ACCA Study Text Book F9 Financial Management Exam 4 Focused Learning

F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 1 of 128
THIS STUDY MATERIAL IS NOT AVAILABLE OFFLINE IN ANY FORM (DVDs, CDs, PRINTED BOOKS)
EXAM TOPICS
Note: click the hyperlinks below for easy navigation. Click to see table of exam topics. EXAM TOPICS ........................................................................................................................................ 1 KEY TERMS ............................................................................................................................................ 3 INTENDED BENEFITS OF THE E-BOOK ................................................................................................... 7 AUTHORS PROFILE ............................................................................................................................. 13 IMPORTANT! ....................................................................................................................................... 14 USER GUIDE ........................................................................................................................................ 16 INTRODUCTION TO F9 FINANCIAL MANAGEMENT ............................................................................ 17 EXAMINER'S GUIDANCE ...................................................................................................................... 20 AUTHORS GUIDANCE ......................................................................................................................... 21 STUDY PLANNER ................................................................................................................................. 22 FORMULA SHEET & TABLES ................................................................................................................ 23 PAST EXAM PAPERS ANALYSIS ........................................................................................................... 27 FINANCIAL MANAGEMENT FUNCTION ............................................................................................... 28 FINANCIAL MANAGEMENT ENVIRONMENT ....................................................................................... 33 THE NATURE, ELEMENTS & IMPORTANCE OF WORKING CAPITAL .................................................... 35 MANAGEMENT OF WORKING CAPITAL ELEMENTS ............................................................................ 37 DETERMINING WORKING CAPITAL NEEDS & FUNDING STRATEGIES ................................................ 56 THE NATURE OF INVESTMENT DECISIONS & THE APPRAISAL PROCESS ............................................ 65 NON DISCOUNTED CASH FLOW TECHNIQUES ................................................................................... 68 DISCOUNTED CASH FLOW (DCF) TECHNIQUES .................................................................................. 72 ALLOWING FOR INFLATION & TAXATION IN DCF ............................................................................... 74 ADJUSTING FOR RISK & UNCERTAINTY IN INVESTMENT APPRAISAL ................................................. 76 SPECIFIC INVESTMENT DECISIONS ..................................................................................................... 78 SHORT & LONG TERM FINANCE ......................................................................................................... 80 INTERNAL SOURCES OF FINANCE & DIVIDEND POLICY ...................................................................... 83 GEARING & CAPITAL STRUCTURE CONSIDERATIONS ......................................................................... 85
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THIS STUDY MATERIAL IS NOT AVAILABLE OFFLINE IN ANY FORM (DVDs, CDs, PRINTED BOOKS) FINANCE FOR SMALL & MEDIUM SIZED ENTITIES (SMEs) .................................................................. 87 ESTIMATING COST OF CAPITAL .......................................................................................................... 89 RELATIONSHIP BETWEEN COST OF CAPITAL, CAPITAL STRUCTURE & INVESTMEMTS .................... 109 BUSINESS VALUATION TECHNICHES ................................................................................................. 111 EFFICIENT MARKET HYPOTHESIS ...................................................................................................... 113 BASICS OF FINANCIAL RISK MANAGEMENT ..................................................................................... 115 HEDGING TECHNIQUES FOR FOREIGN CURRENCY RISK ................................................................... 125 HEDGING TECHNIQUES FOR INTEREST RATE RISK ........................................................................... 127 Be An Affiliate
KEY TERMS
A Agency...........................................................17 Agreement Date..................................218, 234 Annuity ..........................................................76 Average Growth Rate .................................165 B Bad Debt Risk ................................................35 Balance Of Payments ..................................256 Barter Trade ..................................................44 Basis Risk .............................................233, 246 Baumol Model ..............................................57 Benefits .........................................................19 Bill Of Exchange ............................................43 Brand, Copyright & Patents ........................196 Business Risk ...............................................180 Buying & Selling Rate ..................................217 C Cap ..............................................................250 Capital Asset Pricing Model (CAPM) ...........170 Capital Cash Flows ........................................94 Capital Rationing .........................................122 Clientele Effect ............................................145 Collar ...........................................................251 Combine Probability ...................................112 Contingent Assets .......................................195 Contingent Liabilities ..................................196 Contract Price .............................................233 Contract Size ...............................................233 Conventional cash flows ...............................79 Conversion Premium ..................................206 Convertible Loan Notes ..............................138 Convertible preference shares ...................135 Cost of debt.................................................174 Cost of Equity ..............................................163 Credit Control ............................................... 31 Credit Insurance ........................................... 44 Credit Or Customer Analysis ........................ 31 Credit Policy .................................................. 30 Cum dividend market share price .............. 149 Cumulative preference share ..................... 134 Currency Option ......................................... 241 Currency Swap ............................................ 243 Current Asset Ratio....................................... 29 D Debt Finance ............................................... 135 Deep Discount Bonds ................................. 138 Deflation ....................................................... 72 Derivative.................................................... 244 Development Expenditure ......................... 195 Direct Quote ............................................... 216 Discount Rate ............................................... 73 Discounted Payback Period .......................... 88 Discounting ................................................... 73 Dividend Growth Model (DGM) ................. 163 Dividend Valuation Model (DVM) .............. 202 Divisible Projects ........................................ 124 E Earnings Per Share ...................................... 191 Earnings Yield ............................................. 191 Earnings Yield Valuation Method ............... 201 Economic Risk ............................................. 220 Efficient Market Hypothesis ....................... 211 Equity Beta.................................................. 170 Equity Finance ............................................ 130 Equity Risk Premium - ....................... 170 Equivalent Annual Benefit (EAB) ................ 122 Equivalent Annual Cost (EAC) ..................... 121 Ex-dividend market share price.................. 149
THIS STUDY MATERIAL IS NOT AVAILABLE OFFLINE IN ANY FORM (DVDs, CDs, PRINTED BOOKS) Expectation Theory .....................................254 Initial Investment.......................................... 94 Expected Values ..........................................112 Initial Public Offer (IPO) .............................. 131 Export Factoring............................................43 Interest Rate ................................................. 73 Interest Rate Option ................................... 250 F Interest Rate Parity Theory ........................ 227 Factoring .......................................................37 Interest Rate Risk ........................................ 246 Finance Lease ..............................................116 Interest Rate Swap ..................................... 251 Financial Cash Flows ...................................101 Internal Rate of Return (IRR) ........................ 84 Financial Risk ...............................................180 Invoice Discounting ...................................... 42 Fixed Interest Rate Risk ..............................246 Invoicing In Home Currency ....................... 222 Floatation ....................................................132 Irredeemable Loan Notes ........................... 138 Floor ............................................................251 J Floor Value ..................................................206 Fluctuating Assets .........................................59 Joint Venture .............................................. 126 Foreign Exchange Risk ................................218 Just in Time (JIT) ........................................... 53 Forward Contract Hedge ............................228 L Forward Rate ..............................................226 Lapse ........................................................... 157 Forward Rate Agreements (FRAs) ..............248 Lead & Lag Payment ................................... 223 Franchise .....................................................126 Lease ........................................................... 115 Free Cash Flows ............................................90 Lesser & Lessee........................................... 115 Future Contract Hedge ...............................232 Letter Of Credit ............................................. 44 Future Market .............................................232 Liquidity ........................................................ 23 G Liquidity Preference Theory ....................... 254 Geared beta ................................................171 Liquidity Ratios ............................................. 29 Goal congruence ...........................................17 Loan Notes (Bonds or Debenture) ............. 137 Goodwill ......................................................195 M Gordons Growth Rate ................................166 Market Imperfection Theory ...................... 185 Government Grants ....................................127 Market Rate Of Return ............................... 170 H Market Segmentation Theory .................... 254 Hard Capital Rationing ................................122 Matching ..................................................... 222 Hedging .......................................................221 Matching Policy ............................................ 59 Miller & Modigliani (M&M) Theory ........... 184 I Miller & Modigliani Theory ........................ 144 Indirect Quote .............................................216 Miller-Orr Model .......................................... 56 Inflation .........................................................72 Monetary Policy.......................................... 256 Inflation Rate ................................................73 Money Market Hedge ................................ 235 Inflation Rate Parity Theory ........................226 Mutually Exclusive Projects ........................ 126
THIS STUDY MATERIAL IS NOT AVAILABLE OFFLINE IN ANY FORM (DVDs, CDs, PRINTED BOOKS) Q Quick Asset Or Acid Test Ratio ..................... 30 R Real cash flows ........................................... 101 Real discount rate ....................................... 101 Real Return ................................................. 256 Recourse Factoring ....................................... 38 Redeemable Loan Notes ............................ 138 Redemption Value ...................................... 205 Redemption Yield ....................................... 205 Renounce .................................................... 156 Residual Value .............................................. 94 Retained Earnings ....................................... 130 Return Of Equity (ROE) ............................... 189 Return Of Investment (ROI) ........................ 188 Return on Capital Employed (ROCE) ............ 68 Revenue Cash Flows ..................................... 98 Right Issue................................................... 133 Risk.............................................................. 107 Risk Free Rate Of Return ............................ 170 S Sale & Lease Back ....................................... 140 Script Dividend ........................................... 148 Semi Strong Form Efficient ......................... 213 Sensitivity Analysis ..................................... 107 Settlement Date ................................. 218, 234 Settlement On Net Basis ............................ 221 Share Based Payment ................................... 18 Share Options ............................................... 18 Short Term Loan ......................................... 129 Signalling Effect .......................................... 146 Single Period Capital Rationing .................. 124 Smoothing .................................................. 247 Soft Capital Rationing ................................. 123 Spot Rate .................................................... 226 Spread ......................................................... 217
Negative Gap ..............................................246 Net Assets Valuation Model .......................194 Net Present Value (NPV) ...............................80 Netting ........................................................223 Nominal cash flows .....................................101 Nominal discount rate ................................101 Non conventional cash flows ........................79 Non convertible preference shares ............135 Non cumulative preference share ..............135 Non Systematic Risk ....................................169 Non-Recourse Factoring ...............................38 O Operating Lease ..................................118, 130 Optimal or Economic Order Quantity (EOQ) 49 Outsourcing ................................................126 Overdraft.......................................................29 Overdrafts ...................................................129 Overtrading & Undertrading ........................61 P Par Value .....................................................137 Payback Period..............................................68 Pecking Order Theory .................................185 Pension..........................................................19 Permanent Assets .........................................59 Perpetuity .....................................................78 Placing .........................................................132 Positive Gap ................................................246 Pre-Emption Right .......................................133 Preference Share Capital ............................134 Present Value (PV) ........................................72 Price Earnings Ratio ....................................191 Probability Analysis .....................................111 Profit Related Pay .........................................18 Profitability index........................................124 Project Specific Fixed Cost ............................98
THIS STUDY MATERIAL IS NOT AVAILABLE OFFLINE IN ANY FORM (DVDs, CDs, PRINTED BOOKS) Strong Form Efficient ..................................214 ungeared beta ............................................ 171 Subscribe .....................................................156 V Systematic Risk ...........................................169 Variable Interest Rate Risk ......................... 246 T W Tangible Assets ...........................................196 Weak Form Efficient ................................... 212 Tax benefit ..................................................186 Weighted Average Cost of Capital (WACC) 161 Tax Savings On Capital Allowance ................94 Weighted Average Cost Of Capital (WACC) . 73 Theoretical Ex-Right Share Price.................154 Working Capital Cycle ................................... 25 Tick ..............................................................233 Working Capital Investment ......................... 99 Time Value of Money....................................72 Y Traditional View ..................................144, 183 Transaction Risk ..........................................219 Yield Curve .................................................. 255 Translation Risk ...........................................220 Z U Zero Coupon Bond ...................................... 139 Uncertainty .................................................107
INTENDED BENEFITS OF THE E-BOOK

Features & 1) Exam Focused Study Text Book Description for ACCA F9 Financial Management Exam Focused Study Text Book These Exam focused study text books are aimed to help you passing exam with least efforts and time. These study materials aim to educate you in the way you are expected to apply your knowledge in the exam. Length of syllabus areas is adjusted to reflect the importance of each syllabus area for your exam session. Therefore, you will automatically spend time and efforts on different syllabus areas according to their importance for your exam session. These study materials takes account of examiners comments and reports, past exam papers, student accountant articles, tips from other tutors, syllabus areas examined by other professional accountancy bodies, publications in business magazines etc. 2) Examiner's Guidance 3) Author's Guidance Examiner's Guidance are tips given by the examiner in student accountant, examiner's interview and other documents. Author's guidance are applicable to all syllabus areas. It also includes tips to enable you to perform effectively during exams. 4) Exam Awareness Exam Awareness shows the frequency and magnitude (marks) of each syllabus area. It also shows the relationship between various syllabus areas and how each syllabus area contributes toward passing exams.
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AUTHORS PROFILE
Name: Murtaza Lanewala Career Status: Freelance writer & tutor for professional accountancy qualifications. Professional bodies include ACCA, CIMA and ICAEW. Author & CEO of accasupport.com E-mail: kabuli_52@hotmail.com or murtaza@accasupport.com
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INTRODUCTION TO F9 FINANCIAL MANAGEMENT

Antony Head is examiner for Paper F9 Financial Management
2 Aim
To develop the knowledge and skills expected of a finance manager, in relation to investment, financing, and dividend policy decisions.
3 Assumed Knowledge from Previous Papers

You are expected to have knowledge from following papers for the purpose of this exam. F1 Accountant in Business. F2 Management Accounting.
4 Position of F5 Performance Management in ACCA
Exam Support:
Syllabus areas that are not included in the study guide of previous papers are more likely to be examined in F9 Financial Management than those that are already included in pervious papers.
5 Main Capabilities & Relationships
6 Exam Paper Format

4 questions are examinable for 25 mark each. All questions must be attempted. Questions could be comprised of many requirements (a, b, c, d, e etc). Mathematical questions are rewarded separately from text-based questions. If you get calculations wrong, you can still earn marks by commenting reasonably on wrong figures.
THIS STUDY MATERIAL IS NOT AVAILABLE OFFLINE IN ANY FORM (DVDs, CDs, PRINTED BOOKS) Usually each question examines only one part of the syllabus. However, any question may examine many chapters from that part (A, B, C, D, E etc) of the syllabus.
Example:
Question examining Part A (Specialist cost and management accounting techniques) can cover chapters such as Absorption costing, Marginal costing and ABC costing as requirement a, b, c respectively.
7 Duration of Exam
Total time: 3 hours 15 minutes 3 hours are writing and reading time. Additional 15 minutes are reading and planning time. However, you can annotate question paper only during that time.
8 Resources:
http://www2.accaglobal.com/students/acca/exams/f9/ http://www2.accaglobal.com/students/pass/
EXAMINER'S GUIDANCE
1 What was done well? 2 What was not done well? 3 How to improve?
AUTHORS GUIDANCE
1 Preparing for Exams 2 Exam Day Guidance
STUDY PLANNER
FORMULA SHEET & TABLES
PAST EXAM PAPERS ANALYSIS

Key Exam Topics 12/11 06/11 12/10 06/10 12/09 06/09 12/08 06/08 12/07 P/P Financial management function Financial management environment The nature, elements & importance of working capital Management of working capital elements Determining working capital needs & funding strategies The nature of investment decisions & the appraisal process Non discounted cash flow techniques Discounted cash flow techniques Allowing for inflation & taxation in DCF Adjusting for risk & uncertainty in investment appraisal Specific investment decisions Short & long term finance Internal sources of finance & dividend policy Gearing & capital structure considerations Finance for small & medium sized entities Estimating cost of capital Relationship between cost of capital, capital structure & investments Business valuation techniques Efficient market hypothesis Basics of financial risk management Hedging techniques for foreign currency risk Hedging techniques for interest rate risk
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 28 of 128 Exam Topic 1: FINANCIAL MANAGEMENT FUNCTION
Exam Topic 1
FINANCIAL MANAGEMENT FUNCTION

Sub Exam Topics
S.no Headings (click the cross reference below for easy navigation) 1 Agency
Exam Awareness
This chapter explains the objective and scope of financial management. Knowledge of this chapter is not frequently examined. However, it will help you to make reasonable and relevant discussion for other topics. See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
1 Agency
Past paper 12/08 Q.no Q1:e Requirement Explain the nature of the agency problem and discuss the use of share option schemes as a way of reducing the agency problem in a stock-market listed company such as Dartig Co. Marks 8
1.1 Definition of Agency Relationship

Agency is a relationship between principal and agent. Principal delegates some responsibility to be performed on behalf of principal. Principal also gives agent necessary decision-making authority. Agent can be responsible to more than one principal.
Example:
Shareholders delegate responsibility to board of directors to management day-to-day operations of organization. Directors are granted necessary authority through articles of association and employment contract.
1.2 Agency Problem

In the context of company, directors are required to protect the interest of shareholders. Shareholders being too many in numbers and may do not have technical knowledge of the companys operations would not be able to protect their interest themselves. Unfortunately, they have to rely on directors to look after their interest. Danger is that directors do not act in the best interest of shareholders. Directors acting other than in the interest of shareholders are known as agency problem. Agency problem creates the need for building mechanism, which promotes goal congruence or Alignment of interest.
1.3 Goal Congruence

Goal congruence means making directors act in the interest of shareholders. Directors have their own needs and desires, which may be different from shareholders needs and desires. Goal congruence can be achieved by aligning the goals of directors in line with the goals of shareholders.
1.4 Ways to Reduce Agency Problem

Preparing financial statements. Auditing financial statements. Company law. Annual general meeting. Extra ordinary general meeting.
Reward schemes.
1.5 Reward Schemes 1.5.1 Salary

Salary is the most basic form of financial record given to directors and employees. It has no affect on performance and risk management.
1.5.2 Bonus
Bonus is financial reward given to motivate directors and employees in expectation that extra motivation will lead to improved performance. It does not persuade directors to focus on shareholders wealth maximization. It has no affect on risk management to safeguard interest of the shareholders.
1.5.3 Profit Related Pay

Directors remuneration based on profit encourages directors to focus their attention towards generating profit for the shareholders. Profit related pay could lead to directors undertaking excessive risky investment projects, which may be over and above the wish of shareholders. Profit related pay focuses directors attention on short-term performance rather than long-term performance. Financial management objectives are to focus on long-term shareholder wealth maximization.
1.5.4 Share Based Payment

Share based payment is the reward given to directors in the form of shares with a condition to hold those shares for certain period. Share based payment encourages directors to focus their attention on increasing share price. Increase in share price leads to increase in shareholders wealth. It is consistent with the objective of financial management i.e. maximization of shareholders wealth. Share based payment also encourages directors to take controlled risk in line with shareholders expectation.
1.5.5 Share Options

Share options are incentive given to directors to buy shares in the company at future exercise date at pre-determined exercise price.
It encourages directors to increase share price of the company above the exercise price before the exercise date in order to realize gain through buying shares at lower share price than market price at exercise date. Share options direct management attention on primary objective of financial management i.e. maximization of shareholders wealth. Share option also encourages directors to take controlled risk in line with shareholder expectations.
1.5.6 Benefits
Benefits are non-financial reward given to directors and employees. It is given to motivate directors so that work can be performed efficiently.
Example:
A car given to director so he/she can travel to workplace, attend meeting with bankers etc. It does not encourage directors to maximize shareholders wealth.
1.5.7 Pension
Pension is the financial reward as a percentage of basic salary given to directors and employees when they retire. Security of pension funds depends on stability of the organization. Pension may not be realized if organization gets bankrupt. It encourages directors to take long-term view organizational performance. However, it has no contribution towards motivating directors to maximize shareholders wealth.
2 Financial Objectives in Profit Vs Not-for-Profit

Requirement Marks Compare and contrast the financial objectives of a stock 12/11 Q4:d exchange listed company such as Bar Co and the financial 11 objectives of a not-for-profit organisation such as a large charity. Financial objectives in not for profit and public organizations are different from financial objective in profit motive organizations. Profit motive organizations have profitability as its primary objective. It is because profit motive organization is legally accountable to shareholders/owners (primary stakeholder). On the other hand, not for profit organizations do not have profitability as its primary objective. However, not for organizations also need to focus on profitability for meeting day-to-day expenses. Past paper Q.no
Example:
Rent of the premises used as office of the organization. Payment of stipends (remuneration) to volunteers. Not for profit organization may have more than one objective such as providing quality service, providing services to more people, efficient use of funds provided by donors etc. It is because not for profit organization usually exists to provide services to the society. Society involves more than one legitimate stakeholder such as donors, users of services, government, public at large etc. Stakeholders are interest holders, which can affect (claim) or be affected by organizational activities. It becomes difficult to decide which is the primary objective and deciding priority for rest of the secondary objectives. However, profit motive organization may also have objectives other than profit making. These objectives are necessary for achievement of financial objective.
Example:
Increase in number of products offered by organization by 30% in next 2 years. This objective supports the primary objective of profit making. Existing customers may also prefer to buy related goods from the same organization. This will give cross selling (selling more than one product to same customer) benefits to organization. Performance of not for profit organization is usually measured against its ability to provide Value for money (economy, efficiency, effectiveness) to the users of services. However, performance of profit motive organization can also be assessed in terms of value for money. Profit motive organizations must provide value for money to its customers if it has to achieve its financial objectives in short as well as long term.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 33 of 128 Exam Topic 2 FINANCIAL MANAGEMENT ENVIRONMENT
Exam Topic 2
FINANCIAL MANAGEMENT ENVIRONMENT

Sub Exam Topics
S.no Headings
Exam Awareness
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F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 34 of 128 Exam Topic 2 FINANCIAL MANAGEMENT ENVIRONMENT
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 35 of 128 Exam Topic 3 THE NATURE ELEMENTS & IMPORTANCE OF WORKING CAPITAL
Exam Topic 3
THE NATURE, ELEMENTS & IMPORTANCE OF WORKING CAPITAL

Sub Exam Topics
S.no Headings (click the cross reference below for easy navigation) 1 Objectives of Working Capital Management
Exam Awareness
See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 36 of 128 Exam Topic 3 THE NATURE ELEMENTS & IMPORTANCE OF WORKING CAPITAL
1 Objectives of Working Capital Management

Requirement Identify the objectives of working capital management and 12/07 Q4:a discuss the conflict that may arise between them. Discuss whether profitability or liquidity is the primary objective 06/10 Q1:c of working capital management. Working capital management has two main objectives Past paper Q.no Marks 3 4
1.1 Profitability
Profitability is related to the primary objective of financial management i.e. maximization of shareholders wealth. Business must be profitable in the short term to add shareholder value in the long term.
1.2 Liquidity
Liquidity is the ability to meet cash requirements for settling day-to-day expenses such as payment of wages and salaries, electricity bills, office rent etc. Liquidity is essential for survival and long-term profitability of the organization. Failure to meet day-to-day expenses can force organization into dissolution or liquidation by the creditors. Hence, without survival there will be no wealth maximization opportunities available. Profitable may not have enough cash to day-to-day liabilities. It is due to the application of accrual accounting concept to arrive at profit for the year for financial reporting purpose. Profitability and liquidity are two conflicting objectives. Favourable performance at one objective inevitably leads to adverse performance at other objective.
Example:
Maintaining higher cash balance will result in loss of sales to customers. It is due to cash is not used for producing or purchasing finished goods. Effective working capital management depends on achieving a balance between these two objectives.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 37 of 128 Exam Topic 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS
Exam Topic 4
MANAGEMENT OF WORKING CAPITAL ELEMENTS

Sub Exam Topics
S.no 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Headings (click the cross reference below for easy navigation) Download Full Version Download Full Version Download Full Version Download Full Version Download Full Version Download Full Version Factoring Evaluating Proposal for Factoring Invoice Discounting Foreign Trade Receivables Calculating & Commenting Early Settlement Discounts Discounts from Suppliers Economic Order Quantity (EOQ) Model Optimal or Economic Order Quantity (EOQ) Optimal Reorder Quantity with Bulk Purchase Discount Just in Time (JIT)
Exam Awareness
7 Factoring
Requirement Marks Discuss the ways in which factoring and invoice discounting can 06/08 Q3:b 6 assist in the management of accounts receivable. Comment on the financial acceptability of the factors offer and 12/11 Q2:d discuss the possible benefits to Bold Co of factoring its trade 7 receivables. Financial institution providing factoring services is known as factor. Generally, factoring services are provided by insurance companies and banks. Factor takes over organizations sales ledger administration. Factor performs following tasks Assessing creditworthiness of customers both existing and potential. Recording sales transaction and raising invoice. Sending out statements of outstanding debts. Sending reminder letters for debts already overdue or close to due date. Prepare customer age analysis to identify late payers. Follow up customers for recovery of debt and may take legal action if they feel necessary. Usually, factor provides advanced payment of up to 80% against sales made on credit. Rest of the 20% is paid upon receipt of payment. Factor also deducts its flat fee and percentage of interest on advanced payment made by factor. Factoring transfers control of receivable management from organization to factor. Factor can use its own policies and procedures, which can upset customers, particularly those who have to pay their debt now earlier. Factoring service is obtained to improve the account receivable turnover. Factoring is particularly useful for organizations lacking expertise and experience of trade receivable management. Factoring is suitable for small sized organizations that have not enough resources and expertise. Factoring allows organization to direct their skills and resources toward core activities such as making sales to customer without having to worry for payment recovery. Factoring is of two types Past paper Q.no
7.1 Recourse Factoring

In with-resource, factoring factor does not bear the risk of the bad debts.
7.2 Non-Recourse Factoring

In non-resource, factoring factor bears the risk of bad debts.
Exam Support:
Look carefully in the exam which type of factoring (with recourse or without recourse) is under consideration by looking at the information provided in the scenario.
8 Evaluating Proposal for Factoring

Past paper 12/08 Q.no Q2:c Requirement Evaluate whether the proposal to factor trade receivables is financially acceptable. Assume an average cost of short-term finance in this part of the question only. Calculate the value of the factors offer: (i) on a with-recourse basis; (ii) on a non-recourse basis. $ x x x Marks 8
12/11
Q2:c
Performa for evaluating proposal for factoring:

Savings in finance cost of trade receivables (see working 1) Savings in administration cost of sales ledger per year Savings in bad debt expenses (non recourse) per year Total benefit of factoring X Factoring fee per year (see workings 2) (x) Interest cost on cash received in advanced (see workings 3) (x) Total cost of factoring (X) Net benefit/cost of factoring X/(X)
Formulae: Working 1
Working 2 Working 3
Illustration (12/08, Q2: c):
The average variable overdraft interest rate in each year was 5%. The 8% bonds are redeemable in ten years time. A factor has offered to take over the administration of trade receivables on a nonrecourse basis for an annual fee of 3% of credit sales. The factor will maintain a trade receivables
collection period of 30 days and Gorwa Co will save $100,000 per year in administration costs and $350,000 per year in bad debts. A condition of the factoring agreement is that the factor would advance 80% of the face value of receivables at an annual interest rate of 7%.
Required:
Evaluate whether the proposal to factor trade receivables is financially acceptable. Assume an average cost of short-term finance in this part of the question only.
Solution (12/08, Q2: c)

Savings in finance cost of trade receivables per year (see working 1) Savings in administration cost of sales ledger per year Savings in bad debt expenses per year (non recourse) Total benefit of factoring per year 526,000 Factoring fee per year (see working 2) (1,122,000) Interest cost on cash received in advanced per year(see working 3) (49,184) Total cost of factoring per year (1,171,184) Net benefit/cost of factoring per year (644,884) Factoring is not worthwhile on financial grounds because cost of factoring exceeds benefits. $ 76,300 100,000 350,000
Explanation:
In addition, non-financial aspects of factoring as also necessary to be considered such as impact on customers and reaction of shareholders. Shareholders may perceive factoring as lack of expertise of management in controlling trade receivables.
Working 1
Explanation:
Factor has claimed that they will reduce credit period to 30 days. We need to determine new receivable balance for this new credit period.
As discussed earlier, receivable requires to be financed somehow. Therefore, it incurs finance cost, which is the interest payable on overdraft at 5%. That is why; any reduction in receivable balance under this new credit period is savings to the organization at an interest rate of 5%. Interest will be saved at 5% because organization will no longer be required to pay interest to saved amount.
Working 2
Explanation:
Factor has demanded 3% of credit sales as factoring fee. It is possible to come across question in the exam in which factor would demand flat fee.
Working 3
Explanation:
5% of interest rate already been charged by the bank, it has to be incurred regardless of factoring proposal is accepted or not. Therefore, 5% of interest rate is irrelevant for decision-making purpose. Rise in interest rate due to factoring is 2% only not 7% and this 2% is relevant for evaluating proposal for factoring. After factoring average receivable balance of $3,074,000 will be outstanding during the year. Factor will advanced 80% of receivables on which interest is charged at 2% per year. Average receivable balance means receivables balance during the year will rise and fall such as due to seasonal demand for goods or services. However, if we take the average of those balances, then it will be equal to $3,074,000.
Exam Support:
If you are stuck at any stage of the solution, then you should left it and move to the next question. Do so will only result in loss of 1 or 2 marks; you can still earn marks to pass the question. Doing panic will not earn you any marks, it is better to earn marks from elsewhere in that time.
9 Invoice Discounting
Requirement Marks Discuss the ways in which factoring and invoice discounting can 06/08 Q3:b 6 assist in the management of accounts receivable. Invoice discounting is raising cash through pledging sales invoices. In other words, invoice discounting is raising short-term loan by providing sales invoices (Receivable as asset) as security to the invoice discounter (lender). Invoices are used to raise cash at discount. It means cash received will be lower than the total value of invoices. Usually, up to 75% of the invoices value can be received in cash. Invoice discounter returns rest of the amount when customers settle their debts and charges a percentage of interest on cash advanced. To be benefit from invoice discounting, organization must have good quality invoice. It is because invoices represent the security to the invoice discounter. Risk of bad debt rests with the organization. If the customer defaults, organization has to repay the amount advanced by the invoice discounter. Invoice discounting is one off transaction. Each time invoice is discounted represents separate transaction. Unlike factoring, invoice discounting does not takeover administration of sales ledger. Invoice discounting does not setup customers. Customers only become aware of the arrangement when they default. Invoice discounting can be used to raise short-term finance. It can be used by organization having cash flow problem. In practice, those who provide factoring services also provide invoice-discounting services. Past paper Q.no
10 Foreign Trade Receivables

Past paper 06/09 Q.no Q3:c Requirement Discuss how risks arising from granting credit to foreign customers can be managed and reduced. Marks 8
10.1 Problems Involved In Foreign Trade

Foreign trade receivables are considered having higher risk of bad debts In foreign trade, customers are given credit for longer period than in domestic trades. Selling organization may not be able to monitor foreign customers financial position as closely as domestic customers. In the event of default, customers have to be pursued according to their own countries legislation. Foreign trade receivables require higher levels of investment due to cash is invested for longer period before it is received to make another sale transaction.
10.2 Reducing Risks Involved In Foreign Trade 10.2.1 Advance Payment

It is insisting foreign customers to pay cash in advance or on delivery.
Exam Support:
Do not hesitate to write simple and obvious point. Even these points can attract marks in the exams. In addition, there is no negative marking. Therefore, it is better to write down all the points you think as relevant rather than thinking whether to write a particular point or not.
10.2.2
Export Factoring
Export factoring can be used to reduce risk of foreign trade. Export factoring is same as domestic factoring with the only different is that factor is situated overseas in customers country.
10.2.3
Bill of exchange
Bills of exchange are used primarily in international trade, and are written orders by one person to his bank to pay the bearer a specific sum on a specific date. They are not used as often today. A bill of exchange is an unconditional order in writing addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at fixed or determinable future time a sum certain in money to order or to bearer.
10.2.4
Letter Of Credit
Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another.
Letter of credit is demanded by supplier from a customer. Bank guarantees to a beneficiary (supplier) to pay specified sum of money on completion of sales in accordance with agreed term and conditions on behalf on his client (customer). Letter of credit is sent to the supplier, which he/she can use to receive payment and send goods to customer. Bill of laden can be used as evidence of transfer of goods to customer. Issuing letter of credit is costly and time-consuming process. However, it is safer way to carry out foreign transaction. It is not ideal for urgent sales orders.
10.2.5
Credit Insurance
Credit insurance is risk management product used to used cover the risk of default by foreign customers. It covers the risk of default due to bankruptcy, death, deliberate non-payment etc. The cost of insurance is called premium. It can be continuous long-term contract or one off transaction to specific customer.
10.2.6
Barter Trade
Barter trade is receiving goods rather than cash in return for selling goods. Goods are exchanged (despatched) at the same time so it reduces the risk of bad debt.
11 Calculating & Commenting Early Settlement Discounts

Requirement Calculate and comment on whether the proposed changes in receivables management will be acceptable. Assuming that only 12/10 Q3:c 25% of customers take the early settlement discount, what is the maximum early settlement discount that could be offered? Early settlement discount is different from trade discount. Past paper Q.no Marks 6
Early settlement discount is given to reduce finance cost of trade receivables and improve working capital cycle. Early settlement discount is given as percentage of sales. It is given to those who pay early within specified period before usual credit period.
Illustration (12/10, Q3: c):

WQZ Co is considering making the following changes in the area of working capital management: Inventory management
It has been suggested that the order size for Product KN5 should be determined using the economic order quantity model (EOQ). WQZ Co forecasts that demand for Product KN5 will be 160.000 units in the coming year and it has traditionally ordered 10% of annual demand per order. The ordering cost is expected to be $400 per order while the holding cost is expected to be $512 per unit per year. A buffer inventory of 5.000 units of Product KN5 will be maintained, whether orders are made by the traditional method or using the economic ordering quantity model. Receivables management WQZ Co could introduce an early settlement discount of 1% for customers who pay within 30 days and at the same time, through improved operational procedures, maintain a maximum average payment period of 60 days for credit customers who do not take the discount. It is expected that 25% of credit customers will take the discount if it were offered. It is expected that administration and operating cost savings of $753000 per year will be made after improving operational procedures and introducing the early settlement discount. It is expected that administration and operating cost savings of $753,000 per year will be made after improving operational procedures and introducing the early settlement discount. Credit sales of WQZ Co are currently $876 million per year and trade receivables are currently $18 million. Credit sales are not expected to change as a result of the changes in receivables management. The company has a cost of short-term finance of 55% per year.
Required:
Calculate and comment on whether the proposed changes in receivables management will be acceptable. Assuming that only 25% of customers take the early settlement discount, what is the maximum early settlement discount that could be offered?
Solution: (12/10, Q3: c)
Explanation:
Currently customers take 75 days to repay their debts; introduction of early settlement discount will result in 25% of customers paying within 30 days. Therefore, it means those customers that take 60 day on average will be 75%.
Explanation:
Reduction in trade receivable turnover from 75 to 52.5 days will result in decrease in trade receivable level by $5.4m ($18m-$12.6m).
Explanation:
As discussed earlier, trade receivables incurs finance cost, decrease in trade receivable level will require less working capital resulting in savings in finance cost.
Explanation:
Cost of early settlement discount is finance cost for the organization rather than selling and distribution expense, because it is given for reducing the cost of financing trade receivables. $ Savings in finance cost of trade receivables per year 297,000 Savings in administration and operating cost per year 753,000 Finance cost of early settlement discount (219,000) Total benefit of early settlement discount per year 831,000 Maximum early settlement discount is the rate at which benefits of giving early settlement discount becomes zero. 25% of credit sales will receive early settlement discount, which is $21,900,000 ($87,600,000 x 25%). Therefore, maximum early settlement discount that could be offered is 4.8% (100 x (1,050,000/21,900,000). It is because sales revenue could be lowered by 1,050,000 or 4.8% at which benefit will be zero.
12 Discounts from Suppliers

Past paper 06/08 Q.no Requirement Determine whether accepting the discount offered by the Q3:d(ii) supplier will minimise the total cost of inventory for the raw material. Calculate if ZPS Co will benefit financially by accepting the offer of: Q4:(ii) (1) the early settlement discount; (2) the bulk purchase discount. Marks 3
06/11
Illustration (06/11, Q4: b (ii)):

ZPS Co places monthly orders with a supplier for 10,000 components that are used in its manufacturing processes. Annual demand is 120,000 components. The current terms are payment in full within 90 days, which ZPS Co meets, and the cost per component is $750. The cost of ordering is $200 per order, while the cost of holding components in inventory is $100 per component per year. The supplier has offered either a discount of O5% for payment in full within 30 days, or a discount of 36% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding components in inventory would increase to $220 per component per year due to the need for a larger storage facility. Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 45% per year.
Required:
Calculate if ZPS Co will benefit financially by accepting the offer of the early settlement discount.
Solution (06/11, Q4: b (ii)):
Explanation:
Obtaining early settlement discount will result in savings of $4,500 per year. It is considered as finance income.
Note: cost of sales can comfortably be used instead of credit purchase.
Explanation:
Reduction in trade payables will require the use of other source of finance to makeup the short fall in working capital.
Explanation:
Trade payable is usually used as free source of finance because suppliers generally do not charge interest for late payment. Short-term finance will now be used for refinancing working capital, which will give rise to financing (interest) cost. $ Savings from early settlement discount 4,500 Refinancing cost of working capital (6,657) Net benefit/ cost of early settlement discount (2,157) Increase in financing cost exceeds benefits/savings from early settlement discount. Organization will be better by not taking early settlement discount.
13 Economic Order Quantity (EOQ) Model

Past paper 12/07 06/08 Q.no Requirement Calculate the cost of the current ordering policy and determine Q4:b the saving that could be made by using the economic order quantity model. Calculate the total cost of inventory for the raw material when Q3:d(i) using the economic order quantity. Calculate the cost of the current ordering policy and the change in the costs of inventory management that will arise if the Q3:a economic order quantity is used to determine the optimum order size for Product KN5. Marks 7 4
12/10
14 Optimal or Economic Order Quantity (EOQ)

Economic order quantity is the quantity (order size) at which combine cost of inventory ordering and holding is minimized.
14.1 Calculating Economic Order Quantity Formula (given in the formula sheet):
Where Co = ordering cost per order CH = holding cost per unit (for the duration of demand) D = total demand of the period
Illustration (12/07, Q4: b):

PKA Co is a European company that sells goods solely within Europe. The recently-appointed financial manager of PKA Co has been investigating the working capital management of the company and has gathered the following information: Inventory management The current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meet production requirements during the next year is 625.000 units. The cost of placing and processing an order is 250, while the cost of holding a unit in stores is 050 per unit per year. Both costs are expected to be constant during the next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week year and that demand is constant throughout the year.
Required:
Calculate the cost of the current ordering policy and determine the saving that could be made by using the economic order quantity model.
Solution: (12/07, Q4: b)

Total cost under current ordering policy:
Explanation:
Ordering inventory in batches of 100,000 units will require 6.25 (625,000/100,000) orders to fulfil annual demand of 625,000 units.
Explanation:
It is assumed that always half of the inventory ordered will be held in warehouse, which is the average of inventory getting at lower and higher levels during the year. Each unit will require of holding cost per year.
Explanation:
Inventory usage per week is 12,500 (625,000/50) units. If supplier takes 2 weeks then inventory should be ordered when 25,000 (12,500 x 2) units remaining in stock to prevent stock outs. However, supplier may delay delivery or unexpected demand can arise during the lead-time. Therefore, organization has kept 10,000 (35,000-25,000) units as buffer (safety) stock for unexpected situation.
Explanation:
Buffer stock is held in the warehouse during whole year. Each unit of buffer of stock will incur holding cost. Therefore, 10,000 units of inventory has incurred
Total cost under EOQ model:
)(
Explanation:
Orders in smaller quantity than under current ordering policy increased ordering cost by ( ) because of more frequent ordering from 6.25 orders to 25 (625,000/25,000) orders. ( ( ) )
Exam Support:
Previously holding cost of order and buffer stock is calculated separately. However, it can be calculated together to save time in the exam.
Explanation:
Ordering as per EOQ resulted in decrease in holding cost of due to reduction in average inventory level.
). It is
15 Optimal Reorder Quantity with Bulk Purchase Discount

Requirement Marks Calculate if ZPS Co will benefit financially by accepting the offer of: 06/11 Q4:b(ii) 7 (1) the early settlement discount; (2) the bulk purchase discount. EOQ cannot be used when supplier offers bulk purchase discount for ordering above certain quantity. We must find out economical order size through trial and error. If, supplier offers different discount rate for different order size we have to calculate total cost of purchasing for each order size. Past paper Q.no
Formula: Exam Support:

You do not need to calculate total cost of purchasing for evaluating bulk purchase discount for order size below EOQ. Bulk purchase discount will automatically be obtained at EOQ if other order sizes will not result in lower cost than EOQ.
Illustration (06/11, Q4: b (ii)):

ZPS Co places monthly orders with a supplier for 10,000 components that are used in its manufacturing processes. Annual demand is 120,000 components. The current terms are payment in full within 90 days, which ZPS Co meets, and the cost per component is $750. The cost of ordering is $200 per order, while the cost of holding components in inventory is $100 per component per year. The supplier has offered either a discount of O5% for payment in full within 30 days. or a discount of 36% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding components in inventory would increase to $220 per component per year due to the need for a larger storage facility. Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 45% per year.
Required:
Calculate if ZPS Co will benefit financially by accepting the offer of the bulk purchase discount.
Solution: (06/11, Q4: b (ii)) Total purchase cost of current order size at 10,000 units :
Total purchase cost of revised order size at 30,000 units :
( ( )
Savings in obtaining bulk purchase discount is $6,000 (907,600-901,400) per year.
16 Just in Time (JIT)

Requirement Marks Briefly describe the benefits of a just-in-time (JIT) procurement 12/10 Q3:b 5 policy. Just in time in modern inventory management philosophy. It means inventory should only be produced or purchase when there is customer available for it. Ideally, inventory level is assumed $0. However, in practice, some butter stock is maintained to meet unexpected demand. Past paper Q.no
16.1 Benefits
JIT reduces inventory-holding costs. However, it increases inventory-ordering costs but these are not so high because of application of information technology.
Inventory does not generate revenue until it is sold. Cash invested in inventory can be used to earn interest on short-term investments. Inventory occupies floor area. Floor area is valuable asset of the organization, which can be used for producing other products. Inventory possesses a risk of theft and deterioration due to dust, water, fire, storm etc. Inventory may become obsolete or out of fashion as people tastes and behaviour changes over time. Some kind of inventory is perishable in nature such as groceries and chemicals.
16.2 Limitations
JIT is not suitable for organizations operating in health and safety and rescue services sector.
Example:
Stock out of life saving drug in a hospital can be disastrous. In this situation, cost of holding inventory is justified against the risk involved in stock outs. Organization may not be able to meet unexpected demand and suffer lost sales from both existing and potential customer. At worst, customer may turn to buy competitors product and do not return. Efficient operation of JIT depends on reliable suppliers, location and distance of organization premises from suppliers and infrastructure available for communication and delivery of goods.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 56 of 128 Exam Topic 5: DETERMINING WORKING CAPITAL NEEDS & FUNDING STRATEGIES
Exam Topic 5
DETERMINING WORKING CAPITAL NEEDS & FUNDING STRATEGIES

Sub Exam Topics
S.no 1 2 3 4 Headings (click the cross reference below for easy navigation) Cash Management Models Funding Working Capital Requirement Level of Investment in Working Capital Symptoms of Overtrading
Exam Awareness
See PAST EXAM PAPERS ANALYSIS o explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
1 Cash Management Models 1.1 Miller-Orr Model

Past paper Q.no Requirement Renpec Co, a subsidiary of Ulnad Co, has set a minimum cash account balance of $7,500. The average cost to the company of making deposits or selling investments is $18 per transaction and the standard deviation of its cash flows was $1,000 per day during the last year. The average interest rate on investments is 5.11%. Determine the spread, the upper limit and the return point for the cash account of Renpec Co using the Miller-Orr model and explain the relevance of these values for the cash management of the company. ( ) Marks
P/P
Q3:b
Formula (given in the formula sheet):
[ Where;
Return point is ideal level of cash balance, which should be maintained depending on risk, cost and benefits faced by the organization. Interest rate is the Average market interest rate on investments in different marketable securities made by the organization. Variance is the volatility (risk) of cash flows faced by the organization depending on industry in which it operates. Transaction is the cost of buying and selling investments. Spread is the difference between lower limit and upper limit of cash balance. Spread increases with the increase in transaction cost and liquidity risk. It decreases with the increase in average market interest rate on investments. Lower limit is level of cash balance. Level at which lower limit is set depends on risk attitudes of the directors. Cash balance below lower limit represent buffer (safety) cash. According to millerDownload Full Version at: www.accasupport.com. Full Version may have different formatting & pages (270) Copyright 2012 Murtaza Lanewala. All Rights Reserved | Be An Affiliate
orr model lower limit is the level below which cash balance should not fall. Organization has to sell investments to increase cash balance to reach return point. Falling of cash balance below lower limit will increase liquidity risk to the organization to an unacceptable level. However, organization will be earning more interest on investments at same time. Upper limit (lower limit + spread) is the size of spread above the lower limit. According to millerorr model upper limit is the level above which cash balance should not rise. Organization has to buy investments to use decrease cash balance to return point. Rising of cash balance above upper limit will result in opportunity cost to the organization because of cash is not being invested to earn interest. However, organization will have decreased liquidity risk.
1.1.1 Benefits
Miller or model based on the basic objective of working capital management. It helps organization to achieve a balance between profitability and liquidity. It incorporates risk associated with cash flows of the organization. In practice, cash flows are not constant; instead, they vary with day-to-day operations of the organization. It gives the range in which cash balance should be maintained rather than exact amount.
1.1.2 Limitations
This model is very complex and rationale behind this model and formula used is difficult to explain to non-financial managers (CEO & Chairman). Average market interest rate may range from time to time as organization changes its portfolio of investments. In that cases miller Orr model will result in frequent changes in return point, spread and upper limit. Organizations still in growth stage may undertake new investment projects which may change cost structure (variable to fixed ratio) resulting in change in business risk (liquidity risk). This will change standard deviation and variance. Therefore, return point, spread and upper limit will change. Frequent changes in spread will increase cost of cash management. Benefits not exceed cost.
1.2 Baumol Model

Baumol model assumes cash management is similar to inventory management. Baumol model uses same approach to cash management.
Formula:
Where Q = Economical quantity of cash to be raised. C = Selling cost per transaction for selling investments. S = Demand for cash to be spent in particular period such as Year or Quarterly. I = Opportunity cost (loss of interest) of holding cash.
1.2.1 Benefits
Baumol formula is simple and easy to use. It is easier to explain to non-financial managers to secure their commitment to cash management. For the purpose cash management, Baumol is less costly than miller Orr model is. It is suitable for smaller organizations having lesser resources, time and experience.
1.2.2 Limitations
Cash requirement for particular period may be difficult to estimate with accuracy. Inflation rate can change during the period, which will then require more or less cash than previously estimated. It gives particular amount which organization should sell to raise cash to minimize combined cost of selling investments and holding cash to regular intervals. However, it does not account for current liquidity position (cash needs) of the organization. It does not consider liquidity risk associated with cash flows generated by the organization. No allowance for buffer cash is made in Baumol model.
2 Funding Working Capital Requirement

Past paper P/P 06/09 12/09 Q.no Q3:d Q3:a Q4:c Requirement Discuss the key factors to be considered when formulating a working capital funding policy. Discuss the working capital financing strategy of HGR Co. Analyse and discuss the working capital financing policy of APX Co. Marks 7 7 6
Exam Support:
The word analyse (see 12/09) suggests that you have to calculate ratios identifying relationships between data provided in the question. Look carefully for the word AND. It suggest more than one requirement is present in same sentence. In this case analyse AND discuss are two requirements in the same sentence. For working capital management purpose, assets are divided into three categories
2.1 Non-Current Assets

These assets are not brought for resale. These assets are not subject to frequent change and so it is out of the scope of working capital management.
2.2 Permanent Assets

Permanent assets are the minimum level of investment in working capital necessary to finance trade receivables and inventory under normal conditions. Requirement for permanent assets stable overtime until a major macroeconomic change take place.
2.3 Fluctuating Assets

Fluctuating assets are the level of investment in working capital necessary to cope with seasonal and random demands, delays in amount received from customer etc. Requirement for fluctuating assets constantly change to time-to-time. Selection of sources of finance affects profitability and liquidity of the organization, which are two main objectives of working capital management. Long-term sources of finance are expensive to obtain as lenders demand more compensation for increased level of risk to the lender. Risk increases with the duration of credit. However, it is less risky for the borrower in the form of increased certainty of availability and protection against rise in interest rate. Short-term sources of finance are less expensive and more risky for the borrower as renewal of credit can be denied and interest rate can rise. It is subject to higher liquidity risk.
2.4 Matching Policy

It states that organization should match nature of asset with the duration of finance (short or long term). Permanent assets that do not change from time to time should be matched with long-term sources of finance such as share capital, bonds and long-term loan. Fluctuating assets that change frequently should be matched with short-term sources of finance such as overdraft, short-term bank loan, trade payables etc. In addition, there are two extreme working capital funding policies. Organization can position itself between these two policies depending on their circumstances.
2.5 Aggressive Working Capital Policy

Aggressive working capital policy attempts to finance some of the permanent assets using longterm sources of finance while rest of the permanent assets and fluctuating assets are financed by using short-term sources of finance. Suppliers are used as source of free finance as usually it does not involve interest payment to suppliers. However, taking longer periods can erode profitability as supplier may charge higher prices for goods or services offered and in extreme situation denial of further credit. Customers are offered short credit terms and inventory is kept to a minimum level. This approach increases risk but it is more profitable as it requires lower amount of working capital to finance sales. Overdraft facility is used to its maximum limits and interest is paid at the end of due date. However, it is risky as it is repayable on demand and facility can be discounted at any time. Aggressive policy is more risk and more profitable than matching and conservative policy.
2.6 Conservative Working Capital Policy

Conservative working capital policy attempts to finance whole of the permanent assets and some of the fluctuating assets using long-term sources of finance. While, rest of the fluctuating assets are financed using short-term sources of finance. Customers are offered generous credit terms to attract more customers. Inventory levels are kept high to avoid the risk of stock outs and suppliers are paid in time to ensure fluent supply of raw materials. This approach reduces risk but also erodes profitability, as it requires higher amount of working capital to finance sales. Conservative policy is less risky and less profitable than matching and aggressive policy.
3 Level of Investment in Working Capital

Past paper 06/08 06/11 Q.no Requirement Discuss the key factors which determine the level of investment Q3:a in current assets. Discuss the factors that influence the formulation of working Q4:b(i) capital policy; Marks 6 7
3.1 Length of Working Capital Cycle

The working capital cycle is the period between cash paid to suppliers and cash received to customers. During this period, cash is needed for payment of expenses regarding materials, labours and factory overhead. As the length of this period increases amount of working capital requirement also increases.
3.2 Terms of Trade

Terms of trade includes credit period offered to customers, interest charged on late payment, early settlement discounts etc. Organization that is offering more generous terms of trade requires more working capital than its competitors offer.
3.3 Risk Acceptability of Organization

As discussed earlier, organizations can have aggressive and conservative policies of working capital management. Adoption of these policies depends on risk acceptability of organization. Aggressive policy requires more investment in working capital and conservative policy requires less investment in working capital.
3.4 Industry in Which Organization Operates

Different industries take different length of time to manufacture products. Suppliers require their payment according their own credit terms and it may not recover the period of manufacturing. Remaining period manufacturing needs to be financed by investment in working capital.
Example:
Construction industry takes very long time before raw materials are converted into finished goods and cash is received from customers. They need large amount of cash for investment in raw materials, payment of wages etc. These cash flow needs are partly financed by delaying payments to suppliers to raw materials. Supermarkets on the other hand take very short time to sell goods to customers from the date of purchase. They receive credit form suppliers and sell their goods mostly on cash with very few credit sales.
4 Overtrading & Undertrading

Requirement Marks Use the above financial information to discuss, with supporting 12/08 Q2:b 10 calculations, whether or not Gorwa Co is overtrading. Analyse and discuss the forecast financial performance of APX Co 12/09 Q4:d 6 in terms of working capital management. Overtrading is trying to achieve higher level of sales revenue with relatively lower level of investment (from long term sources of finance) in working capital to finance sales. Overtrading is often referred to as over capitalization. Undertrading is generation of lower level of sales revenue with relatively higher level of investment (from long-term source of finance) in working capital. Under trading is often referred to as under capitalization. Overtrading increases the liquidity risk and increases the profitability. However, failure to discharge obligations when they fall due may force the company into liquidation. Shareholders may not realise equal wealth as they would realise by selling company as going concern. Undertrading organizations faces decreased liquidity risk and decreased profitability. Under trading is opposite to overtrading. Both represent extreme viewpoint regarding working capital performance. In practice, organizations tend to be found between these two positions. Past paper Q.no
4.1 Symptoms of Overtrading 4.1.1 Working Capital to Sales Ratio

Working capital to sales ratio determines the amount of working capital used to finance sales. Increase working capital to sales ratio means organization is try to achieve growth at faster rate than finance available.
4.1.2 Increase in Trade Receivable Turnover

Increase in receivable turnover in days suggests organization is relaxing credit terms to attract more customers. Relaxing credit terms requires higher investment in trade receivables (working capital)
4.1.3 Increase in Inventory Turnover

Increase in inventory turnover in days suggests organization is building up inventory to meet increasing demands for goods to generate sales revenue. Building up inventory will require more investment in working capital.
4.1.4 Increase in Trade Payable Turnover

Increase in trade payable turnover suggests organization is delaying payment to suppliers using trade payable as free source of finance. Using trade payables (as short-term source of finance) to finance sales will reduce requirement for investment in working capital. However, delaying excessively beyond due date can result in loss of credit rating among suppliers. Suppliers may refuse to supply or may charge higher mark up.
4.1.5 Overdraft
Over draft is short-term source of finance. It can be discontinued by the bank at any time leaving organization with shortage of cash flows required to meet daily expenses. Using overdraft to its maximum limit increases liquidity risk to the company. If overdraft (negative) balance is consistently high year after year then it suggests that organization is dependent on overdraft for financing sales. Excessive reliance on overdraft leads to overtrading.
4.1.6 Liquidity Ratios

Lower liquidity ratios such as current asset ratios and quick assets suggest the level of current assets available for the settlement of liabilities. Shortage of current assets will require organization to sell its valuable fixed assets. Selling fixed asset in hurry may not realise its market value. In addition, it will reduce ability to generate sales revenue in future because of decreased production capacity. Symptoms of under trading are opposite to the symptoms of overtrading.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 65 of 128 Exam Topic 6: THE NATURE OF INVESTMENT DECISIONS & THE APPRAISAL PROCESS
Exam Topics 6
THE NATURE OF INVESTMENT DECISIONS & THE APPRAISAL PROCESS

Sub Exam Topics
S.no Headings (click the cross reference below for easy navigation) 1 Capital Investment Process
Exam Awareness
1 Capital Investment Process

Past paper 06/09 Q.no Q2:a Requirement Identify and explain the key stages in the capital investment decision-making process, and the role of investment appraisal in this process. Marks 7
Exam Support:
marks per point are available for just identifying each stage and remaining marks can be obtained by explaining these points. If you are running out of time, you can get quick marks through listing these stages. Five stages for capital investment decision-making process are as follows:
1.1 Identifying Investment Opportunities

Identifying investment opportunities depends on analysing opportunities and threats in the macroenvironment and strengths and weaknesses of the organization. Frameworks such as PESTEL and 4ms of economics are particularly useful.
1.2 Screening Investment Proposals

In case of more than one investment opportunity available, organization has to choose most attractive proposals to utilize its resources in most efficient manner. Screening investment proposals with respect to current strategic position of organization in the macro-environment, amount of finance required to undertake the proposal, level of payback period (see later) required etc could be taken into account.
1.3 Analysing & Evaluating Investment Proposals

Investment proposals are examined for their ability to maximize shareholder wealth using investment appraisal techniques such as NPV and IRR (see both later). Investment proposals are also examined for risk using sensitivity analysis, probability analysis etc.
1.4 Approving Investment Proposals

Once investment proposals selected, they must approved from relevant level of authority. Approval of investment proposals are part of internal control system to ensure that investment proposals are rigorously tested using formal policies and procedures. Proposal involving significant value may require approval from board of directors while small proposal can be approved at divisional level.
1.5 Implementing, Monitoring & Reviewing Investments

Implementing investment proposal takes time depending on its size, complexity and level of change required in existing culture.
Investment proposals should be monitored during implementation stage to ensure that it delivers expected benefits and difficulties faced should be resolved quickly to minimize unexpected delay. Once implementation is completed, it should be reviewed against expected results and followed up to maximize the benefits from the proposal. Experience and knowledge gained should be used to update decision-making process so that future proposal can be evaluated more effectively.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 68 of 128 Exam Topic 7: NON DISCOUNTED CASH FLOW TECHNIQUES
Exam Topic 7
NON DISCOUNTED CASH FLOW TECHNIQUES

Sub Exam Topics
S.no 1 2 3 4 Headings (click the cross reference below for easy navigation) Return on Capital Employed (ROCE) Calculating Return on Capital Employed (ROCE) Payback Period Calculating Payback Period
Exam Awareness
1 Return on Capital Employed (ROCE) Exam Support:

You may have learned ROCE in paper F5 Performance Management. Now, you are learning for paper F9 Financial Management. Therefore, you are expected to discuss its impact on financing decisions rather than performance of an individual manager or employee. It determines efficiency with which capital used to finance the investment proposal is used to generate profit. Return on capital employed is the relative measure for investment appraisal. ROCE determined for investment proposal needs to be compared against benchmark to appraise financial acceptability of the proposal for the organization. Benchmark can be Organizations existing years ROCE. ROCE from previous similar projects. ROCE of the competitors etc. Cost of capital (see later).
2 Calculating Return on Capital Employed (ROCE)

Past paper P/P Q.no Q4:b Requirement Calculate the before-tax return on capital employed (accounting rate of return) based on the average investment and comment on your findings. Calculate the following values for the investment proposal: (i) net present value; (ii) internal rate of return; (iii) return on capital employed (accounting rate of return) based on average investment; and (iv) discounted payback period. Marks 5
06/09
Q2:b
13
3 Payback Period
Payback period is time required by an investment proposal to recover capital invested in the project. Payback period reflects the risk involved in investment proposals. Proposals having longer payback period are more risky than proposals having shorter payback period. As the macro-environment are more likely to change between the of investment recovery period.
Payback period can be used as screening device for investment proposals competing for limited capital available. To make an investment decision based on payback period we must have some benchmark against which payback period can be appraised. These can be the following: Payback period of competing investment proposals. Payback period decided by board of directors. Payback period of similar projects undertaken by the competitor.
4 Calculating Payback Period

Past paper Q.no Requirement Directors views on investment appraisal The directors of CJ Co require that all investment projects should be evaluated using either payback period or return on capital employed (accounting rate of return). The target payback period of the company is two years and the target return on capital employed is 20%, which is the current return on capital employed of CJ Co. A project is accepted if it satisfies either of these investment criteria. The directors also require all investment projects to be evaluated over a four-year planning period, ignoring any scrap value or working capital recovery, with a balancing allowance (if any) being claimed at the end of the fourth year of operation. Critically discuss the directors views on investment appraisal. Marks
12/10
Q1:b
Illustration:
An organization is considering investment in project requires an initial investment of $1,000,000. Organization expects following cash flows during its project life. Years 1 Cash flows $(000) 200,000 Discount rate for the period is 10%. 2 400,000 3 500,000 4 300,000 5 100,000
Financial directors have said that any investment undertaken should not exceed 3 years period. Assume cash flow accrues evenly over 5 years period.
Required:
Calculate discounted payback period and comment on the acceptability of project.
Exam Support:
Do not be confused if exam question states the assumption that cash flow accrues evenly during the period. It is given to test your command over the topic.
Solution:
Cash flows Discount payback Years $(000) $(000) 0 (1,000) (1,000) 1 300 300 (700) 2 600 600 (100) 3 500 500 400 4 300 5 100
Explanation:
Payback period completes when first positive cash flow is incurred. In this case, payback period is completed after year 2 and before 3 completion of year 3 because after year 2 $100,000 are required to complete payback period which is incurred in 2.4 months after completion of 2 year.
Comment:
Payback period is 2 years and 2.4 months, which is below the minimum payback period of 3 years required by the finance director. Therefore, project is acceptable to the organization.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 72 of 128 Exam Topic 8: DISCOUNTED CASH FLOW (DCF) TECHNIQUES
Exam Topic 8
DISCOUNTED CASH FLOW (DCF) TECHNIQUES

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F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 73 of 128 Exam Topic 8: DISCOUNTED CASH FLOW (DCF) TECHNIQUES
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 74 of 128 Exam Topic 9: ALLOWING FOR INFLATION &TAXATION IN DCF
Exam Topic 9
ALLOWING FOR INFLATION & TAXATION IN DCF

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F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 75 of 128 Exam Topic 9: ALLOWING FOR INFLATION &TAXATION IN DCF
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 76 of 128 Exam Topic 10: ADJUSTING FOR RISK & UNCERTAINTY IN INVESTMENT APPRAISAL
Exam Topics 10
ADJUSTING FOR RISK & UNCERTAINTY IN INVESTMENT APPRAISAL

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F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 77 of 128 Exam Topic 10: ADJUSTING FOR RISK & UNCERTAINTY IN INVESTMENT APPRAISAL
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 78 of 128 Exam Topic 11: SPECIFIC INVESTMENT DECISIONS
Exam Topic 11
SPECIFIC INVESTMENT DECISIONS

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F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 79 of 128 Exam Topic 11: SPECIFIC INVESTMENT DECISIONS
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 80 of 128 Exam Topic 12: SHORT & LONG TERM FINANCE
Exam Topic 12
SHORT & LONG TERM FINANCE

Sub Exam Topics
S.no 1 2 3 Headings (click the cross reference below for easy navigation) Short Term Sources of Finance Download Full Version Download Full Version
Exam Awareness
This exam topic is mostly theoretical. Knowledge of this exam topic is always required every exam session. It provides background knowledge to enable you to understand information given in the scenario based question and perform calculations for requirements related to other exam topics more effectively. It builds the basic knowledge required for effective evaluation and discussion of various sources of finance. See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
1 Short Term Sources of Finance

Duration of sources of finance is decided based on period lapse between date of issue and date of redemption.
1.1 Account Payables

Supplier usually grants credit for 30 day to 90 days. Account payables are considered as free source of finance. Suppliers usually do not charge interest on overdue accounts. However, exceeding credit period can damage credit rating of the organization. Organization may find difficult to obtain credit in future. Suppliers can charge higher prices for goods or services offered and ultimately refuse to supply to the organization.
1.2 Overdrafts
Overdraft is the facility provided by banks to companies. In which companies are allowed to withdraw more money than balance available in their accounts to the extent of credit limit. Banks charge interest on the overdrawn amount. Overdraft is classified as current liability even if it is stated on balance sheet year after year because it is constantly fluctuating. Overdraft has impact over liquidity ratios, working capital and profitability ratios. Overdrafts are repayable on demand in theory. Overdrafts are considered cheap sources of finance because of its short-term maturity. However, it is also risky as bank may charge higher interest rate and can reduce credit limit. It is also extremely flexible as organization only incurs interest expense for the period and extent account balance is overdrawn. No need of finance, no need to pay interest. It can be used to finance seasonal sales and to meet unexpected demand.
1.3 Short Term Loan

Short-term loan can be provided by banks and other financial institution. Short-term loan can be secured and unsecured. Unsecured loan are expensive in that it requires higher interest payments to compensate lender for increased risk. Short-term loan less flexible as once loan is advanced organization has to pay interest on amount borrowed whether they need cash or not. Even if organization wishes to pay early, it may also have to pay penalties for early termination of contract to compensate lender.
Short-term loan provides certainty that it will not be demand till specified period. This certainty is not available in overdraft.
1.4 Operating Lease

Operating lease is suitable for financing non-current assets to meet temporary demand (see earlier text for details).
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 83 of 128 Exam Topic 13: INTERNAL SOURCES OF FINANCE & DIVIDEND POLICY
Exam Topics 13
INTERNAL SOURCES OF FINANCE & DIVIDEND POLICY

Sub Exam Topics
Exam Awareness
This exam topic is mostly theoretical. However, you may be required to perform minor calculations to support your answer. Dividend policy is important & frequently examined area of paper F9 financial management. This is enforced by rationale of the syllabus given in study guide. Dividend policy has implications for financial and investment decisions so it can be examined in variety of ways individually or accompanied with other exam topics. See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 84 of 128 Exam Topic 13: INTERNAL SOURCES OF FINANCE & DIVIDEND POLICY
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 85 of 128 Exam Topic 14: GEARING & CAPITAL STRUCTURE CONSIDERATIONS
Exam Topic 14
GEARING & CAPITAL STRUCTURE CONSIDERATIONS

Sub Exam Topics
Exam Awareness
This exam topic is calculation as well as knowledge based. Key skill to achieve is the ability to evaluate various sources of finance. Evaluation requires discussion on proposal under consideration and performing calculations, such as ratios, cost benefit analysis etc, in support of discussion. It is amongst the most frequently examined topics and it can attract significant marks in exams. See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 86 of 128 Exam Topic 14: GEARING & CAPITAL STRUCTURE CONSIDERATIONS
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 87 of 128 Exam Topic 15: FINANCE FOR SMALL & MEDIUM SIZED ENTITIES (SMEs)
Exam Topic 15
FINANCE FOR SMALL & MEDIUM SIZED ENTITIES (SMEs)

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S.no Headings (click the cross reference below for easy navigation)
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F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 88 of 128 Exam Topic 15: FINANCE FOR SMALL & MEDIUM SIZED ENTITIES (SMEs)
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 89 of 128 Exam Topic 16: ESTIMATING COST OF CAPITAL
Exam Topic 16
ESTIMATING COST OF CAPITAL

Sub Exam Topics
S.no 1 2 3 4 5 6 7 8 9 Headings (click the cross reference below for easy navigation) Weighted Average Cost of Capital (WACC) Calculating Market Value of Equity & Debt Cost of Equity Systematic Risk & Non Systematic Risk Capital Asset Pricing Model (CAPM) Gearing & Ungearing Betas Benefits & Limitations of CAPM Calculating Cost of Debt Calculating Weighted Average Cost of Capital
Exam Awareness
It can be examined in situation of organizational change such as takeovers, entering new markets and launching new products. See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams. .
1 Weighted Average Cost of Capital (WACC)

Weighted average cost of capital is the minimum level of return it must generate to fulfil the demands of finance providers. WACC is the combined average of the cost of debt, equity and preference shareholders. Preference shares are rarely used as a source of finance; therefore, WACC formula does not include cost of preference share capital. However, it can be modified to account for the cost of preference share capital. Sources of finance used by the organization can be in different ratios. Cost of different sources of finance can be different. In addition, debt attracts tax benefit so the cost of debt is reduced by the percentage of tax rate. We need to account for the portion of finance attracts tax relief. Therefore, cost of capital is weighted in the ratio of different type of capital issued by organization. Market value of securities either equity or debt are used to weight cost of capital. Market value of securities can fairly be used to weight the cost of capital because finance providers demand return on the amount of capital invested in the securities of the organization. If finance providers demands increased return then market value of securities will decrease. If finance providers demands decreased return then market value of securities will decrease. The later will happen if finance providers will perceive decrease in risk of investment in the company.
2 Calculating Market Value of Equity & Debt Formulae:
Illustration:
Equity capital of an organization is $250,000. Par value of each share is $0.25. In addition, organization has share premium of $50,000 in its balance sheet. Debt capital of an organization is $800,000. Par value of each loan note or bond is $100. Bank loan of $100,000 is recognized in the statement of financial position of previous year. Equity shares are currently quoted in stock exchange at price $0.5.
Bond can be brought or sold in the market at price $105.
Required:
Calculate the market value of equity and debt.
Solution:
Market value of bank loan will be same as book value $100,000 because it is the amount to be paid to the bank operating in the market. Market value of bank loan is always its book value or carrying value.
Exam Support:
Share premium is always ignored because it will increase the actual number of shares issued by the company.
2.1 Benefits & Limitations Of WACC 2.1.1 Benefits

WACC takes account of both equity and debt finance used to finance investment proposals. WACC takes account of financial risk faced by the organization with respect to market value. Par value does not reflect underlying value of the assets of the organization due to inflation. WACC determines the average cost of capital for portfolio of investment projects currently undertaken by the organization. Same investments may have higher cost of capital while some have lower cost of capital than average cost of capital (WACC). It recognizes that investments should be evaluated with average cost of capital rather than cost of capital for the particular
investment because investors consider overall performance of the organization rather than particular investment project.
2.1.2 Limitations
WACC is not suitable for investment appraisal purpose when new investment project significantly change financial risk (financial gearing) and business risk (operational gearing). This will change cost of equity and cost of debt (see later) significantly as result existing WACC will not reflect average risk and therefore cost of capital after undertaken investment project. In that case, revised WACC needs to be calculated for investment appraisal purpose. Other method is to use CAPM project specific cost of capital (see later) for investment appraisal purpose. WACC is not suitable for growing organization. Growing organization has to raise finance more frequently. In addition, WACC is not suitable for organization pursuing diversification strategy. Diversification involves entering into new market segment and new product at the same time. This will change business risk significantly.
3 Cost of Equity
Cost of equity is the rate of return on investment in ordinary shares required by the shareholders. Equity is irredeemable in nature therefore; cost of equity represents the return required by investors till perpetuity. Cost of can be calculated using following two models Dividend growth model. Capital asset pricing model.
3.1 Dividend Growth Model (DGM)

Dividend growth model is used to estimate cost of equity.
Formula:
Where Ke = cost of equity. Do = current year dividend. g = dividend growth rate.

Po = ex-dividend market share price.
Exam Support:
If you are given cum dividend share price then you should deduct current dividend payable from cum-dividend share price. ( ) ( )
If you are given future dividend payable instead of current dividend payable then modify the formula as follows:
Formula:
Where: D1 = Dividend in very next year
Illustration:
An organization has declared dividend in current year of 25 cents per share. Dividends has average growth during last five years is 5% per year. Recent market share price of the company after the announcement of dividend is $3.5 per share.
Required:
Calculate cost of equity.
Solution:
( ) ( ( ( ( Or ) ) ) )
3.2 Calculating Growth Rate 3.2.1 Average Growth Rate Formula:

Where n = No of growth years Dividends were from year 2001 to 2012 amounts to 11 growth years. Growth years accrue with the passage of time therefore 1st growth year is completed with the passage of 12 months at the first day of 2002. Dividends can have increasing or decreasing trend. Increasing trend implies growth while decreasing trend implies decline. If latest dividend to earliest dividend ratio is > 1, then it suggests dividend growth. If latest dividend to earliest dividend ratio is < 1, then it suggests decline in dividend and it will result in negative rate of decline in dividends.
Illustration:
Dividends paid during last five years are as follows Years 1 2 3 4 5 Dividends $10,000 $12,000 $16,000 $14,000 $17,000 There are 100,000 no of share in issue since year1. There is no subsequent issue or repurchase of share to date. Par value of the shares issued is $0.5 per share.
Required:
Calculate the average dividend growth rate.
Solution:
3.2.1.1 Limitations
It does not consider dividends between earliest and latest dividends. Latest year dividend can be exceptionally high and earliest year dividend can be exceptionally low. In case, it will overstate cost of equity if used in the dividend growth model. New companies may not have previous year dividend information to apply this formula. It does not take account of future dividend policy of the company. It assumes dividend grows at even rate.
3.2.2 Gordons Growth Rate Formula:

Where g = Growth rate per year b = Rate of return expected on future investments. r = Retention ratio (opposite to payout ratio)
Retention ratio is the amount of earnings not distributed as dividends (retained) out of total earnings.
Exam Support:
If you are given payout ratio then you should deduct payout ratio from 1 or 100%. Rate of return can be internal rate of return (IRR) of existing investment or it can be return on capital employed (ROCE).
Illustration:
Organization has dividend policy of 40% dividend each year out of Profit after tax. Organization has return of capital employed of 18%.
Required:
Calculate dividend growth rate.
Solution:
3.2.2.1 Limitations
Using rate of return generated by existing investment may not representative of future investments. Dividend policy can change in future leading in change in retention ratio.
Exam Support:
Benefits of one (Average growth rate) could be used as limitations of other technique (Gordon growth rate). Similarly, limitations of one could be used as benefits of other technique.
3.3 Benefits & Limitations Of DGM

Past paper 12/11 Q.no Q3:b Requirement Discuss the weaknesses of the dividend growth model as a way of valuing a company and its shares. Marks 5
3.3.1 Benefits
Cost of equity can be easily calculated from readily available data published is financial statements. Dividend growth model uses market share price. Market share price incorporates financial as well as non-financial factors considered in investment decision by investors. It directs management attention to maximize market share price of the company because decrease in share price will increase cost of equity.
3.3.2 Limitations
It ignores market risk associated with the company. This model is so complex that cost of equity calculated using this model could be difficult to explain to the non-financial directors. Dividend growth model estimates cost of equity based on historical data such as average of past growth rates. It takes no account of current and future market conditions. Price share price fluctuates constantly. Therefore, it is difficult to select the market share price.
Private limited companies are not quoted in stock market. Therefore, their share price needs to be determined using similar quoted company share price. Newly established companies may not have enough historical data for calculating average dividend growth rate. Newly established companies usually pay lesser dividends as investments take time to generate cash flows. Therefore, cost of equity calculated may be higher than it should be.
3.4 Assumptions
It assumes that dividend as the only factor, which influence share price. Higher dividend payment will lead to higher share price. However, some investors prefer capital tax gains rather than dividends due to their tax position. It does not incorporate tax position of investors. Higher rate taxpayers may want to defer dividend payments to defer tax liability. As in times of inflation, value of tax liability decreases with time. However, Low rate taxpayers may be dependent on dividends to meet their living expenses. Dividend growth model assumes that current year dividend will grow at constant rate till infinity. However, in practice dividend growth rate fluctuates widely according to market conditions. Dividend growth rate is the average growth rate calculated using dividend payment in previous years. It may happen that in previous years dividends did not grown at constant rate. It is assumed that company will have sufficient earnings growth till infinity to maintain current growth rate of dividends. However, growth rate decrease with the age of the company because best possibilities for growth have already been exploited. It assumed that finance can be raised at any time without incurring issue cost. Therefore, there is no need to retain cash. It assumes that all investors have equal knowledge and will take decision on financial basis. However, investors also take decision on emotionally.
Example:
Investor may prefer investment in company, which behave in socially responsible way such as sponsoring sporting event and donation to charities. Dividend growth model assumes cash flow till perpetuity which it inconsistent with the nature of business. Business is an economic activity for a finite duration. Despite its numerous weaknesses, it is frequently used model in practice.
4 Systematic Risk & Non Systematic Risk 4.1 Systematic Risk

Systematic risk (market risk) is the risk of volatility in cash flows. Systematic risk increases with the increase in gearing or financial risk as gearing (debt/equity) makes cash flows more volatile. In addition, market risk arises due to operating in particular industry.
Example:
Fashion industry is subject to greater market risk. As public will curtail their consumption in times of economic recession and will spend more on fashion goods after fulfilling their basic needs in times of economic boom. On the other hand, farming industry is less risky as public have to eat in order to live. Therefore, farming industry has even cash flows while fashion industry has volatile cash flows. Systematic risk arises due to factors external to the organization.
Example:
Increase in inflation rate, increases interest rate that reduces profitability and so share price. Systematic risk cannot be eliminated or reduced as it affects every organization in the macroenvironment.
Example:
Change in political conditions due to change in government affects every organization equally. Increase in income tax rate will effect each organization equally. Investors must be compensated for systematic or market risk.
4.2 Non Systematic Risk

Non-systematic risk arises due to internal affairs of the company. Non-systemic risk is related to operational efficiency of the organization therefore, it includes business risk (operational gearing).
Example:
Labour strike can lead to idle time cost and decreases profitability. Non-systematic risk can be diversified (spread) by investing in number of different companies and so it is not considered in investment decision making.
5 Capital Asset Pricing Model (CAPM)

Requirement Calculate a project-specific cost of equity for Project B and 12/10 Q1:c explain the stages of your calculation. Capital asset pricing model is considered superior to dividend growth model. Past paper Q.no Marks 6

( Where: Ke = Cost of equity. Rf = Risk free rate of return. Rm = Market rate of return. e = Equity beta. )
5.1 Risk Free Rate Of Return

It can be the interest rate given on government securities such as treasury bonds, saving certificates etc. It will be given in the exam or you will be given cash flows to determine risk free rate of return.
5.2 Market Rate Of Return

It is the average rate of return expected by investors. It will be always given in the exam.
5.3 Equity Risk Premium (
Equity risk premium is the difference between market rate of return and risk free rate of return. It is the additional compensation, which is given to investors in exchange for additional risk faced by the investors to encourage them to invest in equity shares. Equity shares are considered more risky than government securities (debt) considered as risk free.
5.4 Equity Beta

Equity beta takes account of market risk (systematic risk) associated with investment in shares of particular company. Companies facing greater market risk enjoy higher profits in time of economic growth (boom). Therefore, their share price increases with higher percentage than market average and in times of economic decline (recession) share price decreases with higher percentage than market average due to lower profits.
Equity beta of 1 is neutral. It means company is facing market risk equal to other companies listed in stock market. Equity beta higher than 1 suggest company is facing higher market risk than other listed companies. Equity beta, lower than 1 suggest company is facing lower market risk than other listed companies. Equity beta can never be less than $0 because company cannot face lower risk than nothing. Higher the equity beta, higher the market risk and cost of equity will be.
Exam Support:
If exam question allows for calculating cost of equity using both, dividend growth model and capital asset pricing model then you should use capital asset pricing model as it provides more rational basis for determining cost of equity. Equity beta may or may not be given in the exam. In later case, you have to calculate equity beta by gearing beta asset given in the exam.
Illustration:
Rate of return offered on treasury bills is 5%. Rate of return demanded by market is 11% on average. Organization deals in fashion goods therefore it has equity beta 1.9, which considered as very high.
Required:
Calculate the cost of equity using information given.
Solution:
( ( ) )
6 Gearing & Ungearing Betas

Geared beta is called equity beta as it includes the affect of financial gearing or risk as well as market risk (systematic risk). While ungeared beta is called beta asset as it only includes market risk without considering financial gearing or risk.

[ Where a = Asset beta (ungeared). e = Equity beta (geared). d = Debt beta. Ve = Market value of equity. Vd = Market value of debt. t = tax rate ( ) ] [
( (
) )
Debt is assumed risk free; therefore, debt beta (d) is taken as $0. This will reduce to formula to: [ ( ) ]
You may be given equity beta of other similar company. In that case, you have to un gear equity beta to find asset beta, then asset beta will be geared to determine equity beta. Above formula will be manipulated as follows: [ ( ) ]
Illustration:
Organization is considering investment in new product. It has existing debt to equity ratio of 120% Equity beta of another organization operating in same industry is 1.5. However, it has different gearing level of 140%. Debt is assumed risk free in the jurisdiction in which organization operates. Therefore, debt beta is 0. Tax rate in the jurisdiction is 30%.
Required:
Calculate equity beta for the organization.
Solution:
Step1: Ungearing equity asset of similar organization. [ [ [ [ ] ( ( ] ) ) ] ]
Explanation:
Asset beta of 0.757 is lower than equity beta of 0.757 as it excludes financial gearing and risk. Debt to equity ratio of 140% means equity is 100% and debt is 140%. Financial gearing ratios can be used reasonably in place of market value of equity and market value of debt. It is because market values of equity and debt is calculated to account for financial gearing or risk faced by the organization. Step2: Re gearing asset beta to find equity beta of original organization. [ [ [ [ ] ( ( ) ) ] ] ]
Explanation:
Equity beta of original organization is 1.39, which is lower than equity beta of another similar organization. It is because; original organization has lesser financial gearing 120% or risk than another similar organization, which has higher financial gearing 140%, or risk. This equity beta can now be used in CAPM formula to calculate cost of equity as calculated in above question.
7 Benefits & Limitations of CAPM

Past paper 06/08 Q.no Q1:c Requirement Discuss whether the dividend growth model or the capital asset pricing model offers the better estimate of the cost of equity of a company. Marks 7
7.1 Benefits
CAPM is based on empirical (observation) research. Hence, it gives more rational basis for calculating the cost of equity. CAPM considers market risk as equity beta. Basis for cost of equity calculated using CAPM model could be explained to non-financial managers. CAPM can be used to calculate project specific cost of capital when existing WACC cannot be used due to significant change in financial and business risk.
7.2 Limitations
There can be more than one government security. Each security can have different rate of return according different duration. CAPM requires beta asset (ungeared beta) to calculate equity beta (geared beta). It can be difficult to find similar company facing similar market risk. Equity beta may change from time to time as company changes it capital structure. This is true for newly established company raising finance frequently to pursue growth by investing. Calculation of equity beta is complex and lengthy process. It requires time and cost which may not exceed benefits. Basis for determining equity beta is difficult to explain to non-financial managers. Investors are assumed to have a well-diversified portfolio (group of investments). Therefore, they are not compensated for non-systematic risk. However, in practice small investors often do not hold well-diversified portfolio.
8 Calculating Cost of Debt

Past paper Q.no Requirement Marks 12/09 Q2:a Calculate the cost of debt of Bond A. 3 06/10 Q2:a Calculate the aftertax cost of debt of the 9% bonds. 4 12/10 Q4:b Calculate the after-tax cost of debt of NN Co. 4 Cost of debt can be determined using internal rate of return (IRR) technique. Previously we used IRR for investment appraisal but now we will use IRR for determining cost of debt. Interest receipt
gives rise to tax liability while interest payment to rise to tax benefits. Therefore, we must deduct tax benefit from interest payments before calculating present values.
Formula:
Where: t = Tax rate
Exam Support:
Interest payments are made at fixed rate resulting in fixed stream of cash flows are definite period (till maturity). Therefore, we can use annuity factor to save time in the exams. Rest of the calculation will remain same (see earlier).
Formula:
( A = Positive NPV B = Negative NPV a = Discount rate of positive NPV b = Discount rate of negative NPV ( ) ( ))
Illustration:
Organization has issued 10% loan notes amounting to 100,000. Loan notes has par value of $100 per loan note. Loan note has issued for 8 years and three year has been passed to date. Loan notes will be redeemed at premium of 20% to par value. Market value of the loan notes is $105. Tax rate is 30%.
Required:
Calculate the cost of debt to the organization.
Solution:
Years 0 Cash flows $(000) (105) Discount rate 7% 1 Present Value $(000) (105) Discount rate 10% 1 Present value $(000) (105)
Years 1- 5 5
Cash flows $(000) 7 120 NPV
Discount rate 7% 4.1 0.713 ( ( (
Present Value $(000) 28.7 85.55 9.25 ( ) ( )( )
Discount rate 10% 3.79 0.621 )) )
Present value $(000) 26.53 74.51 (3.96)
Explanation:
Interest payment on par value at the rate of 10% will attract tax relief. Therefore interest payments net of tax relief will be 7 (10 x (1 0.3)). Cost of debt is determined from investors perspective because IRR give rate of return (income) rather than rate of payment (cost). Therefore, current market value of loan will be outflow (investment) and redemption value will be cash inflow to the investors.
9 Calculating Weighted Average Cost of Capital

Past paper P/P 06/08 12/08 06/09 Q.no Q1:a Q1:a Q3:a Q1:a Requirement Calculate the current weighted average cost of capital of Droxfol Co. Calculate the market value weighted average cost of capital of Burse Co. State clearly any assumptions that you make. Calculate the after-tax weighted average cost of capital of Rupab Co. Calculate the weighted average cost of capital of KFP Co on a market value weighted basis. Calculate the following values for DD Co: (i) cost of equity, using the capital asset pricing model; (ii) ex dividend share price, using the dividend growth model (iii) capital gearing (debt divided by debt plus equity) using market values; and (iv) market value weighted average cost of capital. Calculate the weighted average after-tax cost of capital of NN Co. Calculate the market value after-tax weighted average cost of capital of AQR Co in the following circumstances: (i) before the new issue of bonds takes place; (ii) after the new issue of bonds takes place. Comment on your findings. Calculate the weighted average after-tax cost of capital of Close Co using market values where appropriate. ( Where Ve = Market value of equity. Vd = Market value of debt. Ke = Cost of equity. Kd = Cost of debt. t = Tax rate. If cost of debt given in the question is after tax or you have deduct tax benefits from interest payments while calculating cost of debt then you do not need apply (1 t) to cost of debt in the formula. Doing so will lead to double deduction of tax benefits.
Marks 9 12 6 10 2 3 2 2 6
12/09
Q2:c
12/10
Q4:c
06/11
Q2:a
12
12/11
Q3:c

) ( ) ( )
Exam Support:
You can use abbreviation for weighted average cost of capital as WACC to save time in the exams.
Illustration:
Market value of ordinary shares is $3 per share. Organization has issued share capital of $10,000 having par value of $0.5. In addition, share premium of $5,000. Market value of debt is $98 per loan note. Organization has issued 8%loan notes amounting to $100,000 at par value of $100. Cost of equity to the organization is 12%. Cost of debt to the organization is 9%. Corporation tax rate is 30%.
Required:
Calculate weighted average cost of capital.
Solution:
( ( ( ) ) ) ( ( ( ) ) ) ( ( ) )
Exam Support:
You can use sum of market value of equity and debt in the denominator to save time in the exam.
Exam Support:
WACC should never be round off two remove decimal figures. It is because minor change in WACC can change the NPV to significant extent that can change investment decision. Show steps involved in calculation with respect to marks available. If more marks are available then show more steps. If fewer marks are available then show fewer steps.
Workings:
( )
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 109 of 128 Exam Topic 17: RELATION BETWEEN COST OF CAPITAL, CAPITAL STRUCTURE & INVESTMENTS
Exam Topic 17
RELATIONSHIP BETWEEN COST OF CAPITAL, CAPITAL STRUCTURE & INVESTMEMTS

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Exam Awareness
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 110 of 128 Exam Topic 17: RELATION BETWEEN COST OF CAPITAL, CAPITAL STRUCTURE & INVESTMENTS
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 111 of 128 Exam Topic 18: BUSINESS VALUATION TECHNIQUES
Exam Topic 18
BUSINESS VALUATION TECHNICHES

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Exam Awareness
Business valuation is one of the main capabilities required for passing exams. This exam topic can be examined as a part of a question or as complete 25 marks question. See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 112 of 128 Exam Topic 18: BUSINESS VALUATION TECHNIQUES
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 113 of 128 Exam Topic 19: EFFICIENT MARKET HYPOTHESIS
Exam Topic 19
EFFICIENT MARKET HYPOTHESIS

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Exam Awareness
This exam topic is examined in combination with previous exam topic (business valuation). Forms of market efficiency are an important area for the purpose of exams. See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
Exam Topic 20
BASICS OF FINANCIAL RISK MANAGEMENT

Headings (click the cross reference below for easy navigation) Direct Vs Indirect Quote Buying & Selling Rate Agreement & Settlement Date Foreign Exchange Risk Types of Foreign Exchange Risk Managing Foreign Exchange Risk Netting Lead & Lag Payment
Sub Exam Topics

S.no 1 2 3 4 5 6 7 8
Exam Awareness
This exam topic builds the necessary skill required for learning subsequent exam topics on risk management. Types of foreign exchange risk are frequently test area for the purpose of exams. See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 116 of 128 Exam Topic 20: BASICS OF FINANCIAL RISK MANAGEMENT
1 Direct Vs Indirect Quote

Foreign exchange rates are quoted in pairs
Example:
Dollar to Pound, Franks to Yen, Rupees to Dinar etc.
1.1 Direct Quote

A foreign exchange rate quoted as the home currency per unit of the foreign currency. In other words, one unit of foreign currency is measured in home currency. If home currency is written first, then it should be direct quote and home currency symbol is written just before exchange rate.
Example:
If home currency is Rupees then Rupees to Pound Sterling (UK) is expressed as Rs140/1. Generally, it is expressed as just Rs140. If home currency is Pound sterling then Pound Sterling/Dollars (/$) is expressed as 1.556. In Direct Quote, exchange rate is multiplied by the foreign currency to convert foreign currency into home currency.
Example:
Suppose exchange rate of Rupees to Dollar is Rs140. If a Pakistani citizen pays ACCA fee 86. He/she will calculate equivalent amount in home currency (Rs) as follows:
Direct quote is used when foreign currency is stronger than home currency. It is used mostly used in developing countries such as Pakistan and India.
1.2 Indirect Quote Exam Support:

Indirect quote is most frequent used in practice and in exams than direct quote. A foreign exchange rate quoted as the foreign currency per unit of the home currency. In other words, one unit of domestic currency is measured in foreign currency. If foreign currency is written first, then it should be indirect quote and foreign currency symbol is written just before exchange rate.
Example:
If home currency is Pound Sterling then Dollar to Pound Sterling ($/) is expressed as $0.643. In Indirect quote, exchange rate is divided by the foreign currency to convert foreign currency into home currency.
Example:
Suppose exchange rate of Pound Sterling to Dollar is 0.643. If a UK citizen pays CFA fee $786. He/she will calculate equivalent amount in home currency as follows:
Exam Support:
If you fail to recognize type of quote used in the exam. You should take care that you are multiply or dividing exchange rate by opposite currency such as dollar is multiplied by rupees (direct quote) and dollar is divided by pounds (indirect quote).
2 Buying & Selling Rate

Buying and selling rates are two different rates. Difference between buying and selling rate is known as spread. Spread represents the profit to the foreign exchange dealer. They buy to cause you loss and sell at profit. Buy Higher rate Sell
Direct Spread Profit
Indirect
Sell
2.1 Direct Quote 2.2 Indirect Quote
Lower rate
Buy
In direct quote, buying rate will be higher rate and selling rate will be lower rate.
In indirect quote, buying rate will lower rate and selling rate will be higher rate.
Remember whichever quote you use, you should select an exchange for buying and selling which would be loss making to you and profitable to foreign exchange dealer. Because, foreign exchange dealer is trading for profit and if they are making profit then you should definitely be losing money. Lower rate is written before is the higher rate.
Example:
Dollar to Pound Sterling rate is $1.554 $1.557
3 Agreement & Settlement Date 3.1 Agreement Date

Agreement date is the time at which organization enters into contract.
Example:
It is the date at which organization commits for buying or selling of goods to supplier or customer respectively.
3.2 Settlement Date

Settlement date is the time at which organization expects to receive cash from customer as per credit term offered or obliged to make payment to suppliers.
Example:
If organization purchases goods on 1/1/2012 on 90 days credit period then settlement date will be 30/3/2012.
4 Foreign Exchange Risk

It is the risk of foreign exchange rate movement will affect profitability and stability. Ultimately, it will prevent an organization from achieving its objective of shareholders wealth maximization. Not for profit organization is also subject to foreign exchange risk which will prevent an organization from providing particular services (education, health care, entertainment etc) to its members or society.
5 Types of Foreign Exchange Risk

Past paper P/P 12/09 Q.no Q2:a Q3:c Requirement Discuss the differences between transaction risk, translation risk and economic risk. Explain the difference between transaction risk and translation risk, illustrating your answer using the information provided. Marks 6 4
5.1 Transaction Risk

Transaction risk is short-term risk rises due to particular transaction. It is the risk that foreign exchange rate will adversely affect organizational profitability. It arises due to following conditions being met if any these condition do not exists there will no transaction risk: Receipt and payment involves foreign currency rather than home currency. Payment and receipt (settlement) date is different from agreement date of goods or services. Increase in foreign exchange rate makes imported goods more costly. Movement in foreign exchange rates makes cost of purchase higher and lower. Cost of purchase for goods cannot be exactly known in home currency until settlement is made. It is due to timing difference between agreement date and settlement date. However, purchased goods are already being sold into market between those dates. If exchange rate moves adversely, organization can do nothing to cover increased cost of purchase.
Example:
If a person situated in UK buys pair of shoes for US for $30 on 90 days credit period. If exchange rate UK to US appreciates between these 90 days from 1.556 to 1.244 for buying. At agreement date, he/she required 19.28 ($30/1.556) to pay $3. At settlement date, he/she will require 24.12 ($30/1.244) to pay $3 because of strengthening of dollar. He/she sold his/her shoes for 22 in home market before settlement date. Net foreign exchange loss is 4.84 (19.28-24.12) which turned his profit of 2.72 (22-19.28) to loss of 2.12 (2.72-4.84) because of exchange rate movement. Similarly, increase in foreign exchange rate makes exported goods cheaper. Period between which goods are sold and receipt is expected, foreign exchange movement can decrease the amount of money received in home currency. Significant foreign exchange losses can create liquidity problem and in extreme cases ends up in liquidation.
Fortunately, transaction risk can be controlled using appropriate hedging techniques.
5.2 Translation Risk

Translation does not involve cash flows. Investment (land and building) in foreign currency will result in lower amount in balance sheet prepared in home currency due to depreciation of foreign currency. Transaction risk is long-term risk because it is subject to long-term investments. Translation risk can affect key ratios such as profitability, gearing and investor ratios. Translation risk can result in violation of loan covenants about maximum gearing level, which should be exceeded. Reduction in assets leads to reduction in equity resulting higher gearing ratio. Moreover, organization may find difficulty raising finance as lenders evaluate credit risk by calculating gearing ratios. Similarly, transaction risk can result in reduction in share price and market capitalization of the organization due to reduction in equity. ROCE will also increase without any improve in performance of the organization. Managers will be wrongly rewarded if ROCE is used for calculating profit related pay (PRP). Translation risk can be controlled by organization through careful planning and using matching principle (see later).
5.3 Economic Risk

Economic risk affects all the organizations regardless of involvement in foreign trade or investment. Increase in foreign exchange rate will make imported goods more costly in home currency terms. Organizations using imported raw material as an input to the goods or services provided by the organization is exposed to economic risk. Increase in the cost of raw materials to the organization will lead to increase in the cost of goods produced or services provided by the organization. Organization may have to raise selling price or reduce profit margin to remain competitive in the market against suppliers to imported goods. Economic risk is beyond the control of the organization. Organization has to accept that risk. However, government can control economic risk in the long term. However, in short term, it is uncontrollable even by government. Organization can use its economic power to influence the actions of government.
6 Managing Foreign Exchange Risk 6.1 Hedging

Hedging is the technique used to control foreign exchange risk. Hedging is based on the idea of creating risk in opposite direction against the risk already faced by the organization.
Example:
Suppose we have to buy foreign currency after 6 months to pay for goods ordered. We must enter into contract to sell foreign currency after 6 months at the time goods are ordered. If foreign currency value increases we lose on buying and gain on selling so the net effect will be no gain/ no loss. If foreign currency value decreases we gain on buying and lose on selling so the net effect will be no gain/no loss. Effectiveness of hedging depends on hedging instrument used. For hedging to be effective following conditions must be satisfied. Period and settlement date of hedging instrument should same as that of period and settlement date for contract resulting in transfer of foreign exchange.
Example:
If a UK supplier is expecting to receive foreign exchange at 1/6/2012 for goods supplied at 1/1/2012 then risk of decreases in exchange rate can be hedged by entering into contract now at 1/1/2012 to sell foreign exchange at 1/6/2012. Sum of money involved in hedging should be equal to Sum of money involved in contract resulting in transfer of foreign exchange.
Example:
If a UK supplier is expecting to receive (inflow) $10,000 then risk of decrease in exchange rate of pounds can be hedged by entering into contract to sell (outflow) $10,000. Hedging mostly involves settlement on net basis.
6.2 Settlement on Net Basis

Settlement on net basis means that there will be no physical buying or selling of foreign exchange. Parties involved in hedging are not legally bound to sell or buy foreign exchange from each other at future date. Cash is transferred only to the extent to gain or loss realised due to foreign exchange movement.
6.3 Invoicing In Home Currency

Foreign exchange risk arises only when seller charges for goods or services in foreign currency or buyer pays for goods or services in foreign currency. To eliminate foreign exchange rate risk, supplier may choose to charge its customers in its home currency. This way you will have revenue and expense in the home currency just as in domestic trade. Supplier can earn profits on sales of goods or services without having to expose with the risk of decrease in revenue due to depreciation (weakening) of foreign currency. This transfers the foreign exchange rate risk to customer as he/she must be required to pay in foreign currency. The ability to charge in home currency is dependent on bargaining power of supplier in relation to that of customers.
Example:
ACCA charges fees from students in Pound Sterling transferring risk of foreign exchange rate movement to students. It is possible to due having greater bargaining power of ACCA in relation to students.
6.4 Matching
Foreign exchange rate risk can be eliminated or reduced by matching receipts and payment or asset and liabilities. For the purpose of 100% effective matching following conditions must be met. Timing of expected receipt and payment required and life of asset and liability should be same. Expected receipt and payment required asset and liability should in same foreign currency. Sum of money for receipt and payment, asset and liability should be same. Organization can hedge the transaction risk by matching receipts and payments.
Example:
US supplier expecting receipts from UK customer in pounds can hedge the risk by creating obligation for payment in pounds through buying goods from UK supplier. Receipts obtained can be used for making payment, it means there will be no buying or selling of foreign currency and therefore no risk. In practice, perfect matching of the amount and timing of receipt and payment is difficult, so matching does not provide 100% hedge.
Organization may consider goods in exchange for goods from another organization rather than payment. This way no foreign exchange transfer will be required. It is known as barter trade. Similarly, organization can hedge the translation risk by matching assets and liabilities.
Example:
UK organization considering investment in US in dollars is subject to the risk of devaluation of asset due to exchange rate movement. UK organization can hedge the risk by creating liability in dollars through raising loan in US. Decrease in the value of dollar will result in decrease value of assets as well as liabilities. Loss of decrease in asset will be compensated by gain on decrease in liabilities.
7 Netting
For netting, following conditions must be met. Timing of expected receipt and payment required should be same. Expected receipt and payment required should in same foreign currency. As discussed earlier, hedging is about creating risk in opposite direction. Organization may already have two opposite risks, which can cancel each other.
Example:
Expected receipts after 1 month should be net off against payment required after 1 month. Only the remaining receipt or payment left after netting should be hedged.
Example:
Receipt of $10,000 can be net off against payment of $12,000, provided both are expected at the same date, and then hedging is required only for the payment of $2,000. This will result in savings in transaction cost of hedging.
Example:
Transaction cost of hedging will be required for only $2,000 rather than $22,000 (10,000+12,000).
8 Lead & Lag Payment

Requirement Marks Evaluate whether a money market hedge, a forward market 12/07 Q4:d hedge or a lead payment should be used to hedge the foreign 8 account payable. As discussed earlier, transaction risk arises due to timing difference between agreement and settlement date. There will be no risk if cash is transferred and goods are delivered at the same time.
Past paper
Q.no
Lead payment involves payment for goods or services before the settlement date ideally at agreement date. It will result in loss of interest, which could be earned by investing cash till settlement date. It should be compared against cost of hedging. Lead payment is useful when organization is expecting increase in strength of foreign currency in future. To calculate lead payment spot rate (current rate) is used which is the rate at the time of delivery of goods or services. Lag payment involves delaying payment beyond the settlement date. It may result in loss of goodwill with the supplier. Lag payment is useful when organization expects decrease in strength of foreign currency in future.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 125 of 128 Exam Topic 21: HEDGING TECHNIQUES FOR FOREIGN CURRENCY RISK
Exam Topic 21
HEDGING TECHNIQUES FOR FOREIGN CURRENCY RISK

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Exam Awareness
Hedging techniques for foreign currency risk is regularly tested in each exam session. Risk management is one of the main capabilities required for passing exams. Hedging techniques for foreign currency risk can be tested in combination with investment appraisal (exam topic). You may be required to evaluate investments in foreign currency. See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 126 of 128 Exam Topic 21: HEDGING TECHNIQUES FOR FOREIGN CURRENCY RISK
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 127 of 128 Exam Topic 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK
Exam Topic 22
HEDGING TECHNIQUES FOR INTEREST RATE RISK

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Exam Awareness
Hedging techniques for interest rate risk are similar to hedging techniques for currency risk. Therefore, both of the exam topics may not be examined in one exam session. It can be examined with sources of finance where you are required to evaluate proposal to raise debt finance. Risk management is essential part of financial management paper F9. See PAST EXAM PAPERS ANALYSIS to explore relationships between exam topics. You can use this relationship to write relevant points in order to answer requirements in the exams.
F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 128 of 128 Exam Topic 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

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F9 Financial Management | Author: Murtaza Lanewala | Specially for June 2012 Exams | Page 1 of 128

INTENDED BENEFITS OF THE E-BOOK

Save mnemonics. Mark as read important, unread, read, Revised etc.

INTRODUCTION TO F9 FINANCIAL MANAGEMENT

3 Assumed Knowledge from Previous Papers

4 Position of F5 Performance Management in ACCA

5 Main Capabilities & Relationships

6 Exam Paper Format

FORMULA SHEET & TABLES

PAST EXAM PAPERS ANALYSIS

FINANCIAL MANAGEMENT FUNCTION

1.1 Definition of Agency Relationship

1.2 Agency Problem

1.3 Goal Congruence

1.4 Ways to Reduce Agency Problem

1.5 Reward Schemes 1.5.1 Salary

1.5.3 Profit Related Pay

1.5.4 Share Based Payment

1.5.5 Share Options

2 Financial Objectives in Profit Vs Not-for-Profit

FINANCIAL MANAGEMENT ENVIRONMENT

THE NATURE, ELEMENTS & IMPORTANCE OF WORKING CAPITAL

1 Objectives of Working Capital Management

MANAGEMENT OF WORKING CAPITAL ELEMENTS

7.1 Recourse Factoring

7.2 Non-Recourse Factoring

8 Evaluating Proposal for Factoring

Performa for evaluating proposal for factoring:

Illustration (12/08, Q2: c):

Solution (12/08, Q2: c)

10 Foreign Trade Receivables

10.1 Problems Involved In Foreign Trade

10.2 Reducing Risks Involved In Foreign Trade 10.2.1 Advance Payment

11 Calculating & Commenting Early Settlement Discounts

Illustration (12/10, Q3: c):

Solution: (12/10, Q3: c)

12 Discounts from Suppliers

Illustration (06/11, Q4: b (ii)):

Solution (06/11, Q4: b (ii)):

Note: cost of sales can comfortably be used instead of credit purchase.

13 Economic Order Quantity (EOQ) Model

14 Optimal or Economic Order Quantity (EOQ)

Illustration (12/07, Q4: b):

Solution: (12/07, Q4: b)

Total cost under EOQ model:

15 Optimal Reorder Quantity with Bulk Purchase Discount

Formula: Exam Support:

Illustration (06/11, Q4: b (ii)):

Total purchase cost of revised order size at 30,000 units :

Savings in obtaining bulk purchase discount is $6,000 (907,600-901,400) per year.

16 Just in Time (JIT)

DETERMINING WORKING CAPITAL NEEDS & FUNDING STRATEGIES

1 Cash Management Models 1.1 Miller-Orr Model

Formula (given in the formula sheet):

1.2 Baumol Model

2 Funding Working Capital Requirement

2.1 Non-Current Assets

2.2 Permanent Assets

2.3 Fluctuating Assets

2.4 Matching Policy

2.5 Aggressive Working Capital Policy

2.6 Conservative Working Capital Policy