ACCA f ffinancial management study noter

ACCA – FM FINANCIAL MANAGEMENT STUDY NOTES Contents Sr # TOPIC Page # Investment Appraisal 01 Inflation 20 Risk & Uncertainty 32 Cost of Capital 39 Cost of Irredeemable Debt 46 Capital Structure and WACC 51 Business Valuation 57 Sources of Finance 64 Cost of Convertible Debt 70 10 Islamic Financing 77 11 Small and Medium Enterprises (SME) 80 12 Working Capital Management 94 13 Inventory Management 99 Study Notes Financial Management - FM Investment Appraisal Decision making Short term Long term (Single period effect) (Having multi period effects) Investment Appraisal:A detailed evaluation of projects/investments to assess the viability, its effects on shareholders wealth is called investment appraisal, What is Appraisal:Any expenditure in the expectation of future benefits There are two types of investment: Capital expenditure: Capital expenditure is an expenditure which results in the acquisition of non-current assets or an improvement in their earning capacity It is not charged as an expense in the income statement; this expenditure appears as a noncurrent asset in the balance sheet Revenue expenditure: Charged to the income statement and is expenditure which is incurred (i) For the purpose of the trade of the business this includes expenditure classified as selling and distribution, administration expenses and finance charges (ii) To maintain the existing earning capacity of non-current asset The capital budgeting process: The process of identifying, analyzing and selecting investments projects whose returns are expected to extend beyond one year These steps are being followed in capital budgeting process I Creation of capital budgets This steps involves assessing the time required by projects, when they are anticipated to start, how they will be financed, how they would effect the current production budget, expected levels of production and long term development of organization II Investment Decision making process It involves the following steps Origination of Proposals Project screening and Acceptance Analysis and Review Monitoring Study Notes i Financial Management - FM Origination:A good understanding of market demand, market conditions and customer perceptions are always needed in order to avail the opportunities There should be a proper mechanism which identifies the potential opportunities available in the market for investment, and if technology is obsoleting, organization should know beforehand that new investment is required ii Project Screening:Each proposal should be screened before doing financial analysis on it This screening would involve the following questions:  What is the purpose of the project?  Does it align with organizations long term objectives? There should not be a single conflict between the organization objectives and projects objectives  Are sufficient resources available?  Necessary management skills are present?  What kind of risk is involved in the project? iii Analysis and acceptance:It involves the following steps  Standard format of financial information as a formal investment proposal should be submitted  Project should be classified e.g what kind of financial appraisal is required, what % of return should be achieved  Financial analysis should be done  Outcome of financial analysis should be compared with predetermined criteria  Consider the project in the light of capital budget for the current and future operating periods  Make the decision (accept or reject)  Monitor the progress of the project a) Financial Analysis:This step would involve the application of organization’s preferred investment appraisal techniques e.g IRR, NPV etc Some projects e.g marketing investment decisions have intangible returns in this case more weight may be given to the consideration and qualitative issues b) Qualitative Issues:Qualitative Issues are those issues which are difficult or impossible to quantify but decisions should be made after considering these issues e.g (i) How the project will affect the company’s image (ii) Would the project help the organization in satisfying the customer needs c) Accept or Reject:Acceptance depends on three factors (i) Type of investment Study Notes (ii) (iii) iv Financial Management - FM Risk of the investment Amount of expenditure required Monitoring the progress:A project progress should be monitored regularly, to ensure that capital spending is not exceeding from the budget, implementation is not delayed and the anticipated benefits are eventually obtained Financial Evaluation Methods Basic Methods  Accounting Rate of Return (ARR)  Payback Period Advanced Methods  Net Present Value NPV  Internal Rate of Return (IRR)  Discounted Payback Period In the above methods, ARR method is based on profits whereas all other methods are based on cash flows The Advanced Methods Includes Time Value of money Basic Methods Accounting Rate of Return (ARR) Definition:The earnings of a project expressed as a percentage of the capital outlay or average investment Or Average return as a percentage of average investment Formula:ARR = Average Annual profit x 100 Initial investment Alternative Version of ARR is: ARR = Average Annual profit x 100 Average Investment Where “Average Investment” is = Initial Investment + Scrap value Decision Rule:Feasibility Decision: If ARR of the project > Target ARR, Accept the project If ARR of the project < Target ARR, Reject the project Comparison Decision: Project with higher ARR shall be preferred Advantages of Accounting Rate of Return:  It considers the readily available accounting information, that’s why eliminating the need of any other additional reporting ARR is simple to calculate and easy to understand, there is no technical knowledge required for its calculations Study Notes    Financial Management - FM It takes into account the whole life of the project, as it takes the average of all profits available in the project life It can be used as a relative measure in case of mutually exclusive projects The expected profitability of a project can be compared with the present profitability of business Disadvantages of Accounting Rate of Return:         ARR does not consider the time value of money It ignores the timing, relevancy of cash inflows It includes:  Sunk costs (money already spent)  Net Book Values of Assets  Depreciation and amortization of intangibles  Allocated Fixed Overheads ARR calculations are based on accounting profits and they can be easily manipulated by applying different accounting policies It ignores the size of investment and length of the project It gives no absolute measure to reach at some conclusion, we need to comparison that’s why it is a relative measure only Calculation of target ARR is a subjective approach ARR does not take into account the risk and uncertainty related to the profits of the project It is an average measure, so does not consider relative life of the project The average annual profit used to calculate ARR, is unlikely to be the profit earned in any year of the project life Relevant Cash flows in Investment Appraisal:Relevant cash flows are those cash flows which are: (i) Directly related with the project (ii) Incremental (iii) Future cash flows Any cash flows or cost incurred in the past, or any committed costs which will be incurred regardless of whether the investment is undertaken or not are non-relevant cash flows e.g sunk lost, allocated overheads etc i The all other cash flows, which should be considered, are as follows: Opportunity Cost:Cost incurred or revenues lost from diverting enlisting resources from their best use are called opportunity cost As this will happen because of new project that’s why it is relevant ii Tax:Relevant costs include the extra taxation that will be payable on extra profits, or the reductions in tax arising from capital allowances or operating losses in any year iii Residual value: The residual value or disposal value of equipment at the end of its life or its disposal date are relevant to the appraisal Infrastructure Costs Marketing Costs: iv v Study Notes Financial Management - FM May be substantial, particularly if the investment is in a new product or service, but if the market research has been done in the past and no further investment in marketing is required then this will be non-relevant cost vi Human resource costs: It includes training costs and the costs of reorganization arising from investment vii Finance Related Cash flows:Finance related cash flows (e.g Interest on Bank Loan) are normally excluded from project appraisal exercises because the discounting process takes account of the time value of money, that is opportunity cost of investing the money in the project Finance Related cash flows are only relevant if the incur a different rate of interest from the rate which is being used as the discount rate viii Relevant Benefits of Investment:Relevant benefits from investments, include not only increased cash flows but also savings and relationships with customer and employees These might consist of benefits of several types; o Savings because assets used currently will no longer be used The savings should include savings in staff costs, or savings in other operating costs, such as consumable materials o Extra savings or benefits because of the improvements or enhancement that the investment might bring These include more sales revenue, greater contribution, more efficient systems operation and savings in staff time o Possibly some off revenue benefits from the sales of assets that are currently in use, but which will no longer be required o Greater customer satisfaction, arising from a more prompt service (e.g because of a computerized sales and delivery service) o Improved staff morale from working with high quality assets o Better decision making may result from better information systems Assumptions of Timing of Cash flows  If Cash flows arise during the period, then it is assumed as it arises at the end of that period  If cash flow arises at the start of the period then it is assumed as if it arises at the end of the preceding period  Period ‘0’ is not a period, instead it represents start of period ‘1’ PAYBACK PERIOD METHOD: Definition:The time period in which initial investment gets recovered, known as payback period The number of years for the cash out lay to be matched by cash inflows Formula:a For constant(Even) cash flows: Study Notes Payback period = Financial Management - FM Initial investment Annual inflows b For Uneven cash flows: Draw a cumulative cash flow column, then calculate project payback period Answer should be compared with the target payback period of the business Decision rule:i Feasibility Decision: If payback period is less than target payback period then ACCEPT the project If payback period is more than target payback period then REJECT the project ii Comparison Decision: Project with minimum payback period should be preferred Advantages of payback period:     It is simple to calculate and easy to understand, as it does not involve complex calculations Payback period method can also be used as a basic screening device at the first stage for short listed projects It considers cash flows rather than accounting profits, that’s why chances of manipulation are very low Payback period method indirectly avoids risk as it gives favor to those investments which have short payback periods This method helps the company to grow, minimize risk and maximize liquidity In the situation of capital rationing, it can be used to identify the projects which generate additional cash for reinvestment quickly Disadvantages of payback period:        It does not consider the time value of money It does not consider the whole life of project It might be possible that it will favor the projects, giving high cash inflows in the starting years only and giving very low cash inflows in the remaining years There are no specific criteria or rule which can justify that company’s target payback period is measured accurately that’s why it is difficult to measure target payback period It may lead to excessive investment in short term projects It does not consider the risk and uncertainty in the projects Uncertainty of cash inflows can deteriorate the results It does not focus on shareholders wealth maximization Life expectancy of a project is ignored Projects with same payback period may have different cash flows Lecture Examples on Payback Period: Example.1 Initial investment in project A is $80,000 Life of the project is six years and project generating equal cash inflows of $20,000 If target payback period of the company is year whether the project should be feasible or not Study Notes Financial Management - FM Required: Calculate payback period using non discounting payback period method and comment whether to accept or reject Example.2 Initial investment in project Z is $5,000 Project life is five years For the year cash flows from project Z are $2,000, $1,500, $1,000, $500 and $250 respectively If target payback period of company is year whether the project should be feasible or not Required: Calculate how much time is required to regain its investment and comment of it acceptability Example.3 Initial investment in project HMZ is $10,000 Project life is five years For the year cash flows from the project HMZ are $5,000, $1,000, $1,500, $1,250 and $2000 respectively If target payback period of the company is year whether the project should be feasible or not Required: Calculate time Compute payback period by using non discounting payback period method and comment of it acceptability Solutions Ex #1 Payback period Initial investment = Constant cash inflow 80,000 = 20,000 = So accept the project 4yrs < targeted 5y Ex #2 Yr T0 T1 T2 T3 T4 T5 Cash flow (5,000) 2,000 1,500 1,000 500 Cumulative cash flow (5,000) (3,000) (1,500) (500) - Payback period is yrs Ex #3 Yr T0 T1 T2 T3 T4 T5 Payback period Cash flow (10,000) 5,000 1,000 1,500 1,250 2,000 = 4𝑦𝑟𝑠 + = 4𝑦𝑟𝑠 + Cumulative cash flow (10,000) (5,000) (4,000) (2,500) (1,250) 750 𝑅𝑒𝑞 𝑅𝑒𝑐 1,250 2,000 4𝑦𝑟𝑠 & [ 1,250 2,000 ] 𝑋12 Study Notes Financial Management - FM = = + 0.625 4.625 yrs years & 7.5 months Advanced Methods Time Value of Money Sum of money received today has more worth than same sum of money received in future because of these reasons • Inflation • Opportunity to reinvest • Risk and uncertainty Simple interest 1000 x 10% = $100 1000 x 10% = $100 1000 x 10% = $100 Cash flows are not reinvested each year Compound interest 1000 x 10% = 100 + 1000 = 1100 1100 x 10% = 110 + 1100 = 1210 1210 x 10% = 121 + 1210 = 1331 Cash flows are reinvested each year resulting in higher principal that increases the interest amount We can also calculate the future amounts using this formula FV = PV (1+r)n FV= future value= 1331 PV= Present Value= 1000 1331 = 1000 x (1+10%)3 Discounting Where r = cost of capital = WACC = required rate of return PV = FV (1+r)-n Assumption: All cash flows are reinvested in the same project or any other at a given rate of return (cost of capital) Year Cash flows 1000 2000 3000 Df@12% 0.893 0.797 0.712 PV 892.9 1594.39 2135 Study Notes Financial Management - FM Accounts Receivable Management Major roles of credit control department/Receivable management To formulate credit policies  Lenient policy  Strict policy  Early settlement discount Assess credit worthiness of customers Collection of debt from customers efficiently Collection of overdue debt Receivable as sources of finance  Factoring  Invoice discounting Foreign receivable management Cost of Receivable o Administrative cost to record and collecting debts o Cost of irrecoverable debts (Sales X % of bad debt) o Cost of early Settlement Discount = (Sales X % of discount X % of customers taken the discount) o Finance Cost (Average Receivable X % of interest rate) Advantages and Disadvantages of using different polices for Receivables Management Lenient Policy Strict policy Advantages Disadvantages Increase in contribution Decrease in potential bad debt Decrease in administration cost Less overdraft cost Increase in potential bad debt Decrease in contribution High overdraft cost Increase in administration cost 101 Study Notes Financial Management - FM How to tackle in Exam Current Policy Cost of Proposed policy receivables=(Credit sales x 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 𝟑𝟔𝟓 )× Cost of receivables=(Credit sales x OD Interest rate Contribution =Sales × C/S ratio% OD Interest rate Contribution =Sales × C/S ratio% Bad debt = sales × % of bad debt Bad debt = sales × % of bad debt Admin cost Admin cost Total cost/Benefit Total cost/Benefit Early Settlement Discount Current Policy 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 𝟑𝟔𝟓 )× Proposed Policy Cost of receivables=(Credit sales x 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 𝟑𝟔𝟓 )× OD Cost of receivables 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 Interest rate =(Credit sales x Contribution = Sales × C/S ratio% OD Interest rate Cost of receivables =(Credit sales x 𝟑𝟔𝟓 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 𝟑𝟔𝟓 availing discount )× % of availing discount x not availing discount )× % of not availing Admin cost discount x OD rate Discount allowed= Sales × % of discount × % of availing discount Contribution = Sales × C/S ratio% Total cost Bad debt = sales × % of bad debt Bad debt=sales×% of bad debt Admin cost Total cost Cost of Early Settlement Discount The percentage cost of early settlement discount to the company offering the discount can be calculated by the following formula Cost of early settlement discount= ( 100 100−𝑑 )^365/t -1 Where  d = discount offered  t = reduction in payment period in days that is necessary to obtain early payment discount 102 Study Notes Financial Management - FM ASSESSING CREDITWORTHINESS methods   Bank reference While a bank reference can be fairly easily obtained, it must be remembered that the other company is the bank’s customer and so a bank reference will stick to the facts It is most unlikely to raise any fears the bank may have about the company Trade reference This is obtained from another company who has dealings with your potential customer/customer Due to the litigious nature of society these days, it may not be so easy to obtain a written reference However, you may be able to call contacts you have in the trade and obtain an informal oral reference ASSESSING CREDITWORTHINESS methods   Financial Statements Financial statements of a company are publicly available information and can be quickly and easily obtained While an analysis of the financial statements may indicate whether or not a company should be granted credit, it must be remembered that the financial statements available could be out of date and may have suffered from manipulation For larger companies, an analysis of their accounting information can generally be found through various sources on the internet  Visit Visiting a potential new customer to discuss their exact needs is likely to impress the customer with regard to your desire to provide a good service At the same time, it gives you the opportunity to get a feel for whether or not the business is one which you are happy to give credit to While it is not a very scientific approach, it can often work quite well, as anyone who runs their own successful business is likely to know what a good business looks, feels and smells like! Credit rating/reference agency These agencies’ professional business is to sell information about companies and individuals Hence, they will be keen to give you the best possible information, so you are more likely to return and use their services again ASSESSING CREDITWORTHINESS methods  Information from the financial media Information in the national and local press, and in suitable trade journals and on the internet, may give an indication of the current situation of a company For example, if it has been reported that a large contract has been lost or that one or more directors has left recently, then this may indicate that the company has problems 103 Study Notes Financial Management - FM Collection of Receivables Collection of overdue debt Collection of funds efficiently           The customer is fully aware of the terms The invoice is correctly drawn up and issued promptly They are aware of any potential quirks in the customer’s system Queries are resolved quickly Monthly statements are issued promptly   Instituting reminders or final demands Chasing payment by telephone Making a personal approach Notifying debt collection section Handling over debt collection to specialist debt collection section Instituting legal action to recover the debt Hiring external debt collection agency to recover debt Debt Factoring Factoring is an arrangement to have debts collected by a factor company, which advances a proportion of the money it is due to collect Factoring can be used to help short-term liquidity or to reduce administrative costs Aspects of Factoring The main aspects of factoring include the following  Administration of the client’s invoicing, sales accounting and debt collection service  Credit protection for the client’s debts, whereby the factor takes over the risk of loss from bad debts ad so insures the client against such losses This is knows as non-recourse service  Making payments to the client in advance of collecting the debts This is referred to as ‘factor finance’ Applying Debt Factoring Before Factoring Cost of receivables=(Credit sales x OD Interest rate After factoring 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 𝟑𝟔𝟓 )× Cost of Factor advance =(Credit sales x 𝟑𝟔𝟓 )× % of factor advance x Factor Interest rate Cost of remaining receivable =(Credit sales x Bad debt = sales × % of bad debt 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 𝑨𝒄𝒕𝒖𝒂𝒍 𝒅𝒂𝒚𝒔 𝟑𝟔𝟓 )× % of remaining finance x OD Interest rate Factor fee = Sales × % of fee Bad debt = sales × % of bad debt ( if with recourse) Admin cost Admin cost Total cost Total cost 104 Study Notes Financial Management - FM Example of Debt Factoring A company makes annual credit sales of $1,500,000 Credit terms are 30 days, but its debt administration has been poor and the average collection period has been 45 days with 0.5% of sales resulting in bad debts which are written off A factor would take on the task of debt administration and credit checking, at an annual fee of 2.5% of credit sales The company would save $30,000 a year in administration costs The payment period would be 30 days It is assumed that the factor would advance an amount equal to 80% of the invoiced debts, and the balance 30 days later The factor would also provide an advance of 80% of invoiced debts at an interest rate of 14% (3% over the current base rate) The company can obtain an overdraft facility to finance its accounts receivable at a rate of 2.5% over base rate Required: Should the factor's services be accepted? Assume a constant monthly turnover Solution (a) The current situation is as follows, using the company’s debt collection staff and a bank overdraft to finance all debts Credit sales Average credit period $1,500,000 pa 45 days The annual cost is as follows: 45/365 x $1,500,000 x 13.5% (11% + 2.5%) Bad debts 0.5% x $1,500,000 Administration costs Total cost $ 24,966 7,500 30,000 62,466 Solution (b) The cost of the factor 80% of credit sales financed by the factor would be 80% of $1,500,000 = $1,200,000 For a consistent comparison, we must assume that 20% of credit sales would be financed by a bank overdraft The average credit period would be only 30 days The annual cost would be as follows Factor’s finance 30/365 x $1,200,000 x 14% Overdraft 30/365 x $300,000 x 13.5% Cost of factor’s services: 2.5% x $1,500,000 Cost of the factor $ 13,808 3,329 17,137 37,500 54,637 105 Study Notes Financial Management - FM Solution (c) Conclusion The factor is cheaper In this case, the factor’s fees exactly equal the savings in bad debts ($7,500) and administration costs ($30,000) The factor is then cheaper overall because it will be more efficient at collecting debts The advance of 80% of debts is not needed, however, if the company has sufficient overdraft facility because the factor’s finance charge of 14% is higher than the company’s overdraft rate of 13.5% Advantages & Disadvantages Advantages        Business can pay its suppliers on time and so be able to take advantage of early payment discounts Optimum inventory level can be maintained because management will have enough cash Growth can be financed through sales rather than injecting new capital The cost of running sales ledger department is over Business can use the expertise of debtor management that the factor specializes Management time is saved because managers don’t have to spend their time on debtor management Business gets its finance linked to its volume of sales Disadvantages  Factoring is likely to be more costly than an efficiently run internal credit control department  Customers may not like to deal with factors  Company loses control to decide to whom to grant credit period and the length of credit period for each customer  Once a company hires a factor, it is difficult to go back to an internal credit control system again  Factoring may have a bad reputation for the company It may indicate that the company has financial issues Invoice Discounting Invoice discount is the purchase of trade debts at a discount by the providers of the discounting service Invoice discount and factoring are linked and mostly factors also provide invoice discounting service too It involves the purchase of a selection of invoices by the factor at a discount but the invoice discounter doesn’t take over administration of the client’s sales ledger  Confidential invoice discounting is an arrangement whereby a debt is assigned to the factor confidentially and the client’s customer will only become aware of the arrangement if he doesn’t pay his debt to client  Non-confidential invoice discount is an arrangement whereby the client’s customer is aware of the relationship of factor to client and acknowledges its liability towards factor Managing Foreign Accounts Receivables  REDUCING INVESTMENT IN FOREIGN ACCOUNTS RECEIVABLE  FORFAITING  LETTER OF CREDIT  COUNTERTRADING 106 Study Notes   Financial Management - FM EXPORT CREDIT INSURANCE EXPORT FACTORING Managing Foreign Accounts Receivables REDUCING INVESTMENT IN FOREIGN ACCOUNTS RECEIVABLE  A company can reduce its investment in foreign accounts receivable by asking for full or part payment in advance of supplying goods However this may be resisted by consumers, particularly if competitors not ask for payment up front Forfaiting  Forfaiting involves the purchase of foreign accounts receivable from the seller by a forfaiter  The forfaiter takes on all of the credit risk from the transaction (without recourse) and therefore the forfaiter purchases the receivables from the seller at a discount  The purchased receivables become a form of debt instrument (such as bills of exchange) which can be sold on the money market  The non-recourse side of the transaction makes this an attractive arrangement for businesses, but as a result the cost of forfaiting is relatively high LETTER OF CREDIT This is a further way of reducing the investment in foreign accounts receivable and can give a business a risk-free method of securing payment for goods or services There are a number of steps in arranging a letter of credit:  Both parties set the terms for the sale of goods or services  The purchaser (importer) requests their bank to issue a letter of credit in favor of the seller (exporter)  The letter of credit is issued to the seller’s bank, guaranteeing payment to the seller once the conditions specified in the letter have been complied with  The goods are dispatched to the customer and the shipping documentation is sent to the purchaser’s bank  The bank then issues a banker’s acceptance Letter of Credit (Continued)  The seller can either hold the banker’s acceptance until maturity or sell it on the money market at a discounted value  It takes significant amount of time and therefore are slow to arrange  The use of letters of credit may be considered necessary if there is a high level of non-payment risk  Customers with a poor or no credit history may not be able to obtain a letter of credit from their own bank Letters of credit are costly to customers and also restrict their flexibility:  Collection under a letter of credit depends on the conditions in the letter being fulfilled Collection only occurs if the seller presents exactly the documents stated in the conditions COUNTERTRADING In a countertrade arrangement, goods or services are exchanged for other goods or services instead of for cash The benefits of countertrading include the fact that it facilitates conservation of foreign currency and can help a business enter foreign markets that it may not otherwise be able to 107 Study Notes Financial Management - FM Disadvantage  The value of the goods or services received in exchange may be uncertain  It includes complex negotiations and logistical issues, particularly if a countertrade deal involves more than two parties EXPORT CREDIT INSURANCE Export credit insurance protects a business against the risk of non-payment by a foreign customer Exporters can protect their foreign accounts receivable against a number of risks which could result in non-payment Export credit insurance usually insures insolvency of the purchaser or slow payment, insures against certain political risks, for example war, and riots Disadvantages include the relatively high cost of premiums and the fact that the insurance does not typically cover 100% of the value of the foreign sales EXPORT FACTORING An export factor provides the same functions in relation to foreign accounts receivable as a factor covering domestic accounts receivable and therefore can help with the cash flow of a business However, export factoring can be more costly than export credit insurance and it may not be available for all countries, particularly developing countries GENERAL POLICIES FOR FOREIGN ACCOUNTS RECEIVABLE None of the methods detailed above would allow the selling company to escape from the basic fact that credit should only be given to customers who are creditworthy Managing Accounts Payable There are three main objectives of accounts payable management  Seeking satisfactory credit terms from suppliers  Extending credit period during periods of cash shortage  Maintaining good relationships with suppliers Trade Credit The cost of lost cash discount can be calculated by the following formula Cost of early settlement discount= ( 100 100−𝑑 ) ^365/t -1 Example: Product Q The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product at $1 per unit on 60 days credit The supplier has offered an early settlement discount of 1% for settlement of invoices within 30 days Plot Co finances working capital with short-term finance costing 5% per year Assume that there are 365 days in each year Calculate the net value in dollars to Plot Co of accepting the early settlement discount for Product Q 108 Study Notes Financial Management - FM Managing Cash Objective of holding Cash: John Maynard Keynes identified three reasons for holding cash  Transactions Motive: Every business needs cash to meet its regular commitments of paying its accounts payable like employee wages, taxes, annual dividends …  Precautionary motive: There is a need to maintain a ‘buffer of cash for unforeseen contingencies  Speculative Motive: Sometimes businesses hold surplus cash as a speculative asset in the hope that interest rates will rise in future Problems associated with cash flows:  Making losses If a business is continually making losses, it will eventually have cash flow problems  Inflation Even if a business is making a profit, it can still face cash flow problems in during period of inflation  Growth During periods of growth, business has an ever increasing need for more non-current assets and for its increasing working capital  Seasonal business When a business has seasonal or cyclical sales, it may have cash flow difficulties at certain times during the year  One-off items of expenditure Sometimes, a single non-recurring item of expenditure may create a cash flow problem Managing Cash Flow Problems Cash flow problems can be eased by taking a number of steps  Postponing capital expenditure: Some capital expenditures can be postponed for a year or so without serious effect on company’s long term performance  Accelerating cash inflows: Business can encourage its account receivables to pay early through discounts on early payments  Reversing past investments: Some assets that are not crucial for business survival can be sold during period of severe cash flow problem   Negotiations with accounts payable: This involves the following  Longer credit can be taken from suppliers 109 Study Notes Financial Management - FM  Loan repayments can be rescheduled through negotiations with bank  Dividend payment can be reduced Cash Flow Forecasts Months Receivable Collection X X X X Dividends Received X X X X Sale of non-current assets X X X X Trade payable payment (X) (X) (X) (X) Purchase of non-current assets (X) (X) (X) (X) Wages (X) (X) (X) (X) Net Cash Flows X X X X Opening Balance X X X X Closing Balance X X X X Cash Inflows Cash Outflow Treasury Management Treasury management can be defined as  Corporate handling of all financial matters,  The generation of external and internal funds for business,  The management of currencies and cash flows,  The complex strategies,  Policies and procedures of corporate finance Treasury department can be centralized or decentralized in an organization depending on its needs Both have certain advantages associated with them Advantages of Centralized Treasure Department  Large volume of cash is available to invest, leading to better short-term investment opportunities  Borrowing can be arranged in bulk at lower interest rate  Foreign exchange risk management will be improved through matching foreign currency income earned by one subsidiary with expenditure in the same currency by another subsidiary  Treasure management will be efficient because a centralized treasury department can employ experts  Liquidity management will be improved through centralized treasury department  It avoids having a mix of cash surpluses and overdrafts in different localized banks  It facilitates bulk cash flow which will result in less transaction costs 110 Study Notes Financial Management - FM Advantages of Decentralized Treasury Management  Greater autonomy will be given to subsidiaries  A decentralized treasury function may be more responsive to the needs of individual operating units  Sources of finance will be diversified Objective of holding Cash: John Maynard Keynes identified three reasons for holding cash  Transactions Motive: Every business needs cash to meet its regular commitments of paying its accounts payable like employee wages, taxes, annual dividends …  Precautionary motive: There is a need to maintain a ‘buffer of cash for unforeseen contingencies  Speculative Motive: Sometimes businesses hold surplus cash as a speculative asset in the hope that interest rates will rise in future Cash Management (The Baumol model) The Baumol model is based on the idea that an optimum cash balance is like deciding an optimum inventory level It uses the same EOQ formula that is used to calculate the optimum inventory level Q = 2CS I Where Q = Optimum amount of cash to be raised S = Amount of cash to be used in each time period C = Cost per sale of securities I = Interest cost of holding cash or near cash equivalents (Interest rate on new borrowings – interest earned on cash investment) EXAMPLE Finder Co faces a fixed cost of $4,000 to obtain new funds There is a requirement for $24,000 of cashover each period of one year for the foreseeable future The interest cost of new funds is 12% per annum; the interest rate earned on short-term securities is 9% per annum Required: How much finance should Finder raise at a time? Solution The cost of holding cash is 12% - 9% = 3% The optimum level of Q (the ‘recorder quantity) is: x 4,000 x 24,000 = $80,000 0.03 The optimum amount of new funds to raise is $80,000 This amount is raised every 80,000 ÷ 24,000 = 31/3 years 111 Study Notes Financial Management - FM Advantages & Disadvantages Advantages  The Baumol model enables companies to find out their desirable level of cash balance under certain assumed conditions  It recognizes the cost of holding extra cash Disadvantages  It is unlikely to be possible to predict amounts required over future periods  No buffer inventory of cash is allowed  There may be a number of other costs associated with holding cash The Miller-Orr Model The miller-Orr model focuses on an optimum amount of cash that a company should held which is called return point The model then sets an upper and lower limit of cash balances which should not be crossed If a company reaches an upper limit, it should buy market securities to return to the “return point” and if it reaches lower limit, it should sell some securities to reach to the “return point” Calculating the Return Point  Spread = ( x transaction cost x variance of cash flows )1/3 Interest rate  Return point = Lower limit + ( x Spread) 112 Study Notes Financial Management - FM Example The following data applies to a company  The minimum cash balance is $8,000  The variance of daily cash flows is 4,000,000, equivalent to a standard deviation of $2,000 per  The transaction cost for buying or selling securities is $50 The interest rate is 0.025 per cent day Required: You are required to formulate a decision rule using the Miller-Orr model Solution The spread between the upper and the lower cash balance limits is calculated as follows Spread = ( 3x transaction cost x variance cash flows)1/3 interest rate = ( 3x 50 x 4,000,000)1/3 = x (6 x 1011)1/3 = x 8,434.33 0.00025 = $25,303, say $25,300 The upper limit and return point are now calculated Upper limit = Lower limit + $25,000 = $8,000 + $25,300 = $33,300 Return point = lower limit + 1/3 x spread = $8,000 + 1/3 x $25,300 = $16,433, say 16,400 The decision rule is as follows If the cash balance reaches $33,300, buy $16,900 (= 33,300 – 16,400) in marketable securities If the cash balance falls to $8,000, sell $8,400 of marketable securities for cash Working Capital Investment Policy A company can adopt a working capital strategy for managing its working capital depending on the important risks associated with working capitals It can choose from three different working capital strategies These strategies are as follows:  Conservative Approach  Aggressive Approach  Rate Approach Conservative Approach “A conservative working capital management policy aims to reduce the risk of system breakdown by holding high levels of working capital”  Customers are allowed generous payments terms to stimulate demand,  Finished goods inventories are high to ensure availability for customers,  Raw material and work in progress are high  Suppliers are paid promptly to ensure their goodwill 113 Study Notes Financial Management - FM Aggressive & Management Approach Aggressive Approach “An aggressive working capital management policy aims to reduce financing cost and increase profitability:  by cutting inventories to kept it at minimum level  speeding up collections: Moderate Approach A moderate working capital management policy is a middle way between the aggressive and conservative approaches Customers are allowed a limited payment period and discounts are given for prompt payment  delaying payments to supplier Working Capital Financing Policy Assets can be divided into three types in order to understand different working capital management strategies  Non-current assets: These are long term assets from which an organization expects to derive benefit over a number of periods For example, plant and machinery  Permanent current assets: This is the amount required to meet minimum long-term needs and sustain normal trading activity For example, inventory and average receivables…  Fluctuating current assets: These are current assets which vary according to normal business activity Example include fluctuate in working capital due to seasonal variations Conservative Approach Policy A can be characterized as a conservative approach to finance working capital where all non-current assets, permanent current assets and part of fluctuating current assets are financed by long-term funding 114 Study Notes Financial Management - FM Aggressive Approach Policy B can be characterized as an aggressive approach to finance working capital where non-current assets and some part of permanent current assets are financed through long-term borrowings while fluctuating current assets and part of permanent current assets are financed through short-term sources Moderate Approach Policy C describes a balance between risk and return which might be best achieved by moderate approach In this case, long-term sources of finance are used to finance permanent current assets while short-term sources of finance are used to finance fluctuating current assets 115 ... compare to market 42 Study Notes Financial Management - FM CAPM Formula Cost of Equity = Rf + β (Risk Premium) Cost of Equity = Rf + β (Rm-Rf) Where, Rf = Risk free rate β = measure of relative systematic... those cash flows in which the effect of specific inflation has been adjusted ii Real cash flows are those cash flows which have not been adjusted for inflation Nominal Cashflow = Real cashflows (... short term in looking Inflation may not be constant The longer a project, the more significant the impact of inflation 20 Study Notes Financial Management - FM Effect of inflation on the discount