Financial Management Function:

A1: Nature and Purpose of Financial Management

●​ What?
➔​ Efficient sourcing and use of financial resources ensuring objectives are met
●​ Why?
➔​ Create wealth
➔​ Generate income
➔​ Adequate return on investment
●​ Involve decision-making in:
➔​ Investment
➔​ Finance
➔​ Dividend
➔​ Risk management

The Nature and Purpose of Financial Management:

●​ Financial Management:
➔​ Long-term
➔​ Controlling resources
➔​ Aimed at achieving objectives
●​ Management accounting:
➔​ Information for operational decision-making
➔​ Has shorter timeframe
➔​ No standard accounting format
●​ Financial accounting:
➔​ Provides historical view
➔​ Used by external parties
➔​ Has a set format & prepared annually

A2: Financial objectives and corporate strategy:

●​ Financial objectives
➔​ Primary objectives: Reason for existing (Maximization of shareholders wealth)
➔​ Secondary objectives: Support primary objectives

Financial objectives and relationship with corporate strategy:

●​ Maximization of shareholder wealth can be achieved using two ways:
➔​ Increasing share price
➔​ Paying dividends
●​ The success can be measured via total shareholder return, which is the dividend
yield plus the capital growth
Financial decisions:
●​ Financial decisions:
➔​ How to raise finance
●​ Investment decisions:
➔​ Where to invest finance
●​ Dividend decisions:
➔​ Whether companies should reinvest profit or distribute them to shareholders as
dividents

Financial constraints:
●​ Ability of managers often constrained by stakeholders:
➔​ Governments:
➢​ Regulations around health & safety concerns
➔​ Banks:
➢​ Restrictions such as loan covenants
➔​ Managers:
➢​ Own pay and perks or popularity

Not for profit organizations:

●​ No shareholders
●​ Central and local government
●​ Schools, hospitals and charities
●​ Limited amount of finance
●​ Spend money well

Value for money:

●​ Economy
➔​ Obtaining inputs at lowest price
●​ Efficiency
➔​ Maximizing outputs from given inputs
●​ Effectiveness
➔​ Achievement of organizational objectives

A3. Stakeholders and impact on corporate objectives:

Stakeholders:
●​ Ordinary shareholders (equity investors):
➔​ They own the company and take on a higher risk
➔​ They expect a higher return than risk-free returns
➔​ They want to maximize the value of their investments through dividend value or
long-term value
➔​ They have long and short-term objectives
●​ Organization’s directors:
➔​ They represent the shareholders
➔​ In the long-run, they aim for profit maximization leading to increased bonuses
➔​ In the long-run, they fend-off takers
●​ Employees and trade unions:
➔​ Fair salaries and safety in the short-term
 ➔​ Job security and pensions in the long-term
●​ Customers:
➔​ They want a quality product which is value for money
●​ Suppliers:
➔​ They supply the organization and get paid on time
➔​ Their long-term objectives are to develop relationships
●​ Finance providers:
➔​ Want the loans they provide to be repaid in full with interest
➔​ Interested in an organization’s ability to generate cash for this repayment in the short
and long-term
●​ Government agencies:
➔​ They want to make sure that the organization is following the relevant legislation
●​ Community at large:
➔​ Want the organization to have a positive impact on its surrounding community and
environment

Agency theory:
●​ Business not managed by owners
●​ The director’s job is to act in the best interest of shareholders
●​ Directors may not always do so
●​ Directors may maximize short-term profitability and receive higher bonus, so the
long-term growth might be compromised
●​ Agency theory deals with conflicts between the shareholders and the directors

Avoiding agency problems:

●​ Align objectives of shareholders and directors
●​ Director’s bonuses bonuses based on net profits
●​ Pay related to achievement of shareholder’s objectives
●​ Avoid short-term decision-making
●​ Provide share options

Measuring corporate achievements:

●​ Return on capital employed

●​ Return on equity

●​ Earnings per share

➔​ Shows shareholder’s share of profits
➔​ Useful to compare EPS growth
 ●​ Dividend per share
➔​ Special one off dividends are deducted from the dividend figure
➔​ Companies avoid increasing dividends due to sustainability
➔​ Increased dividends sends a good message which results in a price increase
➔​ Decreased dividends would send a negative message which would result in a fall of
the share prices

Dividend policy:
●​ Depends on shareholder’s profile
●​ Some shareholders don’t want regular income
●​ Some shareholders want regular income
●​ Shareholders evaluate dividend policy before investing
●​ Changes in policy can cause shareholders to divest
●​ Dividends should be consistent

Total shareholder return:

●​

Corporate governance:
●​ Directors:
➔​ Fiduciary duty
●​ Recent years:
➔​ Countless scandals
●​ Organizations:
➔​ Should implement corporate governance codes of best practice

Impact of corporate governance codes:

●​ Increased director accountability
●​ Reduced shareholder risk
●​ Director salaries independently decided
●​ Inclusion of non-executive directors
●​ Chairman can never be the CEO
●​ Independent chairman

Corporate governance:
●​ Not obliged under law in most countries
●​ Usually required for stock exchange listing
●​ Directors’ salaries disclosed in annual report
●​ Increased corporate social responsibilities
A4: Financial & other objectives for not-for profit organizations

Objectives of non-profit organizations:

●​ Value for money
➔​ Used in reference to something that is well worth the money spent on it
●​ Stewardship
➔​ Money received is used for one purpose and for that purpose only

Performance measurement in not-for profit organizations:

●​ Performance is measured using financial and non-financial indicators
●​ Non-financial data is very important to measure the achievement of non-quantifiable
goals
●​ Performance measurement may not be seen as a priority and it may be seen as a
waste of time and resources
●​ It’s still important for the organization itself and the achievement of its objectives

The Economy: Flow of Income:

●​ Circular flow of income is a diagrammatic representation of the:
➔​ Economy
➔​ Main players
➔​ Terminology
➔​ Approaches

Impact:
●​ Overview of economic environment
●​ Impact of government on companies

Content:
●​ Economy in simplest form
●​ Monetary policy
●​ Fiscal policy
●​ Balance of payments
●​ Other payments

Economy in its simplest forms:

●​ Firms which manufacture goods
●​ Households which supply the factors of production such as labor and capital
●​ Households receive money in exchange for wages:
➔​ Referred to as wages
●​ Households purchase the goods of firms:
➔​ Referred to as consumption

Goals of governments:
●​ Grow the economy
●​ Increase employment
●​ Avoid inflation
​
Types of policy:
●​ Monetary policy:
➔​ Inflation refers to demand exceeding supply
➔​ Governments would want to stop consumers spending
➔​ An approach is to encourage them to save
➢​ By increasing interest rates

Roles of banks:
●​ Take deposits from households
●​ Use these to lend to lenders (both households and firms)
●​ Governments control inflation by reducing the money supply
●​ This combination of using interest rates and the money supply is referred to as
monetary policy

High interest rates:

●​ Sales may fall as consumers save instead
●​ Cost of borrowing will increase which may increase disposable incomes
●​ Companies own borrowing will be more expensive

Fiscal policy:
●​ An alternative approach to reduce inflation is to increase taxes, so households have
less disposable income
●​ The money generated by the government could be redistributed to households or
stimulate sectors of the economy through government spending

Perspectives of firms on fiscal policy:

●​ Sales and profits may suffer
●​ Disposable income may fall

Balance of payments:
●​ Refers to the relative size of imports and exports
●​ Exports are an inflow to the circle
●​ Imports are an outflow to the circle as money is paid to foreign firms

Ways of fixing the balance of payments deficit (when imports exceed exports):
●​ Make exports attractive
●​ Manipulate exchange rates
●​ Increase cost of foreign imports
●​ Reduce consumer demand

Other policies impacting the actions of firms:

●​ Competition policies
➔​ Veto bad acquisitions and mergers
●​ Environmental policies
➔​ Force process charges to increase costs
●​ Health and safety policies
➔​ Process changes may offer competitive advantage
F6: Nature and role of financial markets:

Financial markets:
●​ Buy/sell stocks or bonds
●​ Buy/sell commodities
●​ Where those who need funds can meet those who have funds and they will supply
these funds for a return

Financial markets facilitate:

●​ Organizations to raise capital
●​ Matching those who need capital those who have it
●​ International trade enabling organizations to buy foreign currencies
●​ Match those who need capital with those who have it

Capital and money markets:

●​ Where debt and equity are traded
●​ Where longer term investments are sold
●​ Where organizations are seeking long term finance

Main securities sold in capital markets:

●​ Public sector and foreign stocks
●​ Company securities
●​ Eurobonds/international bonds:
➔​ Bonds not in a national currency of the issuing company

Types of capital markets:

●​ International markets enable access to foreign currencies
●​ Euro-markets where institutions buy/sell currency deposits that are not held
domestically
●​ Money markets offer investors shorter term investments

Financial intermediaries:
●​ The role of intermediaries is to bring the two parties together
●​ Through an intermediary, investors could put their money
●​ You have no contact with the borrower, since you have given the money indirectly
●​ The steps:
➔​ Funds are deposited with an intermediary
➔​ The financial intermediary invests the funds at a higher rate of interest than what you
would earn
➔​ Borrowers pay a return on the funds invested

Types of financial intermediaries:

●​ Banks
●​ Pension funds
●​ Mutual insurance funds
●​ Investment trusts

Intermediaries fulfill the following roles:

 ●​ Group small investors deposits together supplying large borrowers:
➔​ Investors’ funds may be invested in a large investment
●​ Risk transformation:
➔​ Intermediaries offer low-risk securities to primary investors to attract funds, which are
then used to purchase higher-risk securities
●​ Maturity transformation:
➔​ Maturity transformation is the financial practice where institutions, primarily banks,
borrow funds short-term and lend them long-term

The stock market:

●​ Roles:
➔​ Facilitate companies issuing equity to investors
➔​ Facilitate the trading of shares and stocks
➔​ Offers securities to investors and companies
➔​ Shares and other investments can be traded easily

What is traded on the stock market?

●​ Issued shares of public companies
●​ Corporate bonds
●​ Government bonds
●​ Local authority loans

What is the corporate bond market?

●​ A form of debt financing issued by company directly to an investor that offers a rate
of return
➔​ Bonds are sold by the corporation to raise finance
●​ Bonds can be secured or unsecured:
➔​ They can use a specific asset for a collateral, which reduces their risk
➔​ This reduces the risk
➔​ Unsecured bonds do not have a collateral, only that issuing companies promise to
pay
●​ Governments bonds are considered to be less risky than corporate bonds, so offer a
lower return
●​ A bond is a debt instrument
➔​ When an investor invests, they will get the yield of the bond, but will not own shares
of the company like they would if they have bought equity in the company
●​ Bonds are issued on the bond market
➔​ A primary market where companies and governments can issue their new debt
●​ Once issued, bonds can be traded on a secondary market like a stock exchange

Investors must assess risk:

●​ Not making a good enough return
●​ Losing the funds they invested
●​ Investments are categorized according to their level of risk
➔​ The higher the risk, the higher the rate of return

Common securities:
●​ Treasury bills:
 ➔​ Are short term debts sold by a government at a discount
➔​ Because they are short-term, they are considered low-risk
●​ Long-term government bonds:
➔​ Their level of risk depends on the country issuing them
➔​ Their value will fluctuate in line with the interest rates in the issuing country
➔​ Because they are riskier than treasury bills, they have a higher rate of return
●​ Corporate bonds:
➔​ A long-term debt instrument
➔​ They are riskier than the previous two because a country is less likely to default in
paying their bondholders than a company
●​ Preference shares:
➔​ Are paid ahead of ordinary shareholders and often at a fixed rate
➔​ Less risky than ordinary shares
●​ Ordinary shares:
➔​ Carry the most risk
➔​ When a company is waning down, they are the last to get paid, but they can also
make the highest returns

Money market:
●​ Global financial market for short-term borrowing and lending
●​ Investments tend to last up to 12 months
●​ Companies issue short-term debt on the money market
●​ They are perceived to have lower rates of return in comparison to investments on the
long-term capital market

What could be traded on the money market?

●​ Treasury bills
●​ Commercial paper
➔​ Commercial paper is a short-term, unsecured debt instrument issued by corporations
typically for the financing of short-term liabilities
●​ Bankers acceptances
➔​ A banker's acceptance is a document issued by a bank institution that represents a
bank's commitment to make a requested future payment

Role of money markets for institutions:

●​ Raise short-term cash for liquidity
●​ Raise short-term trade finance
●​ Manage foreign exchange currency risk
●​ Manage interest rate risk

Role of financial institutions in Money Market:

●​ Reduce cost of transactions on an individual level
➔​ Financial institutions have a large volume of transactions, so they lower the
transaction cost (economies of scale)
●​ Reduce credit risk:
➔​ Has access to specialists in house, to it can produce more credit risk information at
cheapest rate, reducing this credit risk to the investor
 ●​ Financial institutions can convert illiquid assets into marketable securities and sell
them (securatization)
➔​ These are attached to an underlying asset
➔​ Liquid assets, such mortgage loans can be grouped together and sold as mortgage
backed securities
➔​ Buyer has security that if borrower defaults, they can sell underlying asset

Interest-bearing securities:
●​ Interest bearing
➔​ Any products that bear interest to their owners
➔​ Examples:
➢​ Certificates of deposit
​ A certificate of deposit (CD) is a type of savings account offered by banks and credit
unions. It pays a fixed interest rate for a set period of time
➢​ Repurchase agreements
​ A repurchase agreement (repo) is a short-term agreement where one party sells
securities to another with a commitment to buy them back at a slightly higher price on
a future date
➢​ Bank deposits
​ A bank deposit is an amount of money that a customer places into a bank account for
safekeeping at a financial institution
➢​ Government securities
​ Government securities are debt instruments used by the government to borrow
money from the public to meet their fiscal requirements
➢​ Local authority bonds
​ Local authority bonds are debt securities issued by local public entities to finance
projects like infrastructure, utilities, or public facilities, and are repaid using the
revenue generated by those projects or the general tax revenue of the local
government

Non-interest bearing securities:

●​ Non-interest bearing securities refer to an unconditional promise to pay a specific
sum on a future date or on demand
●​ They could be sold to third parties after their creation

Discount instruments:
●​ Discount instruments don’t pay interest to investors
➔​ They are sold at a discount to investors so for example an organization issues a
security of 100 dollars available at a 20% discount
➔​ Unlike interest-bearing securities, where investors wait to receive interest, investors
can get their game at the beginning
●​ Examples:
➔​ Treasury bills
➢​ Issued by governments on a discount at their face value
➔​ Commercial paper
➢​ Issued by big organizations at a very high credit rating
 ➢​ They are insecure for a short period of time
➢​ They are used to fund-short term investments
➔​ Bankers acceptance
➢​ Issued by companies like commercial paper
➢​ A bank guarantees them
➢​ Guaranteed because an organization may not have a good enough credit rating to
offer on commercial paper
➢​ The guarantee makes them more secure

Derivative products:
●​ They are contracts between two parties
●​ Their price is determined by an underlying asset
●​ Value fluctuates with value of asset
●​ Types of derivatives:
➔​ Future contracts
➢​ Hedge against risk over a certain time
➔​ Forward contracts:
➢​ Like future contracts, but are traded on the counter
➢​ Not traded on a stock exchange (often through dealers)
➔​ Swaps
➢​ Two parties agree to take on the the others (eg. a loan liability)
➢​ Two companies can swap their loan rate, for example
➔​ Options:
➢​ Similar to futures
➢​ However, the buyer or seller can decide to withdraw from the transaction if they want

Types of options:
●​ A short option:
➔​ An investor expects the value of the asset to fall
➔​ You sell the shares at the current market price
●​ A long option:
➔​ An investor owns the assets
➔​ He expects the value of the assets to rise
●​ Call option:
➔​ Gives the right, but not the obligation to purchase a stock or a bond
➔​ On a specific price on a specific time
➔​ The investor gains if the asset value increases from when they put the call in place
because they can access the asset at a lower rate
●​ Put option:
➔​ Opposite of a call option
➔​ It gives the seller of an asset the right, but not the obligation, to sell their securities at
a specific price and within a specific timeframe

Working capital:

What is working capital?

 ●​ Working capital (or net current assets) is represented by current assets minus current
liabilities
●​ Current assets include:
➔​ Inventory
➔​ Receivables
➔​ Cash
●​ Current liabilities:
➔​ Payables
●​ Described by the lifeblood of an organization
●​ Business cannot survive without it
●​ Require some level of investment in this area

Objectives of working capital:

●​ Profitability
➔​ Profitability can be improved if:
➢​ A company appears attractive to its current and potential customers
➢​ Offer generous credit limits
➢​ Offer wide choice
➢​ Offer fast delivery
●​ Liquidity
➔​ The amount of cash that a company can rely on when meeting financial obligations
●​ Working capital management is concerned with finding the correct balance between
investing enough to attract customers and whilst at the same time maintaining
sufficient liquidity resources

How do we measure working capital?

●​ Current ratio:
➔​ Current assets divided by current liabilities
➔​ No optimal value, but we can compare them to industry average or similar companies
in the industry
●​ Quick ratio:
➔​ (Current assets-inventory)/(Current liabilities)
➔​ No optimal value, but we can compare them to industry average or similar companies
in the industry

Why is working capital management important?

●​ To find an appropriate balance between conflicting objectives of profitability and
liquidity
●​ Types of organizations:
➔​ An organization that invests too much in working capital is referred to as
overcapitalized
➔​ A company that does not invest too much in working capital is said to be overtrading

Working capital cycle:

Components of the working capital cycle:
1.​ Receive material
2.​ Raw material inventory
3.​ Work in progress (WIP)
4.​ Finished good inventory
5.​ Receivables
6.​ Cash in
●​ The period between WIP (Cash out) and Cash In (Payment of customer) is referred
to as the working capital cycle

Negative working capital cycle:

●​ In simple terms: the business is getting cash before it needs to spend cash.
●​ This happens particularly when companies can negotiate extended credit terms with
suppliers

Importance of the working capital cycle:

●​ Profitability and liquidity are the objectives of working capital management
●​ The period between these two is called the working capital cycle:
➔​ It puts pressure since money is needed to pay the company’s bills
➔​ There might be adverse costs since the company might need to borrow money to
finance these bills
➔​ There might be interest costs, which might reduce the profit
●​ The amount:
➔​ Current assets-current liabilities
●​ Length of time:
Interpreting the cycle:
●​ In arriving at the above days, a number of estimates and assumptions need to be
made:
➔​ Number of days calculated may not be completely accurate
➔​ Likely to be consistent from one year to the next
➔​ Companies will often use the trend
●​ Year-end values may not be representative:
➔​ No single correct answer
➔​ Influenced by industry norms
➔​ Industry averages
➔​ Receivables and payables days ought to reflect the credit terms agreed with
customers and suppliers

Net working capital ratio:

●​ The sales: net working capital ratio shows the sales that can be generated from an
investment in working capital of 1 pound
●​ This enables the company to estimate the additional investment that will be required
as sales grow

Management of Inventory:

Objectives of Inventory Management:

●​ Guiding or controlling activities in order to achieve predetermined goals or objectives
●​ Objectives of inventory management:
➔​ Avoid stockouts
➔​ Minimize costs associated with the purchasing, ordering and holding of inventory
 ●​ We need to think about each individual item of inventory
➔​ Lots of work
➔​ Managing an item individually may not be justified
➔​ ABC system might be adopted:
➢​ High-value items may be assigned category A (with a lot of controls)
➢​ Low-value items may be assigned category C (with very little controls)
➢​ Category B is in between

Elements of cost:
●​ Buying/purchasing cost (P):
➔​ Acquiring item
➔​ Getting item to current location
➔​ Purchase cost=P X D (annual demand)
●​ Cost of Placing Order (Co)
➔​ Ordering inventory from supplier
➔​ Ordering cost=Co X (Demand/Quantity ordered each time)
●​ Holding cost (CH)
➔​ Holding and moving item around facility
➔​ Money tied to inventory
➔​ Holding cost=Ch X (Average Quantity held or Q/2)

Economic order quantity:

●​ Economic order quantity is the quantity to order each time to minimize inventory
costs:

●​ Assumptions:
➔​ No inventory discounts
➔​ Inventory is used at a steady rate
➔​ Instantaneous replenishment
Quantity discounts:
●​ EOQ model is used to determine the quantity to order to minimize costs
●​ Other quantity would incur a higher combined cost
●​ No consideration of potential existence of quantity discount

Amended approach:
●​ 1. Calculate the total inventory cost incurred at the economic order quantity
●​ 2. Calculate the total inventory cost incurred at the minimum order quantity
●​ 3. Calculate the order quantity at the lowest total annual cost

Just in time (JIT):

●​ Principle of holding little or no inventory
●​ Contrary to EOQ model
➔​ Lots of orders for small quantities may be placed, which will result in incurring high
ordering costs
●​ Support of JIT say that EOQ does not consider all inventory costs

Just in time (JIT) arguments:

●​ Just in time (JIT) supporters argue that companies hold inventory to cover-up
problems in the business:
➔​ Unreliable suppliers
➔​ Poor industrial relations
➔​ Lack of planning systems
➔​ Poor quality work
●​ All of the arguments may “damage” the organization and constitute a cost to the
business

Management of Receivables & Payables:

Considering receivables:
●​ Amounts owed to business:
➔​ Sales made on credit
●​ It does expose the company to risks, so the company should have appropriate
processes and controls
●​ Any benefits of offering the process should be weighted against the costs of
managing the process

Credit control process:

●​ Cash sale:
➔​ Instantaneous, so no record keeping required
●​ Credit sale:
➔​ Should be recorded to safeguard against non-payment

Credit Control Process:

1.​ How much credit?
 ➔​ Market and customer expectations:
➢​ What can a company afford?
2.​ Who to offer?
➔​ Creditworthiness of customer:
➢​ Reference accounts
3.​ Debt collection
●​ Necessary actions:
➔​ Invoice accurately and promptly
➔​ Issue credit notes swiftly
➔​ Issue monthly statements
➔​ Trigger appropriate action for non-payments
➢​ Phonecalls
➢​ Letters
➢​ Visits
➢​ Legal action
➢​ Etc
➔​ Credit limits are reviewed based on trading history
➔​ Credit is withdrawn for non-payers

Costs vs benefit:
●​ A cost vs benefit analysis could be done to the following:
➔​ Debt factors:
➢​ Compare factors to the benefits derived
➔​ Settlement discounts
➢​ Outweighted by savings from lower average receivable levels
➔​ Longer credit period
➢​ Only if the profit on the sales is greater than the financial costs incurred

Working capital needs:

Level of working capital investment:

●​ Length of working capital cycle
●​ Organization’s terms of trade
●​ Organization’s policy on level of investment in current assets
●​ Industry the company is in

Length of working capital cycle:

●​ The length of working capital cycle is the time period between organization paying for
its costs and receiving cash from customers
➔​ The longer this period is the higher the organization’s working capital investment will
be

Organization’s terms of trade:

●​ The length of credit terms will determine the length of cash-flow cycle guided by what
competitors are offering
●​ Cost of business trade:
Impacts of terms of trade:
●​ Impacts:
➔​ More generous terms of trade will result in a higher investment in working capital
➔​ More attractive to customers would mean more sales

Impact of Organization’s policy on the level of investment in current assets:

●​ Conservative attitude to risk:
➔​ Adopt conservative policy and invest in current assets
➔​ It is less risky
●​ Aggressive attitude towards risk:
➔​ Will invest less in current assets with highest profits
➔​ It is riskier

Impact of the industry the Organization is in:

●​ The industry determines the level of working capital investment needed

Key factors when determining working capital funding strategies:

●​ Permanent and fluctuating current assets
➔​ Normal level of investment needed to support a normal level of sales

●​ Short and long term finance

➔​ Increased investments may be needed at certain times
➔​ Risk of short-term finance
➢​ Trade creditors
➢​ Bank overdrafts
➢​ Short-term loans
➢​ Invoice discounting/invoice factoring
➔​ Risk of long-term finance:
➢​ Long-term loans
➢​ Mortgages
➢​ Investors funds
➢​ Retained earnings

●​ Matching principles
➔​ Length of benefits should be matched with length of source of finance
➔​ Match short-term assets with short-term financing
➔​ Permanent investment needed in working capital is matched by long-term source of
finance

●​ Costs and benefits of different funding policies

➔​ Aggressive working capital funding policies
➢​ Higher profits
➢​ Faster growth
 ➢​ Higher risk
➔​ Matching working capital funding policies:
➢​ Medium between aggressive and conservative funding policy
➢​ Cash inflows match cash outflows
➢​ Long-term finance not always available
➔​ Conservative working capital funding policies
➢​ It is less risky
➢​ It has a higher finance cost
➢​ It leads to slower growth

●​ Previous funding decisions

➔​ Management experience and history with funding will determine the current policy
●​ Organizations size
➔​ Organizations size will determine what finance options are available
➢​ A smaller company will not have access to the same resources as a multinational
corporation

Determining Working Capital Needs and funding strategies:

Baumol Model:
●​ Treats cash like inventory
●​ Finds optimal cash inventory to be invested or transferred
●​ Similar to economic order quantity (EOQ)

Key assumptions of Baumol Model:

●​ Cash is used in a steady and predictable manner
●​ Cash inflows are known and regular
●​ Daily cash needs are funded via current account
●​ Buffer cash held in short-term investments
●​ Not suitable in case of uncertainty over cash flows
Miller-Orr Cash Management Model:
●​ The Miller-Orr model is a cash management tool that establishes upper and lower
cash balance limits to manage random cash flow fluctuations, unlike simpler models
that assume constant cash flows.

Setting minimum cash balance (Miller-Orr Cash Management Model):

●​ Factors:
➔​ Management experience
➢​ Management attitude to risk
➔​ Easy of access to cash
➢​ Ease of converting market securities
➢​ Ease of borrowing

Setting Maximum Cash Balance (formula):

●​ Max point=spread+ Min point
●​ Spread calculation
➔​ Difference between max & min cash balance
●​ Return point:
➔​ Lower limit+ ⅓ the spread

Example:
Miller- Orr Model (Critical Analysis):
●​ Advantages:
➔​ Sets clear cash limits
➔​ Defines clear actions
➔​ The company must identify its cash needs
●​ Disadvantages:
➔​ No objective method to set min balance
Accounting Rate of Return:

Financial Strategy:
●​ Finance decision:
➔​ Where do we get our money from?
●​ Investment decision:
➔​ What do we spend it on?
●​ Dividend decision
➔​ Do we return our money to the investors or do we retain it and reinvest?

Examinable Investment Appraisal Techniques:

●​ Discounting:
➔​ Taking into account the time value of money
➔​ Include:
➢​ Net present value (NPV)
➢​ Internal rate of return (IRR)
●​ No discounting:
➔​ Not taking into account the time value of money
➢​ Accounting rate of return (IRR)
➢​ Payback period (PBP)

Accounting Rate of Return:

Assess Impact on Shareholder Wealth (Accounting rate of return):
●​ ARR compared to Return on Capital Employed (ROCE)
●​ Shareholders assess ROCE
●​ ROCE=PBIT/Capital Employed
 ●​ High ARR to increase ROCE
●​ Common measure

Advantages and disadvantages of ARR:

●​ Advantages:
➔​ Percentage measure
➔​ In tune with ROCE
➔​ Consider entire project life
●​ Disadvantages:
➔​ No direct impact on shareholder wealth
➔​ Doesn’t consider time value of money
➔​ Small cash flows at the end of project life can lower annual ARR

Relevant Cash Flows and Payback Period:

Investment decision appraisal:

●​ Criteria:
➔​ Future:
➢​ How the decision will affect the future
➢​ Past cannot be changed
➢​ Past should not be considered in the decision
➔​ Incremental:
➢​ How will decisions change the future?
➔​ Opportunity Cost & Benefits
➢​ The loss of other alternatives when one alternative is chosen
➔​ Cash:
➢​ We cannot spend profits
➢​ Actual cash can be distributed among shareholders
➢​ Therefore cash flows are relevant
➔​ Size & relevance of cash flows:
➢​ The difference of the cash flow between going ahead with a business idea and not
going is the relevant cash flow

Payback period:
●​ Payback period:
➔​ Time taken by project to recover the initial investment
Payback period: Advantages:
●​ Cash flow based approach:
➔​ Accounting profits can be manipulated
➔​ Cash flows directly relate to shareholder’s wealth
●​ Risk addressed:
➔​ Project that pays back quickly is likely to be less risky
●​ Useful in cash constraints:
➔​ Show how long the project has to be financed for

Payback period: Disadvantages:

●​ Time value of money is ignored
●​ Cash flows after the payback period are ignored
Compounding and Discounting:
●​ Compounding is the process of reinvesting earnings from an investment (like interest
or capital gains) to generate new earnings on those accumulated returns, in addition
to the original principal
●​ In finance, discounting is the process of calculating the present value of a future
payment or stream of cash flows by using a discount rate

Annuity:
●​ An annuity is a financial product, typically an insurance contract, that provides a
guaranteed stream of regular income payments to you over a specific period or for
the rest of your life

Annuity tables assumptions:

●​ Assumptions:
➔​ First payment in one year’s time
➔​ Annuity is the sum of discount factors

Calculating annuity factor:

●​

Perpetuity:
●​ A perpetuity is a stream of fixed cash payments that continues indefinitely, with no
maturity date

Net Present Value, IRR and Discounted Payback Period:

Net Present Value:

●​ Estimate future incremental cash flows
●​ Restate future amounts to present value (PV)
 ●​ Ass them all up
●​ Positive result= positive value of project today

NPV Advantages and Disadvantages:

●​ Advantages:
➔​ Cash flow based technique
➔​ Considers the whole life of the project
➔​ Shows direct impact on shareholder’s wealth
●​ Disadvantages:
➔​ Not well understood by non-finance professionals
➔​ Cost of capital (discount rate) required for computation
➔​ Assumes that cash flows arise at the end of the period
Discounted Payback Period:
●​ Modifies the payback period to include discounting
●​ Known as ‘discounted’ or ‘adjusted’ payback period

Internal Rate of Return:

Internal Rate of Return (Example):

IRR Advantages and Disadvantages:
●​ Advantages:
➔​ Relative measure (easily compare to alternatives)
➔​ Based on cash flows
➔​ Includes time value of money
➔​ No need to know the CoC precisely
●​ Disadvantages:
➔​ Of what? (cannot compare two projects)
➔​ Assumes that cash flows are reinvested at IRR (Investment assumption)

Advanced NPV:

Corporation Tax:

Capital allowance (WDV):

●​ A capital allowance is the amount of capital investment costs, or money directed
towards a company's long-term growth, a business can deduct each year from its
revenue via depreciation
➔​ The money saved depends on the corporate tax rate
●​ Methods:
➔​ Tax allowable depreciation:
➢​ Also known as capital allowances, is the annual deduction a business can take for
the cost of acquiring non-current assets, such as machinery or property, to reduce
taxable profit and, consequently, the tax owed
➢​ It is not a cash flow
➔​ Cash flow from savings:
➢​ Is called positive cash flow because it represents the amount of cash remaining after
all expenses have been paid

WDV Pro-Forma:
Working Capital:
●​ Investment to make project operational
●​ Cast tied up in buying inventory

Example:
Inflation:

Example:
Capital Rationing:

Capital Constraint:
●​ Hard constraint:
➔​ Externally imposed
➔​ Money not available
➔​ Money can’t be obtained
➔​ Limit spending
●​ Soft constraint:
➔​ Internally imposed
➔​ Money available
➔​ Doesn’t want to spend it all
➔​ Precautionary motive to retain cash
➔​ Retain cash

Example:

Deciding if projects are divisible or not:

●​ Divisible projects:
➔​ Invest in partial project
●​ Indivisible projects:
➔​ Cannot invest in partial project
Profitability Index:

Investment Plan - Divisible Projects:

Indivisible Projects:
Replacement Analysis:

Example:

Equivalent Comparison (Annual Depreciation) Example:

Equivalent comparison:

Summary:
●​ Can’t compare NPVs of different replacement cycles directly
●​ Convert NPVs into equivalent cost

Lease or Buy:

Remarks:
●​ Already decided to go ahead with the project
●​ Operational cash flows from the project are not relevant
●​ Only consider incremental cash flows
●​ Compare leasing vs buying the asset

Impact of Leasing:
●​ Payment of rentals
 ●​ Tax deduction on rental payments
●​ No initial cost of acquisition
●​ No scrap proceeds available
●​ No capital allowance available on asset

Example:

Approaches on deciding whether to lease or buy:

●​ Prepare 2 NPV tables:
➔​ 1 for leasing & 1 for buying
➔​ Compare both to see which is better
●​ Prepare 1 NPV table:
➔​ ‘Compare leasing as opposed to buying’

Two Table approach:

WDA - Working ($)

Justifications of Leasing instead of Buying:
●​ Leasing company may buy in bulk
●​ Leasing company may have access to cheaper finance
●​ Leasing company may be prepared to take a small lose to encourage sales
●​ Leasing may be the only way a business can finance the acquisition

​
Risk & Uncertainty:

Definitions:
●​ Risk is quantifiable (known possibilities and probabilities)
●​ Uncertainty is difficult to quantify (unknown possibilities and outcomes)

Expected values:
●​ Expected values are an average
●​ Assumes risk neutral attitude
 ●​ Expected values are not suitable for one-off decisions
●​ Expected values are highly dependent on probability estimate

Risk-adjusted discount rate:

●​ Risk could be dealt with by reflecting it in the discount rate
●​ A risk-adjusted discount rate is the expected rate of return an investor
requires for a risky investment, accounting for:
➔​ Interest
➔​ Inflation
➔​ Risk

Payback period:
●​ Payback period gives us a measure of risk
●​ Shorter payback period is considered less risky as the near future is more
knowable than the distant future
●​ We might be concerned if the payback period is long since the conditions may
change in the longer term

Simulations:
●​ Point estimates could be considered a number used to represent a range of
possible values
●​ If some of the estimates are replaced, there won’t be a single number at the
end of the calculation of NPV
●​ The decision-maker would need to consider the graph and make the decision
based on that
●​ The NPV could be higher or lower than the average depending on the
underlying value of the variable
Sensitivity Analysis:

Sensitivity Analysis:
●​ Focus on the estimates used in calculations
●​ Question asked:
➔​ How wrong could I be before the decision changes?
●​ A high change impacting decision = Low sensitivity
●​ A slight change impacting decision = High sensitivity

Example:

Formula to Compute Sensitivity (Example):

Extensions of Sensitivity Analysis:
●​ Cost of Capital (COC)

➔​
●​ Life of the project
 ➔​

Sensitivity Analysis: Advantages and Disadvantages:

●​ Advantages:
➔​ Focus attention on key variables
●​ Disadvantages:
➔​ Looks at 1 variable changing at a time
➔​ Does not come with a decision rule
➔​ Does not include how likely we can be wrong

Certainty equivalents:
●​ A certainty equivalent is the guaranteed amount of money or value that a person
would consider as desirable as a risky or uncertain prospect

Example of Certainty equivalents:

Disadvantages of Certainty Equivalents:
●​ Certainty equivalent factors are not objective
●​ The factors are subjective (made-up)
●​ The above undermine the accuracy

Sources of Finance: