1 The role and responsibility of senior financial executive/advisor

The Finance Director will be charged with setting goals which increase shareholder wealth and will set the principles concernin

a) Investment selection and capital resource allocation (investment decision);

b) Minimising the firms cost of capital (financing decision);
c) Distribution of profit (dividend decision) and retention policy;
d) Communicating financial policy and corporate goals to internal and external stakeholders;
e) Financial planning and control; and
f) The management of risk.

Directors should aim to maximise shareholder return.

Total shareholders return (%) = (Dividend + Annual movement in share price) / Share price * 100%

2 Financial strategy formulation

2.1 Assessing corporate performance

Performance ratios tend to be split into the following four categories:

1) Profitability

Return on capital employed (ROCE) = (PBIT / TALCL) * 100%

TALCL: Total Assets less Current Liabilities

Gross profit margin = (Gross profit / Revenue) * 100%

Operating profit margin = (Operating profit / Revenue) * 100%

Net profit margin = (Profit after tax / Revenue) * 100%

Return on equity = (Profit after tax and preference dividends / (Ordinary share capital + reserves)) * 100%

Asset turnover = Revenue / TALCL

TALCL: Total Assets less Current Liabilities

2) Liquidity

Current ratio = Current assets / Current liabilities

Quick ratio (Acid test) = (Current assets - Inventories) / Current liabilities

Inventory turnover = Cost of sales / Inventories

Inventory days = (Inventory / COS) * 365 days

Receivables collection period = (Trade receivables / Credit turnover or Revenue) * 365 days

Payables payment period = (Trade payables / Credit purchases or COS) * 365 days

3) Gearing/Debt

The term ‘gearing’ refers to the extent to which a business is dependent on loans and preference shares, as opposed to ordina
Gearing ratios indicate the degree of risk attached to the company and the sensitivity of earnings and dividends to changes in

Gearing = (Long term debt / (Long term debt + Equity)) * 100%

Interest cover = PBIT / Interest payable

4) Investor

Earnings per share (EPS) = Profit available to ordinary shareholders / No of shares

Dividend yield = Dividend per share / Market share price * 100%

Dividend cover = EPS / Dividend per share

P/E ratio = Market share price / EPS or Market capitalisation /Profit after tax

Share price = equity value / no of ordinary shares

assess the performance of the business in line with its objective to maximise shareholder wealth, then it is investor measures

2.1.5 Earnings before interest, tax, depreciation and amortisation (EBITDA)

By considering profits before interest, tax and depreciation/amortisation the EBITDA measure has the following benefits:
- It is a fair measure to assess managers with if they have no control over financing or CAPEX as it removes the distortions of d
- It gives a profit measure that roughly approximates to the operating cash flow generated by the business.

2.2 Sources of finance

Gearing measures the current capital structure as follows:

Gearing = Debt / (Debt + Equity)

A company can raise its capital from shareholders (equity finance) and from debt holders (loans).
The annual cost to satisfy equity and debt investors via the payment of dividend and interest is known as the company’s weig

2.3 Initial coin offerings

A cryptocurrency is a digital or virtual currency. It is difficult to counterfeit as it uses cryptography (the computerised encoding
An Initial Coin Offering (ICO) is the cryptocurrency equivalent of an Initial Public Offering (IPO). A quantity of cryptocurrency is
Advantages of ICOs (initial coin offerings)
ICOs are decentralised and largely unregulated by any government. This creates opportunity for companies.
It allows access to a global market of investors when it can often be difficult to fund projects from traditional equity investmen
They do not have the regulatory compliance requirements of venture capitalists, banks and stock exchanges.

Disadvantages of ICOs (initial coin offerings)

As a result of the lack of regulation, some ICOs have been accused of basically being scams on wealthy, under-informed invest

2.4 Dividend policy

A listed company needs to have a published dividend policy which helps investors make their investment decisions based on t

Dividend policy is shaped by the following factors:

1) Investment decision - the level of business risk (ße) in the business will determine the expectation of the dividend level (Ke)
2) Financing decision - the proportion of debt finance in the business will determine a potential dividend as interest payments
3) Investment opportunities - a company strategically focused on growth may prefer to reinvest retained profits at the expen
access to debt finance is restricted (small, start-up company or highly geared).
4) Poor liquidity - a company may choose to lower the dividend if recessionary fears and poor liquidity are present.
5) Investor preference - failure to adopt a policy that is consistent with what investors expect may cause them to sell their hol
6) How will the market perceive the dividend announcement (i.e. what signal does it send out about the likely future perform
7) Is there cash available to pay a dividend. If not, an alternative that could be considered is that of a scrip dividend whereby
This can sometimes be popular with investors and relieve cash flow pressure on the business.
8) Tax implications. Payment of dividends will be subject to income tax in the hands of the shareholder. An increase in the sha
9) Is sufficient cash being retained within the organisation to meet the demands of existing or future projects.
10 Are profits consistent/stable such that a policy of growing dividends can be sustained?

In the real world, investors dislike erratic dividends and so companies tend to use either of the following policies:
1) Growth year on year (either for total dividends or, more usually, dividend per share). Investors often expect dividends to at
2) Constant dividend pay-out percentage. This can work well for owner managed businesses where agreement is reached to o
when profits are erratic since this policy would lead to erratic dividends unless the % pay-out is adjusted.

2.5 Risk definitions

2.6 Risk mapping

Risk mapping involves considering various risks against criteria of severity and frequency. A risk management strategy can the
2.8 Strategies for the management of risk

2.9 Behavioural finance

Behavioural finance proposes psychology-based theories to explain stock market anomalies, in other words ‘what factors actu
Within behavioural finance, it is assumed that the information structure and the characteristics of market participants systema

Behavioural finance uses the psychological factors behind investor decisions such as sentiment and speculation to explain why
Rational decision making can involve the following assumptions;
Decision makers aim to maximise the value of their portfolio or company
Decisions are based on a rational, objective and risk-neutral analysis of relevant information

Examples of instances where these assumptions might not hold include:

1) Investor over-confidence (making bad investments due to lack of knowledge and high self belief)
2) Cognitive dissonance (clinging onto long-held beliefs and ignoring evidence to the contrary)
3) Anchoring (investors using information that is not relevant but is readily available, in order to simplify the decision making p
4) Availability bias (placing too much significance on the latest piece of available information and losing sight of the bigger pict
5) Representativeness (over-reaction to news based on previous trends)
6) Narrow framing (concentrating too much on one piece of information)
7) Miscalculation of probabilities (e.g. over-estimation of the probability of success of dotcom businesses in the late 90's)
8) Ambiguity aversion (aversion to investing in new business areas)
9) Positive feedback (assumption that rising shares will continue to rise and falling shares will continue to fall). Alternatively th
been rising for some time because they think that they must stop rising soon even if evidence suggests they will continue to ri
10) Conservatism (under-reaction to good or bad news due to resistance to changing their opinion)
11) Confirmation bias (focus more on the evidence that supports your current view)
12) If a manager has made a decision they may feel that they have to justify that decision was correct even if subsequently it t

3 Ethical issues in financial management

Ethical behaviour is linked to non-financial objectives such as

3.2 Resolution of stakeholder conflict

Conflicts can arise between the objectives of the shareholders and those of management. The resolution of this shareholder c
Strategies for this include:

A) Regular shareholder communication, helping shareholders to understand the benefits of management actions.
B) Prioritisation of issues allows for compromise where a "middle ground" is agreed.
C) Performance related pay linked to longer term successes as opposed to short term profit.
D) Non-executive Directors providing objectivity to board decisions and preventing self-interest.
E) Separation of roles ensuring too much power does not accrue to a single individual. A Corporate Governance framework res
F) Compliance with Accounting standards/Audit reports provide vital information to investors.

3.4 The ethical framework

A company can then apply the following five step ethical framework to a situation to ensure it applies the highest ethical stand
(1) Ensuring understanding. Gather information confirming the situation and gain an understanding around the circumstances
(2) Compare against ethical principles. Ensure legal and regulatory compliance against published frameworks and ensure com
(3) Perform risk assessment. The Board of Directors should evaluate potential financial exposure, damage to brand/reputation
(4) Mitigation – can counter measures be taken to limit harm to stakeholders?
(5) “Mirror test” - would disclosure of the issue by the press result in negative publicity or financial loss.
Should the issue fail the mirror test, then the issue is likely to be unethical and steps should be taken to resolve the issue.

3.5 Code of Ethics and the Ethics Committee

Ideally, a company should publish a Code of Ethics against which it can be held accountable.
As well as providing guidance to employees when facing difficult decisions, it should also state its position on the environment
The Ethics Committee will monitor compliance with the code of ethics and are empowered to take disciplinary action against u
The Ethics Committee should be independent of the executive board.
It should have the power to override investment decisions where the project is seen to cause harm to a particular group of sta

3.6 Sustainability and Environmental Issues

Sustainability is a target of zero impact that a company’s activities has on the Earth’s resources whilst balancing growth. i.e. a
Environmental risk is the potential damage to shareholder wealth resulting from any adverse public reaction to company’s ac

To ensure damage is minimal, governments pass laws to ensure companies do not abuse their powers in the pursuit of wealth

3.8 The role of the Environment Agency

The Environment Agency (EA) has three official roles:

3.9 Environmental audits and the triple bottom line approach

An environmental audit seeks to measure and report the environment impact of a company’s policies.
The triple bottom line approach allows the formulation of clear objectives as follows:

Lecture example 1.2

Using the triple bottom line approach, formulate the objectives a major retailer may set, such as
Tesco, before undertaking its environmental audit.
SOLUTION
Social
% women in senior management positions
Staff turnover rate
% staff completing diversity training scheme
Sickness levels

Environmental
Audit grades for suppliers
Clear labelling in store for all products to inform the customer about the environmental issues and the choices they have
Improved sales of products with a better impact on the environment
Energy consumption / CO2 emissions at premises
CO2 emissions from vehicles
Improve % of products with recyclable packaging
Reduce the quantity of waste disposal and increase the proportion that is recycled

Economic
% new stores built on brownfield sites
Number of community projects underway
Number of staff completing the community skills training module
Participation in charitable events.

3.10 Integrated reporting

When making decisions regarding investment and financing strategies, the directors should always consider the impact on the
Integrated reporting means that it is easier for stakeholders to see the full consequences of the directors’ decisions.
This should hopefully reduce the agency problem of shareholder conflict.
The International Integrated Reporting Council established Integrated Reporting with the aim of enabling businesses to show h

By analysing these links, Integrated Reporting builds on the foundations of sustainability reporting and should lead to:
1) Businesses being able to take sustainable decisions and make optimum use of scarce resources.
2) Stakeholders being able to better judge the viability of businesses (especially useful for providers of financial capital who wi

Integrated reporting highlights the capitals on which businesses depend. Capitals are the resources and relationships used by
Businesses should report how they use those capitals to create value and their impact upon them.
4.6.1 Securitisation
Securitisation is the process of packaging existing loans and mortgages and selling the future interest cash flows to investors.
These are rated by the rating agencies making the investments attractive to the market.
On sale, the banks use the cash flows generated to offer further loans and mortgages to the market.

Usually the bank will sell the asset (e.g. mortgages, car loans etc) to a company referred to as a Special Purpose Vehicle (SPV).
This SPV might then package a number of these securitised loans together and sell them to investors; these are known as colla
Each package may be of a slightly different risk class and the investors can decide what level of risk they want to take.
The cash generated could then be used by the banks to finance further mortgages.

4.6.2 The Credit Crunch

Once the mortgage market reached saturation, the sub-prime market was targeted (high risk of default).
At the time default risk was considered irrelevant as expected rises in the housing market meant that on mortgage default the

However, when the concern about the levels of debt shook market confidence, as house prices fell then so did the value of mo
This resulted in a lack of debt availability in the market and reduced the ability of companies to fund expansion, or individuals
This was caused by a lack of confidence in the banking industry fuelled by years of liberal lending criteria and a rise in securitis

4.6.3 Traunching
The structure of securitisation deals is referred to a traunching. Claims on cash flows are split into at least three classes.
Each class is called a tranche and has absolute priority in future interest distributions over more junior ones.
Junior tranches are more risky, and therefore command a higher return.

4.6.4 Credit default swaps

Credit default swaps (CDS) are counterparty agreements which allow the transfer of third party credit risk to another party.
These gained popularity alongside Collateralised Debt Obligations (CDOs) in an unregulated market.
The speed and volume of these transactions (over $45 trillion in 2007) resulted in large financial institutions becoming unawar
In effect these are insurance policies that pay off if the customer fails to meet their repayment.

4.6.5 Dark pool trading

Dark pools are trading systems which allows market makers (traders) to trade without quoting prices publicly on the exchange
They tend to arise when large institutions create buying and selling positions not available to the public.
This system allows fund managers to buy/sell large orders anonymously to avoid influencing the market price or to avoid the m
The proportion of trading using alternative platforms or "dark pools" is estimated at 25% in UK/US.
The problems of dark pool trading are:
a) The regulated exchange is not aware about large transactions until the trades are complete; market pricing can be out of da
b) Dark pool transactions reduce transparency and market efficiency which reduce investor confidence (and market liquidity).
c) There is a danger with dark pool trading that the market under estimates risk; with CDOs and CDSs there is a danger that th
d) A two tier market may be seen as unfair undermining market confidence and development.
e) Both the US and European regulators are conducting a review of how dark pools affect price, market stability and fairness b

6 Dividend policy in multinationals and transfer pricing

6.1 Factors affecting the dividend decision
Dividend policy represents the choice directors must make when setting the balance between capital gain in the share price an
Factors to consider are:
1) Increasing capital expenditure reduces dividend capacity (FCFTE ¡V defined in Ch7 section 4).
2) Large stable companies or listed companies are generally in a better position to pay out a stable cash dividend which satisfie
3) Share repurchase agreements return cash to investors (increasing gearing) which will reduce dividend capacity in that year.
4) New issues of debt or equity enable the funding of expansion programmes without affecting the shareholders' expectation
5) A company must ensure it has sufficient liquidity and distributable reserves before it declares the annual dividend.
6) Income tax on dividends will affect shareholders' decision whether dividends are preferred to reinvestment and higher capi
7) Internationally, double tax relief will limit the extra tax payable on overseas dividends to the difference between the rate of
8) Exchange controls reduce the ability of a company to pay dividends from an overseas subsidiary and the value of the divide

6.2 Transfer pricing and impact on profit

Transfer pricing has the effect of moving pre-tax profits around the group, but does not change the total pre-tax profit.
However as different countries have different tax rates, the transfer price can influence the total amount of tax that is paid an

LECTURE EXAMPLE 1.3

Fixed plus variable cost - If the transfer price from Umgaba is based upon fixed cost plus variable cost

Umgaba Mazila Bettuna

Sales 8,200 16,000 14,800

Costs
Variable cost 6,400 3,600 3,000
Fixed costs 1,800 700 900
Transfer price 8,200 8,200
Import duty 820
8,200 13,320 12,100

Taxable profit - 2,680 2,700

Tax 670 864
Profit after tax - 2,010 1,836
Withholding tax
Remittance 1,206 1,102
UK Tax on profits 134
Total remittance - 1,072 1,102

Assembly should take place in Bettuna.

Fixed plus variable cost plus 30%

Umgaba Mazila Bettuna

Sales 10,660 16,000 14,800

Costs
Variable cost 6,400 3,600 3,000
Fixed costs 1,800 700 900
Transfer price 10,660 10,660
Import duty 1,066
8,200 16,026 14,560

Taxable profit 2,460 (26) 240

Tax 984 77
Profit after tax 1,476 (26) 163

Remittance before withholdi 885.60 97.92

Withholding tax 132.84 0
Final remittance 752.76 - 97.92

Assembly should take place in Bettuna.

7 Islamic financing

In Islamic banking there are broadly two categories of financing techniques:

‘fixed income’ modes of finance – murabaha, ijara, sukuk
equity modes of finance – mudaraba, musharaka.

7.1.1 Fixed income

(a) Murabaha
Murabaha is a form of trade credit or loan.
The key distinction between a murabaha and a loan is that, with a murabaha, the bank will take actual constructive or physica
The asset is then sold to the ‘borrower’ or ‘buyer’ for a profit but they are allowed to pay the bank over a set number of instal
The period of the repayments could be extended, but no penalities or additional mark-up may be added by the bank.
Early payment discounts are not within the contract.

(b) Ijara
Ijara is the equivalent of lease finance. It is defined as when the use of the underlying asset or service is transferred for consid
Under this concept, the bank makes available to the customer the use of assets or equipment such as plant or motor vehicles
The lessor (the bank) is responsible for the major maintenance of the underlying assets (ownership costs). An Islamic lease is m

(c) Sukuk
Companies often issue bonds to enable them to raise debt finance.
The bond holder receives interest and this is paid before dividends. This is prohibited under Islamic law.
Instead, Islamic bonds (or sukuk) are linked to an underlying asset, such that a sukuk holder is a partial owner in the underlyin
So, for example, a sukuk holder will participate in the ownership of the company issuing the sukuk and has a right to profits (b
The global debt crisis sent shockwaves through the financial markets and western banks remain reluctant to loan cash to the b

(d) Salam
Salam contracts are like forward contracts where an asset/commodity is sold now for delivery at a future date.
The cash changes hands now (possibly at a discount) and in the contract the quality, quantity and future date are clearly stipu

(e) Istisna
Istisna contracts are often used in major construction (buildings, warehouses, shopping centres etc.).
The financial institution finances the construction on behalf of a client and the client pays an initial deposit followed by pre-de
Consequently the arrangement avoids paying any interest on a ‘loan’.

7.1.2 Equity

(a) Mudaraba
Mudaraba is a special kind of partnership where one partner gives money to another for investing it in a commercial enterpris
The investment comes from the first partner (who is called ‘rab ul mal’), while the management and work is an exclusive respo

(who is called ‘mudarib’).

The Mudaraba (profit sharing) is a contract, with one party providing 100% of the capital and
the other party providing its specialist knowledge to invest the capital and manage the
investment project. Profits generated are shared between the parties according to a pre-agreed
ratio. In a Mudaraba only the lender of the money has to take losses. This arrangement is
therefore most closely aligned with equity finance.

(b) Musharaka
Musharaka is a relationship between two or more parties that contribute capital to a business, and divide the net profit and lo
It is most closely aligned with the concept of venture capital. All providers of capital are entitled to participate in management
The profit is distributed among the partners in pre-agreed ratios, while the loss is borne by each partner strictly in proportion
In a diminishing Musharaka contract one of the finance providers gradually reduces their ‘equity’ by receiving from the other(
This effectively gradually transfers all of the ownership of the asset/investment to the other party(ies).
ill set the principles concerning:
shares, as opposed to ordinary shares and reserves.
and dividends to changes in profitability and activity level.

then it is investor measures that you should concentrate on.

s the following benefits:

removes the distortions of depreciation and interest, both of which can vary hugely between businesses.
nown as the company’s weighted average cost of capital (WACC)

y (the computerised encoding and decoding of information) for security.

quantity of cryptocurrency is sold in the form of “tokens” to investors.
companies.
m traditional equity investment such as VC’s, Angel investors for start-ups etc.
exchanges.

ealthy, under-informed investors.

estment decisions based on the predicted level of future dividends. A dividend is paid from surplus funds after interest, tax and preference

tion of the dividend level (Ke).

dividend as interest payments must be made first.
retained profits at the expense of a dividend pay-out to fund expansion. This may be useful if

uidity are present.

ay cause them to sell their holding and new investors may come along. A turbulent share price may result for a period of time (Clientele eff
bout the likely future performance). If it is considered a positive signal there may be a period of share price growth. (Dividend signalling).
of a scrip dividend whereby additional shares are offered as an alternative to a cash dividend.

holder. An increase in the share price will generate potential capital gains tax for the shareholder. Thus some investors may prefer reinves
uture projects.

llowing policies:
 often expect dividends to at least increase in line with general inflation or an industry growth rate.
re agreement is reached to only pay a fixed % of profits as dividend and retain the rest. Care is needed

management strategy can then be considered. This is known as the TARA framework.
ther words ‘what factors actually can affect investors decision making in the real world?’.
f market participants systematically influence individuals' investment decisions as well as market outcomes.

nd speculation to explain why irrational investor behaviour is likely to have a significant impact on share prices.

simplify the decision making process)

losing sight of the bigger picture).

sinesses in the late 90's)

tinue to fall). Alternatively the opposite may happen where investors sell shares that have
ggests they will continue to rise. This is known as the "gambler's fallacy".

rrect even if subsequently it turns out not to be the case. They may decide to carry on investing in the decision rather than accepting defe

solution of this shareholder conflict is found by bringing about goal congruence between the objectives of the two parties.

agement actions.

te Governance framework restricts the powers of management and holds the board accountable.

plies the highest ethical standards.

ing around the circumstances which created the problem.
frameworks and ensure compliance with the company’s statement of ethical principles.
, damage to brand/reputation and harm to stakeholder groups.
 ken to resolve the issue.

position on the environment, discrimination, bribery and fraud, bullying and intimidation.
ke disciplinary action against unethical behaviour and insist on corrective action.

m to a particular group of stakeholders, which although not strictly illegal, fails a moral test of ‘doing the right thing’.

whilst balancing growth. i.e. a paper manufacturer may follow a policy of sustainability by planting two trees for every tree used.
blic reaction to company’s activities which adversely affect the environment.

owers in the pursuit of wealth, i.e. anti-discrimination and pollution laws, noise, building and health and safety regulations.
 d the choices they have

ys consider the impact on the organisations stakeholders and particularly their shareholders.
directors’ decisions.

enabling businesses to show how they create value over time - demonstrating links between the businesses and the contexts in which the

g and should lead to:

ers of financial capital who will have better quality information, enabling better allocation of capital)

es and relationships used by businesses and which businesses affect.

rest cash flows to investors.

pecial Purpose Vehicle (SPV).

tors; these are known as collateralised debt obligations (CDOs).
sk they want to take.

that on mortgage default the proceeds from the sale of a mortgaged property would always exceed the outstanding loan value.

ell then so did the value of mortgage backed securities.

und expansion, or individuals to obtain mortgages.
criteria and a rise in securitisation.

o at least three classes.

unior ones.

redit risk to another party.

nstitutions becoming unaware of their credit risk exposure and this added to the 2007 economic downturn.

ices publicly on the exchange.

market price or to avoid the market price adjusting before this significant volume of shares is traded.

arket pricing can be out of date as it excludes large transactions until disclosed.
dence (and market liquidity).
CDSs there is a danger that this unregulated risk precipitates events which led to the last credit crunch.

market stability and fairness before any regulatory reforms are proposed.

pital gain in the share price and the annual cash dividend.

e cash dividend which satisfies the expectations of its investors (Ke) than new or small companies.
ividend capacity in that year.
he shareholders' expectation of the annual dividend.
the annual dividend.
reinvestment and higher capital gain. This is known as the "clientele effect".
ifference between the rate of tax overseas and the UK rate.
ry and the value of the dividend reduces with the time value of money.

he total pre-tax profit.

amount of tax that is paid and so many companies will set their transfer prices to minimise the total amount of tax they pay.
actual constructive or physical ownership of the asset.
k over a set number of instalments.
e added by the bank.
rvice is transferred for consideration.
ch as plant or motor vehicles for a fixed period and price.
ip costs). An Islamic lease is more like an operating lease.

artial owner in the underlying assets and profit is linked to the performance of the underlying asset.
k and has a right to profits (but will equally bear their share of any losses).
reluctant to loan cash to the business community. Islamic finance, and in particular sukuk, has to some extent filled the gap left by the trad

a future date.
d future date are clearly stipulated.

al deposit followed by pre-determined instalments.

g it in a commercial enterprise.
and work is an exclusive responsibility of the other

nd divide the net profit and loss pro rata.

to participate in management, but are not required to do so.
partner strictly in proportion to their respective capital.
by receiving from the other(s) amounts greater than their proportionate share in the returns.
er interest, tax and preference dividend have been paid.

a period of time (Clientele effect).

growth. (Dividend signalling).

e investors may prefer reinvestment and growth in the share price.

on rather than accepting defeat (entrapment).

he two parties.
for every tree used.

ty regulations.
and the contexts in which they operate:
standing loan value.
t of tax they pay.
t filled the gap left by the traditional debt markets.
IRR = L + (NPV L / (NPV L - NPV H)) * (H - L)

L % is the lowest rate chosen

H% is the highest rate chosen
Cost of equity

Ke = Rf + Beta * E(m) - Rf

Rf = risk free rate of return

Beta
E(m) = Market rate of return
E(m) - Rf = Risk premium

Value of equity

Ve = price * no of shares

Value of bonds

Vd = price * no of instrument

Cost of capital >> WACC (weighted average cost of capital)

WACC = (Ve/(Ve + Vd)) * Ke) + (Vd/(Ve + Vd)) * Kd * (1-T)

Value of new bonds based on annual yield curve

$7·50 x 1·0456–1 + $7·50 x 1·0508–2 + $7·50 x 1·0576–3 + $115·50 x 1·0655–4 = $109·92

109.9178

4th year is repayment

bond value is 100
bond is 7.5%
repaid at premium of 8%

4th year 115.5

Market value of new bonds

number of bonds 0.6 million

value 109.9178

65.95068 million USD

Colvin Co

(a) Evaluate the suitability of the investment proposal in Canvia, including the impact of the country risk premium
on the net present value of the project.

Year 0 1 2 3 4

Contribution 419.4 500.2 671.3 961.2

Fixed costs -270 -291.6 -314.9 -340.1
Tax allowable depreciation -175 -175 -175 -175

Tax base -25.6 33.6 181.4 446.1

Tax loss carried forward 0 -25.6
Adjusted taxable profit -25.6 8 181.4 446.1

Taxation 0 -2 -45.35 -111.525

Add loss carried forward 25.6
Add depreciation 175 175 175 175

Cash flows after tax 149.4 206.6 311.05 509.575

Working capital -25 -2.5 -2.75 -3.025 33.275

Investment cost -775 214.2

Cash flows -800 146.9 203.85 308.025 757.05

working capital -25 -27.5 -30.25 -33.275 -36.6025

incremental working capital -2.5 -2.75 -3.025
isk premium
Fernhurst

(a) Evaluate the financial acceptability of the investment in the Milland and, calculate and comment on the
investment’s duration.

0 1 2 3
Revenue 13,250,000 16,695,000 22,788,675
VC (5,787,600) (7,292,376) (9,954,093)
FC (900,000) (945,000) (992,250)
Marketing expense (1,500,000)
Depreciation - 20%, reducing balance (3,200,000) (2,560,000) (2,048,000)

Profit before tax 1,862,400 5,897,624 9,794,332

Tax - 25% same year 0 (465,600) (1,474,406) (2,448,583)

Depreciation 3,200,000 2,560,000 2,048,000

Marketing

Investment (16,000,000)
Scrap value
Working capital (1,025,000) (41,000) (53,300) (55,965)

Free CF (17,025,000) 4,555,800 6,929,918 9,337,784

Discount rate % 1 0.901 0.812 0.731

PV (17,025,000) 4,104,776 5,627,093 6,825,920

NPV 7,802,647

The NPV is positive, shareholder wealth will rise, therefore the project should be accepted.

Investments duration

PV 4,104,776 5,627,093 6,825,920

t * PV 4,104,776 11,254,187 20,477,760

Duration = SUM of t*PV / SUM of PV = 68,916,153 = 2.77578272709

24,827,647
Sensitivity margin = NPV / PV of variable *100%

NPV 7,802,647

Sales post tax 9,937,500 12,521,250 17,091,506 17,946,082

PV of sales post tax 8,953,688 10,167,255 12,493,891 11,826,468

18%
ment on the

4
23,928,109 w1 - Revenue
(10,451,798) 1 2
(1,041,863) Volume 132,500 159,000
Price 100 105
(8,192,000) Revenue 13,250,000 16,695,000

4,242,448
w2 - Variable cost
(1,060,612)
cost per unit 43.68 45.864
8,192,000 Variable cost 5,787,600 7,292,376

w3 - Fixed costs
0
1,175,265 900,000 945,000

12,549,101
w4 - Working capital
0.659
working cap required 1,066,000 1,119,300
8,269,858 incremental working capital 41,000 53,300

8,269,858
33,079,431
43,441,301
 3 4
206,700 206,700
110 116
22,788,675 23,928,109

48.1572 50.56506
9,954,093 10,451,798

992,250 1,041,863

1,175,265
55,965
Morada Co

(b) Prepare a report for the board of directors of Morada Co which:

(i) Estimates Morada Co’s cost of equity and cost of capital, based on market value of equity and debt,
before any changes and then after implementing the proposals put forward by the first and by the second
directors;

Cost of equity = Ve
Cost of capital = WACC

Ve = 360,000.00

Kd(1-t) = (Rf + credit risk premiumor spread) * (1-t)

Kd(1-t) = 3.760%
Kd 4.700% >> discount rate
Baa2 sprea90 basispoint

Market price of debt at 4.7%

Vd = 126,427

based on CFs
1 2 3 4
6.2 6.2 6.2 106.2
5.92168099331423 5.655855772 5.401963488 88.3767 105.3562

Be = 1.2
Ba = 0.65

tax 20%

Rf = 3.80%
Rm - Rf = 7%

Ke = Rf + Be*(Rm-Rf)

Ke = 12.200%
WACC 0.09029095844455 + 0.009773 10%

Second directors proposal

Be 1.21
Ke = 12.2700%
Ve 360,000.00

Kd(1-t) 4.9600%
Kd 6.200%

Vd 180,165.06

CFs
1 2 3 4
6.2 6.2 6.2 106.2
5.83804143126177 5.497214154 5.838041431 83.48846 94.82372

WACC 0.08177500419433 0.02 9.832%

First directors proposal

Kd (1-t) 3.5200%
Kd 4.4000%

debt 24000
Vd 25,553.44

1 2 3 4
6.2 6.2 6.2 106.2
5.93869731800766 5.688407393 5.448666085 89.39691 106.4727

Be 0.55

1. Degear all possible units

Maintenance Ba = 0.65 (30%)

Travel Ba = ? (70%)

Morada Ba =

Ba = Be * (Ve / (Ve + Vd*(1-t))

 1.2 360,000.00
126,427

0.780670674 0.936805

2. Equation filling

Morada Ba = Travel Ba + Maintenance Ba

0.93680480864589 = ? *70% + 0.65 * 30%

0.74180480864589 0.195
1.05972115520841 >> Travel Ba

3) Regear

Be 1.05972115520841 380,442.76 1.056785431 1.12

360,000.00

4) Equity cost via CAPM

Ke = Rf + (Rm-Rf) * Be

Ke 11.64%

5) WACC

360,000.00 12% 25,553.44 3.5200%

385,553.44 385,553.44

0.108678647 0.002333 0.111012

Section A
Okan Co

b)
Project Alpha NPV

0 1 2 3 4
Sales 17,325 34,304 62,890 33,821
Production Cost (6,365) (11,584) (24,095) (9,546)
Component Cost (3,707) (5,670) (11,883) (4,585)
Depreciation (12,500) (9,375) (7,031) (11,094)

Operating CF - (5,247) 7,675 19,880 8,596

Tax 20% 1,049 (1,535) (3,976) (1,719)

Investment (50,000)
Scrap 10,000
Working capital (1,733) (2,547) (4,288) 4,360 4,207

Depreciation 12,500 9,375 7,031 11,094

Net cash flows (51,733) 5,756 11,227 27,296 32,178

Base case PV @10% (51,732.50) 5,232.32 9,278.29 20,507.85 21,977.76

NPV 5,263.72

Component cost (w1)

1 2 3 4
Pounds 1200 1800 3700 1400

PPP 3.09 3.15 3.21 3.27

Y$ 3,707.29 5,669.98 11,883.49 4,584.62

Total PV * time 173,223.50

Total PV 56,996.22

Duration 3.04

profit 2678 2% 1830 2%

133900 91500
42400
10600
Project Beta NPV

Base case PV 8,450.00 19,360.00 22,340.00 4,950.00

NPV 5,100.00

Total PV * time 133,990.00

Total PV 55,100.00

Duration 2.43 years

Test

CF $1000 occurs at the end of year 3 and stops at the end of year 7, Discount rate is 5%. PV?

Annuity

AF 3-7 years 3.928

PV 3,928

Example 8

0 1 2

Revenue 300,000 386,250

VC (120,000) (156,750)
FC
Depreciation - 25% reducing balance (111,250) (83,438)

Operating profit 68,750 146,063

Tax - 30% arrears (20,625)

Investment (515,000)
Scrap
Working capital (45,000) - (12,938)

Depreciation 111,250 83,438

FCF (560,000) 180,000 195,938

Discount - 10% 1.000 0.909 0.826

PV (560,000) 163,620 161,844

NPV 58,225

(560,000) 166,950 212,384

PV (560,000) 151,758 175,429

NPV @10% 68,615

(560,000) 151,772.73 175,523.97

NPV @10% 68,796
PV @11% (560,000) 150,405.41 172,375.62
NPV @11% 54,984

NPV @ 10% 68,615 50000

NPV @ 20% -50000

IRR excel 15.37% IRR to free cash flows

IRR formula 15.78%

Example 8, page 5
Payback

Year Free CFs Cum. Free CFs

0 (560,000) (560,000)
1 166,950 (393,050)
2 212,384 (180,666)
3 216,873 36,207
4 201,745 237,952
5 1,232 239,184

Payback = 2 years + 180,666/216,873

0.83 years
Payback period 2.83 years

Discounted Payback

Year PV Cum PV
0 (560,000) (560,000)
1 151,758 (408,242)
2 175,429 (232,813)
3 162,940 (69,873)
4 137,795 67,921
5 765 68,686

Discounted payback 3 years 0.51

3.51 years

Compare these to targets

Example 13 - Page 10

1) Proxy's Beta Equity

N E W
Be 1.05 1.1 1.18

2) Asset Beta of Proxy by ungearing

N's Ba Be * (Ve / (Ve + Vd *(1-t)))

0.807692307692308

E's Ba 0.798882681564246

W's Ba 0.804545454545454

3) Regear to find revised Be

Be = Ba * ((Ve + Vd * (1-t)) / Ve) 1.14245454545455

4) Debt cost - Kd*(1-t)

Kd = 6%

Kd (1-t) = 6% * (1-0.3) = 4.2% 4.2%

5) Equity cost (CAPM)

Ke = Rf + B*(Rm-Rf) 11.71%

6) WACC
WACC = 9%

Example

Rate Pound / AED

Home UK
FX UAE
Transaction AED 50,000 receipt

0.24 0.27
3.7037037037037 4.16666666666667

Receipt 12000
 3 4 5
w1 - Working capital
397,838 245,864 Year 0 1 2 3
(163,804) (102,705) Revenue 1 1.2875 1.03
WC 45,000 45,000 57,938 59,676
(62,578) (187,734) - 12,938 1,738

171,456 (44,576)

(43,819) (51,437) -

70,000
(1,738) 59,676

62,578 187,734

188,477 221,398 -

0.751 0.683 1

141,546 151,215

216,873 201,745 1,232

162,872 137,792 765

162,939.89 137,794.55 764.98

158,575.67 132,895.68 731.13
 4
0.618
36,880