Chapter 01: Introduction

Goals and objectives of financial management of public and private sector enterprise
GOALS OF FINANCIAL MANAGEMENT OF PUBLIC SECTOR ENTERPRISE
Public sector enterprise has an ongoing obligation to build the relationship with Public Bodies to
ensure full compliance with the Public Bodies. Every effort is made to ensure the public bodies
are structured and supported in its goals and objectives through ongoing pursuit of higher service
standards, mutual respect, accountability and transparency.

GOAL 1: Strengthen Public Bodies governance and regulatory frameworks.

GOAL 2: Enhance the profitability, compliance, financial sustainability and service delivery of
Public Trading Bodies.

GOAL 3: Enhance the compliance, financial sustainability and service delivery of Public
Beneficial and Mutual Bodies.

GOAL 4: Effective identification, implementation and monitoring of PPP and Privatization

programs.

GOAL 5: Efficient institutional support services.

OBJECTIVES OF FINANCIAL MANAGEMENT OF PUBLIC SECTOR ENTERPRISE

The general objectives of public sector are:

(a) To provide required investment and promotion of industrial activity by way of indirect public
investment either by supplying financial assistance to private sector or to supply infrastructural
and basic activities;

(b) To supply socio-economic developmental opportunities which should not be transferred to

private sector undertakings;

(c) To nationalize those companies which are foreign dominated,

(d) To supply activities relating to import-substituting and export-promoting which are essential
for the development of the country;

(e) To develop savings by mobilizing resources with the help of proper public sector prices more
quick than others;
(f) To introduce certain activities to take the benefit of foreign aid and co-operation in the public
sector;

(g) To make a balanced regional development by establishing regional promotional undertakings

in less developed regions.
(h) To protect the interest of small farmers by transferring all private licences to the corporations
of agricultural reforms;

(i) To control the concentration of economic power and wealth as well;

(j) To make a social control on long term capital by supplying the necessary financial assistance
through public financial institutions which are quite justified;

(k) To supply necessary finance for various development programs which are essential for the
development of the country;

(l) To make opportunities for employment and to form a rational society which is absolutely
desired;

(m) To re-distribute incomes either by raising wage levels and checking higher salary level or by
supply outputs at a concessional rate to the poor etc.

(n) To generate surplus resources for future growth and development; and

(o) To use human resources and material resources in a better way.

GOALS OF FINANCIAL MANAGEMENT OF PRIVATE SECTOR ENTERPRISE

Goal 1: To ensure profitability in the market.

Goal 2: To protect equity financing & debt financing.
Goal 3: To provide the information and tools to maximize competitiveness and enable economic
growth for Bangladeshi private industries, workers, and customers.
Goal 4: Foster science and technological leadership by protecting intellectual property,
enhancing technical standards, and advancing measurement science.
Goal 5: Observe, protect, and manage the Earth’s resources to promote environmental
stewardship.

OBJECTIVES OF FINANCIAL MANAGEMENT OF PRIVATE SECTOR

ENTERPRISE
(a) To earn high profit.
(b) To maximize the wealth of shareholders.
(c) Growth.
(d) To fulfill needs and wants of the people.

Examples:
Multinational companies
Big corporations

WHAT ARE THE PROBLEMS & PROSPECTS OF FINANCIAL MANAGEMENT

PRACTICE IN BANGLADESH?

PROBLEMS FACED BY PUBLIC & PRIVATE ENTERPRISES IN BANGLADESH

THE FOLLOWING ARE THE PROBLEMS FACED BY PUBLIC & PRIVATE
ENTERPRISES:

1. Bureaucratic management: The organizations are run by bureaucrats who may not have
knowledge of running an enterprise or knowledge of the industry trends and practices.

2. Lack of autonomy: These enterprises lack freedom and flexibility. They are subject to the
control of the politicians and bureaucrats. Due to this, their performance is affected.

3. Delayed decisions: Decisions are delayed due to red-tapes and bureaucratic procedures. A
file may have to pass through many officials for approval before a decision can be taken.
By the time a decision is taken, the business environment might have undergone
considerable changes.
4. No clear-cut price policy: There is no clear cut price policy. Certain organization follow a
cost plus price policy, some administered pricing, a few dual pricing followed by those
adopting association pricing. There is no clarity with regard to the price policy.

5. Delays and cost overruns: Due to poor planning, lack of funds, mismanagement etc.
many projects face delays and the consequent cost overruns. It is common to find new
projects being announced without earlier projects being completed.

6. High overheads: Many of these organizations incur high overheads. There is very little
focus on cost control and cost reduction. Wastage of resources are rampant. Many
organizations even maintain entire townships and incur high costs.

7. Over-staffing: The salary costs and pension costs of many of these organizations are high.
It is because government considers these organizations as generators of employment and
many of them are overstaffed.

8. Poor productivity: Due to reliance on outdated technology, lack of upgradation and

inefficiencies, low levels of employee motivation and poor work culture, the productivity
of many of these enterprises is quite low.
 9. Lack of proper planning: Planning is poor and in some cases even absent. Projects are
commenced without detailed analysis and planning. This results in losses and delays.

10. Low capacity utilization: Capacity utilization is very low because of inefficiencies in
management, inefficiencies in processes and procedures and low employee efficiency.

11. Poor profitability: The profitability of the enterprises is quite low due to several
inefficiencies in the way in which they are managed. Many enterprises incur heavy losses
and the government regularly infuses capital to run them.

12. xv. Low quality of output: The output of public enterprises, whether it is a product or a
service, is not of high quality. This is due to lack of investment in technology, low
employee morale, inferior quality of raw materials, poor work culture and lack of quality
focus. Therefore they are not able to compete with the superior quality products and
services offered by the private sector.

WHAT ARE THE TECHNIQUES OF PUBLIC FINANCIAL MANAGEMENT?

DESCRIBE IN DETAILS.

WORKING IN PUBLIC FINANCIAL MANAGEMENT REQUIRES A STRONG

UNDERSTANDING OF FINANCIAL ANALYSIS TECHNIQUES, INCLUDING:

1. Trend and Ratio Analysis:

Involves comparing financial ratios over multiple years to assess a company’s financial health
and performance trends. Example: Comparing November earnings across different years.

2. Growth Rates:
Refers to the percentage change in a variable over time, such as revenue or GDP. Often
expressed as a compound annual growth rate (CAGR).
Example: Profit Rate (PR) = 30,000250,000×100=1.2\frac{30,000}{250,000} \times 100 =
1.2%250,00030,000×100=1.2

3. Time Value of Money (TVM):

Money today is worth more than the same amount in the future due to its earning potential.
Formula:
FV = PV × (1 + i/n)ⁿᵗ
Example:
Invest $10,000 at 10% for 1 year → FV = $11,000

4. Inflation Adjustment:
Adjusts financial figures to account for inflation or deflation, ensuring comparability over time.

5. Forecasting Techniques:
Tools used to predict future outcomes. Techniques include:
  Delphi Technique: Uses expert feedback in iterative rounds to reach consensus.
 Scenario Writing: Presents best, worst, and most likely outcomes.
 Subjective Forecasting: Relies on personal opinions and brainstorming, prone to bias.
 Time-Series Forecasting: Uses historical data over time to identify trends and patterns
(trend, cyclical, seasonal, irregular).

6. Cash Debt Coverage:

Measures a firm’s ability to cover current liabilities with operating cash flow. A 1:1 ratio is
considered financially healthy.

7. Investment:
The purchase of assets with the expectation of generating future income or profit. In finance, this
often includes stocks, bonds, real estate, etc.

4. DESCRIBE ORGANIZATIONS & MANAGEMENT STRUCTURES.

TYPES OF ORGANIZATIONAL STRUCTURE IN MANAGEMENT

THERE ARE DIFFERENT TYPEES OF ORGANIZATIONAL STRUCTURE IN

MANAGEMENT. FOLLOWINGS ARE SOME OF THEM:

Flat Organizational Structure is commonly used by small companies with fewer than 20
employees. It features minimal management layers, allowing for quick decision-making and
reduced bureaucracy.

Functional Organizational Structure organizes employees by job function, such as marketing,

finance, or R&D. It suits small companies that are project-driven, enabling efficient delegation of
tasks and clear reporting lines within departments.

Product Organizational Structure groups management based on product types. Common in

retail, this structure allows managers to focus on specific product lines. Local support functions
like HR or marketing may still be needed for each region to tailor operations to local needs.

Geographical Organizational Structure is suitable for small businesses that operate in multiple
regions. It decentralizes functions such as marketing and finance, placing relevant personnel in
different locations to better address regional consumer preferences. This enhances local
responsiveness and service effectiveness.

DISCUSS ABOUT CONTROL MEASURES OF FINANCIAL MANAGEMENT.

CONTROL MEASURES OF FINANCAIAL MANAGEMENT
MEANING OF FINANCIAL CONTROL MEASURES
Financial control measures are those measures that is put in place to ensure that financial related
assets or properties of an organization are safeguarded, either from externals or employees of an
organization from any threat whatsoever, whether by theft, loss or misappropriation (intentional
or otherwise). Simply put, as those policies, procedures practices and organizational structures
which are implemented to reduce financial risk to the organization. They are developed to
provide reasonable assurance to management that the organization business objectives will be
achieved and risk prevented, or detected and corrected.

CLASSIFICATIONS OF CONTROL MEASURES

Class Function Example

Preventive - Detect problems before they arise - Monitor both - Employ only qualified
operation and input - Segregate duties (deterrent staff - Segregate duties -
factor) - Attempt to predict potential problems Control access to
before they occur and make adjustments - Prevent an physical facilities
error, omission, or malicious act from occurring
Detective - Use controls that detect and report the occurrence - Duplicate checking of
of an error, omission, or malicious act calculations - Past due
account reports - Internal
audit functions
Corrective - Minimize the impact of a threat - Remedy - Contingency planning -
problems discovered by detective control - Identify Backup procedures
the cause of a problem - Correct errors arising from a
problem
 Chapter 02: Capital Budgeting Techniques

What is the financial manager’s goal in selecting investment projects for the
firm? Explain how it helps managers achieve their goal.

The financial manager's primary goal in selecting investment projects for the firm is to maximize
shareholder wealth, which is typically reflected by maximizing the firm's stock price or firm
value.

How this goal helps managers achieve their objective:

1. Value Creation:
o Investment projects are chosen based on their potential to generate returns greater
than their costs.
o By selecting projects with positive Net Present Value (NPV), managers ensure
that the firm is investing in opportunities that add value to the business.
2. Efficient Use of Capital:
o Capital is limited, so managers must allocate it to projects that offer the best risk-
adjusted returns.
o This prevents wasteful spending and ensures resources are directed to the most
productive uses.
3. Risk Management:
o Part of project evaluation involves assessing risk.
o Managers aim to take on projects that align with the firm’s risk profile and
strategic goals, helping to protect and grow shareholder wealth over time.
4. Market Confidence:
o Investors closely watch how companies invest their money.
o Smart investment decisions signal good management and sound strategy,
increasing investor confidence and potentially boosting stock prices.
5. Long-Term Growth:
o By continuously selecting value-creating projects, the firm can expand operations,
enter new markets, or improve efficiency—leading to sustained profitability and
growth.

What is the payback period? How is it calculated?

The payback period is the amount of time it takes for an investment to recover its initial cost
from the cash inflows it generates. In simple terms, it tells you how long it will take to get your
money back from a project.
How is it calculated?

There are two common methods:

1. When cash inflows are even (same every year):

Payback Period=Initial Investment /Annual Cash Inflow

Example:
If a project costs $50,000 and returns $10,000 per year:

Payback Period=50,000/10,000=5 years

2. When cash inflows are uneven:

You add up the cash inflows year by year until the total equals the initial investment.

Example:
Initial investment = $40,000
Year 1: $10,000
Year 2: $15,000
Year 3: $10,000
Year 4: $10,000

Cumulative inflows:

 After Year 1: $10,000

 After Year 2: $25,000
 After Year 3: $35,000
 After part of Year 4: $40,000 → Payback = 3 + 5,00010,000\frac{5,000}
{10,000}10,0005,000 = 3.5 years

What weaknesses are commonly associated with the use of the payback
period to evaluate a proposed investment?

Weaknesses of Using the Payback Period:

1. Ignores Time Value of Money (TVM):

o It doesn’t account for the fact that money received today is worth more than
money received later.
2. Ignores Cash Flows After the Payback Period:
o A project may have strong long-term profits, but if those occur after the payback
period, they are ignored.
3. No Clear Decision Rule for Ranking Projects:
o It doesn’t help in comparing projects with different lifespans or returns—just
based on speed of return.
 4. No Consideration of Risk:
o It treats all projects equally regardless of risk involved.

What is capital budgeting?

The process of evaluating and selecting long-term investments that contribute to the firm’s goal
of maximizing owners’ wealth.

How Does Capital Budgeting Add Value to the Firm?

1. Maximizes Shareholder Wealth

o By selecting only those projects that are expected to generate returns higher
than their costs, the firm increases its overall value.
o This directly benefits shareholders by increasing the stock price and long-term
profits.

2. Efficient Allocation of Capital

o Capital is limited. Capital budgeting ensures that the firm uses its funds wisely
and profitably, not on low-return or risky ventures.

3. Supports Strategic Growth

o Well-chosen investment projects help the firm expand, enter new markets, or gain
competitive advantages.

4. Risk Management

o The capital budgeting process includes analysis of risks and uncertainties

involved in a project. This helps the firm avoid poor investments.

5. Improves Long-Term Planning

o Since capital budgeting involves forecasting future cash flows and assessing
future business conditions, it strengthens the firm’s long-term strategic and
financial planning.

6. Prioritizes Projects Based on Value

o Firms often face multiple investment options. Capital budgeting helps rank these
based on financial metrics like:
 Net Present Value (NPV)
  Internal Rate of Return (IRR)
 Payback Period
So, the best-value projects are chosen.

When Do Conflicting Rankings of Projects Using NPV and IRR Occur?

Conflicting rankings between NPV (Net Present Value) and IRR (Internal Rate of Return)
happen when the two methods give different preferences for choosing among competing
investment projects.

This typically occurs in two main situations:

1. Mutually Exclusive Projects

Projects are mutually exclusive when only one can be chosen (e.g., choosing between two
different machines to buy).

 Conflict arises if:

o Project A has a higher IRR, but
o Project B has a higher NPV.

 Always choose the project with the higher NPV, because NPV directly measures the
value added to the firm, while IRR can be misleading in such cases

2. Non-Conventional Cash Flows

Cash flows are non-conventional when they change signs more than once over the life of the
project.
Example: An investment with outflows (−), then inflows (+), then another outflow (−).

 This may result in multiple IRRs, or the IRR may not even exist.
 NPV still gives a clear, single value.

What effect do sunk costs and opportunity costs have on a projects net cash
flows?

Sunk Costs
Sunk costs are costs that have already been incurred and cannot be recovered.

Effect on Net Cash Flows:

Sunk costs should not affect a project’s future net cash flows. Since they are past expenses, they
are irrelevant for future decisions. When evaluating a project, you ignore sunk costs because they
do not change regardless of whether the project proceeds or not.

Example:
If you spent $100,000 on market research last year, that amount is a sunk cost. It won’t impact
the incremental cash flows from starting a new project today.

Opportunity Costs

Opportunity costs represent the value of the next best alternative foregone by choosing a
particular project.

Effect on Net Cash Flows:

Opportunity costs should be included in the calculation of a project’s net cash flows. They
reflect the potential benefits lost by not pursuing the alternative option.

Example:
If you use a piece of equipment for Project A instead of renting it out to another company (which
would generate $10,000 in cash flow), that $10,000 is an opportunity cost. It reduces the net
benefit of Project A.

Risk in terms of cash flows from a capital budgeting project

Risk refers to the uncertainty or variability in the expected future cash flows of a project.
Because these cash flows are projections, actual inflows or outflows might be different due to
factors like market changes, cost overruns, competition, or economic conditions. This variability
means the project may not deliver the anticipated returns, creating risk for investors or decision-
makers.

2. How determination of the breakeven cash inflow can be used to gauge project
risk?

 Breakeven cash inflow is the minimum amount of cash the project must generate to
cover all costs (including investment, operating expenses, and capital costs) without
incurring a loss.
 By calculating this breakeven point, you can assess the margin of safety the project has.
If the breakeven cash inflow is very close to the expected cash inflow, the project is
riskier because there is little room for error — even a small shortfall can lead to losses.
 Conversely, if the expected cash inflow is much higher than the breakeven point, the
project is less risky because it has a cushion to absorb adverse changes.

What are Incremental Cash Flows?

 Incremental cash flows are the additional cash inflows and outflows directly resulting
from undertaking a project.
 They represent the difference between the company’s cash flows with the project and
without the project.

Why it is important to evaluate based on incremental cash flows?

1. Focuses on Relevant Cash Flows:

Only cash flows that change because of the project should be considered. Ignoring this
can lead to wrong decisions by including irrelevant costs or revenues.
2. Avoids Sunk Costs and Irrelevant Expenses:
Sunk costs (already incurred) or costs unrelated to the project don’t affect the incremental
cash flows, so they shouldn’t affect the project evaluation.
3. Reflects True Economic Impact:
Incremental cash flows capture the actual financial impact of accepting or rejecting the
project, providing a clear picture of its profitability.
4. Avoids Double Counting:
By focusing only on changes, it prevents counting cash flows that would happen anyway,
whether the project goes ahead or not.

What is the difference between the strategic NPV and the traditional NPV?
Do they always result in the same accept-reject decisions?

The difference between traditional NPV and strategic NPV lies in their scope of evaluation.
Traditional NPV (Net Present Value) focuses strictly on the quantifiable and direct financial
cash flows associated with a project. It involves discounting future cash inflows and outflows to
their present value and subtracting the initial investment. If the NPV is positive, the project is
typically considered acceptable because it is expected to add value to the firm.

On the other hand, strategic NPV takes a broader perspective. It not only considers financial
cash flows but also includes strategic benefits that may not be immediately measurable. These
benefits could involve entering a new market, gaining a competitive edge, or creating
opportunities for future profitable projects. Strategic NPV often includes the value of real
options, such as the option to expand, delay, or abandon a project in the future.

Because of this difference in scope, traditional and strategic NPV do not always lead to the
same accept-reject decisions. A project with a negative traditional NPV might be accepted
under strategic NPV if it supports long-term goals or opens up future opportunities. Therefore,
strategic NPV is especially useful when evaluating projects with long-term or intangible
benefits.
How is an investment’s NPV related to the firm’s market value?

An investment’s Net Present Value (NPV) directly impacts a firm's market value. A positive
NPV indicates that the project is expected to generate returns greater than its cost, thereby
increasing the firm’s future cash flows. This leads to a higher intrinsic value, which can raise the
firm’s stock price and market capitalization. In contrast, a negative NPV reduces value. Since a
company’s market value reflects the present value of expected future cash flows, every dollar of
positive NPV theoretically increases the firm’s market value by one dollar, aligning investment
decisions with the goal of maximizing shareholder wealth.

Explain the similarities and differences between NPV, PI, and EVA

Aspect NPV (Net Present PI (Profitability EVA (Economic Value

Value) Index) Added)
Definition Present value of cash Ratio of present value Net operating profit after
inflows minus of inflows to outflows taxes minus capital cost
outflows
Purpose Measures value Measures value per Measures value added by
created from an unit of investment operations after cost of
investment capital
Formula NPV = PV of PI = PV of inflows / EVA = NOPAT –
inflows – PV of PV of outflows (Capital × Cost of
outflows Capital)
Decision Rule Accept if NPV > 0 Accept if PI > 1 Positive EVA indicates
value creation
Value Absolute value (in Relative measure (a Absolute value (in
Indicator currency) ratio) currency)
Focus Area Project-specific Project-specific Firm-wide performance
Capital Yes Yes Not typically used for
Budgeting individual projects
Use
Time Value Considers Considers Considers
of Money

How can firms mitigate currency risk and political risk when investing in a
foreign country?

Firms can mitigate currency risk by using financial instruments like forward contracts, options,
and currency swaps to hedge against exchange rate fluctuations. They can also match revenues
and expenses in the same currency, borrow locally, or use natural hedging by setting up local
operations. Diversifying investments across multiple countries also spreads currency exposure.
To manage political risk, firms can buy political risk insurance from organizations like MIGA or
private insurers. Forming joint ventures with local partners, hiring local employees, and sourcing
locally can help build goodwill and reduce government hostility. Including legal protections such
as arbitration clauses in contracts and investing in countries with strong bilateral investment
treaties also reduce exposure. Conducting thorough political risk assessments before entering a
market is essential.

By combining financial hedging with operational and strategic measures, firms can effectively
reduce the impact of both currency and political risks when investing abroad.

Describe the three types of net cash flows for a capital budgeting project.

In capital budgeting, three types of net cash flows are considered:

1. Initial Investment: This is the cash outflow at the beginning of the project, covering
costs such as purchasing equipment, installation, and any required increase in working
capital. It occurs at Year 0 and represents the initial cost to start the project.
2. Operating Cash Flows: These are the yearly net cash inflows generated by the project
during its operational life. They include revenues minus operating expenses, adjusted for
non-cash charges like depreciation. Operating cash flows occur from Year 1 through the
project’s lifespan and indicate the project’s ongoing profitability.
3. Terminal Cash Flow: This occurs at the end of the project and includes cash inflows
from the salvage value of assets and the recovery of working capital. It may also consider
any tax effects related to asset disposal.

Discuss NPV and IRR in terms of conflicting rankings and the strengths of
each approach.
Conflicting rankings of projects frequently emerge from NPV and IRR as a result of differences
in the reinvestment rate assumption as well as the magnitude and timing of cash flows. NPV
assumes reinvestment of intermediate cash inflows at the more conservative cost of capital; IRR
assumes rein vestment at the project’s IRR. Theoretically speaking, the NPV approach is
superior because it does a better job of ranking projects and because it does not suffer from some
of the mathematical quirks that occasionally affect IRR calculations. Even so, many firms use the
IRR approach because it has a very intuitive interpretation and is easy for managers to
understand and to communicate to others.

Unlimited Funds versus Capital Rationing

Aspect Unlimited Funds Capital Rationing
Capital Unlimited Limited
Availability

Investment Accept all projects with positive Only select most profitable projects
Criteria NPV or IRR > cost of capital within budget constraints

Number of All viable (profitable) projects A limited number based on capital

Projects Accepted and priority

Decision-Making Project profitability only Profitability + capital efficiency

Focus

Common Tools NPV, IRR NPV, IRR, Profitability Index (PI),

Used Linear Programming

Constraints None Financial, operational, or policy-

based constraints

Risk Management Less focus on constraints and risk Strong focus on risk and capital
allocation efficiency

Objective Maximize overall returns by Maximize returns under limited

funding all viable projects resources

Definition A situation where a firm has A situation where a firm has

unrestricted access to capital for limited capital and must prioritize
investments. investments.

Accept–Reject vs. Ranking Approaches

Aspect Accept–Reject Approach Ranking Approach

Definition Evaluates each option against a Orders all options by preference or

fixed criterion to accept or reject it performance without fixed cutoff

Purpose To determine if an option is To identify the most preferred or

acceptable or not optimal option

Decision Basis Absolute – based on set standards Relative – based on comparison

among alternatives

Outcome Options are either accepted or Options are ranked from best to
rejected worst

Use Case Filtering based on qualifications Choosing the best among several
 or standards acceptable options

Number of Can be many, one, or none All options are evaluated and
Acceptable ranked
Options

Flexibility Less flexible – rigid threshold More flexible – allows trade-offs

and comparisons

Complexity Simpler to implement More complex – involves detailed

comparison

Payback Period
Decision criteria

When firms use the payback period to decide whether to accept or reject an investment
opportunity, managers follow this decision rule:

 If the payback period is less than the maximum acceptable payback

period, accept the project.
 If the payback period is greater than the maximum acceptable payback
period, reject the project.

Net present value (NPV)

A capital budgeting technique that measures an investment’s value by calculating the present
value of its cash inflows and outflows.

Decision criteria

When managers use the NPV method to decide whether to accept or reject an investment
proposal, the decision rule they follow is:

 If the NPV is greater than $0, accept the project.

 If the NPV is less than $0, reject the project.

Internal Rate of Return (IRR

Decision criteria

When managers rely on the IRR approach to accept or reject proposed investments, the decision
rule they apply is:

 If the IRR is greater than the cost of capital, accept the project.
 If the IRR is less than the cost of capital, reject the project.
Conflicting rankings
Conflicts in the ranking given a project by NPV and IRR, resulting from differences in the
magnitude and timing of cash flows

.Multiple IRRs

More than one IRR resulting from a capital budgeting project with a nonconventional cash flow
pattern; the maximum number of IRRs for a project is equal to the number of sign changes in its
cash flows.

Pure economic profit

A profit above and beyond the normal competitive rate of return in a line of business.

Initial investment: The incremental cash flows for a project at time zero

Operating cash flows: The net incremental after-tax cash flows occurring each
period during the project’s life.
Terminal cash flows: The net after-tax cash flow occurring in the final year of the project

Operating Cash Flows vs Terminal Cash Flows

Point Operating Cash Flows (OCF) Terminal Cash Flows (TCF)

Meaning Cash flows during the life of the Cash flow at the end of the project
project

When it Every year or regularly during the Only at the end (last year) of the
happens project project

Includes Revenue, expenses, taxes Salvage value, working capital

recovery, final tax effects

Purpose To show ongoing profitability To capture final value or cost of

shutting down the project

Recurring? Yes (happens yearly or monthly) No (happens once, at the end)

Example Cash earned from sales each year Money received from selling
machines at the end

Importance Shows the project's ability to Shows final return and closing value
generate cash while running
Explain how the terminal cash flow is calculated for replacement projects.
Terminal Cash Flow Calculation for Replacement Projects

When a company replaces an old asset with a new one, the terminal cash flow at the end of the
replacement project's life includes several components related to the old and new assets.

Key components involved:

1. Salvage Value of the New Asset

The amount you get by selling the new asset at the end of its useful life.

2. Recovery of Net Working Capital (NWC)

Any working capital invested in the project is recovered at the end (e.g., inventory,
receivables).

3. Tax Effects from Sale of New Asset

If the new asset is sold for more or less than its book value, there will be a tax impact
(capital gains tax or tax savings from a loss).

4. Sale of the Old Asset (if applicable)

If the old asset is sold at the time of replacement, this sale amount minus book value
creates a tax impact.

5. Tax Effects from Sale of Old Asset

Gains or losses on the sale of the old asset generate taxes or tax savings.

The initial investment is the total upfront cash required to acquire a new asset,
considering both the costs associated with the new asset and the proceeds from disposing
of the old one.

Explain how to use each of the following inputs to calculate the initial
investment: (a) cost of the new asset, (b) installation costs, (c) proceeds from
the sale of the old asset, (d) tax on the sale of the old asset, and (e) change in
net working capital.
1. Cost of the New Asset: This is the purchase price of the new asset. Example: Cost of new
asset: $325,000

2. Installation Costs: These are additional expenses incurred to make the new asset operational,
such as transportation, setup, and testing costs. Example: Installation costs: $5,000

3. Proceeds from the Sale of the Old Asset: This is the amount received from selling the old
asset. It is a cash inflow that reduces the total initial investment. Example: Proceeds from sale
of old asset: $200,000
4. Tax on the Sale of the Old Asset: When selling an old asset, taxes may be due on any capital
gains. The capital gain is calculated as the difference between the sale price and the book value
of the old asset.

Example:

 Book value of old asset: $156,000

 Capital gain: $200,000 (sale price) − $156,000 (book value) = $44,000

 Tax on capital gain: $44,000 × 40% = $17,600

5. Change in Net Working Capital (NWC): This represents the additional investment in
current assets (like inventory or receivables) required for the new asset. An increase in NWC is
an outflow, while a decrease is an inflow. Example: Increase in NWC: $1,500,000

Initial Investment = (Cost of New Asset + Installation Costs) − Proceeds from Sale of Old
Asset + Tax on Sale of Old Asset + Change in NWC

Net working capital: The difference between the firm’s current assets and its
current liabilities.

Change in net working: Capital The difference between the change in current
assets and the change in current liabilities.

Dividends Policy

How Do Dividends Work?

Dividends work in the following manner:

 Declaration: The company's board of directors declares a dividend at a board meeting.

This declaration includes the dividend amount per share.
 Payment Process:
1. Announcement: The company announces the dividend, including the size, ex-
dividend date, record date, and payment date.
2. Ex-Dividend Date: If you purchase a stock on or after this date, you will not
receive the next dividend payment.
3. Record Date: Shareholders who are on the company's books on this date will
receive the dividend.
4. Payment Date: The date on which the dividend will be paid out to shareholders.
  Impact on Share Prices: On the ex-dividend date, the stock price typically drops by
about the amount of the dividend, reflecting the dividend payout.
Reinvestment
 Dividend Reinvestment Plans (DRIPs): Some companies offer options where
shareholders can automatically reinvest the cash dividends to purchase additional shares
in the company.
 Taxation: Dividends are often taxable income for the recipients. The tax rate can vary
based on the type of dividend and the shareholder's tax situation.


How Often are Dividends Paid?

A corporation commonly pays out dividends on a quarterly basis. However, there

is no hard and fast rule governing the frequency of payments; some organizations
only issue one dividend payment per year. Also, if a business is not generating
sufficient cash for a dividend, or the board of directors feels that the money is
better put to other uses, then a dividend may be skipped entirely.

Cum dividend vs Ex-dividend

Cum Dividend:

1. Definition: A stock is considered "cum dividend" when it is trading with the right to
receive the next dividend payment.
2. Entitlement: Buyers of a stock "cum dividend" are entitled to the upcoming dividend,
even if they sell the stock before the payment date.
3. Timing: The "cum dividend" status exists until the ex-dividend date.

Ex-Dividend:

1. Definition: A stock is considered "ex-dividend" when it is trading without the right to

receive the next dividend payment.
2. Entitlement: Buyers of a stock "ex-dividend" do not receive the upcoming dividend
payment; it goes to the seller.
3. Timing: The ex-dividend date is usually one business day before the record date, which
is the date the company uses to determine who is eligible to receive the dividend.
4. Price Adjustment: Typically, the stock price will be adjusted downwards by
approximately the dividend amount on the ex-dividend date to reflect the fact that the
dividend is no longer attached to the stock

Objectives of Dividend Policy

A dividend policy refers to a company’s strategy about how much profit to distribute to
shareholders as dividends and how much to retain for reinvestment. The key objectives of a
sound dividend policy include:
1. Maximizing Shareholder Wealth: The primary goal is to maximize the value of the firm and
enhance shareholder wealth.

2. Providing Stable and Predictable Returns: A stable dividend policy builds investor
confidence by offering a predictable income stream, especially for income-focused investors.

3. Ensuring Adequate Retained Earnings: The policy ensures the company retains enough
profits to fund: Future expansion, Research and development and Debt repayment.

4. Maintaining a Balance Between Dividends and Growth: A good policy maintains a balance
between rewarding shareholders (dividends) and reinvesting in the company (growth).

5. Signaling Financial Health: Dividends often serve as a signal to the market about the
company’s profitability and financial stability.

Factors Influencing Dividend Policy

1. Profitability – Dividends can only be paid from profits, so the company must stay
profitable.
2. Legal Rules – Laws may limit dividends to only what has been earned (realized profits).
3. Government Controls – Sometimes, governments restrict how much dividend can be
paid.
4. Loan Agreements – Lenders may set limits on dividend payments.
5. Inflation – The company may need to keep profits to maintain its current operations.
6. Gearing (Debt Level) – A balanced mix of debt and equity affects how much dividend is
paid.
7. Cash Position – The company must have enough cash to actually pay dividends.
8. Debt Repayment – If debt needs to be repaid soon, less cash may be available for
dividends.
9. Access to Other Finance – Small companies may retain more profits if they can’t raise
money easily elsewhere.
10. Signaling Effect – Dividends send a message to shareholders about the company’s
strength and future.

Declaration of dividend policy

The declaration of dividend policy means a company officially announces how much profit it
will give to shareholders as dividends. This decision is made by the board of directors and shared
with investors. The company also gives important details like the amount of dividend, the record
date (who will get it), and the payment date (when it will be paid). Declaring a dividend shows
that the company is earning well and helps build trust with shareholders.
Theories of dividend policy
1. Residual Theory:
A company should first use its profits to invest in projects with positive NPV (Net
Present Value). Dividends should be paid only if there’s leftover profit after all good
investment opportunities are funded.

2. Traditional View: This theory says that dividends do affect the value of a company.
A proper balance between dividends and growth can increase the share price, as
investors care about both incomes now (dividends) and future returns (growth).

3. Irrelevance Theory (Modigliani & Miller): In a world with no taxes or costs,

dividends do not affect a company’s value. Shareholders are indifferent between
receiving dividends or capital gains. The company’s value depends only on how well it
uses its assets and investments.

Retained earnings
Retained earnings are the most important single source of finance for companies, and financial
managers should take account of the proportion of earnings that are retained as opposed to being
paid as dividends.

Advantages of using retained earnings

 Retained earnings are a flexible source of finance; companies are not tied to
specific amounts or specific repayment patterns.
 Using retained earnings does not involve a change in the pattern of shareholdings
and no dilution of control.
 Retained earnings have no issue costs.

Disadvantages of using retained earnings

 Shareholders may be unhappy because retaining earnings means they get less or no
dividend payments.
 Retaining profits is not free — if dividends were paid, shareholders could invest that
money themselves and earn a return. So, the company giving up dividends has an
opportunity cost.
The case in favour of the relevance of dividend policy (and against MM's
views)
Tax Differences: Different tax rates on dividends and capital gains may make investors prefer
one over the other.

Capital Rationing: When companies have limited access to funds, retaining earnings is better
than paying dividends.

Imperfect Markets: Since it may be hard to sell shares at a fair price, some investors prefer
regular dividends to get cash for other investments.

Transaction Costs: Selling shares to get cash involves costs. So, investors prefer receiving
cash as dividends.

Lack of Information: Shareholders may not fully know the company’s future plans or profits.
Even if forecasts are shared, they may not be trusted.

Preference for Certainty: Investors usually prefer a certain, current dividend over uncertain
future gains, as the future is unpredictable.

Chapter: Working capital

Working capital (or short-term financial) management is to manage each of the firm’s
current assets and current liabilities to achieve a balance between profitability and risk that
contributes positively to the firm’s value.

Working Capital refers to the portion of a firm’s assets used in daily operations. It includes
items like cash, inventories, and accounts receivable, which regularly convert from one form to
another in the normal business cycle.

The nature, elements and importance of working capital

Nature of Working Capital

Working capital refers to the short-term funds required to sustain daily business operations. It is
characterized by:

 Short-term needs – It finances ongoing activities like purchasing materials, paying

wages, etc.

 Circular movement – Often described as a “working capital cycle”: cash → inventory

→ receivables → cash.

 Permanency and fluctuation – Part of working capital is needed continually

(permanent), while another part varies with business activity (variable).
  Liquidity and low risk – It’s more liquid and less risky than long-term assets.

 Simple accounting treatment – No depreciation needed, unlike fixed assets.

2. Elements of Working Capital

Working capital consists of two main components:

 Current Assets (Gross Working Capital):

Includes inventory, receivables (debtors), prepayments, and cash.

 Current Liabilities:
Includes payables (creditors), accruals, short-term loans, and other obligations due within
a year.

 Net Working Capital = Current Assets − Current Liabilities.

3. Importance of Working Capital

 Ensures liquidity – It helps businesses meet short-term obligations like wages, supplier
payments, and taxes on time.

 Supports profitability – Excess funds trapped in working capital earn little; optimizing
it can boost returns.

 Is critical for survival – Many profitable companies fail due to poor short-term cash
flow management.

 Balance between liquidity & efficiency – Too little working capital causes overtrading,
while too much leads to inefficiency or over-capitalization

Describe the nature of working capital and identify its elements.

Elements of Working Capital

Current Assets: Assets expected to be converted into cash or used up within a year. These
include:

 Inventory: Raw materials, work-in-progress, and finished goods.

 Trade Receivables: Amounts owed by customers.

 Cash and Cash Equivalents: Liquid assets readily available for use.

 Prepaid Expenses: Payments made in advance for goods or services to be received in the
future.

Current Liabilities: Obligations due to be settled within a year. These include:

  Trade Payables: Amounts owed to suppliers.

 Short-term Borrowings: Loans and overdrafts repayable within a year.

 Accrued Expenses: Expenses incurred but not yet paid.

 Tax Liabilities: Taxes owed to tax authorities.

Identify the objectives of working capital management in terms of liquidity

and profitability, and discuss the conflict between them.
Objectives of Working Capital Management

1. Liquidity: Ensuring the business has sufficient short-term assets to meet its short-term
obligations as they fall due. This involves maintaining adequate levels of cash, inventory, and
receivables to avoid financial distress.

2. Profitability: Maximizing the return on assets by efficiently utilizing resources. This involves
optimizing the use of current assets to generate sales and profits, thereby enhancing shareholder
wealth.

Conflict Between Liquidity and Profitability

 Liquidity vs. Profitability: There's an inherent trade-off between maintaining liquidity

and maximizing profitability.

o High Liquidity: Holding more cash or liquid assets ensures the ability to meet
short-term obligations but may result in lower returns, as these assets often earn
minimal interest.

o High Profitability: Investing in assets like inventory or extending credit to

customers can boost sales and profits but ties up resources, potentially
compromising liquidity.

 Example: Offering extended credit terms to customers can increase sales (profitability)
but delays cash inflows, affecting liquidity.

Discuss the central role of working capital management in financial

management.
Central Role of Working Capital Management in Financial Management

Working capital management is a core component of financial management, focusing on

managing a company's short-term assets and liabilities to ensure operational efficiency and
financial stability. Its central role encompasses:
 1. Ensuring Liquidity: Maintaining sufficient cash flow to meet short-term obligations,
such as paying suppliers and employees, thereby preventing insolvency.

2. Optimizing Profitability: Efficient use of current assets (like inventory and receivables)
ensures that funds are not tied up unnecessarily, allowing for better returns on
investments.

3. Managing the Working Capital Cycle: Controlling the time between paying suppliers
and receiving cash from customers to maintain liquidity and profitability.

4. Balancing Risk: Ensuring sufficient short-term assets to cover liabilities, reducing

financial distress.

5. Strategic Decision Making: Making informed choices about inventory, credit policies,
and payment terms to impact financial health.

Explain the cash operating cycle and the role of accounts payable and
accounts receivable
Cash Operating Cycle (Cash Conversion Cycle)

The Cash Operating Cycle measures the time it takes for a company to convert its investments
in inventory and other resources into cash flows from sales. It's calculated as:

Cash Operating Cycle= Inventory Days + Receivables Days − Payables Days

Where:

 Inventory Days: Average time inventory is held before sale.

 Receivables Days: Average time taken to collect payments from customers.

 Payables Days: Average time taken to pay suppliers.

Accounts Receivable (Trade Debtors)

 Definition: Amounts owed by customers for goods or services provided on credit.

 Impact on Cash Operating Cycle: Longer receivables days increase the cycle, tying up
cash for longer periods.

 Management Strategies:

o Implementing credit control measures.

o Offering early payment discounts.

 o Using factoring or invoice discounting.

Accounts Payable (Trade Creditors)

 Definition: Amounts a company owes to suppliers for goods or services received.

 Impact on Cash Operating Cycle: Longer payables days can extend the cycle, but
excessive delays may harm supplier relationships.

 Management Strategies:

o Negotiating favorable credit terms with suppliers.

o Evaluating the benefits of discounts for early settlement and bulk purchases.

Working capital characteristics of different businesses

Inventory Management

Retailers maintain low inventory levels due to quick product turnover, minimizing capital tied up
in stock. Manufacturers require higher working capital to manage larger inventories, including
raw materials and finished goods, to support production processes.

2. Accounts Payable

Retailers often pay suppliers after selling goods, sometimes using supplier credit, which helps
maintain liquidity. Manufacturers typically pay suppliers promptly to maintain good
relationships, impacting cash flow.

3. Accounts Receivable

Retailers receive immediate payment from customers (cash or card), resulting in minimal
accounts receivable. Manufacturers and wholesalers often extend credit to customers, leading to
longer receivable periods and a greater need for working capital.

Why is working capital management one of the most important and time-
consuming activities of the financial manager? What is networking capital?
Working capital management is important because it deals with managing the firm's current
assets and current liabilities, which are essential for day-to-day operations. These items
constantly change, requiring continuous monitoring and quick decision-making. Effective
management ensures the firm maintains sufficient liquidity, avoids insolvency, and maximizes
firm value. Because of the frequent and unpredictable nature of cash flows, it becomes one of
the most time-consuming tasks for financial managers.

Net working capital is the difference between the firm’s current assets and its current liabilities.
When current assets exceed current liabilities, the firm has positive net working capital. When
current assets are less than current liabilities, the firm has negative net working capital.

What is the relationship between the predictability of a firm’s cash inflows

and its required level of net working capital? How are net working capital,
liquidity, and risk of insolvency related?
Relationship Between Predictability of Cash Inflows & Required Level of Net Working Capital

1. If a company knows when and how much money is coming in (predictable cash
inflows), it doesn’t need to keep a lot of extra cash or assets on hand.
→ So, it needs less net working capital.

2. But if a company can’t predict its cash inflows, it needs to keep more cash or assets
ready just in case.
→ So, it needs more net working capital.

How Net Working Capital, Liquidity & Risk of Insolvency are Related

 Net working capital (NWC) is the difference between what a company owns short-term
(current assets) and what it owes short-term (current liabilities).
 If a company has positive NWC, it has more assets than debts → this means good
liquidity (easy to pay bills).
 Good liquidity means the company is less likely to go bankrupt (low risk of
insolvency).
 If NWC is negative, the company may not have enough to pay its short-term bills → low
liquidity, and higher risk of insolvency.

Tradeoff Between Profitability and Risk

There is a tradeoff between a firm’s profitability and its risk.

Profitability: Profitability refers to the relationship between the revenues and costs generated by
using the firm’s assets (both current and fixed) in productive activities.

A firm can increase profits by either:

1. Increasing revenues, or

2. Decreasing costs.
 3. Decreasing costs.

Risk: In working capital management, is the chance that the firm will be unable to pay its bills
when they are due. A firm that cannot meet its payments on time is considered insolvent.
Generally, the greater a firm’s net working capital, the lower its risk of insolvency. In other
words, more net working capital means the firm is more liquid, which reduces the risk of
becoming insolvent.

Chapter- Risk and Return

What is risk? How can risk of a security be calculated?

Risk refers to the possibility that the actual return on an investment will be different from the
expected return.

the risk of a security is quantified using:

1. Expected Return (Mean): The average return considering all possible outcomes and
their probabilities.

2. Variance: Measures how much returns deviate (spread out) from the expected return.

3. Standard Deviation: The square root of variance—this provides a risk measure in the
same units as return, making it more intuitive.

What is a risk-free security? What is risk premium? How can it be estimated

from historical data?
A risk-free security is a type of investment that provides a guaranteed return with no
uncertainty or risk of loss. In other words, it is an asset whose return is known in advance and
does not fluctuate. Because of this certainty, its risk (measured by standard deviation) is zero.

The risk premium is the extra return investors expect to earn for taking on additional risk
compared to a risk-free investment.

Risk Premium=Expected Return on Risky Asset − Risk-Free Rate

To estimate risk premium from past data:

1. Calculate the average return of the risky asset (e.g., stock market returns) over a
period.

2. Calculate the average return of the risk-free asset (e.g., government T-bills) over the
same period.

3. Subtract the average risk-free return from the average risky return.
What is a normal distribution? How does it help to interpret standard
deviation?
Normal distribution is a probability distribution that is symmetric and bell-shaped. It shows
how data (such as returns on securities) are spread around the average (mean) value. Most values
cluster near the mean, with fewer observations as you move farther away on either side.

Standard deviation measures the spread or variability of data around the mean. In a normal
distribution:

 About 68% of values lie within ±1 standard deviation from the mean.

 About 95% lie within ±2 standard deviations.

 About 99.7% lie within ±3 standard deviations.

Currency risk occurs in three forms: transaction exposure (short-term), economic exposure
(effect on present value of longer-term cash flows) and translation exposure (book gains or
losses).

Foreign currency risk

The nature and types of risk and approaches to risk management

Different Types of Foreign Currency Risk

(i) Translation Risk

 Happens when a company changes foreign money amounts into its own currency for
reports.

 Exchange rate changes can make profits or assets look bigger or smaller on paper, but no
real money is lost or gained.

(ii) Transaction Risk

 Happens when a company buys or sells something in foreign currency.

 If exchange rates change before payment, the company may lose or gain money when
paying or receiving.

(iii) Economic Risk

 Happens when exchange rate changes affect the company’s business in the long run.

 It can make the company less competitive or change future profits because of changes in
prices and demand abroad.
Causes of Exchange Rate Changes
(i) Balance of Payments

 If a country sells more goods to other countries than it buys (trade surplus), its currency
value usually goes up.

 If it buys more than it sells (trade deficit), its currency value usually goes down.

(ii) Purchasing Power Parity (PPP)

 If prices rise faster in one country than another, that country’s currency tends to lose
value so things cost the same in both places.

(iii) Interest Rate Parity (IRP)

 Countries with higher interest rates may see their currency weaken over time to balance
returns between countries.

(iv) Four-Way Equivalence

 This idea links price levels, interest rates, and exchange rates together—they all affect
each other.

(b) Forecast Exchange Rates

(i) Purchasing Power Parity

 Compare inflation rates: higher inflation means currency will likely fall in value.

(ii) Interest Rate Parity

 Look at interest rates: higher interest rates usually mean the currency will weaken
compared to others.

Hedging techniques for foreign currency risk

a) Traditional and Basic Methods of Foreign Currency Risk Management

(i) Currency of Invoice

 Make the buyer pay in your currency so you don’t face exchange risk.

(ii) Netting and Matching

 Match your foreign currency payments and receipts to cancel each other out and reduce
risk.

(iii) Leading and Lagging

  Pay early if the currency might get stronger, or delay payment if it might get weaker.

(iv) Forward Exchange Contracts

 Agree now to exchange money later at a fixed rate so you know exactly what you’ll get
or pay.

(v) Money Market Hedging

 Use loans and deposits in different currencies to protect yourself from rate changes.

(vi) Asset and Liability Management

 Balance your foreign currency debts and assets to naturally reduce risk.

(b) Comparing These Methods

 Some methods are simple but pass risk to others (like currency of invoice).

 Some methods need good planning and can save money (like netting and matching).

 Forward contracts are safe but might cost money.

 Money market hedging is more complicated but effective.

(c) Main Derivatives Used to Hedge

 Forward Contracts: Fix the exchange rate for a future date.

 Futures: Like forwards but traded on stock exchanges.

 Options: Let you choose to exchange or not at a set rate.

 Swaps: Exchange currencies now and swap back later to manage long-term risks.

Risk and Risk Management:

Risk management involves the policies and techniques a business uses to handle potential risks.
Although entrepreneurship inherently involves risk, businesses still aim to manage it for two
main reasons:

(a) To reduce exposure to risks to an acceptable level, which varies based on factors like
the business’s size and the risk tolerance of its owners or shareholders.

(b) To avoid specific types of risks altogether—such as exchange rate fluctuations—

especially when those risks could threaten the business’s survival.
 Interest rate risk
Interest rate risk is faced by companies with floating and fixed rate debt. It can arise from gap
exposure and basis risk.

Interest rate is the cost of borrowing money or the reward for saving it. It is usually shown as a
percentage of the amount borrowed or saved.

Gap Exposure:
Gap analysis measures a firm's interest rate risk by comparing interest-sensitive assets and
liabilities based on their maturity dates. Two types of gaps can arise:

(a) Negative Gap:

Occurs when interest-sensitive liabilities maturing in a period exceed the maturing interest-
sensitive assets. This indicates the firm is exposed to rising interest rates.

(b) Positive Gap:

Occurs when interest-sensitive assets maturing in a period exceed the maturing interest-sensitive
liabilities. This indicates potential benefit from rising interest rates.

Structure of Interest Rates

(a) Risk:
Riskier borrowers pay higher interest to compensate lenders for the higher chance of default.

(b) Profit for Lenders:

Banks and financial institutions charge more interest on loans than they pay on deposits to make
a profit.

(c) Loan Size:

Larger deposits often earn higher interest rates than smaller ones.

(d) Type of Asset:

Different financial products (like savings accounts, bonds, etc.) offer different interest rates due
to competition between financial institutions.

(e) Duration of Lending (Term Structure):

 Longer-term loans usually have higher interest rates.

 Liquidity Preference Theory: Investors want higher returns for locking money away
longer.

 This creates an upward-sloping yield curve (long-term rates > short-term rates).
(f) Expectations Theory:

 Interest rates reflect what people expect to happen in the future.

 If rates are expected to fall, short-term rates might be higher, causing a downward-
sloping yield curve.

(g) Market Segmentation Theory:

 Different investors focus on specific loan durations (short, medium, long).

 They don't switch even if interest rate expectations change.

 So, the yield curve reflects supply and demand in each segment.

Causes of interest rate fluctuations

(i) Structure of Interest Rates and Yield Curves

Long-term loans usually have higher interest rates than short-term ones. This is shown by a
graph called the yield curve, which normally goes up as time increases.

(ii) Expectations Theory

If people expect interest rates to rise, long-term rates will go up. If they expect rates to fall,
long-term rates might be lower. The yield curve changes based on these expectations.

(iii) Liquidity Preference Theory

People prefer short-term loans because they want quick access to their money. So, they ask for
more interest when lending for a longer time.

(iv) Market Segmentation Theory

Different people invest in different time periods (short, medium, or long). They usually don’t
switch between them, so each part of the market has its own interest rate.

Interest Rate Risk Management

Interest rate risk means that if interest rates go up or down, a business might have to pay more or
earn less money. This can be a problem.

To protect themselves, businesses try to manage this risk by:

1. Using fixed interest loans — so their payments stay the same even if rates change.

2. Using floating loans — which can be cheaper if rates go down, but risky if rates go up.
 3. Swapping interest payments with another company (interest rate swap) — for example,
trading fixed payments for floating ones or the other way around.

4. Making agreements to fix rates in advance (forward rate agreements) — so they know
what interest they will pay or receive in the future.

5. Using options like caps and floors — caps stop rates going too high, floors stop them
going too low.

Interest Rate Derivatives

Interest rate futures are contracts that help protect (hedge) against changes in interest rates
between now and when a loan’s interest rate is fixed.

 If you are a borrower worried that interest rates will rise, you can sell interest rate
futures. This protects you from paying more later.

 If you are a lender worried that interest rates will fall, you can buy interest rate futures.
This protects your income from going down.