BBPW3103 Financial Management I - Esept21 (CS)

BBPW3103
Financial Management I
Copyright © Open University Malaysia (OUM)

BBPW3103
FINANCIAL
MANAGEMENT I
Assoc Prof Dr Yusnidah Ibrahim
Faudziah Zainal Abidin
Norlida Abd Manab
Rusmawati Ismail
Zaemah Zainuddin

Fourth edition 2021 (CS)
Third edition 2019
Second edition 2013
First edition 2009
Developed by Centre for Instructional Design and Technology, OUM.

Copyright © Open University Malaysia (OUM), BBPW3103
All rights reserved. No part of this work may be reproduced in any form or by any means without
the written permission of the President of Open University Malaysia (OUM).
www.oum.edu.my

Table of Contents
Course Guide xiii–xviii
Topic 1 Introduction to Finance 1

1.1 Finance 2
1.2 Roles of a Financial Manager 3
1.3 Objectives of Financial Management 5
1.3.1 Maximising Profit 5
1.3.2 Maximising ShareholdersÊ Wealth 7
1.4 Agency Problems 8
1.5 Types of Business Organisations 9
1.6 Financial Market 12
Summary 17
Key Terms 18
Self-Test 1 18
Self-Test 2 19
Self-Test 3 20
Topic 2 Analysis of Financial Statements 22

2.1 Annual Report and Users of Financial Statements 23
2.2 Income Statement 26
2.3 Balance Sheet 28
2.3.1 Assets 30
2.3.2 Liabilities 32
2.3.3 OwnersÊ Equity or ShareholdersÊ Equity 33
2.3.4 Summary of Basic Accounting 34
2.4 Statement of Retained Earnings 35
2.5 Cash Flow Statement 36
2.5.1 Preparing Cash Flow Statement 37
2.5.2 Differentiating Cash Resources and Usage 41
2.6 Financial Ratio Analysis 44
2.6.1 Income Statement 46
2.6.2 Balance Sheet 47
2.7 Liquidity Ratio 48
2.7.1 Net Working Capital 48
2.7.2 Current Ratio 49
2.7.3 Quick Ratio 50

iv  TABLE OF CONTENTS
2.8 Asset Management Ratio 51

2.8.1 Accounts Receivable Turnover 51
2.8.2 Average Collection Period 52
2.8.3 Inventory Turnover 53
2.8.4 Average Inventory Sales Period 54
2.8.5 Non-current Asset Turnover 55
2.8.6 Total Asset Turnover 55
2.9 Leverage Ratio 56
2.9.1 Debt Ratio 57
2.9.2 Debt-equity Ratio 58
2.9.3 Equity Multiplier 58
2.9.4 Interest Coverage Ratio 59
2.10 Profitability Ratio 60
2.10.1 Gross Profit Margin 60
2.10.2 Net Profit Margin 61
2.10.3 Operating Profit Margin 62
2.10.4 Return on Assets 62
2.10.5 Return on Equity 63
2.10.6 Earnings Per Share 63
2.11 Market Value Ratio 64
2.11.1 Price Earnings Ratio 64
2.11.2 Dividend Yield Ratio 65
2.12 Conducting a Complete Ratio Analysis 66
2.12.1 DuPont Analysis 66
2.12.2 Summarising All Financial Ratios 69
2.13 Weaknesses of Financial Ratios 71
Summary 72
Key Terms 73
Self-Test 1 74
Self-Test 2 76
Self-Test 3 79
Self-Test 4 80
Self-Test 5 80
Self-Test 6 81
Self-Test 7 83

TABLE OF CONTENTS  v
Topic 3 Time Value of Money 87

3.1 Concept of Compounding and Future Value 88
3.1.1 Time Line 88
3.1.2 Compound Interest 89
3.1.3 Calculation of Future Value Using Schedule or Table 91
3.1.4 Graphical Illustration of Future Value 92
3.2 Concept of Discounting and Present Value 94
3.2.1 Calculation of Present Value 95
3.2.2 Calculation of Present Value (Principal) 97
using Schedule or Table
3.2.3 Graphical Illustration of Present Value 98
3.3 Future and Present Values of a Single Cash Flow 100
3.4 Future and Present Values of a Series of Cash Flow 100
3.4.1 Annuity 101
3.4.2 Non-uniform Cash Flow 109
3.4.3 Perpetuity 114
3.5 Compounding and Discounting More Than Once a Year 115
3.6 Continuous Compounding and Discounting 117
Summary 118
Key Terms 119
Self-Test 1 119
Self-Test 2 119
Self-Test 3 120
Self-Test 4 120
Self-Test 5 120
Self-Test 6 121
Self-Test 7 121
Self-Test 8 121
Topic 4 Valuation of Securities 123

4.1 Valuation 124
4.1.1 Definitions of Value 124
4.1.2 Valuation Process 125
4.1.3 Basic Model of Valuation 127
4.2 Bonds 128
4.2.1 Characteristics of Bonds 129
4.2.2 Rating of Bonds 130
4.2.3 Types of Bonds 131
4.3 Valuation of Bonds 132
4.3.1 Basic Valuation of Bonds 133
4.3.2 Value of Bonds and Required Rate of Return 136
4.3.3 Payment of Interest Twice a Year 139

vi  TABLE OF CONTENTS
4.4 Yield to Maturity (YTM) 141

4.5 Relationship between Value and YTM 144
4.5.1 Changes to Required Returns 145
4.6 Ordinary Shares 146
4.6.1 Characteristics of Ordinary Shares 146
4.7 Valuation of Ordinary Shares 148
4.7.1 Valuation of Ordinary Shares – One Holding Period 149
4.7.2 Valuation of Ordinary Shares – Multiple Holding 151
Periods
4.7.3 Required Rate of Return for Ordinary Shares 158
4.8 Preference Shares 160
4.8.1 Characteristics of Preference Shares 161
4.9 Valuation of Preference Shares 163
4.9.1 Expected Rate of Return for Preference Shares 164
Summary 165
Key Terms 166
Self-Test 1 167
Self-Test 2 167
Self-Test 3 167
Self-Test 4 167
Self-Test 5 170
Self-Test 6 171
Topic 5 Risk Analysis 174

5.1 Definition of Risk and Return 175
5.2 Use of Statistics to Determine Risk and Return 176
5.2.1 Random Variable 176
5.2.2 Probability and Its Distribution 176
5.2.3 Mean (Expected Return) 179
5.2.4 Variance and Standard Deviation 180
5.2.5 Coefficient of Variation 180
5.2.6 Covariance 181
5.2.7 Correlation Coefficient 181
5.3 Measuring the Expected Return and Risk of Investing 182
in One Security
5.4 Reducing Risk through Diversification 184
5.4.1 Principle of Systematic and Unsystematic Risk 184
5.4.2 Measuring the Expected Return and Risk of 185
Security Portfolio
5.4.3 Capital Asset Pricing Model (CAPM) 187
5.4.4 Measuring Systematic Risk (Beta) 189
5.4.5 Security Market Line 191

TABLE OF CONTENTS  vii
Summary 194
Key Terms 195
Self-Test 1 195
Self-Test 2 196
Self-Test 3 196
Topic 6 Criteria of Capital Budgeting 200

6.1 Capital Budgeting 201
6.2 Payback Period (PBP) 201
6.2.1 Calculation of PBP 201
6.2.2 Application of PBP 204
6.2.3 Advantages and Disadvantages of PBP 205
6.3 Net Present Value (NPV) 207
6.3.1 Calculation of NPV 207
6.3.2 Application of NPV 209
6.3.3 Advantages and Disadvantages of NPV 210
6.4 Profitability Index (PI) 211
6.4.1 Calculation of PI 211
6.4.2 Application of PI 211
6.4.3 Advantages and Disadvantages of PI 212
6.5 Internal Rate of Return (IRR) 212
6.5.1 Calculation of IRR 212
6.5.2 Application of IRR 215
6.5.3 Advantages and Disadvantages of IRR 216
Summary 217
Key Terms 217
Self-Test 1 218
Self-Test 2 218
Self-Test 3 219
Self-Test 4 220
Self-Test 5 220
Self-Test 6 221

viii  TABLE OF CONTENTS
Topic 7 Cash Flow of Capital Budgeting 224

7.1 Guidelines in Estimating Cash Flow for Capital Budgeting 225
7.2 Initial Outlay (IO) 227
7.3 Operating Cash Flow (OCF) 233
7.4 Terminal Cash Flow (TCF) 236
7.5 Application of Cash Flow for Capital Budgeting in 238
Decision-Making
Summary 239
Key Terms 241
Self-Test 1 241
Self-Test 2 242
Self-Test 3 242
Topic 8 Cost of Capital 245

8.1 Definition for Cost of Capital 246
8.1.1 Financing Policy and Cost of Capital 246
8.2 Determining the Cost of Capital for Each Component 247
of Capital Resources
8.2.1 Cost of Debt 248
8.2.2 Cost of Preference Shares 251
8.2.3 Cost of Ordinary Shares 252
8.3 Weighted Average Cost of Capital (WACC) 255
Summary 257
Key Terms 258
Self-Test 1 258
Self-Test 2 258
Self-Test 3 258
Self-Test 4 259
Topic 9 Financial Planning 262

9.1 Financial Planning 263
9.2 Cash Budget 263
9.3 Pro Forma Income Statement 267
Summary 272
Key Terms 272
Self-Test 1 273
Self-Test 2 274
Reference 274

TABLE OF CONTENTS  ix
Topic 10 Working Capital Management 275

10.1 Importance of Working Capital Management 276
10.1.1 Net Working Capital 277
10.1.2 Current Assets 277
10.2 Strategies of Working Capital Management 279
10.2.1 Moderate Approach 280
10.2.2 Aggressive Approach 280
10.2.3 Conservative Approach 281
10.3 Types of Short-term Financing 282
10.3.1 Spontaneous Financing 282
10.3.2 Negotiated Financing 283
10.4 Cash Conversion Cycle 289
10.5 Management of Marketable Securities 291
10.5.1 Factors in Choosing Marketable Securities 291
10.5.2 Types of Marketable Securities 292
10.6 Balance between Risk-return in Cash Management 293
10.7 Management of Accounts Receivable 294
10.7.1 Accounts Receivable 294
10.7.2 Credit Policy 295
10.7.3 Credit Control 298
10.7.4 Balance between Risk-return in Management 300
of Account Receivable
10.8 Inventory Management 301
10.8.1 Types of Inventory 302
10.8.2 Objective of Inventory Management 303
10.8.3 Cost Related to Inventory 303
10.8.4 Economic Order Quantity (EOQ) Model 306
10.8.5 Balance between Risk-return in 312
Inventory Management
Summary 313
Key Terms 314
Self-Test 1 314
Self-Test 2 315
Self-Test 3 316
Self-Test 4 317
Self-Test 5 317
Self-Test 6 317
Self-Test 7 317
Self-Test 8 317
Self-Test 9 318
Self-Test 10 318

x  TABLE OF CONTENTS
Answers 320
Attachments 371

"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
COURSE GUIDE
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"
"

"
"
"
"
"
"
"
"
"
"
" Copyright © Open University Malaysia (OUM)

COURSE GUIDE  xiii
COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course materials. It also suggests the amount of time you are likely to spend
in order to complete the course successfully. Please keep on referring to the
Course Guide as you go through the course materials as it will help you to
clarify important study components or points that you might miss or overlook.
INTRODUCTION
BBPW3103 Financial Management I is one of the courses offered at Open
University Malaysia (OUM). This course is worth 3 credit hours and should be
covered over 8 to 15 weeks.
COURSE AUDIENCE
This course is offered to all learners taking the Bachelor of Business Administration
(BBA), Bachelor of Marketing (BM), Bachelor of Management (BIM), Bachelor of
Human Resource Management (BHRM) and Bachelor of Accounting (BAC) with
Honours programmes. This module aims to impart an overview of finance related
issues.
As an open and distance learner, you should be able to learn independently

and optimise the learning modes and environment available to you. Before you
begin this course, please ensure that you have the correct course materials,
understand the course requirements, and know how the course is conducted.

xiv  COURSE GUIDE
STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for
every credit hour. As such, for a 3 credit hour course, you are expected to
spend 120 study hours. Figure 1 shows the student learning time (SLT).
Figure 1: Student Learning Time
COURSE LEARNING OUTCOMES

By the end of this course, you should be able to do the following:
1. Explain relevant theories, concepts and key areas of finance.
2. Analyse the various aspects of finance including investment, financing and

planning in achieving financial management goals.
3. Interpret company and individual financing and investment decisions.

COURSE GUIDE  xv
COURSE SYNOPSIS
This course is divided into 10 topics. The synopsis for each topic is listed
as follows:
Topic 1 introduces the topic of finance, the roles of the financial managers in
companies as well as the main objectives of companies to maximise the
shareholdersÊ wealth. Besides that, the types of business entities, agency problems
and financial institutions will also be discussed. This topic also explains the main
financial markets, that is namely the money market and capital market.
Topic 2 discusses the usage of financial ratio analysis such as the liquidity ratio,
asset management, leverage, profitability and market value ratio. Besides that, this
topic also touches on the DuPont analysis and the overall financial analysis.
Topic 3 exposes learners to the basic concept for time value of money, which is the
concept of present value and future value. You will learn the application and
equation for the time value of money for single cash flow and net cash flow,
annuity, perpetuity and derivation cash flow. The discussion will also include
compounding and discounting methods that occur more than once a year and
continuously.
Topic 4 discusses the valuation of bonds and the valuation of ordinary shares. The
topic of discussion will touch and examine the characteristics, ratings, types and
valuation of bonds, yield upon maturity and the connection between the value and
yield upon maturity. The discussion topic will also focus on the characteristics of
ordinary shares, dividend valuation models in ordinary shares, characteristics and
valuation of preferences shares.
Topic 5 introduces you to the relationship between the risk and return from the
financial theories perspective. The discussion covers the definition of risk and
return from the investorsÊ perspective, the usage of statistics in ascertaining the
level of risk and return and the measurement of risk and return. The basic
principles of systematic and unsystematic risks and the capital asset pricing model
or CAPM model (model that explains the relationship between risk and return) are
also discussed.
Topic 6 discusses the four techniques of capital budgeting, which are the payback
period, net present value, profitability index and internal rate of return.
Topic 7 explains how the cash flow for capital budget is estimated and applied in
decision-making for long-term investments. The calculation of initial outlay,
operating cash flow and terminal cash flow are also explained.

xvi  COURSE GUIDE
Topic 8 discusses the cost of capital. This topic touches on the definition for cost of
capital, cost of long-term debt, cost of ordinary shares, cost of preference shares
and weighted average cost of capital.
Topic 9 touches on financial planning, cash budget and pro-forma income

statement.
Topic 10 explains the working capital management, management of marketable

securities, accounts receivable and inventory.
TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
Self-Check: This component of the module is included in strategic locations

throughout the module. It may be located after one subtopic or a few subtopics.
It usually comes in the form of a question. When you come across this component,
reflect on what you have already learnt thus far. By attempting to answer the
question, you should be able to gauge how well you have understood the
subtopic(s). Most of the time, the answers to the questions can be found directly
in the module itself.
Activity: Similar to Self-Check, the Activity component is also placed at various

locations or junctures throughout the module. This component may require you to
answer questions, explore short case studies or conduct an observation or research.
It may even require you to evaluate a given scenario. When you come across an
Activity, you should try to reflect on what you have gathered from the module
and apply it to real situations. You should, at the same time, engage in Higher
Order Thinking skills (HOTs) i.e. analysing, synthesising and evaluating instead
of only recalling and defining.

COURSE GUIDE  xvii
Summary: You will find this component at the end of each topic. It summarises
various important parts of each topic and helps you to recap the whole topic.
By going through the summary, you should be able to gauge your knowledge
retention level. Should you find points in the summary that you do not fully
understand, it would be a good idea for you to revisit the details in the module.
Key Terms: This component can be found at the end of each topic. You should
go through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
References: A list of relevant and useful textbooks, journals, articles, electronic

contents and sources can be found in this section. The list may appear in a few
locations such as in the Course Guide (in the References section), at the end of
every topic or at the back of the module. You are encouraged to read or refer to
the suggested references to obtain additional information and enhance your
overall understanding of the course.
PRIOR KNOWLEDGE
There is no prior knowledge needed.
ASSESSMENT METHOD
Please refer to myINSPIRE.
REFERENCES
Emery, D. R., Finnerty, J. D., & Stone, J. D. (1997). Principles of financial management
(1st ed.). Upper Saddle River, NJ: Prentice Hall.
Gitman, L. J. (2008). Principles of managerial finance (12th ed.). Boston, MA: Addison
Wesley.
Lasher, W. R. (2008). Practical financial management (5th ed.). Mason, OH: South-
Western Thomson Learning.
Martin, J. D., Petty, J. W., Scott, D. F. Jr., & Keown, A. J. (1998). Basic financial
management (8th ed.). Englewood Cliffs, NJ: Prentice Hall.

xviii  COURSE GUIDE
TAN SRI DR ABDULLAH SANUSI (TSDAS)

DIGITAL LIBRARY
The TSDAS Digital Library has a wide range of print and online resources
for learners. This comprehensive digital library, which is accessible through the
OUM portal, provides access to more than 30 online databases and several of
them are shown in Figure 2. As an OUM learner, you are encouraged to make
full use of the resources available through this library.
Figure 2: Among the Online Databases Available at TSDAS Digital Library

Topic  Introduction to
Finance
1
LEARNING OUTCOMES
By the end of the topic, you should be able to:
1. Identify the areas of finance and its importance to businesses;
2. Explain four main activities of a financial manager in a company;
3. Discuss the main objective of financial management, that is to
maximise the wealth of the shareholders;
4. Examine the relationship of an agency;
5. Elaborate on three types of business organisations, which are sole
proprietorship, partnership and company; and
6. Explain the characteristics of financial market.
 INTRODUCTION
This topic introduces the area of finance and discusses the role of financial
managers in companies. Besides that, the main objective and mission of a company
in maximising the wealth of the shareholders as well as the different types of
business entities will also be discussed. Next, we will cover the problems that
might affect agencies due to the existence of two different parties namely, the
manager and the owner in achieving their separate objectives. At the end of this
topic, the financial institutions will be discussed in general.

2  TOPIC 1 INTRODUCTION TO FINANCE
1.1 FINANCE
As you know, nearly all rational individuals and organisations will try to obtain
profit or money as much as possible and later, spend or invest the money for
specific purposes. Finance is closely related to these processes, institutions,
markets and instruments that are involved in the transfer of money between
individuals and businesses.
Finance can be defined as an art and science in managing money. Financial

decisions are made based on basic financial concepts, principles and theories.
These decisions can be divided into three main categories as follows:
(a) Investment decisions related to assets;
(b) Financing decisions related to liabilities and equity shareholders; and
(c) Management decisions related to operating decisions and daily financial

decisions of the company.
Businesses are involved in numerous dealings and each day, the finance manager
will face a variety of questions such as:
(a) Should the company carry out the project?
(b) Will the investment be successful?
(c) How to fund the investment?
(d) Which is the best funding decision? Getting a loan from a bank or issuing
shares?
(e) Does the company have enough cash to meet its daily operations?
(f) What is the level of inventory that needs to be kept?
(g) To which customer should the company offer credit?
(h) What is the optimal dividend policy?
(i) Should the takeover be continued?
The success or failure of a business depends on the quality of the financial decision
made. Each decision made will then have important financial implications.
It is very important for those who do not have vast experience in the area of finance
such as marketing managers, production managers and human resource managers
to understand finance in order for them to perform their duties and responsibilities
better.
TOPIC 1 INTRODUCTION TO FINANCE  3
For example, marketing managers should understand how marketing decisions

can influence and be influenced by the levels of inventory, surplus capacity and
the availability of funds. Meanwhile, accountants should understand how
accounting data can be used in corporate planning and also as a guide to investors
for investing. Therefore, financial implications exist in almost all the business
decisions and managers from other departments should be concerned with the
financial status and issues of the departments and the organisation as a whole.
ACTIVITY 1.1
1. Explain the best way for a finance manager to establish good

relationship with the managers from other departments to ensure
the financial status of the company is always within control.
2. What are the advantages and disadvantages of this bilateral

relationship?
Share your answers with your coursemates in the myINSPIRE online

forum.
1.2 ROLES OF A FINANCIAL MANAGER

The financial manager plays an important role in the operations and success of a
business. The responsibility of a financial manager is not only to obtain and use
funds, but also to ensure that the fund value and companyÊs profit be maximised.
Besides that, a financial manager must make several important decisions
especially in the investment of companyÊs assets and how these assets can be
financed. Meanwhile, the accountant must also think of the best way to manage
the companyÊs resources such as employees, machines, buildings and equipment.
When assets of the company are managed efficiently, the value of the company
can be maximised. Figure 1.1 shows the four main roles of a financial manager.

Figure 1.1: Four main roles of a financial manager
(a) Making Decisions in Short-term and Long-term Investments and Financing

A company that grows rapidly will show a sudden increase in sales.
This increase in sales will require additional investments in the form
of inventory and non-current assets such as industrial plant and equipment.
Therefore, the financial manager must determine the type and quantity of
assets that must be bought in the short-term and long-term. At the same time,
the financial manager must also think of the best way to fund the investment
in assets. For example, does the company have adequate funds to purchase
the assets? Would the company require loans or equities? What are the
implications of having short-term or long-term debts?
(b) Making Financial Planning and Forecasts

A finance manager is supposed to make plans for the companyÊs future.
Therefore, the financial manager must cooperate with managers from other
departments to enable the overall companyÊs strategic planning to be
implemented together.
(c) Dealings in Financial Market

One of the roles of the financial manager is dealing in the money market and
the capital market. Financial managers must be updated in the development
of the financial market, to enable financing decisions to be made efficiently
and effectively.
(d) Control and Coordination

A financial manager should interact and cooperate with other managers
to ensure that the company is operating efficiently. The control and
coordination conducted by the financial manager is important, especially in
large companies that have many departments to enable the organisationÊs
objectives to be achieved together.

ACTIVITY 1.2
If you were assigned as a financial manager, what are the main

responsibilities that you will face in strengthening the financial position
of your organisation?
Share your thoughts with your coursemates in the myINSPIRE online

forum.
1.3 OBJECTIVES OF FINANCIAL

MANAGEMENT
Making effective financial decisions requires a person to understand the objectives
that must be achieved in the company. What are the key objectives in the decision-
making process? What are the decisions that must be achieved by the management
that can provide impact to the owners of the company? In this case, the objective
of the financial manager is to achieve the objectives of the companyÊs owners,
which are its shareholders.
ACTIVITY 1.3
Why is the objective of a company to maximise the shareholdersÊ

wealth and not maximise profit? Post your answers on the myINSPIRE
online forum.
1.3.1 Maximising Profit

Some parties state that the objective of a company is to maximise profit. To achieve
that objective, the financial manager must only take actions that are expected to
contribute in generating profits. Therefore, for every alternative action that can be
made, the financial manager will choose the action plan that can generate the
highest profit.
The companyÊs profit is measured by the earnings per share, that is the profit of
each ordinary share. The earning per share is obtained by dividing the net profit
with the number of ordinary shares issued.
Net Profit
Earnings Per Share 
Ordinary Shares Issued (Units)
However, to maximise profit is not an accurate objective and is rarely used as a

companyÊs objective due to these three reasons:
(a) Cash Inflow and Outflow

In calculating companyÊs profit, all expenses whether in cash (rent, utilities
and others) or non-cash (bad debts, depreciation and loss on asset disposal)
will be taken into account to be matched with the current income in the
accounting period.
This does not illustrate the cash flow obtained during that period. To obtain
a true picture of the companyÊs return, items that do not involve cash flow,
especially depreciation, bad debts and loss on assets disposal must be added
again to the net profit.
(b) Timing of Returns

The objective of maximising profits disregards the timing of returns from a
project. Assuming the company can carry out either project A or project B, as
follows (refer to Table 1.1):
Table 1.1: Profits of Project A and B
Profits
Project
Year 1 Year 2
Project A RM100,000 –0–
Project B –0– RM 100,000
Both the projects show the same profit. If we follow the objective of
maximising profits, both projects are equally good. However, this is
incorrect. In actual fact, Project A is the better project as the returns or the
amount of RM100,000 is received earlier compared to Project B. Thereafter,
this amount can be invested to obtain additional returns. For example, if
we deposit RM100,000 received through Project A in a bank that gives an
interest rate of five per cent, this amount will become RM105,000 after one
year (RM100,000  0.05). This shows that this amount will exceed the
RM100,000 that is obtained through Project B.
(c) Risks
The objective of maximising profits also disregards risks. Risk is defined as
the probability of a result being different from what is expected. One basic
concept in finance states that there exists a relationship between risks and
returns. High returns can only be achieved by bearing higher risk.

A lot of financial decisions made by financial managers involved the

relationship between risks and returns. The higher the risks are, the higher
the expected returns from the action taken will be. For example, a company
that keeps low inventory stock will expect higher returns even with a
possibility of running out of inventory stock. Therefore, in making decision,
the manager will look at the relationship between risks and returns and make
decision based on the assumption that the companyÊs objective is to
maximise shareholdersÊ wealth. The owners of the company will then
evaluate the decisions made and this evaluation will be reflected by changes
of share prices in the market.
Companies that balance the profits and risks can be seen as consistent with
the objective in maximising the shareholdersÊ wealth. By defining the
companyÊs objective from the aspect of the sharemarketÊs value, it will reflect
the managementÊs efforts in optimising between risks and profits. The
manager should find the combination between profits and risks that can
maximise shareholdersÊ wealth.
1.3.2 Maximising Shareholders’ Wealth

The objective of a company from the financial context is to maximise the value of
the company for its owner that is by maximising the shareholdersÊ wealth.
ShareholdersÊ wealth is reflected by the companyÊs share price in the market. This
objective is more appropriate compared with just maximisation of profits as it
takes into account the impacts of all financial decisions. Shareholders will react to
poor investment decisions by causing the companyÊs share price to fall and in
contrary, they will react to good investment decisions by increasing the companyÊs
share price.
Maximising shareholdersÊ wealth means that the management is supposed to

maximise the present return value that is expected to be received by its
shareholders in the future. It is measured by the ordinary share priceÊs market
value. The share price reflects the share value according to the opinion of the
owners. It takes into account the uncertainties or risks, timing and other important
factors to the owners.
Therefore, all problems related to the objective in maximising profits can be

overcome when the manager prioritised the objective in maximising shareholdersÊ
wealth. This objective also enables the decision scenario to be made by taking into
account any complications and difficulties in the real business world. Financial
managers must prioritise the companyÊs shareholders as they are the actual
owners of the company.

ACTIVITY 1.4
In your opinion, besides investing money, what are the roles and
responsibilities of shareholders in the companyÊs operations? Are they
only interested in profit taking or having absolute authority over a
particular company?
Post your answers on the myINSPIRE online forum.
1.4 AGENCY PROBLEMS

The relationship of agency occurs when one or more individuals (principal) hires
another individual (agent) to perform services on behalf of the principal. In the
relationship of agency, the principal normally entrusts the decision making
authority to the agent. In financing, the important relationship of agency is
between the shareholders (as the actual owners of the company) with the manager.
The objective in maximising shareholdersÊ wealth can determine how the financial
decisions should be made. However, in practice, not all decisions made by the
manager are consistent with that objective. The companyÊs efforts in maximising
shareholdersÊ wealth are obstructed by social obligations. Problems also arise
when more attention are given to fulfil the managersÊ interest than the
shareholdersÊ interest. Therefore, there might be deviations from the objective in
maximising shareholdersÊ wealth and the real objective pursued by the manager.
This is known as agency problems. The differences in objective occur because of
the separation of ownership and control in the company.
The separation of ownership and control has caused managers to pursue their own
selfish objectives. They would no longer maximise the ownersÊ objective but
instead, the managers adopt a self-sufficient attitude or only attempt to obtain a
moderate level of achievement, and at the same time, try to maximise their own
interest. They are more focused on their own position and job security. They will
try to limit or minimise the risks borne by the company as unsatisfactory outcome
might result in them being terminated or the company becoming bankrupt.
To avoid or minimise agency problems, the companyÊs owners will have to bear
the costs of agency and to control the actions of the managers. The company will
offer various incentives to motivate the managers to act in the best interest of the
shareholders. Among the steps that can be taken include providing compensation

or incentives based on the companyÊs achievement, threats of termination and

threats of company takeover by another company due to administrative
weaknesses.
SELF-CHECK 1.1
State the differences that might exist between the objectives of the
companyÊs managers with the board of directors or shareholders.
1.5 TYPES OF BUSINESS ORGANISATIONS

Three important types of business organisations are (refer to Figure 1.2):
Figure 1.2: Types of business organisations
Let us discuss each type of the business organisations in detail.
(a) Sole Proprietorship

Sole proprietorship is a business owned by one individual. The
establishment of a sole proprietor business is simple; an individual only
needs to start his businessÊ operation. However, the business must be
registered and acquired a business licence from the Registrar of Businesses.
The capital resources are normally acquired from the ownerÊs savings, loans
from family members and friends or from the bank. The owner owns all the
assets and bears all the business liabilities. The liabilities of a sole proprietor
are unlimited. This means that if the business fails to pay its debts to its
creditors, the owner will have to use his own property to settle the business
debts.

The advantages and disadvantages of a sole proprietorship are explained in

Table 1.2:
Table 1.2: Advantages and Disadvantages of a Sole Proprietorship
Advantages Disadvantages
 Business is simple to establish.  Rather difficult for organisations
 Cost to establish the business is low. of sole proprietors to obtain huge
capital.
 Business is not governed by several
regulations.  BusinessÊ owners have unlimited
liabilities on the businessÊ debts.
 Profit of the business is not taxable.
Income is only subject to personal  The existence of sole proprietors is
tax. not permanent. It will end upon
the death of the businessÊ owner.
 The financial status can be kept
confidential.
(b) Partnership
Partnership is a business operated by two or more partners. The partnership
can be made in writing or verbally. If the partnership is made verbally, the
Partnership Act 1961 will be relevant.
There are two types of partnership:

(i) General partnership; and
(ii) Limited partnership.
In general partnership, all partners have unlimited liabilities. This means that
if the business fails to pay its debts to its creditors, all partners must settle
those debts by using their own personal property. The liabilitiesÊ obligation
might be according to the percentage of ownership among the partners.
In limited partnership, there would be several partners with liabilities

limited to the capital invested into the business. However, there must be at
least one partner with unlimited liability. Partners with limited liability
might contribute only the capital and are not involved in managing the
business.
From taxation aspect, profits from partnerships will be taxed based on

the individual income tax. A partnership can be dissolved if one of the
partnersÊ retreats, passes away or becomes bankrupt.

The advantages and disadvantages of a partnership businesses are explained

in Table 1.3:
Table 1.3: Advantages and Disadvantages of a Partnership
 A partnership is easily formed and  Partnership can be dissolved
the cost of formation is low. upon the death, withdrawal or
 More capital can be acquired bankruptcy of one of the partners.
compared to the sole proprietor  The decision-making process will be
business. rather difficult compared to the sole
 Profits from business will only be proprietor as it must be referred with
subject to individual income tax. consent obtained from the other
partners.
 Partnership combines a variety of
expertise and skills of the partners.  Partners have unlimited liabilities.
Personal assets can be claimed by
 BusinessÊ risks and liabilities can creditors to settle business debts.
be shared among the partners.
 Business risks must be borne by
all partners. A mistake made by one
partner will bind the other partners.
(c) Company
Company is a business entity that exists separately from its owners. Under
the Companies Act 1965, a company is a separate legal entity from the legal
perspective, capable of owning assets, bear liabilities, have the authority to
sue other parties and can be sued by other parties. To incorporate a company,
registration must be made with the Registrar of Companies and is governed
by the Companies Act, such as the preparation of Memorandum of
Understanding and Articles of Association documents.
A company can either be incorporated as a private limited company

(Sendirian Berhad) or public limited company (Berhad). For a private limited
company, the number of shareholders are limited to 50 people only, while
the number of shareholders for a public limited company is unlimited.
The liabilities of shareholders or the owner of the company is limited, that is

if the company suffered losses, the ownerÊs liability is limited to the total
capital invested into the business. There is segregation between the
ownership with management in a public limited company. The owners of
the company are the shareholders but the management of the company are
the people paid with salaries to manage the company.

The advantages and disadvantages of a company are described in Table 1.4:
Table 1.4: Advantages and Disadvantages of a Company
 Owners have their liabilities limited  The incorporation of a company

based on the capital contributed. business is difficult. The business
 Can grow more easily as it has the is governed by several
opportunity to enter the financial regulations.
market.  Require larger capital to start the
 Ownership can be easily transferred. business.
 The lifetime of the business is  Being taxed twice. This means the
continuous. Business does not end companyÊs profits are subject to
with the death of the owner. corporate tax, while dividends
distributed to owners are subject
 Easier to obtain a bigger capital. to personal tax.
ACTIVITY 1.5
A business incorporated can be in the form of sole proprietorship,

partnership or company. If you plan to start a business, which type of
business would you choose? Why?

forum.
1.6 FINANCIAL MARKET

Business firms, individuals and government bodies need to obtain funds.
Assuming Tenaga Nasional Berhad (TNB) expects an increase in electricity
demands in the northern Peninsular Malaysia and TNB decides to build a new
electrical plant. As TNB does not have huge funds to finance the construction of
the plant that cost RM2 billion, the firm is forced to obtain funds from the financial
market. It is the same for Mr. Haron, the owner of a supermarket who plans to
open a new supermarket. He needs to think of the best way to fund that project.
TNB and Mr. Haron can obtain the financing of their projects from the financial
market.

Financial market is the intermediary that connects the capital depositors with
borrowers in the economy. There are two main financial markets:
(a) Money market; and
(b) Capital market.
The main characteristic that differentiates money market from capital market is
the maturity period of the traded securities.
(a) Money Market

Money market is the market that deals with the selling and buying of short-
term securities that have maturity periods of one year or less. Securities in
the money market usually have low default risk. Default risk means the risk
of losses that must be borne by the securitiesÊ holders if the securitiesÊ issuers
delay or are unable to make their interest and/or principal payments issued
by them. Money marketsÊ securities can be easily sold by the securitiesÊ
holders due to the short-term maturity period and low risk. These securities
usually do not require assets as collateral because of its low default risk.
Among the securities in money markets are government treasury bills,
commercial notes, deposit certificates and bankers acceptance.
(b) Capital Market

Capital market is the market that deals with the selling and buying of long-
term securities that have maturity periods of more than one year. These
securities are more risky compared to the securities in the money markets
due to its long-term nature. It is a source for long-term funding and is
commonly used by companies to make capital investments. The default risks
are also higher due to its longer maturity period. Several main securities
available in the capital market are bonds, preference shares and ordinary
shares.

These long-term securities are traded in two types of markets, the main
market and the ACE market (refer to Table 1.5):
Table 1.5: Main Market versus ACE Market
Aspect Main Market ACE Market

Objective  For established companies with  An alternative market
track record. for companies with
growth potential.
Mode of  Profit test  No minimum operating
listing track record or profit
 Uninterrupted profit after
requirement.
tax („PAT‰) of three to five
full financial years („FY‰),
with an aggregate of a least
RM20 million; and
 PAT of at least RM6 million
for the recent full FY.
 Market capitalisation test

 A total market capitalisation
of at least RM500 million
upon listing; and
 Incorporated and generated
operating revenue for at
least one full FY prior to
submission.
 Infrastructure project
corporation test
 Must have the right to build
and operate an
infrastructure project in or
outside Malaysia, with
project costs of not less than
RM500 million; and
 The concession or licence for
the infrastructure project has
been awarded by a
government or state agency,
in or outside Malaysia, with
remaining concession or
licence period of at least 15
years.

Public spread  At least 25 per cent of the  At least 25 per cent of the
companyÊs share capital; and companyÊs share capital; and
 Minimum of 1,000 public  Minimum of 200 public
shareholders holding not less shareholders holding not
than 100 shares each. less than 100 shares each.
Bumiputera  Allocation of 50 per cent of  No requirement upon initial
equity the public spread listing.
requirement* requirement to Bumiputera
investors on best effort basis.  Allocation on best effort
basis of 12.5 per cent of the
enlarged issued and paid-up
share capital to Bumiputera
investors:
 Within one year after
achieving the Main
Market profit track
record; or
 Five years after being
listed on ACE Market,
whichever is the earlier.
Sponsorship  Not applicable.  Engage a sponsor to assess
the suitability for listing; and
 Sponsorship is required for
at least three years post
listing.
Core  An identifiable core business  Core business should not be
business which it has majority holding investment in other
ownership and management listed companies.
control; and
 Core business should not be

holding investment in other
listed companies.
Management  Continuity of substantially  Continuity of substantially
continuity the same management for at the same management for at
and least three full FY prior to least three FY prior to
capability submission; and submission or since its
incorporation (if less than
 For market capitalisation test, three full FY).
since the commencement of
operations (if less than three
full FY).

Financial  Sufficient level of working  Sufficient level of working

position and capital for at least 12 months; capital for at least 12
liquidity months.
 Positive cash flow from the
operating activities for listing
via profit test and market
capitalisation test; and
 No accumulated losses based
on its latest audited balance
sheet for listing via profit test.
Moratorium  PromotersÊ entire  PromotersÊ entire
on shares shareholdings for six months shareholdings for six months
from the date of admission; from the date of admission;
and and
 Subsequently, at least 45 per
 Subsequent sell down with cent must be retained for
conditions for companies another six months and
listed under Infrastructure thereafter, further sell down
Project Corporation test. is allowed on a staggered
basis over a period of three
years.
Transaction  Must be based on terms and  Must be based on terms and
with related conditions which are not conditions which are not
parties unfavourable to the unfavourable to the
company; and company; and
 All trade debts exceeding the  All trade debts exceeding

normal credit period and all the normal credit period and
non-trade debts, owning by all non-trade debts, owning
the interested people to the by the interested people to
company or its subsidiary the company or its
companies must be fully subsidiary companies must
settled prior to listing. be fully settled prior to
listing.
* Companies with MSC status, BioNexus status and companies with predominantly
foreign-based operations are exempted from the Bumiputera equity requirement.
SELF-CHECK 1.2
1. What do you understand by the term financial market?
2. Provide two types of main financial markets in the country and

explain their respective functions.

ACTIVITY 1.6
Visit the Bursa Malaysia website at www.bursamalaysia.com/market

to obtain additional information on the said financial market.
Share your findings with your coursemates in the myINSPIRE online

forum.
 Financial management is influenced by financial decisions that can be divided

into three main categories: investment decisions, financing decisions and
management decisions.
 Every decision made must be relevant to the countryÊs current economic

situation and this is the companyÊs finance managersÊ responsibility.
 A finance manager must be smart and be able to obtain and use the funds to
enable the value of the company to be maximised to attract investors.
 The manager is responsible for making main decisions in short-term and long-
term investment and financing, financial planning and forecasting, control and
coordination with the other managers to ensure the company operates
efficiently and must also understand the financial market issues.
 The companyÊs objective is to maximise the shareholdersÊ wealth. This

objective is more appropriate compared to maximising profit as it takes into
consideration the cash inflow and outflow, uncertainties or risks, timing of
returns and other factors that are important to the companyÊs owner.
 The agency problems that occur due to the separation of internal controls of
the company show that there are differences in objectives between the
managersÊ and the companyÊs actual objective and this can interfere with the
administration of the company.
 The owner must find alternatives to control the managerÊs actions by offering
various incentives and reimbursements. This internal problem arises without
taking into consideration whether the organisation is a sole proprietor,
partnership or company.

 The financial market, which are the money market and the capital market had
set up a forum or platform where the funds suppliers and funds borrowers can
conduct financial assets transactions. It is the medium that connects the capital
depositors with the borrowers in the economy.
Agency problems Money market

Capital market Partnership
Company Sole proprietorship
Financial market
1. Financial theories assumed that the main objective of a company is to

maximise the shareholdersÊ ___________ which means maximising the
__________________ of the companyÊs ordinary shares.
2. _____________________ is the short-term objective that disregards several

factors such as risks and timing of cash flow.
3. Company managers that are effective:
A. Disregard the requirements of shareholders
B. Might make decisions that are different from the interest of

shareholders
C. Are aware of the risks and returns in achieving the objective of financial
management
D. Are not aware of the requirements of the shareholders

4. Maximising shareholdersÊ wealth means maximising _________________.
A. companyÊs cash value
B. companyÊs investment value
C. companyÊs profits
D. market value of companyÊs ordinary shares
1. One disadvantage of a company business is being _______________ on

profits and _________________ that are paid to the shareholders.
2. A partnership can be dissolved when one of the partners _____________ or

________________.
3. ________________ is the distribution of companyÊs profits to the owners.
4. Agency problem is the potential conflict that arises between a principal and
an agent. In finance, the relationship of agency is between ____________ and
____________.
A. owner, manager
B. manager, accountant
C. shareholder, creditor
D. owner, creditor
5. Which type(s) of the following organisation exposes or expose all its or their
owners to unlimited liability?
A. Limited partnership
B. Sole proprietor
C. Company
D. A and B

1. New ordinary shares are sold by a company in the ___________ market and
investors sell and buy financial securities in the _______________ market.
A. money; first level
B. second level; capital
C. first level; second level
D. international; domestic
2. The price of ordinary shares is determined by __________.
A. Bursa Malaysia
B. the government
C. companyÊs management
D. individuals who buy and sell shares
3. The objective of the financial market is to __________.
A. reduce the price of bonds
B. allocate savings efficiently
C. increase the price of shares
D. provide job opportunities for stock brokers
4. Assume you own IBM shares, but you are not allowed to enter the companyÊs
headquarter at any time you feel like doing so. If then, in what sense are you
considered an owner of the IBM Company?
5. Explain why each one of the following might not be appropriate as a

companyÊs objective:
(a) Increasing market shares.
(b) Minimising costs.
(c) Reducing price to overcome competition.
(d) Increasing profit.

6. Which type of compensation will make the manager act in accordance with
the interests of the shareholders? Discuss.
(a) Fixed salary.
(b) Salary linked to the companyÊs profit.
(c) Salary that is partly paid with company shares.

Topic  Analysis of
Financial
2 Statements
LEARNING OUTCOMES
1. Explain the importance of financial statements to different groups of
users;
2. Prepare statement of retained earnings and cash flow statement;
3. Calculate the ratio for liquidity, asset management, financial leverage,
profitability and market value;
4. Evaluate a companyÊs performance based on financial ratios and the
DuPont analysis; and
5. Explain the weaknesses of financial ratio analysis.
 INTRODUCTION
Financial statement is a data summary on asset, liability and equity as well as
income and expenditure of a business for a specific period. Financial statement is
used by finance managers to evaluate the companyÊs financial status and for
planning the companyÊs future.
In this topic, you will learn the four main financial statements, which are income
statement, balance sheet, statement of retained earnings and cash flow statement.
In the beginning, you will be exposed to the basic format of each financial
statement. Subsequently, you will learn how to prepare each of the financial
statement. Understanding of the financial statements is important as these
financial statements will assist you in evaluating the companyÊs performance.

TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS  23
Financial analysis is an evaluation of the companyÊs financial achievements for the

previous years and its prospect in the future. Normally, the evaluation will involve
an analysis of the companyÊs financial statements. Information from the financial
statements is used to identify the relative strengths and weaknesses of the
company as compared to its competitors and providing an indication on areas that
need to be investigated and improved.
Finance managers use financial analysis for their companyÊs future planning. For
example, shareholders and potential investors are interested in the level of returns
and risks of the company. Meanwhile, creditors are interested in the short-term
liquidity level and the ability of the company to settle its interests and debts. They
will also emphasise on the profitability of the company as they want to ensure that
the companyÊs performance is good and will be successful. Therefore, the finance
manager must know the entire spectrum of financial analysis that are being
focused by several parties having their own interests in evaluating the company.
Besides the finance manager, the management also uses financial analysis to
monitor the companyÊs achievement from time to time. Any unexpected changes
will be examined to identify the problems that need to be dealt with.
2.1 ANNUAL REPORT AND USERS OF

FINANCIAL STATEMENTS
Companies are required to report their business financial status at the end of each
accounting period in the annual report. Annual reports usually contain messages
from the chairman, financial statements and notes explaining the practices and
policies adopted in reporting the companyÊs accounts.
There are two types of information in an annual report. The first section is the
message from the chairman. It reports the companyÊs achievement throughout that
year and discusses on new developments that will affect the companyÊs future
operations. The second section will report on the basic financial statements such
as the income statement, balance sheet, statement of retained earnings and cash
flow statement (refer to Figure 2.1):

24  TOPIC 2 ANALYSIS OF FINANCIAL STATEMENTS
Figure 2.1: Information in the annual report
Financial statements illustrate the operations and financial status of a company.

Detailed data are prepared for the past two or three years together with a summary
of the main statistics for the past five or ten years. Normally, financial statements
are followed by notes explaining in detail the items found in the statements. These
notes explain the policies or accounting practices that are used in the preparation
of the financial statements. For example, further notes on inventory might explain
the method of inventory recording being adopted by the company.
Several groups of users may be interested in the information contained in the

financial statements of a company. They will examine the statements in detail and
interpret the information on matters that interest them. The objective of the
analysis is the evaluation on the specific aspect of the companyÊs performance. The
information required by the user depends on the type of intended decision. We
can divide the users of financial statements into two groups (refer Figure 2.2):
Figure 2.2: Two groups of users of financial statements

Now, let us look into the groups one by one (refer to Table 2.1):
Table 2.1: Internal Users versus External Users
Internal Users External Users
 Include the managers and other  They are not directly involved in the
officers that operate the business. operations of the company.
 They are responsible in planning the  They comprise users who have direct
strategies and operations of the interest in the company (such as
company. Therefore, they use the shareholders, investors and creditors)
financial statements to obtain and users who have indirect interest in
information on the overall companyÊs the company (such as customers, tax
performance. agent and labour organisations).
Shareholders and potential investors use financial statements to help them interpret
what will happen to the company in the future. Meanwhile, short-term creditors will
look at the companyÊs liquidity, while long-term creditors look at the ability of the
company to settle the interests and payment of the long-term principal debts.
The Companies Act 1965 stipulates that at least four of the following financial
statements must be included in the Annual Reports, which are:
(a) Income statements;
(b) Balance sheet;
(c) Statement of retained earnings; and
(d) Cash flow statement.
SELF-CHECK 2.1
1. Who are the users of financial statements?
2. What type of information is required by them?

2.2 INCOME STATEMENT

Income statement measures the operating performance of a company for a specific
period, normally for a period of one year ending at a specific date, usually at 31
December.
Monthly statements are also prepared for the usage of the management who
required more frequent information to enable more prudent decisions to be made.
Yearly quarter statements are also prepared for shareholders of public companies.
Income statements provide information to evaluate the firm performance. To

measure a firmÊs performance, several important aspects in the income statement
must be given priority, such as:
(a) Sales figure can be compared with the firmÊs sales for the previous year and
the expected sales in the future. This information can be used for the firmÊs
future planning;
(b) Gross profit or gross loss can be compared with the sales figure to show
profit from the products or services sold; and
(c) Firm expenditures can be compared with the firmÊs expenditures for the
previous year to see which policy can be adopted to reduce costs.
Let us look at these financial statements and the relationship between each of them
based on the financial statements of Company FAZ, as an example.
The following example is the income statement of Company FAZ for year ended
31 December 2018. This statement starts with sales revenue that is the sales value
in ringgit throughout the accounting period. Cost of goods sold is deducted from
the sales revenue to obtain gross profit of RM70,000. This total is the amount
obtained from sales to cover the financial operating costs and tax.

Company FAZ
Income Statement
for the Year Ended 31 December 2018
RM
Sales 170,000
Less: Cost of goods sold 100,000
Gross profit 70,000
Less: Operating expenditure
Sales expenses 8,000
Administrative and general expenses 15,000
Depreciation expenses 10,000
Total operating expenditure 33,000
Profit before interest and tax 37,000
Interest 7,000
Profit before tax 30,000
Tax (40%) 12,000
Profit after tax 18,000
Less: Dividend for preference shares 1,000
Net profit (or profit available for ordinary shareholders) 17,000
Earnings per share = Net profit/Total ordinary shares 0.17
All the operating expenditures such as sales expenses, general and administrative
expenses, and depreciation expenses will be listed and totalled to obtain the total
operating expenditure. This total will then be deducted from the gross profit to
obtain profit from operations of RM37,000. Profit from operations is the profit
obtained from activities of manufacturing and selling of products; it does not take
into account the financial costs and tax. Profit from operations is also known as
profit before interest and tax.
Thereafter, the financial cost that is the interest expenses of RM7,000 will be
deducted from the profit from operations to obtain the profit before tax of
RM30,000. After deducting tax, we will obtain profit after tax (or profit before
preference shares) of RM18,000.

Any dividends for preference shares must be deducted from the profit after tax to
obtain the net profit. This total is also known as profit available to the ordinary
shareholders and is the total obtained by the company on behalf of ordinary
shareholders throughout a specific period. Normally, reports on earnings per
share are provided at the last section of the income statement. Earnings per share
shows the total obtained by the company throughout the specific period for each
ordinary share. In year 2018, Company FAZ obtained RM17,000 for the ordinary
shareholders or RM0.17 for each share issued (total ordinary shares is 100,000).
Earnings per share are often referred as the „bottom line‰ to show that earnings
per share are the most important item in the income statement compared to the
other items.
SELF-CHECK 2.2
What are the uses of income statement to the financial operations of a

company?
ACTIVITY 2.1
If you are one of the preference shareholders in Company FAZ, how

would the information contained in the companyÊs financial statements
be useful to you?

forum.
2.3 BALANCE SHEET

Balance sheet is a statement that summarises the status of a company at a specific
point of time. Balance sheet shows the accounts for assets, liabilities and equities.
It balances the companyÊs assets (what it owns) with its financing, either debts
(provided by creditors) or equity (provided by owner). The balance sheet of
Company FAZ as at 31 December 2017 and 31 December 2018 is shown as follows:

Company FAZ
Balance Sheet
As at 31 December 2017 and 2018
31-12-2018 31-12-2017
RM RM
Assets
Current assets
Cash 40,000 30,000
Marketable securities 60,000 20,000
Account receivables 40,000 50,000
Inventory 60,000 90,000
Total current assets 200,000 190,000
Non-current assets
Land and building 120,000 105,000
Machines and equipment 85,000 80,000
Fixtures and fittings 30,000 22,000
Vehicles 10,000 8,000
Others (including lease) 5,000 5,000
Total non-current assets 250,000 220,000
Less: Accumulated depreciation 130,000 120,000
Non-current assets, net 120,000 100,000
TOTAL ASSETS 320,000 290,000
Liabilities and Equities

Current liabilities
Account payable 70,000 50,000
Notes payable 60,000 70,000
Tax accrual 10,000 20,000
Total current liabilities 140,000 140,000
Total non-current liabilities 60,000 40,000
Total liabilities 200,000 180,000
Equities
Preference shares 10,000 10,000
Ordinary shares 12,000 12,000
Paid-up capital above par 38,000 38,000
Retained earnings 60,000 50,000
Total equities 120,000 110,000
TOTAL LIABILITIES AND EQUITIES 320,000 290,000

2.3.1 Assets
Assets are valuable economic resources owned by a business. It can be used
in several activities such as manufacturing, usage and exchange. Assets have
„service potential‰ or will „bring economic benefit in the future‰. Assets have the
capability to provide services or generate benefit to the business entity that owns
it. In businesses, services or economic benefit will generate cash inflow (receiving
cash) to the business.
Assets can be categorised into current assets and non-current assets. Assets are listed
in the balance sheet according to its liquidity level from the most liquid to the least
liquid. Therefore, current assets are arranged first, followed by non-current assets.
(a) Current Assets

Current assets are assets that can be converted into cash in the shortest period
of time, which is within a year or less. The current assets for Company FAZ
comprised:
(i) Cash;
(ii) Marketable securities;
(iii) Account receivables; and
(iv) Inventory.
Cash is the most liquid of current assets. Marketable securities such as

government bills or deposit certificates are short-term investments that are
highly liquid. Marketable securities can sometimes be seen as a form of cash
due to its high liquidity. Account receivables are debts owed by customers
who bought goods by credit from the company. Inventory consists of raw
materials, work-in-process and finished goods held by the company.
Other current assets which are not in Company FAZÊs balance sheet are
prepaid expenses (prepayment). Prepaid expenses are expenses that have
been paid in advance by cash but the benefits from the expenses have not
been received. Examples of prepaid expenses are prepaid rental, prepaid
insurance and office supplies.

(b) Non-current Assets

Non-current assets are assets that are held by the company for a rather long
period, which is more than a year. Non-current assets are categorised into
tangible fixed assets, long-term investment and intangible fixed assets.
Tangible fixed assets are land and buildings, machines and equipment,
fixtures and fittings, and vehicles. Usually, a company will report the total
tangible fixed asset that is the original cost of all the tangible fixed assets
owned by the company. From that total, the company will deduct the
accumulated depreciation for all tangible fixed assets to obtain net tangible
fixed assets. All tangible fixed assets must be depreciated except for land.
This is because the value of land will always increase, while the values of
other tangible fixed assets such as machines and equipment, as well as
vehicles, will decrease when the life span of the asset increases.
Long-term investments include bonds and shares, prepaid expenses and

account receivables that a company intends to hold for a period of more than
a year.
Besides tangible fixed asset and long-term investment, a business might

show intangible fixed assets in its balance sheet. Intangible fixed assets are
long-term assets that cannot be physically seen and usually provide a
competitive advantage to the firm. Examples of intangible fixed assets are
patents, franchise licences, licences, trademarks, copyrights and goodwill.
Although these assets cannot be physically seen, it is recorded using the same
method as other fixed assets. This means that the assets will be recorded at
its original cost and this cost will be amortised throughout its lifetime.
Among the intangible fixed assets that are famous are the Polaroid patent,
the franchise of McDonaldÊs and the trademark of Colonel SanderÊs Kentucky
Fried Chicken.
ACTIVITY 2.2
If you used a private vehicle to conduct the companyÊs business, would

that vehicle be considered a companyÊs asset?
Discuss this case with your coursemates in the myINSPIRE online

forum.

2.3.2 Liabilities
Most businesses have been in situations where they need to take loans to finance
the businessÊ assets or to buy assets such as raw materials on credit. Liabilities are
claims made by creditors on the companyÊs assets. In other words, liabilities are
debts and obligations of a company. Liabilities comprise of current liabilities and
non-current liabilities.
If a situation occurs where the company is unable to pay its business liabilities, the
creditors can force the company to be liquidated. In this situation, the creditorsÊ
claims must be settled first before the company can settle the claims of the
shareholders.
(a) Current Liabilities

Current liabilities are short-term debts, or debts that will mature within the
period of one year or less. Company FAZÊs current liabilities are:
(i) Account payable;
(ii) Notes payable; and
(iii) Tax accrual.
Account payable is the obligation of the company towards its suppliers when
the company purchases raw materials and finished goods on credit. Notes
payable is a written obligation of Company FAZ. The obligation is with the
bank for the loan to purchase vehicles for the usage of the company. The
company also has tax accrual, that is the tax that must be paid to the
government but is still outstanding.
Another current liability that is not in the balance sheet of Company FAZ is
deferred income. Deferred income is cash that had been received from
customers but the services or products paid had not been provided.
Examples of deferred income are deferred rental and deposit from
customers.

(b) Non-current Liabilities

Non-current liabilities are the responsibilities or obligations that mature
within a period of more than a year. These claims might be in the form of
bonds, long-term notes payable and lease.
Bonds are a type of fixed income securities that are issued by companies.
Notes payables are a type of credit transaction that involves a written
agreement between the company and creditors. Mortgage loans are long-
term loan that use the assets (such as land and buildings) as a mortgage for
the loan. Notes payable can also be mortgaged with the other assets as a
security for the loan. A lease is a contractual agreement between the lessor
and the lessee. The lessor gives the right to the lessee to use the asset for a
specific period and will impose charges for usage of the asset.
2.3.3 Owners’ Equity or Shareholders’ Equity

OwnersÊ or shareholdersÊ claim towards the assets are known as ownersÊ equity or
shareholdersÊ equity. In the balance sheet of Company FAZ, the ownersÊ equity
comprised of:
(a) Preference shares are securities that provide fixed return dividend to its
holders. Preference shareholders do not have ownership of the company;
(b) Ordinary shares are securities that reflect the ownership of the company.
Ordinary shareholders are the real owners of the company. They will receive
returns in dividends that will be paid to them in cash or shares (bonus
issues);
(c) There will be situations where the par value (stated value) is not equal to the
market price of the ordinary shares at the time of issue. Cash earnings from
the issuance of shares might be equal, more or less than the par value. When
this situation occurs, the company will record the issuance of shares at the
par value in the Ordinary Shares Account and the difference between the par
value and the shareÊs selling price (surplus earnings) will be recorded in a
separate account known as Paid-up Capital Above Par; and
(d) Retained earnings are the total accumulated earnings since incorporation
that had not been distributed to the shareholders as dividend but was re-
invested into the company. It is important to remember that retained
earnings are not cash but are earnings that have been used to finance the
companyÊs assets.

SELF-CHECK 2.3
Explain in detail the difference among asset, liability and equity.
2.3.4 Summary of Basic Accounting

Assuming that a newly started business was self-financed by the businessÊ owner.
This means that all the companyÊs assets belong or are claimable by the businessÊ
owner.
This relationship can be shown by the equation as follows:
Assets = OwnerÊs equity
However, businesses are normally financed by the businessesÊ owners and

creditors. Therefore, claims on the assets are equal to the claims by the creditors
(liabilities) added with the claims by the owner of the business (ownerÊs equity)
towards the assets. This relationship can be shown in the equation as follows:
Assets = Liabilities + OwnerÊs equity
This equation is known as the summary of basic accounting where the total assets
must be equal to the total liabilities plus ownerÊs equity. OwnerÊs equity is equal
to total assets less total liabilities. This is because the assets of a business are
financed by either the creditors or the owner. To determine the ownerÊs portion
(ownerÊs equity), we must deduct the creditorsÊ portion (liabilities) from the assets.
The balance will be the claim of the owner on the businessÊ assets. As the creditorsÊ
claims would be given priority over the ownerÊs claims upon liquidation, the
ownerÊs claims are also known as residual equity.
ACTIVITY 2.3
By using the summary of basic accounting, connect the relationship

among cash, account payable, account receivable, retained earnings,
marketable securities and ordinary shares.

forum.

2.4 STATEMENT OF RETAINED EARNINGS

Statement of retained earnings shows how the retained earnings account in the
balance sheet is adjusted between two dates of the balance sheet. Statement of
retained earnings will adjust the net profit generated throughout the period and
any dividends paid, with the changes in the retained earnings in the beginning
and ending of the year. The statement of retained earnings for Company FAZ for
the year ended 31 December 2018 is shown as follows:
Company FAZ
Statement of Retained Earnings
Retained earnings, 1 January 2018 RM50,000

+ Net profit (throughout year 2018) RM18,000
Dividends paid (throughout year 2018)
Preference shares RM1,000
Ordinary shares RM7,000 RM8,000
Retained earnings, 31 December 2018 RM60,000
The statement shows that the company started with retained earnings of RM50,000
on 31 December 2017 or 1 January 2018 and profit after tax of RM18,000 (data
obtained from the income statement). From this total, the company had paid
dividends of RM1,000 for preference shares and dividends of RM7,000 for
ordinary shares. Therefore, the retained earnings had increased by RM10,000 from
RM50,000 as at 1 January 2018 to RM60,000 as at 31 December 2018.

2.5 CASH FLOW STATEMENT

Cash flow statement shows how the activities in a company such as operating,
investing and financing activity can influence the status of cash and marketable
securities. Cash flow statement is the statement that summarises the cash flow
throughout a specific period, normally for the current year ended. Data from the
balance sheet and income statement are used to prepare the cash flow statement.
Cash flow statement has two functions that can assist the finance manager (refer
to Figure 2.3):
Figure 2.3: Functions of cash flow to finance manager
(a) Operating Activities

Operating activities refer to the activities that are directly related to the
production of products, sales and services of the company such as the sales
and purchases of goods/services, rental income, fees income, wages and
salaries of employees, utility expenses, and rental expenses.
(b) Investing Activities

Investing activities refer to the activities that are related to the buying and
selling of non-current assets such as the sale and purchase of fixed assets,
selling of investments, buying of stocks and bonds (investing), and loans to
other entities.
(c) Financing Activities

Financing activities refer to the activities that are related to the current
liabilities and non-current liabilities as well as ownerÊs equity such as
repayment of loans, short-term and long-term loans, and shares buyback.

ACTIVITY 2.4
What will affect the status of cash and marketable securities of a

company?
Discuss this with your coursemates in the myINSPIRE online forum.
2.5.1 Preparing Cash Flow Statement

Data obtained from the balance sheet together with the net profit, depreciation and
dividends obtained from the income statement can be used to prepare the cash
flow statement. You can do this by using the following three steps (refer to
Table 2.2):
Table 2.2: Steps in Preparing Cash Flow Statement
Step Elaboration
Step 1 Classify the data into one of these three components:
 Cash flow from operating activities;
 Cash flow from investing activities; or
 Cash flow from financing activities.
Step 2 List the data according to the arrangement in the following example. All
resources and net profit including depreciation are positive cash flow,
which is the cash flowing in; while all usages, any losses and dividends
payable are negative cash flow, which is the cash flowing out. Obtain the
total for the items in each component.
Step 3 Add the total from each component to obtain the „increase (or decrease) of
net cash and marketable securities‰. To check whether you had prepared
the statement correctly, ensure that the value is equal to the changes in cash
and marketable securities for the relevant year by looking at the opening
and closing balances of cash and marketable securities in the balance sheet.

Components and Data Sources that must be included into the Cash Flow Statement
RM
Cash Flow from Operating Activities
Net profit (Net loss) IS

Depreciation and other non-cash charges IS
Changes in all current assets BS
(except cash and marketable securities)
Changes in all current liabilities BS
(except notes payable)
Cash flow from operating activities xx
Cash Flow from Investing Activities
Changes in total non-current assets BS

Changes in the companyÊs interest BS
Cash flow from investing activities xx
Cash Flow from Financing Activities

Changes in notes payable BS
Changes in long-term loans BS
Changes in shareholdersÊ equity BS
(other than retained earnings)
Cash flow from financing activities xx
Increase (or decrease) in cash and marketable securities

XX
Data Sources
BS = Balance Sheet
IS = Income Statement
"

Example of Cash Flow Statement: Company FAZ

The cash flow statement of Company FAZ for year ended 31 December 2018 is
shown as follows:
Company FAZ
Cash Flow Statement
as at 31 December 2018
RM RM
Net Profit 18,000

Depreciation 10,000
Decrease in account receivable 10,000
Decrease in inventory 30,000
Increase in account payable 20,000
Decrease in tax accrual (10,000)
Cash flow from operating services 78,000
Cash Flow from Investing Activities

Increase in total non-current assets
(30,000)
Cash flow from investing activities (30,000)
Cash Flow from Financing Activities

Decrease in short-term notes payable
(10,000)
Increase in long-term loan 20,000
Changes in shareholdersÊ equity –
Dividends paid (8,000)
Cash flow from financing activities 2,000
Net increase in cash and marketable securities 50,000

Based on this cash flow statement, the company had enjoyed an increase of
RM50,000 in cash and marketable securities for the year 2018. The cash of the
company increased by RM10,000, while the marketable securities increased by
RM40,000 between the two dates.
Let us now discuss Step 1 in greater details.
(a) Cash Flow from Operating Activities

The operating activities in the cash flow statement show that the profit after
tax of Company FAZ is RM18,000 for year 2018. Depreciation expenses of
RM10,000 deducted from the income statement had been added back into the
cash flow statement as it is not cash outflow.
Account receivable had decreased by RM10,000 which means that the

company had collected credit accounts from its customers. Inventory had
also decreased from RM90,000 in year 2017 to RM60,000 in year 2018,
representing cash resources of RM30,000 to the company. In the liabilities
section, notice that the account payable had increased by RM20,000. This
means that the company had increased its debts from the suppliers and this
represents cash inflow. Tax accrual had decreased by RM10,000 indicating
that the company had used RM10,000 to pay tax.
(b) Cash Flow from Investing Activities

Non-current assets of Company FAZ had increased by RM30,000 between
31 December 2017 and 31 December 2018. This increment is reflected the cash
outflow used to buy additional assets.
(c) Cash Flow from Financing Activities

Notes payable for Company FAZ had decreased by RM10,000 indicating a
cash outflow as the company paid its short-term loans. Non-current liabilities
increased by RM20,000 indicating a cash inflow. The company obtained
loans to acquire additional cash.

2.5.2 Differentiating Cash Resources and Usage

Before we can prepare the cash flow, we must classify the cash flow from
operating, investing and financing activities into cash resources or usage.
Table 2.3 lists the basic cash resources and usage.
Several issues can help you to classify between cash resources and usage as shown
in Table 2.3:
Table 2.3: Cash Resources and Usage
Cash Resources Cash Usage

 Decrease in asset  Increase in asset
 Increase in liability  Decrease in liability
 Net profit  Net loss
 Depreciation  Payment of dividends
 Sale of shares  Shares buyback
(a) Decrease in the asset account is a cash inflow resource while increase in the
asset account is a cash usage or cash outflow.
Company bought new assets with cash. Therefore, any increase in the asset
items between the two dates of the balance sheets will indicate that cash
outflow had occurred. Any decrease in the asset items will indicate cash
inflow as the company had sold the assets to obtain cash.
(b) Increase in the liability account and ownerÊs equity is a cash inflow resource
and a decrease in the liability account is cash usage.
The company might use cash to settle its liability and claims on the assets.
Therefore, any decrease in the liability items, preference shares or ordinary
shares between the two dates of balance sheets indicates cash outflow. To
obtain additional cash, the company can take loans. Hence, any increase in
the liability items, preference shares or ordinary shares indicates cash inflow.
(c) Depreciation is a cash flow resource as it is not a cash expense (non-cash

charges). Non-cash expenditures are all expenses deducted from sales in the
income statement but actually do not involve any cash outflow throughout
the period. Depreciation and amortisation are examples of non-cash
expenses.

(d) Direct changes in the retained earnings are not included in the cash flow
statement as these items affect the retained earnings and are shown as profit
after tax (or loss after tax) and cash dividends.
The changes in the balance sheet items of Company FAZ between

31 December 2017 and 31 December 2018 are shown as follows:
Company FAZ
Changes in the Balance Sheet Items between 31 December 2017
and 31 December 2018
Classification
31-12-17 31-12-18 Changes Resource Usage
Assets
RM RM RM RM RM
Cash 30,000 40,000 +10,000 10,000
Marketable 20,000 60,000 +40,000 40,000
securities
Account 50,000 40,000 –10,000 10,000
receivable
Inventory 90,000 60,000 –30,000 30,000
Total non-current 220,000 250,000 +30,000 30,000
assets
Less: (120,000) (130,000) –10,000 10,000
Accumulated
depreciation
Liabilities
Account payable 50,000 70,000 +20,000 20,000
Notes payable 70,000 60,000 –10,000 10,000
Tax accrual 20,000 10,000 –10,000 10,000
Long-term loan 40,000 60,000 +20,000 20,000
Equities
Preference shares 10,000 10,000 0
Original shares at 12,000 12,000 0
par
Paid-up capital 38,000 38,000 0
Retained earnings 50,000 60,000 +10,000 10,000
TOTAL 100,000 100,000

From the changes in the balance sheet items of Company FAZ between
31 December 2017 and 31 December 2018, we find that:
(a) Account receivable decreased by RM10,000 and this is considered as a cash

resource as when debts are collected, the company obtains cash;
(b) Inventory decreased by RM30,000 and this is considered a cash resource as

the company obtains cash from the product sold;
(c) Total non-current assets increased by RM30,000 and this is considered as

cash usage as the company uses the cash to buy non-current assets;
(d) Increase in account payable and long-term loans of RM20,000 are considered
cash sources as the company increases its debt with suppliers; and
(e) Notes payable and tax accrual decreased by RM10,000 and this is considered
as cash usage as the cash is used to settle debts to the creditors and tax to the
government.
These types of classifications are made on every item in the balance sheet. The
result of these classifications will be totalled to obtain the total cash resources and
total cash usage. If these classifications are done correctly, the total cash resources
will be equal to the total cash usages.
ACTIVITY 2.5
All sorts of support and loan assistance had been provided by the
government through organisations such as Perbadanan Usahawan
Nasional Berhad (PUNB) to encourage the participation of
Bumiputeras in the field of entrepreneurship. Many have grabbed this
opportunity to be involved in their own businesses covering various
economic sectors but not all of them succeeded. What is your opinion
on this matter?
Share your opinions on this matter with your coursemates in the

myINSPIRE online forum.

2.6 FINANCIAL RATIO ANALYSIS

Financial ratio analysis involves the calculation of several ratios that will enable
the manager to evaluate the performance and financial status of the company by
comparing its financial ratios with the financial ratios of other companies. These
ratios are divided into five groups or categories as shown in Table 2.4:
Table 2.4: Categories of Financial Ratios
Category Description
Liquidity ratio It refers to the companyÊs ability to fulfil its short-term maturity
claims or obligations.
Asset management It refers to the efficiency of the company to use its assets and how
ratio fast specific accounts can be converted into sales or cash.
Leverage ratio It refers to the level of debt usage or the ability of the company to
fulfil its financial claims such as interest claims.
Profitability ratio It refers to the effectiveness of the company in generating returns
from investments and sales, for example, gross profit margin, net
profit margin, operating profit margin, returns from assets and
returns from equity.
Market value ratio It refers to the ability of the company to create market values in
excess of its investment costs. Liquidity, asset management and
leverage ratios measure the companyÊs risk, while profitability ratio
measures the companyÊs returns.
Within the short-term period, liquidity, asset management and profitability ratios
are important to the management of the company as these ratios provide critical
information on the companyÊs short-term operations. If a business is unable to
sustain within the short-term period, it would be pointless to discuss its long-term
prospects.

Before preparing the ratio analysis, the finance manager must consider the
following issues:
(a) One ratio is unable to give complete information on the status of the
company. This means that several categories of ratios must be looked at
simultaneously before any conclusion can be made;
(b) Comparisons between the financial ratios of one company with other
companies in the industry must be made at the same point of time. Industry
average is not a figure that must be achieved by a company. There are many
companies that had been managed efficiently but the performance of their
financial ratios is much higher or lower than the performance of the industry
average. The obvious difference between the financial ratios of the company
and the industry average is an indication to the analysts to check on the ratio
further;
(c) Use the financial statements that have been audited. This will show the actual
status of the company; and
(d) Use the same method to evaluate items in the financial statement that will be
compared. For example, to record inventory, a company might use different
accounting methods such as first-in-first-out, first-in-last-out or moving
average method. Choose only one of these methods for comparison
purposes. Different methods will provide different ratio values. Therefore,
actual evaluation cannot be done.
Financial statements of the company are the main input for the manager who
intends to prepare the ratio analysis for its company. Each example of the ratios
that will be discussed in the next subtopic will be based on the financial
information extracted from the income statement and balance sheet of Company
ABC.

2.6.1 Income Statement

The income statement for Company ABC for the year ended 31 December 2017
and 31 December 2018 is shown in the following example. The income statement
shows the operating performance of the company for a specific period.
Company ABC
Income Statement
for the Year Ended 31 December 2018 and 2017
2018 2017
RM RM
Sales 307,400 256,700
Less: Cost of goods sold 208,800 171,000
Gross profit 98,600 85,700
Less: Operating expenses
Sales expenses 10,000 10,800
Administrative and general expenses 19,400 18,700
Lease expenses 3,500 3,500
Depreciation expenses 23,900 22,300
Total operating expenses 56,800 55,300
Profit before interest and tax (operating profit) 41,800 30,400
Less: Interest expense 9,300 9,100
Profit before tax 32,500 21,300
Less: Tax (29%) 9,425 6,177
Profit after tax 23,075 15,123
Less: Preference sharesÊ dividend 1,000 1,000
Profit available for ordinary shareholders 22,075 14,123
Earnings per share 0.29 0.18

2.6.2 Balance Sheet

Balance sheet shows the overall value of various assets and claims on these assets
at a specific point of time. For Company ABC, the balance sheet shows the assets,
liabilities and equities as at 31 December 2018 and 31 December 2017 as shown in
the following example.
Company ABC
Balance Sheet
as at 31 December 2018 and 31 December 2017
2018 2017
RM RM
Assets
Current assets
Cash 36,300 28,800
Account receivable 50,300 36,500
Inventory 28,900 30,000
Net non-current assets 237,400 226,600
Total assets 359,700 327,000

Current liabilities
Accruals 15,900 11,400
Total liabilities 164,300 145,000
Equities
Preference shares 20,000 20,000
Ordinary shares, 100,000 shares issued 19,100 19,000
2018:76,262
2017: 76,244
Paid-up capital above par 42,800 41,800
Total equities 195,400 182,000

Total liabilities and shareholdersÊ equities 359,700 327,000

ACTIVITY 2.6
1. What is the relevance in calculating the financial ratios for short-

term and long-term operations?
2. Should its value be in accordance with the average performance

of the industry?
2.7 LIQUIDITY RATIO

Liquidity refers to the ability of asset to be converted easily into cash without
affecting the value of the asset. Liquidity ratio refers to the ability of the company
to discharge its claims or short-term obligations by cash and assets that can be
converted into cash in a short period. Liquidity is important in operating the
business activities. A poor liquidity status is an early indication that the company
is facing fundamental problems. The examples of liquidity ratio are shown in
Figure 2.4:
Figure 2.4: Examples of liquidity ratio
We will discuss these examples further next.
2.7.1 Net Working Capital

Net working capital is the difference between total current assets with total current
liabilities. It measures the funds (cash and items that can be easily converted into
cash) that are owned by the company in managing its daily operating activities.
The higher the value of the working capital the better, as this shows that the
company is able to settle its short-term debts with surplus funds for its daily
operating activities.

Net working capital of Company ABC for the year 2018 is calculated as follows:
Net working capital  Current assets  Current liabilities

 RM122,300  RM62,000
(2.1)
 RM60,300
Industry average  RM42,700
Based on the calculation, the net working capital of Company ABC is higher than
the industry average. This shows that Company ABC is able to settle its short-term
debts and has higher surplus funds than other companies in the industry to
manage its daily operations.
2.7.2 Current Ratio

Current ratio measures the ability of the company to fulfil its short-term loans
using its current assets. The higher the value of this ratio, the better the liquidity
status of the company. This shows that the company is able to settle short-term
debts using its current assets.
Current ratio is obtained by dividing the current assets with the current liabilities.
The current ratio of Company ABC (year 2018) is as follows:
Current assets
Current ratio 
Current liabilities
RM122,300
 (2.2)
RM62,000
 1.97
Industry average  2.05
The current ratio of Company ABC is 1.97 which is lower compared to the industry
average of 2.05. This shows that for every ringgit of current liability, the company
only has RM1.97 current assets for its payment compared to other companies in
the industry that has RM2.05 to settle their current liabilities. However, the current
ratio of the company is not too low for concern.
Current ratio of 2.0 times is acceptable; however, this acceptance depends on the
type of industry. For example, the current ratio of 1.0 is satisfactory for industries
such as utilities that have a rather stable business but it is unsatisfactory for
industries like the manufacturing line due to their business volatility.

Current ratio can be related to the net working capital if:
(a) The current ratio equals to 1.0, the net working capital is zero;
(b) The current ratio is less than 1.0, the net working capital is negative; and
(c) The current ratio is more than 1.0, the net working capital is positive.
2.7.3 Quick Ratio

Quick ratio measures the ability of the company to pay its short-term loans
quickly. Quick ratio is a liquidity test that is more stringent compared to net
working capital and current ratio. This is because quick ratio only takes into
consideration the cash and assets that can easily be converted into cash. However,
inventory is not included with other liquid assets due to the longer period for the
inventory to be converted into cash. Expenses prepaid is also not included as it
cannot be converted into cash. Therefore, it cannot be used to settle the current
liabilities.
Quick ratio is obtained when the most liquid current assets (cash, marketable
securities and account receivables) are divided with current liabilities. The higher
the quick asset ratio compared with the current liabilities, the better the liquidity
level of the company to settle its short-term loans quickly.
The calculation of quick ratio for Company ABC (year 2018) is as follows:
Current assets  (Inventory + Prepayments)

Quick ratio 
Current liabilities
RM122,300  RM28,900
 (2.3)
RM62,000
 1.51 times
Industry average  1.43 times
The quick ratio of Company ABC is 1.51 times, which is higher compared to the
industry average of 1.43 times. This means that the liquidity level of the company
is better compared to the other companies in the industry. For every ringgit of
current liability, the company has RM1.51 cash and assets that can be easily
converted into cash to pay its short-term debts immediately. This is better
compared to other companies in the industry that only has RM1.43 to pay their
short-term debts immediately.

2.8 ASSET MANAGEMENT RATIO

Asset management ratio measures the efficiency of the management in using the
assets and specific accounts to generate sales or cash. Ratios that can be used to
measure the efficiency in asset management are shown in Figure 2.5.
Figure 2.5: Asset management ratio
2.8.1 Accounts Receivable Turnover

Accounts receivable turnover measures the ability of the company to collect debts
from its customers. It provides the total of accounts receivables collected
throughout the year. The higher the ratio, the better it is. This is an indication that
the company:
(a) Can collect debts from its customers quickly;
(b) Has low bad debts; and
(c) Can use the funds for future investments.
Accounts receivable turnover is the net credit sales revenue (if unavailable,
use the total sales) divided by the accounts receivables (or average accounts
receivable). The calculations of accounts receivable turnover for Company ABC is
shown as follows:
Credit sales
Accounts receivable turnover 
Accounts receivable
RM307,400
 (2.4)
RM50,300
 6.11 times
The accounts receivable turnover for Company ABC is unsatisfactory compared to

the industry average. This may indicate the inefficiency of the credit department
in credit collection.
2.8.2 Average Collection Period

Average collection period shows the average days taken by the company to collect
the account receivable, assuming there are 360 days in a year. The comparison
between the average periods with the companyÊs credit term could measure the
efficiency of the company in collecting debts from its customers.
The average collection period of Company ABC is as follows:
360

Account receivable turnover
360
 (2.5)
6.11
 58.9 days
Industry average  44.3 days
The average collection period of Company ABC is 58.9 days which is

unsatisfactory compared with the performance of the industry average of
44.3 days. On average, Company ABC takes 58.9 days to collect its account
receivables while other companies in the industry only takes an average of
44.3 days to collect debts from their customers.
If the credit period for Company ABC is 30 days, the average collection period of
58.9 days is unsatisfactory. This means, on average, the customers did not settle
their payments within the period specified. This could also indicate that the credit
management or credit department is inefficient. If the collection period extends for
several years without changes to the credit policy, the company must take action
to expedite the collection of account receivables. However, if the companyÊs credit
period is 60 days and the average collection period is 58.9 days, this shows a
practical collection period.
The average collection period can also be calculated using equation 2.6.
Account receivables
Average collection period 
Yearly sales/360
RM50,300
 (2.6)
RM307,400/360
 58.9 days

2.8.3 Inventory Turnover

Inventory turnover measures the efficiency of inventory management. It shows
the number of times the inventory can be sold in a year. The higher the inventory
turnover, the better, as it is an indication that the company is able to sell its
inventory quickly and reduce the chances of surplus obsolete inventory.
Inventory turnover is obtained by dividing the cost of goods sold with inventory.
The calculation of inventory turnover for Company ABC is shown as follows:
Cost of goods sold

Inventory turnover 
Inventory
RM208,800
 (2.7)
RM28,900
 7.22 times
Inventory turnover for Company ABC of 7.22 times is better as compared to the
industry average of 6.6 times. This means that the company can sell its inventory
7.22 times in a year compared to the other companies in the industry that can only
sell their inventory 6.6 times in a year. This might be because the company does
not keep surplus inventory. Surplus inventory is not productive and it is an
investment that does not provide any return.
If the company holds a high inventory, the funds that could be invested elsewhere
would be held by the inventory. Furthermore, the transportation and holding cost
of the inventory will be high and the company is at risk of goods becoming
damaged or obsolete. On the other hand, the company might lose sales if it is
unable to fulfil the customerÊs demands due to low inventory keeping. Therefore,
the manager must be efficient in managing its inventory.
Several issues that must to be considered in calculating inventory turnover are as

follows:
(a) Notice that the cost of goods sold and not sales (as this might be done by
some companies) is used as the numeric figure as inventory is recorded at
cost;
(b) The usage of sales as the numeric figure is not appropriate as it will increase
the value of inventory turnover;

(c) Remember that for comparison, the company must ensure that the method
of inventory recording must be similar between the company and the
industry; and
(d) The inventory turnover can be changed into number of days when it is
divided by 360 days (average number of days in a year). This ratio is known
as the average inventory sales period as discussed in the next subtopic.
2.8.4 Average Inventory Sales Period

The average inventory sales period shows the number of days taken to make one
round of inventory sales. A high average inventory sales period is less satisfactory
as this indicates that the company takes a longer time to sell its inventory.
For Company ABC, the average inventory sales period is 50 days as calculated as
follows:
360

Inventory turnover
360
 (2.8)
7.22
 49.86 days
The average inventory sales period for Company ABC of 49.86 days is better
compared to the industrial performance of 55.30 days. This indicates that the
company takes shorter time to sell its inventory compared to the other companies
in the industry.
This ratio can also be calculated using the following equation:
Inventory

Cost of goods sold/360
RM28,900
 (2.9)
RM208,800/360
 49.83 days

2.8.5 Non-current Asset Turnover

Non-current asset turnover shows the efficiency of the company in using its non-
current assets to generate sales. The higher the ratio, the better it is because it
indicates an efficient asset management.
This ratio is obtained when the sales is divided by the net non-current assets. The
calculation of non-current asset turnover for Company ABC is as follows:
Sales
Non-current asset turnover 
Net non-current assets
RM307,400
 (2.10)
RM237,400
 1.29 times
The non-current asset turnover ratio for Company ABC is lower compared to the
other companies in the industry indicating that the asset management of the
company in generating sales is less efficient compared to the other companies. This
might be because the company has lots of non-current assets or unsatisfactory
sales.
2.8.6 Total Asset Turnover

The total asset turnover shows the efficiency of the company in using all its assets
to generate sales. Usually, the higher the ratio, the more efficient the use of the
assets. This ratio might be the most frequent ratio referred to by management as it
can show the overall efficiency of the companyÊs operations.
The calculation of total asset turnover for Company ABC is shown as follows:
Sales

Total assets
RM307,400
 (2.11)
RM359,700
 0.85 times

This performance is more satisfactory compared to the industry average.

However, analysts must be careful in using the non-current asset turnover and
total asset turnover ratio because the calculation of these ratios uses the historical
costs of the assets.
Some companies may have old assets or new assets. Therefore, it might not be
appropriate to compare the non-current asset ratio. Companies that owned new
non-current assets normally will show lower non-current asset turnover.
Therefore, the difference in the performance of the asset turnover might be due to
the costs of the assets and not the efficiency of the managementÊs operations.
ACTIVITY 2.7
The economic and technology status of the country will influence the
operations of a business. To ensure that the company stays competitive
and is expanding, what effective actions can be taken?
Discuss this question with your coursemates in the myINSPIRE online

forum.
2.9 LEVERAGE RATIO

Leverage ratio measures a companyÊs level of debt funding and the ability of the
company to fulfil its financial demands such as interest claim. The examples of
leverage ratio are shown in Figure 2.6:
Figure 2.6: Examples of leverage ratio
Leverage occurs when a company is being funded by debt. Debt includes all
current and non-current liabilities. Debt is also one of the main sources of funding.
It provides tax advantage as interest is a tax deductible item. The costs of debt
transactions are also lower as debts are easier to obtain compared to the issuance
of shares. Usually, the more debt in relation to total assets, the higher the financial
leverage of the company.

Leverage ratios can be divided into two groups:
(a) Ratios to evaluate the debt level used by the company such as debt ratio,
debt-equity ratio and equity multiplier; and
(b) Ratios to see the ability of the company in fulfilling its claims or obligations
to the creditors such as interest coverage ratio.
Normally, analysts would focus their attention on the long-term loans as the
company is bound by interest payments for a longer period and at the end of that
period, the company must repay the principal amount of the loan. As creditorsÊ
claims must be settled first before any earnings can be distributed to the
shareholders, potential shareholders will usually look at the debt level and the
ability of the company to repay the companyÊs debts.
Creditors will also focus on the leverage ratio as the higher the debt level, the
higher the probability of the company being unable to settle the debts of all its
creditors. Therefore, the management of the company must prioritise on the
leverage ratio as it attracts attention from several parties that are concerned with
the debt level of the company.
2.9.1 Debt Ratio

Debt ratio measures the percentage of total assets that are financed by debts.
Creditors prefer lower debt ratio as the lower the debt ratio, the higher the
protection for their losses upon liquidation. Unlike the preference of creditors for
a lower debt ratio, the management might choose a higher leverage to increase
earnings. This is because they do not like to issue new equity as they fear the
degree of control in the company will reduce. The higher the debt ratio, the higher
the percentage of assets being funded by debts.
The debt ratio of Company ABC is calculated as follows:
Total liabilities
Debt ratio   100
Total assets
RM164,300
  100 (2.12)
RM359,700
 45.7%
Industry average  40.0%

The debt ratio of Company ABC is 45.7 per cent and this is higher than the industry
average of 40 per cent. Potential creditors might be reluctant to provide additional
loans to the company as they worry that the company would not be able to settle
the interest and principal payment on time, due to its rather high debt ratio.
2.9.2 Debt-equity Ratio

Debt-equity ratio measures the total long-term debts for each ringgit of equity. The
lower the ratio, the better it is because it shows that the total equity owned by the
company exceeds the long-term debts.
The debt-equity ratio of Company ABC is calculated as follows:
Non-current liabilities
Debt-equity ratio 
Shareholders' equity
RM102,300
  100 (2.13)
RM195,400
 52.4%
Industry average  50%
The debt-equity ratio of Company ABC is higher compared to the industry

average. This shows that the percentage of long-term debt relative to the amount
of equity of the company is higher compared to the industry average. The higher
the ratio indicates that the company relies on long-term creditor-supplied funds
than owner-supplied funds.
2.9.3 Equity Multiplier

Equity multiplier shows the asset ownership for each ringgit of equity. Debt ratio
and equity multiplier provides the same information but in different approach.
Debt ratio of 40 per cent means that the company is being funded by 40 per cent
debts. Based on the balance sheet:
Asset = Liability + Equity
From this information, we know that the company is being funded by 60 per cent
equity. Equity multiplier is 100/60 = 1.67 times. Therefore, when the debt ratio of
Company ABC is 45.7 per cent, the equity multiplier is 100/54.3 = 1.84 times.

In general,
1
Equity multiplier 
1-Debt ratio
Total assets

Total equity
RM359,700
 (2.14)
RM195,400
 1.84 times
The equity multiplier of Company ABC is higher compared to the industry

average. This shows that the funding of the companyÊs assets via equity is higher
compared to the other companies in the industry.
2.9.4 Interest Coverage Ratio

Creditors and other parties would know the companyÊs ability to make interest
payments periodically by using the current operationÊs income. Interest coverage
ratio is used to decide the number of times the company can repay all its interest
expenses with the current income. This ratio is obtained by dividing the operations
profit with interest expenses.
Interest coverage ratio of Company ABC is calculated as follows:
Profit before interest and tax


Interest expenses
RM41,800
 (2.15)
RM9,300
 4.49 times
Interest coverage ratio of 4.49 times is more satisfactory compared to the industry
average performance of 4.3 times. This indicates the interest expenses margin with
current income.

Interest coverage ratio can also be calculated by using the following formula:
Net profit  Interest expenses  Tax expenses

Interest coverage ratio 
Interest expenses
RM22,075  RM9,300  RM9,425
 (2.16)
RM9,300
 4.39 times
2.10 PROFITABILITY RATIO

The profitability ratio measures the effectiveness of the company in generating
returns from investments and sales. It is used as a sign to determine the businessÊ
efficiency and effectiveness in achieving its profit objective. Examples of
profitability ratios are shown in Figure 2.7:
Figure 2.7: Examples of profitability ratio
2.10.1 Gross Profit Margin

Gross profit margin measures the profit for each ringgit of sales that can be used
to pay the sales and administration expenditures. The higher the gross profit
margin, the better the status of the company as this shows lower expenditures or
costs involved in implementing sales activities.
Gross profit margin can be obtained by dividing the gross profit with sales. It
shows the balance percentage for each ringgit of sales after the company had paid
all the costs of goods.

The calculation of gross profit margin for Company ABC is shown as follows:
Gross profit
Gross profit margin   100
Sales
RM98,600
  100 (2.17)
RM307,400
 32.1%
Gross profit margin of 32.1 per cent is higher compared to the industry average of
30 per cent. This shows that the purchasing management and cost of the company
are better compared to the industry average. The company generates 32.1 cents
gross profit after deducting all costs of goods for each ringgit of sale.
2.10.2 Net Profit Margin

Net profit margin measures the ability of the company to generate net profit from
each ringgit of sale after deducting all expenditures including the cost of goods
sold, sales expenditures, general and administrative expenditures, depreciation
expenses, interest expenses, and tax. The higher the net profit margin, the better
the status of the company as this shows an efficient purchasing management with
low purchasing costs.
Net profit margin is calculated by dividing the profit after tax with sales. Hence,
the net profit margin of Company ABC is calculated as follows:
Profit after tax

Net profit margin   100
Sales
RM23,075
  100 (2.18)
RM307,400
 7.5%
The net profit margin for Company ABC of 7.5 per cent is higher compared to the
industryÊs performance of 6.4 per cent. This shows that the management of
purchasing and related purchasing costs are better compared to the industry
average. Company ABC had managed to generate 7.5 cents net profit for each
ringgit of sale compared to the industry average that only managed to generate 6.4
cents for each ringgit of sale.

2.10.3 Operating Profit Margin

The operating profit margin measures the efficiency of operations in reducing
costs and increasing returns before interest and tax. A higher operating profit
margin is better as it indicates that the company is able to operate efficiently. The
operating profit margin of Company ABC is calculated as follows:
Operating profit
Operating profit margin   100
Sales
RM41,800
  100 (2.19)
RM307,400
 13.6%
The operating profit margin of Company ABC is better compared to the industry
average. This shows that Company ABC is more efficient in its operations and
control of its operating expenditures to generate higher earnings before interest
and tax.
2.10.4 Return on Assets

Return on assets or return on investment measures the effectiveness of the
company in using its assets to generate profit. The higher the ratio, the better the
status of the company as it indicates the managementÊs efficiency in using its assets
to generate profit.
The calculation of return on assets for Company ABC is calculated as follows:
Profit after tax

Return on assets   100
Total assets
RM23,075
  100 (2.20)
RM359,700
 6.42%
Return on assets of Company ABC is better compared to the industry average that
only contributes 4.8 per cent. This shows that Company ABC is better in managing
its assets to generate profit compared to the other companies in the industry.

2.10.5 Return on Equity

Return on equity measures the efficiency of the company in generating profit for
its ordinary shareholders. The higher the ratio, the better as the company is able to
generate high profit for its owners.
Return on equity of Company ABC is calculated as follows:
Profit after tax

Return on equity   100
Shareholders equity
RM23,075
  100 (2.21)
RM195,400
 11.8%
Return on equity of Company ABC is 11.8 per cent and this is more satisfactory
compared to eight per cent for the industry average. This shows that the
management of the company is more efficient compared to the industry average.
The calculation of return on equity will be discussed further when we discuss the
DuPont analysis.
2.10.6 Earnings Per Share

Earnings per share calculates the net profit that is generated from each ordinary
share. This information is often given priority by the management and investors
as it is regarded as an important indication of the companyÊs success. Therefore,
the bigger the value of this ratio, the better the status of the shareholders.
Earnings per share is obtained by dividing the net profit with the number of
ordinary shares issued. The calculation of earnings per share for Company ABC is
shown as follows:
Profit available to ordinary shareholders

Earnings per share 
Number of ordinary shares issued
RM23,075
 (2.22)
76,262
 RM0.30
Industry average  RM0.26

Company ABC obtained RM0.30 for each unit of shares issued compared to the
industry average of only RM0.26. The value of this difference is small and in
practice, this value represents the actual amount that will be distributed to the
shareholders.
2.11 MARKET VALUE RATIO

Market value ratio measures the ability of the company to generate market value
in excess of its investment costs. This aspect is very important as these market
value ratios are directly related to the objective of the company, that is to maximise
shareholdersÊ wealth and value of the company. Therefore, it can be said that the
value of market value ratio influences the marketÊs reaction and investorsÊ
confidence towards the ability of the companyÊs management in generating profit
efficiently and effectively.
Examples of market value ratio are shown in Figure 2.8:
Figure 2.8: Examples of market value ratio
We will now discuss these examples in greater detail.
2.11.1 Price Earnings Ratio

Price earnings ratio shows the total ringgit that the investor is willing to pay for
each ringgit of profit reported by the company. The level of price earnings ratio
shows the degree of confidence of the investors towards the future performance of
the company. The higher the price earnings ratio, the higher the confidence of the
investors towards the companyÊs future.
Price earnings ratio can be obtained when the market price per share is divided by
the earnings per share. To calculate the price earnings of Company ABC, we
assumed that the market price for the companyÊs share is RM3.23.

Market price per share

Price earnings ratio 
Earnings per share
RM3.23
 (2.23)
RM0.29
 11.1
Industry average  1.25
The ratio shows that the degree of confidence of the investors towards
the company is significantly higher compared to the industry average as the
investors are willing to pay 11.1 times more for each companyÊs share compared
to 1.25 for each share in the industry average.
The share prices section in most newspapers will usually show the price earnings
ratio of the listed companies. However, the newspapers provide current price ratio
instead of the latest profits. This means investors give more priority to the price
relative to future earnings.
2.11.2 Dividend Yield Ratio

There are investors who will buy ordinary shares to receive dividends. Others will
be more interested in the growth of their share market value. Dividend yield ratio
measures the rate of return in the form of dividends received from a share
investment. Assume that Company ABC practises a stable dividend policy and
pays dividends of RM0.15 per share. This means that the investors will receive
return from dividends of 4.6 per cent.
A lot of companies try to maintain paying a stable dividend and, if possible, they
will try to increase the dividends so that investors will receive more returns from
their share holdings. There are companies that pay small dividends and there are
those that do not pay any dividends to their shareholders. This is because they put
in more effort to expand their businesses by retaining and reinvesting the profit
obtained.
The calculation of dividend yield ratio for Company ABC is shown as follows:
Dividend per share

Dividend yield ratio 
Market price per share
RM0.15
  100 (2.24)
RM3.23
 4.6%
SELF-CHECK 2.4
What are the differences between price earnings ratio and dividend yield
ratio?
2.12 CONDUCTING A COMPLETE RATIO

ANALYSIS
As stated previously, one ratio is not sufficient to evaluate all aspects of the
companyÊs financial status. Therefore, the manager must conduct a complete ratio
analysis to cover all aspects of liquidity, asset management, leverage, profitability
and market value ratio.
The two approaches that can be conducted are (refer to Figure 2.9):
Figure 2.9: Approaches in conducting a complete ratio analysis
2.12.1 DuPont Analysis

DuPont analysis is used by finance managers to evaluate the financial status of a
company. The DuPont analysis combines the income statement and the balance
sheet to become two measurements of profitability, which are:
(a) Return on assets; and
(b) Return on equity.

The first step in DuPont analysis is to show the following DuPont formula:
Return on assets  Net profit margin  Total assets turnover

Profit after tax Sales
 
Sales Total assets
 7.5%  0.85 times
 6.4%
In the DuPont formula, the net profit margin measures the profitability of sales,
while the total asset turnover shows the efficiency of management in using assets
to generate sales.
The value of return on asset is calculated by using the DuPont formula is the same
as the value of return on assets calculated directly parting subtopic 2.10.4.
However, the DuPont formula allows the company to evaluate its return on asset
by separating it into two different components: profit on sales and efficiency in
asset management.
The second step in DuPont analysis is to connect the return on asset with return
on equity. This relationship is shown as follows:
Return on equity  Return on assets  Equity multiplier

Profit after tax Total assets
 
Total assets Total equity
 6.4%  1.84 times
 11.8%
When the values for return on asset and equity multiplier are replaced in this
formula, the result is 11.8 per cent, the same as calculated directly in subtopic 2.10.5.
However, the DuPont analysis has the advantage of allowing the manager to
evaluate the return on equity by looking at three separate components, which are:
(a) Profit on sales;
(b) Efficiency of asset management; and
(c) Effect of using debts in funding assets.
If the DuPont analysis is extended, the return to the owner can be evaluated by
looking at each important dimension as shown in Figure 2.10.

Figure 2.10: Extended DuPont analysis
From Figure 2.10, we found that the return on equity for Company ABC (11.8 per
cent) is higher compared to the industry average (8 per cent). This higher return
on equity is influenced by Company ABCÊs higher return on asset compared to the
industry and less influenced by the pattern of funding as illustrated by the equity
multiplier. (Return on asset of Company ABC is 6.4 per cent, while the return on
asset of the industry is only 4.8 per cent. The difference in equity multiplier
between Company ABC and the industry is quite marginal, 1.84 times for
Company ABC and 1.67 times for the industry).
The difference in returns between Company ABC and the industry is influenced
by the difference in net profit margin compared to the difference in total assets
turnover. Meanwhile, the difference in profit margin between Company ABC and
industry is significant (7.5 per cent for Company ABC and 6.4 per cent for the
industry) compared to the difference in total assets turnover (0.85 times for
Company ABC and 0.75 times for the industry).
Net profit margin of Company ABC is influenced by the higher operating profit
margin compared to the gross profit margin. Therefore, the higher return on equity
for Company ABC is due to the management efficiency in managing its operations.

2.12.2 Summarising All Financial Ratios

The performance of Company ABC is measured based on five groups of ratio,
which are:
(a) Liquidity;
(b) Asset management;
(c) Leverage;
(d) Profitability; and
(e) Market value.
Company ABCÊs financial ratios can be compared with the ratios of other
equivalent companies, or with the industry average at one point of time. These
comparisons provide explanations on the relative financial status and performance
of Company ABC compared to the relative performance of its competitors. This
analysis uses industry average as a benchmark or standard of comparison.
When the industry average cannot be obtained, comparisons are usually made
with other companies in the same industry. This benchmark is assumed to be the
suitable value for a company in the same industry. The assumption here is for the
companies in the same industry to have an almost identical financial ratio. If the
ratio of a company shows a significant difference with the standard ratio, then
further investigation must to be done to find the cause of that difference.
For evaluation, a companyÊs financial ratio is compared to the industryÊs ratios one
by one, and then classified as either satisfactory or unsatisfactory, depending on
the direction and how far it has diverted from the standard.

Table 2.5 summarises the comparison between Company ABCÊs financial ratios
with the industry average for the year 2018.
Table 2.5: Summary of Ratio Analysis for Company ABC Compared with the
Industry Average for Year 2018
Aspect Company ABC Industry Average Notes*

Liquidity Ratio
Current ratio 1.97 times 2.05 times US
Quick ratio 1.51 times 1.43 times US
Asset Management Ratio

Account receivable turnover 6.11 times 8.24 times US
Average collection period 58.92 days 44.3 days US
Inventory turnover 7.22 times 6.6 times S
Average inventory sales period 49.86 days 55.30 days US
Non-current asset turnover 1.29 times 1.35 times US
Total asset turnover 0.85 times 0.75 times S
Leverage Ratio
Debt ratio 45.7% 40.0% US
Debt-equity ratio 52.4% 50% S
Interest coverage ratio 4.49 times 4.3 times S
Profitability Ratio
Gross profit margin 32.1% 30% S
Net profit margin 7.5% 6.4% S
Return on assets 6.42% 4.8% S
Return on equity 11.80% 8.0% S
Earnings per share RM0.29 RM0.26 S
Market Value Ratio

Price earnings ratio 11.1 1.25 US
Dividend yield ratio RM0.046 RM0.50 US
*S = Satisfactory US = Unsatisfactory
From Table 2.5, we can summarise that:
(a) Liquidity
The Company ABCÊs achievement in current ratio and quick ratio are much
different compared with the industry. Overall, Company ABCÊs liquidity is
rather satisfactory.

(b) Asset Management

Company ABCÊs inventory management is quite satisfactory. Company ABC
might face problems with its account receivables as the collection period for
the company is higher compared to the industry. Therefore, attention has to
be given to the management of account receivables.
(c) Leverage
The level of Company ABCÊs debts is higher than that of the industry
average. However, the ability of Company ABC to pay interests is better
compared to the industry.
(d) Profitability
Profitability, relative to the investors (as seen in the return on asset and
return on equity ratios) of Company ABC is better compared to the industry.
This is the same with the gross profit margin and net profit margin.
(e) Market Value

Company ABCÊs shares were sold at the higher price earnings ratio than the
industry. This is the same for dividends yield ratio which is smaller
compared with the industry.
2.13 WEAKNESSES OF FINANCIAL RATIOS

Financial ratios are important tools in financial analysis but when the users apply
the financial ratios, they must take into consideration the weaknesses related to
these financial ratios. Among the weaknesses are:
(a) The accuracy of the financial ratio depends on the accuracy of the data found
in the financial statements;
(b) In using the financial ratio for industrial comparison purposes, the users
must take into consideration that the industry ratio is only a rough estimate.
This is due to the difficulty to obtain the entire similar firms in the same
industry;
(c) Financial ratio is a relative measurement and does not show the actual size
of the firm; and
(d) Financial ratio is used to measure the financial status of the firm but it cannot
show the issues that had caused the situation.

ACTIVITY 2.8
Visit the following websites to obtain additional information regarding

several subtopics that we have discussed in this topic.
(a) http://www.ppkm.net/
Description: Persatuan Pasaran Kewangan Malaysia was
established with the objective to provide an organisation for
individuals who are actively engaged in the foreign exchange and
financial markets in Malaysia.
(b) http://www.finpipe.com/equity/finratan.htm
Description: Introduction to financial ratio analysis
(c) http://www.investopedia.com/university/ratios/
Description: Steps and explanations on the calculations of
financial ratio analysis
(d) https://www.investopedia.com/terms/d/dupontanalysis.asp
Description: Detailed explanation on DuPont analysis. It also
includes a convenient web calculator.
 Financial ratio analysis is suitable to be used when the company wants to

interpret the financial statements of the company.
 Liquidity ratios such as net working capital, current ratio and quick ratio
enable the company to measure its ability to fulfil its short-term maturity
claims.
 Asset management ratios measure the companyÊs efficacy in using the assets.
Examples of this ratio include account receivable turnover, average collection
period, inventory turnover, average inventory sales period, non-current asset
turnover and total asset turnover.
 Leverage ratio measures the level a company is being funded by debt or the
ability of a company to fulfil its financial claims such as interest claims.

 Profitability ratio measures the effectiveness of the company in generating

returns from investment and sales. For example: gross profit margin, net profit
margin, return on assets and return on equity.
 Market value ratios such as price earnings ratio and dividend yield ratio,
measure the ability of a company to create values in the market exceeding its
investment costs. This aspect is very important as these ratios are directly
linked to the companyÊs objective that is to maximise shareholderÊs wealth and
value of the company.
 The DuPont analysis is used by finance managers to evaluate the financial

status of the company by measuring two important ratios, which are return on
assets ratio and return on equity ratio. Meanwhile, the approach on
summarising the financial ratio analysis is to show all aspects of the companyÊs
overall financial status to identify sectors that require further investigation.
Annual report Income statement

Asset management ratio Leverage ratio
Balance sheet Liquidity ratio
Cash flow statement Market value ratio
DuPont analysis Profitability ratio
Financial ratio analysis Statement of retained earnings
Financial statement

1. Balance sheet is the statement on the financial status of a company for a

specific period.
(a) True (b) False
2. Income statement is the statement that attempts to measure the result of a

companyÊs operating decisions at a specific point of time.
(a) True (b) False
3. Non-current assets are items that cannot be converted into cash within a
period of one year.
(a) True (b) False
4. Investments in financial securities are considered as current assets.
(a) True (b) False
5. Which of the following accounting equation is FALSE?
A. Assets = Liabilities + OwnerÊs Equity
B. Assets – Liabilities = OwnerÊs Equity
C. Assets + Liabilities = OwnerÊs Equity
D. Assets – OwnerÊs Equity = Liabilities
6. Mark on each of the accounts listed as follows:
(a) In column (1), state the appropriate statement – whether the account is
in the Income Statement (IS) or the Balance Sheet (BS).
(b) In column (2), state whether the account is a current asset (CA), non-
current asset (NCA), current liabilities (CL), non-current liabilities
(NCL), shareholderÊs equity (SE), income (I) or expenditure (EX).

Account (1) Statement (2) Type of Account

Account payable ____________ ___________________
Account receivable ____________ ___________________
Accrual ____________ ___________________
Building ____________ ___________________
General expenses ____________ ___________________
Interest expenses ____________ ___________________
Sales expenses ____________ ___________________
Operating expenses ____________ ___________________
Administrative expenses ____________ ___________________
Tax ____________ ___________________
Preference sharesÊ dividends ____________ ___________________
Sales revenue ____________ ___________________
Long-term loans ____________ ___________________
Inventory ____________ ___________________
Cost of goods sold ____________ ___________________
Paid-up capital above par ____________ ___________________
Notes payable ____________ ___________________
Retained earnings ____________ ___________________
Equipment ____________ ___________________
Ordinary shares ____________ ___________________
Preference shares ____________ ___________________
Marketable securities ____________ ___________________
Depreciation ____________ ___________________
Accumulated depreciation ____________ ___________________
Land ____________ ___________________
Cash ____________ ___________________
7. Use the relevant items listed as follows to prepare the income statement for
Company PC for period ending 31 December 2018.
Items Value at 31 December 2018

(RM Â000)
Account receivable 3,500
Accumulated depreciation 2,050
Cost of goods sold 2,850
Depreciation expenses 550
General and administrative expenses 600
Interest expenses 250
Preference sharesÊ dividends 100
Sales revenue 5,250
Sales expenses 350
ShareholdersÊ equity 2,650
Tax Rate = 30%

8. Use the relevant items from the following list to prepare the balance sheet for
Company ODC as at 31 December 2018.
Items Value at 31 December 2018

(RM Â000)
Account payable 2,200
Account receivable 4,500
Accrual 550
Building 2,250
General expenses 3,200
Depreciation expenses 450
Sales revenue 3,600
Long-term loans 4,200
Inventory 3,750
Equipment 2,350
Machines 4,200
Paid-up capital above par 3,600
Notes payable 4,750
Retained earnings 2,100
Ordinary shares (at par) 900
Preference shares 1,000
Marketable securities 750
Accumulated depreciation 2,650
Land 2,000
Cash 2,150
1. In the cash flow statement, you will see that both interest expenses and
dividends paid are in the section of financing activities.
(a) True (b) False
2. Depreciation expense is one of the items that will be deducted from the net
profit to determine the cash flow from operating activities.
(a) True (b) False
3. Profit from the sale of non-current assets will be deducted from the net profit
to ascertain the cash flow from operating activities.
(a) True (b) False

4. Payment to suppliers for the purchase of materials will be included into the
cash flow statement in the section of cash from financing activities.
(a) True (b) False
5. Information included in the cash flow statement are obtained from the
_______________.
A. income statement
B. balance sheet
C. income statement and balance sheet
6. Interest expenses are regarded as _________________ in the income

statement and ___________ in the cash flow statement.
A. operating expenses; item from operating activity
B. financing expenses; item from financing activity
C. operating expenses; item from financing activity
D. financing expenses; item from operating activity
7. Hugo Enterprise begun the year 2017 with retained earnings of RM92,800.
Throughout year 2017, the company obtained profit of RM37,700 after tax.
From this amount, preference shareholders were paid dividends of RM4,700.
At the end of year 2017, retained earnings of the company total RM104,800.
14,000 units of ordinary shares were issued throughout year 2017.
(a) Prepare the retained earnings statement for the year ended
31 December 2017. (Ensure that you calculate and include the total
dividends of ordinary shares paid in the year 2017).
(b) Calculate the earnings per share for year 2017.
(c) How much dividend per share was paid by the company to the
ordinary shareholders for the year 2017?
8. Profit after tax of year 2018 for Company Ceria is RM186,000. The closing
balance for retained earnings for years 2018 and 2017 were RM812,000 and
RM736,000 respectively. How much dividend did the company pay in the
year 2017?

9. Classify each of the following items as funds resource (R), usage (U), or
neither one (N).
Item Changes (RM) Cash Flow

Cash +1,000 ________________
Account payable –10,000 ________________
Notes payable +5,000 ________________
Non-current liabilities –20,000 ________________
Inventory +2,000 ________________
Non-current assets +4,000 ________________
Account receivable –7,000 ________________
Net profit +6,000 ________________
Depreciation +1,000 ________________
Share buyback +6,000 ________________
Cash dividend +8,000 ________________
Sale of share +10,000 ________________
10. Use the data from the balance sheet and several items from the income
statement of Suresh Corporation to prepare the cash flow statement for year
ended 31 December 2018.
Suresh Corporation
Balance Sheet
Assets RM RM
Cash 15,000 10,000
Inventory 29,000 28,000
Total non-current assets 295,000 281,000
Less: Accumulated depreciation 147,000 131,000
Total Assets 230,000 218,000
Liabilities
Current liabilities
Wages accrual 2,000 3,000

OwnerÊs Equities
Total shareholdersÊ equity 134,000 128,000
Total Liabilities and
ShareholdersÊ Equities 230,000 218,000
Data from Income Statement (2017)

Depreciation expenses RM16,000
Net profit RM14,000
1. The following data is taken from the financial statements of Fazrul Company:
2017 2016
RM RM
Sales 640,000 560,000
Cost of sold goods 380,000 360,000
Cash 30,000 26,000
Inventory 150,000 140,000
Prepayment items 10,000 10,000
Current liabilities 120,000 140,000
Based on this data, calculate the following liquidity ratios for the years 2016
and 2017:
(a) Net working capital;
(b) Current ratio; and
(c) Quick ratio.

The following data was taken from the financial statements of Fazrul Company:
2017 2016
RM RM
Sales 640,000 560,000
Cost of goods sold 380,000 360,000
Cash 30,000 26,000
Account receivables 70,000 62,000
Inventory 150,000 140,000
Prepayment items 10,000 10,000
Current liabilities 120,000 140,000
Based on this data, calculate the asset management ratios for the years 2016 and
2017. Assume that there are 365 days in a year. The asset management ratios are:
(a) Account receivables turnover;
(b) Average collection period;
(c) Inventory turnover;
(d) Average inventory sales period;
(e) Non-current asset turnover; and
(f) Total asset turnover.
The summary of balance sheet and income statement of Adiy Corporation are
shown as follows:
Adiy Corporation
Balance Sheet Income Statement
Assets: Sales (all credit) RM6,000,000
Cash RM150,000 Cost of goods sold 3,000,000
Account receivable 450,000 Operating expenses 750,000
Inventory 600,000 Interest expenses 750,000
Net non-current assets 1,200,000 Tax 420,000
Net Profit 10,920,000

Liabilities and Equities:

Account payable 150,000
Notes payable 150,000
Non-current liabilities 1,200,000
Equities 1,500,000
Calculate the financial ratios for Adiy Corporation based on the information
given. Assume that there are 365 days in a year. The financial ratios are:
(a) Debt ratio;
(b) Interest coverage ratio;
(c) Return on asset;
(d) Average collection period; and
(e) Total asset turnover.
1. _________ is the ability of the company to fulfil its current liabilitiesÊ

obligations by using its current assets.
2. Current ratio is similar to _________ divided by ___________.
3. _________ is included in the calculation of current ratio but excluded from

the calculation of the quick ratio.
4. Inventory turnover is obtained by dividing _________ by _________.
5. Ratio of total liabilities to ____________ is used to ascertain the level of debt

in the capital structure.
6. Return on equity is obtained when _________ is divided by _________.
7. Price earnings ratio is equal to _________ per share divided by _________ per
share.

8. X-Cell and N-Hance are two companies operating in the same industry. The
financial information for both companies as at 31 December 2017 are as
follows:
X-Cell N-Hance
RM RM
Total assets 3,000,000 1,600,000
Total liabilities 1,800,000 960,000
Total equities 1,200,000 640,000
Net sales 3,700,000 1,880,000
Interest expenses 90,000 38,000
Tax expenses 240,000 100,000
Net profit 380,000 180,000
Earnings per share 5.60 2.10
Market price per share of ordinary shares 35.00 26.50
Dividends per share for ordinary shares 2.40 0.50
For each of the company, calculate the following ratios:
X-Cell N-Hance
(a) Return on assets _______________ _______________
(b) Return on equity _______________ _______________
(c) Net profit margin _______________ _______________
(d) Total asset turnover _______________ _______________
(e) Debt ratio _______________ _______________
(f) Equity multiplier _______________ _______________
(g) Interest coverage ratio _______________ _______________
(h) Price earnings ratio _______________ _______________
(i) Dividend yield ratio _______________ _______________

1. When ratio comparisons show an obvious change in the financial status of a

company, the manager should investigate the matter further.
(a) True (b) False
2. In the DuPont analysis, return on equity is the result of multiplying three

other ratios: net profit margin, total asset turnover and return on asset.
(a) True (b) False
3. Net profit divided by total asset equal to ___________.

A. return on equity
B. current ratio
C. gross profit margin
D. return on asset
4. Dividend yield ratio is ___________.

A. total money distributed to shareholders
B. dividends paid to shareholders divided by retained earnings
C. dividends per share divided by price per share
D. retained earnings divided by sales
5. Use the following information to calculate the net profit.

Return on asset = 2%
Total asset turnover = 0.5 times
Cost of goods sold = RM105,000
Gross profit margin = 30%
6. Calculate the return on equity based on the information given:

Sales = RM100,000
Net profit = RM3,000
Total assets = RM150,000
Total liabilities = RM75,000
7. The following are several transactions made by Fuma Corporation along

with the financial ratios.
For each of the transactions, state whether there is an increase, decrease or no

change to the ratio listed next to the related transaction.
Transactions Financial Ratios

(a) Selling of inventory on credit Current ratio
(b) Issuing ordinary shares to collect cash Return on equity
(c) Issuing long-term bonds for cash Debt ratio
(d) Declaring and paying cash dividends for Dividend yield
ordinary shares
(e) Collecting account receivable Account receivable turnover
(f) Making cash loans by issuing long-term Return on assets
notes payable
8. The finance manager of Lily Corporation provided the following financial

information to you to prepare the companyÊs financial analysis.
Lily Corporation
Balance Sheet as at 31 December 2017
RM RM
Cash 1,000 Account payable 9,000
Account receivable 8,900 Accrual account 6,675
Inventory 4,350
Total current liabilities 15,675 Total current asset 14,250
Total non-current asset 35,000 Long-term loans 4,125
Accumulated
Depreciation 13,250
Net non-current asset 21,750
Total liabilities 19,800
Ordinary shares 1,000
Total equity 16,200
Total asset 36,000 Total liability and equity 36,000

RM
Sales 100,000
Gross profit 13,000
Operating expenditure 11,000
Operating profit 2,000
Interest expenses 500
Tax 420
Net Profit 1,080
Based on the financial information, calculate the following financial ratios:
(a) Current ratio __________________
(b) Quick ratio __________________
(c) Average collection period __________________
(d) Inventory turnover __________________
(e) Non-current asset turnover __________________
(f) Total asset turnover __________________
(g) Debt ratio __________________
(h) Interest coverage ratio __________________
(i) Gross profit margin __________________
(j) Operating profit margin __________________
(k) Net profit margin __________________
(l) Return on asset __________________
(m) Return on equity __________________

9. Complete the balance sheet for Amri Company based on the following
information. Assume that there are 360 days in a year.
Gross profit margin = 38.7%
Inventory turnover = 6 times
Average collection period = 31 days
Sales = RM720,000
Current ratio = 2.35 times
Total asset turnover = 2.81 times
Debt ratio = 49.4%
Amri Company
Balance Sheet
RM RM
Assets Liability and OwnersÊ Equity
Current asset Current liabilities
Cash 8,005 Account payable 28,800
Marketable securities Notes payable
Account receivable Accruals 18,800
Inventory Total current liabilities
Total current assets 159,565
Long-term liabilities
Total non-current assets Total liabilities
Accumulated 50,000
depreciation
Net non-current asset ShareholdersÊ equity
Paid-up capital 6,400
Total assets Total equity
Total liabilities and equity

Topic  Time Value of
Money
3
LEARNING OUTCOMES
1. Apply the concept of compounding and discounting in determining
future value and present value of money;
2. Differentiate between an ordinary annuity and an annuity due;
3. Calculate the present value of a perpetuity; and
4. Calculate the future and present value of money for non-annual
compounding periods.
 INTRODUCTION
The public generally assume time as very precious and must be managed
efficiently. They place the value of time on par with various valuable objects and
one of the globally accepted proverbs is „time is money‰. From the financial
management perspective, this proverb is a phrase that can be measured and
proven quantitatively by using financial mathematics. In fact, this quantitative
proof has been developed as one of the basic principles in financial decisions
known as the concept of time value of money.

88  TOPIC 3 TIME VALUE OF MONEY
3.1 CONCEPT OF COMPOUNDING AND

FUTURE VALUE
Rationally, you will certainly choose the offer at the beginning of the year as
the value of money makes this alternative more profitable. The concept of
compounding is one of the main concepts of time value of money. The concept of
compounding, in brief, explains that RM1 today is more valuable than RM1 in the
future. This is because RM1 today can be invested to generate interest and
subsequently multiply to become more than RM1 at the end of the investment
year.
Among the reasons why time value of money makes this alternative more valuable
are:
(a) In general, individuals are more interested in the present usage than
postponing the usage to the future;
(b) During the inflation periods caused by uncontrollable development in the

economy, the real purchasing power of RM1 now is more than the real
purchasing power of RM1 in the coming years; and
(c) Capital that is obtained now can be invested productively to generate a

higher return in the future.
3.1.1 Time Line

The drawing of time line in Figure 3.1 can ease the understanding of the concept
of time value of money especially for complex problems. Time is divided into
several periods of valuation that are shown along the horizontal line and the
calculation of the period begins from left to right. Time 0 (t0) refers to the present
time or the starting of the first period, time 1 (t1) refers to the end of the first period
or the starting of the second period, time 2 (t2) refers to the end of the second period
or the starting of the third period and so forth.
Figure 3.1: Time line

TOPIC 3 TIME VALUE OF MONEY  89
3.1.2 Compound Interest

There are two types of interest: simple interest and compound interest. Simple
interest is the interest that will be paid or accepted based on the principal amount.
On the other hand, compound interest refers to the interest that will be paid not
only on the principal amount but also on any interest payable not withdrawn
throughout its period (accumulated interest).
In this topic, we will focus our discussion on compound interest as in the

calculation for time value of money, only compound interest is considered.
Example 3.1
If you had invested RM100 in the savings account in a bank with the interest rates
of 10 per cent per year, how much returns will you receive at the end of the first
year? Roughly, you will obtain RM110. These returns can be calculated as follows:
Returns (F) = Total principal (P) + Total interest (i)

= Total principal (P) + [Total principal (P)  Interest (i)]
= RM100 + RM100 (10%)
= RM100 + RM10
= RM110
F1 = P + P(i)
= P(1 + i)
If the stated returns are not withdrawn from the savings account, and the bankÊs
interest rates for the second and third year remained unchanged, how much
returns will you receive at the end of the second and third year? Refer to
Figure 3.2.
Figure 3.2: Estimated time line for the second and third year returns

F2 = P (1+i)2
= F1 (1+i)
= RM100 (1 + 0.1)2
= RM121
F3 = RM121 + RM12.10
= RM133.10 that is
= F2 +F2 (i)
= F2 (1+i)
= P2 (1+i)2 (1+i)
= P (1+i)3
When the savings period is extended to tn, the total amount in period (n) is:
Fn = P (1+i)n (3.1)
The complete time line for savings of RM100 at an interest rate of 10 per cent per
year is as follows (refer to Figure 3.3):
Figure 3.3: Time line for the first till third year returns
ACTIVITY 3.1
If you were given two choices – either an offer of RM1,000 at the

beginning of the year or an offer of RM1,000 at the end of the year,
which offer will you choose?

3.1.3 Calculation of Future Value Using Schedule

or Table
Calculation of future value using the equation of Fn = P (1+i)n with the value of n
being more than one, sometimes can be time consuming. Therefore, the usage of a
financial schedule that is the schedule of future value interest factor (FVIFi,n) helps
to save time in terms of calculations.
Equation 3.2 shows that the future value (FVn) is equivalent to the principal at the
point of time equal to 0 or the original principal amount (PV0) multiplied by the
future value factor as stated in the schedule of future value interest factor (FVIFi,n).
This schedule is enclosed in Attachment A.
FVn = PV0 (FVIFi,n) (3.2)
As a basic guide on the usage of the financial schedule, please refer to the extract
on the schedule of future value interest factor (FVIFi,n) in Table 3.1 to solve
Examples 3.2 and 3.3.
Example 3.2
You deposited RM2,000 in the savings account in a bank at a yearly interest rate of
five per cent for the period of one year. Upon the completion of one year, how
much will you receive?
FVn = PV0 (FVIF i,n)

= RM2,000 (FVIF 5%, 1)
= RM2,000 (1.0500)
= RM2,100
Example 3.3
Assume you deposited RM2,000 in the savings account in your bank at a yearly
interest rate of five per cent for the period of four years. Upon the completion of
four years, how much will you receive?
FVn = PV0 (FVIF i,n)

= RM2,000 (FVIF 5%, 4)
= RM2,000 (1.216)
= RM2,432

Table 3.1: Extract from the Future Value Interest Factor (FVIF i, n) Schedule
Interest Rate
4% 5%
Period no.
1 1.04 1.050
2 1.082 1.102
3 1.125 1.158
4 1.170 1.216
5 1.217 1.276
It must be remembered that sometimes a different answer might exist by using

manual calculation compared to the calculations using the schedule. This is due to
the usage of different numbers of decimal points. However, the difference is not
significant and both answers are acceptable.
3.1.4 Graphical Illustration of Future Value

There are three basic elements which will influence the future value:
(a) Principal (amount that was borrowed or invested);
(b) Time period (the number of periods or frequency of interest payments); and
(c) Interest rate payable (if the money was borrowed) or interest receivable (if
the money was invested).
To show how the interest rate influences the future value of an investment, we
must assume that the principal and the time period are constant. Therefore, any
changes to the future value are caused only by the interest rates. For example, you
intend to deposit RM100 at Bank A, B and C that offer different interest rates of 8
per cent, 10 per cent and 12 per cent respectively. Compounded annually, how
much will the future value of your deposit be three years from now?
Based on the equation
FVn = PV0 (FVIFi, n)

The future value of deposit in Bank A that offers an interest rate of eight per cent
is:
FV0.08’3 = RM100 (FVIF8%,3)

= RM100 (1.26)
= RM126
The future value of deposit in Bank B that offers an interest rate of 10 per cent is:
FV0.1’3 = RM100 (FVIF10%,3)

= RM100 (1.331)
= RM133.10
Meanwhile, the future value of deposit in Bank C that offers an interest rate of 12
per cent is:
FV0.12’3 = RM100 (FVIF12%,3)

= RM100 (1.405)
= RM140.50
The previous examples can also be applied on either the principal value or the time
period by assuming that the other variables are constant. You will discover that
the future value has a positive correlation with the time period (n) and the interest
rates (i) as shown in Figure 3.4.
Figure 3.4: Relationship between future value, time period and interest rates for RM100
ACTIVITY 3.2
As a bank manager, what are your strategies in attracting more people

to deposit and invest in your bank?
Share your ideas with your coursemates in the myINSPIRE online

forum.
3.2 CONCEPT OF DISCOUNTING AND PRESENT

VALUE
The second concept that is related with the time value of money is the concept of
cash flow discounting. This concept is used to ascertain the present value (PV0) or
principal value for a sum of money in the future (FV0) that is discounted at an
interest rate known as rate of return (i) for the valuation period (t).
The process to determine the present value is the reverse process of determining
the future value. The relationship between these two processes is illustrated in the
time line as shown in Figure 3.5.
Figure 3.5: Comparison between future value and present value

3.2.1 Calculation of Present Value

The process of discounting is the reverse process of compounding. The present
value (principal) can be found with a small variation to the basic equation of
calculating the future value (equation 3.1).
Example 3.4
Assume you expect to receive RM2,500 a year from now. How much is the present
value for RM2,500 if the discount rate or rate of return is eight per cent per year?
Refer to Figure 3.6.
FVn  PV0 (1  i)n
RM2,500  PV0 (1  0.08)1

RM2,500
PV0 
1.08
 RM2,314.81
Figure 3.6: Time line for present value of RM2,500
How much must you invest if you expect to receive of RM2,500 in the period (a)
two years and (b) three years at a discount rate of eight per cent per year?

FV2  PV0 (1  i)2
RM2,500  PV0 (1  0.08)2

RM2,500
PV0 
(1  0.08)2
 RM2,143.35
FV3  PV0 (1  i)3
RM2,500  PV0 (1  0.08)3

RM2,500
PV0 
(1  0.08)3
 RM1,984.58
The present value of RM2,500 at a rate of eight per cent in period one, two and
three years are as follows (refer to Figure 3.7):
Figure 3.7: Present value of RM2,500 for period one, two and three years
If the discounting period is extended to tn, the principal amount that must be
invested is:
FVn
PV0 = (3.3)
(1+i)n
OR
PV0 = FVn [1/(1+i)n]

3.2.2 Calculation of Present Value (Principal) using

Schedule or Table
Similar to future value factor, present value factor can also be obtained by using a
schedule that is the present value interest factor (PVIFi,n) as attached in
Attachment B. This schedule helps to simplify the calculation of present value
especially in complex problems. Equation 3.4 shows that the present value (PV0)
is equal to the future value amount (FVn) multiplied by the present value interest
factor (PVIFi,n).
PV0 = FVn (PVIF i,n) (3.4)
As a basic guide on the use of the financial schedule, please refer to the extract on
the schedule of present value interest factor (PVIFi,n) in Table 3.2 to solve Examples
3.5 and 3.6.
Example 3.5
Assume you expect to receive RM3,999 in three years time. How much is the
present value for RM3,999 if the discount rate or rate of return is nine per cent per
year?
PV0 = FVn (PVIF i,n)

= RM3,999 (PVIF 9%,3)
= RM3,999 (0.772)
= RM3,087.23
Example 3.6
You intend to accumulate RM5,713 in a bank savings account within four years.
How much savings must you deposit now if the interest rate offered by the bank
is 10 per cent per year?
PV0 = FVn (PVIF i,n)

= RM5,713 (PVIF 10%,4)
= RM5,713 (0.683)
= RM3,901.98

Table 3.2: Extract of Present Value Interest Factor Schedule (PVIF i, n)
Interest Rate
9% 10%
Period no.
1 0.917 0.909
2 0.842 0.826
3 0.772 0.751
4 0.708 0.683
5 0.650 0.621
It must be remembered that sometimes, you might come up with a different

answer by using manual calculation compared to the calculations using the
schedule. This is due to the different numbers of decimal points used. However,
the difference is not obvious and both answers are acceptable.
3.2.3 Graphical Illustration of Present Value

To show how interest rate influences the present value (principal) of an
investment, we must assume that future value and the time period are constant.
Therefore, any changes to the present value are caused only by the interest rates.
Example 3.7
You intend to obtain a return of RM1,000 within three years in banks A, B and C
that offer different compounding interest rates of 8 per cent, 10 per cent and 12 per
cent. What is the principal value that you should make?
The principal value for Bank A that offers an interest rate of eight per cent is:
PV8%,3 = RM1,000 (PVIF 8%,3)

= RM1,000 (0.7938)
= RM793.80
The principal value for Bank B that offers an interest rate of 10 per cent is:
PV10%,3 = RM1,000 (PVIF10%,3)

= RM1,000 (0.7513)
= RM751.30
The principal value for Bank C that offers an interest rate of 12 per cent is:
PV12%,3 = RM1,000 (PVIF12%,3)

= RM1,000 (0.7118)
= RM711.80
The previous examples can also be applied either in the future value or time period
by assuming that the other variables are constant. You will find that the present
value has a negative relationship both with the time period (n) and interest rates
(i) as shown in Figure 3.8. This graph explains that the principal value of RM1,000
that will be received in the future will decrease when the acceptance period is
extended. The rate of decrease for present value is higher with the increase in
discount rates or interest rates.
Figure 3.8: Relationship between present value, time period and interest rates
for RM1,000
SELF-CHECK 3.1
Explain how is the concept of discounting and present value different

from compounding and future value.

3.3 FUTURE AND PRESENT VALUES OF A

SINGLE CASH FLOW
Single cash flow is a cash flow that only occurs once throughout the period of
valuation. Both the concepts of compounding and discounting that were explained
earlier have used the examples of single cash flow.
The examples stated clearly show that the future value of an amount of single cash
flow invested presently will increase from time to time with the existence of
specific interest rates. In reverse, a sum value of single cash flow that has been
determined in the future will decrease when time approaches zero (refer to
Figure 3.9).
Figure 3.9: Single cash flow: Future and present values
3.4 FUTURE AND PRESENT VALUES OF A

SERIES OF CASH FLOW
The concepts of future value and present value are not limited to the process of
compounding and discounting single cash flow only. These concepts can be
applied to a series of cash flow.
A series of cash flow means that there are a series of receiving or payments of cash
that occur throughout the valuation period. Figure 3.10 lists several categories of
series cash flow.
Figure 3.10: Categories of series cash flow

3.4.1 Annuity
Annuity is a series of payment or receiving of the same amount at the same
intervals throughout the period of valuation. Therefore, a cash flow of RM5 each
month for one year is an annuity. While a cash flow of RM5 that is swap alternately
with a cash flow of RM10 each month for a year is not an annuity.
Annuity has a clearly stated starting point and an ending, in other words, annuity
cash flow would not be indefinite. Normally, annuity occurs at the end of each
period and this annuity is known as ordinary annuity. However, in some cases,
annuity occurs at the beginning of the period and this type of annuity is called
annuity due.
(a) Future Value of Ordinary Annuity

Ordinary annuity is annuity that occurs at the end of each period as shown
in Figure 3.11:
Figure 3.11: Time line of ordinary annuity
The finance manager often makes future planning for the company but he
usually does not know how much investment or savings that must be saved
continuously to accumulate the sum of money required in the future. The
future value of annuity is the number of annuity payments at a specific
amount (n) that will increase at a specific period based on a specific interest
rate (i).
Example 3.8
You had deposited RM100 at the end of each year for three years
continuously in the account that pays a yearly interest of 10 per cent. How
much is the future value of this annuity?

The solution can be illustrated by the following time line (refer to

Figure 3.12):
Figure 3.12: Time line for the future value of ordinary annuity for RM100
First step: Calculate the future value for t1, t2 and t3.
Second step: Total the three future values to get the future value of
ordinary annuity (FVA).
First step:
F1 = RM100 (1+0.1)1
= RM100 (1.1)
= RM110
F2 = RM100 (1+0.1)2
= RM100 (1.21)
= RM121
F3 = RM100 (no increase in the future value as the deposit was made at the
end of the third year).
Second step:
FVA3 = F1 + F2 + F3
= RM110 + RM121 + RM100
= RM331

The steps shown in the previous example take time to do even though it is a
simple example. In cases where the calculations for future value of annuities
are for a period of 20 or 30 years, it will be tedious to calculate as it involves
complicated calculations. Therefore, we can simplify the calculations by
using the following equation:
 (1 + i)n – 1 
FVA n = A   (3.5)
 i 
FVAn = A(FVIFAi,n ) (3.6)
Equation 3.5 is used to solve the future value problems that involve ordinary
annuity is by manual calculation. While Equation 3.6 is the solution formula
for ordinary annuity using schedule. Annuity future value schedule can be
obtained in Attachment C.
Example 3.9
Danon Company deposited RM5,000 at the end of each year for a period of
three years consecutively in an account that pays a yearly interest of 10 per
cent. What is the future value of this ordinary annuity?
(i) Manual solution
A [ (1 + i)n  1]
FVA n 
i
RM5, 000 [(1 + 0.10)3  1]

0.10
 RM16, 550
(ii) Solution using schedule
FVA n = A (FVIFA i, n )
= RM5, 000
= RM5, 000 (3.310)
= RM16, 550

The time line for future value of ordinary annuity of RM5,000 for three years
at a rate of 10 per cent per year is shown as follows (refer to Figure 3.13):
Figure 3.13: Time line for future value of ordinary annuity of RM5,000
(b) Future Value of Annuity Due

Sometimes, we face a situation where the payment of annuity is at the
beginning of a period, for example, the beginning of each month or year. This
type of annuity is known as annuity due where it is different from ordinary
annuity as ordinary annuity is paid at the end of a period. Annuity due
occurs more frequently in future value annuity than present value annuity
(PVA). Figure 3.14 shows the time line for annuity due.
Figure 3.14: Time line for annuity due
The equation of annuity due can be formulated with a little alteration to the
ordinary annuity equation that is by multiplying the equation of ordinary
annuity with (1 + i). This alteration is made because the cash flow for annuity
due occurs at the beginning of a period.
(i) Manual equation
 (1 + i) n – 1 
FVA n  A   (1 + i) (3.7)
 i 

(ii) Equation using schedule
FVAn = A (FVIFA i,n) (1 + i) (3.8)
Example 3.10 helps you to differentiate between ordinary annuity and

annuity due.
Example 3.10
Danon Company deposited RM5,000 at the beginning of each period for
three years consecutively in the account that pays yearly interest of 10 per
cent. How much is the future value for annuity due?
(i) Solving manually
 (1 + i)n – 1 
FVA n  A   (1 + i)
 i 
 [1 + 0.10)3 – 1] (1 + 0.10) 
 RM5, 000  
 0.10 
 RM18, 205
(ii) Solving using schedule
FVA n  A (FVIFA i, n ) (1 + i)
 RM5,000 (3.310) (1.10)
 RM18,205
The time line for future value annuity due of RM5,000 for three years at an
interest rate of 10 per cent per year is shown as follows (refer to Figure 3.15):
Figure 3.15: Time line for future value annuity due of RM5,000
From the previous solution, we found that the future value for annuity due
(RM18,205 in Example 3.10) is higher compared to the future value for
ordinary annuity (RM16,550 in Example 3.9). This is because for annuity due,
the deposit is deposited in the beginning of the period and therefore
generates more interest compared to the ordinary annuity where the deposit
is deposited at the end of the period.
(c) Present Value of Ordinary Annuity

Payment of annuity promises a return rate (investment in bonds) and cash
flow (cash flow resulting from investment in equipment and plant).
Therefore, it is important for a finance manager to know the value of the
investment at the present time.
For instance, a finance manager finds an annuity that promises four yearly
payments of RM500 starting from the current year. How much must be paid
by the finance manager to obtain this annuity? The principal amount that
must be paid by the finance manager is the present value of ordinary annuity.
The present value of ordinary annuity (PVAn) can be obtained by using the
manual equation (Equation 3.9) or by using the financial schedule in
Attachment D (Equation 3.10). Both the following equations refer to the
present value annuity (PVAn) equivalent to the annuity cash flow multiply
by the present value annuity factor.
(i) Manual equation
 [ 1 –[1/(1 + i)n ] 
PVA n = A   (3.9)
 i 
(ii) Equation using schedule
PVAn = A (PVIFAi,n) (3.10)

Example 3.11
Taming Company expects to receive RM3,000 at the end of each year for
three consecutive years. How much is the present value of this annuity if it
is discounted at the rate of six per cent per year?
(i) Solution via manual equation
[ 1 – [1 / (1 + i)n ] 
PVA n = A  
 i 
[ 1 – [1 / (1 + i)3 ] 
= RM3,000  
 0.06 
= RM8,019.04
(ii) Solution via equation using schedule
PVAn = A (PVIFAi, n)
= RM3,000 (PVIFA6%,3)
= RM3,000 (2.673)
= RM8,019
The time line for present value ordinary annuity of RM3,000 for three years
at a discounted rate of six per cent per year is shown as follows (refer to
Figure 3.16):
Figure 3.16: Time line for present value ordinary annuity of RM3,000

(d) Present Value of Annuity Due

The concept of forming an equation for the present value of annuity due is
as per the future value of annuity due where it is based on a small alteration
to the ordinary annuity equation that is by multiplying the Equations 3.9 and
3.10 with (1 + i).
 1 – [1/(1 + i)n 
PVA n = A   (1 + i) (3.11)
 i 
Example 3.12 can help you to differentiate between ordinary annuity with
the annuity due for present value.
Example 3.12
Taming Company expects to receive RM3,000 at the beginning of each year
for three consecutive years. How much is the present value of this annuity if
it is discounted at the rate of six per cent per year?
(i) Manual solution

 1  [1/(1 + i)n 
PVAn  A   (1 + i)
 i 
[ 1  [1/(1 + 0.063)3 ]
 RM3,000 (1 + 0.06)
0.06
 RM8,500.18
(ii) Solution using schedule

PVA n  A (PVIFAi,n ) (1 + i)
 A (PVIFA6%,3 ) (1 + 0.06)
 RM3,000 (2.673) (1.06)
 RM8,500.14

The time line for present value annuity due of RM3,000 for three years at a
discounted rate of six per cent per year is shown as follows (refer to
Figure 3.17):
Figure 3.17: Time line for present value annuity due of RM3,000
As per the difference between ordinary annuity and annuity due for
future value, the solution for present value of annuity due (RM8,500 in
Example 3.12) is also higher compared to the present value of ordinary
annuity (RM8,019 in Example 3.11). This is because in annuity due, the
deposit is deposited in the beginning of the period and therefore generates
more interest compared to ordinary annuity.
3.4.2 Non-uniform Cash Flow

There are many decisions in the financial field, for example involving capital
budgeting and dividend payments contain a mixture of cash flow or cash flow that
is irregular. The calculation of future value and present value of an irregular cash
flow is a combination concept of determining money value for single cash flow
and also annuity.
(a) Future Value of Non-uniform Cash Flows

The calculation for future value of non-uniform cash flow involves the
determination of future value for each of the cash flows and subsequently
totalling all that future values. Equation 3.12 shows the future value (FVn) is
obtained by adding each of the cash flow (Pt) that is adjusted with the
exponent (n – t) that is the number of periods in which the interest is
obtained.
Exponent is used in this equation because the last cash flow happens at the
end of the last period. Therefore, interest is not obtained for it. The Sigma
symbol (  ) is the mathematical symbol for a total of a series of value.

Manual equation
n
FVn   Pt (1 + i)năt
(3.12)
t 1
If the solution by using the schedule is chosen, you can use Equations 3.2, 3.6
or 3.8 according to the suitability of the cash flow. This is because the
calculation of future value of irregular cash flow is a combination concept of
determining the value of money for single cash flow and also annuity.
Example 3.13
Bikin Fulus Company made a decision to deposit RM2,000 at the end of the
first and second year, withdrawing RM3,000 at the end of the third year and
depositing RM4,000 again at the end of the fourth year. How much is the
future value of these cash flows at the end of the fourth year if the annual
interest rate is 10 per cent per year?

n
FVn   P (1 + i)
t 1
t
nt
 (RM2,000)(1.10)4 1 + (RM2,000)(1.10)4  2 + (  RM3,000)(1.10)4  3

+ (RM4,000)(1.10)4-4
 RM5,782
Example 3.13 can be illustrated by using the following time line (refer
to Figure 3.18):
Figure 3.18: Time line for Example 3.13

(ii) Solution by using schedule is shown as follows:
Step 1:
Find the future value of annuity for RM2,000 for two years (end of
second year).
RM2,000 (FVIFA10%, 2) = RM2,000 (2.10)

= RM4,200
Step 2:
Find the future value of RM4,200 at the end of the fourth year.
RM4,200 (FVIFA10%, 2) = RM4,200 (1.21)

= RM5,082
Step 3:
Find the future value at the end of the fourth year for the withdrawal
of RM3,000 that occurred at the end of the third year.
– RM3,000 (FVIFA10%, 1) = – RM3,000 (1.10)

= – RM3,300
Step 4:
The present value cash flow is obtained by adding the result of Steps 2
and 3 with the final cash flow of RM4,000. As RM4,000 occurs at the last
period, there is no interest earnings from it.
FV4 = RM5,082 + (–RM3,300) + RM4,000

= RM5,782
(b) Present Value of Non-uniform Cash Flows

Similar to the concept in determining the future value of derivation cash
flow, the present value of irregular cash flows is also a combination concept
of present value of single cash flow and annuity.
Manual equation
n
PV0   Pt [1/(1 + i)t ] (3.13)
t 1

If the solution by using the schedule is chosen, you can use the formula in
present value of single cash flow, present value of ordinary annuity or
present value of annuity in advance according to the suitability of the type
of cash flow stated in the problem.
Example 3.14
Buat Pitih Company expects to receive RM1,000 at the end of the first and
second year, RM2,000 at the end of the third year and RM4,000 at the end of
the fourth year. How much is the present value of the cash flow if the yearly
interest rate is 10 per cent per year?
n
PV0   Pt (1 + i)t
t 1
 [RM1,000][1/(1.10)1 ]  [RM1,000][1/(1.10)2 ] 
[RM2,000][1/(1.10)3 ]  [RM4,000][1/(1.10) 4 ]
 RM5,970.22
The time line for Example 3.14, the present value for derivation cash
flow is shown as follows (see Figure 3.19):
Figure 3.19: Time line for Example 3.14 (solution via manual equation)

(ii) Solution via schedule is shown as follows:
Step 1:
Find the present value for annuity of RM1,000 for two years.
RM1,000 (PVIFA10%, 2) = RM1,000 (1.736)

= RM1,736
Step 2:
Find the present value for RM2,000 that occurs at the end of third year.
RM2,000 (PVIF10%, 3) = RM2,000 (0.751)

= RM1,502
Step 3:
Find the present value for RM4,000 that occurs at the end of fourth year.
RM4,000 (PVIF10%, 4) = RM4,000 (0.683)

= RM2,732
Step 4:
The present value cash flow is obtained by adding all the previous results
earlier (figure in bold). Figure 3.20 shows the time line for Example 3.14.
PV0 = RM1,736 + RM1,502 + RM2,732

= RM5,970
Figure 3.20: Time line for Example 3.14 (solution via schedule)

3.4.3 Perpetuity
Perpetuity is a series of cash flow that involves the same amount for each period
continuously. In other words, perpetuity is an annuity that has an infinity period.
An example of perpetuity is the payment of dividends for preference shares.
The concept for future value of perpetuity is illogical and cannot be used in making
financial decisions as the concept does not predict the period ending point; while
future value is something that can be expected. Instead, the concept for present
value of perpetuity can be applied in making financial decisions. For example, the
use of this concept to determine the present value for preference shares and
present value for pensions.
From the equation of present value of annuity, we know that:
[ 1 – [1/(1 + i)n ]
PVA n = A (3.14)
i
Try to imagine what will happen if the value of n increases. The value of (1 + i)n
will also increase. This will cause 1/(1 + i)n to become smaller. When (n)
approaches infinity, the value of (1 + i)n will become extremely big, while the value
of 1/(1 + i)n will approach zero.
This situation can be summarised as follows:
PV p = P/i (3.15)
Based on this equation, the present value of perpetuity is equivalent to the

payment of annuity amount (P) divided by the interest rate (i). Solution by
schedule and scientific calculator cannot resolve the present value of perpetuity.
This is because schedule PVIFA does not contain the value for infinity; similarly,
scientific calculators too do not have an „infinity‰ key. Hence, it must be calculated
manually in stages.

Figure 3.21 shows the position of variables in Equation 3.15.
Figure 3.21: Present value of perpetuity
Example 3.15
Sukehati Company issued securities that promised a payment of RM100 per year
at the yearly interest rate of eight per cent to the holders of that security. How
much is the present value for this cash flow?
PVp = P/i
= RM100/0.08
= RM1,250
The financial schedule does not provide the factor for present value of perpetuity
because perpetuity involves an infinity period. Therefore, the solution for
perpetuity cases can only depend on manual calculations.
3.5 COMPOUNDING AND DISCOUNTING

MORE THAN ONCE A YEAR
The practice of compounding or discounting interest more than once a year is also
known as intrayear compounding or discounting. For example, compounding or
discounting twice a year, three times a year, four times a year or each month. The
frequency of compounding or discounting several times in a year is a normal
practice in making financial decisions.
When the frequency of compounding or discounting for future value or present

value is more than once a year, the time period will become (n  m), the interest
rate must also be divided with the said frequency (i/m). The purpose is to adjust
the changes in the period and interest rate to enable both the variables to change
consistently. Therefore, a little alteration must be made to the equations that had
been learnt previously.
The equation for manual solution is:
FV = PV (1 + i/m)nm (3.16)
Where
FV = Future value
PV = Present value
i = Interest rate
m = Frequency of compounding or discounting in a year
n = Number of years
While the solution by schedule is as follow:
FV = PV x (FVIF i/m,nm) (3.17)
Example 3.16
The future value of RM1 now after six years, using the interest rate of 10 per cent
per year with different compounding frequencies (refer to Table 3.3).
Table 3.3: The Future Value of RM1 in Six Years
Presumed Compounding nm i/m FVnm

Once a year 61=6 0.1/1 = 0.1 RM1.77
Twice a year 6  2 = 12 0.1/2 = 0.05 RM1.79
Four times a year 6  4 = 24 0.1/4 = 0.025 RM1.81
Every month 6  12 = 72 0.1/12 = 0.0083 RM1.82
Example 3.17
The present value of RM1 received in six years from now, discounted at the interest
rate of 10 per cent per year with different discounting frequencies (refer to
Table 3.4).
Table 3.4: The Present Value of RM1.00 in Six Years
Presumed Discounting nm i/m PV0

Once a year 61=6 0.1/1 = 0.01 RM0.56
Twice a year 6  2 = 12 0.1/2 = 0.05 RM0.56
Four times a year 6  4 = 24 0.1/4 = 0.025 RM0.55
Every month 6  12 = 72 0.1/12 = 0.0083 RM0.55

The conclusions that can be made based on Examples 3.16 and 3.17 are:
(a) The higher the frequency of compounding, the higher the future value of
cash flow; and
(b) The higher the frequency of discounting, the lower the present value of cash
flow.
3.6 CONTINUOUS COMPOUNDING AND

DISCOUNTING
Before this, you were only exposed to situations where the interest is compounded
or discounted at specific discrete intervals whether yearly or twice a year, monthly
and so forth. However, in some cases of time value of money, interest must be
compounded or discounted continuously or at each micro-second.
Referring to equation 3.16, FV = PV  (1 + i/m)nm, we cannot divide the value (i)

with infinity and multiply (n) with infinity. Instead, we use the term (e) that is
e ~ 2.71828. The value e is an anti-log to 1 and similar to pi (  ) with value of 3.142,
which cannot be represented by one exact value but only as an estimated value.
The new equation for future value and present value that is compounded and
discounted continuously are as follows.
Future value
FVn = PV0 (e in) (3.18)
Present value
PV0 = FVn (e –in) (3.19)
The estimate number for the symbol e in Equations 3.18 and 3.19 is 2.72 (or more
accurately, 2.71828183).

Example 3.18
What is the future value for RM100 that is invested now for six years with an
interest rate of eight per cent per year and compounded continuously?
Manual solution:
FVn = PV0 (ein)

= RM100 (2.72(0.08)(6))
= RM161.66
Example 3.19
What is the present value of RM161.61 that will be received in six years from now
that is discounted continuously at an interest rate of eight per cent per year?
PVn = FVn (e–in)
= RM161.66 (2.72 -(0.08)(6))
= RM100
 This topic explains the key conceptual and computational aspects of the time
value of money.
 It is important to understand the role of time value of money when assessing

the value of the expected cash flow streams associated with investment
alternatives; either based on compounding to find future value or discounting
to find present value.
 There are two types of interest: simple interest and compound interest.
 Simple interest is the interest that will be paid or accepted based on the
principal amount.
 Compound interest is the interest that will be paid not only on the principal
amount but also on any interest payable not withdrawn throughout its period
(accumulated interest).
 Perpetuity is a series of cash flow that involves the same amount for each
period continously.

Annuity Future value

Annuity due Ordinary annuity
Cash flow Perpetuity
Compounding Present value
Discounting Simple interest
1. Salmah deposits RM100 in the savings account at Affin Bank with an interest
rate of five per cent per year for five years. How much would Salmah have
in the savings account at the end of the five-year period?
2. Assume that Ah Seng deposits RM5,000 in the savings account at CIMB at

the interest rate of 10 per cent per year for two years. How much would Ah
Seng have in the savings account at the end of the second year?
Use the schedule of future value interest factor (FVIFi,n) in Attachment A to

calculate the answers for the following questions:
(a) Assume that you keep RM5,555 in the savings account at Affin Bank with an
interest rate of 15 per cent per year for five years. How much will you obtain
at the end of the five year period?
(b) If you keep RM4,321 in the savings account at Maybank with an interest rate
of seven per cent per year for two years, how much will you obtain at the
end of the two-year period?

1. You want RM1,100 in your account a year from now. How much investment
must you make now if the interest rate offered by the bank is 10 per cent?
2. Seri Sdn. Bhd. offers a low risk security that promises a payment of RM3,000
at the end of two-year period with an offer of 15 per cent interest rate per
year. What is the present value for RM3,000?
Use the schedule of present value interest factor to help you solve the following
questions:
(a) Assume that you are given the opportunity to purchase a low risk security
that promised a payment of RM127.63 at the end of five years with an interest
rate of five per cent per year. How much is the present value for RM127.63?
(b) You plan to accumulate RM6,213 in a bank savings account five years from
now. How much savings must you deposit now if the interest rate offered by
the bank is 12 per cent per year?
Solve the following questions by using the manual equation or schedule

(FVIFAi,n).
(a) Assume that you deposit RM100 into the bank at the beginning of the year
for three years in the savings account that gives five per cent interest rate.
How much can be obtained at the end of the third year?
(b) Mr. Yeoh deposits RM10,000 into the bank on 31 December each year for five
years at an interest rate of 10 per cent. How much can he obtain at the end of
the fifth year?

You are offered an annuity payment of RM100 at the end of each year for three
years and is deposited into the bank. The interest rate offered is five per cent per
year. How much is the present value of that annuity payment?
Consider the perpetuity that pays RM100 per year, with an interest rate of 10 per
cent. How much is the present value of this perpetuity?
1. What is the future value for RM260 that is invested now for three years at the
interest rate of 10 per cent per year and compounded continuously?
2. What is the present value for RM200 that will be received five years from
now and discounted continuously at the interest rate of six per cent per year?
3. Mr. Sarbat plans to invest RM3,000 a year in the Pension Investment Scheme
for a period of 15 years. Mr. Sarbat wants to know the result of the RM3,000
investment at the beginning of each year compared with the end of each year.
Calculate the value differences between the two types of cash flow if the
interest rate is eight per cent per year.
4. Mas Joko Company is considering an investment on a new machine that

involves a total purchase and assembly cost of RM30,000. The usage of this
new machine is expected to generate a yearly cash flow for five consecutive
years: end of first year RM4,000, end of second and third year RM5,000, end
of fourth year RM6,000 and end of fifth year RM8,000. If the company
requires a yearly 18 per cent rate of return on its investment, is it reasonable
for the company to continue with its investment?
5. Compute the present value for a series of indefinite yearly payments of

RM180, assuming that the interest rate is:
(a) Five per cent per year; and
(b) Ten per cent per year.

6. You have just won a competition where you were offered

two choice of prizes that is either to accept RM60,000 today or RM12,000 at
the end of each year for five consecutive years. If the cash flow is discounted
at a yearly rate of 12 per cent and compounded twice a year, which prize
would you choose?
7. Mrs. Aimi plans to get a loan for a total of RM6,000 at the interest rate of 10
per cent from a kind-hearted money lender. The money lender agrees to
receive a sum of payment for the same amount at the end of each year for
four years. What is the size of payment that Mrs. Aimi must give to the
money lender each year?
8. What is the present value for RM400 that will be received in seven years from
now and discounted continuously at the interest rate of 10 per cent per year?

Topic  Valuation of
Securities
4
LEARNING OUTCOMES
1. Define the term „value‰ as used in different context;
2. Describe the characteristics and types of bonds;
3. Calculate the value of a bond and yield to maturity (YTM) of a bond;
4. Assess the relationships that exist in bond valuation; and
5. Calculate the value of ordinary shares based on zero growth, constant
growth rate and differential divided growth.
 INTRODUCTION
Valuation is a very important concept in finance. The process of valuation takes
into consideration specific factors that can influence the value. This topic discusses
the general concept of valuation and the process of bonds valuation. This topic will
also touch the characteristics, rating, types and valuation of bonds, rate of yield to
maturity and the relationship between value and rate of yield to maturity.
Moreover, you will get some exposure on the basic concept of valuation. Also, we
will discuss the intrinsic value or economic value that has been identified as
present value of cash flow that is expected to be generated in the future by an
investment or asset.

124  TOPIC 4 VALUATION OF SECURITIES
Subsequently, we will continue with the discussion related to the valuation of

financial assets with focus on the valuation of shares. In this topic, we will discuss
two types of shares that are ordinary shares and preference shares. As you are
aware, the objective of a finance manager is to maximise the value of the
companyÊs ordinary shares. In order to do this, the manager must first understand
how to identify the value of shares.
4.1 VALUATION
Valuation of an asset is a subjective matter. Every individual has a different
perception of the value of a specific asset. The term „value‰ is also used in different
contexts.
There are individuals that value assets by referring to the companyÊs balance sheet.
The value obtained with this method is known as book value. However, if
valuation is made based on the price of the same asset found in the market, then
the value obtained by this method is known as market value. When a business is
in the process of liquidation and most of the assets will be auctioned by offering a
lower price to ensure that it can be sold, and then this sales price will be known as
liquidation value. Assets can also be valued based on the benefit that can be
obtained from the assets. This value is called the intrinsic value or economic value.
4.1.1 Definitions of Value

There are several definitions of value used in different contexts.
(a) Book Value

Book value is the value of an asset as stated in the balance sheet of the
company. It is also known as historical value. For example, you purchase a
business premise two years ago at a price of RM100,000. The book value is
the actual value that was paid for the asset at the time it was bought, that is
RM100,000. This value may not be the same with the current market value.
Assets such as machines and vehicles will depreciate in value and the book
value is the price of the asset at the time it was purchased minus its
accumulated depreciation.
(b) Market Value

Market value is the value of assets available in the market as determined by
forces of demand and supply in the market. For example, the market value
of ordinary shares that is found in Bursa Malaysia is the sale and purchase
value that is agreed among the investors through an intermediary such as
brokers.

TOPIC 4 VALUATION OF SECURITIES  125
(c) Liquidation Value

Liquidation value is the value that will be obtained when an asset is sold
separately and not as part of going concern. For example, if the company is
no longer in operation and needs to be liquidated, then, the assets will be
sold separately and the sales price is the assetÊs liquidation value.
(d) Intrinsic Value

Intrinsic value is also known as economic value and is the sum of all the
potential cash flows that will be obtained from the asset after discounting at
the rate of return required by the investors. The amount obtained is regarded
as the fair value based on the amount, time and risk level of all the expected
cash flow. This value is normally compared with the market value. If the
intrinsic value is higher than market value, then in the opinion of the
investors, the asset was undervalued. However, if the intrinsic value is lower
than the market value, it will be regarded as overvalued. If the market is
efficient, the intrinsic value and the market value will be the same as the
value of the securities traded will always depict all general information
available.
4.1.2 Valuation Process

The valuation process is a process to determine the value of an asset at a specific
period by using the technique of time value of money. As stated previously, the
intrinsic value of an asset is sum of expected cash flows that discounted at a rate
of return required by the investors. There are three main factors that influence the
value of an asset:
(a) Total Cash Flow (Return)

The value of an asset depends on the total cash flow that is expected. To
obtain this return value, it does not only involve a yearly cash flow but also
a single cash flow for a specific period. For example, you as an investor,
expect that you will obtain a dividend of RM0.30 per share every year for a
period of five years if you invest in the shares of Antah Company.
(b) Timing
To estimate cash flow, you must know the timing for each cash flow. For
example, you will make an investment after you expect that you will obtain
RM2,000 in first year, RM4,000 in second year and RM5,000 in third year.

(c) Required Rate of Return

The risk level can have direct effect on the value. Generally, the higher the
risk of the cash flows, the lower the value. According to the Capital Asset
Pricing Model (CAPM), the higher the risk that is measured by beta (β), the
bigger the return (k). The higher the risk means the bigger the rate of return
and the lower the risk means the smaller the rate of return. The determination
of the rate of return required by investors takes into consideration the
investorsÊ attitude towards risk and the investorsÊ perception on the level of
risk for the asset.
Figure 4.1 shows the basic factors to determine the value of assets.
Figure 4.1: Basic factors in determining the value of assets
General rules on cash flow and valuation are coming:
(a) From the aspect of amount – the higher the amount of cash flow, the better;
(b) From the aspect of timing – the sooner it is received, the better; and
(c) From the aspect of risk – the lower the level of risk, the better.

4.1.3 Basic Model of Valuation

The valuation process is the process in giving value to an asset by calculating the
present value of all the expected cash flows from the asset. It uses the rate of return
required by the investors as the discount rate.
There are three basic steps in the valuation process:
(a) Estimating the amount and timing of cash flows that would be received
(CFt);
(b) Determining the rate of return required by investors (k); and
(c) Calculating the intrinsic value of the assets that is, the present value of all the
cash flows that will be obtained from the asset (V).
In the earlier topic, you have learnt that the present value is obtained from the
following equation:
Fn
Pn 1 
(1  i)n
by replacing:
(a) Pn–1 to Vn–1;
(b) Fn to CFt; and
(c) i to k;
we obtained this equation:
CFt
Vt 1  (4.1)
(1  k)t
If the valuation period is more than a year (t > 1), the equation mentioned can be
expanded as follows:
CF1 CF2 CFn

V0  1
 2
 ... 
(1  k) (1  k) (1  k)n
n
(4.1a)
CFt
 t
t=1 (1  k)

Where:
CFt = Cash flow is expected to be received at time t.
V0 = Intrinsic value/present value of asset that will generate cash flow from
period 1 to n.
k = Required rate of return (rate of discount)
n = Period cash flow is expected to be received.
Equation 4.1a measures the present value for future cash flow and it is the basis
for the valuation process. It is very important as all the equations in this unit are
based on this equation.
SELF-CHECK 4.1
Explain the difference between book value, market value, liquidated

value and intrinsic value.
ACTIVITY 4.1
If you intend to buy land in Putrajaya, what is the value that you will
use? Why do you use that value?
4.2 BONDS
Bonds are long-term guarantee notes issued by borrowers. The bondholders will
receive interest at a fixed rate for a determined period. On the maturity date, the
bondholder will receive the interest and principal amount. The payment of fixed
interest on each period is the basic concept of annuity that we had discussed in the
earlier topic.
Figure 4.2 illustrates the concept of bonds in a time line. Based on the example in
Figure 4.2, these bonds have a maturity period of five years. It pays interest of
RM100 each year and has a face value of RM1,000.

Figure 4.2: Concept of bond in a time line
4.2.1 Characteristics of Bonds

Here, we will discuss the characteristics of bonds in detail.
(a) Claims on Assets and Earnings

Bondholders have priority in claims on the earnings and companyÊs assets
compared to preference shareholders and ordinary shareholders. If the
company fails to settle the interest, the bondholders can classify the issuing
company as insolvent or incapable of paying debts and force the company
into bankruptcy.
(b) Par Value

Par value or face value is the value stated on the bond document. It is the
amount that will be paid back to the bondholders on the maturity date.
Usually, the bondÊs par value in the US is USD1,000 per unit, while in
Malaysia, its par value is RM100 per unit.
(c) Coupon Rate

Coupon rate refers to the percentage of par value that will be paid to the
bondholders (investors) as interest based on the frequency that has been
specified. This rate is fixed throughout the lifespan of the bond and the
amount of interest payable is the same for each period.
(d) Indenture
Indenture is a legal contract between the trustees who represents the
bondholders with the company that issued the bond. Indenture specifies the
terms and conditions related to the issuance of the bonds.

4.2.2 Rating of Bonds

The issuance of bonds is given rating based on the potential risks that are related
to the said bonds. Ratings are valuation or grading done by specific agencies to
determine the quality of the bond in the aspect of default. If the rating of a bond is
high, this means that the possibility of default is low.
In Malaysia, there are two rating agencies, RAM Holdings Berhad and the
Malaysian Rating Corporation Berhad (MARC). Both these agencies play
important roles in the ratings of all bonds and commercial notes issued, especially
in the private debt security market.
The valuations by RAM Holdings Berhad are stated in alphabets. For long-term
loans that is more than a year, the valuation of „AAA‰ indicates a high level of
credit trust while loans level between „AA‰ and „BBB‰ is generally regarded as a
prudent investment grade. Long-term loans rated as „BB‰ or lower are classified
as speculative grade.
The valuations by MARC are stated in symbols and numerical symbols. For long-
term loans, its valuation is within the range of AAA – D. For short-term loans, its
valuation is within the range of MARC-1 – MARC-4.
Ratings are done via the financial ratio analysis and cash flow analysis by looking
at the capability of the company to fulfil its specific obligations in bonds. Besides
that, other factors will also provide positive effects on the ratings of bonds. For
example, the level of funding with equity, operations that are profitable, low level
of variables in previous returns and the size of the company.
Valuation given on a bond will influence the returns required by the investors. The
lower the ratings of the bond, the higher the rate of return that is required for the
bond and vice versa. Therefore, the finance manager must be aware of the ratings
given as it will have an effect on the rate of return that must be paid to the
investors.
ACTIVITY 4.2
Visit the websites of RAM at https://www.ram.com.my and MARC at

https://www.marc.com.my and see how the financial securities are
rated by both these agencies.

forum.

4.2.3 Types of Bonds

Bond is the general term for debt security. It is issued in various types with
different characteristics. Therefore, there are several types for bonds. Among them
are:
(a) Mortgage Bonds

Mortgage bond is a secured bond backed by tangible assets such as buildings
and land. Normally, the secured value imposed is higher than the value of
the bond issued. If the company that issued the bond is unable to repay its
loan on the maturity date, the secured assets will be sold to repay the loan to
the investors via a trust fund.
(b) Debentures
Debentures refer to the long-term loans that are not secured with assets but
depend on the ability of the company that issued the bonds to obtain earnings.
This type of bond has a higher risk to the investors as compared to secured
bonds. Therefore, the rate of return that is required by the investors is also
higher. This type of bond provides an advantage to the issuing company as no
property is charged. This enables the company that issued the bonds to maintain
its opportunity to borrow additional loans in the future.
(c) High Yield Bonds

High yield bonds refer to the bonds that pay interest only if the issuing
company has surplus earnings. It is normally issued via the restructuring of
a company that fails to repay its debts. Upon the date of maturity, the issuers
still have to pay the face value of the said bonds.
(d) Convertible Bonds

Convertible bonds refer to the bonds that can be converted by its holders to
ordinary shares at the price and conversion ratio that has been determined
by the issuing company when the bonds were issued. With this, the investors
are given the right to convert its status from creditor to owner when the right
of conversion is exercised.
(e) Zero Coupon Bonds

Zero coupon bonds are bonds that do not pay interest and were issued at a
price lower than the par value. The bondholders will receive returns as a
result of the price differences during purchase compared to its face value that
will be paid at the date of maturity.

(f) Euro Bonds

Euro bonds are bonds that were initially issued in the European countries using
the American currency (USD) by foreign companies. Now, any bonds that are
issued in a country using a currency different from its own are known as Euro
bonds. For example, bonds issued in Europe or Asia by American companies
but the interest and principal are payable in the value of the American dollar.
(g) Foreign Currency Bonds

Unlike Euro bonds, foreign currency bonds are issued in the financial market
of a country using its own countryÊs currency by debtors or issuing company
of a foreign country.
SELF-CHECK 4.2
Describe the types of bonds and their characteristics.
ACTIVITY 4.3
Visit the following website http://rmbond.bnm.gov.my to obtain more

information regarding bonds in Malaysia. Based on the information
obtained, list the types of bonds that are found in our country and
compare them with the types of bonds that had been discussed.
4.3 VALUATION OF BONDS

In subtopic 4.1.2, we had discussed the three main factors that influence the value
of assets, which are the total cash flow, timing and required rate of return. In the
valuation of bonds, three important elements that influence the valuation are (refer
to Figure 4.3):
(a) Amount and Timing of Cash Flow that Will be Received by Investors
This refers to the payment of annual interest and face value or principal
amount.
(b) Maturity Date of Bond

This refers to the date that the bond issuer must pay the face value of the
bond to the bondholders.

(c) Rate of Return Required by Investors

This rate of return takes into consideration the valuation of risk levels on cash
flow and the investorsÊ attitude towards risks taking. This is also a form of
return to the investors due to the opportunity cost faced by the investors.
Figure 4.3: Valuation of bonds using the time line
SELF-CHECK 4.3
Explain the three important elements that influence the valuation

process of bonds.
4.3.1 Basic Valuation of Bonds

Bond value is the total present value of payments that must be paid by the issuer
to the bondholders from now until maturity period. In subtopic 4.1.3, we had
learnt that the basic equation for valuation of assets is:
CF1 CF2 CFn

Vb    ... 
(1  k) 1
(1  k) 2 (1  k)n
(4.1b)
n
CFt
 t
t 1 (1  k)

We also know that bond has a maturity date and it also pays interest at a rate that
is constant for a fixed period. Therefore, the equation for valuation of bonds is
obtained by modifying the previous equation to be as follows:
i i i i M
Vb  1
 2
 3
 ...  n
 (4.2)
(1  k b ) (1  k b ) (1  k b ) (1  k b ) (1  k b )n
OR
n
I M
Vb    (4.2a)
t=1 (1  k b ) t
(1  k b )n
As bond pays interest at a fixed rate for a fixed period, we can also use the schedule
for present value interest factor of annuity (PVIFA) to calculate the value of bonds.
The equation for valuation of bonds using the PVIFA schedule is obtained by
modifying the basic equation of present value annuity. The following is the
equation for valuation of bonds using the PVIFA schedule.
Vb =I (PVIFAkb, n ) + M (PVIFkb, n ) (4.2b)
Where:
Vb = Intrinsic value or value of bond
I = Coupon payment
n = Period of bond till maturity
kb = Rate of return required for the bond
M = Par value or face value of bond
PVIF = Present value interest factor
PVIFA = Present value interest factor of annuity
Example 4.1
Bond A has 10 years maturity period. The coupon rate is 10 per cent per year and
the interest is paid every year. The par value of the bond is RM1,000. The returns
required for the bond is eight per cent per year. What is the value of this bond?
Step 1: Estimate the amount and timing of expected cash flow.
Step 2: Determine the rate of return required to evaluate the cash flow risk of
the bond in the future. Assume that the rate of return required is 10 per
cent.

Step 3: Calculate the intrinsic value of the bond that is the present value of
interest that is expected to be received in the future and the payment of
the principal on the date of maturity, discounted at the rate of return
required by the investors.
Value of the bond is:
100 100 100 100 100 1,000

Vb   2
 3
 4
 ... 10

(1.08) (1.08) (1.08) (1.08) (1.08) (1.08)10
 RM92.59  RM85.73  RM79.38  RM73.50  RM68.06
 RM63.02  RM58.35  RM54.03  RM50.02  RM46.32
 RM463.19
 RM1,134.16
OR
Vb = PV (coupon payment) + PV (par value)

= I (PVIFAkb,n) + M (PVIFkb, n)
= RM100 (PVIFA 8%, 10) + RM1,000 (PVIF8%,10)
= RM100 (6.710) + RM1,000 (0.463)
= RM671 + RM463
= RM1,134
(Note: The difference between the answers that are calculated using the
equation and schedule PVIFA is small and is caused by the decimal
point. Both answers are acceptable.)
The previous calculation result can be illustrated through Figure 4.4.

We found that the intrinsic value or actual value for the bond is
RM1,134.19. If the rate of return required is eight per cent, then the price
is reasonable. However, if the market price of the bond is sold at a
higher price than RM1,134.19, then from the perspective of the
investors it is expensive. Instead, if the market price is less than the
actual value of the bond, then it is a good investment.

Figure 4.4: Calculating the value of bond using the time line
4.3.2 Value of Bonds and Required Rate of Return

When the required rate of return is different from the bondÊs coupon rate, the value
of the bond will be different from the par value. The changes to the required
returns are caused by:
(a) Changes in the economic situation that causes the cost of long-term funds to
change as well; or
(b) Changes in companyÊs risks.
The increase in the cost or risk of long-term funds will increase the required rate
of return. Instead, the decrease in the cost or risk of long-term funds will reduce
the required rate of return.

There are three different situations that can be used to show the relationship
between the required rate of return and the value of the bond.
(a) Required Rate of Return is Larger than the Coupon Interest Rate (kb> i)
Example 4.2
Bond A has a maturity period of 10 years with the coupon interest rate of 10
per cent per year and interest payable every year. The face value is RM1,000.
The required return for this bond is 12 per cent per year.
= I (PVIFAkb,n) + M (PVIFkb,n)
= RM100 (PVIFA12%,10) + RM1,000 (PVIF12%,10)
= RM100 (5.650) + RM1,000 (0.322)
= RM887
Where:
Vb = Value of bond
M = Face value or par value
V < M
In this situation, the value of the bond (Vb) is smaller than the par value,
M (Vb < M). If this bond is traded, its transaction will be at a price lower than
the par value. Therefore, it can be called a transaction at a discounted price.
(b) Required Rate of Return is Lower than the Coupon Interest Rate (kb< i)
Example 4.3
Bond A has a maturity period of 10 years with the coupon interest rate of 10

= I (PVIFAkb,n) + M (PVIFkb,n)
= RM100 (PVIFA8%,10) + RM1,000 (PVIF8%,10)
= RM100 (6.7101) + RM1,000 (0.4632)
= RM1,134.21.

In this situation, the value of bond (Vb) is larger than par value (Vb > M).
If this bond is traded, its transaction will be at a price higher than par value.
Therefore, it can be called a transaction at a premium price.
(c) Required Rate of Return is Same Value with Coupon Interest Rate (kb = i)
Example 4.4
Bond A has a maturity period of 10 years with a coupon interest rate of 10

= I (PVIFA kb, n) + M (PVIF kb, n)
= RM100 (PVIFA 10%, 10) + RM1,000 (PVIF 10%, 10)
= 100 (6.1466) + 1,000 (0.3855)
= RM1,000.16
In this situation, the value of bond (Vb) is the same with the par value (Vb = M).
If this bond is sold or purchased, its transaction is at the same price with the par
value. Therefore, it can be called a transaction at par value.
Table 4.1 shows the conclusion on the relationship between the values of bond and
the required rates of return. The value of bond has an inverse relationship with the
required rate of return that is, if the investors require higher returns, the value of
the bond will decline.
Table 4.1: Values of Bond at Different Required Rates of Return
Required Rate of Coupon Interest Rate, Value of Bond, Vb

Status
Return, kd(%) i (%) (RM)
12 10 887 Discount
10 10 1,000 Par value
8 10 1,134.21 Premium
As in examples 4.2 to 4.4, when investors required a return of 12 per cent compared
to the coupon rate of 10 per cent, the value of bond will fall below par, which is to
RM887 and is sold at a discount. On the other hand, the decrease in the required
rate of return that is 8 per cent compared to the coupon rate of 10 per cent will
cause an increase in the value or price of the bond to RM1,134.21 and it is sold at a
premium price. When the required rate of return is the same as the coupon rate,
the value of the bond is the same with the par value.

The current interest rate is used as the basis to the rate of return required by the
investors. Therefore, it has an inverse relationship with the value or price of the
bond.
4.3.3 Payment of Interest Twice a Year

The valuation process of bonds that pay interest twice a year is the same with
the concept of calculating interest that is compounded more than once a year. The
discussion on interest compounded more than once a year was covered in Topic 3.
The equation for interest compounded more than once a year is shown as follows:
FV
PV=
(1+i/m)nm
Where:
PV = Present value
FV = Future value
i = Interest rate
m = Frequency of compounding or discounting
n = Period
To calculate the value of bonds that pay interest twice a year, you have to:
(a) Change the annual interest (I) to interest twice a year by dividing (I) with 2;
(b) Change the number of maturity period, n, to every six months by

multiplying n with 2 (n  2); and
(c) Change the annual required rate of return, kb, to each half yearly by dividing
kb into 2 (kb/2).

Therefore, the valuation equation for bonds with coupon payments of twice a
year is:
2n
I/2 M
Vb   t
 (4.3)
t 1 (1  k b /2) (1  k b /2)2n
OR
Vb = I (PVIFAkb/2,2n) + M (PVIFkb/2,2n) (4.3a)
Where:
I = Coupon rate  Par value
n = Period
kb = Required rate of return
Example 4.5
Maya Enterprise Company had issued bonds that have a maturity period of eight
years with a coupon rate of eight per cent that is payable every six months. The
par value of the bond is RM1,000. If the required rate of return is 10 per cent, what
is the value of the bond?
I
Vb  (PVIFA kb/2,2N )  M(PVIFkb/2,2N )
2
RM80
 (PVIFA10%/2,82 )  RM1,000(PVIF10%/2,82 )
2
 RM40(PVIFA 5%,16 )  M(PVIF5%,16 )
 RM40 (10.8378)  RM1,000 (0.4581)
 RM891.61
ACTIVITY 4.4
„Do not invest your money until you have fully understood all the
information related to the investment‰.
Share your opinion on this statement with your coursemates in the

myINSPIRE online forum.

4.4 YIELD TO MATURITY (YTM)

Every individual who invests has a minimum expected rate of return from each
investment. This is known as the required rate of return and is different for every
investor. The finance manager will only be attracted to high rates of return. This is
because the present value bonds reflects the rate of return that is expected to be
received by investors.
Yield to maturity or YTM is the rate or return that will be obtained by the investors
if the bond is held until maturity. This expected rate of return is also known as
YTM if the investors hold the bonds until its maturity period. Therefore, when we
refer to bonds, the terms expected rate of return and YTM are used
interchangeably.
YTM is the discount rate that equals the present value for all interest payments
and principal payment of bond with the present value of bond. It can be calculated
using the basic equation for valuation of bonds (equation 4.3b).
Vb = I (PVIFAkb,n) + M (PVIFkb,n) (4.3b)
This discount rate can also be calculated using the PVIF schedule by a method of
trial and error. Through this method, different discount rates, k, will be applied in
the equation for valuation of bonds until the cash flow of present value of the bond
is similar to market value. If this rate is located between the rates found in the
schedule, the interpolation method will be used to obtain the exact value. To
explain this concept in detail, let us look at Example 4.6.
Example 4.6
Orlid Bhd. issued bonds that have a par value of RM1,000 with a coupon rate of 10
per cent per year and a maturity period of 10 years. The present price of the bond
is RM1,080. As the price of the bond is higher than the par value (P0 > M), then the
rate of YTM is smaller than the coupon interest rate (k < I). This shows that the rate
that must be found must be lower than 10 per cent. To begin the process of looking
for the discount rate, the rate of nine per cent will be used.
RM1,080 = I (PVIFAk,n) + M (PVIFk,n)

= RM100 (PVIFA9%,10) + RM1,000 (PVIF9%,10)
= RM100 (6.4177) + RM1,000 (0.4224)
= RM1064.17

When we use the discount rate of nine per cent, the value of bond obtained, that is
RM1,064.17, is lower than the market value, that is RM1,080. To increase the value
we are searching for, the rate of discount must be decreased to eight per cent.
RM1,080 = I (PVIFAk,n) + M (PVIFk,n)

= RM100 (PVIFA8%,10) + RM1,000 (PVIF8%,10)
= RM100 (6.7101) + RM1,000 (0.4632)
= RM1,134.21
When we use eight per cent as the discount rate, the value of bond obtained is
more than its market value. This shows that the rate of YTM is between eight per
cent and nine per cent as illustrated in Table 4.2.
Table 4.2: Searching for the Values of Bond by Using the Trial-and-Error Method
Rate Value
Eight per cent RM1,134.21
YTM RM1,080
Nine per cent RM1,064.17
Next, use the interpolation method to obtain the rate of YTM more accurately (refer
to Table 4.3):
Step 1: Calculate the difference between the value of bond at the rate of eight
per cent and nine per cent.
Difference in value = RM1,134.21 – RM 1,064.17

= RM70.04
Step 2: Calculate the difference between the value required that is the rate of
YTM with the value of the bond at a discount rate that is lower, that is
eight per cent (disregard the symbol of minus or plus).
Difference in value = RM1,134.21 – RM1,080

= RM54.21
Step 3: Divide the value obtained in Step 2 with the result obtained in Step 1.
Ratio obtained = RM54.21/RM70.04

= 0.774
Step 4: Add to the value calculated with the rate of discount that is lower and
multiply it with the gap in discount rate to obtain the rate of YTM (refer
to Table 4.3).
Rate of YTM = 8% + [0.774  (9% – 8%)] = 8.774%
Table 4.3: The Rate of YTM by Using the Interpolation Method
Rate (%) Value (RM) Value (RM)

8 1,134.21 1,134.31
YTM 1,080
9 1,064.17
Difference RM54.21 RM70.04
 RM54.21 
YTM  8%    (9%  8%) 
 RM70.04 
 8%  (0.774  1%)
 8.774%
Besides the interpolation method, you can also use the estimation method to
calculate the rate of YTM by using the following equation:
 M  P0 
i 
YTM   n  (4.4)
M  P0
2
Where:
i = Coupon rate
M = Par value
P0 = Market value of bond
n = Number of years for bond until maturity
Furthermore, by using equation 4.4, you can obtain the rate of YTM as follows:

 RM1,000  RM1,080 
RM100   
YTM   10 
RM1,000  RM1,080
2
 0.0885
 8.85%
Through this estimation method, we find that the rate of YTM is 8.85 per cent. This
answer is not as accurate as when we use the trial-and-error method and
interpolation method that is 8.774 per cent.
4.5 RELATIONSHIP BETWEEN VALUE

AND YTM
When the required rate of return is different from the coupon interest rate, and it
is assumed to be constant until the maturity period, the market value of bond will
approach the par value when it is closer to the maturity period.
Figure 4.5 shows the movement of the bond value based on the calculation from
Table 4.1. The required rates of return of 12 per cent, 10 per cent and 8 per cent are
assumed constant throughout the 10 years for bond maturity and the par value is
assumed to be the same that is RM1,000.
Figure 4.5: Movement of the bond value based on Table 4.1

From Figure 4.5, we can summarise that:
(a) When the required rate of return is the same as the coupon rate of the bond,
that is 10 per cent, the value of bond remains constant on maturity period,
that is RM1,000;
(b) When the required rate of return is 12 per cent, the value of the bond
increases from RM887 to RM1,000 when time passes and approaches the
maturity period; and
(c) Finally, when the required rate of return is eight per cent, the premium value
of the bond decreases from RM1,134.21 to RM1,000 on maturity period.
This shows that when the required rate of return is assumed constant until
maturity, the value of the bond will reach par value of RM1,000 on maturity date.
4.5.1 Changes to Required Returns

As shown in earlier Figure 4.5, the value of bonds has an inverse relationship with the
changes to the required rate of return of an investor. Generally, the increase in the
interest rate will cause a decrease in the value of bond. Instead, a decrease in the
interest rate will cause an increase in the value of the bond. This shows that, the higher
the rate of return required by an investor, the lower the value of the bond. This is
because the increase in interest rate will cause the bondholders to experience loss in
market value, the bond investors will be exposed to the risk of higher interest rate.
Therefore, the bondholders are always aware of the increase in interest rate. The
shorter the maturity period of the bond, the lower the response of market value on
the changes to the required rate of return. In summary, a shorter maturity period
will have lower interest rate risk compared to long-term bonds with the
assumption that the coupon rate, par value and frequency of interest payment are
the same.
Table 4.4 shows the value of the bond with different required rate of return and
different maturity period (summary of examples 4.2 and 4.3).
Table 4.4: Effect of BondsÊ Maturity Period on Different Required Rate of Return
Required Rate of Value of Bond Value of Bond

Return 10 Years 5 Years
(%) (RM) (RM)
8 1,134.21 1,079.87
10 1,000.16 1,000
12 887 927.82

From Table 4.4, we can summarise that:
(a) When the required rate of return decreased from 10 per cent to 8 per cent, the
value of bond with a maturity period of 10 years will increase by RM134.21;
meanwhile, the value of bond with a period of maturity of five years will
only increase by RM79.87; and
(b) When the required rate of return increased from 10 per cent to 12 per cent,
the value of the bond with a period of maturity of 10 years will decrease by
RM113.16. Meanwhile, the value of the bond for five years will decrease by
RM72.18.
Based on the table and explanation mentioned, it is clear that the changes to
interest rate has a bigger effect on the bonds with a longer maturity period
compared to bonds that have shorter maturity period.
4.6 ORDINARY SHARES

Ordinary shares are securities that represent ownership in the company.
Bondholders can be portrayed as the creditors, while ordinary shareholders are
the actual owners of the company. The more ordinary shares held by an investor,
the bigger its portion of ownership in the company. Ordinary shareholders are also
known as equity owners.
Ordinary shares do not have maturity period; it will remain forever as long as the
company is still in operation. It is the same from the aspect of dividend payment,
it is unlimited. Before dividends are paid, it must be announced earlier by the
companyÊs board of directors. If the company goes bankrupt, the ordinary
shareholders, who are the owners of the company, cannot make any claims on the
assets before the claims by the creditors (including bondholders) and preference
shareholders are fulfilled.
4.6.1 Characteristics of Ordinary Shares

Before making valuation on ordinary shares, it is necessary for us to first
understand the following characteristics of ordinary shares:
(a) Claim on Earnings

As owners of the company, ordinary shareholders have rights on surplus
earnings, after the interest for bondholders and dividends for preference
shareholders have been paid. The earnings received, can either be direct or
indirect. Here, direct earnings come in the form of cash dividends, while
indirect earnings are in the form of retained earnings. Retained earnings are
indirect earnings because the earnings obtained are not distributed to the
ordinary shareholders but are used for reinvestment with the hope of
increasing the value of the company.
Receiving surplus earnings has advantages and disadvantages to the

ordinary shareholders. The advantage is that there is no limit to the earnings
receivable. The disadvantage of receiving surplus earnings is that
shareholders might not receive anything if all the earnings were used to fulfil
the claims of creditors and preference shareholders. When the company
experiences reductions in earnings, the ordinary shareholders will have to
bear the effects.
(b) Claims on Earnings and Assets

If liquidation occurs, the ordinary shareholders will be the last to claim the
earnings and assets of the company after the claims of bondholders and
preference shareholders are settled.
(c) Voting Rights

Ordinary shareholders have the right to choose the board of directors of the
company. Ordinary shares are the only securities that grant them the rights
to vote and the right to approve changes to the memorandum of
incorporation to its holders. Voting is conducted at the companyÊs annual
meeting. It can be done individually or via a proxy. Most voting however is
done by proxy. Proxy means giving the right to a third party to vote on behalf
of the party who is unable to attend the annual general meeting of the
company.
The voting procedures involve two methods, which are majority voting and
collective voting. Majority voting is the voting where each share owned
grants one right to vote to the shareholder and each position in the board of
directors will be voted separately. Therefore, the majority shareholders will
have the opportunity to select all the members of the board of directors.
Through collective voting, each share owned grants a voting right equivalent
to the number of positions contested. Shareholders can choose to use all their
rights to vote a particular candidate or divide it among several selected
candidates. This method gives a chance to the minority shareholders to
appoint members of the board of directors who will represent them.

(d) Pre-emptive Rights

Pre-emptive rights allow the shareholder to maintain the ownership in hand
if the company intends to issue new shares. Certificates will be sent to the
existing shareholders to purchase a predetermined number of shares at a
specific price and time period. Shareholders have the choice to exercise those
rights, leave them until the end of the period or sell them in the open market.
(e) Limited Liability

If liquidation of the company occurs, the liability of the ordinary
shareholders is only limited to the total investments in the company.
SELF-CHECK 4.4
Elaborate on five basic characteristics of ordinary shares.
4.7 VALUATION OF ORDINARY SHARES

Similar to how bonds are valued, the value of ordinary shares is also equivalent to
the present value of all cash flow that will be received by shareholders. However,
ordinary shareholders are not promised with fixed income or specific payment
upon maturity period such as bonds and preference shares. Ordinary shareholders
will receive returns in two forms, which are:
(a) Dividends – profits that are distributed to shareholders; or
(b) Capital gain – the difference between the selling price and the purchase price
of shares.
Dividends receivable depends on the profit of the company and the decision of
management to pay dividends or to retain earnings for the purpose of
reinvestment. The amount of dividend receivable is also not the same; it depends
on the companyÊs profit and the rate of growth.
In general, the growth of the company has a direct implication on the dividends
payable and the value of shares. The growth of the company can be achieved
through various ways. For example, through loans, issuance of new shares or by
merger with bigger and more established companies. Normally, a company will
experience growth by using the new funding such as the issuance of bonds and
ordinary shares.

The growth of the company can also be achieved by internal growth; by retaining
a portion or all of the companyÊs profit for the purpose of reinvestment. Retaining
profit is a form of investment by the existing ordinary shareholders.
To illustrate more clearly on the internal growth, assume that the return on equity
of Meru Company is 18 per cent. If the management decides to pay all the profits
as dividends to the shareholders, this means that there will be no internal growth
for the company. If the company retains all its profits, then the shareholdersÊ
investments in the company will grow in the same amount as the profit retained,
which is 18 per cent. If the company only retains 50 per cent of its profits for
investment purposes, then the growth of the company will also be half of that,
equivalent to nine per cent. In general, this relationship can be concluded as
follows:
g = ROE  r (4.5)
Where:
g = Rate of growth of earnings in the future and internal growth of
shareholdersÊ investment in the company
ROE = Return on equity (profit after tax/total equity)
r = Percentage of profit retained by company
Therefore, if the company retains 25 per cent of its profit, then the value of shares
will increase to 4.5 per cent.
g = 0.18  0.25
= 0.045 or 4.5%
4.7.1 Valuation of Ordinary Shares – One Holding

Period
In the previous topic, we had been informed that the value of ordinary shares is
the same with the present value of all cash flows that will be received by the
shareholders. For investors who hold ordinary shares for one period, for example
one year, the value of the share is equivalent to the present value of the dividends
receivable in the period of one year (D1) and the selling price of the shares at the
end of the period (P1). This is because both the cash flows occur at the same time
that is at the end of the period.

The process of valuation of ordinary shares involves three steps (refer to Table 4.5):
Table 4.5: Process of Valuation of Ordinary Shares
Step Description
1 Assume the cash flow that is expected to be received in the future, which is the
amount of dividend and the selling price of the shares at the end of the period.
2 Estimate the cash flow required by investors by taking into consideration the
risk of expected cash flow.
3 Discount the dividend that is expected to be received and the price of shares at
the end of the period at the present value with the rate of return required by the
investors.
Example 4.7
Assume an investor plans to buy shares in Meru Company. It expects that the
dividend payable will be RM0.15 at the end of the year. It believes that the shares
can be sold at the price of RM2.40 after one year of holding. What is the value of
MeruÊs shares if the required rate of return is 12 per cent?
By using the basic equation of present value and following the steps mentioned,
the value of the shares is:
Fn
P
(1  i)n
RM0.15 RM2.40
 1

(1  0.12) (1  0.12)1
 RM0.13  RM2.14
 RM2.27
The equation mentioned can be summarised as follows:
Vcs  Present value of dividends received in year 1 (D1 ) 

(4.6)
Present value of selling price received in year 1 (P1 )
D1 P1
 
(1  k cs ) (1  k cs )1
1

Where:
Vcs = Present value of ordinary shares
D1 = Cash dividend that is expected to be received at the end of the period
P1 = Price of shares that is expected at the end of the period
Kcs = Required rate of return for the shares
4.7.2 Valuation of Ordinary Shares – Multiple Holding

Periods
Ordinary shares do not have maturity period and are usually held for several
years. Therefore, their valuation is more complex from what we have discussed in
the previous topic. The expected cash flows will be different throughout the
holding period. Dividends received throughout the holding period are also not
fixed. This means that the cash flows are discounted for an uncertain period or
until infinity.
If the holding period is more than one or infinity, with a little modification to
equation 4.2, the valuation model of ordinary share is as follows:
D1 D2 Dn D
Vcs    ...  
(1  k cs ) (1  k cs )
1 2
(1  k cs ) n
(1  k cs )

(4.7)
Dt
 
t 1 (1  k cs )
t
Dividends are a part of the companyÊs earnings. When the earnings of a company
fluctuate throughout its period of operations, the risk will increase and this will
then influence the price of the companyÊs shares. To reduce the risk assumed by
investors, the company normally pays dividends based on the long-term growth
of the company. The valuation model for ordinary shares mentioned can be
applied in three levels of growth, which are:
(a) Zero Growth

Zero growth means that dividends are not expected to experience any
growth but at the rate of g = 0. This means that the dividends receivable in
the future is the same with the dividends that were received the previous
year that is D1 = D2 = ⁄ = Dn. Therefore, the value of ordinary shares
experiencing zero growth can be stated as follows:
D1 D2 Dn
Vcs    ...  (4.8)
(1  k cs ) (1  k cs )
1 2
(1  k cs )n
When D1 = D2 = ⁄ = Dn, this shows that the cash flow is in perpetuity as the
cash flow obtained is the same amount for an uncertain period.
With zero growth, the value of ordinary shares is the same with the present
value of perpetuity for D1. By using the basic equation of perpetuity as a
guide, equation 4.8 can be summarised as follows:
D1
Vcs = (4.9)
k cs
Example 4.8
Rias Company has been operating for many years in the fast food industry.
Lately, the company had paid dividends of RM0.20 per share to its ordinary
shareholders. Based on the sales and current earnings of the company, the
management expects the dividends to maintain in the future. If the required
rate of return is 12 per cent, what is the value of shares for Rias Company?
D1
Vcs 
k cs
RM0.20

0.12
 RM1.67
(b) Constant Growth Rate

Although the model of zero growth can be applied to several companies,
most of the companies will experience an increase in earnings and dividends
from time to time. Some will expect to experience growth with fixed
dividends or constant dividends. If the growth is constant, dividends that
will be receivable in the following year (Dt) is equivalent to:
D1 = Dt-1 (1+g) OR Dt = D0 (1+g)t (4.10)
Where:
Dt = Dividend for period t
Dt–1 = Dividend that was paid in the previous year
g = DividendÊs rate of growth

By using equation 4.10, we can find the dividend for any given year.
D1 = D0 (1+g)
D2 = D1 (1+g)
= D0 (1+g) (1+g)
= D0 (1+g)2
D3 = D2 (1+g)
= D0 (1+g)2 (1+g)
= D0 (1+g)3
D4 = D3 (1+g)
= D0 (1+g)3 (1+g)
= D0 (1+g)4
By using the basic method to estimate the dividends in the future, we can
obtain the present value of the shares (Vcs) by using equation 4.6.
Step 1: Find the cash flow that is expected to be received in the future
(dividend).
Step 2: Calculate the present value for all dividend payments; and
present value of dividends that are expected to be received in the
future.
As the growth (g) is constant, equation 4.6 can be modified as follows:
D 0 (1  g) D0 (1  g)2 D 0 (1  g)t
Vcs    ...  (4.11)
(1  k cs ) (1  k cs )2 (1  k cs )t
Subsequently, this equation can be simplified to the following equation if the

holding period is infinity:
D1
Vcs = (4.12)
k cs  g

Formula 4.12 is better known as the Gordon growth model (GGM), named
after Myron J. Gordon, the person who created and popularised the equation.
Equation 4.12 is used to find the present value of ordinary shares that
experienced a constant rate of growth. In theory, the required rate of return
(kcs) must be bigger than the value of the rate of dividend growth (g). If the
required rate of return is lower than the rate of dividend growth, you will
obtain a negative dividend and the value of the shares cannot be determined.
In a real situation, if the investor expects the dividend will increase at a
higher rate, then the required rate of return will also be higher than the rate
of dividend growth.
Example 4.9
BBB Company paid dividends of RM0.20 at the end of last year and is
expected to pay cash dividends every year starting from now until forever.
The rate of growth for each year is 10 per cent, while the rate of return is 15
per cent.
Step 1: Find the dividends that will be received

D1 = D0 (1+g)
= 0.20 (1+0.10)
= RM0.22
Step 2: Find the present value of the shares

D1
Vcs 
k cs – g
0.22

 0.15 – 0.10 
 RM4.40
(c) Differential Dividend Growth

Companies expand according to the product life-cycle that is being
transacted. Sometimes, there are companies that will experience faster
growth in the beginning compared to the overall economic situation. Then,
there is a possibility that it will grow parallel with the economic growth and
finally, its growth will be slower than the economic growth. Companies
facing this kind of situation are known as companies with inconstant growth
or fluctuating growth. Figure 4.6 shows the illustration of inconstant growth
compared with constant growth and zero growth.

Figure 4.6: Illustration of dividend growth rate
Figure 4.6 shows the dividend for a company that experienced inconstant
growth. Dividends are expected to increase by 25 per cent for the first three
years, after which, the growth rate is expected to fall to six per cent a year for
a rather long period. The value of shares for this company is the same with
the present value of the dividends that are expected in the future, as shown
in equation 4.6. It also involves three steps:
(i) Calculate the present value of dividends for the entire period of
inconstant growth;
(ii) Calculate the share price at the end of the period of inconstant growth,
which is at the point it changes to constant growth, next discount this
price at present value; and
(iii) Add the present value obtained from step 1 and step 2 to obtain the
intrinsic value, Vcs.

Example 4.10
By using the illustration in Figure 4.6, calculate the present value of ordinary
shares that experienced inconstant growth. Assume the following five
information are given:
Kcs = Rate of return required by investors (12 per cent)
n = Period of inconstant growth (three years)
gs = Rate of dividend growth throughout the period of inconstant growth
(25 per cent)
gn = Fixed rate (six per cent)
D0 = Amount of the final dividend paid by the company (RM0.20 per share)
Calculations:
Step 1: Calculate the expected dividend at the end of each year

throughout the period of inconstant growth. The rate of
inconstant growth, gs, for the period of three years is 25 per cent.
D1 = D0 (1+g)
= RM0.20 (1+0.25)
= RM0.25
D2 = RM0.25 (1+0.25)
= RM0.3125
D3 = RM0.3125 (1+0.25)
= RM0.3906
Step 2: The price of shares is the present value of dividend from first year
to infinity; therefore, it is required to obtain the value of dividend
at fourth year, D4, by using the constant growth rate of
gn = 6%.
D4 = RM0.3906 (1+0.06)
= RM0.414

Next, we use the equation for constant growth rate to find the
price at third year that is the present value of dividend from
fourth year to infinity.
D4
P3 
k cs  g n
RM0.414

 0.12  0.06 
 RM6.90
Step 3: Discount the cash flow for first year to third year and the present
value of dividend at fourth year at the required rate of return, kcs
= 12 per cent, to obtain the intrinsic value for ordinary shares.
Vcs  RM0.25(PVIF12%,1 )  RM0.3125(PVIF12%,2 ) 

RM0.3906(PVIF12%,3 )  RM6.90(PVIF12%,3 )
 RM0.223  RM0.249  RM0.278  RM4.911
 RM5.66
The valuation process mentioned can be shown by using a time line as

illustrated in Figure 4.7.
Figure 4.7: Process of finding the value of company shares that

experienced inconstant dividend growth

The value of RM6.90 stated in Figure 4.7 is the second cash flow
at third year. The shareholders can sell it at third year at the price
of RM6.90 or in other words, it is the present value of dividend
cash flow from fourth year to infinity.
4.7.3 Required Rate of Return for Ordinary Shares

As explained, the expected rate of return for bonds is the return that is expected to
be received by the bondholders on the investments. The expected rate of return for
ordinary shares is the rate of return expected by ordinary shareholders on their
investment. Finance managers use the expected rate of return for ordinary shares
to evaluate the effect of ordinary shares towards the companyÊs new funding costs.
The rate of return is calculated based on the value or price of shares and dividends
that are received. The equation of share valuation can still be used to estimate the
expected rate of return for ordinary shares. However, this equation must be
modified as the value required is the required rate of return or the rate of return
used to discount cash flow.
The expected rate of return is also shown for the three aspects of growth:
(a) Zero Growth

To find the expected rate of return for dividends that experience no growth,
we can use equation 4.13.
D
Vcs  (4.13)
k cs
As we are looking for the value for the rate of return, the equation mentioned
can be modified as follows:
D
K cs  (4.14)
Vcs

Example 4.11
Cergas Maju Company has just sold its ordinary shares at the price of RM2.30
per share. Last year, the company paid dividends of RM0.25. Based on the
economic situation and the current developments in the company, the
management expects that the company will not experience growth for a long
period of time. What is the expected rate of return for the shares of Cergas
Maju Company?
D
K cs 
Vcs
RM0.25

RM2.30
 10.87 per cent
(b) Constant Growth Rate

To find the expected rate of return for dividends at a constant growth rate,
we can use equation 4.15.
D1
Vcs  (4.15)
K cs  g
As we are looking for the value for the required rate of return, the equation
mentioned can be modified as follows:
D1
K cs  g (4.16)
Vcs
From this equation, the required rate of return for ordinary shareholders is
equivalent to the rate of return for dividend added with the growth factor.
Even though the rate of growth (g) is applied to the rate of growth for
dividend of the company, assume that the value of shares is also expected to
increase at the same rate. This is because (g) represents the percentage of
annual rate of growth for the value of shares. In other words, the rate of
return required by investors is determined by dividends received including
capital gain, as reflected by the expected percentage rate of growth in the
share price.

Example 4.12
The ordinary shares for Maju Jaya Company were recently sold at the price
of RM3.38. The company has just paid dividends of RM0.30 per share and is
expected to experience constant growth of 8.5 per cent. If you purchase these
shares in the market, what are the returns that you would expect to receive?
D1
K cs  g
Vcs
RM0.30 (1  0.085)
  0.085
RM3.38
 0.1813 or 18.13 per cent
ACTIVITY 4.5
1. What is the main purpose of companyÊs owners selling their

companyÊs shares in the share market?
2. Based on the equation g = ROE  r, what are the factors that

influence the value of ordinary shares?
4.8 PREFERENCE SHARES

Preference shares are also known as hybrid securities as they have characteristics
of bonds and ordinary shares. Table 4.6 lists down the similarities and differences
between preference shares with bonds and ordinary shares.

Table 4.6: Similarities and Differences of Preference Shares with Bonds

and Ordinary Shares
Item Bond Ordinary Shares Preference Shares

Dividend Bondholders receive Payment of dividend is Payment of dividend
interest at a fixed unlimited but must be is at a fixed rate and
rate and period. declared first by the period.
board of directors of the
company.
Claims on Has priority claims If liquidation occurs, the Has priority claims on
earnings on the earnings and ordinary shareholders the earnings and
and assets compared to have the last claim on assets compared to
assets preference shares the earnings and assets ordinary shares, but
and ordinary shares. after bondholders and only after the claims
preference shares. of bonds had been
settled.
Maturity Bonds have maturity Ordinary shares do not Preference shares do
period period. have maturity period. not have maturity
Ownership remains as period. Ownership
long as the company is remains as long as the
in operation. company is in
operation.
Voting Bondholders do not Ordinary shareholders Preference
rights have the right to have voting rights as shareholders have
vote the members of they are owners of the voting rights to
the board of company. protect their interest.
directors.
4.8.1 Characteristics of Preference Shares

Before we discuss how preference shares are valuated, we must first understand
the characteristics of preference shares.
(a) Issuance of Several Classes of Preference Shares

Normally, a company will issue several classes of preference shares that have
different characteristics and different degree of priority in the aspect of
claims on assets claim if liquidation occurs.
(b) Claims on Assets and Earnings

Preference shares have priority in the aspect of claims on assets and earnings
compared to ordinary shares. For companies that issue several classes of
preference shares, priority of claims will be specified based on the

characteristics of preference shares. Therefore, in the aspect of risks, the risk

of preference shares are lower compared to the risks of ordinary shares but
higher compared to the risks of bonds.
(c) Cumulative Dividends

If there are dividends in arrears, the company must pay those dividends first
before the payment of dividends for ordinary shares are declared. This
characteristic is to protect the interest of preference shareholders.
(d) Provision for Protection

The provision for protection is normally included in the issuing conditions
of preference shares. It is for the purpose of protecting the interest of
preference shareholders. For example, provide voting rights and if there is
failure in paying dividends or by barring the dividend payment of ordinary
shares if the payment of sinking funds is not made.
(e) Convertible Preference Shares

Convertible preference shareholders have the option to change their existing
preference shares to several units of ordinary shares according to the ratio
prescribed when the shares were issued. This is an attraction to investors and
can also reduce the cost to the issuer of preference shares.
(f) Redeemable Preference Shares

Companies that issue preference shares would normally provide a method
for the purpose of redeeming the preference shares issued. If there is no
redemption method, the company will not benefit from the reduction of
interest rates. When interest rates decrease, the company will redeem the
preference shares that are currently available and issue new preference
shares at a lower rate.
There are two methods for the redemption of preference shares that are
normally used and they are:
(i) Provision for Call Option

This method enables the issuing company to buy back the preference
shares at a price that had been specified and within a period that had
been specified.
(ii) Provision for Sinking Funds

This method requires the issuing company to separate a sum of money
periodically for the purpose of redeeming preference shares. The
amount that has been accumulated will be used to buy back the
preference shares by using the call option or any other cheaper
methods.
ACTIVITY 4.6
1. Why are preference shares less popular compared to ordinary

shares?
2. Dividend of preference shares must be paid before the dividend

of ordinary shares at the amount and period specified. Should this
dividend be categorised as a liability to the company such as
debts?
Share your opinions regarding these questions with your coursemates

in the myINSPIRE online forum.
4.9 VALUATION OF PREFERENCE SHARES

As explained, the owners of preference shares generally receive fixed dividends
from its investment at each period. It does not have a maturity period or in other
words, it is perpetuity. Just like the valuation of ordinary shares, the valuation
process of preference shares also involve three steps as follows:
(a) Assume the amount and timing of the cash flow that will be received from
the investment of the preference shares;
(b) Calculate the risk level of cash flow that is expected to be received and then
determine the rate of return required by the investors; and
(c) Calculate the intrinsic value of preference shares by discounting all the cash
flow that is expected to be received by using the required rate of return.
As preference shares do not have maturity period, the dividends are expected to
be received continuously until infinity. Therefore, the equation to calculate the
value of preference shares is as follows:
Annual dividends
Value of shares =
Required rate of return
(4.17)
D
Vps =
k ps

Example 4.13
The annual dividend that is expected to be received is RM0.36 per share. The rate
of return required by investors is seven per cent. Calculate the value of these
preference shares.
RM0.36
Vps 
0.07
 RM5.14
4.9.1 Expected Rate of Return for Preference Shares

The purpose of finding the expected rate of return for preference shares is the same
with the purpose of finding the expected rate of return for ordinary shares and
bonds; to evaluate the effect of preference shares on the new funding costs for the
company. To calculate the expected rate of return for preference shareholders,
equation 4.17 needs to be modified as follows:
D
k ps  (4.18)
Vps
Example 4.14
Cher Mate Company sold its preference shares at the price of RM5.50 and pays
dividends of RM0.25 per share. What is the expected rate of return if you
purchased the shares at market price?
D
k ps 
Vps
RM0.25

RM5.50
 4.54 per cent

ACTIVITY 4.7
1. There are several types of investments such as shares, real estate,

bonds, equities and unit trust. Which is more suitable for you or
are you the type of person who will only create savings in the
banks?
2. Preference shares enable its holders to receive fixed dividends.
How are fixed dividends paid?

forum.
 Valuation is a very important process in finance. This is because in finance, the

value of an asset is measured based on the factors of timing and risk, and not
based on the historical value.
 Understanding the concept of value and having skills in valuations are very
important to assist the manager in making financial decisions for the company.
It is in accordance with the objective of the company which is to maximise the
shareholdersÊ wealth.
 Bond, which is one of the long-term sources in funding, is becoming more

important in the capital market.
 In the valuation of bonds, you will obtain the intrinsic value, which is the actual
value or true value of an asset and this value is emphasised in finance. This
value will then be compared to the selling price of the bonds in the market.
 If the selling price of the bond in the market is higher than the intrinsic value,
the bond is said to be overvalued and if the reverse occurs, the bond is said to
be undervalued.
 The yield to maturity (YTM) can also be the basis in making investment
decisions as it is the rate of return that can be expected if you hold a bond until
its maturity date. This rate will then be compared with the rate of return
required by investors. If this rate is higher than the required rate of return, then
the investment is a good one.

 The ordinary and preferences shares are sources of long-term funding.
 Ordinary shares are more important sources of funding and the usage is wider
than preference shares.
 The objective of valuating ordinary shares and preference shares is the same
with the objective of valuating bonds, that is to find the intrinsic value or true
value of shares to assist in the decision-making on funding or investing.
 The valuation process of ordinary shares requires you to make estimates on

dividends for the coming years in advance.
 Dividend is an important component in the valuation of ordinary shares and

preference shares because it is a cash flow that must be discounted to obtain
the share value.
 The rate of return that is expected concerns the returns to be received from the
investment in ordinary shares and preference shares. Knowing the expected
rate of return receivable is also important as it influences the funding and
investment of the company.
Bond Liquidation value

Book value Market value
Capital gain Maturity period
Constant growth rate Ordinary shares
Coupon rate Par value
Differential dividend growth Pre-emptive rights
Dividend Preference shares
Expected rate of return Required rate of return
Indenture Yield to maturity (YTM)
Intrinsic value Zero growth
Limited liability

1. Why is valuation important for a finance manager to understand this

valuation process?
2. What are the three main elements in the valuation process of assets?
1. Calculate the value of a bond that has a maturity period of 12 years with a
face value of RM1,000. The coupon rate is eight per cent and the required rate
of return is 13 per cent.
2. Calculate the value of a bond that has a maturity period of eight years with
a par value of RM1,000. The coupon rate of 12 per cent is payable twice a year
and the required rate of return is 10 per cent.
3. How do coupon payments of more than once a year affect the value of the
bond?
Bond A has a par value of RM1,000 and pays interest of RM82 per year. The
maturity period for Bond A is five years and the present market price is RM720.
How much is the YTM for Bond A? Use the trial-and-error method as well as the
estimation method to obtain the YTM.
1. Yield to maturity (YTM) is _______________.
A. low for bonds with high risk
B. returns are required on bonds
C. similar with bondsÊ coupons rate
D. fixed through the lifetime of bond

2. The discount rate used to value bonds is the ________________.
(i) coupon rate of the said bond
(ii) interest rate in the market
(iii) rate determined by the company
(iv) fixed rate for the entire lifetime of the bond
A. i
B. ii
C. i and ii
D. iii and iv
3. Bonds were sold at _________ when the interest rate (coupon) is more than
the required rate of return; sold at _________ when the interest rate is lower
than the required rate of return; and were sold at _________ when the
interest rate is the same with the required rate of return.
A. premium; discount; same with par value
B. premium; same with par value; discount
C. discount; premium; same with par value
D. same with par value; premium; discount
4. Which of the following statements is true?
A. Short-term bonds have higher interest rate risk compared to long-term

bonds.
B. Long-term bonds have higher interest rate risk compared to short-term

bonds.
C. All bonds have the same interest rate risk.
D. None of the mentioned statements are true.

5. Choose the false statements regarding bonds.
(i) Mortgage bond is a bond that is secured with property where the value
of the property usually exceeds the value of bond.
(ii) Indenture is a type of bond with low level of priority claim.
(iii) Euro bond is a bond that is issued in one country using the currency of
the bond issuersÊ original country where the principal and interest
payments are according to the original countryÊs currency.
(iv) Par value is the value of cash flow that is expected to be received by the
bondholders every year.
A. iv
B. i and ii
C. ii and iv
D. i, iii and iv
6. How much is the value of a bond with a par value of RM1,000, pays interest
of RM80 per year and matures in a period of 11 years? Assume that the
required rate of return is 12 per cent.
7. Indah Air Berhad issued bonds that will mature in a period of 10 years. These
bonds pay interest twice a year at a rate of eight per cent and the par value of
the bond is RM1,000. If the yearly required rate of return each year by investors
is six per cent, what is the present market value of the said bond?
8. Bonds with a par value of RM1,000 were issued by KEE Company and have
another 15 years before reaching the maturity period. The coupon rate
promised is five per cent per year, paid twice a year. The market interest rate
of bonds with similar risk level with this companyÊs bond is six per cent.
What is the present market value of this bond?
9. Ms. Nadia bought bonds with a par value of RM1,000 at a price of RM950 per
share. These bonds pay a coupon rate of nine per cent per year, paid yearly
and will mature in another two years. Calculate the YTM for this bond.

10. Company X has issued bonds with a par value of RM1,000 and a maturity
period of three years. The yearly coupon rate offered is 10 per cent. Rating
Agency Malaysia Berhad (RAM) has given a rating of AAA to the bonds of
Company X.
(a) If the required rate of return is 13 per cent, what is the market value of
this bond?
(b) If the bonds were sold at the price of RM975.98, what are their YTM?
11. What is meant by the YTM of bonds?
12. As a risk averse investor, would you choose, the long-term bonds or short-
term bonds to protect the effect of interest rate on bonds?
1. What are the two forms of returns that will be obtained by ordinary
shareholders on their investments?
2. Litar Company is expected to pay dividends of RM0.18 to its companyÊs

ordinary shareholders next year and the growth rate is fixed, that is at five per
cent per year. The market price of shares is estimated to value at RM4.25 at the
end of next year. If the required rate of return is 11 per cent, what is the present
value of the share? If you own shares in Litar Company, will you sell the shares?
Why?
3. TAB Company has just paid dividends of RM0.50 to its shareholders. The
company expects dividends to experience a remarkable growth rate of 15 per
cent for the period of three years from now and subsequently will experience
a constant growth rate of four per cent. The rate of return required by
investors is 12 per cent. What is the price of TAB CompanyÊs shares?
4. What do you understand by the rate of return expected by investors?
5. Ordinary shares of Mesra Company had just been sold at the price of
RM2.30 per share. The company expects to experience a constant growth
rate of 10.5 per cent and the dividend at the end of the year is expected to be
RM0.25.
(a) What is the expected rate of return for the shares of Mesra Company?
(b) If the required rate of return is 17 per cent, will you buy those shares?

1. Ordinary shareholders are ____________.
(i) owners of the company
(ii) managers of the company
(iii) creditors of the company
A. i
B. i and ii
C. ii and iii
D. i,ii and iii
2. Everything below has an effect on the value of ordinary shares EXCEPT:
A. Par value
B. Risk-free rates
C. Growth of dividends in the future
D. Dividends in the future
3. If an investor believes that a share is ____________, he should ____________

the share to receive more profit.
A. devalued; buy
B. undervalued; sell
C. correctly valued; buy
D. correctly valued; sell

4. Preference shares mean __________________

(i) priority over ordinary shares in the aspect of claims on assets.
(ii) priority over ordinary shares in the aspect of dividend payments.
(iii) priority over ordinary shares in the aspect of voting rights.
A. i
B. i and ii
C. ii and iii
D. i, ii and iii
5. Preference shares have characteristics similar to bonds because they

___________.
(i) have a fixed monthly rate.
(ii) have a fixed dividend amount.
(iii) represent the ownership of the company.
A. i
B. ii
C. iii
D. i, ii and iii
6. Why is preference share stated as hybrid security?
7. What is the value of preference shares if the dividend rate is 16 per cent of its
par value of RM10? The required rate of return is 12 per cent.
8. You own 150 units of preference shares of Mapa Company. These shares had
just been sold at the price of RM3.85 per share and the annual dividend is
RM0.35.
(a) What is the expected rate of return?

(b) If the required rate of return is 18 per cent, will you sell or buy these
shares?
9. Maju Company had just paid dividends of RM1.32. If the growth rate is
expected at seven per cent perpetually and the rate of return required by
investors is 11 per cent, what is the price of Maju CompanyÊs shares?

10. Chips Computer Sdn. Bhd. had just paid dividends for ordinary shares of
RM1.15. For the next two years, the company is expected to experience high
growth as high as 15 per cent and 13 per cent for the third year and
consequently with a fixed rate of six per cent. The required rate of return for
the companyÊs shares is 12 per cent. Calculate the value of shares for Chips
Computer Sdn. Bhd.
11. Recently, Tenun Company had just issued its ordinary shares at the price of
RM4.05 per share. Dividend of RM0.25 per share is expected to be paid at
the end of this year and is expected to experience a fixed growth rate of
seven per cent per year. What is the required rate of return for these shares?
12. Last year, Primax Company paid dividend of RM0.40, and this year the
dividend is expected to experience a growth rate of 10 per cent. The
company had just paid dividend of RM0.44. Through a new technique in
producing its products, Primax expects to obtain high achievement in the
short term that is, at 25 per cent per year for the first three years. After this,
the growth is expected to return to normal for a long period, that is 10 per
cent perpetually. If investors required 15 per cent rate of return, what is the
price of the companyÊs shares today?
13. If Cabin Company pays dividends as much as RM1 per year for its
preference shares and the required rate of return is 12 per cent, what is the
value of these preference shares?
14. What is the rate of return required for preference shares if the dividends
payable every year is RM0.15 with a par value of RM4? These shares had
just been sold at the price of RM5.

Topic  Risk Analysis
5
LEARNING OUTCOMES
1. Define risk and return;
2. Apply statistics measures in determining risk and return of an
investment;
3. Measure the expected return and the riskiness of an individual
investment;
4. Differentiate between systematic risk and unsystematic risk;
5. Explain how diversifying investments affects the riskiness and
expected return of a portfolio; and
6. Apply capital asset pricing model (CAPM) in determining an
investorÊs required rate of return on an investment.
 INTRODUCTION
The modern portfolio theory was introduced by Harry Markowitz in the year 1952.
According to this theory, risk and return cannot be separated. The higher the risk,
the higher the expected return. In 1964, this theory analysis has been further
developed by William F. Sharpe to form another theory that is very useful in the
field of finance that is, the capital asset pricing model (CAPM).
In this topic, you will learn the risk and return from the perspective of capital
contributors or shareholders. According to the research on the habits of investors
that were conducted by Markowitz, capital contributors will make valuation on
returns before making investment. Subsequently, they will make analysis on the
changes in returns as a measurement of risk.
TOPIC 5 RISK ANALYSIS  175
Generally, as rational capital contributors, shareholders will do their best to

maximise returns and at the same time, try to minimise risk. Therefore, it is the
responsibility of the finance manager to analyse risk and return before making any
financial decisions. This is important to ensure that the company can maximise its
value including the wealth of shareholders.
5.1 DEFINITION OF RISK AND RETURN

Generally, risk means the possibility of facing some uncertain harm or loss in the
future. From the perspective of financial management, risk is the probability of
changes to the returns received by an investor in a specific period. Assets that have
higher possibility of losses is said to have higher risk compared to assets that have
lower possibility of losses. Return is defined as the profit level received by
investors during the period of their investment. The actual return from an
investment comprised of two main components:
(a) Expected return; and
(b) Unexpected return
Expected return is the return based on the information available as well as

information that can be expected by the investors. On the other hand, unexpected
return is created from information that is beyond the expectation of investors.
In an efficient capital market environment, in theory, return can be completely

expected. However, in practice, the actual return value may be different from the
expected return due to the existence of unexpected return.
Unexpected return consists of systematic return and unsystematic return

components. Systematic return exists as a result of systematic risk, while
unsystematic return exists as a result of unsystematic risk. Systematic and
unsystematic risks will be explained further in later topics.
As a smart investor, you will have to analyse risk-return before making investment
decisions. This analysis is to determine the minimum rate of return that is
appropriate in balancing the risk level that you are willing to accept. The minimum
rate of return is also known as nominal rate of return or required rate of return.
The return that is required by an investor might be the same or different compared
to another investor. The rate of return is normally used as a guide by investors on
whether to buy or sell a financial asset in the market. A rational investor will
normally buy the financial asset if the expected rate of return is higher or equal to

176  TOPIC 5 RISK ANALYSIS
SELF-CHECK 5.1
Explain the relationship between risk and return in investments.
5.2 USE OF STATISTICS TO DETERMINE RISK

AND RETURN
As a basic step in understanding how return and risk are measured as well as
interrelated, you must first know several important terms in statistics such as
random variable, probability and its distribution, mean, variance and standard
deviation, coefficient of variation, covariance and correlation coefficient.
5.2.1 Random Variable

The value of random variable is a statistic data that is difficult to predict accurately.
The value of random variable can only be estimated as the real value is difficult to
obtain. For example, you can only estimate the value of a companyÊs profit based
on several methods such as based on the profit obtained from previous years.
5.2.2 Probability and Its Distribution

As the value of random variable is something that is uncertain, hence the concept
known as probability is used to measure the possible value of random variable.
The concept of probability is a statistics term that is used to predict the occurrence
of an uncertain occurrence. In other words, probability is the numerical figure that
measures the relative frequency of an occurrence in a specific period. Based on
probability, you can make a rather effective decision that can be adopted.
The concept of probability outlines several of the following issues:
(a) Probability cannot be in negative form;
(b) The total overall probabilities are equal to 1 per cent or 100 per cent;
(c) The value 0 shows the probability of a specific occurrence that definitely
would not occur;

(d) The value 0.1 shows the probability of a specific occurrence occurring is 10
per cent; and
(e) The value 1 shows the probability of a specific occurrence that would
definitely occur.
The risk of an investment is usually measured based on the total dispersion of

random variables in the probability distribution. In general, probability
distribution is categorised into two types of distribution, discrete distribution and
continuous distribution.
Discrete probability distribution is a distribution that has a matching probability

value and random variables value that are limited. While the continuous
probability distribution is a calculation of probability value that is related with the
random variables with the assumption that it will create an unlimited numbers of
possibility or infinity return. In other words, continuous distribution can be
formed when you are able to fully determine every matching value of the
probability and return of an investment.
Example 5.1
Nusa Company is currently considering two alternative investments, either to
embark on a project to rear fish (PRF) or project to rear sheep (PRS). The following
are the discrete probability distribution of returns for both investment alternatives
(refer to Table 5.1):
Table 5.1: Discrete Probability Distribution of Returns for Investment Alternatives
Probability PRF Returns (RM) PRS Returns (RM)

0.25 8,000 2,000
0.25 12,000 18,000
0.50 10,000 10,000
Based on the prediction by Nusa Company, both the investment alternatives

showed that the opportunity to obtain the estimated return of RM10,000 is higher
as it stated a higher probability percentage. Figure 5.1 displays the mentioned
information in the form of a bar chart.

Figure 5.1: Discrete probability distribution for the prediction of returns for PRF and PRS
If Nusa Company can predict the matching of probability and return continuously
for both projects, the outline of probability distribution and return from both
projects can roughly be illustrated in Figure 5.2.
Figure 5.2: Continuous probability distribution for the prediction of returns for
PRF and PRS
From the aspect of its concept, the steeper the probability distributions graph on
investment return, the riskier the said investment. A steep graph shows that the
probability distribution gap of return is bigger. The probability distribution gap is
the difference or variation between the estimated highest return and the estimated
lowest return. The smaller the differences in value, the lower the estimated risk
and conversely, the higher the gap, the higher the risk of an investment.

Figure 5.1 shows that the probability distribution gap of return for PRS is bigger
(RM18,000 – RM2,000 = RM16,000) compared to PRF (RM12,000 – RM8,000 =
RM4,000). Meanwhile, Figure 5.2 shows that the probability distribution of return
for PRS is flatter compared to the probability distribution of return for PRF.
Therefore, you can conclude that PRS has a higher risk compared to PRF.
5.2.3 Mean (Expected Return)

Expected return is the mean for random variable. Mean is the arithmetic average
of probability for all the possibilities in the value of random variables. Mean is
obtained when the experiments are repeated several times and the results of these
experiments are obtained that is the weighted average probability for all the
outcomes are determined.
n
X   X t Pt (5.1)
t–1
OR
n
r   rt Pt (5.2)
t–1
Where:
X = Mean of return or expected return in ringgit value

r = Mean of return or expected return in percentage value
n
 = Sum
t 1
Pt = Probability of obtaining returns

Xt = Return in ringgit (usually based on previous returns)
rt = Return in percentage (usually based on previous returns)

5.2.4 Variance and Standard Deviation

Variance is a measure of dispersion or distribution of all possible result around the
mean (expected value). In other words, it is the square of standard deviation.
Standard deviation is the measurement of dispersion around the expected value

of a probability distribution or its frequency, which is the square root of variance.
Both are measurements for risk that take into consideration systematic risk and
unsystematic risk.
n
 2   (ri  r )2 Pi (5.3)
i=1
n
  (ri – r)2 Pi (5.4)
i=1
Where:
σ 2 = Variance
σ = Standard deviation
5.2.5 Coefficient of Variation

Coefficient of variation or CV is a standard deviation ratio on expected return. It
is a standard measurement of risks for each unit of return. Coefficient of variation
is used as the comparison basis for two investments in financial assets.
It is also used if a situation arises where the financial asset of A produces return
that is higher than the financial asset of B; but at the same time, the financial asset
of A has higher risk compared to the financial asset of B. The higher the value of
CV, the higher it will be for the level of risk for each unit of return.

CV  (5.5)
r

5.2.6 Covariance
The use of covariance can explain to you the relationship of returns among the
financial assets that can be compared. In other words, covariance measures how
far two random variables are different from each other. The following are the three
types of covarience:
(a) The value of positive covariance shows that one of the random variables
states a value of more than mean, while the other random variable is also
inclined towards the value of more than mean;
(b) The value of negative covariance shows that one of the random variables
states a value of more than the mean, while the other random variable will
incline towards the value of less than mean; and
(c) The value of zero covariance shows that no pattern had been formed between
the two variables. The covariance for the two random variables (r1, r2) is
usually written as Cov (r1,r2) of sr1r2.
n
Cov (r1 , r2 )   Pi (ri1  r1 ) (ri2  r2 ) (5.6)
i=1
5.2.7 Correlation Coefficient

Correlation coefficient is used to measure the relationship movement magnitude
between two variables that is, the movement of returns on financial assets that are
being analysed. It is obtained by dividing the covariance with the result of
multiplying the standard deviation. The value of correlation coefficient is between
the range of -1 and +1 only. Normally, it is written as Corr (r1,r2) or the symbol
Rho (r).
Cov (r1 , r2 )
Corr (r1 , r2 )  (5.7)
 r1 ,  r2
The three types of correlation coefficient are as follows:
(a) Perfect Negative Correlation [Corr (r1, r2) = –1.0]

Correlation –1.0 explains two variables moving in opposite directions and
with the same magnitude. The combination of investment in these two sets
of financing is said to reduce risk.

(b) Perfect Positive Correlation [Corr (r1, r2) = +1.0]

Correlation +1.0 explains two variables moving in the same directions and
with the same magnitude. The combination of investment in these two sets
of financing would not be able to reduce risk.
(c) Positive Correlation

Positive correlation, for example +0.4 explains two variables moving in
the same direction but at different magnitudes. The combination of these
variables created lower risk compared to cases of perfect positive correlations
but is higher compared to cases of perfect negative correlations.
5.3 MEASURING THE EXPECTED RETURN AND

RISK OF INVESTING IN ONE SECURITY
Before the investment risk in a security can be determined, you must first calculate
the expected return by using the equation 5.1 or 5.2. The investment risk in one
security is known as specific risk. Specific risk is measured using the variance
equation (equation 5.3) and subsequently the equation for standard deviation
(equation 5.4) for the investment return of an asset.
Example 5.2
Rate of Return (r) for

Economic Probability Financial Asset
Condition (P)
A B
Weak 0.20 12% 6%
Moderate 0.50 14% 14%
Strong 0.30 16% 19%
(a) Expected Return or Mean Return
Financial Asset A
r = {(0.20 12%) + (0.50 14%) + (0.30 16%)}

= 14.2%
Financial Asset B
r = {(0.20 6%) + (0.50 14%) + (0.30 9%)}

= 13.9%

(b) Variance
Financial Asset A
2 = [0.20 (12% – 14.2%)2] + [ 0.50 (14% – 14.2%)2] + [0.30 (16% – 14.2%)2]

= 1.96%
Financial Asset B
2 = [0.20 (6% – 13.9%)2] + [ 0.50 (14% – 13.9%)2] +[0.30 (19% – 13.9%)2]

= 20.29%
(c) Standard Deviation
Financial Asset A
  [0.20 (12%  14.2%)2 ]  [ 0.50 (14%  14.2%)2 ]  [0.30 (16%  14.2%)2 ]

 1.4%
Financial Asset B
  [0.20 (6%  13.9%)2 ]  [ 0.50 (14%  13.9%)2 ]  [0.30 (19%  13.9%)2 ]

 4.50%
Based on the previous calculation, financial asset A produces an expected return

that is larger (14.2 per cent) compared to B (13.9 per cent). From the aspect of risks,
however, it is found that the financial asset B is riskier (4.50 per cent) compared to
the financial asset A (1.4 per cent). Therefore, the choice of financial asset A is
better.

5.4 REDUCING RISK THROUGH

DIVERSIFICATION
Diversified investments or a combination of several securities in the capital market
refers to the security portfolio. One the objectives of portfolio is to avoid the
burden of risk in investing in only one asset. The total investment risk of the
portfolio (which is a combination of systematic and unsystematic risks) is
distributed at the minimum level to obtain the maximum return. The reduction of
total risk can be described with the help of Figure 5.3.
Figure 5.3: Effects of diversification on systematic risks and unsystematic risks
5.4.1 Principle of Systematic and Unsystematic Risk

Systematic risk is a risk that cannot be diversified. It is a risk that has an overall
effect on all financial assets in the capital market. Systematic risk is related to
market risk that is, the rise and fall of a countryÊs internal and external markets,
interest rate risks and the risk of purchasing power. These risks cannot be
eliminated by diversification in investments.
Meanwhile, unsystematic risk or risk that can be diversified is a risk that only has
effect on the financial assets of specific companies or group of related companies.
This risk is unique or different among the companies (depends on the nature of
the business). It comprises business risk (operations) of the company and financial
risk of the company. These risks can be distributed or reduced by diversification
in investments.

SELF-CHECK 5.2
What is the principle of systematic and unsystematic risk?
5.4.2 Measuring the Expected Return and Risk of

Security Portfolio
The expected rate of return for investment in the security portfolio is the weighted
average expected return on the financial assets held in the portfolio.
 
n
rport    w1 ×r1    w 2 ×r 2   ⁄   w n ×rn  (5.8)
 
i=1
Where:
rport1. = Expected rate of return for portfolio
r1 = ra Expected rate of return for asset (1)
W1 = Weight for financial asset (1) in the portfolio
r2 = rb Expected rate of return for financial asset (2)
W2 = Weight for financial asset (2) in the portfolio
rn = r n Expected rate of return for financial asset (n)
Wn = Weight for financial asset (n)
The portfolio risk refers to the variability of expected returns or average returns
from investments in the portfolio. The effects from diversification caused the
portfolio risk to become smaller as compared to the risk of individual assets
(portfolio components). The total reduction of risk (through diversification)
depends on the correlation of an asset return with other assets return in the
portfolio that is measured with the coefficient correlation.

For data based on time series, the portfolio formula for standard deviation is
modified as follows:
 portf. 
n
 P n (rportf. in a specific economic situation  rportf. for all securities in the portf.)2
i=1
(5.9)
Example 5.3
Investment portfolio is made up of 50 per cent of financial asset A, 25 per cent of
financial asset of B and the remaining 25 per cent of financial asset C.
Economic Rate of Return (r) for Financial Asset (%)

Probability (P)
Condition
A B C
Strong .45 11 16 21
Weak .55 9 5 0
(a) Expected Return for Each Financial Asset
Financial Asset A
R A = {(0.45  11%) + (0.55  9%)}

= 9.9%
Financial Asset B
R B = {(0.45  16%) + (0.55  5%)}

= 9.95%
Financial Asset C
R C = {(0.45  21%) + (0.55  0%)}

= 9.45%
(b) Expected Return for the Portfolio of Financial Asset of A, B and C
rport1. = {[0.50  9.9%] + [0.25  9.95%] + [0.25  9.45%]}
= 9.8%

(c) Variance
Expected portfolio return during a strong economic condition:
= {[0.50  11%] + [0.25  16%] + [0.25  21%]}

= 14.75%
Expected portfolio return during a weak economic condition:
= {[0.50  9%] + [0.25  5%] + [0.25  0%]}

= 5.75%
σ portf.2 = {[0.45  (14.75% - 9.8%)2] + [0.55  (5.75 – 9.8)2]}

= 20.05%
(d) Standard Deviation
portf = {[0.45  (14.75%  9.8%)2 ]  [0.55  (5.75  9.8)2 ]}
= 11.026  9.02
= 4.477%
5.4.3 Capital Asset Pricing Model (CAPM)

Capital asset pricing model (CAPM) is a principle that explains how the price of
capital assets can be determined based on the reaction of investors in choosing a
portfolio in the capital market. Choosing a portfolio depends on the attitude of the
investor towards risk and return. Most investors, in general, are conservative and
possess risk averse attitude. They ensure that every ringgit they had invested is
able to generate profit. This group of investors is only willing to pay the amount
that is lesser than the value of expected return.
In the capital market, there are many combinations of assets that have uncertain risk-
return levels. Therefore, investors have a chance to choose and diversify the
investment combinations or portfolios that consist of risky and non-risky assets.
Non-risky asset refers to asset that has a standard deviation equals to zero. In other
words, the actual return is the same as the expected return. In reality, there would
not be any asset that is totally free from risk. However, there are assets with very
low risks. For example, treasury bills issued by the government. Although these
treasury bills are not totally risk-free, their returns are guaranteed by the
government; hence, they are categorised as non-risky assets.

According to the CAPM concept, an investor will choose any combination of assets
that are risky and non-risky in an efficient portfolio along the capital market line
(CML). The reason for choosing this portfolio is to create a situation of an optimum
risk-return replacement. CML is a straight line graph that is tangent with the
efficient frontier curve (refer to Figure 5.4).
Figure 5.4: Capital market line
This graph explains the connection between the value of rate of return and
standard deviation. At y axis, the straight line is known as CML, starting from the
point marked rf, which is the return of risk-free asset and subsequently, it touches
the efficient frontier curve (that is the market portfolio known as M).
The market portfolio is the portfolio that contains all securities in the market. The
overall unsystematic risks in the market portfolio has been distributed or reduced
to the lowest level. The balance is the systematic risks. The possibility of these
systematic risks to be distributed is very slim or in theory, it is categorised as risks
that cannot be distributed. M is the risky portfolio that is the best to be chosen
compared to the other risky portfolios in the efficient frontier curve but in reality,
it is not possible for you to own a portfolio containing all the securities in the
market.
The entire portfolio along the CML is a combination of risk-free assets and risky
portfolio that will produce the same risk and return in investments if made in risk-
free assets and market portfolio M. When CML is formed, it is up to the investors
to choose any combination of investments on the CML. This is because based on
the gradient of the CML, any of the combinations will provide the same risk-
return.

The gradient of the CML can measure the amount of expected return for a unit of
total risky investment. The formula is as stated in equation 5.10:
rm  rf
Gradient of CML  (5.10)
σ
Equation rm – rf is known as market risk premium. Market risk premium measures

the reward offered by the market on the willingness of investors to accept an
average total of systematic risks during the period of investment. As unsystematic
risks can be distributed by diversification of investments, therefore, there would
be no reward for the willingness of the investors to bear these risks.
5.4.4 Measuring Systematic Risk (Beta)

Assume you had successfully chosen one of the portfolios that could reduce the
total risks to the minimum level on the CML efficient frontier line. This portfolio
comprised of a combination of risky assets A, B, C, D and one non-risky asset.
Each of these risky assets has a combination of systematic and unsystematic risks.
Therefore, when this portfolio is formed, the unsystematic risk can be fully
distributed. As a result, the only systematic risk left accumulated is due to the
combination of systematic risk from each of the risky assets of A, B, C and D.
You can measure the systematic risk by using the coefficient beta (β) that is the
relative shares diversifiable index. The following are the indicators that are used
to interpret the results of beta multiplier:
(a)  = 0.0: Securities without risk (risk-free assets);
(b)  = 0.5: The level of securities risk is half of the market risk;
(c)  = 1.0: Securities have the same level of risk as the average market
risk; and
(d)  = 2.0: The level of securities risk is twice the average market risk.
The systematic risk for each risky asset portfolio is the total risk that contributes to
the risky market portfolio. Therefore, the systematic risk of the asset influences the
return that is expected in the market. However, how do you know how much is
the return payable on the willingness to receive a certain amount of systematic
assets risk?

Total expected return for a unit of risk that is stated previously, actually can be
measured by the CML gradient that had been learnt in the previous subtopic.
Therefore, you are able to determine the risk premium for a risky asset, for
example asset A, using equation 5.11.
Risk premium for A = (Systematic risk) (CML gradient)
rm  rf
 {[Corr (A, M)]  A } (5.11)
m
Equation 5.11 can be modified to determine the beta for asset A

(equation 5.12).
Cov(A, M)
A  (5.12)
 M2
After each of the beta multiplier for the risky assets portfolio had been calculated,
you will determine the beta for the entire investment portfolio. Your calculation is
based on equation 5.13.
n
portf.   Wi Bi (5.13)
i =1
Example 5.4
Assume you have determined the beta multiplier including the weighted
investment for each of the risky financial assets. Based on this information, you
can then calculate the portfolio beta multiplier for the investment of assets X, Y
and Z (refer to Table 5.2).
Table 5.2: Portfolio Beta Multiplier for the Investment of Assets X, Y and Z
Securities % Portfolio Beta

X 25 1.20
Y 20 0.90
Z 55 0.80
β portfolio x,y,z = {[ (1.20) (0.25)] + [(0.90) (0.20)] + [(0.80) (0.55)]}

= 0.92

5.4.5 Security Market Line

Prior to this, you have seen the graph that forms the CML that is the illustration
that connects the rate of return value with the measurement of overall risks
(standard deviation). Now, you will learn the relationship between rates of return
with the measurement of systematic risk (beta). This relationship is illustrated by
the security market line (SML) graph shown in Figure 5.5. In theory, SML will
fluctuate from time to time depending on the changes in the estimation of inflation,
risk aversion and beta shares.
Figure 5.5: Security market line
Equation 5.14 is the basic formula for CAPM where the expected return for risky
asset A is the sum return for risk-free assets and risk premium for risky assets A.
This equation shows how SML connects the expected returns for risky asset A with
the beta of risky asset A.
rA  rf  (rm  rf ) A (5.14)
Assume that there is an investment portfolio that comprised all the securities in
the market. This type of portfolio is known as market portfolio where the expected
return for this portfolio is stated as rm. As this portfolio represents all the securities
in the market, then it is certain that this portfolio has an average systematic risk
that is bm = 1.0. The SML gradient for market portfolio is:
rm  rf rm  rf
  rm  rf (5.15)
m 1

Example 5.5
First Portfolio
Assume the portfolio consisted of investments in security X (where its beta is 1.5
and the expected return is 18 per cent) and risk-free security (where rf is 7 per cent).
30 per cent of the investment is invested in security X, while 70 per cent is invested
in the risk-free security.
Therefore,
rportf. = {[(0.30) (0.18) + (0.70) (0.07)]}

= 10.3%
Βportf. = {[(0.30) (1.5) + (0.70) (0)]}

= 0.45
Reward to risk ratio can be calculated based on the following equation:

rx – rf
SML gradient =
x
(18  7)
For security X, the reward to risk ratio is =
1.5
= 7.33%
(meaning that security X has a reward to risk ratio of 7.33%)
Example 5.6
Second Portfolio
Assume the portfolio comprised of investments in security Y (where its beta is 1.1
and the expected return is 14 per cent) and risk-free security (where rf is 7 per cent).
30 per cent of the investment is invested in security Y, while 70 per cent is invested
in the risk-free security.
Therefore,
rportf. = {[(0.30) (0.14) + (0.70) (0.07)]}

= 9.1%
βportf. = {[(0.30) (1.1) + (0.70) (0)]}

= 0.33

Reward to risk ratio can be calculated based on the following equation:

ry  rf
SML gradient =
y
(14  7)
For security Y, the reward to risk ratio is =
1.1
= 6.36%
This means that security Y has a reward to risk ratio of 6.36 per cent which is less
than the 7.33 per cent offered by security X.
Figure 5.6 shows the graph position that draws the combination points of expected
returns and beta for security X that is higher compared to security Y. This situation
explains that the return offered by the first portfolio is higher compared to the return
offered in the second portfolio at any level of systematic risk that is measured by
beta.
Figure 5.6: SML gradient for portfolio security X and Y

ACTIVITY 5.1
What is your financial planning after your retirement? How do you

ensure that your savings are enough to provide for your old age?
 In this topic, you have been exposed to the basic knowledge on risk and return
from the perspective of an investor.
 From the perspective of financial management, risk is the probability of

changes to the returns received by an investor in a specific period. Return is
defined as the profit level received by investors during the period of its
investment.
 Return and risk are measured by using some statistics such as random variable,
probability and its distribution, mean, variance and standard deviation,
coefficient of variation, covariance and correlation coefficient.
 There are two types of risks: systematic and unsystematic risks.
 Systematic risk is a risk that cannot be diversified. It is a risk that has an overall
effect on all financial assets in the capital market.
 Unsystematic risk or risk that can be diversified is a risk that only has effect on
the financial assets of specific companies or group of related companies.
 Capital asset pricing model (CAPM) is a principle that explains how the price
of capital assets can be determined based on the reaction of investors in
choosing a portfolio in the capital market.
 Finance managers and financial markets assess the return and risk of all major
decisions to make sure that the best return is being earned for a given level of
risk or that risk is being minimised for a given level of return which is also
known as efficient portfolio.

Capital asset pricing model (CAPM) Return

Capital market line (CML) Risk
Coefficient of variation Risk-free assets
Correlation coefficient Security market line (SML)
Covariance Standard deviation
Diversification Systematic risk
Expected return Unexpected return
Market risk Variance
1. Layar Gemilang Company plans to introduce a new fishing boat model. The
estimated return depends on the degree of market acceptance on this new
fishing boat model.
Market Acceptance Probability Estimated Return (%)

Very discouraging 0.05 0
Not encouraging 0.10 5
Moderate 0.40 20
Encouraging 0.25 30
Very encouraging 0.20 40
Calculate:
(a) The expected return;
(b) The standard deviation of return; and
(c) The coefficient of variation of return and interpret its result.

Amin plans to form an investment portfolio that comprised of 40 per cent

investment in share X, 35 per cent investment in share Y and the remaining 25 per
cent in share Z.
Economic Rate of Return (r) for Share

Probability (P)
Condition
X Y Z
Strong 0.48 10% 15% 20%
Weak 0.52 10% 6% 1%
Calculate:
(a) Expected return for each share;
(b) Expected return for investment portfolio of share X, Y and Z; and
(c) Standard deviation for the investment portfolio.
1. You are considering two alternatives in buying shares from either Company
A or Company B. The share broker had prepared an estimated return for
both these shares as follows:
Shares Company A Shares Company B

Probability Return (%) Probability Return (%)
0.05 5 0.05 15
0.15 30 0.05 35
0.25 25 0.20 20
0.25 15 0.20 30
0.30 20 0.50 25
(a) Draw a bar chart for the shares in Company A and Company B.
(b) Calculate the range of probability distribution for the return of shares
in Company A and Company B.
(c) Determine which of the shares is riskier.

2.
Estimated Return (%)
Economic Condition Probability
Share X Share Y
Strong 0.6 14 7
Moderate 0.4 6 12
50 per cent from the total capital was invested in share X and the remaining
50 per cent was invested in share Y. Calculate:
(a) The expected return for each security;
(b) The expected return for portfolio for share X and share Y; and
(c) The standard deviation for the portfolio of share X and share Y.
3. What will happen to the portfolio investment risks of share K and share L if
the correlation multiplier for return of both these shares changed from a
positive value to a negative value?
4. Recently, Jacob Company is considering a project that has a beta of 1.40.

Currently, the risk-free rate is six per cent and the return for market portfolio
is 11 per cent. It is expected that this project will generate an annual rate of
return of 12 per cent.
(a) By using the CAPM formula, calculate the required rate of return on
the investment in this project.
(b) Based on the answer in (a), is it feasible for Jacob Company to invest in
this project?
(c) What is the required rate of return on the investment in this project if
the rate of return for the market portfolio increased by 10 per cent?
5. What is the risk status for a share if the beta for this share is less than 1.0?
6. The management of Danun Company is considering two choices for the best
investment portfolio that is either (1) a combination of financial assets A and
B or (2) a combination of financial assets A and C. The investment planned is
50 per cent for each asset component in each portfolio.

The following are the estimated returns for all the three types of financial
assets:
Expected Return (%) of Financial Assets

Year
A B C
2015 12 16 12
2016 14 14 14
2017 16 12 16
(a) What is the expected return for each portfolio?
(b) What is the standard deviation for each portfolio?
(c) Which portfolio should Danun Company choose?
7. The estimated beta for the shares in Emas Company is 1.3. The risk-free rate
is eight per cent and the estimated market return is 16 per cent.
(a) Based on the CAPM formula, what is the required rate of return for
investors who invest in the shares of Emas Company?
(b) What is the premium value of the market risk?
8. The following information is the probability distribution for the returns of

share V and share W.
Expected Returns (%)

Probability
Share V Share W
0.1 0 3
0.2 6 4
0.3 7 5
0.4 5 6

Based on the information above, calculate:
(a) Expected returns for each share;
(b) Variance for each share;
(c) Standard deviation for each share;
(d) Covariance between the returns of share V and share W; and
(e) Correlation between the returns of share V and share W.
9. Mesra Company has two choices in investment portfolio.
First Choice Second Choice

 Invest 40 per cent in share N and 60  Invest 50 per cent in share M and 50
per cent in a risk-free security. per cent in a risk-free security.
 Expected return for share N is 13  Expected return for share M is 16
per cent and for the risk-free per cent and for the risk-free
security is six per cent. security is six per cent.
 Beta for share N is 1.25.  Beta for share M is 1.4.
Based on the information, calculate:
(a) Expected portfolio return, portfolio beta and reward to risk ratio for
both investment alternatives; and
(b) Which portfolio should be chosen by Mesra Company?
10. Share A has a beta of 1.2 and expected return of 20 per cent. Meanwhile, share
B has a beta of 0.80 and expected return of 13 per cent. If the risk-free rate is
5 per cent and the market premium risk is 12 per cent, which share is said to
be overpriced or underpriced?

Topic  Criteria of
Capital
6 Budgeting
LEARNING OUTCOMES
1. Determine the acceptability of a new project based on payback period
(PBP), net present value (NPV), profitability index (PI) and internal
rate of return (IRR); and
2. Explain the advantages and disadvantages of each capital budgeting
technique.
 INTRODUCTION
Capital budgeting is a process where firms plan the investments in long-term
assets or activities that have long-term financial implications. It involves a
substantial cash withdrawal and the cash inflow is for a long period in the future.
Just like other decision-making process, capital budgeting involves the

considerations and valuation of available alternatives. Among the important
matters that must be given attention in the valuation process of capital budgeting
projects are the appropriate use of techniques and accurate estimation of cash flow
as inputs to the techniques that will be used.

TOPIC 6 CRITERIA OF CAPITAL BUDGETING  201
6.1 CAPITAL BUDGETING

Capital budgeting refers to the technique used for analysing whether an
investment in an asset or long-term project is profitable or not. These techniques
are often mentioned as the criteria of capital budgeting. There are four basic
techniques in capital budgeting (refer to Figure 6.1):
Figure 6.1: Four basic techniques in capital budgeting
SELF-CHECK 6.1
Give the definition of capital budgeting.
6.2 PAYBACK PERIOD (PBP)

The payback period technique involves the use of payback period criteria as
the basis in decision-making. The payback period, normally referred with the
acronym PBP, is the time period taken by a project to regain the sum of money
invested at the beginning of the project.
6.2.1 Calculation of PBP

Examples 6.1 to 6.3 show how the PBP is obtained.

202  TOPIC 6 CRITERIA OF CAPITAL BUDGETING
Example 6.1
Project A has the following cash flow. What is the PBP of this project? Refer to
Table 6.1.
Table 6.1: Cash Flow of Project A
Year Cash Flow (RM) Cumulative Cash Inflow (RM)

0 –100,000
1 20,000 20,000
2 20,000 40,000
3 30,000 70,000
4 30,000 100,000
5 30,000 130,000
The negative cash flow of RM100,000 at year 0 equals the total that was invested,
or the cash outflow as the money has been spent on this project. Observe that in
fourth year, the cumulative cash inflow is RM100,000, matching the cash outflow
(initial capital) at year 0. Therefore, the PBP for Project A is four years, that is the
time where the total sum obtained matches the total sum withdrawn.
Example 6.2
When PBP is between two different time periods, we can assume that the
distribution of cash flow is uniform. In this situation, we can use the linear
interpolation to estimate the PBP for the project assessed.
The project of purchasing a grinding machine has a cash flow as follows (refer to
Table 6.2):
Table 6.2: Cash Flow of Project of Purchasing a Grinding Machine

0 –200,000
1 50,000 50,000
2 50,000 100,000
3 70,000 170,000
4 70,000 240,000
5

Based on the cash flow, the PBP for this project is found to be within
three years to four years because to achieve PBP, the cash inflow must be equal to
the cash outflow at the beginning of this project that is RM200,000. At the third
year, the cumulative cash inflow of RM170,000 is still short of RM30,000
(RM200,000 – RM170,000) to achieve the PBP. By estimating that the cash flow
distribution is uniform, the calculation of PBP for the project of purchasing a
grinding machine is as follows:
RM30,000
PBP  3 years 
RM70, 000
PBP  3.43 years
*Note: RM30,000 is the remaining balance that needs to be recovered
For projects that generate cash flow in the form of annuity, you can use
equation 6.1 to calculate the PBP.
IO
PBP  (6.1)
ACF
IO = Initial outlay
ACF = Annual cash flow
Example 6.3
Suppose there is a project that involves a cash outflow of RM700,000 and it is
expected to produce a cash inflow of RM200,000 every year throughout the lifetime
of the project, which is five years. By using equation 6.1, the PBP of this project is:
RM700,000
PBP 
RM200, 000
 3.5 years

By using the cash flow schedule, we can also obtain the same answer, which is PBP
= 3.5 years (refer to Table 6.3):
Table 6.3: Cash Flow Schedule

0 –700,000
1 200,000 200,000
2 200,000 400,000
3 200,000 600,000
4 200,000 800,000
5 200,000 1,000,000
6.2.2 Application of PBP

After knowing what is meant by PBP and how it is calculated, the next step is to
use this technique in making decisions, whether to accept or reject a capital
budgeting project.
If a comparison is made between two projects with different PBP, the project with
the lower PBP value is better as the company will be able to regain its invested
capital faster. Therefore, the company will have the opportunity to use that cash
for other investment purposes. Besides that, a shorter PBP shows that the period
where the company is exposed to investment risks is also shorter.
In deciding whether to accept or reject a project, the company must compare the
PBP of the project with the targeted PBP set by the company. This technique
proposed that a project will be rejected if the PBP of that project is longer than the
targeted PBP and vice versa, that is, the project should be accepted if the PBP of
that project is less than the targeted PBP.
By referring to Example 6.1, if the company involved had set the targeted PBP for
the project at three years, the PBP technique proposed that project A to be rejected,
as the PBP of project A of four years exceeded the targeted PBP of three years.
The criteria for accepting or rejecting a capital budgeting project can be

summarised as follows:
(a) Accept project if PBP  targeted PBP; and
(b) Reject project if PBP > targeted PBP.

What is important is to evaluate whether the PBP of the project is less or more than
the targeted PBP. The manager needs to calculate the PBP of the project accurately
as it is important to ensure whether the PBP of the project is higher or lower than
the targeted PBP. To evaluate whether the PBP of the project is higher or lower
than the targeted PBP, we only need to determine whether the cumulative cash
inflow of the targeted PBP is higher or lower than the initial cash outflow.
Example 6.4
Suppose that the targeted PBP for the project in Example 6.2 is four years. Should
the company purchase the grinding wmachine?
Solution
The cumulative cash inflow in the fourth year, which is at the targeted PBP, is
RM240,000. As this total is more than the initial cash outflow of RM200,000, therefore
it can be concluded that the PBP of the grinding machine is higher than the targeted
PBP. Based on the PBP technique, the grinding machine should be purchased.
6.2.3 Advantages and Disadvantages of PBP

The main advantages of using the PBP technique are as follows:
(a) PBP is easy to calculate and understand;
(b) PBP uses cash flows and not accounting profits as the basis of calculation.
The use of cash flow as the basis of calculation is more accurate as it shows
the income and cost involved, and also clearly indicates the time when the
cash flow occurs;
(c) The criteria of PBP is an indication of the liquidity for the project. A shorter
PBP shows that the period where the funds are tied to a project is shorter;
and
(d) The criteria of PBP also takes into account the risk of a project. A cash flow
that is distant has higher uncertainties. Therefore, the company should focus
on a lower PBP to reduce the risk that may be faced by the company.
However, the PBP technique has two main disadvantages, which are:
(a) PBP Does Not Take into Account the Concept of Time Value of Money
The cumulative cash inflow is obtained by totalling the cash flow at different
times without making any adjustments to the time value of money. An
analysis that does not take into account the time value of money concept,
implicitly assumes that the opportunity cost of the funds is 0. Further
explanation on this disadvantage is shown in the following example.
Example 6.5
Cash Flow (RM)

Year
Project A Project B
0 –100,000 –100,000
1 60,000 40,000
2 40,000 60,000
3 30,000 30,000
4 10,000 10,000
Referring to the schedule, both these projects have the same PBP that is in the
second year. This means that both these projects should be given the same
priority if PBP is applied.
Based on the concept of time value of money, we know that project A is better
than project B because it produces an extra cash flow of RM20,000 (RM60,000
– RM40,000) in the first year compared to project B. This extra cash flow can
be reinvested to generate returns. As PBP does not take into account the time
value of money, the use of this technique is limited. Therefore, the finance
manager should not merely depend on the PBP technique in making major
investment decisions.
However, this disadvantage can be overcome by using a discounted payback

period technique. A discounted payback period technique determines the
period that is required to regain the sum of money invested but the cash
inflow is discounted to the present value before making decision on whether
to accept or reject a project.
(b) PBP Does Not Take into Account the Cash Flows After the Payback Period
One of the disadvantages of the PBP technique is that it disregards the cash
flow after the payback period. Thus, long-term projects cannot be valued
accurately. This disadvantage can be shown in the following example.
Example 6.6
Cash Flow (RM)

Year
Project A Project B
0 –100,000 –100,000
1 50,000 50,000
2 50,000 40,000
3 – 40,000
4 – 40,000

Based on PBP, project A is better than project B because the PBP for project A is
shorter than project B (two years compared to four years). If the targeted PBP is
not more than two years, the PBP technique would accept project A and reject
project B even though project B generates cash flow after the targeted PBP. By not
taking into account the cash flow after the payback period, the company may
disregard another better and more profitable investment merely because it does
not fulfil the targeted PBP.
SELF-CHECK 6.2
Explain the advantages and disadvantages of payback period (PBP) in

capital budgeting.
6.3 NET PRESENT VALUE (NPV)

Net present value (NPV) is a technique for making decisions in capital budgeting
that is based on the criteria of net present value or simply known as NPV. It is one
of the techniques of discounted cash flow as it uses the cash flow that has been
adjusted for the time value of money.
6.3.1 Calculation of NPV

NPV is the difference between the present value of cash inflow with the present
value of cash outflow in a project. As the cash outflow for a capital budgeting
project usually occurs at the beginning of a project, the equation for NPV is stated
as follows:
CF1 CF2 CFn

NPV    ...   I0
(1  k) 1
(1  k) 2
(1  k)n
n CFt
  I0
t 1  1  k t
Where:
I0 = Initial cash flow
CFt = Cash flow for period t
k = Cost of capital
n = Project lifetime

The cost of capital is the required rate of return for a firm, from a particular new
capital budgeting project in order to maintain the value of the firm.
Example 6.7
A project has a cost of capital of 15 per cent and the cash flow is as shown in
Table 6.4:
Table 6.4: Cash Flow of a Project
Year Cash Flow (RM)

0 –200,000
1 40,000
2 80,000
3 100,000
4 100,000
Calculation:
RM40, 000 RM80, 000 RM100, 000 RM100, 000

NPV      RM200, 000
(1  0.15) (1  0.15)2 (1  0.15)3 (1  0.15)4
1
As can also be written as PVIF15%,n, the equation mentioned can also
(1  0.15)n
be solved using the present value schedule.
NPV = 40,000(PVIF15%,1) + 80,000 (PVIF15%,2) + 100,000 (PVIF15%,3) +

100,000 (PVIF 15%,4) – 200,000
= 40,000 (0.870) + 80,000 (0.756) + 100,000 (0.658) + 100,000 (0.572) – 200,000
= RM34,800 + RM60,480 + RM65,800 + RM57,200 – RM200,000
= RM18,280

Table 6.5 summarises the calculation of present value.
Table 6.5: Calculation of Present Value
Year Cash Flow (RM) Discounting Factor Present Value (RM)

(1) (2) PVIF15%,n (3) (2)  (3)
1 40,000 0.870 34,800
2 80,000 0.756 60,480
3 100,000 0.658 65,800
4 100,000 0.572 57,200
Present value cash inflow RM218,280
(RM200,000)
– Initial cash outflow
Net present value RM18,280
Example 6.8
If a project has a cash inflow that is in the form of annuity, the calculation for NPV
is easier and simpler as you can use the present value factor annuity in your
calculations.
Suppose a project involves the initial investment cost of RM1 million. It is expected
to produce a cash flow of RM250,000 per year for five years. If the cost of capital
for this project is 12 per cent, the NPV for this project is:
NPV = RM250,000 (PVIFA 12%,5) – RM1,000,000

= RM250,000 (3.605) – RM1,000,000
= RM901,250 – RM1,000,000
= – RM 98,750
6.3.2 Application of NPV

NPV of a project shows the amount of increase or decrease in the value of a firm
that is caused by the investment in the project. NPV that is equivalent to zero
shows that the value of the firm is maintained. A positive NPV will increase the
value of the firm, while a negative NPV will decrease the value of the firm.
Based on this explanation, a project should be accepted if the NPV is positive and
should be rejected if the NPV is negative. Therefore, the project in Example 6.7
earlier should be accepted, while the project in Example 6.8 should be rejected.

The criteria for rejecting or accepting an investment decision based on this

technique of NPV can be summarised as follows:
(a) If the projects that are evaluated are independent projects, accept the projects
that have NPV  0; and
(b) If the projects that are evaluated are mutually exclusive projects, accept the
projects that have the highest NPV and NPV  0.
6.3.3 Advantages and Disadvantages of NPV

The advantages and disadvantages of the NPV technique are as follows (refer to
Table 6.6):
Table 6.6: Advantages and Disadvantages of the NPV Technique
 It uses cash flow and not accounting  The calculation of NPV is rather
profits. complex compared to PBP because it
requires an in-depth understanding of
 It takes into account the timing of cash
the concept and calculation of present
flow by using the discounted cash
value.
flow or the concept of time value of
money.  The calculation of NPV requires
information on the cost of capital for
 It takes into account all the cash flows
the project that is sometimes difficult
of the project.
to ascertain.
 The criteria of NPV is in accordance
with the concept of ownerÊs wealth
where, in theory, NPV of a project
represents the explicit measurement of
the increase or decrease of a firmÊs
value and ownerÊs wealth. Therefore,
the NPV technique is the best
technique in the perspective of
financial theory.
ACTIVITY 6.1
What is the relationship between the cost of capital and NPV?
Post your answer on the myINSPIRE online forum.

6.4 PROFITABILITY INDEX (PI)

This technique uses the criteria that is known as profitability index (PI) as the
evaluation basis for capital budgeting projects.
6.4.1 Calculation of PI
Just like the NPV, the PI uses a discounted cash flow as the evaluation basis.
Therefore, it is grouped in the criteria of discounted cash flow. PI is defined as the
present value per ringgit of investment and is a type of benefit-cost ratio.
Equation for PI is as follows:
n CFt

t 1 (1  k)
t
PI  (6.2)
I0
The PI calculation requires an input similar to the calculation of NPV. If we return

to the project in Example 6.8, we will find that the project PI is 0.90125, which is
the result of RM901,250 divided by RM1,000,000.
6.4.2 Application of PI
In principle, a project is profitable if its benefit exceeds its cost. The general rule
for PI is that the project should be accepted if the PI is the same with or more than
one. As we have discussed, the value of the firm will increase if the NPV is positive.
Observe that a positive NPV is the same with the situation where the PI is more
than one. In accordance to this, the value of the firm will increase if the PI is more
than one. Therefore, the PI technique encourages the project to be accepted if the PI
is more than one and rejected if the PI is less than one.
In summary, the criteria for acceptance or rejection are as follows:
(a) Accept the project if PI  1;
(b) Reject the project if PI ª 1; and
(c) If PI = 0, the project will have no effect on the wealth of the company.
Therefore, the acceptance or rejection of the project will not have any effect
on the company.

6.4.3 Advantages and Disadvantages of PI

In summary, the PI has advantages and disadvantages that are almost the same
with the NPV technique. It has an advantage where it is used together with the
NPV to make decisions in situations where the investment capital of the firm is
limited. On the other hand, its disadvantage compared to the NPV is that it does
not measure the total increase in wealth, as measured by the NPV.
6.5 INTERNAL RATE OF RETURN (IRR)

This technique uses the criteria known as the internal rate of return (IRR) as the
evaluation basis in capital budgeting project.
6.5.1 Calculation of IRR

The IRR of a project is defined as the rate of discount that equates the present value
of cash inflow with the initial cash flow, or the rate of discount when the NPV is
equal to zero.
It is calculated using the following mathematical equation:
n CFt
NPVIRR    I0  0
t 1 (1  IRR)
t
The manual calculation of IRR involves a process of trial and error and linear
interpolation. Example 6.9 shows the calculations involved in using the mentioned
equation.

Example 6.9
Two projects have the following cash flows (refer to Table 6.7):
Table 6.7: Cash Flow of Project A and B
Cash Flow (RM)

Year
Project A Project B
0 –100,000 –1,000,000
1 50,000 250,000
2 40,000 250,000
3 30,000 250,000
4 10,000 250,000
5 – 250,000
IRR for project A is:
RM50,000 RM40,000 RM30,000 RM10,000

NPVA, IRR  0      RM100,000  0
(1  IRR) 1
(1  IRR) 2
(1  IRR) 3
(1  IRR) 4
Manually, you would have to use the trial-and-error method, where you would
include a discount rate (k) and determine whether NPV is equal to zero or not. You
might have to do this process several times until you obtain k when NPV is equal
to zero. (Whenever possible, you should try until you obtain a positive number
and a negative number). There is a bigger possibility that it would involve a linear
interpolation where the IRR is not a whole number. Calculators and certain
computer packages can be used here to help calculate the IRR that is not a whole
number.
Suppose after several trials, you finally tried k = 14 per cent
NPVA,14% = 50,000(0.877) + 40,000(0.769) + 30,000(0.675) + 10,000(0.592) – 100,000

= RM43,850 + RM30,760 + RM20,250 + RM5,920 – RM100,000
= RM780
Based on this NPV value, and the inverse relationship between k and NPV, it is
clear that you should try a discount rate higher than 14 per cent. Suppose you tried
15 per cent.
NPVA,15% = 50,000(0.870) + 40,000(0.756) + 30,000(0.658) + 10,000(0.572) – 100,000

= RM43,500 + RM30,240 + RM19,740 + RM5,720 – RM100,000
= – RM800
As the NPVA,14% is positive and NPVA,15% is negative, we know that the IRR is
between 14 per cent and 15 per cent (refer to Table 6.8):
Table 6.8: IRR for Project A
Rate (%) Value (RM)

14% 780
NPV 0
15% –800
To get the estimated IRR for project A, you can perform the following linear
interpolation:
 780 
 14%   15%  14% 
 780  800 
 14%  0.49%
 14.49%
For project B, the calculation of IRR is easier because you can use the function of
present value annuity to simplify your calculations. This is because the cash inflow
for first year to fifth year is uniform that is at RM250,000.
You can obtain the IRR by using the following equation:
NPVB,IRR  0
250,000 (PVIFAIRR,5 )  1,000,000  0
1,000,000
PVIFAIRR,5 
250,000
 4
Refer to the schedule of present value annuity (refer to row period 5); you will get
eight per cent.

Through the trial-and-error method, you will find that the IRR for project B is
between 7% and 8% as shown in the following table (refer to Table 6.9):
Table 6.9: IRR for Project B
Rate (%) Value (RM)

7% 25,000
NPV 0
8% –1,750
To obtain the estimated IRR, you can perform the linear interpolation as follows:
 25,000 
= 7% +    (8%  7%)
 (25,000 + 1,750) 
= 7% + 0.93%
= 7.93%
The calculation of IRR is much easier if you use a financial calculator. There are
special functions to calculate the IRR and you only have to enter the information
into the schedule mentioned.
6.5.2 Application of IRR

IRR is the expected rate of return that will be obtained by a firm if a project is accepted.
Meanwhile the cost of capital, k, is the required rate of return from the project to
maintain its value. If the IRR of the project is higher than k, then the value of the firm
will increase and the value of the firm will fall when the IRR is lower than k. The value
of the firm will not change if the IRR is equal to k.
Briefly, the criteria for acceptance and rejection of a project based on the IRR are as
follows:
(a) If the projects evaluated are independent projects, accept the project that
have an IRR greater than the cost of capital; and
(b) If the projects evaluated are mutually exclusive projects, accept the project
with the highest IRR and between the projects that have at least an IRR equal
to the cost of capital.
Referring to the projects in Example 6.9, if the cost of capital is 14 per cent, then
project A will be accepted while project B will be rejected.

ACTIVITY 6.2
If the NPV for a project at a discount rate of 15 per cent is (RM350,000),
the IRR for this project is more than 15 per cent. Is this statement true
or false?
6.5.3 Advantages and Disadvantages of IRR

After understanding what is IRR and how it is applied, now we will look at the
advantages and disadvantages of IRR (refer to Table 6.10):
Table 6.10: Advantages and Disadvantages of IRR
 Just like the criteria of PBP and  The calculation of IRR is more complicated
NPV, IRR uses the cash flow compared to NPV.
and not accounting profits as  The calculation of IRR requires information
the basis for calculations. on the cost of capital of the project which is
 Just like the criteria of NPV, the rather difficult to ascertain.
IRR takes into account the time  Decisions are difficult to make when IRR is
value of money in its multiple, which is a situation where the
calculations. solution of the mathematical equation for
IRR gives more than one answer. This
 In a lot of situations, the IRR
situation will be faced in the consideration
technique provides a solution
of projects that are unconventional.
that is parallel with the NPV
 Conventional projects are defined as
technique. The IRR technique is
projects where the cash outflow only
acknowledged to be the best
happens in the beginning of the project,
technique in the perspective of
while in the following years, the project will
financial theory. This is because
generate cash inflow. The signal for this
when a project has IRR more
cash flow has the following pattern: – + + +
than k, its NPV is also more
+ +.
than zero.
 For projects that are unconventional, the
- If k > IRR, NPV < 0; project cash outflow can occur in the middle of a
should be rejected. series of cash inflows, for example, projects
- If k < IRR, NPV > 0; project that have the following cash flow pattern: –
should be accepted. + + - + + - + +. The number of IRR for such
- If k = IRR, NPV = 0; project projects is the same with the number of the
should be accepted. cash flow direction change, in this example,
its number is 5.

 There are four main types of techniques in capital budgeting, which are
payback period, net present value, profitability index and internal rate of
return.
 The payback period (PBP) is the number of years required to regain the project
costs. By using this technique, the project will be accepted if its PBP is less than
the targeted PBP.
 The net present value (NPV) is the difference between the present value of cash
inflow with the present value of cash outflow. By using this NPV technique,
the project will be accepted if its NPV is more than zero.
 The NPV technique is the best technique in the perspective of financial theory
because NPV measures the increase in the firmÊs value and the ownerÊs wealth
that is affected by the evaluated project.
 The profitability index (PI) is the ratio of present value of cash inflow
throughout the project with the initial cash outflow. Based on the PI technique,
this project will be accepted if the PI is more than one.
 The internal rate of return (IRR) is the rate of discount where the NPV is equal
to zero. Based on the IRR technique, a project will be accepted if its IRR is more
than k.
 One of the main disadvantages of IRR is the problem of multiple IRR, which is
a situation where the solution of the mathematical equation gives more than
one answer.
Capital budgeting Net present value (NPV)

Cost of capital Payback period (PBP)
Internal rate of return (IRR) Profitability index (PI)

1. You are considering the following two projects:
Project A
Requires an initial investment of RM250,000 and this project will generate
cash inflow of RM100,000 at the end of the second and third year and
RM150,000 at the end of the fourth year.
Project B
Requires an initial investment of RM400,000 and this project will produce
cash inflow of RM125,000 every year for five years.
Based on the PBP technique, should these projects be accepted if the targeted
PBP is three years?
2. Calculate the PBP for a project that involves the initial cash outflow of RM1
million and an annual cash inflow of RM100,000 for the first five years and
RM200,000 for the next five years.
1. Most companies use the PBP as a guideline for making decisions in capital
investments because of the following reasons EXCEPT:
A. It provides implicit consideration on the timing of cash flow.
B. Identifies cash flow that will be obtained after the PBP.
C. Measures the exposure to risks.
D. Simple calculation.

2. The main disadvantage(s) of the payback period technique is (are)

____________.
i it cannot be used as an indicator of risk
ii it disregards cash flow after the pay back period
iii it does not take into account the time value of money
A. i
B. ii
C. iii
D. ii and iii
1. You are required to evaluate three projects that have a cash flow estimation
as shown in the following table.
Cash Flow (RM)

Year Project A Project B Project C
0 –26,000 –500,000 –100,000
1 4,000 100,000 0
2 4,000 120,000 0
3 4,000 140,000 0
4 4,000 160,000 30,000
5 4,000 180,000 40,000
6 4,000 200,000 0
7 4,000 – 60,000
8 4,000 – 70,000
9 4,000 – –
10 4,000 –
If the cost of capital for these projects is 10 per cent, should you make
investments in these projects if you use the NPV technique?

2. The opening of a mini market required a cost of RM300,000 as the initial

capital. It is expected that the mini market will generate a cash flow of
RM20,000 every year for a period of five years. At the end of the fifth year,
the mini market can be sold to generate a cash flow of RM400,000. What is
the NPV if the cost of capital is equivalent to 10 per cent?
3. When the cost of capital increases, the NPV of the project will
________________.
Calculate the PI for the projects in Question 1 of Self-Test 3.
1. When the NPV is negative, the IRR is _____________ the cost of capital.
A. greater than
B. greater than or equal to
C. less than
D. equal to
2. The IRR is the _______________.
A. rate of discount that produces a positive NPV
B. rate of discount that is equal to the present value of cash inflow with
the present value of cash outflow
C. rate of discount that produces a negative NPV
D. rate of discount that produces a positive PBP

3. Voltex Company is considering a new project. This project will involve an

initial investment of RM1,200,000 and will produce RM600,000 cash flow
every year for three years. The IRR of this project is
A. 14.5%
B. 18.6%
C. 23.4%
D. 20.2%
4. Project M has the following cash flows:

C0 = – 2,000 C1 = 500 C2 = 1,500 C3 = 1,455
What is the IRR value for project M?
A. 10%
B. 18%
C. 28%
D. None of the rates above
1. Multiple internal rate of return (multiple IRR) happens because of

_____________.
A. differences in the timing of cash flow for the project
B. differences in the size of the project investment
C. differences in the assumption of the rate of reinvestment
D. differences in the annual cash flow pattern of the project

2. A project has an initial cash outflow of RM10,000 that produces a single cash
flow of RM16,650 in first year. If the cost of capital is 12 per cent, calculate
the:
(a) PBP;
(b) NPV;
(c) PI; and
(d) IRR.
3. A project has an initial cash outflow of RM10,000 and produces a cash inflow
of RM2,146 every year for the next 10 years. If the cost of capital is equal to
12 per cent, calculate the:
(a) PBP;
(b) NPV;
(c) PI; and
(d) IRR.
4. A project has the initial cash outflow of RM10,000 and produces cash inflow
of RM3,000 at the end of the first year, RM5,000 at the end of the second year
and RM7,500 at the end of the third year. If the cost of capital is equal to 12
per cent, calculate the:
(a) PBP;
(b) NPV;
(c) PI; and
(d) IRR.

5. Bina Company is evaluating two projects of constructing two different

luxury apartments in two towns in the state of Kedah which are Mergong
and Sik. The initial investment for both projects are the same, that is RM160
million. The required rate of return for these projects is 10 per cent. The
following is the estimated annual cash flow for the first six years.
Year Mergong Project (RM) Sik Project (RM)

1 40 million 30 million
Based on the information, you are required to make an analysis for the
decision on capital budgeting based on these techniques:
(a) PBP;
(b) NPV; and
(c) PI.
6. List one advantage and one disadvantage that is unique for each of the
following capital budgeting evaluation techniques:
(a) PBP;
(b) NPV; and
(c) IRR.

Topic  Cash Flow of
Capital
7 Budgeting
LEARNING OUTCOMES
1. Apply the guidelines in estimation of cash flow;
2. Explain the initial outlay (IO);
3. Describe the operating cash flow (OCF) and terminal cash flow (TCF);
and
4. Apply capital budgeting technique in decision-making.
 INTRODUCTION
Several main techniques for capital budgeting discussed in Topic 6 require an
estimated cash flow in its calculations. Without the estimated cash flow, we cannot
apply these techniques. Therefore, it is important for us to understand that a
wrongly estimated capital budgeting cash flow will produce an inaccurate
decision that may result in a company making a loss instead of increasing its profit.
This topic will discuss the estimation for cash flow of capital budgeting by looking
at three types of cash flow during the time it occurs. You will then find that this
separation is appropriate due to the uniqueness of the cash flows involved at that
time. Subsequently, we will analyse the items that must be taken into account in
estimating each type of these cash flows. Finally, we will apply what we had learnt
in the decision-making of capital budgeting.

TOPIC 7 CASH FLOW OF CAPITAL BUDGETING  225
7.1 GUIDELINES IN ESTIMATING CASH FLOW

FOR CAPITAL BUDGETING
To make more accurate decisions on capital budgeting, the finance manager needs
to consider several important guidelines. Generally, cash flow of capital budgeting
must fulfil the following characteristics:
(a) It is an Additional Cash Flow

Cash flow for capital budget only involves the cash flow components that
changes as a result of the evaluated project. Suppose that project A will cause
the cash sale revenue of the firm to increase from RM1 million to RM1.5
million. In the estimation of cash flow for capital budget of project A, we will
only take into account the inflow of RM0.5 million and not the entire RM1.5
million. This is because we should only consider the effect of the project. In
this example, the concept of incremental cash flow is quite obvious.
However, in some situations, we may be confused if we are not careful. The
guidelines to decide whether the cash flow is an incremental cash flow or
not, compare the cash flow if the investment in the related project is made
with the cash flow without that project.
(b) It Takes into Account the Effects of Taxation

Another important characteristic for cash flow of capital budgeting is that it
must take into account the cash flow after tax. It is obvious that tax imposed
on earnings is an expense that must be paid. Therefore, it should be taken
into account at the beginning of the calculation. Emphasis should be given
on taxation as we always disregard the effect of taxation although it
influences the total cash inflow and outflow of a project. Imagine if the
taxation rate of 30 per cent is imposed on a RM1 million profit that our
company made. We have to realise that ultimately, we will not be receiving
RM1 million but only RM700,000.
(c) It Does Not Take into Account the Effect of Financing

Investment in capital assets involves a sum of financing, whether from
external or internal sources. Each of these sources would surely involve cost.
In estimating cash flow of capital budgeting, these costs are not taken into
account. Suppose our investment involves financing from the bank, where
the interest charged is RM30,000 per year. In estimating the cash flow of
capital budgeting, we do not take into account this cost. This
is because, as observed in the topic on cost of capital, the effect of this
financing had been taken into account when the cost of capital is used to
discount the cash flow. If it is taken into account in the calculation of cash
flow, the effect of this financing is taken into account twice. This method can
also differentiate the investment decisions from the financing decisions.
226  TOPIC 7 CASH FLOW OF CAPITAL BUDGETING
Several other guidelines that can assist in the estimation for cash flow of capital
budgeting are:
(a) Disregard Sunk Cost

Sunk cost is the cost that has been spent that does not influence the decision
on accepting or rejecting a project. An example of sunk cost is the cost of
building a research laboratory that had been completed before the project
of producing a new product was considered. Based on the concept of
additional cash flow, sunk cost should not be taken into account in the
calculation for cash flow of capital budgeting, especially the initial cash flow.
(b) Do Not Disregard Opportunity Cost

Opportunity cost can be defined as the cash flow that could had been
obtained if the project under consideration was not implemented. For
example, the rental income from the factory that had been stopped because
of that project. Based on the concept of additional cash flow, this cost should
be taken into account as cash outflow occured due to the decrease in the
firmÊs cash flow as a result of executing the project.
(c) Do Not Disregard Side Effect

Side effect is the effect of accepting the project on the other sections of the
firm. For example, the effect of a project in producing a new product on the
production level of the other products. The effect might be cash outflow or
cash inflow, depending on whether its effect is positive or negative. We need
to take into account the side effects as they are in accordance with the concept
of additional cash flow. The failure to identify the side effects can cause the
project that is expected to be profitable, to be actually unprofitable − resulting
in negative effects to the firmÊs value.
After we have identified several of the important guidelines in estimating cash

flow of capital budgeting, the next step is to identify the types of cash flow
according to the time it occurs. There are three types of cash flow based on the time
it occurs, which are:
(a) Initial outlay (IO);
(b) Operating cash flow (OCF); and
(c) Terminal cash flow (TCF).

Figure 7.1 shows the three cash flows based on a time line.
Figure 7.1: Time line showing the types of cash flow for capital budgeting
SELF-CHECK 7.1
Explain several guidelines that assist in estimating the cash flow for
capital budgeting.
7.2 INITIAL OUTLAY (IO)

Initial outlay (IO) of a capital budget project refers to the total cash outflow that is
expected to occur at the beginning of an investment to enable an asset or project to
operate smoothly. As shown in Figure 7.1 earlier, IO is the cash flow at time 0.
Among the main items that are involved in the estimation of IO are:
(a) Cost of purchasing, installing and transporting the new assets;
(b) Changes to the net working capital of the firm due to the investment made;
and
(c) Sale revenue after tax for the old assets that must be sold if the project is
accepted.
The calculation of IO depends on:
(a) Whether or not it involves all the items stated earlier; and
(b) The taxation system being enforced.

Let us now discuss the items in the estimation of IO.
(a) Cost of Purchasing, Installing and Transporting the New Assets

As discussed in subtopic 7.1, we must be careful not to include the sunk cost,
for example, the cost of setting up the laboratory that was made before the
decision for the capital budgeting was made. To simplify, only the cost that
must be spent to enable the project to be operational will be taken into
account.
(b) Changes to Net Working Capital of the Firm due to the Investment Made
Net working capital (NWC) is equivalent to the current assets deducted by
current liabilities. A capital budgeting project can have effect on the level
of NWC held by the firm. For example, the opening of a new factory is
expected to increase the level of account payable by RM500,000 (due to the
increase of purchases of raw material and others on credit), the level of
account receivable by RM800,000 (due to the increase in credit sales), the
level of inventory by RM400,000 and also the level of short-term loans by
RM100,000.
These increases that are not balanced between the current assets and current
liabilities will cause the level of net working capital to change, whether to
increase or decrease. In summary, the changes in NWC are represented by
the following equation:
NWC = Current assets – Current liabilities (7.1)
In the previous example, the changes in the level of net working capital are
calculated as follows:
Account receivable RM800,000

 Inventory RM400,000
 Short-term loans – RM100,000
Account payable – RM500,000
 NWC RM600,000
The level of net working capital (NWC) has increased by RM600,000. The
level of NWC will decrease if NWC has a negative value. Observe that the
negative symbol is used for the increase in current liabilities and it is the same
when there is a decrease in the current assets.

As the increase in net working capital involves a sum of cash that is tied
to the firm, it is assumed as the cash outflow; meanwhile, the decrease in net
working capital involves the release of cash and this is considered cash
inflow.
The change in NWC is one of the important items in the estimation of IO as

this change usually occurs when the project is started.
(c) Sale Revenue after Tax for the Old Assets That Must Be Sold If the Project is
Accepted
For replacement projects where the new assets are bought to replace old
assets, the revenue from the sale of old assets must be taken into account as
one of the cash inflows in the calculation of IO as this replacement usually
occurs at the beginning of the project.
In some taxation systems, capital gain, which is the profit obtained from selling
the capital assets will be taxed. Meanwhile, the losses that occurred from the sale
of capital assets will be tax savings. Therefore, we must take into consideration the
effect of taxation in the calculation of IO via the calculations of the revenue from
sales, after tax.
It must be noted that:
(a) Tax is imposed on the components of disposal gains only and not on the
entire revenue from the sale of the assets; and
(b) Disposal gain is the surplus of selling price from its book value.
The following equations will help us to understand and calculate the sales revenue
of the old assets after tax:
(a) Sales revenue after tax = Selling price – Increase in tax
(b) Tax in = Tax rate (disposal gain)
(c) Disposal gain = Selling price – Book value
(d) Book value = Original price – Accumulated depreciation
Original cost
(e) Annual depreciation =
Economic life of the asset
The calculation of depreciation mentioned assumes that the asset is depreciated

according to the straight line method and is similar to capital allowance.

Now, we will look at how the sales revenue of assets after tax and the changes in
net working capital are handled via examples 7.1 and 7.2.
Example 7.1
Project A involves the replacement of an old grinding machine with a new
grinding machine. The old grinding machine was bought at a price of RM250,000
three years ago and has a lifetime of five years. What is the sales revenue of the
asset after tax if this old machine can be sold at RM120,000 now and the marginal
tax rate is 30 per cent?
Solution:
Step 1: Obtain the book value of the old machine
Book value of old machine = Original price – Accumulated depreciation

= RM250,000 – RM150,000*
= RM100,000
* Assumption:
• Asset is depreciated in a straight line method.
(RM250,000)
• Annual depreciation is equivalent to RM50,000 per year that is .
5
• Accumulated depreciation is RM150,000 or RM50,000  3 years.
The following calculation can also be used to obtain the book value of the old
machine:
Book value of old machine = Annual depreciation  Surplus lifetime

= RM50,000 per year  2 years
= RM100,000
Step 2: Obtain the capital gain for the old machine
Capital gain = Selling price – Book value

= RM120,000 – RM100,000
= RM20,000

Step 3: Obtain the effect of taxation
= RM20,000  0.3
= RM6,000
Step 4: Calculate the sales revenue after tax for the old grinding machine
= Selling price – Increase in Tax

= RM120,000 – RM6,000
= RM114,000
Observe that in cases of capital losses, we will obtain a tax saving, where to
calculate the assetÊs sales revenue after tax, we must add the tax saving to the
selling price of the asset.
In summary, the equation for sales revenue of asset after tax is as follows:
Sales revenue after tax = Selling price – Increase in Tax

= Selling price – [Tax rate (Selling price – Book value)]
Example 7.2 shows the calculation of IO.
Example 7.2
Teguh Company plans to purchase a new cement mixing machine to replace the
old machine. The old machine was purchased six years ago at a price of RM200,000
and was depreciated using the straight line method to the scrap value equivalent
to zero, throughout its lifetime of 10 years.
If the company plans to replace this old machine, it can be sold at RM120,000 to
the public. The price of the new machine is RM300,000 while the transportation
cost is RM20,000 and the installation cost is RM10,000. To meet this new level of
productivity, the raw materials inventory must be increased by RM20,000 and the
account payable will increase by RM10,000. The marginal tax rate of the company
is 30 per cent. Based on this information, calculate the IO.

Solution:
* Changes in NWC = Inventory – Account payable

= RM20,000 – RM10,000
= RM10,000 (outflow)
** Sale revenue after = Selling price – Increase in Tax

tax for old machine = RM120,000 – RM12,000 ***
= RM108,000 (inflow)
*** Increase in Tax = Tax rate (Selling price – Book value)

= 0.3 [RM120,000 – Unexpired lifetime
(Annual depreciation)]
= 0.3 [RM120,000 – 4 (RM20,000)]
= 0.3 (RM40,000)
= RM12,000
IO = RM300,000 + RM20,000 + RM10,000 + RM10,000 – RM108,000

= RM232,000
SELF-CHECK 7.2
Explain IO in detail.
ACTIVITY 7.1
In Example 7.2, the sales revenue of the old machine after tax had been
deducted in the process of obtaining the IO. Why?

7.3 OPERATING CASH FLOW (OCF)

The operating cash flow (OCF) for a capital budgeting project refers to the
additional cash inflow that is expected to occur in the beginning of the first year
until the end of the project lifetime, due to the investment made in the said project.
As shown before in Figure 7.1, OCF is the cash flow from time 1 to n.
Among the items that must be taken into account in the estimation of OCF are as
follows:
(a) Change in sales revenue;
(b) Change in cash operating costs; and
(c) Change in taxation.
A capital budgeting project can cause changes to any one of the items or all of them
at once. A development project, for example, has a higher possibility of involving
the changes to all the items, while a manufacturing automation project has a higher
possibility of only involving a reduction in the cash operation cost and taxation.
The increase in revenue is a cash inflow while the increase in cost and taxation are
cash outflows. Generally, OCF can be stated in the following equation:
OCF n = ’ S n – ’ E n – ’ T n (7.2)
Where:
∆S n = Increase in the sales revenue for year n
∆E n = Increase in the cash expenditure for year n
∆T n = Increase in taxation for year n
As ∆E n only involves cash expenditure, the changes in depreciation, which is

a type of non-cash expenditure, is not taken into account in its calculation.
However, as a tax deduction item, the change in depreciation will influence the
change to tax as well (assume that this depreciation is equal to capital allowance).
Therefore, it is important to be included for the calculation of OCF.
Suppose, the investment in project A causes an increase in the annual depreciation

by RM50,000. Even though this RM50,000 does not involve cash flow, it can save
on tax by RM50,000  rate of tax. This savings must be taken into account in the
calculation of OCF for this project.

There are several equations to calculate OCF. By using equation 7.2, we can expand
that equation as follows:
OCFm = Sn – En – Tn

= Sn – ’ En – t (’Sn – ’En – Dn)
= (Sn – En) (1+t) + t(Dn) (7.3a)
= (Sn – En – Dn) (1– t) + Dn (7.3b)
= NIn + Dn (7.3c)
Where:
Sn = Increase in the sales revenue for year n
Dn = Increase in depreciation for year n
En = Increase in cash expenditure for year n
Tn = Increase in taxation for year n
NIn = Increase in net income for year n
t = Tax rate
Dn is calculated as follows:
Dn = New depreciation amount – Old depreciation amount
The equation 7.3b states that the cash flow for year n is equivalent to the increase
in net income (NI) plus the increase in depreciation. This can be explained quite
easily; because the calculation of net income (NI) involves the deduction of
depreciation (D), a non-cash cost. Therefore, to calculate OCF, this depreciation is
added back. You will see how these equations are used via example 7.3.

Example 7.3
We return to the project that is being considered by Teguh Company in example
7.2. To estimate the operating cash flow of this project, we need to obtain the
information for the effect of this project on the level of sales, operating expenditure
and also the depreciation expenses.
The following information has been obtained:
(a) The new machine will be used for four years and is depreciated using
straight line method to the scrap value of zero;
(b) At the end of fourth year, this machine is expected to be sold at the price of
RM70,000. With this replacement, the company expects to increase the sales
revenue by RM50,000 per year; and
(c) At the same time, the cash expenditure will reduce by RM5,000 per year.
Based on the information and the information provided in example 7.2, calculate
the OCF for this project.
Solution:
Step 1: Collect all the related information
S = RM50,000
E = –RM5,000
Step 2: Calculate the changes in depreciation
Depreciation of old machine = RM20,000
RM300,000  RM20,000  RM10,000

Depreciation of new machine =
4
= RM82,500
D = RM82,500 – RM20,000
= RM62,500

Step 3: Calculate the OCF
OCF = (Sn – En – Dn) (1 – t) +Dn

= [RM50,000 – (–RM5,000) – RM62,500] (1 – 0.3) + RM62,500
= (RM50,000 + RM5,000 – RM62,500) (0.7) + RM62,500
= RM57,250
7.4 TERMINAL CASH FLOW (TCF)

Terminal cash flow for a capital budgeting project refers to the total cash flow
related to the termination of that project. As shown in Figure 7.1, it is referred to
as TCF.
What are the items involved at the time a project is terminated? One of them is the
disposal price for the assets. The following are among the several important items
that form the TCF:
(a) Sales Revenue After Tax of New Assets

As discussed earlier, we expect that the assets which had been used can be
sold and this will produce cash flow to the firm. The effect of taxation must
be taken into account in estimating cash inflow as a result of selling that asset.
Suppose an asset in the project can be sold at the price of RM100,000 and
assume there is no salvage value. The cash flow after tax can be calculated as
follows:
Cash flow after tax = Selling price – Increase in Tax

= Selling price – (Tax rate  Disposal gain)
= RM100,000 – 0.3 (RM100,000)
= RM70,000
Observe that for asset with its salvage value of zero, the following equation
can be used:
Cash flow after tax = Selling price (1 – Marginal tax rate)

(b) Other Expenditure Related with Project Termination

The termination of a project involves a clean-up cost, moving cost or
refurbishment cost. All these involve cash flow at that time. These
expenditures are calculated as expenditures that are tax deductible.
Therefore, we must obtain these expenditures after taxes by using the
following equation:
Expenditure after tax = Expenditure (1 – Marginal tax rate)
Suppose a project is expected to involve expenditure of RM250,000 for

cleanup works. If the tax rate is 30 per cent, the cleanup expenditure after tax
is RM175,000, which is 0.7  RM250,000.
(c) Regaining the Original Level of Net Working Capital

Normally, the changes to the level of working capital are maintained
throughout the lifetime of the project to provide for the requirement in the
operations of that project. Therefore, the increase only occurs in the beginning
of the project, which has been taken into account in the calculations of IO.
When the project is terminated, the company will return to its original
position before the project was implemented. The level of net working capital
is also expected to return to the original level.
If at the beginning of the project, the level of net working capital had
increased, then at the time of the project termination, this level of net working
capital will decrease to return to its original position. On the other hand, if
the level of this net working capital had decreased in the beginning of the
project, then this net working capital will increase at the time of the project
termination to return to its original position. Regaining the net working
capital level involves a cash flow, whether in or out depending on whether
this level has increases or decreases.
Suppose in the beginning of the project, the level of net working capital has
increased to RM200,000. You need to take into account the regaining of this level
that will involve a cash inflow of RM200,000 in estimating the TCF. This is because
the level of net working capital is expected to decrease by RM200,000.

Look at example 7.4 to understand the TCF more clearly.
Example 7.4
Use the example of Teguh Company (example 7.2) that is evaluating the
replacement of an old grinding machine with a new grinding machine. To assist
this company in making a decision whether or not this replacement should be
made, we need to calculate the TCF of this project. No other information will be
given besides those that had already been included in examples 7.2 and 7.3.
Based on that information, TCF is:
Sales revenue after tax of new machine [RM70,000 (1-0.3)] = RM49,000
Other termination expenditures = (0)

Regaining the level of net working capital (decrease) RM10,000
TCF RM59,000
ACTIVITY 7.2
Explain the differences that exist among the concept of IO, OCF and
TCF.

forum.
7.5 APPLICATION OF CASH FLOW FOR

CAPITAL BUDGETING IN DECISION-
MAKING
After the three types of cash flow have been estimated, we can now use the capital
budgeting techniques that were discussed earlier in Topic 6. Look at example 7.5
to understand how cash flows are estimated and used in capital budgeting.

Example 7.5
We want to make a decision on whether the project of replacing a grinding
machine that is being considered by Teguh Company in examples 7.2, 7.3 and 7.4
should be accepted or not. State your decision based on the PBP and NPV
techniques if the cost of capital used is 12 per cent and the targeted PBP is three
years.
Solution:
Estimation for cash flow of capital budgeting can be obtained as follows (refer to
Figure 7.2):
IO = RM232,000
OCF = RM57,250
TCF = RM59,000
Figure 7.2: Estimation for cash flow of capital budgeting
(a) PBP Technique

The following cash flow schedule is used (refer to Table 7.1):
Table 7.1: Cash Flow Schedule
Time (Year) Cash Flow (RM) Cumulative Cash Flow (RM)

0 ă232,000
1 57,250 57,250
2 57,250 114,500
3 58,250 171,750
4 116,250
The cumulative cash flow for third year is RM171,750. As this total is less
than the initial cash outlay, which is RM232,000, it can be summarised that
the PBP of this project is higher than the targeted PBP. Based on the PBP
technique, this project should be rejected.

(b) NPV Technique

Based on the issues that we have learnt in Topic 6, the following equation can
be used to obtain the NPV for this project:
CF CF2 CFn
NPV    ...   I0
1K   1K 
1 2
1K n
 RM57,250  PVIFA12%,4   RM59,000  PVIF12%,4   RM232,000
 RM48,250 3.037   RM94,000 0.636   RM232,000
 RM211,392.25  RM232,000
 RM20,607.75
The NPV value of this project is –RM20,607.75. The negative NPV value will
decrease the value of the firm. Therefore, this project should be rejected.
 Estimating the cash flows is one of the most important but the most
complicated process in decision-making on capital budgeting.
 The concept of additional cash flow after tax is used to ascertain the cash flow
of capital budgeting.
 Among the important issues that can be used as a guide in estimating the cash
flow for capital budgeting are the sunk cost, opportunity cost and side effects.
 Capital budgeting projects normally involve changes to the level of net

working capital (NWC). These changes must be taken into account in the
calculation of cash flow for capital budgeting as an imbalance increase between
the current asset and current liability will cause the level of NWC to change.
 Increase in NWC must be taken into account in the calculation of initial cash
outlay and in the calculation of terminal cash flow.
 Cash flow for capital budgeting can be classified into three, initial outlay (IO),
operating cash flow (OCF) and terminal cash flow (TCF).

 Among the main items that are involved in the estimation of IO are the
purchasing cost, installation and transportation cost incurred by new assets,
changes to the NWC level of the firm and sales revenue after tax of the old
assets that must be sold if the project is accepted.
 Among the main items that must be taken into account in the estimation of
OCF are the changes to sales revenue, changes to cash operating cost and
changes in taxation. OCF can be seen as an increase in the net income plus the
increase in depreciation.
 Among several important items that form the TCF are the sales revenue after
tax of the new asset, other expenses related to the termination of the project
and regaining the original level of NWC.
Initial outlay (IO) Opportunity cost

Net working capital (NWC) Sunk cost
Operating cash flow (OCF) Terminal cash flow (TCF)
The purchase price of a new machine is RM35,000, the delivery cost

is RM3,000 and the installation cost is RM3,000. The lifetime of this machine is five
years. The old machine was bought at a price of RM15,000 and can be sold at
RM17,000. This machine has a book value of RM10,000. As a result of using the
new machine, inventory had increased by RM5,000. The taxation rate imposed is
30 per cent. What is the initial investment for this replacement project?

The purchase price of a new machine is RM35,000, the delivery cost

is RM3,000 and the installation cost is RM3,000. The lifetime of this machine is five
years. The old machine was bought at the price of RM15,000 and can be sold at the
price of RM17,000. This machine has a book value of RM10,000.
The usage of this new machine will reduce the wages cost by RM9,000, employeesÊ
benefit by RM1,000 per year, the defect cost is reduced from RM8,000 to RM3,000.
However, the maintenance cost will increase by RM4,000 per year. The
depreciation of the old machine is RM2,000 per year. Assuming the taxation rate
is 30 per cent, how much is the annual additional cash flow after tax?
1. Koska Clothing Company intends to replace its old weaving machine which
had been fully depreciated. Two models are being considered:
Item Model 190-4 Model 360-6

Price RM190,000 RM360,000
Lifetime 4 years 6 years
Additional cash flow after tax RM87,000 RM120,000
(per year)
The cost of capital for Koska is 14 per cent while the marginal tax rate is 20
per cent. Which model should be chosen based on the information given?

2. Matasashita Company, which is a main manufacturing company of electrical

components, is considering replacing its current machine with a more
sophisticated machine. The following are information on the old machine
and new machine:
Old Machine New Machine

Cost RM100,000 RM135,000
Selling price RM85,000 –
Lifetime 5 years 5 years
Usage period 2 years –
Sales revenue per year RM18,000 RM34,000
Installation cost – RM5,000
Decrease in yearly wages – RM1,200
Increase in yearly maintenance – RM4,000
expenses
Additional information:
• Depreciation using the straight line method
• Corporate tax is 20 per cent
• Cost of capital is 10 per cent
(a) You are required to calculate:
(i) Book value of old machine;
(ii) Tax from sale of the old asset;
(iii) Initial investment;
(iv) Net operating cash flow; and
(v) NPV.
(b) Should the company replace the old machine with the new machine?
Justify your answer.

3. By using the information given, compute the initial cash outlay.
Purchase price of new machine RM8,000

Delivery expenses RM2,000
Market value of old machine RM2,000
Book value of old machine RM1,000
Decrease in inventory if new machine is installed RM1,000
Increase in account receivable if new machine is RM500
installed
Tax rate 34%
4. You are considering whether or not to replace the current metre with a new
metre. The old metre can be sold at the price of RM500. It involves a cost of
RM300 per year to operate. The new metre costs RM4,000 and has a lifetime
of 10 years. It also involves a cost of RM140 per year to operate. If the cost of
capital is 12 per cent with taxation disregarded, should the old machine be
replaced?
5. „Depreciation is not important in the calculation of cash flow for capital

budgeting‰. Is this statement true or false? Provide an explanation to your
answer.

Topic  Cost of Capital
8
LEARNING OUTCOMES

1. Apply the principles in determining the cost of capital;
2. Calculate the cost of debts, ordinary shares and preference shares; and
3. Determine a companyÊs weighted average cost of capital (WACC).
 INTRODUCTION
In Topics 4 and 5, we have discussed the relationship between the rate of return
with the risk in a security and the valuation process of bonds and shares. Next, we
will discuss cost of capital. Cost of capital is related to financing and investment
decisions. It is the rate that must be achieved in an investment before the
shareholdersÊ wealth can be increased. The cost of capital is often used
interchangeably with the required rate of return by a company, the rate of discount
to evaluate new investments and opportunity cost of funds. Even though its name
is different, the concept remains the same.
In this topic, we will discuss the principle in determining the cost of capital of a
company and its rationale from the aspect of its usage and calculation. To obtain
the overall cost of the company or the weighted average cost of capital, we must
first obtain the cost for each capital resources, which are the cost of debts,
preference shares and ordinary shares.

246  TOPIC 8 COST OF CAPITAL
8.1 DEFINITION FOR COST OF CAPITAL

Cost of capital is the minimum rate of return that must be obtained by the company
from its investments. It is for the purpose of guaranteeing the required rate of
return for the bond holders and the shareholders of the company. In other words,
the cost of capital acts as the main liaison between the decision of long-term
investment by the company with maximising the shareholdersÊ wealth. It is very
important to ascertain whether the investment proposal will increase or decrease
the share price or the value of the company. If the risk is constant, a project with a
higher rate of return than the cost of capital will increase the value of the company,
while a project with a lower rate of return than the cost of capital will decrease the
value of the company.
The rate of return required by investors is defined as the minimum rate of return
required to attract investorsÊ interest to buy or hold a security. The rate of return
is the return from the investment that pays the cost of capital and is also an
incentive to attract investors.
There are two factors that differentiate between the rate of return with the cost of
capital, which are taxation and the types of transactions involved. When a
company borrows funds for the purpose of buying assets, the interest expenses is
deducted from the earnings before tax. This means that the cost of debt of the
company will reduce. The second factor that differentiates the cost of capital with
the required rate of return is the cost of transaction involved when the company
increases its funds by issuing securities. The cost of this transaction is known as
the flotation cost and this cost increases the companyÊs overall costs.
SELF-CHECK 8.1
What is the role for cost of capital in the operations of a company?
8.1.1 Financing Policy and Cost of Capital

The financing policy of a company refers to the policy that has been specified by
the management in the financing of investments. In this topic, we will assume that
the company has a preset financial policy. The combination of financing that is
often used comprised of debts and equity.

TOPIC 8 COST OF CAPITAL  247
The cost of capital, which is the combined cost of all the companyÊs financing
resources (debt and equity) is known as the weighted average cost of capital
(WACC). It is the average cost after tax for each capital resources that is used by
the company to finance its project. Weight refers to the percentage of usage for
each resources from the total overall financing. Most companies will make an
effort to maintain the optimal financing combination of debt and equity or better
known as the target capital structure.
ACTIVITY 8.1
„To maintain the market value of a company, the required rate of return
must be the same as the cost of capital‰.
How far do you agree with the statement above?
8.2 DETERMINING THE COST OF CAPITAL FOR

EACH COMPONENT OF CAPITAL
RESOURCES
A company has various financial instruments or securities to attract new
investments. A company can increase its capital by borrowing (issuing bonds to
investors) or issuing ordinary shares or preference shares. The entire total of a
companyÊs capital depends on the returns that are required by the investors. To
determine the total cost of capital, a company must determine the three capital
resources, which are debts, preference shares and ordinary shares. The cost of
capital for each financing resource is obtained by getting the required rate of return
for investors by taking into account the flotation cost and taxation impacts.
ACTIVITY 8.2
How do you think total cost of capital for the company is computed?
Share your answer with your coursemates in the myINSPIRE online

forum.

8.2.1 Cost of Debt

The cost of capital for debts is obtained by getting the rate of return for debt by
taking into account the flotation cost and taxation impacts. In Topic 4, you have
learnt that the rate of return required by investors is the minimum returns
anticipated by the investors in an investment.
There are three important steps in the calculation for cost of debt, which are:
Step 1: Calculate the net value of debt (NPb) by taking into account the flotation
cost.
NPb = Market value (P0) – Flotation cost
Step 2: Calculate the rate of return for debt that is required by investors. The
rate of debt return can be obtained by using the trial-and-error method or the
estimation method as explained in subtopic 4.4, Topic 4.
By using the trial-and-error method, the different rates of discount kb, will be
applied in the following equation (equation 4.2b in Topic 4):
NPb = I (PVIFAkb,n) + M (PVIFkb,n)
The equation to calculate the rate of return by using the estimation method is as
follows:
 M  NPb 
i 
kb   n 
 M  NPb 
2
Step 3: Calculate the cost of capital by taking into account the effect of taxation.
Cost after tax = Cost of returns (kb) – Tax savings (kb T)

= kb – kb T
= kb (1 – T)

Example 8.1
Indah Company has sold bonds that have a maturity period of 20 years with a
coupon rate of nine per cent. The par value is RM1,000. The bond is sold at the
price of RM980 with a flotation cost of two per cent based on the par value (2% 
RM1,000). What is the cost of debt for Indah Company?
Calculation:
(a) First Step: Calculate the Net Value of Bond
NPb = RM980 – RM20

= RM960
(b) Second Step: Calculate the Rate of Return for the Bond
You can use the trial-and-error method or the estimation method to obtain
(i) Trial-and-error Method

The bond is sold at a discount, where the selling price is lower than the
par value (RM980 < RM1,000). Therefore, the required rate of return is
higher than the coupon rate (k > I). To begin the calculation process,
you can try using the rate of 10 per cent.
NPb = I (PVIFAk,n) + M (PVIFk,n)

= 90 (PVIFA10%,20) + 1,000 (PVIF10%,20)
= 90 (8.514) + 1,000 (0.149)
= RM915.26
From the calculation, we find that the share value at the rate of 10 per
cent is RM915.26. This means that the cost of capital is between 9 per
cent and 10 per cent.

Next, we use the interpolation method to obtain the rate of return (refer
to Table 8.1).
Table 8.1: Interpolation Method
Rate (%) Value (RM) Value (RM)

9 1,000 1,000
NPb 960 –
10 – 915.26
Difference 40 84.74
 40.00 
k b  9%     (10%  9%)
 84.74 
 9.47%
(ii) Estimation Method

You can also use the estimation method to obtain the required rate of
return by using the equation (equation 4.4 in Topic 4) as follows:
M  NPb
i
kb  n
M  NPb
2
 RM1, 000  RM960 
90   
  20 
RM1, 000  RM960
2
 9.4%
(c) Step 3: Calculate the Capital Cost of Debt by Taking into Account the Effect
of Taxation
Assume that corporate tax is 34 per cent per year.
(i) Trial-and-error Method

The required rate of return is 9.47 per cent, that is the cost of debt before
taking into account the tax. Therefore, the capital cost of debt is as
follows:
Cost of debt after tax = 9.47% (1 – 0.34)

= 6.25%

(ii) Estimation Method

As the interest on debt is tax deductible, therefore it can reduce the cost
of capital for the company. The cost of debt by using the estimation
method is:
Cost of debt after tax = 9.4% (1 – 0.34)

= 6.2%
The estimation method gives the answer of 6.2 per cent, while the trial-
and-error method gives a more accurate answer of 6.25 per cent.
8.2.2 Cost of Preference Shares

Preference shareholders have the rights to receive fixed dividends before earnings
are distributed to the ordinary shareholders. As preference shares are in the form
of ownership, therefore the net profit from sales is expected to be held for an
unlimited period of time. The dividends for preference shares are normally in the
form of amounts (RM) per year such as RM4.00 per year. There are also dividends
in the form of annual percentage rate where it is represented by a percentage based
on the par value of shares. For example, the dividend for preference shares is eight
per cent of the par value of RM5.00, which is RM0.40.
The cost of preference shares (kps) is the rate of return for preference shares, which
is the ratio of dividends for preference shares (Dps) compared to the net earnings
from sales of preference shares (Nps). Net earnings are the selling price of
preference shares minus the flotation cost.
To obtain the cost of preference shares (kps), we can use the equation 4.18 in Topic
4 as follows:
D ps
k ps 
NPps
As the dividends of preference shares are paid from the cash flow after tax,
therefore the adjustment on tax is not required.

Example 8.2
Calculate the cost of preference shares for Indah Company based on the following
information:
Selling price = RM8.70 value per share

Cost of issuance and sale of shares = RM0.50 per share
Annual dividends = RM0.87
Calculation
(a) Net price (NPps) = RM8.70 – RM0.50

= RM8.20
RM0.87
(b) Kps =
RM8.20
= 10.6%
8.2.3 Cost of Ordinary Shares

The cost of ordinary shares is the rate of return that is required by investors for
ordinary shares. The determination for the cost of ordinary shares is unique due
to two factors, which are:
(a) Firstly, it is difficult to estimate as the returns to ordinary shareholders are a

surplus after the payment of interest for bonds and dividends for preference
shares; and
(b) Secondly, there are two sources of financing for ordinary shares, which are
the retained earnings and the issuance of new ordinary shares. Both these
sources are different from the aspect of flotation cost. The use of retained
earnings does not involve flotation cost, while the sale of new ordinary
shares involves flotation cost.

There are several methods that you can use to determine the cost of retained
earnings or the rate of return that is required by ordinary shareholders, and they are:
(a) Constant Growth Valuation Model or the „Gordon Model‰

The cost of ordinary shares is the return required by the existing shareholders
on their investments. The valuation model for constant growth or better
known as the Gordon model assumes that the value of shares (P0) is equal to
the present value of all dividends in the future (D1). You may refer to
Topic 4. Therefore, the value of ordinary shares is obtained by using the
equation 4.12 in Topic 4 as follows:
D1
P0 
k cs  g
Where:
P0 = Value of ordinary shares
D1 = Current dividends
kcs = Required rate of return
g = Rate of dividend growth
To find the cost of ordinary shares or the rate of return for ordinary shares,
the equation mentioned can be modified as follows:
D1
K cs  g
P0
As the dividends of ordinary shares are paid from earnings after tax,
therefore there is no adjustment on tax.
Example 8.3
The following is the financial information on Tuah Company.
Price of ordinary shares (P0) = RM5.00

Expected dividends (D1) = RM0.40
Rate of growth (g) = 5%
0.40
kcs =  0.05
5.00
= 0.13 or 13%

(b) Use of Capital Asset Pricing Model (CAPM)

The CAPM shows the relationship between the returns required or the cost
of ordinary shares (kcs) with the systematic risk that is measured by beta (β).
The CAPM equation is as follows:
kcs = krf + (km – krf) βj
Where:
kcs = Cost of ordinary shares for security j
krf = Risk-free rate
km = Rate of market returns
βj = Beta of security j
Based on the equation, we can estimate the use of cost for retained earnings
as one of the components of capital as shown in example 8.4:
Example 8.4
Assume that the risk-free rate of Indah Company is seven per cent, the rate
of market return is 11 per cent and the ordinary shares for the company have
a beta of 1.5. What is the cost of retained earnings?
Kcs = 7% + (11% – 7%) 1.5

= 7% + 6%
= 13%
(c) Cost of Issuing New Ordinary Shares

The cost of issuing new ordinary shares (kcs) is obtained by taking into
account the effect of flotation cost or sales cost. Normally, new ordinary
shares are sold at a price that is lower than the current market price.
Therefore, the net value of the new shares after sale will be lower. The cost
of ordinary shares (kcs) is calculated by using the valuation model for
constant growth, but at net price (NPcs). Net price is obtained by deducting
the flotation cost from the selling price. Therefore, the equation to obtain the
cost of issuing new ordinary shares is as follows:
D1
k cs  g
NPcs

The cost of issuing new ordinary shares is usually higher than the cost of
existing shares and is usually higher than any other types of long-term
financing cost. As the dividend is paid from the cash flow after tax, there will
be no adjustment for tax.
Example 8.5
Based on the financial information of Indah Company as follows, calculate
the cost of issuing new ordinary shares.
Expected dividends (D1) = RM0.40

Current market price (P0) = RM5
Flotation cost = RM0.25 per share
Rate of dividend growth = 5%
Sale of new ordinary shares = RM4.70
Solution:
RM0.40
K cs   0.05
RM4.45
 0.14 or 14%
ACTIVITY 8.3
Why must we calculate all the costs for capital resources before
calculating the overall cost of capital?
Discuss this question with your coursemates in the myINSPIRE online

forum.
8.3 WEIGHTED AVERAGE COST OF CAPITAL

(WACC)
After the cost for each capital resources had been determined, the next step is to
calculate the overall cost of capital for the company. The overall cost of capital
takes into account all individual costs of financing resources used. It is better
known as the weighted average cost of capital (WACC).

There are three main steps in determining WACC:
(a) Calculate the cost for each capital resource (cost of debt, preference shares
and ordinary shares);
(b) Calculate the combined financing or capital structure that is the weight of
each resource that is used from the overall total financing of the company
(the capital structure is usually predetermined by the company); and
(c) Calculate the WACC.
The calculation for WACC is as follows:
WACC = (wb  kb) + (wps  kps) + (wcs  kcs)
(Note: wb + wps + wcs = 1)
Where:
Wb = Weightage of debt
Kb = Cost of debt after tax
Wps = Weightage of preference shares
Kps = Cost of preference shares
Wcs = Weightage of ordinary shares
Kcs = Cost of ordinary shares
Example 8.6
Based on the financial information of Indah Company, calculate the WACC.
Cost of debt (kb) = 6.25%

Cost of preference shares (kps) = 10.6%
Cost of retained earnings (kcs) = 13%
Cost of new ordinary shares (kcs) = 14%
Capital resources Ratio/Weightage

Long-term loans 40%
Preference shares 10%
Ordinary shares 50%
100%

Therefore, if the company uses the retained earnings, its WACC is:
WACC = (0.40  6.25%) + (0.1  10.6%) + (0.5  13%)

= 2.5% + 1.06% + 6.5%
= 10.06%
If the company issues new ordinary shares, then the WACC is:
WACC = (0.40  6.25%) + (0.1  10.6%) + (0.5 14%)

= 2.5% + 1.06% + 7%
= 10.56%
 The cost of capital is also known as the rate of return that is required by the
company.
 The rate of discount and the opportunity cost of fund is the minimum rate of
return required by the company for its investments. Usually, it consists of three
main components of capital resources, which are debt, preference shares and
the ordinary equities of the company that consist of retained earnings and new
ordinary shares.
 The cost of capital is influenced by the combination of financing resources and

usually the company will try to maintain the optimal financing combination or
better known as target capital structure.
 To obtain the cost of capital for the entire financing of the company, firstly you
must determine the cost of capital for each component of the capital resources,
which are the cost of debt, cost of preference shares and cost of ordinary equity.
Next, you have to determine the overall cost of capital or the weighted average
cost of capital, which is the combination of all financing resources by taking
into account the financing combination.

Cost of capital Equity

Cost of debt Flotation cost
Cost of ordinary shares Targeted capital structure
Cost of preference shares Weighted average cost of capital
(WACC)
Debt
Maju Indah Company plans to issue bonds that have a maturity period of 10 years
with a par value of RM1,000 and pays an interest of RM55 every six months. These
bonds are sold at the net amount of RM840.68 after taking into account the
additional costs involved. If the rate of corporate tax is 25 per cent, what is the cost
of debt after tax?
Jaya Financial Company has preference shares in its capital structure that pays a
dividend of RM0.35 and is sold at the price of RM2.50. The cost of issuing and
selling the preference shares is RM0.60 per share. If the rate of corporate tax is 34
per cent, what is the cost of preference shares after tax?
1. Ordinary shares of Tunas Damai Company were recently sold at the price of
RM5.00 per share. The dividend for next year is RM0.18 per share. Investors
expect the dividend to increase at the rate of nine per cent per year in the
future.
(a) What is the internal cost of equity of the company?
(b) The sale of new ordinary shares is expected to involve an issuing cost
of RM0.50 per share. What is the cost of the new ordinary shares?
2. Differentiate between the internal equity of the company with new ordinary
shares.

3. What is the cost that can be connected with the internal equity of the
company?
4. Explain two approaches that can be used in the calculation for the cost of
ordinary shares.
1. Match the following information with the statements provided.
Cost of capital (a) Additional expenditure that

is involved in the issuance of
a security.
Dividend valuation model (b) The result of cost multiplying

for each item in the capital
structure with the financing
ratio in the entire capital
structure and the results are
added together.
Capital financing (c) The result of adding the best

among the debts, preference
shares, retained earnings
and new ordinary shares.
Floatation cost (d) Determining the value of

shares by taking into account
the present value of
dividends that are expected
to be received in the future.
Optimal capital structure (e) The companyÊs alternative

cost of financing structure.
Weighted average cost of (f) It is found in the balance

capital sheet under long-term
liabilities and equity.

2. Maju Company is determining the optimal capital structure based on the

following information:
Capital Resource Percentage of Financing (%)

Long-term debt 35
Preference shares 10
Ordinary shares 55
The company can issue bonds that have a maturity period of 20 years with a
face value of RM1,000. The coupon rate for the bonds is nine per cent and is
sold at the price of RM980. The cost of issuing the bonds is two per cent from
the face value of the bonds.
Preference shares:
The company found that it can issue preference shares at the price of RM6.50
per share with the annual dividend payment of RM0.80. The cost involved
in issuing and selling shares is RM0.30 per share.
Ordinary shares:
The ordinary shares of the company are sold at the present price of RM4.00
per share. The dividend that is expected to be paid at the end of next year is
RM0.50. The growth rate of dividends is constant, that is at eight per cent
every year. The company must pay the flotation cost of RM0.10 per share.
Corporate tax is 40 per cent.

(a) Calculate the cost for each of the capital resources; and
(b) Calculate the WACC.
3. The following information is the total financing for each capital resource of
Jati Company.
Capital Resources Total Financing (RM)

Long-term debt 40,000
The cost of debt before tax is 9.37 per cent, the cost of preference shares is 10
per cent, the cost of ordinary shares is 13 per cent and the marginal cost of
tax is 34 per cent. What is the WACC for the company?

4. How does the tax rate of the company affect the cost of capital?
5. What is the effect of flatation cost on the issuance of a security?

Topic  Financial
Planning
9
LEARNING OUTCOMES
1. Explain the importance of cash budget and pro forma income
statement in financial management; and
2. Prepare cash budget and pro forma income statement.
 INTRODUCTION
Topic 9 discusses the importance of financial planning, preparation of cash budget
and pro forma income statement. This topic also discusses the importance of
working capital management and the types of short-term financing. Besides that,
this topic will focus on the basis of cash management. It explains the cash
conversion cycle and its components, and the types of marketable securities that
are found in the market. It also touches on the management of account receivable
that is a part of the current asset of the company or the working capital of the
company. Finally, it discusses the management of current asset with the lowest
level of liquidity, which is the inventory.

TOPIC 9 FINANCIAL PLANNING  263
9.1 FINANCIAL PLANNING

Before understanding the income statements even further, we need to look at the
guidelines for preparing the financial planning correctly. Generally, a financial
plan that is correct and complete should have the following criteria:
(a) Objective, strategy and operational plans that are clear;
(b) Assumptions that are used in the preparation of financial plans;
(c) Budgets that are classified according to the period and type;
(d) Projects financing that are classified according to the type and time period;
and
(e) Pro forma financial statement throughout the planning period.
After having a picture of the initial steps in preparing a financial plan, the next
step is to understand the method of preparing a cash budget.
ACTIVITY 9.1
Financial planning that is practical and effective is very important in

the operations of a company. Who is responsible to plan and implement
these guidelines? Is it the responsibility of one individual or through
collective discussions?

forum.
9.2 CASH BUDGET

Efficient cash management involves the forecast of cash requirements in the future.
One of the normal methods used to estimate the cash requirements in the future is
by preparing a cash budget.
Cash budget is a summary of the receipt and payment of cash that is expected for
a short period of time. Normally, it is prepared for a planning period of six months
or one year. It can show how the cash flow is planned for a specific time, whether
it is a cash inflow or cash outflow.

264  TOPIC 9 FINANCIAL PLANNING
Besides that, cash budget is very important to the company as the sales and profit
obtained cannot ensure that the company will have enough cash to fulfil its
financial obligations. Instead, the cash budget can assist the company to know the
cash status of the company in the effort to ensure that the cash flow of the company
is strong and stimulating. The following are several terms that are often used in
cash budget:
(a) Cash Receipts or Cash Inflow

Receiving of cash is the entire cash inflow for the financial period given. For
example, cash sales and collection of account receivables.
(b) Payment of Cash or Cash Outflow

Payment of cash is the entire cash outflow for the financial period given. For
example, purchase of equipments, wages and salaries, rental, payment of
interests, dividend, taxes and capital expenses. Depreciation and other non-
financial charges are not included in the cash budget.
(c) Changes in Net Cash

Changes in net cash can be obtained as a result of comparison made between
cash inflow with cash outflow and with the opening balance of cash flow for
that period (refer to Figure 9.1). Besides that, the additional financing cost that
is predicted at the beginning of the period that is, the interest will also be taken
into account.
Figure 9.1: Comparison of changes in net cash flow
(d) Cash Surplus or Additional Financing Requirement

The amount of cash surplus or additional financing requirement depends on the
changes of net cash and the targeted balance determined by the company. A
positive amount shows that the company has cash surplus, while a negative
amount shows that the company requires additional financing.

Example 9.1
This example shows how a cash budget is prepared. Several information and
assumptions for preparing the cash budget of Nuri Company are as follows:
(a) Cash budget will be prepared for the months of March, April and May. The
information required are as follows:
(i) Actual sales for January and February.
(ii) Sales forecast for the months of March, April and May.
(iii) Cash sales are 25 per cent and the balance are credit sales. For credit
sales, 80 per cent of it will be collected in the next month and 20 per
cent will be collected two months after the sale (refer to Table 9.1):
Table 9.1: Cash Sales of Nuri Company
Month Sales (RM)

January 45,000
February 65,000
March 60,000
April 90,000
May 85,000
(b) The purchase of raw materials is predicted at 60 per cent of sales and the
payment will be made a month later.
(c) Office and warehouse rentals are RM4,500 per month.
(d) Payments of wages are RM5,000 per month.
(e) The company will pay insurance premiums of RM2,800 in the month of
March.
(f) The purchase of a new asset involving a cost of RM25,000 will be made in the
month of March.
(g) Opening cash balance for the month of March is RM15,000.
(h) The cash balance that the company intends to hold every month is RM10,000.

Solution
Step 1: Complete the schedule of cash received for the months of March to May.
Schedule of Cash Received for the Months of March to May
Jan Feb Mar Apr May

Total sales 45,000 65,000 60,000 90,000 85,000
Credit sales (75%) 33,750 48,750 45,000 67,500 63,750
Collections:
Cash sales (25%) 15,000 22,500 21,250
80% from last monthÊs sales 39,000 36,000 54,000
20% from last two monthÊs sales 6,750 9,750 9,000
Total cash inflow 60,750 68,250 84,250
Step 2: Complete the schedule of cash payment for the months of March to May
Schedule of Cash Payment for the Months of March to May
Feb Mar Apr May

Total purchase of raw materials 39,000 36,000 54,000 51,000
Credit purchase of raw materials 39,000 36,000 54,000 51,000
Payment a month after purchase 39,000 36,000 54,000

Rental 4,500 4,500 4,500
Wages 5,000 5,000 5,000
Insurance premiums 2,800
Purchase of new asset 25,000
Total cash outflow 76,300 45,500 63,500
Step 3: Prepare the cash budget
Cash Budget
Mar Apr May

Total cash receipt 60,750 68,250 84,250
Total cash payment 76,300 45,500 63,500
Changes in cash (15,550) 22,750 20,750
Opening balance 15,000 10,000 22,200
Closing cash balance (without loans) (550) 32,750 42,950
Cumulative cash balance (550) 32,750 42,950
Minimum balance required 10,000 10,000 10,000
Financing requirement (repayment) 10,550 (10,550) –
Closing cash balance 10,000 22,200 42,950

Next, we will make the following financial forecast for the purpose of forming a
series of pro forma financial statements, such as:
(a) The company can estimate the level of account receivables, inventory,
account payable and other accounts in the future to fulfil the requirement for
loans and expected profits;
(b) The finance officer can make a detailed evaluation of the actual financial
statements that had been planned and from thereon make adjustments; and
(c) The finance manager and creditors can evaluate in advance the level of the
companyÊs profitability and the overall achievement of the company.
SELF-CHECK 9.1
Define cash budget.
ACTIVITY 9.2
Budget is a forecast and forecast is often not accurate. What is the way
to ensure that the forecast in the estimation of the companyÊs cash flow
achieves its objective without any contradiction or error?

forum.
9.3 PRO FORMA INCOME STATEMENT

Pro forma income statement provides the forecast on the total profitability that can
be obtained by the company throughout a specific time period. There are two main
steps in preparing a pro forma financial statement, which are:
(a) Preparing Sales Forecast

Sales forecast is defined as a forecast on the unit and amount of sales in the
future. Sales forecast is the main precondition activity in the process of
financial planning. Several sources are needed to make this forecast (refer to
Figure 9.2).

Figure 9.2: Factors that influence sales forecast
Sales forecast must at least be based on:
(i) Any sales trend expected for the company which will be repeated in
the coming years; and
(ii) Any factor or occurrence that may have a significant effect on the sales
trend of the company.
As a result of this information, the finance manager can make an estimated

cash inflow and outflow that are related with the sales and inventory
operations. Besides that, this information can also assist the finance manager
in determining the assets used and the amount that is required to finance the
forecasted production level.
(b) Forecasting Financial Variables

Financial variables are the items from expenditure, current assets and
fixed assets, liabilities and equity (Keown, Martin, Petty & Scott, 2002). After
you have successfully estimated the increase in sales, determine the effect of
this increase in sales on these financial variables.
Generally, these variables should change according to the changes in sales.

For example, if sales increase, then surely its expenditure, especially the costs
will change. Expenditure will increase with the increase in sales. Assets must
also be increased as more assets, whether current assets or fixed assets, are
needed to support the increase in sales and those financial variables.

The process of preparing a pro forma financial statement is as follows:
Step 1
Prepare the sales forecast.
Step 2
Determine the production schedule and requirements for materials, labour and
expenditure.
(a) Determine the Total Units That Will Be Produced

Total unit that will be produced depends on the opening inventory, sales
forecast and the targeted closing level of inventory. This can be seen in the
following equation:
Expected unit sales

+ Closing inventory
– Opening inventory
= Production requirement
(b) Determine the Production Cost Per Unit
Cost per unit = Material + Labour + Overhead

Total product cost = Number of units to be produced x Cost per unit
Calculate the cost of goods sold
(i) Estimated sales unit
(ii) Cost of goods sold = Sales unit x Cost per unit
(c) Calculate the Closing Inventory
RM
Opening inventory xxxx
+ Total production cost xxx
= Total inventory for sale xxxx
– Cost of goods sold xxx
= Closing inventory xxxx

Step 3
Calculate other expenditures:
(a) Administration and general expenses; and
(b) Interest expenses.
Step 4
Prepare the pro forma income statement
RM
Sales revenue xxxx
– Cost of goods sold xxx
– Depreciation xxx
= Gross profit xxxx
– Administration and general expenses xxx
= Operating profit (profit before interest and tax) xxx

– Interest expenses xx
= Earnings before tax xxx
– Tax xx
= Earnings after tax xxx
– Dividend of ordinary shares (cash) xx
= Increase (decrease) in retained earnings xxx
Example 9.2
By using the information in example 9.1, prepare a pro forma income statement
for Nuri Company for the month of May. The following are the additional
information:
Total fixed assets = RM300,000

Depreciation = 10% from the total fixed assets
Inventory as at 30 April = RM20,000
Inventory as at 30 May = RM40,000
Tax rate = 30%

Nuri Company
Pro forma Income Statement
for the Month of May
(RM) (RM)
Sales revenue 85,000
Cost of goods sold
Opening inventory 20,000
Purchases (60%  85,000) 51,000
71,000
Closing inventory (40,000)
Cost of goods sold (31,000)
Gross profit 54,000
Operating expenditure
Office and warehouse rental expenses 4,500
Wages expenses 5,000
Operating expenditure (9,500)
Operating profit before interest and tax 44,500
Tax (13,350)
Earnings after tax 31,150
ACTIVITY 9.3
1. An auditor has detected an obvious variance in the net cash flow

from the accounting files of your company for the last two years.
There is a possibility that it might be due to a recording error or there
is a discrepancy by the companyÊs employees. What action should
be taken?
Share your thoughts with your coursemates in the myINSPIRE
online forum.
2. Please visit the following websites to obtain additional information

on the topics discussed in this topic.
(a) http://www.va-interactive.com/inbusiness/editorial/finance/
ibt/cash_bud.html
Description: Valuation of cash budget as well as an interactive
web calculator.
(b) http://www.learningforlife.fsu.edu
Description: Basis to financial planning.
(c) http://www.businesstown.com
Description: Introduction and definition of pro forma income
statement.

 You have been exposed to the importance of financial planning via the
preparation of pro forma income statement and cash budget.
 Companies can make evaluations and detailed adjustments to maximise profit

through the comparisons of cash inflow with cash outflow.
 Cash budget is a summary of the receipt and payment of cash that is expected
for a short period of time.
 Terms that are used in cash budget are as follows:
– Cash receipt;
– Payment of cash;
– Changes in net cash; and
– Cash surplus.
 A pro forma income statement provides the forecast on the total profitability
that can be obtained by the company throughout a specific time period.
Cash budget Financial planning

Cash inflow Net cash
Cash outflow Pro forma income statement
Cash surplus

1. What is the appropriate time period for cash budget?
2. One of your duties as an employee of Zitroe Company is to prepare the cash

budget for the period from 1 January to 30 June 2018.
Please prepare the following:
(a) Forecasted cash received schedule;
(b) Forecasted monthly cash payment schedule; and
(c) Cash budget from 1 January until 30 June 2018.
Use the following information to assist you in preparing that budget:

(i) 80 per cent are credit sales; 80 per cent of credit sales will be
collected in the next month; 15 per cent will be collected 60 days
after sales and 4 per cent more will be collected 90 days after sales.
The company had to bear one per cent of credit sales as
uncollectible debt (bad debt).
(ii) Purchases made every month are 65 per cent of sales forecasted
for the next month. Payment for these purchases will only be
made one month after purchase.
(iii) The company intends to maintain a minimum cash balance of
RM300,000. The cash balance on 1 January is RM300,000.
(iv) The company expects the delivery of a new machine in the month
of April. Payment of RM400,000 will be made after delivery had
been done.
(v) Payment for tax of RM500,000 will be made in the month of March
and June.
(vi) Rental of RM100,000 per month. Other cash expenditure is three
per cent of sales.
(vii) The depreciation expenses are RM150,000 per month.
(viii) Labour expenses are 10 per cent of sales for the next month.
(ix) The companyÊs board of directors intends to maintain the
dividend payment of RM450,000 that will be made in the month
of June.

(x) Sales in the month of October are RM3,000,000 and RM2,000,000 in

the months of November and December 2017.
(xi) Sales forecast for the first seven months in the year 2018 is as
follows:
Month Sales (RM)

January 3,000,000
February 5,000,000
March 5,000,000
April 6,000,000
May 3,000,000
June 2,000,000
July 2,000,000
(xii) The company will make interest payments in the month of June
for RM310,000.
1. What is the use of a pro forma income statement?
2. State four sections that are found in the cash budget.
3. Based on the following information, prepare a pro forma income statement

for Tulip Company for the year 2018.
Sales forecast RM10,000,000

Cost of goods sold 60% of sales
Administration and sales expenses RM100,000 per month
Depreciation expenses RM140,000 per month
Interest expenses RM120,000
Tax rate 34%
Keown, A. J., Martin, J. D., Petty, J. W., & Scott, D. F. (2002). Financial management:
Principles and applications (9th ed.). New York, NJ: Prentice Hall.
Topic  Working
Capital
10 Management
LEARNING OUTCOMES
1. Describe the importance and strategies of working capital
management;
2. Explain the types and sources of short-term financing;
3. Evaluate the efficiency of a firmÊs management of its working capital
based on cash conversion cycle;
4. Elaborate on the importance of marketable securities;
5. Assess the factors that influence the management of accounts
receivable;
6. Identify costs that are related to inventory; and
7. Explain how inventory management decisions are made.
 INTRODUCTION
Working capital management refers to the management of current assets and
current liabilities that are required for the daily operations of the company. It
involves the determination of working capital policy and the implementation of
this policy in the daily operations.

276  TOPIC 10 WORKING CAPITAL MANAGEMENT
Working capital policy comprises of the working capital level and how the
working capital should be financed. For example, a firm needs to make a decision
on how much cash that needs to be kept in the accounts and the inventory level
that needs to be maintained. Besides that, a firm also needs to make decisions on
whether to finance its current assets with short-term fund, long-term funds or a
combination of both.
Working capital management is more obvious in small or medium sized

companies. This is because small and medium sized companies have limited
alternative financing compared to larger companies. The financing resources are
focused on trade credit and bank loans. Therefore, the finance managers of small
and medium sized companies are more inclined to use short-term fund resources
to fulfil their financing requirements.
10.1 IMPORTANCE OF WORKING CAPITAL

MANAGEMENT
Working capital management is required for the daily operations of the company.
Efficient working capital management is important to ensure that the firm does
not have any liquidity problems that will effect the operations of the company. At
the same time, efficient working capital management also means that the company
was successful in conducting its business without too much funds being tied up in
the form of current assets.
Current assets and current liabilities are the main items in the daily operations.
Most of the managementÊs time is focused on the working capital management
such as:
(a) Controlling the cash inflows and outflows;
(b) Preparing credit facilities to customers; and
(c) Always ensuring adequate stock.
ACTIVITY 10.1
What is the difference between current assets and current liabilities?

forum.

TOPIC 10 WORKING CAPITAL MANAGEMENT  277
10.1.1 Net Working Capital

Net working capital is the difference between current assets and current liabilities.
Net working capital = Current assets ă Current liabilities
To have a better understanding of the concept of net working capital, look at

example 10.1.
Example 10.1
Balance Sheet of Endah Company
ASSETS RM LIABILITIES AND EQUITY RM
Current assets 376,600 Current liabilities 162,700

Non-current assets 203,800 Non-current liabilities 94,000
Owners equity 323,700
580,400 580,400
Based on the summary balance sheet, the net working capital for Endah Company
is:
Net working capital = Current assets ă Current liabilities

= RM376,600 ă RM162,700
= RM213,900
This shows that Endah Company has the ability to fulfil its short-term financial
claims whenever required. In other words, the net working capital can be used as
a measurement of the companyÊs liquidity.
10.1.2 Current Assets

Current assets comprise of cash and assets that can be converted into cash in a
period not more than one year. Current assets are also known as liquid assets as
they are easily converted into cash in a short period of time. Current assets consist
of:
(a) Cash
Money in hand or bank.

(b) Marketable Securities

Marketable securities are short-term investments that can be converted into
cash in a short period of time.
(c) Account Receivables

Account receivables exist when the company makes sales by credit.
Normally, the credit period given is short and customers are expected to
settle their debts within the predetermined date. When payments have been
made, the account receivables will convert to cash.
(d) Inventory
Commercial goods that will be sold to customers.
To fully understand the approach used in working capital management, we

categorised the current assets of the company into permanent current assets and
temporary current assets.
(a) Permanent Current Assets

Permanent current assets are investment in the current assets that are
expected to be permanently held by the company for a period of more than
one year. The company will keep emergency or safety stocks as inventory to
fulfil unexpected requirements.
(b) Temporary Current Assets

Temporary current assets are assets that are held by the company for only a
short period of time, which is less than a year. This situation is more obvious
for seasonal businesses where at certain times, the expected sales are more
than the sales in normal situations.
For example, when the festive season is approaching, companies that sell
clothes will increase their inventory to fulfil the demand that will normally
increase. This increase in inventory is only temporary because after the
festival, the inventory level will return to its normal level.
After the current assets had been categorised into permanent current assets and
temporary current assets, the next question will be related to the sources of capital
financing that are used to finance the investment in these assets. To match the
financing with the investments, the sources of financing also have to be categorised
into permanent financing source and temporary financing source.

ACTIVITY 10.2
Try to obtain the annual reports of several companies and refer to their
balance sheets. Calculate the average percentage of current assets
compared to the total assets of the companies. What can you summarise
from the results of your calculations?

forum.
10.2 STRATEGIES OF WORKING CAPITAL

MANAGEMENT
The net working capital management is especially drawn up to explain the level
of investments that are suitable for current assets. Working capital management
involves financial decision-making that are made simultaneously and interrelated
with investments in current assets together with the financing of these assets. One
of the methods used in working capital management is the matching of the assetsÊ
lifetime with the financing period used. This method is known as the hedging
principle. This principle is also known as the matching principle or the principle
of self-liquidating debt.
The hedging principle matches the cash flow characteristics of an asset with the
maturity period of financial source that is used to finance that asset. How is this
hedging principle implemented? There are three approaches that can be used to
implement this principle, which are:
(a) Moderate approach;
(b) Aggressive approach; and
(c) Conservative approach.

10.2.1 Moderate Approach

Through this moderate approach (refer to Figure 10.1), the permanent current
assets are financed by permanent financing, while temporary current assets are
financed by temporary financing. Permanent financing is a long-term financing
such as equities and bonds that have a maturity period of more than one year.
Temporary financing involves short-term debt. This type of financing can be stated
as a negotiated financing that has a short maturity period. For example, bank
loans, overdrafts and commercial papers.
Figure 10.1: Moderate approach
10.2.2 Aggressive Approach

Through this aggressive approach (refer to Figure 10.2), the company uses more
temporary financing to finance the temporary assets and permanent assets.
Therefore, the company is exposed to higher risk as a result of the fluctuating
interest rates and the inability of the company to pay its short-term debts in a short
period of time due to the low level of net working capital. However, this approach
can increase the returns due to the reduction in financing cost that is temporary.

Figure 10.2: Aggressive approach
10.2.3 Conservative Approach

Through this conservative approach (refer to Figure 10.3), the permanent current
assets and a part of the temporary current assets are financed by permanent
financing. A company that practises this approach has a high level of net working
capital. Therefore, it can fulfil its short-term claims at the predetermined time.
However, this approach will cause the company to be exposed to long-term
financing cost.
Figure 10.3: Conservative approach

SELF-CHECK 10.1
State the difference between permanent financing and temporary

financing.
10.3 TYPES OF SHORT-TERM FINANCING

Current liabilities and short-term liabilities are debts or responsibilities of the
company that must be settled within a year or less. In summary, short-term
financing is very important to ensure the smooth running of the daily operations
of the company so that it would not be disrupted due to shortage of cash.
10.3.1 Spontaneous Financing

Spontaneous financing exists due to the daily activities of the company. For
example, when the companyÊs sales increases, the inventory must also be
increased and these additional purchases are usually financed by trade credit.
Spontaneous financing can also exist as a result of the differences in timing
between the actual cash flow with the cash flow that should have occurred. For
example, a company had obtained the services of companyÊs employee for the
period of 1 to 15 January but payments were only made on 16 January.
The main sources for spontaneous financing are:
(a) Trade Credit

Trade credit is the credit facility offered by suppliers to customers. For
suppliers, trade credits will be recorded in the balance sheet at the current
assets section (account receivable). While for the customers, trade credits are
located in the current liabilities section (account payable).
This financing source is obtained based on the trust by the suppliers to

customers. The cost of trade credit cannot be obtained directly, as the
suppliers usually would not charge any interest on the trade credits offered.
However, when the suppliers offer discount, customers will bear a higher
effective cost if the discounts were not taken.

Example 10.2
Endah Company has made a purchase on credit from the supplier for RM800
on the terms of 3/10 net 30. If the company made the payment within 10
days, it will pay only RM776 because the cash discount of RM24 would be
deducted from the invoice.
In summary, the company is assumed to have made a loan of RM776 for the
period of 20 days with the interest payment of RM24. Therefore, with the
assumption of 365 days a year, the annual cost borne by Endah Company as
a result of foregoing the discount offered can be estimated as follows:
RM24 365
Annual cost  
RM776 20
 0.564 or 56.4%
Based on the calculation above, Endah Company had to bear the annual cost
of 56.4% if it did not accept the discount offer of 3/10 net 30.
(b) Accruals
Accruals exist when there is a delay in payment. For example, the employeesÊ
salaries will only be paid at the end of each month and also the employeesÊ
salaries deduction (EPF and SOCSO) by the employer will only be made on
the 20th of the month. Financing sources through accruals do not involve any
costs. It is free for the company as long as it does not affect the credibility of
the company.
10.3.2 Negotiated Financing

The sources of negotiated financing are often obtained formally from financial
institutions. It has to undergo various procedures that have been predetermined.
In this topic, we will focus on the facilities provided by commercial banks, which
are overdrafts and short-term loans only. Other financing sources that will be
discussed are commercial papers and factoring.
(a) Overdrafts
Overdraft is a credit facility provided by banks to its customers. It is
channelled through the customerÊs current accounts, where the customer is
allowed to withdraw money in excess of the balance in its current account.
However, there is a limit set on the withdrawal. For example, Endah
Company received an overdraft facility for RM50,000. This means that the
company can use the funds provided by the bank until the balance in its
account reaches RM50,000.

Overdraft facilities are very useful to a company that wishes to take the cash
discount offered by the supplier. The cost that needs to be borne by the
customer who uses the overdraft service is the interest that is applied based
on the negative balance of the customerÊs current account.
(b) Short-term Loans

Besides overdrafts, banks will also provide services for short-term loan
facilities. To understand this negotiated financing via bank loans, you may
refer to example 10.3.
Example 10.3
Endah Company has obtained a bank loan of RM200,000 for a period of three
months at the rate of 15 per cent per year. At the end of the period, Endah
Company repaid the principal together with its interest.
Before making calculations for the effective cost of the loan, the interest
amount must be ascertained in advance.
Interest  RM200,000  0.15  ô1

4
 RM7,500
RM7,500
Effective cost 
RM200,000  1
4
 0.15 or 15%
If you look at the example, the effective cost of 15 per cent is the same with
the rate of the bank loan. However, there are two characteristics in the cost
of short-term loan that will make its value higher than the nominal interest
rate. These characteristics are the compensating balance and the discounted
interest.
(i) Compensating Balance

The compensating balance is the amount that must be kept in the bank
account and remains as a balance throughout the loan period. The
requirement for this compensating balance makes the actual amount
received by the borrower to be less by the compensating balance amount.
However, the interest is still calculated based on the entire loan.

By using example 10.3 and several additional information, we can see

the effect of the compensating balance on the effective cost of the loan.
The bank that provides the loan imposed the condition for
compensating balance to be 10 per cent of the total loan. Assuming that
Endah Company does not have the balance as required by the
compensating balance. Calculate the effective cost of this loan.
To obtain the effective cost of this loan, we need to obtain the value for:
Ć Interest amount;
Ć Compensating balance; and
Ć Value of net loan
These information can be calculated as follows:
Interest amount = RM200,000  15%  1 = RM7,500

4
Compensating balance = RM200,000  10% = RM20,000
Net loan = RM200,000 ă RM20,000 = RM180,000
RM7,500
Effective cost 
RM180,000  1
4
 0.1667 or 16.7%
Based on the calculation, the effective cost of the loan is higher

compared to the value before there was a compensating balance.
(ii) Discounted Interest

Through this characteristic, the borrower must pay interest when the
loan amount is withdrawn. This means that the payment of interest has
to be settled in advance before the loan can be used. This condition
makes the net amount obtained by the loan to be less than the amount
borrowed. However, the effective cost still increases as the interest is
made based on the entire loan.

By using example 10.3, the calculation of interest, net amount and the
effective cost for Endah Company are as follows:
Interest amount = RM200,000  15%  1 = RM7,500

4
Net loan = RM200,000 ă RM7,500 = RM192,500
RM7,500
Effective cost =
RM192,500  1
4
= 0.15584 or 15.6%
From the explanation, it is clear that the condition of compensating

balance and discounted interest will increase the cost of the company
doing the borrowing.
(c) Commercial Papers

In Malaysia, the use of commercial papers is not widespread. Commercial
papers are promissory notes for short-term debt that are issued by companies
with strong financial standing. The issuance of this instrument is based on
the confidence of investors towards the companyÊs ability to repay the loan
at the date that has been predetermined.
Commercial papers are issued at a discounted price where the selling price
is the face value after deducting interest. The cost involved in the issuance of
commercial papers comprised of all the expenditures that are directly
involved in the issuance of this security. For example, a company that issues
commercial papers will obtain the services of a merchant bank to sell it to the
investors. All these expenditures must be taken into account in estimating
the effective cost of financing through commercial papers.
Example 10.4
Endah Company will issue commercial papers that have a value of
RM20,000,000 with a maturity period of six months. The interest rate for
these commercial papers is 10 per cent. The cost involved in issuing these
commercial papers is RM50,000.

The calculation of the effective cost is as follows:
Interest amount = RM20,000,000  10%  1 2 year

= RM1,000,000
Total cost = Interest + Issuing cost

= RM1,000,000 + RM50,000
= RM1,050,000
Net loan = RM20,000,000 ă RM1,000,000

= RM19,000,000
RM1.05
Effective cost =
RM19,000,000  1 2
= 0.1105 or 11%
(d) Factoring
Factoring is a transaction that involves the purchase of account receivables
or the invoices from supplier companies by the factoring companies.
Financial institutions that conduct these factoring activities are known as
factor. It comprised of takeover and administration of account receivables as
well as the activity of collecting debt.
The cost of financing that is counted by factoring is the total financing and
expenditure involved such as the factoring fee (one to three per cent from the
invoice value), interest on deposit and reserves (a small percentage that is
held by factor). The balance value of the invoice payable by factor will only
be settled to the company when the entire account receivables have been
collected.
Example 10.5
Endah Company has factorised the account receivable totalling RM200,000.
The credit period of the company is 60 days. The factoring fee is 3.5 per cent
of the invoice value while the reserves are at 7.5 per cent. The interest rate
that is charged on the deposit is 12 per cent per year. When the deposit is
received, the fees and interest must be settled. Based on previous practice of
the company, it will give cash deposit of 60 per cent of the invoice value.

The following is the effective cost of financing through factoring:
Deposit = RM200,000  60% = RM120,000

Reserves = RM200,000  7.5% = RM15,000
Fees = RM200,000  3.5% = RM7,000
Interest = (RM120,000 ă RM15,000 ă RM7,000)  12%  2 12
= RM1,960
Net amount = RM120,000 ă RM15,000 ă RM7,000 ă RM1,960

= RM96,040
RM7,000  RM1,960
Effective cost =
RM96,040  2 12
= 0.5598 or 55.98%
Based on the calculation, the effective cost of this financing is 55.98 per cent
and the company obtains a deposit of RM96,040 for the period of two months
at the cost of RM8,960 (fees and interest). If all the account receivable can be
collected successfully, the balance of RM80,000 including reserves of
RM15,000 will be given by the factor to Endah Company.
SELF-CHECK 10.2
State examples of short-term financing. Why is short-term financing

important for a company?
ACTIVITY 10.3
A telecommunication company in our country is facing losses of

millions of Malaysian Ringgit (MYR) due to the burden of their bad
debts from customers who refuse to settle the payment of their bills.
Several notices and summon letters had been sent yet the customers are
still ignoring them. What is the way to solve this dilemma?

forum.

10.4 CASH CONVERSION CYCLE

The cash conversion cycle refers to the time period taken from the payment for the
purchase of raw materials to the receipt of cash from the sale of goods. Figure 10.4
shows the three main components in the cash conversion cycle, which are:
(a) Cash/Inventory Conversion Period

The average time period taken to convert raw materials into finished goods
and selling them.
(b) Accounts Receivable Collection Period

The average time period taken to obtain cash from credit sales.
(c) Deferred Payment Period

The time period taken from the purchase of raw materials and labour until
the payment of cash for these items.
Figure 10.4: Cash conversion cycle
Example 10.6
Now, we will look at an example on how the calculation for cash conversion cycle
is made. Jaya Jati Company manufactures office fittings such as tables and chairs.
The following are the cash dealings of the company:
(a) Purchase of raw materials on credit for the production of tables and chairs
and the company is given a period of 30 days to make payment;
(b) Employees will be paid at the end of the month (that is after 30 working
days);
(c) The customers of the company will purchase the goods on credit. Therefore,
the accounts receivables will exist when sales are made;
(d) The payment for raw materials and wages must be made at the date
promised. As the cash from the credit sales have not been received, the
company has to finance the cash flow with short-term loans; and
(e) The cash cycle will be completed when cash from the credit sales are
received. Subsequently, the cash will be used to pay the short-term loans that
were taken to pay for the raw materials and wages of employees.

Sales of Jaya Jati Company are RM1,500,000, while the average inventory is
RM350,000. Accounts receivables are RM85,750. Assume that there are 360 days in
a year.
Based on the information, the cash conversion cycle for Jaya Jati Company can be
Step 1: Calculate the cash conversion period.
Inventory
Inventory conversion period 
Sales/360
RM350,000

RM1,500,000/360
 84 days
Step 2: Calculate the accounts receivable conversion period.
Accounts receivable
Accounts receivable 
Sales/360
RM85,750
Conversion period 
RM1,500,000/360
 21 days
Step 3: Calculate the deferred payment period.

Based on the information given, the deferred payment period is 30 days
(items a and b).
Step 4: Calculate the cash conversion cycle period.
Cash conversion cycle = 84 days + 21 days ă 30 days

= 75 days
Based on the calculation, Jaya Jati Company:
(a) Requires 84 days to convert the raw materials into finished goods (office
chairs and tables);
(b) Has 21 days to obtain cash from the sales made on credit; and
(c) Has 30 days to make payment on the purchase of raw materials and
utilisation of labour.

Therefore, the time period between the withdrawal of cash (payments that were
made for the purchase of raw materials and utilisation labour) and the receiving
of cash from the sales is 75 days.
ACTIVITY 10.4
What will happen if the cash conversion cycle exceeds the period that
had been set?
10.5 MANAGEMENT OF MARKETABLE

SECURITIES
Marketable securities is a short-term financial instrument that provides returns to
the investors. Marketable securities are also known as cash equivalent as these
securities can be converted into cash within a short period of time.
Companies that have surplus funds can temporarily invest these funds in
marketable securities. By doing this, the company can quickly convert the
securities into cash and obtain some return from the investment.
10.5.1 Factors in Choosing Marketable Securities

Marketable securities can be valued based on these factors (refer to Table 10.1):
Table 10.1: Factors in Choosing Marketable Securities
Factor Description
Default risk The probability of the interest and principal cannot be repaid in the
amount promised at the specific time.
Liquidity or Liquidity or marketability refers to the ability of the security to be
marketability converted into cash in a short period of time.
Taxation Interest that is obtained from the marketable security which is not
financed by the federal government will be taxed.
Returns The criteria of returns involve evaluation of risk and interest for each
factor stated above.

10.5.2 Types of Marketable Securities

The following are several types of marketable securities that are found in the
market:
(a) Treasury Bills

Treasury bills are short-term securities that are issued by the Central Bank of
Malaysia (Bank Negara Malaysia) with a maturity period of 91 days, 182 days
or 365 days. This bill is offered on discount basis. Therefore, investors will
not receive interest payments. The return received is the difference between
the purchase price and the face value of the bill. It is also risk-free as it is
guaranteed by the government.
(b) Commercial Papers

Commercial papers are short-term promissory notes that are issued by large
companies to obtain additional capital. These promissory notes are issued
without guarantee and the maturity period for this instrument is between 30
to 270 days. Just like treasury bills, these commercial papers have a face value
and are sold at a discounted price.
(c) Bankers Acceptance

Bankers acceptance is a draft (instruction to pay) that is issued by exporters
to obtain payment for goods that are sold to customers who have accounts
with the said bank. Normally, the financing period of these bills is between
30 to 200 days. Bankers acceptance can be traded in the money market where
the rate of discount is determined by the market.
(d) Negotiable Certificate of Deposit

Negotiable certificate of deposit is a receipt that is issued by the commercial
bank or merchant bank as a savings evidence for a sum of money that is kept
and the certificate investor has the right to obtain the specific interest rates.
This certificate can only be issued by commercial banks or merchant banks

that have permission from Bank Negara Malaysia with the minimum
amount of RM50,000 to RM1,000,000 for a period between 3 months and 36
months. The interest rate charged is determined by the bank issuing the said
certificate. This certificate can be negotiated in the money market or between
an individual with another individual.

ACTIVITY 10.5
The companiesÊ owners would sometimes use the surplus funds of the
company to insert in marketable securities to obtain some returns. Is this
a wise action?

forum.
10.6 BALANCE BETWEEN RISK-RETURN IN

CASH MANAGEMENT
Cash management involves a balance between risk and rate of return. Cash that is
insufficient will expose the company to risk of liquidity or insolvency such as the
failure to fulfil liabilities at the predetermined time. A cash holding that is too high
will reduce the companyÊs returns as cash is an asset that does not have any return.
Therefore, the management must look at the effect of risk and rate of return of
the company in determining the optimal holding level of cash and marketable
securities. Decisions on the level of risk that will be taken by the company depend
on the decisions that have been made by the companyÊs management.
Cash management has the purpose of achieving the following objectives:
(a) Company has sufficient cash to fulfil the requirements of its transactions; and
(b) Cash surplus must be at the minimum level as cash does not have any return.
ACTIVITY 10.6
1. Explain the difference among the balance between risk-return in
cash management, management of account receivables and
management of inventories.
2. By taking an example of a prospectus from one company listed on

the Main Market of Bursa Malaysia, provide a review on the cash
budget and income statement of that company.

forum.

10.7 MANAGEMENT OF ACCOUNTS

RECEIVABLE
In this subtopic, you will be exposed to some aspects that are involved in the
management of accounts receivable. The aspects are accounts receivable, credit
policy, credit control and balance between risk-return in management of account
receivable.
10.7.1 Accounts Receivable

Accounts receivable exists when sales were made on credit. It is a promise from
the customers to make payment on the purchases that were made in a period that
has been mutually agreed upon.
The importance of managing accounts receivable can be determined by looking at

the percentage of the companyÊs sales that were made on credit or the total account
receivable for the company.
The total accounts receivable for a company at a specific time is determined by the
following factors:
(a) Credit sales level of the company; and
(b) Average collection time.
Changes in any one of these factors will cause a change in the total account
receivable for the company. Therefore, the accounts receivable for a company at a
specific time can be determined as follows:
Accounts receivable = Credit sales per day  Average collection time
To further strengthen your understanding on the calculation of accounts

receivable, refer to example 10.7.
Example 10.7
Rania Company is a company that manufactures plastic goods. It has an annual
sales of RM250,000 per year. All sales were made on credit and the credit terms is
2/15 net 30. Based on previous experience, 60 per cent of the companyÊs customers
will take the discount and pay on the 15th day. In the meantime, the other 40 per
cent will make payments on the 30th day. Assuming that there are 360 days in a
year, calculate the total accounts receivable for Rania Company.

Accounts receivable = Credit sales per day  Average collection time

RM250,000
=  [(0.6) (15)  (0.4) (30)]
360
= RM14,583.33
This means that the average accounts receivable for Rania Company at a specific
time is RM14,583.33.
10.7.2 Credit Policy

The credit policy of a company is the procedure that has been set by the
management in managing the accounts receivable. Generally, the credit policy of
a company consists of credit terms, credit standards and collection policies.
(a) Credit Terms

Credit terms refer to the terms that are made for the credit sales of the
company. It is normally written as x/y net z which means that the customer
is entitled to get a discount or reduction in price for x% of the purchase price
if the payment is made within the period of y days. If the customer does not
want to take that discount, it has z days to make full payment.
Assuming the credit terms of 2/10 net 30. This means that customers will get
a two per cent discount from the invoice price if payment is made within 10
days of the invoice date. Customers who do not take this discount will have
to make payment within 30 days.
You can refer to Figure 10.5 to see an illustration of credit terms.
Figure 10.5: Credit terms period

There are two elements that form the credit term, which are:
(i) Credit Period

Credit period refers to the time period given to customers to make
payments for credit purchases. A longer credit period can increase sales
and accounts receivable. A shorter credit period decreases sales and
account receivable.
(ii) Cash Discount

Cash discount is the reduction in price that is offered to the customers
who made early payments. The purpose of giving cash discounts to
customers is to encourage early payments, attract new customers and
also to increase the sales.
Figure 10.6 shows two components that are involved in determining

cash discounts.
Figure 10.6: Components in determining cash discounts
Example 10.8 can help you to understand the credit terms of a company more
clearly.
Example 10.8
On 2 February 2001, U-Pen Company made credit sales amounting to
RM85,000 based on the terms 3/15 net 30. If the customers pay within the
period of 15 days, which is until 17 February, they will get a discount of three
per cent.
The discount amount can be calculated as follows:
Discount = Percentage of discount  Selling price

= 3%  RM85,000
= RM2,550
Total payments if discount is taken:

= Invoice price  ( 1 ă Discount percentage)
= RM85,000  (1 ă 0.03)
= RM82,450
Customers who do not take the discount are given 30 days to settle the
payment at the invoice price of RM85,000.
(b) Credit Standards

Customers who intend to deal in credit must fulfil the credit standards that
had been determined by the company. Credit standards can be seen as a
minimum qualification test that must be fulfilled by customers to obtain
credit. The determination of credit standards will affect the risk and rate of
return. There are two types of credit standards:
(i) Strict Credit Standard

Reduces sales, returns and financing cost for account receivables.
(ii) Loose Credit Standard

Increases sales, returns and the financing cost for account receivables.
The application of the credit standards can be seen via an analysis of the
customersÊ credit applications conducted by companies via the 5C system.
This system is a subjective value measurement method that is widely used
among credit managers.
This method measures the credit quality that comprised of five main
sections, which are:
(i) Capacity or Capability

The capacity factor refers to the capacity or capability of the customer
to make payments as predetermined. Valuation can be made based
on the consideration of business practice including the customersÊ
previous records, especially those related to the pattern and trend of
payments.
(ii) General Economic Conditions

The general economic conditions refer to the development in local
or general economy that may influence businesses that are being
conducted by the customers. The economic conditions may indirectly
affect the ability of the customers in fulfilling their obligations.
(iii) Capital
The capital factor refers to the overall financial status of the customers.
For the purpose of credit evaluations, emphasis is made on the ratio
related to the customersÊ ownership status such as the debt equity ratio,
liquidity ratio and interest coverage ratio.

(iv) Character
Character refers to the enthusiasm shown by the customers in fulfilling
their promise to make payments as mutually agreed.
An experienced credit officer can make accurate estimates on the

enthusiasm and sincerity of a customer based on information such as
the customerÊs previous record with suppliers, banks and background
information regarding the business owned by the customer.
(v) Collateral
Collateral refers to any fixed assets that are pledged for the credit
facilities. Finance managers will evaluate the collateral based on the
value and the marketability of the asset pledged.
(c) Collection Policies

Although most customers will make payments within the set time period,
there are those who had to delay payment unintentionally due to financial
problems.
The following are the methods normally used to collect account receivable
that had exceeded the payment period set:
(i) Sending reminder letters;
(ii) Making telephone calls;
(iii) Personal visits;
(iv) Forwarding the accounts to collection agency;
(v) Legal action; and
(vi) Including those accounts as bad debt account.
10.7.3 Credit Control

The next discussion involves another important aspect in the management of
account receivable, which is the evaluation on the effectiveness of the credit policy
set. The optimal credit policy is unique to a company as it is determined by the
operating feature of that company itself. There are two common methods used by
companies to control account receivable, which are:

(a) Average Collection Period Method

The average collection period refers to the average period that is required to
collect cash from the sales made on credit.
Example 10.9
E-Zet Company sells goods on credit with the terms of 2/15 net 40. Based on
previous experience, the total percentage of customers who will take the
discount and make payments on the 15th day is 70 per cent and the rest will
pay on the 40th day. The credit sales of the company are RM80,000. Assume
that there are 360 days in a year.
Based on the information given, the average collection period can be

Period collection period = 0.7 (15 days) + 0.3 (40 days)

= 22.5 or 23 days
If the annual sales are RM80,000, therefore the average credit sales per day
are as follows:
RM80,000
Average credit sales per day =
360
= RM222.22
Therefore, the average account receivable:
Average account receivable = Credit sales per day  Average collection

period
= RM222.22  23
= RM5,111.11
(b) Ageing Schedule Method

The ageing schedule is a schedule that lists all the account receivables of
customers based on the age of that account. This schedule provides
information on the percentage of account receivables that have yet to be
collected and also the percentage that exceeded the credit period for a
specific period.

Example 10.10 shows how the ageing schedule assists the management in
controlling the companyÊs account receivables. Both company NZJ and company
ZBZ had offered credit terms of 4/15 net 30 days to customers who deal on credit.
The total account receivables for both of these companies are RM4,000,000. Table
10.2 is the ageing schedule for both companies.
Example 10.10
Table 10.2: Ageing Schedule of NZJ Company and ZBZ Company
NZJ Company ZBZ Company

Age of Account
(Days) Account Value Account Value
% from Sales % from Sales
(RM) (RM)
0ă15 2,400,000 60 1,400,000 35
16ă30 1,000,000 25 1,200,000 30
31ă45 600,000 15 800,000 20
More than 45 0 0 600,000 15
4,000,000 100 4,000,000 100
The ageing schedule shows that 15 per cent of the customers from NZJ Company
had exceeded the credit period that has been set while 35 per cent of customers
from Company ZBZ had failed to pay within the period set.
Both these companies need to look at the credit policy that was set to identify the
problems faced in credit management of the company.
10.7.4 Balance between Risk-return in Management

of Account Receivable
As in management of cash and marketable securities, management of account
receivables is also important as it has an effect on risk and the rate of return for the
company. The balance between risk and the rate of return is a decision that must
be made by the management in managing the account receivable of the company.
The management of account receivable starts from the decision on whether the
company should sell by credit or not. In relation to this, the company will set
specific policies in managing the account receivable which is normally known as
companyÊs credit.

A loose credit policy normally will increase sales and this will bring a higher rate
of return. However at the same time, this policy will also increase the risk of bad
debts for the company. The increase in this risk will have a negative effect on the
rate of return for the company.
On the other hand, a strict credit policy will reduce the sales of the company.
However, this policy will reduce the risk of bad debts and will indirectly have a
positive effect on the rate of return for the company. Therefore, in choosing a
specific credit policy, the management of the company must take into account the
effect of the credit policy on the overall risk level and the rate of return of the
company.
ACTIVITY 10.7
You were shocked to receive a tax claim of RM2,000,000 for the business
period of the last three years. Before this, you had expected your
business to be given tax exemption by the government but you do not
have any written documents regarding this matter. This tax must be
settled in full without any instalment payments and you must inform
this issue to the members of the board of directors. What will be your
next course of action?
10.8 INVENTORY MANAGEMENT

In this subtopic, we will discuss several aspects that are involved in the inventory
management. They are types of inventory, objective of inventory management,
cost related to inventory, economic order quantity (EOQ) model and balance
between risk-return in inventory management.

10.8.1 Types of Inventory

Before starting the discussion on inventory, we need to understand the types of
inventory that are normally held by companies. Generally, inventory is divided
into four categories as follows:
(a) Raw Materials

Raw materials are the basic items that are bought by the company to be used
in the manufacturing process to produce finished goods. Raw materials are
the main materials in the production of the final product. For example,
timber is used to make furniture.
(b) Supplies
Supplies are goods that are used in the manufacturing process or the
operations of a business. However, supplies are not the main items in
finished goods. It is the supplementary items that are used in the production
of final product.
(c) Goods in Process

These are goods undergoing the manufacturing process. They are half-
completed goods that are at a specific production stage and must undergo
further production process as well.
(d) Finished Goods

Finished goods are goods that have completed the manufacturing process
and are ready for sale.
The type of inventory held by a company depends on the operations of that

company.
ACTIVITY 10.8
By using the example of Kentucky Fried Chicken restaurant, complete

the following types of inventory:
(a) Raw materials ______________________
(b) Supplies ______________________
(c) Goods in process ______________________
(d Finished goods ______________________

10.8.2 Objective of Inventory Management

Generally, the objective of inventory management is to prepare sufficient
inventory to enable the company to operate efficiently and productively. To
achieve this objective, particularly the inventory management, two questions need
to be answered, which are:
(a) How much inventory must be held (bought) at a specific period of time?
(b) When is the appropriate time to reorder inventory?
10.8.3 Cost Related to Inventory

Management must identify the costs that are related to inventory in its efforts to
minimise the costs. The costs that are related to inventory are:
(a) Carrying Cost of Inventory

Carrying cost of inventory is the cost of keeping the inventory from the
moment it is stored by the company until it is sold. Among the carrying costs
of inventory are warehouse cost, depreciation cost, insurance and tax, and
capital tied to the inventory.
The carrying cost of inventory has a direct connection with the average
inventory. This means that the carrying cost of inventory will increase with
the increase in the average inventory held.
The average inventory depends on the frequency of orders made. The

following is the equation to obtain the average inventory.
Number of units per order (Q)

Average inventory (A) =
2
S/N

2

Figure 10.7 shows how the average inventory is obtained graphically.
Figure 10.7: Average inventory
The equation and Figure 10.7 assume that when inventory is ordered, the
total inventory kept is equal to 0 (all inventory ordered had been completely
sold).
Example 10.11:
Intoll Company sells 150,000 (S) units of mentol bulb per year. The inventory
is ordered four times per year (N) and each order (Q) is 37,500 units. The
purchase price (P) is RM3.50 per unit. The cost of capital to finance the
inventory is 10 per cent of the average inventory value. Warehouse cost is
RM3,500, insurance cost is RM1,000 and depreciation cost is RM500.
37, 500
Average inventory (A) =
2
 18,750

By using the information that the inventory purchasing price is RM3.50 per
unit, the average value of inventory is:
Average value of inventory = (P)(A)

= (RM3.50) (18,750 units)
= RM65,625
The next step is to identify the costs involved in holding the inventory. Based
on the information given, the costs involved are financing cost, warehousing
cost, insurance cost and depreciation cost.
Total carrying cost of inventory (TCC) = (RM65,625  0.10) + RM3,500 +

RM1,000 + RM500
= RM11,562.50
The percentage cost of carrying inventory can be calculated as follows:
Total carrying cost

% of carrying inventory 
Average value of inventory
RM11,562.50

RM65,625
 0.17619 or 17.62%
(b) Ordering Cost of Inventory (TOC)

The ordering cost of inventory or TOC is the cost involved in the process of
preparing an order to obtain inventory. Examples of ordering cost are cost of
telephone calls, cost of preparing paperwork, delivery cost and handling
cost.
The ordering cost of inventory is a constant cost. Ordering cost is fixed for a
specific order without taking into account the size of the order made. The
total ordering cost can be calculated as follows:
Sales units per year

Total ordering cost (TOC)  Fixed cost for an order 
2 (Average inventory)
 S 
F  
 2A 

Where:
F = Fixed cost for an order
S = Sales unit per year
A = Average inventory
Example 10.12
If S = 150,000 units, A = 18,750 units and F = RM500, what is the total ordering
cost?
150,000
Total ordering cost (TOC)  500 
2(18,750)
 RM2,000
(c) Total Inventory Cost (TIC)

Total inventory cost or TIC consists of all the costs related with inventory,
which are the carrying costs of inventory and the ordering cost of inventory.
Based on the previous calculation example, the total inventory costs can be
Total inventory cost (TIC) = TCC + TOC

= RM11,562.50 + RM2,000
= RM13,562.50
10.8.4 Economic Order Quantity (EOQ) Model

This subtopic will answer the first question which was raised in achieving the
objective of inventory management, which is:
How much inventory must be held at a specific period of time?
The economic order quantity model which is also known as EOQ model is the
method used to ascertain the optimal order quantity of inventory for a company.
Figure 10.8 shows the EOQ model graphically.

Figure 10.8: EOQ model
Figure 10.8 shows that the cost of carrying inventory increases with the increase in
average inventory (please refer to the TCC line; total carrying cost). This means
that a high order quantity will increase the carrying cost of inventory
that must be borne by the company. Therefore, costs that are related with this
inventory activity such as insurance, tax and storage will increase with the increase
in average inventory.
The ordering cost will decrease when the order quantity of inventory increases.
This is because a bigger order size will reduce the frequency of the orders. This can
be seen in the Figure 10.8 which shows that the TOC (total ordering cost) curve
will decrease when the order quantity increases.
The total carrying cost and ordering cost are the total inventory cost (please refer to
the TIC curve; total inventory cost). The minimum level at the TIC curve (as shown by
the dotted lines) is the EOQ level which is the optimal order quantity of inventory for
the company. In Figure 10.8, we found that the TCC curve (total carrying cost curve)
and the TOC curve (total ordering cost curve) also cross at this level. This shows that
at EOQ level, the total carrying cost and the total ordering cost are the same. Also at
this level, the total inventory cost is at the minimum level.
The EOQ level can be calculated by using the following equation:
2(F)(S)
EOQ =
(C)(P)

Where:
EOQ = Economic order quantity
F = Fixed cost in ordering
S = Annual sales (units)
C = Carrying cost (percentage of inventory value)
P = Purchase price per unit of inventory
The usage of EOQ model is based on several assumptions, which are:
(a) Sales are equal throughout the year;
(b) Sales can be predicted accurately;
(c) Orders made will be received according to schedule; and
(d) Storage cost and ordering cost are constant.
Example 10.13
The sales of Zulia Company is 50,000 units per year. The percentage of storage cost
is 20 per cent of inventory value. The purchase price is RM15.00 per unit and the
ordering cost for each order is RM1,500. Based on the information given, the EOQ
level is as follows:
S = 50,000 units per year
C = 20% or 0.2
P = RM15
F = RM1,500
2(1,500) (50,000)
EOQ 
(0.2)(15)
 7,071 units

This means that Zulia Company will order 7,071 units each time an order is made.
Therefore, the orders will be made seven times per year (50,000/7,071). The total
cost involved with the order level of 7,071 units is:
TIC = TCC + TOC

= (C) (P) (Q/2) + (F)(S/Q)
= (0.2) (15.00)(7,071/2) + (RM1,500)(50,000/7,071)
= 10,606 + 10,606
= RM21,212
Therefore, the total inventory cost at EOQ is RM21,212, while the total carrying
cost (TCC) and total ordering cost (TOC) are the same at RM10,606.
The second question to be answered in fulfilling the objective of inventory

management is:
When is the appropriate time to reorder inventory?
The appropriate time to reorder inventory is known as the reorder point. The reorder
point refers to the inventory level where the next order needs to be made. The
determination of the reorder level is important to avoid problems in shortage of
inventory or depleted inventory. Three factors that influence the reorder point are:
(a) Safety Stock

Safety stock is the surplus stock that is held by the company to overcome the
problem of shortage of stock. When the total stock reaches the safety stock
level, the company will make a new order. Figure 10.9 shows the effect of
safety stock on the reorder point (the effect of lead time and goods in transit
on the reorder point is not taken into account).

Figure 10.9: Effect of safety stock on the reorder point
(b) Receiving Order Lead Time

Lead time refers to the period taken from the time the order is made until the
the inventory is received by the company. Figure 10.10 shows the effect of
lead time on the reorder point (the effect of goods in transit on the reorder
point is not taken into account).
Figure 10.10: Effect of lead time and safety stock on the reorder point
The reorder point can be calculated using the following equation:
Sales
Reorder point   Lead time
52 weeks

Example 10.14
D-Dee Company sells 130,000 units of inventory per year. Assume that the
sales are constant throughout the year. Therefore, the usage of inventory per
week is 2,500 units (assume that there are 52 weeks in a year). If the lead time
is three weeks, the calculation of the reorder point is as follows:
Reorder point = 2,500  3 weeks

= 7,500 units
(c) Goods in Transit

Goods in transit are goods that have been ordered but have yet to be
received. Goods in transit exist when the lead time or the time taken when
one order was made until the time it is received is longer than the time
between one order and the next order. Let us look at an example of how
goods in transit are taken into account in determining the reorder point.
Figure 10.11 shows the effect of safety stock, lead time and goods in transit
on the reorder point.
 Sales 
Reorder point    Lead time   Goods in transit
 52 weeks 
Figure 10.11: Effect of safety stock, lead time and goods in transit on the reorder
point

Example 10.15
Assume that a company takes three weeks to wait for a new order to be received
and the weekly usage is 2,500 units. The order quantity is 2,000 units and the time
between orders is two weeks. The inventory level when new orders must be made
is as follows:
Reorder point = (3  2,500) ă 2,000

= 7,500 ă 2,000
= 5,500 units
In the example, the company needs to reorder inventory at the level

of 5,500 units after taking into account the stock lead time for the order of
7,500 units to be received and the goods in transit of 2,000 units that would arrive.
10.8.5 Balance between Risk-return in Inventory

Management
As discussed earlier, the management of cash and marketable securities as well as
account receivable involve a balance between risk and rate of return. The same
consideration must be noted by finance managers when managing the companyÊs
inventory.
Inventory management cannot be separated from the management of account

receivable as both are closely related to one another. Changes in sales will have
effects on account receivable and inventory. Therefore, management must take
into account the relationship between both these items before making any decision
that involves account receivable and inventory.
The next example that will be discussed will show how the holding level of the
companyÊs inventory will affect the rate of return of the company. A grocery store
must make investments in inventory because it cannot operate if there is no
inventory to sell. Therefore, the store owner must make estimation on the level and
type of inventory that will be sold in his store. It will be risky if there is no
inventory estimation, as the store owner is at risk of losing his customers. For
example, holding inventory that is too low will cause the store to be always out of
stock and regular customers will have to go to another store.

To overcome the problem of inventory shortages or depleted inventory, the

storekeeper will start to purchase lots of inventory. However, you must remember
that a higher inventory will involve higher costs and this will also bring an overall
negative effect on the rate of return of the company. Therefore, the store owner
must determine the minimum inventory holding level to be parallel with
acceptable risk level and the required rate of returns.
ACTIVITY 10.9
Please visit the following website to obtain information on the topic

discussed.
https://efinancemanagement.com/sources-of-finance/short-term-
finance
Description: Detailed explanation on short-term finance management.
 This working capital management consists of the balance of risk-return in

management of cash, management of accounts receivable and management of
inventory in ensuring that the level of profit returns are in accordance with the
budget made.
 Accounts receivables exist when sales are made on credit.
 Accounts receivables at a specific period are influenced by the credit sales level
of the company and the time period required in collecting cash from those
credit sales.
 Inventory management involves a balance between risk and the rate of return.
 Inventory must be managed wisely as it is an investment by the company that

is tied up and cannot be used for other purposes.

Accounts receivable Economic order quantity (EOQ) model

Accruals Factoring
Aggressive approach Marketable securities
Bank loans Moderate approach
Bankers acceptance Negotiable certificate of deposit
Cash conversion cycle Negotiated financing
Commercial papers Net working capital
Conservative approach Overdraft
Credit control Spontaneous financing
Credit policy Trade credit
Credit terms Treasury bills
Current assets Working capital management
1. What are the main components of current assets and why are these
components also known as liquid assets?
2. How are the assets and liabilities of a company classified for the purpose of
capital management?
3. What is meant by hedging principle?

1. The following are the total loan by Zie-zam Company throughout the year.
Month Total (RM)

January 12,000
February 13,000
March 9,000
April 8,000
May 9,000
June 7,000
July 6,000
August 5,000
September 6,000
October 5,000
November 7,000
December 9,000
(a) Calculate the average total loans of Zie-zam Company; and

(b) Calculate the annual loan costs of the company at the interest rate of 15
per cent.
2. Z-tron Company has obtained a loan from the bank for RM10,000 for a period
of 90 days at the interest rate of 15 per cent payable on the maturity date of
the loan. Assume that there are 360 days in a year.
(a) How much is the total interest (in Malaysia Ringgit) that must be paid
by Z-tron Company for this loan?
(b) Calculate the effective cost for this loan.
3. Commercial papers are usually sold at a discounted rate. Fang Company has
just sold its commercial papers that had been issued for a period of 90 days
at the face value of RM1,000,000. The company receive as much as
RM978,000.
(a) What is the effective annual interest rate that must be paid to finance
the commercial papers?
(b) If the brokerÊs fee is RM9,612 and had been paid at the beginning of the
issuance of these commercial papers, how much is the annual effective
rate that must be paid by the company?

4. D-ban Company Berhad intends to get an advance from the factoring

account for RM100,000 and will mature within a period of 30 days. The factor
holds 10 per cent of the total account that will be factorised (reserves). There
is also a two per cent fee on factoring and a prepayment interest rate of 15
per cent per year.
(a) Calculate the maximum amount (in Malaysia Ringgit) of the interest
that must be paid.
(b) What is actual amount that will be obtained by the company?
(c) What is the annual cost factor (in percentage) for this transaction?
1. What is meant by cash conversion cycle?
2. Explain three components in the cash conversion cycle.
3. U-Tany CompanyÊs ventures in a teakwood furniture business. Its supplier,

Mr. Chong had been given a 20-day period to settle his payments for the
inventory ordered.
Sales RM 450,000
Average inventory RM 50,000
Account receivables RM 15,000
Based on the information above, calculate the:
(a) Inventory conversion period;
(b) Account receivable conversion period;
(c) Deferred payments period; and
(d) Cash conversion cycle period.
Assume that there are 360 days in a year.

1. State four criteria that are used in choosing marketable securities.
2. List three types of marketable securities that are found in Malaysia.
Give the definition for the following terms:
(a) Liquid assets;
(b) Cash; and
(c) Marketable securities.
1. What is meant by accounts receivable?
2. Provide two factors that influence the total account receivable.
1. Describe the components of credit policy.
2. Explain the meaning of credit term 3/15 net 40.
3. List five factors that are evaluated in the usage of the 5C system.
1. Biru Company offers the term of 3/10 net 30 to all the customers who
purchased its goods. Assume that 60 per cent of its customers took
the discount, while the rest paid on the 30th day. The annual sales
of Biru Company is RM500,000. Calculate the average accounts receivables
of Biru Company with the assumption that there are 360 days in a year.

2. Kiki Grocery Store ordered goods totalling RM3,000 every three months. The
credit term set by the supplier is 2/10 net 30. If the company took the
discount offered by the supplier, calculate the savings that can be obtained
in a year. Assume that there are 360 days in a year.
3. Mrs. Latifah bought supplies for her bakery for RM3,500 from Zarina
Supplier Company with the credit term of 2/15 net 30 on 15 June 2018. What
is the payment amount made by Mrs. Latifah if she paid for the supplies on
27 June 2018?
1. Explain the objectives of inventory management in general.
2. What is the use of the EOQ model?
3. Explain the assumptions that are made to enable the usage of the EOQ
model.
1. The following are the information obtained on Bertam Company:
Annual sales = 20,000 units

Purchase price per unit = RM1.50
Carrying cost = 15 per cent from the inventory value
Ordering cost = RM5
Lead time = Two weeks
Calculate:
(a) The economic order quantity for Bertam Company;
(b) The total inventory cost for Bertam Company at the EOQ level; and
(c) The reorder point for Bertam Company.

2. The following are the information obtained on Keat Company.
Annual sales = 100,000 units

Purchase price per unit = RM2.50
Economic order quantity (EOQ) = 35,000
Delivering period of inventory = 15 days
Carrying cost = 10 per cent of inventory value
Assume that there are 365 days in a year.
Based on the information given, determine the:
(a) Reorder point for inventory;
(b) Average inventory level; and
(c) Annual carrying cost.

320  ANSWERS
Answers
TOPIC 1: INTRODUCTION TO FINANCE
Self-Test 1
1. wealth; price
2. Maximising profit
3. D
4. D
Self-Test 2
1. taxed twice; dividends
2. withdraws; dies or becomes bankrupt
3. Dividend
4. A
5. B
Self-Test 3
1. C
2. D
3. B
4. Separation of ownership and management means that you cannot be

interacting with the manager whenever you want. However, you are the
co-owner of the company; you share the success or failure of the company
via dividends payment by the company and the price of the shares traded;
you can vote in the election of the members of the board of directors who
control and appoint the management.

ANSWERS  321
5. (a) Increasing the market share is not appropriate as a company objective

if it means lowering the price until it is detrimental to the company.
Increasing market share can be a part of the companyÊs management
strategy but it must be remembered, that market shares is not an
objective on its own. The owner of the company wants the management
to maximise the value of their investments.
(b) Minimising cost might also be against the objective of maximising the
value of the company. For example, assume that the company accepts
a large order for its product. The company must be willing to pay
wages for overtime and bear the additional costs to fulfil that order only
if it can sell the additional product at a price in excess of these costs.
(c) Lowering prices to compete with rivals may result in the company
selling the goods at a price lower than the price needed to maximise
shareholdersÊ wealth. Again, in certain situations, this strategy can be
accepted but it must not be regarded as the ultimate objective of the
company. It must be valued by taking into consideration its effect on
the value of the company.
(d) Increasing profit is not appropriate as a companyÊs objective. This

objective might be achieved in one year compared to the other years.
Which yearÊs profit should be maximised? Increasing investment in the
company can also increase profit, even though the increase in the profit
is not justifiable with the additional investment. In this situation, the
additional investment increases profit but reduces the shareholdersÊ
wealth.
6. (a) Fixed salary means that compensation (in the short term) does not
depend on the achievement of the company.
(b) Salary that is related to the profit of the company will bind the
managerÊs compensation with the success of the company. However,
profitability is not the appropriate method to measure a companyÊs
success. We had already discussed earlier that the objective to
maximise profit is only a short-term objective that does not look at the
long-term prospects of the company.
(c) Salary that is partially paid by company shares means that the manager
will obtain the highest returns when the shareholdersÊ wealth are
maximised. Therefore, this compensation will lead the manager to act
in accordance with the interest of the owners.

322  ANSWERS
TOPIC 2: ANALYSIS OF FINANCIAL STATEMENTS

Self-Test 1
1. (b) False
2. (b) False
3. (a) True
4. (b) False
5. C
6.
(1) (2)
Account
Statement Type of Account
Account payable BS CL
Account receivable BS CA
Accrual BS CL
Building BS FA
General expenses IS EX
Interest expenses IS EX
Sales expenses IS EX
Operating expenses IS EX
Administrative expenses IS EX
Tax IS EX
Preference sharesÊ dividends IS EX
Sales revenue IS R
Long-term loans BS LTL
Inventory BS CA
Cost of goods sold IS EX
Paid-up capital above par BS SE
Notes payable BS CL or LTL
Retained earnings BS SE
Equipment BS FA
Ordinary shares BS SE
Preference shares BS SE
Marketable securities BS CA
Depreciation IS EX
Accumulated depreciation BS FA (contra account)
Land BS FA
Cash BS CA

ANSWERS  323
7.
Company PC
Income Statement
RM5,250,000
Sales
Less: Cost of goods sold 2,850,000
Gross profit RM2,400,000
Less Operating expenditure
Sales expenses RM350,000
Administrative and general expenses 600,000
Depreciation expenses 550,000
Total operating costs RM1,500,000
Profit before interest and tax RM900,000
Interest expenses 250,000
Profit before tax RM650,000
Tax (30%) 195,000
Profit after tax RM455,000
Less: Preference sharesÊ dividend 100,000
Net profit (or profit available for ordinary
shareholders) RM355,000
Earnings per share RM 0.17

324  ANSWERS
8.
Company ODC
Balance Sheet
Assets
Current assets
Cash RM2,150,000
Marketable securities 750,000
Account receivable 4,500,000
Inventory 3,750,000
Total current assets RM11,150,000
Non-current Assets
Land RM2,000,000
Building RM2,250,000
Machines 4,200,000
Equipment 2,350,000
Total non-current assets RM10,800,000
Less: Accumulated depreciation 2,650,000
Non-current assets, net 8,150,000
TOTAL ASSETS RM19,300,000

Current liabilities RM2,200,000
Account payable 4,750,000
Notes payable 550,000
Accruals
Total current liabilities RM7,500,000
Total non-current liabilities 4,200,000
Total liabilities RM11,700,000
Equities
Preference shares RM1,000,000
Paid up capital 3,600,000
Retained earnings 2,100,000
Total equities RM7,600,000
TOTAL LIABILITIES AND EQUITIES RM19,300,00

ANSWERS  325
Self-Test 2
1. (b) False
2. (b) False
3. (a) True
4. (b) False
5. C
6. D
7. (a)
Hugo Enterprise
Statement of Retained Earnings
for the year ended 31 December 2017
Retained Earnings, 1 January 2017 RM92,800

+ Net Profit (throughout year 2017) 37,000
ă Dividends paid (throughout year 2017)
Preference shares RM4,700
Retained Earnings, 31 December 2017 RM104,100
RM37,700 ă RM4,700
(b) Earnings per share = = RM2.36
14,000
RM21,000
(c) Dividends per share = = RM1.50
14,000

326  ANSWERS
8. Dividends paid = RM736,000 + RM186,000 ă RM812,000

= RM110,000
9.
Changes
Items Cash Flow
(RM)
Cash +1,000 U
Account payable ă10,000 U
Notes payable +5,000 R
Non-current liabilities ă20,000 U
Inventory +20,000 U
Fixed assets +4,000 U
Account receivable ă7,000 R
Net profit +6,000 R
Depreciation +1,000 R
Share buyback +6,000 U
Cash dividend +8,000 U
Sale of share +10,000 R

ANSWERS  327
10.
Suresh Corporation
Changes in Balance Sheet Items
between 31 December 2017 and 31 December 2018
2017 2018 Changes Resource Usage
Assets
RM RM RM RM RM
Cash 15,000 10,000 +5,000 5,000
Marketable securities 18,000 12,000 +6,000 6,000
Account receivable 20,000 18,000 +2,000 2,000
Inventory 29,000 28,000 +1,000 1,000
Total non-current assets 295,000 281,000 +14,000 14,000
Less: Accumulated depreciation 147,000 131,000 (16,000) 16,000
Liabilities
Account payable 16,000 15,000 +1,000 1,000
Notes payable 28,000 22,000 +6,000 6,000
Wages accrual 2,000 3,000 ă1,000
Non-current liabilities 50,000 50,000 0
Equities
Preference shares 100,000 100,000 0
Retained earnings 34,000 28,000 +6,000 6,000 1,000
TOTAL RM29,000 RM29,000

328  ANSWERS
Suresh Corporation
Cash Flow Statement
RM RM
Net Profit 14,000
Depreciation 16,000
Increase in account receivable (2,000)
Increase in inventory (1,000)
Increase in account payable 1,000
Decrease in accrual (1,000)
Cash flow from operating activities RM27,000
Cash Flow from Investing Activities (14,000)

Increase in total non-current assets
Cash flow from investing activities
Cash Flow from Financing Activities 6,000

Decrease in short-term notes payable (8,000)
Dividends paid
Cash flow from financing activities (2,000)
Net increase in cash and marketable securities RM11,000
Self-Test 3
1. Fazrul Company
2017 2016
(a) Net working capital RM180,000 RM150,000
(b) Current ratio 2.5 times 2.07 times
(c) Quick ratio 1.17 times 1 time

ANSWERS  329
Self-Test 4
Fazrul Company
2017 2016
(a) Account receivable turnover 9.14 times 9.03 times
(b) Average collection period 39.9 days 40.4 days
(c) Inventory turnover 2.54 times 2.57 times
(d) Average inventory sales period 144.27 days 142.02 days
= 144 days = 142 days
(e) Non-current asset turnover 2.13 times 2.15 times
(f) Total asset turnover 1.07 times 1.02 times
Self-Test 5
(a) Debt ratio = 50%
(b) Interest coverage ratio = 3 times
(c) Return on asset = 36%
(d) Average collection period = 27 days
(e) Total asset turnover = 2 times
Self-Test 6
1. Liquidity
2. current asset; current liability
3. Inventory
4. cost of goods sold; inventory
5. total asset
6. net profit; ownersÊ equity
7. share price; earnings

330  ANSWERS
8.
X-Cell N-Hance
(a) Return on assets 12.67% 11.25%
(b) Return on equity 31.67% 28.13%
(c) Net profit margin 10.27% 9.57%
(d) Total asset turnover 1.23 times 1.18 times
(e) Debt ratio 60% 60%
(f) Equity multiplier 2.5 times 2.5 times
(g) Interest coverage ratio 7.89 times 8.37 times
(h) Price earnings ratio 6.25 12.62
(i) Dividend yield ratio 6.86% 1.89%
Self-Test 7
1. (a) True
2. (b) False
3. D
4. C
5. Net profit = RM6,000
6. Return on equity = 4.0%
7. Fuma Corporation
(a) Current ratio increased.
(b) Return on equity decreased.
(c) Debt ratio increased.
(d) Dividend yield increased.
(e) Account receivables turnover decreased.
(f) Return on asset decreased.

ANSWERS  331
8. Lily Corporation
(a) Current ratio = 0.91 times
(b) Quick ratio = 0.63 times
(c) Average collection period = 32.5 days
(d) Inventory turnover = 20 times
(e) Non-current asset turnover = 4.60 times
(f) Total asset turnover = 2.8 times
(g) Debt ratio = 55%
(h) Interest coverage ratio = 4.0 times
(i) Gross profit margin = 13%
(j) Operating profit margin = 2%
(k) Net profit margin = 1.08%
(l) Return on asset = 3%
(m) Return on equity = 6.7%
9. Amri Company
Marketable securities = RM16,000
Account receivable = RM62,000
Inventory = RM73,560
Total non-current asset = RM146,663
Net non-current asset = RM96,663
Total asset = RM256,228
Notes payable = RM20,300
Total current liabilities = RM67,900
Long-term liabilities = RM58,677
Total liabilities = RM126,577
Total equity = RM129,651
Total liabilities and equity = RM256,228

332  ANSWERS
TOPIC 3: TIME VALUE OF MONEY

Self-Test 1
1. RM127.63
2. RM6,050
Self-Test 2
(a) RM11,171.10
(b) RM4,974.55
Self-Test 3
1. RM1,000
2. RM2,268.43
Self-Test 4
(a) RM100.06
(b) RM3,522.77
Self-Test 5
(a) RM330.96
(b) RM61,050
Self-Test 6
RM272.30
Self-Test 7
RM1,000

ANSWERS  333
Self-Test 8
1. RM346.06
2. RM149.40
3. FVOA = RM3,000 (FVIFA8%,15)

= RM3,000 (27.1521)
= RM81,456.30
FVAD = RM3,000 (FVIFA8%,15) (1.08)

= RM3,000 (29.32)
= RM87,960.00
The difference: RM6,516.50
4. PV1 = RM4,000 (PVIF18%,1) = RM3,390.00

PV2 = RM5,000 (PVIF18%,2) = RM3,591.00
PV3 = RM5,000 (PVIF18%,3) = RM3,043.00
PV4 = RM6,000 (PVIF18%,4) = RM3,094.80
PV5 = RM8,000 (PVIF18%,5) = RM3,496.80
Total PV = RM16,615.60
RM16,615.60 ă RM30,000 = ăRM13,384.40
Therefore, Mas Joko Company should not continue with its investment.
5. (a) RM180/5% = RM3,600
(b) RM180/10% = RM1,800
6. PVOA = RM12,000 (PVIFA6%,10)

= RM12,000 (7.3601)
= RM88,321.20
The second choice should be chosen (RM88,321.20) as the present value is

more compared to the first choice (RM60,000).

334  ANSWERS
7. PMTA = PVA/(PVIFA10%,4)
= RM6,000/3.170
= RM1,892.74
8. PV = RM400 (0.513)
= RM205.20
TOPIC 4: VALUATION OF SECURITIES

Self-Test 1
1. Assists in making investment/financing decisions
2. (a) Amount and timing of future cash flow
(b) Cash flow risk
(c) Attitude of investors towards risks
Self-Test 2
1. Vb = 80 (PVIFA13%,12) + 1000 (PVIF13%,12)
= 80 (5.918) + 1000 (0.231)
= 473.44 + 231
= RM704.44
2. Vb = 60 (PVIFA5%,16) + 1000 (PVIF5%, 16)

= 60 (10.838) + 1000 (0.458)
= 650.28 + 458
= RM1108.28
3. The value of bond will be higher as the time period (t) for the payment is
shorter and the present value of the bond will increase. Therefore, the value
of the bond will also increase.

ANSWERS  335
Self-Test 3
Trial-and-error method = 16.96% @ 17%
Estimation method = 16.01%
Self-Test 4
1. B
2. B
3. A
4. B
5. C
6. Vb = 80 (PVIFA12%,11) + 1000 (PVIF12%,11)

= 80 (5.9377) + 1000 (0.2875)
= 475.02 + 287.50
= RM762.52
7. Vb = 40 (PVIFA3%,20) + 1000 (PVIF3%,20)

= 40 (14.8775) + 1000 (0.5537)
= 595.1 + 553.70
= RM1148.8
8. Vb = 25 (PVIFA3%,30) + 1000 (PVIF3%,30)

= 25 (19.5004) + 1000 (0.4120)
= 487.51 + 412
= RM899.51
9. RM950 = 90 (PVIFA9%,2) + 1000 (PVIF9%,2)

= 90 (1.759) + 1000 (0.842)
= 158.31 + 842
= RM1000.31

336  ANSWERS
10. (a) Vb = 100 (PVIFA13%,3) + 1000 (PVIF13%,3)

= 100 (2.361) + 1000 (0.693)
= 236.10 + 693
= RM929.10
(b) YTM = 11%
11. The rate of discount that equalises the present value for all interest and
capital payment for the bonds with the present value of the bond.
12. Short-term bond.
Self-Test 5
1. (a) Dividends, and
(b) Capital gains.
0.18
2. VCS =
0.11  0.05
= RM3.00
Yes, the shares will be sold as the actual value of these shares is lower than
the market price and it will be profitable.
3. D1 = 0.50 (1 + 0.15) = 0.575

D2 = 0.575 (1 + 0.15) = 0.661
D3 = 0.661 (1 + 0.15) = 0.760
D4 = 0.760 (1 + 0.04) = 0.790
0.79
P3 =  9.875
0.12  0.04
Vcs = 0.575(PVIF12%,1) + 0.661(PVIF12%,2) + 0.760(PVIF12%,3) + 9.875(PVIF12%,3)

= 0.51 + 0.53 + 0.54 + 7.12
= RM8.70

ANSWERS  337
4. The rate of return is the return, calculated as a percentage of investment that

is expected to be received by investors. For ordinary shares, it is the rate of
dividend yield added with the rate of yield from capital gains.
0.25
5. (a) Kcs = + 0.105
2.30
= 0.2137
= 21.37%
(b) Yes. As the expected return (21.36%) is higher than 17%, therefore the
shares should be bought.
Self-Test 6
1. A
2. A
3. A
4. B
5. B
6. Because it has similarities with the characteristics of ordinary shares and

bonds.
0.16
7. VPS = = RM1.33
0.12
0.35
8. (a) K ps =  9.09%
3.85
(b) Sell as the expected rate of return is lower than the required rate of
return.
D
9. VCS =
K cs ă g
1.32
=
0.11  0.07
= RM33

338  ANSWERS
10. D1 = D0 (1 + g)
= 1.15 (1 + 0.15)
= 1.32
D2 = 1.32 (1 + 0.15)
= 1.52
D3 = 1.52 (1 + 0.13)
= 1.72
D4 = 1.72 (1 + 0.06)
= 1.82
1.82
P3 =
0.12  0.06
= RM30.33
VCS = 1.32(PVIF12%,1) + 1.52(PVIF12%,2) + 1.72(PVIF12%,3) + 30.33(PVIF12%,3)

= 1.32 (0.893) + 1.52 (0.797) + 1.72 (0.712) + 30.33 (0.712)
= 1.18 + 1.21 + 1.22 + 21.59
= RM25.20
D
11. KCS = +g
P0
0.25
= + 0.07
4.05
= 0.1317
= 13.17%

ANSWERS  339
12. D1 = 0.44 (1 + 0.25)

= 0.55
D2 = 0.55 (1 + 0.25)
= 0.688
D3 = 0.688 (1 + 0.25)
= 0.86
D4 = 0.859 (1 + 0.1)
= 0.945
0.945
P4 =
0.15  0.10
= RM18.90
Vcs = 0.55(PVIF15%,1) + 0.688(PVIF15%,2) + 0.859(PVIF15%,3) +

18.9(PVIF15%,3)
= 0.55 (0.870) + 0.688 (0.756) + 0.859 (0.658) + 18.9 (0.658)
= 0.478 + 0.520 + 0.565 + 12.44
= RM14.00
RM1
13. VPS =
0.12
= RM8.33
RM0.15
14. kPS =
RM5
= 3%

340  ANSWERS
TOPIC 5: RISK ANALYSIS

Self-Test 1
(a) Value of expected return = 24%
(b) Standard deviation of return = 11.47%
(c) Variance multiplier of return = 0.48; There is a 0.48% risk for each 1% return)
Self-Test 2
(a) Value of expected return for:
Share x = 10%
Share y = 10.32%
Share z = 10.12%
(b) Expected return for investment portfolio = 10.14%
(c) Standard deviation for investment portfolio = 3.95%
Self-Test 3
1. (a) Shares of Company A Shares of Company B

ANSWERS  341
(b) Range of A return = 30% ă 5% = 25%

Range of B return = 35% ă 15% = 20%
(c) Shares A are riskier as they have a bigger range of return and show a
flatter probability distribution.
2. (a) Expected return for shares X = 10.8%; shares Y = 9%

(b) Expected return for portfolio = 9.9%
(c) Standard deviation for portfolio = 0.73%
3. The risks for portfolio shares K and L will reduce.
4. (a) Required rate of return = 13%

(b) 12% > 13%; therefore Jacob Company should not invest in this project.
(c) The required rate of return = 27%
5. The share has a lower level of risk than the average securities risk in the
capital market.
6. (a) Average expected return of portfolio AB = 14%

Average expected return of portfolio AC = 14%
(b) Standard deviation of portfolio AB = 0%

Standard deviation of portfolio AC = 2%
(c) Portfolio AB should be chosen
7. (a) Required rate of return = 18.4%
(b) Premium value of market risks = 8%
8. (a) E(rv) = (0.1)(0) + (0.2)(6) + (0.3)(7) + (0.4)(5)

= 0 + 1.2 + 2.1 + 2.0 =5.3%
Expected return of share V = 5.3%
E(rw) = (0.1)(3) + (0.2)(4) + (0.3)(5) + (0.4)(6)

= 0.3 + 0.8 + 1.5 + 2.4 = 5%
Expected return of share W = 5%

342  ANSWERS
(b) 2v = (0.1)(0 ă 5.3)2 + (0.2)(6 ă 5.3)2 + (0.3)(7 ă 5.3)2 + (0.4)(5 ă 5.3)2
= 2.809 + 0.098 + 0.867 + 0.036 = 3.81
Variance of share V = 3.81
2w= (0.1)(3 ă 5)2 + (0.2)(4 ă 5)2 + (0.3)(5 ă 5)2 + (0.4)(6 ă 5)2

= 0.4 + 0.2 + 0 + 0.4 = 1
Variance of share W = 1
(c) v = “3.81 = 1.95%
Standard deviation of share V = 1.95%
w = √1 = 1%
Standard deviation of share W = 1%
(d) covvw = (0 ă 5.3)(3 ă 5)(0.1) + (6 ă 5.3)(4 ă 5)(0.2) + (7 ă 5.3)(5 ă 5)(0.3)

+ (5 ă 5.3)(6 ă 5)(0.4)
= 1.06 ă 0.14 + 0 ă 0.12
= 0.8
Covariance between the return of shares V and W = 1.04
(e) ρAZ = 0.8/(1.95  1) = 0.8/1.95 = 0.410
Correlation between the return of shares V and W = 1.09
9. (a)
Alternative I Alternative II
Expected return of portfolio 8.8% 11%
Beta portfolio 0.5 0.7
Risk reward ratio 5.6% 7.14%
(b) Therefore, alternative II should be chosen

ANSWERS  343
10. Required return for shares A = 19.4%

Required return for shares B = 14.6%
20% > 19.4% = underpriced
13% < 14.6% = overpriced
TOPIC 6: CRITERIA OF CAPITAL BUDGETING

Self-Test 1
1. The cash flow for project A is stated in the following table:

0 ă250,000
1 0 0
2 100,000 100,000
3 100,000 200,000
4 150,000 350,000
Project A should be rejected as the cumulative cash inflow at the end of the
third year, which is at the targeted payback period is less than the initial cash
outflow showing that this projectÊs PBP is more than three years.
For project B, we can immediately calculate the PBP as follows:
PBP = RM400,000/RM125,000
= 3.2 years
Project B should also be rejected as its PBP is more than three years, which is
the targeted PBP.

344  ANSWERS
2. The cumulative cash flow for this project at the end of the fifth year is
RM500,000. To regain the capital of another RM500,000, the time period that
will be taken is calculated as follows:
RM500,000/RM200,000 = 2.5 years
Therefore, the project PBP is calculated as follows:
PBP = 5 years + 2.5 years

= 7.5 years
Self-Test 2
1. B
2. D
Self-Test 3
1. The NPV for project A is calculated as follows:
NPVA = 4,000 PVIFA10%,10 ă 26,000

= 4,000 (6.1446) ă 26,000
= 24,578 ă 26,000
= ăRM1,421.60
Investment A should not be made as the NPV < 0.
The NPV for project B is calculated as follows:
NPVB = 100,000 PVIF10%,1 + 120,000 PVIF10%,2 + 140,000 PVIF10%,3 +

160,000 PVIF10%,4 + 180,000 PVIF10%,5 + 200,000 PVIF10%,6 ă 500,000
= 100,000 (0.909) + 120,000 (0.8264) + 140,000 (0.7513) +
160,000 (0.683) + 180,000 (0.6209) + 200,000 (0.5645) ă 500,000
= 629,192 ă 500,000
= RM129,192
Investment B should be made as the NPV > 0.

ANSWERS  345
The NPV for project C is calculated as follows:
NPVc = 30,000 PVIF10%,4 + 40,000 PVIF10%,5 + 60,000 PVIF10%,7 +

70,000 PVIF10%,8 ă 100,000
= 30,000 (0.6830) + 40,000 (0.6209) + 60,000 (0.5132) +
70,000 (0.4665) ă 100,000
= 108,773 ă 100,000
= RM8,773
Investment C should be made as the NPV > 0
2. The NPV for this project can be obtained as follows:
20,000 PVIF10%,5 + 400,000 PVIF10%,5 ă 300,000

= 20,000 (3.7908) + 400,000 (0.6209) ă 300,000
= 324,176 ă 300,000
= RM 24,176
3. When the cost of capital increases, the NPV for the project will decrease.
Self-Test 4
PIA = 24,578/26,000
= 0.945
PIB = 629,192/500,000
= 1.258
PIC = 108,773/100,000
= 1.088

346  ANSWERS
Self-Test 5
1. C
2. B
3. C
4. C
Self-Test 6
1. D
2. (a) PBP = RM10,000/RM 16,650

= 0.6 years
(b) NPV = (RM16,650/0.893) ă RM10,000

= RM18,645.02 ă RM10,000
= RM8,645.02
(c) PI = (RM16,650/0.893)/RM10,000
= RM18,450.02/RM10,000
= 1.86
(d) RM16,650/(1 + IRR) ă RM10,000 = 0
Therefore,
10,000 (1 + IRR) = 16,650
IRR = (16,650/10,000) ă 1
= 1.67 ă 1
= 0.67
= 67%

ANSWERS  347
3. (a) PBP = RM10,000/RM2,146

= 4.7 years
(b) NPV = RM2,146 (PVIFA12%,10) ă RM10,000

= RM2,146 (5.65) ă RM10,000
= RM12,124.9 ă RM10,000
= RM2,124.90
(c) PI = RM2,146 (PVIFA12%,10)/RM10,000

= RM12,124.9/RM10,000
= 1.21
(d) RM2,146 (PVIFAIRR,10) ă RM10,000 = 0
Therefore,
RM2,146 (PVIFAIRR,10) = RM10,000

(PVIFAIRR,10) = 10,000/2,146
(PVIFAIRR,10) = 4.66
From the PVIFA table, we found that the IRR is 17%.
4. (a) It is clear that PBP is between two and three years because the
cumulative cash inflow in the second year is RM8,000, while the
cumulative cash inflow for the third year is RM15,500.
PBP = 2 + (RM2,000/RM7,500)
= 2.27 years
(b) NPV = 3,000 (PVIF12%,1) + 5,000 (PVIF12%,2) + 7,500 (PVIF12%,3) ă 10,000

= 3,000 (0.893) + 5,000 (0.797) + 7,500 (0.712) ă 10,000
= RM12,004 ă RM 10,000
= RM2,004
(c) PI = RM12,004/RM10,000
= 1.2004

348  ANSWERS
(d) RM3,000 (PVIFIRR,1) + RM5,000 (PVIFIRR,2) + RM7,500 (PVIFIRR,3) ă

RM10,000 = 0
We use the trial-and-error method to get the IRR.
In question 3(b), when we use the discount rate of 12%, the NPV is
RM2,004. This means that the IRR is higher than 12%.
Assuming we use the discount rate of 20%.
NPV = RM3,000(PVIF 20%,1) +RM5,000(PVIF20%,2) +

RM7,500 (PVIF20%,3) ă RM10,000
= RM3,000 (0.833) + RM5,000 (0.694) +
RM7,500 (0.579) ă RM10,000
= RM10,311.50 ă RM10,000
= RM311.50
The NPV is still positive.
Try to change the calculation of the NPV by using a higher discount

rate, say at 24%:
NPV = RM3,000(PVIF 24%,1) +RM5,000(PVIF24%,2) +

RM7,500 (PVIF24%,3) ă RM10,000
= RM3,000 (0.806) + RM5,000 (0.650) + RM7,500 (0.514) ă
RM10,000
= RM9,523 ă RM10,000
= ăRM477
The NPV is negative.
It is clear that the IRR is between 20% and 24%.
Using the interpolation linear,
 311.50 
IRR  20%    (24%  20%)
 311.50  402.00 
 21.75%

ANSWERS  349
5. (a) PBP for Mergong is:
PBP M = RM160 million/RM40 million

= 4 years
PBP for Sik is more than 4 years because the cumulative cash inflow at
the end of year 4 is RM130 million less than the initial investment.
Based on the PBP technique, the Mergong project will be accepted

while the Sik project is rejected.
(b) NPVM = RM40 million (PVIFA10%,6) ă RM160 million

= RM40 million (4.355) ă RM160 million
= RM174.2 million ă RM160 million
= RM14.2 million
NPVS = RM30 million (PVIF10%,1) + RM35 million (PVIF10%,2) +

RM35 million (PVIF10%,3) + RM30 million
(PVIF10%,4) + RM40 million (PVIF10%,5) + RM50
million (PVIF10%,6) ă RM160 million
= RM30 million (0.909) + RM35 million (0.826) + RM35
million (0.751) + RM30 million (0.683) + RM40 million
(0.621) + RM51 million (0.564) ă RM160 million
= RM156.56 million ă RM160 million
= ăRM3.44 million
Based on the NPV technique, the Mergong project will be accepted

because its NPV is positive while the Sik project will be rejected because
its NPV is negative.

350  ANSWERS
(c) PIM = RM40 million PVIFA10%,6/RM160 million

= RM174.2 million/RM160 million
= 1.09
PIS = [RM30 million PVIF10%,1 + RM35 million PVIF10%,2 +

RM35 million PVIF10%,3 + RM30 million PVIF10%,4 +
RM90 million PVIF10%,5]/RM160 million
= RM158.85 million/RM160 million
= 0.99
Based on the PI technique, the Mergong project will be accepted because its
PI is more than 1 while the Sik project will be rejected because its PI is less than
1.
6. (a) PBP:
Advantages: It is easy to calculate and there is no need to estimate
the cash flow after the targeted PBP.
Disadvantages: It does not take into account the time value of
money.
(b) NPV:
Advantages: Its measurement is in accordance with the ownerÊs
wealth.
Disadvantages: Its calculation is more complex as the entire cash
flow and cost of capital must to be estimated.
(c) IRR:
Advantages: It takes into account the concept of time value of
money.
Disadvantages: Its calculation is more complicated than NPV and
there is a possible problem on multiple IRR.

ANSWERS  351
TOPIC 7: CASH FLOW OF CAPITAL BUDGETING

Self-Test 1
Initial outlay:
Price of new machine: RM35,000
Delivery and installation cost: RM6,000
Change in net working capital: RM5,000
Sales revenue after tax of old machine*: (RM14,900)
IO: RM31,100
*Selling price ă Increase in tax

= RM17,000 ă 0.3 (Price ă Book value)
= RM17,000 ă 0.3 (RM17,000 ă RM10,000)
= RM17,000 ă RM2,100
= RM14,900
Self-Test 2
The additional annual cash flow after tax = (Sm ă ’Em ă ’Dm ) (1 ă t) +Dm
Sm = 0
Em:
Decrease in wages ă RM9,000

Decrease in employeesÊ benefit ă RM1,000
Decrease in defect cost ă RM5,000
Increase in maintenance cost ă RM4,000
E m ă RM11,000

352  ANSWERS
Dm:
Depreciation of new machine ă RM8,200

(RM35,000 + RM3,000 + RM3,000)/5 years
Depreciation of old machine ă RM2,000
T = 30%
Therefore,
The additional annual cash flow after tax

= [0 ă (ă RM11,000) ă RM6,200] (1 ă 0.3) + RM6,200
= RM9,560
Self-Test 3
1. NPV190-4 = RM87,000 (PVIFA14%,4) ă RM190,000
= RM87,000 (2.91) ă RM190,000
= RM253,170 ă RM190,000
= RM63,170
NPV360-6 = RM120,000 (PVFA14%,6) ă RM360,000

= RM120,000 (3.89) ă RM360,000
= RM466,800 ă RM360,000
= RM106,800
The model that should be chosen is Model 360-6 because its NPV is higher
than the NPV for Model 190-4. However, you will learn that the analysis
based on NPV is not accurate in this case because the comparison made
involved assets with different lifetime. The equivalent annual annuity (EAA)
technique will be recommended in cases such as this.

ANSWERS  353
2. (a) (i) Book value of old machine:

= Annual depreciation  Balance of lifetime
= (RM100,000/5 years)  3 years
= RM60,000
(ii) Tax from sale of old assets:

= Tax rate Capital gain
= 0.4 (Selling price ă Book value)
= 0.4 (RM85,000 ă RM60,000)
= RM10,000
(iii) Initial outlay (IO):

Cost of new machine RM135,000
Installation cost RM5,000
Selling price of old assets (RM85,000)
Effect of tax from sale of old assets RM10,000
IO RM65,000
(iv) Net operating cash flow

= (Sm ă Em ă Dm) (1 ă t) +’Dm
Sm = RM54,000 ă RM18,000

= RM36,000
E m :
Decrease in wages ă RM1,200

Increase in maintenance cost RM4,000
Em ă RM3,000
Dm
Depreciation of new machine
[(RM 135,000 + RM 5,000)/3 years] RM46,667
Depreciation of old machine ă RM20,000
[RM 100,000/5 years]
Dm RM26,667
t = 40%

354  ANSWERS
Therefore,
OCF = [RM36,000 ă (ăRM3,000) ă RM26,667] (1 ă 0.4) + RM26,667

= RM34,067
(v) NPV = RM34,067 (PVIFA10%,5) ă RM65,000

= RM84,827 ă RM65,000
= RM19,827
(b) Yes, the company should replace the old machine with the new
machine because the NPV of this replacement is positive.
3. The initial cash outlay:
Cost of new machine RM8,000

Delivery cost RM2,000
Sales revenue after tax of old assets RM1,660
[RM2,000 ă increase in tax]
[RM2,000 ă 0.34 (RM2,000 ă RM1,000)]
Change to net working capital ă RM500
[ă RM1,000 + RM500]
IO RM11,160
4. To make a decision on whether to replace the old metre with the new metre,
we need to calculate the NPV for this replacement project. The steps that
need to be taken are as follows:
(i) Calculate the IO, OCF and TCF
Price of new metre RM4,000

Sale revenue of old metre ă RM500
IO RM3,500
Operating cash flow (OCF) = (’Sm ă Em ă Dm ) (1ă t) + Dm

ANSWERS  355
However when no tax is imposed, students should observe that Dm is

not relevant for calculation of OCF as its relevancy in the analysis of
capital budget is only from the aspect of tax savings. This is proven
when t is replaced by the value 0:
OCF = (Sm ă Em ă Dm) + ’Dm

= ’Sm ă Em
Sm = 0
E m = RM 140 ă RM500 = ăRM360
OCF1-10 = 0 ă (ăRM360)
= RM360
TCF = 0
(ii) Calculate the NPV at the cost of capital, which is 12%
NPV = RM360 (PVIFA12%,10) ă RM3,500

= RM360 (5.65) ă RM3,500
= ăRM1,466
As the NPV value is negative, the decision that should be made is to

not make the said replacement.
5. This statement is false because although the depreciation in itself is not cash
but as a tax deductible expense, it affects the tax for the capital budget project.
Tax is a cash flow item.

356  ANSWERS
TOPIC 8: COST OF CAPITAL

Self-Test 1
RM 840.68 = 55 (PVIFA7%,20) + 1000 (PVIF7%,20)
= 55 (10.594) + 1000 (0.258)
= RM840.67
k=72 = 14%
Cost of debt = 14% (1 ă 0.25) = 10.5%
Self-Test 2
RM0.35
Cost of preference shares = = 18.42%
RM1.90
Self-Test 3
0.18
K  0.09  0.126
1. (a) 5
 12.6%
0.18
K  0.09  0.13
(b) 4.50
 13%

ANSWERS  357
2. The capital equity can be increased either by retained earnings in the

company or by issuing new ordinary shares. Both are funds that are invested
by ordinary shareholders.
3. Opportunity cost.
4. Dividend growth model and capital asset pricing model (CAPM).
Self-Test 4
1. (d)
2. (f)
3. (e)
4. (b)
5. (a)
6. (c)
2. (a) Debt:
980 ă 20 = 90 (PVIFA 10%,20) + 1000 (PVIF 10%,20)

960 = 90 (8.5136) + 1000 (0.1486)
= 914.8
Interpolation:
980  960
= 9
980  914.8
= 9 + 0.307
= 9.307%

358  ANSWERS
Preference shares:
RM 8
Kp =  3%
RM 65
= 9.31%
Ordinary shares:
5.07
Ks =  0.08
40  1
= 21%
(b) WACC = 9.307 (1 ă 0.4) (0.35) + 12.69 (0.1) + 21 (0.55)

= 1.95 + 1.27 + 11.55
= 14.77%
3. WACC = 9.37% (1 ă 0.34) (0.4) + 10% (0.2) + 13% (0.4)

= 9.67%
4. Interest is a tax deduction item. Therefore, the cost of debt becomes lower
because it takes into account the taxes.
5. The flotation cost will cause the cost of capital for each capital component
that is issued to become higher.
TOPIC 9: FINANCIAL PLANNING

Self-Test 1
1. The time period that is suitable for preparing the cash budget is three months
or six months.
2. Cash budget for Zitroe Company.

ANSWERS  359
Forecasted Cash Received Schedule

(a)

360  ANSWERS
Forecasted Monthly Cash Payment Schedule

(b)

ANSWERS  361
Cash Budget, 1 January ă 30 June 2018

(c)

362  ANSWERS
Self-Test 2
1. Pro forma financial income statement is used by the finance manager and
the creditors to make initial evaluation on the level of the companyÊs overall
profitability and achievements.
2. Four sections that are found in the cash budget:
(a) Section I consists of all cash received and cash inflow;
(b) Section II consists of all cash outflow or cash withdrawal;
(c) Section III is the change in net cash that is obtained from the
comparison of cash outflow and cash inflow; and
(d) Section IV provides information on cash surplus or the required

financing to support cash deficit. This amount is determined by the
change in net cash and the targeted cash balance by the management.
3. Pro forma Income Statement
Tulip Company
Pro forma Income Statement
For the Year Ended 31 December 2018
Sales RM10,000,000
Cost of goods sold 6,000,000
Gross profit RM4,000,000
Depreciation expenses 1,680,000
Administration and sale expenses 1,200,000
Operating profit (EBIT)
Interest expenses RM1,120,000
Tax (34%) RM1,000,000
Net income 340,000
Less Dividend RM660,000
Increase in retained earnings 330,000
RM330,000

ANSWERS  363
TOPIC 10: WORKING CAPITAL MANAGEMENT

Self-Test 1
1. The main components of current assets include cash, marketable securities,
account receivable and inventory. These assets are liquid assets as they are
easily converted into cash in a short period of time without any obvious loss
of value.
2. For working capital management, assets are divided into permanent assets
and temporary assets. While liabilities are categorised into permanent
financing, temporary financing and spontaneous financing. This
classification is suitable to apply the principle of interest protection in the
working capital management.
3. The principle of interest protection matches the cash flow generation aspect
of an asset with the maturity period of the financing source that was used to
obtain the asset.
Self-Test 2
1. (a) Average loans = [(RM12,000 + RM13,000 + RM9,000 + RM8,000 +
RM9,000 + RM7,000 + RM6,000 + RM5,000 +
RM6,000 + RM5,000 + RM7,000 + RM9,000)/12)]
= RM96,000/12 = RM8,000
(b) Annual cost of loans = RM8,000 0.15 = RM1,200
2. (a) Interest = (RM10,000 0.15) (90/360) = RM375
(b) Effective cost for 90 days = RM375/RM10,000 = 3.75%
3. (a) Annual effective interest rate = [(RM1,000,000 ă RM978,000)/

RM978,000 (360/90)]
= 9.0%
(b) Annual effective interest rate = [(RM1,000,000 ă RM978,000 +

RM9,612)/(RM978,000 ă
RM9,612)) (360/90)]
= 0.0512

364  ANSWERS
4. (a)
Account book value RM100,000
Less; Reserves (10% RM100,000) 10,000
Less: Fees (2%  RM100,000) 2,000
Total available for advance RM88,000
Interest on advance = (0.16/12 88,000)

= RM1173.33
(b) Revenue from advance = RM1173.33

Annual effective cost = (RM1,173/RM86,827)  12 = 16.21%
(c) Annual effective = [(Interest + Factoring cost) + Revenue]  12

factoring cost (RM1,173 + RM2,000)/RM86,827]  12
= 43.85%
Self-Test 3
1. The cash conversion cycle refers to the time period taken from the time
payment is made on the purchase of raw materials to the time cash is
received from the sales made.
2. The three components in the cash conversion cycle are:
(a) The cash conversion period is the time period taken to convert raw
materials into finished goods which will be sold;
(b) The account receivable collection period refers to the average time
period taken to convert account receivable into cash; and
(c) Deferred payment period refers to the average time taken beginning
from the purchase of raw materials and labour until the payment of
cash is made on the purchase of raw materials and labour.
3. (a) Inventory conversion period
RM50,000

RM450,000/360
 40 days

ANSWERS  365
(b) Account receivable conversion period

RM15,000
=
RM450,000/360
= 12 days
(c) Deferred payment period

= 20 days
(d) Cash conversion cycle period

= 40 + 12 ă 20
= 32 days
Self-Test 4
1. Four criteria that are taken into account in choosing marketable securities
are:
(a) Default risk;
(b) Marketability or liquidity risk;
(c) Tax; and
(d) Returns.
2. Three types of marketable securities found in Malaysia
(a) Treasury bills;
(b) Negotiable certificate of deposit; and
(c) Investment certificate by government of Malaysia.
Self-Test 5
1. (a) Liquid Assets
Assets that can be converted into cash in a short period of time (less
than a year). For example, cash and marketable securities.
(b) Cash
Banknotes and coins that are owned by a company in its petty cash,
cash register or in its bank accounts.

366  ANSWERS
(c) Marketable Securities

The short-term investments (less than one year period) which are
conducted in the money market that can be immediately converted into
cash.
Self-Test 6
1. Account receivable is the account that is formed when sales are made on
credit where it is a promise from the customer to make payment on the
purchase within an agreed time period.
2. The two factors that influence the total of account receivable are:
(a) The credit sales level of a company; and
(b) Average collection time.
Self-Test 7
1. The three components of credit policy:
(a) Credit terms;
(b) Credit standards; and
(c) Collection policies.
2. Credit term 3/15 net 40 means that the customer who pays within the first
15 days are eligible to get a discount of three per cent, while customers who
do not take this discount will have a period of 40 days to make payment.
3. The five factors that are evaluated in the usage of the 5C system:
(a) Character;
(b) Capacity;
(c) Capital;
(d) Collateral; and
(e) Conditions.

ANSWERS  367
Self-Test 8
1. Average account receivables for Biru Company
= Average collection period Daily sales
= {(0.6) (10) + (0.4) (30)} (RM500,000/360)
= 18 days RM 1,389
= RM25,002
2. Savings obtained in a year:

= (RM3,000) (0.02) (Four orders per year)
= RM240
3. Amount that needs to be paid on 27 June 2011

= RM3,500 ă (0.02) (RM3,500)
= RM3,430
Self-Test 9
1. Generally, inventory management is for the purpose of preparing sufficient
inventory for the operations of the company and to control the costs related
to inventory to be at the minimum level.
2. The EOQ model is a method that is used to determine the order quantity that
is optimal for a company. This level is also the level where the inventory cost
is at the minimum level.
3. Assumptions that are made to enable the usage of the EOQ model:
(a) Sales are constant throughout the year;
(b) Sales can be forecasted accurately;
(c) Orders made will be received on schedule; and
(d) Carrying cost and receiving cost are constant.

368  ANSWERS
Self-Test 10
1. (a) Economic Order Quantity for Bertam Company
S = 20,000 units
C = 0.15
P = RM1.50
O = RM5
(2) (5) (20,000)

EOQ =
0.15 (1.50)
= 942.809 ~ 943
(b) Total inventory cost for Bertam Company at the EOQ level
Total inventory cost = Total carrying cost and Total ordering cost
= (C) (P) (Q/2) + (O) (S/Q)
= (0.15) (RM1.50) (943/2) +
(RM5) (20,000/943)
= 106.088 + 106.045
= 212.133
(c) The reorder point for Bertam Company

20,000/52 weeks = 384.615 or 385 (Sales per week)
If the orders take 2 weeks to be received, the company needs

770 (385 2) units of inventory for the period of 2 weeks.

ANSWERS  369
2. (a) Inventory reorder point
Sales/365 15 days = (100,000/365 15 days)

= 4109.6 units
(b) Average inventory level
EOQ/2 = 35,000/2 = 17,500 units
(c) Annual carrying cost
= (C) (P) (Q/2)

= (0.10) (RM2.50) (35,000/2)
= RM4,375

xxvi X COURSE ASSIGNMENT GUIDE

ATTACHMENT A
Financial Schedule for Future Value Interest Factor {FVn = PV0 (FVIFi,n)}
Period

ATTACHMENTS  373
ATTACHMENT B
Financial Schedule for Present Value Interest Factor {PV0 = FVn (PVIFi,n)}
374  ATTACHMENTS

ATTACHMENT C
Financial Table for Future Value Interest Factor Annuity {FVAn = A (FVIFAi,n)}
Period

ATTACHMENTS  375
ATTACHMENT D
Financial Table for Present Value Interest Factor Annuity {PVAn = A (PVIFAi,n)}
376  ATTACHMENTS

MODULE FEEDBACK
MAKLUM BALAS MODUL
If you have any comment or feedback, you are welcome to:
1. E-mail your comment or feedback to modulefeedback@oum.edu.my
OR
2. Fill in the Print Module online evaluation form available on myINSPIRE.
Thank you.
Centre for Instructional Design and Technology

(Pusat Reka Bentuk Pengajaran dan Teknologi )
Tel No.: 03-78012140
Fax No.: 03-78875911 / 03-78875966


BBPW3103 Financial Management I - Esept21 (CS)

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

BBPW3103 Financial Management I - Esept21 (CS)

Uploaded by

Copyright:

Available Formats

BBPW3103

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Developed by Centre for Instructional Design and Technology, OUM.

Copyright © Open University Malaysia (OUM)

Topic 1 Introduction to Finance 1

Topic 2 Analysis of Financial Statements 22

Copyright © Open University Malaysia (OUM)

2.8 Asset Management Ratio 51

Copyright © Open University Malaysia (OUM)

Topic 3 Time Value of Money 87

Topic 4 Valuation of Securities 123

Copyright © Open University Malaysia (OUM)

4.4 Yield to Maturity (YTM) 141

Topic 5 Risk Analysis 174

Copyright © Open University Malaysia (OUM)

Topic 6 Criteria of Capital Budgeting 200

Copyright © Open University Malaysia (OUM)

Topic 7 Cash Flow of Capital Budgeting 224

Topic 8 Cost of Capital 245

Topic 9 Financial Planning 262

Copyright © Open University Malaysia (OUM)

Topic 10 Working Capital Management 275

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

" Copyright © Open University Malaysia (OUM)

COURSE GUIDE DESCRIPTION

As an open and distance learner, you should be able to learn independently

Copyright © Open University Malaysia (OUM)

Figure 1: Student Learning Time

COURSE LEARNING OUTCOMES

1. Explain relevant theories, concepts and key areas of finance.

2. Analyse the various aspects of finance including investment, financing and

3. Interpret company and individual financing and investment decisions.

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Topic 9 touches on financial planning, cash budget and pro-forma income

Topic 10 explains the working capital management, management of marketable

TEXT ARRANGEMENT GUIDE

Self-Check: This component of the module is included in strategic locations

Activity: Similar to Self-Check, the Activity component is also placed at various

Copyright © Open University Malaysia (OUM)

References: A list of relevant and useful textbooks, journals, articles, electronic

Copyright © Open University Malaysia (OUM)

TAN SRI DR ABDULLAH SANUSI (TSDAS)

Figure 2: Among the Online Databases Available at TSDAS Digital Library

Copyright © Open University Malaysia (OUM)

Copyright © Open University Malaysia (OUM)

Finance can be defined as an art and science in managing money. Financial

(a) Investment decisions related to assets;

(b) Financing decisions related to liabilities and equity shareholders; and

(c) Management decisions related to operating decisions and daily financial

(a) Should the company carry out the project?

(b) Will the investment be successful?

(c) How to fund the investment?

(f) What is the level of inventory that needs to be kept?

(g) To which customer should the company offer credit?

(h) What is the optimal dividend policy?

(i) Should the takeover be continued?

For example, marketing managers should understand how marketing decisions

1. Explain the best way for a finance manager to establish good

2. What are the advantages and disadvantages of this bilateral