Chapters1 10 Questions

1 Finance & Investment: Questions Chapter 1-8
CHAPTER 1: TERMS AND DEFINITIONS

Finance Corporate finance is concerned with the efficient and effective management of the finances of
an organisation to achieve the objectives of that organisation.
This involves planning and controlling the provision of resources (where funds are raised
from), the allocation of resources (where funds are deployed to) and finally the control of
resources (whether funds are being used effectively or not).
Shareholder A shareholder is any person, company, or institution that owns shares in a company's stock.
shareholder value Shareholder value is the value delivered to the equity owners of a corporation due to
management's ability to increase sales, earnings, and free cash flow, which leads to an
increase in dividends and capital gains for the shareholders.
Stakeholder A stakeholder is a party that has an interest in a company and can either affect or be affected
by the business. The primary stakeholders in a typical corporation are its investors,
employees, customers, and suppliers.
Agency theory Agency theory is a principle that is used to explain and resolve issues in the relationship
between business principals and their agents. Most commonly, that relationship is the one
between shareholders, as principals, and company executives, as agents.
Agency problems Agency problems are when managers make decisions that are not consistent with the
objective of shareholder wealth maximisation.
Three contributing factors:
 Divergence of ownership and control: Shareholders (owners) do not manage but higher
managers to run it for them.
 Goals of managers are different than shareholders: Managers want more money.
 Asymmetry of information: Managers have all the information; shareholders have
yearly meetings basically get told what manager wants them to know.
Risk Risk is defined in financial terms as the chance that an outcome or investment's actual gains
will differ from an expected outcome or return. Risk includes the possibility of losing some or
all of an original investment.
Return  A return is the change in price of an asset, investment, or project over time, which may
be represented in terms of price change or percentage change.
 A return, also known as a financial return, in its simplest terms, is the money made or lost
on an investment over some period of time.
Time value of money  Time value of money means that a sum of money is worth more now than the same sum
of money in the future.
 This is because money can grow only through investing. An investment delayed is an
opportunity lost.
 The formula for computing the time value of money considers the amount of money, its
future value, the amount it can earn, and the time frame.
Cash flows  The term cash flow refers to the net amount of cash and cash equivalents being
transferred in and out of a company.
 Cash received represents inflows, while money spent represents outflows.
 A company’s ability to create value for shareholders is fundamentally determined by its
ability to generate positive cash flows or, more specifically, to maximize long-term free
cash flow (FCF).
 FCF is the cash generated by a company from its normal business operations after
subtracting any money spent on capital expenditures (CapEx).
Profit  Normal profit is a profit metric that takes into consideration both explicit and implicit
costs. It may be viewed in conjunction with economic profit.
 Normal profit occurs when the difference between a company’s total revenue and
combined explicit and implicit costs are equal to zero.
 Normal profit occurs when economic profit is zero or alternatively when revenues equal
explicit and implicit costs.
Total Revenue - Explicit Cost - Implicit Cost = 0
or
Total Revenue = Explicit + Implicit Costs
 Economic profit is the profit an entity achieves after accounting for both explicit and
implicit costs. (Economic Profit = Revenues - Explicit costs – Implicit costs)
Value Value is the monetary, material, or assessed worth of an asset, good, or service. "Value" is
attached to a myriad of concepts including shareholder value, the value of a firm, fair value,
and market value.
Valuation  Valuation is the analytical process of determining the current (or projected) worth of an
asset or a company.
 There are many techniques used for doing a valuation.
 An analyst placing a value on a company looks at the business's management, the

composition of its capital structure, the prospect of future earnings, and the market value
of its assets, among other metrics.
Investment  An investment is an asset or item acquired with the goal of generating income or
appreciation.
 Appreciation refers to an increase in the value of an asset over time. When an individual
purchases a good as an investment, the intent is not to consume the good but rather to use
it in the future to create wealth.
 An investment always concerns the outlay of some capital today, time, effort, money, or
an asset—in hopes of a greater payoff in the future than what was originally put in.
investor Investors use different financial instruments to earn a rate of return to accomplish financial
goals and objectives.
Assets  An asset is a resource with economic value that an individual, corporation, or country
owns or controls with the expectation that it will provide a future benefit.
 Assets are reported on a company's balance sheet and are bought or created to increase a
firm's value or benefit the firm's operations.
 An asset can be thought of as something that, in the future, can generate cash flow,
reduce expenses, or improve sales, regardless of whether it's manufacturing equipment or
a patent.
Current assets  Current assets represent all the assets of a company that are expected to be conveniently
sold, consumed, used, or exhausted through standard business operations with one year.
 Current assets appear on a company's balance sheet, one of the required financial
statements that must be completed each year.
 Current assets would include cash, cash equivalents, accounts receivable, stock
inventory, marketable securities, pre-paid liabilities, and other liquid assets.
 Current assets may also be called current accounts.
Non-current assets  Non-current assets are assets whose benefits will be realized over more than one year and
cannot easily be converted into cash.
 The assets are recorded on the balance sheet at acquisition cost, and they include
property, plant and equipment, intellectual property (patents, copyrights), intangible
assets (brand recognition), and other long-term assets (bond, stocks, notes).
Fixed assets  The term fixed asset refers to a long-term tangible piece of property or equipment that a
firm owns and uses in its operations to generate income.
 The general assumption about fixed assets is that they are expected to last, be consumed,
or converted into cash after at least one year.
 As such, companies are able to depreciate the value of these assets to account for natural
wear and tear.
 Fixed assets most commonly appear on the balance sheet as property, plant, and
equipment (PP&E)
Compounding  Compounding is the process in which an asset's earnings, from either capital gains or
interest, are reinvested to generate additional earnings over time.
 This growth, calculated using exponential functions, occurs because the investment will
generate earnings from both its initial principal and the accumulated earnings from
preceding periods.
 Compounding, therefore, differs from linear growth, where only the principal earns
interest each period.
Discounting  Discounting is the process of determining the present value of a payment or a stream of
payments that is to be received in the future.
 Given the time value of money, a dollar is worth more today than it would be worth
tomorrow.
 Discounting is the primary factor used in pricing a stream of tomorrow's cash flows.
Future value  Future value (FV) is the value of a current asset at a future date based on an assumed rate
of growth.
 The future value is important to investors and financial planners, as they use it to estimate
how much an investment made today will be worth in the future.
 Knowing the future value enables investors to make sound investment decisions based on
their anticipated needs.
 However, external economic factors, such as inflation, can adversely affect the future
value of the asset by eroding its value.
Present value  Present value (PV) is the current value of a future sum of money or stream of cash flows
given a specified rate of return.
 Future cash flows are discounted at the discount rate, and the higher the discount rate, the
lower the present value of the future cash flows.
 Determining the appropriate discount rate is the key to properly valuing future cash
flows, whether they be earnings or debt obligations.
Annuity  An annuity is a financial product that provides certain cash flows at equal time intervals.
 Annuities are created by financial institutions, primarily life insurance companies, to
provide regular income to a client.
Perpetuity  A perpetuity is a security that pays for an infinite amount of time.
 In finance, perpetuity is a constant stream of identical cash flows with no end.
 The concept of perpetuity is also used in several financial theories, such as in the
dividend discount model (DDM)
Discounted cash flow (DCF)  Discounted cash flow (DCF) is a valuation method used to estimate the value of an
investment based on its expected future cash flows.
 DCF analysis attempts to figure out the value of an investment today, based on
projections of how much money it will generate in the future.
 This applies to the decisions of investors in companies or securities, such as acquiring a
company or buying a stock, and for business owners and managers looking to make
capital budgeting or operating expenditures decisions.
Net present value (NPV)  Net present value (NPV) is the difference between the present value of cash inflows and
the present value of cash outflows over a period of time.
 NPV is used in capital budgeting and investment planning to analyse the profitability of a
projected investment or project.
 NPV is the result of calculations used to find today’s value of a future stream of
payments.
 If the NPV of a project or investment is positive, it means that the discounted present
value of all future cash flows related to that project or investment will be positive, and
therefore attractive.
 To calculate NPV, you need to estimate future cash flows for each period and determine
the correct discount rate.
Corporate governance  Corporate governance is the structure of rules, practices, and processes used to direct and
manage a company.
 A company's board of directors is the primary force influencing corporate governance.
 Bad corporate governance can cast doubt on a company's operations and its ultimate
profitability.
 Corporate governance entails the areas of environmental awareness, ethical behaviour,
corporate strategy, compensation, and risk management.
 The basic principles of corporate governance are accountability, transparency, fairness,
and responsibility.
Financial accounting  Financial accounting is a specific branch of accounting involving a process of recording,
summarizing, and reporting the myriad of transactions resulting from business operations
over a period of time.
 These transactions are summarized in the preparation of financial statements, including
the balance sheet, income statement and cash flow statement, that record the company's
operating performance over a specified period.
Managerial accounting  Managerial accounting is the practice of identifying, measuring, analysing, interpreting,
and communicating financial information to managers for the pursuit of an organization's
goals.
 It varies from financial accounting because the intended purpose of managerial
accounting is to assist users internal to the company in making well-informed business
decisions.
Financial market  Financial markets refer broadly to any marketplace where the trading of securities occurs,
including the stock market, bond market, forex market, and derivatives market, among
others.
 Financial markets are vital to the smooth operation of capitalist economies.
Money market  The money market refers to trading in very short-term debt investments.
 At the wholesale level, it involves large-volume trades between institutions and traders.
 At the retail level, it includes money market mutual funds bought by individual investors
and money market accounts opened by bank customers.
 Examples for some Types of Money markets: Money Market Funds, Money Market
Accounts, Certificates of Deposit (CDs), Commercial Paper
Capital Market  Capital markets refer to the venues where funds are exchanged between suppliers of
capital and those who demand capital for use.
 Primary capital markets are where new securities are issued and sold.
 The secondary market is where previously issued securities are traded between investors.
 The best-known capital markets include the stock market and the bond markets.
Internal financing  Internal financing happens when a company uses its own profits as a source of capital for
a new investment rather than getting the money from outside sources.
External financing  External financing describes money a company may raise from outside its business. It
can refer to equity issues, where the firms in question raise funds thanks to outside
investment.
Dividend  A dividend is the distribution of corporate profits to eligible shareholders.
 Dividend payments and amounts are determined by a company's board of directors.
 Dividends are payments made by publicly listed companies as a reward to investors for
putting their money into the venture.
 Announcements of dividend pay-outs are generally accompanied by a proportional
increase or decrease in a company's stock price.
 Many companies do not pay dividends and instead retain earnings to be invested back
into the company.
Balance sheet  The balance sheet is one of the three fundamental financial statements and is key to both
financial modelling and accounting.
 The balance sheet displays the company’s total assets and how the assets are financed,
either through debt or equity.
 It can also be referred to as a statement of net worth or a statement of financial position.
 The balance sheet is based on the fundamental equation:
Assets = Liabilities + Equity.
Liabilities  A liability is something a person or company owes, usually a sum of money.
 Liabilities are settled over time through the transfer of economic benefits including
money, goods, or services.
 Recorded on the right side of the balance sheet, liabilities include loans, accounts
payable, mortgages, deferred revenues, bonds, warranties, and accrued expenses.
Interest  Interest is the monetary charge for the privilege of borrowing money, typically expressed
as an annual percentage rate (APR).
 Interest is the amount of money a lender or financial institution receives for lending out
money.
 Interest can also refer to the amount of ownership a stockholder has in a company,
usually expressed as a percentage.
Interest payment The amount of interest that a borrower pays to a lender on a loan each month. Depending on
how a loan is amortized, the interest payment may vary each month, even if the total payment
is the same.
Debt  Debt is something, usually money, borrowed by one party from another.
 Debt is used by many corporations and individuals to make large purchases that they
could not afford under normal circumstances.
 A debt arrangement gives the borrowing party permission to borrow money under the
condition that it is to be paid back at a later date, usually with interest.
Equity  Equity, typically referred to as shareholders' equity (or owners' equity for privately held
companies), represents the amount of money that would be returned to a company’s
shareholders if all of the assets were liquidated and all of the company's debt was paid off
in the case of liquidation.
 In the case of acquisition, it is the value of company sales minus any liabilities owed by
the company not transferred with the sale.
 In addition, shareholder equity can represent the book value of a company. Equity can
sometimes be offered as payment-in-kind. It also represents the pro-rata ownership of a
company's shares.
 Equity can be found on a company's balance sheet and is one of the most common pieces
of data employed by analysts to assess the financial health of a company.
Retained earnings  Retained earnings (RE) is the amount of net income left over for the business after it has
paid out dividends to its shareholders.
 The decision to retain the earnings or distribute them among the shareholders is usually
left to the company management.
 A growth-focused company may not pay dividends at all or pay very small amounts
because it may prefer to use the retained earnings to finance expansion activities.
Liquidity  Liquidity refers to the ease with which an asset, or security, can be converted into ready
cash without affecting its market price.
 Cash is the most liquid of assets, while tangible items are less liquid.
 The two main types of liquidity include market liquidity and accounting liquidity.
 Current, quick, and cash ratios are most commonly used to measure liquidity.
Working Capital  Working capital, aka net working capital (NWC), represents the difference between a
company’s current assets and current liabilities.

 NWC is a measure of a company's liquidity and short-term financial health.
 A company has negative working capital if its ratio of current assets to liabilities is less
than one.
 Positive working capital indicates that a company can fund its current operations and
invest in future activities and growth.
 High working capital is not always a good thing. It might indicate that the business has
too much inventory or is not investing its excess cash.
Diversification  Diversification is a strategy that mixes a wide variety of investments within a portfolio.
 Portfolio holdings can be diversified across asset classes and within classes, and also
geographically—by investing in both domestic and foreign markets.
 Diversification limits portfolio risk but can also mitigate performance, at least in the short
term.
1. What is the fundamental relationship between risk and return?

 Return is financial rewards gained as a result of making an investment.
 Risk is that the expected return may be different than the actual return.
 Therefore, all investments require risk in order to make a return.
 For example, a risky investment is when there is a high possibility of the actual return being different than the
expected one. As the possibility between the actual return is quite different to the expected return , investors
and companies demand higher expected return
 A risky investment is therefore one where there is a significant possibility of its actual return being different
from its expected return.
2. What is meant by the “time value of money”? Why is a Euro today worth more than a Euro in one year
from now? Why are future cash flows “risky”?
 Simply refers to the value of money changing over time. Three factors are relevant to this term.
o Time: invest the money you have now so that in X number of years you have Y amount of money
plus income on your investment.
o Inflation: inflation undermines the purchasing power of money. Therefore, money invested now
will buy more than in one years’ time.
o Risk: possibility that you will lose investment.
 Future cash flows are risky, because of uncertainty that the cash flow will continue into the future.
(Competitive risks, financial risks). The more risk there is the less value a company has.
3. What is the use of discounting and compounding cash flows?
 Compounding is a way to know the future value of a sum of money invested now. (i.e. bank interest
earned) (how much will it be worth in ... years)
 Discounting is a way of going back from the future value of a cash flow to its present value. Cash flows
occurring at different points in time cannot be compared directly because they have different time values.
4. What does a financial manager do in a company? What typical decisions does he take? How do these
decisions effect the company? What tasks would a financial manager typically have in a tourism company?
 Responsibilities: investment decisions, advising on the allocation of funds in terms of the total amount of
assets, the composition of non-current and current assets, the consequent risk profile of the choices,
raising funds, choosing from a wide variety of financial institutions and markets, with each source of
finance having different features as regards cost, availability, maturity, and risk.
 Must strike a balance between the amount of earnings they retain and the amount they pay out to
shareholders as dividends. (in the financial market, consisting of short-term money markets and longer-
term capital markets)
 Financial managers make 3 general types of decisions:
o 1) Investment decisions
o 2) Financing decisions
o 3) Dividend decisions
 High level of interdependence between three areas. (How will decision here affect other two areas?)
 In a tourism company the financial manager may make contracts with tour operators, airlines, hotels.
Invest in smaller growing tourism markets.
5. What is meant by “maximizing shareholder value”? Why is this an appropriate goal of all companies?
Why are for example “maximizing profits” or “maximizing sales” less reasonable goals for companies?
 Primary objective of corporate finance (also financial manager) is to make decisions that maximise the value
of the company for its owners. Owners are shareholders, primary objective is maximisation of shareholder
wealth, shareholders receive their wealth through dividends and capital gains (increases in the value of
shares), shareholder wealth is maximised by increasing the value of dividends and capital gains that
shareholders receive over time.
 Maximising profits or sales is short sighted and may not meet the goals of company’s stakeholders. Three
fundamental problems with profit maximisation as an overall corporate goal:
a) Quantitative difficulties: profit must be defined and measured properly, all factors are known and
can be considered. This is difficult to do.
b) Timescale: short-term or long-term maximisation of profit? Profit considers one year at time , likely
focus on short term at the expense of long-term investment. Doubtful long-term survival of company.
c) Profit does not account for risk. Inappropriate to concentrate only on maximising accounting profit
when this objective does not consider key determinant of shareholder wealth. Shareholder dividends
paid with cash not with profit. Timing and associated risk of dividend payments are important factors
in determining shareholder wealth.
 So, maximising profit is not a good sub-objective for maximising shareholder wealth.
 Maximising sales: as only overriding long-term objective, company will reach a stage where it is
overtrading and might have to liquidate. Unbelievably bad if products are not at a profit/ correctly priced.
Maximizing sales can be a good short-term goal i.e. entering a new market.
6. What is the agency theory? Why is this theory? Why is this theory used for financial management? How could
interest of principals and agents collide in the example of financial managers? What can be done in order to
overcome any principal agent-problem?
 Agency problem: when managers make decisions that are not consistent with the objective of shareholder
wealth maximisation. Three contributing factors:
a) Divergence of ownership and control: Shareholders (owners) do not manage but higher managers run it
for them.
b) Goals of managers are different than shareholders: (Managers want more money..)
c) Asymmetry of information: managers have all the information; shareholders have yearly meetings
basically get told what manager wants them to know.
 From corporate finance perspective, important agency relationship exists between shareholders as agents, and
the providers of debt finance, as principles. Agency problem: shareholders will have preference for using
debt for progressively riskier projects (since shareholders make gains on such risky projects, but debt
bearers hold the risk)
 Financing decisions, unsystematic risk through diversification (pg.14),
 Goal congruence between shareholders and managers:
o Shareholders can monitor managers
o Incorporation of clauses in managerial contracts
o Performance related pay (prp): open to manipulation by same managers who benefit,
o executive share option schemes: external factors effect share value.
7. What is meant by the term “corporate governance?
 Corporate Governance refers to the way in which companies are governed and to what purpose.
 It identifies who has power and accountability, and who makes decisions.
 It is, in essence, a toolkit that enables management and the board to deal more effectively with the
challenges of running a company.
 Corporate governance ensures that businesses have appropriate decision-making processes and controls in
place so that the interests of all stakeholders (shareholders, employees, suppliers, customers, and the
community) are balanced.
 Governance at a corporate level includes the processes through which a company’s objectives are set and
pursued in the context of the social, regulatory and market environment.
 It is concerned with practices and procedures for trying to make sure that a company is run in such a way
that it achieves its objectives, while ensuring that stakeholders can have confidence that their trust in that
company is well founded.
 As the home of good governance, the Institute believes that good governance is important as it provides
the infrastructure to improve the quality of the decisions made by those who manage businesses.
 Good quality, ethical decision-making builds sustainable businesses and enables them to create long-term
value more effectively.
Be able to:
 Compound and discount cash flows
Be able to explain exhibit 1.4 (page 12)
Figure 1.4 illustrates the link between cash flows arising from a company’s projects all the way through to the wealth
of its shareholders.
At stage 1, a company takes on all investment projects with a positive NPV. By using NPV to appraise the financial
acceptability of potential projects the company is considering the three factors that affect shareholder wealth, i.e., the
magnitude of expected cash flows, their timing (through discounting) and their associated risk (through the selected
discount rate).
At stage 2, given that NPV is additive, the corporate NPV should equal the sum of the NPVs of the projects it has
undertaken.
At stage 3 the corporate NPV is accurately reflected by the market value of the company through its share price. The
link between stages 2 and 3 (i.e., the market value of the company reflecting the true value of the company) will
depend heavily on the efficiency of the stock market and hence on the speed and accuracy with which share price
changes reflect new information about companies.
At stage 4, the share price is taken to be a substitute for shareholder wealth and so shareholder wealth maximisation
(SHWM) will occur when the market value (market capitalisation) of the company is maximised.
Now that we have identified the factors that affect shareholder wealth and established share price maximisation as a
surrogate objective for shareholder wealth maximisation, we need to consider how a financial manager can achieve
this objective. The factors identified as affecting shareholder wealth are largely under the control of the financial
manager, even though the outcome of their decisions will also be affected by the conditions prevailing in the financial
markets. From our earlier discussion, a company’s value will be maximised if the financial manager makes ‘good’
investment, financing, and dividend decisions
Chapter 2: Terms and Definitions
Equity finance The acquisition of funds by issuing shares of common or preferred

stock. Firms usually use equity financing when they are unable to
raise sufficient funds through retained earnings or when they have to
raise additional equity capital to offset debt.
Debt finance The act of a business raising operating capital or other capital by
borrowing. Most often, this refers to the issuance of a bond,
debenture, or other debt security. In exchange for lending the money,
bond holders and others become creditors of the business and are
entitled to the payment of interest and to have their loan redeemed at
the end of a given period. Debt financing can be long-term or short-
term. Long-term debt financing usually involves a business' need to
buy the basic necessities for its business, such as facilities and major
assets, while short-term debt financing includes debt securities with
shorter redemption periods and is used to provide day-to-day
necessities such as inventory and/or payroll.
Internal & External finance External financing is the phrase used to describe funds that firms
obtain from outside of the firm. It is contrasted to internal
financing which consists mainly of profits retained by the firm
for investment. There are many kinds of external financing. The two
main ones are equity issues, (IPOs or SEOs), but trade credit is also
considered external financing as are accounts payable, and taxes
owed to the government. External financing is generally thought to
be more expensive than internal financing, because the firm often
has to pay a transaction cost to obtain it.
Retained earnings The retained earnings of a corporation is the accumulated net income
of the corporation that is retained by the corporation at a particular
point of time, such as at the end of the reporting period. At the end of
that period, the net income (or net loss) at that point is transferred
from the Profit and Loss Account to the retained earnings account. If
the balance of the retained earnings account is negative it may be
called accumulated losses, retained losses or accumulated deficit.
Perfect markets Any market in which assets are priced with total efficiency. In a
perfect capital market, there are no possibilities for arbitrage.
Efficient markets Market efficiency refers to the degree to which market prices reflect
all available, relevant information. If markets are efficient, then all
information is already incorporated into prices, and so there is no way
to "beat" the market because there are no undervalued or overvalued
securities available.
Behavioural finance Behavioural finance is an area of study focused on how psychological
influences can affect market outcomes.
Behavioural finance can be analysed to understand different
outcomes across a variety of sectors and industries. One of the key
aspects of behavioural finance studies is the influence of
psychological biases.
Financial statements Financial statements are written records that convey the business
activities and the financial performance of a company. (Balance
sheet, Income statement, Cash flow statement)
Financial analysis Financial analysis is the process of evaluating businesses, projects,
budgets, and other finance-related transactions to determine their
performance and suitability. Typically, financial analysis is used to
analyse whether an entity is stable, solvent, liquid, or profitable
enough to warrant a monetary investment.
Ratio analysis Ratio analysis is a quantitative method of gaining insight into a
company's liquidity, operational efficiency, and profitability by
studying its financial statements such as the balance sheet and income
statement. Ratio analysis is a cornerstone of fundamental equity
analysis.
Cash flow statement A cash flow statement is a financial statement that provides aggregate
data regarding all cash inflows a company receives from its ongoing
operations and external investment sources. It also includes all cash
outflows that pay for business activities and investments during a
given period.
Profit Profit describes the financial benefit realized when revenue generated
from a business activity exceeds the expenses, costs, and taxes
involved in sustaining the activity in question. Any profits earned
funnel back to business owners, who choose to either pocket the cash
or reinvest it back into the business. Profit is calculated as total
revenue less total expenses.
EBITDA EBITDA, or earnings before interest, taxes, depreciation, and
amortization, is a measure of a company's overall financial
performance and is used as an alternative to net income in some
circumstances. EBITDA, however, can be misleading because it
strips out the cost of capital investments like property, plant, and
equipment.
EVA Economic value added (EVA) is a measure of a company's financial
performance based on the residual wealth calculated by deducting its
cost of capital from its operating profit, adjusted for taxes on a cash
basis. EVA can also be referred to as economic profit, as it attempts

to capture the true economic profit of a company.
Opportunity cost (of capital)  The opportunity cost of capital is the incremental return on
investment that a business foregoes when it elects to use funds
for an internal project, rather than investing cash in a
marketable security.
 Thus, if the projected return on the internal project is less
than the expected rate of return on a marketable security,
one would not invest in the internal project, assuming that
this is the only basis for the decision.
 The opportunity cost of capital is the difference between the
returns on the two projects.
 Example for opportunity cost of capital:
The senior management of a business expects to earn 8% on a
long-term $10,000,000 investment in a new manufacturing
facility, or it can invest the cash in stocks for which the expected
long-term return is 12%. Barring any other considerations, the
better use of the cash is to invest $10,000,000 in stocks. The
opportunity cost of capital of investing in the manufacturing
facility is 2%, which is the difference in return on the two
investment opportunities.
Sample Exam Tasks:

1. What is the difference between profit, cash flow and return? (Closed book exam)
Profit and cash flow are absolute figures.
Sales – expenses = profit
Cash flow = cash inflow – cash outflow
Return: not mentioned in the balanced sheet.
The difference is that profit can increase or decrease the equity of the company, but the cash flow doesn’t
increase the profit
Equity is on the right side of the balance sheet and the liquidity is on the left side and therefore, there is
income that is not at the same time a cash inflow and there are expenses that are not the same time a cash
outflow. An example is the depreciation, it is an expense but at the same time it is not associated with cash
outflow.
The return is not mentioned in the balance sheet. The return set the profit or the cashflow in relation to an
investment sum.
To measure the return, for example I make an investment of 100 euros today and then I get 110 euros back in
one year, so my return will be 10 euros.
There is income that is not at the same time cash inflow
2. In chapter 1.3.2 it is stated that sales maximization could eventually lead to a company’s liquidation.
How does that happen?
If you maximize your sales, you also increase your costs of marketing, therefore you also need a higher working
capital, but it could happen that you do not have the working capital needed and therefore you can become illiquid. If
you have higher costs than income, than you have a negative profit, if you are at equity levels closer to 0 already then
this brings you to negative equity or indebtedness.
3. What does the following sentence mean? “The cost of monitoring management must be weighed against
the benefits accruing from a decrease in sub-optimal managerial behaviour.”
If the management is not working properly than you have to weight if it costs you more what you lose or if it cost
you more to control them. Improve their performance by monitoring them the cost of monitoring your staff should
be less than the costs of not doing it. When you improve the performance of your staff by monitoring them, what
you gain from this, is less that what it cost to monitored them. For example, you have a worker, who is not
motivated and does not do his job correctly, and therefore you lose a little bit of business, to improve the
performance of this worker you need to talk with him and try to motivate him. If you do it right, than your
business will start to work better again. You can control the work more frequently for example. It only make
sense, if the work associate with it is bigger, than the costs associated with controlling this worker better.
CHAPTER 2: BASIC QUESTIONS OF UNDERSTANDING

Sub-chapters 2.3.2 to 2.3.6 (pages 40 – 45) and vignette 2.2 and 2.3 (pages 47 – 49) are not relevant!
1. Which types of financing do we know and how are they different from each other? What major
characteristics do the different financing forms feature? What are examples for each of those financing
forms?
Definition of Internal Sources of Finance
 In business, internal sources of finance delineate the funds raised from existing assets and day to day
operations of the concern.
 It aims at increasing the cash generated from regular business activities. For this purpose, evaluation and
control of costs are made, along with reviewing the budget.
 Moreover, the credit terms with customers are verified, so as to effectively manage the collection of
receivables.
 Internal sources of finance include selling of surplus inventories, ploughing back of profit, accelerating
collection of receivables, and so on.
Definition of External Sources of Finance
 External sources of finance refer to the cash flows generated from outside sources of the organization, whether
from private means or from the financial market.
 In external financing, the funds are arranged from the sources outside the business.
 There are two types of external sources of finance, i.e., long term source of finance and short-term sources of
finance.
 External sources of Financing are Equity Financing and Debt Financing
o Debt financing: The source of finance wherein fixed payment has to be made to the lenders is
debt financing. It includes:
- Bank loans
- Corporate Bonds
- Leasing
- Commercial Paper
- Trade Credit
- Debentures
o Equity Financing: Equity is the major source of finance for most of the companies which
indicate the share in the ownership of the firm and the interest of the shareholders. The firms
raise capital by selling its shares to the investors. It includes:
- Ordinary shares
- Preference shares
Key Differences Between Internal and External Sources of Finance
 When the cash flows are generated from sources inside the organization, it is known as internal sources of
finance. On the other hand, when the funds are raised from the sources external to the organization, whether
from private sources or from the financial market, it is known as external sources of finance.
 Internal sources of finance include Sale of Stock, Sale of Fixed Assets, Retained Earnings and Debt
Collection. In contrast, external sources of finance include Financial Institutions, Loan from banks, Preference
Shares, Debenture, Public Deposits, Lease financing, Commercial paper, Trade Credit, Factoring, etc.
 While internal sources of finance are economical, external sources of finance are expensive.
 Internal sources of finance do not require collateral, for raising funds. Conversely, assets are sometimes
mortgaged as security, so as to raise funds from external sources.
 Amount raised from internal sources is less and they can be put to a limited number of uses. On the contrary,
large amounts can be raised from external sources, which have various uses.
2. With regard to which factors are financing decisions taken in companies?

There are number of factors which define the proportion and type of financing:
- the level of finance required (small investments from retained earnings);
- the cash flow from existing operations (if cash flow is high, internal financing can be applied)
- the opportunity cost of retained earnings
- the costs associated with raising external finance
- the availability of external sources of finance
- dividend policy
Capital markets: markets for trading long-term financial securities. Most important are ordinary shares,
bonds, and preference shares.
Main functions of capital markets are:
 meeting place of companies and investors to raise funds
 place, where investors sell and buy shares and bonds.
3. Explain the factors characterizing perfect and efficient markets (pg. 39; chapter 2.3.1).
Perfect market characteristics:
 the absence of factors inhibiting buying and selling, like taxes and transaction costs.
 all participants have the same expectations regarding asset prices, interest rates and other economic
factors.
 entry to and exit from the market is free.
 information has no cost and is freely available to all market participants.
 a large number of buyers and sellers, none of whom dominates the market.
 NO stock market anywhere in the world is a perfect market!
Efficient market characteristics:

 Operational efficiency: transaction costs in the market should be as low as possible
and any trading can be quickly achieved.
 Pricing efficiency: the prices of capital market securities, such as shares and bonds, fully
and fairly reflect all information concerning past events and all events that the market
expects to occur in the future. The prices of securities are therefore fair prices.
 Allocational efficiency: the capital market, through the medium of pricing efficiency,
allocates funds to where they can best be used.
 The efficient market hypothesis or theory states that share prices reflect all information.
- The efficient hypothesizes that stocks trade at their fair market value on exchanges.
- Proponents of efficient hypothesizes posit that investors benefit from investing in a low-cost, passive
portfolio.
- Opponents of efficient hypothesizes believe that it is possible to beat the market and that stocks can
deviate from their fair market values.
4. What is meant by „behavioural finance“? Create own examples to explain the term.
 Behavioural finance, a subfield of behavioural economics, proposes that psychological influences and
biases affect the financial behaviours of investors and financial practitioners. Moreover, influences and
biases can be the source for explanation of all types of market anomalies and specifically market anomalies in
the stock market, such as severe rises or falls in stock price.
 For example, buy shares when they reach their maximum value because the investor believes that they will
continue rising up and for this reason invest a lot of money in that share. And then he sells the share when it
goes down, because he thinks the stock will not recover and so he sells it and lose the money you invested.
Decision making process:

 Traditional
- Traditional finance purports that humans calculate probabilities of outcomes to maximize utility.
 Behavioural:
- Behavioural finance suggests that we make decisions based on bounded rationality, whereby rather
than fully optimizing our decision-making process, we instead focus on coming to sufficient or
satisfactory conclusions. To make efficient use of our time we often consider and process information
until we know what is required but not necessarily what is best.
5. What is financial analysis and ratio analysis? Where does the information come from and who uses it?
 Financial analysis is the process of evaluating businesses, projects, budgets, and other finance-related
transactions to determine their performance and suitability. Typically, financial analysis is used to analyse
whether an entity is stable, solvent, liquid, or profitable enough to warrant a monetary investment.
- Financial analysis process whereby investors and creditors evaluate the financial health of a business.
Internal decision making.
- For shareholders, financial analysis assists them in making buy and sell decisions, comparing
performance with other companies, assessing managers performance as agents (maximizing
shareholder wealth).
- For investors, financial analysis helps to agree/disagree to request for debt finance. For company
managers, financial analysis helps assess the performance of company’s divisions and company as
whole.
- Information derives from company’s financial statements, financial databases, the financial press, the
Internet.
 Ratio analysis refers to the analysis of various pieces of financial information in the financial statements of a
business. They are mainly used by external analysts to determine various aspects of a business, such as its
profitability, liquidity, and solvency. Analysts rely on current and past financial statements to obtain data to
evaluate the financial performance of a company. They use the data to determine if a company’s financial
health is on an upward or downward trend and to draw comparisons to other competing firms.
6. What information is provided by the different financial statements?

 Financial statements are written records that convey the business activities and the financial performance of a
company. Financial statements are often audited by government agencies, accountants, firms, etc. to ensure
accuracy and for tax, financing, or investing purposes. Financial statements include:
- Balance sheet: The balance sheet provides an overview of assets, liabilities, and stockholders' equity as a
snapshot in time.
- Income statement: The income statement primarily focuses on a company’s revenues and expenses during a
particular period. Once expenses are subtracted from revenues, the statement produces a company's profit
figure called net income.
- Cash flow statement: The cash flow statement measures how well a company generates cash to pay its debt
obligations, fund its operating expenses, and fund investments.
 Investors and financial analysts rely on financial data to analyse the performance of a company and make
predictions about its future direction of the company's stock price. One of the most important resources of
reliable and audited financial data is the annual report, which contains the firm's financial statements.
 The financial statements are used by investors, market analysts, and creditors to evaluate a company's
financial health and earnings potential. The three major financial statement reports are the balance sheet,
income statement, and statement of cash flows.
7. How are ratios evaluated? Which different types of ratios are there and why are there different types of
ratios? What are typical occasions for ratio analysis?
 Investors and analysts employ ratio analysis to evaluate the financial health of companies by examining
past and current financial statements. Comparative data can demonstrate how a company is performing
over time and can be used to estimate likely future performance. This data can also compare a company's
financial standing with industry averages while measuring how a company stacks up against others
within the same sector.
 When using ratios for analysing financial performance, calculation and interpretation is assisted by using
some sort of analytical framework. Ratios are divided into different groups, as far as they are linked to the
particular concern (profitability, activity, liquidity, investor). There are categories that all ratios need to
consider:
Liquidity ratios:
Measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs
for cash.
- Working capital
- Current ratio
- Acid-test ratio
- Primary users: short term creditors such as bankers and suppliers are particularly interested on
assessing liquidity.
Efficiency ratios
Measure how effectively the company utilizes its assets, as well as how well it manages its liabilities.
- Inventory turnover
- A/R turnover
- Day’s sales outstanding
- Primary users: shareholders have provided capital for management to acquire assets and our most
concerned in assessing efficiency.
Solvency ratios
Measure the ability of a company to survive over a long period of time.
- Debt ratio
- Debt to equity ratio
- Time interest earned
- Primary users: shareholder as well as long-term creditors, like banks and bondholders, are concerned
about a business’s ability to pay off debt.
Profitability ratios
Measure the income or operating success of a company for a given period of time.
- Return of sales
- Return on equity
- Earnings per share
- Primary users: shareholders invest in a company in hopes that it will be profitable so that share prices
will increase, and profits will be paid out as dividends.
Marketability ratios
Evaluate the stock’s performance and attractiveness in the stock market.
- Price-earnings ratio
- Dividend yield
- Primary users: shareholders and investors are usually interested in the market price of a corporation’s
common stock.
8. Why were dynamic profitability measures, such as EVA, invented?
 As noted by Stern Value Management, in 1983 the management team developed EVA, "a new model for
maximizing the value created that can also be used to provide incentives at all levels of the firm. The goal
of EVA is to quantify the cost of investing capital into a certain project or firm and then assess
whether it generates enough cash to be considered a good investment. A positive EVA shows a
project is generating returns in excess of the required minimum return.
 The Economic value added (EVA), also known as economic profit, aims to calculate the true economic
profit of a company. EVA is used to measure the value a company generates from funds invested in it.
However, EVA relies heavily on invested capital and is best used for asset-rich companies, where
companies with intangible assets, such as technology businesses, may not be good candidates.
 EVA is the incremental difference in the rate of return (RoR) over a company's cost of capital. Essentially,
it is used to measure the value a company generates from funds invested in it. If a company's EVA is
negative, it means the company is not generating value from the funds invested into the business.
Conversely, a positive EVA shows a company is producing value from the funds invested in it.
The formula for calculating EVA is:
EVA = NOPAT - (Invested Capital * WACC)
- NOPAT = Net operating profit after taxes
- Invested capital = Debt + capital leases + shareholders' equity
- WACC = Weighted average cost of capital
Sample Exam Question:
1. Imagine Airline company A had an EBITDA of EUR 100m and Airline company B an EBITDA of
Eur 10m in 2016. Which of those two is the more successful company and why? (Closed book)
It looks like company A is more successful than B, but it could be that company A has more liabilities,
taxes, etc, than company B.
We don’t know also about the size of the company. To know if company A is more successful than
company B we need more information about the company, like a financial analysis and a ratio analysis
to have an insight into the liquidity, operational efficiency, and profitability by comparing information
contained in its financial statements.
2. On page 39 (chapter 2.3.1) you can find the statement “Clearly, no stock market anywhere in the
world is a perfect market.” Explain this with the help of the characteristics of perfect markets:
Mention perfect market criteria and then explain that one criterion is not fulfilled such as
Transaction cost, not the same level of information or Market entry barriers.
CHAPTER 3: TERMS AND DEFINITIONS

(Net) working capital Net Working Capital (NWC) is the difference between a company’s current
assets and current liabilities on its balance sheet.
Current assets and current liabilities  Current assets are all the assets of a company that are expected to be
sold or used as a result of standard business operations over the next
year.
 Current assets include cash, cash equivalents, accounts receivable,
stock inventory, marketable securities, pre-paid liabilities, and other
liquid assets.
 Current assets are important to businesses because they can be used
to fund day-to-day business operations and to pay for the ongoing
operating expenses.
 Current liabilities are a company's short-term financial obligations that
are due within one year or within a normal operating cycle.
 Current liabilities are typically settled using current assets, which are
assets that are used up within one year.
 Examples of current liabilities include accounts payable, short-term debt,
dividends, and notes payable as well as income taxes owed.
Profitability versus liquidity From a business point of view, both liquidity and profitability are vital
ingredients found in a successful and sustainable business and while related
in part, they are usually measured and managed as two separate functions.
Liquidity measures the ease at which a business can meet its immediate
and short-term financial obligations (usually due within the next 12
months).
 These obligations typically include the use of cash to make payments for
expenses, repayment of loans, purchase of assets (equipment, vehicles,
machinery) or distribution of profits and dividends.
 So, a business is said to have good liquidity when it has cash, together
with assets that can easily be converted to cash, that total significantly
more than the immediate and short-term financial obligations of the
business.
 As a general rule, a business is said to have good liquidity if for every $1
of immediate and short-term financial obligation (current liabilities) it has
at least $2 of cash and assets that can be easily converted to cash (current
assets).
 This liquidity measurement ratio is called the Current Ratio (i.e. Current
Assets / Current Liabilities) and is calculated from information reported
on the Statement of Financial Position (Balance Sheet)
Profitability is a measure of business success. It ensures the financial
sustainability of the business and gives the business the capacity to
endure.
 Profitability is the amount of revenue remaining after deducting all the

expenses incurred in earning that revenue. So profitability measures the
ability of a business to use its resources to generate revenues in excess of
its expenses. It is calculated by the formula: Profit = Revenue - Expenses
 Revenue is the money that customers pay the business for their provision
of goods/services and expenses include those costs used up in earning
that revenue for the business (i.e. wages, purchases, rent)
 Profitability is a financial performance measure that is reported on the
Statement of Financial Performance (Profit & Loss Statement) as the
‘bottom line’ Net Profit.
 Profitability provides the financial rewards needed to attract and retain
financing. Without a competitive return on investment on capital created
by the profitability of a business, investors will look to remove their
funding and invest in something better.
Now while high levels of profitability can help a business maintain their
liquidity, it is not guaranteed. See if too much profit is taken from the
business by owners or if profits are invested in fixed assets then you can (and
often do) have a situation where a profitable business has poor liquidity.
Bank loan  A loan is when money is given to another party in exchange for
repayment of the loan principal amount plus interest.
 Loan terms are agreed to by each party before any money is
advanced.
 A loan may be secured by collateral such as a mortgage or it may be
unsecured such as a credit card.
 Revolving loans or lines can be spent, repaid, and spent again, while
term loans are fixed-rate, fixed-payment loans.
Overdraft  An overdraft occurs when an account lacks the funds to cover a
withdrawal, but the bank allows the transaction to go through
anyway.
 The overdraft allows the customer to continue paying bills even when
there is insufficient money.
 An overdraft is like any other loan: The account holder pays interest
on it and will typically be charged a one-time insufficient funds fee.
 Overdraft protection is provided by some banks to customers when
their account reaches zero; it avoids insufficient funds charges, but
often includes interest and other fees.
Fixed and floating interest rates  A floating interest rate is an interest rate that moves up and down
with the market or an index. It can also be referred to as a variable
interest rate because it can vary over the duration of the debt
obligation.
 This contrasts with a fixed interest rate, in which the interest rate of a
debt obligation stays constant for the duration of the loan's term.
Trade credit  Trade credit is a business-to-business (B2B) agreement in which a
customer can purchase goods without paying cash up front and
paying the supplier at a later scheduled date. Usually, businesses that
operate with trade credits will give buyers 30, 60, or 90 days to pay, with
the transaction recorded through an invoice.
 Trade credit can be thought of as a type of 0% financing, increasing
a company’s assets while deferring payment for a specified value of
goods or services to sometime in the future and requiring no interest
to be paid in relation to the repayment period.
Permanent and fluctuating current assets  A permanent current asset is the minimum amount of current assets
a company needs to continue operations. Inventory, cash, and
accounts receivable fall under the category of current assets. Base
amounts of these assets need to be sustained to continue business.
 The assets are regarded as being current because they will turnover
within the year. However, permanent current assets will always be
replaced by similar current assets within the one-year time period.
 Permanent current assets represent the core level of working capital
investment needed to support a given level of sales. As sales increase,
this core level of working capital also increases.
 Fluctuating current assets represent the changes in working capital
that arise in the normal course of business operations, for example
when some accounts receivables are settled later than expected, or when
inventory moves more slowly than planned.
Cash  Cash is legal tender currency or coins—that can be used to exchange
goods, debt, or services. Sometimes it also includes the value of assets
that can be easily converted into cash immediately, as reported by a
company.
Cash conversion cycle  The cash conversion cycle (CCC) is a metric that expresses the length
of time (in days) that it takes for a company to convert its
investments in inventory and other resources into cash flows from
sales.
 This metric considers the time needed to sell its inventory, the time
required to collect receivables, and the time the company is allowed
to pay its bills without incurring any penalties.
 CCC will differ by industry sector based on the nature of business
operations.
Cash budget  A cash budget is a company's estimation of cash inflows and outflows
over a specific period of time, which can be weekly, monthly,
quarterly, or annually.
 A company will use a cash budget to determine whether it has
sufficient cash to continue operating over the given time frame.
 A cash budget will also provide a company with insight into its cash
needs and any surpluses, which help it determine an efficient use of
cash.
 Cash budgets can be viewed as short-term cash budgets, usually, a
time frame of weeks to months, or long-term cash budgets, which are
viewed as years.
 A company must manage its sales and expenses to reach an optimal level
of cash flows.
Inventory  Inventory is the raw materials used to produce goods as well as the
goods that are available for sale.
 It is classified as a current asset on a company's balance sheet.
 The three types of inventories include raw materials, work-in-
progress, and finished goods.
 Inventory is valued in one of three ways, including the first-in-first out
method, the last-in-first-out method, and the weighted average method.
 Inventory management can help companies minimize inventory costs
because goods are created or received only when needed.
Inventory conversion period  Inventory Conversion Period determines how much time it takes to
convert the inventory into sales i.e., the time taken from the purchase
of the new inventory to the actual sale of the product. It is calculated
as inventory divided by average sales or cost of sales and multiplied
by 365 so as to know the exact days of conversion of inventory into
sales.
Trade receivables  Trade receivables are the total amounts that a company has billed to
a customer for goods and services that they have delivered but have
not yet received payment for. These amounts are reflected in the
invoices that a company sends to its clients.
 Trade receivables are likely to be one of the largest assets on your
company’s books, aside from inventory. It is important to remember that
trade receivables are also known as accounts receivable.
Trade payables  Trade payables are obligations to pay for goods or services that have
been acquired from suppliers in the ordinary course of business.
 Trade payables are classified as current liabilities if payment is due
within one year or less. If not, they are presented as non-current
liabilities.
Overtrading  Overtrading is a prohibited practice when brokers trade excessively
for their client accounts in order to generate commission fees.
 Individual professional traders may also overtrade, but this type of
activity is not regulated by the SEC.
 Individuals can greatly reduce the risk of overtrading by following
best practices such as self-awareness and risk management.
Economic order quantity (model) Economic order quantity (EOQ) is the ideal order quantity a company
should purchase to minimize inventory costs such as holding costs,
shortage costs, and order costs.
Buffer inventory, lead time  Buffer Inventory is the extra stock of either raw material or final
product a company maintains as a protection against unforeseen
circumstances.
 In simple words, we can say it is the excess inventory that a company
keeps in reserves to protect itself against an uncertain future.
 Lead time measures how long it takes to complete a process from

beginning to end.
 In manufacturing, lead time often represents the time it takes to
create a product and deliver it to a consumer.
 Factors that can impact lead time include lack of raw materials,
breakdown of transportation, labour shortages, natural disasters,
and human errors.
 In some cases, companies can improve lead times by implementing
automated stock replenishment and just-in-time (JIT) strategies.
Just-in-time  The just-in-time (JIT) inventory system is a management strategy
that aligns raw-material orders from suppliers directly with
production schedules.
 Companies employ this inventory strategy to increase efficiency and
decrease waste by receiving goods only as they need them for the
production process, which reduces inventory costs.
 This method requires producers to forecast demand accurately.
Bad debts  Bad debt refers to loans or outstanding balances owed that are no
longer deemed recoverable and must be written off.
 This expense is a cost of doing business with customers on credit, as
there is always some default risk inherent with extending credit.
 To comply with the matching principle, bad debt expense must be
estimated using the allowance method in the same period in which
the sale occurs.
 There are two main ways to estimate an allowance for bad debts: the
percentage sales method and the accounts receivable aging method.
 Bad debts can be written off on both business and individual tax
returns.
Creditworthiness  Creditworthiness is how a lender will tell if you default on your debt
obligations.
 Creditworthiness is determined by several factors including your
repayment history and credit score.
 Improving or maintaining your creditworthiness is as simple as
making your payments on time.
Factoring  Factoring implies a financial arrangement between the factor and
client, in which the firm (client) gets advances in return for
receivables, from a financial institution (factor).
 It is a financing technique, in which there is an outright selling of trade
debts by a firm to a third party, i.e. factor, at discounted prices.
Chapter 3: Basic Questions of Understanding

1. What is working capital management? What are its goals? Why do these goals conflict each other?
In your opinion, what role does work capital management play in different tourism businesses?
 Working capital management is a business strategy designed to ensure that a company operates
efficiently by monitoring and using its current assets and liabilities to the best effect.
 The two main objectives of working capital management are to increase the profitability of a company
and to ensure that it has sufficient liquidity to meet short-term obligations as they fall due and so continue
in business.
o Profitability = the goal of shareholder wealth maximisation, so investment in current assets should
be made only if an acceptable return is obtained.
o Liquidity = is needed for a company to continue in business, a company may choose to hold more
cash than is needed for operational or transaction needs, for example, for precautionary or
speculative reasons.
The main goals of Profitability and Liquidity will often conflict since liquid assets give the lowest returns. Cash
kept in a safe will not generate a return, for example, while six-month
bank deposit will earn interest in exchange for loss of access for the six-month period.
 In my opinion capital management is of huge importance in tourism business as it is all about liquidity and
profitability as well as growth. Additionally, working capital serves as a metric for how efficiently a company
is operating and how financially stable it is in the short-term.
2. What is the „cash conversion cycle“? How is it connected to the topic of „working capital
management“?
 Cash conversion cycle (net operating cycle) is the number of days it takes a business to convert its production
inputs into cash receipts. Calculation to measure time between company's initial investment in working capital
can company's cash collection. (Cash conversion cycle (CCC) = days sales of inventory (DSI) + Day’s sales
outstanding (DSO) (prepayments are negative)- Days payable outstanding (DPO)). Short = indicates high
liquidity and effective management of inventory and credit sales. Long = longer to sell product / receive
payments, paying bills too quickly.
 Cash conversion cycle and working capital management are connected because one of working capital
management’s main objectives is to ensure a business's liquidity.
 Tourism industry, low and high season. Meaning as working capital can be forecasted, it is important to make
sure there are no over investments made during low season (too much staff, too many perishable goods...).
3. What is „inventory management“? Which costs occur for inventory? What is the purpose of the
„economic order quantity model“ and how does it work?
 Efficient management of inventory is especially important to a company. For example, storage costs
money so, inventory management involves seeing the minimum amount of space for the maximum
amount of inventory. The inventory turnover ratio is one of the key metrics managers use to
determine if they are doing a good job. Higher is better because it means that inventory is not sitting
idle on shelves.
 Economic order quantity model is an inventory management model which calculates (determines)
used to determine inventory orders. Ordering costs and carrying costs of inventory are related and
counterbalance each other. For example: ordering less at one time reduces carrying costs but
increases ordering costs. Managers use EOQ to see ideal amount of inventory to order at one time
which will minimize both ordering and carrying costs.
4. What is cash management? What implications does it have for a company if it has especially low
or especially high cash amounts? On which factors does the optimal amount of cash in a company
depend on? What are possibilities to generate cash if needed? Create realistic examples for such
possibilities in tourism companies.
Cash management is a broad term referring to the collecting, managing, and investment of cash. Balance between the
money a company takes in and pays out. When done well, cash management enables businesses to avoid insolvency
and manage unexpected costs. High amounts of cash in a company incurs an opportunity cost equal to the return
which could have been earned if the cash had been invested or put to productive use. Low amounts of cash in a
company increases their risk of being unable to meet debts when due. Therefore, optimum cash balance should be
found.
Optimum cash level depend on the following factors:
 forecasts of the future cash inflows and outflows of the company
 the efficiency with which the cash flows of the company are managed
 the availability of liquid assets to the company
 the borrowing capability of the company
 the availability and cost of short-term finance
 the company's tolerance of risk / risk appetite
if a company does not have enough cash there are many possible remedies. They can:
 postpone non-essential capital expenditure
 accelerate rate of cash flow into the business through discounts for early payment, chasing overdue accounts,
having a sale to clear unwanted inventory.
 If a company has investments, bought when there was a cash surplus, they can sell them to generate cash.
 Find ways to reduce / postpone cash outflows (taking longer to pay suppliers, rescheduling loan repayments)
 Reduce / pass dividend payments. Used as a last resort because in a capital market no/low dividend payments are
a sign of financial weakness.
Seasonality in tourism could lead to trying to keep up occupancy (reduced prices) (in a hotel) to increase liquidity
although it does not increase profitability, this way you can cover your high fixed costs. Or, non-refundable prices for
nights paid in advance or immediately, which are lower in comparison to refundable rates.
5. What are the main goals of management of receivables? And what are its major tasks?
 The main goal of receivables management is maximising expected profits. Through achieving company's desired
cash position, satisfying expected demand, and properly implementing credit management policy. Tasks include:
debt collection, measuring the costs and benefits of offering credit to customers, setting up and managing a credit
analysis system (should customers get credit?), a credit control system (ensure customer keeps to the credit limit
and terms of trade), and a trade receivables collection system (aged trade receivables analysis and take steps to
chase late payers).
Be able to:
• Make easy calculations with regard to the topic of the chapter
Chapter 3: Sample Exam Questions

 Explain the cash conversion cycle with the help of a catering business! Do you think that they have a rather high
or low cash conversion cycle, if compared to other industries?

Equity (finance)  Process of raising capital through the sale of shares.
Nominal versus market values of shares  Nominal value is the original, unadjusted value.
Face value/ par value of a security.
Nominal value of ordinary shares cannot be sold
for less than this amount.
 Market value refers to the price an asset would
fetch in the marketplace, or the value that the
investment community gives to a particular equity
or business.
 Fair market value says that information should be
publicly available and is a key requirement in the
integrity of a fair market system. (From market
value, market capitalization can be established)
Authorised share capital  is the number of stock units (shares) that a
company can issue as stated in its memorandum of

association/ articles of incorporation. Often, it is
not fully used by management, in order to leave
room for future issuance of additional stock in case
the company needs to raise capital quickly, also to
retain controlling interest in the business.
Pre-emptive right  A contractual clause giving a shareholder the right
to buy additional shares in any future issue of the
company's common stock before the shares are
available to the general public.
 Shareholders who have such a clause are usually
early investors or majority owners who want to
maintain the size of their stake in the company
when/ if additional shares are offered. (Meaning:
gives investor the option of maintaining a certain
% of ownership of the company as it grows.)
Creditor hierarchy, secured and unsecured creditors,  Creditor hierarchy refers to the particular order
preference, and ordinary shareholders which creditors are paid in the event of company
liquidations. Everyone in each tier of creditors
must be paid in full before any money is repaid to
the next tier.
 Secured creditors (bond holders, banks) are paid
first, next are unsecured creditors (suppliers of
goods/ services), preference shareholders are next,
in the order of precedence. And finally, ordinary
shareholders.
Liquidation  The process of bringing a business to an end and
distributing its assets to claimants. Usually occurs
when a company is insolvent, meaning it cannot
pay its obligations when they are due.
Stock exchange  Acts as a market where financial securities are
bought and sold. Companies pay an annual fee to
have the price of their ordinary shares listed
(quoted) on the stock exchange and undergo a
rigorous financial assessment before being listed.
Buying and selling shares on the stock market are
subject to statutory regulation in order to ensure
fair trading.
Financial securities  Paper traded for value, where profits are
anticipated through third party management.
 Two basic types: stocks (equity- gives ownership
in security) and bonds (debt security - give
customer loaner ship positions).
Initial public offering (IPO)  Issuing shares for the first time in order to obtain a
stock market listing.
Placing versus public offering  Placing is a form of issuing ordinary shares, used
most frequently. Shares are issued at a fixed price
to a number of institutional investors who are
approached by broker before issue takes place.
Carries little risk and is low cost in comparison to
other ways. Public offering usually made at a fixed
price. Normally used for a large issue when a
company is coming to the market (seeking a
listing) for the first time. Price should be low
enough to attract investors, high enough that
required financing can be met without issuing
more shares.
Institutional investor  A nonbank person or organization that trades
securities in large enough share quantities or dollar
amounts that is qualifies for preferential treatment

and lower commissions.
 Examples are insurance company, pension
funds...)

Sub-chapters 4.3.1 to 4.3.5 and chapter 4.4 (completely) including vignettes 4.3, 4.4, 4.5 and 4.6 (pages 115 – 124) are not
relevant!
1. Why do companies issue shares? Why do investors buy shares?

 Companies issue shares as a form of equity finance, by raising capital through the sale of shares on the stock
market .((they can meet short term debts (not good because of trust issue and to develop shareholder value
maximisation). Other reasons may be to pay off debt, expanding into new markets or regions or enlarging
facilities/ building new ones.
o issue shares for development and growth of the business.
o gain market share (price setting power = monopoly)
o Profitability (equity grows and therefore gain additionally debt)
o Profitability also raises your equity and the economies of scale.
o Acquisition is even more interesting as the company has already a market share and you gain more
market share (moving towards a monopoly) faster growth, higher returns.
 Investors buy shares for capital appreciation (when share price rises), dividend payments (when company
distributes earnings, part of the returns) and the ability to vote shares and influence the company (depending on
how many are bought). Shares offer investors great potential for growth over time. Risk can be offset by investing
in a number of different shares or investing in other kinds of assets which are not shares, like bonds, as well.
o protect profits from taxation
o
2. How can shareholders participate in reaching their investment goals?
= all interlinked with legal rights
 Maximizing shareholder value
 Attend the general meetings
 Vote on the numeration on the value of auditors
 Trade-off between Profitability and Liquidity (what is more important long-term profitability and having cash
means right now)
3. What does an IPO mean for the financial management of a company? What are advantages and disadvantages of
being publicly traded?
 Issuing shares to the public require the ability to meet strict requirements of the stock market, it also dilutes
control and ownership of the company in question. In relation to financial management, aspects considering
equity vs. debt financing, (trust of other shareholders, to high debt levels =gives investors the signals that
you get small shares and not that appealing, collect information on all accounting information = doing
analysis and see if you are liquid enough to go forward) shareholder satisfaction, dividend payments,
transparency are all aspects that financial managers must consider before listing shares for the first time on the
stock market.
 Advantages of being publicly traded include:
o Raising finance through coming to market (management buyouts / raise funds for own use)
o Access to finance (company will have easier access to external sources of equity capital, since
more attractive to institutional investors. Lenders look more favourably on quoted companies
since both credibility and reputation are enhanced by a listing, increasing a company's security,
and lowering perceived risk. This may result in a lower cost of debt)
o Uses of shares (taking over another company. Shares of a listed company are more likely to be
accepted by target company shareholders in exchange for their existing shares than shares in a
private company. Partially because the shares of listed companies are easier to sell: a ready
market exists in them, at least 25% of shares must be in public hands), private company shares
may not have a ready market. Marketability increases the value of shares = value of company.
 Disadvantages of being publicly traded include:
o Costs of quotation (cost of obtaining a listing, reduces amount of finance raised by a new issue. Initial
listing costs include admission fee, sponsors fee, legal fees, reporting accountants fee, ongoing annual
costs of satisfying legal requirements, including increased financial disclosure since stock exchange
requirements are more demanding- this leads to increased public scrutiny of the company and its
performance.
o Shareholder expectations (i.e., institutional shareholders may want to focus of short-term profitability
and dividend income. Possibility of being taken over increases if shareholders are not satisfied, since they
are willing to sell shares to a bidding company. Therefore, stock exchange is seen as providing a market
for corporate control meaning that poor performance may be corrected by removing managers through a
takeover. Financial transparency means bidders can tell more easily whose shares they want.
4. What is the difference between an ordinary and a preference share from a company‘s and an investor‘s point of
view?
 Ordinary share allows the investor to receive dividends and entitles them to vote at shareholder meetings.
From a company’s point of view, these shares hold the lowest risk, yet they must also be satisfied. For an
investor, these shares have the highest risk, as they are the last to receive dividend payments and
compensation in the event of company liquidation. Therefore, investors expect a high return (coherent with
the risk involved).
 Preference shareholders usually do not have voting rights; however, they receive dividend payments before
ordinary shareholders and have priority over ordinary shareholders in the event of company liquidation and
the distribution of assets. Preference shares are less risky than ordinary shares.
 Preference shares can be cumulative or non-cumulative. Non-cumulative: if distributable profits are
insufficient to pay the preference dividend, the dividend is lost. Cumulative, if distributable profits are
insufficient to pay the preference dividend, the right to receive it is carried forward and unpaid preference
dividends must be settles before any ordinary dividend can be paid in subsequent years.
 Preference shares can be non-participating or participating. If preference shares are non-participating, the
preference dividend represents the sole return to the holders of the shares, irrespective of the company's
earnings growth. Participation preference shares, in addition to paying a fixed preference dividend , offer the
right to receive an additional dividend if profits in the year exceed an agreed amount.
 From a company perspective these shares are beneficial in terms of maintaining control of the company
since preference shareholders generally do not have voting rights. However, these shareholders have more
rights related to dividend payments (participating), and compensation in the event of company liquidation,
therefore, the company is 'on the hook' especially for cumulative, participating preference shareholders. It is
important that a company can pay out all preference shareholders to also satisfy ordinary shareholders to
avoid a takeover.
 From an investor’s perspective, preference shares are attractive as they are higher up on the creditor
hierarchy. Cumulative shares guarantee dividend payments and therefore the return on investment is
somewhat secured. This is lower risk than ordinary shares.
= Therefore, depending on the agenda of the individual investing, ordinary and preference shares have both
their advantages and disadvantages.
 (Underwriting shares- a form of insurance. In the event you do not reach market capitalization expected, you
can ensure a certain amount in the event that you do not collect the funds expected. )

Tax efficiency of debt Taxes are deducted from profits, when paying interest on
debt it is taken from profits, therefore profits are lower,
leading to lower taxes.
(Income tax!)
Indebtedness Condition of owing money. Debt in comparison to total
capital
Unsecured and secured bonds  Secured bonds are on specified non-current assets which
cannot be disposed of while the debt is outstanding.
(Land, buildings = mortgage debenture)
 Unsecured bonds are on a class of assets, like current
assets, therefore disposal of some assets is permitted. In
the event of default (non-payment of interest) floating
charge will become a fixed charge on the specified class
of assets.
Refinance Replacing one kind of financing with one or more different
forms of finance with different characteristics, such as
replacing fixed rate long-term debt with floating rate long-
term debt, or with equity.
Fixed and floating interest rates  Floating interest rates: linked to a current market
interest rate. Attractive to investors who want a return
that is consistently comparable to market interest rates
who want to protect themselves against unanticipated
inflation.
 Fixed interest rates: protects investors against
anticipated inflation, taken into account when the fixed
rate was set on issue.
(Credit) rating An assessment of the creditworthiness of a company's debt
securities based on its borrowing and repayment history, as
well as the availability of assets.
Eurobonds Long-term debt securities denominated in a currency outside
of the control of the country of their origin.
Convertible bonds Bonds that can, at some specified date (s), be converted at
the option of the holder into a predetermined number of
ordinary shares.
Warrants Tradeable share options issued by companies, usually
attached to an issue of bonds.
Leasing, operating and finance lease  Leasing is a form of short- to medium-term financing
which in essence refers to hiring an asset under an
agreed contract.
 Operating leases and finance leases: An operating
lease is a contract that allows for the use of an asset but
does not convey ownership rights of the asset. Operating
leases are counted as off-balance sheet financing
meaning that a leased asset and associated liabilities of
future rent payments are not included on a company's
balance sheet, to keep the ratio of debt to equity low.

Sub-chapter 5.9 (pages 161/162) is not relevant!
1. What is debt (financing)? How is debt different from equity?

 Debt financing occurs when a firm raises funds for working capital by selling debt instruments. In
return for lending, the lender becomes a creditor and receives a promise that the amount and interest
on the debt will be repaid. Occurs when a firm sells fixed income products, such as bonds or finances
through a long-term bank loan.
 The main difference between debt and equity finance is that debt finance is an allowable deduction
from profit chargeable to tax.
 In terms of equity finance dividends are not an allowable deduction from profit; dividends are a share
of the after-tax profit itself.
 Interest on long-term debt has to be paid, dividend payments are only paid out if directors choose to
do so.
 In the event of liquidation, debt holders are paid off before shareholders because they rank higher in
the creditor hierarchy. If the company must liquidate, shareholders may receive only part-payment or
nothing at all. (Therefore, long-term debt finance carries less risk for investors than equity finance-
reflected in its lower required return)
2. What different forms of debt are there and what are the major characteristics of each form?
 Debt financing can be separating into two main forms, bonds, and bank/institutional debt.
 Bonds: Many different forms of bonds exist including deep discount and zero-coupon bonds,
Eurobonds, Convertible bonds. Bonds can be broken down depending on different characteristics
such as the interest rates attached to bonds, bond warrants, fixed and floating charge security, deep
discount, and zero-coupon bonds.
o Deep discount bond: company issues a bond at a price below its nominal value in exchange for
a lower interest rate coupled with redemption at nominal (or premium) on maturity. Attractive to
investors who prefer to receive a higher proportion of return in the form of capital gains as
opposed to interest income. (Different taxation).
o Zero coupon bond: no interest at all is paid on a bond issued at a deep discount so that all of the
return to investors will be in the form of capital appreciation. Advantages must be weighed
against the high cost of redemption compared with the amount of finance raised.
o Euro bonds: outside the control of the country in whose currency they are denominated, sold in
different countries at the same time by large companies and governments.
o Convertible bonds: fixed interest debt securities which can be converted into ordinary shares of
the company at the option of the holder, on a predetermined date and at a predetermined rate. If
not converted, can be redeemed. Interest is less than that on an unconvertable bond. Can be seen
as delayed equity by company.
 Bond interest rates:
o Floating interest rates: linked to a current market interest rate. Attractive to investors who want
a return that is consistently comparable to market interest rates who want to protect themselves
against unanticipated inflation.
o Fixed interest rates protects investors against anticipated inflation, considered when the fixed
rate was set on issue.
 Bond warrants: the right to buy new ordinary shares in a company at a future date, at a fixed,
predetermined price (exercise price).
 Bond Ratings: key feature of bond. Measures investment risk by considering degree of protection
offered on interest payment and repayment of principal (now and in future). Bond rating is conducted by
commercial organizations. Rating is based on detailed analysis of the issuing company's expected
financial performance, and expert forecasts of the economic environment.
 Security charge:
o Fixed charge security: on specified non-current assets which cannot be disposed of while the debt
is outstanding. (Land, buildings = mortgage debenture)
o Floating charge security: on a class of assets, like current assets, therefore disposal of some assets
is permitted. In the event of default (non-payment of interest) floating charge will become a fixed
charge on the specified class of assets.
 Loan notes: another term for bond
 Loan stocks: (synonym of debenture) : refers to an unsecured bond (not secured against a specific asset,
have claim on defaulted issuers, after collateral from secured bonds have been paid off).
 Debentures: (synonym of loan stock) : a written acknowledgement of indebtedness, usually a bond that
is secured by a trust deed against corporate assets. (Debenture trust deed covers: any charges on the
assets of the issuing company (security), how interest is paid, procedures of redemption of the issue,
production of regular reports, power of trustees to protect investors of debt finance)
Loan notes, loan stock and debentures are examples of long-term bonds or debt securities with a nominal
value and a market price determined by buying and selling in the bond markets. Interest rate (coupon) is
based on the nominal value (usually paid 1-2 p.a.)
Bank and Institutional Debt

Long-term loans available from banks/ other financial institutions at both fixed and floating interest
rates.
 Cost is usually an agreed amount above bank base rate, depending on perceived risk. Bank charges
an arrangement fee on bank loans, secured by fixed or floating charge (this depends on availability of
assets of good quality acting as a security). Repayment schedule is often agreed upon, payments will
include both interest and capital elements.
 Long-term bank loans cannot be sold directly by the company to a third party.
 Bond compared to loan: bond is tradeable.
3. How is debt evaluated? (Or in other words: Why do the calculations for the evaluation of debt look
like /they do?)Find an easy explanation! Think about finance fundamentals that you have learned already
during earlier chapters.)
From the viewpoint of the debt giver, it is an investment (from a banks perspective) because banks have
a return expectation. Are there other/ better investment opportunities? Evaluated as every other form of
investment opportunity.
4. What is leasing and how does it normally work? Why is leasing part of financial management?
 Leasing is a form of short-to medium-term financing which refers to hiring an asset under an
agreed contract. Lessee obtains the use of an assets of a period of time while legal ownership of
the leased assets remains with the lessor.
 Leasing is part of financial management because it can be seen as equivalent to borrowing as a
way of acquiring assets. Operating leases are 'rental agreements'. Finance leases mean most of
the risks and rewards of ownership are transferred to the lessee and the leased assets must be
partialized in the financial position statement.
1. Fixed and floating rates have their own advantages and disadvantages. Basically, the main difference is
that the fixed rate remains constant throughout the whole life of the debt, whereas a floating interest rate
fluctuates over the duration of the debt. However, the decision should be taken after analysing the
market rate, if the market rate is expected to increase – fluctuating makes more sense. It is about the
expectations of the future.
2. Convertible bonds can be converted into shares, then one needs to make sure that the share value Is
more attractive than constant fixed interest. Investment opportunity makes sense when you create the
positive return.
3. CV = Po(1+g)nR
Expected annual growth rate of ordinary share price

Investment appraisal methods A collection of techniques used to identify the
attractiveness of an investment. Does it create
return? Should I invest or not/ which
investment is the most attractive?
Payback method, payback period Payback period is the amount of time it takes
to cover the cost of an investment (length of
time an investment reaches a breakeven point.)
Return on capital employed (ROCE) method, return on Financial ratio that measures a company's
investment (ROI) profitability and the efficiency with which its
capital is used. Measures how well a company
is generating profits from its capital, important
profitability ratio.
Mutual exclusiveness Statistical term describing two or more events
that cannot coincide. Commonly used to
describe a situation where the occurrence of
one outcome supersedes the other.
Net present value (NPV) method The difference between present value of cash
inflows and the present value of cash outflows
over a period of time. NPV used in capital
budgeting and investment planning to analyse
the profitability of a projected investment or

project.
Non-conventional CFs Refers to raising money from small public
investors. Primarily thought online forums and
social media. In exchange for relatively small
amounts of cash, investors get a proportionate
slice of equity in a business venture.
Hard and soft capital rationing Hard capital rationing occurs when a company
has issues raising additional funds, either
through equity or debt. Rationing arises from
an external need to reduce spending and can
lead to a shortage of capital to finance future
projects. Soft capital rationing is internal
rationing, due to the internal policies of a
company.

1. Answer for the following investment calculation methods
 Payback period, discounted payback period
Method
 Payback period: Cost of investment/ annual cash flow
Discounted payback period:
1) discount (bring to present value) net cash flows that will occur during each year of project
2) subtract the discounted cash flows from the initial cost figure in order to obtain the discounted
payback period. Once discounted cash flow for each period of project has. Been calculated, can
subtract from the initial cost figure until arriving at 0.
 How calculation works
Determined by counting the number of years it takes to recover funds invested.
Discounted payback period formula shows how long it will take to recoup an investment based on
observing the present value of the projects projected cash flows.
 What is the investment decision criteria?
Desirability of an investment is related to payback period; shorter paybacks mean a more attractive
investment. Can be used to make a quick judgement on investments
 When is the method used? Benefits/ Shortcomings
1) Shortcomings: the payback period ignores the time value of money, does not account for what
happens after payback (ignoring overall profitability), not really an indication of whether
investment project increases value of company
2) Benefits: simple, can be an additional point of reference, straightforward, not open to

manipulation by manager preferences, longer ppp = more uncertainty = risk = ppp accounts for
risk, DPP: more accurate than payback period- factors in time value of money.
 ROCE
Method
 ROCE= average annual accounting profit / average investment x 100
The average investment must take account of any scrap value. Assuming straight-line depreciation
from the initial investment to the terminal scrap value, we have:
Average investment = initial investment + scrap value / 2
Or can use initial or final investment rather than average investment:
ROCE= average annual accounting profit / initial (final) investment x 100
Higher ROCE indicates more efficient use of capital. ROCE should be higher than the company's
capital cost, otherwise, it indicated that the company is not employing its capital effectively and not
generating shareholder value. Compares profitability across companies based on the amount of
capital they use. Two key metrics necessary are EBIT which shows how much a company earns from
its operations alone without regard to interest or taxes (revenue - cost of goods sold and operating
expenses) And capital employed, which is the total amount of capital that a company has utilized in
order to generate profits.
Useful when comparing the performance of companies in capital-intensive sectors. ROCE considers
debt and other liabilities as well.
1) Benefits: gives value in %, can be used to compare mutually exclusive projects , relatively
simple, can compare mutually exclusive projects, considers all cash flows arising during the life
of an investment project (unlike payback period), can indicate whether a project is acceptable by
comparing the ROCE of the project with a target rate.
2) Shortcomings: uses accounting profit (open to manipulation), not linked to objective of
maximizing shareholder wealth, average profits ignores the timing of profits, does not consider
time value of money (equal weight to all cash flows when they occur), does not take length of
project life into account (% = relative measure), ignores size of investment made.
 NPV

Difference between the present value of cash coming in and the current value of cash going out over
a period of time. Positive NPV indicates that the projected earnings generated by a project/
investment (in present currency) exceeds the anticipated costs, also in present currency.
It is assumed that an investment with a positive NPV will be profitable and an investment with a
negative NPV will result in a net loss. Number of periods, discount rate, future cash flows.

1) Benefits: considers the time value of money, cash flows rather than accounting profit, takes
account of amount and timing of project cash flows and relevant cash flows over the life of an
investment project. Is the academically preferred method of investment appraisal, offers sound
investment advice.
2) Shortcomings: difficult to estimate the value of the cash inflows and outflows over the life of a
project (issue in general, not specific), only possible to accept all projects with a positive NPV in
a perfect capital market (restrictions in finance available), assumes that company's cost of capital
is known and remains constant over the life of the project (if changes can be forecasted NPV can
still accommodate)
 IRR – Internal Rate of Return

Set NPV to 0 and solve for discount rate (t), which is the IRR. Because of nature of formula cannot
be calculated analytically, must be calculated either through trial and error or using software
programmed to calculate IRR. Calculated by the condition that the discount rate is set such that the
NPV = 0 for a project
Used in capital budgeting to decide which projects or investments to undertake and which to forgo.
IRR can be seen as the rate of growth a project is expected to generate, may differ but high IRR
provides better chance of strong growth. IRR is the rate of growth a project is expected to generate.
1) Shortcomings: misleading when used alone (ex. Low IRR but high NPV returns may be slows
but project adds a great deal of overall value to company, similar when using IRR to compare
projects of different lengths (ex. High IRR but low NPV or low IRR but adds a lot of value to
company over time)
2) Strengths:
 What is capital rationing and how does it play a role for evaluating investment projects
Capital rationing can be hard (externally imposed) or soft (internally imposed). Reasons for hard capital
rationing can occur because capital markets are depressed or because a company is thought to be too risky.
Reasons for soft capital rationing can occur because a company wishes to avoid dilution of control, dilution
of EPS or further fixed interest commitments. The company may wish to pursue a policy of steady growth or
believe that restricting funds will encourage better projects. In a single-period capital rationing, divisible,
non-deferrable and non-repeatable investment projects can be raked using the profitability index in order to
find the optimal investment schedule. The profitability index is the ratio of the present value of future cash
flows divided by the initial capital invested . Multiple-period capital rationing requires the use of linear
programming.
 What is capital rationing and how does it play a role for evaluating investment projects?
Capital rationing is the act of placing restrictions on the number of new investments or projects undertaken
by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by
setting a ceiling on specific portions of a budget. Companies may want to implement capital rationing in
situations where past returns of an investment were lower than expected.
Be able to calculate:
• Payback periods and discounted payback periods
It is determined by counting the number of years it takes to recover the funds invested. For example, if it
takes five years to recover the cost of an investment, the payback period is five years.
Payback Period = Initial Investment

Net Cash Flow per Period
• ROCEs and ROIs
Average annualaccounting profit

ROCE= x 100
Average investment
• NPVs
C1 C2 C3 Cn
2+
NPV =−I 0+ + + …+
(1+r ) (1+r ) (1+r )3
(1+r )
n

Investment appraisal A collection of techniques used to identify the
attractiveness of an investment. Does it create return?
Should I invest or not/ which investment is the most
attractive?
Expected future cash flows The cash flow an investor or company expects to realize
from a project before that project begins. The actual cash
flows may be greater or less than the expected future cash
flows. They are often measured according to their present
value.
Incremental CFs Incremental cash flow is the additional operating cash flow
(= relevant CFs, = marginal CFs) an organization expects to generate from a new project.
 positive=good investment
 negative=will not make money for company)
Sunk costs and apportioned fixed costs  Sunk cost refers to money that has already been spent
which cannot be recovered. They are excluded from
future business decisions because the cost will remain
the same regardless of the outcome of a decision.
 Apportioned fixed costs are the costs that will be
incurred regardless of whether a project in undertaken
or not, such as rent and building insurance (apportioned
fixed costs) or apportioned head office charges. These
costs are not relevant and should be excluded.
 Fixed costs do not depend on output units.
Opportunity costs What benefits an individual, investor or business
sacrifices/misses when they choose one option over
another. Should be used to make educated decisions,
understand the potential of missed opportunities allowing
for better decision making in the future.
Capital expenditure (CAPEX) A company's spending on physical assets, cannot be
deducted from income for tax purposes. Added to
companies’ assets and depreciated / amortized every year.
Any type of expense that a company capitalizes, or shows
on balance sheet as investment, rather than income
statement as an expenditure.
Nominal and real values  Nominal value is the unadjusted rate/ current price
without taking inflation or other factors into account
the real value is where adjustments are made for
general price level changes over time.
 The real value of an item, also called its relative price,
is its nominal value adjusted for inflation and measures
that value in terms of another item.

Chapter 7.5 (and corresponding sub-chapters, pages 218 - 222) is not relevant!
1. What are relevant project cash flows for investment appraisal? Why are sunk costs and
apportioned fixed costs not relevant and what role do opportunity costs play?
 Relevant project cash flows necessary for investment appraisal are incremental cash flows, which are
changes in the company's cash flow resulting directly from undertaking an investment project. To tell
if a cash flow is relevant or not, is to ask whether is stems because of undertaking a project.
 Sunk costs are the costs incurred before the start of an investment project, even if these costs haven't
been paid yet they should not be included in the investment appraisal. This is because these costs will
be paid whether the project is undertaken or not. Examples of sunk costs could be market research,
machinery already owned or research and development expenses.
 Apportioned costs are costs that will be incurred regardless of whether a project is undertaken or not,
such as rent and building insurance (apportioned fixed costs) or apportioned head office charges.
These costs are not relevant and should be excluded. Only incremental or additional fixed costs that
arise because of taking on a project should be included as relevant project cash flows.
 The role that opportunity costs play in investment appraisal is that by using an asset for one purpose
rather than another, it is important to ask what benefit has been lost, since this lost benefit
(opportunity cost) is the relevant cost as far as the project is concerned.
2. Is inflation taken into consideration when appraising investments, and if so, how?
 Inflation is taken into consideration when appraising investments. This is because inflation can have
a serious effect on capital investment decisions, by reducing the real value of future cash flows and
by increasing their uncertainty. Future cash flows must be adjusted to take account of any expected
inflation to express them in nominal terms (actual cash mounts to be received or paid in the future,
done with NPV method. (7.3)
 Individual costs and prices will inflate at different rates, need to be inflated by specific rates of
inflation. Forecasted as part of the investment appraisal process. General rate of inflation is
calculated for example from the consumer price index, representing increases in consumer prices.
 Working capital recovered at the end of a project will not have the same nominal value as the
working capital invested at the start. Nominal value of the investment in working capital needs to be
inflated each year to maintain its value in real terms. The golden rule is to discount real cash flows
with a real cost of capital and to discount nominal cash flows with a nominal cost of capital.
 In reality, while inflation will influence the discount rate used in investment appraisal, it may not be
a major factor in investment appraisal decisions.
3. How do risk and uncertainty play a role in appraising investments? What is a sensitivity analysis,
how is it done and what would be key variables for sensitivity analyses in tourism businesses?
 Risk can be quantified, and uncertainty cannot. Risk can therefore be assigned probabilities.
Distinction has little importance in business decisions, Managers are neither completely ignorant nor
certain about the probabilities of future events.
 Risk averse company are concerned about the possibility of receiving a return less than expected.
 A sensitivity analysis is a way of assessing the risk of an investment project by evaluating how
responsive the NPV of the project is to changes in the variables from which it has been calculated.
The result is an indication of the key variables associated with an investment project. A small change
in these variables result in a significant effect on project’s NPV. These variables should be further
investigated, to determine the extent to which their values can be relied upon, and where attention
should be focused to ensure project success.
 Sensitivity analysis problems: only one variable at a time can be changed implying that all project variables
are independent (unrealistic). Also doesn't address risk, only addresses key variables but not the probability of
changes in the variables which are needed.
For the tourism industry key variables would be, travel habits of target market.

Mean return The expected value (mean) of all the likely returns of
multiple investments. forecasts returns (off past and future
returns) and associated probabilities.
Risk by means of standard deviation Calculates potential risks involved in investments.
Diversification A risk management strategy, mixing a wide variety of
investments in an investment portfolio. Consists of a mix
of distinct asset types to limit exposure to any single asset
or risk.
Systematic and unsystematic risk  Systematic risk refers to the risk inherent to the
entire market or market segment affects the overall
market, not just a particular stock or industry.
This type of risk is both unpredictable and
impossible to completely avoid. It cannot be
mitigated through diversification. (BETA)
 Unsystematic risk impacts only a particular
company or industry. Can be reduced by
diversification.
Risk attitudes: risk-loving, risk-neutral,  Risk loving preference of high return for a higher
risk-averse
level of risk.
 Risk neutral indifferent to level of risk faced.
 Risk averse preference of low risk, low return
investments.
Markowitz‘s Portfolio Theory, efficient  Markowitz's Portfolio Theory is the calculation of
frontier/line, capital market line (CML) maximize expected return based on a given level of
market risk. According to the theory, it's possible
to construct an "efficient frontier" of optimal
portfolios offering the maximum possible expected
return for a given level of risk.
 Efficient Frontier/Line is the set of frontiers that
offers the highest ideal return over a defined/
lowest level of risk for expected return.
 A theory on how risk-averse investors can
construct portfolios to optimize or CML market
line, is the line on the graph that shows the
optimum combination between risk and return.
Starts at the risk-free rate on the Y axis (therefore
preferred over efficient frontier/line).
Capital asset pricing model (CAPM) CAPM describes the relationship between systematic
risk and expected return for assets, particularly stocks.
Beta (β)  Used to quantify a securities level of systematic
risk. Index of responsiveness of the changes in
returns of the security (relative to a change in the
stock exchange or market).
 Beta of the market is always 1 and acts as a
benchmark against which the systematic risk of
securities can be measured. The beta of a security
measures the sensitivity of the returns (on the
security) to changes in systematic factors.
Ignore 8., 8.1., 8.2, Portfolio Theory, neglect calculations

1. What is risk and how is it measured? Explain the concept of risk with the help of the statistical values
„mean” return and „standard deviation “. What is the difference between systematic and unsystematic
risk? What factors could have an influence on risk levels of tourism companies?
Risk is measured by the standard deviation of returns of a share. The calculation of the standard
deviation draws data from historical returns or the expected future returns. The mean return is the
expected value (mean) of all the likely returns of multiple investments.
It forecasts returns (off past and future returns) and associated probabilities. Systematic risk is the risk
inherent to the entire market or market segment affecting the overall market. It is unpredictable and
impossible to completely avoid; therefore, it cannot be mitigated through diversification. Unsystematic
risk on the other hand, is risk involved solely in a particular industry, or for a certain company.
Therefore, it can be reduced through diversification. For example, a recession would affect the overall
market, also impacting the tourism industry, it is therefore an unsystematic risk. In case the cost of
ingredients rises, it will affect the prices of raw goods for restaurants, or travel laws/ legislations making
travel to certain countries more difficult would impact tourism related companies more, and maybe not
impact other industries. In countries with a great deal of political instability, directly influencing travel
habits, the risk factor of a travel company would be increased.
2. What is more efficient, to diversify at a company or at an investor level? Why?
Diversification at investor level = Markowitz's portfolio
It is more efficient to diversify at an investor level for the following reasons:
 If business operations are scaled down, valuable economies of scale will be lost.
 Diversified companies will have to operate in areas of business in which they have little or no
expertise
 Diversification is likely to complicate and increase the cost of company management.
 If you are a diversified company, not attractive to risk loving investors (lower risk, lower return)
Therefore, it is more efficient for investors to diversify away unsystematic risk through holding a
diversified portfolio of shares.
3. Where do investor preferences play a role when investing?
Investor preferences play a role in investing with the level of risk opted for when selecting
investments. There are 3 main forms of risk attitudes:
1. Risk loving: where the preference is for high return in exchange for high level of risk
2. Risk neutral: where the investor is indifferent to the level of risk faced
3. Risk averse: where the preference is for low risk, low return investments.
= more diversified portfolio
While attitudes towards risk may be different, it is expected that investors act rationally and do not
expose themselves to higher risk without the possibility of higher returns.
4. What is Portfolio Theory used for?
To diversify away unsystematic risk by holding portfolios consisting of several different shares.
Envelope curve represents the set of portfolio choices available to investors when investing in different
combinations of risk assets. Investors can locate themselves anywhere within the envelope curve, but
rational investors will invest only in those portfolios on the efficient frontier. Its name comes from that
all portfolios on this arc are superior to all other portfolios within the envelope curve (giving either the
maximum return minimal risk/ minimum risk for maximum return.
By assuming that investors can both lend and borrow at a risk-free rate of return, the capital market line
(CML) can be constructed. (can be seen on graph as RfMN)
Starting point is to estimate the rate of return on the risk-free asset. Risk free rate is usually
approximated by using the rate of return on government treasury bills (essentially risk free). If the CML
meets the efficient frontier line = market portfolio, which represents the optimal combination of risky
assets given the existence of the risk-free asset.
5. What is the CAPM used for? What are Betas and what role do they play in finance?
Positive CAPM uses the systematic risk of individual securities to determine their fair price. To
ignore the influence of unsystematic risk it is assumed that investors have eradicated unsystematic
risk by holding diversified portfolios. Follows the following assumptions:
 Investors are rational and want to maximize utility (no risk for the sake of risk)
 All information is freely available to investors
 Investors can borrow and lend at the risk-free rate
 Investors hold diversified portfolios
 Capital markets are perfectly competitive
 Investment occurs over a single, standardized holding period
CAPM is the existence of a linear relationship between risk and return. The linear relationship is defined
by what is known as the security market line (SML). Which compares the systematic risk of a security to
the risk/return of the market and the risk-free rate of return to calculate a required return = fair price
A stock's beta or beta coefficient is a measure of a stock or portfolio's level of systematic and
unsystematic risk based on in its prior performance. The beta of an individual stock only tells an investor
theoretically how much risk the stock will add (or potentially subtract) from a diversified portfolio.
For beta to be meaningful, the stock and the benchmark used in the calculation should be related. Using
beta to choose stocks is one of the tools to reduce volatility and create a more diversified portfolio.
6. How valuable are Portfolio Theory and CAPM in reality?
Problems with the practical application of the portfolio theory in reality are:
1. Unrealistic to assume borrowing and lending at a risk-free rate.
2. Problems identifying the market portfolio as it requires knowledge of the risk and return of all
risky investments and their corresponding correlation coefficients.
3. Expensive to construct market portfolio
4. Market portfolio changes over time because of shifts in risk free rate of return and the envelope
curve.
Difficulty for investors to directly apply portfolio theory in practice can be overcome by buying a stake
in a large, diversified portfolio.
CAPM assumes many facts which are at odds with the real world. While empirical tests do not reinforce
the validity of the CAPM, the model does provide a useful aid to understanding the relationship between
systematic risk and the required rate of return of securities.
Be able to:
 Calculate mean returns and standard deviation of future investment opportunities as well as of
actual historical figures
Expected Return
Expected return measures the mean, or expected value, of the probability distribution of investment
returns. The expected return of a portfolio is calculated by multiplying the weight of each asset by its
expected return and adding the values for each investment.
For example, a portfolio has three investments with weights of 35% in asset A, 25% in asset B, and
40% in asset C. The expected return of asset A is 6%, the expected return of asset B is 7%, and the
expected return of asset C is 10%.
Asset Weight Expected Return
A 35% 6%
B 25% 7%
C 40% 10%
Therefore, the expected return of the portfolio is

[(35% * 6%) + (25% * 7%) + (40% * 10%)] = 7.85%
This is commonly seen with hedge fund and mutual fund managers, whose performance on a particular
stock is not as important as their overall return for their portfolio.
Standard deviation:
The expected return of a portfolio is the anticipated amount of returns that a portfolio may generate,
whereas the standard deviation of a portfolio measures the amount that the returns deviate from its mean.
Conversely, the standard deviation of a portfolio measures how much the investment returns
deviate from the mean of the probability distribution of investments.
The standard deviation of a two-asset portfolio is calculated as:

σP = √(wA2 * σA2 + wB2 * σB2 + 2 * wA * wB * σA * σB * ρAB)
Where:
σP = portfolio standard deviation
wA = weight of asset A in the portfolio
wB = weight of asset B in the portfolio
σA = standard deviation of asset A
σB = standard deviation of asset B; and
ρAB = correlation of asset A and asset B
Expected return is not absolute, as it is a projection and not a realized return.
For example, consider a two-asset portfolio with equal weights, standard deviations of 20% and 30%,
respectively, and a correlation of 0.40. Therefore, the portfolio standard deviation is:
[√(0.5² * 0.22 + 0.5² * 0.32 + 2 * 0.5 * 0.5 * 0.2 * 0.3 * 0.4)] = 21.1%
Standard deviation is calculated to judge the realized performance of a portfolio manager. In a large fund
with multiple managers with different styles of investing, a CEO or head portfolio manager might
calculate the risk of continuing to employ a portfolio manager who deviates too far from the mean in a
negative direction. This can go the other way as well, and a portfolio manager who outperforms their
colleagues and the market can often expect a hefty bonus for their performance.
Historical returns:
Historical returns are often associated with the past performance of a security or index, such as the S&P
500. Analysts review historical return data when trying to predict future returns or to estimate how a
security might react to a particular situation, such as a drop in consumer spending. Historical returns can
also be useful when estimating where future points of data may fall in terms of standard deviations.
How to Calculate Historical Returns

Calculating or measuring the historical return of an asset or investment is relatively straightforward.
Subtract the most recent price from the oldest price in the data set and divide the result by the oldest
price. We can move the decimal two places to the right to convert the result into a percentage.
For example, let's say we want to calculate the return of the S&P 500 for 2019. We start with the
following data:
2,506 = the S&P 500 closing price on December 31, 2018

3,230 = the S&P 500 closing price on December 31, 2019
3,230 - 2,506 = 724
724/2,506 = .288 or 29%*
*The returns were rounded to the nearest number.
The process can be repeated if an investor wanted to calculate the return for each month, year, or any
period. The individual monthly or yearly returns can be compiled to create a historical return data set.
From there, investors and analysts can analyze the numbers to determine if there are any trends or
similarities between one period or another.
https://www.investopedia.com/terms/h/historical-returns.asp
 Explain figure 8.9 (page 247)
You will not have to calculate risk for portfolios, Betas or special return rates for securities!

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1 Finance & Investment: Questions Chapter 1-8

CHAPTER 1: TERMS AND DEFINITIONS

 An analyst placing a value on a company looks at the business's management, the

company’s current assets and current liabilities.

1. What is the fundamental relationship between risk and return?

Be able to explain exhibit 1.4 (page 12)

Chapter 2: Terms and Definitions

Equity finance The acquisition of funds by issuing shares of common or preferred

basis. EVA can also be referred to as economic profit, as it attempts

Sample Exam Tasks:

CHAPTER 2: BASIC QUESTIONS OF UNDERSTANDING

2. With regard to which factors are financing decisions taken in companies?

Efficient market characteristics:

Decision making process:

6. What information is provided by the different financial statements?

Sample Exam Question:

CHAPTER 3: TERMS AND DEFINITIONS

 Profitability is the amount of revenue remaining after deducting all the

 Lead time measures how long it takes to complete a process from

Chapter 3: Basic Questions of Understanding

Chapter 3: Sample Exam Questions

Chapter 4: Terms and Definitions

company can issue as stated in its memorandum of

amounts that is qualifies for preferential treatment

Chapter 4: Basic Questions of Understanding

1. Why do companies issue shares? Why do investors buy shares?

Chapter 5: Terms and Definitions

Chapter 5: Basic Questions of Understanding

1. What is debt (financing)? How is debt different from equity?

Bank and Institutional Debt

Chapter 6: Terms and Definitions

the profitability of a projected investment or

Chapter 6: Basic Questions of Understanding

2) Benefits: simple, can be an additional point of reference, straightforward, not open to

 How calculation works

 When is the method used? Benefits/ Shortcomings

 How calculation works

Payback Period = Initial Investment

• ROCEs and ROIs

Average annualaccounting profit

Chapter 7: Terms and Definitions

Chapter 7: Basic Questions of Understanding

Chapter 8: Terms and Definitions

Ignore 8., 8.1., 8.2, Portfolio Theory, neglect calculations

Asset Weight Expected Return

Therefore, the expected return of the portfolio is

The standard deviation of a two-asset portfolio is calculated as:

How to Calculate Historical Returns

2,506 = the S&P 500 closing price on December 31, 2018

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