Exp Fia-Ffm Notes

Notes
FIA-Paper FFM
Foundations in Financial
Management
For exams in 2015
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ExPress Notes
FIA Foundations of Financial Management
Contents
About ExPress Notes
Page | 2
1.
Cash receipts and payments
2.
Cash balances
12
3.
Working capital management
17
4.
Credit granting
23
5.
Debt collection
26
6.
Sources of finance
29
7.
Short-term decisions
37
8.
Capital investments
44
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ExPress Notes
Chapter 1
Cash Receipts and Payments
KEY KNOWLEDGE
Cash and Cash Flow
Cash comprises both cash and bank deposits payable on demand and also cash equivalents
which are defined as short-term, highly liquid investments that are readily convertible to
known amounts of cash and which are subject to an insignificant risk of changes in value.
The amount of cash held by a business at a point in time is found in the balance sheet
under current assets.
Cash flow refers to the movement of cash in and out of a business over a period of time.
This information is found in a statement of cash flows, which is a primary financial
statement. Such a statement is useful in that it is structured to show the extent to which a
company is able to generate net cash from its operating activities and how such net cash is
used in investing and/or financing activities.
Page | 7
ExPress Notes
Examples of cash receipts and payments include:
Operating: cash flow from trading activities, e.g. cash received from customers, cash
paid to suppliers and to employees;
Financing: Cash paid on interest;
Taxation: Actual cash paid during the year;
Investing: Cash flows on purchase or sale of non-current assets;
Financing: Cash flows on raising or redeeming long-term finance, such as shares or
debentures; dividends can also be included here.
Cash flow accounting

The relationship between cash flow accounting and accounting for income and expenditure
lies in the use of accruals and decisions as to the capitalisation of expenditures. Cash flow
accounting dispenses with the matching principle in financial accounting.
As the cash flow statement is derived from the income statement and the balance sheet,
adjustments need to be made to remove the effects of accrual accounting so that the cash
movements can be made more transparent.
Importance of cash flow management
Planning, tracking and collecting cash are all important because cash PAYS THE BILLS.
The failure to pay bills puts a company in danger of bankruptcy.

What begins as a condition of illiquidity can evolve into insolvency.
Cash flow is vital to going concern and commercial success, regardless of profitability.
Having enough cash on hand is therefore critical in being able to settle obligations when
they fall due (both planned and unforeseen); however, holding too much cash in a business
is costly. There is a trade-off between liquidity and profitability.
Determining the optimal amount of cash to hold becomes the challenge facing managers.
Cash management functions are typically handled by treasury, and include:
Page | 8
Collecting cash from customers (as soon as possible);

Disbursing cash to suppliers (as late as practically possible);
Investing short-term cash surpluses in low-risk interest-bearing investments (such as
Treasury bills) in order to generate additional income for the company;
ExPress Notes
KEY KNOWLEDGE
Cash budgets
A cash budget is an estimate of the receipt and payments of cash in and out of the business
for a defined future period based on existing conditions and operating assumptions.
By understanding the nature and timing of cash receipts and expenditures, management is
better able to influence them and plan/budget for the future. The purpose is to ensure that
the company has sufficient cash on-hand to avoid missing disbursements when they fall
due.
There are statistical techniques which assist management in planning cash levels.
Cash budget/forecast
Businesses should develop their cash budget/forecast formats in a way which best reflects
the type of business conducted and transactions generated. Such tools serve as a
mechanism for monitoring and control.
KEY KNOWLEDGE
Cash forecasting
A cash forecast format/structure is shown below, in this case covering 6 months. Both
operating and non-operating cash flows are included.
The bottom of the table shows opening and closing cash balances.
Cash Budget
Jan
$
Feb
$
Mar
$
Apr
$
Receipts
Credit sales
Cash sales
Page | 9
May
$
June
$
ExPress Notes
Equipment disposal
Total
Payments
Materials
Labour
Variable Overheads
Fixed Costs
Equipment acquisition
Overdraft Interest
Current account interest
Income tax
Total
Net cash m-o-m variance
Cash balance at monthend
Completing the table above requires forecast assumptions relating to volume of

production/sales as well as prices and costs.
EXAMPLE
Unit Selling Price (on

credit)
Unit Selling Price (cash)
$/unit
$/unit
payment terms given to credit customers:

discount granted to cash customers
Unit Variable Cost:

Material
Labour
Overheads
$/unit
$/unit
$/unit
payment terms taken from suppliers:

paid in the month
Fixed Costs
$/month
< Actual
Sales/Production
volumes
actuals/forecast
Production (units)
Page | 10
Nov
Dec
Forecast >
Jan
Feb
Mar
Apr
May
June
Total
ExPress Notes
Credit sales (units)

Cash sales (units)
Capex forecast
New equipment
acquisition
Old equipment sale
Inventory levels required
+/- planned
Bank interest at % pa
Bank interest at % pa
KEY KNOWLEDGE
Sensitivity of variables
Preparing cash forecasts requires assumptions, and assumptions are exposed to uncertainty.
This means that the actual amount of cash received or disbursed may vary from that
budgeted.
Budgeting processes therefore include the testing of assumptions for sensitivity. If, for
example, wage levels rise by 10% (instead of 5%), then what effect will this have on the
level of cash? Same question with regard to materials (and overheads and prices, etc.).
Page | 11
ExPress Notes
Chapter 2
Cash Balances
KEY KNOWLEDGE
Investing and financing
Cash surpluses and deficits occur as a result in timing differences between the receipt of
cash and the necessity to settle obligations punctually. If a deficit results, then the company
should have overdraft faciltities in place with a bank.
If deficits prove to be longer-term in nature, then the company should consider short-term
borrowing, or possibly, longer-term forms of finance if the deficit is expected to persist.
In the event of surpluses, these can be invested (e.g. T-bills mentioned earlier); other types
of investments include:
Bank deposits
Page | 12
ExPress Notes
Money- market deposits

Certificates of deposit
Government bonds
Local authority stock
KEY KNOWLEDGE
Optimum liquidity levels
Cash management models

Holding too much cash is sub-optimal. A business with permanently excessive balances (not
required for operating purposes) should be paid out to shareholders.
Two techniques for monitoring the optimal level of cash are discussed below.
Baumol model
This model was developed several decades ago. One can think of:
cash as inventory;
selling marketable securities transactions as ordering costs;
Interest rate, representing the opportunity cost of holding cash
By determining the following:

N = the total annual amount of cash required
F = the cost of each securities transaction (sale)
i = the annual interest rate obtainable on the investment in securities
then
Z = the amount of cash that needs to be raised per transaction
Page | 13
ExPress Notes
The optimal level of Z =
2NF / i
The main drawback of the Baumol method is that it makes the simplified (and unrealistic)
assumption that cash disbursements are constant and predictable.
Miller-Orr
A second method addresses the issue of optimal cash balances and attempts to improve on
the drawback of the Baumol model.
Miller-Orr is based on statistically tracking the variability of net daily cash flows; this is
denoted as
V = Variability of net daily cash flows (variance or sigma squared)
The other variables are:

F = Cost of each securities transaction;
k = Interest rate per day on marketable securities; and
LL = Lower cash limit, which needs to be established by management
Based on the above, the cash balance return point (R) is

________
R = 33xFxV/4k + LL
The level R is the cash balance which must be restored when either the upper limit (UL) or
lower limit (LL) have been reached.
Once R is known, then the upper cash limit, or UL, is calculated thus:
UL = 3 R 2(LL)
Page | 14
ExPress Notes
KEY KNOWLEDGE
Working capital needs and funding strategies
The level of working capital required in a business depends on the industry it operates in,
the length of its working capital cycle and the range of funding options open to it. Retaining
flexibility is a key requirement. While overdraft financing is expensive, it does permit
spontaneous drawdowns and rapid repayments.
Funding strategies are guided by the following considerations:
Temporary cash shortages can be funded short-term, while

Permanent shortages should be funded long-term
The matching principle can be applied to the assets being financed:
Fixed assets are generally funded long-term, along with the permanent portion of
current assets (e.g. buffer stocks);
Current assets of a fluctuating nature can rely on short-term finance (e.g. seasonal
upswings in inventories / receivables)
Cash surpluses, on the other hand, can be dealt with based on whether they are:
Short-term: in this case they may be invested in short-term, low-risk, liquid

investments (e.g. Treasury bills or marketable securities);
Long-term: Make acquisitions; Reduce debt; Pay extraordinary dividend, etc.
KEY KNOWLEDGE
Liquidity ratios
The relationship between current assets and current liabilities is used as a measure of
liquidity in the firm:
Current ratio = Current assets
Current liabilities
Page | 15
ExPress Notes
Quick ratio = Current assets - Inventories

Current liabilities
KEY KNOWLEDGE
Legal relationship between bank and customer
The relationship between bank and customer is established contractually. When opening an
account with the bank, the client is at the same time accepting the general terms and
conditions of the bank. In return, the bank has a professional duty toward the client in
matters of confidentiality.
Law enforcement (and tax authorities) has the ability to penetrate banking confidentialty at
institutions within their jurisdictionand, usually in connection with pending investigations and
upon obtaining a court order.
Page | 16
ExPress Notes
Chapter 3
Working Capital Management
START
The Big Picture
The nature, elements and importance of working capital
This is a core function of management which has day-to-day implications.
Working capital definition: Current assets Current liabilities
This is an accounting definition. The discussion and analysis of working capital management
focuses on the operating elements of current assets and liabilities:
Page | 17
Cash
Inventory
Receivables
Payables
ExPress Notes
KEY KNOWLEDGE
Cash Operating Cycle
These elements are linked through the Cash conversion cycle, also known as the Cash
Operating Cycle.
Raw materials
received
Receipt of
cash
Payment to supplier
Sale of goods
Conversion into
finished goods
The above diagram shows the operating cash flows for a typical manufacturing company
converting raw materials into finished goods for sale. The company needs its own cash to
pay the supplier and can only recover this from the sale of the finished goods.
The cash invested in inventories and receivables represents a cost to the company. This is
most directly obvious in opportunity cost terms: the cash could be earning interest, reducing
interest-bearing debt, or ultimately find its way into shareholders pockets as a dividend
payment.
The presence of payables indicates that cash payments (outflows) are delayed; this is
beneficial to the company as long as it is not overdue on its payments, as late payment
could lead to penalties or damage to the companys reputation (creditworthiness).
Managing the individual parts of working capital means managing the whole picture in an
optimal way; doing this well can give a firm a significant competitive advantage over its
competitors.
Page | 18
ExPress Notes
KEY KNOWLEDGE
Ratio Analysis
Liquidity ratios
Liquidity ratios (current ratio and quick ratio) have been covered in an earlier chapter. Other
ratios include:
Turnover ratios
(1) Trade debtors (receivables)
(2) Inventory turnover
(3) Trade creditors (payables)
Sales revenue/net working capital ratio

Sales____
Working capital
This ratio establishes the link between the level of sales and the amount of working capital a
business needs to maintain. It is useful for cash flow forecasting. The ratio need not remain
constant as sales grow, but alternate assumptions should usually be based on arguments
specific to the business.
Page | 19
ExPress Notes
KEY KNOWLEDGE
Economic Order Quantity (EOQ)
Within a company, there is a natural temptation to accumulate buffer stocks (raw materials
and semi-finished goods) so that production is never interrupted.
Similarly, in order to avoid stock-outs, sales managers will insist on maintaining a plentiful
level of finished goods. All of this costs money.
The EOQ is a method which seeks to minimize the costs associated with holding inventory.
To determine the total costs, the following data is required:
Q = order quantity
D = quantity of product demanded annually
P = purchase cost for one unit
C = fixed cost per order (not incl. the purchase price)
H = cost of holding one unit for one year
The total cost function is as follows:

Total cost = Purchase cost + Ordering cost + Holding cost
which can be expressed algebraically as follows:
TC
=PxD
+ C x D/Q
+ H x Q/2
It is this total cost function which must be minimized.

Recognizing that:
Page | 20
PD does not vary;

Ordering costs rise the more frequently one places (during the year); and
Holding costs rise the fewer times one places orders (due to larger quantities being
ordered each time),
ExPress Notes
It follows that there is a trade-off between the Ordering and the Holding costs.
The optimal order quantity (Q*) is found where the Ordering and Holding costs equal each
other, i.e.
C x D/Q = H x Q/2
Rearranging the above and solving for Q results in
EXAMPLE
A trucking company uses disposable carburetor units with the following details:
Weekly demand
Purchase price
Ordering cost
Holding cost
500 units
USD 15 / unit
USD 40 / order
7% of the purchase price
Assume a 50 week year. What is the optimal order quantity?
KEY KNOWLEDGE
Just-In-Time (JIT)
Page | 21
JIT is more than an inventory management model; it is a manufacturing philosophy

which puts at its core minimization of inventories on the basis that most of inventoryrelated activities are non-value-added.
JITs ultimate objectives are increased competitiveness and higher profits through
higher productivity (output per unit of time), better product quality and lower
operating costs.
ExPress Notes
Chapter 4
Credit Granting
KEY KNOWLEDGE
Credit assessment
Assessing the creditworthiness of customers

When assessing the creditworthiness of (potential) clients, companies can use the approach
typically employed by banks, referred to (originally) as the 3 Cs of credit, later expanded to
the 5 Cs. They are:
(1) Character: Focuses on the reputation of the principals/decision makers at a company;
credit checking agencies and bank references assist to this end;
(2) Capacity: Examines the companys cash flow generation in the context of managements
ability to perform competently and reliably in meeting their obligations, based on an
Page | 22
ExPress Notes
examination of their track record (either directly or via the experiences of others).
Financial statement analysis is a major part of the exercise here (and in the next point);
(3) Capital: Identifies and assesses the financial staying power and resources of the
business; how much of a capital cushion do they have to withstand losses and how
much do they have committed at risk in a proposed transaction that incentivizes them to
succeed (one can refer to this as the pain factor);
(4) Collateral: Assesses what (if any) security the company is willing to provide in support of
the intended transaction. Banks refer to this as providing additional exits (ways out)
from a transaction.
(5) Conditions: This is a general review of the economic environment to appreciate to what
extent a customer may be affected by a decline in general business conditions (business
cycle influences).
KEY KNOWLEDGE
Internal and external sources of information
The decision to grant credit to customers is the job of the credit manager.
In determining credit limits, the manager takes into consideration market intelligence. These
consist of sources of information that are:
Internal: This is based on the experience acquired in qorking with a customer over time; and
External: Data obtained as a result of credit checkings (with credit agencies) or from publicly
available sources.
The resulting information must be evaluated and a decision taken as to how much credit to
approve for individual customers.
Page | 23
ExPress Notes
KEY KNOWLEDGE
Early settlement discounts
The objective of granting a settlement discount is to give customers a financial incentive to

pay their bills more quickly (before the standard due date).
A company granting settlement discounts must ensure that the benefits of doing so will
outweigh the costs.
Page | 24
ExPress Notes
Chapter 5
Debt Collection
KEY KNOWLEDGE
Collection of debts
A company must have in place a clear policy on the collection of debts.

Even if a good screening/assessment procedure is in place for accepting and reviewing
customers, late payments are a fact of life and must be handled pro-actively. Much time can
be spent in chasing late payments and if this process is not well-organized, management
may come to the conclusion that it is not worthwhile. This is especially true in cases where a
company is growing very quickly and celebrates the signing of contracts and issuance of
invoices as signs of success. If, however, these invoices are not collected in due time (or at
all), then the company is throwing away the rewards of success.
Page | 25
ExPress Notes
Deductions
Another phenomenon which results in significant write-offs of receivable is the practice of
deductions in which a customer pays less than the full amount of the invoice, giving a
reason for withholding the difference. This amounts to a renegotiation of the original invoice
and is often accepted as a fait accompli by the supplier.
A company managing its receivables diligently will have the following:
(1) A monitoring system that clearly flags late payers, known as an aging system. This
includes identifying properly the practice of deductions mentioned above;
(2) A follow-up system that assigns responsibility to specific staff doing the follow-up; this
includes an elevating of difficult cases to more senior and/or more experienced staff to
handle;
(3) Training for staff involved in handing follow-ups, whether performed by phone, mail or
personal visits;
(4) A policy determining when to involve refer the case to lawyers (preferably in-house, for
cost reasons) in preparation of follow-up letters. An external lawyer may carry more
weight, but is also more costly;
(5) Use of a collection agent to chase the receivable. Here again, a company must calculate
the costs and benefits of involving an external agent. In such an analysis, the savings of
management time (opportunity cost) is the most difficult to estimate.
KEY KNOWLEDGE
Credit policies
Financial implications of different credit policies

Evaluating a change in a credit policy requires the identification of relevant cash flows
structured as before (the change) and after scenarios.
Page | 26
ExPress Notes
KEY KNOWLEDGE
Factoring and invoice discounting
Note the distinction between factoring and invoice discounting:

Invoice discounting is effectively a short-term loan in which a company borrows against its
outstanding receivables. The unpaid sales invoices are pledged as collateral to the company
(or bank) provides the financing. The borrowing company receives less than the face value
of the invoice, the difference being the cost of borrowing, or discount.
Factoring involves the administration of debt collection, in which the factor buying a
receivable manages the process. The factor may do so on a recourse or non-recourse basis.
Recourse: In the event a debt is written-off, the factor has the right to demand payment
from the company from which it acquired the debt/receivable;
Non-recourse: The factor bears the full credit risk of the debtors failure to pay.
KEY KNOWLEDGE
Follow-up processes
Follow-up processes could follow the following steps:

1. (Before payment due date) Reminder to prepare payment;
If payment is not made punctually (i.e. past due):
2. Reminder to execute payment;
3. Inform that penaties will be charged;
4. Advice that further delivery is stopped;
5. Advice that receivable will be sold to a factor or referred to legal action
Page | 27
ExPress Notes
Chapter 6
Sources of Finance
KEY KNOWLEDGE
Macro-economics
The impact of macro-economics

Businesses must also take macro-economic factors into account:
Page | 28
Demand levels in the future (return to pre-crisis levels unlikely);
In a recovery phase, how government policies are likely to be adjusted with respect
to:
(a) Monetary policy: Effect on interest rates, exchange rates and inflation,
(the latter may eventually increase with economic recovery);
ExPress Notes
(b) Labor policy: If labor markets tighten, how fast will restrictions (imposed
on foreign labor, for example) be relaxed?
(c) Fiscal policy: Tax increases (both personal and corporate);
(d) Trade policy: to what degree is any protectionism likely to stay in place?
Again, actively keeping up with reading on these issues will be the best way to stay
informed.
KEY KNOWLEDGE
The banking process
According to English common law, a bank has traditionally been characterized as an

institution which holds current accounts for depositors, pays cheques which are drawn upon
it, and collects cheques on behalf of customers.
In addition to chequing accounts, banks offer an increasingly broad range of services,
including overdraft and loan facilities, foreign exchange, trade finance (bills of exchange and
promissory notes) and investment management.
Banks in the UK are licensed by the Financial Services Act, which has over time extended its
reach to other types of financial institutions, such as Building Societies, which traditionally
specialized in offering mortgage loans.
UK banking clearing system
There are different systems designed to clear payments within the UK. These include:
London Bankers Clearing House A cheque-clearing system operated by members,
designated as clearing banks; the use of cheques remains an important payment method
in the UK, particularly for small businesses. The clearing system works on a 3-day cycle:
(1) Sending the item to the clearing center;
(2) Sorting of items submitted;
(3) Debit to the bank on which the item is drawn.
the use of cheques remains an important payment method in the UK, particularly for
small businesses.
Other systems:
Page | 29
ExPress Notes
Bankers' Automated Clearing Services (BACS) A system for the electronic transfer of
payments between banks; 3-day clearing of funds, therefore slow but cheap;
Clearing House Automated Payment System (CHAPS) This is for Sterling payments within
the UK; beneficiaries receive same day funds; relatively expensive;
KEY KNOWLEDGE
Financing sources
Ordinary shares (or common shares)

These are the basic units of ownership of a corporation. The common shareholders are the
main beneficiaries of the success of a business. Their potential upside gain is therefore
theoretically unlimited. This potential gain is associated with the risk that such shareholders
face: in the event of bankruptcy or liquidation, they are the residual claimants on a
corporations assets after all other claims (whether suppliers, employees, lenders, the state,
etc.) have been satisfied.
Preference shares
Preference shares (or pref shares) This is often referred to as a form of non-equity capital.
Page | 30
Preference shareholders rank preferentially to common shareholders;
Pref shares may be redeemable or irredeemable;
Dividends are not tax deductible;
The dividend rate is usually fixed (as a percentage of the par value of the issue);
The dividend rate can be participating, i.e. share in some of the excess profits;
Voting rights: may or may not be accorded preference shares;
Prefs may be cumulative, where dividends not paid in one year are carried forward
and have to be paid before a common dividend payment resumes;
ExPress Notes
Prefs may be convertible into common shares
Debt
In contrast to equity, debt:
Is a liability of the business;
Pays interest which is tax deductible;
Does not represent ownership in the firm
Other types of securities

Companies are imaginative in creating hybrid securities as debt in order to achieve tax
deductibility but with conditions that avoid bankruptcy costs (i.e. payouts contingent only on
the achievement of profits).
Debt comes in many forms. Straight long-term debt (also called loan capital avoid
confusion!) includes:
Bonds: Secured by a mortgage on tangible assets of the firm
Debentures: Unsecured corporate debt
Note: The term bonds is commonly used for both categories above. In the event of
default, debt holders with a security interest over assets enjoy a prior claim in the event
such assets are sold. Debenture holders can be paid only after (secured) bondholders have
been repaid.
Page | 31
Convertible debt: This is debt which is convertible (at the option of the convertible
debt holder) into equity, based on pre-defined conversion conditions;
Subordinated loans: Refers to any kind of debt which ranks inferior to more senior
debt; it cannot be repaid until more senior-ranked creditors have been repaid;
Warrants: A security giving the holder the option to buy common shares from a
company for a pre-set price valid for a period of time. These are usually tradable in a
secondary market and therefore have a market price;
Deep discount bonds: Debt issued with a very low or no (zero) coupon, so that
the issue price will be far below the par value of the bond. Such instruments with no
coupon are also called pure-discount or zero bonds.
ExPress Notes
Junk (high yield) bond: A speculative debt instrument that either carries no rating
or a low rating by the rating agencies (below investment grade);
Types of interest rates
Interest rates can be set at a specific percentage rate and not change during the
contractual period of a loan. Bonds issued with fixed (rate) coupons (making them
fixed rate instruments) will vary in value as market interest rates change.
Floating rates fluctuate with the movement in market interest rates. They are used in
debt instruments and (bank) loan contracts by defining how the interest rate is to be
set on a periodic basis.
Choosing the right capital structure

Choosing between ordinary shares, preference shares and loan capital is based on financial
strategic decisions taken by a corporation regarding capital structure.
Debt and equity
The amounts of debt and equity appropriate at a company depends mainly on the industry
in which the company operates, and also its internal policies and attitudes toward financial
risk.
The industry in which the company operates has an important impact on:
Revenue volatility; and
Operating leverage (cost structure)
A company cannot use too much debt for fear of encountering bankruptcy when economic
conditions decline.
The reasons for issuing different kinds of debt (loan capital).
Companies need to take a variety of factors into consideration when deliberating the use of
debt:
Page | 32
Capital structure constraints: Is there enough equity underpinning?
Term of borrowing: This must be determined in relation to the use to which the
proceeds will be put. Cash flow projections and repayment provisions must be
analyzed (bullet repayment or amortizing schedule).
ExPress Notes
Currency and interest rate base (fixed/floating): What are the companys views on
currency and interest rate market risks? What hedging possibilities exist?
Security: What tangible security is available to support borrowings?
Leasing
Leasing is a form of fixed asset financing, in which a lessor, as owner of an asset, makes it
available to, and for the use of, a lessee in return for a stream of payments over a period of
time.
Operating leases
These are generally short-term rental contracts in which the lessor services and insures the
asset. They are usually cancelable during the lease period at the choice of the lessee.
Finance leases
These are also known as capital leases and are in substance similar to the use of a
secured bank loan to acquire and use an asset. Main features include:
Lease term covering most of the assets economic useful life;
The lessee assumes responsibility for servicing the asset;
Any cancellation clause would require the lessee to cover the lessor for any losses;
Lessee will usually have an option to buy the asset at the termination of the lease
(note: the transfer of ownership, if any, outside and after the end of the lease
contract);
The lessee must show the lease asset and liability on its balance sheet.
Attractiveness of leasing
Leasing has been attractive to lessees (the users of the asset) for a several possible
reasons:
Page | 33
Conservation of cash flow: If a bank loan cannot be arranged, then leasing provides
a way of financing the asset;
Cost reasons: The leasing costs may be more competitive than a bank loan;
From the lessors perspective, leasing can be attractive for tax reasons, where the
tax benefits of ownership are useful to the lessor.
ExPress Notes
Sale-and-lease-back
Under a sale-and-lease-back, a company sells an asset in its possession to another company
and then immediately leases the same asset back again.
In this way, the company will receive cash from the sale proceeds, and can plan to make
periodic lease payments to the new owner in return for continuing to operate the asset.
This technique has been a favored one for companies with a large exposure to the property
market. A chain of retail stores, for example, can raise possibly much-needed cash in this
way, while removing fixed assets from its balance sheet.
For the same reason, a bank may sell the properties occupied by its branch network, thus
freeing up capital for its main business; in addition, it retains operating flexibility in the
location of branches (which need to be where the business is). In this way, it escapes
exposure to real estate market risk.
Hire purchase
These are more typical installment payment plans for an asset, which is eventually
transferred to the ownership of the company making use of the asset. Payments are
structured to incorporate capital and interest elements.
Public Private Partnership

The National Air Traffic Services (which has responsibility for civilian air traffic control in the
UK) was placed into a Public Private Partnership with the transfer of 51% of its shares to the
private sector in 2001. A decline in air traffic following the September 11, 2001 attacks
made an additional investment of 130m necessary (65m each from the UK government
and the British Airports Authority, BAA, the latter receiving 4% of the company in return).
The current shareholders are: UK government (49%); The Airline Group (42%) which is a
consortium of British Airways, BMI, EasyJet, Monarch Airlines, Thomas Cook Airlines,
Thomson Airways and Virgin Atlantic; BAA (4%); and NATS employees (5%).
Internal funds
As a matter of practicality, managers usually choose to finance new projects or investments
by making use of the following sources in the order shown:
Page | 34
ExPress Notes
(i)
Internal funds (retained earnings)
(ii)
Debt
(iii)
Equity
The above sequence is referred to as the pecking order theory and is based on
observations of business behavior. The first choice is a natural one: retained earnings are
already at the disposal of the company without involving costs or formalities. They are not
considered to be a free (costless) form of finance, however; they are available for
distribution to the shareholders. As along as they are retained by the firm, management is
expected to earn a cost of equity return on such funds.
Short-term financing
The starting point for a business is to determine how it can finance its operations at a
minimal (or no) cost.
Negotiating long payment terms to suppliers can be a most attractive way of conserving
cash.
Other sources of short-term financing involve a cost to the business:
Overdraft facility at the bank

Invoice discounting and debt factoring (recourse/non-recourse)
Bills of exchange and acceptance credits
Choosing the right financing

Financing options to a business can be determined by generating financial projections of its
statement of financial position (previously known as the balance sheet), the statement of
comprehensive income (income statement) and statement of cash flows.
Page | 35
ExPress Notes
Chapter 7
Short-term Decisions
KEY KNOWLEDGE
Cost-Volume-Profit (CVP) Analysis
The breakeven formula

Total Costs = Fixed Costs + Unit Variable Cost x Number of Units
Total Revenue = Sales Price x Number of Units
If
TC = Total Costs,
FC = Fixed Costs,
V = Unit Variable Cost,
X = Number of Units,
Page | 36
ExPress Notes
TR = Total Revenue,
SP = Selling Price,
C = SP V = Unit Contribution and
CM%= C/SP = Contribution Margin,
Then the break-even point (the output level at which TR=TC) is:
In units sold: X = FC/C

In dollar sales: TR = FC/CM%
Safety Margin = Budgeted Sales Break-even point (units/dollars)

C is an important indicator, as it shows the contribution of each unit sold towards
covering fixed costs. Therefore, in the short run, the firm may prefer to produce/sell
below break-even in order to recover some of its fixed costs.
KEY KNOWLEDGE
Break-Even Analysis
Marginal costing is useful in calculating the break-even level of sales.
Page | 37
ExPress Notes
The break-even point is the level where the company achieves zero profit (neither gain
nor loss). It just manages to cover its fixed costs.
Below is data on a manufacturing company.
Cost per unit (of product):
Direct materials
45
Direct labour
18
Variable production O/Hs
Total variable production costs
72
Distribution & selling (variable)
Additional info:
Selling price per unit
120
Fixed production costs
16,500
Fixed Selling, General, Admin

costs
7,000
EXAMPLE
Based on the data in the previous example, calculate the break-even point of the
company.
Total fixed costs:
Page | 38
23,500
ExPress Notes
Contribution per unit:
46
Break-even point: 23,500/46 = 511 units

Contribution per sale C/S ratio
This is understood as the amount of contribution generated by every dollar sold.

In the previous example, the companys C/S ratio is: $ 0.3833 (120/46)
The break-even level of sales can be calculated as:
Fixed costs
C/S ratio
Break-even point (sales) = $ 61,310
KEY KNOWLEDGE
Short-term decision-making
Limiting factors
When a single limiting factor is present in a production plan, then it is necessary to identify
it and to plan production around it.
Take the following example:
Product
Selling price
Labour cost per unit ($)
Material cost per unit ($)
X
30
10
5
Y
40
16
8
Z
50
20
10
Contribution
15
16
20
It appears that in the face of unlimited demand for all three products, Product Z would be
given priority as it maximizes the contribution per unit.
Page | 39
ExPress Notes
Now, assume that labour hours are limited to 500 and that labour costs $2 per hour
(demand remains unlimited for all three products).
In the above case,
Product
Labour cost per unit ($)
No. of hours per unit
Contribution per hour
X
10
5
Y
8
8
Z
20
10
Now it becomes clear that Product X is favoured for the full number of hours available (500).
100 units of X can be produced.
If demand for X were limited to, say, 80 units (requiring 400 labour hours), then the
remaining available hours (100) could be used to produce either Y or Z (in this case there is
indifference between the two).
The steps to be followed in working out the optimal production plan are:
(1)
(2)
(3)
(4)
Calculate the contribution per unit of product;

Calculate the contribution per unit of limited resource;
Rank the products according to Step 2;
Produce according to the priority established in Step 3, up to the demand limit of
each product or until the limited resource is exhausted
Make-Buy
A make-buy decision requires the determination of all relevant costs.
EXAMPLE
An automotive components producer can supply itself externally with car heaters for USD
210 per unit. In considering whether to make these internally, the company calculates that
an equivalent unit can be made in 2 labour hours using USD 100 worth of materials.
Labour is currently at full capacity producing carburettors which generate contribution of
USD 100. A carburettor takes 2.5 hours to produce. Labour costs USD 10 per hour. The
carburettor also absorbs fixed overhead costs at the rate of USD 20 per labour hour.
Page | 40
ExPress Notes
Relevant costs
One of managements responsibilities involves making decisions affecting the firm in the
short-run based on relevant costs.

What is relevance?
A relevant cost is a cash cost which is uniquely incurred (or avoided) as a consequence of
taking a decision; cash, because it is the main determinant of value (unlike accounting
profit); and unique in the sense that is not common to the alternative choices that are under
consideration.
EXAMPLE
A company seeking to determine whether to continue to transport its products by truck or to
switch to the railroad discovers that insurance costs are identical in both choices; in that
case, insurance costs are not relevant to the decision.
If, however, there is a difference in the two insurance costs, then one can speak as the
difference between the two choices as being incremental; this difference (referred to in
some places as the differential) is relevant to the decision under consideration.
Future
Relevant costs refer to the future, i.e. they can be influenced prospectively by choice. It
follows that:
Sunk costs are not relevant: They have already taken place and cannot be reversed.
Committed costs, if they cannot be avoided, are likewise not relevant, even if the timing of
their occurrence is in the future. Their unavoidability has already been established in the
past (making them effectively the equivalent of sunk costs).
In keeping with the above logic, relevant costs therefore involve cash, are incremental and
relate to the future.
Page | 41
ExPress Notes
Costing projects
It is a standard management accounting practice to determine the relevant costs of a new
project in order to come up with a price quotation. Setting a price without having an
accurate understanding of costs can put a company at a competitive disadvantage,
particularly if there is intense competition.
Relevant costs need to be identified with care, as they may include opportunity costs.
EXAMPLE
A company considers building a storage facility on the site of a parking lot. If the parking lot
had been generating parking fees which will now be lost, then this foregone revenue is an
opportunity cost.
Page | 42
ExPress Notes
Chapter 8
Capital Investments
KEY KNOWLEDGE
Long-term investment decisions
Key features of long-term investment decisions

Long-term investment decisions typically involve the investment of resources in non-current
assets that will produce a benefit in the future.
When considering long-term investments, it is necessary to include all relevant cash flows,
including investment in working capital (one of the frequently-forgotten items!) and also the
proceeds on disposal of final inventories and equipment at the end of the projects life (if
there is any cash to be recovered at that time).
When appraising such investments, the time value of cash flows is critical, i.e. the timing of
such cash flows can determine whether or not an investment is acceptable.
Page | 43
ExPress Notes
Accounting Rate of Return (ARR)

ARR is an accounting-based measure of return on investment.
Its definition varies. Here are some:
5 year project
Initial Investment
(20% p.a. depreciation)
40,000
Avg. Investment
20,000
Year
Year
Year
Year
Year
Profit Before
Depreciation
10,000
13,000
18,000
20,000
12,000
1
2
3
4
5
Profit After
Depreciation
2,000
5,000
10,000
12,000
4,000
Avg. profit (p.a.)
6,600
(1)
ARR =
Avg. profits
Avg. Investment
6,600
20,000
33%
(2)
ARR =
Avg. profits
Total Investment
6,600
40,000
16.5%
(3)
ARR =
82.5%
Total profits
Total Investment
= 33,000
40,000
Note: Always use the accounting profit after deduction of depreciation

Recalculate the above if there is a 5,000 residual value.
5 year project
Initial Investment
(20% p.a. depreciation)
Residual value
Avg. Investment
Page | 44
40,000
5,000
22,500
ExPress Notes
Total profit before

Depreciation
73,000
Total depreciation
35,000
Total profit after

Depreciation
38,000
Avg. Profit
7,600
(1)
ARR =
Avg. profits
Avg. Investment
7,600
22,500
33.8%
(2)
ARR =
Avg. profits
Total Investment
7,600
40,000
19%
(3)
ARR =
95%
Total profits
Total Investment
= 38,000
40,000
Whats wrong with this measure?

1) It is using an accounting measure of profit (not cash)
2) It does not take the timing of cash flows into consideration.
Re-calculate the ARRs (above) if the profits were reversed as follows:
Profit After
Depreciation
Year
Year
Year
Year
Year
1
2
3
4
5
4,000
12,000
10,000
5,000
2,000
Average profits and average investment amount remain unchanged.
Page | 45
ExPress Notes
Payback method
Initial Investment:
40,000
Cash flows
(A)
Year 1
Year 2
Year 3
Year 4
Year 5
Total
Payback
5,000
6,000
12,000
13,000
15,000
51,000
Year 5
Cashflows
(B)
15,000
13,000
12,000
6,000
5,000
51,000
Year 3
What are the advantages and disadvantages of this method?

Advantages
It is easy to understand and to use. It focuses on the time needed to cover the investment
(in money terms) and no more; it can be considered a minimalists approach
(psychologically).
If you invest in a Central American country where you expect a coup in the next 2 years, the
payback method may be for you! But remember, the net (money) returns start only after
that point!
Disadvantages
It is a crude measure. It does not take opportunity costs or expected returns on money
invested into account.
The preeminence of cash

Cash, both its receipt and possession, lies at the basis of economic value. Cash is used to
pay the bills and bonuses. It is a better indicator of wealth when compared with measures
defined by accounting conventions, such as accounting profit.
Page | 46
ExPress Notes
The relevance of cash flow to capital investment appraisal

The appraisal process is predicated on the fact that capital expenditures are investments
which will (hopefully) confer future benefits referred to as the payback. The payback may be
a lengthy (and risky) one.
Timing and value
Tracking and measuring cash flows on a time-adjusted basis is critical: cash received quickly
can be used to repay debt (avoiding interest costs) or invested (earning interest). Cash paid
with a delay can reduce costs (as long as penalties are not incurred).
It follows that the longer one waits for a receipt of cash, the less that cash is worth in
todays terms. Among other factors, its purchasing value may diminish due to the effects of
inflation.
Compounding
Instead of receiving USD 100 today, assume it will be received after one year. To
compensate for the delay, what should the value be after one year?
Present Value (PV)
Future Value (FV)
100
100 x (1+r)
In the above example, if r = 5% p.a. then the FV after one year will be USD 105.
This process can be repeated year after year.
Discounting
The above relationship between PV and FV:
PV x (1+r) = FV
can be re-arranged to:
PV = FV
(1+r)
with r representing the discount rate.

The above refers to one-period discounting, with r corresponding to the period.
If discounting is done over more than one period, then the discounting effect will be:
PV = FV
Page | 47
ExPress Notes
(1+r)n
where n refers to the number of periods.
Thus, 100 received after two years, discounted at 10% p.a. will be
PV = 100 = 82.6
(1.10)2
This reflects that the uncertainty of getting money back increases with time.
This allows one to discount future values into present values and can be applied to a series
of cash flows:
Year:
Future Values:
100
100
125
105
140
If discounted at r = 10%, then the above cash flows can be restated at their present values:
FV discounted:
100
1.10
100
(1.10)2
125
(1.10)3
105
(1.10)4
140
(1.10)5
PV:
90.9
82.6
93.9
71.7
86.9
Added together results in total PV = 426.

Reducing future cash flows of different timings and amounts to one PV is a powerful
tool.
Note: If all the cash flows had been equal say 100 then the PV calculation would have
been simplified:
FV discounted:
100
1.10
100
(1.10)2
100
(1.10)3
100
(1.10)4
100
(1.10)5
PV:
90.9
82.6
75.1
68.3
62.1
The addition of the above is = 379
Page | 48
ExPress Notes
Net Present Value (NPV)

To add meaning to the future cash flows, we can include the amount invested (which gives
rise to the FVs):
Year:
100
100
125
105
140
Investment: (200)
FV:
PV:
(200)
90.9
82.6
93.9
71.7
86.9
Year 0 amounts denote the present and are automatically = PV.

The NPV of the above cash flows is therefore = 226.
Internal rate of Return (IRR)

The internal rate of return (IRR) is defined as the discount rate (r) at which the net present
value (NPV) of a stream of cash flows will be equal to zero. In other words,
If, at a discount rate r, NPV = 0, then IRR = r
The IRR includes among its assumptions the following: any cash flows generated in the
course of a project being evaluated are calculated as being reinvested at the IRR rate. This
is illustrated thus:
Time
Cash flows
0
1
2
(20,000)
5,000
30,000
The IRR of the above cash flows (using interpolation or calculator) is 35.61%.
The above cash flows is equivalent to re-investing the 5,000 (Year 1) at the IRR rate
(35.61%) to maturity (Year 2).
Page | 49
Time
Cash flows (A)
0
1
(20,000)
5,000
Cash flows (B)

(20,000)
0
ExPress Notes
30,000
36,780.5 (30,000 + 6,780.5*)
* 5,000 x 1.3561 = 6,780.5

The IRR of the cash flows shown in Column (B) is 35.61% -- exactly the same as in Column
(A).
Note: Column (B) cash flows resemble that of a zero-coupon bond, with investment at time
0 and no cash returns until the final year.
This calculation confirms that interim cash flows are re-invested at the IRR rate. This
assumption has been criticized for being unrealistic, since cash paid out of a project
(returned to the investors, for example) is unlikely to obtain the same rate if invested
elsewhere: they may be higher (i.e. interest rates may have risen in the meantime), or
lower (placed in the bank to earn deposit interest).
Comparison of NPV and IRR methods

The following decision rules apply to appraisal methods:
NPV: Positive NPV projects are acceptable; the higher the better.
IRR: An IRR in excess of a hurdle rate (set by the company) indicates acceptability; the
higher (the IRR) the better.
EXAMPLE
Year
-5,000
6,000
-7,500
8,850
IRR
NPV:
10%
14%
20%
454
263
172
18%
545
263
129
Intuitively, IRR should be preferable, as it relates return to amount invested.

Equal investment amounts do not necessarily remove the ambiguity.
Page | 50
16%
ExPress Notes
EXAMPLE
Year
IRR
-500
-500
NPV (9%)
100
600
20%
97
500
155
25%
89
Discounted Payback
We can apply the concept of discounting to the Payback method in order to capture the time
value of money element.
Year:
100
100
125
105
140
Investment: (200)
FV:
PV:
(200)
90.9
82.6
93.9
In the table above, the (simple) payback period is in Year 2;

The Discounted Payback period is longer (Year 3).
Page | 51
71.7
86.9

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Notes

Cash receipts and payments

Working capital management

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Our ExPress notes fit into our portfolio of materials as follows:

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Cash Receipts and Payments

Examples of cash receipts and payments include:

Cash flow accounting

The failure to pay bills puts a company in danger of bankruptcy.

Collecting cash from customers (as soon as possible);

Completing the table above requires forecast assumptions relating to volume of

Unit Selling Price (on

payment terms given to credit customers:

Unit Variable Cost:

payment terms taken from suppliers:

Credit sales (units)

Money- market deposits

Cash management models

selling marketable securities transactions as ordering costs;

Interest rate, representing the opportunity cost of holding cash

By determining the following:

The optimal level of Z =

The other variables are:

Based on the above, the cash balance return point (R) is

Temporary cash shortages can be funded short-term, while

The matching principle can be applied to the assets being financed:

Short-term: in this case they may be invested in short-term, low-risk, liquid

Quick ratio = Current assets - Inventories

Working Capital Management

(2) Inventory turnover

(3) Trade creditors (payables)

Sales revenue/net working capital ratio

The total cost function is as follows:

It is this total cost function which must be minimized.

PD does not vary;

Assume a 50 week year. What is the optimal order quantity?

JIT is more than an inventory management model; it is a manufacturing philosophy

Assessing the creditworthiness of customers

The objective of granting a settlement discount is to give customers a financial incentive to

A company must have in place a clear policy on the collection of debts.

Financial implications of different credit policies

Note the distinction between factoring and invoice discounting:

Follow-up processes could follow the following steps:

The impact of macro-economics

Demand levels in the future (return to pre-crisis levels unlikely);

According to English common law, a bank has traditionally been characterized as an

Ordinary shares (or common shares)

Preference shareholders rank preferentially to common shareholders;

Pref shares may be redeemable or irredeemable;

Dividends are not tax deductible;

Voting rights: may or may not be accorded preference shares;

Prefs may be convertible into common shares

Is a liability of the business;