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20 02
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Foundations in
Financial
Management (FFM)
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Chapter 1
WORKING CAPITAL MANAGEMENT (1)
1. Introduction
The purpose of this chapter is to explain the nature of working capital and the importance of it to
the financial manager. We will also consider various ratios and measures which may be useful to
the financial manager in assessing how well working capital is being controlled.
It normally includes inventories, receivables, cash (and cash equivalents), less payables.
Think of working capital as operating in a cycle: goods are bought by a business (but usually not
paid for immediately), the goods re stored in inventory, they are sold (but often on credit, not for
cash), suppliers are paid then money is received from customers....and the cycle is repeated.
However, it is the investment in non-current assets such as machinery that (hopefully!) earns profits
for the company. Investment in working capital does not directly earn profits.
If this were the only consideration, then it would be better to invest all the finance available in non-
current assets and to keep working capital to an absolute minimum.
On the other hand, all companies need some working capital in order to keep the business running
๏ they need to allow customers to buy on credit (and therefore have receivables) otherwise
they would lose business to competitors.
๏ they need to carry inventories of finished goods in order to be able to fulfil demand
๏ they need to have a short-term cash balance in order to be able to pay their bills.
The company therefore faces a trade-off between profitability and liquidity, and it is up to the
financial manager to decide on the optimal level of working capital and to ensure that it is
managed properly.
September 2021 to June 2022 exams FFM Foundations in Financial Management 4
Long-term finance is either raised from equity in the form of share issues etc., or from long-term
borrowing.
Short-term finance generally involves overdraft borrowing and/or delaying payment to payables.
Short-term finance is often cheaper (although not always – interest rates on overdrafts can be very
high, and delaying payment to payables can involve the loss of discounts).
In the past it was generally thought that since working capital involved short-term assets it should
be financed by short-term finance, whereas non-current assets – being long-term – should be
financed by long-term finance.
A more modern view is that in fact the overall level of working capital remains fixed in the long-
term (permanent working capital) and that there are day-to-day fluctuations above this
permanent level (temporary working capital).
Permanent working capital, being long-term, should be financed by long-term sources of finance.
Temporary working capital (for example, if s shop is increasing is inventory in preparation for a
holiday period) should be financed by short-term sources of finance.
September 2021 to June 2022 exams FFM Foundations in Financial Management 5
Current assets
Current ratio =
Current liabilities
A current ratio of less than 1 could indicate liquidity problems. For example, it will be difficult to
keep suppliers who are owed $10,000 happy if the business has only $1,000 in the bank or coming
in from customers
The same idea as the current ratio, but without inventory on the basis that it is inventory that will
take the longest time to turn into cash.
Clearly the Quick Ratio will be lower than (or equal to!) the Current Ratio, and a Quick Ratio of
slightly less than 1 is not necessarily dangerous – it very much depends on the type of business.
These ratios can be 'turned around' to show the number of days of receivables, payables and
inventory.
Average inventory
Number of days of inventory =
Cost of sales per day
September 2021 to June 2022 exams FFM Foundations in Financial Management 6
Average receivables
Receivables days =
Sales per day
This shows how many days of credit customers are taking on average.
Average payables
Payables days =
Purchases per day
(a) The use of statement of financial position is dangerous in that they represent only one point
in time which may be unusual (due to, for example, seasonal factors)
(b) There may be window-dressing
(c) They only look at the past – not the future
(d) They are of little value unless used in comparisons.
Note that if opening balances are not available, instead of using average amounts year-end
balances are used.
September 2021 to June 2022 exams FFM Foundations in Financial Management 7
Purchases are made, goods stay in inventory for some time, sales are made and eventually credit
customers pay us. At some point we have to pay our suppliers for our purchases. So, if we have to
pay suppliers quickly but it takes some time for goods to sell and for customers to pay us then we
will have to find additional cash for the working capital. If, however, our customers pay cash and
our inventory sells quickly, then we might not have to pay suppliers until after we have received
money for our sales. Financing working capital will then be much easier.
It is useful to compare the operating cycle of a company from year to year, or with similar
companies – a lengthening operating cycle will normally be cause for concern.
Illustration
The table below gives information extracted from the annual financial statements of Management
plc for the past year.
Management plc - Extracts from annual accounts
Inventories $108,000
Purchases $518,400
Cost of goods sold $756,000
Sales $864,000
Receivables $172,800
Payables $ 86,400
Calculate the length of the working capital cycle (assuming 365 days in the year).
Solution
Days
Receivables
1 Receivables days 73
Credit sales/365
Inventory
2 Inventory days 52
Cost of sales/365
LESS:
Payables (61)
3 Payables days
Credit purchases/365
Note that different business sectors can have very different workings capital cycle lengths. For
example, supermarkets receive almost instant payment from customers, hold inventory for only a
short time yet take weeks to pay suppliers. Their working capital cycle length will be short.
Engineering and building firms can, however, have very large amounts of inventory and might
have to wait some time for payment. Their working capital cycle length will be long.
For example, too much inventory or cash are being held. Although this will tend to mean that the
business can always easily supply customers and has lots of cash for emergencies, there are risks.
Inventory can go out of fashion or deteriorate so that sales become difficult. Cash sitting needlessly
in a bank account is wasteful and better use could probably be made of it eg by updating
machinery to make the business more efficient. The solution is to reduce the level of working
capital by better management of receivables, cash and inventory.
As a result the company will need less financing, or alternatively will have more finance available
for profit-earning investment in non-current assets.
Over-trading (or under-capitalisation) is where the level of working capital is too low.
September 2021 to June 2022 exams FFM Foundations in Financial Management 9
Illustration
A company intends to double in size over the next year. They raise $500 long-term capital and
invest it all in fixed assets. We will make the reasonable assumption that if the company doubles in
size its inventory, payables and receivables will also double.
Current
Next year
year
Non-current Assets 500 1,000
Current Assets
Inventory 100 200
Receivables 200 400
Cash 50 -
350 600
Current liabilities
Payables 150 300
Overdraft - 100
150 400
200 200
$700 1,200
Here $500 has been added to long-term capital and non-current assets and inventory, receivables
and payables have been doubled. To make the balance sheet 'work', the company has been forced
to switch from having 50 cash in the bank to having an overdraft of 100.
In this situation the company has severe liquidity problems, even though they may well be trading
very profitably
This might have taken the company by surprise as it is a successful company raising finance and
expanding. However, although it has budgeted for increasing non-current assets it might not have
realised that financing working capital also takes up capital. If the company had instead raised
$650, then it would still have $50 cash in the bank.
The solution is to raise additional long-term finance. Assuming the company is trading profitably
then this should be possible.
September 2021 to June 2022 exams FFM Foundations in Financial Management 10
Chapter 1 questions
Question 1
Question 2
What is the working capital cycle length of a company with the following data?
Debt collection period 45 days; supplier payment period 35 days; inventory holding 23 days.
Question 3
$0.00 $000
Non current assets 1,000
Current assets
Inventory 500
Receivables 200
Cash 300
Sales 3,000
A Quick ratio
B Current ratio
Question 4
Which of the following industry sectors is likely to have the shortest working capital cycle
length?
A A supermarket chain
B An engineering company
September 2021 to June 2022 exams FFM Foundations in Financial Management 11
Chapter 2
WORKING CAPITAL MANAGEMENT (2) –
INVENTORY
1. Introduction
The purpose of this chapter is to examine approaches to managing inventory efficiently. The two
most important approaches are the EOQ model and ‘Just-in-time’ inventory.
For example, if a company needs a total of 12,000 units each year, then it could decide to order
1,000 units to be delivered 12 times a year. Alternatively, it could order 6,000 units to be delivered 2
times a year. There are obviously many possible fixed order quantities.
We will consider the costs involved and thus decide on the order quantity that minimises these
costs (the economic order quantity).
3. Costs involved
This is the cost of actually placing orders. It includes such costs as the administrative time included
in placing an order, and the delivery cost charged for each order. The re-order cost does not vary
with the quantity ordered - the same administration is needed whether 10 or 1,000 units are
ordered at a time.
If there is a fixed cost for each order then higher order quantities will result in fewer orders needed
over a year and therefore a lower total reorder cost over a year.
This is the cost of holding items in inventory. It includes costs such as providing warehousing space
and insurance and also the interest cost of money tied up in inventory.
Higher order quantities will result in higher average inventory levels in the warehouse and
therefore higher inventory holding costs over a year.
4. Minimising costs
One obvious approach to finding the economic order quantity is to calculate the costs p.a. for
various order quantities and identify the order quantity that gives the minimum total cost.
Illustration
Janis has demand for 30,000 desks p.a. the purchase price of each desk is $30. There are ordering
costs of $32 for each order placed. Inventory holding costs amount to 10% p.a. of inventory value.
Calculate the inventory costs p.a. for the following order quantities, and plot them on a
graph:
(a) 500 units
(b) 800 units
(c) 1000 units
(d) 1500 units
Solution
Average Number of
Annual cost of Annual Total annual
quantity of orders pa
Order holding stock ordering cost cost of
stock (Annual
quantity (Average quantity x (Number of ordering and
(Order demand/order
Cost per unit x 10%) orders x $32 holding stock
quantity/2) size)
500 250 750 60 1,920 2,670
800 400 1200 38 1,200 2,400
1,000 500 1,500 30 960 2,460
1,500 750 2250 20 640 2,890
You can see that the lowest annual total costs occur when the reorder quantity is 800 units.
September 2021 to June 2022 exams FFM Foundations in Financial Management 13
EOQ = √(2CoD/Ch)
D = annual demand
Illustration
For the information given above use the EOQ formula to calculate the Economic Order Quantity.
Solution
EOQ = √(2 x 32 x 30,000/30 x 0.1) = 800
September 2021 to June 2022 exams FFM Foundations in Financial Management 14
6. Quantity discounts
Often, discounts will be offered for ordering in large quantities. The problem may be solved using
the following steps:
Illustration
For the information given above the supplier now offers us a 1% discount on the purchase price if
at least 1,000 units are ordered at a time.
Solution
Existing EOQ is 800 and at that order quantity the total annual costs (holding + ordering +
purchasing) =
The discount first becomes available at 1,000 units, and then the total costs would be:
2,460 (holding + ordering from the table above) + 30,000 x 30 x 0.99 = $893,460
The conditions necessary for the business to be able to operate with minimum inventories include
the following:
7.2. Work-in-Progress:
๏ a short production period. If the production is faster, then the level of WIP will automatically
be lower.
๏ a flexible workforce to allow expansion and contraction production at short notice.
A ‘just-in-time’ approach is a philosophy affecting the whole business and obviously required great
coordination both within the business and with outside entities. The benefits are not just cost
savings from lower inventory-holding costs and less risk of obsolete inventory, but benefits in
terms of better quality production (and therefore less wastage), greater efficiency, greater flexibility
to meet customers' orders quickly and therefore greater customer satisfaction.
September 2021 to June 2022 exams FFM Foundations in Financial Management 16
Chapter 2 questions
Question 1
In the theory used to reach an economic order quantity for inventory, which TWO of the
following costs are considered if there are no quantity discounts?
Question 2
If a company orders 1,200 units of a component at a time, how many units are assumed to be
in inventory on average?
Question 3
A company orders 2,000 units at a time and uses 10,000 units per month. Units cost $10 each but
the company would be given a 10% discount if it ordered at least 5,000 units per order.
If the company ordered 5,000 units at a time, what value of discount would it enjoy per
year?
Question 4
What is the economic order quantity of an item of inventory with the following
characteristics?
Cost of holding 1 unit per year is 10% of its purchase price (each unit costs $20)
EOQ = √(2CoD/Ch)
Question
Which one of the following is the most likely risk to arise from a just-in-time inventory
system?
Chapter 3
WORKING CAPITAL MANAGEMENT (3) –
ACCOUNTS PAYABLE AND RECEIVABLE
1. Introduction
We discussed the importance of payables earlier in the context of the cash operating cycle. In this
chapter we will look at the factors that need considering in the good management of payables.
2. Trade credit
Rather than paying immediately for goods and services purchased from suppliers, it is standard
practice to take credit i.e. to delay making payment. This benefits the cash flow of the business and
is effectively a means of obtaining short-term finance (as opposed to, for example, running an
overdraft).
However, although taking credit is a normal feature of business, it is important that we monitor the
payment of our payables and bear in mind two important considerations:
๏ If we take too long to pay then we risk losing the goodwill of our suppliers and they may
refuse to allow us credit in the future (or in the extreme, refuse to supply to us)
๏ Taking too long to pay may result in us losing discounts offered by suppliers for early
payment.
Illustration
A supplier offers a 2% discount if invoices are paid within 10 days of receipt. Currently we take 30
days to pay invoices and therefore do not receive the discount.
Calculate the annual % effective cost of refusing the discount.
Solution
Consider an invoice for $100. Currently this is paid in full after 30 days; going for the discount
would mean that $98 is paid after 10 days. The company's cash has fallen by $98 20 days earlier and
in exchange $2 is saved. It's like investing $98 for 20 days to earn $2
The return on that investment is 2/98 over 20 days = 2.0408%
To convert the rate r (as a decimal) for a period of p days to an annual rate R, the formula is
September 2021 to June 2022 exams FFM Foundations in Financial Management 18
1 + R = (1 + r)365/p
Here
1 + R = (1 + 0.020408)365/20 = 1.4458
R = 0.4458 or 44.58%
This is the effective cost of paying 30 days after the invoice and not receiving the discount instead
of paying after 10 days
Illustration
A company currently takes 40 days credit from suppliers on the basis that this is ‘free’ finance.
Annual purchases are $100,000 and the company pays overdraft interest of 13%.
Payment within 15 days would attract a 1.5% quick settlement discount.
Should the company pay sooner in order to take advantage of the discount?
Solution
To obtain the discount the company would have to pay 40 – 15 = 25 days sooner.
For an invoice of $100, the company would then pay $98.5, saving $1.5 over 25 days.
The return over 25 days is 1.5/98.5 = 1.5228% = 0.015228
1 + R = (1 + r)365/p
Here
1 + R = (1 + 0.015228)365/25 = 1.2469
R = 0.2469 or 24.69%
As this is greater than the overdraft interest rate of 13% the company should pay more quickly to
receive the discount. Receiving the discount is worth 24.69% and borrowing more to pay earlier
would cost only 13%.
Alternative solution
Assume that current sales are $1m per year (it doesn't matter what figure you choose).
Current payables are $1m/365 x 40 = $109,589
New payables would be $1m/365 x 15 = $41,096
Fall in payables = $109,589 - $41,096 = $68,493
To achieve this fall in payables more cash has to be with suppliers and to finance that costs 13%.
Therefore, the annual cost of paying suppliers more quickly is 13% x $68,493 = $8,904
In return, the company wins a 1.5% discount on all its purchases and this will be worth:
1.5% x $1m = $15,000 pa
It is worth paying $8,904 in bank interest to obtain $15,000 in discounts, so pay earlier and win the
discount.
September 2021 to June 2022 exams FFM Foundations in Financial Management 19
๏ Payment in cash
๏ Payment by cheque
๏ Standing orders and direct debits. A standing order is when the payer agrees to pay a
constant amount per period (eg per month) to a payee (recipient of the money). It uses a
transfer between bank accounts. A direct debit is when the payer gives authorisation to the
payee to transfer amounts as needed from the payer's bank account to the payee's bank
account.
๏ Electronic funds transfer (eg internet banking)
5. Receivables
Many of the same principles apply to receiving payment from customers. Typically customers will
be given 30 day of credit and to encourage payment within that time discounts are often offered.
The annual cost of giving discounts can be surprisingly expensive.
Illustration
A company makes sales of $1.2m/year and currently offers no discount for prompt payment.
Accordingly, customers are paying after 60 days instead of the required 30 days. The company has
estimated that if it offers a offers a 2.5% discount for payment within thirty days, 80% of its
customers will pay in that time.
Solution
For an invoice of $100, instead of paying $100 after 60 days, a customer who goes for the discount
will pay $97.5 after 30 days. The company gains an extra $97.5 for a month for a cost of $2.50
Cost over 30 days = 2.5/97.5 = 0.02564
1 + R = (1 + r)365/p
Here
1 + R = (1 + 0.02564)365/30 = 1.36
R = 0.36 or 36%
Note: the 20% who ignore the offer of the discount do not affect the cash balance and cost nothing
by way of receiving a discount.
September 2021 to June 2022 exams FFM Foundations in Financial Management 20
Chapter 3 questions
Question 1
A business pays its suppliers after 70 days. The suppliers start to offer a discount of 3% for payment
within 30 days. What is the effective annual cost of NOT taking up this offer?
Question 2
What is the name of the payment method where the payer gives authorisation to the payee to
transfer amounts as needed from the payer's bank account to the payee's bank account.
September 2021 to June 2022 exams FFM Foundations in Financial Management 21
Chapter 4
CASH BUDGETING (1) – THE NATURE
AND SOURCES OF CASH
1. Introduction
We have already looked at the importance of cash in terms of the cash operating cycle. It is vital to
the survival of a company that it manages its cash efficiently. In this chapter we will discuss what
we mean by cash and why it is so important that it is managed well.
Cash flow forecasts (or cash flow budgets) are essential when trying to forecast cash balances
during the year. These will be covered in the next chapter.
The type of business will have a large impact on the pattern of cash flows - retail businesses receive
cash immediately upon sale, whereas for manufacturing businesses there will be a delay in
receiving cash.
Some businesses, for example those renting out properties, have relatively predictable and stable
cash inflows whereas others, for example engineering firms working on large contracts, are likely to
have more erratic cash flows.
๏ Regular revenue receipts and payments: cash received from sale and cash paid for expenses
๏ Capital payments and receipts: cash payments for the purchase of non-current assets and
cash received from the sale of non-current assets
๏ Drawings and dividends: cash paid to the owner(s) of the business
๏ The issue and redemption of shares
๏ The taking and repaying of loans, and the interest on any loans
๏ Irregular receipts and payments: e.g. the payment to the state of tax on profits
September 2021 to June 2022 exams FFM Foundations in Financial Management 22
However, it is vital that a business keeps track of its cash position: businesses go into liquidation
primarily because they run out of cash, not because they make losses. It is very easy for a profitable
business to run out of cash if it buys too many non-current assets, pays dividends that are too high
or has to pay an unexpected amount of tax. So, it is vital to calculate the net cash flow over a period
and to make forecasts of cash balances looking at when cash is actually received or paid.
There are many reasons why the profits and the net cash flows will be different:
๏ Receivables and payables: all sales and expenses during the period are recorded when
calculating the profit, but if there are receivables and payables at the end of the period then
the cash received and paid will differ.
๏ Purchase of non-current assets: if a non-current asset is purchased then there is a cash
outflow of the entire cost. However when calculating the profit, this cost is spread over the
life of the asset and only part is charged (as depreciation) each year.
๏ Sale of non-current assets: if a non-current assets is sold then there is a cash inflow of the
entire proceeds. However when calculating the profit we only bring in the profit on the sale.
๏ Inventories: if we purchase goods but do not use them all in the period (and therefore have
inventory remaining at the end) then the cash outflow is the cost of all the purchases,
whereas when calculating the profit we only take account of the cost of the goods actually
used.
๏ Other cash receipts and payments that do not affect the profit: e.g. an issue of shares to raise
cash; the taking and repaying of loans.
September 2021 to June 2022 exams FFM Foundations in Financial Management 23
5. Chapter 4 questions
Question 1
If income and expenditure are matched on a time basis, this is known as:
Question 2
Which of the following will affect profit but not cash or cash but not profit.
A Depreciation
B Sales
C Dividends
D Capital expenditure
E Tax
F Capital introduced
G Wages
September 2021 to June 2022 exams FFM Foundations in Financial Management 24
September 2021 to June 2022 exams FFM Foundations in Financial Management 25
Chapter 5
CASH BUDGETING (2) – PREPARING
CASH BUDGETS
Cash budgets are probably the most important tool in practice for the management of any
company’s cash position. They are vital to identifying in advance a likely deficit or surplus in order
that appropriate action can be taken to avoid any problem or profit from any opportunity.
Notes
1. Delayed from when the sale takes place. If debtors take two months credit then receipts from
January sales will be received in March.
2. For example, interest, capital injections and proceeds from the sale of non-current assets.
3. Delayed from when the purchase takes place. If suppliers are paid after one month then
purchases made in January sales will be paid for in February.
4. Non-regular and easy to forget. However, if cash is tight capital expenditure can often be
deferred or cut back.
5. Easy to overlook - no flexibility.
6. Non-regular and easy to forget. However, if cash is tight dividends can be cut either partially
or completely.
7. The key figure. Is the company staying within its borrowing limits? If not it must either boost
receipts (eg more capital paid in), cut back on expenditure (eg salaries, capital expenditure or
dividends), or make an appointment with the bank manager to negotiate a larger loan or
overdraft
Illustration
A new business is started on 1 January 2020.
On 1 January it purchases materials for $100,000 and the supplier allows credit of 1 month after
invoicing at the end of each month. Other expenses paid every month amount to $30,000, paid in
the month they are incurred.
It takes the business 3 months to manufacture goods which they then sell immediately for
$350,000, invoicing immediately, and customers take 2 months' credit.
In March the business spends $80,000 buying non-current assets.
(a) What profit does the business make for the period to 30 June 2020?
(b) What is the cash balance of the business at the end of each month during the six months
to 30 June 2020?
September 2021 to June 2022 exams FFM Foundations in Financial Management 27
Solution
(a) Profit statement
$ $
Sales 350,000
Purchases 100,000
Other expenses 180,000
(280,000)
Profit 70,000
Note that even though the business shows a profit over the six months, it has a need for a $150,000
overdraft n, in practice it would arrange a larger overdraft to give some 'head room' for unexpected
delays in cash receipts or additional expenses.
It is worth noting that the business started with $70,000 cash and ended with $140,000 cash. The
increase of $70,000 represents the profit that has been made.
September 2021 to June 2022 exams FFM Foundations in Financial Management 28
However it is also important that we use the forecast as a means of controlling cash by comparing,
month by month, our actual cash receipts and payments and comparing them to the forecast
receipts and payments.
When the actual figures differ from what we had forecast, we will expect the relevant managers to
explain the reason. We will then be in a position to attempt to take corrective action. For example, if
our suppliers have increased the price of materials, we might look for alternative suppliers or
alternative materials. Alternatively we might decide to increase our selling prices. By comparing the
actual receipts and payments with the forecast amounts month-by-month we will be able to
update the cash budgets for the subsequent months.
Inflation will usually affect costs before revenues because businesses will usually put up their prices
after the costs have risen. Unless the business manages to increase selling prices by more than the
increase in costs this will have a negative effect on profitability and on net cash flows.
The approach is exactly the same as the approach taken when preparing a cash budget (but on a
daily basis rather than on a monthly basis) except that in addition we need to take account of the
fact that there is generally a short delay in transactions appearing on the bank statements.
For example, if we receive cheque from a customer on Monday, the bank might not credit it to our
account until Wednesday and it is therefore only on Wednesday that the money because available
for us to put on deposit. ‘Cleared funds’ is the name given to cash actually available in the bank
account.
September 2021 to June 2022 exams FFM Foundations in Financial Management 29
Chapter 5 question
At the start of the year James had inventories of $24,000; payables of $22,000; and receivables of
$15,000. His cash balance was $10,000
During the year James made purchases of $358,000 and had sales of $400,000.
At the end of the year inventories were $42,000; payables were $28,000, and receivables were
$48,000.
Chapter 6
CASH BUDGETING (3) – STATISTICAL
TECHNIQUES
1. Introduction
As previously explained, budgets require us to make forecasts and therefore depend on the
assumptions that we make. In this chapter we will look at several techniques that may be useful
when making our forecasts.
Illustration
A company has had the following sales revenue in each of the past 5 years:
Year Sales Revenue
$
20Y1 300,000
20Y2 384,000
20Y3 410,000
20Y4 480,000
20Y5 520,000
Solution
Although there are five years shown there are only four increments: Y1 to Y2, Y2 to Y3, Y3 to Y4 and
Y4 to Y5.
If the average annual growth rate is g, then we can say that, as four applications of growth are
needed:
300,000 x (1 +g) x (1 +g) x (1 +g) x (1 +g) = 520,000
or
300,000 x (1 + g)4 = 520,000
(1 + g)4 = 520,000/300,000 = 1.733
1=g = 4√1.733 = 1.147
g = 0.147 or 14.7%
September 2021 to June 2022 exams FFM Foundations in Financial Management 32
3. Regression
If there is a reasonable degree of linear correlation between two variables, we can use regression
analysis to calculate the equation of the best fit for the data.
For example, if we have forecast the production each month for our budget, then if we know the
relationship between the cost and the level of production we can then forecast the cost each
month.
y = a + bx
then the values of a and b may be calculated using the following formulae (which are given in the
examination).
Regression analysis
y = a + bx
∑𝑦 𝑏∑𝑥
a= −
𝑛 𝑛
𝑛 ∑ 𝑥𝑦− ∑ 𝑥 ∑ 𝑦
b=
𝑛 ∑ 𝑥 2 −(∑ 𝑥)2
𝑛 ∑ 𝑥𝑦− ∑ 𝑥 ∑ 𝑦
x is the independent variable (like output); y is the dependent variable (like cost). Output causes
√(𝑛 ∑ 𝑥 2 −(∑
costs so cost is dependent on production 𝑥)2 )(𝑛 ∑ 𝑦 2 − (∑ 𝑦)2 )
volume.
2𝐶0 𝐷
√ 𝐶ℎ
2𝐶0 𝐷
√𝐶 𝐷
ℎ (1− 𝑅 )
Ʃ𝑥 Ʃ𝑓𝑥
𝑥̅ = 𝑥̅ =
𝑛 Ʃ𝑓
∑(𝑥−𝑥̅ )2 ∑ 𝑓𝑥 2 ∑ 𝑓𝑥 2
σ=√ σ √ ∑𝑓
−(∑ )
𝑛 𝑓
September 2021 to June 2022 exams FFM Foundations in Financial Management 33
Illustration
The following table shows the number of units produced each month and the total cost incurred:
Units Cost
($ ‘000)
January 100 40
February 400 65
March 200 45
April 700 80
May 600 70
June 500 70
July 300 50
Calculate the regression line, y = a + bx
Solution
To keep the numbers smaller, the volume made has been converted to hundreds (eg 200 becomes
2)
× y xy x2 y2
1 40 40 1 1,600
4 65 260 16 4,225
2 45 90 4 2,025
7 80 560 49 6,400
6 70 420 36 4,900
5 70 350 25 4,900
3 50 150 9 2,500
28 420 1,870 140 26,550
nΣxy − ΣxΣy (7 ×1,870) − (28 × 420) 1,330
b= 2 = = = 6.7857
nΣx 2 − ( Σx ) (7 ×140) − (28 × 28) 196
This predicts the cost (in $000, for any volume produced where the volume is in hundreds of units.
If x is in units, then the line would be:
y = 32.86 + 0.0679x
And if the cost were to be in $ also, the equation would become:
y = 32,860 + 67.9x
September 2021 to June 2022 exams FFM Foundations in Financial Management 34
It is obvious from the graph that the cost/volume relationship is not a perfect straight line....but it's
not bad. The measure how good the fit is you need to calculate the correlation coefficient, r.
A correlation coefficient of +1 indicates perfect positive linear correlation: as one variable increases
so does the other and all the points can be placed on a straight line. An example could be total
variable cost plotted against volume of production.
A correlation coefficient of -1 indicates perfect negative linear correlation: as one variable increases
the other decreases and all the points can be placed on a straight line. An example could be
volume of goods sold plotted against selling price
The further away from + or – 1, the less linear correlation exists. A correlation coefficient of zero
means that there is no association - they points are effectively randomly distributed. An example
could be your age in days plotted against your mobile phone number.
n xy -
 x y
r=
(n x - ( x ) )(n y - ( y ) )
2 2 2 2
September 2021 to June 2022 exams FFM Foundations in Financial Management 35
The coefficient of determination is r2. So if r, the coefficient of correlation, = 0.9, the coefficient of
determination is 0.81. This can be interpreted as meaning that 81% of the variation in the y value
can be explained by (or is associated with) the change in teh value of the x variable.
Illustration
Using the data in the illustration above, calculate the correlation coefficient
Solution
Coefficient of correlation:
nΣxy − Σx Σy 7 ×1,870 − 28 × 420
r= =
( ( Σx ) )⎛⎜⎝ nΣy − ( Σy ) ⎞⎟⎠ (7 ×140 − 282 )(7 × 26,550 − 4202 )
2 2
nΣx 2 − 2
+1330
= = +0.98
196 × 9, 450
This is almost 1, showing that there is a very good fit to a straight line....and, indeed, the graph
supports this conclusion.
September 2021 to June 2022 exams FFM Foundations in Financial Management 36
7. Definitions
Time series: a set of observations taken at equal intervals of time e.g. monthly
๏ Trend: the underlying pattern of a time series when the short term fluctuations have been
smoothed out.
๏ Cyclical Variations: the wave-like appearance of a number of time series graph when taken
over a number of years. Generally this corresponds to the influence of booms and slumps in
an industry.
๏ Seasonal variations: the regular rise and fall over shorter periods of time (<1 year). For
example, umbrella sales are likely to be higher than average every winter and lower than
average every summer. Or sales of certain products could be higher every weekend.
๏ Random (residual) variations: these are other, unpredictable variations.
8. Moving averages
In order to estimate the trend and the seasonal variations, we use the method of moving averages.
Illustration
Set out below are the sales per quarter (in 000’s of units) of a company over 3 years.
Quarter
1 2 3 4
2000 80 87 82 90
2001 90 95 93 102
2002 105 112 103 116
Identify the trend and calculate the average seasonal variation.
September 2021 to June 2022 exams FFM Foundations in Financial Management 37
Solution
2 87
84.75
3 82 86.00 –4.00
87.25
4 90 88.25 +1.75
89.25
2001 1 90 90.63 –0.63
92.00
2 95 93.50 +1.50
95.00
3 93 96.88 –3.88
98.75
4 102 100.88 +1.12
103.00
2002 1 105 104.25 +0.75
105.50
2 112 107.25 +4.75
109.00
3 103
4 116
1 2 3 4
2000 –4.00 +1.75
2001 –0.63 +1.50 –3.88 +1.12
2002 +0.75 +4.75
+0.12 +6.25 –7.88 +2.87
average +0.06 +3.13 –3.94 +1.44
Steps:
Looking at the columns from left to right:
1. The quarters of are listed in time order: 2000 Qtr 1, 2, 3, 4 2001 Qtr1, Qtr 2 .. etc
2. The sales are listed in time order: 80, 78, 82, 90, 90, 95 etc
3. Each group of four quarters is added up and the average taken. One new quarter at a time is
added and the oldest dropped as the calculations progress. So: (80 + 87 + 82 + 90)/4 = 84.75;
(87 + 82 + 90 + 90)/4 = 87.25...etc. The idea is that each average contains one reading from
each season so the high and low seasonal effects are averaged out.
4. Because this is based on 4 seasons, the averages above are 'between' quarters 2 and 3, then 3
and 4. To get them 'opposite a particular quarter, each adjacent pair is averaged again. So,
(84.75 +87.25)/2 = 86 and this is opposite quarter 3 of 2002. These figures represent the
trend.
5. Comparing the trend (in which seasonal effects have been ironed out) to the original data
gives the seasonal variation..
September 2021 to June 2022 exams FFM Foundations in Financial Management 38
6. Finally, all the seasonal variations for particular quarters are collected and averaged.
The trend line can be quantified by saying its value has gone from 86.00 to 107.25 in 7 increments
so:
(107.25 - 86.00)/7 = 3.04 per season
The trend and seasonal variations can then be used to make predictions. For example, the sales for
season 3 of 2003 would be predicted as follows:
Last trend figure, above is for Season 2, 2002. Season 3 of 2003 is 5 seasons further on, so its trend
will be predicted as:
107.25 + 5 x 3.04 = 122.45
The Season 3 seasonal variation is -3.94, so adjusting for this seasonal dip, Season 3 of 2003 is
predicted to be:
122.45 - 3.94 = 118.51
However, if the trend is increasing it would perhaps be more sensible to accept an increasing
seasonal variation.
The multiplicative model deals with this by measuring the actual seasonal variation as a
percentage of trend.
Illustration
Using the data from above together with the trend already calculated, calculate the average
seasonal variation using the multiplicative model.
September 2021 to June 2022 exams FFM Foundations in Financial Management 39
2 87
3 82 86.00 95.3%
4 90 88.25 102.0%
2 95 93.50 101.6%
3 93 96.88 96.0%
3 103
4 116
1 2 3 4
2000 95.3 102.0
2001 99.3 101.6 96.0 101.1
2002 100.7 104.4
Chapter 6 questions
Question 1
What are the average growth rates for the following periods:
Question 2
The following are the four elements of a time series. Which two are estimated using the
moving average technique?
A The trend
B Cyclical variations
C Random variations
D Seasonal variations
Question 3
If the coefficient of correlation is 0.7, what is the coefficient of determination and what is its
interpretation?
Question 4
A linear regression analysis on sales data against time has produced a line in the format
y = a + bx. The specific equations is:
Question 5
In the context of linear regression, what is 'extrapolation' and why is care needed with that
process?
September 2021 to June 2022 exams FFM Foundations in Financial Management 41
Chapter 7
MANAGING CASH BALANCES (1) – THE
TREASURY FUNCTION
This involves:
๏ cash forecasting
๏ investing surplus cash balances, both short-term and long-term surpluses
๏ raising funds - both short-term borrowings and long-term raising of finance from the issue or
loan stock or shares either privately or on a stock exchange.
๏ management of policies regarding the giving of credit to customers and taking credit from
suppliers
๏ managing risk, in particular the risk of interest rates changing and the risk of foreign
exchange rates changing (if the business has dealings with foreign companies)
However, companies will not wish to hold too much cash because they will be losing income that
they could be earning by investing the extra cash. This will mean that although their liquidity is
higher, they will be losing potential profit.
Companies need to take into account that delays in cash receipts might occur. For example:
๏ Ensure that all cheques are banked the same day as receipt. This also minimises the risk of
cheques going astray.
๏ Encouraging customers to pay by internet transfer rather than by cheque.
Banks - banks take money from depositors and lend it out to individuals and businesses who need
funds. Often depositors can ask to be repaid immediately and if the bank seems unable to pay up
then all depositors get anxious and may demand repayment. This causes a 'run on the bank' and
can lead to banks' failure. Therefore banks are required to maintain a minimum liquidity level (ie a
minimum amount of cash quickly available) and are subject to lending limits. The most recent
regulations are known as Basel III, agreed in 2010, two years after the 2008 financial crisis in which a
very large American bank, Lehyman Brothers, failed.
Public authorities - for example, local councils, are allowed to invest only in very safe investments,
paying little or no interest, so as not to put public funds at risk.
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Trusts - a trust means, typically, that ownership of an asset rests with a trustee and income from
the asset goes to beneficiaries. Sometimes, ownership of the assets eventually passes to the
beneficiaries. For example, a relative could leave money for a child and the money would be held in
a trust, managed by trustees and e the child reached the age of 21 (say) the child gains full control
of the money. Pension funds are also often held by trustees. In most cases the law seeks to protect
the long-term interests of the beneficiaries by restricting the type of investment that can be held so
that the money is not subject to unreasonable, speculative risks.
September 2021 to June 2022 exams FFM Foundations in Financial Management 44
Chapter 7 questions
Question 1
Which of the following functions would typically be carried out by the treasury department
of a company? Select all that apply.
B Sales accounting
C Investment appraisal
F Inventory control.
Question 2
Question 3
What city gave its name to regulations formulated in 2010 to increase banks' liquidity?
September 2021 to June 2022 exams FFM Foundations in Financial Management 45
Chapter 8
MANAGING CASH BALANCES (2) – AN
OVERVIEW OF FINANCIAL MARKETS
1. Introduction
This chapter is outlining the banking system, the different types of banks, and the way that the
stock market operates from the point of view of the financial manager.
2. Types of banks
There are various types of banks in the banking system, each of which performing a different
function:
Retail/Commercial banks - these are the ‘high street banks’ that most of us use. They provide
basic banking services, such as providing a current account, providing credit cards, offering deposit
accounts earning interest, and providing loans.
Investment banks - these banks exist to assist both companies and governments in the raising of
money, e.g. advising and assisting on the issuing of shares and debt finance
Central banks - each country has a central bank that not only supervises the operations of the
commercial banks but also implements the monetary policies of the government, fixes the official
interest rates, and act as banker to the government and to the other banks. The central bank is also
responsible for issuing paper money and act as ‘lender of last resort’ to the commercial banks.
3. Financial intermediaries
There are always many people who have spare cash and wish to deposit it and earn interest, and
also many people who wish to borrow money (and will therefore have to pay interest). It is
obviously possible for people with spare cash to lend directly to those wishing to borrow cash, but
this has not been common because it is difficult to match:
๏ the amounts individuals want to lend and amounts others want to borrow.
๏ the periods some people want to lend for to the periods others want to borrow.
Recently, there has been some growth in peer-to-peer lending websites which apply technology to
finance (Fintech) to match up people who have cash to lend with individuals or companies
wanting to borrow. Because the banking intermediary is cut out investors lending cash can get
higher rates than they would from a savings account, while borrowers often pay less than with a
September 2021 to June 2022 exams FFM Foundations in Financial Management 46
conventional loan. The sites themselves profit by taking a fee. However, there are greater risks of
bad debts and it can be difficult to retrieve funds as easily as with a conventional bank savings
account.
Other financial intermediaries include pension funds and unit trusts (mutual funds).
๏ Aggregation: for example, many small deposits can be used to make several large loans
๏ Maturity transformation: for example, many deposits of different durations allow loans of
long duration
๏ Risk transformation: for example, banks take money from depositors and depositors only
face the risk of the bank getting into trouble (often rescued by governments). The banks risk
some their many borrowers getting into financial trouble but if properly managed this can be
survived as the banks will still have many viable customers.
Placing money in a bank deposit account from where it can be immediately withdrawn will provide
low income but high safety as the bank is unlikely to fail, the balance will not go down and the
money is instantly available.
Investing temporary surplus cash in shares would be very risky because dividends are not
guaranteed, the share price can be very volatile and the investment could turn out to be worthless
if the company failed, However, if the company whose shares were invested in did well the investor
could make a large. This type of investment of r cash balances is so risky that few companies would
do it.
๏ Bank deposits - Money is deposited with the bank, usually (but not always) for a fixed period
of time, and usually (but not always) at a fixed rate of interest. Withdrawing the money early is
usually allowed (subject to the terms of the deposit), but there will be a penalty for doing so.
๏ Certificates of deposit (CD’s) - This is money deposited with a bank for a fixed period of time
and at a fixed rate of interest. The CD is the receipt provided by the bank and this CD is
usually negotiable. This means that the company is able to sell the CD to someone else, and
the purchaser will then receive the interest and the repayment of the deposit on the due
date.
๏ Government stocks -These are bonds issued by the government. The government pays fixed
interest and repays the investment after a fixed period of time. As with CD’s these bonds are
negotiable and may be sold to others at any time - but their price is variable and the investor
can make capital losses.
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๏ Local authority bonds - There are similar to government stocks, except that they are issued
by local authorities as a way for them to borrow money
๏ Bills of exchange - Bills of exchange are different from the previous investments in that they
do not earn interest. They are rather a promise to pay money on a future date. If, for example,
company X were due to pay company Y an amount in 2 months time, then they might
provide them with a bill of exchange - a written promise to make the payment on the due
date. The bill of exchange would normally be guaranteed by a bank, so that company Y
would be certain of receiving payment. Although they used to be commonly used (especially
for international trade) they are much less common these days.
6. Money markets
Money markets facilitate the borrowing and lending of money for periods ranging form overnight
until a year. They are used by banks and large companies.
๏ Deposits (simple bank deposits) - These will pay interest and often they allow money to be
withdrawn immediately. Sometimes they can be term accounts which ties up cash for a fixed
term, like three months. Sometimes they require some days or weeks notice for a withdrawal
to be made. Term and notice accounts pay higher rates of interest than instant access
accounts but, of course, they are not as flexible.
๏ Bills - To borrow, governments issue Treasury Bills which pay a stated rate of interest.
Companies can also issue bills, most commonly as a mechanism to pay for imports.
๏ Commercial paper - Simple IOUs evidencing a debt. They can be held until the loan matures
or could be sold to another entity.
๏ Certificates of deposit -These can be issued to bank customers who deposit substantial
amounts. If a customer needs to retrieve cash earlier than the terms of the deposit, the CD can
be sold on the market.
๏ Repo market - A repurchase agreement (repo) is a short-term secured loan: one party sells
securities to another and agrees to repurchase those securities later at a higher price. The
securities serve as collateral. The difference between the securities’ initial price and their
repurchase price is the interest paid on the loan, known as the repo rate. The repo market
allows financial institutions that own lots of securities (e.g. banks and hedge funds) to borrow
cheaply and allows parties with lots of spare cash to earn a small return on that cash without
much risk, because securities, often government securities, serve as collateral.
๏ Inter-bank market - Used for borrowing and lending between banks. The interest rate is the
London Inter-bank Offered Rate (LIBOR).
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From time-to-time, when a company carries out its cash flow budget it might find that it has cash
surpluses ie an amount of cash that will not be needed for either day-to-day operations or for
capital investment for some time. Perhaps the cash has been earmarked to pay a tax bill in several
months' time; perhaps an asset has been sold and a replacement will not be bought for some
months; perhaps really good profits have been made and the company has as yet not plans for
spending the cash. Seasonal trading can also produce surpluses during good months but these are
then used up during lean months.
It would be wasteful to simply let surplus cash sit in a non-earning bank account. Instead it should
be invested to earn income. When identifying cash surpluses and deciding on investment
strategies the company should be careful not to tie up too much cash for too long or too inflexibly.
If something suddenly goes wrong in the company (for example, a large receivable going bad), the
cash surplus could soon turn into a cash deficit and the company would need to make use of its
invested cash.
Broadly, surplus cash can be invested as in the ways outlined above, under money markets. In
addition, companies could invest in Government bonds or in shares in listed companies. However,
although these can be quickly and easily resold they can fall in value as well as rise and the
company could find that they do not realise enough cash.
If a company finds it has a permanent cash surplus and can find no acceptable way in which to
invest more money in non-current assets to grow the business, it is generally considered wrong for
a company to hang onto that surplus cash indefinitely in case 'something turns up'. If the company
had no convincing plans for spending the cash then it should return money to investors who can
then, individually, decide how to invest it. Companies can return cash to investors by paying
additional dividends or by buying up its own shares from investors.
Some deficits can be forecast (like those caused by seasonal trading); some are nasty surprises (like
a customer going broke).
September 2021 to June 2022 exams FFM Foundations in Financial Management 49
๏ Bank overdrafts. Here, the bank allows customers to draw out more money from their
current bank account than is actually there. The balance 'goes negative' or 'into the red'.
Overdrafts should be agreed in advance as the bank is under no obligation to allow the
arrangement. Overdrafts offer a very flexible borrowing facility and borrowers can repay
whenever they want, so they are ideal for short-term cash problems. Why arrange a loan for a
year, costing a year's worth of interest, if the company might be able to repay after three, four
or five months? The downside is that overdrafts are repayable on demand so if a bank
begins to get worried about a customer's ability to repay it might 'call in' the overdraft to get
its money back before other creditors. This can cause the business to fail. Overdrafts are ideal
for cash deficits caused by seasonal trading because they are needed for only a short time
and the cash deficit should change into a surplus allowing the overdraft to be repaid.
๏ Term loans. These need to be arranged in advance and the bank will require cash flow
projections showing how their customer will repay the borrowings. They are very suitable for
buying new machinery as the machinery should produce profits from which repayments can
be made.
๏ Injections of permanent capital. Sometimes the deficit will not repair itself. For example, if a
business has spent a lot developing a new product which turns out to be a flop. Or, a business
a lost money because of an economic recession. In cases like these a more permanent
injection of cash is needed and the company will turn to its shareholders. Effectively the
business is saying 'Pay in more capital or the business will fail and you will lose your
investment'. Of course, even after more capital is injected the business could still fail and
Investors have to decide if the gamble is worthwhile.
For example, if a large cash balance is held then the company will rarely have to sell investments or
raise cash for unexpected cash deficits. The funding transaction costs will be very low, but the large
amount of cash sitting dormant in the current account most of the time represents a considerable
waste of opportunity, and cash holding costs will therefore be high. At the other extreme, if
minimal cash is held it will often have to be topped up so large transaction costs but low
opportunity costs.
The Baumol model does not specify what a company's target cash balance should be. Instead it
tells the company when cash should be taken out of the current account and invested and also
when cash should be put back into the current account.
In the diagram below cash moved up and down as time passes. When it hits the maximum level as
calculated by the Baumol model, cash is taken out of the current account and invested. The cash
balance falls to the 'Return Point' level. If cash falls to the minimum level, cash is realised from
investments and paid into the current account to bring the balance up to the return level once
more.
September 2021 to June 2022 exams FFM Foundations in Financial Management 50
Cash
Balance
Upper Limit
Return Point
Lower Limit
Time
As said above, the model does not determine the Return level balance, but it will indicate how far
away from that balance the Maximum and Minimum cash levels are.
The return point is an indication of the liquidity of the business and the prudent liquidity level can
vary widely depending on the organisation's activities. As mentioned earlier, some businesses, for
example those renting out properties, have relatively predictable and stable cash inflows whereas
others, for example like engineering firms working on large contracts, are likely to have more
erratic cash flows. Erratic cash flows imply that more cash needs to be readily available.
September 2021 to June 2022 exams FFM Foundations in Financial Management 51
Chapter 8 questions
Question 1
The Baumol model predicts the optimal level at which a company should keep its cash balance.
Question 2
(a) Aggregation
Question 3
Question 3
Chapter 9
LONG TERM FINANCE
Short term finance is used for short term assets whilst long-term finance is used for long-term
assets. If a company wishes to make a major investment in, for example, new machinery, they are
likely to need to raise the money from somewhere. Given that new projects are likely to be long-
term investments, they will want to raise long-term finance.
There are two ways in which a company can raise long-term finance - either by issuing shares or by
issuing long-term debt.
2. Share capital
If a company issues shares in the company, then investors pay cash to the company and in return
receive shares in the company.
There are two types of shares - ordinary shares (or equity) and preference shares.
Shareholders owning these shares are entitled to receive company profits in the form of a dividend.
The amount paid as dividend will fluctuate and depends on how much profit the company has
made, how much cash the company has available, and how much cash the company wishes to
retain in order to be able to expand the company.
The ordinary shareholders have the right to attend company general meetings and to vote on
matters such as the appointment of directors. The company will not repay the money initially
invested by the shareholders unless the company goes into liquidation. In that case the
shareholders will receive whatever cash remains after payment of all amounts owing by the
company (which may mean that they end up receiving nothing!).
If the company does well the value of the equity shares will generally rise so equity shareholders
can enjoy large capital gains.
September 2021 to June 2022 exams FFM Foundations in Financial Management 54
Preference shares
Preference shareholders are entitled to a fixed dividend each year, regardless of the level of profits,
and they are informed of the amount of the dividend when the share are first issued. For example,
6% $1 preference shares will receive a fixed dividend of $0.06 per year; 5% $0.50 preference shares
will receive an annual dividend of $0.025 per year.
Preference shares take priority over ordinary shares, and so ordinary shareholders are only entitled
to whatever profit is left after payment of the preference dividend.
The dividend is limited to the amount of profit available, but if the shares are cumulative
preference shares then in future years the preference shareholders must receive any arrears from
previous years as well as their dividend for the current year.
Redeemable preference shares are repaid on a fixed date in the future. These are treated in the
financial accounts like loans and are shown as non-current liabilities. The dividend is treated like
interest on loans and included in finance costs.
The company will state how much in total they wish to borrow, the rate of interest they will pay,
and the date on which the borrowing will be repaid. Investors are then invited to lend however
much money they want (usually in units of $100) and will receive a certificate for the amount they
have invested called a ‘loan note’ or 'debenture'
Secured loan notes are secured on assets of the company. This means that if they company is
unable to pay the interest or falls into liquidation, then the holder of the loan notes can take what
they are owed from the sale of these assets (in priority to anyone else owed money).
These loan notes are not secured on specific assets. So if the company does go into liquidation,
then although they are repaid before any money goes to equity, it is only out of money left after
the secured loan notes have been repaid. Because there is more risk therefore to the investors,
these loan notes will pay a little more interest than that paid to secured loan notes.
Redeemable (i.e. repayable) debt is when the loan notes are repaid in cash on a fixed future date.
Convertible debt is when the holders of the loan notes (the lenders) have the choice on the fixed
future date of either taking cash or alternatively taking a fixed number of shares in the company. It
September 2021 to June 2022 exams FFM Foundations in Financial Management 55
is the investors who choose which to do when it comes time for repayment. Convertible debt is
popular because it makes it more attractive for investors to lend money in the first place (relatively
safe), then if the company does very well they the loan can be converted into equity shares so that
capital gains can be made.
These are loan notes issued in one of the ways listed above but, in addition to receiving a certificate
for the amount they have lent (and then receiving interest and then either repayment or
conversion), lenders also receive a warrant, which is a bit like getting a gift voucher. The warrant
entitles them to buy a certain number of shares in the company at a fixed price on a future date. It
is the investors' choice on whether or not to buy the shares at the fixed price. It is completely
separate from the loan notes themselves, but does make lending the money more attractive to
investors.
4.1. Introduction
When a company is established it will normally obtain capital from its founders, their families and
friends. As the company grows it can boost its capital by retained profits and sometimes by outside
investors such as business angels and venture capitalists (of which more later).
As companies become large, many choose to obtain a listing (quotation) on a stock exchange and
this provides the opportunity to raise large amounts of capital from private individuals an
organisations such as pension funds, hedge funds and insurance companies.
Many countries have several 'levels' of stock exchange. In the UK there are:
The AIM is used by smaller companies, often as a stepping stone to a full listing. It is subject to
regulation but much less so than the main market. Therefore, shares on the AIM are more risky to
invest in because the regulations are less onerous and also because the companies are younger.
The main market is where major national and international companies are listed and it is subject to
tight regulation.
A listing shows a company's share price (which will often change on a second-by-second basis) and
will provide a platform for the instant purchase and sale of shares. The ease by which shares can be
sold increases investors' confidence to invest in shares because they know it will be easy to sell
their investment at any time. The market is said to be 'liquid'. One of the problems that arises with
investing in unlisted (unquoted) companies is that it can be difficult and slow to find a buyer for
shares if an investor wants out. The market for unlisted shared is said to be 'illiquid'.
As part of the listing process the company has to present lots of financial information (eg its trading
history) in a prospectus. Drafting the prospectus and ensuring that regulations are adhered to
requires the services of professional firms such as accountants, lawyers merchant banks and
stockbrokers. The fees charges by these firms are eye-watering, typically about 10% of the amount
of capital raised.
There are several ways in which shares in a company can be listed (ie become 'floated' on the stock
exchange:
A public offer
Shares are offered to the public and institutions. Typically, the offer is advertised in the financial
press and application forms are submitted. The offer can be fixed price or an offer for sale by
tender.
๏ Fixed price - shares are offered at say, $4.00 each. If applications are made for more shares
than available then the offer has been oversubscribed and applications have to be scaled
back. For example, everyone might receive 80% of the shares they applied for. Sometimes the
share offer is undersubscribed so that is fewer shares are applied for than are available. That is
very undesirable because the large costs of publishing the prospectus and organising the sale
have been incurred for a disappointing amount of capital raised. It is also somewhat
embarrassing for the company as it implies that the shares were offered at too high a price.
To prevent the company being left with unsold shares, public issues are underwritten,
meaning that a financial institution (for a fee) promises to buy all unsold shares. This
insurance means that the company will always raise the capital it wanted to raise and so will
be able to carry out its investment plans.
๏ Offer for sale by tender - investors bid for the shares. A range of prices will be offered and
these are arranged in descending sequence. The highest price at which all shares would be
sold is the strike price and all shares are sold at that price even if the investor offered a
higher amount. For example, a company has 50,000 shares for sale and receives offers for
100,000 shares as follows:
Number of shares bid Bid amount per share
for ($)
5,000 10
15,000 8
30,000 5
50,000 3
At a price of $5/share, 50,000 shares could be sold (obviously if someone offered $10.share
they would be very happy to buy at $5). The strike price is $5 per share and all are sold at that
price to the top three categories of investor. Those who offered only $3/share are allocated
no shares.
Offers for sale allows the company to avoid deciding on a strike price and lets the market
decide.
A placing
In this listing method, used for smaller flotations, shares are offered to institutions only. members
of the public can only get shares by then buying from the institutions. It is a cheaper way to list
shares and raise capital than a full public offer.
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An introduction
An introduction is a method for listing shares already in issue.The shares are already so widely held
by a diverse set of investors that there is an open market for the trading in these shares. No
additional capital is raised via an introduction.
Subsequent to an initial listing in which it is normal to raise substantial new amounts of equity
capital, a successful company may be able to expand using its retained profits. Retained profits are
the cheapest way in which a company can be financed. However, sometimes there is a need for
more equity capital to be injected from outside. This can happen if the company has been making
losses and more capital is needed to ensure short-term survival. Or, perhaps the company wants to
expand faster than retained profits allow, for example, if the company wanted to takeover another
company.
New equity is then raised by means of a rights issue. This is where new shares are offered to
existing shareholders on a pro-rata basis and they are usually issued below current market price to
make the issue look attractive to investors. For example:
So, if you were the owner of 200 shares, you are being offered 200/4 = 50 (ie one new share for
every old four shares) shares at $5 per share. You would pay $250 for those shares. If every
shareholder took up their rights then the company would raise:
500,000/4 x 5 = $625,000
Shareholders do not have to buy more shares and if they don't they will receive some money for
selling their rights to other investors. If shares are bought under the rights issue then each
shareholder maintain their relative stake in the company ie no dilution of control.
Advantages:
Disadvantages:
๏ Dilution of ownership and control as many new shares are issued and many more
shareholders are entitled to vote.
๏ Original owners can resent that more people are now involved and so others can determine
the company's future.
September 2021 to June 2022 exams FFM Foundations in Financial Management 58
๏ Greater scrutiny and comment. For example, newspapers can comment on every decision,
result and piece of news leaving the company. Dealing with this can distract management.
๏ Greater focus on short term results and share prices. This can make it difficult for
management to carry out long-term plans which might involve short term falls in profit.
Debt is much safer. The interest rate of a debenture is printed on the document and loans are often
secured on valuable assets. Interest is therefore predictable and if the company goes into
liquidation, debenture-holders will often recover all their investment.
Because equity is relatively risky, shareholders expect relatively high returns. Because debt is much
safer, debt-holders are satisfied with lower returns.
Therefore, it makes sense for companies to have some relatively cheap debt finance in their capital
structures. Debt is made even cheaper for companies because they receive tax relief on their
interest payments but do not get tax relief on dividend payments.
The term 'gearing' in finance (or 'leverage' in the USA and some other countries) is used in analogy
to mechanical systems. For example, you turn the pedals of a bicycle once and if you are in a high
gear the rear wheel might turn more than once. Similarly levers allow a small movement on one
side of the pivot to produce a large movement on the other side.
Low profits are half medium profits and high profits are twice medium profits. You will see that
exactly there is exactly the same relationship in the profit after tax available for dividend.
Now see what happens if the company is geared and has to pay interest on its borrowings of, say,
$400,000
September 2021 to June 2022 exams FFM Foundations in Financial Management 59
The top line profits are still fall by 50% from medium to low and rise by 100% from medium to high
but now profits available for dividends fall from 450 to 75 (to only 17% of what they were) and rise
from 450 to 1,200 (a rise of 266% on what they were). So the profits available for dividends have
become much more volatile.
This is fine if the company is doing well and profits before interest are increasing, but worrying if
profits before interest fall. Profits wouldn't have to fall much further (or interest rates rise by much)
before profits do not cover interest.
Therefore, the conclusion is that it is good to have some borrowing in a company's capital structure
to make use of relatively cheap finance, but as borrowings rise shareholders are exposed to more
risk, both more volatile dividends and a higher chance that the company will fail because it can't
meet its interest payments. Lenders are also exposed to more risk because all good company assets
will already have been used to secure loans and there is an increasing risk of company failure if
interest and loan repayments cannot be made on time.
Earnings per share show the same volatility. Look at the calculations below on the assumption that
the capital structure of the ungeared company is 10,000000 shares and the structure of the geared
company is 6,000,000 shares and 4,000,000 10% debentures.
Ungeared Geared
Shares in issue at $1 each 10,000,000 6,000,000
10% Debentures - 4,000,000
Total capital 10,000,000 10,000,000
Very small, new companies are initially funded by their founders either using their own money,
personal loans from banks and sometimes investment by friends and relatives.
Large and very large companies can raise capital through the Alternative Investment Market (AIM)
or by a listing on the full market.
However, medium-sized companies can often find it difficult to raise capital: they are too large for
friends and family to make an impact and too small for a listing. The absence of suitable finance for
these companies is known as the funding gap. In particular they have difficulty in obtaining
medium-term finance (typically for 3 - 5 years and this is the maturity gap. Being small and new
means that it can be difficult for these companies to provide lenders with adequate security for
loans. Additionally they have short trading records and this makes risk assessment difficult.
To some extent. the problem is addressed by business angels and venture capitalists. Business
angels are wealthy individuals who invest in young companies, providing them with venture
capital. Venture capitalists are organisations which specialise in funding relatively new businesses.
Both hope that they will earn gains through the companies' future success and they do not expect
profits or dividends in the short term. Typically, a venture capitalist will invest in up to just below
50% of the company's shares and will very likely expect a seat on the board so that they can keep
an eye on their investment.
To make a profit from their investment the investors have to have an exit route that will allow them
to realise their investment. This is usually either via selling the company to another (a takeover) or
obtaining a listing for the company on a stock exchange. This lets the investors easily sell theirs
shares - hopefully at a profit. Occasionally, the exit route is via the original founders buying out the
other investors, but this is rare.
Because of the high risk involved when investing in relatively new companies, business angels and
venture capitalists are typically looking for returns in the order of 30%pa.
September 2021 to June 2022 exams FFM Foundations in Financial Management 61
Government schemes
Local government, national government and supra-government organisations (like the European
Union) often offer grants and incentives to smaller businesses. The grants and incentives are
usually made available to directed at companies which are in regions where the economy is
relatively poor with high unemployment and where regeneration is needed. Grants are amounts of
money given permanently to a business (though the business usually has to comply with certain
undertakings if the grant is not to be repaid. Other forms of incentive include soft loans (where the
interest rate is reduced because of government contributions) or loan guarantee schemes (where
banks are encourages to lend money because the government will underwrite any bad debts.
This is an important source of medium term finance and is often used for the purchase of non-
current assets with lives of around five years, such as vehicles, computers and some machinery.
With HP, the supplier of the equipment retains ownership of the asset and the user company pays
(typically) monthly instalments for the use of the asset. This is the 'hire' element of HP. If the user
stops paying instalments the supplier can seize the goods. When the last instalment is due the
company can opt pay a purchase fee (usually small) and it is then that ownership of the asset
transfers.
Instalment credit invoices the seller of the asset arranging a loan for the user of the asset. The loan
is used to buy the asset immediately and the loan is gradually paid off. If the buyer of the asset
stops paying then finance company can pursue the borrower for unpaid amounts, but the asset
remains the property of the buyer.
Leasing
Similar to hire purchase and instalment credit but ownership of the asset never transfers. In effect,
the asset is being rented. This is also useful as a source of medium term finance.
Usually applies to land and buildings but can also apply to large, valuable items of equipment. The
business owns the asset and this is then sold to a finance company which leases it back to the
seller. The business receives a large influx of cash from the sale then pays lease instalments to keep
using the asset. This would usually be regarded as a long-term source of finance.
A factor takes over the receivables of a business, maintaining the receivables ledger and chasing
customers for payment. Customers pay the factor who then pays the original seller net of a
commission . The normal arrangement is that the factor pays the seller earlier than the money is
received from the customer. Speeding up cash receipts is of great help to the seller. Additionally,
the seller is relieved of the administrative burden and expense of maintaining the receivables
ledger.
An invoice discounter pays the seller a percentage of certain sales invoices when these are
presented. Again, the seller receives sales revenue more quickly but in this case sellers of goods
maintain their own receivables ledger.
September 2021 to June 2022 exams FFM Foundations in Financial Management 62
Chapter 9 questions
Question 1
Expenditure
Finance
1 A rights issue
2 Instalment credit
3 An overdraft
Question 2
A company has 200,000 $1 shares in issue, with market value $3.50 per share. It intends to raise
money by a 1 for 5 rights issue at $3.20 per share.
If all investors take up their rights, how much will be raised and how many shares will then be
in issue?
Question 3
A company is financed by both ordinary and preference shares. Which type of share:
(d) Is paid out ahead of the other if the company goes into liquidation?
Question 4
If earnings before interest fall by 10%, which company will suffer the bigger fall in profits available
for equity shareholders?
Question 5
Chapter 10
MONEY IN THE ECONOMY
M0 = cash held by individuals (notes and coin) and in bank accounts plus banks' operational
balances with the central bank.
M4 = notes and coin, deposits, certificates of deposit, securities with a maturity of less than five
years held by the non-bank private sector.
However, for our purposes, the precise definitions are not very important but it is important to
appreciate why the money supply is important in economics.
You will understand, on a personal basis, that if you do not have much money and you are unable
to access any more then you will not be able to spend much whether on day-to-day living or the
purchase of major assets. It is the same for all participants in the economy, including businesses. If
the economy has a very restricted supply of money then economic expansion is difficult.
Furthermore, there will be competition for whatever money is available and this will push up
interest rates and this makes borrowing to invest more expensive and less attractive.
In contrast, if the money supply is very loose, expenditure is easy and there will be greater
competition for the purchase of goods and services. This is likely to increase prices and the
economy is likely to suffer from inflation
Governments have two main ways in which to control or regulate their economies:
The word “fisc” is an old word which referred to the king’s purse. Where does the state get the
money from? Where does it spend it? If the state wants to spend money it either has to raise
income through taxes or borrow money. If it wants to reduce taxes it either has to reduce
expenditure or borrow money. The three - expenditure, borrowing and tax - have to be in balance.
In the Covid 19 recession governments sought to spend more money to support businesses which
were unable to trade because of lock-down rules. This is a way of putting money into the economy
to try to stimulate it. To finance the expenditure governments increased their borrowing (there was
no point in trying to increase taxes if businesses were not functioning). So, borrow money, spend it,
once it’s spent it will be earned by people who will spend it again. And that’s the way in which
governments hope the recession will be brought to an end.
The second way in which governments attempt to control their economies is by their monetary
policy: managing the supply of money in the economy. The more money in the economy the more
the economy is likely to be stimulated. This creates demand for goods and labour and boost
employment. However, too much fast expansion of an economy can cause prices to rise (demand
pull inflation as explained below). If the money supply is reduced, then economic growth slows
down and a country might even have a recession (economic contraction). This an increase
unemployment and is likely to reduce inflation.
๏ Interest rates. If interest rates are very high people will tend not to want to borrow money. If
you don’t borrow money you can’t spend it, and if you can’t spend it then, for example,
inflation will be relatively low because of low demand for goods. If however you greatly
reduce the interest rates more people will be encouraged to borrow. They spend that
borrowed money on televisions, cars, houses, whatever. And once it’s spent the money is in
the economy, other people earn it, demand goes up, and the economy is stimulated. In most
countries interest rates are controlled by the central bank such as the Bank of England in the
UK and the Federal Reserve in the USA
๏ Credit controls. This is a control over institutions, typically banks, on how much they are
allowed to lend. So for example if you put $1,000 into a bank and the reserve requirement
was only 10%, that means that the bank could lend $900 out of the $1,000 deposited. That
$900 could be deposited again and the bank could lend on $810 and so on. So the initial
deposit of $1,000 can create a much higher amount of money in the economy. Say however
that the reserve requirement was 50% - $1,000 in the bank; the bank only lend on $500. That
$500 is put into another account, the bank can lend on only $250 and so on. You can see that
at the end of the cycles a much smaller amount of money will be created in the economy.
Of course, to increase the money supply governments can simply introduce more money into the
economy. This used to be done by simply physically printing more currency notes but nowadays it
is accomplished through a process known as 'quantitative easing'.
September 2021 to June 2022 exams FFM Foundations in Financial Management 65
3. Inflation
Inflation is the year-to-year (or in cases of hyper-inflation, the day -to-day) increases in prices.
๏ Huge amounts of time and effort are expended negotiating wages, salaries and prices. This
effort is entirely non-productive.
๏ Planning becomes very difficult as future cash flows are made much less predictable.
๏ Savers lose out because the purchasing power of their savings is eroded.
๏ Pensioners often lose out if they are on a fixed pension because each year it will buy less.
๏ Demand pull. This is where there is a lot of money in the economy, lots of people who want
to spend money, and because demand is therefore high, prices are pulled upward.
๏ Cost push. An example of cost push inflation is where people in the manufacturing industry,
let’s say coal mining, have a large wage rise. Inevitably that wage rise is passed on and will
find itself reflected in the cost, say, of electricity. The cost of electricity goes up and that’s an
example of cost push inflation.
๏ Import cost inflation. A good example of that was the huge increase in the cost of oil that
happened towards the end of 2008.
๏ Expectation. This is where people expect there to be inflation and because they expect
inflation, they make higher wage demands and the higher wage demands inevitably push up
the price of goods that are going to be sold.
๏ Increase in the money supply. An increase in the money supply will stimulate demand.
More people have money to buy goods and this will cause demand pull inflation.
For example, assume that there is no inflation in an economy and to persuade investors to put
money in a bank for a year, the bank has to pay 3% interest. If $1,000 is deposited now then in 1
year $1,030 is available to spend and, because there is no inflation, $30 (ie 3%) more goods can be
purchased. The investor is really richer by $3% and this is known as the real return or real interest
rate. The 3% is what the investor requires to defer the enjoyment and utility of expenditure by a
year.
Now let's say that inflation is running at 5%. Just to be able to buy the same goods in a year as
could be bought now by $1,000 will take $1,050 (ie a 5% increase to allow expenditure to keep up
with inflation. However, that has not increased the investor's wealth in terms of goods that could
be purchased and presumable to defer expenditure the investor still needs a real 3% increase in
purchasing ability.
Therefore, the investor needs the deposit to grow by 5% to stay level with inflation and then an
additional 3% to generate an increase in wealth.
September 2021 to June 2022 exams FFM Foundations in Financial Management 66
Here:
8.15% is the interest rate that banks would need to offer to persuade investors to deposit cash with
them
It is called a 'money rate' because this is the amount by which the investor's money must increase
by to cover both required returns. It is called the 'nominal rate' because it is a headline rate. The
investor is not 8.15% richer and therefore 8.15% is certainly not a measure of the real rate of return
(which remains at 3%).
The rates advertised by banks and other institutions are the money or nominal rates available.
September 2021 to June 2022 exams FFM Foundations in Financial Management 67
Chapter 10 questions
Question 1
If the real interest rate if 4% and inflation is 7% what is the nominal (money) interest rate?
Question 2
What are the two groups of mechanisms (policies) that the government can use to control the
economy?
Question 3
Question 4
Chapter 11
INVESTMENT DECISIONS – FINANCIAL
CONCEPTS
1. Interest calculations
In the previous chapter frequent reference was made to interest rates. We not have to look in just a
little more detail about how interest is calculated and how the timing of receipts and payments
affects their values.
Simple interest
If an interest rate is 5% and an amount of $1,000 is deposited in the bank (known as the principal)
then, assuming no withdrawals are made, the amount of cash in the investor's account will be as
follows:
etc
The 5% interest rate is always applied to the principal of the loan and not to the whole account
balance ie it is not applied to any interest previously earned.
Exactly the same calculation would be applied if e had borrowed $1,000 at 5% simple interest. After
10 years, $1,500 would be owed to the bank.
Compound interest
With compound interest, the interest rate is applied to not only the original principal but also to
any interest added. Assuming no withdrawals are made the balances at the end of each year would
be:
You will see that with compound interest the bank balance rises much more sharply than with
simple interest
The formula for the future value of the bank deposit (or loan) is:
n
S = P(1 + r)
where
P = the principal
Illustration
A business borrows $50,000 at 12% interest. After 15 years how much is owed
(i) Using simple interest?
(ii) Using compound interest?
Solution
(i) Interest will amount to 12% x 50,000 = $6,000 per year. After 15 years this will have
accumulated to $90,000 so the total amount owing is $140,000.
2. Discounting
Interest calculations project forward to show how much will be in a bank account after a number of
years. Discounting does the reverse: it says something like "If I want to end up with $1,000 in a bank
account after 3 years and the interest rate if 5%, how much do I have to deposit now?
n
S = P(1 + r)
3
1,000 = P (1.05)
3
So, P = 1,000/(1.05) = $863.84
(You can check this by working out the final amount after three years if $863.84 is invested at 5%).
$863.84 is known as the present value of $1,000 received after 3 years at a 5% discount rate.
Similarly, if $1,000 were received after 10 years at a discount rate of 10%, the present value would
be:
10
P = 1,000/(1.10) = $3,855
To make the calculation easier, discount tables are used and provided in the exam. Here's an
extract:
September 2021 to June 2022 exams FFM Foundations in Financial Management 72
For the last example, go down the left hand column until you get to10, the number of years hence
that the flow occurs, then go rightwards until the discount rate is 10%. The table figure is 0.386
(rounded to 3 decimal places) so the present value of any amount received after 10 years at a 10%
discount rate is 0.386 times the amount, here $3,860.
Discounting is required for you to properly evaluate cash flows as not just the raw amount needs to
be considered but also when it is received. For example, say you were offered the following choice:
Interest rate = 7%
We would instinctively choose option (i): if we receive the money now we can invest it now at 7%
whereas that possibility is only available after 4 years in option (ii). The present value quantifies the
benefit from earlier receipts:
(ii) Receiving $10,000 in 4 years at 7% interest rate is equivalent to receiving $10,000 x 0.763 =
7,630 now (0.763 is the 4 year 7% table figure).
You might not have needed discounting to make the right decision here, but what about this
choice:
Interest rate = 8%
Both amounts need to be turned into their present values, eliminating timing differences and
allowing us to concentrate on the amounts.
2.2. Annuities
An annuity is a constant amount of money paid or received for a number of years. This can be a
relatively common pattern of cash flow, for example, annual rents, insurance premiums or pension
receipts.
The present value of annuities can be worked out using the method we have seen above, but
another set of tables is available that makes the calculation much faster. These tables are known as
annuity tables or cumulative discount tables.
Illustration
A business must pay $4,000 every year for 4 years starting at time 1 ie starting one year from now.
The discount rate of 6%
What is the present value of these receipts?
Solutions
Method 1 - the long way
The factor of 3.465, above is the 4-year 6% cumulative (annuity) factor and it will allow the
calculation of the present value for years 1 - 4 in one line instead of four. Note that the name
'cumulative discount factor is because the cumulative factor is the sum of the four individual
factors (3.465 = 0.941 + 0.890 + 0.840 + 0.792)
It is important to be aware that the annuity factor can only be used as it stands for flows starting at
time 1 and then occurring every period thereafter. Other patterns of flow need a bit of work on the
discount factor.
Illustration
A business will receive annual rent of $12,000 from a tenant, for 5 years starting at time 3. The
discount rate is 4%.
What is the present value of the rental receipts?
Solution
The receipts will be received for times: 3, 4, 5, 6, 7. Here is where the first error is likely to be made
as you might think you should be looking at time 8 for the last receipt (as 3 +5 = 8).
The seven year cumulative factor would let us calculate the present value of receipts for times 1 - 7
inclusive. But we want 3 - 7 inclusive so we don't want times 1 - 2.
The required factor is therefore:
1 to 7 factor = 6.002
less:
1 to 2 factor = (1.886)
3 to 7 factor = 4.116
The present value of the five flows is therefore: 12,000 x 4.116 = $49,392
September 2021 to June 2022 exams FFM Foundations in Financial Management 75
2.3. Perpetuities
A perpetuity is a constant annual amount, starting at time 1 and going on for ever. Once you get up
to around an annuity for a period of 50 years, the inflows can effectively be regarded as a
perpetuity because flows after 50 years are discounted so heavily that they can usually be ignored.
Illustration
A building is leased for 999 years at an annual rent of $120,000. The discount rate if 6%.
What is the present values of the rental flows if:
(i) The first rent is paid at Time 1
(ii) The first rent is paid at Time 0
(iii) The first rent is paid at Time 5
Solutions
(i) 120,000 x 1/0.06 = $2,000,000
(Note: the perpetuity discount factor of 1/Discount rate implies the flows begin at time 1)
(ii) Times 1 - 999 (ie for ever in essence): 120,000 x 1/0.06 = $2,000,000
Time 0 120,000
Times 0 - 999 $2,120,000
Chapter 11 questions
Question 1
How much will be in a bank account at the end of the following investments?
(c) $600 invested for 5 years. For the first two years 3% compound interest was earned and 5%
compound interest was then earned for the final three years.
Question 2
What is the present value of $345 received after 4 years if the discount rate to be used is 7%?
Question 3
What is the present value of $250 received every year from time 1 to time 10 is the discount
rate is 4%?
Question 4
What is the present value of $1,200 received in perpetuity, starting at time 1, if the discount
rate is 5%?
Question 5
What is the present value of receiving $1,000 for years 4 - 8 inclusive if the discount rate is
5%?
Question 6
What is the present value of a perpetuity of $500 pa that starts at time 3 if the discount rate is
7%
September 2021 to June 2022 exams FFM Foundations in Financial Management 77
Chapter 12
CAPITAL BUDGETING AND
INVESTMENT APPRAISAL
1. Capital investment
Capital investment (or expenditure) is an amount spent to acquire or significantly improve the
capacity or capabilities of a long-term assets such as equipment or buildings. It should enhance the
profit-making capabilities of the business. The cost is recorded in a statement of financial position
(balance sheet) under non-current asset headings such as:
The assets' cost (except for the cost of freehold land) will then be depreciated (expensed) over the
useful life of the asset.
In contrast to capital expenditure, revenue expenditure is for day-to-day running expenses of the
business of to maintain the profit-earning capacity if the non-current assets (for example, repair,
servicing, redecoration).
Capital investment expenditure is to acquire expensive items large and once the purchase of assets
has begun it is usually difficult to stop the process. For example, if constructing a new factory,
stopping half way through will probably leave the business with a useless shell or construction site.
Furthermore, once an asset is purchased it is usually difficult to retrieve anything close to the
amount spent as second hand values (other than for land and buildings) are often very low.
So, capital expenditure can irreversibly permanently remove large amounts of cash from a
business. Therefore, it is vital that capital expenditure is carefully planned and budgeted for if the
business is not to find itself with liquidity problems. It is also important that individual purchases of
non-current assets are properly scrutinised before orders are placed to ensure that money is being
spent properly on assets needed by the business and also that the best possible purchase heals are
obtained.
When a business raises capital, it has two ways in which the amount raised can be invested:
Putting too much money into non-current assets can leave the business with insufficient working
capital. Putting too much into working capital can mean that the business is not making good use
of the cash raised (it is simply sitting in the bank or in inventory).
September 2021 to June 2022 exams FFM Foundations in Financial Management 78
Businesses must carefully assess the volatility of their cash flows to try to ensure that capital raised
is deployed in the best possible way and that a balance is achieved between prudence (lots of cash
in working capital) and performance (lots of cash used to buy productive non-current assets).
Illustration
A machine is bought for $24,000 and over the next four years is expected to produce pre-
depreciation earnings as follows:
Year 1 $7,000
Year 2 $8,000
Year 3 $12,000
Year 4 $8,000
The estimated scrap value of the machine at the end of 4 years is $4,000.
Calculate the ARR
September 2021 to June 2022 exams FFM Foundations in Financial Management 79
Solution
The ARR is calculated as follows:
Total earnings = $35,000.
Total depreciation charge = $24,000 - $4,000 = $20,000
Average annual earnings after depreciation = ($35,000 - $20,000)/4 = $3,750
Average value of the investment (starts at $24,000 and falls to $4,000) =
($24,000 + $4,000)/2 = $14,000
ARR = 3,750/14,000 = 0.268 or 26.8%
The method draws an analogy with calculating an interest rate earned from a bank deposit where
the rate = Interest earned/Amount invested.
So, 26.8% might look good, but whereas you are unlikely to lose the amount you invest in a bank,
there is no guarantee that the company's expenditure of $24,000 will produce the income that is
forecast. Capital investments always suffer from considerable risk and to compensate for this they
should pay considerably more than could be earned in a bank deposit account. How much more
depends on the company's owners because, ultimately they put up the money for the new
investment either by forgoing dividends or by paying more capital into the company.
Therefore, companies establish a target rate of return that projects should meet or exceed. If in the
example above the target rate had been 25%, because the ARR is above that the project would be
accepted. If the target rate were 30%, the project would be rejected.
Sometimes the ARR is calculated using the initial capital employed instead of the average
investment. In the above example the ARR on that basis would be:
$3,750/$24,000 = 0.156 or 15.6%
This doesn't mean that the project has suddenly become worst - it's just a different way of assessing
it and it be compared to a different target rate to decide whether or not it was an acceptable
project.
This has not bee recouped by the end of year 2, but it is recouped part way r year 3 because at the
end of that year $27,000 has been received in total - $3,000 more than needed. To get payback,
therefore, only $12,000 - $3,000 = $9,000 of year 3's earnings have to be received. This represents
9,000/12,000 = 0.75 of the year's total earnings so should be received 9 months into year 3.
Companies will set targets for acceptable payback. If the company had a target payback period of 4
years then achieving a payback of 2 years 9 months is acceptable as money is recouped faster than
it needs to be.
If the target payback had been 2 years, then 2 years 9 months is unacceptable.
Payback gives some information about risk as the longer the actual payback, the more risk there is
as it is much more difficult to have confidence about cash flows 8 years away (say) than inflows
expected to arise after only 3 years. Companies in different business sectors will have their own
acceptable criteria. For example, a company whose business is drilling for oil in the middle of an
ocean will be used to long payback periods whereas a company in retail will expect much shorter
payback.
One of the main problems with payback is that it 'loses interest' after payback either is or is not
reached by the target period. Say that in the above example the target payback was 2 years; the
actual payback of 2 years 9 months means that the project would be rejected. But would that be a
reasonable decision if the expected cash flows were as follows?
Cash earnings
($)
Year 1 7,000
Year 2 8,000
Year 3 12,000
Year 4 80,000
September 2021 to June 2022 exams FFM Foundations in Financial Management 81
The project now is massively profitable, but the payback period is still 2 years 9 months. However, it
is unlikely that rejecting the project would be a good decision. Therefore, it is dangerous to use
payback on its own as not all cash flows are considered.
Advantages of payback:
Disadvantages of payback
๏ Largely ignores the timing of cash flows within the payback period
๏ Total profits are ignored as the method does not consider earnings after payback has or has
not been achieved in the target period.
๏ Can be difficult and arbitrary to establish the target payback period.
Cumupative
Cash inflow 5% discount Discounted cash
Time discounted cash
($) factor from tables flow ($)
inflow ($)
1 7,000 0.952 6664 6664
2 8,000 0.907 7256 13920
3 12,000 0.864 10368 24288
4 8,000 0.823 6584 30872
The initial cash outlay was $24,000, so cash break-even is obtained during Year 3 as before.
For all practical purposes, and given the uncertainty relating to cash flows and an appropriate
discount rate, payback is achieved at the end of year 3. This would be compared to the company's
target discounted payback period.
As for payback with the added difficulty of having to estimate a proper discount rate, but once that
is done then the time-value of money has been taken into account.
September 2021 to June 2022 exams FFM Foundations in Financial Management 82
Outflows are shown as negative cash flows; inflows are positive. Time 0 = now
Illustration 1
A company is considering investing in a machine that costs $75,000 and which then produces
inflows of $30,000, $50,000 and $20,000 at times 1,2 and 3. (Note: time 1 in 12 months from now etc
and for simplicity cash flows are assumed to happen at the end of each 12 month period.)
If the discount rate is 10%, is the project worthwhile?
The analysis is as follows:
Discounted cash flow (=
Time Cash flow $ 10 Discount factor
present value of the flow)
0 (60,000) 1 (75,000)
1 30,000 1 27,270
2 50,000 1 41,250
3 20,000 1 15,020
Net present value 8,540
The NPV is $8,540 positive. This means that the investor would be the equivalent of $8,540 better
off now if the project is undertaken even after allowing for the effect of the inflows not happening
until some time in the future. The advice, therefore, is to ACCEPT this project.
If the NPV had been negative then this means that the investor is poorer by that amount if the
project is carried out. That loss can be avoided by REJECTING the project.
September 2021 to June 2022 exams FFM Foundations in Financial Management 83
Illustration 2
A company is considering in buying a machine for $250,000 to be spent at time 0 and $50,000 to be
spent at time 1. The machine will produce annual income $35,000 for 10 years starting at time 2
and will be sold for $20,000 scrap value just as the final income is received.
Is the project worthwhile if the discount rate is 9%?
The analysis is as follows:
Discounted cash flow (=
Time Cash flow $ 9% Discount factor
present value of the flow)
0 (250,000) 1 (250,000)
1 (50,000) 0.917 (45,850)
6.805 - 0.917 = 5.888
๏ Uses cash flows - which are more difficult to manipulate than profits
๏ The time value of money is taken into account
๏ Higher discount rates can be used when assessing riskier projects giving them a higher hurdle
to clear
๏ More distant cash flows are more heavily discounted so that those far-off less certain flows
have less importance in the calculation
Disadvantages
Illustration
A business bought leasehold land for $500,000(1) three years ago. It has a current market value of
$750,000(2) .
The business can erect an office for $800,000(3) that would be depreciated at £20,000 (4) per year
over the next 40 years. The office would be rented out for £150,000(5) pa for 20 years. 10% of
current administration costs of $50,000(6) pa would be allocated to the project's budget.
Is the project worthwhile is the discount rate is 10%pa.
This is also a discounted cash flow technique. The internal rate of return is defined as:
IRR = the discount rate at which the net present value is zero
If IRR > actual discount rate, the NPV is > 0 and the project should be accepted.
Think of it as the project earning at a higher rate than is being used to discount the cash flows so
undertaking the project will make the investor richer.
If IRR < actual discount rate, the NPV is < 0 and the project should be rejected.
Think of it as the project earning at a lower rate than is being used to discount the cash flows so
undertaking the project will make the investor poorer.
A 'normal' project is one where there is an outflow now and inflows in the future.
The initial outflow, happening now, is already the present value amount and is therefore not
affected by discount rates. The future inflows are discounted and the higher the discount rate the
lower the present value figures (you can see this by looking along any year in the discount tables:
as discount rates increase, the discount factors decrease and so too will the present value of future
flows.
Consider this project: Expenditure at Time 0 = $12,000. Income for times 1,2 and 3 = $5,000 pa.
You can see that the NPV crosses through zero between a discount rate of 10 and 15, perhaps
around 12%. So, the internal rate of return (IRR) is about 12%.
If discount rate used for the NPV is less than 12%, ie to the left, all the NPV values are > 0 and the
project should be accepted.
If discount rate used for the NPV is greater than 12%, ie to the right, all the NPV values are < 0 and
the project should be rejected.
To estimate the NPV, two discount rates are used to find two NPVs. The discount rates are more or
less randomly chosen but ideally they yield one positive and one negative NPV.
You may have noticed that the line on the graph, above, is not quite straight, but in this following
estimation we have to pretend that is straight. A simplified view is therefore:
The triangles ABF and ACE are similar, meaning that their sides have the same proportions.
If BF = 7.3 then OF = 5 + 7.3 = 12.3, close to what we estimated by eye using the graph.
You can either use this type of diagram, or use a formula (not provided in the exam):
Where
NA= NPV at A%
NB= NPV at B%
There is one tricky part and that is the (NA - NB) term. If NB is negative then when to subtract this
negative number you need to add it to NA. You need the total distance A to C on the diagram and
that is 1616 + 585.
The formula above has to be used if the cash flows are uneven, however, there are some situations
where calculating the IRR is easier
IRR of an annuity
Illustration
In return for an investment of $5,000, $650 will be received for each of years 1 - 10. What is the IRR
of this this investment?
To solve this you have to remember the definition of IRR: it is the rate at which the NPV of the cash
flows is zero. Therefore at IRR
Investment = PV of inflows (= the cumulative discount factor x annual inflow)
Here, 5,000 = Cumulative 10 year factor x 650
Cumulative 10 year factor = 5,000/650 = 7.7
So, look along the 10-year row of the cumulative discount table until you find a discount factor as
near as possible to 7.7. The 10 year, 5% factor is very close to 7.7, so 5% is approximate IRR.
September 2021 to June 2022 exams FFM Foundations in Financial Management 88
IRR of a perpetuity
Illustration
An investment of $12,000 pays $1,000 pa in perpetuity.
What is the IRR?
Illustration
A company owns a piece of land. IT can either:
(i) Build an office for $3m which it would then rent out for $300,000 pa in perpetuity.
or
(ii) Lease to a charity incurring legal costs of $200 and from which it would receive $50 pa in
perpetuity.
NPV IRR
(i) Office -$3m + $300,000 x 1/0.08 =
300,000/$3m = 10%
$750,000
(ii) Charity -$200 + $50 x 1/0.08 = $425 50/200 = 25%
Using IRR, option (ii) looks much better, paying 25% as opposed to only 10% from option (i).
However, the sums involved in option (ii) are trivial and the NPV shows that it enriches the
company by an NPV of only $425. Option (i) makes the company $750,000 better off.
Here, the correct decision if to go for option (i). NPV shows in absolute terms how much a project
enriches an investor. The IRR shows returns only in relative terms and says nothing about which
project is more valuable.
September 2021 to June 2022 exams FFM Foundations in Financial Management 89
Multiple yields
A 'normal' project has cash outflows now (the initial investment) then inflows in the future. Such a
project has only one discount rate for which the NPV = 0: there is only one IRR.
However, some projects can have more complex cash flow patterns. For example:
Time 0 Build a chemical works for $50m (shown as a negative flow on the NPV
calculation)
Time 11 Spend $15m on environmental clean-up after the factory closes. Shown as a
negative flow
Mathematically, there is a discount rate where the NPV is zero every time the direction of the cash
low changes. For the chemical works the flows are -, +, - so there are two changes in flow direction
so two IRRs. This obviously complicates using IRR to decide whether a project is acceptable. For
example, if the two IRRs were 5% and 15% and the discount rate is 10% then one IRR is above the
discount rate and the other below it.
There are ways in which this complication can be solved, but they are beyond your needs for this
syllabus.
๏ Uses cash flows - which are more difficult to manipulate than profits
๏ The time value of money is taken into account
๏ For simple, non-mutually exclusive projects, gives a clear accept/reject indication
๏ More distant cash flows are more heavily discounted so that those far-off less certain flows
have less importance in the calculation
๏ Many managers feel more comfortable with a % rate compared to an NPV
Disadvantages
Chapter 12 questions
Question 1
An machine costs $50,000 and will last for 5 years after which it has a scrap value of $10,000. Pre
depreciation earnings over its life are:
Year 1 10,000
Year 2 15,000
Year 3 20,000
Year 4 15,000
Year 5 10,000
(a) What is the accounting rate of return on this investment (using the average amount
invested).
Question 2
Using the data in the above question, what is the pay-back period of this investment?
Question 3
Using the data from Question 1, above, what is the net present value of this investment if the
discount rate is 10%?
Question 4
At a discount rate of 7% a project has an NPV of 12,000. At 13%, the NPV is -6,000.
Question 5
Which of the costs should be brought into an NPV calculation with the following
information?
A company bought patent rights for $20,000 three years ago. They could now be sold for $30,000
and have a book value of $25,000. The patent rights can be used to make a product that would
need a production line costing $300,000 which would cost $200,000 pa to run. The $200,000
contains a depreciation charge of $30,000
September 2021 to June 2022 exams FFM Foundations in Financial Management 91
Chapter 13
CREDIT MANAGEMENT – LEGAL ISSUES
Offers
An offer is made by the offeror, who will be bound by that offer if it accepted by the offeree. Offers
can be:
๏ Express, such as if you said to someone “I will sell you this car for $6,000.”
๏ Implied, such as bidding at an auction, or taking an item to a shop check-out and allowing it
to be scanned and charged to your account.
Note that most contracts do not have to be in any particular form eg most can be oral as well as
written. However, contracts for the sale of land, consumer credit contracts and certain a limited
number of others have to be written.
An offer must be distinguished from an invitation to treat. This is where one party makes it known
that they are ready to receive an offer. For example, products on supermarket shelves with prices
attached do not constitute offers: these are invitations to you to offer to buy the articles by placing
them in your basket and proceeding to the checkout. Similarly, sales adverts in catalogues,
newspapers and on the Internet are not offers: they are invitations to treat.
๏ Acceptance. Once an offer has been accepted by one person it is not then available to be
accepted by another. Acceptance means that agreement has been reached.
๏ Rejection. Express rejection will terminate the offer but also any attempt to negotiate or
making a counter offer is also rejection. Note that simply asking for more information does
not count as rejection.
September 2021 to June 2022 exams FFM Foundations in Financial Management 92
Acceptance
Acceptance must be unqualified and unconditional, otherwise it will constitute a counter-offer that
will terminate the original offer.
Acceptance can be given in writing or orally or be construed by conduct, but silence cannot
constitute acceptance. The offeree has to do something to indicate acceptance.
Consideration
Offer and acceptance are not enough to form a contract: consideration is also needed. This means
that both sides of the contract must give to or do something for the other side (or promise to do
so). The exchange of considerations could be:
Consideration must not be in the past. Past consideration refers to value that was promised before
the contract was negotiated. So, if you tidy an elderly neighbour’s garden and she then promises
that she will then pay you $20, the payment cannot be enforced because tidying the garden was
not dependent on receiving $20. The tidying is on the past.
An action to enforce a contract or to claim damages can only be enforced by someone who has
given consideration.
The consideration given must have some value (sufficient) but does not need to match or be even
close to the value being received (does no need to be adequate).
Sometimes consideration is not needed in the formation of a valid contract. These contracts are
known as ‘speciality’ or ‘deed’ contracts, and they are made under seal. Promises under seal are
called ‘covenants’ and are enforceable even though consideration was not given. For example, a
grandparent could promise to fund a grandchild at university. This would be unenforceable unless
the promise is given in a deed, which is a formal document that requires signatures and witnesses.
A term is any provision that is part of a contract. Terms specify the details about what each
promised to do. Most terms are expressly agreed between the parties but there can also be implied
terms.
Terms divide into conditions and warranties. A condition is vital to a contract and if breached will
give the innocent party the right to repudiate (terminate) the contract and to claim damages. A
September 2021 to June 2022 exams FFM Foundations in Financial Management 93
warranty is less fundamental than a term. The breach of a warranty will not cause the contract to
end, but can give rise to damages.
2. Misrepresentation
A misrepresentation is a false statement of fact or law which induces one party to enter into a
contract.
๏ False.
๏ Relating to fact or law.
๏ Induces one party to enter a contract.
Contracts based on misrepresentations are voidable, if wished, by the innocent party – meaning
that the parties are returned to their original positions.
๏ Innocent: the person making the misrepresentation believed the statement to be true.
Damages or rescission (reversal of the contract to place both parties back into their original
positions) are the remedies.
๏ Negligent: a negligent misrepresentation is a statement made without reasonable grounds
for belief in its truth. Damages and rescission can be awarded.
๏ Fraudulent: where the statement is made knowing it to be false, or without belief in its truth,
or recklessly, careless as to whether it be true or false. Damages and rescission are the
remedies.
3. Breach of contract
This occurs when one party does not fulfill their obligations under the contract. There are some
defences available (such as if the contract becomes illegal to perform), but generally a breach will
lead to a remedy. Remedies are:
Specific performance: the court orders the party in breach to carry out their obligations.
Injunction: the court orders the party in breach not to break the contract (eg if an employment
contract specified that a leaving employee must not work for a rival for 1 year).
Quantum meruit: the injured party can claim on the basis of work done under, say, an abandoned
contract.
Action for the price: Where, under a contract of sale, the goods have passed to the buyer and the
buyer neglects or refuses to pay for the goods according to the terms of the contract, the seller can
take legal action against the buyer for the price of the goods.
Where the price is payable on a specified day irrespective of delivery and the buyer neglects or
refuses to pay such price, the seller can take legal action for the price, although the property in the
goods has not passed and the goods have not been appropriated to the contract.
September 2021 to June 2022 exams FFM Foundations in Financial Management 94
4. Statute
The Sale of Goods Act 1979 applies to business-to-business sales. The Consumer Rights Act 1979
applies to business to consumer sales. This section of the notes applies to business-to-business
sales as that is where credit arrangements between the parties is most common.
The quality of the goods sold must be satisfactory meaning that the standard that they meet a
standard that a reasonable person would regard as satisfactory, taking into account the price,
description and any other relevant factors.
If the purpose of the goods known to the seller, then the seller is obliged to make sure the goods
provided are fit for that purpose, if it is reasonable for the buyer to rely on the seller's expertise.
With regard to when title (ownership) of the goods transfers, there are a number of 'rules'
presumed to apply unless other arrangements are agreed:
Rule 1: in an unconditional contract for sale and delivery of specific goods property passes
immediately on contract formation ie even if delivery or payment have not been made.
Rule 2: where the seller has to meet a condition condition before the sale is possible (like carrying
out a certain act), property passes when this condition is performed.
Rule 3: where the seller has to measure or weigh the goods to ascertain the price, property passes
when this is done and the buyer is notified.
Rule 4: when goods are delivered on sale or return, or on approval, property passes when the buyer
adopts the transaction.
Rule 5: in a sale of unascertained goods, the property will pass once the goods are ascertained. So,
if a company orders one tonne of gravel from a supplier and the gravel is stored in a larger pile,
then title passes once the tonne for the buyer is separated from the rest.
An important alternative agreement on the transfer of ownership is a Retention of Title clause. This
means that the supplier retains ownership of the goods until full payment for the goods has been
received.
So long that the clause is clearly defined, and the contract is signed by both parties, it can be used
as documentary proof to the appointed insolvency practitioner, that a retention of title claim can
be made. This protects supplier and limits their chances of not being paid for goods delivered. It
acts as a form of security against the buyer's insolvency.
Bankruptcy and liquidation means that the company's or individual's assets are listed and valued
and the assets used to repay a portion of outstanding debt. Any debts still due can be written off.
September 2021 to June 2022 exams FFM Foundations in Financial Management 95
6. Data protection
Many jurisdictions have laws protecting their population from misuse and exploitation of personal
data. In the European Union, this is achieved through the General Data Protection Regulation
which, in the UK, has been implemented in the Data Protection Act 2018.
The Data Protection Act in the UK relates to personal data ie data relating living people who can be
identified from the information and which is processed wholly or partly automatically. We are not
talking here about data relating to companies: we are talking about data relating to people.
However, some company data might include personal data
You do not have to specifically ask for consent when processing business data, but consent is
needed when processing personal data - and personal data can relate to sole traders and
partnerships.
September 2021 to June 2022 exams FFM Foundations in Financial Management 96
Chapter 13 questions
Question 1
Question 2
Question 3
What is consideration?
Question 4
You gave a neighbour's daughter help with studying for an accountancy exam. The girl passed the
exam and the family was so delighted that they promised to pay you for your assistance. However,
after several months no money has yet been received.
Question 5
An art gallery tells a client that they believe that the paintings of a new artist will substantially
increase in value. This is their honest, genuine judgement On the basis of this the client buys a
painting, but subsequently its value drops sharply.
Question 6
Question 7
Question 8
Chapter 14
CREDIT MANAGEMENT – GRANTING
CREDIT, MONITORING AND
COLLECTING
๏ The company has to do without receiving cash for the credit period and this will require
funding in some way, for example, by having a larger overdraft on which interest will be
payable.
๏ The customer might never pay, for example, if the customer becomes bankrupt.
๏ Often discounts will be offered to encourage prompt payment.
๏ If credit is offered to retain customers by allowing payment by credit cards, the credit card
company will take a commission (say 1 - 2% depending on the type of card)
The company may be able to increase its selling prices to cover these costs, but competitive
pressures will mean that price increases are often constrained.
2. Credit granting
The decision to offer credit at all, the period of credit, the establishment of credit limits and the
monitoring of receipts from credit sales requires a credit policy to be set at a management level.
Remember, credit sales means that valuable goods are leaving the company without cash being
received then in exchange and good policies, frequently reviewed are essential.
๏ The decision by the business to offer credit at all. As stated above, this should be justified if it
leads to a profit increase.
๏ The period of credit to be offered (and this could be different for different customers
depending on their importance, bargaining power and financial resources).
๏ Establishing credit limits for each customer.
๏ Deciding on discount terms (if any)
๏ Policies and mechanisms for following up payments not received when due.
September 2021 to June 2022 exams FFM Foundations in Financial Management 98
๏ Policies on removing or reducing credit facilities from 'bad payers' or companies which look in
trouble.
๏ Establishing policies on bad debt recovery.
๏ Examining their financial statements. These will show trading history, profitability, liquidity
and the size of the company. All of these factors will influence the credit limit and for how
long it might be safe to offer credit for. If the company has just started to trade financial
statements will not be available and if so budgets might be the only financial information
that can be supplied.
๏ Trade references. A trade reference is a letter from another supplier stating that the
customer has a good credit history with them. This is open to some abuse eg references
might be supplied only from the few suppliers who are paid promptly. Also, companies might
be reluctant to criticise other companies for fear of causing trouble.
๏ Bank references. Banks have considerable information about their customers and their cash
flows, however, banks are cautious about either praising or criticising their customers and
replies to queries are often rather bland.
๏ Credit reference agencies. These are commercial organisations which collect information
about companies to allow assessment of their credit-worthiness. For example, they will
search court judgement records to see if the company has been taken to court about debt
disputes. For individuals they will have information about defaults on credit card payments
etc. The result of their investigations will be a credit rating for the potential credit customer.
๏ Companies House (Company Registrar) information. Typically shows financial information
owners and directors. Credit reference agencies can then be used to investigate the owners
and directors who stand behind the company.
๏ Court judgement information. Instead of getting a credit reference agency to look for
payment defaults, companies can search judgement records themselves.
๏ Consideration of the type of business. Different businesses are exposed to different risks.
For example, building companies tend to be greatly affected by economic confidence
whereas a company that is renting out many properties on long leases is likely to have more
predictable income. New businesses with inexperienced management are likely to be riskier
than established businesses.
Typically, with a new application from a customer for credit, the initial credit limit will be relatively
low. If the customer establishes a good, reliable payment behaviour then the credit limit can be
raised and this process can be repeated as trust grows.
Once the decision has been made at a high level to offer credit, most of the other activities credit
sale transactions are carried out by the company's credit control department.
3. Discounts
Many businesses offer discounts for prompt payment (settlement discounts). This was discussed in
the earlier chapter on working capital because receiving cash more quickly from customers eases
working capital problems.
The principle is easy: offer a 2.5% (say) discount for payment within 30 days (say). However, it is
important to always appreciate how expensive the modest-looking discount actually is.
September 2021 to June 2022 exams FFM Foundations in Financial Management 99
Solution
Receivables are now only $100,000 and the other $200,000 has moved from receivables into cash,
which is now $100,000 higher permanently.
Over the year, all customers earn the discount on all sales so the cost of the discounts will be 12 x
2.5% x 100,000 = $30,000.
So the company is paying $30,000 pa to raise its cash by $100,000 which is just like borrowing at
30,000/200,000 = 15%........a relatively high rate of interest.
Of course, if the discount also attracted more customers the $30,000 would be at least partially
compensated for by the profit from additional sales,
Solution
Although receivables have fallen by $200,000 cash has risen by only $195,500 (because the
discount is given to customers)
Cost of the discount over 2 months is 5,000/195,500 = 0.02564
Cost over 12 months is [(1 + 0.02564)12/6 - 1] = 16.4%
September 2021 to June 2022 exams FFM Foundations in Financial Management 100
4. Monitoring receivables
It is very important that receivables are closely monitored to see that amounts are received when
due and that discounts are not incorrectly calculated and or taken when not due. In general, the
older a debt becomes the less chance there is of it ever being paid. You have to consider that the
customer is not paying on time because the customer is having financial problems.
Usually at the end of every month statements are sent to each customer. These act as reminders
and also allow customers to compare their version of the account on their payables ledger with the
supplier's version on their receivables account. Disputed items should be sorted out as soon as
possible because customers sometimes claim they won't pay anything until disputes are settled.
Looking at the days of credit taken by customers is an easy an useful calculation. In particular, it is
worrying if a customer begins to take more and more days of credit and it is especially worrying if
customers move from paying quickly enough to receive settlement discounts to paying more
slowly so that the discount is lost. We know from calculations set earlier that this is a very expensive
way of borrowing (effectively the debtor is borrowing from the seller by not paying on time).
To show you again how this calculation is done consider the following:
Receivables = $190,000
This period is not necessarily either good or bad: it depends on what period of credit has been
agreed with the customer and also whether the period has changed. For example, if last year 28
days of credit were taken and it has not risen to near 50, then we need to ask why the company has
done that. Perhaps they are having difficulty paying more quickly and are suffering liquidity
problems. The situation needs careful monitoring.
In addition, aged receivables analysis should be produced showing the age of unpaid invoices for
each customer. Typically these are set out like:
Customers ABC Ltd, DAB Ltd and EAT Ltd look normal and cause no worries.
CAB Ltd seems to have a problem with an old invoice for $500. Perhaps that needs to be
investigated.
September 2021 to June 2022 exams FFM Foundations in Financial Management 101
BBC Ltd will probably give cause for concern as the company has been owing a large amount for
over three months.
The credit controller will often ring customers asking to speak to their payables department to
discuss outstanding amounts and to try to reach an agreement as to when amounts will be paid. If
that fails a meeting is likely to be requested.
At some point the credit controller might say that no more goods should be sent until payment has
been received and might lower credit limits for future dealings. Some care is needed here,
however, as there is play-off between encouraging faster payment and perhaps losing a valuable
customer, so jeopardising future sales, if pressure is applied inappropriately.
If payments are still not received the company might resort to:
๏ Arbitration. This is a legal process agreed between the parties. Their evidence is presented,
under oath, to an independent arbitrator. The arbitrator's decision is final and binding on
both parties. This is a cheaper and faster alternative to going to court.
๏ Formal legal action. In the UK this would be in the Small Claims Court, County Court or High
Court, depending on the amount of the claim.l
๏ Selling the old debts to a debt collection agency who might get legal permission to seize and
sell the debtors goods.
5. Debt factoring
This was mentioned in an earlier can be involved in approving credit facilities and will give advice
on setting credit limits. They will record invoices and receipts and will carry out professional credit
control. They often advance amounts to the sellers before customers have themselves paid and this
helps with working capital financing. Debt factors have their own legal departments and once
customers know that the relationship is being managed by a firm of professionals who can easily
resort to legal action there are often fewer collection problems. The factor needs to take care when
pursuing debts not to antagonise the seller's customers.
Factors can offer a 'with recourse' or 'without recourse' service. 'With recourse' means that if the
customer goes into liquidation so that the debt will not be paid to the factor then the factor can ask
the seller to pay back any monies advanced to them.
'Without recourse' means that the factor bears the cost of the bad debt and suppliers can keep all
monies advanced to them. The factor is then offering:
This service is obviously more expensive than with recourse arrangements. Because the factor is at
risk from incurring bad debts they will have more involvement with customer approval and credit
limit setting.
Remember how factoring is different from invoice discounting: the latter service advances cash to
sellers, but sellers continue to manage their own receivables ledgers so that their use of the invoice
discounter is confidential and a fuller relationship is maintained between seller and customer.
Invoice discounting can also be with recourse or without recourse.
September 2021 to June 2022 exams FFM Foundations in Financial Management 102
Chapter 14 questions
Question 1
What are five sources of information that can be used to decide on the credit- worthiness of a
new customer?
Question 2
What does 'non-recourse' or 'without recourse' mean in the context of debt factoring and
invoice discounting?
Question 3
Receivables = $2.1m
Question 4
ANSWERS TO QUESTIONS
Chapter 1
1. D
2. 45 + 23 – 35 = 33 days.
4. A
Supermarkets keep inventories low (especially fresh food which is perishable) and are paid
either by cash or bank card (banks then pay up within a couple of days. Yet, they often take
weeks of credit from suppliers. Engineering companies often have construction work in
progress representing substantial inventories yet they might not be paid until substantial
proportions of the work is complete.
Chapter 2
1. B, C
2. 1,200/2 = 600
3. The company currently purchases goods worth 12 x 10,000 x $10 = $1,200,000. If it now
receives a 10% discount on purchase price it will save 10% x $1,200,000 = $120,000
4. EOQ = √(2CoD/Ch) = √(2x 100 x 12 x 3,000/0.1 x 20) = 1,897 [Note D = annual demand]
5. C – disruption can be caused if suppliers are late. There are no items in inventory to let
production keep going. As little or no inventory is held the other options are not risks.
Chapter 3
1. Consider an amount owing of $1,000. If paid within 30 days the amount that has to be paid
reduces to $970, a saving of $30. The return over 40 days is 30/970 = 0.0309.
R = 32% and that would be the annual cost of not responding to the discount offer and still
paying after 70 days.
2. Direct debit
September 2021 to June 2022 exams FFM Foundations in Financial Management 104
Chapter 4
1. D
C – a payment to shareholders out of profits so dividends are cash flows which do not affect
profit
E – a payment to the government out of profits so tax is a cash flow which does not affect
profit
Chapter 5
Profit for the year
Customer $ $
Sales 400,000
Opening stock 24,000
Purchases 358,000
Less: Closing stock (42,000)
Cost of sales (340,000)
Expenses (48,000)
[Note: receivables at the end of last year received this year; receivables at the end of this year not
received this year]
Cash at the end of the year = 10,000 + 367,000 – 352,000 – 48,000 = -23,000 (ie, overdrawn)
September 2021 to June 2022 exams FFM Foundations in Financial Management 105
Chapter 6
1. (a) 2019 – 2021
2. A, D
3. 0.72 = 0.49. This means that 49% of the variation in the y value can be explained by the
variation in the x value.
4. If 2015 = 1, 2016 = 2 etc, then 2024 = 10, so forecast sales are 12,304 + 650 x 10 = 18,803.
5. ‘Extrapolation’ is the process of predicting a value outside the range of values used for the
linear regression analysis. Costs v volume might have been investigated over the range of
output 1,000 units to 3,000 units. Predicting costs at output of 5,000 units is extrapolation as
that output is beyond what has been investigated. There is no evidence that the cost v
volume relationship derived up to 3,000 units will be the same beyond 3,000 units. Eg
overtime might have to be paid and this would add to costs more than predicted.
Chapter 7
1. False. The Baumol model predicts when cash should be moved to or from a current account
to restore it to a desired level, but it does not predict what that level should be.
Chapter 8
1. False. The Baumol model predicts when cash should be moved to or from a current account
to restore it to a desired level, but it does not predict what that level should be.
2. (a) Aggregation: many small deposits can be used to make several large loans
(b) Maturity transformation: many deposits of different durations allow loans of long
duration
(c) Risk transformation: banks take money from depositors and depositors only face the risk of
the bank failing. The banks risk some their many borrowers getting into financial trouble but
if properly managed this can be survived as the banks will still have many viable customers.
3. True
4. A repurchase agreement (repo) is a short-term secured loan: one party sells securities to
another and agrees to repurchase those securities later at a higher price. The securities serve
as collateral. The difference between the securities’ initial price and their repurchase price is
the interest paid on the loan, known as the repo rate. For example, a company owns some
Government stock valued at $483,000. It sells to another party (receiving $483,000) and at the
same time agrees to buy the stock back in 3 months at $490,000). IN essence the company
has enjoyed a short term borrowing of $483,000 for a cost of $7,000. If the stocks are not
bought back the other party can still sell them and so has enjoyed security for the loan.
Chapter 9
1. A – 3; B – 1; C – 2
2. 1 for 5 means that 40,000 shares will be offered at $3.20. If all are bought then the amount
raised will be $128,000 and 240,000 hares will be in issue.
3. A Preference shares; B Ordinary; C Ordinary; Preference shares are repaid before equity
5. A method of floating a company on the stock exchange whereby potential investors bid for
shares. All shares are sold at the strike price, which is the highest price at which offers have
been received for all shares
Chapter 10
1. 1 + Nominal = (1 + Real rate )(1 + Inflation rate) = 1.04 x 1.07 = 1.1128
3. Demand pull inflation is where there is a lot of money in the economy, there are lots of
people who want to spend money, and because demand is therefore high, prices are pulled
upward.
Chapter 11
1. (a) 4% x 5 x 1,000 = 200. Therefore, the balance will be $1,000 + $200 = $1,200
4. PV = $1,200/0.05 = $24,000
5. 1,000 x (6.463 – 2.723) = $3,740 [Note: 6.463 is the 8 year cumulative factor and 2.723 is the 3
year cumulative factor. Subtracting creates the 4 – 8 cumulative factor.
6. If the money was received for times 1 – infinity, the cumulative discount rate would be
14.286. Money is not received for times 1 and 2, therefore the 2-year cumulative factor of
1.808 needs to be removed: 14.286 – 1.808 = 12.478
Chapter 12
1. (a)
Depreciation = $40,000
1 10,000
2 25,000
3 45,000
4 60,000
So, as expenditure was $50,000, payback occurs during year 4: another $5,000 has to be
added to what was received at the end of year 3, ie 1/3 of the $15,000 earned during year 4.
This investment therefore is acceptable because payback is achieved in a shorter time than
required.
September 2021 to June 2022 exams FFM Foundations in Financial Management 108
3. NPV
Discount
Time Description $ DCF
factor
0 Purchase (50,000) 1 (50,000)
1 Pre-depreciation income = cash received 10,000 0.909 9,090
2 “ 15,000 0.826 12,390
3 “ 20,000 0.751 15,020
4 “ 15,000 0.683 10,245
5 “ 10,000 0.621 6,210
5 Scrap 10,000 0.621 6,210
NPV 9,165
Because the IRR is less than the discount rate, this project should be rejected.
5. $30,000 = opportunity cost, so relevant as this cash flow is affected by the decision to use the
patent.
$200,000 - $30,000 = $170,000. This is the incremental CASH outflow for running production
NB the employees are irrelevant: were paid $75,000 and are still paid $75,000.
Chapter 13
1. Agreement (offer and acceptance)
Consideration
Intention to create legal relations
Capacity
2.
๏ Acceptance.
๏ Rejection. Express rejection will terminate the offer but also any attempt to negotiate or
making a counter offer is also rejection.
๏ Revocation (withdrawal) of the offer before it is accepted.
๏ Lapse.
๏ Death of the offeror where the offer was for personal services
๏ Failure of a condition that attached to the offer.
3. Consideration means that both sides of the contract must give to or do something for the
other side (or promise to do so). The consideration given must have some value (sufficient)
but does not need to match or be even close to the value being received (does no need to be
adequate).
September 2021 to June 2022 exams FFM Foundations in Financial Management 109
4. No. Your help was freely given before the undertaking to pay you money was made. This is
past consideration and means that a valid contract does not exist.
5. A misrepresentation is a false statement of fact or law which induces one party to enter into a
contract. The statement must be:
๏ False.
๏ Relating to fact or law.
๏ Induces one party to enter a contract.
The art gallery’s opinion is not fact, so this is not a misrepresentation. Note that there would
be fraudulent misrepresentation if the statement had been made knowing it to be false, or
without belief in its truth, or recklessly, careless as to whether it be true or false.
6. They are remedies for breach of contract. An order from the court for specific performance
forces compliance with the contract. An injunction prevents behaviour that would breach the
contract.
7. It states that ownership of the goods does not pass until payment has been made.
8. GDPR = General Data Protection Regulation. The EU regulation which protects individuals
from the misuse and exploitation of personal data.
Chapter 14
1. Any five of:
๏ Financial statements
๏ Trade references
๏ Bank references
๏ Credit reference agencies
๏ Companies House information
๏ Court judgement records
๏ Consideration of the type and age of business
2. If the debtor does not pay then the invoice discounter or factor bears the loss and cannot
reclaim monies advanced to the seller.
3.
2.1
= 54.75 days
(14/365)
4. They administer clients’ receivables ledgers, in particular recording amounts owed and
chasing up slow payers to encourage payment. If necessary, they will initiate legal action for
debt recovery. Clients’ customers are aware that a factor is involved because payments are
made to the factor. In addition, factors often advance amounts to sellers before the amounts
are received by the factors themselves and this is a form of working capital financing.
Factoring can be with or without recourse. If without recourse the factor bears the cost of bad
debts.