Financial Management and Financial Objectives

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1
How have the syllabus learning outcomes been examined?
Syllabus learning outcomes
How syllabus outcomes are
examined Example past papers
Purpose of financial management,
and relationship to financial &
management accounting.
Discussion question examining
importance of shareholder
wealth maximisation.
Discuss the relationship
between investment decisions,
dividend decisions and
financing decisions

QSX
- June 2010, part (c), 8 marks
Financial objectives and relationship
with corporate strategy.
Use of ratio analysis to assess
achievement of objectives.
NG
- Dec 2009, part (b), 9 marks
QSX
YNM
- June 2011, part (a) 13 marks
Bar Co
- Dec 2011, parts (b) & (c) 11 marks
GWW Co
- Dec 2012, part (c) 5 marks
Stakeholders and impact on
corporate objectives.
Discussion of how to motivate
managers to achieve objectives.
Discussion of conflict between
stakeholders
Dartig
- Dec 2008, part (e), 8 marks
Zigto
- June 12, part (a), 4 marks
Financial and other objectives in
not-for-profit organisations.
Comparison of objectives of not
for profit and profit seeking
organisations
Bar
- Dec 2011, part (d), 11 marks

Financial management
and financial objectives
1: FINANCIAL MANAGEMENT AND FINANCIAL OBJECTIVES
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Overview

Linking to
Corporate objectives
Needs for other stakeholders
Dividend decision Investment decision Financing decision
Maximisation of
shareholder wealth
Pay out or reinvest?
New projects
Acquisitions
Working capital
Raising capital to finance
investment
Minimise cost of capital
Reporting / monitoring
Financial accounting
Management accounting
Value for money if a not for
profit organisation
Encouraged by
Corporate governance
Agency theory
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1 Financial objectives
1.1 Profit maximisation is often assumed to be the main objective of a business. However,
shareholders sometimes express disappointment in a companys performance even when
profits are rising; this suggests that profit is not sufficient as a business objective.

Lecture example 1 Exam standard for 8 marks

At the end of 2007 Ryanair announced, as part of a stock market briefing, that pre-tax profit for the
year had risen by 33%. Immediately after the announcement the share price fell by 8%.
Required
(a) Discuss why shareholders might be dissatisfied, despite higher profits? (6 marks)
(b) What other measure could be used to assess Ryanairs performance? (2 marks)

Solution

1.2 For a profit making company, maximisation of shareholder wealth is assumed to be the
financial objective. The ability of a firm to create wealth for shareholders is measure by total
shareholder return.
Total shareholder return =
dividend+ change in share price
share price at the start of the year

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2 A framework for maximising shareholder wealth

Investment decisions
2.1 Investment decisions (in projects, takeovers or working capital) need to be analysed to
ensure that they are beneficial to the investor; this is covered in later chapters.
2.2 Investments can help a firm to achieve key corporate objectives such as market share,
quality etc; these will be monitored by the management accounting department. Investments
also help a firm to achieve key financial objectives such as improving earnings per share.
Lecture example 2 Exam standard for 6 marks

Magneto plc has objectives to improve earnings per share and dividends per share by 10% pa.
m Last year Current year
Profits before interest and tax 22,300 23,726
Interest 3,000 3,000
Tax 5,790 6,218
Profits after interest and tax 13,510 14,508
Preference dividends 200 200
Dividends 7,986 8,585
Retained earnings 5,324 5,723
No ordinary shares issued (millions) 100,000 100,000
Required
Evaluate whether Magneto has achieved its earnings & dividend per share objectives (6 marks)

Solution

Dividend decision Investment decision Financing decision
Maximisation of
shareholder wealth

Sections 1.5, 2.1 2.2
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Financing decision
2.3 Financing decisions mainly focus on how much debt a firm should use, and aim to
minimise the cost of capital. This is covered in later chapters.
Dividend decision
2.4 The dividend decision is determined by how much a firm has decided to spend on
investments and how much of the finance needed for this it has decided to raise externally,
and is a good example of the interrelationship between these 3 decisions. The dividend
decision is covered in chapter 13.
3 Encouraging shareholder wealth maximisation
Agency theory
3.1 Why do managers (and other agents of the shareholders, such as employees) sometimes
have different objectives?
Unless they are also owners of the business, managers may prefer to:
(a) Maximise short-term profits to trigger bonuses
(b) Minimise dividends to free up funds to use within the business
(c) Reduce risk by diversifying but shareholders can do this themselves
(d) Boost their own pay & perks
(e) Avoid debt finance to avoid the need for careful cash management
3.2 The danger that managers may not act in the best interest of shareholders is referred to as
the agency problem; it can be dealt with by monitoring the actions of management
performance or by the use of incentive schemes, these are discussed below.
Corporate governance
3.3 In the UK corporate governance regulations have been designed to monitor the actions
of management. Here are some of the main requirements:
Board of directors Key committees
Separate MD & chairman
Minimum 50% non executive directors
Chairman independent
Max 1 year notice period
NEDs should be independent (3 year
contract, no share options)
Remuneration committee
Pay & incentives of executive directors
Audit committee
Risk management
NEDs only
Nomination committee
Choice of new directors

Case 1
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Lecture example 3 Supplementary Home Study Example

ERTIN PLC
The following information relates to Ertin plc, a fictitious company incorporated in England.
Outstanding
Board of directors Basic salary share options
()
Chairman and
Chief executive: H A Mefftord 210,000 500,000
Finance director: Mrs F M Barnfield FCCA 120,000 100,000
Production director: M L T Hojjy 85,000 100,000
Other executive directors: S Lompertas 75,000 50,000
P T Figler 80,000 50,000
Lord Gwumba 100,000 100,000
Non-executive directors: Dr P Dorecton 20,000 60,000
Mrs B D Mefftord 25,000 100,000
The agenda of a board meeting of Ertin plc is as follows.
Minutes of the last meeting
Proposed investment in France
Consideration of the remuneration of board members
Proposal for the formation of an audit committee, with Mrs F M Barnfield, P T Figler and Dr
P Dorecton as nominated committee members
Required
Identify weaknesses in the corporate governance of Ertin plc and describe what actions are
required to comply with best practice.

Solution

3.4 There are two main types of incentive schemes that you need to be aware of:
(a) Performance related pay either against profit or a strategic performance measure
(b) Share options options to buy shares in say 3 years time at todays share price
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4 Needs of other stakeholders
4.1 Stakeholders are defined as any groups affected by the activities of the firm, they can be
classified as:
(a) Internal staff, managers
(b) Connected finance providers (shareholders, banks), customers, suppliers
(c) External government, trade unions , pressure groups
4.2 Shareholders are normally the most important stakeholder group, but the interests of other
stakeholders are often important too. To ensure that the interests of these other stakeholder
groups are not neglected, non financial objectives can be used; here are some examples:
(a) Staff staff turnover
(b) Bank gearing, interest cover
(c) Customers liquidity ratios, complaints, market share
(d) Suppliers payables (creditor) days
4.3 Note that there is often a conflict between stakeholder objectives eg profit to
shareholders and pay rises to staff. This will require the development of acceptable
compromises eg pay rises linked to productivity gains.
5 Measuring the achievement of stakeholder objectives
5.1 As indicated above, ratio analysis is often used by stakeholders to assess the performance
of a company. Ratios are normally split into 4 categories :
(a) Profitability important to assess managerial performance
(b) Debt important to banks
(c) Liquidity important to suppliers and customers
(d) Shareholder investor ratios important to shareholders
5.2 Profitability ratios include:
ROCE =
Profit from operations
%
Capital employed

ROCE =
Revenue

Revenue
Capital employed

Profit margin Asset turnover
Note. ROCE should ideally be increasing. If it is static or reducing it is important to
determine whether this is due to a reduced profit margin or asset turnover. If both profit
margin and asset turnover are getting worse then the company has a profitability problem.
Profit from operations = before interest and tax.

Section 3

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5.3 Debt ratios include:
Gearing =
Book value of debt
Book value of equity

Interest cover =
Interest

5.4 Liquidity ratios include:
Current ratio = Current : Current
assets liabilities
Acid Test ratio = Current : Current
assets (less inventory) liabilities
5.5 Shareholder investor ratios include:
Dividend yield =
Dividend per share
100
Market price per share

Earnings per share =
Profits distributable to ordinary shareholders
Number of ordinary shares issued

Price-earnings ratio =
Market price per share
EPS

The value of the P/E ratio reflects the markets appraisal of the shares future prospects
the more highly regarded a company, the higher will be its share price and its P/E ratio.

Lecture example 4 Technique demonstration

Summary financial information for Robertson plc is given below, covering the last two years.
000s Previous year Current year
Turnover 43,800 48,000
Cost of sales 16,600 18,200
Salaries and Wages 12,600 12,900
Other costs 5,900 7,400
Profit before interest and tax 8,700 9,500
Tax 2,400 2,800
Profit after interest and tax 5,100 5,700
Dividends payable 2,000 2,200
Shareholders funds 22,600 25,700
Long term debt 11,300 9,000
Number of shares in issue (000) 9,000 9,000
P/E ratio (average for year)
Robertson plc 17.0 18.0
Industry 18.0 18.2
Required
Review Robertsons performance using profit, debt, and shareholder investor ratios, and assess its
total shareholder return in the current year.
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Solution

6 Not for profit organisations
Value for money
6.1 Many organisations are not for profit, in this case a more appropriate objective is to make
sure that the organisation is getting good value for money; economy, efficiency,
effectiveness.
(a) Economy purchase of inputs of appropriate quality at minimum cost
(b) Efficiency use of these inputs to maximise output
(c) Effectiveness use of these inputs to achieves it goals (quality, speed of response)

Section 6
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7 Chapter summary
Section Topic Summary
1 Objectives The prime financial objective of a profit making
company is to maximise shareholder wealth, this
can be measure by total shareholder return.

2 Framework for
achieving
objectives
To maximise shareholder wealth an organisation
must take sensible investment, financing and
dividend decisions.
3 Encouraging
shareholder
wealth
maximization
Corporate governance regulations and incentive
schemes are used to check that shareholder wealth
maximisation is taken seriously.
4 Needs of other
stakeholders
Internal staff, managers
Connected finance providers, customers,
suppliers
External government, trade unions , pressure
groups

5 Ratio analysis To assess the impact of these decisions on
shareholders and other stakeholders, it is important
to monitor profit, debt, liquidity and shareholder
ratios. These ratios are not given in the exam and
need to be learnt.
6 Not for profit
organisations
Economy purchase of inputs of appropriate
quality at minimum cost
Efficiency use of these inputs to maximise output
Effectiveness use of these inputs to achieves it
goals (quality, speed of response)

END OF CHAPTER

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Explain macroeconomic targets
and the policies used to achieve
these targets
Analysis of how a proposed
government policy can impact
on a firms investment, financing
or dividend plans.

Explain how government
economic policy impacts on
business decision making
Discussion of competition policy Gorwa
- Dec 2008, part (a), 7 marks

Economic environment
for business
2: ECONOMIC ENVIRONMENT FOR BUSINESS
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Overview

Maximisation of
shareholder wealth
Financing decision Investment decision Dividend decision
Impact of government
economic policy (to achieve
economic growth, low
inflation or balance of
payments stability/) on
investment decisions
Impact of interest rate policy
(monetary policy) on the
decision to borrow money
Impact on changes in taxation
(fiscal policy)
Economic environment for
business
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1 Introduction
1.1 This is not an exam that will test economic theories. You only need to be aware of what a
governments general economic objectives are, and how this can impact on a business.
1.2 Government objectives for the economy are referred to as macroeconomic objectives or
targets. The three main targets are usually:
(a) Economic growth & high employment
(b) Low inflation
(c) Balance of payments stability
2 Policies for achieving macroeconomic targets
Policy type Definition
Fiscal policy How much the government decides to spend, and to raise as tax
revenue
Monetary policy Control over the money supply and of interest rates
Exchange rate policy If the value of the is forced down in value it makes imports
more expensive and exports cheaper
Competition policy Policies to encourage competition e.g. blocking takeovers
Green policy Policies to encourage protection of the environment
3 Target 1 : achieving economic growth /high
employment

Lecture example 1 Idea generation

Required
Identify the impact on a business of the policy changes outlined in the table below.
Policy Impact on a businesss planning & decision making
Fiscal policy
boosting spending
cutting taxes

Monetary policy
increasing money supply
lower interest rates

Exchange rate policy
lower exchange rates

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4 Target 2 : achieving low inflation


Required
Fiscal policy
cutting spending
raising taxes

Monetary policy
higher interest rates

higher exchange rates

5 Target 3 : achieving balance of payments stability
5.1 It is very difficult for a country to spend more on imports than it earns from exports for a
sustained period of time. Where imports exceed exports this is often called a balance of
payments deficit, and governments will often take action to correct this situation using the
policies described below.


Required
Fiscal policy
cutting spending
raising taxes

Monetary policy
higher interest rates

lower exchange rates

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6 Other policies
6.1 Other policies include:
(a) Competition policy eg the Competition Commission prevents takeovers that are
against the public interest
(b) Government assistance for business grants may be available to attract firms to
invest in depressed areas
(c) Green policies may either threaten a business (eg tax on petrol) or create
opportunities (eg subsidies for loft insulation)
(d) Corporate governance regulation see chapter 1

Section 5
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7 Chapter summary

1 Introduction The three main economic objectives are: economic
growth & high employment, low inflation and balance
of payments stability
2 Policies To achieve these objectives, governments use fiscal
policy, monetary policy, and exchange rate policy
3 Achieving high
economic
growth
This often requires stimulating the economy by
cutting taxes or interest rates.
4 Achieving low
inflation
This often requires the opposite i.e. raising taxes
and interest rates
5 Achieving
balance of
payments
stability
This is often achieved by devaluing the exchange
rate
6 Other policies Competition
Government assistance for business
Green policies
Corporate governance regulation see chapter 1

END OF CHAPTER

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3
Role of money and capital
markets (stock market and bond
market)
Would be a short discussion
part of a question.

Role of financial intermediaries Discussion of the meaning and
functions of financial
intermediaries.
APX

Treasury Function (Introduced
to Syllabus in 2013)
Describe the role & uses of
money markets and various
money market instruments

Financial markets and
institutions
3: FINANCIAL MARKETS AND INSTITUTIONS
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Overview

Maximisation of
shareholder wealth
Financial markets
Money market
Capital market
(stock market & bond market &
euromarket)
Financial institutions
Banks
Pension funds
Insurance companies
Investors
Businesses, government,
individuals
Direct investment Use of financial intermediary
Financial markets &
institutions
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1 Introduction
1.1 When a firm is making its financing decision it has the choice of obtaining finance directly
from investors through the financial markets or indirectly through financial institutions
that they have deposited their money with; these financial institutions act as financial
intermediaries.
2 Financial institutions
Types Functions
Merchant banks Provide large corporate loans, often syndicated. Manage
investment portfolios for corporate clients.
Pension funds Invest to meet future pension liabilities.
Insurance companies Invest to meet future liabilities.
2.1 These financial institutions dominate share ownership, and also the provision of debt
finance; because they are investing their clients money they are referred to as financial
intermediaries.
3 Financial intermediaries
3.1 Financial intermediaries provide the following functions: (remember as MAP)
Functions Description
Maturity transformation
A bank can make a 10-year loan (long-term) while still
allowing its depositors to take money out whenever they
want; so short-term deposits become long-term investments.
Aggregation of funds
A bank can aggregate lots of small amounts of money into a
large loan.
Pooling losses
Any losses sustained from a bad debt will not impact directly
on an individual depositor.
4 Financial markets
4.1 A financial market brings a firm into direct contact with its investors. The trend to borrowing
directly from investors is sometimes called disintermediation.
4.2 Financial markets are split into those that provide short-term finance (money markets) and
those that provide long-term finance (capital markets).
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5 Money markets
5.1 If a company or a government needs to raise funds for the short-term, they can access the
money markets and issue:
(a) Treasury bills (issued by governments)
(b) Certificates of deposit (can be sold on)
(c) Commercial paper (issued by companies with a high credit rating)
(d) Bills of exchange (company IOU signed by customer, may be
accepted)
5.2 Higher risk investments require a higher return to be paid. Commercial paper and bills of
exchange are discussed in more detail later in the course.
6 Capital markets
6.1 If a company needs to raise funds for the long-term, it can access the capital markets; this
is a market on which the following are traded:
(a) Bonds / loan notes (secured on an asset or by covenants)
(b) Junk bonds (unsecured)
(c) Shares traded on the main Stock Market
(d) Shares in Alternative Investment Market
6.2 Higher risk investments require a higher return to be paid, so shares will give a higher return
(and therefore cost more) than bonds. Bonds & shares are covered in more detail later
in the course.


Required
What advantages are there to a firm of:
(a) A listing on the main Stock Market
(b) A listing on the Alternative Investment Market
(c) Issuing bonds
Increasing
risk to the
investor
Increasing
risk to the
investor

Case 2
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Solution

(a)

(b)

(c)

7 Eurobonds
7.1 In recent years a strong market has built up which allows large companies with excellent
credit ratings to raise finance in a foreign currency. This market is organised by international
commercial banks. The key features of Eurobonds are summarised below. This market is
much bigger than the market for domestic bonds.

Advantages Explanation
Cheap debt finance Can be sold by investors, and a wide pool of investors share the
risk

Unsecured, no
covenants

Only issued by large companies with an excellent credit rating
Long-term debt in a
foreign currency

Typically 5-15 years, normally in euros or dollars but possible in
any currency

Case 3
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8 Chapter summary
1 Introduction When a firm is making its financing decision it has
the choice of borrowing sources.
2 Financial
institutions
These include merchant banks.
3 Financial
intermediaries
Institutions are investing their clients money, they
are financial intermediaries; this allows Maturity
transformation, Aggregation and Pooling of losses.
4 Financial
markets
These consist of the capital markets and money
markets.
5 Money
markets
The markets for short-term funds e.g. commercial
paper, bills of exchange.
6 Capital
markets
The markets for long-term funds e.g. bonds, shares.
7 Eurobonds A recent development in the capital markets: allow
companies with an excellent credit rating the ability
to borrow in a variety of different currencies.

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9 Additional Notes - Money Market Instruments

9.1 There are 3 main money market instruments in the UK: -
Interest bearing instruments
Discount Instruments
Derivatives
9.2 Interest Bearing Instruments
Interest bearing instruments pay interest, the investor receives face value plus interest at
maturity.
Typical instruments are Money Market Deposits, Certificates of Deposit (CD) and
Repurchase Agreements (Repos).
9.2.1 Money Market Deposits are very short term loans between banks or other institutions
including Governments.

9.2.2 A Certificate of Deposit is a certificate or receipt for funds deposited at a bank or other
financial institution for a specified term, that pays interest at a specified rate. The coupon
rate is expressed as an annual percentage and needs to be adjusted to reflect that maturity
is less than a year.
Value of a CD on maturity = Face Value x [1 + (coupon rate x days to maturity days
in the year)]
Therefore if we had a 180 day CD with a face value of 100,000 and a coupon rate of 5%
the value on maturity would be 100,000 [1 + (0.05 180 365)] = 102,466
The holder of a negotiable CD has two options: to hold it until maturity and receive the
value of maturity, or, if they need the cash before then, they can sell it on at the market price
(as per the above example it is likely to be between 100,000 and 102,466, the closer the
date to maturity the higher the market value).
9.2.3 A Repurchase Agreement (Repo) is an agreement between two counterparties under
which one counterparty agrees to sell an instrument to the other on an agreed date for an
agreed price, and simultaneously agrees to buy back the instrument from the counterparty
at a later date for an agreed price. The security sold acts as collateral in case of default and
will typically be initially sold at below its value.
As with CDs the repo rate is expressed as an annual percentage and needs to be adjusted
to reflect that maturity is less than a year. If a company entered into a repo agreement with a
bank and sold 1m of government bonds with an obligation to repurchase the security in 50
days and the repo rate was 8% the repurchase price would be 1m x [1 + (0.08 50 365)]
= 1,010,959.

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9.3 Discount Instruments
Typical discount instruments include Treasury Bills (debt instruments issued by
governments), Commercial Paper (unsecured corporate debt with maturity up to 270 days)
and Bankers acceptance (negotiable bills (can be sold on) issued by a company and
guaranteed by a bank)
Discount instruments do not explicitly pay interest. They are issued and traded at a
discount to face value. The investors return is the difference between what they initially
paid and the price at maturity. Expressing this as a percentage is the difference between
face value and the price paid divided by the face value. However, for comparative purposes
this needs to be annualised so we need to multiply by the number of days in the year and
divide by the days to maturity.
Number of days in the year Face Value settlement price
Discount Rate =
Days to maturity Face Value
e.g a 90 day treasury bill with a face value of 10m is issued for 9.9m has a discount rate
of: -365 90 x [(10m 9.9m) 10m] = 4%
9.4 Derivatives
Derivatives are used to remove the risk of prices fluctuating and are so called as the price of
derivatives is derived from the value of the underlying asset. Typical derivatives include
forwards, futures and options. Chapter 19 covers these in more detail in the context of
exchange rates, the same principles can be applied to reduce risk for a whole range of
goods, services, assets and liabilities.

END OF CHAPTER

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4
Syllabus detail
How has this been
examined?
Example past paper
questions
Objectives and importance of
working capital management
Brief discussion part of a larger
question on working capital
management, note the conflict
between the objectives
PKA
FLG
ZSE
The cash operating cycle Use of ratios to calculate the
cash operating cycle, discussion
of the result and how the cycle
might be improved.
FLG
Gorwa
Bold
Wobnig Co
Working capital policy Discussion of factors that
influence policy formulation
ZPS
- June 2011, part (b) 7 marks

Working capital
4: WORKING CAPITAL
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Overview

Maximisation of
shareholder wealth
Working capital
Receivables and inventory can help
to boost future cash flows / profits (ie
they are a short-term investment)
Working capital
Money tied up in working capital can create short-term
liquidity problems, policies also need to provide sufficient
liquidity to pay short-term debts as they fall due
Conflict between objectives
4: WORKING CAPITAL
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1 Working capital
1.1 Working capital is the value of current assets less the value of current liabilities.
Key terms Definition
Current assets Cash, inventory, receivables.
Current liabilities Payables, loans falling due within 1 year, overdraft.
2 Objectives of working capital management
2.1 The two main objectives of working capital management are:
(a) To increase the profits of a business
(b) To provide sufficient liquidity to meet short term obligations as they fall due


Required
How can investment in higher levels of inventory or receivables affect
(a) Profits ?
(b) Liquidity ?

Solution

2.2 There is often a conflict between the two main objectives of working capital management;
ie management need to carefully consider the level of investment in working capital and to
consider the impact that this is having on a companys liquidity position; an overview of this
is given by the cash operating cycle.
4: WORKING CAPITAL
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3 Overview cash operating cycle
3.1 The cash operating cycle (also known as the working capital or the cash conversion cycle) is
the period of time between the outflow of cash to pay for raw materials and the inflow of
cash from customers.
Purchases Production In Warehouse Sale

Raw materials WIP Finished goods Credit sales

Credit purchases Cash Operating Cycle (needs funding)

3.2 The optimal length of the cycle depends on the industry.
Calculating the cash operating cycle

1 Inventory days

(a) Finished goods
les Cost of sa
oods Finished g

365 = days

(b) WIP
oduction Cost of pr
WIP

365 = days

(c) Raw material
es al purchas Raw materi
al Raw materi

365 = days

2 Av. collection period
ales (credit) s
ceivables Re

365 = days
3 Av. payables period
urchases (credit) p
Payables
=
365 = (days)

Cash operating cycle =
3.3 By comparing the cash operating cycle from one period to the next or one company to
another it should be possible to identify potential deficiencies.
Cash outflow
Cash inflow

Section 4

4: WORKING CAPITAL
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The table below gives information extracted from the annual accounts of Management plc for the
past year.
Management plc Extracts from annual accounts

Year 1

Inventory: raw materials 108,000
work in progress 75,600
finished goods 86,400
Purchases of raw materials 518,400
Cost of production 675,000
Cost of goods sold 756,000
Sales 864,000
Receivables 172,800
Payables 96,400
Required
Calculate the length of the working capital cycle (assuming 365 days in the year).

Solution

1 Inventory days

(a) Finished goods
les Cost of sa
oods Finished g

365 = days

(b) W.I.P
oduction Cost of pr
WIP

365 = days

(c) Raw material
es al purchas Raw materi
al Raw materi

365 = days
ales (credit) s
ceivables Re

365 = days

urchases (credit) p
Payables
=
365 = (days)

Cash operating cycle =

4: WORKING CAPITAL
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3.4 The working capital ratios can be used to work backwards to for example, the amount of
sales or overdraft.

A business has a current ratio of 2. Current assets consist of inventory of $10m and current
liabilities of $15m. The company gives on average 36.5 days credit to its customers .

Required
Calculate the annual credit sales.

Solution

4 Forecasting cash flow needs
4.1 The cash operating cycle can be used to determine the amount of cash needed at any sales
level, and to identify the possibility of a cash shortfall if sales rise too rapidly. Referring back
to the previous lecture example, we can identify a relationship between sales and cash
required by using the sales / net working capital ratio.
Management plc Extracts from annual accounts
Year 1
Sales 864,000
Inventory: raw materials 108,000
work in progress 75,600
finished goods 86,400
Receivables 172,800
Payables
( 96,400)

Net working capital 346,400

Sales / net working capital ratio = 864,000 / 346,400 = 2.49

4: WORKING CAPITAL
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Required
What level of net working capital (ie cash) is needed to support sales, if sales rise by 30% over the
next year?

Solution

4.2 If a business fails to plan how to supply its forecast level of cash flow needs, it will be in
danger of overtrading. Overtrading is where a business has inadequate cash to support its
level of sales. To deal with this risk a business must either:
(a) Plan the introduction of new long-term capital
(b) Improve working capital management
(c) Reduce business activity
5 Chapter summary
1 Working
capital
Working capital is the value of current assets less
the value of current liabilities.
2 Objectives The two main objectives of working capital
management are to increase the profits of a
business and to provide sufficient liquidity to meet
short term obligations as they fall due. These two
objectives conflict.
3 Overview This is given by the cash operating cycle.

4 Forecasting The cash operating cycle can be used to determine
the amount of cash needed at any sales level, and
to identify the possibility of a cash shortfall if sales
rise too rapidly.
4: WORKING CAPITAL
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END OF CHAPTER

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Discuss and evaluate the use of
EOQ and JIT in the management
of inventory
This has been examined both as a
numerical and a discussion area.
With EOQ it is common to see
questions asking whether to order
more than the EOQ to take
advantage of a supplier discount.
PKA
FLG
- June 2008, part (d), 7 marks

techniques for managing
receivables including discounts,
factoring and foreign accounts
receivable
Normally a combination of
numbers and discussion of
general techniques for managing
receivables.
Ulnad
- Pilot paper, parts (a) & (c), 12
marks
PKA
- Dec 2007, part (c), 7 marks
FLG
- June 2008, part (b), 6 marks
Gorwa
HGR
ZSE
Bold
- Dec 2011, parts (c) & (d),14 marks
KXP
- Dec 2012, parts (a) & (d) 14 marks
techniques for managing payables
including discounts, and foreign
accounts payable
Whether to accept a supplier
discount (see EOQ above) or
foreign exchange risk management
(see chapter 19)
ZPS
KXP

Managing working
capital
5: MANAGING WORKING CAPITAL
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Overview

Maximisation of
shareholder wealth
Managing working capital
Higher inventory is an investment
that may bring benefits to a
company but will result in higher
holding costs.
Higher receivables can be an
investment that help to boost future
cash flows but can cause higher
finance (eg overdraft) costs.
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1 Managing inventory (stock)
1.1 Inventory management has traditionally been about minimising the total cost of inventory
without running the risk of stock-outs.
1.2 The inventory days ratio (see chapter 4) gives an overview of a companys overall
inventory position and is a useful method of monitoring a companys overall inventory
position; but major companies may well have thousands of items in inventory, and will want
to calculate how much to hold of each individual item. A simple inventory classification
system called an ABC system is often used to achieve this.
A High value inventory items, requiring careful control using sophisticated methods
such as the EOQ method discussed below with regular review and control
B Medium value inventory items, as above but with less frequent review
C Low value inventory items, aim to keep a continuous availability
Economic order quantity model
1.3 The order quantity affects a firms total inventory costs, these are:
(a) Holding costs
(i) Warehouse
(ii) Insurance
(iii) Obsolescence
(iv) Opportunity cost of capital
(b) Ordering costs admin & delivery costs.
1.4 The economic order quantity model quantifies the above costs and calculates the order
quantity which minimises the total inventory costs; the model uses the following terms:
D = Annual demand in units
C
o
= Cost of placing an order
C
h
= Annual cost of holding one unit in inventory
P = Purchase price per unit
Q = Number of units ordered.
1.5 Quantifying the costs of holding inventory:
(a) Holding Cost =

Q is the initial order quantity, if inventory falls to 0 then average inventory is Q/2.

C
h
x Q/2

Q
time
0
Inventory
level
Average = Q/2
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(b) Ordering Cost =

D is the level of demand, and Q is the initial order quantity, so D/Q is the number of
orders placed during the year.
1.6 EOQ formula

This formula gives the ideal order quantity to minimise total inventory cost (holding +
ordering); the inventory level that results from this is Q/2.


Firm X faces regular demand of 150 units per month, it orders from its supplier at a purchase cost
per unit of 25. Each order costs 32, and holding cost is 18% p.a. of the purchase price.
Required
(a) Calculate the economic order quantity, and the average inventory level.
(b) Calculate total inventory related cost at this economic order quantity.

Solution

Economic Order Quantity = EOQ =
h
o
C
D C 2

C
o
x D/Q

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Discounts
1.7 Discounts may be available if the order quantity is above a certain size. Thus this needs to
be considered in determining the best order quantity. The following approach should be
used:
(a) Calculate EOQ in normal way
(b) Calculate annual costs using EOQ
(c) Calculate annual costs at the lower boundary of each discount above the EOQ
(d) Select order quantity which minimises costs.


Required
Using the same information given in lecture example 1 calculate the minimum total cost assuming
the following discount applies:
Discount of 1% given on orders of 150 and over
Discount of 2% given on orders of 300 and over
Discount of 4% given on orders of 800 and over.

Solution

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1.8 The simplified version of the EOQ model ignores the delay between ordering and receiving
the order from the supplier; in reality there is a need for buffer inventory to deal with this
delay.
No buffer inventory (av Q/2) Buffer inventory

The expected usage during the lead time requires buffer inventory (B) to be held, and the
average inventory level becomes B + Q/2.
1.9 The drawbacks of the EOQ model are that it:
(a) Assumes 0 lead times, and 0 bulk purchase discounts although these can be
adjusted for as shown above
(b) Ignores the possibility of supplier shortages or price rises
(c) Ignores fluctuations in demand
(d) Ignores the benefit of holding inventory to customers (choice, short lead times)
(e) Ignores the hidden costs of holding inventory (see just-in-time below)
JIT (just-in-time)
1.10 JIT is a philosophy which involves the elimination of inventory. According to JIT, inventory
allows a firm to compensate for inefficient processes; its failure to deal with its inefficient
processes are seen as hidden costs. This is often illustrated as a ship diagram.

firm
Long
lead -times
Poor
quality
Unreliable
staff
Unreliable
suppliers
inventory
Q
Q + B
time time
0
B
Q1
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1.11 Lowering the inventory level forces a company to hit the rocks ie to deal with its inefficient
processes, leading to:
(a) Faster / high quality suppliers
(b) More motivated staff who care about quality
(c) Faster delivery of high quality products
(d) Cost savings from carrying lower inventory
2 Managing receivables (debtors)
Policy formulation
2.1 The decision to offer credit can be viewed as an investment decision, resulting in higher
profits. For many businesses offering generous payment terms to customers is essential in
order to be competitive.

Lecture example 3 Exam standard question for 6 marks

Greedy Ltd is considering a proposal to change its credit policy from allowing debtors credit of 2
months to credit of 3 months. Sales are currently 600,000 p.a. and as a result of the proposed
change will increase by 15%. The contribution/ sales ratio is 20% and the cost of capital is 10%.
Required
Should the proposed change be made?

Solution

Framework for managing receivables
2.2 To keep control over the level of the level of receivables it is important to have an effective
receivables policy; this will involve:
(a) A credit analysis system
(b) A credit control system
(c) A debt collection system
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Credit analysis system
2.3 Before offering credit to particular customer, it is important to analyse the risk of trading
with that customer by asking for bank references and trade references. A credit rating
agency will also provide details on a customers trading history, debt levels and payment
performance.
Credit control system
2.4 After credit analysis, a decision will be taken on the credit limit to be offered. It is important
that this is not exceeded without senior management approval. Credit limits should also be
regularly reviewed.
Debt collection system
2.5 On a regular basis a company should:
(a) Prepare an aged listing of receivables
(b) Issue regular statements and reminders
(c) Have clear procedures for taking legal action or charging interest
(d) Consider the use of a debt factor (considered later)
(e) Analyse whether to use cash discounts to encourage early payment


Pips Limited is considering offering a cash settlement discount to its customers. Currently its
annual sales are $10m and its normal payment terms are 90 days. Customers will be able to take
a 2% discount for payments after 10 days. Pips anticipates that 20% of customers will take the
discount.
Currently Pips has an overdraft on which it is paying 10% interest.
Required
Assess whether Pips should offer the discount.

Solution

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Managing foreign accounts receivable
2.6 Exporting carries a high risk of slow or non payment by customers, and requires closer
control, this can involve :
(a) Letters of credit
The customers bank guarantees it will pay the invoice after delivery of the goods.
(b) Bills of exchange
An IOU signed by the customer. Until it is paid, shipping documents that transfer
ownership to the customer are withheld; it can also be sold to raise finance
(c) Invoice discounting
Sale of selected invoices to a debt factor, the firm keeps control of its sales ledger.
(d) Export factoring
1. Invoicing & debt collection 2. Cash advances in advance of the customer paying
3. Optional bad debt insurance (if used this is non-recourse factoring).
Advantages Disadvantages
(i) Saving in staff time/administration
costs
(i) Can be expensive
(ii) Providing a new source of finance to
help with short term liquidity
(ii) Possible loss of customer goodwill if too
aggressive at chasing for payment
(iii) Supports a business when sales are
rising (unlike a bank overdraft)
(iii) Sometimes viewed as an indication that
the company is in financial difficulty


A company with export sales of $480m pa has an average collection period of 3 months, bad debts
are 2%. A factoring company will provide non-recourse factoring for a fee of 5% of revenue. As a
result of this, administration savings will be made of 8m p.a. and the credit period will fall to 2
months.
The company has a cost of capital of 10%, and the exchange rate is currently 2 $/.
Required
Assess, in s, whether the factor should be used.

Solution

Q2
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3 Managing trade payables
3.1 It is important that when suppliers offer credit, invoices are not paid early; an exception to
this is when early payment discounts are offered.


Pips Limited has been offered a discount of 2.5% for an early settlement by a major supplier from
which it purchases goods worth 1,000,000 each year. Pips normal payment terms are 30 days,
early settlement requires the payment to be made within 10 days.
Currently Pips has an overdraft on which it is paying 10% interest.
Required
Assess whether Pips should take the discount and settle the invoice after 10 days.

Solution

3.2 It is also important to be careful that when suppliers offer credit, invoices are not paid so
late that this endangers the firms long term relationship with the supplier. The benefits of a
long term relationship include:
(a) Better quality
(b) Lower inventory
(c) Lower switching costs
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Managing foreign accounts payable
3.3 To avoid the risk of the weakening by the time an invoice is due to be paid, companies
sometimes pay into an overseas bank account today and then let the cash earn some
interest so that they can pay off the invoice in the future.
4 Chapter summary
1 Inventory The economic order quantity model attempts to
manage inventory costs. This model ignores the
hidden costs of inventory. JIT suggests that
inventory should be driven down to as close to zero
as possible.
2 Receivables Requires a 4 step approach:
(a) A receivables policy
(b) A credit analysis system
(c) A credit control system
(d) A debt collection system
3 Payables Effective payables management involves
controlling the timing of the payment of invoices to
exploit attractive early payment discounts, and the
credit period offered by suppliers; but ensuring that
invoices are not paid so late as to endanger long-
term supplier relationships.

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END OF CHAPTER

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6
Cash management including
forecasts and the use of cash
management models
Cash forecasting with comments
on how to fund any deficits or
invest any surpluses.
Forecast income statement and
statement of financial position
using ratios to calculate forecast
values
Use of cash management models
to identify ideal cash holding levels.
Factors to consider when
determining the optimum level of
cash to be held
HGR
-June 2009, part (b), 10 marks
APX
Ulnad Co
- Pilot paper, part (b), 6 marks
Wobnig Co
KXP
Working capital funding Discussion of different strategies
towards funding working capital.
Also general awareness that tighter
management of inventory,
payables and receivables can
provide finance.
Ulnad Co
- Pilot paper, part (d), 7 marks
HGR
APX
Wobnig Co
June 2012, part (b), 9 marks

Working capital finance
6: WORKING CAPITAL FINANCE
56
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Overview

Maximisation of
shareholder wealth
Working capital finance to fund
investments in working capital
Cash forecasting to plan how
to deal with cash shortages
Cash forecasting to ensure
that dividends can be paid
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1 The management of cash
1.1 As a business grows, its working capital funding needs to also grow. A key question for a
treasury department is how to fund this working capital growth. This is complicated by the
fact that some current assets are permanent (eg a certain amount of inventory and
receivables are always present) and some are fluctuating (due to seasonal fluctuations in
business).
1.2 In this chapter we look at how to:
(a) Forecast cash needs
(b) Manage (forecast) cash surpluses
(c) Manage (forecast) cash shortages
2 Forecasting cash needs
2.1 The main reason for holding cash is so that a business can meet its regular commitments,
this is sometime called the transactions motive. The amount of cash that a business
needs to keep in its bank account can be assessed in one of two ways:
(a) A cash flow forecast
(b) A mathematical model of a businesss cash flows
3 Cash flow forecasting
3.1 This is the most important tool in short-term cash flow planning. Cash flow forecasts will be
prepared continuously during the year and will allow a business to plan how to deal with
expected cash flow surpluses or shortages.
3.2 You will need to produce forecasts in the exam that reflect:
(a) The expected timing of receipts and payments of cash during the period
(b) That not all items in the income statement will be in the cash budget eg depreciation
Cash forecast
for the three months ended 31 March 20X1

January

February

March

Cash receipts

Sales receipts (W1)

X

X

X

Issue of shares

X

Cash payments

Purchase payments (W2)

X

X

X

Dividends/Taxes

X

Purchase of non-current assets

X

Wages

X

X

X

Cash surplus/deficit for month

X

(X)

X

Cash balance, beginning

X

X

(X)

Cash balance, ending

X

(X)

X

Section 3

Section 1.1
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Lecture example 1

Exam standard question for 12 marks

Ben is a wholesaler of motorcycle helmets, it is 1 January 20X2.
Credit sales in the last quarter of 20X1 were as follows:
Helmets
October 2,000
November 2,000
December 2,500
His credit sales in the first quarter will be as follows:
Helmets
January 3,000
February 5,000
March 4,500
Customers are given 60 days' credit and the average selling price is 10. His biggest customer,
Mickster, is given a 2% discount for paying cash when the sale is made. Mickster is planning to
buy 150 helmets in January and 250 Helmets in March. The sales to Mickster are in addition to
those credit sales stated above.
Purchases (an average of 30 days credit) are 4 per helmet. Ben plans to buy in the helmets a
month in advance of selling them. Total overheads are 2,000 per month, this includes 400
depreciation and wages of 1,000. All other overheads are paid for after a credit period of 30 days.
Ben plans to inject a further 5,000 of his own money into the business in March to help to buy
non-current assets for 24,000. These assets will be depreciated over 5 years.
Required
Prepare a monthly cash flow forecast for the 1st quarter of 20X2; the opening balance is negative
4,550.

Solution

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4 Mathematical models
4.1 The cash flow forecast calculates the cash needed for a period eg 1.5m might be needed
to fund forecast cash outflows expected by a division in a particular year. Some businesses
pay the expenses of a particular department or division from a separate sub account. If so, it
is not sensible to deposit the 1.5m into this sub-account at the start of the year because
this will lead to a loss of interest earned from a high interest account or from securities.
Instead, it is better to gradually transfer the funds as they are needed.
4.2 How much to transfer can be calculated by using mathematical models, there are two
mathematical models that you need to be aware of:
(a) Baumols model
(b) Miller-Orrs model
Baumol model
4.3 The Baumol Model is an adaptation of the EOQ Model to manage cash. It assumes that
cash is used at a steady rate during the year, which will often not be the case.
The Economic Order =
Quantity of Cash

cash holding of cost interest Net
required cash Annual cash ordering of Cost 2

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A division requires 1.5m per year; cash use is constant throughout the year.
Required
What is the optimal economic quantity of cash transfer into this divisions sub-account if ordering
costs are 150 per transaction, and the interest lost on the funds transferred is 4.5% pa?

Solution

Miller-Orr model
4.4 Another cash management model is the Miller Orr Model which recognises that cash inflows
and outflows vary considerably on a day to day basis (unlike the Baumol model). This is
clearly more realistic.
It works as follows:
(a) A safety stock (lower limit) of cash is decided upon.
(b) A statistical calculation is completed taking into account the variation in cash flow to
agree an allowable range or spread of cash flow fluctuations.
(c) Using this spread, an upper limit of cash balances is agreed.
(d) The cash balance is managed to ensure that the balance at any point in time is kept
between the lower and upper limits.
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Cash
Balance

Upper Limit

Return Point

Lower Limit

4.5 The return point is calculated as:

Lower limit + (1/3 spread)


If a company must maintain a minimum cash balance of 8,000, and the variance of its daily cash
flows is 4m (ie std deviation 2,000). The cost of buying/ selling securities is 50 & the daily
interest rate is 0.025 %.
Required
Calculate the spread, the upper limit (max amount of cash needed) & the return point (target level).

Time
Cash balance increased ie sell securities
or transfer funds from a deposit account
Cash balance reduced ie buy securities
/ transfer funds to a deposit account
The difference between the upper & the lower limits is called the spread, calculated as (formula given)
Spread = 3
3
1
rate interest
flows cash of variance cost n transactio
4
3

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Solution

4.6 This model assumes that cash flows are unpredictable, in fact an experienced financial
controller should be able to predict the cash flows so enabling a company to operate on
lower cash levels than the Miller-Orr model calculates.
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5 Managing cash flow surpluses
5.1 Most companies would want to avoid risk on short-term cash surpluses that are invested
because the funds will be needed in the near future. Desirable investments would generally
be low risk and liquid. These could include:
Investments Definition
Treasury bills Short-term government IOUs, can be sold when needed.
Term deposits Fixed period deposits.
Certificates of
deposit
Issued by banks, entitle the holder to interest + principal, can be
sold when needed.
Commercial paper Short-term IOUs issued by companies, unsecured.
5.2 Long term cash surpluses may be used to fund:
(a) Investments new projects or acquisitions
(b) Financing repay debt, buy back shares
(c) Dividends
6 Managing cash flow shortages
Working capital funding policy
6.1 Cash shortages can be funded by either long-term finance or short-term borrowings; these
will be covered in detail in later chapters.

6.2 In between these extremes is a matching policy which uses short-term finance to fund
fluctuating current assets and long term finance to fund permanent current assets
and non-current assets.
6.3 The likelihood of a company adopting an aggressive approach depends on:
(a) Management attitude to risk
(b) Strength of relationship with the bank providing an overdraft
(c) Ability to raise long-term finance
Short-term
Usually cheaper so some companies
adopt an aggressive approach & rely
mainly on short-term finance. Risky but
potentially results in higher profits.
Long-term
Other companies adopt a conservative
approach and rely mainly on long-term
finance.

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7 Chapter summary
1 Management
of cash
Working capital movements have cash flow
implications that need to be carefully managed.
2 & 3 Forecasting Cash flow forecasts will be prepared continuously
during the year and will allow a business to plan how
to deal with expected cash flow surpluses or
shortages.
4 Mathematical
models
There are two mathematical models that you need to
be aware of:
(a) Baumols model
(b) Miller-Orrs model

5 Managing cash
flow surpluses
Desirable investments would generally be low risk
and liquid
6 Managing cash
flow shortages
A matching policy which uses short-term finance to
fund fluctuating current assets and long term finance
to fund permanent current assets and non-current
assets.

END OF CHAPTER

Q3
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Checkpoint 1 Progress Review
To reinforce your learning to date you should now follow the study guidance in the
following pages. On completion, your progress towards full exam preparation will be:

Key messages from Stage 1
You have now completed Stage 1 of the course. Dont worry if you are finding this paper challenging, not
many people have practical experience (at this stage in their careers) of using the techniques in this paper
and many people find it difficult as a result.
Take some time to reflect on the knowledge and skills you covered during Stage 1. If you feel you need
further clarification on any of the key areas listed below, you can use the on-line lecture for the relevant
chapter. The Course Notes section for each chapter (starting overleaf) provides helpful guidance (and time
commitments) on how to focus your review on the key learning points in your notes.
Key knowledge
The main aim of financial management is to construct investment, financing and dividend policies that
will help to maximise shareholder wealth.
You need to be able to calculate a number of key ratios including: return on capital employed, gearing,
interest cover, earnings per share and total shareholder return.
You need to be able to discuss the objectives of working capital management and to measure the
operating cycle and the sales/net working capital ratio.
You need to be able to evaluate inventory management using the EOQ model.
You need to be able to evaluate cash flow management using forecasts and mathematical models.
Key skills
You need to be able to analyse the meaning of a number of key ratios including: return on capital employed,
gearing, interest cover, earnings per share and total shareholder return.
You need to be able to discuss the conflict between the objectives of working capital management and to
analyse the impact of the operating cycle and the sales/net working capital ratio.
You need to be able to analyse and discuss the management of each individual type of working capital.
You need to be able to analyse and discuss the impact of a cash flow forecast.

CHECKPOINT 1
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Checkpoint 1 Study Support

Chapter 1 Financial management and financial objectives 70 mins
Key areas
The framework for maximising shareholder wealth, and for value for money
The needs of internal, connected and external stakeholders
Calculation of profitability, debt, liquidity and shareholder investor ratios

Course Notes
This chapter sets up the framework for the paper; carefully review section 2 to
check your understanding.
Discussion questions will require you to understand the concept of agency theory
(section 3) and how it can be managed by corporate governance and incentive
schemes.
Review Lecture Example 4 and make sure that you understand the types of
profitability, debt, liquidity and shareholder investor ratios (including total
shareholder return) and how they are calculated remember that you will not be
given the definition of these ratios in the real exam.

20 mins

Question practice
Do an answer plan for Question 1 (Earnings per share) from the Study Text
Question Bank; this is a good test of your understanding of shareholder and
stakeholder needs.

20 mins
Additional Resources
Real-life example
In the real-life examples section you will find a recent web article illustrating the
relationship between the investment decision and the dividend decision. It is strongly
recommended that you read this to help you understand how businesses make such
decisions.
Study Text
Work through section 1.5 to ensure that you understand the difference between
management and financial accounting, and financial management. Review sections
2.1 2.2; the achievement of a range of corporate objectives (shareholder wealth
maximisation is arguably the most important) requires sound financial management
(investment / financing / dividend decisions). These corporate objectives address
the needs of a number of stakeholders; the likely needs of these stakeholders are
outlined in section 3.
Review section 4.4.4 and note that return on equity is also referred to as return on
shareholders funds.
Read section 6 and make sure you can give examples of economy, efficiency and
effectiveness. This area is likely to be tested in the exam as part of a question on
objectives.

10 mins

10 mins

10 mins

CHECKPOINT 1
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Checkpoint 1 Study Support (cont)
Chapter 2 Economic environment for business 70 mins
Key areas
How government economic policy affects a business

Course Notes
Carefully work the lecture examples in this chapter, and make sure that you
understand the meaning of each of the policy types.
This is not an economics exam you need to understand that as a government tries
to achieve its three main macroeconomic targets, the policies that it uses may affect
the financial strategy of a business.

30 mins
Question Practice
Question 2 (News for you) from the Study Text Question Bank plan out an answer
to this question to ensure you are comfortable with the issues involved; concentrate
on part (a).

20 mins
Study Text
Read the practical examples in sections 5.4, 5.7 and 7.2 to see the relevance of the
topics covered in this chapter.
Carefully review section 5; competition policy is an area of government policy that
directly affects companies and is a likely area to be tested as a part of an exam
question.

5 mins

15 mins

Chapter 3 - Financial markets and institutions 25 mins
Key areas
The functions of financial intermediaries
The difference between the money market and the capital market, and the link
between risk and return for the securities traded on these markets
The importance of the stock market and of the Euromarkets

Course Notes
Review the chapter. Make sure that you understand the difference between financial
institutions / intermediaries and financial markets.
Also make sure that you can discuss the money markets and the capital markets -
concentrate on the learning points from Lecture Example 1. The Euromarkets are an
emerging an important source of capital so carefully review section 7 of this chapter.

10 mins
Additional resources
Real-life example
In the real-life examples section you will find a recent article which explains the
growing use of bonds and also an article explaining Eurobonds in more detail. It is
strongly recommended that you read these to develop your understanding of
sources of finance.

15 mins
CHECKPOINT 1
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Chapter 4 Working capital 60 mins
Key areas
The two objectives of working capital management and how they may conflict
Calculation of cash operating cycle and use of the sales/net working capital ratio
The problem of overtrading and how it can be managed

Course Notes
Review the chapter ensuring you can calculate all ratios involved in the calculation
of the operating cycle and that your rework example 4 to make sure that you
understand the importance of the sales / net working capital ratio.

10 mins
Question Practice
Attempt Question 4 (Gustaffson) in the Study Text Question Bank this tests
calculations, the key liquidity ratios and the concept of overtrading.

45 mins
Study Text
Read section 2 to reinforce the objectives of working capital management and
section 3 which contains a practical case study.

5 mins

Chapter 5 Managing working capital 20 mins
Key areas
Different approaches to inventory management (EOQ, JIT)
The key features of accounts receivable management, including foreign accounts
receivable

Course Notes
This is an important chapter and needs to be carefully reviewed. It would be
sensible to rework as many of the lecture examples as you can.
Make sure that you understand the impact of bulk purchase discounts and buffer
inventory on the EOQ; rework Lecture Example 2.
Ensure that you understand the potential benefits of JIT.
Review paragraph 2.2, this is a useful framework for discussing the management of
receivables. Finally, management of foreign exchange receivables is an area of this
chapter that is easy to neglect; make sure that you cover this section carefully.

10 mins

5 mins
5 mins

CHECKPOINT 1
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Chapter 6 Working capital finance 30 mins
Key areas
Preparation of a cash flow forecast, including the use of cash management models
Management of cash flow surpluses and deficits

Course Notes
This chapter was tested in the pilot paper and in June 2009. Rework examples 2 & 3
to make sure that you can use the Baumol & Miller-Orr models.
Also make sure that you can discuss how to manage cash flow surpluses and
shortages, this is covered in sections 5 & 6.

10 mins
Question Practice
Attempt Question 7 (SF) from the Study Text Question Bank plan out an answer
to the question and review the solution.

20 mins

CHECKPOINT 1
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Checkpoint 1 - Progress Test
Having completed the home study guidance contained on pages 65 to 69, you are now ready to attempt the
Progress Test. You should aim to complete the test in 1 hour. If you find it takes you significantly longer to
do so then please contact your course tutor for guidance.
The multiple choice questions contained within this Progress Test will thoroughly test your understanding of
the material and your ability to perform the required calculations. Note that the F9 exam does not contain
multiple choice questions. The four short questions that follow will test your ability to apply your knowledge.
These skills will prove important when answering exam standard questions.
It is important that you continually review your progress (solutions are on page 73) and revise further any
areas where you feel your understanding is weak.
A Multiple choice questions (10 questions approximate time 40
minutes)
Data for questions 1 and 2
A company has the following income statement and statement of financial position extracts:
$

$

P.B.I.T

500,000

Non-current assets

5,000,000

Interest

(50,000)

PBT

450,000

Current assets

2,500,000

Tax (50%)

(225,000)

225,000

Less:

Current Liabilities

(1,500,000)

Preference Dividend

(25,000)

Ordinary Dividend

(100,000)

Net Assets

6,000,000

Dividend Retained

100,000

1 The ROCE is:
A 10%
B 7.5%
C 8.3%
D 3.75% (2 marks)
2 Dividend cover is:
A 1.8
B 2
C 1.0
D 1.4 (2 marks)
3 Interest cover(age) is:
A 9.0
B 4.5
C 10.0
D 2.0 (2 marks)

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4 Extracts of financial details of a company are as follows:

$

Sales

500,000

Cost of sales

420,000

Purchases

280,000

Receivables

62,500

Payables

42,000

Inventory

185,000

The operating cycle to the nearest whole day is:
A 190 days
B 140 days
C 152 days
D Cannot be calculated (4 marks)
5 Using the data from Question 4, the sales to net working capital ratio is:
A 2.43
B 8.00
C 1.46
D Cannot be calculated (2 marks)
6 Using the data from Questions 5 and 6 the increase in cash required to support a sales increase of
30%, to the nearest $000 is:
A $6
B $215
C $62
D $65 (2 marks)
7 You are given the following details.
Share capital 500,000 5c shares

Income Statement

$

Profit before tax

400,000

Tax

(100,000)

Earnings

300,000

Dividends

(100,000)

Retained

200,000

The EPS is:
A 80c
B 40c
C 60c
D 30c (2 marks)
8 A company faces demand of 500 units per month for imported ipods that it purchases for $50 per
unit. The cost of an order is $100 and holding costs are 10% p.a. of inventory value. The economic
order quantity (to the nearest unit) is:
A 100
B 490
C 333
D 1,000 (2 marks)
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9 A company with annual sales of $960,000 has average receivables of two months are considering
offering a 2% prompt payment discount. They estimate that half of their customers will take up this
discount and that that this will have the effect of reducing average receivables to one month. This
company currently has a bank overdraft which costs 15% p.a.
The net benefit / (cost) of this change will be:
A ($7,200) cost
B $70,400 benefit
C ($22,400) cost
D $2,400 benefit (2 marks)
10 Bonds that are issued by a company at a large discount to their eventual redemption value, but on
which no interest is paid until redemption, are called:
A Debentures
B Zero coupon bonds
C Equity bonds
D Floating rate bonds (2 marks)
B Short written questions (4 questions approximate time 20 minutes)
1 Compare the objectives of a listed company with those of a not for profit organisation (6 marks)
2 Identify the three key elements of a financial strategy (3 marks)
3 Discuss the impact of a devaluation of the pound on a UK firm exporting to the USA (3 marks)
4 Describe the functions of a financial intermediary (3 marks)

END OF PROGRESS TEST

CHECKPOINT 1
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Checkpoint 1 - Progress Test solutions
Section A
1 C ROCE = 500/6,000 = 8.3%
2 B Dividend cover = times 2
$100,000
$200,000

dividend Ordinary
dividend preference after Profit

3 C Interest cover = times 10
$50,000
$500,000

interest
PBIT

4 C Inventory days = 365
$420,000
$185,000
= 161 days
Receivables days = 365
$500,000
$62,500
= 46 days
Payables days = 365
$280,000
$42,000
=
55 days

=
152 days

5 A Sales / net working capital = 500,000 / (185,000 + 62,500 42,000) = 2.43
6 C Sales increase = $150,000, divide this by 2.43 = $62,000 approx
7 C EPS = 60c
500,000
$300,000

issue in Shares
Earnings

8 B (2 x $100 (500 12 months) / 5) = 490
9 D The net benefit / (cost) of this change will be:
Cost = 0.5 $960,000 0.02 = $9,600
Benefit = reduction of 1 month = 1/12 $960,000 = $80,000 reduction in receivables leading
to an overdraft saving of $80,000 0.15 = $12,000
Net benefit = $12,000 $9,600 = $2,400
10 B Zero coupon bonds are rare. Floating rate bonds are bonds on which the interest rate is altered
periodically to bring it into line with current market rates of interest.

Section B
1 A listed companys primary objective will be to maximise shareholder wealth; it will also have other
financial objectives such as improving earnings and sometimes dividend per share. To reflect the
importance of other stakeholders, there may be corporate objectives for improving market share or
reducing CO
2
emissions etc.
A not for profit organisation must try to achieve its objectives while operating within its budget. A
typical objective for this type of business is to maximise value for money, ie achieve good economy
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(in purchasing inputs) efficiency (in the use of these inputs) and effectiveness (time or quality
targets).
2 These are:
Investment planning finding investments that will achieve a good return for shareholders
Financial planning using a mix of debt and equity that is acceptable to the stakeholders of a business
Dividend planning identifying whether it is better to pay out a dividend or re-invest it into the
business.
3 The value of the $ will have gone up, so the value of $ receipts will be higher. This will mean that the
exports are more profitable, which is likely to stimulate UK exports to the USA.
4 Financial intermediaries provide the following functions: (remember as MAP)
Functions Description
Maturity transformation A bank can make a 10 year loan (long-term) while still allowing its
depositors to take money out whenever they want; so short-term
deposits become long-term investments.
Aggregation of funds A bank can aggregate lots of small amounts of money into a large
loan.
Pooling losses Any losses sustained from a bad debt will not impact directly on an
individual depositor.

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Checkpoint 1 Real-life examples
Case 1 - Ryanair ponders sober maturity
Financial Times December 2009

Rebellious youths often mellow into conformity later in life. Does the same hold true for upstart companies?
The question was raised on Friday by the announcement from Ryanair that it was planning to scale back its
rapid expansion in order to maximise the distribution of cash to shareholders between 2012 and 2015.
Such a move would be a big strategic shift, given that the abrasively successful Irish group has reinvested
cash in the business instead of paying a dividend during its 12 years as a listed company.
But fast-growing companies that decide to reinvent themselves as income generators risk losing something
valuable in the transition, says Joseph Lampel, a professor of strategy at Londons Cass Business School.
He views Ryanair as a classic breakthrough company whose appeal is its ability to tear up the rule book, in
this case by undermining the higher-cost business model that constrained older airlines, such as British
Airways.
Shifting to a consolidation strategy can make innovative managers too focused on delivering stable income
to investors, sacrificing sparkle for steadiness, says Prof Lampel.
The financial forces push them towards conformity with other corporations, he says, adding that
companies in this position often end up diversifying as a way of spreading risk.
He also adds that upstarts that embrace a consolidation strategy usually shut the door on their past: few are
able to rediscover a freewheeling style should they tire of sober maturity.
Freek Vermeulen, an associate professor of strategic and international management at London Business
School, agrees that it is very difficult for a company to regain its innovative edge after it has shifted focus
from exploration to exploitation.
He cites the example of Microsoft, which became much more a part of the corporate mainstream when it
started paying dividends in 2003 but which has struggled to replicate the enormous PC-based success of
Windows on the internet.
That said, Prof Vermeulen suggests that Ryanairs move to distributing cash would not be such an extreme
step for the group, given that the roll-out of its low-cost network involved a fair amount of repetition as well
as innovation.
In a conference call with analysts in November, Michael OLeary, Ryanair chief executive, appeared to
anticipate fears that the company might become too focused on steady disbursements to shareholders.
He said that any cash distributions resulting from a change in strategy were likely to be one-offs rather than
regular payments.
This approach may limit Ryanairs appeal to conventional income investors in the UK, who seek out
companies that offer a steady stream of payments, and who have had to weather a succession of dividend
cuts recently.
Were not going to get into some kind of dividend stream, Mr OLeary says.
But I think youll see very substantial one-off distributions every two or three years.
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Case 2 Bonds
Times January 2010

Their word is their bond but whose credit do you trust? A famous football club, an 800-year old university or
the Treasury? All would like to borrow your money or tap your pension fund.
The University of Cambridge wants 400 million to finance property development, Manchester United wants
twice as much to cut its debt and the Government is hoping to raise more than 200 billion to pay for
everything from nurses salaries to new helicopters for the Army. At the same time, the corporate sector is
throwing bonds about like confetti. Non-financial companies issued more than $1 trillion in bonds last year
as businesses rushed to take advantage of cheaper money and easier terms in the global capital markets.
Instead of borrowing from banks, companies are going direct to the prime source of cash the pension
funds of ordinary savers. They are offering bonds, which are promises to pay a sum at a fixed interest rate
and instruments that can be bought and sold like an equity share.
The reason for the surge in bond finance is that the crippled banks have been shut out of the lending market.
Required to boost their reserves after suffering stupendous losses, the banks want to lend at high rates of
interest and charge big fees to arrange loans. Businesses find better terms in the capital markets, where bond
investors are hankering for income at a time when bank deposits yield almost nothing.
Bond markets are less developed in Britain than in the United States, where every municipality issues bonds
to fund infrastructure. Some institutions, such as the Crown Estate, are prohibited by law from borrowing.
Britains public sector bond market was virtually shut down by Margaret Thatcher when she sought to get a
grip on spendthrift local authorities. Since then, the Treasury calls the tune but there is a growing clamour for
more fund-raising by local government. Transport for London has issued bonds and many local authorities
would like to raise funds for housing or transport with bonds backed by rents or bus fares.
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Case 3 Eurobonds
Financial Management May 2008

What is a eurobond?
Eurobonds are defined as bonds which are outside the control of the country in whose currency they are
denominated; but dont make the mistake of thinking that they are issued in Europe, or only denominated in
euros - the eurobond market is global and involves a wide range of currencies (although dollars and euros
are the most common).

Eurobonds are normally repaid after 5-15 years, and are for major amounts of capital ie $10m or more.

Large companies with excellent credit ratings regularly issue eurobonds, recent examples include: Cadbury-
Schweppes (1,200m 2004) and VW (34 trillion Turkish lira 2004).

What are the advantages of Eurobonds?
Eurobonds are bearer instruments, which means that the certificate is the sole title to ownership. Interest is
paid gross of tax. Eurobonds are useful because they create a liability in a foreign currency to match against
a foreign currency asset. The motive behind Walt Disney Corp issuing eurobonds in 1992 was to finance the
launch of Euro Disney. Without this matching effect Walt Disney Corp would have faced the risk that a
declining euro would have reduced the dollar value of their overseas investment.

Eurobonds are often cheaper than a foreign currency bank loan because they can be sold on by the investor,
who will therefore accept a lower yield in return for this greater liquidity. Eurobonds also are extremely
flexible. Most eurobonds are fixed rate but they can be floating rate or linked to the financial success of the
company. For example, in 1992 Walt Disney Corp issued a $300m Eurobond with a 3% coupon plus the
right to benefit from the success of 13 named films which meant that the bonds could potentially provide a
13.5% p.a. yield.

Eurobonds are typically issued by companies with excellent credit ratings and are normally unsecured, which
makes it easier for companies to raise debt finance in the future. Eurobond issues are not normally advertised
because they are placed with institutional investors (this is discussed below); this reduces issue costs.

The eurobond market can be used by companies to raise debt in dollars or euros (the majority of eurobond
issues involve these currencies) and swap this into another currency using a currency swap; most eurobond
issues are swapped in this way. For example, in 1984 Disney issued 80m of euro-denominated Eurobonds
and swapped them into yen to act as a hedge to the yen revenue from Disneys Japanese operations.

Eurobonds are an extremely important source of finance for major companies with strong credit ratings.
Eurobonds accounted for about 70% of all funds raised by UK listed companies in 2007.

Like any form of debt finance there will be issue costs to consider (approximately 2% of funds raised in the
case of eurobonds) and there may also be problems if gearing levels are too high. For example, Walt Disney
Corp recently had to suspend royalty payments made by its European subsidiary because of financial
difficulties at Euro Disney caused in part by the high levels of debt that it has taken on.

Doug Haste is an education specialist working at BPP Professional Education.
CHECKPOINT 1
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Answers to
Lecture Examples
21: ANSWERS TO LECTURE EXAMPLES
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Chapter 1
Lecture Example 1a
- Profits are historic, shareholders care about the future perhaps they were concerned by the
potential impact of the recession. Ryanair were still planning expansion at that time investment
decisions are very important to investors
- Investment decisions require new finance , shareholders care about debt levels perhaps they
were concerned by information in the press briefing concerning this financing decisions are
very important to investors
- Profits are not cash flows, shareholders often want to see what returns they will be getting as
dividends perhaps they were concerned by information in the press briefing concerning the level
of dividend that Ryanair was planning to pay (zero, but this policy has now changed) dividend
decisions are very important to investors
- Also profit can be manipulated by depreciation policy and by short-termism
Lecture Example 1b
- The share price is generally felt to capture shareholders feelings about future cash flows and risk
Lecture Example 2
m Last year Current year
Profits before interest and tax 22,300 23,726
Tax 5,790 6,218
Profits after interest and tax 13,510 14,508
Preference dividends 200 200
Earnings 13,310 14,308
Earnings per share 13.3p 14.3p
Growth rate = (14.3 / 13.3) 1 = 0.075 or 7.5%
Dividends 7,986 8,585
Dividend per share = (0.086/ 0.08) 1 = 0.075 or 7.5%
Magneto has failed to hit these financial objectives but short term profit based measures are not a
sufficient basis on which to fully assess the performance of Magneto.
Lecture Example 3
- Not enough NEDs (min 50%)
- NEDs dont seem to be independent, and should not be paid share options
- Remuneration should not be discussed by the main board
- Audit committee should only include NEDs
- No split between Chair & Chief Executive
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Lecture Example 4
The question does not tell us what the share price has been over the period, but it does provide the
price/earnings (P/E) ratio. We can derive the share price at the time of the announcement of the results
as follows:

Previous year

Current year

ROCE
8700/33900 =25.7% 9
9500/34700 = 27.4%

Gearing
1130
11300/22600 = 50%

9000/25700 = 35%

Interest cover 8700/1200 = 7.25 9500/1000 = 9.5
Share price

17 5100/9000 = 9.63

18 5700/9000 = 11.40

Dividend yield
(2000/9000) / 9.63 = 2.3%
2
(2200/9000) / 11.40 = 2.1%

Total shareholder return

0.244 dividend + 1.77 increase in share price
9.63 start of year share price
= 21%
- Gearing does not appear to be a problem, and interest cover is high; and
- The P/E ratio, which is influenced by perceived growth potential, has improved.
- Total shareholder return looks impressive
Chapter 2
Lecture Example 1
Fiscal policy
- boosting spending
- cutting taxes

Bidding for government contracts
Higher consumer spending
Higher profits from investments
Monetary policy
- increasing money
supply
- lower interest rates

Higher consumer demand
More likely to use debt finance
- lower exchange rates
Possibly caused by lower interest rates
Overseas suppliers become more expensive
Export markets become more attractive

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Lecture Example 2
Fiscal policy
- cutting spending
- raising taxes

Lower consumer spending, export markets attractive
Higher prices (if VAT) so lower sales
Lower profits from investments
Dividend policy affected if taxes on dividends increased
Monetary policy
- higher interest rates

Less likely to use debt finance, consumer demand falls
- higher exchange rates

Export markets become less attractive
Lecture Example 3
Fiscal policy
- cutting spending
- raising taxes

Designed to cut spending on imports but will have a knock on effect
on domestic sales
Monetary policy
- higher interest rates

Designed to attract capital into the domestic economy from abroad,
but reduces investment by local firms.
- lower exchange rates

Designed to make exports more competitive,
Chapter 3
Lecture Example 1
(a) The main Stock Market
Public profile, investor confidence (audited accounts, regular briefings, NEDs, 3 years of
successful trading history), access to wider pool of equity finance, allows owners to realise some
of their investment
(b) The Alternative Investment Market
Lower membership fees & compliance requirements (no successful trading history or corporate
governance requirements)
(c) Bonds are a liquid investment, so will often be cheaper than a bank loan. A bond will be called in
if its terms are breached, a bank may be more willing to renegotiate a loan whose terms have
been breached (they hope to do more business with the company). Another advantage of bonds
is that often they can be redeemed over a range of dates at the companys discretion.
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Chapter 4
Lecture Example 1
(a) Profits
Higher inventory means greater availability & possibly more choice to the customer of different
variants of the product and therefore higher sales and higher profits. Higher receivables may
mean better payment terms, which may lead to higher sales and this again may lead to higher
profits.
(b) Liquidity
Higher inventory & higher receivables mean more cash tied up in the short term which may lead to
cash flow problems.
There is sometimes a conflict between these 2 objectives.
Lecture Example 2

1 Inventory days

(a) Finished goods
756,000
86,400

365 = 41.7 days

(b) W.I.P
000 675
600 75
,
,

365 = 40.9 days

(c) Raw material
400 518
000 108
,
,

365 = 76.0 days
864,000
172,800

365 = 73.0 days

518,400
96,400

365 = (67,9) days

Cash operating cycle = 163.7
Lecture Example 3
2
s liabilitie Current
assets Current
=
2
15
s Receivable 10
=
+

Receivables = (2 15) 10
= 20
36.5 365
sales Credit
s Receivable
=
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sales Credit
365 20
= 36.5
Credit sales = (20 365)/36.5
= $200m
Lecture Example 4

864,000 1.3 = 1,123,200
1,123,200 / 2.49 = 451,084

Chapter 5
Lecture Example 1
(a) EOQ =
.18 25
32 1,800 2

= 160 units
Average inventory = Q/2 = 80 units
(b) Total cost = Purchasing + C
h

2
Q
+ C
o

Q
D

= 1,800 25 + 4.50
2
160
+ 32
160
1,800

= 45,720
Lecture Example 2
Qualifies for 1% discount so recalculate
0.99 25 0.18
1,800 32 2
EOQ New

= = 161 units

Q Order Holding Purchase Total
cost cost cost
(D/Q C) (Q/2 H) (D P)
161 357.8 358.6 44,550 45,266.4
300 192 661.5 44,100 44,953.5
800 72 1,728 43,200 45,000.0
Order 300 units at a time.
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Lecture Example 3
Cost

Finance cost was 600,000 2/12 10% = 10,000

Finance cost will be 600,000 1.15 3/12 10% = 17,250

Additional cost = 7,250

Benefit

Additional contribution = 600,000 15% 20% = 18,000

Net benefit =
10,750

Lecture Example 4
Cost
$10m 0.2 0.02 = $40,000
Benefit
Current receivables = 90/365 10 = $2,465,753
New receivables = (0.2 10/365 10) + (0.8 90/365 10) = $54,795 + $1,972,603 = $2,027,398
Reduction in receivables = $438,355
Saving in overdraft interest =
$43,836
Net benefit = 3,836

Sales may also rise as a result of the policy.
The policy should be introduced.
Lecture Example 5
Cost of debt factor

m

Factors charge

$480m 5% / 2 (the exchange rate)
12.0
Benefit of the debt factor

(i) Financing costs

Current receivables
($480
12
3
) / 2 = 60m
New receivables ($480 x 2/12 ) / 2= 40m
Reduction in receivables 20m leads to interest saved of

2.0

(ii) Bad debts

($480 2%) / 2

4.8

(iii) Administration savings 8.0

14.8
Use the factor as it is estimated to save 2.8m p.a.
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Lecture Example 6
Cost
Current payables = 30/365 1,000,000 = 82,192
New payables = 10/365 1,000,000 = 27,397
Reduction of 54795 0.1 =
5,480

Benefit
0.025 1,000,000 = 25,000
Saving =
19520

Nb this is an approximate calculation, acceptable for exam purposes many other approaches are
possible
The discount should be accepted
Chapter 6
Lecture Example 1

Jan

Feb

Mar

Inflows

Sales

Mickster (Cash)

(98% 10 150; 250)

1,470

2,450

November sales (2 months credit)

December sales
January sales

20,000

25,000

30,000

Capital

5,000

Total inflows

21,470

25,000

37,450

Outflows

Dec purchases (for Jan sales incl

Mickster)
January purchases (for Feb sales)
February purchases (for March sales)

12,600

20,000

19,000

Overheads

(2,000 400 1,000)

600

600

600

Wages

1,000

1,000

1,000

Fixed assets

24,000

Total outflows

14,200

21,600

44,600

Net cash flow

7,270

3,400

(7,150)

Balance b/f

(4,550)

2,720

6,120

Balance c/f

2,720

6,120

(1,030)

Lecture Example 2
EOQ =
.045
150 1,500,000 2
= 100,000

(ie. Arrange 15 transfers of money into the account of 100,000 each over the year).
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Lecture Example 3
The spread between the upper and the lower cash balance limits is calculated as follows.
Spread = 3
3
1
rate interest
flows cash of variance cost n transactio
4
3
|
.
|
\
|

= 3
3
1
0.00025
4,000,000 50
4
3
|
.
|
\
|

= 25,303, say 25,300
The upper limit and return point are now calculated.
Upper limit = Lower limit + 25,300 = 8,000 + 25,300 = 33,300
Return point = lower limit +
1
/
3
spread = 8,000 +
1
/
3
25,300 = 16,433, say 16,400
If the cash balance reaches 33,300, buy 16,900 (= 33,300 16,400) in marketable securities. If the
cash balance falls to 8,000, sell 8,400 of marketable securities for cash.

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Lecture example 2 Exam standard for 6 marks

Lecture example 2 Exam standard question for 6 marks

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