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Session 0 Introduction to

BA1

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Syllabus outline!

•  Macroeconomic and Institutional Context of Business – 25%!

•  Microeconomic and Organisational Context of Business – 30%!

•  Informational Context of Business – 20%!

•  Financial Context of Business – 25%!

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Exam Format!
•  2 hour time limit!

•  60 objective test questions in a range of styles:!

•  Multiple choice, drag and drop, number entry, hot spot, multiple
response (will say how many correct answers)!

•  Must be sat at a CBA centre: instant result!

•  You choose when to do it: !

•  Ideally: leave 1 week after the end of the course, but not more than
3 weeks!

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Session structure!
1 Microeconomic and organisational context I: the goals and decisions of
organisations
2 Microeconomic and organisational context I: the market system!
3 Financial context of business I
4 Macroeconomic and institutional context I: the domestic economy
5 Macroeconomic and institutional context I: the international economy!
6 Financial context of business I: international aspects
7 Financial context of business III: discounting and investment appraisal
8 Informational context of business I: summarising and analysing data
9 Informational context of business II: index numbers!
10 Informational context of business III: inter-relationships between variables

11 Informational context of business IV: forecasting

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Session 1
Microeconomic and Organisational Context I:
The Goals and Decisions of Organisations

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The Business Organisation!

Views of
Profit!

Profit Not For Profit


Maximisation! (NFP)!

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Not for Profit Organisations!

NFP’s will not follow the principles of


shareholder wealth maximisation. Instead their
goals will be set by their key stakeholders.
These key stakeholders are determined by two
criteria:

•  the stakeholders interest, and


•  the stakeholders influence.

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Types of Organisation!

Control!

Public! Private!

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Shareholder Wealth!

Profit oriented businesses are believed to have shareholder wealth


maximisation as a key organisational goal. This goal can be assessed
in two ways:!

•  the returns provided to shareholders!

•  the value of the shareholders’ shares in the organisation!

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Shareholder Interest!

•  Shares – Funds that are raised for the business activity by dividing up
ownership of the company into equal parts!

•  Shareholder – Someone who owns the shares in the company!

•  Equity – The ownership interest of the shareholder in the which represents


his ownership of profits, losses and assets of the company. This is
proportional to the number of shares held!

•  Dividend – Profits paid out to the shareholders!

•  Stock Exchange – The place where shares in quoted companies are bought
and sold!

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Shareholder Returns!
•  The returns to a business owner can be considered
either as happening:
–  In a single instance in time (short run) and could
be measured by:
•  Return on capital employed
•  Earnings per share
–  Over a period of time (long run)
•  This would involve consideration of the time
value of money (more on this later in the
syllabus)

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Short Term Measures!

•  Return on Capital Employed


–  Measured as:

ROCE = Profit before interest and tax × 100


[EBIT]
Capital employed

•  Profit can be measured in different ways.


•  Capital employed can be measured differently.

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Short Term Measures!

•  Earnings per share measures the profit available to


shareholders expressed per share

–  To calculate two steps may need to be made:

Number of shares in issue = Issued share capital


Nominal value of a share

Earnings per share (EPS) = Earnings after interest


and tax
Number of shares in issue

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Long Term Measures!
The key to measuring long term success will be to
ensure that returns to shareholders are at least equal to
the cost of acquiring the capital required to produce a
long term flow of earnings.

This “cost of capital” is then used to value the future


income from any investment.

See later session on ‘Discounting and Investment


Appraisal’

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Long Term Measures!
Share Values

An investment in shares is no different than any other


investment. With shares, the future income will be in the
form of dividends from the company and the net present
value of these dividends should represent the value of
the share.

Also, any change in future dividends should impact on


the value of these shares.

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Stakeholders!
Interest and
Influence!

Internal! Connected! External!

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Risk & Return!

Before deciding whether to buy, hold or sell shares in a firm the investor will
consider whether the returns from the firm are adequate to compensate them
for the risks of investing in the firm. The minimum rate of return that is
acceptable to shareholders is called the required rate.!

Systematic risk is the risk associated with investing in any equities in a


particular section of the market. For example shares in pharmaceutical
industries may have greater systematic risks than shares in bakeries. !

Unsystematic risk (or specific risk) is the risk associated with investing in a
particular firm. For example a firm’s shares may have high unsystematic risk
due to the firm’s high dependence on the sales of a single line of product!

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Risk Return Curve!

Time value of
money!
Risk Free Rate!

Rate of inflation!

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Corporate Governance!

Profit seeking companies should be run for the benefit


of shareholders. But it is directors who make decisions
and manage the company so there is a threat that they
will follow their own goals rather than the goals of the
organisation.

Therefore some principles of good corporate


governance have been created for companies and
summarised into a “Combined Code”

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Key Principles!

•  separation of CEO and Chairman’s roles


•  the board to have equal numbers of executive and
non-executive directors
•  transparency, openness and fairness
•  reflect the interests of all stakeholders
•  a fully accountable board
•  remuneration committee
•  nomination committee for directors
•  hold an AGM

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Transaction Costs!

•  Production costs vs transaction costs


•  Transaction costs of outsourcing
•  Variables that impact on transaction costs

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Session 2
Microeconomic and Organisational
Context II: The Market System

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Session 2
Microeconomic and Organisational Context I:
Measuring Returns to the Shareholder

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Influences on Prices!

Demand: Supply:
The plans of consumers The plans of producers

Price

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Influences on Prices!

Demand: Supply:
The plans of consumers The plans of producers

Price

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Consumer Behaviour and Demand!
•  Construction of a demand curve.!

Price

P2

P1

D
Q2 Q1 Quantity
Contraction

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Conditions of Demand!
•  Income!
•  Tastes and preferences!

•  Prices of other goods!

•  Substitutes!
•  Complements !

•  Population!

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Shift in a demand curve!

Price
Shift due to a change in one
of the conditions of demand

P1

D2
D1
Q1 Q2 Quantity
increase

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Elasticity of Demand!
•  Elasticity measures responsiveness of one variable to changes in another
variable in percentage terms.!

•  The sign indicates the direction of the relationship!

•  The number indicates the strength of the relationship!

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Price Elasticity of Demand!
•  This is measured as:!

Percentage change in quantity demanded!

Percentage change in price!

•  Calculated using either the non-average arc method or the average


arc method!

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Price Elasticity of Demand!

Meanings of elasticity values:


PED Meaning

<1 Relatively If price changes by 10%, then


inelastic quantity changes by less than 10%
=1 Unit If price changes by 10%, then
elastic quantity changes by exactly 10%

>1 Relatively If price changes by 10%, then


elastic quantity changes by more than 10%

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Position on the demand curve!
•  Elasticity varies along the length of straight line demand curves as
shown:!

Price PED = infinity = perfectly elastic

Elastic section Midpoint PED = 1 =


unit elastic

PED = 0 =
Inelastic section perfectly
inelastic

Quantity
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Determinants of PED!
•  Income!
•  Availability and closeness of substitutes!

•  Necessities!

•  Habit!

•  Time!

•  Definition of market!

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Supply and Market!
•  Construction of a supply curve.!

Price
S1

P2

P1

Q1 Q2 Quantity
extension

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Conditions of Supply!
•  Costs of production change!
•  Technological change!

•  Import prices change!

•  Indirect taxes!

•  Number of firms!

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Shift in a supply curve!
Price
S1 S2

Shift due to a change in one


of the conditions of supply
P1

Q1 Q2 Quantity
increase

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Elasticity of Supply!
•  This is measured as:!

Percentage change in quantity supplied!

Percentage change in price!

•  Calculated using either the non-average arc method or the average


arc method!

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Supply Elasticity!
•  Elasticity of straight line supply curves:!

•  Any supply curve cutting the quantity axis,


regardless of slope, is relatively inelastic.!

•  Any supply curve cutting the price axis, regardless


of slope, is relatively elastic.!

•  Any supply curve passing through the origin,


regardless of slope, is unit elastic.!

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Determinants of Price Elasticity
of Supply!

•  Time!

•  Factors of production!

•  Stocks!

•  Number of firms in the industry!

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The Price Mechanism!
•  Equilibrium price determination:!

S1
Price
Excess supply
P1
Equilibrium point
P2 where demand = supply

D1

Qd Q2 Qs Quantity

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An example:!

Price Demand Supply

30p 1000 200

Equilibrium: 40p 800 400


Demand = Supply
quantity
50p 600 600

60p 400 800

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Changes to the equilibrium!
From the initial demand and supply curves and
equilibrium position:!

– Decide from the information whether the question


involves a change in the conditions of demand or
supply (shift)!

– Determine whether to shift curve to right or left!

– Put in new demand or supply curve!

– Identify the new equilibrium!

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Effect of a change in demand
conditions!
S1
Price

P2
New equilibrium point where
P1 new demand = supply

D2
D1

Q1 Q2 Quantity

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Effect of a change in supply
conditions!
S1
Price S2

P1
P2 New equilibrium point where
demand = new supply

D1

Q1 Q2 Quantity

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Market failure!
The inability of a market to allocate resources in a way that maximises
utility!

•  Public goods!

•  Externalities!

•  Merit goods!

•  Demerit goods!

•  Competition policy and fair trading regulations!

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Interferences in market prices!
•  Governments will sometimes interfere with the equilibrium position when
they feel this is necessary. An example of this are the minimum wage
rule.!

•  This
can lead to excess supply (i.e. unemployment) which the
government then have to deal with (through paying unemployment
benefits).!

•  Minimum prices!

•  Maximum prices!

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Economies and diseconomies of scale!
•  Internal economies of scale:!

– technical!

– financial!

– trading!

•  External economies of scale!

•  Diseconomies of scale!

– technical!

– trading!

– managerial!

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Session 3

Financial Context of Business I

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Financial Markets!

•  money markets!
•  capital markets!
•  foreign exchange markets!
•  commodity markets!
•  derivatives markets!
•  insurance markets !

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Financial intermediaries!
Channelling funds between lenders and borrowers can be achieved
by:!

•  direct contact: unlikely due to the mismatch


between the two parties involved!

•  through a financial market!

•  through financial intermediaries: these provide


assets and liabilities to meet the needs of borrowers
and lenders !

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Financial Intermediaries!

•  Risk reduction!

•  Aggregation!

•  Maturity transformation!

•  Financial intermediation!

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Liquidity surpluses and deficits!
Businesses!

•  Receipts!

•  Payments!

•  Lack of synchronisation!

Government!

•  Receipts!

•  Payments!

•  Lack of synchronisation!

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Financial products!
Considerations:!

•  Yield / cost!

•  Risk!

•  The amounts involved / divisibility!

•  Time period!

•  Liquidity!

•  Transaction costs!

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Capital and money markets!
Capital markets – maturities > 1 year!

Money markets – maturities < 1 year!

Products:!

•  Ordinary shares / equity!

•  Bonds!

•  Certificates of deposit (CD)!

•  Credit agreements!

•  Mortgages!

•  Bills of exchange!

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Yields on financial products!
•  Returns/Yields:!

– Coupon rate or bill rate: nominal published rate!

– Interest Yield, running yield or flat yield = !

Annual interest or coupon × 100


Market price of the security

•  This
means that yields rise when the market
price of the security falls.!

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Relationship with interest rates!

The market value of debt/bonds/gilts normally moves inversely to any


movement in interest rates. So if interest rates were to fall, the value of
debt should rise.!

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The Central Bank & Interest
Rates!
•  Interest
rates in a free market economy will be determined by the
demand and supply of money (just like any other economy).!

•  However because interest rates effect other parts of the economy (such
as inflation, the housing market, the value of bonds and shares), the
central bank often control the supply and demand for money in order to
control interest rates.!

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Banks!
Main activities:!

•  safeguarding money!

•  transferring money!

•  lending money!

•  facilitating trade!

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Credit creation!

BANK
£100 Loans £90
£ Loans £81
Dep £90
Spends Spends
Dep £81 Vault £81 £90
£10
£9
£8.10

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Merchant banks!
Main activities:!

•  deal in larger amounts!

•  advise companies in money management!

•  negotiate bills of exchange!

•  underwrite new share issues!

•  supervise company takeovers!

•  guarantee commercial bills!

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Non-bank financial
intermediaries!
•  Building societies!

•  Investment and unit trusts!

•  Pension funds!

•  Insurance companies!

•  Finance companies!

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The Central Bank!
Roles:!

•  banker to the banks!

•  banker to the government!

•  supervision of the banking system!

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Session 4
Macroeconomic and Institutional
Context I: The Domestic Economy

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Macroeconomics and
Government Policy Goals!

Government policies!

•  Economic growth!

•  Manage inflation!

•  Manage unemployment!

•  Manage the balance of payments!

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The Circular Flow Model!

In order for government economic policy to be effective, it is not just


important to have the figures for national income, but to also
understand the factors and processes which determine it’s level and
growth.!

These are analysed using the framework of the circular flow model of
income.!

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Simple circular flow model!
This assumes:!

•  Closed economy: no exports or imports!

•  No government!

•  No savings or investment!

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Simple circular flow model!
Expenditure Income
Households

Land Rent
Consumption Output of goods Labour Wages
Expenditure and services or Capital Interest
real income Enterprise Profit

Firms

Income Expenditure

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A more complex model!

This adds the following assumptions:!

•  household may save, and financial institutions can use these savings
for investment!

•  governments tax incomes, and use these taxes for public


expenditure!

•  international trade occurs!

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Abbreviations!
Ø  Y national income!

Ø  C consumption!

Ø  S savings!

Ø  Iinvestment!

Ø  T taxation!

Ø  G government expenditure!

Ø  X exports!

Ø  M imports!

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Incorporating withdrawals and injections!
Financial Savings & hoarding Government
Institutions
Income tax
Outflow Households
& NIC
on B of P
Inflow on Wages &
Overseas the B of P salaries
Sector
Overseas
Consumption Sector Government
Financial
Expenditure Institutions
Overseas
Overseas Sector
Sector investment
Government Imports
Specific
taxes &
Exports Contracts
VAT Taxes Government

Firms
Financial
Government
Institutions
Savings

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Withdrawals and injections!
Withdrawals [W] are not passed on as expenditure and reduce the level of
income!

•  Savings [S]!

•  Taxation [T]!

•  Import expenditure [M]!


Injections [J] is spending which is additional to the circular flow and
increase the level of income!

•  Investment [I]!

•  Government expenditure [G]!

•  Export expenditure [X]!

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Equilibrium!
Inflow = Outflow
Expenditure [E] = Income [Y] 1
Fact E ≡ C+J
Fact Y ≡ C+W
C+J = C+W
J = W 2
Fact J≡I+G+X
Fact W≡S+T+M
I+G+X = S+T+M 3

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Consumption!
•  Average propensity to consume (APC):!

•  Proportion of income that is spent given by:!

•  Consumption/income!

•  APC = C/Y!

•  Marginal propensity to consume (MPC):!

•  Proportion of any extra income that is spent given by:!

• Additional consumption out of/additional income!

•  MPC = ∆C/ ∆ Y!

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Savings!

The level of savings depends on:!

•  income!

•  interest rates!

•  inflation!

•  credit!

•  contractual savings (e.g. pensions)!

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Investment!
This is affected by:!

•  expectations about future profits!

•  the present value of those future profits!

•  the accelerator!

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The multiplier!
•  Disturbancesto equilibrium can arise because of increases or
decreases in injections!

•  Any
change in an expenditure results in income changing by smaller
and smaller steps towards a new final equilibrium level!

•  The total eventual change in income is given by:!

•  ΔY = Δ Exp × 1/(1 – MPC)!

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The Trade Cycle!
Aggregate demand!

•  is made up of all components of expenditure in the economy!

•  is inversely related to prices!

•  shifts if a component changes through the multiplier effect!

Aggregate supply!

•  is the collective result of production decisions!

•  is positively related to price levels!

•  is limited by the availability of resources!

•  can only shift in the long run!

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The Trade Cycle!

Boom! Recession!

Recovery! Stagflation!

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Government Economic Policy!
•  Fiscal policy!

•  Supply side policy!

•  Monetary policy!

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Fiscal Policy!
This involves changing:!

•  taxation!

•  raises revenue!

•  changes markets!

•  influences aggregate monetary demand!

•  finances public goods!

•  changes the distribution of income and wealth!


•  government spending!

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Supply Side Policy!
This is aimed at increasing aggregate supply by:!

•  reducing social security payments!

•  providing more labour training!

•  reducing the power of trade unions!

•  deregulation and privatisation!

•  switching from direct to indirect taxes!

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Monetary policy!
In effect, this means managing the interest rate. For example a rise in
interest rates should result in:!

•  a fall in spending!

•  a fall in investment!

•  a fall in asset values!

•  foreign funds attracted to the country!

•  a rise in exchange rates!

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Managing interest rate risk!
Avoid the effects of a drop in interest rates for monetary deposits and a rise
in interest rates for borrowings!

Forward rate agreement (FRA)!

- locks company into target interest rate!

- hedges against both adverse and favourable interest rate movements!

Interest rate guarantee (IRG)!

-  allows company to take advantage of favourable interest rate


movements whilst still protecting against downside movements!

Interest rate futures!

Tradable versions of forward rate agreements – standardised values and


dates!

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Unemployment!
•  Demand deficiency!

•  consumer expenditure!

•  business investment!

•  exports!

•  government expenditure!
•  Structural change!

•  Supply side problems!

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Effects of unemployment!

•  Under-utilisation of resources!

•  Labour lose skills!

•  Increased costs to the government!

•  Social problems!

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Inflation!

Causes of inflation:!

•  demand-pull inflation!

•  cost-push inflation!

•  expectations effect!

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Session 5
Macroeconomic and Institutional
Context II: The International Economy

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International Trade!
Reasons countries trade:!
•  To obtain goods they cannot produce!
•  To obtain goods more cheaply from other
countries!
Advantages to trade!
•  More output for same amount of inputs!
•  Increased productivity from repetition!
•  Economies of scale!
•  Greater consumer choice!

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Protectionism!
Reasons for restrictions on trade:!

•  to protect employment!

•  to help infant industries!

•  to prevent unfair competition!

•  to protect the balance of payments!

•  to raise revenue!

•  to maintain security!

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Protectionism!

Arguments against protectionism:!

•  inefficiency is encouraged!

•  resources are misallocated!

•  the cost of living is raised!

•  retaliation may occur!

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Protectionism!
Methods of protection:!

•  tariffs!

•  quotas!

•  hidden restrictions!

•  subsidies!

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Trade agreements!

•  Bi-lateral vs multi-lateral!

•  Free trade areas!

•  Customs unions!

•  Single markets!

•  Economic unions!

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World Trade Organisation!
The major functions are:!

•  administer trade agreements!

•  aid trade negotiations!

•  handle trade disputes!

•  monitor national trade policies!

•  provide assistance to developing countries!

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Balance of Payments!
This is a record in account form of all the transactions arising between
the residents of one country and the inhabitants of the rest of the world
for a specified time period.!

It is made up of two accounts:!

•  the current account!

•  the capital and financial account!

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The Current Account!
Typical Current Account!

Value of physical exports £400,000


£20,000
Value of physical imports (£800,000)
(£30,000)

Balance of trade (£10,000)


(£400,000)

Services £3,000
Rent interest profits &
£1,000
dividends
Invisible trade balance £4,000

Current account balance (£6,000)

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Capital Financial Account!
Capital & Financial Account!

Capital Account
This includes transfers of capital and +£300,000
£1,000
acquisition/disposal of non-produced assets £0

Balance £1,000
£300,000
Financial Account
UK Overseas investment ( (£40,000)
£40,000)
Overseas investment in the UK £35,000
£35,000
Reserve assets £9,000
£100,000
Balance £4,000
£400,000
Net movement in external assets/liabilities £5,000

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Reconciliation!

Current account balance (£400,000)


(£6,000)
Balance on capital and financial accounts £5,000
£400,000
Errors and omissions £1,000 £0
Reconciliation £0£0
If the balance on the capital and financial accounts had been £8,000:

Current account balance (£6,000)


Balance on capital and financial accounts £275,000
£8,000
Errors and omissions (£2,000)
Reconciliation £0

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Deficit Solutions!
•  Expenditure switching strategies:!

•  Import controls and regulations!

•  Export subsidies and advertising!

•  Devaluation !
•  Expenditure reducing strategies (deflation):!

•  Contractionary monetary policy!

•  Contractionary fiscal policy!

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Globalisation!

IMF Definition involves:!


•  the growing interdependence of countries
worldwide !
•  increasing volume and variety of cross-border
transactions in goods and services!
•  free international capital flows !
•  more rapid and widespread diffusion of
technology!

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Globalisation!
Other aspects would involve:!
•  the reduction of trade barriers!
•  homogenisation of tastes!
•  firms selling the same product all markets!
•  greater harmonisation of laws!
•  dilution of traditional cultures!

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Globalisation!
Consequences of globalisation:!

•  Industrial relocation!

•  Emergence of growth markets!

•  Increased competition!

•  Cross-national business alliances and mergers!

•  Increasing economic divisions!

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Globalisation!

Factors driving globalisation:!


•  Improved communications!

•  Political realignments!

•  Growth of global industries and institutions!

•  Cost differentials!

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External analysis of the macro environment!

PESTEL analysis:!

•  Political!

•  Economic!

•  Social!

•  Technological!

•  Ecological / environmental!

•  Legal!

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Session 6
Financial Context of Business II:
International Aspects

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Foreign Exchange!
•  An exchange rate is the price of one currency in terms of another
currency!

•  Currency is traded on international exchanges!

•  One view of determination of the rate is basic demand and supply


analysis!

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Exchange rates: determinants of demand!
•  Exports of goods!

•  Exports of services (invisibles)!

•  Demand for capital purposes!

•  Direct capital inflows!

•  Portfolio investment from abroad!

•  Short term capital inflows (bank deposits)!

•  Interest rates!

•  Speculation!

•  Medium of exchange (some currencies)!


•  Demand by the authorities!

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Exchange rates: determinants of supply!
•  Imports of goods!

•  Imports of services (invisibles)!

•  Supply for capital purposes!

•  Direct capital outflows!

•  Portfolio investment abroad!

•  Short term capital outflows (bank deposits)!

•  Interest rates!

•  Speculation!

•  Supply by the authorities!

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Floating Exchange Rate!

P
P1

D1

D2

Q1 Q2

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Foreign exchange risks!
•  Transaction risk!

- mitigated with forward exchange contracts, futures and options!

•  Economic risk!

•  Translation risk!

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Session 7
Financial Context of Business III:
Discounting and Investment Appraisal

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The time value of money!

Shareholders would prefer to get their returns sooner


rather than later, and income in the future will have a
lower value than the same income today. So when
evaluating future income we need to “discount” (reduce)
it’s value to get an equivalent current value.

This is achieved using the cost of capital.

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The time value of money!

Three reasons:

Potential for earning interest / cost of finance

Impact of inflation

Effect of risk

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Simple interest!

Interest is paid or received on the principal only!

!
Interest = P × r × n!
!

!
Future Value = P + (P × r × n)!
!

P = amount invested!

r = interest rate per annum as a decimal!

n = number of years!

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Illustration of simple interest!

£1,000 is invested for 5 years. The sum earns 10% simple interest each
year. How much will accumulate by the end of the fifth year?!

Answer!

Future value at the end of year 5 !

= P + (P × r × n)!

= £1,000 + (£1,000 × 0.1 × 5)!

= £1,500!

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Compound interest!
Interest is paid or received on the principal plus any accumulated interest!

Formula is given !

•  S = value after n years !


S = X (1 + r)n!
•  X = amount invested!

•  r = annual rate of interest (as a decimal)!

•  n = number of years!

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Illustration of compound interest!

£1,000 is invested in an account for 5 years. The compound interest rate


is 10% per annum. Find the value of the account (to the nearest pound)
after 5 years and calculate the interest earned.!

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Illustration of compound interest!

£1,000 is invested in an account for 5 years. The compound interest rate is


10% per annum. Find the value of the account (to the nearest pound) after 5
years and calculate the interest earned.!

Answer!

Value after 5 years, S = X (1 + r)n!

= £1,000 (1 + 0.1)5!

= £1,611!

Interest = £1,611 - £1,000 = £611!

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Illustration of compound interest!

The formula should be used in the exam but it may help to look at the
calculation in this way:!

Year 1: £1,000 + 10% interest = £1,000 × 1.1 = £1,100!

Year 2: £1,100 + 10% interest = £1,100 × 1.1 = £1,210!

Year 3: £1,210 + 10% interest = £1,210 × 1.1 = £1,331!

Year 4: £1,331 + 10% interest = £1,331 × 1.1 = £1,464!

Year 5: £1,464 + 10% interest = £1,464 × 1.1 = £1,611!

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Equivalent annual interest rates!

•  As mentioned, compound interest is often paid or received more than once


a year!

•  It is useful to convert this period rate to an annual rate of interest!

•  This is called the equivalent annual interest rate or the annual percentage
rate (APR)!

Annual percentage rate = (1 + r) n -1!

r = period interest rate (as a decimal)!

n = the number of compounding periods in a year !

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Illustration of equivalent annual interest rates!

An account charges compound interest of 1% per month. Calculate


the equivalent annual rate. !

Answer!

APR = (1.01)12 – 1= 0.1268 or 12.68%!

Some financing companies can be economic with the truth when


describing their products. The APR is usually the best indicator of the
true cost.!

!
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Terminal values!

•  When evaluating investments, may wish to calculate the terminal value at


the end of the investment for the cash flows!

•  Compound each cash flow over the life of the investment using the interest
rate!

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Illustration of terminal values!
An investment of $3,000 is made initially and then $1,800 at the end of the
first, second and third years and finally $600 at the end of the fourth year.!

If interest is paid annually at 6.5%, calculate the terminal value at the end of
the fifth year.!

Answer!

$3,000 × 1.0655 = $4,110.26!

$1,800 × (1.0654 + 1.0653 + 1.0652) = $6,531.55!

$600 × 1.065 = $639!

Total = $11,280.81!

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Sinking funds!
•  These have equal sums paid into them each period, e.g. a regular savings
account!

•  Use the formula to calculate the amount at the end of the investment period!

!
S = A (Rn – 1)!
(R – 1)!
!

S = amount at the end of investment period!

A = Equal sum!

R = 1 + interest rate (as a decimal)!

n = number of periods!
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Illustration of sinking funds!

Suppose I pay £1000 a year into an account for 3 years at an interest


rate of 10% with all payments made at the end of each year. How much
will the fund accumulate to?!

Answer!

Value after 3 years, S = A(Rn - 1)!

(R – 1)!

= £1,000 (1.13 – 1)!

(1.1 – 1)!

= £3,310!

!
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Illustration of sinking funds!

How would the answer differ if the funds were paid in at the start of each
year?!

Answer!

In the previous illustration we said that if the payments were made at the
end of each year we would have £3,310 by the end of year 3!

However, if the payments are made at the start of each year they will
attract an extra year’s interest and the final sum will be £3,310 × 1.1 =
£3,641!

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Discounting!
•  When we looked at compound interest we said that the future value after n periods,!

S = X (1 + r)n!

•  However, we may know the future value, S, but need to calculate the present value, X
Rearranging the equation we get:!

S = future sum!

n = number of periods!

r = cost of capital/ discount rate as a decimal (we called this the interest rate
previously)!

Present value, X = S !
(1 + r)n!

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Illustration of discounting!

Find the present value of £25,000 receivable in 6 years’ time, if the


interest rate is 10% pa.!

(Calculate your answer to the nearest £)!

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Illustration of discounting!
Find the present value of £25,000 receivable in 6 years’ time, if the
interest rate is 10% pa.!

(Calculate your answer to the nearest £)!

Answer!

Present value, X = S!

(1 + r)n!

= £25,000!

1.16!

= £14,112!
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Discounting the quick way!
•  We already know that present value, X = S !
n!
(1 + r)

•  Or we could rewrite this to give X=S× 1!

(1 + r)n!

•  This is called the discount factor and can be found in our mathematical
tables!

•  This gives an alternative and quick method of calculating the present value !

!
Present value, X = S × Discount Factor (from tables)!

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Illustration of discounting using tables!

Use the present value table to find the present value of £25,000
receivable in 6 years’ time, if the interest rate is 10% pa.!

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Illustration of discounting using tables!
Use the present value table to find the present value of £25,000
receivable in 6 years’ time, if the interest rate is 10% pa.!

Answer!

Present value, X = S × Discount factor 6 years at 10%!

= £25,000 × 0.564!

= £14,100!

Note: in part 1 of the illustration our answer was £14,112. This is a


rounding difference only!

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Net present value (NPV)!

•  The NPV method is used to appraise investments and involves


discounting.!

NPV = present value of all the cash inflows minus the present value of
all the cash outflows.!

•  If the NPV is positive we accept the project. !

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Illustration of NPV!

A company is considering investing £100,000 in a project, which is


forecast to yield the following net cash flows:!

Year 1 2 3 4 5!

Net cash flow (£000) 40 35 32 25 19!

Calculate the net present value of this project if the firm has a cost of
capital of 10%!

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Illustration of NPV!
Answer!
•  Project has a positive NPV of £18,176: accept!

! Time! Cash Flow Discount Present


£000! Factor 10%! Value £000!
! 0! (100)! 1! (100)!
1! 40! 0.909! 36.36!
2! 35! 0.826! 28.91!
3! 32! 0.751! 24.032!
4! 25! 0.683! 17.075!
5! 19! 0.621! 11.799!
18.176!

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Annuities!
!
•  Questions may require us to calculate the present value of a constant
amount!

•  An annuity is a constant amount paid or received for a number of


periods !

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!
Illustration of annuities!

Suppose I expect to receive £1,000 per annum for 3 years, starting in one
year’s time, and want to calculate the present value using a discount rate of
5%.!

Answer!

There are actually three methods available:!

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Illustration of annuities!
Method 1!

•  One approach would be to discount each cash flow separately and sum the
results:!

•  Present value, X = S × Discount factor!

Present value for year 1 amount = £1,000 × 0.952 = £952!

Present value for year 2 amount = £1,000 × 0.907 = £907!

Present value for year 3 amount = £1,000 × 0.864 = £864!

2.723 £2,723!

•  The present value of £2,723 is correct but this is a time consuming method,
particularly if the annuity continues for a long period!

!
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!
Illustration of annuities!
Method 2!

•  This is a quicker method than method 1. Rather than discounting each


cash flow individually we can discount the annuity using a cumulative
present value.!

•  This is the sum of all of the individual discount factors and can be found
from the tables.!

! Present value of an annuity = annuity × cumulative present value factor!

•  Using tables this = £1,000 × 2.723 (as seen in method 1)!

= £2,723 (method 1 gave the same answer)!

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Illustration of annuities!
Method 3!

•  The cumulative present value factor may not be available from the tables. !

They are only available for whole numbers from 1% to 20%!

•  The calculation is the same as in method 2 but we will need to calculate the
cumulative present value factor.!

Present value of an annuity = annuity × cumulative present value factor!

•  The cumulative present value factor is calculated using the formula:!


1⎡
1
1 ⎤ 1 ⎡ 1 ⎤

r ⎢⎣ (1! + r )n ⎥⎦
1 −
0.05 ⎢⎣ (1 + 0.05)3 ⎥⎦
(given) PV = £1,000 × !

= £2,723 (as before) !

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Perpetuities!

!
A perpetuity is an annuity that continues forever.!

!
Present value of a perpetuity =
perpetuity × 1/r!
!

r = cost of capital/ discount rate!

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Illustration of a perpetuity!

Jo is looking to purchase a perpetuity that guarantees a payment of


£10,000 per annum. What is a fair price for the perpetuity, assuming a
discount rate of 3% per annum? (Round the answer to the nearest £)!

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Illustration of a perpetuity!

Jo is looking to purchase a perpetuity that guarantees a payment of


£10,000 per annum. What is a fair price for the perpetuity, assuming a
discount rate of 3% per annum? (Round the answer to the nearest £)!

Answer!

Present value of the perpetuity = £10,000 × 1/0.03!

= £333,333!

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Internal rate of return (IRR)!
!
•  IRR is another method of appraising investments and involves discounting!

The IRR is the discount rate at which NPV is zero!

•  Accept the project if the IRR is more than the company’s cost of capital!

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Internal rate of return (IRR)!
NPV £

Positive
! NPV

! IRR

Cost of
Capital %
Company cost
of capital

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Internal rate of return (IRR)!

Estimate of IRR!

•  The process on the previous slide is too time consuming. An estimated


IRR is calculated using a three step approach:!

•  Step 1: Take a small discount rate r1 and calculate the NPV (NPV1 )!

•  Step 2: Take another discount rate r2 and calculate the NPV (NPV2 )!

•  Step 3: Use the formula to calculate the IRR!

⎡ NPV1 ⎤
IRR = r1 + ⎢ (r2 − r1 )⎥
⎣ NPV1 − NPV2 ⎦
(learn)!

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Illustration of IRR!

A project involves investing £140,000, and will produce the following


year-end cash flows:!

Year 1 2 3 4!

Net cash flow (£000) 60 50 45 30!

Discount the project at 10% and at 15%, then calculate the internal rate
of return of the project!

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Illustration of IRR!

Answer!

Step 1: Calculate the NPV at 10% (r1)!

! Year ! Cash Flow Discount Present


(£)! Factor 10%! Value (£)!
! 0! (140,000)! 1! (140,000)!
1! 60,000! 0.909! 54,540!
!
2! 50,000! 0.826! 41,300!
! 3! 45,000! 0.751! 33,795!
4! 30,000! 0.683! 20,490!
10,125!

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Illustration of IRR!

Answer!

Step 2: Calculate the NPV at 15% (r2)!

! Year ! Cash Flow Discount Present


(£)! Factor 15%! Value (£)!
! 0! (140,000)! 1! (140,000)!
1! 60,000! 0.870! 52,200!
!
2! 50,000! 0.756! 37,800!
! 3! 45,000! 0.658! 29,610!
4! 30,000! 0.572! 17,160!
(3,230)!

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Illustration of IRR!
Step 3: Calculate the IRR!

!
⎡ NPV1 ⎤
!
IRR = r1 + ⎢ (r2 − r1 )⎥
! ⎣ NPV1 − NPV2 ⎦
!

IRR = 10 + 10,125 × (15 -10)!

(10,125 + 3,230)!

= 13.79%!

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Session 8
Informational Context of Business I:
Summarising and Analysing Data

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Information!
Data vs information!

Characteristics of good information:!

•  A!

•  C!

•  C!

•  U!

•  R!

•  A!

•  T!

•  E!

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Bar charts!
•  Height of the bar is proportional to the frequency!

•  There are three types of bar chart:!

(a) Simple !

(b) Multiple!

(c) Compound!

•  The data on the continent of origin of a class of students will be used to


construct each type of bar chart. !

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Illustration of simple bar chart!

!
!

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Illustration of multiple bar chart!

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Illustration of compound bar chart!

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Scatter diagrams!
•  Visual way of determining if there might be a relationship between two
variables!

•  If the variables are related, they are said to be correlated!

•  Stronger correlation shows as more obvious relationship on the scatter


diagram!

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Illustration of scatter diagram!

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Types of correlation!
!
!
!
! x
x ! x
! x x
!
x
! !
x
x

! x
! x

! !
! !

Perfect positive correlation! Perfect negative correlation!

r = +1!
r = - 1!
!
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Types of correlation!
!
!
!
x x x
!
!
x
! x
! x
x
!
!
x x
! x
!

! !

! !

High positive correlation! High negative correlation!

(r is close to +1)! (r is close to -1)!

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!
!
Types of correlation!
!
!
!
x
x x
!
! x x
x
x !
! x x x
x
x
x x !
! x

! !

No correlation! !
r = 0! !

! !
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Histograms!

•  Graph of frequency distribution!

•  Exam tip: AREA of each bar is proportional to the frequency!

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Illustration of a histogram!
12

10

10 20 30 40 50 60 70 80 90 100 110 120 130 140 150

Weight (kg)

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Ogives!

•  Graph of the cumulative frequency distribution.!

•  More useful for continuous data since the intermediate values of x mean something!

•  Step 1: Plot the cumulative frequency on the y axis against the UPPER end of each class interval on the x axis!

•  Step 2: Join the points together to form the ogive!

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Illustration of an ogive!
•  The following cumulative frequency distribution relates to the weight of some sand bags:!

Weight of bag Number of bags Cumulative frequency!

(kg)!

> 10 ≤ 20 1 1!

> 20 ≤ 30 6 1 + 6 = 7!

> 30 ≤ 40 8 7 + 8 = 15!

> 40 ≤ 50 10 15 + 10 = 25!

> 50 ≤ 70 10 25 + 10 = 35!

> 70 ≤ 90 6 35 + 6 = 41!

> 90 ≤ 120 6 41 + 6 = 47!

> 120 ≤ 150 3 47 + 3 = 50!

50!

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Illustration of an ogive!

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Session 9
Informational Context of Business II:
Index Numbers

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Simple index numbers!

•  All index numbers show the percentage changes over time!

•  value in any given year × 100 !

value in base year!

•  The most common type of indices are price indices. They compare the price in one
year to the price in another year, called the base year !

•  The index in the base year = 100!

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Example of a simple price index!
Turn the following prices into an index series with 2003 as the base year!

Year 2003 2004 2005 2006 2007 2008!

Price £56 £62 £67 £72 £76 £84!

Answer!

Index 100 110.7 119.6 128.6 135.7 150.0!

Sample working 2004: (62 ÷ 56) × 100 = 110.7!

Sample interpretation In 2004 the price was 10.7% higher than in 2003.!

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Changing the base year!

•  Over time a base year may become less meaningful!

•  Exam tip: To change to a new base year divide all index numbers by the
index number of the new base year and multiply by 100!

Example of changing the base year!

Re-base the index calculated in the previous worked example to the Year
2006 !

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Changing the base year!
Answer!

Year 2003 2004 2005 2006 2007 2008!

Price £56 £62 £67 £72 £76 £84!

Index if 2003 is base year:!

100 110.7 119.6 128.6 135.7 150.0!

Index if 2006 is base year:!

77.8 86.1 93.0 100 105.5 116.6!

Sample working 2003: (100 ÷ 128.6) × 100 = 77.8!

Sample interpretation The price in 2003 was 77.8% of the price in the year 2006.!

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Combining series of index numbers!

•  If an index has been re-based it can be difficult to make


comparisons to earlier years which were measured using the old
index!

•  Splicing the series together solves this problem!

•  Involves redefining the base year of an index in a particular year and


then restating the index values in previous years so that comparisons
can be made!

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Illustration of combining indices!
•  The price index below changed its base to 1983 after many years with base 1970.
Recalculate it as a single series with base 1983. By how much have prices risen from 1981
to 1985?!

Year Price index !

(1970 = 100)!
1981 271!

1982 277!
1983 280!

(1983 =100)!

1984 104!

1985 107!
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Illustration of combining indices!
Answer!

Year Price index Single index

(1970 = 100)!

1981 271 = 271/280 × 100 = 97!

1982 277 = 277/280 × 100 = 99!

1983 280 100!

(1983 =100)!

1984 104 104!

1985 107 107!

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Illustration of combining indices!
•  Now that we have a single series spanning both 1981 and 1985, we
can compare the two:!

100 × (107/97) = 110!

•  So prices have risen by 10 per cent from 1981 to 1985!

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Relative price indices!
•  When several items are being considered it is important to recognise the
importance of the different items within the group. Hence a weighting is
usually attached to each item. In the examination the weightings will
always be given.!

•  Relative price index = ∑(w x (P1 /P0) × 100 (given)!

∑w!

P1 = price in current year!

P0 = price in base year!

w = weight: either base or current year weight!

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Illustration on relative price
indices!
Item Price (2007) Price (2008) Weighting!

Milk 40p per pint 45p per pint 10!

Meat £6.50 per kg £6.00 per kg 7!

Caviar £12.40 per jar £14.00 per jar 1!

•  Calculate a weighted relative price index for the data above and interpret your answer.!

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Illustration on relative price
indices!
Answer!

P1/P0 W P1/P0 x W!

Milk 45/40 = 1.125 10 11.250!

Meat 6.00/6.50 = 0.923 7 6.461!

Caviar 14.00/12.40 = 1.129 1 1.129!

18 18.84!

•  Weighted relative price index = 18.84/18 × 100!

= 104.7!

•  The average price rise of the three items has been 4.7%!

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Choice of weighting!
Advantages of base year weights!

•  Weightings can be used for several periods!

•  Comparisons can be made between several periods!

Advantage of current year weights!

•  Weights remain up to date and reflect current trends and fashions!

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Quantity indices!
•  Calculated in a similar way to the price indices but changing quantities are
measured instead of price!

•  Formula for a weighted relative quantity index!

= ∑(w x (Q1/Q0)) × 100 (given)!

∑w!

where Q1 = the current year quantity!

and Q0 = the base year quantity!

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Illustration on quantity indices!
A company manufactures two products, A and B. The sales figures over the
past three years have been as follows:!

Year A B!

Sales (000s) Sales (000s)!

2006 386 533!

2007 397 542!

2008 404 550!

Weighting 22 19!

Using 2006 as a base, compute a weighted relative quantity index for 2007 and
2008, and interpret their values.!

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Illustration of quantity indices!
Answer!

2006 to 2007!

Q1/Q0 W Q1/Q0 x W!

A 397/386 = 1.028 22 22.616 !

B 542/533 = 1.017 19 19.323!

41 41.939!

•  Weighted relative price index = 41.939/41 × 100 = 102.29!

•  The sales rose by an average of 2.29% from 2006 to 2007!

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Illustration of quantity indices!
2006 to 2008!

Q1/Q0 W Q1/Q0 x W!

A 404/386 = 1.047 22 23.034 !

B 550/533 = 1.032 19 19.608!

41 42.642!

•  Weighted relative price index = 42.642/41 × 100 = 104.00!

•  The sales rose by an average of 4.00% from 2006 to 2008!

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Session 10
Informational Context of Business III:
Inter-relationships Between Variables

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Big data!
Helps companies make more informed business decisions by!

•  expanding their knowledge of customers!

•  giving them a deeper understanding of how their customers behave!

•  analysing customer behaviour to make marketing activities more


likely to work!

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Correlation!
•  Correlation establishes the strength of the relationship between
variables that are related to each other!

•  There are three different calculations:!

(a) Pearson’s correlation coefficient!

(b) Coefficient of determination!

(c) Spearman’s rank correlation coefficient!

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Pearson’s correlation coefficient, r!
!

r= n∑xy - ∑x∑y (given)!

!
2 2 2 2
√(n∑x – (∑x) )(n∑y - (∑y) )!

•  r = +1 denotes perfect positive linear correlation !

•  r = -1 denotes perfect negative linear correlation!

•  r = 0 denotes no linear correlation !

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Illustration of Pearson’s correlation
coefficient!
A new machine has been purchased and management are keen to
explore the link between output and cost. Output and cost figures for the
last four months are as follows:!

Output 3! 4! 5! 6!
(000s)!
Cost 6! 7! 7! 10!
(£000s)!

Calculate the correlation coefficient between these two sets of data!

!
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Illustration of Pearson’s correlation
coefficient!
Answer!
r= n∑xy - ∑x∑y!
x! y! xy! x2! y2!
2 2 2 2
√(n∑x – (∑x) )(n∑y - (∑y) )! 3! 6! 18! 9! 36!

4! 7! 28! 16! 49!


= 4(141) − (18)(30)!
5! 7! 35! 25! 49!
√ (4 x 86) − (18)2(4 x 234 − (30)2)!
6! 10! 60! 36! 100!
= 24! ∑x = 18! ∑y = 30! ∑xy = 141! ∑x2 = 86! ∑y2 =234!

√(20)(36) = + 0.89!

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Coefficient of determination, r2!

!
•  Coefficient of determination is calculated by squaring the correlation
coefficient i.e. r2!

•  It measures the proportion of changes in y that can be explained by


changes in x !

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Illustration of coefficient of
determination!
Using the information in the previous illustration calculate, and comment on, the
coefficient of determination !

Answer!

From the previous illustration, r = 0.89!

Therefore, the coefficient of determination, !

r2 = 0.892 = 0.7921!

This means that 79.21% of the change in cost relating to the machine can be
explained by a change in machine output!

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Spurious correlation!

•  A high correlation coefficient does not always mean there is always a


cause and effect relationship between the data. This is known as
spurious correlation!

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Rank correlation: Spearman’s coefficient!

•  Used when a distribution is given in terms of rank, rather than actual values!

2 !
R = 1 - 6 ∑ d
2
n(n - 1 ) (given)!

d = the difference in ranks !

n = the sample size!

•  The rank correlation coefficient can be interpreted in the same way as the ordinary correlation!

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Illustration of Spearman’s rank coefficient!

As part of its recruitment procedures, a company awards applicants


ratings from A (excellent) to E (unsatisfactory) for their interview
performance and marks out of 100 for a written test. The results for five
interviewees are as follows:!

Calculate the rank correlation coefficient for this data and comment on its
value!
Interviewee! Interview grade! Test score!
!
One! A! 60!
Two ! B! 61!
Three! A! 50!
Four! C! 72!
Five! D! 70!

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Illustration of Spearman’s rank coefficient!
Answer!

Note: Interviewees one and three share the best interview grade. They
therefore share the ranks 1 and 2 giving them 1.5 each!
Interviewee! Rank of Rank of test d! d2!
interview score!
grade!
One ! 1.5! 4! 2.5! 6.25!
Two! 3! 3! 0! 0!
Three! 1.5! 5! 3.5! 12.25!
Four! 4! 1! 3! 9!
Five! 5! 2! 3! 9!
∑= 36.50!

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Illustration of Spearman’s rank
coefficient!

2 !
R=1 - 6 ∑ d
2
n(n - 1 )!
= 1 – (6 x 36.50)!
5(25-1)!
= −0.825!

!
•  There is a strong negative correlation between the interview grade and the test score!

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Regression!
•  Expresses the relationship between two sets of data using the equation
of a straight line, !

y = a + bx!

•  Can be used for forecasting!

•  There are two possible methods !

Method 1: Draw a scatter diagram and estimate the line of best fit (not
directly examinable but it is useful to understand this method)!

Method 2: Use least squares regression analysis (exam)!

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Regression using scatter
diagram!
•  A scatter graph is drawn showing the sales achieved (£000’s) for different
levels of advertising spend (£000)!

•  A straight line of best fit is then drawn:!


Independent
! variable =
Y=a + bx! advertising spend
(£000)!
! Dependent
variable =
sales (£000)!
!
Intercept on Gradient!
y axis!

•  This straight line can then be used to forecast the sales for any given level
of advertising spend.!

!
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Regression using least squares
method!

•  Finds the line of best fit computationally by minimising the sum of the
squares of the distances between the data and the line.!

•  i.e. rather than drawing a graph this method uses formulae to calculate the
values of ‘a’ and ‘b’ in the equation of a straight line, y = a + bx!

•  We can then forecast the value of ‘y’ (e.g. sales)for any given value of
‘x’ (e.g. advertising spend)!

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Regression using least squares method!

Formulae: (both given)!

b = n∑xy - ∑x ∑y !
2 2
n∑x - (∑x) !

a = y - bx!

n = number of pairs of data in the sample!

y and x = mean (average) of y and mean (average) of x!

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Regression using least squares
method!
Interpolation and extrapolation!

•  As mentioned, the regression equation can be used for predicting the


value of y for a given value of x!

•  if x is within the range of the original the prediction is known as


interpolation !

•  if x is outside the range of our original data the prediction is known as


extrapolation!

•  in general interpolation is much safer than extrapolation !

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Regression using least squares
method!
Limitations of linear regression analysis!

•  Assumes a linear relationship between the variables!

•  Only measures the relationship between two variables!

•  Only interpolated forecasts tend to be reliable!

•  Assumes historical behaviour of the data continues into the


foreseeable future!

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Illustration of least squares
method!
Using the data given below, establish the least squares regression line!

! Advertising Expenditure Sales (£000)!


(£000)!
! 10! 62!
14! 75!
6! 53!
9! 48!
3! 28!
12! 70!

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Illustration of least squares method!
Answer!

Calculation of b: begin by setting up a table!


! Advertising Sales £000 = xy! x2!
£000 = x! y!
! 10! 62! 620! 100!
14! 75! 1,050! 196!
!
6! 53! 318! 36!
9! 48! 432! 81!
3! 28! 84! 9!
12! 70! 840! 144!
∑x = 54! ∑y = 336! ∑xy = 3,344! ∑x2 = 566!

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Illustration of least squares method!
b = n∑xy - ∑x ∑y !
2 2
n∑x - (∑x) !

= 6(3,344) – (54)(336)!

6(566) – (54)2!

= 1,920!

480!

= 4.0!

Calculation of a!

a = y - bx = 336 - 4 54 = 56 - 36 = 20!

6 6!

!
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Illustration of least squares method!
Least squares regression line: y = a + bx!

y = 20 + 4x!

The result should be more precise than method 1!

Illustration 2: Using the line for forecasting!

Using the regression line ‘y = 20 + 4x’ obtained above, predict the average
daily sales of a supermarket if the monthly advertising expenditure is:!

(i) £11,000, and!

(ii) £100,000!

In each case, comment on the level of accuracy!

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Illustration of least squares
method!
Answer!

(i) y = 20 + 4(11) =64, i.e. £64,000!

Prediction found by interpolation and some reliance may be placed on this


prediction!

(ii) y = 20 + 4(100) =420, i.e. £420,000!

Prediction found by extrapolation, which is dangerous, and may not be placed on


this prediction!

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Session 11

Informational Context of Business IV:


Forecasting

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Time series analysis!

•  A time series is a series of figures recorded over time!

•  Time series analysis is a tool to help forecast the future,


particularly sales!

•  The basic idea is to analyse the past to identify a pattern, of say


sales, which can then be used to forecast the future!

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Time series analysis
components!

•  Trend (T): this is a general movement of the time series over a long period
of time!

•  Seasonal variation (SV): a recurring pattern, due to repetitive events, over


a shorter but fixed time period!

•  Cyclical variation (C): recurring patterns over a long time period, not
generally fixed in nature!

•  Random variation or residual value (R): unpredictable variations due to


random or chance events!

!
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Time series analysis models!

•  Calculation questions tend to focus on the trend and seasonal variation only. These
can be combined together in two ways to give the actual results, i.e. the time series:!

(a) Additive model: TS = T + SV !

(b) Multiplicative model: TS = T × SV !

•  It will be clear as to which one should be used!

•  Some questions also ask for the calculation of the residual (R). In this case, the two
equations above should be extended to include R!

!
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Illustration of residual
calculation!
•  The multiplicative model for a time series shows that at a certain time the actual,
trend and seasonal variations are 555, 463 and 1.16. Find the residual at this point.
(Round your answer to four decimal places).!

Answer!

•  In the multiplicative model TS = T × SV x R!

•  Therefore, R = TS/ (T × SV)!

= 555/ (463 × 1.16) !

= 1.0334 (to four decimal places)!

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Seasonal variations!
•  For the additive model the seasonal variations will be given as a
positive or negative number. The total of the seasonal variations will
be zero!

•  For the multiplicative model the seasonal variations will be given as a


percentage or a decimal. The total of the seasonal variations will be
four. !

•  If this is not the case, any difference should be spread evenly across
the seasonal variations!

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Illustration of seasonal variations!
Using the multiplicative model the seasonal variations are found to be !

1.04, 1.15, 0.91 and 0.95. !

They are subsequently adjusted so that their total = 4. What is the new
value of the average currently valued at 1.04?!

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Illustration of seasonal variations!
Using the multiplicative model the seasonal variations are found to be !

1.04, 1.15, 0.91 and 0.95. !

They are subsequently adjusted so that their total = 4. What is the new value
of the average currently valued at 1.04?!

Answer!

Total = 1.04 + 1.15 + 0.91 + 0.95 = 4.05, !

hence we adjust by subtracting 0.05/4 = 0.0125 from each average. !

The adjusted first average = 1.04 – 0.0125 = 1.0275!

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!

!
Forecasting with time series!
!

method 1: using least squares regression!

•  Step 1: The forecasted trend can be calculated using least squares


regression (as seen in previous session). This is appropriate if there is a
linear trend!

•  Step 2: Using the appropriate time series model, i.e. additive or


multiplicative, an adjustment can be made to the trend for the seasonal
variation and the time series can be calculated!

(Ignore the residual, R, unless stated otherwise!

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Illustration using least squares analysis!

•  Least squares regression was used to calculate the straight line of best
fit, y= a + bx, for sales against time.!

•  This was found to be y = 13.7 + 1.5x, where y is equal to the sales


value and x is the quarter!

•  What are the forecast sales for quarter 14 if:!

(a) The seasonal variation is +2.4 for this quarter!

(b) The seasonal variation is +10% or +0.1 for this quarter!

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Illustration using least squares analysis!
Step 1!

•  Using the least squares regression line the trend, T, can be calculated
for quarter 14!

y = 13.7 + 1.5x!

y = 13.7 + (1.5 × 14)!

y = 34.7 This is the forecasted sales trend (T)!

Step 2!

•  An adjustment can be made to the trend to reflect the seasonal


variation and the sales can be forecast for quarter 14!

!
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Illustration using least squares analysis!
(a)  If the seasonal variation is given as a number (positive or negative) we must use
the additive model:!

Forecast sales for Q14 (TS) = T + SV!

= 34.7 + 2.4!

= 37.1!

(b) If the seasonal variation is given as a percentage or decimal we must use the
multiplicative model:!

Forecast sales for Q14 (TS) = T × SV!

= 34.7 × 1.1!

= 38.17!

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Forecasting with time series!

method 2: using moving averages !

•  Step 1: The forecasted trend can be calculated using moving


averages. This is appropriate if there is no linear trend!

•  Step 2: Using the appropriate time series model, i.e. additive or


multiplicative, an adjustment can be made to the trend for the seasonal
variation and the time series can be calculated (as for method 1)!

(Ignore the residual, R, unless stated otherwise)!

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Illustration using moving
averages!

Sales for article B (‘000units)!

Q1! Q2! Q3! Q4!

2006! 24.8! 36.3! 38.1! 47.5!

2007! 31.2! 42.0! 43.4! 55.9!

2008! 40.0! 48.8! 54.0! 69.1!

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Illustration using moving averages!
Year! Qtr! Sales (Y)! 4 point 8 point 4 point moving
moving total! moving total! average (T)!
2006! 1! 24.8! -! -!
2! 36.3! -! -!

! 3! 38.1! 146.7! 299.8! 37.4750!


4! 47.5! 153.1! 311.9! 38.9875!
!
2007! 1! 31.2! 158.8! 322.9! 40.3625!
2! 42.0! 164.1! 336.6! 42.0750!
3! 43.4! 172.5! 353.8! 44.2250!
4! 55.9! 181.3! 369.4! 46.1750!
2008! 1! 40.0! 188.1! 386.8! 48.3500!
2! 48.8! 198.7! 410.6! 51.3250!
3! 54.0! 211.9! 438.5! 54.8125!
4! 69.1! 226.6! -!

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Seasonal adjustment!
•  If the seasonal variations (SV) are already known, then it is possible to de-
seasonalise the actual results (TS) to identify the trend (T)!

Multiplicative model!

Based upon: Actual (TS) = Trend × SV !

Trend = Actual ÷ SV!

Additive model!

Based upon: Actual (TS) = Trend + SV!

Trend = Actual – SV!

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Illustration of seasonal adjustment!
Unemployment numbers actually recorded in a town for the second quarter of
20X8 were 2,400. The seasonal variation for this quarter is 0.95. Using the
multiplicative model for seasonal adjustment, calculate the seasonally-
adjusted figure (in whole numbers) for the quarter!

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Illustration of seasonal adjustment!
Unemployment numbers actually recorded in a town for the second quarter of
20X8 were 2,400. The seasonal variation for this quarter is 0.95. Using the
multiplicative model for seasonal adjustment, calculate the seasonally-
adjusted figure (in whole numbers) for the quarter!

Answer!

Seasonally adjusted figure, trend = Actual ÷ SV!

= 2,400 ÷ 0.95!

= 2,526!

!
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Revision!

•  Read your course notes. !

•  Make short notes, and attempt all the Test your Understanding exercises!

•  Visit the cimaglobal website to check on any recent articles that may be
relevant!

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On the assessment day!

•  Make sure that you are thoroughly familiar with the software before the
exam starts !

•  Work out your answer first!

•  Write down all the question numbers on a piece of paper and use a key
to identify questions!

•  Do all the easy questions first. !


•  Flag questions you have not answered and return to
them later !

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On the assessment day!

•  Remember: you have not answered until you press ‘submit’ !


•  your answer can always be changed later by hitting ‘clear’, changing the
answer and then again pressing ‘submit’!

•  Answers only become final when you finish the exam!

•  You will be given a five minute warning before the end of the
exam!
•  Make sure before you finish the exam that you have submitted answers to
all questions: guessing if necessary. !

•  Panic is likely to be your worst enemy. You don’t need to know


everything: just enough to pass!!

• GOOD LUCK!!

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