ACCA F9 Financial Management Key Point Notes

June 2010

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ACCA
F9
Financial Management

Key Point
Notes
June 2010
These notes are not intended to cover the whole syllabus, but target key examinable areas.

Tutor:

Sunil Bhandari

Tutor Contact Details

Mobile: 07833 096979
E-mail: via
www.IntelligentAccountancyTutorsLtd.co.uk

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Bhandari
– IAT
Ltd
Copyright
Intelligent
Accountancy
Tutors Ltd
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Use of these Key Point Notes
These notes have been written as an aid to assist students
preparing for the ACCA F9 June 2010 Exam. They accrue for
the topics tested in the past exams.
It is of paramount importance that they are used with an up
to date Revision Kit (KAPLAN, BPP or CIMA). A combination
of using the notes and question practice is the best way to
prepare for the forthcoming exams.

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Index
Chapter Number Chapter Name

Page Numbers

Preliminaries

5-11

Chapter One

Financial Objectives

13-20

Chapter Two

Dividend policy

21-23

Chapter Three

Cost of Capital

25-28

Chapter Four

29-30

Chapter Five

Bonds-Yields & Market
Value
Risk Adjusted WACC

Chapter Six

CAPM

35-43

Chapter Seven

Capital Structure

45-48

Chapter Eight

Project Appraisal

49-62

Chapter Nine

Business Valuations

63-64

Chapter Ten

Sources of Finance

65-71

Chapter Eleven

Ratios

73-75

Chapter Twelve

Working Capital

77-80

Chapter Thirteen

Inventory Control

81-83

Chapter Fourteen

Receivables& Payables

85-87

Chapter Fifteen

Cash Management

89-92

Chapter Sixteen

Foreign Currency Risk

93-99

Chapter Seventeen

Interest Rate Risk

101-108

31-34

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Exam Technique
First 15 minutes
 Read the questions carefully
 Recognise the topic being tested (eg NPV, Rights Issue
etc)
 Rank the questions according to your ‘strongest’ to

‘weakest’

Next 180 minutes
 Attempt the questions in your ranked order.
 Stay within your time allocation both on each part of
the question and on the question itself.
 If the written elements are unrelated to the
computations-try front load as they represent ‘easier’
marks.
 Try to attempt all parts to all the questions.
 If in doubt about how to compute a value-make a
reasonable estimate and move on.

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General
Numerical Questions
 State formula
 Show method
 Explain as you go
 Make assumptions if in doubt

Written Questions
 Check format – report / essay/ listed points
 Headings / subheadings / columnar
 Simple short paragraphs-essays and reports
 Use ‘numbered’ points for most questions-simple
sentence approach.

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Tips
These will be posted on my website sometime in late
April/early May 2010.

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Chapter One
Financial Objectives
1

Primary Financial Objective

1.1 For profit making business “Maximise Shareholder(S/H)
Wealth”
1.2 To Measure S/H wealth
Value of Equity (Ve) =Number of issued Equity/Ordinary
Shares X Current Market Price (Po)

1.3 To find Po:
 Given in the Question if it is a listed company(see
below)
 Compute Using:


Asset Valuation Models
Dividend Valuation Model(DVM)
Earnings Based Models
Discounted Cash Flow Approach(DCF)

1.4 Check the question very carefully for the size of the
company is it: Listed*
 Private Company
* Market value exist on a stock exchange
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2

Indicators

2.1 Financial indicators pointing towards maximising S/H
wealth include:




Earning per share(EPS)
Dividend per share(DPS)
Return on Capital Employed(ROCE)
Return on Shareholder Capital(ROSC)
Profit after tax
Revenue

2.2 Non-Financial Indicators include:
 Market Share
 Customer Satisfaction
 Quality Measures
The above are all Key Performance Indicators (KPI’s)
that need to be measured and reviewed on a regular
basis by the board of directors. (Board)
3. External Factor Affecting Ve & Po
3.1 The Board cannot control all aspects that effect
Ve and/or Po. Two major external factors are: Economic Variables
 Regulators

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3.2 Economic Variables
3.2.1 Interest Rates- If they fall: Stimulate demand and revenue
 Lower the cost of debt and improve profits
 Investors switch to share market for better
returns
3.2.2

Inflation Rates- If it rises: Costs rise causing a drop in profits
 Cause interest rates to rise.
 Devalues the home currency

3.2.3

Foreign Exchange Rate(FOREX)- If it rises: Reduce cash receipts for exporters
 Lowers the cost for importers
 Discourage exporting

3.2.4

Gross Domestic Product- If it falls: Reduce demand and revenue
 Cause interest rates to fall to stimulate demand

3.2.5 General Taxation –If it rises: Damage company profits
 Not encourage investment by companies
Important to relate your comments to the effect upon
Po & Ve.

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3.3 Agency Problem
3.3.1 S/H are the owners of the company and expect
their directors (agents) to take decisions to maximise
S/H wealth. The agency problem occurs when directors
take decisions that DO NOT lead to maximising S/H
wealth.
3.3.2 Examples of decisions that ‘may’ damage S/H wealth:



Directors pay
Taking high risk business decisions
Non-payment of dividends
Using debt finance (against the wishes of the
S/H)

3.3.3 Solutions to this problem include:
 Company Law
 Corporate Governance (eg UK Combined Code)
 Share Options (ESOPS)
3.3.4 ESOPS
This provides a way of rewarding Directors by
granting them options to buy shares in their company
at a fixed price. They can buy the shares in future
(normally 1 year) at the fixed price which usually is
today’s price.Hence, directors are encouraged to take
decisions to maximise future share prices. This
benefits both the directors and the shareholders.

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4 The Three Key Decisions
4.1 To maximize S/H wealth the board must take
 Investment
 Finance
 Dividend
4.2 Investment
4.2.1 Allocate cash for: Organic Growth (Projects)
 Acquisitions
4.2.2 Must always consider how investments
impact upon: Company Liquidity
 Future Profits and Asset values
 Business Risk Profile i.e. effect upon
variability of the cash flows and profits.
4.3 Finance
4.3.1 To finance investments the board have to
decide the best balance of equity and debt.
4.3.2 They will consider: Cash available within the company
 Access to new sources of finance
 Impact on KPI’s like gearing
ratio(Debt:Equity)
 Cost of Finance (WACC or Ko)

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4.4 Dividends
4.4.1 The Board needs to establish a dividend policy –
see Chapter 2
4.5 The three decisions are interlinked.
Example: New projects need new finance but must
generate cash to service the finance providers
including paying dividends to the shareholders.

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5

Objectives of Not-For-Profit- Organisations (NFP’S)

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Chapter Two
Dividend Policy
1 Introduction
To maximise S/H wealth the Board should establish a
dividend policy-the payment pattern to the equity investors.
2 Theories
Several theories have been put forward to assist:2.1 Residual – If spare cash exists at the end of the year pay
dividend.
2.2 Pattern – Be consistent with dividend payments. Either
a) Pay the same dividend per share (DPS) each year.
b) Maintain the payout ratio (DPS/EPS)
c) Maintain the same year-on-year growth rate in
dividends. The latter links into the Po via the
dividend valuation model (DVM)
Po= Do (1+g)
(re-g)

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2.3 Irrelevancy
In a perfect capital market providing the directors can
invest in projects with a positive NPV no dividends
are required. The Ve will rise and the S/H can sell shares
to create the cash the need(Manufacture Dividends).
3 Practical Considerations
There are many to consider:
 Availability of Cash
 What dividends to S/H want (clientele effect)?
 Signalling effect –payment of dividends indicates a
healthy company
 Retaining cash is a key source of Finance.
 Dividend growth should be greater than inflation
 Tax impact upon S/H
 Effect the dividend
will have
on dividend
cover(EPS/DPS)
 Number of investment opportunities will restrict
dividend payments.
 Risk-paying now is safer than promising to pay next
year
 Is the dividend within the company law regulations?
4 Alternatives to Cash Dividends
4.1 Scrip Dividends
4.1.1 The S/H will receive extra shares instead of cash on a
pro rata basis.
4.1.2 This will allow the S/H to sell extra shares for cash and
the gain will be subject to CGT.

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4.1.3 The effect will:a) Increase the issued equity capital
b) Dilute EPS and Po values
c) Create pressure for the board to pay more total
dividends in the future as more shares are in issue
4.2 Share Buy Back
4.2.1 If the board has “one off” period of excess cash, they
could consider a share buy back.
i.e. Buy back shares at Po and cancel them.
4.2.2 Considerations:a) Allowable under company law.
b) Increase gearing as Ve may fall.
c) Tax implications for the S/H(CGT)
d) Reduced number of shares will cut supply for
trading purposes.
e) Less dividend pressure on the board in future.
f) Criticism-is this the best use of company cash.

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Chapter Three
Cost of Capital
1 Weighted Average Cost of Capital (WACC)

Ke=Cost of Equity
Kd=Should be “Kd(1-t)”=Cost of Debt
Ve=Market Value of Equity
Vd=Market Value of Debt
2 Market Values
2.1 Ve=Total Number of Issued Shares X Po
2.2 Vd=Total Book value of the Debt X

Po
$100

2.3 Alternative Presentations
a) Ratio (Vd:Ve) e.g. 1:4
b) Gearing Percentage e.g. 35%
Hence Vd=35,Ve=65
For WACC equation

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3 Cost of Equity (Ke)
3.1 The minimum return required by the S/H to compensate
for the risks they face from the equity investment.
3.2 CAPM
Ke=Rf+ (Rm-Rf)βe
where Rf=Risk free return
Rm=Return on the market portfolio
(Rm-Rf)=Equity Risk Premium
βe=Risk measure for the risks being
faced by the S/H
3.3 DVM

Where Po=Ex Dividend Share Price
d1=The DPS at Time 1
do=The DPS at Time 0
g =Constant annual future growth rate
in the DPS
4 Cost of Debt (Kd (1-t))
Depends upon the type of Debt
Also note:a) Kd=Called Yield(the minimum return of the lender)
b) “Kd (1-t)”=Cost of Debt*
* This is part of the cost of capital computation.
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4.1 Non traded debt (Bank Loans)
 Kd is the Interest rate on the loan(i.e. the yield)
 “Kd (1-t)”=Interest Rate X (1-t)
4.2 Traded Bonds
4.2.1 These are issued and traded in blocks of $100
or £100.Do all computations per block of “100”.
4.2.2 Undated Bonds-the process is:a) Establish the Kd(Yield)
 Given in the question
 Kd(Yield)= Ints
Po
b) “Kd (1-t)”= Yield X (1-t)
4.3.3 Redeemable Bonds-the process is via IRR computation
Time
To
Po
T1-Tn Ints x (1-t)
Tn Capital Repayment

$
(X)

Take two guesses at
the Kd(1-t) like
10% & 1% and
Perform IRR computation

X
X

5 Uses of the WACC
5.1 The Ko is the money or nominal cost of capital to use in
project DCF approaches. It can be used:a. To compute the NPV as the discount rate.
b. Compare with the project IRR.
IRR>WACC-Accept
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5.2 The WACC is useable if the new project under
consideration:a) Is a core activity –same as the company’s
normal activities
b) Does not alter the capital structure of the
company (Vd:Ve)
5.3 In all the past F9 exam questions, it has been very clear
within the question details that the conditions exist to
use the WACC. If the WACC can’t be used then the Risk
Adjusted Cost of Equity per Chapter 5 may be used.
6 What if’s?
6.1 Extend the WACC formula for all extra methods of
company finance. So you could have a WACC with:


Equity
Preference Capital
Bank loans
Traded Bonds

6.2 For Preference Capital
> Kp=D.P.S
Po
> Vp= No of issued
Preference shares

X Market price per
share (PO)

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Chapter Four
Bonds –Yields and Market Values
1 Bonds
Debt which is issued in blocks of “100” and trades on the
stock exchange.
2 Market Value
2.1 The market value is Po/$100 and can be established via
the DVM
“The present value of future cash flows received by the
investor and discounted at the yield(Kd)”
2.2 Undated Debt
Po=

Ints
Yield

2.3 Redeemable Bonds
Time

$

Yield%

Ti-Tn Ints

X

X

X

Tn Capital
Repayment*

X

X

X
Po

PV

=

XX

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2.4 Convertible Bonds
Replace the * Capital repayment with the share value if
higher than the cash repayment.
2.5 Bank loans market value is the book value.
3 Yield (the minimum return required by the lender)
3.1 Yield is the minimum return of a lender. Practically we
would expect:RF<Inter-Bank rate(LIBOR)<Yield required by the lender
3.2 Undated Bonds
Yield =

Ints
Po

3.3 Redeemable Bonds
Time
To

Po

$
(X)

T1-Tn Ints

X

Tn Capital Repayment

X

Take two guesses at
the yield say 10% &
1% and perform IRR
computation

3.4 Bank Loans
 Yield=Interest Rate on the loan

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Chapter Five
Risk Adjusted Cost of Equity
1 Uses
When the company wants to assess a project that is noncore.
2 Process
a. Take the Proxy Company Beta equity and degear via

b. Repeat the above for other Proxy Company Betas.
Then average all the βa
c. Re-gear βa to find the project βe
d. Put the Project βe into CAPM
Project Ke =Rf + (Rm-Rf) Project βe
Note:(Rm-Rf) is the Equity Risk Premium.

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3 Concerns
 Will the project finance truly have no effect upon the
company’s gearing?
 Proxy company βe:a) Does it exist?
b) Does the proxy company specialise in the noncore field or does it have many different business
activities
c) If we are not listed-how do we gear up the βa

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4 Examiners Article

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Chapter Six
CAPM
1 CAPM Equation
Minimum return = Rf+ (Rm-Rf) β
There are several uses of the CAPM equation: To find the company’s Ke(Chapter 3)
 Risk Adjusted Ke (Chapter 5)
 Assist a stock market investor to buy or sell equities
2 CAPM & Buy/Sell Equities
2.1 Single Equity
 Take/Find βe
 Put into CAPM
Minimum Return = Rf+(Rm-Rf)βe
 Forecast a return for the investment (could use
past returns)
 Forecast exceeds/equals
minimum return-Buy or Keep the share

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2.3 Combining Equities (portfolio)
a) Created a weighted average portfolio Beta
i.e (Cash in Share (1)/Total Cash in Equities X β1) + (Cash
In Share (2)/Total Cash in Equities X β2 )

b) Put into CAPM
Minimum Return = Rf+(Rm-Rf)Weighted Average β

c) Forecast exceeds/equals
minimum return-Buy or keep the portfolio.
3 Meaning of a βe
3.1 A βe is the measure of risk being faced by equity
shareholders
3.2 βe can be split into: Systematic Business Risk-measured by βasset
 Financial Risk

3.3 Systematic risk is how market factors effect that
investment. Market factors are: Macroeconomic variables
 Political factors
The measure is relative to the benchmark of the
market portfolio.
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3.4 CAPM assumes that the investor eliminated the
unsystematic risk.

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4

Criticisms of CAPM

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5 Examiners Articles

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Chapter Seven
Capital Structure
1 Introduction
How should the company decide the mix of
equity and debt capital?
2 Practical Issues
If the company uses Debt capital funding it should
consider:





Credit Rating of the company
Rate of interest it will pay
Market conditions- access to Debt capital
Forecast Cash Flows-to service and repay the debt.
Level of Tangible Assets on which secure the loans.
Interest will lead to tax savings i.e Tax Shield
Constraints on the level of debt from
a) Articles Of Association
b) Loan Agreements.

 Effect upon the company gearing ratio
Debt/Equity+Debt OR Debt/Equity

 Will the debt providers exercise influence over the
company?
 The chance of bankruptcy.

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3

Theories of Optimal Capital Structure

3.1

Common Ground-both major views accept two facts:a) Yield<Ke
b) Gearing causes Ke to rise

3.2

Traditional View

Key Points:1) Ke rises due to financial risk caused by gearing.
2) Kd is initially uneffected by gearing but rises at “high”
gearing levels due to the perception of the possibility of
bankruptcy.
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3) Ko (WACC) -trade off of Ke and Kd. Point X is the
optimum gearing level where WACC is lowest.
4) Once point X is reached via trial and error it must be
maintained.
3.3 MM and Tax

Key points:1) Assumption behind the model:All debt is risk free
Only corporation tax exists
Debt is issued to replace Equity
All types of debt carry one yield, the risk free
rate
 Full distribution of profits
 Perfect Capital Market



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2) MM concluded companies should gear up to the
maximum levels.
4 Pecking Order Theory

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Chapter Eight
Project Appraisal
1 Accounting Rate of Return (ARR)
1.1 Average Annual Post Depreciation Profit
Investment

X 100

1.2 Investment is:a) Initial Investment
b) (Initial Investment +Scrap Value)
2
1.3 Decision rule is:ARR> Target return-accept the project
OR
Take the project with the highest ARR
1.4 Limitations and Strengths

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2 Payback
2.1 Time it takes the project to payback it’s initial
investment.
2.2 General Approach:Time
To
T1
T2
T3
T4
T5

Cash Flows
(X)
X
X
X
X
X

Cumulative Cash flows
(X)
(X)
(X)
X
-

2.3 Annuity and Perpetuity cash flows
Payback period=Initial Outflow
Annual Inflows

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3 Net Present Value (NPV)
3.1 NPV is the increase in S/H wealth arising from the
project.
3.2 Two formats to consider
Format (A)

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Format B
Time

To
T1-Tn
T2-Tn

CF

R%

PV$’000

(X)
X
X
NPV

1.0
X
X

(X)
X
X
$XXX

3.3 Incremental Cash Flows
 Result from/caused by the project
 Include opportunity cash flows
 Ignore: Non-Cash Flows
 Sunk Costs
 Interest /Dividend payments
3.4 Financial Maths Required:1) Compounding
Eg: Inflation is 5% pa
Real cash flow at time 7 is $250
Money cash flow =$250 x 1.057= $352
2) Discounting (tables)
Eg: Cash flow at T5 is $390.
r=10%pa
PV=$390 x 0.621 =$242
3) Annuity (tables)
Eg: Cash flow from T1-T9 is $400 pa r=5%
PV =$400 x 7.108 = $2843
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4) Delayed Annuity
Eg: Cash flow T3-T5 =$300 pa
r=10%
PV=$300 x (AF1-5 –AF1-2)
=$300 x (3.791-1.736)
=$617
5) Perpetuity
Eg:Cash flow is $500 pa from T1 each year forever.
r= 4%
PV= $500 x 1
r
=$500 x 1 = $12,500
0.04
6) Delayed Perpetuity
Eg: Cash flow is $600 from T4-Tperp
r= 5%
PV=$600 x (1/r –AF1-3)
=$600 x (1/0.05-2.723)= $10,366
7) Perpetuity with Growth
Eg: Cash Flow at time 1 will be $120 and then it
will grow at 3% pa.
r=12%
PV= $120 x 1
(r-g)
PV=$120 x
1
= $1,333
(0.12-0.03)
8) Delayed Perpetuity with Growth
Eg: As for (7) above but $120 is cash flow at T5.
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PV= $120 x Effective Discount Rate.
Effective Discount Rate=
1 x DF4 at 12%
(r-g)
1
x 0.636
(0.12-0.03)
= 7.067
PV =$120 x 7.067 = $848
3.5 Inflation- Factors to consider:
a) ‘h’ is symbol for inflation
b) ‘r’ is symbol for real –excludes inflation
c) ‘i’ is symbol for money/nominal –includes inflation
d) Two approaches are possible
3.6 Include Inflation
Money cash flows can be: Given in the question
 Computed via
Real CF x (1+h)n
Money cost of Capital can be
 Given in the question
 WACC (see earlier chapter)
 Computed via
Money rate=Real Rate x (1+general ‘h’)

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Exclude Inflation
 Not yet tested by the examiner at F9
 Cash flows are REAL
 Discounted at REAL Cost of Capital
3.7 Working capital-think of as a project bank account:i.
ii.
iii.

Invest at To
Adjust each year
Close at end of the project.

Eg: Project needs WC at end of each year as follows:

Relevant
CF’s

T0
(300)

T1
300
(50)

T2
350
(25)

T3
375
375

3.8 Taxation-relevant cash flows to be included in the NPV
computation.(RTQ re timings of tax flows!!!)
1) Operating Flows x Tax rate
2) Tax saved on Capital allowances or Tax Allowable
Depreciation(TAD):a) TAD-straight line.
eg: CAPEX is $1m.Scrap value at T4=$200K.TAD
is 4 years and tax rate is 30% (No delay)
Tax saved= [($1000-$200)] x 30% =$60 pa
T1-T4
4
b) TAD-Reducing Balance
eg: Asset is bought at T0 (1/1/09)cost
$1m.Sold at T4 for $200k.TAD is 25% reducing
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balance. Tax is 30% (1 year delay).
Time

Tax saved
$’000
75
56
42
67
240

T2 $1000 x 25% x 30%
T3 75 x (100% -25%)
T4 56 x75%
T5 Bal Figure
30% x (1000-200)
4 Internal Rate of Return (IRR)

4.1 The cost of capital that gives an NPV=Nil
4.2 Approach-Take the following example:
NPV@ 10% =$200K
NPV@ 20% = ($15K)
IRR= 10+ (200/200-(-15)) x (20-10) =19.30%
4.3 Decision Rule
IRR>Project Cost of Capital-Accept
4.4

PROS

CONS

*Easier to explain
*Simple decision rule

*Will mislead if comparing
projects
* If cash flows are nonregular (-, +, +, +,-)
IRR computed above is
incorrect

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5 Capital Rationing
5.1 A restriction of cash preventing the company from
accepting all projects with a positive NPV
5.2 Causes:
Hard

Soft

External constraint on
Raising cash.Eg:- Credit
Crunch Crisis

Internal within the
Company
Eg:- Capex Budget

5.3 Period –only single period is examinable i.e. cash may
Be restricted at T0 or T1.
5.4 Divisible projects –can invest in proportions of a project
from 0% to 100% maximum.
Approach:1)Compute Project NPV’s
2)Compute Profitability Index(PI) =
NPV
Cash Invested at critical period
3) Rank-High to Low PI
5.5 Non-Divisible –take all or none of any project.
Approach:1)Compute Project NPV’S
2)Take best combination of projects that
maximise
The total NPV but spend less than or equal to cash
available in the critical period.
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6 Asset Replacement
6.1 If assets have to be replaced on a periodic basis,
Equivalent Annual NPV is the method to use.
6.2 Process
a) Compute the NPV for each replacement cycle.
b) E.A.NPV =

NPV

Annuity Factor for life of the project @cost of capital

c) As (b) will give negative values, take the least
expensive.
7 Accruing for Risk or Uncertainty within NPV
Several methods, the best are:7.1 Certainty Equivalents-Reduce cash flows by C.E factor
prior to discounting .Example:Time
T0
T1
T2

$’000
(1000)
700
900

C.E Factor
1.0
0.90
0.85

Adj CF
(1000)
630
765

RF%
1.0
X
X

7.2 Probabilities –One project cash flow may be
uncertain.
Example Sales in year 1
$’000
2000
1000

P
0.70
0.30
1.0

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Sales in T1 for NPV=
(2000 X 0.70)+ (1000 X 0.30) =$1700K
7.3 Risk adjusted Cost of Equity –See Chapter 5
7.4 Sensitivity Analysis-What if?

NPV
X 100% For Cash flows
PV of the cash flow
that is uncertain

 IRR-Cost of Capital X 100% For the Cost of capital
Cost of Capital
 Lower the sensitivity % the higher the risk
7.5 Discounted Payback
 Payback using discounted cash flows
 Format
Time
T0
T1
T2
T3
T4
T5

D.C.F
(X)
X
X
X
X
X

Cumulative D.C.F
(X)
(X)
(X)
X
-

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8 Post Completion Audit (PCA)

9 NPV and S/H wealth
9.1 As stated earlier, NPV represents the change in S/H
wealth arising from the project. It is the only method
that can be directly related to the primary objective of
financial management.
9.2 The NPV is effectively the change in the market
capitalisation of the company and the movement in its
share price. It relies upon markets being efficient
(see chapter 9) to reflect the project data within the new
market price.

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Appendix – Capital Rationing Question
HIJ is a private transport and distribution entity. It is
considering three investment opportunities, which are not
mutually exclusive. HIJ is no cash reserves ,but could
borrow a maximum of $30 million at the present time at a
gross interest rate of 10%.Borrowing above this amount
might be possible, but at much higher rate of interest.
The initial capital investment required, the NPV and the
duration o each project is as follows:

Project A
Project B
Project c

Initial
Investment
$million
15.4
19.0
12.8

NPV
$million(after
tax)
2.75
3.60
3.24

Duration
years
6
7
Indefinite

Notes:
1) The projects are not divisible and cannot be postponed.
2) The discount rate considered appropriate for all three
investments is 12% net of tax.
3) HIJ pays corporate tax at 30%
4) Assume cash flows, other than the initial investment,
occur evenly throughout the duration of the
investments.
Required:
(a) (i) Calculate the profitably index and equivalent annual
annuities for all three projects ,explain the usefulness
of these methods of evaluation in the circumstances
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here, and recommend which project(s) should be
undertaken.
(10marks)
(ii) Explain the differences between ‘hard’ and ‘soft’
capital rationing and which type is evident in the
scenario here. Discuss, briefly, the advisability of the
directors of HIJ limiting their capital expenditure in
this way.
(5 marks)
(iii) You later discover that the discount rate used was
nominal but the cash flows have been calculated in
real terms.
Explain, briefly, how the calculation for NPV should be
adjusted and what effect the changes might have and
on your recommendation. You are not required to do
any calculations for this section of the question.
(4 marks)

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Chapter Nine
Business Valuations
1 Equity
1.1 To value equity /ordinary shares on a per share basis
two primary methods exists.
1.2 DGM/DVM
Po is the present value of future dividends discounted at
the cost of equity(re or Ke)
Po= Do (1+g)
(re-g)
1.3 P/E Model
PO =EPS X P/E Ratio
P/E Ratio may have to come from a proxy company.
2 Others
2.1 Preference shares
PO = D
rp

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2.2 Traded Debt-Undated
PO per $100 = Ints
rd
2.3 Traded debt –Redeemable
PO per $100:Time
T1-Tn Ints
Tn
Capital Repayment

$

rd

PV

X
X

X
X

X
X

PO

X

3 Efficient Market Hypothesis (EMH)
3.1 EMH explains how stock market prices change to reflect
data /information. The market can be efficient at 3
levels: Weak
 Semi-Strong
 Strong
3.2 Weak –the prices reflect only historic/past data.
3.3 Semi-Strong-prices include past data +public
announcements.
3.4 Strong-prices reflect past, public and insider (secret)
data.
3.5 Most of the world’s stock markets are closer to
semi strong.
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Chapter Ten
Sources of Finance
1 Introduction
Where and how do companies raise long term capital.
2 Equity –General Factors
2.1 Ordinary shares of the company with voting rights.
2.2 Carry the greatest risk but also the best possible
returns.
2.3 Could be traded on the stock exchange if company is
listed.
2.4 “A Stock Exchange Listing”

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3 Equity- Raising New Capital
3.1 Retained Earnings-First source of cash. Hold back the
payment of dividends. Will effect the dividend policy
and can raise a small amount of cash.

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3.2 Rights Issue-Pro Rata issue to existing S/H.
3.2.3 From the exam questions will need to obtain or
compute:a) Po just before the rights issue (Cum Rights
price)
b) Issue Price
c) Ex Rights Price-price directly after the share
issue (TERP)
For Example: 1 for 3 rights issue at 550p and
cum rights is 600p
No
3 at 600p
1 at 550p
4

£
18.00
5.50
£ 23.50

TERP =£ 23.50/4 =£5.88
d) Value of the right
£ 5.88- £5.50 =38p
3.2.4 Shareholder can sell the rights to another
shareholder at the value of the rights.
3.3 Placing- Sell a large batch of new shares to
institutions.
3.4 Prospectus- Sell shares to investors at a fixed price
after issuing a prospectus.
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3.5 Tender- Request investors to tender for the shares
at a price they would want to pay. The board then
establishes final price.
4 DEBT
4.1 Loans provided to the company on a long term basis.
Debt holders will:a)Interest paid from pre-tax profits
b) Security via
 Fixed charged
 Floating charge
 Securitisation of future income.
c) Covenants-restrict company activity in areas
such as:
 Dividend payments
 Issues of further debt
4.2 Bank Loans
4.2.1 Funds come from one bank or group of banks.
4.2.2 Terms & Conditions depend upon market
conditions and credit rating.
4.3 Traded Bonds
4.3.1 Loan is split into blocks of $100 and issue on the
market.
4.3.2 Can be undated or redeemable.
4.3.3 Bond has a yield and market value (Chapter 4)
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4.4 Other Types of Debt
a) Convertible Bonds-Debt that can be converted
to shares, normally at redemption.
b) Eurobonds-Rare large foreign currency loan in
the home country. Used by MNC’s and minimum
values normally $1m.
c) Mezzanine Loan-Loan used in MBO’s. Loan that
carries high interest but normally only paid if
profits are made.
d) Grants-Free government finance providing
conditions are met.
5 Leases

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5.2 Lease Vs Buy Evaluation
3 Step approach
1. Ascertain the post tax cost of debt
i.e Pretax % X (1-t)
2. NPV of the lease cash flows using (1)
Lease cash flows are:
 Payments/Rental
 Tax savings caused by rentals.
3. NPV of buy cash flows using (1)
Relevant flows are: Capital Cost
 Scrap value
 Tax saved on Capital allowances or Tax
allowable depreciation.

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6 The role of Treasury Function
6.1 Treasury functions mainly exist in Large MNC.
6.2 Roles include:Managing the groups cash resources
Liaise with the banks.
Advising on Heading strategies for: Forex Risk
 Interest Rate Risk
Establishing source of Finance and cost of capital
for the group.
 Deciding upon investment policy.

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Chapter Eleven
Ratios
1. Ratios-You must Learn!!!!
1.1 Investor
EPS = PAT less Preference Dividends
No of ordinary shares in issue
P/E = Po
EPS
Dividend Cover= EPS
DPS
Payout Ratio = DPS
EPS
Dividend Yield = DPS
Po
1.2 Gearing
Capital Gearing= Debt or Debt
X 100
Equity
Debt+Equity
NB Preference shares are generally treated as debt.
Interest Cover = Operating Profit
Interest
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1.3 Profitability
ROCE = Operating Profit X 100
Equity +Debt
ROE = PAT X 100
Equity
Margin = Operating Profit X 100
Turnover
1.4 Liquidity
Current Ratio= C.Assets
C.Liabilities
Quick/Acid Test = (C.Assets-Inventory)
Ratio
C.Liabilities
Inventory Days=

Inventory
x 365
COS or purchases

Receivables Days= Trade Receivables x 365
Sales
Payables Days = Trade Payables x 365
COS or Purchases
2 Important


Learn the ratios
State on answer book, substitute the relevant
figures from the question and compute the ratio.
Comment on each ration in a sensible manner.

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 Be ready to change the ratios around
Eg: C.Ratio is 1.25:1.C.Assets are $260K and
C.Liabilities are made up of bank overdraft and
payables. Payables are $108K.What is the value of
the bank overdraft?
Solution
CA=1.25($260K)
CL=1.00(?)
CL=$260K=$208K
$1.25
Bank O/D=$208K-$108K
=$100K

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Chapter Twelve
Working Capital

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Chapter Thirteen
Inventory Control
1
INVENTORY MANAGEMENT

Economic Order Qty(EOQ)
-Optimise stock order quantity
and Re-order level
-Minimises stock associated
costs

No discounts

Just In Time(JIT)
-Nil/minimum
stock

With discounts

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EOQ

Assumptions

Demand is known

Purchase price is
constant
(No discounts)

Lead time is
constant
(No Stock outs)
Re-order level =
demand in lead
time

Graphs

EOQ + DISCOUNTS

Q

Method
1)

Calculate the EOQ
using the formula,
ignoring
any
potential discounts.
This is the starting
point.

2)

If, and only if, the
EOQ calculated in
1) would result in a
discounted
purchase
price,
recalculate the EOQ
using the formula
taking into account
the
relevant
discount.

3)

Finally,
calculate
the total annual
cost using the EOQ
calculated
in
2)
AND
the
total
annual
cost
ordering
in
quantities
higher
than the EOQ but
where
greater
discounts
are
available.

Q/2
ROL
0
TIME

Co=Fixed cost per
order
D=Annual Demand

£

Total relevant
costs

Variable
holding
costs

CH=Variable holding
cost per unit.

All costs are known
and constant

Fixed order
costs

EOQ

Q

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Forecast Sales qtys

(2)
Demand Driven
(1)

No Finished (3)
Goods inventory

Close Link
with suppliers
(7)

No or Ltd
Raw material
Inventory(6)

JIT
(Factors)

NO WIP(5)

JIT
Production (4)

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Chapter Fourteen
Receivables and Payables
1 Receivables
1.1 Receivables management is the balance between: liquidity (hold a lower balance)
 profitability(offer more credit)
1.2 Factors to consider when offering credit.
 Do competitors offer credit?
 Industry norms
 Check the credit rating of both new and existing
customers
 Set realistic credit limits
1.3 To collect cash from receivables efficiently:



Invoice promptly
State terms on the invoice
Send out monthly statements
Call customers to chase payment
Consider legal proceedings as a last resort.

1.4 Factoring companies offer “contracted out” receivables
management.
 Receivables administration/collection of cash.
 Advances of cash
 Insurance cover for “bad” debts.
All the above have costs & fees attached.
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1.5 Recourse- Services can be offered with or without
recourse. If without recourse, the factoring company will
suffer any bad debts should they arise.
1.6 Invoice discounting-this is where cash can be raised
using certain receivables balances as security.
Customers are not aware of the transaction. The debt is
paid off when the receivables settle their debt.
1.7 Offering early settlement discounts to customers.
Eg Receivables normally pay in 45 days a settlement
discount of 1.0% is offered for payment within 30
days. Bank overdraft rate is 20%pa
Solution
 Assume sale of $100
 Discount is $ 1.00 = 0.01
$99.00
 Effectively, Annual value is:365
(45-30)

= 24.33

(1+0.01)24.33-1 x 100
=27.4%
 Discounts costs the company 27.4 % but save
20%.Hence, don’t offer these terms.

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1.8 Changes of Policy
 Prepare all computations on an annual basis
 Show incremental relevant cash costs and savings
when changing from old to new policy.
2 Payables
2.1 Again balancing act: Maximise use of free credit
 Not to over extend and lead to:a) Costs/Charges
b) Supplier withdrawing supply
c) Supplier going out of business.
2.2 Taking early settlement discount offered by suppliers –
same approach as receivables as per 1.7.

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Chapter Fifteen
Cash Management
1 GENERAL
Motives to hold cash
 Transactions-Day to Day payments
 Precautionary-To cover “rainy day”
 Speculative-Possible investment
opportunities

Business may have
 Surpluses
 Deficits

Surpluses
Consider:  Amount
 Time
 Access
 Return
 Risk

Deficits
Uses: 1. Extend trade
payables
finance.
2. Bank facils.

Investments
 Deposits
 Building society
a/c’s
 Inter bank
market
 Gilts
 Aim
 London SE
 Futures

3. Factoring
co’s.

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2 CASH BUDGETS-LAYOUT
January

February

March

Receipts
Cash sales
Receipts from debtors
Sale of assets

Payments
Cash purchases
Payments to creditors
Expenses
Purchase of assets
Tax
Dividends
Interest

Net cash inflow/(outflow)
Balance b/f

Balance c/f
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Exam Technique
 Proforma (as above)
 Copy in easy figures.
 Workings for others e.g. receivables receipts, payables
payments.
 Total & tidy!!
3 CASH MODELS
Aim is to optimise the amount of cash held in the longterm.
3.1 Baumol Model
The “inventory control” model of cash.
£
Max Bal

Spread

Min Bal

Time

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3.2 Spread comes from EOQ formula:

3.3 Miller Orr
A model to cope with the daily variances in the use of cash.
£
Max Bal

SPREAD

Return
Point

One third
of spread
Min Bal
Time
Sell Investments and
Replenish cash

Formulae are:

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Chapter Sixteen
Foreign Currency Risk
1. Translation Exposure
This is a Financial Reporting risk. The change in the value
of an asset /liability caused by a change in the spot
exchange rate.
1.1 Example-ABC plc has a US subsidiary worth $10m.
2008 -

at $1.50

£6.67m

2009 -

at $1.75

£5.71m

Loss to equity

(£0.96m)

Funded by a $10m loan.
2004

-

at $1.50

£6.67m

2005

-

at $1.75

£5.71m

Gain to equity

£0.96m

1.2 Not a cash risk, only due to financial reporting!!!!
2.

Transaction Exposure

Change in the value of the spot rate over the short term
(less than a year) causing a cash gain or loss.
2.2 Must hedge!!
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3. Economic Exposure
Longterm change in the spot rates effecting project cash
flows .Risk can be reduced by Global Diversification.
4. SPOT and Forward Rates
4.1 Typical presentation of SPOT and Forward Rates.
(Bid)
(Offer)
$1.5000 - $1.5555 / £

Reciprocal and
cross over!!!!!

£0.6429 - £0.6667 / $
(Bid)
(Offer)

4.2 Picking the correct rate –Good Method
 Spot and Forward rates presented as FX/Home
currency
 If “we” are Receiving Forex
 Use the right hand rate
5. Internal Hedges for Transaction Risk
5.1 Invoice in home currency
 All transactions in home currency
 Transfer risk to the other party
 Only useable rarely-if “we” have monopoly power.
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5.2 Foreign currency bank account
 Held in the main currencies ($, Euro)
 Pool all transactions in same FX
 Liking have 3 bank accounts with 3 cheque books!!
5.3 Leading and Lagging
 Watcher / predictor of spot rate changes
 Leading – accelerate exchange
 Lagging – delay the exchange
 Used a lot by Importers who have to sell their home
currency
5.4 Netting
 Match all FX transactions in the same FX occurring on
the same day
 Eg: 30 June we expect
Receive $200K
Pay
($50k)
Net Rec $150k

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6. External Hedges for Transaction Risk
6.1 Forward Market
“Fix the rate today that will apply on a set future date”
Technique: 1. Net the future transactions in same FX and same
date. Ascertain if “buying” or “selling” the £.
2. Forward contract, X months, at
Given as a ‘spread’
3. Exchange FX at the forward rate(Remember if
receiving FX use the right hand rate)
6.2 Money Market Hedge
“The exchange will take place today at the known spot
rate”.
Technique
Home
Today

£Answer

Abroad
Today’s Spot

FX

X
1+ints home

÷ 1+ ints foreign

Future Date

£ Answer

FX

FX

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7. Pros & Cons
Pros







Cons

Forward Market
Fixed Rate, certainty
 Inflexible/contract
Easy
 Lose out on the
Cheap
upside potential or
Tailored(Any size of
gain
transaction)
 Must ensure FX
receipts arrive
Convert today
Cheap
Tailored
Flexible

MMH

 Complicated
 May not apply for FX
receipt as borrowing
may not be possible
abroad

8. Predicting Future Exchange Rates
 Best long term prediction model is PPPT

S0=Spot Today
S1=Spot 1 years time
hc=annual inflation rate foreign
hb=annual inflation rate base/home country
 In the short term use IRPT

F0=Forward/future spot rate
i=interest rate
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 Practical Factors influencing the Spot Rate
1. Political stability-strengthens home currency value
2. Economic growth-strengthens home currency
value
3. Commodity pricing-oil is priced in dollars
4. Trader activity-buying & selling of currencies
5. Central bank action acting as a trader in FX
6. Changing interest rates-protect the value of the
home currency.
9 Derivatives (written questions only at F9)
9.1 Futures
 This is a method of hedging which is trying to fix the
future spot rate at a value approximately equal to the
current spot rate.
 “Futures exchange rates” are always similar to spot
rates and this is a key factor.
 Hedge is based upon:1) Find the direction of the change in the spot rate that
would cause a transaction loss.
2) Use the Futures market and effectively “spread bet” on
the futures rate moving in directions that cause a loss.
3) If:a) Spot rate moves in the direction to cause a
transaction loss, a profit will be made on the
futures market, hence two will cancel out.
b) Spot rate moves in the direction to cause a
transaction profit, a loss will be made on the
futures market, hence two will cancel out.
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 It’s not a perfect hedge due to basis risk and “odd”
contract sizes.
9.2 Options
 If “we” could take the current spot rate and use it in
the future, there would be no transaction risk.
 With an option:1) Take a contract to give us the option (right)to
exchange in the future at approx current spot
rate.
2) Pay a non-refundable premium
3) Future-use the option rate if spot rate has
move unfavourably. Otherwise the option
lapses.
 Think of an insurance policy-very similar

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Chapter Seventeen
Interest Rate Risk
1

What are the issues?

We have loan finance
and interest rates are
set at a variable rate on a
regular basis
(more likely exam questions)

We have deposits
earning a variable
interest rate

Cover an interest
Rate rise

Cover an interest
rate fall

Note
1) Interest rate relationship:Yield on Govt Stock<Interbank Rates<Rates set by
(see yield curves)
lender(as above)
2) F9 syllabus requires students to discuss:
a) How to fix rates.
b) How to create a ceiling on interest rates.
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2 How to fix the Interest Rate
Forward rate agreements
(FRA)

Purchased from a
merchant bank

Pros
- easy
- flexible
- cheap

Cons
- contract
size (≥ $1m)

Contract that fixes future
interest rates for a set period
eg FRA 3-9

Fix start 3
Months from
now

@ 4% pa

Fixed Rate
Fix stops 9 months
from now

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Interest rate future

Fixing the interest rate can be achieved by using futures.
One of the main markets that is used is the UK LIFFE
(London International Financial Futures Exchange).

The hedge is achieved by effectively ‘betting’ on the futures
market that its interest rate will change. The bet is always
on the downside (ie those with loans are betting that rates
will increase). Also, the futures interest rate is derived from
the market interest rates.

If the downside occurs, the company will have to pay more
on its loans as the market rate has risen, but would have
made a profit on the futures market. If rates go down, loan
interest will fall but a loss will be made on the futures
market. In both cases, the effective interest rate is fixed.

Futures are complicated by a number of factors.
 Contract sizes
 Margins / deposits payable at the start of the
hedge(Refundable)
 Speculators – who dominate the market and can
effect the future rates.

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Overview Illustration-to enhance understanding.
Concerned ints rate will go up
T Now

T 6 months

LOAN = £10m

Ints = 6% p.a.

Ints = 4% p.a.

LIFFE
Ints = 6.2% p.a.

LIFFE Ints = 4.1%
Bet that this
will rise.

Win on the bet

Pay more ints.

Match up!!!!!

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3 How to set Ceiling Rates
Interest rate guarantee
(IRG)

Purchased from
a merchant bank for
a fee

Covers the adverse
side of interest rate
changes, but at a cost!!!

Contract that caps
the future interest
rate for a set
period
eg IRG 3-9

@ 4% pa at cost of 0.1% of loan

Cap starts in
3 months time

Cap stops 9
months from now

Capped Rate

Non –refundable
Fe

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Interest Rate Option
The future and options market provides a product that can
cap interest rates for borrowers like an IRG. The hedge is to
effectively have the ‘right to bet’ on an interest rate increase
as shown on the futures market.
As an example, suppose that today is 30 June and the
following data is available on September LIFFE options.
Strike price
(SP)
%
93.75
94.25
94.75

Interest rate
cap
(100 – SP)
%
6.25
5.75
5.25

Call options
premium
%

Put options
premium
%\\

1.29
0.69
0.16

0.23
0.77
1.33

If a company wished to protect itself against an interest rate
increase above, say, 5.75%, it would purchase a put option.
A premium of 0.77% would be payable now. If the market
interest rates started to rise, the company would have to
pay more interest on its loans. However, interest rates on
the futures market will also rise and should this exceed
5.75%, the business will exercise its put option. The cash
received from this should cover most of the extra interest
paid on the loan.
Contract sizes and a standard length of three months
complicate interest rate options.

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4. Yield Curves

The shape of the yield curve is influenced by:
 Liquidity Preference Theory – the longer cash is
loaned /invested with any entity the greater the
returns are needed for not having access to the cash.

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 Expectations Theory- the yield curve reflects money
interest rates which incorporates predicted inflation
rates.

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