fia ffm 2013 notes

FIA-Paper FFM Foundations in Financial Management For exams in 2013

theexpgroup.com

Notes

ExPress Notes FIA – Foundations of Financial Management

Page | 2 © 2013 This material is the copyright of the ExP Group. Individuals may reproduce this material if it is for their own private use. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means, be it printed, photocopied, on electronic devices or any other means of reproduction. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Given the nature of information presented in these materials, and given that legislation may change at any time, The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases.

theexpgroup.com

Contents About ExPress Notes

1. Cash receipts and payments 7

2. Cash balances 12

3. Working capital management 17

4. Credit granting 23

5. Debt collection 26

6. Sources of finance 29

7. Short-term decisions 37

8. Capital investments 44



theexpgroup.com

START About ExPress Notes

We are very pleased that you have downloaded a copy of our ExPress notes for this paper. We expect that you are keen to get on with the job in hand, so we will keep the introduction brief.

First, we would like to draw your attention to the terms and conditions of usage. It’s a condition of printing these notes that you agree to the terms and conditions of usage. These are available to view at www.theexpgroup.com. Essentially, we want to help people get through their exams. If you are a student for the ACCA exams and you are using these notes for yourself only, you will have no problems complying with our fair use policy.

You will however need to get our written permission in advance if you want to use these notes as part of a training programme that you are delivering.

WARNING! These notes are not designed to cover everything in the syllabus!

They are designed to help you assimilate and understand the most important areas for the exam as quickly as possible. If you study from these notes only, you will not have covered everything that is in the ACCA syllabus and study guide for this paper.

Components of an effective study system

On ExP classroom courses, we provide people with the following learning materials:

• The ExPress notes for that paper • The ExP recommended course notes / essential text or the ExPedite classroom

course notes where we have published our own course notes for that paper • The ExP recommended exam kit for that paper. • In addition, we will recommend a study text / complete text from one of the ACCA

official publishers, but we do not necessarily give this as part of a classroom course, as we think that it can sometimes slow people down and reduce the time that they are able to spend practising past questions.

ExP classroom course students will also have access to various online support materials, including:

• The unique ExP & Me e-portal, which amongst other things allows “view again” of the classroom course that was actually attended.

• ExPand, our online learning tool and questions and answers database



theexpgroup.com

Everybody in the World has free access to ACCA’s own database of past exam questions, answers, syllabus, study guide and examiner’s commentaries on past sittings. This can be an invaluable resource. You can find links to the most useful pages of the ACCA database that are relevant to your study on ExPand at www.theexpgroup.com.

How to get the most from these ExPress notes

For people on a classroom course, this is how we recommend that you use the suite of learning materials that we provide. This depends where you are in terms of your exam preparation for each paper.

Your stage in study for each paper

These ExPress notes

ExP recommended course notes, or ExPedite notes

ExP recommended exam kit

ACCA online past exams

Prior to study, e.g. deciding which optional papers to take

Skim through the ExPress notes to get a feel for what’s in the syllabus, the “size” of the paper and how much it appeals to you.

Don’t use yet Don’t use yet Have a quick look at the two most recent real ACCA exam papers to get a feel for examiner’s style.

At the start of the learning phase

Work through each chapter of the ExPress notes in detail before you then work through your course notes.

Don’t try to feel that you have to understand everything – just get an idea for what you are about to study.

Don’t make any annotations on the ExPress notes at this stage.

Work through in detail. Review each chapter after class at least once.

Make sure that you understand each area reasonably well, but also make sure that you can recall key definitions, concepts, approaches to exam questions, mnemonics, etc.

Nobody passes an exam by what they have studied – we pass exams by being efficient in being able to prove what we know. In other words, you need to have effectively input the knowledge and be effective in the output of what you know. Exam practice is key to this.

Try to do at least one past exam question on the learning phase for each major chapter.

Don’t use at this stage.



theexpgroup.com

Your stage in study for each paper

These ExPress notes

ExP recommended course notes, or ExPedite notes

ExP recommended exam kit

ACCA online past exams

Practice phase Work through the ExPress notes again, this time annotating to explain bits that you think are easy and be brave enough to cross out the bits that you are confident you’ll remember without reviewing them.

Avoid reading through your notes again. Try to focus on doing past exam questions first and then go back to your course notes/ ExPress notes if there’s something in an answer that you don’t understand.

This is your most important tool at this stage. You should aim to have worked through and understood at least two or three questions on each major area of the syllabus. You pass real exams by passing mock exams. Don’t be tempted to fall into “passive” revision at this stage (e.g. reading notes or listening to CDs). Passive revision tends to be a waste of time.

Download the two most recent real exam questions and answers.

Read through the technical articles written by the examiner.

Read through the two most recent examiner’s reports in detail. Read through some other older ones. Try to see if there are any recurring criticism he/ she makes. You must avoid these!

The night before the real exam

Read through the ExPress notes in full. Highlight the bits that you think are important but you think you are most likely to forget.

Unless there are specific bits that you feel you must revise, avoid looking at your course notes. Give up on any areas that you still don’t understand. It’s too late now.

Don’t touch it! Do a final review of the two most recent examiner’s reports for the paper you will be taking tomorrow.

At the door of the exam room before you go in.

Read quickly through the full set of ExPress notes, focusing on areas you’ve highlighted, key workings, approaches to exam questions, etc.

Avoid looking at them in detail, especially if the notes are very big. It will scare you.

Leave at home. Leave at home.



theexpgroup.com

Our ExPress notes fit into our portfolio of materials as follows:

Notes

Notes

Notes

Provide a base understanding of the most important areas of the syllabus only.

Provide a comprehensive coverage of the syllabus and accompany our face to face professional exam courses

Provide detailed coverage of particular technical areas and are used on our Professional Development and Executive Programmes.

To maximise your chances of success in the exam we recommend you visit www.theexpgroup.com where you will be able to access additional free resources to help you in your studies.

START About The ExP Group

Born with a desire to be the leading supplier of business training services, the ExP Group delivers courses through either one of its permanent centres or onsite at a variety of locations around the world. Our clients range from multinational household corporate names, through local companies to individuals furthering themselves through studying for one of the various professional exams or professional development courses.

As well as courses for ACCA and other professional qualifications, our portfolio of expertise covers all areas of financial training ranging from introductory financial awareness courses for non financial staff to high level corporate finance and banking courses for senior executives.

Our expert team has worked with many different audiences around the world ranging from graduate recruits through to senior board level positions.

Full details about us can be found at www.theexpgroup.com and for any specific enquiries please contact us at [email protected].



theexpgroup.com

Chapter 1

Cash Receipts and Payments

KEY KNOWLEDGE

Cash and Cash Flow

Cash comprises both cash and bank deposits payable on demand and also cash equivalents which are defined as “short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value”. The amount of cash held by a business at a point in time is found in the balance sheet under “current assets”.

Cash flow refers to the movement of cash in and out of a business over a period of time. This information is found in a statement of cash flows, which is a primary financial statement. Such a statement is useful in that it is structured to show the extent to which a company is able to generate net cash from its operating activities and how such net cash is used in investing and/or financing activities.



theexpgroup.com

Examples of cash receipts and payments include:

• Operating: cash flow from trading activities, e.g. cash received from customers, cash paid to suppliers and to employees;

• Financing: Cash paid on interest; • Taxation: Actual cash paid during the year; • Investing: Cash flows on purchase or sale of non-current assets; • Financing: Cash flows on raising or redeeming long-term finance, such as shares or

debentures; dividends can also be included here.

Cash flow accounting The relationship between cash flow accounting and accounting for income and expenditure lies in the use of accruals and decisions as to the capitalisation of expenditures. Cash flow accounting dispenses with the “matching” principle in financial accounting. As the cash flow statement is derived from the income statement and the balance sheet, adjustments need to be made to remove the effects of accrual accounting so that the cash movements can be made more transparent.

Importance of cash flow management Planning, tracking and collecting cash are all important because cash PAYS THE BILLS.

• The failure to pay bills puts a company in danger of bankruptcy. • What begins as a condition of illiquidity can evolve into insolvency.

Cash flow is vital to going concern and commercial success, regardless of profitability. Having enough cash on hand is therefore critical in being able to settle obligations when they fall due (both planned and unforeseen); however, holding too much cash in a business is costly. There is a trade-off between liquidity and profitability. Determining the “optimal” amount of cash to hold becomes the challenge facing managers. Cash management functions are typically handled by treasury, and include:

• Collecting cash from customers (as soon as possible); • Disbursing cash to suppliers (as late as practically possible); • Investing short-term cash surpluses in low-risk interest-bearing investments (such as

Treasury bills) in order to generate additional income for the company;



theexpgroup.com

KEY KNOWLEDGE

Cash budgets

A cash budget is an estimate of the receipt and payments of cash in and out of the business for a defined future period based on existing conditions and operating assumptions.

By understanding the nature and timing of cash receipts and expenditures, management is better able to influence them and plan/budget for the future. The purpose is to ensure that the company has sufficient cash on-hand to avoid missing disbursements when they fall due.

There are statistical techniques which assist management in planning cash levels.

Cash budget/forecast Businesses should develop their cash budget/forecast formats in a way which best reflects the type of business conducted and transactions generated. Such tools serve as a mechanism for monitoring and control.

KEY KNOWLEDGE

Cash forecasting

A cash forecast format/structure is shown below, in this case covering 6 months. Both operating and non-operating cash flows are included.

The bottom of the table shows opening and closing cash balances.

Cash Budget

Jan Feb Mar Apr May June

$ $ $ $ $ $

Receipts

Credit sales

Cash sales



theexpgroup.com

Equipment disposal

Total

Payments

Materials

Labour

Variable Overheads

Fixed Costs

Equipment acquisition

Overdraft Interest

Current account interest

Income tax

Total

Net cash m-o-m variance

Cash balance at month-end

Completing the table above requires forecast assumptions relating to volume of production/sales as well as prices and costs.

EXAMPLE

Unit Selling Price (on credit)

$/unit payment terms given to credit customers:

Unit Selling Price (cash)

$/unit discount granted to cash customers

Unit Variable Cost: Material

$/unit payment terms taken from suppliers:

Labour

$/unit paid in the month Overheads

$/unit

Fixed Costs

$/month

< Actual Forecast >

Nov Sales/Production volumes Dec Jan Feb Mar Apr May June Total

actuals/forecast

Production (units)



theexpgroup.com

Credit sales (units) Cash sales (units)

Capex forecast New equipment

acquisition Old equipment sale

Inventory levels required +/- planned

Bank interest at % pa

Bank interest at % pa

KEY KNOWLEDGE

Sensitivity of variables

Preparing cash forecasts requires assumptions, and assumptions are exposed to uncertainty. This means that the actual amount of cash received or disbursed may vary from that budgeted. Budgeting processes therefore include the testing of assumptions for sensitivity. If, for example, wage levels rise by 10% (instead of 5%), then what effect will this have on the level of cash? Same question with regard to materials (and overheads and prices, etc.).



theexpgroup.com

Chapter 2

Cash Balances

KEY KNOWLEDGE

Investing and financing

Cash surpluses and deficits occur as a result in timing differences between the receipt of cash and the necessity to settle obligations punctually. If a deficit results, then the company should have overdraft faciltities in place with a bank. If deficits prove to be longer-term in nature, then the company should consider short-term borrowing, or possibly, longer-term forms of finance if the deficit is expected to persist. In the event of surpluses, these can be invested (e.g. T-bills mentioned earlier); other types of investments include:

• Bank deposits



theexpgroup.com

• Money- market deposits • Certificates of deposit • Government bonds • Local authority stock

KEY KNOWLEDGE

Optimum liquidity levels

Cash management models Holding too much cash is sub-optimal. A business with permanently excessive balances (not required for operating purposes) should be paid out to shareholders.

Two techniques for monitoring the optimal level of cash are discussed below.

Baumol model

This model was developed several decades ago. One can think of:

• cash as inventory;

• selling marketable securities transactions as ordering costs;

• Interest rate, representing the opportunity cost of holding cash

By determining the following:

N = the total annual amount of cash required F = the cost of each securities transaction (sale) i = the annual interest rate obtainable on the investment in securities

then

Z = the amount of cash that needs to be raised per transaction



theexpgroup.com

The optimal level of Z = √2NF / i

The main drawback of the Baumol method is that it makes the simplified (and unrealistic) assumption that cash disbursements are constant and predictable.

Miller-Orr

A second method addresses the issue of optimal cash balances and attempts to improve on the drawback of the Baumol model.

Miller-Orr is based on statistically tracking the variability of net daily cash flows; this is denoted as

V = Variability of net daily cash flows (variance or sigma squared)

The other variables are:

F = Cost of each securities transaction;

k = Interest rate per day on marketable securities; and LL = Lower cash limit, which needs to be established by management Based on the above, the cash balance return point (R) is ________ R = 3√3xFxV/4k + LL The level R is the cash balance which must be restored when either the upper limit (UL) or lower limit (LL) have been reached. Once R is known, then the upper cash limit, or UL, is calculated thus: UL = 3 R – 2(LL)



theexpgroup.com

KEY KNOWLEDGE

Working capital needs and funding strategies

The level of working capital required in a business depends on the industry it operates in, the length of its working capital cycle and the range of funding options open to it. Retaining flexibility is a key requirement. While overdraft financing is expensive, it does permit spontaneous drawdowns and rapid repayments.

Funding strategies are guided by the following considerations:

• Temporary cash shortages can be funded short-term, while • Permanent shortages should be funded long-term

The “matching principle” can be applied to the assets being financed:

• Fixed assets are generally funded long-term, along with the permanent portion of current assets (e.g. buffer stocks);

• Current assets of a fluctuating nature can rely on short-term finance (e.g. seasonal upswings in inventories / receivables)

Cash surpluses, on the other hand, can be dealt with based on whether they are:

• Short-term: in this case they may be invested in short-term, low-risk, liquid investments (e.g. Treasury bills or marketable securities);

• Long-term: Make acquisitions; Reduce debt; Pay extraordinary dividend, etc.

KEY KNOWLEDGE

Liquidity ratios

The relationship between current assets and current liabilities is used as a measure of liquidity in the firm:

Current ratio = Current liabilities

Current assets



theexpgroup.com

Quick ratio = Current liabilities

Current assets - Inventories

KEY KNOWLEDGE

Legal relationship between bank and customer

The relationship between bank and customer is established contractually. When opening an account with the bank, the client is at the same time accepting the general terms and conditions of the bank. In return, the bank has a professional duty toward the client in matters of confidentiality. Law enforcement (and tax authorities) has the ability to penetrate banking confidentialty at institutions within their jurisdictionand, usually in connection with pending investigations and upon obtaining a court order.



theexpgroup.com

Chapter 3

Working Capital Management

START The Big Picture

The nature, elements and importance of working capital

This is a core function of management which has day-to-day implications.

Working capital definition: Current assets – Current liabilities

This is an accounting definition. The discussion and analysis of working capital management focuses on the “operating” elements of current assets and liabilities:

• Cash • Inventory • Receivables • Payables



theexpgroup.com

KEY KNOWLEDGE

Cash Operating Cycle

These elements are linked through the Cash conversion cycle, also known as the Cash Operating Cycle.

Raw materials

received Receipt of cash Payment to supplier Sale of goods Conversion into finished goods

The above diagram shows the operating cash flows for a typical manufacturing company converting raw materials into finished goods for sale. The company needs its own cash to pay the supplier and can only recover this from the sale of the finished goods. The cash invested in inventories and receivables represents a cost to the company. This is most directly obvious in opportunity cost terms: the cash could be earning interest, reducing interest-bearing debt, or ultimately find its way into shareholders’ pockets as a dividend payment. The presence of payables indicates that cash payments (outflows) are delayed; this is beneficial to the company as long as it is not overdue on its payments, as late payment could lead to penalties or damage to the company’s reputation (creditworthiness). Managing the individual parts of working capital means managing the “whole picture” in an optimal way; doing this well can give a firm a significant competitive advantage over its competitors.



theexpgroup.com

KEY KNOWLEDGE

Ratio Analysis

Liquidity ratios

Liquidity ratios (current ratio and quick ratio) have been covered in an earlier chapter. Other ratios include:

Turnover ratios

(1) Trade debtors (receivables)

(2) Inventory turnover

(3) Trade creditors (payables)

Sales revenue/net working capital ratio Working capital

Sales____

This ratio establishes the link between the level of sales and the amount of working capital a business needs to maintain. It is useful for cash flow forecasting. The ratio need not remain constant as sales grow, but alternate assumptions should usually be based on arguments specific to the business.



theexpgroup.com

KEY KNOWLEDGE

Economic Order Quantity (EOQ)

Within a company, there is a natural temptation to accumulate buffer stocks (raw materials and semi-finished goods) so that production is never interrupted.

Similarly, in order to avoid stock-outs, sales managers will insist on maintaining a plentiful level of finished goods. All of this costs money.

The EOQ is a method which seeks to minimize the costs associated with holding inventory.

To determine the total costs, the following data is required:

Q = order quantity

D = quantity of product demanded annually

P = purchase cost for one unit

C = fixed cost per order (not incl. the purchase price)

H = cost of holding one unit for one year

The total cost function is as follows:

Total cost = Purchase cost + Ordering cost + Holding cost

which can be expressed algebraically as follows:

TC = P x D + C x D/Q + H x Q/2

It is this total cost function which must be minimized.

Recognizing that:

• PD does not vary; • Ordering costs rise the more frequently one places (during the year); and • Holding costs rise the fewer times one places orders (due to larger quantities being

ordered each time),



theexpgroup.com

It follows that there is a trade-off between the Ordering and the Holding costs.

The optimal order quantity (Q*) is found where the Ordering and Holding costs equal each other, i.e.

C x D/Q = H x Q/2

Rearranging the above and solving for Q results in

EXAMPLE

A trucking company uses disposable carburetor units with the following details:

• Weekly demand 500 units • Purchase price USD 15 / unit • Ordering cost USD 40 / order • Holding cost 7% of the purchase price

Assume a 50 week year. What is the optimal order quantity?

KEY KNOWLEDGE

Just-In-Time (JIT)

• JIT is more than an inventory management model; it is a manufacturing philosophy which puts at its core minimization of inventories on the basis that most of inventory-related activities are non-value-added.

• JIT’s ultimate objectives are increased competitiveness and higher profits through higher productivity (output per unit of time), better product quality and lower operating costs.



theexpgroup.com

Chapter 4

Credit Granting

KEY KNOWLEDGE

Credit assessment

Assessing the creditworthiness of customers When assessing the creditworthiness of (potential) clients, companies can use the approach typically employed by banks, referred to (originally) as the 3 C’s of credit, later expanded to the 5 C’s. They are: (1) Character: Focuses on the reputation of the principals/decision makers at a company;

credit checking agencies and bank references assist to this end;

(2) Capacity: Examines the company’s cash flow generation in the context of management’s ability to perform competently and reliably in meeting their obligations, based on an



theexpgroup.com

examination of their track record (either directly or via the experiences of others). Financial statement analysis is a major part of the exercise here (and in the next point);

(3) Capital: Identifies and assesses the financial “staying power” and resources of the

business; how much of a capital cushion do they have to withstand losses and how much do they have committed at risk in a proposed transaction that incentivizes them to succeed (one can refer to this as the “pain factor”);

(4) Collateral: Assesses what (if any) security the company is willing to provide in support of

the intended transaction. Banks refer to this as providing additional exits (“ways out”) from a transaction.

(5) Conditions: This is a general review of the economic environment to appreciate to what

extent a customer may be affected by a decline in general business conditions (business cycle influences).

KEY KNOWLEDGE

Internal and external sources of information

The decision to grant credit to customers is the job of the credit manager. In determining credit limits, the manager takes into consideration market intelligence. These consist of sources of information that are: Internal: This is based on the experience acquired in qorking with a customer over time; and External: Data obtained as a result of credit checkings (with credit agencies) or from publicly available sources. The resulting information must be evaluated and a decision taken as to how much credit to approve for individual customers.



theexpgroup.com

KEY KNOWLEDGE

Early settlement discounts

The objective of granting a settlement discount is to give customers a financial incentive to pay their bills more quickly (before the standard due date). A company granting settlement discounts must ensure that the benefits of doing so will outweigh the costs.



theexpgroup.com

Chapter 5

Debt Collection

KEY KNOWLEDGE

Collection of debts

A company must have in place a clear policy on the collection of debts. Even if a good screening/assessment procedure is in place for accepting and reviewing customers, late payments are a fact of life and must be handled pro-actively. Much time can be spent in chasing late payments and if this process is not well-organized, management may come to the conclusion that it is not worthwhile. This is especially true in cases where a company is growing very quickly and celebrates the signing of contracts and issuance of invoices as signs of success. If, however, these invoices are not collected in due time (or at all), then the company is throwing away the rewards of “success”.



theexpgroup.com

Deductions Another phenomenon which results in significant write-offs of receivable is the practice of “deductions” in which a customer pays less than the full amount of the invoice, giving a reason for withholding the difference. This amounts to a renegotiation of the original invoice and is often accepted as a “fait accompli” by the supplier. A company managing its receivables diligently will have the following: (1) A monitoring system that clearly “flags” late payers, known as an aging system. This

includes identifying properly the practice of deductions mentioned above; (2) A follow-up system that assigns responsibility to specific staff doing the follow-up; this

includes an elevating of difficult cases to more senior and/or more experienced staff to handle;

(3) Training for staff involved in handing follow-ups, whether performed by phone, mail or

personal visits; (4) A policy determining when to involve refer the case to lawyers (preferably in-house, for

cost reasons) in preparation of follow-up letters. An external lawyer may carry more weight, but is also more costly;

(5) Use of a collection agent to chase the receivable. Here again, a company must calculate

the costs and benefits of involving an external agent. In such an analysis, the savings of management time (opportunity cost) is the most difficult to estimate.

KEY KNOWLEDGE

Credit policies

Financial implications of different credit policies Evaluating a change in a credit policy requires the identification of relevant cash flows structured as “before” (the change) and “after” scenarios.



theexpgroup.com

KEY KNOWLEDGE

Factoring and invoice discounting

Note the distinction between factoring and invoice discounting: Invoice discounting is effectively a short-term loan in which a company borrows against its outstanding receivables. The unpaid sales invoices are pledged as collateral to the company (or bank) provides the financing. The borrowing company receives less than the face value of the invoice, the difference being the cost of borrowing, or discount. Factoring involves the administration of debt collection, in which the factor buying a receivable manages the process. The factor may do so on a recourse or non-recourse basis. Recourse: In the event a debt is written-off, the factor has the right to demand payment from the company from which it acquired the debt/receivable; Non-recourse: The factor bears the full credit risk of the debtor’s failure to pay.

KEY KNOWLEDGE

Follow-up processes

Follow-up processes could follow the following steps:

1. (Before payment due date) – Reminder to prepare payment; If payment is not made punctually (i.e. past due):

2. Reminder to execute payment;

3. Inform that penaties will be charged;

4. Advice that further delivery is stopped;

5. Advice that receivable will be sold to a factor or referred to legal action



theexpgroup.com

Chapter 6

Sources of Finance

KEY KNOWLEDGE

Macro-economics

The impact of macro-economics Businesses must also take macro-economic factors into account:

• Demand levels in the future (return to pre-crisis levels unlikely);

• In a recovery phase, how government policies are likely to be adjusted with respect to:

(a) Monetary policy: Effect on interest rates, exchange rates and inflation, (the latter may eventually increase with economic recovery);



theexpgroup.com

(b) Labor policy: If labor markets tighten, how fast will restrictions (imposed on foreign labor, for example) be relaxed?

(c) Fiscal policy: Tax increases (both personal and corporate); (d) Trade policy: to what degree is any protectionism likely to stay in place? Again, actively keeping up with reading on these issues will be the best way to stay informed.

KEY KNOWLEDGE

The banking process

According to English common law, a bank has traditionally been characterized as an institution which holds current accounts for depositors, pays cheques which are drawn upon it, and collects cheques on behalf of customers. In addition to chequing accounts, banks offer an increasingly broad range of services, including overdraft and loan facilities, foreign exchange, trade finance (bills of exchange and promissory notes) and investment management. Banks in the UK are licensed by the Financial Services Act, which has over time extended its reach to other types of financial institutions, such as Building Societies, which traditionally specialized in offering mortgage loans. UK banking clearing system There are different systems designed to clear payments within the UK. These include: London Bankers Clearing House – A cheque-clearing system operated by members, designated as “clearing banks”; the use of cheques remains an important payment method in the UK, particularly for small businesses. The clearing system works on a 3-day cycle:

(1) Sending the item to the clearing center; (2) Sorting of items submitted; (3) Debit to the bank on which the item is drawn.

the use of cheques remains an important payment method in the UK, particularly for small businesses.

Other systems:



theexpgroup.com

Bankers' Automated Clearing Services (BACS) – A system for the electronic transfer of payments between banks; 3-day clearing of funds, therefore slow but cheap; Clearing House Automated Payment System (CHAPS) – This is for Sterling payments within the UK; beneficiaries receive “same day” funds; relatively expensive;

KEY KNOWLEDGE

Financing sources

Ordinary shares (or common shares) These are the basic units of ownership of a corporation. The common shareholders are the main beneficiaries of the success of a business. Their potential “upside” gain is therefore theoretically unlimited. This potential gain is associated with the risk that such shareholders face: in the event of bankruptcy or liquidation, they are the residual claimants on a corporation’s assets after all other claims (whether suppliers, employees, lenders, the state, etc.) have been satisfied. Preference shares Preference shares (or “pref” shares) This is often referred to as a form of non-equity capital.

• Preference shareholders rank preferentially to common shareholders;

• Pref shares may be redeemable or irredeemable;

• Dividends are not tax deductible;

• The dividend rate is usually fixed (as a percentage of the par value of the issue);

• The dividend rate can be participating, i.e. share in some of the excess profits;

• Voting rights: may or may not be accorded preference shares;

• Prefs may be cumulative, where dividends not paid in one year are carried forward and have to be paid before a common dividend payment resumes;



theexpgroup.com

• Prefs may be convertible into common shares Debt In contrast to equity, debt:

• Is a liability of the business;

• Pays interest which is tax deductible;

• Does not represent ownership in the firm Other types of securities Companies are imaginative in creating hybrid securities as debt in order to achieve tax deductibility but with conditions that avoid bankruptcy costs (i.e. payouts contingent only on the achievement of profits). Debt comes in many forms. Straight long-term debt (also called “loan capital” – avoid confusion!) includes:

• Bonds: Secured by a mortgage on tangible assets of the firm

• Debentures: Unsecured corporate debt

Note: The term “bonds” is commonly used for both categories above. In the event of default, debt holders with a security interest over assets enjoy a prior claim in the event such assets are sold. Debenture holders can be paid only after (secured) bondholders have been repaid.

• Convertible debt: This is debt which is convertible (at the option of the convertible debt holder) into equity, based on pre-defined “conversion” conditions;

• Subordinated loans: Refers to any kind of debt which ranks inferior to more senior debt; it cannot be repaid until more senior-ranked creditors have been repaid;

• Warrants: A security giving the holder the option to buy common shares from a company for a pre-set price valid for a period of time. These are usually tradable in a secondary market and therefore have a market price;

• Deep discount bonds: Debt issued with a very low or no (zero) coupon, so that the issue price will be far below the par value of the bond. Such instruments with no coupon are also called “pure-discount” or “zero” bonds.



theexpgroup.com

• Junk (high yield) bond: A speculative debt instrument that either carries no rating or a low rating by the rating agencies (below “investment grade”);

Types of interest rates

• Interest rates can be set at a specific percentage rate and not change during the contractual period of a loan. Bonds issued with fixed (rate) coupons (making them “fixed rate” instruments) will vary in value as market interest rates change.

• Floating rates fluctuate with the movement in market interest rates. They are used in

debt instruments and (bank) loan contracts by defining how the interest rate is to be set on a periodic basis.

Choosing the right capital structure Choosing between ordinary shares, preference shares and loan capital is based on financial strategic decisions taken by a corporation regarding capital structure. Debt and equity The amounts of debt and equity appropriate at a company depends mainly on the industry in which the company operates, and also its internal policies and attitudes toward financial risk. The industry in which the company operates has an important impact on:

• Revenue volatility; and

• Operating leverage (cost structure) A company cannot use too much debt for fear of encountering bankruptcy when economic conditions decline. The reasons for issuing different kinds of debt (loan capital). Companies need to take a variety of factors into consideration when deliberating the use of debt:

• Capital structure constraints: Is there enough equity underpinning?

• Term of borrowing: This must be determined in relation to the use to which the proceeds will be put. Cash flow projections and repayment provisions must be analyzed (bullet repayment or amortizing schedule).



theexpgroup.com

• Currency and interest rate base (fixed/floating): What are the company’s views on currency and interest rate market risks? What hedging possibilities exist?

• Security: What tangible security is available to support borrowings?

Leasing Leasing is a form of fixed asset financing, in which a lessor, as owner of an asset, makes it available to, and for the use of, a lessee in return for a stream of payments over a period of time. Operating leases These are generally short-term rental contracts in which the lessor services and insures the asset. They are usually cancelable during the lease period at the choice of the lessee. Finance leases These are also known as “capital” leases and are in substance similar to the use of a secured bank loan to acquire and use an asset. Main features include:

• Lease term covering most of the asset’s economic useful life;

• The lessee assumes responsibility for servicing the asset;

• Any cancellation clause would require the lessee to cover the lessor for any losses;

• Lessee will usually have an option to buy the asset at the termination of the lease (note: the transfer of ownership, if any, outside and after the end of the lease contract);

• The lessee must show the lease asset and liability on its balance sheet. Attractiveness of leasing Leasing has been attractive to lessees (the users of the asset) for a several possible reasons:

• Conservation of cash flow: If a bank loan cannot be arranged, then leasing provides a way of financing the asset;

• Cost reasons: The leasing costs may be more competitive than a bank loan;

• From the lessor’s perspective, leasing can be attractive for tax reasons, where the

tax benefits of ownership are useful to the lessor.



theexpgroup.com

Sale-and-lease-back Under a sale-and-lease-back, a company sells an asset in its possession to another company and then immediately leases the same asset back again. In this way, the company will receive cash from the sale proceeds, and can plan to make periodic lease payments to the new owner in return for continuing to operate the asset. This technique has been a favored one for companies with a large exposure to the property market. A chain of retail stores, for example, can raise possibly much-needed cash in this way, while removing fixed assets from its balance sheet. For the same reason, a bank may sell the properties occupied by its branch network, thus freeing up capital for its main business; in addition, it retains operating flexibility in the location of branches (which need to be where the business is). In this way, it escapes exposure to real estate market risk. Hire purchase These are more typical installment payment plans for an asset, which is eventually transferred to the ownership of the company making use of the asset. Payments are structured to incorporate capital and interest elements. Public Private Partnership The National Air Traffic Services (which has responsibility for civilian air traffic control in the UK) was placed into a Public Private Partnership with the transfer of 51% of its shares to the private sector in 2001. A decline in air traffic following the September 11, 2001 attacks made an additional investment of £130m necessary (£65m each from the UK government and the British Airports Authority, BAA, the latter receiving 4% of the company in return). The current shareholders are: UK government (49%); The Airline Group (42%) which is a consortium of British Airways, BMI, EasyJet, Monarch Airlines, Thomas Cook Airlines, Thomson Airways and Virgin Atlantic; BAA (4%); and NATS employees (5%). Internal funds As a matter of practicality, managers usually choose to finance new projects or investments by making use of the following sources in the order shown:

http://en.wikipedia.org/wiki/September_11,_2001_attacks�

http://en.wikipedia.org/wiki/UK_government�

http://en.wikipedia.org/wiki/BAA_plc�

http://en.wikipedia.org/wiki/Consortium�

http://en.wikipedia.org/wiki/British_Airways�

http://en.wikipedia.org/wiki/BMI_(airline)�

http://en.wikipedia.org/wiki/EasyJet�

http://en.wikipedia.org/wiki/Monarch_Airlines�

http://en.wikipedia.org/wiki/Thomas_Cook_Airlines�

http://en.wikipedia.org/wiki/Thomson_Airways�

http://en.wikipedia.org/wiki/Virgin_Atlantic_Airways�



theexpgroup.com

(i) Internal funds (retained earnings)

(ii) Debt

(iii) Equity The above sequence is referred to as the “pecking order theory” and is based on observations of business behavior. The first choice is a natural one: retained earnings are already at the disposal of the company without involving costs or formalities. They are not considered to be a free (costless) form of finance, however; they are available for distribution to the shareholders. As along as they are retained by the firm, management is expected to earn a cost of equity return on such funds. Short-term financing The starting point for a business is to determine how it can finance its operations at a minimal (or no) cost. Negotiating long payment terms to suppliers can be a most attractive way of conserving cash. Other sources of short-term financing involve a cost to the business:

• Overdraft facility at the bank • Invoice discounting and debt factoring (recourse/non-recourse) • Bills of exchange and acceptance credits

Choosing the right financing Financing options to a business can be determined by generating financial projections of its statement of financial position (previously known as the balance sheet), the statement of comprehensive income (income statement) and statement of cash flows.



theexpgroup.com

Chapter 7

Short-term Decisions

KEY KNOWLEDGE

Cost-Volume-Profit (CVP) Analysis

The breakeven formula

Total Costs = Fixed Costs + Unit Variable Cost x Number of Units

Total Revenue = Sales Price x Number of Units

If

TC = Total Costs,

FC = Fixed Costs,

V = Unit Variable Cost,

X = Number of Units,



theexpgroup.com

TR = Total Revenue,

SP = Selling Price,

C = SP – V = Unit Contribution and

CM%= C/SP = Contribution Margin,

Then the break-even point (the output level at which TR=TC) is:

• In units sold: X = FC/C • In dollar sales: TR = FC/CM%

• Safety Margin = Budgeted Sales – Break-even point (units/dollars) • C is an important indicator, as it shows the contribution of each unit sold towards

covering fixed costs. Therefore, in the short run, the firm may prefer to produce/sell below break-even in order to recover some of its fixed costs.

KEY KNOWLEDGE

Break-Even Analysis

Marginal costing is useful in calculating the “break-even” level of sales.



theexpgroup.com

The break-even point is the level where the company achieves zero profit (neither gain nor loss). It just manages to cover its fixed costs.

Below is data on a manufacturing company.

Cost per unit (of product): $

Direct materials 45

Direct labour 18

Variable production O/Hs 9

Total variable production costs

Distribution & selling (variable)

Additional info:

Selling price per unit

72

2

120

Fixed production costs

Fixed Selling, General, Admin costs

16,500

7,000

EXAMPLE

Based on the data in the previous example, calculate the break-even point of the company. Total fixed costs: 23,500



theexpgroup.com

Contribution per unit: 46 Break-even point: 23,500/46 = 511 units Contribution per sale – C/S ratio This is understood as the amount of contribution generated by every dollar sold. In the previous example, the company’s C/S ratio is: $ 0.3833 (120/46) The break-even level of sales can be calculated as: C/S ratio

Fixed costs

Break-even point (sales) = $ 61,310

KEY KNOWLEDGE

Short-term decision-making

Limiting factors

When a single limiting factor is present in a production plan, then it is necessary to identify it and to plan production around it.

Take the following example:

Selling price 30 40 50 Product X Y Z

Labour cost per unit ($) 10 16 20 Material cost per unit ($) 5 8 10 Contribution 15 16 20 It appears that in the face of unlimited demand for all three products, Product Z would be given priority as it maximizes the contribution per unit.



theexpgroup.com

Now, assume that labour hours are limited to 500 and that labour costs $2 per hour (demand remains unlimited for all three products). In the above case,

Labour cost per unit ($) 10 8 20 Product X Y Z

No. of hours per unit 5 8 10 Contribution per hour 3 2 2 Now it becomes clear that Product X is favoured for the full number of hours available (500). 100 units of X can be produced. If demand for X were limited to, say, 80 units (requiring 400 labour hours), then the remaining available hours (100) could be used to produce either Y or Z (in this case there is indifference between the two). The steps to be followed in working out the optimal production plan are:

(1) Calculate the contribution per unit of product; (2) Calculate the contribution per unit of limited resource; (3) Rank the products according to Step 2; (4) Produce according to the priority established in Step 3, up to the demand limit of

each product or until the limited resource is exhausted

Make-Buy

A make-buy decision requires the determination of all relevant costs.

EXAMPLE

An automotive components producer can supply itself externally with car heaters for USD 210 per unit. In considering whether to make these internally, the company calculates that an equivalent unit can be made in 2 labour hours using USD 100 worth of materials.

Labour is currently at full capacity producing carburettors which generate contribution of USD 100. A carburettor takes 2.5 hours to produce. Labour costs USD 10 per hour. The carburettor also absorbs fixed overhead costs at the rate of USD 20 per labour hour.



theexpgroup.com

Relevant costs One of management’s responsibilities involves making decisions affecting the firm in the short-run based on relevant costs. What is relevance? A relevant cost is a cash cost which is uniquely incurred (or avoided) as a consequence of taking a decision; cash, because it is the main determinant of value (unlike accounting profit); and unique in the sense that is not common to the alternative choices that are under consideration.

EXAMPLE

A company seeking to determine whether to continue to transport its products by truck or to switch to the railroad discovers that insurance costs are identical in both choices; in that case, insurance costs are not relevant to the decision.

If, however, there is a difference in the two insurance costs, then one can speak as the difference between the two choices as being “incremental”; this difference (referred to in some places as the “differential”) is relevant to the decision under consideration.

Future

Relevant costs refer to the future, i.e. they can be influenced prospectively by choice. It follows that:

Sunk costs are not relevant: They have already taken place and cannot be reversed.

Committed costs, if they cannot be avoided, are likewise not relevant, even if the timing of their occurrence is in the future. Their “unavoidability” has already been established in the past (making them effectively the equivalent of sunk costs).

In keeping with the above logic, relevant costs therefore involve cash, are incremental and relate to the future.



theexpgroup.com

Costing projects

It is a standard management accounting practice to determine the relevant costs of a new project in order to come up with a price quotation. Setting a price without having an accurate understanding of costs can put a company at a competitive disadvantage, particularly if there is intense competition.

Relevant costs need to be identified with care, as they may include opportunity costs.

EXAMPLE

A company considers building a storage facility on the site of a parking lot. If the parking lot had been generating parking fees which will now be lost, then this foregone revenue is an opportunity cost.



theexpgroup.com

Chapter 8

Capital Investments

KEY KNOWLEDGE

Long-term investment decisions

Key features of long-term investment decisions Long-term investment decisions typically involve the investment of resources in non-current assets that will produce a benefit in the future. When considering long-term investments, it is necessary to include all relevant cash flows, including investment in working capital (one of the frequently-forgotten items!) and also the proceeds on disposal of final inventories and equipment at the end of the project’s life (if there is any cash to be recovered at that time). When appraising such investments, the time value of cash flows is critical, i.e. the timing of such cash flows can determine whether or not an investment is acceptable.



theexpgroup.com

Accounting Rate of Return (ARR) ARR is an accounting-based measure of return on investment. Its definition varies. Here are some: 5 year project Initial Investment 40,000 (20% p.a. depreciation) Avg. Investment 20,000 Profit Before Profit After Depreciation Depreciation Year 1 10,000 2,000 Year 2 13,000 5,000 Year 3 18,000 10,000 Year 4 20,000 12,000 Year 5 12,000 4,000 Avg. profit (p.a.) 6,600

(1) ARR = Avg. profits = 6,600 Avg. Investment 20,000

= 33%

(2) ARR = Avg. profits = 6,600 Total Investment 40,000

= 16.5%

(3) ARR = Total profits = 33,000 Total Investment 40,000

= 82.5%

Note: Always use the accounting profit after deduction of depreciation Recalculate the above if there is a 5,000 residual value. 5 year project Initial Investment 40,000 (20% p.a. depreciation) Residual value 5,000 Avg. Investment 22,500



theexpgroup.com

Total profit before Depreciation 73,000 Total depreciation 35,000 Total profit after Depreciation

38,000

Avg. Profit 7,600

(1) ARR = Avg. profits = 7,600 Avg. Investment 22,500

= 33.8%

(2) ARR = Avg. profits = 7,600 Total Investment 40,000

= 19%

(3) ARR = Total profits = 38,000 Total Investment 40,000

= 95%

What’s wrong with this measure?

1) It is using an accounting measure of profit (not cash)

2) It does not take the timing of cash flows into consideration. Re-calculate the ARRs (above) if the profits were reversed as follows: Profit After Depreciation Year 1 4,000 Year 2 12,000 Year 3 10,000 Year 4 5,000 Year 5 2,000 Average profits and average investment amount remain unchanged.



theexpgroup.com

Payback method Initial Investment: 40,000 Cash flows Cashflows

(A) (B) Year 1 5,000 15,000 Year 2 6,000 13,000 Year 3 12,000 12,000 Year 4 13,000 6,000 Year 5 15,000 5,000 Total 51,000 51,000 Payback Year 5 Year 3 What are the advantages and disadvantages of this method? Advantages It is easy to understand and to use. It focuses on the time needed to cover the investment (in money terms) and no more; it can be considered a minimalist’s approach (psychologically). If you invest in a Central American country where you expect a coup in the next 2 years, the payback method may be for you! But remember, the net (money) returns start only after that point! Disadvantages It is a crude measure. It does not take opportunity costs or expected returns on money invested into account. The preeminence of cash Cash, both its receipt and possession, lies at the basis of economic value. Cash is used to pay the bills and bonuses. It is a better indicator of wealth when compared with measures defined by accounting conventions, such as accounting profit.



theexpgroup.com

The relevance of cash flow to capital investment appraisal The appraisal process is predicated on the fact that capital expenditures are investments which will (hopefully) confer future benefits referred to as the payback. The payback may be a lengthy (and risky) one.

Timing and value Tracking and measuring cash flows on a time-adjusted basis is critical: cash received quickly can be used to repay debt (avoiding interest costs) or invested (earning interest). Cash paid with a delay can reduce costs (as long as penalties are not incurred). It follows that the longer one waits for a receipt of cash, the less that cash is worth in today’s terms. Among other factors, its purchasing value may diminish due to the effects of inflation. Compounding Instead of receiving USD 100 today, assume it will be received after one year. To compensate for the delay, what should the value be after one year? Present Value (PV) Future Value (FV) 100 100 x (1+r) In the above example, if r = 5% p.a. then the FV after one year will be USD 105. This process can be repeated year after year.

Discounting The above relationship between PV and FV: PV x (1+r) = FV can be re-arranged to: PV = (1+r)

FV

with r representing the discount rate. The above refers to “one-period” discounting, with r corresponding to the period. If discounting is done over more than one period, then the discounting effect will be: PV = FV



theexpgroup.com

(1+r)n where “n” refers to the number of periods. Thus, 100 received after two years, discounted at 10% p.a. will be PV = 100 (1.10)2

= 82.6

This reflects that the uncertainty of getting money back increases with time. This allows one to discount future values into present values and can be applied to a series of cash flows: Year: 1 2 3 4 5 Future Values: 100 100 125 105 140 If discounted at r = 10%, then the above cash flows can be restated at their present values: FV discounted: 100 100 125 105 1.10 (1.10)2 (1.10)3 (1.10)4 (1.10)5

140

PV: 90.9 82.6 93.9 71.7 86.9 Added together results in total PV = 426. Reducing future cash flows – of different timings and amounts – to one PV is a powerful tool. Note: If all the cash flows had been equal – say 100 – then the PV calculation would have been simplified: FV discounted: 100 100 100 100 1.10 (1.10)2 (1.10)3 (1.10)4 (1.10)5

100

PV: 90.9 82.6 75.1 68.3 62.1 The addition of the above is = 379



theexpgroup.com

Net Present Value (NPV) To add meaning to the future cash flows, we can include the amount invested (which gives rise to the FVs): Year: 0 1 2 3 4 5 Investment: (200) FV: 100 100 125 105 140 PV: (200) 90.9 82.6 93.9 71.7 86.9 Year 0 amounts denote the present and are automatically = PV. The NPV of the above cash flows is therefore = 226. Internal rate of Return (IRR) The internal rate of return (IRR) is defined as the discount rate (r) at which the net present value (NPV) of a stream of cash flows will be equal to zero. In other words, If, at a discount rate r, NPV = 0, then IRR = r The IRR includes among its assumptions the following: any cash flows generated in the course of a project being evaluated are calculated as being reinvested at the IRR rate. This is illustrated thus: Time Cash flows 0 (20,000) 1 5,000 2 30,000 The IRR of the above cash flows (using interpolation or calculator) is 35.61%. The above cash flows is equivalent to re-investing the 5,000 (Year 1) at the IRR rate (35.61%) to maturity (Year 2). Time Cash flows (A) Cash flows (B) 0 (20,000) (20,000) 1 5,000 0



theexpgroup.com

2 30,000 36,780.5 (30,000 + 6,780.5*) * 5,000 x 1.3561 = 6,780.5

The IRR of the cash flows shown in Column (B) is 35.61% -- exactly the same as in Column (A). Note: Column (B) cash flows resemble that of a zero-coupon bond, with investment at time 0 and no cash returns until the final year. This calculation confirms that interim cash flows are re-invested at the IRR rate. This assumption has been criticized for being unrealistic, since cash paid out of a project (returned to the investors, for example) is unlikely to obtain the same rate if invested elsewhere: they may be higher (i.e. interest rates may have risen in the meantime), or lower (placed in the bank to earn deposit interest). Comparison of NPV and IRR methods The following decision rules apply to appraisal methods: NPV: Positive NPV projects are acceptable; the higher the better. IRR: An IRR in excess of a hurdle rate (set by the company) indicates acceptability; the higher (the IRR) the better.

EXAMPLE

Year 0 1 IRR NPV: 10% 14% 16% A -5,000 6,000 20% 454 263 172 B -7,500 8,850 18% 545 263 129 Intuitively, IRR should be preferable, as it relates return to amount invested. Equal investment amounts do not necessarily remove the ambiguity.



theexpgroup.com

EXAMPLE

Year 0 1 2 IRR NPV (9%) A -500 100 600 20% 97 B -500 500 155 25% 89 Discounted Payback We can apply the concept of discounting to the Payback method in order to capture the time value of money element. Year: 0 1 2 3 4 5 Investment: (200) FV: 100 100 125 105 140 PV: (200) 90.9 82.6 93.9 71.7 86.9 In the table above, the (simple) payback period is in Year 2; The Discounted Payback period is longer (Year 3).

fia ffm 2013 notes

Documents

course materials

exp group

nature of information

commercial use

private use

capital management

specific cases

means of reproduction