Chapter 5&6

Independent projects and mutually exclusive project (definition)

Payback period (ads&disad, calculation)
Calculation- NPV, PI(4dp)
IRR (ads&disad, calculation) in %

Chapter 7
Risk (risk attitude, classification of risk)
Return (components of return, classification of returns)
Calculation (expected rate of return, standard deviation, coefficient of variation)
Portfolio &diversification
Correlation
Beta Coefficient

Chapter 8
Calculation (inventory turnover ratio, days& day sales outstanding)
Calculation of cash conversion cycle and operating cycle (inventory conversion period, debtor
collection period, payable credit period)
Types of investment
Working capital financing policy
Concerns for working capital management (situation)

Chapter 9
Motives of Holding Cash
Why cash flow problems arise
Ways to overcome cash shortages
How Cash Surplus May Arise
Categories of Cash Surplus
The Uses of Cash Surplus
Types of marketable securities

Chapter 12
Types of Finance
Classification of Source of Finance
Security in Financing
Common Types of Short-Term Finance
Advantages and Disadvantages of Factoring
Advantages and Disadvantages of Short-Term Financing
Chapter 4
Simple Interest
Interest earned on the initial investment (principal)
Compounded Interest
Interest earned on the initial investment (principal). Interest earned on interest.
Compounding
The process of determining the final value of a cash flow when compound interest is applied
Discounting
The process of finding the present value of a cash flow
Annuities
A series of equal payment at fixed intervals for a given period
Eg: housing loans
Chapter 5&6
Independent Projects
Projects that are not affected by the acceptance or non-acceptance of other projects, hence more
than 1 project may be accepted.
Mutually Exclusive Projects
A set of projects where only one can be accepted.

Payback period: The number of years required to recover the funds invested in a project
from its cash flows. (shorter better)
Advantages
• Provide information about liquidity and risk
Disadvantages
• Time value of money is ignored.
• Cash flows beyond the payback year are given no consideration.
• No relationship between given payback and investor wealth maximisation.

Net Present Value: Present value of the project’s cash flows discounted at the cost of capital.
Profitability index: Measures the ratio between the present value of cash flows and the initial
investment. (make comparisons of project with different sizes)

Internal Rate of Return: The discount rate that forces a project’s NPV to equal zero.
Advantages of IRR
• It uses cash flows which reflect the true timing of the benefits and costs involved with a
project.
• It applies the time value of money concept that compares project cash flows in a logical
manner.
• It is easily understood as it stresses the ‘rate of return’ a project earns.

Disadvantages of IRR
time consuming as it is normally required to use a trial-and-error basis to determine the IRR
Chapter 7
Risk
The chance that some unfavorable event will occur
Risk Attitude
1. Risk averse
The tendency of a person to reject a bargain with an uncertain payoff and accept another
bargain with a more certain, but possibly, a lower expected payoff
2. Risk taker
Willingness to take additional risk for an investment with a relatively low expected return
3. Risk neutral
The level of risks does not matter, as long as the return is correspondent

Return
• Reward for investing, the total gain/loss experienced on an investment over a given period
• Components of return:
✓ Periodic cash payments or income (interest, dividends or rent)
✓ Capital gains (losses)
i.e. when the sales price is greater than the purchase price (when the sales price is lesser
than the purchase price)

Classification of Return
1. Realised return
• The actual return that has been earned or obtained
2. Required return
• The minimum rate of return required by investors to compensate for taking a comparable
level of risk
• Comprises 2 basic components: the risk-free rate of return and a risk premium
3. Expected return
• The return that is anticipated or expected

Expected Rate of Return

The rate of return expected to be realised from an investment
Expected rate of return= ∑pr

Standard Deviation
A measure of how far the actual return would be deviate from the expected return
Coefficient of Variation
𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛
• Measures risk per unit of return
• Invest in investment with lower CV value- with the same return (1 unit of return), less risky

Portfolio- a collection of investments

Diversification
A technique that mixes a wide variety of investments within a portfolio so that risks are spread
out.
Correlation
• The tendency of two variables to move together
• Measured by correlation coefficient, 𝜌
1. Perfect Positive Correlation
• 𝜌 = +1.0
• Returns of two investments move in the same direction
• Diversification is completely useless
2. Perfect Negative Correlation
• 𝜌 = −1.0
• Returns of two investments move in the opposite direction
• Risk can be effectively diversified away
3. Zero Correlation / Independent
• 𝜌=0
• Returns of two investments are independent of each other
• Risk can be diversified away but not as effective as perfect negative correlation

Portfolio Risk
The portfolio’s risk is smaller than the average of the stocks’ because diversification lowers the
portfolio’s risk.
portfolio risk declines, number of stocks in a portfolio increases.

Would risk be completely eliminated if enough partially correlated stocks are added?
No, because:
Risk declines at a decreasing rate
Market risk remains

Classification of Risk
1. Market risk (non-diversifiable / systematic risk)
• Cannot be reduced by diversification
• E.g. recessions, wars
2. Specific risk (diversifiable / unsystematic risk)
• Specific to individual security
• Can be diversified away as number of securities increases
• Eg: a new governmental regulation affecting a particular group of companies
Total risk = Systematic risk + Unsystematic risk

Beta coefficient, β
• Shows the extent to which a given stock’s returns move up and down with the stock market
• Measures market risk
• When a stock’s beta:
✓ β = 1.0, same risk as the market
✓ β ˃ 1.0, riskier than the market
✓ β ˂ 1.0, less risky than the market

The Relationship between Risk and Rates of Return

Capital Asset Pricing Model (CAPM)
• A model that describes the relationship between risk and expected return, and is used in the
pricing of risky securities
• Any stock’s required rate of return is equal to the risk-free rate of return plus a risk premium
that reflects only the risk remaining after diversification
Chapter 8
Working Capital
Net working capital
the difference between firm’s current assets and current liabilities
Current assets
Can be converted into cash within one year or less
Inventories, accounts receivable, cash and short-term securities
Current liabilities
Obligations due within one year or less
Accounts payable, accruals, short-term borrowings, taxes payable

Working Capital Management

• Goal : ensure that a firm is able to continue its operations, has sufficient ability to satisfy both
maturing short-term debt and upcoming operational expenses.

2. Asset Management Ratios

a) Inventory turnover ratio
Show how many times a company’s inventory is sold and replaced over a period
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝐸𝑛𝑑𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
Interpretation: On average, the firm has produced and sold inventories xx times in a year.

b) Inventory turnover days

Shows how long it takes a company to turn its inventory into sales
𝐸𝑛𝑑𝑖𝑛𝑔 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑥 365𝑑𝑎𝑦𝑠
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
On average, the firm takes xx days to sell its inventories

c) Day sales outstanding

Represents the average length of time the firm must wait after making a sale before receiving
cash
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝑥 365𝑑𝑎𝑦𝑠
𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
On average, the firm takes xx days to collect the amounts due from its trade debtors

Operating cycle= inventory+ debtors

Cash Conversion Cycle = inventory+ debtors- payables
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑= 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 𝑥 365𝑑𝑎𝑦𝑠

𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
𝐷𝑒𝑏𝑡ors’ 𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑= 𝑥 365𝑑𝑎𝑦𝑠
𝑆𝑎𝑙𝑒𝑠

𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝑐𝑟𝑒𝑑𝑖𝑡 𝑝𝑒𝑟𝑖𝑜𝑑= 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 𝑥 365𝑑𝑎𝑦𝑠
A shorter CCC is better since it indicates that a company is efficient in converting its assets into
cash.
Types of Investment
Permanent asset investment
• An investment that the firm expects to hold for the foreseeable future, whether fixed or
current assets
• Example of permanent current assets are the minimum level of inventory held by a firm

Temporary asset investment

• Current assets that will be liquidated, used up or consumed, and not replaced within the
current year
• It is made in inventory and receivables
• For example, seasonal increase and decrease in inventory

Working Capital Financing Policy

1. Moderate (matching) financing policy
• Match the maturity of the assets with the maturity of the financing.
• permanent assets are financed by permanent sources while temporary assets are financed by
temporary sources.
• This approach balances the same amount of risk by the same amount of expected return.

2. Conservative Financing Policy

• Uses long-term borrowing to finance current assets.
• Long term borrowing is less risky because the borrower has a longer time to use the loan
proceeds before repayment is due.
• Long term financing is more expensive than short term financing, which reduces return.

3. Aggressive Financing Policy

• Use short-term financing to finance permanent assets.
• The firm’s risk increases due to the risk of fluctuating interest rates of using short-term
financing, but the potential for higher returns increases because of the lower cost financing.

Question (Concerns on the working capital management)

Inventory Turnover Period
• too long- required to sell within xx days
• inefficient in converting inventories into sales
Debtors Collection Period
• Longer than the agreed credit period
• Inefficient in collecting debts- increase in the risk of bad debt
Payables Credit Period
• Inefficient in repaying its supplier- deterioration in relationship with supplier
Cash conversion Cycle
• Too long- compare to other companies in the industries
• Costing the company money in terms of cash tied up in working capital and lost its
opportunities elsewhere
 Chapter 9
Cash
• It can be defined as money , in the form of notes and coins.
• It is the most liquid assets and represents the lifeblood for growth and investment.
Cash flow
• A term for receipts and payments of cash.
• It represents the cash movement for a particular organisation.
• Cash flow can be subdivided into cash inflow and cash outflow
Net cash flow = the cash received in a period - the cash paid out in the same period

Motives of Holding Cash

1. The transactions motive
make necessary payments to keep the business going (wages, taxes and payments) to suppliers
2. The precautionary motive
• some unforeseen expenses may arise
• businesses cover themselves against this by arranging overdraft facilities with their banks
3. The speculative motive
in case an opportunity to invest and earn money arises.

Cash flow problem may arise due to the following circumstances:

Business that is loss making
If a business continually makes losses, it will eventually have cash flow problems.
Inflation
In a period of rising prices, business need more cash to replace used up and worn-out assets.
Growth
As its sales increases, the growing company may need additional financing to sustain the growth.
Seasonal business
When a business has seasonal or cyclical sales, it may have cash flow difficulties at certain times
of the year.

Ways to Overcome Cash Shortages

1. Postponing cash outflows
2. Accelerating cash inflows
3. Sell assets / investments

How Cash Surplus May Arise

i. Unexpectedly large amounts of cash generated from operations
ii. Lower expenses -improved productivity or a cost-cutting exercise
iii. Improvements in working capital management
iv. Sales of non-current assets
v. Seasonal factors – surpluses generated in good months of sales

Categories of Cash Surplus

Long Term Surpluses
• These surpluses are rare.
• These are cash surpluses that a business has no foreseeable use for.
Short Term Surpluses
• These surpluses need to be invested temporarily.
• In short term securities or deposit accounts as they have higher liquidity.

The Uses of Cash Surplus

• To purchase fixed assets or acquire another company
• To be used as a ‘buffer’ by keeping in the company
• To be re-invested to expand or grow business
• To be returned to shareholders as dividends

Marketable Securities (Money Market Instruments/ Cash investment)

• Have short-term maturity in which the investor can convert this investment into cash easily.
• very liquid and extraordinarily safe.
• offer lower returns than most other securities.

Types of Marketable Securities

Marketable Certificate of Treasury Bills Bankers’ Commercial
Securities Deposits (CDs) Acceptance (BA) Paper (CP)
Issuer Banks Government Banks Banks and
Corporation
Purpose As an investment To fund the To provide To fund for short-
facility for operation financing to term debt or
companies or expenses of the clients of the bank expenses
clients of the government for import/ export
bank transactions
Maturity 7d-5y (mostly 6 Usually 3 months 21d- 365d Less than 1 year
months)
Discount No Yes No Yes
instrument?

Advantages of CDs
• It is very liquid.
• The CDs trading market is large where flexibility to convert into cash in a short time is
possible.
• CDs can be bought and sold any time before maturity.
Chapter 12
The major sources of finance for companies are:
Internal funds – The firms’ accumulated earnings
• Company’s net profit after paying dividends to the stockholders.
• Serving as a measure of the economic ability of a corporation to pay such cash distributions.
External funds – These include borrowing and the issue of shares and bonds

Types of Finance
(1) Short term finance
• Usually in the form of short-term bank loan or overdraft facility
• Used by business as a form of working capital to aid in its day-to-day business operation
• For example, Treasury bills, certificates of deposit (CDs), commercial paper, bankers'
acceptances, etc.
• Financing requirement is usually for less than 1 year

(2) Medium term finance

• Usually in the form of medium-term loan, hire purchase and leasing
• Provided largely by banks usually in the form of loan with repayment targets
• Bank lending may be a volatile source of finance i.e. interest is sensitive to the state of
economy
• Financing requirement is usually for between 2 to 5 years

(3) Long term finance

• Usually in the form of ordinary shares, preference shares, bonds, retained earnings
• Firm can issue shares and bonds to raise financing
• Issue of shares will require the shareholders to pump in additional capital or else their
shareholdings will be diluted.
• Issue of bonds means the issuer are borrowing money from the investor. These securities are
fixed interest loans to firms. Their interest must be paid in full before shareholders can
receive any dividends and bondholders have a prior financial claim on the company.
• Financing requirement is usually for between 6 years and beyond

Classification of Sources of Finance

(1) Spontaneous source of finance
• It consists of trade credit and other accounts payable (accruals) that arise in firm’s day-to-
day operations.
• Has following characteristics:
✓ Arise from the normal course of business
✓ Normally no explicit cost attached
✓ Unsecured
• For example, as the firm acquires materials for its inventories, trade credit is often made
available spontaneously from the firm’s suppliers.
• Accrued wages and salaries, accrued interest and taxes also provide valuable sources of
spontaneous financing.
• These expenses accrue throughout the period until they are paid.
(2) Temporary source of finance= Short term finance
• Usually in the form of short-term bank loan or overdraft facility
• Used by business as a form of working capital to aid in its day-to-day business operation

(3) Permanent source of finance

• Do not mature or come due within the year
• Including intermediate term loans, long-term debt, bonds, preferred stock and common
equity

Security in Financing
Unsecured loans
- Financing obtained without pledging specific assets as collateral
- Major sources include accrued wages and taxes, trade credit, unsecured bank loans and
commercial paper

Secured loans
- A loan backed by collateral
- Major source include accounts receivable and inventories
- In the event of default, lender can seize the pledged assets and sell them to settle the debt

Common Types of Short-Term Finance

(1) OVERDRAFT
• A deficit in a bank account caused by drawing more money than the account holds.
• When payments from a bank current account exceed income for a temporary period, the
bank finances the deficit by means of an overdraft.
• It is a form of short-term lending. The bank will earn interest on the lending
• The bank will charge a commitment fee when a customer is granted an overdraft facility.

Advantages
a facility can be renewed every time it comes
up for review
has the flexibility to review the customers’
overdraft facility periodically
customer only pays interest when the account
is overdrawn
Disadvantages
Overdraft is subject to annual reviewed by
the bank. The bank has the absolute right to
withdraw the facility or charge higher interest.
Overdraft is repayable on demand.
Customer must repay in full if the bank
decides to withdraw the facility granted.
the overdraft interest rate is higher than a
loan.

(2) SHORT TERM BANK LOAN

• A contract which a borrower agrees to make interest and principal payments on specific
dates to the lender.
• It is a loan made by a financial institution to business
• It’s initial maturity less than 1 year.
• Commercial banks are a source of short-term financing for non-financial corporation.
 OVERDRAFT
It is used to finance working capital
It is repayable on demand ie. The bank has
the right not to renew the facility
TERM LOAN
It is used to finance purchase of non-current
asset
If the periodic installments are adhered to,
the borrower does not have to worry
whether the bank will renew the facility or
not.

There is no periodic payment of installments There are periodic payments of installment

that cover both interest and principal.

(3) ACCOUNT PAYABLE (TRADE CREDIT)

• Account payable is the percentage of unsecured short-term financing for business.
• The percentage is larger for smaller firms.
• Small companies often do not qualify for financing from other sources, they rely especially
heavily on trade credit.
Trade credit is one of the best forms of short-term credit because:
• Trade credit does not carry any interest charges.
• Trade credit need not be negotiated regularly.
The amount of trade credit will increase as business increases. In that sense, there is no fear of
insufficient credit.

(4) FACTORING
• An arrangement to have debts collected by a factor which advances a proportion of the
money it is due to collect
• Factoring enables companies to overcome the problem of insufficient cash.

Advantages of Factoring
• Relieved from the collection of account receivable. Save time
• Relieved from the risk of default by purchasers.
• Smoother cash flow and financial planning.
• Factors will credit check your customers and can help your business trade with better quality
customers.

Disadvantages of Factoring
• A reduction in profit margin on each order or service fulfilment.
• May reduce the scope for other borrowing
• Factors will restrict funding against poor quality debtors or poor debtor spread.
• How the factor deals with the firm’s customers will affect what the customers think of the
firm.
Advantages of Short-Term Financing
Speed
short-term loan can be obtained much faster than a long-term loan. Lenders will insist on a more
thorough financial examination before extending long-term credit.
Flexibility
a firm may not want to commit itself to long-term debt if it needs funds for seasonal or cyclical
use
Cost of Long-term debts versus short-term debt
The yield curve is normally upward sloping, indicating that interest rates are generally lower on
short-term debt.

Disadvantages of Short-Term Financing

Risk
Short-term credit is riskier for two reasons:

The interest expense of short-term debt will fluctuate widely at time going quite high.
If a firm borrows heavily on a short-term basis, a temporary recession may make it impossible to
repay the debt on schedule.
If the borrower is in a weak financial position, the lender may not extend the loan, which
could force the firm into bankruptcy.