financial management subject guide

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Financial managementJ. Dahya, R.E.V. Groves

AC3059,2790059

2011

Undergraduate study inEconomics, Management,Finance and the Social Sciences

This subject guide is or a Level 3 course (also known as a 300 course) oered as

part o the University o London International Programmes in Economics, Management,

Finance and the Social Sciences. This is equivalent to Level 6 within the Framework or

Higher Education Qualifcations in England, Wales and Northern Ireland (FHEQ).

For more inormation about the University o London International Programmes

undergraduate study in Economics, Management, Finance and the Social Sciences, see:

www.londoninternational.ac.uk


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This guide was prepared for the University of London International Programmes by:

J. Dahya, Bacc., Macc, Lecturer in Accounting and Business Finance, Cardiff Business School,University of Wales, Cardiff.

R.E.V. Groves, B.Com., MSc, PhD, FCA, Sir Julian Hodge Professor of Accounting, CardiffBusiness School, University of Wales, Cardiff.

It was updated in 2008 by Professor Groves.

This is one of a series of subject guides published by the University. We regret that dueto pressure of work the authors are unable to enter into any correspondence relating to,or arising from, the guide. If you have any comments on this subject guide, favourable orunfavourable, please use the form at the back of this guide.

The University of London International Programmes

Publications OfficeStewart House32 Russell Square

London WC1B 5DNUnited Kingdom

Website: www.londoninternational.ac.uk

Published by: University of London

University of London 2008

Reprinted with minor revisions 2011

The University of London asserts copyright over all material in this subject guide except whereotherwise indicated. All rights reserved. No part of this work may be reproduced in any form,

or by any means, without permission in writing from the publisher.We make every effort to contact copyright holders. If you think we have inadvertently usedyour copyright material, please let us know.


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Contents

i

Contents

Introduction ............................................................................................................ 1

Aims and objectives ................................. ................................. ................................ ..... 1

Learning outcomes ................................. ................................. ................................. ..... 2

Syllabus ............................... ................................ ................................. ........................ 2

Studying financial management .......................................... ................................. ......... 2

Reading advice ............................... ................................. ................................. ............ 3

Online study resources ................................. ................................. ................................. 4

How to use the subject guide .................................. ................................. ..................... 5

Solutions to learning activities .......... ................................. ................................. .......... 6

Examination advice ............................... ................................. ................................ ....... 6

Summary ................................. ................................. ................................. ................... 7

Abbreviations ................................ ................................. ................................. ............. 7

Chapter 1: Introduction to financial management ................................................ 9

Aims of the chapter ............................. ................................. ................................. ....... 9

Learning outcomes .............................. ................................. ................................. ........ 9

Essential reading ................................ ................................. ................................. ...... 10

Further reading ............................. ................................. ................................ ............. 10

Key tasks of financial management ........ ................................ ................................. .... 10

Financial environment ............................... ................................ ................................. . 10

Organisational forms of business ... ................................. ................................. ........... 11

Corporate objectives ................................ ................................. ................................ .. 11

Role of managers ................................... ................................ ................................. ... 12

Conflicts of interest and their resolution ............................................ .......................... 12

Corporate governance ............................ ................................. ................................. .. 13

Financial management and risk ............................................................. ...................... 13

Financial management and accounting ..... .................................. ................................ 13

Financial management and taxation ............................... ................................. ........... 14

A reminder of your learning outcomes ............................. ................................. ........... 14

Practise questions ............................. ................................ ................................. ......... 14

Problems .............................. ................................ ................................. ..................... 15

Chapter 2: Basic investment appraisal methods .................................................. 17

Aims of the chapter .......................... ................................. ................................. ........ 17Learning outcomes ................................. ................................. ................................ .... 17

Essential reading ............................. ................................. ................................. ......... 17

Further reading ............................... ................................. ................................. .......... 17

Time value of money ............................. ................................. ................................. .... 18

Future value and compounding .......................................... ................................. ........ 18

Present value and discounting ............................... ................................. .................... 18

Interest rates, discount rates and real rates ............................... ................................. . 19

Basic investment appraisal techniques ............................... ................................. ........ 19

Application problems some considerations ............................. ................................. . 21

What-if questions .............................. ................................. ................................. ..... 25The examination ................................. ................................. ................................. ...... 26

A reminder of your learning outcomes ................................................ ......................... 26


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59 Financial management

ii

Sample examination questions ................................. ................................. .................. 26

Practise question 2.1 ................................... ................................. .............................. 26

Problems ............................. ................................. ................................. ..................... 27

Chapter 3: Introduction to risk and return ........................................................... 29

Aims of the chapter ............................... ................................. ................................ .... 29

Learning outcomes ................................ ................................. ................................. .... 29

Essential reading .................................. ................................. ................................. .... 29Further reading ............................... ................................. ................................ ........... 29

Introduction ...............................................................................................................29

Rate of return: a review ............. ................................. ................................. ............... 30

Calculating expected return, variance and standard deviation ....... ............................... 31

Risk and diversification .......................................................... ................................. .... 33

Market risk versus unique risk ................................ ................................. .................... 35

A reminder of your learning outcomes ................................................ ......................... 35

Practise questions ............................... ................................. ................................. ...... 35

Problems ................................ ................................. ................................. .................. 36

Chapter 4: Capital budgeting risk and return .................................................. 37Aims of the chapter ............................ ................................. ................................. ...... 37

Learning outcomes .............................. ................................ ................................. ....... 37

Essential reading ................................ ................................ ................................. ....... 37

Further reading .................................. ................................. ................................ ........ 37

Introduction ............................... ................................. ................................. .............. 37

Measuring market risk .................................. ................................. ............................. 38

Measuring beta ................................ ................................. ................................. ........ 38

Portfolio betas .................................. ................................. ................................ ......... 39

Risk and return ............................................................ ................................. .............. 39

Capital asset pricing model ........................................... ................................. ............. 40Project returns and the opportunity cost of capital ................................................... .... 41

Capital budgeting and project risk ................................. ................................. ............ 42

A reminder of your learning outcomes ............................. ................................ ............ 43

Practise questions .................................. ................................ ................................. .... 43

Problems ............................. ................................. ................................ ...................... 43

Chapter 5: Sources of funds ................................................................................. 45

Aims of the chapter ............................... ................................. ................................ .... 45

Learning outcomes ................................ ................................. ................................. .... 45

Essential reading ............................. ................................ ................................. .......... 45

Capital markets .............................. ................................. ................................. .......... 46

Efficient market hypothesis .................... ................................. ................................ .... 46

Tests of the efficient market hypothesis ......................... ................................. ............. 47

Anomalies, fads, insider trading and doubts concerning efficiency ....... ......................... 48

Implications of capital market efficiency .............. ................................ ........................ 48

London capital market .......................................................... ................................. ..... 49

Share capital ................................ ................................. ................................. ............ 50

Methods of raising share capital ................................. ................................. ............... 50

Rights issues, share prices and shareholder wealth .................... ................................. . 51

Other sources and types of equity ............................... ................................ ................ 52

Retained earnings ............................... ................................ ................................. ....... 53

Long-term debt finance ...................... ................................. ................................. ...... 53

The issue of loan capital ................................ ................................. ............................ 54

Hybrid capital .............................. ................................. ................................ .............. 54


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The attitude of investors and managers to the financing decision .......................... ....... 54

A reminder of your learning outcomes ............................. ................................. ........... 55

Practise questions .................................. ................................ ................................. .... 55

Problems ............................. ................................. ................................. ..................... 55

Chapter 6: Cost of capital and valuation of a business........................................ 57

Aims of the chapter ............................... ................................ ................................. .... 57

Learning outcomes ................................ ................................. ................................ ..... 57Essential reading .................................. ................................. ................................ ..... 57

Further reading .............................. ................................. ................................. ........... 57

The value of economic assets debt .................................. ................................. ........ 58

The value of economic assets equity ........................................................... .............. 59

The required return on investment .............................. ................................. ............... 60

The capital asset pricing model (CAPM) ............................. ................................ ......... 61

The cost of retained earnings ..................... ................................. ................................ 61

Valuation of warrants ............................... ................................. ................................. 62

The reasons for capital gearing ................................... ................................ ................ 62

Capital gearing and risk ............................................................. ................................. 63The relationship between the level of capital gearing and the cost of capital the

traditional view ................................. ................................. ................................ ........ 63

The relationship between the level of capital gearing and the cost of capital the

Modigliani and Miller view ............................ ................................. ............................ 64

Weighted average cost of capital (WACC) ... ................................. ............................... 65

Valuation on the basis of the businesss earnings ................................ ........................ 65

Other approaches to share and business valuation ................................... ................... 66

A reminder of your learning outcomes .............................. ................................. .......... 70

Practise questions ............................. ................................. ................................. ........ 70

Problems .............................. ................................. ................................. .................... 71

Chapter 7: Dividend policy ................................................................................... 73

Aims of the chapter ........................... ................................. ................................ ........ 73

Learning outcomes .................................. ................................ ................................. ... 73

Essential reading .............................. ................................. ................................. ........ 73

Further reading ................................ ................................. ................................. ......... 73

Introduction .............................. ................................. ................................ ................ 73

Dividend policy and shareholder wealth .... ................................. ................................. 74

Dividend irrelevancy argument ...................................... ................................. ............. 74

Traditional view of dividends .............................. ................................. ........................ 74

Information content of dividends .................................. ................................. ............. 75

Clientele effect ............................... ................................. ................................. .......... 75Share repurchase ................................. ................................. ................................. ..... 76

Scrip dividends .............................. ................................. ................................. ........... 76

Determining dividend policy in practice ............................... ................................ ........ 77

A reminder of your learning outcomes ................................. ................................ ........ 77

Practise questions ................................ ................................. ................................. ..... 77

Problems ....................................................................................................................79

Chapter 8: Financial analysis, methods and uses, and financial planning ............ 81

Aims of the chapter ........................ ................................ ................................. ........... 81

Learning outcomes .............................. ................................. ................................. ...... 81

Essential reading ................................ ................................. ................................. ...... 81Further reading ............................. ................................. ................................ ............. 81

Statement analysis .............................. ................................. ................................ ....... 81


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iv

Cash based ratios ........................................................ ................................ ............... 82

Practical applications ............................. ................................. ................................. ... 83

Financial planning introductory comments .............................. ................................. 88

Financial planning process ................................................. ................................. ........ 88

Technical aspects of financial planning ........................... ................................. ............ 88

Planning outputs .................................. ................................. ................................. .... 89

A reminder of your learning outcomes ................................. ................................. ....... 90Practise questions ................................. ................................ ................................. ..... 91

Problems ....................................................................................................................91

Chapter 9: Short-term finance and asset management ...................................... 93

Aims of the chapter .............................. ................................ ................................. ..... 93

Learning outcomes ............................... ................................. ................................ ...... 93

Essential reading ................................. ................................. ................................ ...... 93

Further reading .............................. ................................ ................................. ............ 93

Long- versus short-term finance ........................................ ................................. ......... 94

Trade credit ....................................................... ................................. ........................ 94

Debt factoring .............................. ................................. ................................. ............ 94Bank borrowing .................................. ................................ ................................. ....... 95

Specialist finance ................................ ................................ ................................. ....... 96

Leasing ................................. ................................ ................................. .................... 96

Evaluation of sources of finance ............................................................. ..................... 96

Management of short-term assets .......................................................... ..................... 99

The management of cash ............................................... ................................. ............ 99

The management of trade debtors ............................. ................................ ............... 100

The management of stock-in-trade ............................. ................................. .............. 101

Working capital and the problem of overtrading ................................................. ....... 102

A reminder of your learning outcomes .............................. ................................ ......... 104

Practise questions ............................. ................................. ................................ ....... 104

Problems .............................. ................................. ................................ ................... 105

Chapter 10: Treasury management and international aspects of

financial management ....................................................................................... 107

Aims of the chapter .......................... ................................. ................................ ....... 107

Learning outcomes ................................. ................................ ................................. .. 107

Essential reading ............................. ................................. ................................. ....... 107

Further reading ............................... ................................. ................................. ........ 107

Introduction ............................. ................................. ................................ ............... 108

Why should financial managers of firms be concerned with options and other

financial instruments? ................................. ................................. ............................. 108Calls and puts .......................... ................................ ................................. ............... 108

What the value of a call option depends upon ...................................... ..................... 109

Option valuation model ....................... ................................. ................................. ... 110

Using options to allow the expansion or abandonment of real assets ......................... 111

Options on financial assets .............. ................................ ................................. ........ 112

Why do companies hedge? .............................................. ................................. ........ 112

International financial management ................................................... ....................... 113

Interrelationships between variable affecting exchange rates ....................... .............. 114

Exchange risk exposure ............................. ................................. ............................... 116

Management of foreign exchange exposure .................. ................................ ............ 116A reminder of your learning outcomes ............................................... ........................ 119

Practise question ............................... ................................. ................................. ..... 119

Problems ..................................................................................................................120


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Contents

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Chapter 11: Mergers, corporate restructuring and off-balance sheet funding .. 121

Aims of the chapter ......................... ................................ ................................. ........ 121

Learning outcomes ............................... ................................. ................................. ... 121

Essential reading ................................. ................................. ................................. ... 121

Further reading .............................. ................................. ................................. ......... 121

Introduction ................................. ................................. ................................. .......... 122

Merger waves ................................ ................................ ................................. .......... 122Motives for individual mergers ............................... ................................. .................. 123

Economic theories of mergers ..................... ................................ .............................. 123

Management motives ............................... ................................. ............................... 126

Takeover tactics ....................................................... ................................. ................ 127

Takeover defences ........................................ ................................. ........................... 129

Glamorous defence tactics .............................................. ................................. ......... 129

Company restructuring ............................. ................................ ................................ 130

Divestments .............................................................................................................130

Off-balance sheet funding ............................... ................................. ......................... 131

Leasing ....................................................................................................................131A reminder of your learning outcomes ............................................... ........................ 132

Practise questions .............................. ................................. ................................. ..... 132

Problems ..................................................................................................................133

Appendix 1: Review questions ........................................................................... 135

Question 1 ...............................................................................................................135

Question 2 ................................. ................................. ................................. ............ 135

Question 3 ................................. ................................. ................................ ............. 136

Question 4 ................................ ................................. ................................. ............. 137

Question 5 ................................ ................................. ................................ .............. 137

Question 6 ................................ ................................ ................................. .............. 138

Question 7 ................................ ................................. ................................. .............. 138

Question 8 ............................... ................................. ................................. .............. 139

Appendix 2: Suggested solutions to review questions ..................................... 141

Solution to Question 1 ............................................ ................................. ................. 141



Solution to Question 4 .................................. ................................. ............................ 145





Appendix 3: Sample examination paper ........................................................... 151


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Notes


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Introduction

1

Introduction

59 Financial management is a Level 3 course (also known as a 300

course) offered on the Economics, Management, Finance and the SocialSciences (EMFSS) suite of programmes.

Financial management is part of the decision-making, planning and

control subsystems of an enterprise. It incorporates:

the treasury function, which includes the management of working

capital and the implications arising from exchange rate mechanisms

due to international competition

the evaluation, selection, management and control of new capital

investment opportunities

the raising and management of the long term financing of an entity

the need to understand the scope and effects of the capital markets fora company, and

the need to understand the strategic planning processes necessary to

manage the long and short term financial activities of a firm.

The management of risk in the different aspects of the financial

activities undertaken is also addressed.

Studying this course should provide you with an overview of the problems

facing a financial merger in the commercial world. It will introduce you to

the concepts and theories of corporate finance that underlie the techniques

which are offered as aids for the understanding, evaluation and resolution

of financial managers problems.

This subject guide is written to supplement the Essential and

Further reading listed for this course, not to replace them. It makes no

assumptions about prior knowledge other than that you have passed

the course 25 Principles of accounting(or its predecessor, course

19 Elements of accounting and finance). This course may not be

taken with 92 Corporate finance. The aim of the course is to provide

an understanding and awareness of both the underlying concepts and

practical application of the basics of financial management. The readings

and the subject guide should also help to build in your mind the ability to

make critical judgements of the strengths and weaknesses of the theories,

just as it should be helping to build a critical appreciation of the uses andlimitations of the same theories and their possible applications.

Aims and objectives

This course is designed to:

place financial management as a clear part of the decision making,

planning and control subsystems of an enterprise

provide an overview of the problems facing a financial merger in the

commercial world

introduce the concepts and theories of corporate finance that underlie

the techniques

which are offered as aids for the understanding, evaluation and

resolution of financial managers problems.


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2

Learning outcomes

At the end of this course, and having completed the Essential reading

and activities, you should be able to:

discuss the theoretical models underpinning the practices in financial

management

apply the techniques derived from the models and theories in financialmanagement

explain the long and short-term financial needs of a business

describe the techniques used for the selection and management of long

and short-term assets

discuss and give examples of the wider aspects of financial

management so as to include international considerations and the need

to communicate decisions made to other members of a management

team.

The above provides a broad checklist for you to refer to as you work

through the guide.

Syllabus

A critical perspective of the topic of finance, the role of financial managers

and the place of financial markets within the business environment in

developed and developing economies. Topics will be set in both national

and international contexts.

Sources and methods of raising finance including venture capital, public

offerings, private placements and project finance.

A critical review of the different forms of finance such as equity, debt

and their derivatives and incorporating critical consideration of theircosts individually and in combination. Valuation methods for costing the

different elements of capital such as the Capital Asset Pricing Model and

the Arbitrage Pricing Model. Theories of capital gearing, dividend policy

and corporate restructuring and refinancing. Mergers and acquisitions.

Evaluation of risk measurement theories and methods and their

application to both sources of finance and to investment appraisal.

Investment appraisal techniques in the certain and uncertain world, with

and without constraints.

Analytical tools, techniques and methods for analysing financial reports

incorporating an assessment of their relevance for evaluation and planning

purposes. Strategic considerations of financial planning and control,models and methods, for management of corporate liabilities and assets.

Consideration of theories and techniques for management of short term

funds including treasury and currency management.

An introduction to risk management including hedging, futures, options

and derivatives and their uses in both long and short term situations.

Studying financial management

This subject guide highlights the key theoretical and practical issues

relating to financial management.

The topics to be covered in this subject can be divided into six elements:

the theories and techniques of appraisal and management of long-term

investments under conditions of both certainty and risk


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Introduction

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the various sources of long-term funds, the methods used to raise them,

their individual costs and the effect of gearing in the corporate financial

mix

the valuation models used to derive capital costs, incorporating

theoretical and empirical aspects of investors behaviour both

individually and as a capital market, noting differences in capital

market operations and effects between developed and developing

capital markets

the analytical tools necessary for corporate evaluation, valuation,

prediction and planning

short-term funds, their sources and management, both nationally and

internationally

general elements of corporate financial activity such as mergers

and acquisitions, risk management, treasury management using the

currency and futures markets.

From the practical viewpoint, these elements of financial management

can be condensed to the three broad areas of the provision, allocation

and control of a businesss financial resources to enable it to achieve its

objectives. The financial manager must be able to identify and quantify

the amount of capital required for investment, whether this is in fixed or

current assets. To do this, the manager will use financial planning models

to determine the quantity of funds required. Where, why, and how the

funds are obtained is all part of the financial managers function just as

deciding to what use the funds should be put. Having decided upon the

capital mix on the one hand, and the selection of the investments on

the other, the financial manager must then fulfil the control function of

this role thus ensuring that the planning goals are achieved. Overall, the

financial manager has a wide and very important role.

Reading advice

Essential reading

You need to purchase or have regular access to the following

textbook:

Brealey, R.A., S.C. Myers and A.J. MarcusFundamentals of Corporate Finance .

(McGraw-Hill Inc, 2007) fifth edition (Intl) [ISBN 9780073012384].

This textbook gives a good introduction to the subject, but on its own is

insufficient since it does not provide the depth of discussion and analysis

required for an undergraduate degree course. It is therefore necessary to

read the appropriate chapters in one of the additional texts listed below

to provide this depth. These texts tend to be reflective of the corporate

finance perception of the subject matter rather than the more applied view

of financial management. This has to be born in mind. In the text it will be

referred to in this subject guide as BMM.

Detailed reading references in this subject guide refer to the editions of the

set textbooks listed above. New editions of one or more of these textbooks

may have been published by the time you study this course. You can use

a more recent edition of any of the books; use the detailed chapter and

section headings and the index to identify relevant readings. Also check

the virtual learning environment (VLE) regularly for updated guidance on

readings.


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Further reading

Please note that as long as you read the Essential reading you are then free

to read around the subject area in any text, paper or online resource. You

will need to support your learning by reading as widely as possible and by

thinking about how these principles apply in the real world. To help you

read extensively, you have free access to the VLE and University of London

Online Library (see below).

Other useful texts for this course include:

Brealey, R.A., S.C. Myers and F. AllenPrinciples of Corporate Finance.

(McGraw-Hill, 2008) ninth edition (Intl) [ISBN 9780073368696].

For those of you who are studying on your own who find difficulty with

the recommended basic text of BMM another text is offered, but note that

it does not cover the subjects to the same depth and rigour required. This

supplementary primer is:

Atrill, P.Financial Management for Decision makers. (FT Prentice Hall

Europe, 2005) fourth edition [ISBN 9780273702498].

Online study resources

In addition to the subject guide and the Essential reading, it is crucial that

you take advantage of the study resources that are available online for this

course, including the VLE and the Online Library.

You can access the VLE, the Online Library and your University of London

email account via the Student Portal at:

http://my.londoninternational.ac.uk

You should have received your login details for the Student Portal with

your official offer, which was emailed to the address that you gave

on your application form. You have probably already logged in to the

Student Portal in order to register! As soon as you registered, you will

automatically have been granted access to the VLE, Online Library and

your fully functional University of London email account.

If you forget your login details at any point, please email: uolia.support@

london.ac.uk quoting your student number.

The VLE

The VLE, which complements this subject guide, has been designed to

enhance your learning experience, providing additional support and a

sense of community. It forms an important part of your study experience

with the University of London and you should access it regularly.

The VLE provides a range of resources for EMFSS courses:

Self-testing activities: Doing these allows you to test your own

understanding of subject material.

Electronic study materials: The printed materials that you receive from

the University of London are available to download, including updated

reading lists and references.

Past examination papers andExaminers commentaries : These provide

advice on how each examination question might best be answered.

A student discussion forum: This is an open space for you to discuss

interests and experiences, seek support from your peers, workcollaboratively to solve problems and discuss subject material.

Videos: There are recorded academic introductions to the subject,

interviews and debates and, for some courses, audio-visual tutorials

and conclusions.


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Introduction

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Recorded lectures: For some courses, where appropriate, the sessions

from previous years Study Weekends have been recorded and made

available.

Study skills: Expert advice on preparing for examinations and

developing your digital literacy skills.

Feedback forms.

Some of these resources are available for certain courses only, but weare expanding our provision all the time and you should check the VLE

regularly for updates.

Making use of the Online Library

The Online Library contains a huge array of journal articles and other

resources to help you read widely and extensively.

To access the majority of resources via the Online Library you will either

need to use your University of London Student Portal login details, or you

will be required to register and use an Athens login:

http://tinyurl.com/ollathens

The easiest way to locate relevant content and journal articles in the

Online Library is to use the Summon search engine.

If you are having trouble finding an article listed in a reading list, try

removing any punctuation from the title, such as single quotation marks,

question marks and colons.

For further advice, please see the online help pages:

www.external.shl.lon.ac.uk/summon/about.php

How to use the subject guide

This subject guide is divided into 11 chapters, plus appendicies. Somechapters in the subject guide are self-contained; others lead into one or

more following chapters. Complete whichever chapter you are studying

and the associated work before moving on.

A suggested order for your studying is as follows:

For each chapter, read the aims and/or introduction and the learning

objectives to appreciate the scope of the material to be covered.

Carefully read the suggested chapters in Brealey, Myers and Marcus,

with the aim of gaining an initial understanding of the topics.

Read the remainder of the chapter in the subject guide. You may then

approach the Further reading suggested in Brealey, Myers and Allen.

The subject guide material is aimed to identify the scope of your

studying of this topic as well as attempting to reinforce the basic

messages set out in Brealey, Myers and Marcus. Therefore you should

pay careful attention to the examples in both the texts and the subject

guide to ensure you achieve that basic understanding. By taking notes

from Brealey, Myers and Marcus and then from any other books you

should have obtained the necessary material for your understanding,

application and later revision.

Pay particular attention to the practise questions and the examples

given in the subject guide. The material covered in the examples and in

working through the exercises is both complementary to the textbookand important in your preparation for the examination.

Ensure you have achieved the listed learning outcomes.


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Attempt the problems at the end of each chapter, and if you have the

time attempt those at the end of the Brealey, Myers and Marcus chapters.

Check you have mastered each topic before moving on to the next.

At the end of your preparations, attempt the Sample examination

questions at the end of the subject guide. Then compare your answers

with the suggested solutions, but do remember that they may well

include more information than the Examiner would expect in anexamination paper, since the guide is trying to cover all possible

angles in the answer, a luxury you do not usually have time for in an

examination.

Solutions to learning activities

Solutions to certain learning activities is provided online in the VLE at

http://emfss.elearning.london.ac.uk/

This is indicated in the subject guide as: See VLE for solution

Examination adviceImportant: the information and advice given here are based on the

examination structure used at the time this guide was written. Please

note that subject guides may be used for several years. Because of this

we strongly advise you to always check both the current Regulations

for relevant information about the examination, and the VLE where you

should be advised of any forthcoming changes. You should also carefully

check the rubric/instructions on the paper you actually sit and follow

those instructions.

The examination paper will normally be made up of two sections each

containing four questions. One section will include data handling andnumerical analysis type questions each requiring analysis, composition

and presentation. Each question will also have a small section requiring

a written answer which may be a discussion of the theory used in the

application, or a request for interpretation of your results or something

related to the problem or theory used. The other section will contain

essay or report-style questions requiring written answers. You will need to

answer four questions with a minimum of one question from each section.

Remember when sitting the examination to maximise the time spent

on each question and although, throughout, the subject guide will give

you advice on tackling your examinations, remember that the numerical

type questions on this paper take some time to read through and digest.

Therefore try to remember and practise the following approach. Always

read the requirement(s) of a question first before reading the body of the

question. This is appropriate whether you are making your selection of

questions to answer, or when you are reading the question in preparation

for your answer.

In the question selection process at the start of the examination, by

reading only the requirements, which are always placed at the end of a

question, you then only read material relevant to your choice, you do

not waste time reading material you are not going to answer. Secondly,

by reading the requirements first, your mind is focused on the sort of

information it should be looking for in order to answer the question,

therefore speeding up the analysis and saving time.


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Introduction

7

Remember, it is important to check the VLE for:

up-to-date information on examination and assessment arrangements

for this course

where available, past examination papers and Examiners

commentaries for the course which give advice on how each question

might best be answered.

Summary

Remember this introduction is only a complementary study tool in your

efforts with this subject guide. Its aim is to give you a clear understanding

of what is in the subject guide and how to study successfully.

Systematically study the next eleven chapters along with the listed texts

for your desired success.

Good luck and enjoy the subject!

Abbreviations

AIM Alternative Investment Market

APM Arbitrage Pricing model

ARR Accounting rate of return

BMA Brealey, Myers and Allen

BMM Brealey, Myers and Marcus

CAPM Capital asset pricing model

CME Capital market efficiency

EMH Efficient market hypothesis

EPS Earnings per shareIRR Internal rate of return

ISE International Stock Exchange of the UK and the

Republic of Ireland

NPV Net present value

MM Modigliani and Miller

MPT Modem portfolio theory

PA Peter Atrill

PE Price earnings ratio

PI Profitability indexPP Payback period

WACC Weighted average cost of capital


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Notes


8


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Chapter 1: Introduction to financial management

9

Chapter 1: Introduction to financial

management

Aims of the chapterThis chapter is clearly one of the most important in the subject guide

because it deals with the fundamentals of financial management. Without

a clear understanding of the fundamentals the remainder of this subject

will not be easy to grasp. As with any subject area, a knowledge of the

background, the environment to which the subject relates, is important as

it helps to put everything learnt later into appropriate perspective.

The chapter starts by looking at the key tasks of financial management.

Since knowledge of the financial environment is vital to managers this

comes next before the review of the differing organisational forms of

business that are in use.

An outline of corporate objectives follows because these form the basis of

much of the theory that is covered in this subject. The roles of financial

managers come next, to be followed by a discussion of some of their

conflicts of interest and how they might be resolved. One area of major

interest is the corporate governance debate on how the relationship

between owners and controllers should be systemised to maximise the

corporate gain.

Brief descriptions of how risk is treated in financial management theory,

and how accounting is linked in with financial management, are included

and the chapter is concluded with a note of the direction and importance

of taxation in todays financial decisions.The course 25 Principles of accounting, if studied carefully and fully,

should have meant you already have all this background knowledge. If

that is true, then perhaps only a quick review of this subject matter is

necessary, but if the practise questions and problem(s) here and in the

Essential text cause you any problems, then a more detailed and careful

review of your prerequisite course may be needed.

Learning outcomes

By the end of this chapter, and having completed the Essential reading and

activities, you should be able to:

describe the general financial environment in which corporations

operate

explain the importance and roles of financial markets

list/outline the roles financial managers can have within an

organisation

outline such things as taxation, accounting information and form of

business and their implications for financial management

give examples of the various objectives a company may have and why

the main objective is deemed to be shareholder wealth maximisation

explain and give examples of how the influence of risk will permeate allaspects of financial management, the theories presented, the appraisal

and selection, the changes suggested, and the control methods used.


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10

Essential reading


(McGraw-Hill Inc, 2007) Chapters 1, 2 and 3.

Further reading

Brealey, R.A., S.C. Myers and F. AllenPrinciples of Corporate Finance. (McGraw-

Hill, 2008) Chapter 1.

Atrill, P.Financial Management for Decision makers. (FT Prentice Hall Europe,

2005) Chapters 1 and 2.

Key tasks of financial management

There are five key tasks undertaken in financial management:

financial planning

investment project appraisal

financial decisions capital market operations

financial control.

Financial planning provides the means, through plans and projections, to

evaluate the proposed courses of action. Similarly financial control deals

with the ways and means by which the plans are achieved. The next two

tasks, investment project appraisal and financing decisions are seen by

some, including Brealey and Myers, as the two most important tasks.

Investment project appraisal is the assessment and evaluation of the

relative strengths of a companys investment propositions. The financing

decisions involve the identification and choice of the sources of funds

which will provide the cash to be invested into the selected projects. Part

of the finance function is dealing with the capital market since a large

part of the finance is obtained through the capital market, not least those

funds provided by the equity owners, the ordinary shareholders.

This function does not just deal with the raising of funds but also with

the ongoing relationship between the company and the market place;

information disseminated to the capital markets affects the markets

perception of the company and the price of the companys shares, and thus

wealth of the shareholder.

Financial environment

The economic and social background of a country is a major influence on a

firm, on its structure and on its objectives and operations. Firms in socialist

or communist countries have different structures and objectives from those

that operate in capitalist economies. Countries that are still developing

may not have a public market place (i.e. a stock market) in which the

shares in a company can be traded. Different phases of the trade cycle

have different implications for financial operations. In depressed times,

interest rates payable on loans will be higher, trading conditions much

more risky and so returns to shareholders may be lower or non-existent.

In the capitalist economies of developed countries where there are

stockmarkets, the owners of the shares in trading companies will expectreturns on those shares. The quality and amount of that return, the

dividend, will be one of the elements influencing the price at which the

share is quoted in the market. Potential owners of shares as well as existing


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11

owners of shares are interested in the quoted price of a companys share

and in the return obtainable from that investment. How and why those

returns and share prices can be influenced will be covered later. The extent

of a countrys capital markets, of which the stockmarket is but a part, vary

enormously from the very large, very sophisticated, very structured markets

such as London and New York to some of the very small nascent markets in

some developing countries in Africa and the Middle East.

Each country has its own sets of laws and regulations which provide the

parameters for the structure of the entity and how it can operate on a

daily basis.

Organisational forms of business

Businesses established for profit-making purposes generally are

organised into one of two forms: incorporated and un-incorporated.

The incorporated firm are the companies or corporations, while the un-

incorporated are either proprietorships or partnerships.

The corporation or company is a legal entity of unlimited life, independent

of its owners. The owners of a company, its shareholders, have limited

liability for the debts and obligation of the company. The liability being

limited to the par or nominal value of the shares or equity held. With

ownership usually comes some form of control through voting rights, but

this does not extend to managerial control of day to day operations. For

that, management, by way of directors, have to be appointed to act as the

shareholders agents. Therefore, in theory, ownership and management are

likely to be separate, unless of course managers are also major shareholders.

The unincorporated form of business make up the majority of the numbers

of businesses, though not the majority in terms of value or employment.

These businesses are generally sole proprietorships or partnerships. The

liability of the owners of these entities is unlimited. They are managedby the owners and do not have a separate legal entity even though they

may have a separate trading name. Ownership and management risks

are intertwined which makes raising very large sums of capital almost

impossible. If the owner/partners want the entity to continue to grow then

usually a change in form for the entity will be necessary. In this subject

guide we will be viewing financial management from the perspective of

a corporate entity, but much of what is covered is also relevant to the

unincorporated business.

Corporate objectives

Generally we assume that a companys objective is to increase the value of

the shareholders investment in the firm. We also assume that all managers

act to further that objective. Shareholder wealth maximisation is the

normative objective of a company that underlies financial management

theory.

In practice, a company has many stakeholders, employees, customers,

government, creditors, lenders as well as shareholders. As groups they

have their objectives for the company and as individuals they have their

own objectives for their stake in the company. Some of these individual

objectives may be at slight variance with the others, for example,

customers want the company to provide the product with the highest

quality and lowest price, but this may not result in high profits and share

price maximisation. Corporate objectives are determined by a relatively

small group of senior management, probably the directors. These can


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12

be influenced by a number of things with an outcome which may not be

shareholder wealth maximisation, and which can be allowed to vary with

circumstances and over time. It is often argued in the UK financial press

that though companies may be trying to increase shareholder wealth it is

not with a long-term perspective but is only short-term oriented.

Activity 1.1

Consider the stakeholders of a business as described earlier.

Try to list what you believe are the major objectives of each group. There may be two,

three or more for each group.

Then try to rank each groups objectives in order of importance.

Now draft your reasons for your rankings.

Next assume you are the Board of Directors and you are required to publish the

companys objective(s).

Which one(s) would you list and why? Do they all directly or indirectly lead to

shareholder wealth maximisation?

Your lists could be based upon the company(s) you know or work for. Do not be surprisedby the differences and variations, and do not forget the power of the financial market

place in steering you towards your final selection.

See VLE for solution

Role of managers

A company is a complex organisation made up of many employees each

with their own objectives. In theory, the manager is expected to act in

furtherance of the goals of the owners. The financial manager is expected

to act as the intermediary who will undertake the tasks of financial

management. That is, the manager, using the evaluation, planning andcontrol techniques and systems, will attempt to maximise the return

from the optimal selection of investments so as to satisfy the providers of

finance from whom (s)he has obtained the cheapest and best combination

of funds via the capital markets. However, managers may not be owners.

Conflicts of interest and their resolution

One of the major disadvantages of the corporate form is the separation

of management and ownership. This separation can create costs which

have been called the costs of agencysince management is deemed to

be the agent of the owners (the principals).Agency theoryattempts to

explain this situation and how conflicts between principal and agent canarise, as well as possible ways in which the costs of any such conflict can

be minimised. It is argued that agents will tend to pursue their own goals

and the greater the deviation of those goals from the corporate goals, the

greater the agency costs. Therefore incentives should be provided to try

to ensure convergence of goals between principal and agent (e.g. share

option schemes). Systems should be used to monitor and ensure control of

agents, for example use of annual reports, the setting up of an appropriate

governance structure which restricts, minimises and hopefully enables

the removal of management, and in particular directors, who abuse their

powers and who are therefore not attempting to ensure the company

achieves its goals.


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13

Corporate governance

The essence of the corporate governance debate is the effects of the

particular relationship between directors and shareholders. The greater

the separation between the two, the greater the potential for abuse and

also the greater the possibility of suboptimal behaviour by managers

as viewed by shareholders. At present in the UK there is a voluntary

system of governance in place. The framework has evolved through,

or been impacted upon, by six key reports starting with the Cadbury

report in 1992. The various recommendations of these reports have been

incorporated into the combined code which is included in the Listing

Rules of the London Stock Exchange as an appendix. The rules require

a company to make a disclosure statement in its annual report about its

compliance with the combined code. Though not legally enforceable,

the regulations require compliance and provide for penalties. Different

corporate structures, business, legal and social environments require

different governance requirements and systems. All this is important

because it highlights the differences between the normative theory and the

practical application.

Financial management and risk

Since financial management is concerned with making decisions, and

decision making is concerned with the future and the future is uncertain,

risk must be a major factor in all aspects of financial management. Risk

may be defined as the extent to which what we estimate will happen in

the future may or may not happen. If there is only one single possible

outcome, there is no risk. If there are many possible outcomes and many

of them are very different from our estimate of the outcome, then there is

a lot of risk.

Broadly speaking, both theory and practice show us that risk and return

are correlated. We seek higher expected returns for investing in riskier

projects. Where we perceive little risk (e.g. an investment in government

securities), we are prepared to accept relatively small returns.

Activity 1.2

Choose a few practical situations where a business faces the effect of risk,

(e.g. projecting next years sales budget or evaluating a new investment proposal).

Try to identify the causes of that riskiness.

Then think of ways to try to measure it and ways to control it.


Financial management and accounting

Financial management is not the same as, or even a branch of,

accounting.

Accounting has been defined as:

the process of identifying, measuring and communicating

economic information to permit informed judgements and

decisions by users of the information. (American Accounting

Association).


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14

Given this definition, it is clear that financial managers will be major users

of accounting information.

Those who work as financial managers may very well have a background

in accounting. In many small businesses one person combines the roles

of accountant and financial manager. Despite these facts, the role of the

accountant and that of financial manager are distinctly different. The

accountant is concerned with the provision of information: financial

managers use information supplied by the businesss accounting system

and other sources to help them to make financing and investment

decisions.

Financial management and taxation

Virtually all decisions taken by financial managers have tax effects. In the

UK, for example, the tax treatment of loan interest is different from that

of dividends paid to shareholders. Therefore the decision between raising

funds from shareholders and from lenders has tax implications. Returns

from investments made by the business (i.e. profits) are taxed. It is not

one of the objectives of this course to turn you into an expert on the UKtax system. It is important, however, that you have a broad appreciation of

the major aspects of the UK tax system, which has much in common with

the tax systems which prevail in other of the worlds countries.

Activity 1.3

Think of similarities and differences between the UK tax systems and another country you

are familiar with. Are there any major differences in the corporate taxation system?

A reminder of your learning outcomes

By the end of this chapter, and having completed the Essential reading andactivities, you should be able to:

describe the general financial environment in which corporations

operate

explain the importance and roles of financial markets

list/outline the roles financial managers can have within an

organisation

outline such things as taxation, accounting information and form of

business and their implications for financial management

give examples of the various objectives a company may have and why

the main objective is deemed to be shareholder wealth maximisation explain and give examples of how the influence of risk will permeate all

aspects of financial management, the theories presented, the appraisal

and selection, the changes suggested, and the control methods used.

Practise questions

1. Consider what objectives might be important to a company other

than shareholder wealth maximisation. Describe these objectives and

show how there may or may not be consistency between the different

objectives. Discuss the implications of your findings.

2. How might a managers objectives differ from those of the company?What are the implications for corporate policies in order to ensure

congruence between the sets of objectives?


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15

Problems

In BMM, attempt the following problems:

Chapter 1, p.23, numbers 2, 5, 7, 8 and 9

Chapter 2, pp.44 and 45, numbers 4, 10 and 17

Chapter 3, p.65, numbers 2, 3 and 4.


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Notes


16


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Chapter 2: Basic investment appraisal methods

17

Chapter 2: Basic investment appraisal

methods

Aims of the chapterLike the topics in the first chapter of this guide, the topics in this chapter

are integral to the subject as a whole since these basic techniques of time

value of money and discounting are used in numerous other aspects of

financial management. So carefully learn these concepts, and the process

as well as the principles and the pros and cons concerning them.

This chapter defines and explains the time value of money concept

and applies it to problems of investment appraisal in a certain world.

The relaxation of the assumption of certainty occurs in the following

two chapters. Here we concentrate on the basics since the technique

can be and is used in long-term and short-term investment appraisal,

in evaluation of financing methods, valuing monetary assets, risk

management etc.

We start by describing the time value of money and then explain the

concept and approach to the computational methodology used in a

practical example of investment appraisal and selection. The net present

value (NPV) is described very fully both in principle and application and

in how the decision rules are derived. Different sets of circumstances are

introduced to show how the NPV approach can cope with the situations

met in an imperfect world, (e.g. taxation, inflation, different interest rates,

repeat investments, mutually exclusive investments, capital rationing).

Alternative methods of appraisal are also described, such as internal

rate of return and pay-back. The major problem of an imperfect world

and uncertain outcomes is dealt with later in Chapters three and four.

Learning outcomes

By the end of this chapter and having completed the Essential reading and

activities, you should he able to:

describe and apply the time value of money in project evaluation,

whether it be future or present value oriented

defend the use of NPV as the method of appraisal against other

suggested methods

prepare evaluations of investment proposals and state which decision

rule is appropriate in the specific set of circumstances.

Essential reading


(McGraw-Hill Inc, 2007) Chapters 4, 7, 8 and 9

Further reading

Brealey, R.A., S.C. Myers and F. AllenPrinciples of Corporate Finance. (McGraw-

Hill, 2008) Chapters 2, 3, 6 and 7.Atrill, P.Financial Management for Decision makers. (FT Prentice Hall Europe,

2005) Chapters 4 and 5.


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18

Time value of money

Money (i.e. cash) has a different value over time; holders of money can

either spend the money on consumption now or delay the consumption

by investing the money until it is required for consumption. The reward

for the delay in spending is the interest received by investing. The amount

of interest is dependent upon the amount of time and the rate of interest.

The further into the future a consumer has to wait, the greater the interest

compensation required. So if one knows of a certain future receipt of

cash then there must be a certain value today, which we call the present

value, which will be its equivalent. By receiving today an amount of cash

equal to the present value, the recipient would be indifferent between the

future receipt and todays receipt. The difference between the two receipts

is the time value, the compensation for the passage of time. The present

value of a future amount is also known as the discounted value.

Future value and compounding

Whenever someone makes an investment, he or she expects to earn areturn which can take the form of interest when the investment is in some

form of monetary asset. If the interest earned is reinvested rather than

withdrawn then the total amount invested grows at a compound rate.

At the end of the life of the investment (at maturity) it will have a value F

the future or maturity value. IfP is the amount invested today at r%

with compound interest for tyears then the future value will beF.

F=P(1 + r)t

Present value and discounting

The converse of compounding is discounting. This uses as its basis thesane algebraic relationship but in the opposite way. The aim of discounting

is to determine the present value of a future amount (i.e. todays amount)

which, if invested at the rate of interest r, would achieve the future

value predicted. With prospective new investments we can predict the

incremental cash flows which will occur because of the investment, but

as these predictions are all in money terms of differing values they must

all be converted into a value at a common date (i.e. today, the day of the

investment). Therefore we need to convert all cash flows into present

values, todays values. So if we predict receiving Fin tyears time during

which r is rate of interest then P is the present value of F, derived thus:

tt

r

F

r

FP

)1(

1

)1( +=

+

=

Notet

r)1(

1

+

is the discount factor.

Using a computer, a table of discount factors for all combinations ofr

and t has already been prepared. This can be found at the back of all

reputable texts. You should familiarise yourself with the compounding and

discounting formulae and procedures and where they are used. Apply this

knowledge to annuity payments or receipts. Remember an annuity is a

constant annual amount and so the annuity factor for any year is the sum

of the annual discount factors up to and including that year.


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19

Interest rates, discount rates and real rates

An interest rate is the proportionate return on an investment

appropriate for the risk level of the investment. So it could be the return

on a bond, a companys investment or the required return a company

has to pay on its loan etc. The expression discount rate is often used

synonymously with interest rates because the discount factor is derived

using an interest rate. Similarly, because companies use a mixture of

capital types to fund their investments, that mixture has an average cost

which the company has to service. Any investments made from that mix

of capital must generate flows and in the evaluation of those flows we

use the discounting process. We can use the expressions cost of capital,

opportunity cost of funds, as alternatives to discount rate since the

discounting factor is derived using the cost of capital.

You must learn the difference between real and nominal interest rates.

(The terms, money and actual interest rates, are also used to mean

nominal rate). The nominal rate is the rate to be found in the market

place. The real rate is the rate of interest that would persist if there were

no inflation or deflation.

(1 + real rate)(1+ infation rate) = (1 + nominal rate)

(1+ r)(1+ i) = (1+ n)

N.B. Note the short cut sometimes used to derive the nominal rate (r+ i)

= n. Do remember this is only an approximation and will usually lead to

over-valuing the present value of the future flows.

Remember that different items of operating expenditure and revenues

may have their own specific inflation rates and, when undertaking an

investment appraisal, all cash flows prior to discounting should be quoted

in actual or money flows for the specific period. All individual and specific

inflation rates will have been separately accounted for (e.g. the degree ofinflation may have been different from year to year or between say wages

and materials). The discount factor used should only incorporate the

inflation rate relevant to the capital providers who have to be serviced and

repaid from the investment.

Activity 2.1

What is the time value of money? How is it different from the real and actual rates of

interest of a risky investment?


Basic investment appraisal techniques

Using BMM learn how to compute the net present value (NPV) for

an investment, as well as an investments internal rate of return

(IRR). Likewise learn how to compute the payback period (PP) and

the accounting rate of return (ARR). The decision rules for each

appraisal method should be learnt for the range of different types of

decisions a manager might face, simple go/no go, selection between

mutually exclusive projects and so on. See BMM sections 7.1 and 7.2.

Activity 2.2

Solve self-tests in BMM, numbers 4.1, 4.3, 4.4, 4.5, 4.8 and 4.14.


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20

You must remember:

that long term projects under consideration should be consistent with

the long term corporate plan

that the estimated cash inflows from the project when discounted

to a common date, the present, exceed the estimated outflows, also

discounted to the present

that the theory in this section assumes certainty of knowledge andforecasting this is relaxed in the next chapter

that, in practice, businesses do not wholeheartedly follow the

theoretically correct route of using the net present value approach

(NPV) all the time.

You should learn the process of identifying, analysing and estimating the

investment flows, remembering the projections should be in cash not profit

flows, unless ARR is being used. Profit flows will need adjustment to cash

if only profit estimates are given. You should learn the theory behind the

four main analytical techniques with emphasis on why NPV is superior to

IRR, PP and ARR. The amount and timing of the net cash flows of a project

are crucial to the viability of an investment.

Given below is an example of two mutually exclusive investments, A and

B, with an explanation of why only NPV will give the correct signal to

management. Assuming an annual cost of capital of 15% and estimated

net actual annual cash flows as stated, then the four methods will give

conflicting results. Each method has its own set of decision rules.

Project Time periods (years)

0 1 2 3 4 Total

A (25,000) 5,000 12,500 12,500 12,500 17,500

B (10,000) 5,000 10,000 (1,000) - 4,000

NPV() IRR (%) Payback (Years) ARR(%)

A 4,166* 22 2.6 35*

B 1,251 24* 1.5* 26.7

Separately using each evaluation method the pairs of values for projects

A and B are shown above. Using the NPV approach A will have an NPV

of 4,166 and B an NPV of 1,251. The decision rule is to select the

investment with the higher NPV regardless of the size of the original

investment. Therefore A will be preferred to B, which is why it is marked

with an asterisk (*). Under each of the evaluation methods and using the

appropriate decision rule the preferred choice can be made. It is marked

with an asterisk (*) in each case.

Using the payback approach would suggest B is preferred as it has the

shorter payback period. If one only used ARR, then A is preferred since it

has the higher rate. Since neither method is the correct one, it is by chance

one gives us the appropriate selection. The main reason for disregarding

the outcomes under these two methods is that neither payback nor

ARR take into account the pattern of flows (i.e. the time value of the

cashflows). Also payback does not take into account the post payback

flows which, in the case of A, are considerable, while for B they are less so

and it even has a net outflow in one period. From the textbooks note the

rationales presented for the still considerable use of payback by managersin practice. See BMM p.202 and PA pp.14043.


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22

An alternative way of acquiring the services of an asset is to lease it rather

than buy it. The same principles of evaluation should be applied to the

incremental cash flows arising as a result of taking out a lease in order to

see whether it is a better way of funding the asset as opposed to buying it.

Worked example 1

A business is considering an investment in equipment which requires an initial outlay of

10 million. The investment will be allowed a 20% writing down allowance (depreciation)

on a straight line basis for tax purposes. It is estimated the equipment will be sold at the

end of the project, the end of the fourth year for 3 million. Any tax received on a loss, or

paid on a gain, arising from the sale of the equipment would occur in the fifth year.

The incremental revenues and costs and the annual price rises incorporated in the

estimates arising from the investment are as follows:

million

Years 1 2 3 4

Sales 30 40 50 4

Wages (4% p.a. increases) 10 11 15 16

Materials (20% p.a. increases) 7 13 17 19

Other costs (5% p.a. increases) 10 11 12 13

Book depreciation 2 29 2 37 2 46 1 49

Net trading surplus 1 3 4 5

Increases in working capital 1 0.5 0.5 (2.0)

The business estimates that the average annual inflation rate will be 4.5% p.a. during

the five years and the businesss real after tax opportunity cost of capital is 10% p.a. The

corporate tax rate for each of the five years is 30% payable a year in arrears.Required:

Compute the NPV, IRR, Payback and ARR for the project.

Solution to Worked example 1

First compute the depreciation for tax purposes. Obviously one uses the tax regime

requirements appropriate to the country in which one is investing.

Writing down allowance computation (straight line)

Tax allowance

Outlay 10

Year 1 (20%) 2 2

8

Year 2 (20%) 2 2

6

Year 3 (20%) 2 2

4

Year 4 Sale 3

Year 4 1 Loss on sale 1

(The same approach can be used for reducing balance based allowances.)

Then compute the tax payments or receipts based upon the taxable profits. This may

require a transfer of tax depreciation for book depreciation (in this case they are similar).


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Tax computation (million)

Years

1 2 3 4

Net trading surplus 1 3 4 5

Add book depreciation 2 2 2 1

Trading surplus (adjusted) 3 5 6 6

Less tax depreciation 2 2 2 1

Taxable profit 1 3 4 5

Tax (30%) 0.3 0.9 1.2 1.5

Tax is paid in year following the year in which the profits were earned, i. e. tax on year 1s

profits of 0.3 paid at end of year 2.

Cost of capital (discount rate) (i)

The actual or money rate is the rate to use. Then:

(1+i) = (1 + 0.1)(1 + 0.045)

= (1 + 0.1495)Thus i = 0.15 (i.e. 15%)

(Some authors and businesses use the quick way and get an approximate value by

summing the real and inflation rates. Here: 10% + 4.5% = 14.5% = 15%. You should

use the theoretically correct method given above unless an approximation is called for.)

To calculate the NPV

million

Year 0 1 2 3 4 5 Total

Outlay (10.0) (10.0)

Trading surplus

(adjusted) 3.0 5.0 6.0 6.0 20.0

Working capital

change (1.0) (0.5) (0.5) 2.0

S

financial management subject guide

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