L5 FINANCIAL MANAGEMENT

CORE CONCEPTS IN FINANCIAL MANAGEMENT

Question 1.
Risk is not the same as uncertainty. Risk refers to the possibility that the actual
return may be different (usually worse) than the expected return. Uncertainty, in
investment terms, can be used to describe a situation when there are multiple
outcomes (returns) and the likelihood of each outcome cannot be predicted.

Return is what an investor expects in exchange for accepting risk. Again, in

investment terms this usually means income or capital growth or both.

From a rational investor's point of view, risk and return should be positive correlated.
That is, the riskier the investment is, the more return it should generate. This is
because a rational investor will require greater compensation (return) for accepting a
situation that could result in an unacceptable return or even negative return (i.e.
higher risk).

Further reading: see Watson and Head: Section 1.1.2

Question 2.
The term time value of money refers to the fact that the value of money changes
over time. Investment cashflows, whether by a company or an individual, tend to
occur over periods of time. Sometimes these time periods are very long, which can
lead to a substantial change in the value of the investment and exposes the
investment to certain pressures.

There are 3 main factors when considering the time value of money:

(a) Time - intrinsically most people would prefer to receive money now rather than at
some point in the future. If you have it now you can spend it now or you can invest it
until you are ready to spend it. From that point of an amount of money received now
is more valuable that the same amount of money received at some point in the
future.

(b) Inflation - inflation erodes the purchasing power of money in the future.
Consequently, an amount of money received now will have more purchasing power
(i.e. will buy more goods and services) than the same amount of money received in
the future.

(c) Risk - if you have money in your possession (i.e. you receive it now) then the risk
of not receiving the money at all or receiving an amount lower than expected is zero.
Money receivable in the future is subject to risk of non-payment or reduced payment.
Therefore, it is always preferable to receive an amount of money now rather than the
same amount of money at some point in the future.

Further reading: see Watson and Head: Section 1.1.1

Question 3.
(a) £1,000 x 1.125 = £1762.34 (also same as £1000/0.567 from tables)
(b) £1,000/ x 0.567 = £567 (also same as £1000/1.125)
(c) £1,000/0.12 = £4167 (often referred to as a perpetuity)

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 L5 FINANCIAL MANAGEMENT
CORE CONCEPTS IN FINANCIAL MANAGEMENT

(d) £1,000 x 3.605 = £3605 (3.605 is 12%/5yr cumulative factor from tables)
Question 4.
Son's Compounded
Date age value of deposit
Jan-20 3 1557.97
Jan-21 4 1512.59
Jan-22 5 1468.53
Jan-23 6 1425.76
Jan-24 7 1384.23
Jan-25 8 1343.92
Jan-26 9 1304.77
Jan-27 10 1266.77
Jan-28 11 1229.87
Jan-29 12 1194.05
Jan-30 13 1159.27
Jan-31 14 1125.51
Jan-32 15 1092.73
Jan-33 16 1060.90
Jan-34 17 1030.00 This is the last payment as Maurice's son will be 18 before Jan 35
19,156.88

The total investment value when Maurice's son reaches 18 will be £19,156.88 (by
Jan 2035). His university course fees will be 3 x £9000 = £27,000. Therefore,
Maurice will have a shortfall of £27,000 - £19,157 = £7,843

Question 5.
The finance manager's 3 main decision areas are generally accepted to be:

(a) Investment decisions: means the analysis, advice and approval of allocation of
funds to legal and regulatory, discretionary or developmental spend. In reality this
means the finance manager will have a role in analysing the investment and
recommending it for approval or not.

Examples of investment decisions:

 The split of funds between non-current assets and current assets

 The relationship between current assets and current liabilities
 The selection of appropriate new investment projects
 The effect of investment decisions on the risk profile of the company

(b) Financing decisions: these concern the raising of funds. There are many aspects
for a finance manager to consider when raising funds including cost, duration, risk,
effect on capital structure (gearing) and subsequent effect on other finance costs, as
well as availability, currency and competitor financing structure. The decision of how
internal sources of finance (predominantly retained earnings) are used also falls into
this decision area.

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CORE CONCEPTS IN FINANCIAL MANAGEMENT

Examples of financing decisions:

 size and duration of the funding requirement

 level of internal finance available and how much is used
 availability of external finance including the access to external markets
 the different types of external finance that are available, what their cost is and
how much of each type is used
 how raising new finance impacts on the company’s existing capital structure

(c) Dividend decisions: these are a consideration of retention of cash versus

distribution of cash. In essence, a finance manager must consider from a cost of
funding point of view of where the balance lies between retaining cash in the
company to use for future investments (and therefore reducing funding cost) versus
distributing cash to shareholders, which may have a long term reduction in the cost
of equity and make raising further equity finance more palatable (to shareholders).

Examples of dividend decisions:

 how much dividend to pay to shareholders at a particular point in time

 the long-term strategy in terms of dividend payments over time
 whether to use scrip dividends and special dividends

The key to the 3 decision areas for a finance manager is to recognise that they are
interrelated. Investment decisions can only be made once financing costs have been
considered. Additionally, financing decisions can only be made once the dividend
policy has been considered (for predominantly equity funded companies).

Further reading: see Watson and Head: Section 1.2