0.30 5.6% 0.30  5.6% = 1.68%
Preference Shares 0.22 10.2% 0.22  10.2 = 2.244%
Ordinary Shares 0.48 12.25% 0.48  12.25% = 5.88%
Weighted Average Cost of Capital 9.804%
The Equation of Weighted Average Cost of Capital

WACC = WD CD (1 – T) + WPS CPS + WE CE
A capital structure that minimises a weighted average cost of capital will

maximise share price and will be considered as an optimum capital structure for
the company.
6.4 IMPORTANCE OF CAPITAL STRUCTURE TO

THE FIRM
The cost of capital is the average payment rate for the usage of capital funds.
Factors affecting cost of capital are:
(a) The type of capital used by a firm;
(b) Dividend policy;
(c) Interest rate in the economy; and
(d) Government tax policy.
Cost of capital is important to financial managers when making decisions on:
(a) Capital budgeting; and
(b) The type of capital components which should be used by a firm.

The types of capital components are:
(a) Debt;
(b) Preference shares; and
(c) Equity (ordinary shares and retained earnings).
Capital structure refers to capital components, which are debt, preference shares
and ordinary shares used by a company. Optimum capital structures are a
combination of debt, preference shares and ordinary shares that can maximise the
companyÊs wealth or share price. The weighted average cost of capital is the
weighted average of costs of capital components, that is, its weight depends on
the total of each capital component used.
The appropriate cost of debt is after-tax cost of debt because interest is eligible
for tax shelter.
The rate of return desired by investors of a firmÊs preference shares is calculated

as dividend of preference shares divided by the net issue price of shares.
Cost of common equity is:
CE  D1

g P0 (1  F)
SELF-CHECK 6.5
Normally, cost of debt is lower than ordinary shares.
In determining capital cost, nominal cost is more accurate as compared to

effective cost.
As retained earnings are considered as profit not distributed, therefore this

capital cost is zero.
The cost of every capital component depends on the return desired by

investors who offer their funds.
6.5 OPTIMUM CAPITAL STRUCTURE

An optimum capital structure can be defined as a combination of debt,
preferences shares and common equity that can maximise the companyÊs wealth
or share price. But in practice, it is difficult for financial managers to form an
optimum capital structure because this will change over time.
6.5.1 Target of Capital Structure

Factors beyond the firmÊs control that affect its optimum capital structure
include market interest rate, financial policy, government tax policy,
environmental policy and many more. Although changes in capital structure may
influence risk, return and cost, financial managers still need to determine the
optimum capital structure as it can be used as a guide or target in order to achieve
the firmÊs objective, which is to maximise its wealth.
Effective management of capital structure can increase the companyÊs financial

performance as well as its share price. To form a good capital structure, financial
managers must understand and differentiate the related risks. This is because
capital structure involves the exchange of risk and returns. Changes in capital
structures may increase performance, but it may also increase risks.
6.5.2 Risk
ACTIVITY 6.4
What is the difference between business risk and financial risk? Share your
thoughts on myINSPIRE.
Risk arises due to the elements of uncertainty. In the business world, risk can be
divided into two types:
(a) Business Risk

Business risks arise when firms do not use debt and these risks are in
relation with a firmÊs expected future returns on its assets. These risks
change over time and are different between industries, as well as between
firms in the same industry. In general, small firms and firms that produce
only a single type of product have greater business risk. Besides this, firms
that experience business cycles also face higher business risk. Examples of
firms that have low business risk are the retail business and food industries.
The following are factors that affect business risk:
(i) Fluctuations in demand;
(ii) Sales price;
(iii) Fluctuations in input price;
(iv) The ability to adapt output price to changes in input price; and
(v) Fixed cost levels. If most of the firmÊs costing is fixed, business risk
is higher because if sales drop, the firmÊs cost still remains almost the
same due to the fact that a major portion of the costs are fixed costs.
(b) Financial Risk

Risks faced by shareholders are due to the usage of financial leverage. This
risk is the risk borne by shareholders apart from business risk.
6.6 LEVERAGE
Capital structures and leverage are closely tied. Leverage refers to the ability to
double the effect of an action. In finance, leverage can be divided into two types:
(a) Operating leverage; and
(b) Financial leverage.
Before we discuss both types of leverage, let us go through several related and
important concepts. Among them are break-even point, contribution margin and
earnings before interest and tax.
6.6.1 Break-even Point

The break-even point (BEP) refers to the total sales needed for a firm to achieve
zero earnings. BEP can be stated in sales units or sales value in ringgit.
The BEP technique is used to determine the level of activity needed to be

achieved by a firm to ensure that it will be able to continue the business in the
long term. To continue doing business, a firm must at least be able to support
its production cost.
BEP (Units) Fixed cost

 Selling price per unit  Variable cost per unit
FC
PV
Where FC = Total fixed cost;

P = Selling price per unit; and
V = Variable cost per unit.
BEP can also be stated in ringgit based on the following formula:
BEP (RM)  FC
P  V P
or
BEP (units)  P
6.6.2 Contribution Margin

Contribution of a product unit is the difference between the selling price per unit
and the variable cost per unit. This can be calculated from the following equation:
Contribution = Selling price per unit – Variable cost per unit

C=P–V
When C = Contribution;
Contribution margin is the contribution stated as a percentage from revenue.

Therefore, contribution margin can be calculated as follows:
P V
CM 
P
When CM = Contribution margin

Example 6.3
The following information relates to the product from Raytec Private Limited:
Selling price per unit = RM50

Variable cost per unit = RM32
Calculate:
(a) The contribution of a product unit; and
(b) The contribution margin for the product of Raytec Private Limited company.
Answers:
(a) Contribution:
C=P–V
= RM50 – RM32
= RM18
(b) Contribution Margin:

PV
CM 
P
50  32
 50
18
 50
 0.36
 36%
6.6.3 Earnings Before Interest and Tax

Earnings before interest and tax (EBIT) are revenue minus cost. The equation of
earnings before interest and tax is as follows:
EBIT = Total revenue – (Total fixed cost – Variable cost)

= Total revenue – Total cost
EBIT = P(Q) – (V(Q) – FC)
EBIT = Earnings before interest and tax;

P = Selling price per product unit;
Q = Sales quantity;
V = Variable cost per unit; and
FC = Total fixed cost.
6.6.4 Operating Leverage

A firmÊs cost structure refers to the percentage of fixed cost and variable cost in
total cost. The firmÊs cost can be divided into two components:
(a) Fixed Cost

This is the cost that does not change when production output changes, for
example rent, overhead cost and cost of equipment.
(b) Variable Cost

This is the cost that changes directly with production output, for instance
cost of raw materials and cost of workersÊ wages.
Operating leverage is linked to the cost structure, in which the higher the
percentage of fixed cost as part of total cost, the higher the operating leverage.
Operating leverage is also linked to the degree of reaction of the firmÊs

earnings before interest and tax (EBIT) to fluctuations in sales. If most of the
firmÊs costs are fixed costs, thus the firm will have a high degree of operating
leverage. If other factors are considered constant, a high degree of operating
leverage means a small change in sales will cause a huge change in the operating
income. By linking percentage of the fluctuations in earnings before interests and
tax to the percentage of fluctuations in sales, we can calculate a particular
measurement for operating leverage. Degree of operating leverage (DOL) can be
Q(P  )V )
DOL 
Q(P  V)  FC
 Contribution EBIT
When Q = Quantity sold;

P = Selling price per unit;
V = Variable cost per unit;
FC = Total fixed operating cost;
EBIT = Earnings before interest and tax.
Example 6.4
Berjaya Private Limited Company sold their products at RM30 per unit. Fixed
operating cost is RM150,000 and variable cost per unit is RM10.
Requirements:
(a) Calculate the break-even point in product units.
(b) If total current sale is 10,000 units, calculate the firmÊs earnings before
interest and tax.
(c) Calculate the degree of operating leverage on total current sales.
(d) Explain the implication of the firmÊs degree of operating leverage.

Answers:
Fixed cost
(a) Break-even Point =
Contribution per unit
FC
= (P 
V)
RM150,000
= RM(30  10)
= 7,500 units
(b) EBIT = Total revenue – Total cost

= P(Q) – V(Q) – FC
= 30(10,000) – 10(10,000) – 150,000
= RM50,000
Q(P  V) Contribution
(c) Degree of Operating Leverage or
= Q(P  V)  FC EBIT
10,000(30  10)
= 50,000
= 4 times
(d) Degree of operating leverage is 4 times at 10,000 units means that if total
sales increases, for instance at 15% or 1,500 units, operational profits will
increase to as much as 15%  4 = 60%, that is to a sum of RM30,000. This
can be seen as follows:
Based on Sale Based on Sale

10,000 Units 11,500 Units
RM RM
Sales 300,000 345,000
Deduct: Total variable cost 100,000 115,000
Contribution 200,000 230,000
Deduct: Total fixed cost 150,000 150,000
Earnings before interests and tax (EBIT) 50,000 80,000
The calculation above shows the firmÊs EBIT had increased by RM30,000.
ACTIVITY 6.5
In your opinion, what will happen to a firmÊs earnings before interest and tax
if total sales decrease to as much as 30%. Refer to the previous example to
answer this question and go to myINSPIRE forum to crosscheck your answer
with your coursemates.
6.6.5 Financial Leverage

A firmÊs financial leverage is linked to its capital structure, which consists of
debt as a capital component. Company capital components consist of debt,
preference stock and common equity. Capital structure refers to the percentage of
debt, preference stocks and common equity as the companyÊs capital.
Financial leverage refers to the level of fixed income securities used in capital
structure. Fixed income securities can include debt and preference stocks. The
reason companies use fixed income securities as a financing resource is to
increase return to common shareholders. However, when the percentage of debt
increases, common shareholders will be exposed to higher financial risk.
Financial leverage also refers to the reaction of net profit after tax caused by the
usage of fixed securities such as debt and preference stocks. If a firm has a high
ratio of debt capital in its capital structure, this firm is said to have a high degree
of financial leverage. If other factors are considered constant, a high degree of
financial leverage means a small change in earnings before interest and tax
(EBIT) will relatively cause huge changes in earning per share.
The degree of financial leverage (DFL) can be calculated as follows:
DOL Q(P  V)  FC
Q(P  V)  FC  1
= EBIT orEBIT
EBTEBIT  1
When DFL = Degree of financial leverage;

Q = Sales quantity;
P = Selling price per unit;
V = Variable cost per unit;
FC = Total of handling
cost;
I = Yearly interest expenditure or preference stock dividend, which
has been modified on before tax;
EBIT = Earnings before interest and tax;
and EBT = Earnings before tax.
Now, let us look at Example 6.5.
Example 6.5
Suka Limited sells its product at the price of RM50 per unit. Yearly total fixed
cost is RM210,000 and variable cost per unit is RM20. The firm has a debt
capital of RM500,000 at an interest rate of 6%. The firmÊs tax rate is 30% and
total shares issued are 200,000.
You are required to:
(a) Calculate earnings before interest and tax (EBIT) and earnings per share at
total sales of 12,000 units.
(b) Calculate the firmÊs degree of financial leverage at a sales level of 12,000
units.
(c) By using the degree of financial leverage that is acquired in (b), show its
impact on earnings per share if:
(i) EBIT increases by 30%; and
(ii) EBIT decreases by 30%.

Answers:
(a) RM
Sales revenue (RM50  12,000 units) 600,000
Deduct: Total variable cost (RM20  12,000 units) 240,000
Total contribution 360,000
Deduct: Total fixed cost 210,000
Earnings before interest and tax (EBIT) 150,000
Deduct: Interest (6%  RM500,000) 30,000
Earnings before tax 120,000
Tax at 30% 36,000
Earnings after tax 84,000
Total shares issued 200,000
Earnings per share (84,000  200,000) RM0.42
(b) Degree of Financial Leverage (DFL)
EBIT
DFL 
EBIT  1
150,000
 150,000  30,000
150,000
 120,000
 1.25 times
(i) If earnings before interest and tax (EBIT) increases by 30%, earnings
per share will increase by as much as 30  1.25% = 37.5%.
(ii) If earnings before interests and tax (EBIT) decreases by 30%,

earnings per share will decrease by as much as 37.5%.
This can be shown as follows:
If EBIT Increases by 30% If EBIT Decreases by 30%

(RM) (RM)
EBIT 195,000 105,000
Interest 30,000 30,000
Earnings before tax (EBT) 165,000 75,000
Tax 49,500 22,500
Earnings after tax 115,500 52,500
Total shares issued 200,000 200,000
Earnings per share (EPS) 0.5775 0.2625
Percentage changes on
(0.5775  0.42) (0.2625  0.42)
EPS   100
100 0.42
0.42  37.5%
 37.5%
6.6.6 Combination of Operating Leverage and

Financial Leverage
Changes in sales revenue cause huge changes to EBIT. Whereas, changes in
EBIT is translated to a bigger variance of earnings per share and existing total
earnings to common shareholders if the firm chooses to use financial leverage. A
combination of both leverages will widen the variance of earnings per shareÊs
probability.
If a firm uses high total operating leverage and financial leverage, the firm is said
to have high leverage. For this firm, if there is a small change in sales, it will
cause significant fluctuations in earnings per share.
The degree of combined leverage (DCL) at any particular sales level can be
DCL  DOL  DFL

 Q(P  V)  Q(P  V)  F
Q(P  V)  FQ(P  V) 
F  1
= Q(P  V) Q(P  V)  F  1
 Contribution
EBIT 
1
Now, let us look at Example 6.6.
Example 6.6
Information on Kayu Limited Company is as follows:
Selling price per unit RM60
Variable cost per unit RM25
Total fixed cost per year RM350,000
Debt capital RM550,000 at 6.5%
Tax rate 30%
Requirements:
(a) Calculate operating leverage, financial leverage and combined leverage for
Kayu Limited Company at a sales level of 15,000 units.
(b) Using the combined leverage acquired in part (a), show its impact on
earnings per share if sales increase by 25%.
Answer:
(a) At a sales level of 15,000 units:
RM
Sales revenue (RM60  15,000 units) 900,000
Deduct: Total variable cost (RM25  15,000) 375,000
Deduct: Fixed cost 350,000
Earnings before interests and tax (EBIT) 175,000
Deduct: Interest (6.5%  RM550,000) 35,750
Earnings before tax (EBT) 139,250
Deduct: Tax (30%) 41,775
Earnings per share (EPS) RM1.9495
Contribution
Degree of Operating Leverage (DOL) =
EBIT
525,000
= 175,000
= 3 times
EBIT
Degree of Financial Leverage =
EBIT  1
175,000
= 175,000  35,750
175,000
=
139,250
= 1.26 times
Degree of Combined Leverage = DOL  DFL

= 3  1.2567
= 3.77 times
Or
Contribution
Degree of Combined Leverage =
EBIT  1
252,000
= 139,250
= 3.77
(b) If sales increase by 25%, the changes in earnings per share are:
= 25%  3.77 = 94.25%

This can be shown as follows:
RM
Sales (1.25  900,000) 1,125,000
Deduct: Total variable cost (1.25  375,000) 468,750
Deduct: Fixed cost 350,000
Earnings before interest and tax (EBIT) 306,250
Deduct: Interest 35,750
Earnings before tax (EBT) 270,500
Deduct: tax (30%) 81,150
Earnings per share (EPS) RM3.787
Therefore, the change in earnings per share is:
(3.787  1.9495)
 1.9495  100%
 94.25%
ACTIVITY 6.6
In your opinion, what is the implication on earnings per share (EPS) if sales
decline by 15%? (Refer to Example 6.6). Share and compare your answer with
your coursemates on myINSPIRE.
6.6.7 Implication
The total risk borne by firms can be managed by combining operating leverage
and financial leverage in various degrees. Knowledge of various leverage
measurements will help financial managers determine overall risk that is
acceptable. If high business risk exists in a particular type of business, the
financial risk status will minimise fluctuations to additional earnings caused by
changes in sales.
On the contrary, if a firm has a low fixed operating cost, it may choose a higher
degree of financial leverage with the hope of increasing both its earnings per
share and rate of return on its common equity investment.
6.7 RESTRUCTURING CAPITAL AND LEVERAGE

Sometimes, a firm restructures its capital with the intention of increasing its
performance. Restructuring of a firmÊs capital happens when a firm replaces part
of its equity capital with debt or vice versa. When this happens, the firmÊs capital
structure will change because the percentages of the capital structureÊs
components (in the form of debt and equity) have changed. Changes in the
combination of debt and equity will cause changes in leverage. Therefore, a
financial manager must evaluate the issue of restructuring capital and leverage
before making a decision.
SELF-CHECK 6.6
A firm with a high ratio of fixed cost has a high degree of financial leverage.
Operational profit is the difference between total revenue and total fixed
cost.
Financial leverage exists when a firm has debt as a capital component in its
capital structure.
A firm should use more leverage during economic recession to improve its
performance.
A firm that only uses equity capital is said to have no leverage.
 In this topic, we explored three types of capital components, debt, preference

shares and ordinary shares and how they are connected to the capital
structure.
 It is important for financial managers to know how to calculate the weighted

average cost of capital, as well as the cost for each capital component.
 Capital structure and risks are interrelated. Changes in the capital structure
can impact the performance of a firm.
 An optimum capital structure refers to the combination (in percentages) of

debt, preference stock and common equity that can maximise a companyÊs
wealth.
 Business risks are risks that occur when a firm uses debt, and these risks
are associated with the firmÊs expected future return on its assets.
Financial risk is the risk borne by shareholders due to the usage of
financial leverage.
 Break-even point, contribution, and earnings before interest and tax are
concepts related to capital structure and leverage.
 The break-even point refers to the total sales needed by a firm to achieve
earnings equivalent to zero. Contribution of a product unit is the difference
between sales price per unit and its variable cost. Earnings before interest and
tax (EBIT) are the revenue minus cost.
 There are two types of leverage, namely operating leverage and financial
leverage.
Break-even point Common equity

Business risk Financial leverage
Cost of capital Financial risk
Capital components Operating leverage
Topic  Working
Capital
7 Management
LEARNING OUTCOMES
Discuss working capital management and its importance to an organisation;
Identify the items categorised as current assets and current liabilities;
Calculate a firmÊs net working capital;
Explain the relationship between net working capital and liquidity; and
Analyse the correlation between working capital and liquidity, as well as
liquidity and returns.
 INTRODUCTION
In Topic 3 entitled „Financial Statement and Financial Ratio Analysis‰, we
discussed the key components of a balance sheet and the items included under
assets, liabilities and equities. Under the assets side, there are current assets and
non-current assets. Likewise, under liabilities, there are current liabilities and
non-current liabilities. To measure the firmÊs liquidity, we have discussed the
correlation between current assets and current liabilities in terms of liquidity
ratio. We have also understood why liquidity is important and the implication of
a firmÊs liquidity ratio. In this topic, we shall cover working capital management
to give a general explanation concerning the management of current assets and
current liabilities. The subsequent topics will explain the management of every
current asset, namely cash, inventory and accounts receivable, in further detail.
TOPIC 7 WORKING CAPITAL MANAGEMENT  127
7.1 DEFINITION OF WORKING CAPITAL

MANAGEMENT
ACTIVITY 7.1
Based on your prior experience, explain the importance of working capital

management. Share your opinion on myINSPIRE.
Working capital management refers to the management of current assets and

current liabilities needed for the companyÊs day-to-day operations. This involves
determining the working capital policy and the implementation of this policy in
its daily operations. Items included in the working capital are short term in
nature. Working capital policies include:
(a) Determining suitable investments for every type of current asset; and
(b) Determining appropriate kinds of financing resources to finance current

assets. This includes discussions on current liabilities because it is a source
of financing for current assets.
7.2 WORKING CAPITAL

ACTIVITY 7.2
What do you understand about working capital management? Why is it

important for financial managers to have knowledge on working capital
management? Share and crosscheck your answers with your coursemates on
myINSPIRE.
A firm needs working capital for its daily operations. Efficient working capital
management is important to ensure the firm does not have liquidity problems,
which will affect its financial standing. A firm cannot run its business without
working capital. Efficient working capital management means that firms run their
businesses without committing too much cash in current assets.
128  TOPIC 7 WORKING CAPITAL MANAGEMENT
7.2.1 Current Assets

Working capital encompasses current assets. These assets can easily be converted
into cash in a short period of time. Current assets that can be categorised as
working capital include cash, marketable securities, accounts receivable and
inventory. Amongst them, cash is the most liquid asset because it can be used to
make payments at any time.
(a) Marketable Securities

Marketable securities are also liquid assets because it can be sold on short
notice and converted into cash easily.
(b) Accounts Receivable

Payments yet to be collected by a firm are called accounts receivable and
this account exists when there are credit sales. The normal credit periods
given are 30 days, 60 days, 90 days or 120 days. Since the credit period is
short, accounts receivable can also be considered as liquid assets.
(c) Inventory
Inventory or stocks are goods still unsold that are owned by a firm. When
there are sales, a firm will get cash, which can be used as capital for its day-
to-day operations.
7.2.2 Current Liabilities

Current liabilities are claims by other parties on a firm and the claim period is
less than one year. Current liabilities encompass:
(a) Accounts Payable

When a firm buys supply of raw materials from other firms on credit, this
gives rise to accounts payable. The credit term is between 30 and 120 days.
As long as payment is yet unpaid, the firm still owes its suppliers and this is
regarded as accounts payable under current liabilities.
(b) Accrual
Accrual happens when there is a time difference when cash flow should
have occurred and the actual time the cash flow occurred. For instance,
when consultancy work or firm auditing has already been completed but the
firm delays the payment to the consultant or audit firm. Such payments,
which are the responsibility for a firm to pay to other parties, are
categorised as
„accrual‰.
(c) Short-term Debt

Short-term debt refers to bank overdrafts and all short-term loans from
various resources.
ACTIVITY 7.3
List examples of current assets and current liabilities. Share and compare your
list with your coursemates on myINSPIRE.
Current Assets Current Liabilities
7.2.3 Gross Working Capital and Net Working Capital

Gross working capital refers to the current assets used for the firmÊs day-to-day
operations. Net working capital is the difference between current assets and
current liabilities.
Net working capital = Current assets – Current liabilities
A positive net working capital reflects current assets exceeding current liabilities.
It happens when part of the current assets is financed by long-term financing
resources.
Now, let us take a look at Example 7.1.
Example 7.1
The current assets and current liabilities for Wira Company are as follows:
Current assets RM80,000

Non-current assets RM120,000
Total assets RM200,000
Current liabilities RM50,000
Non-current liabilities RM60,000
Equity RM90,000
Total liabilities and equity RM200,000
Net working capital for Wira Company is RM80,000 – RM50,000 = RM30,000
Example 7.1 shows that RM30,000 of current assets had been financed by long-
term debts and equity. The positive net working capital of RM30,000 shows that
Wira Company has liquid assets to pay short-term claims with.
7.2.4 Correlation between Working Capital and

Liquidity
As mentioned, working capital management refers to the management of current
assets and liabilities for the daily operations of a firm. In Topic 3 „Financial
Statement and Financial Ratio Analysis,‰ you learnt of several ratios to measure
liquidity such as the acid test ratio and current ratio. The current ratio, taking into
consideration current assets with current liabilities, is as follows:
Current ratio  Current assets

Current liabilities
Since both the working capital and liquidity ratio involves current assets and
current liabilities, we will see the correlation between these two concepts.
Based on Example 7.1 (Wira Company):

Net working capital = RM80,000 – RM50,000
= RM30,000
80,000
Current ratio =
50,000
= 1.6 times
Now, assume that the current liabilities of Wira Company increase from
RM50,000 to RM60,000.
Net working capital = RM80,000 – RM60,000
= RM20,000
80,000
Current ratio =
60,000
= 1.33 times
In the example of Wira Company, it can be clearly seen that, when net working
capital decreases from RM30,000 to RM20,000, the current ratio (which
measures liquidity), also decreases from 1.6 times to 1.33 times. From this, we
can conclude that there exists a positive correlation or direct correlation between
net working capital and liquidity. This means that, when net working capital
decreases, liquidity also decreases and when net working capital increases,
liquidity also increases.
SELF-CHECK 7.1
The following is some financial information about Trillion Private

Limited Company for the years 2017 and 2018:
2017 2018
Current assets RM150,000 RM180,000
Non-current assets RM350,000 RM370,000
Total assets RM500,000 RM550,000
Current liabilities RM120,000 RM165,000

Non-current liabilities RM150,000 RM155,000
Equity RM230,000 RM230,000
Total liabilities and equity RM500,000 RM550,000
Calculate the net working capital and current ratio of Trillion Private
Limited Company for the years 2017 and 2018. What can you conclude
regarding this firmÊs liquidity position?
ACTIVITY 7.4
Discuss the following with a coursemate and share the conclusions of your
discussion with others on myINSPIRE.
What is the meaning of liquidity asset?
What is the correlation between liquidity and returns?

7.2.5 Correlation between Liquidity and Returns

For effective working capital management, a financial manager must determine
an appropriate combination of assets for his firm to achieve the firmÊs objective.
As previously discussed, if a firmÊs working capital increases, its liquidity ratio
will also increase. When a firm has higher liquidity, it means the company is able
to fulfil short-term claims when the situation demands. But this does not mean
that a firm needs to put most of its assets in the form of current assets.
A financial manager should take into consideration the correlation between

liquidity and returns. Even though current assets are more liquid, its returns are
less. Firms that have most of their assets in the form of current assets will face
lower risk because these assets can be converted into cash in a short period of
time. But returns that can be attained from current assets are also lower compared
to non-current assets. This is based on the principle of exchanging risk with
returns according to these principles:
(a) The lower the risk, the lower is the return earned; and
(b) The higher the risk, the higher is the return earned.
7.3 ZERO WORKING CAPITAL

A sound working capital management policy should minimise the duration
between cash expense of materials and the collection of cash from sales. Based
on this, the principle of zero working capital is introduced with this definition:
Working capital = Inventory + Accounts receivable – Accounts payable
Inventory and accounts receivable are important to sales. Inventory can be

financed by suppliers through credits given by them.
The principle of zero working capital is explained by assuming that on average, a

company uses 20% of its working capital for each sale of one ringgit. This means
that on average, working capital is rotated five times per year. If a company can
reduce the needed working capital and at the same time increase rotation, it will
enjoy the following benefits:
(a) Each ringgit freed by reducing inventory or accounts receivable or

increasing accounts payable can contribute to cash flow.
(b) Funds that are tied to working capital incur costs. If working capital can be
decreased, the cost of funds can also be decreased.
(c) If a firm reduces its working capital, it must produce and deliver goods
faster than its competitors. This is an advantage because clients will be
attracted to its efficient service.
(d) If inventory is reduced, the costs of storage, wages of warehouse workers

and warehouse equipment can be reduced. Furthermore, if inventory is
reduced, no-sales and cannot-be-sold risks, fire risk and risk of theft can be
reduced as well.
Figure 7.1: Advantages in decreasing working capital

Even though the principle of zero working capital can contribute to the efficiency
of working capital management, a financial manager should also consider the
maturity matching principle.
Conditions for this principle are:
(a) The date of financing maturity should be about the same with the asset
duration or the project to be financed;
(b) Financing conditions should match with the duration of the item that is
financed; and
(c) A loan taken to finance a project should be paid back about the same date
the project is completed.
7.4 FACTORS INFLUENCING THE SUM OF

WORKING CAPITAL
These are some of the factors that influence the sum of a firmÊs working capital.
(a) Uncertainty
Sometimes working capital management becomes more complicated
because of uncertainty in the future. Due to the element of uncertainty, it is
difficult for a financial manager to forecast the exact sum of working capital
needed.
(b) Technological Development

With the development of technology, cash receipts and cash payments can
be done more quickly through automatic credit and debit or transfer. Thus,
the amount of working capital needed by a firm changes due to
technological development.
SELF-CHECK 7.2
It is important for firms to have working capital in order to run their

businesses.
The higher the working capital, the more efficient the firmÊs management.
Working capital will decrease if the sum of current assets increases while the
sum of current liabilities remains unchanged.
The higher the working capital, the higher the liquidity.
Normally, the correlation between liquidity and returns is positive.
 Working capital management refers to the management of current assets and

current liabilities needed for daily operations.
 Working capital policies encompass:
– Determining the right investment for every type of current asset; and
– Determining suitable types of financing resources to finance current assets.
 In working capital management, it is important for financial managers to take

into account the following matters:
– Correlation between working capital and liquidity (indirect correlation);

and
– Correlation between liquidity and returns (inverse correlation).
 Working capital management is important to prevent liquidity problems,

which might arise due to inefficient working capital management.
 There are several important factors to help financial managers manage

working capital more effectively, such as the correlation between working
capital and liquidity, the correlation between liquidity and returns, as well as
the principle of zero working capital.
Current assets Net working capital

Current liabilities Returns
Liquidity Working capital management
Topic  Cash and
Marketable
8 Securities
Management
LEARNING OUTCOMES
Discuss the motives for firms to hold cash;
Explain the importance of a cash budget;
Elaborate cash management techniques; and
Identify the characteristics of marketable securities.
 INTRODUCTION
As discussed in Topic 3 „Financial Statements and Financial Ratio Analysis‰,
cash is the most liquid among a firmÊs assets but it does not bring any returns to
the firm. Despite that, cash is important for a firmÊs liquidity purposes. Like
cash, a marketable security is also an asset that is quite liquid and its returns are
low. Both types of assets – cash and marketable securities – are held by a firm for
the purposes of fulfilling the need to pay when the situation warrants it.
In the management of cash and marketable securities, firms are in a dilemma of

not willing to hold on to too many assets due to unsatisfactory returns. However,
it needs to hold them for liquidity purposes. Good cash and marketable securities
management is important to achieve balance. Financial managers can use excess
cash for investments, which can give higher returns while at the same time
preserving the liquidity level needed.
TOPIC 8 CASH AND MARKETABLE SECURITIES MANAGEMENT  139
As explained throughout this module, the firmÊs objective is to maximise its

value. One of the steps to achieve this objective is to have a good system of cash
and marketable securities management.
8.1 CASH
Cash refers to a firmÊs bank account balance. As can be seen in the
arrangement of a balance sheet, cash is the most liquid asset. Holding cash
does not give any return but it is needed for liquidity purposes. Thus, it can be
clearly understood that cash holding involves an opportunity cost because if
the cash was not being held by the firm, it could be invested and give returns.
ACTIVITY 8.1
From your point of view, why is cash considered a liquid asset? Engage your
coursemates in an online discussion through myINSPIRE.
8.1.1 A Firm’s Motives in Holding Cash

ACTIVITY 8.2
What are the motives for a firm to hold cash? Share your thoughts and
compare them with your coursemates on myINSPIRE.
Firms have several motives to hold cash. Amongst them are:
(a) Business Transaction Motives

Firms hold cash for the purpose of making payments such as workersÊ
salaries, utility bills (electricity, water, telephone, etc.), and payments to
suppliers. Business motives exist because there are differences between
payment dates and cash receipt dates. If a firm can ensure the date of cash
inflow and the date of payment or outflow, it can lessen the sum of cash
needed to be held for business transaction purposes.
(b) Precautionary Motives

Firms hold cash to meet unexpected contingencies and when payments are
needed. It is almost the same as the „safety stock‰ concept in inventory
management. Holding cash for precautionary purposes is needed because
of the element of uncertainty in business, such as for repairing factory
140  TOPIC 8 CASH AND MARKETABLE SECURITIES MANAGEMENT
machines that have broken down. This involves cash expenditure. The sum
of cash for precautionary motives can be reduced if a firm has other liquid
assets such as marketable securities, which can be converted into cash
quickly and easily, or if the firmÊs relationship with a bank is quite close,
which would enable it to get a bank loan at short notice.
(c) Speculative Motives

Cash is also held for speculative motives. A firm may take a chance on
a business opportunity that arises, such as when suppliers with financial
problems want to sell off their supplies quickly at a low price. If a firm has
extra cash, it could take this opportunity to buy those supplies and make a
profit from this business transaction.
(d) Compensating Balance Motive

This refers to a sum of a minimum percentage of bank loan that must be
held in the debtor Ês account. This is one of the conditions imposed by a
bank and this compensating balance motive is one of the reasons why firms
hold cash.
These motives can be summarised as in Figure 8.1.
Figure 8.1: Motives for holding cash

ACTIVITY 8.3
What do you understand about cash budgeting? Discuss with a coursemate and
come up with a short description, and share it on myINSPIRE.
8.1.2 Cash Budget

In cash management, it is important for a firm to hold a sufficient amount of cash
and at the same time maximise the firmÊs value. Towards this end, a financial
manager should have a cash management plan and this can be achieved by
preparing a cash budget.
A cash budget refers to a schedule that shows the inflow and outflow as well
as the cash balance of a firm over a specific period of time. In the process of
preparing a cash budget, a financial manager needs to obtain information
from other departments. This information includes the sales forecast,
inventory needs, payment of accounts receivable, a firmÊs total fixed assets
and so on. All the information will be combined with other information such
as the date of collection of accounts receivable, the date of dividends, and
interest and tax payments. All cash inflows and outflows are then recorded in
a schedule known as a cash budget. This schedule will show the inflow and
outflow expected for a certain period of time. As an example, let us refer to
Table 8.1, which is the cash budget for CBS Company. A monthly cash
budget is usually used for planning purposes, while a weekly and daily cash
budget are used for controlling actual cash.
Table 8.1: Cash Budget for CBS Company
CBS Company
Cash Budget (April 30, 2019 – June 30, 2019)
April May June Total

Initial cash balance 20,000 15,000 15,000 20,000
Cash Receipt:
Cash received from customers 85,000 200,000 167,500 452,500
Total cash available 105,000 215,000 182,500 472,500
Cash Disbursement:
Direct materials 20,000 36,150 36,350 92,500
Direct labour 6,500 11,500 7,250 25,250
Factory overhead 28,000 38,000 29,500 95,500
Sales and administration 35,000 42,500 37,500 115,000
Dividends 25,500 – – 25,500
New furniture – 71,850 24,400 96,250
Total disbursement 115,000 200,000 135,000 450,000
Cash surplus (decrease) (10,000) 15,000 47,500 22,500

Financing:
Loan 25,000 – – 25,000
Loan repayment – – (25,000) (25,000)
Interest – – (1,000) (1,000)
Total financing 25,000 – (26,000) (1,000)
Monthly cash balance 15,000 15,000 21,500 21,500
ACTIVITY 8.4
List two reasons why preparing a cash budget is important in cash

management. Share your answers on myINSPIRE.
ACTIVITY 8.5
By using the following information, prepare a cash budget for SBC

Company for the months of April, May and June 2019:
April May June

Initial cash balance 30,000 43,000 14,500
Cash sales 95,000 125,000 185,000
Direct materials 30,000 45,000 55,000
Direct labour 7,000 8,500 9,800
Factory overhead 20,000 25,000 28,000
Sales and administration 25,000 27,000 29,500
New furniture – 48,000 23,750
Crosscheck your work with your coursemates on myINSPIRE.
8.1.3 Cash Management Techniques

Efficient cash management encompasses a good method of managing cash
inflows and cash outflows. This includes several factors that can be summarised
as in Figure 8.2.
Figure 8.2: Cash management techniques

Let us take a look at each technique in detail.
(a) Coordination of Cash Flows

A firm should coordinate both cash inflows and cash outflows in order to
lessen the amount of cash being held because this involves opportunity cost.
(b) Float Utilisation

A cheque needs several days before it is cleared. During this period of time,
the balance in the firmÊs cheque book may differ from its account in the
bank because the cheque it has issued has yet to be cleared by the bank.
This difference in balance is called „float‰. The following are several
types of float used by a firm:
(i) Payment Float

After a firm makes a payment by issuing a cheque, several days are
needed before the cheque is cleared by the bank and the sum is
debited from the firmÊs account. The firm can still use the balance
in its account to finance its daily expenditures from the time the
cheque is issued until it is cleared.
(ii) Collection Float

Collection float occurs when a firm receives a payment by cheque.
It needs several days before a cheque is cleared and the amount is
credited into the firmÊs account. A financial manager must make sure
that cheques are collected and quickly processed by his department so
that the cheques can be entered into the firm's bank account to quickly
receive payments. By making the process of receiving cheques faster,
the firm will be able to use the funds collected to finance its
operational expenditures and hence decrease the usage of bank
overdrafts or bank loans, which incur interest payment and would
result in additional costs to the firm. The faster the collection is done,
the more effective is the firmÊs cash management.
ACTIVITY 8.6
What are the cash management techniques normally used by an organisation?

What are the benefits of those techniques? Discuss with your coursemates on
myINSPIRE.
(iii) Net Float

Net float is the difference between collection float and disbursement
float. A firm that is efficient in cash management will try to make the
collection process, as well as the clearance of cheques received, faster.
This way, a firm can attain funds to finance its expenditures. At the
same time, a firm will try to delay making payments so that the cash
for such payments can be used for several more days to finance its
daily operations.
Basically, floats exist because of the following reasons:
 If payment is made through the mail, it needs several days before

the cheque is received;
 A firm might take several days to process the payment received

due to administrative processes; and
 Banks need several days to clear the cheque.
(c) Speeding Up Collections and Slowing Down Disbursement

As discussed in the subtopic „float‰, firms will try to speed up
collections and slow down disbursement so that the cash received can be
used for the daily financing of the firmÊs expenditures. With the
development of technology, firms (especially big firms) may suggest
that its clients pay through automatic debit or transfer to expedite
collection. If payment is made via cheque, collection is delayed several
days because of the time period needed for the process of posting and
clearing of the cheque by the bank.
In terms of cash outflow, firms will try to delay their payments so that the funds
used for payments can be used to finance expenditures for several days. For
instance, a firm may try to delay salary payments to its workers or payments to its
suppliers, to enable it to use the cash to finance its operating expenditure for
several days.
SELF-CHECK 8.1
Fill in the Blanks
1. Write down the meaning of float.
2. Fill in the blanks with the right floatation.
(a) float is a situation where it takes a few days

for a cheque to be cleared and its amount debited from the
account of a firm.
(b) float is the difference between a collection

float and a disbursement float.
(c) float happens when a firm receives payment

by cheque but needs several days before the cheque is
cleared and the amount is credited into the firmÊs account.
8.2 MARKETABLE SECURITIES

ACTIVITY 8.7
Explain the importance of marketable securities. Share your answer and

crosscheck with your coursemates on myINSPIRE.
As an alternative to holding cash, firms can use marketable securities because this
asset is liquid and can be converted easily and quickly into cash. Apart from this,
marketable securities can also give some returns, unlike cash, which does not
give any returns at all. A firm that has temporary excess funds but does not wish
to invest those funds – because they are needed to pay accounts payable or settle
debts in a short period of time – can hold it in the form of marketable securities.
By doing so, a firm may quickly change the securities into cash when the debt
matures and at the same time, attain some returns. If the fund is held in the form
of cash, firms will not be able to obtain any returns.
ACTIVITY 8.8
Write down the importance of marketable securities in financial management.
SELF-CHECK 8.2
Cash is the most liquid of assets.
Cash management involves a balance between the ability to fulfil a firmÊs

cash needs with the cost of holding cash.
To prevent liquidity problems, a firm should keep a big sum of cash.
A cash budget is a schedule that shows the amount of cash that a firm has
each day.
Cash holding involves opportunity cost.
 Cash holding is important for the purpose of the firmÊs liquidity, but it does
not give any returns.
 In cash and marketable securities management, a financial manager must

provide a suitable balance between liquidity and returns.
 The most common motives for firms to hold on to cash are:
– Business transactions;
– Precautionary;
– Speculative; and
– Compensating balance.
 Capital budgeting refers to a schedule that shows a firmÊs cash inflows

and outflows as well as cash balance over a certain period of time.
 Effective cash management comprises these factors:
– Coordination of cash flows;
– Float utilisation; and
– Speeding up collections and slowing down disbursement.
 There are the three types of float, namely payment float, collection float and
net float.
 Apart from cash, firms hold on to marketable securities because they can be
an alternative form of liquid asset that can be converted into cash easily and
quickly.
• Individuals and firms hold cash for business transactions, as well as for
precautionary, speculative and compensating balance motives.
 Although holding cash is important for liquidity purposes, it does not give
any returns. Thus, it involves an opportunity cost.
 It is necessary for a good financial manager to adopt a more efficient

technique of cash management to maximise returns. Thus, it is important for
firms to prepare a cash budget to show the cash flow and cash balance for a
certain period of time.
Cash Cash management

Cash budget Marketable securities
Topic  Accounts
Receivable
9 Management
LEARNING OUTCOMES
Explain the meaning of accounts receivable and its importance in working
capital management; and
Differentiate between credit conditions, credit policy and collection policy.
 INTRODUCTION
Alpha Company sells its goods by cash as well by credit. If it sells by cash, it will
get instant payment. But if the company sells by credit, payment will only be
collected after a certain period of time. Even though payment is yet to be
collected, the cash is still an asset to the company and regarded as „accounts
receivable‰ in the balance sheet. When money is received for payment, the sum
of accounts receivable can be decreased by as much as the amount of money
collected. As discussed in Topic 7, a good policy of working capital management
is to minimise the time period between cash expenditure of materials and cash
collection from sales. Hence, the faster the cash is collected from sales made, the
better the working capital management. Among the reasons are:
(a) A company should spend interest to support the accounts receivable; and
(b) This will decrease the risk of bad debts that might arise from credit sales.
150  TOPIC 9 ACCOUNTS RECEIVABLE MANAGEMENT
9.1 ACCOUNTS RECEIVABLE

ACTIVITY 9.1
What is the meaning of accounts receivable? Why is it important for firms to

manage its accounts receivable? Discuss with your coursemates on myINSPIRE.
Accounts receivable exist because the firm sells its goods to customers on credit.
This is one way for a firm to attract customers and increase its sales. The
important factors in accounts receivable management are as follows:
(a) Percentage of the Sum of Sales Credit to the Sum of Sales

What percentage of the amount of credit sales from the total sales are
offered by the business to its customers? The credit sales are dependent on
the firmÊs type of business. Some businesses only do cash sales if their
business transactions involve small sums of money (for example, book
shops, restaurants, boutiques, etc).
(b) Credit Period

This is the time period between sales and cash collection. It depends on the
credit policies and the firmÊs collection.
ACTIVITY 9.2
Write down two advantages that a firm might get by offering credit sales.
Share your answers on myINSPIRE.
The sum of accounts receivable that has not been paid at a particular time can be
calculated by using the following formula:
Accounts receivable = Daily credit sales  Credit period

TOPIC 9 ACCOUNTS RECEIVABLE MANAGEMENT  151
Now, let us take a look at Example 9.1, which shows the calculation method of
accounts receivable.
Example 9.1
The annual credit sales of Alpha Company is RM600,000 and customers are
given a credit period of 30 days. Assuming there are 360 days in a year, the
average percentage of accounts receivable for the company is:
Accounts Receivable = Daily credit sales  Credit period
RM600,000
= 360  30
= RM50,000
SELF-CHECK 9.1
By using the formula to calculate accounts receivable, try to answer this

question:
Impian Company has credit sales totalling RM120,000 per year. The credit
period given is 60 days. Calculate the average accounts receivable of Impian
Company if it is assumed that one year = 360 days
9.1.1 Credit Policy and Collection

A firmÊs credit policy or accounts receivable policy involves the
determination of credit conditions, credit policy and collection policy.
(a) Credit Conditions

Credit conditions encompass the following questions:
(i) What is the duration of the credit period to be given to the

customers? This may be influenced by the type of business and credit
period given by other competitors in that industry.
(ii) Should firms consider giving a discount to customers who pay much
earlier than the period of credit given?
A discount is given to customers as an incentive to pay quickly to
benefit from the discount. If a discount is given, how much is given
and how long is the discount period? If a firm gives the discount, the
sales collection will decrease because the discount given to the
customers is deducted. Does this bring benefit to the firm? A financial
manager must calculate the benefit and cost involved in giving the
discount in order to make a wise and beneficial decision for the firm.
(b) Credit Policy

This determines the types of customers who qualify for a credit facility.
This is related to the customerÊs quality and credit standing. Although
selling by credit can attract more customers and increased sales, the firm
needs also to consider the risk of bad debts when credit sales are offered.
Hence, customersÊ quality and credit standing two important factors in

accounts receivable management. A firm should consider bad debt risks.
Checking a customerÊs credit standing is important to minimise bad debts.
Relevant information can be obtained from credit agencies or from the
companyÊs financial statement, bank reference and the companyÊs
reputation in the industry.
Normally, a company needs the following information before a firm/

customer is given a credit facility:
(i) When the company was set up – that is, how long the firm has been
doing business;
(ii) Net asset value;
(iii) Current ratio; and
(iv) OwnerÊs credit standing or the firmÊs board of directors.
ACTIVITY 9.3
Assume that you are a credit manager. List down the information you would
scrutinise to measure the credit standing of a customer. Where would you get
the required details or information? Discuss with a coursemate, then share and
compare your list with others on myINSPIRE.
TOPIC 9 ACCOUNTS RECEIVABLE MANAGEMENT  153
(c) Collection Policy

Collection is important in accounts receivable management because even
if sales are high, if the firm faces collection problems, this will affect the
liquidity of the firm due to cash flow problems. This, in turn, will affect the
firmÊs financial standing.
Collection policy refers to the policy of collecting overdue accounts

receivable or its late payments. Usually, firms would make phone calls or
send reminders to inform customers that the account receivable is due, but
payment has yet to be made by them. Sometimes this involves complicated
cases where despite notices being sent, payments have yet to be paid by the
customers concerned. Firms might use the services of a collection agency.
This means that the firm will incur a higher cost to pay for the services of
the collection agency.
SELF-CHECK 9.2
A strict credit policy might decrease a firmÊs sales.
A more liberal credit policy will increase sales but it might also increase risk.
Accounts receivable can be regarded as a liability in a balance sheet.
Accounts receivable exists because firms buy goods or supplies on credit.
Efficient accounts receivable management will contribute to more efficient

working capital management.
9.2 IMPORTANT NOTES ON ACCOUNTS

RECEIVABLE
Accounts receivable exist when a firm sells its goods on credit.
Important factors in accounts receivable management are:
(a) Total sales on credit; and

(b) Credit period.
Credit policies involve determining:
(a) Credit standard;
(b) Credit condition; and
(c) Collection procedures.
Credit condition involves determining:
(a) Credit period; and
(b) Discount rate given to customers to encourage them to pay early.
A credit policy determines the type of customers qualified to be given credit

facilities.
A collection policy refers to the process of collecting late payments of accounts

receivable.
 Accounts receivable exist because firms sell their goods on a credit basis.
 The purpose is to attract more customers to increase sales. In any case, a

financial manager needs to emphasise some important factors related to
accounts receivable management such as credit condition, credit policy and
collection policy.
 These factors are important to ensure that not too much capital is tied to
accounts receivable, and to avoid the risk of bad debts.
Accounts receivable Credit policy

Credit conditions Collection policy
To pic  Inventory
Management
1 0
LEARNING OUTCOMES
Identify the four categories of inventory;
Explain the importance of inventory management;
Identify the assumptions and components of the economic order quantity (EOQ)
model;
Calculate the inventory holding cost, ordering cost and total inventory cost; and
Discuss factors in inventory management such as holding cost, ordering cost,
safety stocks, quantity discount, inflation and risk.
 INTRODUCTION
In Topic 7, we discussed working capital management, or the management of
current assets and current liabilities. Since inventory is one of the items in current
assets in a balance sheet, our discussion in this final topic will show that
inventory management is part of working capital management.
The importance of inventory management differs according to a firmÊs type

of business. Inventory is not too critical for firms that offer services as compared
to retail and manufacturing businesses. For retail firms such as supermarkets,
inventory may be in the form of several hundred types of different goods, where
the quantity of each good might be small or medium. Managing inventory might
be boring and time consuming. Hence, more workers are needed to manage and
control it.
156  TOPIC 10 INVENTORY MANAGEMENT
As for manufacturing firms, inventory consists of raw materials needed for the
processing and production of goods and ready-made products. Managing raw
materials is important to ensure production is not impeded due to lack of
materials. The management of processed goods and ready-made products is
important to ensure firms can fulfil customersÊ demands in order to gain their
loyalty and retain them.
10.1 INVENTORY
ACTIVITY 10.1
Based on your prior experience, explain what is meant by inventory. Post your
explanation on myINSPIRE and crosscheck you answer with your coursemates.
What is meant by inventory? As previously described, inventory is one of the

items under current assets. Even though inventory is included as a current asset, it
is less liquid as compared to other assets such as cash and accounts receivable.
This is because inventory has to be sold first before it can be converted into cash.
In short, inventory refers to goods or supplies kept by a firm for future sales or
usage.
Inventory can be divided into four categories:
(a) Supplies;
(b) Raw materials;
(c) Goods-in-process; and
(d) Ready-made products.

TOPIC 10 INVENTORY MANAGEMENT  157
ACTIVITY 10.2
Think about a manufacturing industry and write down examples for each type
of the following inventories:
Supply
Raw materials
Goods-in-process
Ready-made products.
Share and compare your list with other coursemates on myINSPIRE.
10.2 THE IMPORTANCE OF INVENTORY

MANAGEMENT
Firms should keep inventories because it is difficult for them to predict the
amount of sales, production and demand accurately. Therefore, inventory is
deemed as a buffer to fulfil the firmÊs needs when actual demand exceeds
predicted demand.
Inventory management is important at all levels of production because if a

problem occurs due to the lack of inventory at any stage of production, this might
affect the entire production and sales, and in turn will influence the firmÊs
working capital.
Even though inventory is important, firms do not wish to keep too much of it
because this will incur costs such as storage and capital costs. Keeping a lot of
inventory necessitates a large storage space, which involves high storage costs.
Apart from this, risks such as fire, theft and unsold goods will increase with the
size of inventory. To mitigate the risks of fire and theft, firms can buy insurance –
but again, the insurance premium will increase because the value insured is high
due to the high inventories. A higher insurance premium will result in a higher
expenditure for the firm, thus contributing to the decreasing profit. On the other
hand, firms do not want to keep too little inventories because this might cause the
firm to lose customers. This happens when there is demand but the firm has no
stock. Hence, inventory management and control is important for the firm to
achieve a balanced level of inventory – one that minimises cost but maximises
returns. Efficient inventory management will contribute to a lower working
capital.
ACTIVITY 10.3
As a financial manager, write a simple note to your store supervisor explaining

why it is not encouraged to keep too much inventory. Share your note on
myINSPIRE and discuss with your coursemates about any omissions or
additional information that may be required.
Now, let us look at several important issues in inventory management and

control.
(a) How Much Inventory Should be Ordered at Each Period of Time?

This is related to the size of inventory that a firm needs in each time period.
(b) When Should Inventory be Ordered?

This is related to the frequency of the order made. The more times orders
are made, the more the administrative work will be and this will result in an
increase in administration costs.
(c) What Inventory Items Need Special Attention?

This is related to the goods kept as inventory. Are the goods non-perishable
or perishable? Figure 10.1 shows the inventory for a supermarket. Goods
such as meat and vegetables are perishable goods and their inventory needs
more attention. These goods need special storage, such as refrigerators, so
that they can last longer. On the other hand, non-perishable goods such as
shampoo, soap, stationeries, etc., require less attention.
Figure 10.1: Perishable (left) and non-perishable foods (right)

10.3 IMPORTANT FACTORS IN

INVENTORY MANAGEMENT
There are several important factors that should be taken into consideration in
inventory management. These factors include:
(a) Economic order quantity model (EOQ) such as inventory holding cost and
ordering cost;
(b) Safety stock;
(c) Quantity discount;
(d) Inflation; and
(e) Risks.
10.3.1 Economic Order Quantity (EOQ) Model

This model is suitable if the demand is constant and the quantity ordered is
accurate at any particular time. The economic order quantity is the sum of
inventory orders that minimise yearly holding cost and ordering cost.
The assumptions for the EOQ model are:
(a) Demand is predictable and its quantity is constant;
(b) Each order is of the same quantity and the cost of every order is fixed;
(c) The cost per unit of goods does not change;
(d) The holding cost per unit is fixed;
(e) The time period for sending each order is fixed; and
(f) The status of the inventory is continuously monitored and orders are made
when they reach the reordering level.
Two important components in the EOQ model are:
(a) Holding Cost of Inventory

Holding cost is the cost incurred for keeping an inventory at a certain level.
This cost depends on the size of the inventory and encompasses several
types of costs, such as:
(i) Capital cost that is tied to inventory. If a firm borrowed money from a
bank, it has to pay interest. If the firm used its own cash reserves, it
involves opportunity cost. Normally, capital cost is calculated as a
percentage of the sum invested;
(ii) Paying insurance;
(iii) Risk of theft and burglary; and
(iv) Warehouse cost.
The method for calculating the cost of holding is as follows:
Cost of Holding = (Average inventory level) 

(Yearly holding cost per unit)
= ½ QCh
When ½ Q = Average inventory level; and

Ch = Yearly holding cost per unit per year.
(b) Ordering Cost of Inventory

Ordering cost comprises administrative costs such as preparing vouchers,
processing orders such as payment for delivery, receiving, etc. All these
costs are fixed costs.
The method for calculating ordering cost is as follows:
Ordering Cost = (The sum of ordering cost per year)  (Cost of every
order)
= (D/Q) Co
When D = Demand per year; and
Co = Cost per order.
Total cost of inventory comprises of yearly holding cost and yearly

ordering cost.
The method to calculate total cost of inventory (TC) is:
TC = Yearly holding costs + Yearly ordering costs

= ½ QCh + (D/Q)Co
(i) How Much Inventory Should be Ordered?

To answer this question, we should find the ordering quantity Q* to
minimise the total costs per year.
Here is the equation for the economic order quantity (EOQ):
2D
Q* Co

Ch
(ii) When Should Inventory be Ordered?

This question is related to the status of inventory – the current total
of the firmÊs inventory added to the total of inventory ordered. The
result is called the reorder point.
Two important factors needed to be taken into consideration in

deciding when orders are to be made:
 Delivery period – or the time needed to send new orders; and
 Expected demand during delivery period.
Both are given as in the following equation:
r = dm
When r = Reorder point;

D = Demand per day; and
M = Delivery period for new orders (days).
Now, let us take a look at Example 10.1.
Example 10.1
The following is the information regarding Evergreen Company, which sells
orange juice:
(Assume that there are 300 working days per year).
Demand = 3,000 boxes per year

Cost per box = RM2
Ordering cost = RM20 per order
Holding cost = 20% of inventory value
2
(a) Economic order quantity (EOQ) = Q* =
D
C
o
2(3,000)(20)
= C
0.2(2)
h
Q* = 547.72 boxes
= 548 boxes
(b) If given delivery period = 5 days

Reorder Point (r) = dm
3,000(5)
= 300
= 50
(c) Total Yearly Cost (TC) = ½ QC h + (D/Q) Co

= ½ (547.72)(0.2  2) + (3000/547.72)20
= 109.54 + 109.55
= RM219.09
SELF-CHECK 10.1
Information for East West Auto Company is as follows:
Demand per year = 24,000 components

= RM50
Cost every order Yearly
= 25% of inventory value
holding cost
Component cost per unit = RM50
Total working days per year = 300
Delivery period = 10 days
From the above information, calculate:
Economic order quantity (EOQ)
Reorder point
Total cost per year
10.3.2 Safety Stocks

Even though economic order quantity (EOQ) is one of the basics in inventory
management, sometimes a warehouse manager might want to make a slight
change to the inventory kept. This is because the EOQ model is based on the
assumption that demand is constant and delivery period for every order is timely.
Sometimes, demand may increase and delivery of new stocks may be late. Hence,
to ensure that firms do not face the problem of the lack of stocks, the warehouse
manager might consider a higher level of inventory compared to the economic
order quantity.
As shown in Example 10.1 of Evergreen Company, the economic order quantity is

547.72 boxes based on the constant demand of 3,000 boxes per year. To protect
firms from the problem of shortage of stocks, the warehouse manager might order
600 boxes per order. This excess stock is known as „safety stock‰. This will
directly increase the average inventory that is kept by the firm and as a result, the
inventory cost will also increase.
10.3.3 Discount Quantity and Economic Order

Quantity Model
Suppliers usually give a quantity discount to encourage customers to buy goods
in large quantities. This is to reduce the processing cost of orders and provide
faster stock turnover. If a quantity discount is given, would a firm change the
economic order quantity?
To see how we can enter quantity discount in the EOQ model, let us refer to
Example 10.2.
Example 10.2
Information on Pelita Company, which sells electric sockets, is given as
follows: Demand rate = 10,000 units per year

Ordering cost = RM20 per order
Holding cost = 25% value of
inventory Cost of socket per unit = RM10
2(10,0
Economic Order Quantity =
00)(20)
(0.25)
= 400 units
(10)
Now, let us assume that if Pelita Company orders 500 units of sockets, the
supplier will give a quantity discount of 2%, that is, 2%  RM10 = RM0.20. With
that, the price per unit socket will decrease to RM9.80. Should Pelita Company
take this discount and make a quantity order of 500 units instead of 400?
To find the answer, we need to do an analysis of the total cost of the order when
it is 400 units and also the total cost of the order when it is 500 units.
Order Quantity = 400 units
TC = ½(400)(0.25  10) + (10,000/400)20

= 500 + 500
= RM1,000
Order Quantity = 500
TC = ½(500)(0.25  9.80) + (10,000/500)20

= 612.50 + 400
= RM1,012.50
The total cost of inventory will increase from RM1,000 to RM1,012.50 if Pelita
Company increases its order from 400 units to 500 units so that it may benefit
from the quantity discount of 2%. Whether Pelita Company will take the quantity
discount opportunity depends on whether it can save costs or not. Even if the
inventory cost increases, Pelita Company can still benefit from the discount
savings because the price will decrease from RM10 to RM9.80 per unit. Thus, the
discount savings per year is:
Discount Savings Per Year = (RM10 – RM9.80)  10,000

= RM0.20  10,000
= RM2,000
Comparison:
Discount Savings Per Year = RM2,000

Increase in the Total Cost of Inventory = RM1,012.50 – RM1,000 = RM12.50
Net Savings = RM2,000 – RM12.50
= RM1987.50
Thus, it clear that Pelita Company should benefit from the quantity discount
offered and order 500 units of sockets, even though the economic order
quantity is 400 units.
10.3.4 Inflation and the Economic Quantity Model

Even though EOQ is the basis for a firm to make orders, it may not be strictly
followed because there are other factors that a firm needs to consider, such as
forecasted inflation. If the rate of inflation increases, this will result in the price
of goods and supplies to increase. Thus, the firm might wish to make a bigger
order before there is an increase in prices. However, the decision to do so
depends on whether the total cost can be saved if orders are made now – taking
into consideration the increase of holding cost and other risks such as unsold
goods, theft and fire.
10.3.5 Risks
The bigger the size of inventories, the higher the risks such as theft, fire, unsold
goods and goods that cannot be sold. Risk can be categorised into two categories:
(a) Risks that can be insured, such as theft risk and fire risk; and
(b) Risks that cannot be insured, such as unsold goods and goods that
cannot be sold.
Regarding risks that can be insured, a financial manager needs to take into
account the insurance premium and its effects to the firmÊs cost. Even though it
is difficult to measure risk, it is an important factor that cannot be disregarded by
the management.
SELF-CHECK 10.2
Inventory refers to ready-made goods only.
The cost of holding inventory is equal to warehouse cost.
Total cost of inventory comprises of yearly holding cost and yearly ordering
cost.
The economic order quantity (EOQ) model tries to minimise the total cost of
inventory.
A high level of inventory should be encouraged to ensure that a firm is able to

fulfil the demands of its clients.
 Inventory refers to the goods or idle materials kept by a firm for sale or for
future consumption. The objective of inventory management is to achieve a
balanced level of inventory, that is, at a cost level that can be minimised and
its returns maximised.
 Inventory management is important because holding too much inventory will

result in higher costs and risks. But if a firm holds too little inventory, it
might lose customers.
 To minimise the total cost of inventory, we can use the economic order
quantity model, which combines the holding and ordering costs of
inventories.
 Important questions in controlling inventory are: How much inventory should

a firm order in every period of time? When should the inventory be ordered?
and What type of inventory should be given special attention?
 A manager can determine how much inventory should be ordered each time,
as well as the time when they should be ordered.
 Since the demand situation is uncertain, a warehouse manager might consider

storing safety stocks to prevent the occurrence of lack of stocks.
 Holding costs are costs incurred to keep a certain level of inventory,

dependent on their size.
 Safety stocks are needed because prediction of demand is not accurate and
delivery of new stocks may be impeded.
 There are factors that can influence inventory management such as inflation
and risks. A financial manager should take into consideration the rate of
inflation as well as risks when making decisions regarding inventory
management.
 Quantity discounts are given to encourage customers to purchase in huge

quantities and at the same time decrease administrative costs.
Economic order quantity model Ordering stock

Inflation Quantity discount
Inventory Risk
Inventory management Safety stock
Inventory holding cost Total inventory cost
Ordering cost
Answers
TOPIC 1: INTRODUCTION TO FINANCIAL
MANAGEMENT
Self-Check 1.1
Essay Question
1. (a) Maximising the manager Ês utilities
(b) Implementing social responsibilities
(c) Maintaining continuous existence
(d) Uplifting the standards and welfare of workers
Self-Check 1.2
TRUE (T) or FALSE (F) Statements
1. F
2. F
3. T
4. T
5. T
ANSWERS  169
Self-Check 1.3
Fill in the Blanks
1. Maximising the firmÊs wealth
2. Unlimited, limited
3. Financial manager
4. Difficult to set up/double taxation
5. Technology, globalisation
TOPIC 2: FINANCIAL ENVIRONMENT
Self-Check 2.1
Match the Correct Answers
1. Commercial paper
2. Negotiable certificates of deposit
3. Treasury bills
4. Money market
Self-Check 2.2
Multiple Choice Questions
1. B
2. A
3. C
4. A
5. A
170  ANSWERS
TOPIC 3: FINANCIAL STATEMENT AND

FINANCIAL RATIO ANALYSIS
Self-Check 3.1
Working capital = 24,300 – 6,600
(2017) = 17,700
Working capital = 30,000 – 9,300

(2018) = 20,700
Self-Check 3.2
Essay Question
2018: = 15,154 – 3,525

= 11,629
2017: = 14,390 – 3,660
= 10,730
Self-Check 3.3
1. T
2. F
3. F
4. T
ANSWERS  171
Self-Check 3.4
Essay Question
The current ratio of Emas Limited Company was 1.80 times for the year 2017,
which was higher compared to the year 2018 which had a current ratio of only
1.24 times. This means that the firmÊs liquidity for the year 2017 was better than
for the year 2018. In the year 2017, for each ringgit of current liabilities the
company had cash of RM1.80 and it also had assets that were easily convertible
into cash, which could be used to pay off its short-term debts quickly. This
indicates that the firm was in a better condition in the year 2017 than in the year
2018.
Self-Check 3.5
1. T
2. F
3. F
4. T
TOPIC 4: FINANCIAL MATHEMATICS
Self-Check 4.1
1. FV = RM500(1 + 0.05)2
= RM500(1.1025)
= RM551.25
2. FV = RM2,000(1 + 0.08)5
= RM2,000(1.4693)
= RM2,938.66
172  ANSWERS
Self-Check 4.2
1. Compounding: future value; discounting; present value.
RM1,500
2. (a) PV =
(1  0.05)
RM1,500
= 1.1025
= RM1,360.54
(b) PV = RM10,000
(1  0.08)4
RM10,000
= 1.3605
= RM7,350.24
Self-Check 4.3
Higher, decrease.
Self-Check 4.4
RM500
1. 0.08 = RM6,250
2. RM500(5.8666) = RM2,933.30
3. RM500(5.8666)(1+ 0.08) = RM500(6.3359)

= RM3,167.95
ANSWERS  173
Self-Check 4.5
1. RM500(1.2597) + RM800(1.1664) + RM1,000(1.08) + RM1,200
= RM3,842.97
2. RM5,000(0.9259) + RM7,000(0.8573) + RM5,000(0.7938) + RM3,000(0.7350)

= RM16,804.60
Self-Check 4.6
n = 5 years 12 = 60 months
9%
i=  0.75%
12
PVA = B(PVIFAi = 0.75%, n = 60)

200,000 = B(48.1734)
B = RM4,151.67
B = monthly installment
Self-Check 4.7
1. (a)
(2) (3) (5) = (3) – (4)

(1) (4) = 1%  (2) (6) = (2) – (5)
Balance Brought Payment Principal Loan
Period Interest (1%) Last Balance
Forward (RM) (RM) Reduction
5 2,726.96 100 27.27 72.73 2,654.23
6 2,654.23 100 26.54 73.46 2,580.77
7 2,580.77 100 25.81 74.19 2,506.58
8 2,506.58 100 25.07 74.93 2,431.65
(b) If the period of payment increases, the interest decreases while the
principal loan reduction increases even if the instalment is fixed at
RM100.
174  ANSWERS
Self-Check 4.8
1. F
2. F
3. T
4. F
5. T
TOPIC 5: CAPITAL BUDGETING AND CASH FLOW

PROJECTION
Self-Check 5.1
100, 000
(a) Payback period =
30, 000
= 3 1/3 years
= 3 years 4 months
(b) No because the payback period exceeds 3 years.
Self-Check 5.2
1. 100,000 = 30,000 (PVIFA i = ?, n = 4)
2. Based on the PVIFA table for a period of 3 years, it shows that PVIFA at an
interest rate of 7% is 3.3782 and at an interest rate of 8% is 3.3121.
Therefore, the internal rate of return is between 7% and 8%.
ANSWERS  175
Self-Check 5.3
Fill in the Blanks
1. bigger, higher
2. higher, lower
TOPIC 6: COST OF CAPITAL AND CAPITAL

STRUCTURE
Self-Check 6.1
Weighted debt : 150,000
500,000
Preferences shares : 80,000

500,000
Ordinary shares : 270,000

500,000
Capital Components Weight Capital Cost

Debts 0.3 0.3  7% = 2.1%
Preferences shares 0.16 0.16  8% = 1.28%
Ordinary shares 0.54 0.54  12% = 6.48%
TOTAL 1.00 9.86%
Self-Check 6.2
Debt cost after tax = 7%(1 – 0.30)
= 4.9%
176  ANSWERS
Self-Check 6.3
8
Cost of preference shares =
100  3  100  8.25%
Self-Check 6.4
D
(a) Common equity = 1
g
H0
0.20
=  0.05
3.00
= 11.67$
D1
(b) 
Common equity cost = g H (1  A)
0
0.20
= 3(1  0.20)  0.06
= 13.33%
Self-Check 6.5
1. T
2. F
3. F
4. T
5. T
ANSWERS  177
Self-Check 6.6
1. F
2. F
3. T
4. F
5. T
TOPIC 7: WORKING CAPITAL MANAGEMENT
Self-Check 7.1
For year 2017 – Net working capital is RM30,000 and its current ratio is
1.25. For year 2018 – Net working capital is RM15,000 and its current ratio
is 1.09.
For the year 2018, increase in current liabilities is higher than increase in current
assets (liabilities) leading to a decrease in the firmÊs liquidity position.
Self-Check 7.2
1. T
2. F
3. F
4. T
5. F
178  ANSWERS
TOPIC 8: CASH MANAGEMENT

AND MARKETABLE
SECURITIES
Self-Check 8.1
Fill in the Blanks
1. The difference between the balance in the firmÊs cheque book and its
account in the bank.
2. (a) Payment
(b) Net
(c) Collection
Self-Check 8.2
1. T
2. T
3. F
4. F
5. T
TOPIC 9: ACCOUNTS RECEIVABLE

MANAGEMENT
Self-Check 9.1
Accounts receivable = 120,000  60

360
= RM20,000
ANSWERS  179
Self-Check 9.2
1. T
2. T
3. F
4. F
5. T
TOPIC 10: INVENTORY MANAGEMENT
Self-Check 10.1
(a) EOQ = 439 components
(b) Reorder point = 800 components
(c) Annual total cost = RM5,477.24
Self-Check 10.2
1. F
2. F
3. T
4. T
5. F
MODULE FEEDBACK
MAKLUM BALAS
MODUL
If you have any comment or feedback, you are welcome to:

1. E-mail your comment or feedback to modulefeedback@oum.edu.my
OR
2. Fill in the Print Module online evaluation form available on myINSPIRE.
Thank you.
Centre for Instructional Design and Technology (Pusat

Reka Bentuk Pengajaran dan Teknologi )
Tel No.: 03-78012140
Fax No.: 03-78875911 / 03-78875966

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BDPW3103

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Module Writer: Loo Sin Chun

Moderators: Dr Shaari Abd Hamid

Ratna Khuzaimah Mohamad

Enhancer: Farhana Aini Omar

Developed by: Centre for Instructional Design and Technology

First Edition, November 2008

Topic 1 Introduction to Financial Management 1

Topic 2 Financial Environment 17

Topic 3 Financial Statements and Financial Ratio Analysis 29

Topic 4 Financial Mathematics 55

Topic 5 Capital Budgeting and Cash Flow Projection 75

5.3 Making Decisions on Expansion Projects and 95

Topic 6 Cost of Capital and Capital Structure 98

Topic 7 Working Capital Management 126

7.3 Zero Working Capital 133

Topic 8 Cash and Marketable Securities Management 138

Topic 9 Accounts Receivable Management 149

Topic 10 Inventory Management 155

COURSE GUIDE DESCRIPTION

As an open distance learner, you should be acquainted with learning

Table 1: Estimation of Time Accumulation of Study Hours

COURSE LEARNING OUTCOMES

1. Explain the basic terms and concepts related to finance;

2. Apply the principles learnt in making financial decisions; and

3. Analyse various aspects of finance including financial statements,

Topic 1 begins with differentiating between accounting and finance.

Topic 2 introduces learners to the financial environment. It also introduces the

Topic 4 discusses financial mathematics or the concept of the value of money

Topic 5 discusses capital budgeting and cash flow projection to better

Topic 6 discusses cost and capital structures.

Topic 9 discusses accounts receivable management in further detail.

Topic 10 discusses the importance of inventory management, which differs

TEXT ARRANGEMENT GUIDE

Self-Check: This component of the module is inserted at strategic locations

Activity: Like Self-Check, the Activity component is also placed at various

References: The References section is where a list of relevant and useful

TAN SRI DR ABDULLAH SANUSI (TSDAS)

Research regarding finance is divided into three fields as follows:

(a) Money market and capital market;

(b) Investment; and

(c) Financial management.

This topic provides an overview of financial management. We will discuss the

Based on your prior knowledge and understanding, explain the differences

1.1 THE DIFFERENCE BETWEEN

1.2 FINANCIAL MANAGEMENT

Financial management refers to how we manage money to get maximum return

1.3 THE OBJECTIVES OF THE FIRM

The objectives of a firm are shown in Figure 1.1:

Figure 1.1: The objectives of a firm

1.3.1 Maximise Profit

In financial management, we need to establish the firmÊs objective so that we

1.3.2 Maximise the Wealth of a Firm or Shareholders

The goal of maximising the wealth of shareholders necessitates the management

1.3.3 Maximise the Manager’s Utility

1.3.4 Uplift the Standards and Welfare of Workers

1.3.5 Carry Out Social Responsibility