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 - June 2010, part (c), 10 marks 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 company’s 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 Ryanair’s 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 priceshare 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


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 today’s 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 = Profit from operationsRevenue

× RevenueCapital 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 debtBook value of equity

Interest cover = Profit from operationsInterest

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 ×100Market price per share

Earnings per share = Profits distributable to ordinary shareholdersNumber of ordinary shares issued

Price-earnings ratio = Market price per shareEPS

The value of the P/E ratio reflects the market’s appraisal of the share’s 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 Interest 1,200 1,000 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 Robertson’s 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 firm’s 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


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

government’s 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 business’s 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



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



cutting spending

raising taxes

Monetary policy





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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

Section Topic 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



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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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 Banker’s 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 investor’s 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

- June 2008, part (a), 6 marks

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

- Dec 2008, part (b), 10 marks

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 company’s 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

lesCost of saoodsFinished g

× 365 = days

(b) WIP

oductionCost of prWIP

× 365 = days

(c) Raw material

esal purchasRaw materialRaw materi

× 365 = days

2 Av. collection period

ales(credit) sceivablesRe

× 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

lesCost of saoodsFinished g

× 365 = days

(b) W.I.P

oductionCost of prWIP

× 365 = days

(c) Raw material

esal purchasRaw materialRaw materi

× 365 = days

2 Av. collection period ales(credit) s

ceivablesRe

× 365 = days

3 Av. payables period

urchases(credit) pPayables

= × 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


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 - Dec 2007, part (b), 7 marks FLG - June 2008, part (d), 7 marks

Discuss and evaluate the use of 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 - Dec 2008, part (c), 8 marks HGR - June 2009, part (c), 8 marks ZSE - June 2010, part (b), 8 marks Bold - Dec 2011, parts (c) & (d),14 marks KXP - Dec 2012, parts (a) & (d) 14 marks

Discuss and evaluate the use of 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

- June 2011, part (b), 7 marks

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 company’s overall inventory position and is a useful method of monitoring a company’s 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 firm’s 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 Co = Cost of placing an order Ch = 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.

Ch x Q/2

Q

time0

Inventory level

Average = Q/2


46 ANF913

(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

CD C2

Co 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

timetime0

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 customer’s 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 customer’s 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


52 ANF913

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. Pip’s 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 firm’s 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.


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

- Dec 2012, part (c), 5 marks

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

- Dec 2009, part (c), 6 marks

Wobnig Co

June 2012, part (b), 9 marks

Working capital finance

6: WORKING CAPITAL FINANCE

56 ANF913

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 business’s 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


58 ANF913


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) Baumol’s model (b) Miller-Orr’s 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

cashholdingofcostinterestNet

requiredcashAnnualcashorderingofCost2 ××


60 ANF913


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 division’s 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

rateinterest

flows cash of variance cost ntransactio

4

3

×

×


62 ANF913

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.


64 ANF913


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) Baumol’s model (b) Miller-Orr’s 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

65 ANF913

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. Don’t 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

66 ANF913

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)

CHECKPOINT 1

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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)

CHECKPOINT 1

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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

73 ANF913

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

dividendOrdinary

dividend preference afterProfit

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

interestPBIT

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 company’s 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 CO2 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 London’s 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 Ryanair’s 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 O’Leary, 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 Ryanair’s 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.

“We’re not going to get into some kind of dividend stream,” Mr O’Leary says.

“But I think you’ll 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. Britain’s 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 don’t 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 Disney’s 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.

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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 Interest 3,000 3,000 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 don’t 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% 99500/34700 = 27.4%

Gearing 113011300/22600 = 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

Policy Impact on a business’s planning & decision making

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



Possibly caused by lower interest rates

Overseas suppliers become more expensive

Export markets become more attractive


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Lecture Example 2

Policy Impact on a business’s planning & decision making

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


Less likely to use debt finance, consumer demand falls


higher exchange rates

Export markets become less attractive

Lecture Example 3


cutting spending

raising taxes

Designed to cut spending on imports but will have a knock on effect on domestic sales

Monetary policy


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



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 company’s 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

000675

60075

,

,

365 = 40.9 days

(c) Raw material

400518

000108

,

,

365 = 76.0 days

2 Av. collection period

864,000

172,800

365 = 73.0 days

3 Av. payables period

518,40096,400

365 = (67,9) days

Cash operating cycle = 163.7

Lecture Example 3

2sliabilitieCurrent

assetsCurrent

215

sReceivable 10

Receivables = (2 × 15) – 10

= 20

36.5 365 salesCredit

sReceivable


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salesCredit 36520

= 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 + Ch 2

Q + Co

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


$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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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

rateinterest

flows cash of variance cost ntransactio

4

3

= 33

1

0.00025

4,000,00050

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.

financial management and financial objectives

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