1.

Distinguish between weak form, semi-strong form and strong form stock market efficiency, and discuss the
significance to a listed company if the stock market on which its shares are traded is shown to be semi-strong
form efficient.

Stock market efficiency usually refers to the way in which the prices of traded financial securities reflect relevant
information. When research indicates that share prices fully and fairly reflect past information, a stock market is
described as weak-form efficient. Investors cannot generate abnormal returns by analysing past information,
such as share price movements in previous time periods, in such a market, since research shows that there is no
correlation between share price movements in successive periods of time. Share prices appear to follow a
‘random walk’ by responding to new information as it becomes available.

When research indicates that share prices fully and fairly reflect public information as well as past information, a
stock market is described as semi-strong form efficient. Investors cannot generate abnormal returns by
analysing either public information, such as published company reports, or past information, since research
shows that share prices respond quickly and accurately to new information as it becomes publicly available.

If research indicates that share prices fully and fairly reflect not only public information and past information,
but private information as well, a stock market is described as strong form efficient. Even investors with access
to insider information cannot generate abnormal returns in such a market. Testing for strong form efficiency is
indirect in nature, examining for example the performance of expert analysts such as fund managers. Stock
markets are not held to be strong form efficient.

The significance to a listed company of its shares being traded on a stock market which is found to be semi-
strong form efficient is that any information relating to the company is quickly and accurately reflected in its
share price. Managers will not be able to deceive the market by the timing or presentation of new information,
such as annual reports or analysts’ briefings, since the market processes the information quickly and accurately
to produce fair prices. Managers should therefore simply concentrate on making financial decisions which
increase the wealth of shareholders.

2. Discuss the key factors which determine the level of investment in current assets.

There are a number of factors that determine the level of investment in current assets and their relative
importance varies from company to company.

Length of working capital cycle - The working capital cycle or operating cycle is the period of time between
when a company settles its accounts payable and when it receives cash from its accounts receivable. Operating
activities during this period need to be financed and as the operating period lengthens, the amount of finance
needed increases. Companies with comparatively longer operating cycles than others in the same industry
sector, will therefore require comparatively higher levels of investment in current assets.

Terms of trade - These determine the period of credit extended to customers, any discounts offered for early
settlement or bulk purchases, and any penalties for late payment. A company whose terms of trade are more
generous than another company in the same industry sector will therefore need a comparatively higher
investment in current assets.

Policy on level of investment in current assets - Even within the same industry sector, companies will have
different policies regarding the level of investment in current assets, depending on their attitude to risk. A
company with a comparatively conservative approach to the level of investment in current assets would
maintain higher levels of inventory, offer more generous credit terms and have higher levels of cash in reserve
than a company with a comparatively aggressive approach. While the more aggressive approach would be more
profitable because of the lower level of investment in current assets, it would also be more risky, for example in
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 terms of running out of inventory in periods of fluctuating demand, of failing to have the particular goods
required by a customer, of failing to retain customers who migrate to more generous credit terms elsewhere,
and of being less able to meet unexpected demands for payment.

Industry in which organisation operates - Another factor that influences the level of investment in current
assets is the industry within which an organisation operates. Some industries, such as aircraft construction, will
have long operating cycles due to the length of time needed to manufacture finished goods and so will have
comparatively higher levels of investment in current assets than industries such as supermarket chains, where
goods are bought in for resale with minimal additional processing and where many goods have short shelf-lives.

3. Discuss the attractions of operating leasing as a source of finance.

Operating leasing is a popular source of finance for companies of all sizes and many reasons have been
advanced to explain this popularity. For example, an operating lease is seen as protection against obsolescence,
since it can be cancelled at short notice without financial penalty. The lessor will replace the leased asset with a
more up-to-date model in exchange for continuing leasing business. This flexibility is seen as valuable in the
current era of rapid technological change, and can also extend to contract terms and servicing cover.

Operating leasing is often compared to borrowing as a source of finance and offers several attractive features in
this area. There is no need to arrange a loan in order to acquire an asset and so the commitment to interest
payments can be avoided, existing assets need not be tied up as security and negative effects on return on
capital employed can be avoided. Since legal title does not pass from lessor to lessee, the leased asset can be
recovered by the lessor in the event of default on lease rentals. Operating leasing can therefore be attractive to
small companies or to companies who may find it difficult to raise debt.

Operating leasing can also be cheaper than borrowing to buy. There are several reasons why the lessor may be
able to acquire the leased asset more cheaply than the lessee, for example by taking advantage of bulk buying,
or by having access to lower cost finance by virtue of being a much larger company. The lessor may also be able
use tax benefits more effectively than the lessee. A portion of these benefits can be made available to the lessee
in the form of lower lease rentals, making operating leasing a more attractive proposition that borrowing.
Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire
use of the leased asset does not appear in the balance sheet.

4. Identify the objectives of working capital management and discuss the conflict that may arise between them.

The objectives of working capital management are profitability and liquidity. The objective of profitability
supports the primary financial management objective, which is shareholder wealth maximisation. The objective
of liquidity ensures that companies are able to meet their liabilities as they fall due, and thus remain in business.
However, funds held in the form of cash do not earn a return, while near-liquid assets such as short-term
investments earn only a small return. Meeting the objective of liquidity will therefore conflict with the objective
of profitability, which is met by investing over the longer term in order to achieve higher returns. Good working
capital management therefore needs to achieve a balance between the objectives of profitability and liquidity if
shareholder wealth is to be maximised.

5. Discuss the circumstances under which the weighted average cost of capital can be used in investment
appraisal.

The weighted average cost of capital (WACC) can be used as a discount rate in investment appraisal provided
that the risks of the investment project being evaluated are similar to the current risks of the investing company.
The WACC would then reflect these risks and represent the average return required as compensation for these
risks.

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 WACC can be used in investment appraisal provided that the business risk of the proposed investment is similar
to the business risk of existing operations. Essentially this means that WACC can be used to evaluate an
expansion of existing business. If the business risk of the investment project is different from the business risk of
existing operations, a project specific discount rate that reflects the business risk of the investment project
should be considered. The capital asset pricing model (CAPM) can be used to derive such a project-specific
discount rate.

WACC can be used in investment appraisal provided that the financial risk of the proposed investment is similar
to the financial risk of existing operations. This means that financing for the project should be raised in
proportions that broadly preserve the capital structure of the investing company. If this is not the case, an
investment appraisal method called adjusted present value (APV) should be used. Alternatively, the CAPM-
derived project-specific cost of capital can be adjusted to reflect the financial risk of the project financing.

A third constraint on using WACC in investment appraisal is that the proposed investment should be small in
comparison with the size of the company. If this were not the case, the scale of the investment project could
cause a change to occur in the perceived risk of the investing company, making the existing WACC an
inappropriate discount rate.

6. Discuss the role of financial intermediaries in providing short-term finance for use by business organisations.

The role of financial intermediaries in providing short-term finance for use by business organisations is to
provide a link between investors who have surplus cash and borrowers who have financing needs. The amounts
of cash provided by individual investors may be small, whereas borrowers need large amounts of cash: one of
the functions of financial intermediaries is therefore to aggregate invested funds in order to meet the needs of
borrowers. In so doing, they provide a convenient and readily accessible route for business organisations to
obtain necessary funds.

Small investors are likely to be averse to losing any capital value, so financial intermediaries will assume the risk
of loss on short-term funds borrowed by business organisations, either individually or by pooling risks between
financial intermediaries. This aspect of the role of financial intermediaries is referred to as risk transformation.
Financial intermediaries also offer maturity transformation, in that investors can deposit funds for a long period
of time while borrowers may require funds on a short-term basis only, and vice versa. In this way the needs of
both borrowers and lenders can be satisfied.

7. Explain how the capital asset pricing model can be used to calculate a project-specific discount rate and
discuss the limitations of using the capital asset pricing model in investment appraisal.

The capital asset pricing model (CAPM) can be used to calculate a project-specific discount rate in circumstances
where the business risk of an investment project is different from the business risk of the existing operations of
the investing company. In these circumstances, it is not appropriate to use the weighted average cost of capital
as the discount rate in investment appraisal.

The first step in using the CAPM to calculate a project-specific discount rate is to find a proxy company (or
companies) that undertake operations whose business risk is similar to that of the proposed investment. The
equity beta of the proxy company will represent both the business risk and the financial risk of the proxy
company. The effect of the financial risk of the proxy company must be removed to give a proxy beta
representing the business risk alone of the proposed investment. This beta is called an asset beta and the
calculation that removes the effect of the financial risk of the proxy company is called ‘ungearing’.

The asset beta representing the business risk of a proposed investment must be adjusted to reflect the financial
3
 risk of the investing company, a process called ‘regearing’. This process produces an equity beta that can be
placed in the CAPM in order to calculate a required rate of return (a cost of equity). This can be used as the
project-specific discount rate for the proposed investment if it is financed entirely by equity. If debt finance
forms part of the financing for the proposed investment, a project-specific weighted average cost of capital can
be calculated.

The limitations of using the CAPM in investment appraisal are both practical and theoretical in nature. From a
practical point of view, there are difficulties associated with finding the information needed. This applies not
only to the equity risk premium and the risk-free rate of return, but also to locating appropriate proxy
companies with business operations similar to the proposed investment project. Most companies have a range
of business operations they undertake and so their equity betas do not reflect only the desired level and type of
business risk.

From a theoretical point of view, the assumptions underlying the CAPM can be criticised as unrealistic in the real
world. For example, the CAPM assumes a perfect capital market, when in reality capital markets are only semi-
strong form efficient at best. The CAPM assumes that all investors have diversified portfolios, so that rewards
are only required for accepting systematic risk, when in fact this may not be true. There is no practical
replacement for the CAPM at the present time, however.

8. Explain the nature of the agency problem and discuss the use of share option schemes as a way of reducing
the agency problem in a stock-market listed company.

The primary financial management objective of a company is usually taken to be the maximisation of
shareholder wealth. In practice, the managers of a company acting as agents for the principals (the
shareholders) may act in ways which do not lead to shareholder wealth maximisation. The failure of managers
to maximise shareholder wealth is referred to as the agency problem.

Shareholder wealth increases through payment of dividends and through appreciation of share prices. Since
share prices reflect the value placed by buyers on the right to receive future dividends, analysis of changes in
shareholder wealth focuses on changes in share prices. The objective of maximising share prices is commonly
used as a substitute objective for that of maximising shareholder wealth.

The agency problem arises because the objectives of managers differ from those of shareholders: because there
is a divorce or separation of ownership from control in modern companies; and because there is an asymmetry
of information between shareholders and managers which prevents shareholders being aware of most
managerial decisions.

One way to encourage managers to act in ways that increase shareholder wealth is to offer them share options.
These are rights to buy shares on a future date at a price which is fixed when the share options are issued. Share
options will encourage managers to make decisions that are likely to lead to share price increases (such as
investing in projects with positive net present values), since this will increase the rewards they receive from
share options. The higher the share price in the market when the share options are exercised, the greater will be
the capital gain that could be made by managers owning the options.

Share options therefore go some way towards reducing the differences between the objectives of shareholders
and managers. However, it is possible that managers may be rewarded for poor performance if share prices in
general are increasing. It is also possible that managers may not be rewarded for good performance if share
prices in general are falling. It is difficult to decide on a share option exercise price and a share option exercise
date that will encourage managers to focus on increasing shareholder wealth while still remaining challenging,
rather than being easily achievable.
9. Discuss the ways in which factoring and invoice discounting can assist in the management of accounts
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 receivable.

Factoring involves a company turning over administration of its sales ledger to a factor, which is a financial
institution with expertise in this area. The factor will assess the creditworthiness of new customers, record sales,
send out statements and reminders, collect payment, identify late payers and chase them for settlement, and
take appropriate legal action to recover debts where necessary.

The factor will also offer finance to a company based on invoices raised for goods sold or services provided. This
is usually up to 80% of the face value of invoices raised. The finance is repaid from the settled invoices, with the
balance being passed to the issuing company after deduction of a fee equivalent to an interest charge on cash
advanced.

If factoring is without recourse, the factor rather than the company will carry the cost of any bad debts that
arise on overdue accounts. Factoring without recourse therefore offers credit protection to the selling company,
although the factor’s fee (a percentage of credit sales) will be comparatively higher than with non-recourse
factoring to reflect the cost of the insurance offered.

Invoice discounting is a way of raising finance against the security of invoices raised, rather than employing the
credit management and administration services of a factor. A number of good quality invoices may be
discounted, rather than all invoices, and the service is usually only offered to companies meeting a minimum
turnover criterion.

10. Discuss the factors to be considered in choosing between traded bonds, new equity issued via a placing and
venture capital as sources of finance.

Traded bonds are debt securities issued onto the capital market in exchange for cash received by the issuing
company. The cash raised must be repaid on the redemption date, usually between five and fifteen years after
issue. Bonds are usually secured on non-current assets of the issuing company, which reduces the risk to the
lender. In the event of default on interest payments by the borrower, the bond holders can appoint a receiver to
sell the assets and recover their investment. Interest paid on the bonds is tax-deductible, which reduces the cost
of debt to the issuing company. Provided the borrower continues to pay the interest, however, bond finance is a
low risk financing choice by the issuer.

There are a number of differences between bond finance and a new equity issue via a placing that will influence
the choice between them. Equity finance does not need to be redeemed, since ordinary shares are truly
permanent finance. While bond interest is usually fixed, the return to shareholders in the form of dividends
depends on the dividend decision made by the directors of a company, and so these returns can increase,
decrease or be passed. Furthermore, since dividends are a distribution of after-tax profit, they are not tax-
deductible like interest payments, and so equity finance is not tax-efficient like debt finance.

Venture capital is found in specific financing situations, i.e. where risk finance is needed, for example, in a
management buyout. Both equity and debt finance can be part of a venture capital financing package, but the
return expected on venture capital is very high because of the level of risk faced by the investor.

11. Describe methods a company could use to hedge against exchange rate risk.

If a company receives foreign currently income from its export sales and makes annual foreign currency-
denominated interest payments to bond-holders. It could consider opening foreign currency bank account in the
overseas country and use this as a natural hedge against exchange rate risk.

A company can consider using lead payments to settle foreign currency liabilities. This would be beneficial only
5
 if the foreign currency is expected to appreciate in value. It is inadvisable to lag payments to foreign suppliers,
since this would breach sales agreements and lead to loss of goodwill.

Foreign currency derivatives include currency futures, currency options and currency swaps. Currency futures
are standardised contracts for the purchase or sale of a specified quantity of a foreign currency. These contracts
are settled on a quarterly cycle, but a futures position can be closed out any time by undertaking the opposite
transaction to the one that opened the futures position. Currency futures provide a hedge that theoretically
eliminates both upside and downside risk by effectively locking the holder into a given exchange rate, since any
gains in the currency futures market are offset by exchange rate losses in the cash market, and vice versa. In
practice however, movements in the two markets are not perfectly correlated and basis risk exists if maturities
are not perfectly matched. Imperfect hedges can also arise if the standardised size of currency futures does not
match the exchange rate exposure of the hedging company. Initial margin must be provided when a currency
futures position is opened and variation margin may also be subsequently required.

Currency options give holders the right, but not the obligation, to buy or sell foreign currency. Over-the-counter
(OTC) currency options are tailored to individual client needs, while exchange-traded currency options are
standardised in the same way as currency futures in terms of exchange rate, amount of currency, exercise date
and settlement cycle. An advantage of currency options over currency futures is that currency options do not
need to be exercised if it is disadvantageous for the holder to do so. Holders of currency options can take
advantage of favourable exchange rate movements in the cash market and allow their options to lapse. The
initial fee paid for the options will still have been incurred, however.

Currency swaps are appropriate for hedging exchange rate risk over a longer period of time than currency
futures or currency options. A currency swap is an interest rate swap where the debt positions of the
counterparties and the associated interest payments are in different currencies. A currency swap begins with an
exchange of principal, although this may be a notional exchange rather than a physical exchange. During the life
of the swap agreement, the counterparties undertake to service each other’s foreign currency interest
payments. At the end of the swap, the initial exchange of principal is reversed.

12. Identify and explain the key stages in the capital investment decision-making process, and the role of
investment appraisal in this process.

Identifying investment opportunities - Investment opportunities or proposals could arise from analysis of
strategic choices, analysis of the business environment, research and development, or legal requirements. The
key requirement is that investment proposals should support the achievement of organisational objectives.

Screening investment proposals - In the real world, capital markets are imperfect, so it is usual for companies to
be restricted in the amount of finance available for capital investment. Companies therefore need to choose
between competing investment proposals and select those with the best strategic fit and the most appropriate
use of economic resources.

Analysing and evaluating investment proposals - Candidate investment proposals need to be analysed in depth
and evaluated to determine which offer the most attractive opportunities to achieve organisational objectives,
for example to increase shareholder wealth. This is the stage where investment appraisal plays a key role,
indicating for example which investment proposals have the highest net present value.

Approving investment proposals - The most suitable investment proposals are passed to the relevant level of
authority for consideration and approval. Very large proposals may require approval by the board of directors,
while smaller proposals may be approved at divisional level, and so on. Once approval has been given,
implementation can begin.
Implementing, monitoring and reviewing investments - The time required to implement the investment
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 proposal or project will depend on its size and complexity, and is likely to be several months. Following
implementation, the investment project must be monitored to ensure that the expected results are being
achieved and the performance is as expected. The whole of the investment decision-making process should also
be reviewed in order to facilitate organisational learning and to improve future investment decisions.

13. Discuss whether a change in dividend policy will affect the share price of a company.

Miller and Modigliani showed that, in a perfect capital market, the value of a company depended on its
investment decision alone, and not on its dividend or financing decisions. In such a market, a change in dividend
policy would not affect its share price or its market capitalisation. They showed that the value of a company was
maximised if it invested in all projects with a positive net present value (its optimal investment schedule). The
company could pay any level of dividend and if it had insufficient finance, make up the shortfall by issuing new
equity. Since investors had perfect information, they were indifferent between dividends and capital gains.
Shareholders who were unhappy with the level of dividend declared by a company could gain a ‘home-made
dividend’ by selling some of their shares. This was possible since there are no transaction costs in a perfect
capital market.

Against this view are several arguments for a link between dividend policy and share prices. For example, it has
been argued that investors prefer certain dividends now rather than uncertain capital gains in the future (the
‘bird-in-the-hand’ argument). It has also been argued that real-world capital markets are not perfect, but semi-
strong form efficient. Since perfect information is therefore not available, it is possible for information
asymmetry to exist between shareholders and the managers of a company. Dividend announcements may give
new information to shareholders and as a result, in a semi-strong form efficient market, share prices may
change. The size and direction of the share price change will depend on the difference between the dividend
announcement and the expectations of shareholders. This is referred to as the ‘signalling properties of
dividends’.

It has been found that shareholders are attracted to particular companies as a result of being satisfied by their
dividend policies. This is referred to as the ‘clientele effect’. A company with an established dividend policy is
therefore likely to have an established dividend clientele. The existence of this dividend clientele implies that
the share price may change if there is a change in the dividend policy of the company, as shareholders sell their
shares in order to reinvest in another company with a more satisfactory dividend policy. In a perfect capital
market, the existence of dividend clienteles is irrelevant, since substituting one company for another will not
incur any transaction costs. Since real-world capital markets are not perfect, the existence of dividend clienteles
suggests that if a company changes its dividend policy, its share price could be affected.

14. Briefly explain the reasons why a company may choose to finance a new investment by an issue of debt
finance.

Pecking order theory suggests that companies have a preferred order in which they seek to raise finance,
beginning with retained earnings. The advantages of using retained earnings are that issue costs are avoided by
using them, the decision to use them can be made without reference to a third party, and using them does not
bring additional obligations to consider the needs of finance providers.

Once available retained earnings have been allocated to appropriate uses within a company, its next preference
will be for debt. One reason for choosing to finance a new investment by an issue of debt finance, therefore, is
that insufficient retained earnings are available and the investing company prefers issuing debt finance to issuing
equity finance.

Debt finance may also be preferred when a company has not yet reached its optimal capital structure and it is
mainly financed by equity, which is expensive compared to debt. Issuing debt here will lead to a reduction in the

7
 WACC and hence an increase in the market value of the company. One reason why debt is cheaper than equity
is that debt is higher in the creditor hierarchy than equity, since ordinary shareholders are paid out last in the
event of liquidation. Debt is even cheaper if it is secured on assets of the company. The cost of debt is reduced
even further by the tax efficiency of debt, since interest payments are an allowable deduction in arriving at
taxable profit.

Debt finance may be preferred where the maturity of the debt can be matched to the expected life of the
investment project. Equity finance is permanent finance and so may be preferred for investment projects with
long lives.

15. Discuss how risks arising from granting credit to foreign customers can be managed and reduced.

When credit is granted to foreign customers, two problems may become especially significant. First, the longer
distances over which trade takes place and the more complex nature of trade transactions and their elements
means foreign accounts receivable need more investment than their domestic counterparts. Longer transaction
time increase accounts receivable balances and hence the level of financing and financing costs. Second, the risk
of bad debts is higher with foreign accounts receivable than with their domestic counterparts. In order to
manage and reduce credit risks, therefore, exporters seek to reduce the risk of bad debt and to reduce the level
of investment in foreign accounts receivable.

Many foreign transactions are on ‘open account’, which is an agreement to settle the amount outstanding on a
predetermined date. Open account reflects a good business relationship between importer and exporter. It also
carries the highest risk of non-payment.

One way to reduce investment in foreign accounts receivable is to agree early payment with an importer, for
example by payment in advance, payment on shipment, or cash on delivery. These terms of trade are unlikely to
be competitive, however, and it is more likely that an exporter will seek to receive cash in advance of payment
being made by the customer.

One way to accelerate cash receipts is to use bill finance. Bills of exchange with a signed agreement to pay the
exporter on an agreed future date, supported by a documentary letter of credit, can be discounted by a bank to
give immediate funds. This discounting is without recourse if bills of exchange have been countersigned by the
importer’s bank.

Documentary letters of credit are a payment guarantee backed by one or more banks. They carry almost no
risk, provided the exporter complies with the terms and conditions contained in the letter of credit. The exporter
must present the documents stated in the letter, such as bills of lading, shipping documents, bills of exchange,
and so on, when seeking payment. As each supporting document relates to a key aspect of the overall
transaction, letters of credit give security to the importer as well as the exporter.

Insurance can also be used to cover some of the risks associated with giving credit to foreign customers. This
would avoid the cost of seeking to recover cash due from foreign accounts receivable through a foreign legal
system, where the exporter could be at a disadvantage due to a lack of local or specialist knowledge.

Export factoring can also be considered, where the exporter pays for the specialist expertise of the factor as a
way of reducing investment in foreign accounts receivable and reducing the incidence of bad debts.

16. Identify and discuss the factors to be considered in formulating a trade receivables management policy.

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The factors to be considered in formulating a policy to manage trade receivables will relate to the key areas of
credit assessment or analysis, credit control and collection procedures. A key factor is the turbulence in the
company’s business environment and the way it affects the company’s customers.

Credit analysis - The main objective of credit analysis is to ensure that credit is granted to customers who will
settle their account at regular intervals in accordance with the agreed terms of sale. The risk of bad debts must
be minimised as much as possible. Key factors to consider here are the source and quality of the information
used by a company to assess customer creditworthiness. The information sources could include bank
references, trade references, public information such as published accounts, credit reference agencies and
personal experience. The quality of the information needs to be confirmed as part of the credit analysis process.
Some organisations have developed credit scoring systems to assist in the assessment of creditworthiness.

Credit control - Once credit has been granted, it is essential to ensure that agreed terms and conditions are
adhered to while the credit is outstanding. This can be achieved by careful monitoring of customer accounts and
the periodic preparation of aged debtor analyses. A key factor here is the quality of the staff involved with credit
control and the systems and procedures they use to maintain regular contact with customers, for example
invoices, statements, reminders, letters and telephone contacts.

Collection procedures - The objective here is to ensure timely and secure transfer of funds when they are due,
whether by physical means or by electronic means. A key factor here is the need to ensure that the terms of
trade are clearly understood by the customer from the point at which credit is granted. Offering credit
represents a cost to the seller and ensuring that payment occurs as agreed prevents this cost from exceeding
budgeted expectations. Procedures for chasing late payers should be clearly formulated and trained personnel
must be made responsible for ensuring that these procedures are followed. Legal action should only be
considered as a last resort, since it often represents the termination of the business relationship with a
customer.

The factors can be further analysed as follows:

The level of investment in trade receivables - If the amount of finance tied up in trade receivables is substantial,
receivables management policy may be formulated with the intention of reducing the level of investment by
tighter control over the way in which credit is granted and improved methods of assessing client
creditworthiness.

The cost of financing trade credit - If the cost of financing trade credit is high, there will be pressure to reduce
the amount of credit offered and to reduce the period for which credit is offered.

The terms of trade offered by competitors - In order to compete effectively, a company will need to match the
terms offered by its competitors, otherwise customers will migrate to competitors, unless there are other
factors that will encourage them to be loyal, such as better quality products or a more valuable after-sales
service.

The level of risk acceptable to the company - Some companies may feel that more relaxed trade credit terms
will increase the volume of business to an extent that compensates for a higher risk of bad debts. The level of
risk of bad debts that is acceptable will vary from company to company. Some companies may seek to reduce
this risk through a policy of insuring against non-payment by clients.

The need for liquidity - Where the need for liquidity is relatively high, a company may choose to accelerate cash
inflow from credit customers by using invoice discounting or by factoring.

The expertise available within the company - Where expertise in the assessment of creditworthiness and the
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 monitoring of customer accounts is not to a

17. Discuss the relationship between capital structure and weighted average cost of capital.

A discussion of capital structure could start from recognising that equity is more expensive than debt because of
the relative risk of the two sources of finance. Equity is riskier than debt and so equity is more expensive than
debt. This does not depend on the tax efficiency of debt, since we can assume that no taxes exist. We can also
assume that as a company gears up, it replaces equity with debt. This means that the company’s capital base
remains constant and its weighted average cost of capital (WACC) is not affected by increasing investment.

The traditional view of capital structure assumes a non-linear relationship between the cost of equity and
financial risk. As a company gears up, there is initially very little increase in the cost of equity and the WACC
decreases because the cost of debt is less than the cost of equity. A point is reached, however, where the cost of
equity rises at a rate that exceeds the reduction effect of cheaper debt and the WACC starts to increase. In the
traditional view, therefore, a minimum WACC exists and, as a result, a maximum value of the company arises.

Modigliani and Miller assumed a perfect capital market and a linear relationship between the cost of equity and
financial risk. They argued that, as a company geared up, the cost of equity increased at a rate that exactly
cancelled out the reduction effect of cheaper debt. WACC was therefore constant at all levels of gearing and no
optimal capital structure, where the value of the company was at a maximum, could be found.

It was argued that the no-tax assumption made by Modigliani and Miller was unrealistic, since in the real world
interest payments were an allowable expense in calculating taxable profit and so the effective cost of debt was
reduced by its tax efficiency. They revised their model to include this tax effect and showed that, as a result, the
WACC decreased in a linear fashion as a company geared up. The value of the company increased by the value
of the ‘tax shield’ and an optimal capital structure would result by gearing up as much as possible.

It was pointed out that market imperfections associated with high levels of gearing, such as bankruptcy risk and
agency costs, would limit the extent to which a company could gear up. In practice, therefore, it appears that
companies can reduce their WACC by increasing gearing, while avoiding the financial distress that can arise at
high levels of gearing.

It has further been suggested that companies choose the source of finance which, for one reason or another, is
easiest for them to access (pecking order theory). This results in an initial preference for retained earnings,
followed by a preference for debt before turning to equity. The view suggests that companies may not in
practice seek to minimise their WACC (and consequently maximise company value and shareholder wealth).

18. Discuss how an optimal investment schedule can be formulated when capital is rationed and investment
projects are either divisible or non-divisible.

When capital is rationed, the optimal investment schedule is the one that maximises the return per dollar
invested. The capital rationing problem is therefore concerned with limiting factor analysis, but the approach
adopted is slightly different depending on whether the investment projects being evaluated are divisible or
indivisible.

With divisible projects, the assumption is made that a proportion rather than the whole investment can be
undertaken, with the net present value (NPV) being proportional to the amount of capital invested. If 70% of a
project is undertaken, for example, the resulting NPV is assumed to be 70% of the NPV of investing in the whole
project.
For each divisible project, a profitability index can be calculated, defined either as the net present value of the
project divided by its initial investment, or as the present value of the future cash flows of the project divided by
10
 its initial investment. The profitability index represents the return per dollar invested and can be used to rank
the investment projects.
The limited investment funds can then be invested in the projects in the order of their profitability indexes, with
the final investment selection being a proportionate one if there is insufficient finance for the whole project.
This represents the optimum investment schedule when capital is rationed and projects are divisible.

With indivisible projects, ranking by profitability index will not necessarily indicate the optimum investment
schedule, since it will not be possible to invest in part of a project. In this situation, the NPV of possible
combinations of projects must be calculated. The most likely combinations are often indicated by the
profitability index ranking. The combination of projects with the highest aggregate NPV will then be the
optimum investment schedule.

19. Discuss how the net present value method of investment appraisal contributes towards the objective of
maximising the wealth of shareholders.

The primary financial management objective of private sector companies is often stated to be the maximisation
of the wealth of its shareholders. While other corporate objectives are also important, for example due to the
existence of other corporate stakeholders than shareholders, financial management theory emphasises the
importance of the objective of shareholder wealth maximisation.

Shareholder wealth increases through receiving dividends and through share prices increasing over time.
Changes in share prices can therefore be used to assess whether a financial management decision is of benefit
to shareholders. In fact, the objective of maximising the wealth of shareholders is usually substituted by the
objective of maximising the share price of a company.

The net present value (NPV) investment appraisal method advises that an investment should be accepted if it
has a positive NPV. If a company accepts an investment with a positive NPV, the market value of the company,
theoretically at least, increases by the amount of the NPV. A company with a market value of $10 million
investing in a project with an NPV of $1 million will have a market value of $11 million once the investment is
made. Shareholder wealth is therefore increased if positive NPV projects are accepted and, again theoretically,
shareholder wealth will be maximised if a company invests in all projects with a positive NPV. This is sometimes
referred to as the optimum investment schedule for a company.

The NPV investment appraisal method also contributes towards the objective of maximising the wealth of
shareholders by using the cost of capital of a company as a discount rate when calculating the present values of
future cash flows. A positive NPV represents an investment return that is greater than that required by a
company’s providers of finance, offering the possibility of increased dividends being paid to shareholders from
future cash flows.

20. Discuss the reasons why different bonds of the same company might have different costs of debt.

A key factor here could be the duration of the bond issues, linked to the term structure of interest rates.
Normally, the longer the time to maturity of a debt, the higher will be the interest rate and the cost of debt.

Liquidity preference theory suggests that investors require compensation for deferring consumption, i.e. for not
having access to their cash in the current period, and so providers of debt finance require higher compensation
for lending for longer periods. The premium for lending for longer periods also reflects the way that default risk
increases with time.

Expectations theory suggests that the shape of the yield curve depends on expectations as to future interest
rates. If the expectation is that future interest rates will be higher than current interest rates, the yield curve will
11
 slope upwards. If the expectation is that future interest rates will be lower than at present, the yield curve will
slope downwards.

Market segmentation theory suggests that future interest rates depend on conditions in different debt markets,
e.g. the short-term market, the medium-term market and the long-term market. The shape of the yield curve
therefore depends on the supply of, and demand for, funds in the market segments. If the two bonds had been
issued by different companies, a different business risk might have been a reason for the difference in the costs
of debt. The size of the debt could be a contributory factor since the greater the size the higher cost.

21. Discuss the difference between a nominal (money terms) approach and a real terms approach to calculating
NPV.

A nominal (money terms) approach to investment appraisal discounts nominal cash flows with a nominal cost of
capital. Nominal cash flows are found by inflating forecast values from current price estimates, for example,
using specific inflation. Applying specific inflation means that different project cash flows are inflated by
different inflation rates in order to generate nominal project cash flows. A real terms approach to investment
appraisal discounts real cash flows with a real cost of capital. Real cash flows are found by deflating nominal
cash flows by the general rate of inflation. The real cost of capital is found by deflating the nominal cost of
capital by the general rate of inflation, using the Fisher equation:

The net present value for an investment project does not depend on whether a nominal terms approach or a
real terms approach is adopted, since nominal cash flows and the nominal discount rate are both discounted by
the general rate of inflation to give real cash flows and the real discount rate, respectively. Both approaches give
the same net present value.

22. Discuss the sources and characteristics of long-term debt finance which may be available to a company.

Long-term bank loan – A company could obtain finance required for investment purposes via a bank loan, from
either a single bank or from a syndicate of banks. Interest payments on the bank loan could be annual, twice
yearly or quarterly, and at either a fixed rate or a floating rate of interest. Repayments of capital may be
required along with interest payments and it is possible that a constant cash amount would be regularly paid,
with the amount of interest in the payment declining and the amount of capital in the payment increasing over
time. It is likely that the bank loan would be secured against particular non-current assets of the company, so
that the bank could recover its loan if the company defaults on interest payments.

Bonds or loan notes - Bonds or loan notes may be redeemable or irredeemable (permanent), although in recent
years irredeemable corporate bonds have been very rare. Fixed rate or floating rate interest is paid on the
bonds, either annually or half yearly, with the interest being based on nominal (par) value of the bonds rather
than on their market value. Bonds, like ordinary shares, are mainly traded on the capital markets and can be
issued in a variety of foreign currencies. Redemption of a large bond issue can pose a serious cash flow problem
for a company and may call for refinancing rather than outright redemption. The return required on debt
finance (the cost of debt) is lower than the return required on equity (the cost of equity), and so a company
could reduce its average cost of capital by issuing debt finance.

Convertible bonds or loan notes - Convertible bonds or loan notes are bonds which, at the option of the holder,
can be converted into a specified quantity of ordinary shares (the conversion ratio) on a specified future date
(the conversion date). They have the advantage for the issuing company that, assuming conversion terms are set
appropriately, conversion will occur and so redemption can be avoided. If conversion occurs, there can be a
significant reduction in the gearing of the issuing company. The future option to convert into equity has value to
investors and as a consequence, the interest rate on convertible debt is lower than that on ordinary bonds.
Convertible bonds can pay interest annually or twice annually, at a fixed or a floating rate of interest. If
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 conversion does not take place, however, redemption of the bonds or loan notes will be required.

Deep discount bonds and zero coupon bonds - The return to a bond holder consists of regular interest
payments (income) and repayment of the principle amount on redemption (capital). Investors may accept lower
interest payments (lower income) in exchange for an increase in capital return. This can be achieved if the bond
is issued at a deep discount to nominal value, but redeemed at nominal value. This kind of financial security is
called a deep discount bond and may be suitable for companies which do not expect an immediate return on
invested capital. A zero coupon bond goes a step further and pays no interest (coupon) at all, so that the return
to the investor is entirely in the form of capital appreciation. Bonds like these are useful for companies which
expect cash flows from invested capital to occur mainly later in the life of an investment project, rather than
more evenly throughout its life.

23. In Islamic finance, explain briefly the concept of riba (interest) and how returns are made by Islamic financial
instruments.

Interest (riba) is the predetermined amount received by a provider of finance, over and above the principal
amount of finance provided. Riba is absolutely forbidden in Islamic finance. Riba can be seen as unfair from the
perspective of the borrower, the lender and the economy. For the borrower, riba can turn a profit into a loss
when profitability is low. For the lender, riba can provide an inadequate return when unanticipated inflation
arises. In the economy, riba can lead to allocational inefficiency, directing economic resources to sub-optimal
investments.

Islamic financial instruments require that an active role be played by the provider of funds, so that the risks and
rewards of ownership are shared. In a Mudaraba contract, for example, profits are shared between the partners
in the proportions agreed in the contract, while losses are borne by the provider of finance. In a Musharaka
contract, profits are shared between the partners in the proportions agreed in the contract, while losses are
shared between the partners according to their capital contributions. With Sukuk, certificates are issued which
are linked to an underlying tangible asset and which also transfer the risk and rewards of ownership. The
underlying asset is managed on behalf of the Sukuk holders. In a Murabaha contract, payment by the buyer is
made on a deferred or instalment basis. Returns are made by the supplier as a mark-up is paid by the buyer in
exchange for the right to pay after the delivery date. In an Ijara contract, which is equivalent to a lease
agreement, returns are made through the payment of fixed or variable lease rental payments.

24. Discuss the relationship between investment decisions, dividend decisions and financing decisions.

Investment decisions, dividend decisions and financing decisions have often been called the decision triangle of
financial management. The study of financial management is often divided up in accordance with these three
decision areas. However, they are not independent decisions, but closely connected.

For example, a decision to increase dividends might lead to a reduction in retained earnings and hence a greater
need for external finance in order to meet the requirements of proposed capital investment projects. Similarly, a
decision to increase capital investment spending will increase the need for financing, which could be met in part
by reducing dividends.

The question of the relationship between the three decision areas was investigated by Miller and Modigliani.
They showed that, if a perfect capital market was assumed, the market value of a company and its weighted
average cost of capital (WACC) were independent of its capital structure. The market value therefore depended
on the business risk of the company and not on its financial risk. The investment decision, which determined the
operating income of a company, was therefore shown to be important in determining its market value, while the
financing decision, given their assumptions, was shown to be not relevant in this context. In practice, it is
recognised that capital structure can affect WACC and hence the market value of the company.
13
 Miller and Modigliani also investigated the relationship between dividend policy and the share price of a
company, i.e. the market value of a company. They showed that, if a perfect capital market was assumed, the
share price of a company did not depend on its dividend policy, i.e. the dividend decision was irrelevant to value
of the share. The market value of the company and therefore the wealth of shareholders were shown to be
maximised when the company implemented its optimum investment policy, which was to invest in all projects
with a positive NPV. The investment decision was therefore shown to be theoretically important with respect to
the market value of the company, while the dividend decision was not relevant.

In practice, capital markets are not perfect and a number of other factors become important in discussing the
relationship between the three decision areas. Pecking order theory, for example, suggests that managers do
not in practice make financing decisions with the objective of obtaining an optimal capital structure, but on the
basis of the convenience and relative cost of different sources of finance. Retained earnings are the preferred
source of finance from this perspective, with a resulting pressure for annual dividends to be lower rather than
higher.

25. Identify and discuss briefly the factors that influence the market value of traded bonds.

Amount of interest payment - The market value of a traded bond will increase as the interest paid on the bond
increases, since the reward offered for owning the bond becomes more attractive.

Frequency of interest payments - If interest payments are more frequent, say every six months rather than
every year, then the present value of the interest payments increases and hence so does the market value.

Redemption value - If a higher value than par is offered on redemption, the reward offered for owning the bond
increases and hence so does the market value.

Period to redemption - The market value of traded bonds is affected by the period to redemption, either
because the capital payment becomes more distant in time or because the number of interest payments
increases.

Cost of debt - The present value of future interest payments and the future redemption value are heavily
influenced by the cost of debt, i.e. the rate of return required by bond investors. This rate of return is influenced
by the perceived risk of a company, for example as evidenced by its credit rating. As the cost of debt increases,
the market value of traded bonds decreases, and vice versa.

Convertibility - If traded bonds are convertible into ordinary shares, the market price will be influenced by the
likelihood of the future conversion and the expected conversion value, which is dependent on the current share
price, the future share price growth rate and the conversion ratio.

26. Discuss the factors to be considered in formulating the dividend policy of a stock-exchange listed company.

Profitability - Companies need to remain profitable and dividends are a distribution of after-tax profit. A
company cannot consistently pay dividends higher than its profit after tax. A healthy level of retained earnings is
needed to finance the continuing business needs of the company.

Liquidity - Although a dividend is a distribution of profit, it is a cash payment by the company to its shareholders.
A company must therefore ensure it has sufficient cash to pay a proposed dividend and that paying a dividend
will not compromise day-to-day cash financing needs.
Legal and other restrictions - A dividend can only be paid out in accordance with statutory requirements, such
as the requirement in the United Kingdom for dividends to be paid out of accumulated net realised profits.
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 There may also be restrictions on dividend payments imposed by, for example, restrictive covenants in bond
issue documents.

The need for finance - There is a close relationship between investment, financing and dividend decisions, and
the dividend decision must consider the investment plans and financing needs of the company. A large
investment programme, for example, will require a large amount of finance, and the need for external finance
can be reduced if dividend increases are kept in check. Similarly, the decision to increase dividends may reduce
retained earnings to the extent where external finance is needed in order to meet investment needs.

The level of financial risk - If financial risk is high, for example due to a high level of gearing arising from a
substantial level of debt finance, maintaining a low level of dividend payments can result in a high level of
retained earnings, which will reduce gearing by increasing the level of reserves. The cash flow from a higher level
of retained earnings can also be used to decrease the amount of debt being carried by a company.

The signalling effect of dividends - In a semi-strong form efficient market, information available to directors is
more substantial than that available to shareholders, so that information asymmetry exists. This is one of the
causes of the agency problem. If dividend decisions convey new information to the market, they can have a
signalling effect concerning the current position of the company and its future prospects. The signalling effect
also depends on the dividend expectations in the market. A company should therefore consider the likely effect
on share prices of the announcement of a proposed dividend.

27. Briefly explain the factors that will influence the rate of interest charged on a new issue of bonds.

Company-specific factors - The interest rate charged on a new issue of bonds will depend upon such factors as
the risk associated with the company and any security offered. The risk associated with the company will be
assessed by considering the ability of the company to meet interest payments in the future, and hence its future
cash flows and profitability, as well as its ability to redeem the bond issue on maturity. Where an issue of new
bonds is backed by security, the interest rate charged on the issue will be lower than for an unsecured bond
issue. A bond issue will be secured on specific non-current assets such as land or buildings, and as such is
referred to as a fixed-charge security.

Economic environment factors - As far as the duration of a new issue of bonds is concerned, the term structure
of interest rates suggests that short-term debt is usually cheaper than long-term debt, so that the yield curve
slopes upwards with increasing term to maturity. The longer the duration of an issue of new bonds, therefore,
the higher will be the interest rate charged. The shape of the yield curve, which can be explained by reference to
liquidity preference theory, expectations theory and market segmentation theory, will be independent of any
specific company.

The rate of interest charged on a new issue of bonds will also depend on the general level of interest rates in the
financial system. This is influenced by the general level of economic activity in a given country, such as whether
the economy is in recession (when interest rates tend to fall) or experiencing rapid economic growth (when
interest rates are rising as capital availability is decreasing). The general level of interest rates is also influenced
by monetary policy decisions taken by the government or the central bank. For example, interest rates may be
increased in order to exert downward pressure on demand and hence decrease inflationary pressures in an
economy.

28. Explain the difference between risk and uncertainty in the context of investment appraisal, and discuss how
risks can be incorporated into the investment appraisal process.

15
 Risk refers to the situation where probabilities can be assigned to a range of expected outcomes arising from an
investment project and the likelihood of each outcome occurring can therefore be quantified. Uncertainty refers
to the situation where probabilities cannot be assigned to expected outcomes. Investment project risk therefore
increases with increasing variability of returns, while uncertainty increases with increasing project life. The two
terms are often used interchangeably in financial management, but the distinction between them is a useful
one.

Sensitivity analysis assesses how the net present value of an investment project is affected by changes in
project variables. Considering each project variable in turn, the change in the variable required to make the net
present value zero is determined, or alternatively the change in net present value arising from a fixed change in
the given project variable. In this way the key or critical project variables are determined. However, sensitivity
analysis does not assess the probability of changes in project variables and so is often dismissed as a way of
incorporating risk into the investment appraisal process.

Probability analysis refers to the assessment of the separate probabilities of a number of specified outcomes of
an investment project. For example, a range of expected market conditions could be formulated and the
probability of each market condition arising in each of several future years could be assessed. The net present
values arising from combinations of future economic conditions could then be assessed and linked to the joint
probabilities of those combinations. The expected net present value (ENPV) could be calculated, together with
the probability of the worst-case scenario and the probability of a negative net present value. In this way, the
downside risk of the investment could be determined and incorporated into the investment decision.

Risk-adjusted discount rate - It appears to be intuitively correct to add a risk premium to the ‘normal’ discount
rate to assess a project with greater than normal risk. The theoretical approach here would be to use the capital
asset pricing model (CAPM) to determine a project-specific discount rate that reflected the systematic risk of an
investment project. This can be achieved by selecting proxy companies whose business activities are the same as
the proposed investment project: removing the effect of their financial risk by ungearing their equity betas to
give an average asset beta; regearing the asset beta to give an equity beta reflecting the financial risk of the
investing company; and using the CAPM to calculate a project-specific cost of equity for the investment project.

Adjusted payback - Payback can be adjusted for risk, if uncertainty is considered to be the same as risk, by
shortening the payback period. The logic here is that as uncertainty (risk) increases with the life of the
investment project, shortening the payback period for a project that is relatively risky will require it to pay back
sooner, putting the focus on cash flows that are more certain (less risky) because they are nearer in time.
Payback can also be adjusted for risk by discounting future cash flows with a risk-adjusted discount rate, i.e. by
using the discounted payback method. The normal payback period target can be applied to the discounted cash
flows, which will have decreased in value due to discounting, so that the overall effect is similar to reducing the
payback period with undiscounted cash flows.

29. Discuss why the cost of equity is greater than the cost of debt.

The cost of equity is the return required by ordinary shareholders (equity investors), in order to compensate
them for the risk associated with their equity investment, i.e. their investment in the ordinary shares of a
company. If the risk of an investment increases, the return expected by the investor also increases. If the risk of
a company increases, therefore, its cost of equity also increases.

If a company is liquidated, the order in which the claims of creditors are settled is a factor in determining their
relative risk. The claims of providers of debt finance (debt holders) must be paid off before any cash can be
distributed to ordinary shareholders (the owners). The risk faced by shareholders is therefore greater than the
risk faced by debt holders, and the cost of equity is therefore greater than the cost of debt.

16
 Interest on debt finance must be paid before dividends can be paid to ordinary shareholders, so the risk faced by
ordinary shareholders is greater than the risk faced by debt holders, since the necessity of paying interest may
mean that dividends have to be reduced.

30. Discuss the nature and causes of the problem of capital rationing.

In real-world capital investment decisions, companies are limited in the funds that are available for investment.
However, the basis for investment decisions should still be to maximise the wealth of shareholders. The NPV
decision rule calls for a company to invest in all projects with a positive net present value, but this is
theoretically possible only in a perfect capital market, i.e. a capital market where there is no limit on the finance
available. Since investment funds are limited in the real world, it is not possible in the real world for a company
to invest in all projects with a positive NPV.

The reasons why investment funds are limited in the real world are either external to the company (hard capital
rationing) or internal to the company (soft capital rationing). Several reasons have been suggested for hard
capital rationing, such as that investors may feel that a company is too risky to invest in, with its credit rating
being seen as too low for the amount of investment it needs. Perhaps capital markets may be depressed, so that
there is a general unwillingness by investors to provide funds for capital investment. Capital may be in short
supply due to ‘crowding-out’ as a result of high government borrowing.

Soft capital rationing may be due to reluctance by a company to raise finance. For example, the amount of
funds needed may be small in relation to the costs of raising the finance: or the company may wish to avoid
dilution of control or earnings per share by issuing new equity; or the company may wish to avoid a commitment
to paying fixed interest because it believes future economic conditions may put its profitability under pressure.
Alternatively, the company may limit the funds available for capital investment in order to encourage
competition between potential investment projects, so that only robust investment projects are accepted. This
is the ‘internal capital market’ reason for soft capital rationing.

If a company cannot invest in all projects with a positive NPV, it must ensure that it generates the maximum
return per dollar invested. With single-period capital rationing, where investment funds are limited in the first
year only, divisible investment projects can be ranked in order of desirability using the profitability index. This
can be defined either as the NPV divided by the initial investment, or as the present value of future cash flows
divided by the initial investment. The optimal investment decision for a company is then to invest in the projects
in turn, moving from highest profitability index downwards, until all the funds have been exhausted. This may
require partial investment in the last desirable project selected, which is possible with divisible investment
projects.

Where investment projects are not divisible, the total NPV of various combinations of projects must be
compared, within the limit of the investment funds available, in order to select the combination of projects with
the highest NPV. This will be the optimum investment decision. Surplus funds may be left over, but since the
highest-NPV combination has been selected, the amount of surplus funds is irrelevant to the selection of the
optimal investment schedule. Investing these surplus funds in a bank or in the money market would have an
NPV of zero.

31. Explain briefly the relationships between exchange rates and interest rates and exchange rates and inflation
rates.

Movements in exchange rates can be related to changes in interest rates and to changes in inflation rates. The
17
 relationship between exchange rates and interest rates is called interest rate parity, while the relationship
between exchange rates and inflation rates is called purchasing power parity.

Interest rate parity holds that the relationship between the spot exchange rate and the forward exchange rate
between two currencies can be linked to the relative nominal interest rates of the two countries. The forward
rate can be found by multiplying the spot rate by the ratio of the interest rates of the two countries. The
currency of the country with the higher nominal interest rate will be forecast to weaken against the currency of
the country with the lower nominal interest rate. Both the spot rate and the forward rate are available in the
current foreign exchange market, and the forward rate can be guaranteed by using a forward contract.

Purchasing power parity holds that the current spot exchange rate and the future spot exchange rate between
two currencies can be linked to the relative inflation rates of the two countries. The future spot rate is the spot
rate that occurs at the end of a given period of time. The currency of the country with the higher inflation rate
will be forecast to weaken against the currency of the country with the lower inflation rate. Purchasing power
parity is based on the law of one price, which suggests that, in equilibrium, identical goods should sell for the
same price in different countries, allowing for the exchange rate. Purchasing power parity holds in the longer
term rather than the shorter term and so is often used to provide long-term forecasts of exchange rate
movements, for example for use in investment appraisal.

32. Explain the meaning of the term ‘cash operating cycle’ and discuss the relationship between the cash
operating cycle and the level of investment in working capital.

The cash operating cycle is the average length of time between paying trade payables and receiving cash from
trade receivables. It is the sum of the average inventory holding period, the average production period and the
average trade receivables credit period, less the average trade payables credit period. Using working capital
ratios, the cash operating cycle is the sum of the inventory turnover period and the accounts receivable days,
less the accounts payable days.

The relationship between the cash operating cycle and the level of investment in working capital is that an
increase in the length of the cash operating cycle will increase the level of investment in working capital. The
length of the cash operating cycle depends on working capital policy in relation to the level of investment in
working capital, and on the nature of the business operations of a company.

Working capital policy - Companies with the same business operations may have different levels of investment
in working capital as a result of adopting different working capital policies. An aggressive policy uses lower levels
of inventory and trade receivables than a conservative policy, and so will lead to a shorter cash operating cycle.
A conservative policy on the level of investment in working capital, in contrast, with higher levels of inventory
and trade receivables, will lead to a longer cash operating cycle. The higher cost of the longer cash operating
cycle will lead to a decrease in profitability while also decreasing risk, for example the risk of running out of
inventory.

Nature of business operations - Companies with different business operations will have different cash operating
cycles. There may be little need for inventory, for example, in a company supplying business services, while a
company selling consumer goods may have very high levels of inventory. Some companies may operate
primarily with cash sales, especially if they sell direct to the consumer, while other companies may have
substantial levels of trade receivables as a result of offering trade credit to other companies.

33. Discuss the factors to be considered by a company in choosing to raise funds via a rights issue.

A rights issue raises equity finance by offering new shares to existing shareholders in proportion to the number
of shares they currently hold. Existing shareholders have the right to be offered new shares (the pre-emptive
18
 right) before they are offered to new investors, hence the term ‘rights issue’. There are a number of factors
which a company should consider.

Issue price - Rights issues shares are offered at a discount to the market value. It can be difficult to judge what
the amount of the discount should be.

Relative cost - Rights issues are cheaper than other methods of raising finance by issuing new equity, such as an
initial public offer (IPO) or a placing, due to the lower transactions costs associated with rights issues.

Ownership and control - As the new shares are being offered to existing shareholders, there is no dilution of
ownership and control, providing shareholders take up their rights.

Gearing and financial risk - Increasing the weighting of equity finance in the capital structure can decrease its
gearing and its financial risk. The shareholders of the company may see this as a positive move, depending on
their individual risk preference positions.

34. Explain the nature of a scrip (share) dividend and discuss the advantages and disadvantages to a company of
using scrip dividends to reward shareholders.

A scrip (or share) dividend is an offer of shares in a company as an alternative to a cash dividend. It is offered pro
rata to existing shareholdings. From a company point of view, it has the advantage that, if taken up by
shareholders, it will conserve cash, i.e. it will reduce the cash outflow from a company compared to a cash
dividend. This is useful when liquidity is a problem, or when cash is needed to meet capital investment or other
financing needs.

Another advantage is that a scrip dividend will lead to a decrease in gearing, whether on a book value or a
market value basis, because of the increase in issued shares. This decrease in gearing will increase debt capacity.
A disadvantage of a scrip dividend is that in future years, because the number of shares.
35. Briefly describe the benefits of a just-in-time (JIT) procurement policy.

Holding costs can be reduced by reducing the level of inventory held by a company. Holding costs can be
reduced to a minimum if a company orders supplies only when it needs them, avoiding the need to have any
inventory at all of inputs to the production process. This approach to inventory management is called just-in-
time (JIT) procurement.

The benefits of a JIT procurement policy include a lower level of investment in working capital, since inventory
levels have been minimised: a reduction in inventory holding costs; a reduction in materials handling costs, due
to improved materials flow through the production process; an improved relationship with suppliers, since
supplier and customer need to work closely together in order to make JIT procurement a success; improved
operating efficiency, due to the need to streamline production methods in order to eliminate inventory between
different stages of the production process; and lower reworking costs due to the increased emphasis on the
quality of supplies, since hold-ups in production must be avoided when inventory

36. Identify and discuss the factors to be considered in determining the optimum level of cash to be held by a
company.

The transactions need for cash - The amount of cash needed for the next period can be forecast using a cash
19
 budget, which will net off expected receipts against expected payments. This will determine the transactions
need for cash, which is one of the three reasons for holding cash.

The precautionary need for cash - Although a cash budget will provide an estimate of the transactions need for
cash, it will be based on assumptions about the future and will therefore be subject to uncertainty. The actual
need for cash may be greater than the forecast need for cash. In order to provide for any unexpected need for
cash, a company can include some spare cash (a cash buffer) in its cash balance. This is the precautionary need
for cash. In determining the optimal level of cash to be held, a company will estimate the size of this cash buffer,
for example from past experience, because it will be keen to minimise the opportunity cost of maintaining funds
in cash form.

The speculative need for cash - There is always the possibility of an unexpected opportunity occurring in the
business world and a company may wish to be prepared to take advantage of such a business opportunity if it
arises. It may therefore wish to have some cash available for this purpose. This is the speculative need for cash.
Building ‘a war chest’ for possible company acquisitions reflects this reason for holding cash.

The availability of finance - A company may choose to hold higher levels of cash if it has difficulty gaining access
to cash when it needs it. For example, if a company’s bank makes it difficult to access overdraft finance, or if a
company is refused an overdraft facility, its precautionary need for cash will increase and its optimum cash level
will therefore also increase.

37. Discuss why market value weighted average cost of capital is preferred to book value weighted average cost
of capital when making investment decisions.

Market values of different sources of finance are preferred to their book values when calculating weighted
average cost of capital (WACC) because market values reflect the current conditions in the capital market. The
relative proportions of the different sources of finance in the capital structure reflect more appropriately their
relative importance to a company if market values are used as weights. For example, the market value of equity
is usually much greater than its book value, so using book values for weights would seriously underestimate the
relative importance of the cost of equity in the weighted average cost of capital.

If book values are used as weights, the WACC will be lower than if market values were used, due to the
understatement of the contribution of the cost of equity, which is higher than the cost of capital of other
sources of finance. If book value WACC were used as the discount rate in investment appraisal, investment
projects would be accepted that would be rejected if market value WACC were used. Using book value WACC as
the discount rate will therefore lead to sub-optimal investment decisions. As far as the cost of debt is concerned,
using book values rather than market values for weights may make little difference to the WACC, since bonds
often trade on the capital market at or close to their nominal (par) value. In addition, the cost of debt is lower
than the cost of equity and will therefore make a smaller contribution to the WACC. It is still possible, however,
that using book values as weights may under- or over-estimate the contribution of the cost of debt to the WACC.

38. Discuss the attractions to a company of convertible debt compared to a bank loan of a similar maturity as a
source of finance.

Convertible debt is debt that, at the option of the holder, can be converted into ordinary shares. If not
converted, it will be redeemed like ordinary or straight debt on maturity. Convertible debt has a number of
attractions compared with a bank loan of similar maturity, as follows:

Self-liquidating - Provided that the conversion terms are pitched correctly and expected share price growth
occurs, conversion will be an attractive choice for bond holders as it offers more wealth than redemption. This
occurs when the conversion value is greater than the redemption value (if conversion and redemption are on
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 the same date), or when the conversion value is greater than the floor value on the conversion date (if
conversion is at an earlier date than the redemption date). If the debt is converted into ordinary shares, it will
not need to be redeemed, i.e. self-liquidation has occurred. A bank loan of a similar maturity will need to have
all of the capital repaid.

Lower interest rate - The interest rate on convertible debt will be lower than the interest rate on ordinary debt
such as a bank loan because of the value of the option to convert. The returns on fixed-interest debt will not
increase with corporate profitability, so debt providers will have a limited share of the benefits from the
investment of the funds they have provided. When debt has been converted, however, bond holders become
shareholders and will potentially have unlimited returns, or at least returns that are higher than the returns on
debt finance.

Increase in debt capacity on conversion - Gearing will increase with a bank loan for the time that the debt is
outstanding, and gearing will then return to its previous level when the bank loan has been paid off. Gearing also
increases when convertible debt is issued, but if conversion occurs, the gearing will fall not only because the
debt has been removed, but will fall even further because equity has replaced the debt. The capacity of the
company to service debt (debt capacity) will therefore be enhanced by conversion, compared to redemption of
a bank loan of a similar maturity.

More attractive than ordinary debt - It may be possible to issue convertible debt even when ordinary debt such
as a bank loan is not attractive to lenders, since the option to convert offers a little extra that ordinary debt does
not. This is the option to convert in the future, which can be attractive to optimists, even when the short- and
medium-term economic outlook may be poor.

39. Explain the different types of foreign currency risk faced by a multinational company.

Foreign currency risk can be divided into transaction risk, translation risk and economic risk.

Transaction risk - This is the foreign currency risk associated with short-term transactions, such as receiving
money from customers in settlement of foreign currency accounts receivable. The risk here is that the actual
profit or cost associated with the future transaction may be different from the expected or forecast profit or
cost. The expected profit on goods or service sold on credit to a foreign client, for example, invoiced in the
foreign currency, could be decreased by an adverse exchange rate movement. Transaction risk is therefore cash
exposure, since cash transactions are affected by it. This type of foreign currency risk is usually hedged.

Translation risk - This is the foreign currency risk associated with the consolidation of foreign currency
denominated assets and liabilities. Movements in exchange rates can change the value of such assets and
liabilities, resulting in unrealised foreign currency losses or gains when financial statements are consolidated for
financial reporting purposes. These gains and losses exist only on paper and do not have a cash effect.
Translation exposure is often referred to as accounting exposure. Translation exposure can be hedged using
asset and liability management, but hedging this type of foreign currency risk may be deemed unnecessary.

Economic risk - This is the foreign currency risk associated with longer-term movements in exchange rates. It
refers to the possibility that the present value of a company’s future cash flows may be affected by future
exchange rate movements, or that the competitive position of a company may be affected by future exchange
rate movements. From one point of view, transaction exposure is short-term economic exposure. All companies
face economic exposure and it is difficult to hedge against.
40. Discuss whether the dividend growth model or the capital asset pricing model offers the better estimate of
the cost of equity of a company.

The dividend growth model has several difficulties attendant on its use as a way of estimating the cost of equity.
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For example, the model assumes that the future dividend growth rate is constant in perpetuity, an assumption
that is not supported by the way that dividends change in practice. Each dividend paid by a company is the
result of a dividend decision by managers, who will consider, but not be bound by, the dividends paid in
previous periods. Estimating the future dividend growth rate is also very difficult. Historical dividend trends are
usually analysed and on the somewhat risky assumption that the future will repeat the past, the historic
dividend growth rate is used as a substitute for the future dividend growth rate. The model also assumes that
business risk, and hence business operations and the cost of equity, are constant in future periods, but reality
shows us that companies, their business operations and their economic environment are subject to constant
change. Perhaps the one certain thing about the future is its uncertainty.

It is sometimes said that the dividend growth model does not consider risk, but risk is implicit in the share price
used by the model to calculate the cost of equity. A moment’s thought will indicate that share prices fall as risk
increases, indicating that increasing risk will lead to an increasing cost of equity. What is certainly true is that the
dividend growth model does not consider risk explicitly in the same way as the capital asset pricing model
(CAPM). Here, all investors are assumed to hold diversified portfolios and as a result only seek compensation
(return) for the systematic risk of an investment. The CAPM represent the required rate of return (i.e. the cost of
equity) as the sum of the risk-free rate of return and a risk premium reflecting the systematic risk of an
individual company relative to the systematic risk of the stock market as a whole. This risk premium is the
product of the company’s equity beta and the equity risk premium. The CAPM therefore tells us what the cost of
equity should be, given an individual company’s level of systematic risk.

The individual components of the CAPM (the risk-free rate of return, the equity risk premium and the equity
beta) are found by empirical research and so the CAPM gives rise to a much smaller degree of uncertainty than
that attached to the future dividend growth rate in the dividend growth model. For this reason, it is usually
suggested that the CAPM offers a better estimate of the cost of equity than the dividend growth model.

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