1

CA1 110 Manaalna llnance noLes bv Seah


ChapLer 1 Cash and cash flows 2
ChapLer 2 lorecasLlna cash flows 3Ŵ3
ChapLer 3 Cash forecasLlna Lechnlques 6
ChapLer 4 Cash and Lreasurv manaaemenL 7
ChapLer 3 lnvesLlna surplus funds 8Ŵ9
ChapLer 6 Worklna caplLal manaaemenL 10Ŵ11
ChapLer 7 Manaalna pavables and lnvenLorv 12Ŵ13
ChapLer 8 Manaalna recelvables 14Ŵ16
ChapLer 9 Assesslna credlLworLhlness 17Ŵ18
ChapLer 10 MonlLorlna and collecLlna debLs 19Ŵ20
ChapLer 11 1he banklna svsLem and flnanclal markeLs 21Ŵ22
ChapLer 12 Lconomlc lnfluences 23Ŵ24
ChapLer 13 ShorL and medlumŴLerm flnance 23Ŵ27
ChapLer 14 LonaŴLerm flnance 28Ŵ31
ChapLer 13 llnanclna of small and medlumŴslzed enLerprlses 32Ŵ33
ChapLer 16 ueclslon maklna 34Ŵ36
ChapLer 17 CvÞ analvsls 37Ŵ38
ChapLer 18 CaplLal expendlLure budaeLlna 39
ChapLer 19 MeLhods of pro[ecL appralsal 40Ŵ43
key areas of sy||abus are source of flnance (chapLer 11Ŵ13)ţ cash
budaeLs (chapLer 2)ţ worklna caplLal manaaemenL (chapLer 6Ŵ7)ţ credlL
manaaemenL (chapLer 8Ŵ10)ţ caplLal lnvesLmenL appralsal (chapLer 19)
and shorLŴLerm declslon maklna (chapLer 16Ŵ17)Ŧ Small areas musL sLlll
be consldered Lo maxlmlze chances of success (noL onlv pass)Ŧ
2

apter 1 as and cas f|ows
A buslness whlch falls Lo make proflLs wlll ao under ln Lhe lonaŴLermŦ Poweverţ a
buslness whlch runs ouL of cashţ even for a small perlodţ wlll fall alLhouah lL ls
proflLableŦ
AccounL showlna Lradlna proflLs are noL Lhe same as sLaLemenL of cash flows as
accounL ls prepared under accrual accounLlna (earnlna basls)Ŧ
Cash budaeLs wlll be prepared under cash accounLlna (recelpL and pavmenL basls)ţ
onlv lLems LhaL lnvolve cash flows wlll be lncludedŦ

Cash LransacLlons can be caplLal or revenueţ excepLlonal (unusual) or unexcepLlonal
and reaular or lrreaularŦ
Cash flow can be deflned ln manv wavsť
O -eL cash flow Ŷ LoLal chanae ln cash balances
O peraLlonal cash flow Ŷ neL cash flow from Lradlna acLlvlLles
O ÞrlorlLv cash flows Ŷ noL relaLe Lo Lrade buL lmporLanL for conLlnulna
operaLlonţ eaŦ lnLeresL pavmenLs and Lax pavmenLsŦ
O ulscreLlonarv cash flows Ŷ cash flows LhaL do noL have Lo be madeţ eaŦ
purchase of nonŴcurrenL asseLsŦ
O llnanclal cash flows Ŷ cash flows from lonaŴLerm caplLalţ eaŦ lssue of share
caplLalţ repavmenL of loan noLesŦ

?ou should have knows Lhe meanlna of accrual concepLţ buL when plannlna for Lhe
use of cashţ we wlll use cash accounLlnaŦ dvantages of cas f|ow account|ng areť
(l) ÞoLenLlal lenders are more lnLeresLed ln companv's ablllLv Lo repav Lhem (llquldlLv)
Lhan lLs proflLablllLvŦ
(ll) SaLlsfles Lhe needs of oLher flnanclal reporL users beLLerŦ
(lll) Cash flow forecasLs are easler Lo prepareţ as well as more useful Lhan proflL
forecasLsŦ
lor cash accounLlnaţ vou have Lo waLch ouL for Llmlna dlfferences beLween sales
belna made and cash belna recelvedţ and purchases/expendlLure and cash pavmenLsŦ











3

apter 2 Iorecast|ng cas f|ows
1he ma|n purpose of prepar|ng budgets ls Lo measure wheLher Lhere are llkelv Lo be
cash shorLaaes or larae surplusesŦ Cash flow forecasLs provlde an earlv warnlna of
llquldlLv problems and fundlna needsŦ
LlquldlLv ƹ companv's ablllLv Lo repav debLs/cash poslLlonŦ
A cas budget ls a deLalled forecasL of expecLed cash recelpLsţ pavmenLs and
balances over a budaeL perlodŦ lf vou see budaeL proflllna ln examţ lL means process
of preparlna a budaeLŦ
ln examţ vou mav be asked Lo prepare a cash budaeL for slx monLhs and Lhls wlll Lake
some Llmeţ vou musL remember Lo read Lhe lnformaLlon carefullv and lanore nonŴ
cash lLems such as depreclaLlon and proflL on dlsposal (buL lnclude cash recelved
from dlsposal)Ŧ 1he Llmlna ls lmporLanLţ for example a new dellverv vehlcle was
brouahL ln !une and Lhe cosL of $8000 ls Lo be pald ln AuausLţ Lhen vou should record
$8000 ln AuausLŦ SomeLlme quesLlon mav alve vou markŴup or maraln and vou are
requlred Lo use lL Lo flnd ouL Lhe amounL of purchases (Lake noLe LhaL vou don'L
record Lhe full amounL ln Lhe monLhţ vou onlv record Lhe amounL acLuallv pald)Ŧ

A aood sLep Lo prepare cash budaeL ls Lo seL ouL Lhe proŴforma flrsL and lnclude
amounL whlch does noL or [usL requlre easv calculaLlonţ Lhen onlv do worklnas and
lnclude Lhe resL of Lhe amounLŦ Lxample of cash budaeL formaL ls as followť
as budget for s|x monts end|ng 31 December 2010
Iu| ug 5ep Cct Nov Dec
kece|pts $ $ $ $ $ $
red|t sa|es 100
100
Þayments
orporat|on tax 50
Mater|a|s 10
60
5urp|us/ (Def|c|t) 40
8a|ance b/f 10 50
8a|ance c/f 50
-ow Lrv Lo do !une 2008 quesLlon 1 (a)Ŧ
Cash budaeL ls parL of masLer budaeL and can be used for conLrol purposes bv
produclna rolllna forecasL (conLlnuallv updaLed forecasL) uslna spreadsheeL Lo helpŦ
|eared funds forecasts are used for shorLŴLerm plannlnaŦ 1hev Lake clearance delavs
lnLo accounLŦ Cleared funds ƹ acLual cash avallable ln bank for lmmedlaLe spendlnaŦ
uncleared funds ƹ floaL ƹ cash recorded ln accounL buL noL veL avallable Lo use
because of delavsŦ

4

Wavs Lo prepare are same as cash budaeL (sLarL bv preparlna proŴforma)ţ buL Lhe
dlfferences are vou should be aware of Lhe cleared and uncleared fundsţ for example
8ACS pavmenL wlll usuallv cleared Lhe cash lnsLanLlv buL cheque wlll Lake abouL
Lhree davsŦ Lxample of cleared funds forecasL formaL are as followť
|eared funds forecast
Mon 1ue Wed 1urs Ir|
kece|pts $ $ $ $ $
red|t sa|es 1000 4000
1000 4000
Þayments
5upp||ers Ŵ 3000
Ŵ 3000
|eared excess rece|pts
over payments 1000 1000
|eared ba|ance b/f 1000 2000
|eared ba|ance c/f 2000 3000

Unc|eared funds f|oat
kecepts 4000 Ŵ
Þayments (3000) Ŵ
1000 Ŵ
1ota| book ba|ance c/f 3000 3000
uncleared funds floaL represenL recelpLs and pavmenLs LhaL are recorded ln accounL
buL noL veL cleared ln bankţ when lL ls clearedţ lL wlll be cancelled and recorded ln
cleared fundsţ ln Lhls example are $4000 and $3000Ŧ
-ow Lrv uecember 2008 quesLlon 3Ŧ

?ou mav also be alven a forecasL lncome sLaLemenLţ hlsLorlcal sLaLemenL of flnanclal
poslLlon (SlÞ) and forecasL SlÞţ vou are requlred Lo prepare a forecast cas f|ow
statementŦ ?ou do noL need Lo follow accounLlna sLandard formaLţ buL meLhods are
slmllar Lo sLaLemenL of cash flow LhaL vou had done ln flnanclal accounLlnaŦ
?ou have Lo compare boLh SlÞ Lo know Lhe cash flowsŦ An lncrease ln currenL
asseLs such as lnvenLorles and recelvables wlll cause cash ouLflowŦ 1hls ls because
Lhe companv has brouahL more lnvenLorles or has effecLlvelv lenL lLs cusLomers
some cashŦ lncreases ln currenL llablllLles such as pavables wlll cause cash lnflow
because effecLlvelv suppllers have lenL Lhe companv monev Lo buv suppllesŦ
Lxamples of forecasL cash flow sLaLemenL wlLh auldellne on Lhe lLems are as followť




3

Iorecast cas f|ow statement for te year ended 31 December 2010
$000
Cperat|ng prof|t (from |ncome statement)
+ Deprec|at|on (nonŴcas |tem)
Ŵ 1ax pa|d (ba|ance c/d + |ncome statement amount Ŷ ba|ance b/d)
Ŵ I|nance cost (from |ncome statement)
Ŵ D|v|dend pa|d (ba|ance c/d + d|v|dends amount g|ven |n add|t|ona| |nformat|on Ŷ
ba|ance b/dţ or somet|me amount actua||y pa|d |s g|ven)
Ŵ Þurcase of nonŴcurrent asset (open accountţ |tem w|c reduce va|ueţ egŦ
deprec|at|on and d|sposa| w||| be on cred|t s|deţ te ba|ance w||| be add|t|ons to
nonŴcurrent assets)
Ŵ Increase |n |nventor|es (ba|ance c/d Ŷ ba|ance b/d)
Ŵ Increase |n rece|vab|es (ba|ance c/d Ŷ ba|ance b/d)
+ Increase |n payab|es (ba|ance c/d Ŷ ba|ance b/d)
Þro[ected |ncrease/ decrease |n cas
-ow Lrv !une 2006 quesLlon 2 (a)Ŧ
?ou mav also be requlred Lo prepare forecast |ncome statementŦ
-ow Lrv !une 2007 quesLlon 3 (a)Ŧ

lf Lhe forecasL shows LhaL Lhere wlll be cash deflclLsţ correcLlve acLlons musL be Laken
(Lhls ls called feedŴforward conLrol)Ŧ Lxamples of correcLlve acLlons are ralslna share
caplLalţ leadlna and laaalna (obLaln monev from recelvables fasLer and delav
pavmenL Lo suppllers)ţ lssulna loan noLes and so onŦ


















6

apter 3 as forecast|ng tecn|ques
lnflaLlon (chapLer 12) and oLher varlables creaLe uncerLalnLv and Lhelr posslble
effecLs musL be reflecLed ln cash budaeLsŦ lnflaLlon can be measured uslna reta||
pr|ce |ndex (kÞI) bv Laklna currenL value dlvlded bv lasL vear/pasL vear's value and
mulLlplv bv 100Ŧ Index number can be used Lo ad[usL budaeLed flauresŦ lor exampleţ
alven LhaL forecasLed prlce lndex for 2010 ls 120 and Lhls vear are 100ţ budaeLed
cosL for Lhls vear ls $100000ţ Lo ad[usL Lhls vear cosL Lo nexL vear prlceţ vou have Lo
do as followť
120/ 100 x $100000 ƹ $120000ţ Lhls wlll be Lhe forecasL cosL for vear 2010ţ prlce
lndex of 120 means LhaL Lhe prlce wlll lncrease bv 20ƷŦ

5ens|t|v|ty ana|ys|s LesLs Lhe resulLs of a forecasL Lo see how senslLlve Lhev are Lo
chanaes ln lnpuLs (eaŦ lnLeresL raLes)Ŧ lor example lL would be posslble Lo LesL Lhe
lncome sLaLemenL budaeL and cash budaeL for a shorLfall ln sales volume of 10Ʒ and
see whaL happen Lo Lhe proflL and cash flowŦ SpreadsheeL modellna ls used for Lhls
purpose as lL can manlpulaLe Lhe daLe verv fasLţ bv chanalna Lhe sales valueţ Lhe
amounL relaLed (eaŦ Cross proflLţ cash balance) wlll also chanae accordlnalvŦ
-ow Lrv !une 2008 quesLlon 1 (b)Ŧ























7

apter 4 as and treasury management
Cash manaaemenL ls concerned wlLh prof|tab|||tyţ ||qu|d|ty and safetyŦ
ÞroflLablllLv Ŷ refers Lo a surplus of lncome over expendlLureŦ
LlquldlLv Ŷ ablllLv of a companv Lo pav lLs suppllers on LlmeŦ
SafeLv Ŷ securlLv of cashŦ
ln opLlmlzlna cash balancesţ Lhe flnanclal manaaer musL Lrv Lo balance llquldlLv wlLh
proflLablllLvŦ Make sure LhaL Lhe floaL should be reducedţ Lhere are tree reasons
wy tere m|gt be a |engty f|oatť
1ransmlsslon delav Ŷ when pavmenL ls posLedţ lL wlll Lake Llme for Lhe pavmenL Lo
reach Lhe paveeŦ
LodaemenL delav Ŷ delav ln banklna pavmenLs recelvedŦ
Clearance delav Ŷ Llme needed for bank Lo clear a chequeŦ

8aumo| cas management mode| ls based on Lhe ldea LhaL decldlna on opLlmum
cash balances ls slmllar Lo decldlna on opLlmum lnvenLorv levelsŦ lL ls based on Lhe
formula C ƹ

ţ C ls opLlmum cash balanceţ l ls flxed annual cash ouLflowţ S ls
cosL per sale of securlLlesţ l ls lnLeresL raLeŦ ?ou wlll noL be requlred Lo do Lhe
calculaLlon buL mav need Lo explaln how lL worksŦ
1he ||m|tat|ons of 8aumo| cas management mode| are as followť
(l) ln reallLvţ amounLs requlred over fuLure perlods wlll be dlfflculL Lo predlcL wlLh
much cerLalnLvŦ
(ll) 1here mav be cosLs assoclaLed wlLh runnlna ouL of cash
(llll) 1he model works saLlsfacLorllv for a flrm whlch uses cash aL sLeadv raLe buL noL
lf Lhere are laraer lnflows and ouLflows of cash over LlmeŦ
(lv) 1here mav be dlfflculLv ln predlcLlna fuLure lnLeresL raLesŦ

1reasury management ln a modern enLerprlse covers varlous areasţ and ln laraer
buslness mav be a cenLrallzed funcLlonŦ 1he ro|e of treasurer |nc|udes llquldlLv
manaaemenLţ fundlna manaaemenLţ currencv manaaemenLţ formulaLlna corporaLe
flnanclal ob[ecLlvesţ handllna corporaLe flnance and rlsk manaaemenLŦ
dvantages of centra||zed treasury department areť beLLer shorLŴLerm lnvesLmenL
opporLunlLlesţ lmproved forelan exchanae rlsk manaaemenLţ able Lo emplov experLs
(cash ls pooled) and easler Lo manaae cashŦ
-ow Lrv !une 2007 quesLlon 3 (b)ţ (c)Ŧ







8

apter 5 Invest|ng surp|us funds
Companles mav face slLuaLlons where Lhev have cash surplusesŦ 1haL surplus needs
Lo be used ln Lhe besL wavţ and Lhls wlll ofLen mean lnvesLlna lLŦ Surplus funds mean
exLra cash afLer all Lhe expendlLureŦ
keynes had ldenLlfled tree reasons wy company sou|d o|d te surp|us cas
raLher Lhan lnvesLlna lLť
(l) 1ransacLlon moLlve Ŷ hold cash Lo meeL reaular commlLmenLsŦ
(ll) ÞrecauLlonarv moLlve Ŷ hold cash ln case of emeraencv purposeŦ
(lll) SpeculaLlve moLlve Ŷ hold cash Lo walL for aood opporLunlLv Lo lnvesLŦ

8efore lnvesLlna surplus fundsţ key factors to cons|der are as followť
(l) 8lsk Ŷ Lhe hlaher Lhe rlskţ Lhe hlaher Lhe reLurnŦ 1here are Lwo Lvpes of rlsksţ
svsLemaLlc rlsk (rlsk LhaL affecLs Lhe whole markeL and cannoL be dlverslfled awav)
and unsvsLemaLlc rlsk (rlsks LhaL affecLs onlv speclflc markeLţ can be reduce bv
dlverslflcaLlonţ means Lo hold more Lhan one/porLfollo of lnvesLmenL)Ŧ
(ll) LlquldlLv Ŷ Lhe ease of converLlna lnLo cashţ hlah llquld low reLurnŦ
(lll) MaLurlLv Ŷ Lhe duraLlon of lnvesLmenLţ lona maLurlLv hlah reLurnŦ
(lv) 8eLurn Ŷ afLer consldered rlskţ llquldlLv and maLurlLvţ companv ls ln poslLlon of
conslderlna how much reLurn Lhev wanLŦ

1he |nterest y|e|d from lnvesLmenL ls Lhe coupon raLe expressed as percenLaae of
markeL prlceŦ lor exampleţ Lhe markeL prlce of 9Ʒ Lreasurv sLock ls $134Ŧ1734ţ Lhe
lnLeresL vleld can be calculaLed as coupon raLe / markeL prlce x 100Ʒ ƹ (9Ʒ x $100) /
$134Ŧ1734) x 100Ʒ ƹ 6Ŧ71Ʒţ $100 ls known as ÞA8 value/face valueţ vou should
assume LhaL lL ls alwavs $100 ln exam unless alvenŦ

1here are manv Lvpes of |nvestment opt|ons for companvť
CllLs Ŷ securlLles lssued bv Lhe uk aovernmenLŦ
CerLlflcaLe of deposlL (Cu) Ŷ a cerLlflcaLe lndlcaLlna LhaL a sum of monev has been
deposlLed wlLh a bank and wlll be repald aL a laLer daLeŦ As Cus can be bouahL and
soldţ Lhev are llquld Lvpe of lnvesLmenLŦ
8lll of exchanae Ŷ an uncondlLlonal order ln wrlLlna from one person or companv Lo
anoLherţ requlrlna Lhe reclplenL Lo pav a speclfled sum of monev on demand (slahL
blll) or aL a fuLure daLe (Lerm blll)Ŧ
Commerclal paper Ŷ shorLŴLerm lus lssued bv companles whlch can be held unLll
maLurlLv or sold Lo oLhersŦ
Loan sLock Ŷ lonaŴLerm debL caplLal ralsed bv companv for whlch lnLeresL ls paldţ
usuallv half vearlv and aL a flxed raLeŦ
ÞermanenL lnLeresL bearlna securlLles (Þl8S) Ŷ a Lvpe of securlLv speclallv creaLed Lo
enable bulldlna socleLles Lo ralse funds whlle lmprovlna Lhelr caplLal raLlosŦ
9

8ond Ŷ a Lerm alven Lo anv flxed lnLeresL securlLvţ wheLher lL ls lssued bv
aovernmenLţ a companvţ a bank or oLher lnsLlLuLlonŦ 1hev are usuallv for lona Lerm
and mav or mav noL be securedŦ
Shares Ŷ Lhere are Lwo Lvpes of sharesţ ordlnarv and preference shares whlch wlll be
dlscussed ln chapLer 14ţ buL vou can use !une 2004 quesLlon 1's answer Lo learn lL ln
deLallŦ
-ow Lrv !une 2009 quesLlon 2 and !une 2004 quesLlon 1 (learn from Lhls
quesLlon for lnvesLlna surplus funds)Ŧ

































10

apter 6 Work|ng cap|ta| management
Work|ng cap|ta| ls Lhe caplLal avallable for conducLlna Lhe davŴLoŴdav operaLlons of
an oraanlzaLlonŦ 1he neL worklna caplLal of a buslness can be deflned as currenL
asseLs less currenL llablllLlesŦ
Work|ng cap|ta| management ls lmporLanL Lo ensure LhaL sufflclenL llquld resources
are malnLalnedŦ lL alms Lo balance noL havlna Loo much or Loo less worklna caplLalŦ
Worklna caplLal manaaemenL lnvolvesť
O ConLrolllna Lhe llquldlLv poslLlonŦ
O ConLrolllna Lhe worklna caplLal elemenLs whlch are lnvenLorvţ recelvables and
pavablesŦ
Cash ls Lhe mosL llquld asseLţ lnvenLorv ls consldered nonŴcash and so lL ls leasL llquld
asseLŦ 8ecelvables fall ln Lhe mlddle of cash and lnvenLorvŦ
Work|ng cap|ta| cyc|e/cas operat|ng cyc|e ls Lhe perlod beLween Lhe suppllers
belna pald and Lhe cash belna recelved from Lhe cusLomersŦ Worklna caplLal cvcle ln
a manufacLurlna buslness equalsť
1he averaae Llme LhaL raw maLerlals remaln ln sLock (lnvenLorv davs)
Ŵ perlod of credlL Laken from suppllers (pavables davs)
+ Llme Laken Lo produce Lhe aoods (lnvenLorv davs)
+ Llme flnlshed aoods remaln ln sLock afLer producLlon ls compleLed (lnvenLorv davs)
+ Llme Laken bv cusLomers Lo pav for Lhe aoods (recelvables davs)
ln brlefţ work|ng cap|ta| cyc|e ƹ |nventory days + rece|vab|es days Ŷ payab|e daysŦ

L|qu|d|ty rat|os mav help Lo lndlcaLe wheLher a companv ls overŴcaplLallsedţ wlLh
excesslve worklna caplLalţ or lf a buslness ls llkelv Lo fallŦ A buslness whlch ls Lrvlna Lo
do Loo much Loo qulcklv wlLh Loo llLLle lonaŴLerm caplLal ls overLradlnaŦ
CurrenL raLlo ƹ currenL asseLs/currenL llablllLlesţ ldeal ls 2ť1Ŧ
Culck or acld LesL raLlo ƹ (currenL asseLs Ŷ lnvenLorles)/currenL llablllLlesţ ldeallv
should be aL leasL 1ť1Ŧ
8ecelvables davs ƹ recelvables/credlL sales x 363 davsţ Lhls shows Lhe lenaLh of Llme
lL Lakes for companv's cusLomers Lo pavŦ 1hls formula can be chanaed Lo recelvables
davs/363 davs x credlL sales Lo aeL recelvablesŦ
Þavables davs ƹ pavables/credlL purchases x 363 davsţ Lhls shows Lhe Llme Laken for
companv Lo pav suppllersŦ 1hls formula can be chanaed Lo pavables davs/363 davs x
credlL purchases Lo aeL pavablesŦ
lnvenLorv Lurnover perlod (flnlsh aoods) ƹ lnvenLorv/cosL of sales x 363 davs
8aw maLerlals davs ƹ raw maLerlals lnvenLorv/purchases x 363 davs
WorkŴlnŴproaress (WlÞ) perlod ƹ (WlÞ lnvenLorv/cosL of sales x Ʒ of compleLlon) x
363 davs
lnvenLorv Lurnover ƹ cosL of sales/averaae lnvenLorv
11

?ou mav need Lo use Lhe raLlos Lo calculaLe Lhe operaLlna cvcleţ raw maLerlal davs +
WlÞ davs + flnlsh aoods davs + recelvables davs Ŷ pavables davs ƹ worklna caplLal
cvcleŦ
-ow Lrv uecember 2008 quesLlon 2Ŧ
?ou mav also be requlred Lo calculaLe worklna caplLal requlremenLsţ vou need Lo
calculaLe Lhe currenL asseLs and currenL llablllLles bv chanalna Lhe formula as l
showed ln recelvables and pavables davsţ vou wlll be alven Lhe davsţ vou need Lo
calculaLe Lhe values Lhls LlmeŦ
-ow Lrv uecember 2007 quesLlon 2 (a)Ŧ

lf Lhere are excesslve lnvenLorlesţ recelvables and cashţ and verv few pavablesţ Lhere
wlll be an overŴlnvesLmenL bv Lhe companv ln currenL asseLsŦ Worklna caplLal wlll be
excesslve and Lhe companv wlll be overŴcap|ta||sedŦ
verLradlna ls excesslve Lradlna bv a buslness wlLh lnsufflclenL lonaŴLerm caplLal aL
lLs dlsposalţ ralslna Lhe rlsk of llquldlLv problemsŦ 5ymptoms of overtrad|ng are
lncreased revenueţ lncreased currenL/nonŴcurrenL asseLsţ currenL llablllLles more
Lhan currenL asseLsţ asseLs flnanced bv credlL and noL share caplLalţ reduced currenL
and qulck raLlosţ lnvenLorv and recelvables are more Lhan salesŦ























12

apter 7 Manag|ng payab|es and |nventory
LffecLlve manaaemenL of pavables lnvolves seeklna saLlsfacLorv credlL Lerms from
suppllersţ aeLLlna credlL exLended durlna perlods of cash shorLaaeţ and malnLalnlna
aood relaLlons wlLh suppllersŦ
1rade cred|t ls a useful and cheap source of flnanceţ buL a successful buslness needs
Lo ensure LhaL lL ls seen as a aood credlL rlsk bv lLs suppllersŦ Some suppllers musL be
pald on speclflc daLesŦ 1hls musL be remembered and cash musL be avallableŦ 1he
cosL of losL cash dlscounLs ls calculaLed as (100/100 Ŷ d) Ɗ (363/L) Ŷ 1ţ d ƹ Ʒ of
dlscounLţ L ƹ Llme dlfference beLween cash dlscounL daLe and Lhe credlL LermŦ

A buslness wlll use a varleLv of metods to make paymentsŦ lanorlna pavroll (waaes
and salarles) and peLLv cashţ Lhe mosL common and convenlenL meLhods of pavmenL
are bv cheque and bv 8ACSŦ Lher pavmenL meLhods are ofLen arranaed based on
Lhe Lvpes LhaL suppllers wanLţ and Lhls explalns much of Lhe use of banker's drafLsţ
sLandlna order and Lelearaphlc LransfersŦ ulrecL deblLs are noL ofLen used for
pavmenLs bv buslnessesţ buL mlahL occaslonallv be used for convenlenceŦ
SLandlna order Ŷ flxed amounL and reaular pavmenLŦ
1elearaphlc Lransfers Ŷ lnsLrucLlons for Lhe pavmenL are senL from Lhe paver's bank
Lo Lhe pavee's bank bv LelecommunlcaLlons svsLemŦ
8ankers' AuLomaLed Clearlna Servlces (8ACS) Ŷ a Lvpe of dlrecL deblLŦ

Lconom|c order quant|ty (LCC) ls Lhe opLlmal orderlna quanLlLv for an lLem of
lnvenLorv LhaL wlll mlnlmlze cosLsţ aL Lhe same Llme balanclna Lhe need Lo meeL
cusLomer demandŦ Inventory costs lncludeť
(l) Poldlna cosLs Ŷ eaŦ renLal of warehouseţ LhefL of sLockŦ
(ll) rderlna cosLs Ŷ eaŦ Lelephone charaesţ dellverv cosLsŦ
(lll) ShorLaae cosLs Ŷ eaŦ loss of sale
(lv) Þurchase cosLs Ŷ prlce of Lhe aoods
LC/C ƹ 2cd/ţ c ƹ cosL of per order for one vearţ d ƹ annual demandţ h ƹ
holdlna cosL per unlL of lnvenLorv for one vearţ C ƹ reorder quanLlLv
1oLal annual cosL ƹ holdlna cosL + orderlna cosL + purchase cosL
Poldlna cosL ƹ Ch/2ţ orderlna cosL ƹ cd/C
ln examţ LC formula ls llkelv Lo be alvenŦ

ssumpt|ons of LCC formu|a are purchase cosLs are consLanLţ lead Llme ls consLanLţ
demand ls consLanL and no lnflaLlonŦ
-ow Lrv !une 2004 quesLlon 3 and !une 2007 quesLlon 2Ŧ




13

Lher formulas lncludeť
8eorder level ƹ maxlmum usaae x maxlmum lead Llmeţ measure Lhe lnvenLorv level
aL whlch replenlshmenL order should be placedŦ
Maxlmum level ƹ reorder level + reorder quanLlLv Ŷ (mlnlmum usaae x mlnlmum lead
Llme)ţ lnvenLorv level should noL exceed Lhls levelŦ
Mlnlmum level/buffer lnvenLorv ƹ reorder level Ŷ (averaae usaae x averaae lead
Llme)ţ lnvenLorv level should noL fall under Lhls levelŦ
Averaae lnvenLorv ƹ (reorder level/2) + mlnlmum level

ln examţ lL mav be alven LhaL Lhere are bu|k d|scounts from oLher suppller and vou
have Lo declde ls lL worLh Lo chanae suppllerţ even Lhouah Lhe prlce ls reducedţ
annual holdlna cosLs wlll lncrease lf more aoods are orderedŦ 1o decldeţ compare Lhe
LoLal annual cosL lf used LC and Lhe LoLal annual cosL lf Lakes Lhe bulk dlscounLs
(companv mav order more Lo aeL Lhe dlscounL)ţ Lhe lower cosLs wlll be chosenŦ

8esldes flnanclal facLorţ companv also has Lo conslder Lhe nonŴflnanclal facLors such
as Lhe rellablllLv of new suppllerţ Lhe relaLlonshlp wlLh currenL suppllerţ and sLandard
of aoods and servlces offered bv new suppllerŦ

IustŴ|nŴt|me (II1) alms Lo hold as llLLle lnvenLorv as posslble and producLlon svsLems
need Lo be verv efflclenL Lo achleve LhlsŦ uellverles wlll be small and frequenL raLher
Lhan ln bulkŦ Companv needs Lo have a rellable suppller as LhaL suppller wlll
auaranLee Lo dellver raw maLerlals componenLs of approprlaLe quallLv alwavs on
LlmeŦ unlL purchaslna prlces mav be hlaher as suppller auaranLees Lhe quallLv and
also on Llme dellvervŦ Workforce musL also be flexlble and mulLlŴskllled ln order Lo
mlnlmlze delav and ellmlnaLe poor quallLv producLlonŦ 8educed lnvenLorv levels
mean LhaL a lower level of lnvesLmenL ln worklna caplLal wlll be requlredŦ !l1 ls also
ofLen assoclaLed wlLh LoLal quallLv manaaemenL (1CM) as Lhe Lwo prlnclples of 1CM
are aeL Lhlnas rlahL flrsL Llme and conLlnuous lmprovemenLŦ
-ow Lrv uecember 2009 quesLlon 1 and uecember 2010 quesLlon 2Ŧ











14

apter 8 Manag|ng rece|vab|es
8uslnesses have Lo Lake cerLaln declslons reaardlna wheLher Lo offer credlL Lo
cusLomersŦ 1hls wlll be aulded ln credlL pollcvŦ lf Lhev doţ Lhe exLenLţ amounL and
perlod of credlL LhaL wlll be offered need Lo be decldedŦ
CredlL conLrol deals wlLh a flrm's manaaemenL of lLs worklna caplLalŦ 1rade credlL ls
offered Lo buslness cusLomersŦ Consumer credlL ls offered Lo household cusLomersŦ
CredlL ls offered Lo enhance sales and proflLŦ
red|t contro| po||c|es are auldellne on alvlna credlLţ can be seL based on before
offerlna credlL (assess credlLworLhlnessţ check pasL record of cusLomers)ţ durlna
credlL perlod (monlLor Lhe recelvables) and afLer credlL perlod (chase slow paversţ
aaed recelvables analvsls)Ŧ 1he amounL of LoLal credlL LhaL a buslness offers depend
onť
(l) 1he flrm's worklna caplLal needs and Lhe lnvesLmenL ln recelvablesŦ
(ll) ManaaemenL responslblllLv for carrvlna ouL Lhe credlL conLrol pollcvŦ
An lmporLanL aspecL of Lhe credlL conLrol pollcv ls Lo devlse sulLable pavmenL Lermsţ
coverlna when and how should pavmenL be madeŦ

Some flrms offer ear|y sett|ement d|scount lf pavmenL ls recelved earlvŦ ueclslon
wheLher Lo offer seLLlemenL dlscounL depend on Lhe cosL of caplLal (requlred raLe of
reLurn) of companvŦ lf Lhe cosL of seLLlemenL dlscounL ls lower Lhan cosL of caplLalţ
Lhen lL ls worLh Lo offerŦ CosL of seLLlemenL dlscounL ƹ (100/100 Ŷ d) Ɗ (363/L) Ŷ 1ţ d
ƹ Ʒ of dlscounLţ L ƹ Llme dlfference beLween cash dlscounL daLe and Lhe credlL LermŦ
8enef|ts of sett|ement d|scounts areť
(l) CusLomers are more llkelv Lo pav earlv
(ll) Cash ls recelved qulcklvţ lmprovlna cash flow of companv
(lll) CusLomers mav make laraer orders
(lv) lewer bad debLs as more cusLomers pav earlv

?ou mav also be requlred Lo determ|ne te max|mum d|scount LhaL Lhe companv
should offerţ lL ls baslcallv Lhe same wav of calculaLlna effecLlve lnLeresL raLes whlch
ls d ƹ ż(1 + r) Ɗ (L/363) Ŷ 1Ž x 100Ʒţ d ls dlscounLţ r ls Lhe raLe of lnLeresLţ L ls Llme
dlfference beLween cash dlscounL daLe and Lhe credlL LermŦ 1hls ls based on Lhe ldea
LhaL max|mum d|scount ƹ effect|ve |nterest rates tat company |s pay|ng for |ts
overdraftŦ

CredlL conLrol deparLmenL ls responslble for Lhose sLaaes ln Lhe collecLlon cvcle
deallna wlLh offer of credlL and collecLlon of debLsŦ ko|es of te cred|t contro|
department lncludeť
O keeplna recelvables ledaer upŴLoŴdaLe
O Þursulna overdue debLs
O ueallna wlLh cusLomer querles
13

O 8eporLlna Lo sales sLaff abouL new querles
O Clvlna references Lo Lhlrd parLles (eaŦ credlL reference aaencles)
O Checklna ouL cusLomers' credlLworLhlness
O Advlslna on pavmenL Lerms

Ieatures of cred|t contro| department LhaL would encouraae cusLomers Lo pav on
Llme areť
(l) Awareness of suppller's Lerms Ŷ Lhe cusLomer musL be fullv aware of Lhe
suppller's LermŦ ÞavmenL Lerms should be cleared sLaLed ln wrlLlna when Lhe order ls
conflrmedŦ
(ll) AccuraLe and prompL lnvolclna Ŷ lnvolces should be correcLlv drawn up and senL
up prompLlv Lo maxlmlze Llme for pavmenLŦ
(lll) Awareness of cusLomer's svsLems Ŷ undersLand Lhe pavmenL svsLem aL
cusLomer's buslnessŦ WlLhouL Lhls knowledaeţ debLs cannoL alwavs be collecLed
prompLlvŦ
(lv) SvsLem of sLaLemenLs and remlnders Ŷ send monLhlv sLaLemenL Lo cusLomers
and lssue remlnders Lo laLe paversŦ lf debLs sLlll remaln unpaldţ a flnal remlnder
should be lssuedŦ
-ow Lrv uecember 2006 quesLlon 3Ŧ

A contract ls an aareemenL whlch leaallv blnds Lhe parLles (Lhose enLerlna lnLo Lhe
aareemenL)Ŧ 1he key e|ements of contract are ICLť
(l) lorm Ŷ mosL conLracLs do noL need Lo be ln sLrlcL form unless sale or purchase of
land under uk law and consumer credlL aareemenLs musL also be ln wrlLlnaŦ
(ll) ffer Ŷ a flrm proposal Lo alve or do someLhlnaŦ
(lll) Leaal lnLenLlon Ŷ boLh parLles musL have lnLenLlon Lo creaLe leaal relaLlonshlpŦ
(lv) AccepLance Ŷ uncondlLlonal aareemenL Lo all Lhe Lerms of Lhe offerŦ
(v) ConslderaLlon Ŷ conslderaLlon ls whaL a promlsee musL alve ln exchanae of whaL
has been promlsed Lo hlmŦ -ormallvţ Lhls would be Lhe prlceŦ

5pec|f|c terms and cond|t|ons tat may be |nc|uded |n contracts ln order Lo
mlnlmlze losses and manaae cusLomers more effecLlvelv areť
(l) LenaLh of free credlL Ŷ each lnvolce should clearlv sLaLe Lhe credlL perlodŦ
(ll) lnLeresL charaed on laLe pavmenLs Ŷ lnLeresL charaed should be prlnLed on each
lnvolce as remlnderŦ
(lll) 8eLenLlon of LlLle clause Ŷ such clause would sLaLe LhaL Lhe buver does noL obLaln
ownershlp of Lhe aoods unless and unLll pavmenL ls madeŦ




16

A parLv has a number of remed|es wen one party breaced te contractť
(l) uamaaes Ŷ clalm for compensaLlons for damaaesŦ
(ll) 1ermlnaLlon Ŷ cancel Lhe conLracLŦ
(lll) CuanLum merulL Ŷ clalm for work doneŦ
(lv) Speclflc performance Ŷ applled when damaaes would be an approprlaLe remedvţ
order Lhe parLv Lo perform an obllaaLlonŦ
(v) AcLlon for Lhe prlce Ŷ seeks Lo recover Lhe sum owed bv Lhe parLvŦ

k|gt to sue for breach of conLracL becomes sLaLuLeŴbarred normallv afLer 6 vears
from daLe of Lhe breachŦ































17

apter 9 ssess|ng cred|twort|ness
ln lasL chapLerţ Lhe word ºassess credlLworLhlness" was menLloned ln Lhe credlL
conLrol pollcvţ ln Lhls chapLer lL wlll be dlscussedŦ
A credlL assessmenL ls a [udaemenL abouL Lhe credlLworLhlness of a cusLomerŦ lL
provldes a basls for a declslon as Lo wheLher credlL should be aranLedŦ lf Lhe credlL
rlsk (posslblllLv LhaL Lhe debL aoes bad) ls hlahţ Lhe cusLomers need Lo be manaaed
carefullvŦ

Companles can look aL exLernallv aeneraLed lnformaLlon and lnLernallv aeneraLed
lnformaLlon when assesslna Lhe credlLworLhlness of cusLomerŦ
Lxamples of externa||y generated |nformat|on are fromť
(l) 8ank Ŷ banks are cauLlous as Lhev owe duLles of care Lo cusLomer and enqulrerţ
Lherefore Lhe lnformaLlon abouL cusLomers are llmlLedŦ
(ll) 1rade references Ŷ aeL lnformaLlon from cusLomers' suppllersţ useful buL careful
as cusLomers wlll alve name of suppllers LhaL Lhev have aood hlsLorv wlLhŦ
(lll) CredlL reference aaencles Ŷ supplv a varleLv of leaal and buslness lnformaLlonţ
Lhls saves Llme for enqulrerŦ An aaencv mlahL alve lLs own suaaesLed raLlna for Lhe
cusLomers (credlL raLlnas)Ŧ 1he problem of aaencv reporLs are mav be ouLŴofŴdaLeŦ
-ow Lrv !une 2009 quesLlon 4 and uecember 2006 quesLlon 1Ŧ

lor |nterna||y generated |nformat|onţ some companles are able Lo emplov credlL
analvsLs Lo examlne a flrm's flnanclal accounLsŦ As Lhese are hlsLorlcal sLaLemenLsţ
Lhev have no aulde Lo a cusLomer's fuLure credlLworLhlnessŦ Poweverţ rat|o ana|ys|s
can alve some ldea abouL cusLomers' poslLlon and hlahllahL areas for furLher
lnvesLlaaLlonŦ ?ou should had learnL raLlo analvsls ln earller sLudlesţ here ls Lhe
formula buL vou musL be able Lo explaln each raLlosţ [usL look carefullv Lhe formula
and vou wlll know whaL Lo savť
O ÞroflL maraln ƹ proflL before lnLeresL and Lax (Þ8l1)/revenue
O AsseL Lurnover ƹ revenue/caplLal emploved
O 8eLurn on caplLal emploved (8CL) ƹ Þ8l1/caplLal emplovedţ caplLal
emploved ƹ equlLv + debL
O Larnlnas per share (LÞS) ƹ (proflL afLer Lax Ŷ preference dlvldend)/number of
ordlnarv shares
O Þrlce earnlnas raLlo (Þ/L raLlo) ƹ markeL prlce per share/LÞS
O CurrenL raLlo ƹ currenL asseLs/currenL llablllLles
O Culck raLlo ƹ (currenL asseLs Ŷ lnvenLorles)/currenL llablllLles
O 8ecelvables davs/recelvables' collecLlon perlod ƹ recelvables/credlL sales x
363 davs
O Þavables davs/pavables' pavmenL perlod ƹ pavables/credlL purchases x 363
davs
18

O Cearlna raLlo (measure rlsk) ƹ debL/equlLv x 100Ʒţ debL ƹ nonŴcurrenL
llablllLlesţ equlLv ƹ ordlnarv share + reserves
O lnLeresL cover ƹ Þ8l1/lnLeresL charaes
O uebL raLlo ƹ LoLal llablllLles/LoLal asseLs
O 8ad debL raLlo ƹ bad debLs/credlL sales x 100Ʒ
-ow Lrv uecember 2007 quesLlon 2 (b)Ŧ
1here are ||m|tat|ons of rat|o ana|ys|s as bellowť
(l) -oL useful lf wlLhouL comparlsonŦ
(ll) 8ased on hlsLorlcal lnformaLlonţ wlll noL Lake lnLo accounL lnflaLlonŦ
(lll) uaLa mav noL alwavs avallableŦ
(lv) 1here musL be a careful deflnlLlon of raLlos usedŦ lor exampleţ should ºreLurn"
equal Þ8l1ţ proflL afLer Lax or reLalned proflL?

AnoLher lnLernallv aeneraLed lnformaLlon ls Lhrouah customer v|s|tsŦ Such vlslL has
Lwo purposesť
O ulscuss anv speclflc querles arlslna from credlL reference daLaŦ
O CeL a feel for Lhe cusLomer's buslness and how Lhev runŦ
1hrouah vlslLţ companv can also emplov people Lo raLe Lhe credlLworLhlness of
cusLomersţ AAA belna Lhe besL and so onŦ
AfLer collecLlna cusLomer lnformaLlon from a varleLv of sourcesţ lL should be used
effecLlvelv Lo come Lo a concluslon (wheLher Lo provlde credlL and Lhe Lerms of
credlL)Ŧ

We cannoL have all Lhe lnformaLlon LhaL we wanL from a cusLomer because of Data
Þrotect|on ct 1998 (Uk)Ŧ 1hls acL aLLempLs Lo proLecL Lhe lndlvldual (noL corporaLe
bodles)Ŧ lndlvlduals have cerLaln leaal rlahLs and daLa holders musL adhere Lo daLa
proLecLlon prlnclplesŦ 8ecause of LhaLţ Lake care whlle asklna for lnformaLlon or
when alvlna lnformaLlon abouL vour cusLomersŦ













19

apter 10 Mon|tor|ng and co||ect|ng debts
1he mosL common wav Lo monlLor recelvables ls Lhrouah aged rece|vab|es ana|ys|s
and vou mav be requlred Lo prepare lLŦ A slmple example ls as followť
ged rece|vab|es ana|ys|s as at 31 December 2010
ustomer name 0Ŵ30 days 31Ŵ60 days 61Ŵ90 days ƽ90 days
8a|ance
8 1000 300 700 0 0
DLI 2000 0 900 200 900
1ota| 3000 300 1600 200 900
1hls helps Lo declde whaL acLlon Lo Lake abouL older debLs (cusLomers who pav laLe)ţ
Lhls represenLs Lhe acLual lnvolces ouLsLandlnaŦ
Lxterna| sources can also be used Lo monlLor Lhe debLsţ for example press (look for
anv sLorles relevanL Lo Lhe companv) and compeLlLorsŦ

1he earller Lhe cusLomers pavţ Lhe beLLerŦ Lar|y payment can be encouraged bv
aood admlnlsLraLlonţ sendlna ouL lnvolces lmmedlaLelvţ lssue monLhlv sLaLemenL and
earlv seLLlemenL dlscounLŦ 1he rlsk LhaL some cusLomers don'L pav can be parLlv
secured bv defaulL lnsuranceŦ
1here should be efflclenLlv oraanlzed procedures for ensur|ng tat overdue debts
and s|ow payers are dea|t w|t effect|ve|yţ some examples areť
O lssulna remlnder leLLers
O Chaslna pavmenL bv Lelephone
O Charae lnLeresL for laLe seLLlemenL
O Lmplov servlces of debL collecLlon aaencv (pav commlsslon)
O Send auLhorlzed person Lo vlslL and requesL pavmenL
O 1ake leaal acLlon

1he bas|c |ega| procedures for co||ect|on of debts are Lhrouah conLacLlna sollclLor
and Lhev wlll send ouL ºleLLer before acLlon"ţ alvlna Lhe cusLomer one lasL chance Lo
pav before a courL summons ls lssuedŦ

Some buslnesses mlahL have dlfflculLles ln flnanclna amounLs owed bv cusLomersţ
Lhev can emplov Lhe servlce of facLorlnaŦ Iactor|ng ls an arranaemenL Lo have debLs
collecLed bv a facLor companv whlch advances a proporLlon of Lhe monev LhaL lL ls
due Lo collecLŦ
An eas|er way to understand factor|ng ls Lhrouah sLepsť
1Ŧ Companv asks for facLorlna servlce from facLorŦ
2Ŧ lacLor wlll admlnlsLer Lhe sales ledaer (conLrol Lhe recelvables of Lhe companv)
and alve monev ln advance Lo companv (abouL 80Ʒ)Ŧ
3Ŧ AfLer facLor recelved monev from recelvablesţ facLor wlll pav back Lhe companv an
amounL whlch has been deducLed for lnLeresLŦ
20

1here are two types of factor|ngť
(l) WlLh recourse Ŷ lf debL cannoL be collecLedţ facLor can clalm back Lhe advance
from companv
(ll) WlLhouL recourse Ŷ lf debL cannoL be collecLedţ facLor cannoL clalm back Lhe
advance from companvŦ

Invo|ce d|scount|ng ls Lhe purchase of Lrade debLs aL a dlscounLŦ lnvolce dlscounLlna
enables companv Lo ralse worklna caplLalŦ lL ls slmllar Lo facLorlnaţ buL lnvolce
dlscounLer does noL admlnlsLer sales ledaerţ wlLh Lhlsţ cusLomers wlll noL know LhaL
Lhe companv ls emplovlna Lhls servlceŦ 1he arranaemenL ls purelv for Lhe advance of
cashŦ

?ou mav be asked ln exam Lo determ|ne weter |t |s f|nanc|a||y v|ab|e for te
company to use factor|ngŦ 1o decldeţ vou have Lo calculaLeť
1Ŧ 1he cosL of noL facLorlna Ŷ Lhls means LhaL Lhe cosLs lf companv uses own svsLem
of manaalna recelvablesŦ Lxamples lnclude credlL conLroller salarlesţ lnLeresL charaed
on overdrafL and admlnlsLraLlon cosLsŦ
2Ŧ 1he cosL of facLorlna Ŷ Lxamples of cosLs are lnLeresL charaed for advance of
monevţ lnLeresL charaed for flnanclna remalnlna recelvables and admlnlsLraLlon feesŦ
1hen compare boLh cosLsţ lf cosL of facLorlna ls lowerţ Lhen companv ls vlable Lo use
facLorlna servlceŦ
-ow Lrv uecember 2007 quesLlon 4Ŧ

Inso|vency ls when companv ls dlssolved as a leaal enLlLvţ lLs asseLs are Lhen sold Lo
ralse cashţ whlch ls used Lo pav credlLors and anv monev lefL over (usuallv none) ls
Lhen alven Lo Lhe shareholdersŦ

rb|trat|on ls Lhe process where debLor and credlLor enLer lnLo a wrlLLen aareemenL
Lo submlL Lhelr dlspuLe Lo a Lhlrd parLv who asslsLs ln lLs resoluLlonŦ 1he parLles
produce all relevanL documenLs Lo Lhe arblLraLor and are Lhen examlnedŦ 1he
declslon of Lhe arblLraLor ls flnalŦ (used when companv and cusLomer has dlspuLe
buL wanL Lo save monev)Ŧ
-ow Lrv !une 2007 quesLlon 4Ŧ

8ankrupLcv ls where an lndlvldual's properLv ls sold for Lhe credlLors' beneflLŦ 5tages
|nvo|ved |n bankruptcy procedures lncludeť
1Ŧ CredlLor lssues sLaLuLorv demand for pavmenLŦ
2Ŧ lf debLs remaln unseLLledţ credlLors mav peLlLlon Lhe courLs for a bankrupLcv orderŦ
3Ŧ CredlLor appolnLs LrusLee ln bankrupLcvŦ


21

apter 11 1e bank|ng system and f|nanc|a| markets
8anklna svsLem and Lhe flnanclal markeLs are kev sources of buslnessŦ
A f|nanc|a| |ntermed|ary brlnas LoaeLher lenders and borrowers of monevţ elLher as
broker (an aaenL handllna a LransacLlon on behalf of oLhers) or as prlnclpal (holdlna
monev balances of lenders for lendlna on Lo borrowers)Ŧ Lxamp|es of f|nanc|a|
|ntermed|ar|es areť
(l) 8ank
(ll) 8ulldlna socleLles Ŷ alve loans Lo borrowers for house purchaseŦ
(lll) llnance houses Ŷ provlde hlre purchase servlce (chapLer 13)
(lv) lnsurance companles
(v) Þenslon funds
(vl) unlL LrusLs
(vll) lnvesLmenL LrusL companles
8enef|ts of f|nanc|a| |ntermed|at|on areť
(l) AaareaaLlon Ŷ bank can aaareaaLe Lhe amounL of monev from lenders and Lhen
lend Lo borrowers who need Lhe monevţ Lhls makes Lhlnas easler for lenders and
borrowers Lo lend or obLaln monevŦ
(ll) 8lsk reducLlon Ŷ bank should be beLLer aL assesslna credlL rlskŦ
(lll) MaLurlLv LransformaLlon Ŷ lenders mav wanL Lo keep monev for llquldlLv whlle
borrowers mav need loan (lonaŴLerm borrowlna)ţ flnanclal lnLermedlarv can faclllLaLe
shorLŴLerm and lonaŴLerm needs of lenders and borrowersţ Lhls ls called maLurlLv
LransformaLlonŦ

Þr|mary/reta||/commerc|a|/c|ear|ng banks are banks LhaL provlde monev
Lransmlsslon servlceŦ 1hev also provlde a place where people sLore monev and lend
monev on overdrafL or bv loanŦ Þrlmarv banks are commonlv used bv buslnessţ eaŦ
Mavbankţ PS8Cţ SLandard CharLeredŦ
5econdary/wo|esa|e/mercant banks lnvolve small numbers of cusLomers wlLh
laraer deposlLs or requlrlna laraer loansŦ

entra| bank ls an lnsLlLuLlon whlch has roles of conLrolllna Lhe moneLarv svsLem of a
counLrvţ acLlna as banker Lo Lhe banks and aovernmenL and acLlna as lender of lasL
resorL (lend monev Lo banks when banks have no monev for Lhe borrowers)Ŧ lL also
acLs as aaenL for aovernmenL ln carrvlna ouL lLs moneLarv pollclesŦ

I|nanc|a| markets lnclude monev markeLs and caplLal markeLs (chapLer 14)Ŧ Money
markets are markeLs for shorLŴLerm borrowlna and lendlnaţ ln wholesale amounLŦ
Monev markeLs lnclude a prlmarv markeL and a secondarv markeLŦ 1he prlmarv
markeL ls used bv Lhe cenLral bank and oLher approved banks and securlLles flrmsŦ
1he cenLral bank uses lL Lo balance shorLaaes and surpluses of cashŦ Ma|n money
market's f|nanc|a| |nstruments areť
22

(l) ueposlLs Ŷ deposlLs of monev ln flnanclal lnLermedlarlesŦ
(ll) 8llls Ŷ shorLŴLerm flnanclal asseLs whlch can be converLed lnLo cash aL verv shorL
noLlceţ bv selllna Lhem ln Lhe dlscounL markeLŦ
(lll) Commerclal paper Ŷ shorLŴLerm lus lssued bv larae companles whlch can be
held unLll maLurlLv or sold Lo oLhersŦ lL ls lssued when companv wanLs Lo ralse shorLŴ
Lerm monevŦ
(lv) CerLlflcaLes of deposlLs (Cus) Ŷ flxed Lerms deposlLţ cusLomer can obLaln cash
before Lhe Lerm ls up bv selllna Cu ln Cu markeLŦ

Lher secondarv uk markeLs lncludeť
(l) Local auLhorlLv markeLs Ŷ provlde local auLhorlLv bonds and blllsŦ
(ll) lnLer bank markeL Ŷ unsecured loans beLween banksŦ
(lll) Cus markeL
(lv) lnLer companv markeL Ŷ companles wlLh surplus funds lend dlrecL (Lhrouah a
broker) Lo Lhose whlch need Lo borrowŦ 1hev do noL lnvolve flnanclal lnLermedlaLlon
and Lhls ls called dlslnLermedlaLlonŦ
(v) Commerclal paper markeL
(vl) Lurocurrencv markeLs Ŷ eurocurrencv deposlL ls a forelan currencv deposlLţ a
deposlL of own counLrv's funds ln oLher counLrles whlch have dlfferenL currencvţ eaŦ
deposlL of uS dollars wlLh a bank ln LondonŦ
-ow Lrv !une 2008 quesLlon 4Ŧ




















23

apter 12 Lconom|c |nf|uences
lnLeresL raLesţ lnflaLlon and moneLarv pollcv are all lnLerrelaLedŦ
Þeople's ||qu|d|ty preference reflecLs Lhelr demand for monevŦ LlquldlLv preference
ls Lhe Lerm used bv kevnes for Lhe deslre Lo hold monev raLher Lhan lnvesLlna lLŦ 1he
demand for money w||| be |g (llquldlLv preference wlll be hlah) wen |nterest
rates are |owŦ 1hls ls because Lhe speculaLlve (lnvesLlna purpose) demand for monev
wlll be hlah when lnLeresL raLes are lowŦ

1he raLe of lnLeresL acLuallv pald ln monev Lerms ls Lhe nomlnal raLe of lnLeresLŦ We
can aeL real raLe of lnLeresL afLer ad[usLlna for lnflaLlonŦ Accordlna Lo f|ser effectť
(1 + N) ƹ (1 + k)(1 + I)ţ - ls nomlnal raLe of lnLeresLţ 8 ls real raLe of lnLeresLţ l ls
lnflaLlon raLeŦ We can also see from Lhls equaLlon LhaL when Lhere ls lnflaLlonţ Lhe
cosL of caplLal (requlred raLe of reLurn) of companv wlll lncrease as shown as -Ŧ

Genera| |eve| of |nterest rates w||| be affected by lnflaLlonţ hlaher demand for
borrowlna from lndlvldualsţ chanaes ln level of aovernmenL borrowlnaţ moneLarv
pollcv and Lhe need for a real raLe of reLurnŦ

Money supp|y ls Lhe LoLal sLock of monev ln Lhe economvŦ lL ls measured ln a
number of wavsť
M0 Ŷ narrow deflnlLlon of monev supplvţ conslsLs of noLes and colns onlvŦ
M4 Ŷ broader deflnlLlon of monev supplvţ lnclude deposlLs ln banks and varlous
oLher shorLŴLerm deposlLs ln Lhe monev markeLŦ

Government po||cy ls dlvlded lnLoť
O MoneLarv pollcv Ŷ alm Lo lnfluence quanLlLv of monevţ lnLeresL raLes and
monev supplv ln Lhe economvŦ
O llscal pollcv Ŷ concerned wlLh aovernmenL spendlna and LaxaLlonŦ

Money supp|y (ava||ab|||ty of cred|t |n economy) may be contro||ed byť
(l) 8eserve requlremenL Ŷ cenLral bank seLs mlnlmum cash LhaL commerclal banks
musL keepŦ 1hls reduces Lhe monev borrowed and Lherefore conLrolled Lhe monev
supplvŦ
(ll) lnLeresL raLe Ŷ lnLeresL raLe ls Lhe prlce of monevţ so lncreases ln lnLeresL raLe
reduce Lhe demand for monevŦ
(lll) CuanLlLaLlve conLrol Ŷ lnLroduced bv aovernmenL Lo resLrlcL Lhe amounL of
monev lenL bv commerclal banksŦ
(lv) CuallLaLlve conLrol Ŷ lnLroduced bv aovernmenL noL Lo resLrlcL Lhe amounL of
monev able Lo lendţ buL Lo resLrlcL Lhe Lvpe of lendlna LhaL bank can doŦ
(v) pen markeL operaLlons Ŷ Chanae Lhe moneLarv base bv buvlna or selllna
flnanclal securlLles (allLs and bllls) ln Lhe open markeL so LhaL lL reduces bank
24

deposlLs and Lherefore banks' ablllLv Lo lendŦ CllLs are lssued bv aovernmenL Lo
borrow monevŦ
-ow Lrv uecember 2003 quesLlon 4Ŧ

Inf|at|on ls aeneral lncreases ln prlceŦ lnflaLlon reduces Lhe power of monevŦ Wen
tere |s |nf|at|onţ |nterest rates w||| be |ncreasedŦ 1hls ls because hlah demand for
monev can cause lnflaLlon as Lhe power of monev mav reduceŦ 1o lower Lhe demand
for monevţ lnLeresL raLes wlll be lncreasedŦ
ulfferenL raLes of lnflaLlon ln dlfferenL counLrles can have an |mpact on te
|nternat|ona| compet|t|veness of f|rmsŦ 1hls ls because Lhe prlce mav ao up buL
overseas cusLomer wlll noL wlsh Lo pav moreŦ
lnflaLlon also has a d|stort|ng effect on |nformat|on about company performanceţ
maklna comparlsons across dlfferenL Llme perlods dlfflculLŦ
ln mosL cases lnflaLlon wlll reduce prof|ts and cas f|owţ especlallv ln Lhe lona runŦ
Cter consequences of |nf|at|on |n economy lncludeť
8edlsLrlbuLlon Ŷ lnflaLlon redlsLrlbuLes lncome awav from Lhose on flxed lncomes
and Lhose ln a weak baraalnlna poslLlonţ people wlLh economlc power wlll aaln aL
Lhe expense of oLhersŦ
8esources Ŷ LxLra resources are llkelv Lo be used Lo cope wlLh Lhe effecLs of lnflaLlonŦ
uncerLalnLv and lack of lnvesLmenL Ŷ lnflaLlon Lends Lo cause uncerLalnLv amona Lhe
buslnessţ especlallv when Lhe raLe of lnflaLlon flucLuaLesŦ lL ls dlfflculL for flrms Lo
predlcL Lhelr cosLs and revenuesţ so Lhev mav be dlscouraaed from lnvesLlnaŦ
unemplovmenL mav rlse Ŷ lnflaLlon wlll cause Lhe need Lo lncrease waaes or salarles
of emplovees and emplovers mlahL noL wanL Lo emplov Loo manv peopleŦ
-ow Lrv !une 2006 quesLlon 3Ŧ
















23

apter 13 5ort and med|umŴterm f|nance
ShorL and medlum Lerm flnance mav come from a varleLv of sourcesŦ lL ls lmporLanL
Lo declde whlch ls mosL approprlaLe for dlfferenL slLuaLlonŦ
Worklna caplLal ls ofLen flnanced bv shorL and medlumŴLerm flnanceŦ

Companles ofLen have Lo relv on bank f|nance (overdraft and |oan)Ŧ
8efore bank lends monev Lo companvţ Lhev wlll conslder MÞkIť
(l) CharacLer of Lhe borrower Ŷ bv lnLervlew or looklna aL Lhe pasL recordŦ
(ll) AblllLv Lo borrow and repav Ŷ bv looklna aL cusLomer's flnanclal performance Lo
undersLand Lhelr llkelv fuLure poslLlonŦ
(lll) Maraln of proflL Ŷ bank lends monev ln order Lo make monevŦ lL needs Lo ensure
LhaL lL makes enouah of a proflL Lo cover Lhe rlsk LhaL lL Lakes bv lendlnaŦ
(lv) Þurpose of borrowlna Ŷ eaŦ 8ank wlll noL lend monev for llleaal purposeŦ
(v) AmounL of borrowlna Ŷ make sure LhaL cusLomer ls noL asklna for Loo much or
more Lhan ls neededŦ
(vl) 8epavmenL Lerms Ŵ bank musL noL lend monev Lo a person or companv who does
noL have Lhe ablllLv Lo repav lLţ even lf lL also has securlLv for Lhe loanŦ 8epavmenL
Lerm should be seL whlch ls reallsLlcţ eaŦ overdrafLs are repavable on demandŦ
(vll) lnsurance aaalnsL Lhe posslblllLv of nonŴpavmenL Ŵ When lendlna larae sums of
monev Lo an lndlvldual or Lo a companvţ Lhe bank mav ask for securlLv for Lhe loanŦ

1he secur|ty for a |oan should have Lhe followlna caracter|st|csť
(l) Lasv Lo Lake Ŵ Lhe securlLv should be easv Lo obLaln ln Lhe flrsL placeţ for exampleţ
LlLle documenLs Lo properLvŦ
(ll) Lasv Lo value Ŵ 1he securlLv should have a clearlv ldenLlflable value whlch ls elLher
sLable or lncreaslnaŦ
(lll) Lasv Lo reallze Ŵ 1he securlLv should ldeallv be readllv avallable for sale and
converL lnLo cashŦ

Cverdrafts are sub[ecL Lo an aareed llmlL and musL be pald lf bank demand for
repavmenL (repavable on demand)Ŧ lL ls a form of shorLŴLerm borrowlnaŦ verdrafL ls
commonlv used as a supporL for normal worklna caplLalţ eaŦ Lo lncrease Lhe currenL
asseLs or Lo reduce oLher currenL llablllLles (Lake advanLaae of aLLracLlve dlscounLs
offered bv suppllers for earlv seLLlemenL)Ŧ1he cusLomers onlv pavs lnLeresL when he
ls overdrawn (credlL balance of bank accounL)Ŧ

Loan ls a Lvpe of medlumŴLerm flnanceŦ lL ls drawn ln full aL Lhe bealnnlna of Lhe loan
perlod and repald aL a speclfled Llme or ln lnsLallmenLsŦ 1he Lerm of Lhe loan wlll be
deLermlned bv Lhe useful llfe of asseL purchasedţ Lhe auldellnes of Lhe bankţ
aovernmenL's quanLlLaLlve conLrol (chapLer 12) and Lhe resulLs of anv neaoLlaLlonsŦ
Loans can be repa|d |n tree waysť
26

(l) 8ulleL Ŷ no repavmenL of loan prlnclpal amounL (baslc amounL) ln Lhe loan perlodţ
lL ls repald ln full aL Lhe end of loan perlodŦ
(ll) 8alloon Ŷ some of Lhe loan prlnclpal ls repald durlna loan perlodţ Lhe resL of Lhe
amounL wlll be pald aL Lhe end of loan perlod (maLurlLv)Ŧ
(lll) AmorLlslna/sLralahL repavmenL loan Ŵ Lhe prlnclpal ls repald araduallv over Lhe
Lerm of Lhe loanţ alona wlLh Lhe lnLeresL pavmenLsŦ AL Lhe end of loan perlodţ Lhe
prlnclpal amounL wlll be zeroŦ
-ow Lrv uecember 2004 quesLlon 4Ŧ

Loan |nterest Lo be charaed Lo cusLomers wlll depend onť
O Level of rlsk
O SLaLus of Lhe borrower
O SecurlLv offered bv Lhe borrower
O AmounL of Lhe loan
O Þurpose of Lhe loan
O uuraLlon of Lhe loan

1aklna ouL loan ofLen lnclude obllaaLlons for Lhe borrowerţ Lhls ls called |oan
covenants (promlses)ť
(l) ÞoslLlve covenanLs are promlses bv borrower Lo do someLhlnaţ for example
provlde Lhe bank wlLh lLs annual flnanclal sLaLemenLsŦ
(ll) -eaaLlve covenanLs are promlses bv borrower noL Lo do someLhlnaţ for example
noL Lo borrow monev unLll Lhe currenL loan ls repaldŦ
(lll) CuanLlLaLlve covenanLs seL llmlLaLlons on Lhe borrower's flnanclal poslLlonţ for
example LoLal borrowlnas cannoL exceed 100Ʒ of shareholders' fundsŦ

dvantages of tak|ng |oan areť
(l) Lasler for plannlna because cusLomer and bank know exacLlv Lhe amounL of
repavmenL and lnLeresL charaedŦ
(ll) -o repavmenL on demandŦ
8uL ln addlLlon Lo lnLeresL pavableţ flrm mlahL have Lo pav arranaemenL feeţ leaal
cosLs and commlLmenL fees before Laklna Lhe loanŦ

1he relaLlonshlp beLween bank and cusLomer arlses from a leaal conLracL beLween
Lhem whlch lL ls necessarv Lo undersLandŦ 1here are four Lvpes of contractua|
re|at|ons|p between bank and customerť
(l) uebLor and credlLor Ŷ bank ls Lhe debLor lf cusLomer deposlLsţ cusLomer ls debLor
lf accounL ls overdrawnŦ
(ll) 8allor and ballee Ŷ Lhls arlses when cusLomer (ballor) dellvers personal properLv
Lo bank (ballee) and bank has Lo safeauard lLŦ 1hls ls a safe deposlL servlce Lo
cusLomersŦ
27

(lll) Þrlnclpal and aaenL Ŷ bank (aaenL) mav acL for cusLomer (prlnclpal)Ŧ
(lv) MorLaaaor and morLaaaee Ŷ bank (morLaaaor) asks a cusLomer (morLaaaee) Lo
secure a loan bv handllna over asseLs such as properLvŦ lf cusLomer does noL repav
Lhe loanţ bank can sell Lhe asseLŦ

Cter med|umŴterm f|nance lncludes hlre purchaseţ flnance leases and operaLlna
leasesť
Cperat|ng |eases Ŷ renLal aareemenLs beLween lessor and lessee (person who applv
for leaslna)ţ lessor supplles Lhe asseL Lo lessee for shorL perlodţ usuallv less Lhan Lhe
expecLed economlc llfe of Lhe asseLŦ Lessor wlll be responslble for servlclna and
malnLalnlna Lhe leased asseLŦ

I|nance |eases Ŷ an aareemenL beLween Lhe lessorţ who provldes flnance for Lhe
asseLţ and Lhe lesseeŦ AsseL ls usuallv supplled bv a Lhlrd parLv and lessor [usL provlde
flnanceŦ 1he lease has a prlmarv perlod whlch covers all or mosL of Lhe useful
economlc llfe of Lhe asseLŦ AL Lhe end of prlmarv perlodţ lessee ls allowed Lo
conLlnue Lo lease Lhe asseL for an undeflned secondarv perlod wlLh verv low nomlnal
renLŦ 1he lessee ls responslble for servlclna and malnLalnlna Lhe asseLŦ
-ow Lrv !une 2003 quesLlon 4Ŧ

n|re purcase Ŷ a form of lnsLallmenL credlLţ wherebv an lndlvldual or buslness
purchases aoods on credlL and pavs for Lhem bv lnsLallmenLsŦ 1he suppller of Lhe
aoods sells Lhem dlrecLlv Lo Lhe flnancler (usuallv a flnance house)Ŧ 1he suppller Lhen
supplles Lhe lessee wlLh Lhe aoodsŦ 1he lessee wlll usuallv be requlred Lo pav a
deposlL Lowards Lhe purchase prlce of Lhe aoodsŦ 1he aoods remaln Lhe properLv of
Lhe flnancler unLll Lhe end of Lhe aareemenLţ whlch ls when lessee had pald Lhe
aoods ln fullŦ 1he lessee makes reaular pavmenLs LhrouahouL Lhe lease perlod LhaL
conslsL of parLlv caplLal repavmenL and parLlv lnLeresLŦ













28

apter 14 LongŴterm f|nance
LonaŴLerm flnance ls usuallv obLalned from Lhe caplLal markeLs ln Lhe form of debL
(nonŴcurrenL llablllLles) and equlLv (shares) securlLlesŦ
ap|ta| markets are markeLs for Lradlna ln lonaŴLerm flnanceţ ln Lhe form of lonaŴ
Lerm flnanclal lnsLrumenLs such as equlLles and loan noLesŦ

1he stock excange ls Lhe maln markeL place for laraer buslnesses ln ukŦ lL ls a
markeL for buvlna and selllna of sLocksŦ 1here are two ma|n types of stock marketsţ
an aucLlon markeL and a dealer's markeLŦ
ln an aucLlon markeLţ lndlvlduals are buvlna and selllna from one anoLher and Lhere
ls an aucLlonŦ Speclallsed people wlll maLch Lhe buvers and sellersţ belna sure Lo
maLch Lhe hlahesL offered prlce (bv sellers) Lo Lhe lowesL asklna prlce (from buvers)ţ
Lhev make proflL from maLchlna correcL personŦ
ln a dealer's markeLţ markeL parLlclpanLs buv and sell from and Lo a dealerţ usuallv
known as a 'markeL maker'Ŧ

ln Lhe ukţ Lhe sLock markeL ls known as Lhe London 5tock LxcangeŦ 1here are
acLuallv Lwo markeLs wlLhln Lhls sLock exchanaeŦ 1he flrsL of Lhese ls Lhe fflclal LlsLŦ
1hls ls Lhe Lop Ller (level) of Lhe markeL and ls onlv avallable for larae companles who
can meeL Lhe sLrlcL llsLlna requlremenLsŦ 1he second Ller ls Lhe AlLernaLlve
lnvesLmenL MarkeL (AlM)Ŧ 1he llsLlna requlremenLs for Lhls markeL are less sLrlcLţ
hence lL ls used bv new and smaller companlesŦ

8emember LhaL sLock markeL has noLhlna relaLed Lo lnvenLorvţ sLocks refer Lo sharesŦ

lndlvlduals lnvesL ln Lhe sLock markeLţ buL Lhe mosL lmporLanL parLlclpanLs are Lhe
|nst|tut|ona| |nvestors (speclallse ln provldlna caplLal for reLurns) such as penslon
fundsţ lnsurance companles and unlL LrusLsť
(l) Þenslon funds Ŷ lndlvlduals pav penslon conLrlbuLlon Lo Lhe fundŦ lund manaaers
aeneraLe a reLurn from Lhese monles bv lnvesLlna caplLal ln flnanclal and oLher
asseLsŦ lnvesLors usuallv wlLhdraw from a penslon fund when Lhev reLlreŦ
(ll) lnsurance companles Ŷ lnsurance companles lnvesL premlums recelved bv
lnsurance pollcles holders (people who buv lnsurance)Ŧ 1hev alm Lo make a reLurn on
all Lhe monev Lhev holdţ [usL llke penslon companlesŦ
(lll) lnvesLmenL LrusLs Ŷ aeneraLe revenue bv lnvesLlna ln Lhe shares of oLher
companles and Lhe aovernmenLŦ
(lv) unlL LrusL companles Ŷ a unlL LrusL lnvesLs ln a ranae of companles' sharesŦ 1he
unlL LrusL companv creaLes a larae number of smaller unlLs and sells Lo lndlvldual
lnvesLorsŦ 1hese lnvesLors earn lncome from Lhe lnvesLmenLs and beneflL (hopefullv)
from Lhe lncrease ln Lhe value of Lhelr lnvesLmenLsŦ
29

(lv) venLure caplLallsLs Ŷ venLure caplLallsLs are oraanlsaLlons LhaL speclallse ln Lhe
ralslna of funds for new buslnessŦ 1he oraanlsaLlons provlde debL and equlLv caplLalŦ
1hev wlll usuallv wanL Lo have a represenLaLlve on Lhe companv's board of dlrecLorsŦ
1hev are rlskŴLaklna lnvesLorsŦ
Inst|tut|ona| |nvestors are ||ke |ntermed|ar|es beLween suppllers of funds and
people who demand for fundsŦ Suppllers of funds lnvesL ln Lhese lnsLlLuLlonsţ Lhen
Lhese lnsLlLuLlons lnvesL ln people who demand for fundsţ Lhen some amounL of
reLurns wlll be pald Lo suppllers of fundsŦ

I|otat|on (aolna publlc) refers Lo Lhe lssue of shares bv new or prlvaLe companv for
sale Lo Lhe aeneral publlcŦ ln ukţ Lnterpr|se Investment 5ceme (LI5) ls used Lo
encouraae lnvesLmenL ln smaller companv (unquoLed ln sLock markeL)Ŧ 1he
lndlvldual wlll save some lncome Lax for subscrlblna Lo lnvesL ln Lhese companlesŦ
Small and medlum slzed enLerprlse wlll be dlscussed ln chapLer 13Ŧ
A new lssue of shares lnvolves varlous cosLs Lo aeL Lhe lssue launchedŦ Lxamp|es of
costs of sare |ssue lncludeť
O underwrlLlna cosLs
O SLock exchanae llsLlna fee
O SollclLors' fees
O AdverLlslna cosLs
O AccounLanLs' fees
A r|gts |ssue ls an offer Lo exlsLlna shareholders enabllna Lhem Lo buv more sharesţ
usuallv aL a prlce lower Lhan Lhe currenL markeL prlceŦ 1hls ls Lo malnLaln Lhe voLlna
rlahLs of exlsLlna shareholdersŦ
-ow Lrv uecember 2008 quesLlon 4Ŧ

1he reasons for company to seek a stock market ||st|ng are LII1ť
(l) Access Lo wlder pool of flnance Ŷ sLock markeL llsLlna wldens Lhe number of
poLenLlal lnvesLorsŦ lL mav also lmprove Lhe companv's credlL raLlnaţ meanlna LhaL
more lnvesLors are wllllna Lo lnvesL ln lLŦ
(ll) LnhancemenL of Lhe companv lmaae Ŷ a companv's lmaae ls aenerallv lmproved
when lL becomes llsLedţ as lL ls belleved as belna more flnanclallv sLableŦ
(lll) lncreased markeLablllLv of shares Ŷ shares LhaL are Lraded on Lhe sLock markeL
can be bouahL and sold ln relaLlvelv small quanLlLles aL anv LlmeŦ
(lv) laclllLaLlon of arowLh bv acqulslLlon Ŷ lf a llsLed companv wlsh Lo make an offer
Lo Lakeover (buv) anoLher companvţ Lhev are ln a much beLLer poslLlon Lo do so Lhan
an unllsLed oneŦ
(v) 1ransfer of caplLal bv oLher uses Ŷ a sLock exchanae llsLlna alves founder
members more opporLunlLv Lo sell Lhelr shareholdlnaţ leavlna Lhem free Lo lnvesL ln
oLher pro[ecLsŦ
-ow Lrv uecember 2009 quesLlon 3Ŧ
30

Scrlp dlvldendsţ scrlp lssues/bonus lssues and sLock spllLs are meLhod of lncreaslna
Lhe lssued share caplLal of Lhe companvŦ
5cr|p d|v|dend ls a dlvldend pavmenL whlch Lakes Lhe form of new shares lnsLead of
cashŦ 1hereforeţ lL converLs reLalned earnlnas/losses lnLo lssued share caplLal (dld
noL pav dlvldend wlLh cash so reLalned earnlnas wlll lncreaseţ companv pavs
dlvldend bv lssulna new shares so lssued share caplLal lncreasesŦ)
8onus |ssue ls an lssue of new shares Lo exlsLlna shareholders bv converLlna equlLv
reserves lnLo lssued share caplLalţ leŦ lncrease Lhe lssued share caplLal bv reduclna
share premlum accounLŦ 8v creaLlna more shares ln Lhls wavţ a bonus lssue does noL
ralse new funds buL does have Lhe advanLaae of maklna shares cheaper and
Lherefore more easllv markeLable on Lhe sLock exchanaeŦ 1hls advanLaae of bonus
lssue ls also Lhe reason for a sLock spllLŦ
5tock sp||t occurs whereţ for example each ordlnarv share of $1 ls spllL lnLo Lwo
shares of 30c eachţ Lhus creaLlna cheaper shares wlLh areaLer markeLablllLvŦ

1he sources of |ongŴterm f|nance you need to be aware of areť
O rdlnarv shares/share caplLal Ŷ an equlLv flnanceŦ lL carrles voLlna rlahLs and
shareholders can parLlclpaLe ln ownershlp of companvŦ Shareholders recelve
lncome ln Lhe form of dlvldendsŦ
O 8eLalned earnlnas
O CranLs (supporL from aovernmenL)
O venLure caplLal (chapLer 13)
O 8onds Ŷ verv larae flxed lnLeresL loansŦ
O Lurobonds Ŷ bonds LhaL are bouahL and sold on lnLernaLlonal baslsŦ
O Þreference shares Ŷ shares whlch have flxed percenLaae dlvldendţ pald
before dlvldend pald Lo ordlnarv shareholdersŦ lL does noL have Lo be pald lf
companv cannoL afford lLŦ Þreference shareholders do noL carrv voLlna rlahLs
and Lherefore avold reduclna Lhe conLrol of exlsLlna shareholdersŦ Þreference
share caplLal ls noL secured on Lhe asseLs of Lhe companv llke debL and
Lherefore does noL resLrlcL Lhe companv's borrowlna power or lLs use of lLs
asseLsŦ lL ls noL Lax deducLlbleŦ lssulna preference shares reduce aearlna (as lL
lncreases equlLv)Ŧ
O Loan noLes/loan sLock Ŷ lonaŴLerm debL caplLalţ lnLeresL ls pald usuallv half
vearlv and aL flxed raLeŦ Polders of loan noLes are Lherefore lonaŴLerm
credlLors of Lhe companvŦ
O uebenLures Ŷ a form of loan sLockţ normallv conLalnlna provlslons abouL Lhe
pavmenL of lnLeresL and Lhe repavmenL of caplLalŦ
O ConverLlble bonds/loan noLes Ŷ flxed reLurn securlLlesţ ln addlLlonţ Lhev offer
rlahL Lo Lhe holder Lo converL Lhem lnLo ordlnarv shares aL a preŴdeLermlned
daLe aL a preŴdeLermlned prlceŦ
31

O WarranLs Ŷ rlahL alven bv a companv Lo an lnvesLorţ allowlna hlm Lo buv new
shares aL a fuLure daLe for a preŴdeLermlned prlce (Lhe exerclse prlce)Ŧ
WarranLs are usuallv lssued as parL of loan noLesţ purpose ls Lo make Lhe loan
noLes more aLLracLlveŦ WarranLs are deLachable from loan noLes and can be
soldŦ When markeL value of companv's shares lncreaseţ warranLs wlll be
valuable as lL allows holder Lo buv Lhe new shares wlLh exerclse prlceţ leŦ wlll
be cheaperŦ
-ow Lrv uecember 2006 quesLlon 4 and !une 2009 quesLlon 3Ŧ

ap|ta| structure refers Lo Lhe wav ln whlch an oraanlsaLlon ls flnancedţ bv a
comblnaLlon of equlLv and nonŴcurrenL llablllLles (ordlnarv shares and reservesţ
preference sharesţ loan sLockţ bank loansţ converLlble loan noLes and so on) and
currenL llablllLlesţ such as a bank overdrafL and pavablesŦ

When dec|d|ng on te m|x of debt and equ|ty f|nanceţ companv should Lake lnLo
accounL Lť
(l) CosL Ŷ Lhe cosL of equlLv ls hlaher Lhan Lhe cosL of debLŦ 1hls ls because an equlLv
lnvesLor Lakes a areaLer rlskŦ lf Lhe companv aoes lnLo llquldaLlonţ an equlLv lnvesLor
ls Lhe lasL person Lo be pald anv monevŦ 1hereforeţ an equlLv lnvesLor expecLs a
hlaher reLurn Lo reflecL Lhe rlsk he ls LaklnaŦ uebL flnance ls cheaper as lnLeresL
pavmenLs are Lax deducLlble buL dlvldends (for equlLv flnance) are noLŦ uebL flnance
also has lower rlskŦ
(ll) ConLrol of Lhe buslness Ŷ equlLv ls normallv lnvesLed lnLo Lhe buslness Lhrouah
Lhe lssue of ordlnarv sharesŦ Shareholders wlll share Lhe ownershlp of Lhe buslness
and carrv voLlna rlahLsŦ Penceţ a shareholder can parLlclpaLe ln buslness declslonsŦ
uebL flnance avolds Lhe share of conLrol (companv wlll sLlll have full conLrol)Ŧ
(lll) AmounL and maLurlLv of currenL debLs Ŷ a slanlflcanL dlfference beLween debL
and equlLv ls LhaL debL has Lo be repaldţ whereas equlLv does noLŦ lL ls Lherefore
essenLlal Lo revlew Lhe level of companv's currenL debL and Lhe Llme whlch lL has Lo
be repaldŦ
(lv) AvallablllLv of flnance Ŷ equlLv flnance ls llmlLed for prlvaLe companv as lL ls noL
allowed Lo offer lLs shares Lo aeneral publlcŦ uebL flnance wlll be more useful ln Lhls
caseŦ
(v) LffecL on aearlna Ŷ aearlna ƹ debL/equlLvŦ lf debL lncreased Loo much compare Lo
equlLvţ poLenLlal lenders wlll Lhen see companv as a hlah rlsk lnvesLmenLŦ 1hev wlll
Lhen expecL beLLer reLurns Lo reflecL Lhelr lncreased level of rlskŦ AL worsLţ Lhev wlll
refuse Lo lend aL allŦ
-ow Lrv !une 2004 quesLlon 4Ŧ



32

apter 15 I|nanc|ng of sma|| and med|umŴs|zed enterpr|ses
5ma|| and med|umŴs|zed enterpr|ses (5MLs) ofLen have dlfflculLv ralslna flnance as
Lhev are llkelv Lo be unquoLed ln sLock markeLţ ownershlp ls resLrlcLed Lo few
lndlvlduals and run verv small buslnessesŦ 1he rlsks faced bv SMLs caused dlfflculLv ln
obLalnlna flnance (people are afrald Lo lnvesL ln Lhem)Ŧ
SMLs mav noL know abouL Lhe sources of flnance avallableŦ
5|gn|f|cant |nf|uences on te cap|ta| structure (way of f|nanc|ng) of sma|| f|rms areť
O Lack of separaLlon beLween ownershlp and manaaemenLŦ
O Lack of equlLv flnanceŦ

CovernmenLs from around Lhe world provlde ald for SMLs ln Lhelr counLrvŦ 1hls ls
ofLen ln Lhe form of grantsŦ Uk government a|d lncludesť
(l) Loan auaranLee scheme Ŷ help buslnesses Lo aeL a loan from Lhe bank because
bank would be unwllllna Lo lend as SMLs cannoL offer Lhe securlLv LhaL Lhe bank
would wanLŦ
(ll) uevelopmenL aaencles Ŷ encouraae Lhe sLarLŴup and developmenL of small
companles bv provldlna asslsLance such as free facLorv accommodaLlon and flnanclal
asslsLanceŦ
(lll) LnLerprlse lnvesLmenL Scheme (LlS) Ŷ encouraae lnvesLmenL ln Lhe ordlnarv
shares of unquoLed companles and Lhose who lnvesL are quallfled for reducLlon ln
lncome LaxŦ

Þoss|b|e sources of f|nance for 5MLs lncludeť
(l) LqulLv Ŷ owner's personal resources or Lhose of famllv connecLlons are aenerallv
Lhe lnlLlal sources of flnanceŦ Slnce Lhe buslness wlll have few Lanalble asseLs aL Lhls
sLaaeţ lL wlll be dlfflculL Lo obLaln equlLv from elsewhereŦ
(ll) verdrafL flnanclna Ŷ dlscussed ln chapLer 13 buL Lhe lnLeresL mav be expenslve
as bank Lakes Lhe rlskŦ
(lll) 8ank loans Ŷ dlscussed ln chapLer 13ţ bank loans are llkelv Lo be avallable onlv for
pro[ecLs or asseLs whlch are ln lonaŴLermŦ
(lv) 1rade credlL Ŷ Laklna exLended credlL from suppllers ls a source of flnance for
manv SMLsŦ Powever Lhls mlahL cause loss of earlv seLLlemenL dlscounLs and loss of
suppller aoodwlllŦ
(v) 8uslness anael flnanclna Ŷ 8uslness anaels are wealLhv lndlvlduals who lnvesL
dlrecLlv ln small buslnessesŦ Powever Lhe amounL of monev avallable from lndlvldual
anaels mav be llmlLedŦ
(vl) Leaslna Ŷ dlscussed ln deLalled ln chapLer 13Ŧ
(vll) lacLorlna Ŷ dlscussed ln deLalled ln chapLer 10Ŧ
(vlll) venLure caplLal Ŷ venLure caplLallsLs are prepared Lo lnvesL ln new buslnesses
and speclflc expanslon pro[ecLsŦ Powever Lhev wlll be less lnLeresLed ln provldlna Lhe
monev requlred Lo flnance runnlna expendlLure and worklna caplLal requlremenLs (ln
33

Lhls caseţ overdrafL wlll be more sulLable)Ŧ Alsoţ venLure caplLallsLs wlll wanL Lo
lnvolve ln runnlna Lhe buslness because of Lhelr need Lo proLecL Lhelr lnvesLmenLŦ
-ow Lrv !une 2006 quesLlon 4 and uecember 2010 quesLlon 3Ŧ

Venture cap|ta||sts w||| take |nto account certa|n factors |n dec|d|ng weter or not
to |nvestť
(l) 1he naLure of companv's producL Ŷ Lhe selllna poLenLlal of producLsŦ
(ll) LxperLlse ln producLlon Ŷ Lechnlcal ablllLv Lo produce efflclenLlvŦ
(lll) LxperLlse ln manaaemenL Ŷ commlLmenLţ skllls and experlenceŦ
(lv) MarkeL and compeLlLlon Ŷ LhreaL from currenL compeLlLors and also fuLure new
compeLlLorsŦ
(v) luLure proflLs Ŷ Lhev wlll wanL Lo see Lhe deLalled buslness planŦ
(vl) 8oard membershlp Ŷ Lhev wlll ensure LhaL Lhev are parL of represenLaLlves of Lhe
board of dlrecLors and have sav ln fuLure sLraLeavŦ
(vll) LxlL rouLes Ŷ Lhev wlll conslder poLenLlal exlL rouLes ln order Lo reallse Lhe
lnvesLmenLŦ
-ow Lrv uecember 2007 quesLlon 3Ŧ
























34

apter 16 Dec|s|on mak|ng
?ou would have learnL shorLŴLerm declslonŴmaklna ln earller sLudlesţ now vou can
applv whaL vou learnL ln lonaer quesLlonsŦ
1he re|at|ons|p between cost beav|our and t|me can be summarlsed as followť
O CosLs wlll be flxedţ varlable or semlŴvarlable ln shorL Llme perlodŦ
O ln lonaer Lermţ all cosLs wlll Lend Lo chanae ln response Lo larae chanaes ln
acLlvlLv levelŦ
?ou are assumed Lo have aood knowledae ln absorpLlon and maralnal cosLlnaŦ
Maralnal cosLlna provldes more useful declslonŴmaklna lnformaLlon Lhan absorpLlon
cosLlna as lL uses conLrlbuLlon concepLŦ
1rv !une 2010 quesLlon 4 (d)Ŧ

?ou mav be asked Lo ldenLlfv relevanL cosLs from lnformaLlon alvenţ |f te cost |s not
re|evantţ you sou|d state |t rater tan |eave |tŦ
8elevanL cosLs are fuLure cosLsţ lncremenLal cosLs and cash flowsŦ Lher Lerms can
be used Lo descrlbe relevanL cosLsť
(l) Avoldable cosL Ŷ cosLs whlch can be avolded lf Lhe relaLed acLlvlLv dld noL exlsLŦ
(ll) ulfferenLlal cosL Ŷ dlfference ln relevanL cosL beLween alLernaLlvesŦ LaŦ lf opLlon A
wlll cosL an exLra $300 and opLlon 8 wlll cosL an exLra $360ţ Lhe dlfferenLlal cosL ls
$60Ŧ
(lll) pporLunlLv cosL Ŷ beneflL foraone/conLrlbuLlon loss bv chooslna one opLlon
lnsLead of anoLherŦ LaŦ lf Lhls [ob ls noL underLakenţ machlne can be used Lo aeneraLe
$100 from oLher [obţ opporLunlLv cosL of dolna Lhls [ob ls $100Ŧ

1here are some ru|es |n |dent|fy|ng re|evant costs for mater|a| and |abourţ some
quesLlons wlll be askedť
(l) MaLerlal Ŷ sLock avallable? lf noţ relevanL cosL ls purchase cosLţ lf vesţ move on Lo
nexL quesLlonŦ Wlll Lhe maLerlal be replaced/used? lf vesţ relevanL cosL ls purchase
cosLţ lf noţ Lhe relevanL cosL wlll be Lhe hlaher of resale value and value from
alLernaLlve useŦ
Look aL uecember 2010 mulLlple cholces quesLlon 10 for LhlsŦ
(ll) Labour Ŷ anv spare capaclLv (free Llme)? lf vesţ relevanL cosL ls zeroţ lf noţ move
on Lo nexL quesLlonŦ Can hlre people? lf vesţ relevanL cosL ls Lhe baslc raLe of hlred
peopleţ lf noţ relevanL cosL ls Lhe lower of overLlme and opporLunlLv cosL (Lake
people from oLher work Lo do Lhls workţ oLher work's lncome wlll be Lhe opporLunlLv
cosL) + baslc raLeŦ

A number of Lerms are used Lo descrlbe cosLs LhaL are lrrelevanL for declslon maklna
(nonŴre|evant costs)ť
(l) Sunk cosL Ŷ pasL/old cosLŦ
(ll) CommlLLed cosL Ŷ fuLure cash ouLflow LhaL wlll be lncurred anvwavŦ
33

(lll) -oLlonal cosL/lmpuLed cosL Ŷ lmaalnarv cosLţ eaŦ noLlonal lnLeresL charaes on
caplLal emplovedŦ

unless vou are alven speclal caseţ lf noLţ assume Lhe followlnať
O Var|ab|e costs w||| be re|evant costsŦ
O I|xed costs are |rre|evant to a dec|s|onŦ
nlv aLLrlbuLable flxed cosLs/lncremenLal flxed cosLs (lncrease lf cerLaln exLra
acLlvlLles are underLaken) are relevanLţ aeneral flxed overheads are noL relevanLŦ
A aood quesLlon Lo Lrv on ls Lhe 17 uecember 2004 quesLlon 2Ŧ
Some of Lhe assumpt|ons are made |n re|evant cost|ngť
O CosL behavlour paLLerns are knownŦ
O AmounL of flxed cosLsţ unlL varlable cosLsţ sales prlce and sales demand are
known wlLh cerLalnLvŦ
O lnformaLlon ls compleLe and rellableŦ

A llmlLlna facLor ls a facLor whlch llmlLs Lhe oraanlsaLlon's acLlvlLlesŦ 1here are 4
Lvpes of shorLŴLerm declslons Lo learnŦ ?ou would have know how Lo make product
m|x dec|s|onsţ here ls some recallť
1Ŧ ldenLlfv llmlLlna facLorŦ
2Ŧ CalculaLe conLrlbuLlon per unlL for each producLŦ
3Ŧ CalculaLe conLrlbuLlon per llmlLlna facLorŦ
4Ŧ 8ank producLs (flrsL for producL wlLh hlahesL conLrlbuLlon per llmlLlna facLor)Ŧ
3Ŧ pLlmal producLlon planţ sLarL wlLh Lhe flrsL ranked producL unLll scarce resource
ls used upŦ

Companv wlll have make or buy dec|s|on when Lhev can make Lhe producL or buv
from ouLslde (ouLsource)Ŧ 1here are Lwo posslblllLlesť
(l) Pave enouah resources Ŷ ln Lhls caseţ Lo declde wheLher or noL Lo buv ouLsldeţ
Lake purchase cosL per unlL from ouLslde Ŷ varlable cosL per unlLţ lf poslLlveţ lL means
savlna cosL per unlL lf makeţ companv shall noL buvŦ
(ll) uon'L have enouah resourcesţ musL buv some Ŷ ln Lhls caseţ companv has Lo
declde whlch maLerlals Lo buv ln order Lo mlnlmlse cosLsţ for each maLerlalsţ Lake
purchase cosL per unlL from ouLslde Ŷ varlable cosL per unlL and Lhen dlvlde bv
llmlLlna facLor Lo aeL savlna cosL per llmlLlna facLorţ companv should buv Lhe
maLerlals wlLh lowesL savlna cosL per llmlLlna facLorŦ

5ut down dec|s|ons lnvolve decldlna wheLher or noL Lo shuL down a facLorvţ
deparLmenL or producL llneŦ Companv should noL shuL down facLorles whlch can help
Lo aeneraLe proflL ln Lhe fuLureŦ

36

CneŴoff dec|s|on concerns a conLracL whlch would uLlllse spare capaclLv buL would
have Lo be accepLed aL lower prlceŦ ?ou can assume LhaL conLracL wlll be accepLed lf
lL lncreases conLrlbuLlon and hence proflLŦ

1e ma|n argument |n favour of opportun|ty cost|ng ls LhaL manaaemenL are more
aware of how well Lhev are uslna resourcesţ and wheLher resources could be used
beLLer ln oLher wavsŦ
1e ma|n drawback to opportun|ty cost|ng ls a pracLlcal oneŦ lL ls noL alwavs easv Lo
recoanlse alLernaLlve uses for cerLaln resources and puL an accuraLe value on
opporLunlLv cosLŦ lL ls onlv llkelv Lo be accuraLe ln slLuaLlons where resources have an
alLernaLlve use whlch can be valued aL an exLernal markeL prlceŦ






























37

apter 17 VÞ ana|ys|s
VÞ ana|ys|s/breakeven ana|ys|s ls Lhe sLudv of lnLerrelaLlonshlps beLween cosLsţ
volume and proflL aL varlous level of acLlvlLvŦ Make sure LhaL vou undersLand how Lo
calculaLe Lhe breakeven polnLţ Lhe C/S raLloţ Lhe maraln of safeLv and LaraeL proflLsţ
and can applv Lhe prlnclples of CvÞ analvsls Lo declslons abouL wheLher Lo chanae
sales prlces or cosLsŦ ?ou should also be able Lo consLrucL breakeven charLs and
proflL/volume charLsŦ

8reakeven po|nt ls Lhe acLlvlLv level aL whlch Lhere ls no aaln no lossţ calculaLed as
flxed cosLs/conLrlbuLlon per unlL for unlLs flaureţ flxed cosLs dlvlde bv C/S raLlo Lo aeL
$ flaureŦ C/S raLlo ƹ conLrlbuLlon per unlL/selllna prlce per unlL or LoLal
conLrlbuLlon/LoLal salesŦ AL breakeven polnLţ LoLal conLrlbuLlon ƹ flxed cosLsŦ

Marg|n of safety ƹ budaeLed sales Ŷ breakeven salesţ lL ls an lndlcaLlon of safe (no
loss) lf sales are wlLhln maraln of safeLvŦ
lf asked Lo assess performance on Lhe basls of C/S raLloţ maraln of safeLv and
breakeven polnLţ vou need Lo conslder Lhe followlna facLorsť
O |ow marg|n of safety |nd|cates a |g |eve| of r|skŦ
O 1e c|oser te breakeven po|nt to budgeted/recent sa|es |eve|sţ te |ger
te r|skŦ
O 1e |ger te /5 rat|oţ te faster prof|ts w||| growŦ
1argeted sa|es (un|ts) ƹ (flxed cosLs + LaraeL proflL)/conLrlbuLlon per unlLŦ
-ow Lrv !une 2010 quesLlon 4Ŧ

1he breakeven polnL can also be deLermlned araphlcallv uslna breakeven charLŦ A
breakeven cart ls a charL whlch shows approxlmaLe levels of proflLs or loss aL
dlfferenL sales volume levels wlLhln a llmlLed ranaeŦ 1he charL wlll look llke Lhlsť

?Ŵaxls shows cosLs and xŴaxls shows sales volumeŦ llrsL sLep ls Lo draw Lhe flxed cosLs
llne and Lhen onlv Lhe LoLal cosLs llneŦ 1he lnLersecLlon beLween LoLal sales revenue
and LoLal cosL ls breakeven polnLŦ Maraln of safeLv wlll be Lhe area beLween
breakeven polnL and LoLal sales revenueŦ
38

1he prof|t/vo|ume (Þ/V) cart provldes slmple lllusLraLlon of Lhe relaLlonshlp of
cosLs and proflLs Lo salesŦ 1he charL wlll look llke Lhlsť


?Ŵaxls shows proflL/loss and xŴaxls shows sales volumeŦ 1he llne wlll sLarL from flxed
cosLs polnL ($13000)ţ Lhen puL a polnL on accordlna Lo proflLs earned from sales (ln
hereţ aL sales of 2000 unlLsţ proflLs are $13000)ţ Lhen [oln Lhe llneţ Lhe lnLersecLlon ln
xŴaxls ls breakeven polnL (selllna 1000 unlLs of Lhe producL wlll aeL no aaln no loss)Ŧ
ne more Lhlna Lo noLe hereţ Lhe aradlenL of Lhls llne wlll be Lhe conLrlbuLlon per
unlL (or C/S raLlo lf sales value ls used Lo draw Lhls araph)Ŧ

uo noL foraeL LhaL CvÞ analvsls does have ||m|tat|onsť
(l) lL ls onlv valld wlLhln a ºrelevanL ranae" of volumesŦ
(ll) lL measures proflLablllLvţ buL does noL conslder Lhe volume of caplLal emploved Lo
achleve such proflLsŦ
(lll) Assume LhaL all cosLs can be classlfled as elLher flxed or varlableŦ
(lv) Assume flxed cosLs are same ln LoLal and varlable cosLs are Lhe same per unlL aL
all levels of ouLpuLţ Lhls ls wronaŦ
(v) Assume LhaL sales prlces wlll be consLanL aL all levels of acLlvlLvŦ
(vl) ÞroducLlon and sales are assumed Lo be Lhe sameŦ

8reakeven analvsls should be used wlLh full awareness of lLs llmlLaLlonsţ buL can
usefullv be applled Lo prov|de s|mp|e and qu|ck est|mates of breakeven vo|umes or
prof|tab|||ty wlLhln a ºrelevanL ranae" of ouLpuL/sales volumesŦ
-ow Lrv uecember 2009 quesLlon 2 and uecember 2010 quesLlon 4Ŧ








39

apter 18 ap|ta| expend|ture budget|ng
ap|ta| expend|ture budget ls essenLlallv a nonŴcurrenL asseL purchase budaeLţ and
lL wlll form parL of lonaer Lerm plan of a buslnessŦ 8eaular and mlnor nonŴcurrenL
asseL purchases mav be covered bv an annual allowance provlded for ln Lhe caplLal
expendlLure budaeLŦ Ma[or pro[ecLs wlll need Lo be consldered lndlvlduallv and wlll
need Lo be fullv appralsedŦ
ap|ta| expend|ture ls expendlLure whlch resulLs ln Lhe purchases or lmprovemenL of
nonŴcurrenL asseLsŦ
kevenue expend|ture ls expendlLure whlch ls lncurred for elLher of Lhe followlna
reasonsť
O 1radlna purpose Ŷ eaŦ selllna and dlsLrlbuLlon expensesŦ
O MalnLaln Lhe exlsLlna earnlna capaclLv of nonŴcurrenL asseLsŦ

MosL oraanlzaLlons keep an asset reg|sterŦ 1hls ls a llsLlna of all nonŴcurrenL asseLs
owned bv Lhe oraanlzaLlon broken down bv deparLmenLţ locaLlon or asseL LvpeŦ
ulfference beLween asseL realsLer and acLual nonŴcurrenL asseLs presenL (and
aeneral ledaer) musL be lnvesLlaaLedŦ AsseL realsLer mav lnclude deLalls llke
descrlpLlon of asseLţ locaLlon of asseLţ purchase daLeţ cosLţ depreclaLlon meLhodţ
esLlmaLed useful llfeţ dlsposal proceeds and accumulaLed depreclaLlonŦ

5teps |nvo|ved |n pro[ect appra|sa| areť
(l) lnlLlal lnvesLlaaLlon Ŷ llrsLlvţ a declslon musL be made as Lo wheLher Lhe pro[ecL ls
Lechnlcallv and commerclallv feaslbleŦ 1hls lnvolves assesslna Lhe rlsks and decldlna
wheLher Lhe pro[ecL ls ln llne wlLh Lhe companv's lonaŴLerm sLraLealc ob[ecLlvesŦ
(ll) ueLalled evaluaLlon Ŷ a deLalled lnvesLlaaLlon wlll Lake place ln order Lo examlne
Lhe pro[ecLed cash flows of Lhe pro[ecLŦ SenslLlvlLv analvsls ls performed and sources
of flnance wlll be conslderedŦ lnvesLmenL appralsal wlll Lake place aL Lhls sLaaeŦ
(lll) AuLhorlsaLlon Ŷ for slanlflcanL pro[ecLsţ Lhere musL be auLhorlsaLlon from Lhe
companv's senlor manaaemenL and 8oard of ulrecLorsŦ 1he pro[ecLs wlll onlv sLarL lf
lL ls auLhorlsedŦ
(lv) lmplemenLaLlon Ŷ responslblllLv for Lhe pro[ecL ls alven Lo a pro[ecL manaaer or
oLher responslble personŦ 1he resources wlll be made avallable for lmplemenLaLlon
and speclflc LaraeLs wlll be seLŦ
(v) Þro[ecL monlLorlna Ŷ now Lhe pro[ecL has sLarLedţ proaress musL be monlLored
and senlor manaaemenL musL be kepL lnformed of proaressŦ
CosLs and beneflLs mav have Lo be reŴassessed lf unforeseen evenLs occurŦ
(vl) ÞosLŴcompleLlon audlL Ŷ aL Lhe end of Lhe pro[ecLţ an audlL wlll be carrled ouL so
LhaL lessons can be learned Lo help fuLure pro[ecL plannlnaŦ



40

apter 19 Metods of pro[ect appra|sa|
A lonaŴLerm vlew of beneflLs and cosLs musL be Laken when revlewlna a caplLal
expendlLure pro[ecLŦ Some nonŴf|nanc|a| factors should also be Laken lnLo accounL
before maklna an lnvesLmenL declslonť
(l) Leaal lssues Ŷ posslble leaal acLlons should be conslderedŦ
(ll) LLhlcal lssues Ŷ uneLhlcal acLlons could be damaalnaŦ
(lll) Chanaes Lo reaulaLlons
(lv) CuallLv
(v) Level of compeLlLlon Ŷ lnvesLmenL ln new producL mav be maLched bv a
compeLlLor durlna Lhe producL's llfeŴLlmeţ affecLlna revenuesŦ

key metods of pro[ect appra|sa| are accounLlna raLe of reLurn (A88)ţ pavback
perlodţ neL presenL value (-Þv)ţ dlscounLed pavback perlod and lnLernal raLe of
reLurn (l88)Ŧ 8elevanL and nonŴrelevanL cosLs (chapLer 16) should be used when
applvlna Lhese meLhodsŦ

kk or reLurn on lnvesLmenL (8l) calculaLes esLlmaLed averaae proflLs/esLlmaLed
averaae lnvesLmenL x 100Ʒ Lo evaluaLe an lnvesLmenLŦ
Averaae proflL can be calculaLed as LoLal proflLs for x vear/x vearŦ Averaae
lnvesLmenL can be calculaLed as (lnlLlal lnvesLmenL cosLs + resldual value)/2Ŧ
1he formula can also be proflLs/lnvesLmenL x 100Ʒţ so vou have Lo clearlv sLaLe Lhe
formula ln examŦ Þro[ecLs wlLh hlaher A88 would be chosenŦ

dvantages of kk areť
(l) A wldelv undersLood and used meLhodţ lL ls ln percenLaae as wellŦ
(ll) use readllv avallable accounLlna daLaŦ
D|sadvantages of kk areť
(l) 8ased on accounLlna proflLs (accrual concepL) raLher Lhan cash flow whlch
lncluded cosLs llke depreclaLlonţ Lherefore mav noL be relevanL Lo Lhe pro[ecL
performanceŦ
(ll) uoes noL Lake lnLo accounL Lhe Llmlna of cash lnflows and ouLflowsŦ

1he payback per|od ls Lhe Llme Laken for Lhe lnlLlal lnvesLmenL Lo be recovered bv
cash lnflowsŦ LaŦ an lnvesLmenL would cosLs $10000 and aeneraLe cash lnflows of
$3000 per annumţ whaL ls Lhe pavback perlodť
Answerť ?ear cash flows ($) accumulaLed cash flows ($)
0 ($10000) ($10000)
1 $3000 ($7000)
2 $3000 ($4000)
3 $3000 ($1000)
4 $3000 $2000
41

Þavback perlod ƹ 3 vears + 2000/3000 x 12 monLhs ƹ 3 vears 8 monLhsŦ
1he pro[ecL wlLh shorLer pavback perlod wlll be chosenŦ

dvantages of payback per|od areť
(l) lL ls easv Lo calculaLe and undersLand
(ll) Wldelv used ln pracLlce as a flrsL screenlna meLhod (fasL check)Ŧ
(lll) ldenLlfv qulck cash aeneraLlna pro[ecLsŦ

D|sadvantages of payback per|od areť
(l) 1oLal proflLablllLv ls lanoredŦ
(ll) 1lme value of monev ls lanoredŦ
(lll) uoes noL Lake lnLo accounL poslLlve cash lnflows occurrlna afLer Lhe end of Lhe
pavback perlodŦ

1|me va|ue of money ls an lmporLanL conslderaLlon ln declslonŴmaklnaŦ l wlll use 10
vears as exampleŦ MosL people would prefer $100 Lodav raLher Lhan $100 ln 10
vearsƌ LlmeŦ 8ecause $100 wlll probablv buv vou less ln 10 vearsƌ Llme Lhan lL wlll
LodavŦ
D|scount|ng helps us Lo undersLand how much we would need Lo lnvesL Lodav lf we
wanLed Lo recelve $100 ln 10 vearsƌ Llmeţ alven a cerLaln raLe of lnLeresLŦ ulscounLlna
ls a meLhod of converLlna fuLure cash flows lnLo presenL value (Lhe value now)ţ vou
need Lo know how Lo use Lhe presenL value Lable (alLhouah normallv examlner
exLracLs Lhe dlscounL facLor for vou and presenL value Lable ls noL provlded ln exam
for Lhls paper)Ŧ

ompound|ng ls slmplv Lhe reverse of LhlsŦ lL helps us Lo calculaLe Lhe fuLure sum
LhaL wlll be recelved lf Lhe $100 were lnvesLed Lodav for 10 vearsŦ Compoundlna ls
Lherefore a meLhod of converLlna presenL value Lo fuLure value bv uslna Lhe formulať
I ƹ Þ (1 + r) Ɗ nţ l ls fuLure valueţ Þ ls amounL lnvesLed nowţ r ls raLe of lnLeresL ln
declmalţ n ls number of vearsŦ LaŦ Lhe cosL of lnvesLmenL ls $2000 now aL 10Ʒţ whaL
would Lhe lnvesLmenL be worLh afLer 3 vears?
Answerť l ƹ $2000 (1 + 0Ŧ10) Ɗ 3 ƹ $3222Ŧ

8v Laklna lnLo accounL Lhe Llme value of monev and dlscounLlna Lhe cash flowsţ
pro[ecLs can be appralsed before Lhe lnvesLmenL declslon ls madeŦ ulscounLed cash
flow (uCl) can be used ln -Þv meLhodţ dlscounLed pavback meLhod and l88Ŧ

NÞV metod calculaLes Lhe presenL value of all cash flowsţ and sums Lhem Lo alve
Lhe -ÞvŦ lf Lhls ls poslLlveţ Lhen Lhe pro[ecL ls accepLableŦ -Þv meLhod ls verv
lmporLanL and ls examlned ln everv slLLlnaţ vou should be confldenL deallna wlLh lLŦ
When performlna -Þv calculaLlonsţ Lhe fo||ow|ng approac sou|d be takenť
42

(l) ldenLlfv Lhe relevanL cash lnflows and ouLflows of Lhe pro[ecLţ noL foraeLLlna Lhe
lnlLlal lnvesLmenLŦ
(ll) Add up Lhe cash lnflows and ouLflows for each vearţ Lhen dlscounL each of Lhe
cash flows Lo lLs presenL valueţ uslna Lhe companvƌs cosL of caplLal (requlred raLe of
reLurn) Ŷ dlscounL Lables wlll be provldedŦ
(lll) CalculaLe Lhe neL presenL value of Lhe pro[ecL bv addlna all presenL values for
each vearŦ
(lv) ueclde wheLher or noL Lhe pro[ecL should be accepLed (accepL lf poslLlve -Þv)Ŧ
-ow Lrv !une 2003 quesLlon 2ţ uecember 2007 quesLlon 1 and uecember
2010 quesLlon 1Ŧ

dvantages of NÞV areť
(l) Maxlmlslna shareholder wealLhŦ
(ll) 1akes lnLo accounL Lhe Llme value of monevŦ
(lll) 8ased on cash flows whlch are less sub[ecLlve Lhan proflLŦ
(lv) Shareholders wlll beneflL lf a pro[ecL wlLh a poslLlve -Þv ls accepLedŦ

D|sadvantages of NÞV areť
(l) Can be dlfflculL Lo ldenLlfv an approprlaLe dlscounL raLe (Lhls depends on cosL of
caplLal/requlred raLe of reLurn)Ŧ
(ll) Cash flows are assumed Lo occur aL vear ends onlvŦ
(lll) Some manaaers are unfamlllar wlLh Lhe concepL of -ÞvŦ

1he d|scounted payback metod ls slmllar Lo pavback meLhod buL lL uses presenL
values lnsLead of cash flowsŦ
-ow Lrv !une 2003 quesLlon 3Ŧ

nnu|t|es are annual cash flows whlch ls Lhe same amounL everv vear for a number
of vearsŦ When Lhere ls annulLv Lo be dlscounLedţ Lhere ls a shorLcuL meLhod of
calculaLlon whlch ls uslna Lhe annulLv facLor (provlded ln exam)Ŧ ?ou should use
annulLv facLor whenever posslble Lo save LlmeŦ
-ow Lrv !une 2009 quesLlon 1 and !une 2006 quesLlon 1Ŧ

1he Ikk Lells us Lhe raLe aL whlch Lhe -Þv of a pro[ecL ls zeroŦ 1here are four steps to
an Ikk ca|cu|at|onť
1Ŧ CalculaLe Lhe pro[ecLƌs -Þv aL cosL of caplLal (requlred raLe of reLurn)Ŧ
2Ŧ lf Lhe above -Þv ls poslLlveţ choose a hlaher dlscounL raLe (Lhls mav be alven ln
Lhe exam) and calculaLe Lhe -Þv aaalnŦ lf Lhe above -Þv was neaaLlveţ choose a
lower dlscounL raLeŦ 1hls ls because vou need a poslLlve and a neaaLlve -ÞvŦ
3Ŧ ?ou musL now calculaLe Lhe l88 bv uslna Lhe followlna formulať
Ikk ƹ + ż(a/a Ŷ b) x (8 Ŷ )Ž
43

Where A ls Lhe lower dlscounL raLe and 8 ls Lhe hlaher raLeţ a ls Lhe -Þv aL Lhe lower
raLe and b ls Lhe -Þv aL Lhe hlaher raLeŦ

4Ŧ 1he l88 musL Lhen be compared Lo Lhe companvƌs cosL of caplLal (requlred raLe of
reLurn)Ŧ lf l88 ls hlaher Lhan Lhe requlred raLe of reLurnţ Lhe pro[ecL should be
accepLedŦ lf lL ls lower Lhan Lhe requlred raLe of reLurnţ Lhe pro[ecL should be
re[ecLedŦ
lor exampleţ companv's cosL of caplLal ls 10Ʒ and conslderlna a pro[ecLŦ -Þv uslna
10Ʒ raLe of reLurn ls $1000ţ afLer calculaLlna -Þv aL raLe of reLurn of 13Ʒţ -Þv ƹ
($3000)ţ calculaLe l88Ŧ
Answerť l88 ƹ 10 + ż(1000/1000 + 3000) x (13 Ŷ 10)Ž ƹ 11Ŧ23Ʒţ lL ls hlaher Lhan cosL
of caplLal of companv and Lherefore Lhe pro[ecL ls accepLableŦ
SomeLlmes Lhere ls a mutua||y exc|us|ve pro[ect where -Þv shows poslLlve buL l88 ls
lower Lhan cosL of caplLalŦ ln Lhls caseţ we wlll Lake -Þv as prlorlLv and accepL Lhe
pro[ecLŦ

dvantages of Ikk areť
(l) 1ake lnLo accounL Lhe Llme value of monevŦ
(ll) 8esulLs are expressed as slmple percenLaaeţ easler Lo undersLandŦ
(lll) lndlcaLes how senslLlve calculaLlons are Lo chanaes ln lnLeresL raLesŦ

D|sadvantages of Ikk areť
(l) Mav be confused wlLh A88Ŧ
(ll) Þroblems occur lf Lhere ls muLuallv excluslve pro[ecLŦ
(lll) Some manaaers are noL famlllar wlLh l88 meLhodŦ
-ow Lrv !une 2004 quesLlon 1 and !une 2007 quesLlon 1Ŧ

ap|ta| budget|ng dec|s|ons |n te pub||c sector are noL ofLen made wlLh Lhe
lnLenLlon of earnlna proflLsŦ Soclal cosLs and soclal beneflLs can be verv lmporLanL ln
publlc secLor lnvesLmenL appralsalsŦ

Lnd of notesţ now do any past year quest|on tat |s |eft and you are we||ŴpreparedŦ

Sign up to vote on this title
UsefulNot useful