1.9.Financial Management (1)

Study Notes Financial Management - FM Preference Shares Irredeemable Preference Shares Redeemable Preference Shares The cost of capital is calculated in the same way as theThe cost of capital is calculated in the same way as the cost of equity, assuming a constant annual dividend. cost of redeemable debt. Assuming before tax preference dividend as no tax deduction is allowable on M.v = Preference Dividend preference dividend. r r or KD = Preference Dividend Market value Weighted Average Cost of Capital The WACC is a weighted average of the (after-tax) cost of all the sources of capital for the company. Steps for Calculating WACC Calculate cost of each source of finance. e.g. Ke , Kd , Kp Calculate market value of each source of finance  M.v of Equity = (Issued share capital / par value) × M.v per share  M.v of Debt = (Book value / par value) × M.v per bond  M.v of Preference share = (Book value / par value) × M.v per share  Bank loan market value = book value Calculate WACC using this formula: Source Proportion (in Market Values) X Cost WACC Equity Proportion of Equity X Ke X% Debt Proportion of Debt X Kd(net) X% Preference Share Proportion of Preference X Kp X% WACC X% Example Bar plc has 20m ordinary 25p shares quoted at $3, and $8m of loan notes quoted at $85. The cost of equity has already been calculated at 15% and the cost of debt (net of tax) is 7.6%. Required: Calculate WACC? SOLUTION Market Value of Equity = 20m X $3 = $60m Market Value of Debt = $8m X 85/100 = $6.8m Total capital (60+6.8) = $66.8m 49

Study Notes Financial Management - FM Source Propotion X Cost WACC Equity (60/66.8) X 15% 13.47% Debt (6.8/66.8) X 7.6% 0.77% 14.25% 50

Study Notes Financial Management - FM Capital Structure and WACC Gearing Theories The Traditional View Cost of equity: At relatively low levels of gearing the increase in gearing will have relatively low impact on Ke. As gearing rises the impact will increase Ke at an increasing rate Cost of debt: There is no impact on the cost of debt until the level of gearing is prohibitively high. When this level is reached the cost of debt rises. Gearing (D/E) Key point : As the gearing level increases initially the WACC will fall. However, this will happen upto an appropriate gearing level. After that level WACC will start to rise. There is an optimal level of gearing at which the WACC is minimized and the value of the company is maximized. The MM View (With Out Tax) Cost of equity: Ke rises at a constant rate to reflect the level of increase in risk associated with gearing. Cost of debt: There is no impact on the cost of debt. Assumptions: 1. Perfect capital market exist where individuals and companies can borrow unlimited amounts at the same rate of interest. 2. There are no taxes or transaction costs. 3. Personal borrowing is a perfect substitute for corporate borrowing. 4. Firms exist with the same business or systematic risk but different level of gearing. 5. All projects and cash flows relating thereto are perpetual and any debt borrowing is also perpetual. 6. All earnings are paid out as dividend. 7. Debt is risk free. 51

Study Notes Financial Management - FM The increase in Ke directly compensates for the substitution of expensive equity with cheaper debt. Therefore, the WACC is constant regardless of the level of gearing. If the weighted average cost of capital is to remain constant at all levels of gearing it follows that any benefit from the use of cheaper debt finance must be exactly offset by the increase in the cost of equity. The MM View (With Tax) In 1963 M&M modified their model to include the impact of tax. Debt in this circumstance has the added advantage of being paid out pre-tax. The effective cost of debt will be lower as a result. Implication: As the level of gearing rises the overall WACC falls. The company benefits from having the highest level of debt possible. 52

Study Notes Financial Management - FM (a) Market imperfections: This suggests that companies should have a capital structure made up entirely of debt. This does not happen in practice due to the existence of other market imperfections which undermine the tax advantage of debt finance. (b) Bankruptcy costs: MM’s theory assumes perfect capital markets so a company would always be able to raise finance and avoid bankruptcy. In reality however, at higher levels of gearing there is an increasing risk of the company being unable to meet its interest payments and being declared bankrupt. At these higher levels of gearing, the bankruptcy risk means that shareholders will require a higher rate of return as compensation. (c) Agency costs: At higher levels of gearing there are also agency costs as a result of action taken by concerned debt holders. Providers of debt financed are likely to impose restrictive covenants such as restriction of future dividends of the imposition of minimum levels of liquidity in order to protect their investment. They may also increase their level of monitoring and require more financial information. (d) Tax exhaustion: As companies increase their gearing they may reach a point where there are not enough profits from which to obtain all available tax benefits. They will still be subject to increased bankruptcy and agency costs but will not be able to benefit from the increased tax shield. Pecking Order Theory Pecking order theory states that the firm will prefer certain types of finance over others. It comes up with its ranking for the sources of finance that a company should prefer over other. The order of preference is as follows:  Retained earnings  Straight Debt  Convertible debt  Preference shares  Equity shares 53

Study Notes Financial Management - FM Pecking Order Theory Reasons Limitations of Pecking Order Theory  lt is easier to use retained funds than go to the Pecking order theory fails to take into account trouble of obtaining external finance and have to taxation, financial distress, agency costs or how live up to the demands of external finance the investment opportunities that are available providers. may influence the choice of finance.  There are no issue costs if retained earnings are Pecking order theory is an explanation of what used, and the issue costs of debt are lower than businesses actually do rather than what they those of equity. should be looking forward to do.  investors prefer safer securities i.e. debt with its guaranteed income and priority on liquidation.  Some managers believe that debt issues have a better signaling effect that equity issues because the market believes that managers are better informed about shares' true worth than the market itself is. Their view is the market will interpret debt issues as a sign of confidence, that business are confident of making sufficient profits to fulfill their obligations on debt and that they believe that the shares are undervalued Marginal Cost of Capital Marginal cost of capital is the incremental cost of capital of additional 1 $ raise of finance. It is the incremental cost of capital of additional finance raised. Marginal cost of capital should be used if following conditions does not fulfill.  Financial risk of new project is not same as the existing financial risk of company  The required return of investors increased from existing level  Size of the new project is not smaller that the existing size of business. CAPM and MM Combined Systematic Risk Equity Beta (βe) Business Risk Financial Risk Asset Beta (βa) 54

Study Notes Financial Management - FM Business Risk Financial Risk Business risk arises due to the nature of a company's Financial risk arises due to the use of debt as a source business operations, which determines the business of finance., and hence is related to the capital structure sector into which it is classified, and to the way in which of a company. Financial risk is the variability in a company conducts its business operations. Business shareholder returns that arises due to the need to pay risk is the variability in shareholder returns that arises as interest on debt. Financial risk can be assessed rom a a result of business operations. It can therefore be shareholder perspective in two ways. Firstly, balance related to the way in which profit before interest and tax sheet gearing can be calculated. Secondly, the interest (PBIT or operating profit) changes as revenue or turnover coverage ratio can be calculated changes. This can be assessed from a shareholder perspective by calculating operational gearing, which essentially looks at the relative proportions of fixed operating costs to variable operating costs. One measure of operational gearing that can be used is (100 x contribution/ PBIT), although other measures are also used. Systematic Risk From the shareholder perspective, systematic risk is the sum of business risk and financial risk, Systematic risk is the risk that remains after a shareholder has diversified investments in a portfolio, so that the risk specific to individual companies has been diversified away and the shareholder is faced with risk relating to the market as a whole. Market risk and diversifiable risk are therefore other names for systematic risk. From a shareholder perspective, the systematic risk of a company can be assessed by equity beta of the company. If the company has debt in its capital structure, the systematic risk reflected by the equity beta will include both business risk and financial risk. If company is financial entirely by equity, the systematic risk reflected by the equity beta will be business risk alone, in which case the equity beta will be the same as the asset beta. The Formula  ������������ = ������������ ������ ������������ ������������+������������(������−������) Where: Ve = Market Value of Equity Vd = Market Value of Debt Should Company’s WACC be Used for Investment Appraisal? If the Investment’s Business risk and Financial Risk are similar to the company, then we use the company’s WACC to appraise the investment. However, if any of the risk is different then we have to calculate investment specific cost of capital. 55

Study Notes Financial Management - FM Project Specific Cost of Capital Following are the steps of calculating the project specific cost of capital. Financial Risk is Different Business Risk is Different 1. Chose the βe of the company. 1. Identify a proxy company having same 2. Calculate the βa using the company’s current Business Risk financial structure (Un-gearing Beta). 2. Chose the βe of that proxy company. ������������ = ������������ ������ ������������ 3. Calculate the βa using the Proxy company’s ������������ + ������������(1 − ������) current financial structure (Un-gearing Beta). 3. Calculate βe of the investment using capital ������������ = ������������ ������ ������������ + ������������(1 − ������) structure to be used for the investment. (Re- ������������ gearing Beta) 4. Calculate βe of the investment using capital ������������ = ������������ + ������������(1 − ������) ������ ������������ structure to be used for the investment. (Re- ������������ gearing Beta) 4. Use βe to calculate Ke using CAPM ������������ = ������������ + ������������(1 − ������) ������ ������������ ������������ 5. Calculate WACC 5. Use βe to calculate Ke using CAPM 6. Calculate WACC Example Techno, an all equity agro-chemical firm, is about to invest in a diversification in the consumer pharmaceutical industry. Its current equity beta is 0.8, whilst the average equity β of pharmaceutical firms is 1.3. Gearing in the pharmaceutical industry averages 40% debt, 60% equity. Corporate debt is available at 5%. Rm = 14%, Rf = 4%, corporation tax rate = 30%. Required: What would be a suitable discount rate for the new investment if Techno were to finance the new project with 30% debt and 70% equity? SOLUTION 1. Pharmaceutical Industry ������������ = 1.3 2. ������������ = 60 ������ 1.3 = 0.89 60+40(1−30%) 3. ������������ = 70+30(1−30%) ������ 0.89 = 1.16 70 4. Ke = 4% + 1.16 (14% - 4%) = 15.6% 5. WACC Propotion X Cost WACC Source 70% X 15.6% 10.92% Equity 30% X 5% (1-30%) 1.05% Debt 11.97% WACC 56

Study Notes Financial Management - FM Business Valuation Equity valuation Debt Valuation Businesses need to be valued for a number of reasons such as • For Acquisitions & Merger • To get listed on stock Exchange • For tax Purpose Equity Valuation Cash-Flow based Method • Dividend Valuation Model Net Asset Method • The book value approach • Net Realizable values of the assets less liabilities • Replacement values Income based Method • P/E Ratio • Earning Yield Cash-Flow based Method Dividend Valuation Model ( two methods) Single Growth model: P0 = D0(1 + g) / (Ke – g) Multiple Growth model: Year 1 2 3 4-Infinity Dividends D1 D2 D3 D3*(1+g)/Ke-g D.F at Ke D.f of last year Market capitalization=Mv/share × number of shares 57

Study Notes Financial Management - FM Dividend Growth Model Assumptions: The dividend models are underpinned by a number of assumptions that you should bear in mind. a) Investors act rationally and homogenously. The model fails to take into account the different expectations of shareholders, nor how much they are motivated by dividends versus future capital appreciation on their shares. b) The D0 figure used does not vary significantly from the trend of dividends. If D0 does appear to be a rouge figure. It may be better to use an adjusted trend figure, calculated on the basis of the past few years dividends. c) The estimates of future dividends and prices used, and also the cost of capital are reasonable. As with other methods, it may be difficult to make a confident estimate of the cost of capital. Dividend estimates may be made from historical trends that may not be a good guide for a future, or derived from uncertain forecasts about future earnings. d) Directors use dividends to signal the strength of the company’s position (however company’s that pay zero dividends do not have zero share values). e) Dividends either show no growth or constant growth. If the growth rate is calculated using “g=b x R”, then the model assumes that ‘b’ and ‘R’ are constant. f) Other market influences on share prices are ignored. g) The company’s earnings will increase sufficiently to maintain dividend growth levels. h) The Discount Rate used, always exceeds the dividend growth rate. Asset Based Approach The business is estimated as being worth the value of its Net Assets. Net Assets = Total Assets – Total Liabilities – Preference Share Value Ways of valuing Net Assets • Book Value Approach -The book value of non-current assets is based on historical (sunk) costs. These amounts are unlikely to be relevant to any purchaser (or seller). • Net Realizable values of the assets less liabilities - This amount would represent what should be left for shareholders if the assets were sold off and the liabilities settled. • Replacement values - The approach tries to determine what it would cost to set up the business if it were being started now. Adjustments: Monetary assets: book value Tangible assets: Replacement value( if purpose is going concern) Realizable Value( if purpose is of disposal) Book value( if above values are not available) Intangible Assets: consider if market value is available Inventory: at NRV Receivable: less any allowance for doubtful debt Liabilities: redemption value 58

Study Notes Financial Management - FM EXAMPLE The minimum amount that the shareholders should accept for this business is $1,550,000, the amount of share capital plus reserves after revaluation (or alternatively, $2,550,000 – 400,000 – 600,000). Market relative based Approach Price/Earning Method / Earning Multiple This method relies on finding listed companies in similar businesses to the company being valued (the target company), and then looking at the relationship they show between share price and earnings. P/E ratio = Market Value of Share / Earnings per Share 59

Study Notes Financial Management - FM Market Value of Target Company = Earnings per Share of Target Company X P/E Ratio of Proxy or (Industry Average) Adjustments.  Adjust earnings for one off exceptional items (After-tax).  If target company is a private company then downwards adjust the calculated market value because:  Public company has better image over private company  Public company shares are more marketable and liquid  Public company is less risky as compared to private company. If we are using P/E ratio of quoted company for the valuation of unquoted company then we reduced it by 30% to reflect the poor quality of earnings. Price/Earning Method  If private company has better growth prospects then upwards adjust the calculated market value.  For better analysis use Forecasted earnings.  M.V of Target Co= Forecasted Earnings x P/E Ratio of Industry In exam we will calculate both values (using historic earnings and forecasted earnings) and suggest that market value of the company should be in between Income Based Approach Earning Yield Method : Earnings yield = Earning per share/ Market value per share. For example, if EPS was £1 per share and the market price per share was £10, then the earnings yield would be 10%. Earnings yield is the mirror image of the PRICE-EARNINGS RATIO. Market Value of Target Company/ Share = EPS of Target Company X 1/ Earning Yield (Proxy) Problems of using P/E Ratio However using the P/E Ratio of quoted companies to value unquoted companies maybe problematic. a) Finding a quoted company with a similar range of activities may be difficult. Quoted companies are often diversified. b) A single year’s P/E Ratio may not be a good basis, if earnings are volatile or the quoted company’s share price is an abnormal level, due for example to the expectation of a takeover bid. c) If a P/E Ratio trend is used, the historical data will be use to value how the unquoted company will do in the future. d) The quoted company may have a different capital structure to the unquoted company. Use of Forecast Earnings When one company is thinking about taking over another it should look at the target company’s forecast earnings, not just its historical results. 60

Study Notes Financial Management - FM Forecasts of Earnings Growth should only be used if: a) There are good reasons to believe that earnings growth will be achieved. b) A reasonable estimate of growth can be made. c) Forecasts supplied by the target company’s directors are made in good faith, using reasonable assumptions and fair accounting policies. Valuation of Debt Irredeemable Debt • These debts involve a company paying interest every year in perpetuity, without ever having to redeem the loan. • M.V = Annual Interest paid/Rate of Return by debt investors • Tax effect should be ignored. • Rate of Return by debt investors=Before tax Kd Redeemable Debt • The market value of the redeemable debt is the discounted present value of future interest receivable, up to the year of redemption, plus the discounted present value of the redemption payment at before tax Kd • Bank loan or Variable rate loan • Book Value=Market Value Convertible Debt • Convertible bonds give bondholders the right but not the obligation to convert their bonds into a predetermined number of shares at predetermined dates prior to the bond's maturity. • This is calculated same way as Redeemable debt. • Conversion value = P0 (1+g)^n R WHERE - P0 = Current ex-dividend ordinary share price g = Expected annual growth rate of ordinary share price n = Number of years to conversion R = Number of shares received on conversion Valuation of convertible debt Years Cashflows Dicount factor at befor Present value tax Kd 1-5 Interest 5 year annuity factor 5 Higher off (Redemption 5th year discount factor Value or Conversion value) Total present value=M.V 61

Study Notes Financial Management - FM Efficient Markets Features of Efficient Markets It has been argued that the UK and USA stock markets are efficient capital markets i.e. the markets in which: i. Informational Processing Efficiency: The prices of securities bought and sold reflect all the relevant information which is available to the buyers and sellers, in other words, share prices change quickly to reflect all new information about future prospects. Market will absorb information in no time. ii. No individual dominates the market. iii. Operational efficiency Transaction costs of buying and selling are not so high as to discourage trading significantly. iv. Allocative efficiency: Investors are rational and will invest in high profit company instead of loss making. v. There are low, or no costs of acquiring information. Efficient Market Hypothesis A market is said to be “efficient” if prices adjust quickly and, on average, without bias, to new information. The key reason for the existence of an efficient market is the intense competition among investors to profit from any new information. Weak-Form Efficiency • In weak form efficiency, the hypothesis asserts that all past information and data are fully reflected in the price of securities. • No investor can earn excess returns by developing trading rules based solely on historical price or return information. Semi-Strong Form Efficiency If a stock market displays semi-strong efficiency, current share prices reflect both • All relevant information about past price movements and their implications and • All knowledge which is available publicly. This means that individuals cannot ‘beat the market’ by reading the newspapers or annual reports, since the information contained in these will be reflected in the share prices. Strong Form Efficiency • In strong form efficiency, the hypothesis asserts that all information is fully reflected in the price of securities, including insider information. • No investor can earn excess returns using any information whether publicly available or not. Technical Analyst: Charting or ‘Technical analysis’ attempt to predict share price movements by assuming that past price patterns will be repeated. There is no real theoretical justification for this approach, but it can at times be spectacularly successful. Studies have suggested that the degree of success is greater then could be expressed merely from chance. Fundamental Analyst:It is based on the theory that the realistic market price of a share can be derived from a valuation of estimated future dividends. The value of a share will be the discounted present value of all future expected dividends on the shares, discounted at the shareholders’ cost of capital. 62

Study Notes Financial Management - FM Insider: Technical analyst Fundamental analyst insiders Weak form efficiency Semi-strong form efficiency Strong form efficiency . Random Walk Theory The key feature of Random Walk Theory is that although share prices will have an intrinsic or fundamental value, this value will be altered as new information becomes available, and that the behavior of investors is such that the actual share price will fluctuate from day to day around intrinsic value. 63

Study Notes Financial Management - FM Sources of Finance Factors to consider in choosing appropriate source of finance 1) Cost of funds (Normally debt is cheaper) o Since secured hence low risk for provider o Guaranteed returns o Definite maturity o Tax saving by interest 2) Duration of need (Matching) 3) Gearing ratio (High gearing  High risk) 4) Accessibility - Generally difficult for small co. to raise debt Equity Ordinary Shares  Owning a share confers part ownership.  High risk investments offering higher returns.  Permanent financing.  Post-tax appropriation of profit, not tax efficient.  Marketable if listed Stock Market Listing Advantages  Access to wider pool of finance  Better image  Releasing capital for other uses  Possibilities of acquisition and growth Disadvantages  Increased public scrutiny of the company  Possibility of dilution of control  Increased costs e.g. corporate governance, internal audit Types of Equity Finance  Retained Earnings ( Retain funds) These are readily available and have no issuance cost however they may be not sufficient to fund large projects.  Methods for Share Issuance  Offer for Sale  Placing  Rights Issue 64

Study Notes Financial Management - FM Methods of Share Issuance (i) Offer for Sale A situation in which a company advertises new shares for sale to the public as a way of launching itself on the stock exchange. This method involves a corporation selling a new issue of share to an issuing house, and the issuing house will bear the risks of selling shares to other investors. Offer for sale at a fixed price Shares are offered at a fixed price to the public. The price is determined by the company in consultation with the sponsor and the broker who also helps to manage the issue. The price is decided in such a manner that it is attractive to shareholders, as it is lower than the market price. The issue is underwritten so that the company can be confident of the success of the issue. (The underwriters subscribe to the shares that are not taken up by the public). Offer for Sale by tender A minimum price is decided. The public is invited to bid for the shares at a price that is equal to or above this level. The striking price is determined after the offers been received. (A striking price is a price that ensures that all the shares on offer are sold) Comparison Between Offer for Sale of its Shares & Placing (ii) Placing This is an arrangement whereby the shares are not all offered to the public, but instead, the sponsoring market maker arranges for the most of the issue to be bought by a small number of investors. • Usually institutional investors such as pension fund and insurance companies • When a company first comes to the market in UK, the maximum proportion of shares that can be placed is 75%, to ensure some shares are available to wider public. • Placing is much cheaper. • Placing is a relatively quicker method • Placing involves less disclosure of information • Placing might give institutional shareholders the control of the company (iii) Right Issue A right issue is an offer to existing shareholders to buy more shares, usually at lower than the current share price. 65

Study Notes Financial Management - FM Advantages • Right issues are cheaper then offer for sale to general public. • A right issue secures the discount on market price for existing shareholders, who may either keep the shares or sell them if they want. • Relative voting rights are unaffected if shareholders all take up their rights. • The finance raised may be used to reduce gearing in book value terms by increasing share capital • To pay off long-term debt which will reduce gearing in market value terms Disadvantages • The amount finance that can be raised by right issues of unquoted companied is limited by funds available to existing shareholders. • Choosing the best issue price may be problematic. • If the price is considered too high, the issue may not be fully subscribed. • If the price too low, the company will not have raised all the funds. • Right issues cannot be used to widen the base the base of shareholders. Valuing a Right Issue Theoretical ex rights price = Existing market value + Funds raised Existing no of shares + Rights Issue shares  Fund Raised= Right issue shares × right issue price  Value of rights = TERP – Rights issue price Example Existing Shares = 1,000,000 Existing Share Price = $4/Share Company wants to raise $800,000 using a rights issue, incurring an issuance cost of 20,000. Right Price = $3/Share Solution Rights Shares = 800000/3 = 266,667 TERP = (1000000 x 4) + (800000 – 20000) 1000000 + 266667 = $3.77/Share Value of Right = TERP – Right Price = 3.77 – 3 = $0.77 Example 2 (Part a) Existing no of share = 400,000 Existing share price = $5 Right Price = $4.20 Company is issuing one new share against every four shares currently held. 66

Study Notes Financial Management - FM Solution = (400000 x 5) + (4.2 x 400000/4) TERP 400000 + (400000/4) Value of Right = $4.84 = 4.84 – 4.20 = $0.64 Value of Right/Existing Share = 0.64/4 = $0.16 Example 2 (Part b) An investor has 1000 shares of this company. What are the different options available to this investor at time of rights issue? Is the Right Issue Beneficial For Shareholders? Shareholders get return in the form of dividends and share price appreciation. Use of right issue funds • Funds raised through rights issue can be used to repay a loan this will reduce interest expense and earnings would increase. • Funds raised through rights issue can be used to invest in new project which will increase the profitability of project. Steps • Calculate revised earnings or revised EPS • Right issue funds invested in new project or redeeming the loan which will directly increase the earnings • Existing Price-to-earnings ratio will remain constant and calculate new market value using this equation. • Revised M.V= Revised Earning × Constant P/E ratio • If revised market value > TERP, then shareholders wealth will be Maximized. 67

Study Notes Financial Management - FM Preference Shares  Cumulative Preference Shares  Non-Cumulative Preference Shares  Participating Preference Shares  Non-Participating Preference Shares Loan Stock and Debentures key Components  Nominal or Par Value  Market Value  Interest Rate or Coupon Rate  Security • Fixed charge • Floating charge  Ratings  Redemption  Restrictive terms and conditions Types of Bonds  Deep Discount Bonds  Zero Coupon Bonds  Convertible Bonds • Market Value • Floor Value • Conversion Premium Deep Discount Bond: • Deep discount bonds are loan notes issued at a price which is at a large discount to the nominal value of the notes, and which will be redeemedable at par (or above par) when they eventually mature. • Deep discount bonds will carry a much lower rate of interest than other types of bond. • Investors might be attracted to large capital gain offered by the bonds, which is the difference between the issue price and the redemption value. Zero Coupon Bonds: Zero coupon bonds are bonds that are issued at a discount to their redemption value, but no interest is paid on them. The investor gains from the difference between the issue price and the redemption value. a) The advantage for borrowers is that zero coupon bonds can be used to raise cash immediately and there is no cash repayment until redemption date. The cost of redemption is known at the time of issue. b) The advantage for lenders is restricted, unless the rate of discount on bonds offers a high yield. The only way of obtaining cash from the bonds before maturity is to sell them. The market value will depend upon the remaining term to maturity and current market interest rates. 68

Study Notes Financial Management - FM Convertible Bonds: Convertible bonds are fixed interest debt securities, which the holder can choose to convert into ordinary shares of the company. • This conversion takes place at a pre-determined rate and date. • If the conversion doesn’t take place, the bonds will run their full life and be redeemed on maturity. Conversion Rate: The conversion rate is expressed as a conversion ratio i.e the number of ordinary shares to be issued in exchange of one bond, or part of it. Conversion Value: The conversion value is the market value of shares expected to be issued in conversion of one bond. Conversion Premium: The conversion premium is the difference between the market price of the convertible bond and the market price of the shares into which the bond is expected to converted. For example: The market value of a convertible bond is $14. It is convertible into 3 ordinary shares . Market Value of one ordinary share is $4. Conversion Premium = $14 – (3x$4) = $2 Example of Cost of Convertible Debt 7% loan stock will be redeemed at per after four years or convertible into 20 ordinary shares. Current share price is $4.44 and it is expected that it will grow with a growth of 5% per year. Before tax kd is 5%. Required: Calculate the after-tax cost of the bonds for the company. Answer: Conversion Value = 20× 4.44 × 1.05^4=$108 Redemption Value=$100 Investor are rational and will chose the higher Value 69

Study Notes Financial Management - FM Cost of Convertible Debt Warrants: The right to buy the new ordinary shares in a company at a future date, at the exercise price (a fixed, pre-determined price) is known as warrant. Usually warrants are issed along with loan stock, in order to make the loan stock attractive. Advantages of warrants to investor: a) Low intital investment b) Due to lower intial investment, the risk of loss of investment is also lower. Advantages of warrants to company a) Lower interest rate on loan stock, due to attraction of warrants. b) Even when security for the loan stock is insufficient or not available, it may be possible to issue them because of warrants. c) In the future, when the warrants are exercised, they will lead to an actual cash inflow. This is not the case for convertible bonds. Venture Capital Venture capital is a risk capital, normally provided in return for an equity stake. Venture capital requires representative in BOD. Types of Venture:  Business start-ups  Business development  Management buyout  Helping a company where one of its owners wants to realize all or part of his investment 70

Study Notes Financial Management - FM Factors considered by Venture Capital organizations before providing finance to a company  The nature of the companies product  Viability of production  Expertise in Production  Technical ability to produce efficiently  Expertise in Management  Commitment, skills and experience  The market and competition  Threat from rival producers or future new  Future profits entrants  Representation in the Board  Risk borne by existing owners  Detailed business plan showing profit prospects that compensate for risks  To take account of VC’s interests and ensure VC has say in future strategy  Owners bear significant risk and invest significant part of their overall wealth Ratio Analysis  Financial Performance  Shareholders Wealth  Financial Risk Pro forma Performance Ratios  Return on Capital Employed 71

Study Notes Financial Management - FM Profit before interest & tax x 100 Book value of equity + Book Value of Debt  Return on Equity x 100 Profit after tax Book value of equity Shareholders Wealth  Dividend Yield = D x 100 Po Where, D = dividend per share  Po = Opening market value/share  Capital Gains = Closing market value – Opening market value x 100 Opening market value  Total Return = Dividend Yield + Capital Gains = Closing market value – Opening market value + DPS x 100 Opening market value Financial Risk Or Debt  Gearing = Prior Charge Capital Debt + Equity Prior Charge Capital + Equity If overdraft is material  Gearing = Long term debt + Overdraft Long term debt + overdraft+ Equity  Debt to Equity Ratio = Debt/Equity x 100  Interest Cover = Profit Before Interest & Tax Interest 72

Study Notes Financial Management - FM Assuming that company wants to raise some funds, based on financial risk decide whether we should raise funds through debt or equity When Debt Financing Would Be More Appropriate than Equity Financing  When company has lower financial risk  The gearing and interest cover are close to industry average  When company is in healthy comparative position  Cash flows and profit margins are stable  Tangible assets are available to be offered as a security  Operational gearing is low Dividend Policy Theories Dividend policy is a strategy whereby the management distribute profits to the shareholders. There are two such theories:  Irrelevancy theory  Relevancy theory Irrelevancy Theory According to MM theory dividends are irrelevant, it does not matter, what actually matters that is earning power. The extent and timing of dividend payouts is irrelevant. Investors are indifferent to whether they receive their earnings by way of dividends or capital gains. Since prime importance is given to investment decisions, dividends are determined as a residual amount. There may even be no dividends if the retained earnings are consumed by investment projects. However, the expected future earnings of the company will push the share prices up. In this manner, a shareholder gains in capital appreciation even if he does not receive dividend payments. 73

Study Notes Financial Management - FM It was argued that if shareholders needed cash when no dividends were declared, they could sell some of their shares and generate cash. Assumptions This theory is based on the following assumptions: Capital markets are perfect. There are no taxes at the corporate or personal level. There are no issue costs for the securities. Relevancy Theory Markets are not perfect, dividends play a role of signal  A dividend which differs from shareholders expectations about dividends might send signals to the market and affect share price. „ A higher than expected dividend may signal that the board of directors are confident about the future and may lead to an increase in share price „ A lower than expected dividend may signal that the company is in financial difficulties and lead to a fall in share price. Liquidity Preference  Investors have their own liquidity needs so they will prefer cash now to later Tax Position  Tax on dividends is income tax whereas tax on selling shares is capital gains tax  If company changes its dividend policy, it will distribute investors tax position Factors Affecting Dividend Policy  The need to remain profitable  The government impose direct restrictions on the amount of dividends companies can pay  Any dividend restraints that may be imposed by loan agreements  The effect of inflation and the need to retain some profit in the business just to maintain its operating capacity  The company’s gearing level  The need to repay debt in near future  The ease with which the company can raise extra finance from sources other than retained earnings  The signaling effect of dividends to shareholders and financial markets in general  The amount of earnings the company wishes to retain may be affected by the number suitable investment opportunities available to the company. if there are few investment projects available which can generate sufficient return than surplus cash should be returned to shareholders Scrip Dividend A scrip dividend is the dividend paid by issue of additional company shares, rather than cash. A company that wants to retain cash for reinvestment but does not want to reduce its dividends might offer its shareholders a scrip dividend. The rules of the stock exchange might require that when a company wants to make a scrip dividend, it must offer a cash dividend alternative, so that shareholders can choose between new shares and cash. 74

Study Notes Financial Management - FM Advantages  They can preserve a companies cash position if a substantial number of shareholders take up the shares option.  Investors may be able to take tax advantages if dividends are in form of shares.  Investors looking to expand their holding can do so without incurring the transaction costs of buying more shares.  A small scrip issue will not dilute the share price significantly.  A share issue will decrease the company’s gearing and therefore enhance its borrowing capacity Stock Split & Scrip Issue Stock Split A stock split occurs where, for example, each share of $1 each is split into two shares of 50c each, thus creating greater marketability. Advantage of Stock Split Investors may expect a company which splits its shares in this way to be planning for substantial earnings and dividend growth. Scrip Issue  A bonus (scrip) issue is a method of altering the share capital without raising cash. It is done by changing the company’s reserves into share capital.  The rate of bonus issue is normally expressed in terms of the number of new shares issued for each existing share held, e.g. one for two (one new share for each two shares currently held). As a consequence market price of share mat benefit. Share Repurchase Purchase by a company of its own shares can take place for various reasons and must be in accordance with any requirements of legislation. If a company has surplus cash in the form of a higher dividend. If a company chooses to pay higher dividend, this might act as a signal shareholder who then expect high dividends in future years too. If the cash is used for share repurchases instead of higher dividends, future dividend expectations will not be affected. Share Repurchase Advantages  Finding a use of surplus cash, this may be a ‘dead assets’.  Increase in earnings per share through a reduction in the number of shares in issue.  Readjustment of the company’s equity base to more appropriate level, for a company whose business is in decline.  Possibly preventing a takeover or enabling a quoted company to withdraw from the stock market.  Increase in gearing. Disadvantages  It can be hard to arrive at a price that will be fair both to the vendors and to any shareholders who are not selling shares to the company. 75

Study Notes Financial Management - FM  A repurchase of shares could be seen as an admission that the company cannot make better use of funds than the shareholders.  Some shareholders may suffer from being taxed on capital gains following the purchase of their shares rather than receiving dividend income. 76

Study Notes Financial Management - FM Islamic Financing Riba It is forbidden Islamic finance.Riba is generally interpreted as the predetermined interest collected by a lender, which the lender receives over and above the principal amount it has lent out. The Quranic ban on riba is absolute. Riba can be viewed as unacceptable from three different perspectives, as outlined below For the borrower Riba creates unfairness for the borrower when the enterprise makes a profit which is less than the interest payment, turning their profit into a loss. For the lender Riba creates unfairness for the lender in high inflation environments when the returns are likely to be below the rate of inflation. For the economy Riba can result in inefficient allocation of available resources in the economy and may contribute to instability of the system. In an interest-based economy, capital is directed to the borrower with the highest creditworthiness rather than the borrower who would make the most efficient use of the capital Islamic Financing Contracts  Musharaka Mudaraba – a partnership contract  Mudaraba – a form of equity where a partnership exists and profits and losses are shared  Murabaha – a form of credit sale  Ijara – a form of lease  Sukuk – similar to a bond MURABAHA: (Trade Credit) Murabaha is a form of trade credit for asset acquisition that avoids the payment of interest. Instead, the bank buys the item and then sells it on to the customer on a deferred basis at a price that form a cost plus sale.  It include three parties: a) the client i.e the buyer of the asset b) the seller of the asset c) the financer of assets • The mark-up is fixed in advance and cannot be increased, even if the client does not take the goods within the time agreed in the contract. Payment can be made by instalments. MUDARABA: (Equity Finance) • Mudaraba is essentially like equity finance in which the bank and the customer share any profits. The bank will provide the capital, and the borrower, using their expertise and knowledge, will invest the capital. • Profits will be shared according to the finance agreement, but as with equity finance there is no certainty that there will ever be any profits, nor is there certainty that the capital will ever be recovered. This exposes the bank to considerable investment risk. 77

Study Notes Financial Management - FM Musharaka: (Joint venture) Musharaka is a joint venture or investment partnership between two parties. Both parties provide capital towards the financing of projects and both parties share the profits in agreed proportions. • This allows both parties to be rewarded for their supply of capital and managerial skills. Losses would normally be shared on the basis of the equity originally contributed to the venture. • Because both parties are closely involved with the ongoing project management, banks do not often use Musharaka transactions as they prefer to be more ‘hands off’. Ijara: (Lease) Ijara is a lease finance agreement whereby the bank buys an item for a customer and then leases it back over a specific period at an agreed amount. • Ownership of the asset remains with the lessor bank, which will seek to recover the capital cost of the equipment plus a profit margin out of the rentals payable. • Under ijara the responsibility for maintainence of the leased item remains with the lessor. Sukuk (debt finance) A conventional, non-Islamic loan note is a simple debt, and the debt holder's return for providing capital to the bond issuer takes the form of interest. Islamic bonds, or sukuk, cannot bear interest. • Sukuk are Shariah-compliant, the sukuk holders must have a proprietary interest in the assets which are being financed. • The sukuk holders’ return for providing finance is a share of the income generated by the assets. • Most sukuk, are ‘asset-based’, not ‘asset-backed’, giving investors ownership of the cash flows but not of the assets themselves. Asset-based is obviously more risky than asset backed in the event of a default. 78

Study Notes Financial Management - FM Islamic Finance Transactions Islamic Finance Similar To Differences Transaction There is a pre-agreed mark-up to be paid in recognition of the convenience of paying later for an asset that is transferred Murabaha Trade credit / loan immediately. There is no interest charged Musharaka Venture Capital Profits are shared according to a pre-agreed contract. There are no dividends paid. Losses are solely attributable to the provider of capital Mudaraba Equity Profits are shared according to a pre-agreed contract. There are no dividends paid. Losses are solely attributable to the provider of capital Ijara Leasing Whether an operating or finance transaction, in Ijara the lessor is Sukuk Bonds still the owner of the asset and incurs the risk of owners hip. This means that the lessor will be responsible for major maintenance and insurance which is different from a conventional finance lease. There is an underlying tangible asset that the sukuk holder shares in the risk and rewards of ownership. This gives the sukuk properties of equity finance as well as debt finance 79

Study Notes Financial Management - FM Small and Medium Enterprises (SME) What is an SME? SME is something larger than those business that are fundamentally a vehicle for the self-employment of their owner. SME is unlikely to be listed on any stock exchange and likely to be owned by relatively small numbers of shareholders Importance of SME • It covers the wide range of business • Important for the economies of many countries • Account for about half of the employment and half of national income • Flexible and quicker to innovate than larger companies due to their small size • They are often thought to be better at embracing new trends and technologies • It is easier for SME’S to survive and flourish in service sector (service sector is a growing market) Why do SMEs find difficulty to finance raising? The directors of SMEs often complaint that the lack of finance stops them growing and fully exploiting profitable investment opportunities. This gap between the finance available to SME’s and the finance that they could productively use is often known as the “funding or financing gap”. The SME sector tends to suffer because SMEs are viewed as a less attractive investment opportunity than many others due to the high levels of uncertainty and risk they are perceived to have. This perception of risk is due to a number of reasons including: • SMEs often have a limited track record in raising investment and providing suitable returns to their investors • SMEs often have a non-existent or very limited internal controls • SMEs often have few external controls. For instance they are unlikely to be abiding by the rules of any stock exchange and due to their size they are unlikely to attract much press scrutiny • SMEs often have a one dominant owner-manager whose decisions may face little questioning • SMEs often have a few tangible assets to offer as security. Potential source of finance for SMEs In reality there are quite a few potential sources of finance for SMEs. However, many of them have practical problem that may limit their usefulness. Some key sources and their limitations are briefly described below SME owner, family and friends This is potentially a very The good source of finance because these investor may be willing to accept lower return than many other investors as their motivation to invest is not purely financial. The key limitation is that, foe most of us , the finance that we can raise personally, and form friend and family , is somewhat limited. The business angel A business angel is a wealthy individual willing to take the risk of investing in SMEs. One limitation is that these individuals are not common and are very often quite particular about what they are prepared to invest in. Once a business angel is interested they become very useful to the SME. 80

Study Notes Financial Management - FM Trade credit SMEs, like any company, can take credit from their suppliers. However, this is only short term and, indeed, if their suppliers are larger companies who have identified them as a potentially risky SME the ability to stretch the credit period may be limited. Factoring and invoice discounting Both of these sources of finance effectively let a company raise finance against the security of their outstanding receivables. Again, the finance is only short term and is often more expensive than an overdraft. However, one of the features of these sources of finance is that, as an SMEs grows, their outstanding receivables grow and so the amount they can borrow from their factor or from invoice discounting will also grow. Leasing Leasing asset rather than buying them is often very useful for an SME as it avoids the need to raise the capital cost. However, leasing is only really possible on tangible asset such as car, machine etc. Bank Finance Bank may be willing to providing an overdraft of some sort and may be willing to lend in the long-term where that lending can be secured on major asserts such as land and buildings. However, raising medium-term finance to fund operations is often more difficult for SMEs as banks are traditionally rather conservative. This is understandable that as the loss on one defaulted loan requires many good loans to recover that loss. Hence, many SMEs end up financing medium term, and potentially longer-term assets, with short-term finance such as an overdraft. This is poor matching and very less than ideal. This issue is often known as “maturity gap” as there is a mismatch of the maturity of the assets and liabilities within the business Listing By achieving a listing on stock exchange an SME would become a quoted company and, hence, raising finance would become less of an issue. However, before a listing can be considered the company must grow to such a size that a listing is feasible. Many SMEs never hope to achieve this The Venture Capitalist A venture capitalist company is very often a subsidiary of a company that has significant cash holdings that they need to invest. The venture capitalist subsidiary is a high-risk, potentially high-return part of their investment portfolio. Hence, many banks will have venture capitalist subsidiaries. In order to attract venture capital funding an SME has to have a business idea that may create the high returns the venture capitalist is seeking. Hence, for many SMEs, operating in regular business, venture capitalist financing may not be possible. Furthermore, a venture capitalist rarely wants to remain invested in the long term and, hence, any proposal to them must show how they will be able to ‘exit’ or release their value after a number of years. This is often done by selling the company to a bigger company operating in the same trade or by growing the company to such a size that a stock exchange listing is possible. Supply chain financing In supply chain financing (SCF) the finance follows the value as it moves through the supply chain. SCF is relatively new and is different to traditional working capital financing methods, such as factoring or offering settlement discounts, because it promotes collaboration between buyers and sellers in the supply chain. Traditionally there was competition as the buyer wanted to take extended credit, and the seller wanted quick payment. SCF works very well where the buyer has a better credit rating than the seller. 81

Study Notes Financial Management - FM Crowdfunding Crowdfunding involves funding a venture by raising finance from a large number of people (the crowd) and is very often achieved over the internet. The internet platforms are set up and run by moderating organisations who bring together the project initiator with the idea, and those organisations and individuals who are willing to support the idea. A feature of crowdfunding is that it lets people search for and invest in ideas and projects that they have an interest or a belief in. Hence, these investors are sometimes willing to take bigger risks and/or accept lower returns than would be usual. A further feature is that, just as in a real crowd, there is potential for interaction within the crowd. Hence, keen supporters of a particular idea will very often encourage others to participate. Example Company A (which has an A+ credit rating) buys goods from Company B (which has a B+ credit rating). Co B has agreed to give Co A 30 days credit. Co B invoices Co A. Co A approves the invoice. Co A is expected to pay the amount due to its financial institution – ‘Bank C’ –in 30 days at which point the funds are immediately remitted to Co B. However, Co B can request the funds from Bank C prior to the due date. If they do this they receive the payment less a suitable discount. This discount is likely to be less than the discount charged if Co B used traditional factoring or invoice discounting. This is because they are using Bank C (Co A’s financial institution) and benefit from Co A’s higher credit rating as the debt is the debt of Co A, and by approving the invoice Co A has confirmed this. Equally, if Co A wants to delay payment beyond the 30-day point, then it can do so. However, when Co A does finally pay Bank C some interest will be due. Obviously this interest charge reflects the credit rating of Co A. WHY AND HOW DO GOVERNMENTS HELP FINANCE SMES? Governments are often keen to assist as to the extent that SMEs are unable to raise finance for their profitable projects, investment opportunities are potentially lost and, hence, national wealth is lower than it could be. Additionally, governments are keen to support innovation, which is one area where SMEs often excel, and are keen to support the growth of SMEs as this boosts employment. A number of key ways governments assist include the following: • Providing grants. • Providing tax breaks – for instance, tax incentives may be available to those willing to take the risk of investing in SMEs. • Providing advice – for instance, in Scotland there is a government-funded organisation known as ‘Business Gateway’, which provides assistance to those setting up and running a business, including advice on raising finance. • Guaranteeing loans – for instance, for a small fee from the SME, a large proportion of any loan advanced by a bank is guaranteed by the government. As this significantly reduces the risk to the bank, they are potentially more willing to lend. In the UK this is currently called the ‘Enterprise Finance Guarantee’ scheme. 82

Study Notes Financial Management - FM • Providing equity investment – many countries have government-backed venture capital organisations that are willing to invest in the equity of SMEs. This is often done on a matching basis, where the organisation will match any equity investment raised from other sources. In the UK this is done through ‘Enterprise Capital Funds’, while in the US there is the ‘Small Business Investment Company’ programme. Foreign Currency Risk Management - When dealing with converting FOREX it is important to consider the following points  Always consider yourself at Adverse Position How Currency Fluctuate Supply & Demand • Speculation • Export and Import • Foreign Direct Investment (FDI) • Foreign Currency Loans • Foreign Currency Remittance 83

Study Notes Financial Management - FM How Currency Fluctuate Purchasing Power Parity (PPP) It follows law of one price. Different commodities in two different currencies will have same price, if there is any difference that will be absorbed by exchange rate. According to PPP the exchange rate between two currencies can be explained by the difference between inflation rated in respective countries. PPP says country with HIGH inflation rate normally faces the decrease in its currencies value and a country with a LOW inflation rate has an expectation of increase in its currencies value. The businesses normally use PPP for calculation of expected spot rate against the forward rate offered by banks. Expected spot rate Future Spot rate= current spot rate × ( 1+ inflation of first currency) ( 1 + inflation of 2nd currency) How Currency Fluctuate Interest rate parity (IRP) This concept says that the difference between 2 currencies worth can be explained by interest rate structure in the countries of these 2 currencies. According to IRP a country with a high interest rate structure normally has a currency at discount in relation to another currency whose country has a low HIGH INTEREST in country LOWER will be the value of currency LOWER INTEREST in country HIGHER will be the value of currency Forward rate Forward rate = current spot rat rate x ( 1+ interest of first currency) (1 + interest of 2nd currency) 84

Study Notes Financial Management - FM How Currency Fluctuate Fisher Effect This concept tells us the relation between interest rate and inflation. It assumes that real interest rate between two economies are same and nominal interest rates are different because of inflation. Countries with relatively high rate of inflation will generally have high nominal rates of interest, partly because high interest rates are a mechanism for reducing inflation. USA [1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate] K [1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate] Expectation Theory Future spot rate and forward rate should be equal. If temporary difference arises b/w these two rates it will be reduced due to expectation of investors over the time. For example – if forward rate is lower than future spot rate, investors will start buying in forward rates and starts selling in future spot markets. Until the difference is negligible. Four way equivalence theories 85

Study Notes Financial Management - FM Foreign Currency Risk Management Types of Foreign Exchange Risk Transaction Risk Translation Risk Economic Risk  Transaction risk refers to Translation risk refers to the Long-term movement in the rate adverse charges in the possibility of accounting loss that of exchange which puts the exchange rate between could occur because of foreign company at some competitive contract date and the subsidiary, as a result of the disadvantage is known as settlement date. conversion of the value aisssets and economic risk.  It is the risk that occurs in liabilities which are denominated in E.g. if competitor currency stars transactions where foreign foreign currency, due to depreciating or our company currency is involved, for movements in exchange rate. currency starts appreciating. example exports 1 imports.  This risk is involved where a parent It may affect a company's company has foreign subsidiaries in performance even if the a depreciating currency company does not have any environment. foreign currency transactions. Methods of Hedging FOREX Risk Translation Risk Economic Risk Shift manufacturing to cheaper labor areas  Arrange Maximum Borrowing in Subsidiary Co. Create innovative and differentiate units to create brand loyalty currency.  Diversify into new products and into new markets  Maintain Surplus Assets in Parent Co. currency which will reduce the overall exposure of Translation risk. Methods of Hedging FOREX Risk Transaction Risk - Internal Hedging Method • Invoice in Home Currency Should have bargaining power to negotiate • Matching Foreign Currency (Receipts and Payments) Timing and currencies should be same • Netting Netting is a process in which all transaction of group companies are converted into the same currencies and then credit balances are netted off against the debit balances, so that only reduced net amounts remain due to be paid or received. Leading and Lagging 86

Study Notes Financial Management - FM Methods of Hedging FOREX Risk Transaction Risk - External Hedging Method Forward Contract : A forward contract is a legally binding agreement between two parties to buy or sell currencies in future at pre dertemined rate and pre specified date. Example - Home Currency is British Pound £ , Exports receipts = $ 500,000 after six months Spot Rate = 1.30 – 1.31 $/£ Six month forward rate = 1.32 – 1.33 $/£ Expected Net Receipt if Forward Contract is taken = $500,000/1.33 = £ 375,940 Forward Contracts It is a legally binding contract between two parties to buy or sell in future at a pre-determined rate and a pre- specified date. Advantages Eliminate currency risk, as foreign exchange costs are determined upfront. They are tailor made and can be matched against the time period of exposure as well as for the cash size of the exposure, therefore they are referred to as a complete hedge. They are easy to understand. Disadvantages It is subject to default risk. There may be difficult to find a counter-party. They are legally binding so difficult to cancel. Transaction Risk - External Hedging Method Money Market Hedging : Foreign Currency Receipts / Exports Steps: a) Calculate present value of foreign currency using borrowing rate of foreign currency and take loan of this amount. Present Value = Foreign Currency amount (1+ borrowing rate of FCY) b) Convert that present value into home currency using spot exchange rate. c) Deposit the home currency at the deposit rate of home currency. 87

Study Notes Financial Management - FM Total receipts= Home currency × ( 1 + lending rate of HCY ) Money Market Hedging : Foreign Currency Payments / imports Steps: a) Calculate present value of foreign currency using lending rate of foreign currency and deposit that amount. Present Value = Foreign Currency amount (1+ lending rate of FCY) b) Convert that present value into home currency using spot exchange rate. c) Borrow the home currency at the borrowing rate of home currency. Total payment= Home currency × ( 1 + borrowing rate of HCY ) Money Market Hedging A money market hedge is a mechanism for the delivery of foreign currency, at a future date, at a specified rate without recourse to the forward FOREX market. If a company is able to achieve preferential access to the short term money markets in the base and counter currency zones then it can be a cost effective substitute for a forward agreement. However, it is difficult to reverse quickly and is cumbersome to establish as it requires borrowing/lending agreements to be established denominated in the two currencies. With relatively small amounts, the OTC market represents the most convenient means of locking in exchange rates. Where cross border flows are common and business is well diversified across different currency areas then currency hedging is of questionable benefit. Where, as in this case, relatively infrequent flows occur then the simplest solution is to engage in the forward market for hedging risk. The use of a money market hedge as described may generate a more favorable forward rate than direct recourse to the forex market. However the administrative and management costs in setting up the necessary loans and deposits are a significant consideration. Derivatives • Future Settlement • Initial amount to be paid is nil or low • Drive their value from some underlying • Traded in two types of market (Over the counter Market & Exchange Traded Derivatives 88

Study Notes Financial Management - FM Methods of Hedging FOREX Risk Transaction Risk - External Hedging Method Future Contract • These contracts are highly standardized both in • Futures are standardized contracts traded on a • size and in terms of their delivery mechanism. regulated exchange to make or take delivery of a • Physical delivery is very rare. Contracts are usually specified quantity of a foreign currency, or a • settled prior to the settlement date. financial instrument at a specified price, with • An initial margin is required, a further mark-to- delivery or settlement at a specified future date. market margin may be necessary. • They are available in major currencies and quoted • Standardized contracts against USD. Exchange traded derivatives are settled daily by • There are four settlement dates M ARC H ,J U N E settling the difference in the contracted price and ,S E P.T .DEC the traded price in cash. This is called the mark-to- • Tick = minimum movement of future contract, market mechanism. No Default Risk 0.01% of contract size. More liquid in nature (e.g. futures contracts). • Basis= current spot rate - future rate Methods of Hedging FOREX Risk Option Contract TYPES: Currency options give the buyer the right but notCALL OPTION Right to buy at a specified rate the obligation to buy or sell a specific amount ofPUT OPTION Right to sell at a specified rate foreign currency at a specific exchange rate (the strike price) on or before a predetermined future date. For this protection, the buyer has to pay aOPTION BUYER - OPTION HOLDER LONG POSITION premium. OPTION SELLER - OPTION WRITER SHORT POISTION A currency option may be either a call option or a put option Currency option contracts limit the maximum lossAmerican Option - can be exercised at anytime before maturity to the premium paid up-front and provide theEuropean Option - can be exercised at maturity only. buyer with the opportunity to take advantage of favorable exchange rate movements. Interest Rate Risk Management Interest rate risk (IRR) can be explained as the impact on an institution’s financial condition if it is exposed to negative movements in interest rates. This risk can either be translated as an increase of interest payments that it has to make against borrowed funds or a reduction in income that it receives from invested funds. Methods of Hedging Interest Rate Risk • Forward rate Agreement (FRA) • Interest Rate Future 89

Study Notes Financial Management - FM • Options • Interest Rate Swaps • CAP, FLOOR & COLLAR Reasons for Interest Rate Fluctuation 1. RISK  High risk, high return  Low risk, low return  No risk, some return 2. Need to make profit on re- lending The more the changing hands, more the interest rate (due to margins of intermediation) 3. Size of the loan More amount, more risk so more required interest rate Less amount, low risk so low interest rate. 4. Duration of the loan Longer the period, higher the risk and so high interest required Shorter the period, lower the risk and so lower the required interest 5. Types of financial assets and liabilities 6. Government policy Methods of hedging interest rate risk Forward rate Agreement (FRA)  FRA is a contract in which two parties agree on interest rate to be paid on a notional amount at a specified future time.  The “buyer” of FRA is partly wishing to protect itself against a rise in rates while the “seller” is a party protecting itself against an interest rate decline.  FRAs can be used to hedge transactions of any size or maturity and offer an alternative ta interest rate futures for hedging purpose.  FRAs do not involve any margin requirements.  Interest rate set for FRA is reflection of the expectation of interest rate movements. Forward rate Agreement (FRA) EXAMPLE  Company wants to borrow $10m in three months’ time for a period of 6 months. Company is expecting that interest rate will rise in future and wants to hedge its position using FRA. Following FRAs are available 3-6 6%-6.5% 3-9 7.5%-8% 90

Study Notes Financial Management - FM Calculate the effective interest rate if forward hedge is taken. If after three months interest rates are 10% 5% FRA In case if interest moves to 10% In case if interest moves to 5% Borrow from bank= 10% Borrow from bank= 5% Compare forward rate with actual interest rate. If Compare forward rate with actual interest rate. If actual is higher than bank will pay the difference actual is lower than bank will receive the difference Difference from bank=10%-8%=2% Difference from bank=5%-8%=3% Effective interest rate=8% Effective interest rate=8% Methods Of Hedging Interest Rate Risk Interest Rate Futures • An interest rate futures contract is a futures contract with an interest-bearing instrument as its underlying asset. The underlying asset could be Treasury bills and notes, certificates of deposit (CD), commercial paper (CP), etc. • IRF is an exchange traded derivative and has standard terms and conditions like contract size, settlement dates etc. • A borrowing company is concerned about a rise in interest rates and therefore, it will use an IRF to hedge against a rise in interest rates. Conversely, a depositing company will use an IRF to hedge against a fall in interest rates. Interest Rate Options An interest rate option is an option on a notional borrowing or a deposit which guarantees a minimum or a maximum rate of interest (called strike price) for the option holder. The option is settled in cash This product is available on payment of an upfront fee, called a premium. An interest rate call option guarantees the borrower a maximum rate of interest, whereas an interest rate put option guarantees the depositor a minimum rate of interest. Methods of Hedging Interest Rate Risk Interest Rate CAPS • An interest rate cap is a contract that enables companies with floating rate debt to limit or \"cap\" their exposure to rising interest rates. • A CAP fixed the interest rate to be paid on the borrowing. 91

Study Notes Financial Management - FM Interest Rate FLOOR • An interest rate floor is a series of European put options, that protects the lender against a decline in the floating interest rates • A floor guarantees that the interest rate received on a deposit will not be less than a specified level. Interest Rate COLLAR An interest rate collar is a combination of a cap and a floor transacted simultaneously. The buyer of an interest rate cap, purchases an interest rate cap while selling a floor indexed to the same interest rate, for the same amount and covering the same period. Interest Rate SWAP It’s instrument in which two parties agree to exchange interest rate cash flows based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another called plain vanilla swap. 92

Study Notes Financial Management - FM Currency Swaps Advantages • Swaps are easy to arrange and are flexible since they can be arranged in any size and are reversible. • Transaction costs are low, only amounting to legal fees, since there is no commission or premium to be paid. • The parties can obtain the currency they require without subjecting themselves to the uncertainties of the foreign exchange markets. • The company can gain access to debt finance in another country and currency where it is little known, and consequently has a poorer credit rating, than in its home country. It can therefore take advantage of lower interest rates than it could obtain if it arranged the currency loan itself. • Currency swaps may be used to restructure the currency base of the company's liabilities. This may be important where the company is trading overseas and receiving revenues in foreign currencies, but its borrowings are denominated in the currency of its home country. Currency swaps therefore provide a means of reducing exchange rate exposure. • At the same time as exchanging currency, the company may also be able to convert fixed rate debt to floating rate or vice versa. Thus it may obtain some of the benefits of an interest rate swap in addition to achieving the other purposes of a currency swap. Disadvantages • If one party became unable to meet its swap payment obligations, this could mean that the other party risked having to make them itself. • A company whose main business lies outside the field of finance should not increase financial risk in order to make speculative gains. • There may be a risk of political disturbances or exchange controls in the country whose currency is being used for a swap. • Swaps have arrangement fees payable to third parties. Although these may appear to be cheap, this is because the intermediary accepts no liability for the swap. (However, the third party does suffer some spread risk, as it warehouses one side of the swap until it is matched with the other, and then undertakes a temporary hedge on the futures market.) 93

Study Notes Financial Management - FM Working Capital Management Definition Working capital is current assets less current liabilities. It is the capital available to conduct day to day operations of business Current Assets  Inventory  Receivables  Cash Current Liabilities  Payables  Overdraft Liquidity Liquidity is availability of cash for day to day activities.  How it is ensured?  By maintaining liquid assets and liabilities.  E.g. Maintaining cash balance, having a line of credit Liquidity Vs Profitability  There is always a conflict between liquidity and profitability.  If we maintain more liquid assets, profitability will be reduced.  If we maintain less liquid assets, profitability will be increased as more assets are invested but risk of insolvency increased Working Capital Management It is the management of both current assets and current liabilities to minimize risk of insolvency and to maximize return on assets. Objective: Working capital facilitates two main objectives  To ensure business has enough liquid resources to reduce risk of insolvency  To increase return on assets This can be achieved by holding optimum level of investments in working capital.  To minimize investment in working capital, it will reduce the overdraft cost because lower funds will be required  To minimize working capital cycle, by quickly moving items around working capital cycle. 94

Study Notes Financial Management - FM Working capital cycle Measure in Days, Weeks and Months Short Conversion Cycle is a good sign Current Assets Current Liabilities 95

Study Notes Financial Management - FM LIQUIDTY RATIOS Current Ratio It is used to assess the ability of business to pay, what it owes. It also indicates margin of safety. This ratio depicts that how much we have in current assets to pay $1 of current liabilities. Current Ratio of 2:1 is usually considered good. This ratio depicts that how much we have in current assets to pay $1 of current liabilities. Current Ratio of 2:1 is usually considered good. Quick Ratio (Acid Test) If we want to have a more conservative view of liquidity, we exclude inventory from current assets as it takes longer to convert inventory into cash. Quick Ratio of 1:1 is a sign Current Ratio & Quick Ratio Current ratio Current assets Current liabilities Quick ratio Current assets less inventory Current liabilities Accounts receivable payment period Accounts receivable payment period or =Avg receivables x 365 days Accounts receivable days Credit sales Receivable turnover = Credit Sales (in times) Average receivable 96

Study Notes Financial Management - FM Inventory Turnover Period Cost of sales (in times)  Inventory turnover = Average inventory  Inventory turnover period (Finished goods)= Average inventory x365 days Cost of sales Where  Average inventory = Opening balance + Closing balance 2  Raw materials inventory holding period =Average raw materials x 365 day Annual purchases  Average work-in-progress period =Average WIP x 365days Cost of sales×% of completion  Generally closing balances will be considered as average balances.  If not mentioned, all the sales and purchases are considered to be on credit.  In the absence of purchases, Cost of sales will be used.  If not given, all inventory will be considered as finished goods Accounts payable payment period & Sales revenue/net working capital ratio  Accounts payable payment period =Average trade payables x 365days Purchases or cost of sales  Payable turnover = Credit purchases ( in times) Average payables  Sales to Working capital ratio = Sales Working Capital Over Trading “A business which is trying to do too much too quickly with too little long-term capital is overtrading” Symptoms of over trading:  Rapid increase in turnover.  Rapid increase in the volume of current assets and possibly also non-current assets. High Inventory and accounts receivable period.  Only a small increase in equity capital. Most of the increase in assets is financed by credit, especially:  Trade accounts payable 97

Study Notes Financial Management - FM  Bank overdraft  Some debt and liquidity ratios alter dramatically.  Current ratio and quick ratio fall  Business might have a liquid deficit i.e. an excess of current liabilities over current assets.  Proportion of total assets financed by equity capital falls and the proportion financed by credit rise.  Sales/working capital ratio is increasing over time, working capital should increase in line with sales. Solution to Overtrading  New capital could be injected from shareholders The growth can be financed through long-term loans.  Better control could be applied to management of inventories and accounts receivable.  The company could postpone ambitious plans for increased sales and fixed asset investment. Over Capitalized “If there are excessive inventories, accounts receivable and cash and very few accounts payable, there will be an over- investment by company in current assets and the company will be in this respect over-capitalized.” Symptoms:  Rapid increase in turnover.  Rapid increase in the volume of current assets e.g. inventory and receivable .  High Inventory and accounts receivable period.  Not much rise in Trade accounts payable and overdraft.  Current ratio and quick ratio rise significantly. Current assets are more than current liabilities  Sales/working capital ratio is decreasing over time, working capital should be increased in line with sales. 98