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Notes

FIA-Paper FFM
Foundations in Financial
Management
For exams in 2015

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ExPress Notes
FIA – Foundations of Financial Management

Contents
About ExPress Notes

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1.

Cash receipts and payments

7

2.

Cash balances

12

3.

Working capital management

17

4.

Credit granting

23

5.

Debt collection

26

6.

Sources of finance

29

7.

Short-term decisions

37

8.

Capital investments

44

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ExPress Notes
FIA – Foundations of Financial Management

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FIA – Foundations of Financial Management

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. highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of changes in value”. Such a statement is useful in that it is structured to show the extent to which a company is able to generate net cash from its operating activities and how such net cash is used in investing and/or financing activities. and given that legislation may change at any time. photocopied.ExPress Notes FIA – Foundations of Financial Management Chapter 1 Cash Receipts and Payments KEY KNOWLEDGE Cash and Cash Flow Cash comprises both cash and bank deposits payable on demand and also cash equivalents which are defined as “short-term. Page | 7 © 2015 This material is the copyright of the ExP Group. Cash flow refers to the movement of cash in and out of a business over a period of time. which is a primary financial statement. on electronic devices or any other means of reproduction. This information is found in a statement of cash flows. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. be it printed. Individuals may reproduce this material if it is for their own private use. The amount of cash held by a business at a point in time is found in the balance sheet under “current assets”. Given the nature of information presented in these materials.

cash paid to suppliers and to employees. regardless of profitability. Cash management functions are typically handled by treasury. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Cash flow accounting The relationship between cash flow accounting and accounting for income and expenditure lies in the use of accruals and decisions as to the capitalisation of expenditures. Investing: Cash flows on purchase or sale of non-current assets. Determining the “optimal” amount of cash to hold becomes the challenge facing managers.g. Individuals may reproduce this material if it is for their own private use. photocopied.ExPress Notes FIA – Foundations of Financial Management Examples of cash receipts and payments include:      Operating: cash flow from trading activities. dividends can also be included here. holding too much cash in a business is costly. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. adjustments need to be made to remove the effects of accrual accounting so that the cash movements can be made more transparent. however. cash received from customers. . e. There is a trade-off between liquidity and profitability. tracking and collecting cash are all important because cash PAYS THE BILLS. such as shares or debentures. Financing: Cash paid on interest. As the cash flow statement is derived from the income statement and the balance sheet. © 2015 This material is the copyright of the ExP Group. Investing short-term cash surpluses in low-risk interest-bearing investments (such as Treasury bills) in order to generate additional income for the company. on electronic devices or any other means of reproduction. be it printed. Taxation: Actual cash paid during the year. Given the nature of information presented in these materials. Cash flow accounting dispenses with the “matching” principle in financial accounting. and include:    Page | 8 Collecting cash from customers (as soon as possible). Cash flow is vital to going concern and commercial success. What begins as a condition of illiquidity can evolve into insolvency.   The failure to pay bills puts a company in danger of bankruptcy. Disbursing cash to suppliers (as late as practically possible). and given that legislation may change at any time. Financing: Cash flows on raising or redeeming long-term finance. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Importance of cash flow management Planning. Having enough cash on hand is therefore critical in being able to settle obligations when they fall due (both planned and unforeseen).

management is better able to influence them and plan/budget for the future. May $ June $ . Cash budget/forecast Businesses should develop their cash budget/forecast formats in a way which best reflects the type of business conducted and transactions generated. Such tools serve as a mechanism for monitoring and control. KEY KNOWLEDGE Cash forecasting A cash forecast format/structure is shown below. Individuals may reproduce this material if it is for their own private use. The purpose is to ensure that the company has sufficient cash on-hand to avoid missing disbursements when they fall due. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. Both operating and non-operating cash flows are included.ExPress Notes FIA – Foundations of Financial Management KEY KNOWLEDGE Cash budgets A cash budget is an estimate of the receipt and payments of cash in and out of the business for a defined future period based on existing conditions and operating assumptions. photocopied. Given the nature of information presented in these materials. The bottom of the table shows opening and closing cash balances. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. and given that legislation may change at any time. There are statistical techniques which assist management in planning cash levels. By understanding the nature and timing of cash receipts and expenditures. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. be it printed. in this case covering 6 months. Cash Budget Jan $ Feb $ Mar $ Apr $ Receipts Credit sales Cash sales Page | 9 © 2015 This material is the copyright of the ExP Group. on electronic devices or any other means of reproduction.

Given the nature of information presented in these materials. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. photocopied. EXAMPLE Unit Selling Price (on credit) Unit Selling Price (cash) $/unit $/unit payment terms given to credit customers: discount granted to cash customers Unit Variable Cost: Material Labour Overheads $/unit $/unit $/unit payment terms taken from suppliers: paid in the month Fixed Costs $/month < Actual Sales/Production volumes actuals/forecast Production (units) Page | 10 Nov Dec Forecast > Jan Feb Mar © 2015 This material is the copyright of the ExP Group. Individuals may reproduce this material if it is for their own private use. be it printed.ExPress Notes FIA – Foundations of Financial Management Equipment disposal Total Payments Materials Labour Variable Overheads Fixed Costs Equipment acquisition Overdraft Interest Current account interest Income tax Total Net cash m-o-m variance Cash balance at monthend Completing the table above requires forecast assumptions relating to volume of production/sales as well as prices and costs. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. Apr May June Total . and given that legislation may change at any time. on electronic devices or any other means of reproduction. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases.

wage levels rise by 10% (instead of 5%). and given that legislation may change at any time.ExPress Notes FIA – Foundations of Financial Management Credit sales (units) Cash sales (units) Capex forecast New equipment acquisition Old equipment sale Inventory levels required +/.planned Bank interest at % pa Bank interest at % pa KEY KNOWLEDGE Sensitivity of variables Preparing cash forecasts requires assumptions. Page | 11 © 2015 This material is the copyright of the ExP Group. Budgeting processes therefore include the testing of assumptions for sensitivity. Given the nature of information presented in these materials.). All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. etc. and assumptions are exposed to uncertainty. on electronic devices or any other means of reproduction. . If. for example. Individuals may reproduce this material if it is for their own private use. This means that the actual amount of cash received or disbursed may vary from that budgeted. be it printed. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. then what effect will this have on the level of cash? Same question with regard to materials (and overheads and prices. photocopied. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means.

these can be invested (e. If a deficit results.g. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Individuals may reproduce this material if it is for their own private use. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. If deficits prove to be longer-term in nature. then the company should consider short-term borrowing. In the event of surpluses. longer-term forms of finance if the deficit is expected to persist. and given that legislation may change at any time.ExPress Notes FIA – Foundations of Financial Management Chapter 2 Cash Balances KEY KNOWLEDGE Investing and financing Cash surpluses and deficits occur as a result in timing differences between the receipt of cash and the necessity to settle obligations punctually. other types of investments include:  Bank deposits Page | 12 © 2015 This material is the copyright of the ExP Group. then the company should have overdraft faciltities in place with a bank. . Given the nature of information presented in these materials. on electronic devices or any other means of reproduction. be it printed. or possibly. photocopied. T-bills mentioned earlier).

photocopied. Two techniques for monitoring the optimal level of cash are discussed below. and given that legislation may change at any time.  selling marketable securities transactions as ordering costs. Baumol model This model was developed several decades ago. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases.market deposits Certificates of deposit Government bonds Local authority stock KEY KNOWLEDGE Optimum liquidity levels Cash management models Holding too much cash is sub-optimal. Individuals may reproduce this material if it is for their own private use. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. be it printed. on electronic devices or any other means of reproduction. A business with permanently excessive balances (not required for operating purposes) should be paid out to shareholders. Given the nature of information presented in these materials.ExPress Notes FIA – Foundations of Financial Management     Money. One can think of:  cash as inventory.  Interest rate. . It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. representing the opportunity cost of holding cash By determining the following: N = the total annual amount of cash required F = the cost of each securities transaction (sale) i = the annual interest rate obtainable on the investment in securities then Z = the amount of cash that needs to be raised per transaction Page | 13 © 2015 This material is the copyright of the ExP Group.

and LL = Lower cash limit. be it printed. on electronic devices or any other means of reproduction.ExPress Notes FIA – Foundations of Financial Management The optimal level of Z = √2NF / i The main drawback of the Baumol method is that it makes the simplified (and unrealistic) assumption that cash disbursements are constant and predictable. then the upper cash limit. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. is calculated thus: UL = 3 R – 2(LL) Page | 14 © 2015 This material is the copyright of the ExP Group. or UL. Miller-Orr A second method addresses the issue of optimal cash balances and attempts to improve on the drawback of the Baumol model. k = Interest rate per day on marketable securities. Once R is known. which needs to be established by management Based on the above. Given the nature of information presented in these materials. and given that legislation may change at any time. photocopied. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. . Individuals may reproduce this material if it is for their own private use. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. this is denoted as V = Variability of net daily cash flows (variance or sigma squared) The other variables are: F = Cost of each securities transaction. the cash balance return point (R) is ________ R = 3√3xFxV/4k + LL The level R is the cash balance which must be restored when either the upper limit (UL) or lower limit (LL) have been reached. Miller-Orr is based on statistically tracking the variability of net daily cash flows.

can be dealt with based on whether they are:   Short-term: in this case they may be invested in short-term. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. along with the permanent portion of current assets (e. and given that legislation may change at any time. liquid investments (e. Treasury bills or marketable securities). buffer stocks). low-risk.ExPress Notes FIA – Foundations of Financial Management KEY KNOWLEDGE Working capital needs and funding strategies The level of working capital required in a business depends on the industry it operates in. While overdraft financing is expensive. Pay extraordinary dividend. etc. Current assets of a fluctuating nature can rely on short-term finance (e. Given the nature of information presented in these materials. Reduce debt. seasonal upswings in inventories / receivables) Cash surpluses. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. photocopied. KEY KNOWLEDGE Liquidity ratios The relationship between current assets and current liabilities is used as a measure of liquidity in the firm: Current ratio = Current assets Current liabilities Page | 15 © 2015 This material is the copyright of the ExP Group. on the other hand. Retaining flexibility is a key requirement. the length of its working capital cycle and the range of funding options open to it. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice.g. be it printed. it does permit spontaneous drawdowns and rapid repayments. on electronic devices or any other means of reproduction. Individuals may reproduce this material if it is for their own private use. while Permanent shortages should be funded long-term The “matching principle” can be applied to the assets being financed:   Fixed assets are generally funded long-term.g. Long-term: Make acquisitions. Funding strategies are guided by the following considerations:   Temporary cash shortages can be funded short-term.g. .

It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Given the nature of information presented in these materials. Law enforcement (and tax authorities) has the ability to penetrate banking confidentialty at institutions within their jurisdictionand.Inventories Current liabilities KEY KNOWLEDGE Legal relationship between bank and customer The relationship between bank and customer is established contractually. Page | 16 © 2015 This material is the copyright of the ExP Group. In return. usually in connection with pending investigations and upon obtaining a court order. When opening an account with the bank. Individuals may reproduce this material if it is for their own private use. be it printed. photocopied. the client is at the same time accepting the general terms and conditions of the bank. and given that legislation may change at any time. the bank has a professional duty toward the client in matters of confidentiality. .ExPress Notes FIA – Foundations of Financial Management Quick ratio = Current assets . on electronic devices or any other means of reproduction. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice.

Individuals may reproduce this material if it is for their own private use. .ExPress Notes FIA – Foundations of Financial Management Chapter 3 Working Capital Management START The Big Picture The nature. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. be it printed. photocopied. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Given the nature of information presented in these materials. on electronic devices or any other means of reproduction. elements and importance of working capital This is a core function of management which has day-to-day implications. and given that legislation may change at any time. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Working capital definition: Current assets – Current liabilities This is an accounting definition. The discussion and analysis of working capital management focuses on the “operating” elements of current assets and liabilities:     Page | 17 Cash Inventory Receivables Payables © 2015 This material is the copyright of the ExP Group.

Given the nature of information presented in these materials. Individuals may reproduce this material if it is for their own private use. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. on electronic devices or any other means of reproduction.ExPress Notes FIA – Foundations of Financial Management KEY KNOWLEDGE Cash Operating Cycle These elements are linked through the Cash conversion cycle. Raw materials received Receipt of cash Payment to supplier Sale of goods Conversion into finished goods The above diagram shows the operating cash flows for a typical manufacturing company converting raw materials into finished goods for sale. The presence of payables indicates that cash payments (outflows) are delayed. as late payment could lead to penalties or damage to the company’s reputation (creditworthiness). Page | 18 © 2015 This material is the copyright of the ExP Group. This is most directly obvious in opportunity cost terms: the cash could be earning interest. Managing the individual parts of working capital means managing the “whole picture” in an optimal way. also known as the Cash Operating Cycle. doing this well can give a firm a significant competitive advantage over its competitors. . or ultimately find its way into shareholders’ pockets as a dividend payment. be it printed. The company needs its own cash to pay the supplier and can only recover this from the sale of the finished goods. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. this is beneficial to the company as long as it is not overdue on its payments. The cash invested in inventories and receivables represents a cost to the company. and given that legislation may change at any time. reducing interest-bearing debt. photocopied.

. and given that legislation may change at any time. Individuals may reproduce this material if it is for their own private use. but alternate assumptions should usually be based on arguments specific to the business. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Other ratios include: Turnover ratios (1) Trade debtors (receivables) (2) Inventory turnover (3) Trade creditors (payables) Sales revenue/net working capital ratio Sales____ Working capital This ratio establishes the link between the level of sales and the amount of working capital a business needs to maintain.ExPress Notes FIA – Foundations of Financial Management KEY KNOWLEDGE Ratio Analysis Liquidity ratios Liquidity ratios (current ratio and quick ratio) have been covered in an earlier chapter. be it printed. on electronic devices or any other means of reproduction. The ratio need not remain constant as sales grow. Page | 19 © 2015 This material is the copyright of the ExP Group. photocopied. It is useful for cash flow forecasting. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Given the nature of information presented in these materials.

on electronic devices or any other means of reproduction. © 2015 This material is the copyright of the ExP Group. The EOQ is a method which seeks to minimize the costs associated with holding inventory. sales managers will insist on maintaining a plentiful level of finished goods. . Ordering costs rise the more frequently one places (during the year). To determine the total costs. Similarly.ExPress Notes FIA – Foundations of Financial Management KEY KNOWLEDGE Economic Order Quantity (EOQ) Within a company. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. there is a natural temptation to accumulate buffer stocks (raw materials and semi-finished goods) so that production is never interrupted. All of this costs money. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. the purchase price) H = cost of holding one unit for one year The total cost function is as follows: Total cost = Purchase cost + Ordering cost + Holding cost which can be expressed algebraically as follows: TC =PxD + C x D/Q + H x Q/2 It is this total cost function which must be minimized. the following data is required: Q = order quantity D = quantity of product demanded annually P = purchase cost for one unit C = fixed cost per order (not incl. and given that legislation may change at any time. be it printed. and Holding costs rise the fewer times one places orders (due to larger quantities being ordered each time). in order to avoid stock-outs. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Individuals may reproduce this material if it is for their own private use. photocopied. Recognizing that:    Page | 20 PD does not vary. Given the nature of information presented in these materials.

The optimal order quantity (Q*) is found where the Ordering and Holding costs equal each other. . It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. better product quality and lower operating costs. i. and given that legislation may change at any time. Given the nature of information presented in these materials. photocopied. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. C x D/Q = H x Q/2 Rearranging the above and solving for Q results in EXAMPLE A trucking company uses disposable carburetor units with the following details:     Weekly demand Purchase price Ordering cost Holding cost 500 units USD 15 / unit USD 40 / order 7% of the purchase price Assume a 50 week year. on electronic devices or any other means of reproduction. © 2015 This material is the copyright of the ExP Group.  JIT’s ultimate objectives are increased competitiveness and higher profits through higher productivity (output per unit of time).ExPress Notes FIA – Foundations of Financial Management It follows that there is a trade-off between the Ordering and the Holding costs. Individuals may reproduce this material if it is for their own private use. it is a manufacturing philosophy which puts at its core minimization of inventories on the basis that most of inventoryrelated activities are non-value-added. What is the optimal order quantity? KEY KNOWLEDGE Just-In-Time (JIT) Page | 21  JIT is more than an inventory management model. be it printed.e. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases.

photocopied. Given the nature of information presented in these materials. (2) Capacity: Examines the company’s cash flow generation in the context of management’s ability to perform competently and reliably in meeting their obligations. referred to (originally) as the 3 C’s of credit. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. based on an Page | 22 © 2015 This material is the copyright of the ExP Group. They are: (1) Character: Focuses on the reputation of the principals/decision makers at a company. be it printed. Individuals may reproduce this material if it is for their own private use. later expanded to the 5 C’s. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. companies can use the approach typically employed by banks. and given that legislation may change at any time. credit checking agencies and bank references assist to this end. on electronic devices or any other means of reproduction. .ExPress Notes FIA – Foundations of Financial Management Chapter 4 Credit Granting KEY KNOWLEDGE Credit assessment Assessing the creditworthiness of customers When assessing the creditworthiness of (potential) clients.

the manager takes into consideration market intelligence. on electronic devices or any other means of reproduction. Banks refer to this as providing additional exits (“ways out”) from a transaction. photocopied. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. (3) Capital: Identifies and assesses the financial “staying power” and resources of the business. be it printed. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. (4) Collateral: Assesses what (if any) security the company is willing to provide in support of the intended transaction. and External: Data obtained as a result of credit checkings (with credit agencies) or from publicly available sources. KEY KNOWLEDGE Internal and external sources of information The decision to grant credit to customers is the job of the credit manager. The resulting information must be evaluated and a decision taken as to how much credit to approve for individual customers. how much of a capital cushion do they have to withstand losses and how much do they have committed at risk in a proposed transaction that incentivizes them to succeed (one can refer to this as the “pain factor”). Individuals may reproduce this material if it is for their own private use. Given the nature of information presented in these materials. . and given that legislation may change at any time. In determining credit limits. Page | 23 © 2015 This material is the copyright of the ExP Group. (5) Conditions: This is a general review of the economic environment to appreciate to what extent a customer may be affected by a decline in general business conditions (business cycle influences). These consist of sources of information that are: Internal: This is based on the experience acquired in qorking with a customer over time. Financial statement analysis is a major part of the exercise here (and in the next point).ExPress Notes FIA – Foundations of Financial Management examination of their track record (either directly or via the experiences of others).

A company granting settlement discounts must ensure that the benefits of doing so will outweigh the costs. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. Page | 24 © 2015 This material is the copyright of the ExP Group. Given the nature of information presented in these materials. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. be it printed. . and given that legislation may change at any time. on electronic devices or any other means of reproduction. Individuals may reproduce this material if it is for their own private use. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. photocopied.ExPress Notes FIA – Foundations of Financial Management KEY KNOWLEDGE Early settlement discounts The objective of granting a settlement discount is to give customers a financial incentive to pay their bills more quickly (before the standard due date).

then the company is throwing away the rewards of “success”. Page | 25 © 2015 This material is the copyright of the ExP Group. on electronic devices or any other means of reproduction. Much time can be spent in chasing late payments and if this process is not well-organized. late payments are a fact of life and must be handled pro-actively. If. and given that legislation may change at any time. these invoices are not collected in due time (or at all). management may come to the conclusion that it is not worthwhile. . The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. Even if a good screening/assessment procedure is in place for accepting and reviewing customers. photocopied. This is especially true in cases where a company is growing very quickly and celebrates the signing of contracts and issuance of invoices as signs of success. Individuals may reproduce this material if it is for their own private use. however. Given the nature of information presented in these materials.ExPress Notes FIA – Foundations of Financial Management Chapter 5 Debt Collection KEY KNOWLEDGE Collection of debts A company must have in place a clear policy on the collection of debts. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. be it printed.

This includes identifying properly the practice of deductions mentioned above. the savings of management time (opportunity cost) is the most difficult to estimate. (2) A follow-up system that assigns responsibility to specific staff doing the follow-up. KEY KNOWLEDGE Credit policies Financial implications of different credit policies Evaluating a change in a credit policy requires the identification of relevant cash flows structured as “before” (the change) and “after” scenarios. . Individuals may reproduce this material if it is for their own private use. This amounts to a renegotiation of the original invoice and is often accepted as a “fait accompli” by the supplier. (5) Use of a collection agent to chase the receivable. be it printed. mail or personal visits. whether performed by phone. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. and given that legislation may change at any time. (4) A policy determining when to involve refer the case to lawyers (preferably in-house. Given the nature of information presented in these materials. known as an aging system. photocopied. Here again. a company must calculate the costs and benefits of involving an external agent. In such an analysis. on electronic devices or any other means of reproduction. giving a reason for withholding the difference. An external lawyer may carry more weight. Page | 26 © 2015 This material is the copyright of the ExP Group. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. A company managing its receivables diligently will have the following: (1) A monitoring system that clearly “flags” late payers. for cost reasons) in preparation of follow-up letters. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. but is also more costly.ExPress Notes FIA – Foundations of Financial Management Deductions Another phenomenon which results in significant write-offs of receivable is the practice of “deductions” in which a customer pays less than the full amount of the invoice. this includes an elevating of difficult cases to more senior and/or more experienced staff to handle. (3) Training for staff involved in handing follow-ups.

and given that legislation may change at any time. The unpaid sales invoices are pledged as collateral to the company (or bank) provides the financing. Given the nature of information presented in these materials. Non-recourse: The factor bears the full credit risk of the debtor’s failure to pay. be it printed. 3. the difference being the cost of borrowing. Recourse: In the event a debt is written-off. the factor has the right to demand payment from the company from which it acquired the debt/receivable. photocopied. Inform that penaties will be charged. The factor may do so on a recourse or non-recourse basis. on electronic devices or any other means of reproduction. Factoring involves the administration of debt collection. 5.e.ExPress Notes FIA – Foundations of Financial Management KEY KNOWLEDGE Factoring and invoice discounting Note the distinction between factoring and invoice discounting: Invoice discounting is effectively a short-term loan in which a company borrows against its outstanding receivables. Individuals may reproduce this material if it is for their own private use. KEY KNOWLEDGE Follow-up processes Follow-up processes could follow the following steps: 1. The borrowing company receives less than the face value of the invoice. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. in which the factor buying a receivable manages the process. 4. . Advice that receivable will be sold to a factor or referred to legal action Page | 27 © 2015 This material is the copyright of the ExP Group. Reminder to execute payment. past due): 2. or discount. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Advice that further delivery is stopped. (Before payment due date) – Reminder to prepare payment. If payment is not made punctually (i. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means.

be it printed.ExPress Notes FIA – Foundations of Financial Management Chapter 6 Sources of Finance KEY KNOWLEDGE Macro-economics The impact of macro-economics Businesses must also take macro-economic factors into account: Page | 28  Demand levels in the future (return to pre-crisis levels unlikely). Individuals may reproduce this material if it is for their own private use. (the latter may eventually increase with economic recovery). © 2015 This material is the copyright of the ExP Group. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. photocopied. on electronic devices or any other means of reproduction. exchange rates and inflation. and given that legislation may change at any time. . how government policies are likely to be adjusted with respect to: (a) Monetary policy: Effect on interest rates. Given the nature of information presented in these materials. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means.  In a recovery phase.

such as Building Societies. KEY KNOWLEDGE The banking process According to English common law. which traditionally specialized in offering mortgage loans. and collects cheques on behalf of customers. the use of cheques remains an important payment method in the UK. Other systems: Page | 29 © 2015 This material is the copyright of the ExP Group. (d) Trade policy: to what degree is any protectionism likely to stay in place? Again. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. The clearing system works on a 3-day cycle: (1) Sending the item to the clearing center. Banks in the UK are licensed by the Financial Services Act. actively keeping up with reading on these issues will be the best way to stay informed. particularly for small businesses. In addition to chequing accounts. be it printed. designated as “clearing banks”. Given the nature of information presented in these materials. the use of cheques remains an important payment method in the UK. These include: London Bankers Clearing House – A cheque-clearing system operated by members. particularly for small businesses.ExPress Notes FIA – Foundations of Financial Management (b) Labor policy: If labor markets tighten. foreign exchange. (2) Sorting of items submitted. including overdraft and loan facilities. UK banking clearing system There are different systems designed to clear payments within the UK. . a bank has traditionally been characterized as an institution which holds current accounts for depositors. which has over time extended its reach to other types of financial institutions. Individuals may reproduce this material if it is for their own private use. photocopied. and given that legislation may change at any time. (3) Debit to the bank on which the item is drawn. pays cheques which are drawn upon it. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. banks offer an increasingly broad range of services. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. trade finance (bills of exchange and promissory notes) and investment management. how fast will restrictions (imposed on foreign labor. on electronic devices or any other means of reproduction. for example) be relaxed? (c) Fiscal policy: Tax increases (both personal and corporate).

 Pref shares may be redeemable or irredeemable. Individuals may reproduce this material if it is for their own private use. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice.  Prefs may be cumulative. be it printed. where dividends not paid in one year are carried forward and have to be paid before a common dividend payment resumes.ExPress Notes FIA – Foundations of Financial Management Bankers' Automated Clearing Services (BACS) – A system for the electronic transfer of payments between banks. employees. etc.) have been satisfied. Their potential “upside” gain is therefore theoretically unlimited.  The dividend rate is usually fixed (as a percentage of the par value of the issue). lenders. . Preference shares Preference shares (or “pref” shares) This is often referred to as a form of non-equity capital. Given the nature of information presented in these materials. This potential gain is associated with the risk that such shareholders face: in the event of bankruptcy or liquidation. the state.  Dividends are not tax deductible. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. The common shareholders are the main beneficiaries of the success of a business. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. Page | 30  Preference shareholders rank preferentially to common shareholders.e. they are the residual claimants on a corporation’s assets after all other claims (whether suppliers. Clearing House Automated Payment System (CHAPS) – This is for Sterling payments within the UK. on electronic devices or any other means of reproduction. photocopied.  Voting rights: may or may not be accorded preference shares. and given that legislation may change at any time.  The dividend rate can be participating. KEY KNOWLEDGE Financing sources Ordinary shares (or common shares) These are the basic units of ownership of a corporation. 3-day clearing of funds. share in some of the excess profits. relatively expensive. © 2015 This material is the copyright of the ExP Group. therefore slow but cheap. beneficiaries receive “same day” funds. i.

Given the nature of information presented in these materials. © 2015 This material is the copyright of the ExP Group.  Subordinated loans: Refers to any kind of debt which ranks inferior to more senior debt. based on pre-defined “conversion” conditions. Individuals may reproduce this material if it is for their own private use. be it printed. Debenture holders can be paid only after (secured) bondholders have been repaid. Straight long-term debt (also called “loan capital” – avoid confusion!) includes:  Bonds: Secured by a mortgage on tangible assets of the firm  Debentures: Unsecured corporate debt Note: The term “bonds” is commonly used for both categories above. on electronic devices or any other means of reproduction. debt:  Is a liability of the business. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. These are usually tradable in a secondary market and therefore have a market price. Such instruments with no coupon are also called “pure-discount” or “zero” bonds. Page | 31  Convertible debt: This is debt which is convertible (at the option of the convertible debt holder) into equity.  Does not represent ownership in the firm Other types of securities Companies are imaginative in creating hybrid securities as debt in order to achieve tax deductibility but with conditions that avoid bankruptcy costs (i. and given that legislation may change at any time. In the event of default. it cannot be repaid until more senior-ranked creditors have been repaid.ExPress Notes FIA – Foundations of Financial Management  Prefs may be convertible into common shares Debt In contrast to equity. payouts contingent only on the achievement of profits). so that the issue price will be far below the par value of the bond. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. .  Deep discount bonds: Debt issued with a very low or no (zero) coupon. debt holders with a security interest over assets enjoy a prior claim in the event such assets are sold.e. photocopied.  Pays interest which is tax deductible.  Warrants: A security giving the holder the option to buy common shares from a company for a pre-set price valid for a period of time. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Debt comes in many forms.

Debt and equity The amounts of debt and equity appropriate at a company depends mainly on the industry in which the company operates. preference shares and loan capital is based on financial strategic decisions taken by a corporation regarding capital structure. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. Companies need to take a variety of factors into consideration when deliberating the use of debt: Page | 32  Capital structure constraints: Is there enough equity underpinning?  Term of borrowing: This must be determined in relation to the use to which the proceeds will be put. The industry in which the company operates has an important impact on:  Revenue volatility. photocopied. © 2015 This material is the copyright of the ExP Group.ExPress Notes FIA – Foundations of Financial Management  Junk (high yield) bond: A speculative debt instrument that either carries no rating or a low rating by the rating agencies (below “investment grade”). Cash flow projections and repayment provisions must be analyzed (bullet repayment or amortizing schedule). Given the nature of information presented in these materials. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Choosing the right capital structure Choosing between ordinary shares. and  Operating leverage (cost structure) A company cannot use too much debt for fear of encountering bankruptcy when economic conditions decline. Individuals may reproduce this material if it is for their own private use. and given that legislation may change at any time. The reasons for issuing different kinds of debt (loan capital). . and also its internal policies and attitudes toward financial risk. Types of interest rates  Interest rates can be set at a specific percentage rate and not change during the contractual period of a loan. They are used in debt instruments and (bank) loan contracts by defining how the interest rate is to be set on a periodic basis. on electronic devices or any other means of reproduction. be it printed. Bonds issued with fixed (rate) coupons (making them “fixed rate” instruments) will vary in value as market interest rates change.  Floating rates fluctuate with the movement in market interest rates.

 From the lessor’s perspective. where the tax benefits of ownership are useful to the lessor. be it printed. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Attractiveness of leasing Leasing has been attractive to lessees (the users of the asset) for a several possible reasons: Page | 33  Conservation of cash flow: If a bank loan cannot be arranged. on electronic devices or any other means of reproduction.  The lessee assumes responsibility for servicing the asset. Operating leases These are generally short-term rental contracts in which the lessor services and insures the asset. outside and after the end of the lease contract). a lessee in return for a stream of payments over a period of time. They are usually cancelable during the lease period at the choice of the lessee. and given that legislation may change at any time.  Cost reasons: The leasing costs may be more competitive than a bank loan. Main features include:  Lease term covering most of the asset’s economic useful life. © 2015 This material is the copyright of the ExP Group. then leasing provides a way of financing the asset. Individuals may reproduce this material if it is for their own private use. photocopied.  The lessee must show the lease asset and liability on its balance sheet. in which a lessor. Finance leases These are also known as “capital” leases and are in substance similar to the use of a secured bank loan to acquire and use an asset.  Lessee will usually have an option to buy the asset at the termination of the lease (note: the transfer of ownership. leasing can be attractive for tax reasons. as owner of an asset. if any. Given the nature of information presented in these materials.ExPress Notes FIA – Foundations of Financial Management  Currency and interest rate base (fixed/floating): What are the company’s views on currency and interest rate market risks? What hedging possibilities exist?  Security: What tangible security is available to support borrowings? Leasing Leasing is a form of fixed asset financing. makes it available to.  Any cancellation clause would require the lessee to cover the lessor for any losses. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. and for the use of. . The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases.

BAA. EasyJet. The current shareholders are: UK government (49%). and can plan to make periodic lease payments to the new owner in return for continuing to operate the asset. for example. the company will receive cash from the sale proceeds. photocopied. thus freeing up capital for its main business. which is eventually transferred to the ownership of the company making use of the asset. Monarch Airlines. . be it printed. The Airline Group (42%) which is a consortium of British Airways. Thomson Airways and Virgin Atlantic.ExPress Notes FIA – Foundations of Financial Management Sale-and-lease-back Under a sale-and-lease-back. Public Private Partnership The National Air Traffic Services (which has responsibility for civilian air traffic control in the UK) was placed into a Public Private Partnership with the transfer of 51% of its shares to the private sector in 2001. can raise possibly much-needed cash in this way. and given that legislation may change at any time. it escapes exposure to real estate market risk. Hire purchase These are more typical installment payment plans for an asset. In this way. Internal funds As a matter of practicality. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. BAA (4%). on electronic devices or any other means of reproduction. a bank may sell the properties occupied by its branch network. BMI. in addition. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. it retains operating flexibility in the location of branches (which need to be where the business is). In this way. while removing fixed assets from its balance sheet. Given the nature of information presented in these materials. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. and NATS employees (5%). the latter receiving 4% of the company in return). A chain of retail stores. managers usually choose to finance new projects or investments by making use of the following sources in the order shown: Page | 34 © 2015 This material is the copyright of the ExP Group. Individuals may reproduce this material if it is for their own private use. A decline in air traffic following the September 11. This technique has been a favored one for companies with a large exposure to the property market. Thomas Cook Airlines. 2001 attacks made an additional investment of £130m necessary (£65m each from the UK government and the British Airports Authority. For the same reason. Payments are structured to incorporate capital and interest elements. a company sells an asset in its possession to another company and then immediately leases the same asset back again.

ExPress Notes FIA – Foundations of Financial Management (i) Internal funds (retained earnings) (ii) Debt (iii) Equity The above sequence is referred to as the “pecking order theory” and is based on observations of business behavior. Other sources of short-term financing involve a cost to the business:    Overdraft facility at the bank Invoice discounting and debt factoring (recourse/non-recourse) Bills of exchange and acceptance credits Choosing the right financing Financing options to a business can be determined by generating financial projections of its statement of financial position (previously known as the balance sheet). All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Negotiating long payment terms to suppliers can be a most attractive way of conserving cash. Given the nature of information presented in these materials. . Page | 35 © 2015 This material is the copyright of the ExP Group. They are not considered to be a free (costless) form of finance. be it printed. management is expected to earn a cost of equity return on such funds. on electronic devices or any other means of reproduction. Individuals may reproduce this material if it is for their own private use. As along as they are retained by the firm. photocopied. the statement of comprehensive income (income statement) and statement of cash flows. and given that legislation may change at any time. however. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Short-term financing The starting point for a business is to determine how it can finance its operations at a minimal (or no) cost. The first choice is a natural one: retained earnings are already at the disposal of the company without involving costs or formalities. they are available for distribution to the shareholders.

Individuals may reproduce this material if it is for their own private use.ExPress Notes FIA – Foundations of Financial Management Chapter 7 Short-term Decisions KEY KNOWLEDGE Cost-Volume-Profit (CVP) Analysis The breakeven formula Total Costs = Fixed Costs + Unit Variable Cost x Number of Units Total Revenue = Sales Price x Number of Units If TC = Total Costs. FC = Fixed Costs. Page | 36 © 2015 This material is the copyright of the ExP Group. be it printed. and given that legislation may change at any time. on electronic devices or any other means of reproduction. . photocopied. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. Given the nature of information presented in these materials. V = Unit Variable Cost. X = Number of Units. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases.

ExPress Notes FIA – Foundations of Financial Management TR = Total Revenue. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. be it printed. KEY KNOWLEDGE Break-Even Analysis Marginal costing is useful in calculating the “break-even” level of sales. photocopied. the firm may prefer to produce/sell below break-even in order to recover some of its fixed costs. C = SP – V = Unit Contribution and CM%= C/SP = Contribution Margin. Then the break-even point (the output level at which TR=TC) is:   In units sold: X = FC/C In dollar sales: TR = FC/CM%   Safety Margin = Budgeted Sales – Break-even point (units/dollars) C is an important indicator. . on electronic devices or any other means of reproduction. and given that legislation may change at any time. Therefore. SP = Selling Price. in the short run. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. as it shows the contribution of each unit sold towards covering fixed costs. Page | 37 © 2015 This material is the copyright of the ExP Group. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Individuals may reproduce this material if it is for their own private use. Given the nature of information presented in these materials.

ExPress Notes FIA – Foundations of Financial Management The break-even point is the level where the company achieves zero profit (neither gain nor loss). Admin costs 7. It just manages to cover its fixed costs.000 EXAMPLE Based on the data in the previous example. General. Total fixed costs: Page | 38 23. . on electronic devices or any other means of reproduction. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. be it printed. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Cost per unit (of product): $ Direct materials 45 Direct labour 18 Variable production O/Hs 9 Total variable production costs 72 Distribution & selling (variable) 2 Additional info: Selling price per unit 120 Fixed production costs 16. calculate the break-even point of the company. and given that legislation may change at any time.500 © 2015 This material is the copyright of the ExP Group. Given the nature of information presented in these materials. photocopied. Individuals may reproduce this material if it is for their own private use. Below is data on a manufacturing company.500 Fixed Selling.

then it is necessary to identify it and to plan production around it. Take the following example: Product Selling price Labour cost per unit ($) Material cost per unit ($) X 30 10 5 Y 40 16 8 Z 50 20 10 Contribution 15 16 20 It appears that in the face of unlimited demand for all three products. be it printed. Product Z would be given priority as it maximizes the contribution per unit.3833 (120/46) The break-even level of sales can be calculated as: Fixed costs C/S ratio Break-even point (sales) = $ 61. Individuals may reproduce this material if it is for their own private use. Given the nature of information presented in these materials. In the previous example. and given that legislation may change at any time. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. photocopied. Page | 39 © 2015 This material is the copyright of the ExP Group.ExPress Notes FIA – Foundations of Financial Management Contribution per unit: 46 Break-even point: 23. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. on electronic devices or any other means of reproduction. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice.310 KEY KNOWLEDGE Short-term decision-making Limiting factors When a single limiting factor is present in a production plan. the company’s C/S ratio is: $ 0.500/46 = 511 units Contribution per sale – C/S ratio This is understood as the amount of contribution generated by every dollar sold. .

Rank the products according to Step 2. and given that legislation may change at any time. 100 units of X can be produced. photocopied. A carburettor takes 2. Calculate the contribution per unit of limited resource. up to the demand limit of each product or until the limited resource is exhausted Make-Buy A make-buy decision requires the determination of all relevant costs. . of hours per unit Contribution per hour X 10 5 Y 8 8 Z 20 10 3 2 2 Now it becomes clear that Product X is favoured for the full number of hours available (500). Individuals may reproduce this material if it is for their own private use. Page | 40 © 2015 This material is the copyright of the ExP Group. The carburettor also absorbs fixed overhead costs at the rate of USD 20 per labour hour. Labour costs USD 10 per hour. then the remaining available hours (100) could be used to produce either Y or Z (in this case there is indifference between the two). Produce according to the priority established in Step 3. In the above case. Labour is currently at full capacity producing carburettors which generate contribution of USD 100. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. be it printed. 80 units (requiring 400 labour hours). The steps to be followed in working out the optimal production plan are: (1) (2) (3) (4) Calculate the contribution per unit of product. the company calculates that an equivalent unit can be made in 2 labour hours using USD 100 worth of materials.5 hours to produce. Product Labour cost per unit ($) No. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. In considering whether to make these internally. say. on electronic devices or any other means of reproduction. EXAMPLE An automotive components producer can supply itself externally with car heaters for USD 210 per unit. If demand for X were limited to. Given the nature of information presented in these materials. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice.ExPress Notes FIA – Foundations of Financial Management Now. assume that labour hours are limited to 500 and that labour costs $2 per hour (demand remains unlimited for all three products).

however. and given that legislation may change at any time. they can be influenced prospectively by choice. because it is the main determinant of value (unlike accounting profit). cash. It follows that: Sunk costs are not relevant: They have already taken place and cannot be reversed. Committed costs. if they cannot be avoided. in that case. Individuals may reproduce this material if it is for their own private use. this difference (referred to in some places as the “differential”) is relevant to the decision under consideration. then one can speak as the difference between the two choices as being “incremental”. i. be it printed. and unique in the sense that is not common to the alternative choices that are under consideration.ExPress Notes FIA – Foundations of Financial Management Relevant costs One of management’s responsibilities involves making decisions affecting the firm in the short-run based on relevant costs. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. are likewise not relevant. on electronic devices or any other means of reproduction. photocopied. . Given the nature of information presented in these materials. Page | 41 © 2015 This material is the copyright of the ExP Group. even if the timing of their occurrence is in the future. relevant costs therefore involve cash. Future Relevant costs refer to the future. insurance costs are not relevant to the decision. Their “unavoidability” has already been established in the past (making them effectively the equivalent of sunk costs). The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. In keeping with the above logic. EXAMPLE A company seeking to determine whether to continue to transport its products by truck or to switch to the railroad discovers that insurance costs are identical in both choices. there is a difference in the two insurance costs. If. are incremental and relate to the future. What is relevance? A relevant cost is a cash cost which is uniquely incurred (or avoided) as a consequence of taking a decision.e.

All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Relevant costs need to be identified with care. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. photocopied. Page | 42 © 2015 This material is the copyright of the ExP Group. Setting a price without having an accurate understanding of costs can put a company at a competitive disadvantage. as they may include opportunity costs. EXAMPLE A company considers building a storage facility on the site of a parking lot. then this foregone revenue is an opportunity cost. If the parking lot had been generating parking fees which will now be lost. Given the nature of information presented in these materials. . It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. particularly if there is intense competition. be it printed. Individuals may reproduce this material if it is for their own private use.ExPress Notes FIA – Foundations of Financial Management Costing projects It is a standard management accounting practice to determine the relevant costs of a new project in order to come up with a price quotation. on electronic devices or any other means of reproduction. and given that legislation may change at any time.

Page | 43 © 2015 This material is the copyright of the ExP Group. i. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Given the nature of information presented in these materials.ExPress Notes FIA – Foundations of Financial Management Chapter 8 Capital Investments KEY KNOWLEDGE Long-term investment decisions Key features of long-term investment decisions Long-term investment decisions typically involve the investment of resources in non-current assets that will produce a benefit in the future.e. the timing of such cash flows can determine whether or not an investment is acceptable. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. photocopied. be it printed. the time value of cash flows is critical. Individuals may reproduce this material if it is for their own private use. When appraising such investments. and given that legislation may change at any time. When considering long-term investments. . on electronic devices or any other means of reproduction. including investment in working capital (one of the frequently-forgotten items!) and also the proceeds on disposal of final inventories and equipment at the end of the project’s life (if there is any cash to be recovered at that time). it is necessary to include all relevant cash flows.

Investment = 6. profits Total Investment = 6.000 13.000 = 16. Investment 20. Given the nature of information presented in these materials.000 1 2 3 4 5 Profit After Depreciation 2.000 12. 5 year project Initial Investment (20% p.000 20.000 5.5% Total profits Total Investment = 33. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means.a. on electronic devices or any other means of reproduction.600 20. profits Avg.000 5. depreciation) Residual value Avg.000 Year Year Year Year Year Profit Before Depreciation 10. depreciation) 40.000 residual value.) 6. be it printed.000 22. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases.000 Avg. Investment Page | 44 40. .a.600 40. profit (p. and given that legislation may change at any time.ExPress Notes FIA – Foundations of Financial Management Accounting Rate of Return (ARR) ARR is an accounting-based measure of return on investment.000 12.600 (1) ARR = Avg. Here are some: 5 year project Initial Investment (20% p.000 Note: Always use the accounting profit after deduction of depreciation Recalculate the above if there is a 5. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice.500 © 2015 This material is the copyright of the ExP Group.000 10.000 = 33% (2) ARR = Avg. Individuals may reproduce this material if it is for their own private use.000 Avg.000 40.000 4.5% (3) ARR = = 82.a. photocopied. Its definition varies.000 18.

All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Re-calculate the ARRs (above) if the profits were reversed as follows: Profit After Depreciation Year Year Year Year Year 1 2 3 4 5 4. photocopied.000 5.000 10.000 40. Given the nature of information presented in these materials.600 40. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases.000 Total profit after Depreciation 38.000 2. on electronic devices or any other means of reproduction.000 Avg.500 = 33. Profit 7.8% (2) ARR = Avg.000 Average profits and average investment amount remain unchanged. Investment = 7. Page | 45 © 2015 This material is the copyright of the ExP Group. be it printed.000 What’s wrong with this measure? 1) It is using an accounting measure of profit (not cash) 2) It does not take the timing of cash flows into consideration. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means.600 22. Individuals may reproduce this material if it is for their own private use. and given that legislation may change at any time.600 (1) ARR = Avg.000 = 19% (3) ARR = = 95% Total profits Total Investment = 38.000 12. .000 Total depreciation 35. profits Avg.ExPress Notes FIA – Foundations of Financial Management Total profit before Depreciation 73. profits Total Investment = 7.

Given the nature of information presented in these materials.000 12.000 5.000 15. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. The preeminence of cash Cash. If you invest in a Central American country where you expect a coup in the next 2 years.000 51.000 13. lies at the basis of economic value.000 Year 5 Cashflows (B) 15.000 Cash flows (A) Year 1 Year 2 Year 3 Year 4 Year 5 Total Payback 5.ExPress Notes FIA – Foundations of Financial Management Payback method Initial Investment: 40. It focuses on the time needed to cover the investment (in money terms) and no more.000 Year 3 What are the advantages and disadvantages of this method? Advantages It is easy to understand and to use. both its receipt and possession. such as accounting profit. Cash is used to pay the bills and bonuses. It does not take opportunity costs or expected returns on money invested into account.000 12. Individuals may reproduce this material if it is for their own private use. the payback method may be for you! But remember. and given that legislation may change at any time. photocopied. on electronic devices or any other means of reproduction.000 6. . All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. be it printed. It is a better indicator of wealth when compared with measures defined by accounting conventions. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means.000 13. the net (money) returns start only after that point! Disadvantages It is a crude measure.000 6. Page | 46 © 2015 This material is the copyright of the ExP Group. it can be considered a minimalist’s approach (psychologically).000 51.

what should the value be after one year? Present Value (PV) Future Value (FV) 100 100 x (1+r) In the above example. then the FV after one year will be USD 105. Timing and value Tracking and measuring cash flows on a time-adjusted basis is critical: cash received quickly can be used to repay debt (avoiding interest costs) or invested (earning interest). All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. . Compounding Instead of receiving USD 100 today. its purchasing value may diminish due to the effects of inflation. Discounting The above relationship between PV and FV: PV x (1+r) = FV can be re-arranged to: PV = FV (1+r) with r representing the discount rate. the less that cash is worth in today’s terms. photocopied. To compensate for the delay. on electronic devices or any other means of reproduction. Individuals may reproduce this material if it is for their own private use. This process can be repeated year after year. Among other factors. It follows that the longer one waits for a receipt of cash. if r = 5% p. then the discounting effect will be: PV = FV Page | 47 © 2015 This material is the copyright of the ExP Group. Given the nature of information presented in these materials.a. assume it will be received after one year. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. be it printed.ExPress Notes FIA – Foundations of Financial Management The relevance of cash flow to capital investment appraisal The appraisal process is predicated on the fact that capital expenditures are investments which will (hopefully) confer future benefits referred to as the payback. and given that legislation may change at any time. The above refers to “one-period” discounting. with r corresponding to the period. Cash paid with a delay can reduce costs (as long as penalties are not incurred). It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. If discounting is done over more than one period. The payback may be a lengthy (and risky) one.

3 62.10 100 (1. be it printed. Reducing future cash flows – of different timings and amounts – to one PV is a powerful tool. and given that legislation may change at any time. Given the nature of information presented in these materials.10)3 100 (1. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases.9 82. will be PV = 100 = 82.9 71. on electronic devices or any other means of reproduction.10)3 105 (1.7 86.9 82. discounted at 10% p. . 100 received after two years.a.10)4 100 (1. This allows one to discount future values into present values and can be applied to a series of cash flows: Year: Future Values: 1 2 3 4 5 100 100 125 105 140 If discounted at r = 10%. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. then the above cash flows can be restated at their present values: FV discounted: 100 1.10)5 PV: 90.6 (1.6 93.10)5 PV: 90. Note: If all the cash flows had been equal – say 100 – then the PV calculation would have been simplified: FV discounted: 100 1.1 68.10)2 100 (1.9 Added together results in total PV = 426.ExPress Notes FIA – Foundations of Financial Management (1+r)n where “n” refers to the number of periods. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. Thus.10)2 This reflects that the uncertainty of getting money back increases with time. photocopied.1 The addition of the above is = 379 Page | 48 © 2015 This material is the copyright of the ExP Group.10)2 125 (1.6 75. Individuals may reproduce this material if it is for their own private use.10)4 140 (1.10 100 (1.

All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice.9 82.000 The IRR of the above cash flows (using interpolation or calculator) is 35. then IRR = r The IRR includes among its assumptions the following: any cash flows generated in the course of a project being evaluated are calculated as being reinvested at the IRR rate. on electronic devices or any other means of reproduction. The NPV of the above cash flows is therefore = 226. Individuals may reproduce this material if it is for their own private use. . Internal rate of Return (IRR) The internal rate of return (IRR) is defined as the discount rate (r) at which the net present value (NPV) of a stream of cash flows will be equal to zero. photocopied.000 30. The above cash flows is equivalent to re-investing the 5.000) 5.9 71.000 (Year 1) at the IRR rate (35.61%) to maturity (Year 2).000) 5.7 86. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. In other words.ExPress Notes FIA – Foundations of Financial Management Net Present Value (NPV) To add meaning to the future cash flows. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases.9 Year 0 amounts denote the present and are automatically = PV. we can include the amount invested (which gives rise to the FVs): Year: 0 1 2 3 4 5 100 100 125 105 140 Investment: (200) FV: PV: (200) 90. Page | 49 Time Cash flows (A) 0 1 (20. This is illustrated thus: Time Cash flows 0 1 2 (20. If. NPV = 0. Given the nature of information presented in these materials.000 Cash flows (B) (20.000) 0 © 2015 This material is the copyright of the ExP Group. and given that legislation may change at any time. at a discount rate r.6 93. be it printed.61%.

e.780. Given the nature of information presented in these materials. interest rates may have risen in the meantime).5*) * 5.5 The IRR of the cash flows shown in Column (B) is 35. or lower (placed in the bank to earn deposit interest). Note: Column (B) cash flows resemble that of a zero-coupon bond. Page | 50 © 2015 This material is the copyright of the ExP Group. This calculation confirms that interim cash flows are re-invested at the IRR rate. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. Equal investment amounts do not necessarily remove the ambiguity. on electronic devices or any other means of reproduction. as it relates return to amount invested. This assumption has been criticized for being unrealistic. photocopied. EXAMPLE Year 0 1 A -5. IRR: An IRR in excess of a hurdle rate (set by the company) indicates acceptability. and given that legislation may change at any time.000 x 1.000 + 6.780.000 36. with investment at time 0 and no cash returns until the final year. the higher the better.000 6.850 IRR NPV: 10% 14% 20% 454 263 172 18% 545 263 129 Intuitively.780.500 8. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. since cash paid out of a project (returned to the investors.5 (30. the higher (the IRR) the better. Individuals may reproduce this material if it is for their own private use. be it printed. IRR should be preferable.61% -.ExPress Notes FIA – Foundations of Financial Management 2 30. for example) is unlikely to obtain the same rate if invested elsewhere: they may be higher (i.000 B -7. Comparison of NPV and IRR methods The following decision rules apply to appraisal methods: NPV: Positive NPV projects are acceptable.exactly the same as in Column (A). 16% .3561 = 6.

be it printed. It is illegal for any individuals to reproduce this for commercial use or for companies to reproduce this material partially and/or in full by any means. Page | 51 © 2015 This material is the copyright of the ExP Group. Individuals may reproduce this material if it is for their own private use.9 In the table above. photocopied. All examples presented in these course materials are for information and educational purposes only and should not be applied to a specific real life situation without prior advice. The ExP Group will not be held liable for any information presented in these materials as to its application to any specific cases. The Discounted Payback period is longer (Year 3).9 . Year: 0 1 2 3 4 5 100 100 125 105 140 Investment: (200) FV: PV: (200) 90. Given the nature of information presented in these materials.7 86.9 82.6 93. 71. the (simple) payback period is in Year 2. on electronic devices or any other means of reproduction. and given that legislation may change at any time.ExPress Notes FIA – Foundations of Financial Management EXAMPLE Year 0 1 2 IRR A -500 B -500 NPV (9%) 100 600 20% 97 500 155 25% 89 Discounted Payback We can apply the concept of discounting to the Payback method in order to capture the time value of money element.