Financial Management eBook for Entrepreneurs & Professional Students by Murtaza Lanewala

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TABLE OF CONTENTS Note: click the cross-reference below for easy navigation. Click press Ctrl + Home to see table of contents.

TABLE OF CONTENTS........................................................................................................................... 1 KEY TERMS ............................................................................................................................................ 3 AUTHOR’S PROFILE .............................................................................................................................. 8 IMPORTANT! .......................................................................................................................................... 9 DISCOUNT & ANNUITY FACTOR TABLES ......................................................................................... 11 Chapter 1: FINANCIAL MANAGEMENT FUNCTION ............................................................................ 13 Chapter 2: FINANCIAL MANAGEMENT ENVIRONMENT .................................................................... 19 Chapter 3: THE NATURE, ELEMENTS & IMPORTANCE OF WORKING CAPITAL ............................ 29 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS ....................................................... 32 Chapter 5: DETERMINING WORKING CAPITAL NEEDS & FUNDING STRATEGIES ........................ 64 Chapter 6: THE NATURE OF INVESTMENT DECISIONS & THE APPRAISAL PROCESS ................. 67 Chapter 7: NON DISCOUNTED CASH FLOW TECHNIQUES .............................................................. 68 Chapter 8: DISCOUNTED CASH FLOW (DCF) TECHNIQUES ............................................................ 69 Chapter 9: ALLOWING FOR INFLATION & TAXATION IN DCF ........................................................... 72 Chapter 10: ADJUSTING FOR RISK & UNCERTAINTY IN INVESTMENT APPRAISAL ...................... 74 Chapter 11: SPECIFIC INVESTMENT DECISIONS .............................................................................. 75 Chapter 12: SHORT & LONG TERM FINANCE .................................................................................... 79 Chapters13: INTERNAL SOURCES OF FINANCE & DIVIDEND POLICY ............................................ 83 Chapter 14: GEARING & CAPITAL STRUCTURE CONSIDERATIONS ............................................... 85 Chapter 15: FINANCE FOR SMALL & MEDIUM SIZED ENTITIES (SMEs) .......................................... 87 Chapter 16: ESTIMATING COST OF CAPITAL .................................................................................... 89 Chapter 17: RELATIONSHIP B/W COST OF CAPITAL, CAPITAL STRUCTURE & INVESTMENTS ... 92 Chapter 18: BUSINESS VALUATION TECHNIQUES ........................................................................... 95 Chapter 19: EFFICIENT MARKET HYPOTHESIS................................................................................. 98 Chapter 20: BASICS OF FINANCIAL RISK MANAGEMENT ................................................................ 99 Chapter 21: HEDGING TECHNIQUES FOR FOREIGN CURRENCY RISK........................................ 101 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK ................................................. 104 RELATED eBOOKS ............................................................................................................................ 107 Buy Full Financial Management Book (380 ±) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

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REPORT ABUSE................................................................................................................................. 108

Financial Management eBook Free Download

Special Offer Place a http://accasupport.com link at any ONE of your or other account to get any TWO chapters above of your choice for free not included in free version by emailing at kabuli_52@hotmail.com or murtaza@accasupport.com Email should contain web page URL where you have placed a link and name of any TWO chapters you want.

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KEY TERMS Combine Probability · 74 Confidence · 22 Contingent Assets · 96 Contingent Liabilities · 96 Contract Price · 102 Contract Size · 102 Conversion Premium · 97 Convertible Loan Notes · 81 Cost of Equity · 90 Credit Control · 40 Credit Insurance · 52 Credit Or Customer Analysis · 39 Credit Policy · 39 Currency Option · 103 Currency Swap · 103 Current Asset Ratio · 38

A Agency · 14 Aggregate demand · 22 Aggregate Supply · 22 Agreement Date · 100, 102 Annuity · 70 Average Growth Rate · 90 B Bad Debt Risk · 42 Balance Of Payments · 106 Barter Trade · 52 Basis Risk · 102, 105 Baumol Model · 65 Benefits · 16 Bill Of Exchange · 51 Boom · 28 Brand, Copyright & Patents · 96 Business Angels · 88 Business Cycle · 27 Business Risk · 93 Buying & Selling Rate · 100

D Debt Finance · 81 Deep Discount Bonds · 81 Deflation · 70 Deflationary Gap · 27 Depression · 27 Derivative · 103 Development Expenditure · 96 Direct Quote · 100 Discount Rate · 70 Discounted Payback Period · 71 Discounting · 70 Dividend Growth Model (DGM) · 90 Dividend Valuation Model (DVM) · 96

C Cap · 105 Capital Asset Pricing Model (CAPM) · 90 Capital Cash Flows · 73 Clientele Effect · 84 Collar · 105

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Divisible Projects · 77

Future Contract Hedge · 102 Future Market · 102

E G

Earnings Per Share · 94 Earnings Yield · 94 Economic Risk · 100 Efficient Market Hypothesis · 98 Equity Beta · 91 Equity Finance · 80

Goal congruence · 14 Goodwill · 96 Gordon’s Growth Rate · 90 Government Grants · 78 Government Policy · 22

Equity Risk Premium - · 90 Equivalent Annual Cost (EAC) · 77 Exchange Rate · 23 Expectation Theory · 106 Expected Values · 74 Export Factoring · 51

H Hard Capital Rationing · 77 Hedging · 100 I

Indirect Quote · 100 Inflation · 24, 70 Inflation Rate · 70 Inflation Rate Parity Theory · 102 Inflationary Gap · 27 Initial Investment · 73 Initial Public Offer (IPO) · 80 Interest Rate · 70 Interest Rate Option · 105 Interest Rate Parity Theory · 102 Interest Rate Risk · 105 Interest Rate Swap · 105 Invoice Discounting · 49 Invoicing In Home Currency · 100 Irredeemable Loan Notes · 81

Factoring · 44 Finance Lease · 76 Financial Cash Flows · 73 Financial Risk · 93 Fiscal Policy · 21 Fixed Interest Rate Risk · 105 Floatation · 80 Floor · 105 Floor Value · 97 Fluctuating Assets · 65 Foreign Exchange Risk · 100 Forward Contract Hedge · 102 Forward Rate · 102 Forward Rate Agreements (FRAs) · 105 Franchise · 78 Free Cash Flows · 71

J Joint Venture · 78

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Just in Time (JIT) · 62

Net Assets Valuation Model · 96 Netting · 100 Non Systematic Risk · 90 Non-Recourse Factoring · 45

L Lapse · 86 Lead & Lag Payment · 100 Lease · 76 Lesser & Lessee · 76 Letter Of Credit · 51 Liquidity · 30 Liquidity Preference Theory · 106 Liquidity Ratios · 38 Loan Notes (Bonds or Debenture) · 81

O Operating Lease · 76, 80 Optimal or Economic Order Quantity (EOQ) · 57 Outsourcing · 78 Overdraft · 38 Overdrafts · 80 Overtrading & Undertrading · 65

Macro Economics · 20 Macroeconomic Policy · 20 Market Imperfection Theory · 93 Market Rate Of Return · 90 Market Segmentation Theory · 106 Matching · 100 Matching Policy · 65 Micro Economics · 20 Miller & Modigliani (M&M) Theory · 93 Miller & Modigliani Theory · 84 Miller-Orr Model · 65 Monetary Policy · 20, 106 Money Market Hedge · 103 Mutually Exclusive Projects · 78

Par Value · 81 Pecking Order Theory · 93 Pension · 16 Permanent Assets · 65 Perpetuity · 70 Placing · 80 Positive Gap · 105 Pre-Emption Right · 80 Preference Share Capital · 80 Present Value (PV) · 70 Price Earnings Ratio · 94 Probability Analysis · 74 Profit Related Pay · 15 Project Specific Fixed Cost · 73 Q

Quick Asset Or Acid Test Ratio · 39

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Subscribe · 86 Systematic Risk · 90

R Real Return · 106 Recession · 27 Recourse Factoring · 45 Recovery · 28 Redeemable Loan Notes · 81 Redemption Value · 96 Redemption Yield · 97 Renounce · 86 Residual Value · 73 Retained Earnings · 80 Return Of Equity (ROE) · 94 Return Of Investment (ROI) · 93 Revenue Cash Flows · 73 Risk · 74 Risk Free Rate Of Return · 90

T Tangible Assets · 96 Tax Savings On Capital Allowance · 73 Theoretical Ex-Right Share Price · 86 Tick · 102 Time Value of Money · 70 Traditional View · 84, 93 Transaction Risk · 100 Translation Risk · 100 U Uncertainty · 74 Unemployment · 25

Sale & Lease Back · 81 Script Dividend · 84 Semi Strong Form Efficient · 98 Sensitivity Analysis · 74 Settlement Date · 100, 103 Settlement On Net Basis · 100 Share Based Payment · 15 Share Options · 15 Short Term Loan · 80 Signalling Effect · 84 Single Period Capital Rationing · 77 Smoothing · 105 Soft Capital Rationing · 77 Spot Rate · 102 Stagnation · 26 Strong Form Efficient · 98

Variable Interest Rate Risk · 105 Venture Capitalist · 88 W Weak Form Efficient · 98 Weighted Average Cost of Capital (WACC) · 90 Weighted Average Cost Of Capital (WACC) · 70 Working Capital Cycle · 33 Working Capital Investment · 73

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Yield Curve 路 106

Zero Coupon Bond 路 81

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AUTHOR’S PROFILE Name: Murtaza Lanewala Career Status: Freelance writer & tutor for professional accountancy qualifications. Professional bodies include ACCA, CIMA and ICAEW. Author & CEO of accasupport.com E-mail: kabuli_52@hotmail.com or murtaza@accasupport.com

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IMPORTANT! 1 Disclaimer This material is sold only through accasupport.com website. However, Clickbank.com is the credit card processing organization for collecting payments for this material. This material is not available offline (shops, schools etc.) in any form such as DVDs, CDs, Printed books etc. Materials purchased from unauthorized source can be out of date and incomplete. In addition, you will not be able to receive free updates given to the buyers of original material. Demo version of this material is available free of cost, please take care, not to pay for demo version of this e-book to unauthorized sellers. Readers of this material will be solely responsible for the consequences of any decisions made in real life. Author & accasupport.com are not responsible to the readers of this material under any circumstances. Recommendations made of any kind are intelligent guesses to the best of author’s knowledge. Names of individuals, organizations, countries, religions etc are used for educational purpose only. It is not intended to abuse, discriminate and hurt anyone's feelings and dignity. 2 Copyright Notice This material is subject to copyright protection law. Infringement of copyright law results in criminal liability (fine or imprisonment or both). Copyright infringement is effectively theft of intellectual property; therefore, it is unethical from social viewpoint and sinful act from religious viewpoint as well. Copyright ©2012 Murtaza Lanewala. All rights reserved. 2.1 Do You can make a backup copy of this material. You can use parts of this material provided you quote the appropriate reference to the author and material. Buy Full Financial Management Book (380 ±) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

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2.2 Do Not You cannot publicly share this material in the form of hard copy or soft copy (physically and over the internet) for cash or for free. You cannot transform this material into other means of communication such as photocopy, video, audio etc. Unless needed for accessibility purpose or personal use. You cannot change the file format of this material or make it editable. You cannot resell this material unless you are selling the original copy purchased. You cannot use any part of this material in or with contents associated with violence, politics, religious and pornographic contents in any way.

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DISCOUNT & ANNUITY FACTOR TABLES

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Financial Management | Page 13 of 108 Chapter 1: FINANCIAL MANAGEMENT FUNCTION

Chapter 1:

FINANCIAL MANAGEMENT FUNCTION Sub Headings S.no Headings (click the cross-ref below for easy navigation) 1 Agency 2 Financial Objectives in Profit Vs Not-for-Profit

Pg.no 14 16

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1 Agency 1.1 Definition of Agency Relationship Agency is a relationship between principal and agent. Principal delegates some responsibility to be performed on behalf of principal. Principal also gives agent necessary decision-making authority. Agent can be responsible to more than one principal. Example: Shareholders delegate responsibility to board of directors to management day-to-day operations of organization. Directors are granted necessary authority through articles of association and employment contract. accasupport.com 1.2 Agency Problem In the context of company, directors are required to protect the interest of shareholders. Shareholders being too many in numbers and may not have technical knowledge of the company’s operations would not be able to protect their interest themselves. accasupport.com

Unfortunately, they have to rely on directors to look after their interest. Danger is that directors do not act in the best interest of shareholders. Directors’ acting other than in the interest of shareholders is an agency problem. Agency problem creates the need for building mechanism, which promotes goal congruence or Alignment of interest. 1.3 Goal Congruence Goal congruence means making directors act in the interest of shareholders. Directors have their own needs and desires, which may be different from shareholders needs and desires. Goal congruence can be achieved by aligning the goals of directors in line with the goals of shareholders. 1.4 Ways to Reduce Agency Problem 1.5 Reward Schemes 1.5.1 Salary Salary is the most basic form of financial record given to directors and employees. It does not affect performance and risk attitudes of managers. Buy Full Financial Management Book (380 ±) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 15 of 108 Chapter 1: FINANCIAL MANAGEMENT FUNCTION

1.5.2 Bonus Bonus is financial reward given to motivate directors and employees in expectation that motivation will lead to improved performance. It does not ensure that directors focus on shareholders wealth maximization. accasupport.com It does not affect performance and risk attitudes of managers. 1.5.3 Profit Related Pay Directors’ remuneration based on profit encourages directors to focus their attention towards generating profit for the shareholders. Profit related pay could lead to directors undertaking excessive risky investment projects, which may be over and above the wish of shareholders. accasupport.com Profit related pay focuses directors’ attention on short-term performance rather than long-term performance. Financial management primary objective is to focus on long-term shareholder wealth maximization. 1.5.4 Share Based Payment Share based payment is the reward given to directors in the form of shares with a condition to hold those shares for certain period. Share based payment encourages directors to focus their attention on increasing share price. Increase in share price leads to increase in shareholders wealth. It is consistent with the primary objective of financial management i.e. maximization of shareholders wealth. Share based payment also encourages directors to take controlled risk in line with shareholders expectation. 1.5.5 Share Options Share options are incentive given to directors to buy shares in the company at specified future exercise date and at pre-defined exercise price. It encourages directors to increase share price of the company above the exercise price in order to realize gain through buying shares at lower share price than market price at exercise date.

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Share options direct management attention on primary objective of financial management i.e. maximization of shareholders wealth. Share option also encourages directors to take controlled risk in line with shareholder expectations. 1.5.6 Benefits Benefits are non-financial reward given to directors and employees. It is given to motivate directors so that work can be performed efficiently. Example: A car given to director so he/she can travel to workplace, attend meeting with bankers etc in time. accasupport.com It does not encourage directors to maximize shareholders wealth. 1.5.7 Pension Pension is the financial reward as a percentage of basic salary given to directors and employees when they retire. accasupport.com Security of pension funds depends on stability of the organization. Pension may not be realized if organization gets bankrupt. It encourages directors to take long-term view organizational performance. However, it has no contribution towards motivating directors to maximize shareholders wealth beyond existing level. 2 Financial Objectives in Profit Vs Not-for-Profit Financial objectives in not for profit and public organizations are different from financial objective in profit motive organizations. Profit motive organizations have profitability as its primary objective. Profit motive organization is legally accountable to shareholders/owners (primary stakeholder). accasupport.com

On the other hand, not for profit organizations do not have profitability as its primary objective. However, not for profit organizations also need to focus on profitability for meeting day-to-day expenses.

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Example: Rent of the premises used as office of the organization. accasupport.com

Payment of stipends (remuneration) to volunteers.

Not for profit organization usually exists to provide services to the society. Society involves more than one legitimate stakeholder such as donors, users of services, government, public at large etc. Not for profit organization may have more than one objective such as providing quality service, providing services to greater number of people, efficient use of funds provided by donors etc. Stakeholders are interest holders, which can affect (claim) or be affected by organizational activities. accasupport.com

It becomes difficult to decide which is the primary objective and deciding priority for rest of the secondary objectives. However, profit motive organization may also have objectives other than profit making. These objectives are necessary for achievement of primary financial objective. Example: Increase in number of products offered by organization by 30% in next 2 years. This objective supports the primary objective of profit making. Existing customers may also prefer to buy related goods from the same organization. This will give cross selling (selling more than one product to same customer) benefits to organization. accasupport.com Performance of not for profit organization is usually measured against its ability to provide Value for money (economy, efficiency, effectiveness) to the users of services. However, performance of profit motive organization can also be assessed in terms of value for money. Profit motive organizations must provide value for money to its customers if it has to achieve its financial objectives in short term (such as profitability, liquidity) as well as long term (such as growth).

Financial Management | Page 18 of 108 Chapter 1: FINANCIAL MANAGEMENT FUNCTION

Financial Management | Page 19 of 108 Chapter 2: FINANCIAL MANAGEMENT ENVIRONMENT

Chapter 2:

FINANCIAL MANAGEMENT ENVIRONMENT Sub S.no 1 2 3

Headings Headings (click the cross-ref below for easy navigation) Macro Vs Micro Economics Macro-economic Policy Macro-Economic Factors Affecting Business Activity

Pg.no 20 20 22

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1 Macro Vs Micro Economics 1.1 Macro-Economics Macro-economics is study of effects of total activities of households, firms & government on the national & international economy. accasupport.com

Macro-economics include all the economic activities of private as well as public sector. 1.2 Micro-Economics Micro-economics is study of effects of separate activities of individuals, individual households and firms. Micro-economics refers to study of one economics entity at a time. 2 Macro-economic Policy Macro-economic policy is the government decisions on the operation of markets. Government may decide to operate market without any regulation as free market in the hope that free movement of capital will result in best economic growth. accasupport.com

In practice, government generally intervenes through making regulations to promote economic growth. Macroeconomic policy has following objectives. Government has following two main policies to achieve its objectives. 2.1 Monetary Policy Monetary policy deals with the interest and exchange rates. Interest rate influences individual investment decisions. Government can encourage investment by reducing interest rates and conversely reduce investments by increasing interest rates. Reduction in interest rate changes public preference from savings to investment. accasupport.com

Example: Reduction in interest rates leads to increased activity in stock market and bullion market. Exchange rate influences imports and export from/to the country. Government can encourage the use of imported goods by increasing Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 21 of 108 Chapter 2: FINANCIAL MANAGEMENT ENVIRONMENT

exchange rate of home currency and conversely reduce the use of imported goods by decreasing exchange rate of home currency. accasupport.com

Similarly, government can encourage exports from the country by reducing exchange rate of its home currency. Reduction in exchange rate will make goods produced by the country cheaper to foreign countries. Conversely, government can reduce exports from the country by increasing exchange rate of its home currency. Increase in exchange rate will make goods more expensive to foreign countries. 2.2 Fiscal Policy Fiscal policy deals with taxation and government spending. Taxation is the source of revenue for government. It influences public spending on consumer and capital goods by increasing or decreasing the level of disposable income for private sector. accasupport.com

Increase in taxation results in decreased disposable income for spending on satisfaction of needs and capital investments. Conversely, decrease in taxation results in increased disposable income for spending. Disposable income is the earnings remaining after meeting all liabilities. Level of spending influences demand for goods or services and prices of goods or services. If demand exceeds in relation to supply then prices of goods or services arises (inflation). Conversely, if demand lacks in relation to supply then prices of goods or services reduces (deflation). accasupport.com

Government spending also influences the demand for goods or services and prices of goods or services. Government can spend its income (taxation) on industries/sectors in which government wishes to raise supply of goods or services to provide goods or services to private sector and to control price inflation. Government spending can be used to reduce the economic imbalance between rich and poor by providing basic goods or services to society at subsidised or free of charge.

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3 Macro-Economic Factors Affecting Business Activity 3.1 Aggregate Demand Aggregate demand is the sum of demands for different goods or services produced in country. Formula:

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3.2 Aggregate Supply Aggregate supply is the sum of supplies for different goods or services produced in country. Formula: Government aim is to equal aggregate demand and aggregate supply at a level where workforce is fully employed. Full employment is one of the objectives of the macroeconomic policy of government. 3.3 Confidence accasupport.com Confidence is psychological factor influencing economic activities. Confidence is the expectation of future stability and growth of economic activities. accasupport.com

Confidence among consumers makes them to spend higher percentage of income on goods or services. Confidence among firms makes them invest more money in the business. Confidence depends on expectation of political, environmental, employment level, inflation, demand, expected future conditions etc. 3.4 Government Policy Government can encourage economic activities in following ways. Government can increase demands for goods or services through fiscal policy (taxation and government spending) and monetary policy (exchange rates, interest rates and money supply). accasupport.com

Government can provide infrastructure (transportation, roads, power, sewage, communication media etc) to boost economic activities. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 23 of 108 Chapter 2: FINANCIAL MANAGEMENT ENVIRONMENT

Government can boost confidence by providing security to the assets of individuals, household and firms. This can be done by making legislations and providing policing services. 3.5 Use of Resources Resources are factors of production, which enables production of goods or services. To promote maximum economic growth all the resources (labour, materials, money and machine) in an economy should be fully employed. Resources can be used more efficiently by provision of training and use of advanced technology. accasupport.com

Economic growth depends on using resources to its maxim capacity and using it more efficiently. 3.6 Finance Finance enables us to employ other resources such as labour, material and workers. Financing decisions depend on the cost of using finance such as interest rate. If interest rate will rise individual and firms will reduce their borrowings and individual will consume less and firms will abandon their investment projects, which were previously attractive. As investment projects will reduce, demand for goods or services of suppliers to the firm will reduce, which lead to decrease in aggregate demand. accasupport.com If interest rate will fall individuals and firms will increase their borrowings and individual will consume more and firms will undertake investment project, which were previously unattractive. As investment projects will be undertaken, demand for goods or services of suppliers to the firm will increase, which lead to increase in aggregate demand. 3.7 Exchange Rate Exchange rate is the rate at which home currency can be traded in return for other currency. Exchange rates can impact balance of payment (import versus export). Adverse balance of payments makes government to borrow foreign exchange for repayment. It affects credit rating of a country in the long Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download accasupport.com

Financial Management | Page 24 of 108 Chapter 2: FINANCIAL MANAGEMENT ENVIRONMENT

term, as beyond certain level it can be difficult to borrow foreign exchange. Exchange rate need to be stable. Volatility in exchange rate increases risk of foreign exchange gains or losses and leads to increase in cost of Hedging100. Wide fluctuation in exchange rate also discourages investment by foreign firms in a country. It increases the risk of foreign exchange gain or losses in assets of the firms when assets are translated in their home currency. 3.8 Inflation Inflation is the increase in prices of goods or services for consumption and capital investment. Inflation results in reduced purchasing power of money. accasupport.com

Certain percentage of inflation is considered as indication of economic growth. It is because demand is allowing the use of economic resources (labour, capital, natural resources and machinery) to its full capacity. Increase in prices (inflation) is considered as an indication of full employment of resources. Prices are increased to take the advantage of excess demand by providing goods or services to people that are able to pay more for limited goods or services. accasupport.com

Inflation increases the economic imbalance between rich and poor by redistributing wealth in a society. Rich get richer as assets increase in market value and poor get poorer if he/she is not able to increase his/her service charges in proportion to inflation. Households require more money to continue consuming same quantity and quality of goods or services. Households with limited income (pension, government relief etc) have to limit their consumption. Thus, inflation results in reduced standard of living. Businesses having sound assets may enjoy capital gains on its asset. Similarly, businesses having greater liabilities with enjoy economic profits on repayment. As the money borrowed will have lesser value (purchasing power) when making repayment. accasupport.com

Government aim is to control inflation to reduce the uneven distribution of wealth. It is possible to achieve economic growth in times of high Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 25 of 108 Chapter 2: FINANCIAL MANAGEMENT ENVIRONMENT

inflation but this growth will not benefit all the members of the society in equal. Inflation has impact on other objectives of economic policy also. Inflation will lead to depreciation of exchange rates. Exchange rate depreciation will make imports expensive for a home country and exports cheaper for foreign countries. Expensive imports will result in less demand for imported goods and cheaper exports will result in more demand for goods to export. This will make balance of payment favourable. accasupport.com

All these events will be beneficial for economic growth but benefits may not be evenly distributed among the members of society. In times of high inflation, people tend to invest their earnings as earlier as possible. Because keeping money in form of cash will erode the purchasing power of their earnings. High inflation leads to uncertainty about future economic wellbeing for individuals and firms. Individual tends consume less to save money for the future. Inflation has some additional drawbacks as well. accasupport.com

Inflation makes planning and budgeting difficult for individuals and firms. More time have to spend on revising budgets and selling prices for goods or services. This will put additional cost burden on firms. Customers have to face frequently new prices, which forces them comparing price again and again. In times of high inflation, financial figures have little meaning in evaluating performance of managers and entire organization, which makes financial and resource allocating decisions difficult and less meaningful. 3.9 Unemployment Unemployment is the unavailability of opportunities for individual to contribute their services to the economy. Rate of unemployment is determined by dividing unemployed labours with total labours. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 26 of 108 Chapter 2: FINANCIAL MANAGEMENT ENVIRONMENT

Unemployment means certain portion of countryâ&#x20AC;&#x2122;s workforce (labour resource) is not utilized to promote economic growth. 3.9.1 Side Effects of Unemployment Unemployment will lead to reduced standard of living in the economy as whole. Crime rates and illiteracy increases with the increase in unemployment rate. accasupport.com

Unemployment will also leads to reduction in wage rates. However, employment legislation has given some protection to labours by implementing minimum wage rate requirement. As the level of unemployment increases, bargaining power of employer also increase in comparison with employees. accasupport.com

Unemployment may result in reduced demand for goods or services. This is put strain on business profitability and increase competition on the grounds of prices rather than quality among businesses. Quality may deteriorate to produce goods or services at reduced prices to attract price sensitive consumers. Unemployment for long period will result in loss of skill due to lack of work available to retain level of skill. Loss of skilled workforce is the loss of human capital to the country. accasupport.com

Unemployment increases the government expenditure for providing benefits (support) to unemployed people. 3.9.2 Stagnation Stagnation is the period of significant slow economic growth of long period. 3.9.3 International Payments Disequilibrium International payments disequilibrium is the surplus or deficit in the balance of payments. Surplus results where total exports exceeds total imports. Deficit results where total imports exceeds total exports.

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3.10 Inflationary Gap Inflationary gap is the excess of demand over supply when workforce is fully employed. It results in increased price. Supply cannot be increased using domestic factors of production (men, machine, material, money). accasupport.com

Inflationary gap can be reduced by either reducing demand or by importing goods to satisfy demand. 3.11 Deflationary Gap Deflationary gap is lack of actual supply than fully employed workforce can supply, as aggregate demand is below the level required for the full employment of the workforce. Prices tend to remain constant or fall. accasupport.com

3.12 Business Cycle Business cycle has following four phases. Diagram:

Boom

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Recession

Recovery

Depression 3.12.1 Depression Depression is the extremely adverse economic condition. Demand, prices and employment level falls and at their bottom. Businesses tend to shut down and investors lose their confidence in the market. 3.12.2 Recession Recession is the less serious economic condition than depression. If recession continues for long period time, it may turn in depression. However, government intervention and technological changes can rescue in situation. accasupport.com

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3.12.3 Boom Boom is the extremely favourable economic condition. Demand, prices, employment level all increases and reaches at peak. Businesses launches new products and investors have optimistic view of the future economic growth. accasupport.com

3.12.4 Recovery Recovery is the period of medium growth and is a way to boom. Recovery is generally considered a slower process than recession.

Financial Management | Page 29 of 108 Chapter 3: THE NATURE ELEMENTS & IMPORTANCE OF WORKING CAPITAL

Chapter 3:

THE NATURE, ELEMENTS & IMPORTANCE OF WORKING CAPITAL Sub Headings S.no Headings (click the cross-ref below for easy navigation) 1 Objectives of Working Capital Management

Pg.no 30

Financial Management | Page 30 of 108 Chapter 3: THE NATURE ELEMENTS & IMPORTANCE OF WORKING CAPITAL

1 Objectives of Working Capital Management Working capital is material item in balance sheet of most organizations. Working capital is the blood of any organization without it cannot continue its operations regardless of how much fixed assets are owned by the organization. Working capital management has two main objectives. 1.1 Profitability Profitability is related to the primary objective of financial management i.e. maximization of shareholders wealth. Business must be profitable in the short term to add shareholder value in the long term. 1.2 Liquidity Liquidity is the ability to meet cash requirements for settling day-to-day expenses such as payment of wages and salaries, electricity bills, office rent etc. accasupport.com

Liquidity is essential for survival and long-term profitability of the organization. Failure to meet day-to-day expenses can force organization into dissolution or liquidation by the creditors. Hence, without survival there will be no wealth maximizing opportunities available. Profitable organization may not have enough cash to day-to-day liabilities. It is due to the application of accrual accounting concept to arrive at profit for the year for financial reporting purpose. accasupport.com

Profitability and liquidity are two conflicting objectives. Favourable performance at one objective inevitably leads to adverse performance at other objective. Example: Maintaining higher cash balance will result in loss of sales to customers. It is due to cash is not used for producing or purchasing accasupport.com finished goods. Effective working capital management depends on achieving a balance between these two objectives.

Financial Management | Page 31 of 108 Chapter 3: THE NATURE ELEMENTS & IMPORTANCE OF WORKING CAPITAL

Financial Management | Page 32 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Chapter 4:

MANAGEMENT OF WORKING CAPITAL ELEMENTS Sub S.no 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

Headings Headings (click the cross-ref below for easy navigation) Working Capital Cycle Working Capital Ratios Liquidity Ratios Account Receivable Management Factors Affecting Trade Receivables Policy Credit Policy Evaluation Factoring Evaluating Proposal for Factoring Invoice Discounting Foreign Trade Receivables Calculating & Commenting Early Settlement Discounts Discounts from Suppliers Economic Order Quantity (EOQ) Model Optimal or Economic Order Quantity (EOQ) Optimal Reorder Quantity with Bulk Purchase Discount Just in Time (JIT)

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Financial Management | Page 33 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

1 Working Capital Cycle Working capital cycle is also called cash management cycle. Working capital is fund required to finance trading activities organization. Trading activities can be payment of wages to workers, purchasing goods and selling for profit etc. accasupport.com

Not for profit organization needs working capital in the same way as profit making organization. Working capital is as important for organizations as blood for human body. Working capital is excess of current assets over current liabilities. Formula: Or

accasupport.com

Working capital is also called net current assets if current assets are greater than current liabilities or net current liabilities if current assets are less than current liabilities. Efficiency of working capital depends on efficient control over elements of working capital as above. accasupport.com

Working capital requirement depends on time taken to pay suppliers and time taken to receive payment from customers.

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Example: Suppose, we pay supplier in 30 days, but we receive payment from customers in 40 days. We will need working capital (cash) for ten days to meet day to day trading expenses between 10 (40-30) days. This need can be fulfilled through personal savings or raising finance. accasupport.com

If we pay suppliers in 25 days but we receive payment from customers in 20 days. We will have surplus cash for 5 (20-25) days after settling all liabilities. Surplus cash can be invested elsewhere to earn interest income. Therefore, longer working capital cycle requires more cash and cost of raising cash to finance working capital will erode profitability. Even, if personal savings are used to finance working capital it involves opportunity cost because of not being able to earn interest by investing it elsewhere. Diagram: Credit purchase or Trade payables

Credit sales or Trade receivables accasupport.com

Cash paid to suppliers

Working capital or cash requirement

Cash received from customers

2 Working Capital Ratios Working capital cycle depends on the following: 2.1 Trade Receivables Revision Trade receivable turnover is the average number of days customers take to repay their debts. Trade receivable balance given in the balance sheet is taken as accasupport.com representative of balance owed from customers at any point in time during the accounting period. accasupport.com

Financial Management | Page 35 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Increase in trade receivables level increases working capital. Similarly, decrease in trade receivable level decrease working capital. If we assume credit sales are made as constant rate, then increase in trade receivable turnover in days increases trade receivables level and working capital requirement. Similarly, decrease in trade receivable turnover in days decreases trade receivables level and working capital requirement. Trade receivable turnover depends on credit term offered by organization and effectiveness of credit control system. Credit sales for the year are $200,000. Trade receivable turnover in days is 40 days. Required: Calculate the change in trade receivable level if customers would have taken 45 days on average to pay their debts.

To find trade receivables level or amount, we can manipulate the equation as follows: accasupport.com

Trade receivable level or amount is increased to $2,740 ($21,918$24,658) and working capital requirement to finance credit sales of $200,000 is increased by the same amount. It is because of increase in trade receivable turnover from 40 to 45 days.

Financial Management | Page 36 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

2.2 Inventory Revision Inventory turnover is the average number of days inventory is held before it is sold to customers. Inventory balance given in the balance sheet is taken as representative of balance of inventory held at any point in time during the accounting period. Increase in inventory levels increases working capital. Similarly, decease in inventory level decreases working capital. If we assume inventory is purchased at constant rate, then increase in inventory turnover in days will lead to increase in inventory levels and working capital requirement. Similarly, decrease in inventory turnover in days will lead to decrease in inventory levels and working capital requirement. Credit purchases for the year are $150,000. Inventory turnover in days is 30 days. Required: Calculate the change in inventory level if inventory is sold to customer after 25 days from the date of purchase.

To find inventory level or amount, we can manipulate the equation as follows accasupport.com

Financial Management | Page 37 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Inventory level or amount is decreased to $2,055 ($12,329-$10,274) and working capital requirement decreased by the same amount. It is because of decrease in inventory turnover from 30 to 25 days. Inventory is converted to trade receivables 5 days earlier. 2.3 Trade Payables Revision Trade payable turnover is average number of days taken by organization to pay its suppliers. Trade payable balance given in the balance sheet is taken as representative of balance owed to customers at any point in time during the accounting period. Decrease in trade payable level increases working capital. Similarly, increase in trade payable level decreases working capital. If we assume credit purchases are made at constant rate, then increase in trade payable turnover in day increase trade payable level and decrease working capital requirement. Similarly, decrease in trade payable turnover in days decrease trade payable level and working capital requirement. Credit purchases for the year are $150,000. Account trade payables turnover in days is 50 days. Required: Calculate the change in trade payable level if trade payable is sold to customer after 60 days from the date of purchase.

To find trade payable level or amount, we can manipulate the equation as follows

Financial Management | Page 38 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Trade payable level or amount is increased to $4,110 ($20,548-$24,658) and working capital requirement is decreased by the same amount. It is because of increase in trade payable turnover from 50 to 60 days. Trade payable has inverse relationship with working capital. Increase in trade payable leads to decrease in working capital requirement. However, Trade receivables and inventory has direct relationship with working capital. Increase in trade receivables and inventory leads to increase in working capital requirement. 2.4 Overdraft Overdraft is a current liability. It is used to makeup shortfall in working capital requirement. 3 Liquidity Ratios Working capital should be monitored for liquidity. Using current liabilities for financing working capital needs may work well for increasing profitability and it will deteriorate liquidity of the organization. Following ratios is calculated for determining liquidity position of the organization. 3.1 Current Asset Ratio Current asset ratio suggests the ability of organization to repay its debt when they fall due. Formula:

accasupport.com

Current asset ratio should not be interpreted in isolation it should be considered in combination with working capital ratio. Example: Trade payable turnover suggests how often suppliers demand their payment. If suppliers demand more often, then high levels of current Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS accasupport.com Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 39 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

assets should be available. We will have less time to arrange for payment. Trade receivable turnover suggests how often customers pay us. If customers pay us more often, then low levels of current assets will suffice. We can arrange cash for payment to supplier in lesser time. 3.2 Quick Asset or Acid Test Ratio Quick asset ratio suggests the ability of organization to convert its current assets into cash quickly. Formula:

Inventory is excluded as it takes more time than other current assets to be converted into cash. Inventory is distant from cash in that it first has to be converted into receivables before it is converted into cash. 4 Account Receivable Management There are four key areas of account receivable management. 4.1 Credit Policy Credit policy is a framework for managing accounts receivables in the business. An effective credit policy should consider following elements: accasupport.com

In short, credit policy provides guidance for implementing below three key areas of account receivable management. 4.2 Credit or Customer Analysis The purpose of credit analysis is to ensure that goods or services are sold only to those customers that have goods credit rating. It means those customers who are reasonably likely to settle their debts within due date. Quality of credit analysis depends on the source and quality of information used to assess customer creditworthiness. accasupport.com

Following sources of information would be helpful in performing credit analysis. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 40 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

4.3 Credit Control Credit control involves monitoring customers to limit the risk of bad debts and cost of interest expense to the organization for financing increased requirement of working capital. Credit control involves the following tasks 4.4 Collection Procedures Funds collection procedures should ensure that organization receives funds from debtor within agreed terms and conditions and customers are aware and understand those terms and conditions. Issuing of invoice and collection of funds from customers is the responsibility of sales ledger staff. Sales ledger staff should ensure that customer understands the terms and conditions at the time of issuing invoice. Terms and conditions could include mode of payment, delivery date, early settlement discounts etc. accasupport.com

They should send monthly statements to customers and ensure that any differences are reconciled in timely manner. They should also deal with any issues raised by customers in timely manner. Sales ledger staff should follow up overdue debts. Following are the actions that can be taken: Cost of debt collection should not exceed the amount of debt. 5 Factors Affecting Trade Receivables Policy/Credit Policy These are factors affecting the formulation of trade receivable management policy or credit policy. 6 Credit Policy Evaluation Points to consider for evaluating credit policy are as follows. 6.1 Incremental Cost/Savings of Financing Trade Receivables Please keep reading till the end. You will probably do not understand the text below. However, illustration given at the end will make you accasupport.com understand the text below. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 41 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Trade receivables need to be financed just like inventory and noncurrent assets. Trade receivables are usually financed through shortterm source of finance such as overdraft and short-term bank loan. Financing trade receivables involve financing cost such as interest charge on overdraft and bank loan. accasupport.com

However, even if organization uses its own retained profits to finance trade receivables, then it has opportunity cost of not being used to generate interest through investment in marketable securities. In addition, time taken by customers to repay their debt have effect on the profitability of the organization. Interest expense incurred in financing trade receivables will erode profitability. Conversely, savings in interest expense will improve profitability Incremental financing cost is additional cost of interest incurred due to extending credit term. Reduction in financing cost is savings in cost of interest incurred due to reduction in credit term. 6.2 Administration Cost/Savings Receivables results in administration cost to the organization. Maintaining sales ledger and monitoring customers result in additional cost to the organization. accasupport.com

Giving extended credit terms requires more frequent monitoring of customers to reduce the increased risk of bad debts associated with longer credit terms. In addition, early settlement discounts give rise to more record keeping and reviewing cost. Customer may attempt to claim discounts even if they are not entitled. Incremental (additional) administration cost needs to be taken into account in the evaluation. Reduction is credit term usually leads to savings in administration cost. accasupport.com

Financial Management | Page 42 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Formula: (

)

(

)

6.3 Cost of Early Settlement Discount Early settlement discounts are given to encourage early payment by customer. It is done to improve working capital cycle. Early payment by customers results in savings in finance costs to the organization. However, it results in loss of revenue by the amount of discount offered. Reduction in early settlement discount leads to savings in finance cost. Saving in financing cost is already accounted for when calculating incremental cost of financing. Now, only incremental cost of early settlement discount should be included in evaluation. accasupport.com

Formula: ( )

(

)

6.4 Contribution from Sales Extending or contracting credit period can result in increased or decreased sales revenue respectively. Incremental contribution from additional sales needs to be taken account or loss of contribution from reduced sales should be taken into account. Later, can happen rarely, as organization would not evaluate credit policy that will obviously result in reduced sales. Only incremental contribution is relevant for the purpose of credit policy evaluation. Formula: (

)

â &#x201E;

(

)

accasupport.com

6.5 Bad Debt Expense/Savings Risk of bad debts increases with the increase in credit term. Organization may have estimates available for range of credit terms. Bad debt expense needs to be included in the evaluation of credit policy. accasupport.com

If reduction in credit term is proposed, then bad debt expenses could be saved. Then these savings should be included in the evaluation of credit policy. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 43 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Formula: (

)

(

) accasupport.com

Illustration: Ulnad Co has annual sales revenue of $6 million and all sales are on 30 dayâ&#x20AC;&#x2122;s credit, although customers on average take ten day more than this to pay. Contribution represents 60% of sales and the company currently has no bad debts. Accounts receivable are financed by an overdraft at an annual interest rate of 7%. accasupport.com

Ulnad Co plans to offer an early settlement discount of 1.5% for payment for payment within 15 days and to extend the maximum credit offered to 60 days. The company expects that these changes will increase annual credit sales by 5%, while also leading to additional incremental costs equal to 0.5% of turnover. The discount is expected to be taken by 30% of customers, with the remaining customers taking an average of 60 days to pay. Required: Evaluate whether the proposed changes in credit policy will increase the profitability of Ulnad Co.

30 days are official and 10 days for delay by customers.

Accountable receivable turnover formula is manipulated to calculate account receivable amount. accasupport.com

(

)

(

)

Weighted average is taken for 30% customers that would pay in 15 day and 70% customers that would pay in 60 days.

Financial Management | Page 44 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

To account for new credit sales those are increased by 5% from existing sales.

New trade receivable level under new credit policy. (

) (

)

$ Incremental in interest cost (10,155) Incremental administration costs ($6.3m x 0.5%) (31,500) Cost of discount ($6.3m x 1.5% x 30% (28,350) Contribution from increased sales ($6m x 5% x 60%) 180,000 Net benefit of credit policy change 109,995 accasupport.com

7 Factoring Financial institution providing factoring services is known as factor. Generally, factoring services are provided by insurance companies and banks. Factor takes over organizationâ&#x20AC;&#x2122;s sales ledger administration. Factor performs following tasks on behalf on organization: accasupport.com

Usually, factor provides advanced payment of up to 80% against sales made on credit. Rest of the 20% is paid upon receipt of payment from customer. Factor also deducts its flat fee and percentage of interest on advanced payment made by factor. Factoring transfers control of receivable management from organization to factor. Factor can use its own policies and procedures, which can upset customers, particularly those who have to pay their debt now earlier. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 45 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Factoring service is obtained to improve the account receivable turnover. accasupport.com

Factoring is particularly useful for organizations lacking expertise and experience of trade receivable management. Factoring is suitable for small sized organizations that have not enough resources and expertise. Factoring allows organization to direct their skills and resources toward core activities such as making sales to customer without having to worry for payment recovery. Factoring is of two types 7.1 Recourse Factoring In with-resource factoring, factor does not bear the risk of bad debts. 7.2 Non-Recourse Factoring In non-resource factoring, factor bears the risk of the bad debts. 8 Evaluating Proposal for Factoring Performa for evaluating proposal for factoring: $ x x x

Savings in finance cost of trade receivables (see working 1) Savings in administration cost of sales ledger per year Savings in bad debt expenses (non-recourse) per year Total benefit of factoring X Factoring fee per year (see workings 2) (x) Interest cost on cash received in advanced (see workings 3) (x) Total cost of factoring (X) accasupport.com Net benefit/cost of factoring X/(X)

Financial Management | Page 46 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Formulae:

Financial Management | Page 47 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

The average variable overdraft interest rate in each year was 5%. The 8% bonds are redeemable in ten yearsâ&#x20AC;&#x2122; time. A factor has offered to take over the administration of trade receivables on a non-recourse basis for an annual fee of 3% of credit sales. The factor will maintain a trade receivables collection period of 30 days and Gorwa Co will save $100,000 per year in administration costs and $350,000 per year in bad debts. A condition of the factoring agreement is that the factor would advance 80% of the face value of receivables at an annual interest rate of 7%. Required: Evaluate whether the proposal to factor trade receivables is financially acceptable. Assume an average cost of short-term finance in this part of the question only. $ 76,300

Savings in finance cost of trade receivables per year (see accasupport.com working 1) Savings in administration cost of sales ledger per year 100,000 Savings in bad debt expenses per year (non-recourse) 350,000 Total benefit of factoring per year 526,000 Factoring fee per year (see working 2) (1,122,000) Interest cost on cash received in advanced per year(see (49,184) working 3) Total cost of factoring per year (1,171,184) Net benefit/cost of factoring per year (644,884) Factoring is not worthwhile on financial grounds because cost of factoring exceeds benefits. In addition, non-financial aspects of factoring are also necessary to be considered such as impact on customers and reaction of shareholders. Shareholders may perceive factoring as lack of expertise of management in controlling trade receivables.

Financial Management | Page 48 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Factor has claimed that they will reduce credit period to 30 days. Therefore, we needed to determine new receivable balance for this new credit period.

Factoring is always expected to decrease in trade receivables. If factoring is expected to increase trade receivable period then factoring is obviously worthless.

As discussed earlier, receivable requires to be financed somehow. Therefore, it incurs finance cost, which is the interest payable on overdraft at 5%. That is why; any reduction in receivable balance under this new credit period is savings to the organization. Interest will be saved at 5% because organization will no longer be required to pay interest on amount saved.

Factor has demanded 3% of credit sales as factoring fee. It is possible to come across question in the in which factor would demand flat fee. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 49 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

5% of interest rate already been charged by the bank, it has to be incurred regardless of factoring proposal is accepted or not. Therefore, 5% of interest rate is irrelevant for decision-making purpose. Rise in interest rate due to factoring is 2% only not 7% and this 2% is relevant for evaluating proposal for factoring. accasupport.com

After factoring average receivable balance of $3,074,000 will be outstanding during the year. Factor will advanced 80% of receivables on which interest is charged at 2% per year. Average receivable balance means receivables balance during the year will rise and fall such as due to seasonal demand for goods or services. However, if we take the average of those balances, then it will be equal to $3,074,000. 9 Invoice Discounting Invoice discounting is raising cash through pledging sales invoices. In other words, invoice discounting is raising short-term loan by providing sales invoices (Receivables as an asset) as security to the invoice discounter (lender). Invoices are used to raise cash at discount. It means cash received will be lower than the total value of invoices. Usually, up to 75% of the invoices value can be received in cash. Invoice discounter pays rest of the amount when customers settle their debts and charges a percentage of interest on cash advanced. accasupport.com

To be benefit from invoice discounting, organization must have good quality invoice. It is because invoices represent the security to the invoice discounter. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 50 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS accasupport.com Risk of bad debt rests with the organization. If the customer defaults, organization has to repay the amount advanced by the invoice discounter.

Invoice discounting is one off transaction. Each time, invoice is discounted represents separate transaction. Unlike factoring, invoice discounting does not takeover administration of sales ledger. Invoice discounting does not setup customers. Customers only become aware of the arrangement when they default. accasupport.com

Invoice discounting can be used to raise short-term finance. It can be used by organization having cash flow problem. In practice, those who provide factoring services also provide invoicediscounting services. 10 Foreign Trade Receivables 10.1 Problems Involved In Foreign Trade Foreign trade receivables are considered having higher risk of bad debts In foreign trade, customers are given credit for longer period than in domestic trades. Selling organization may not be able to monitor foreign customersâ&#x20AC;&#x2122; financial position as closely as domestic customers. In the event of default, customers have to be pursued according to their own countries legislation. accasupport.com

Foreign trade receivables require higher levels of investment in working capital due to cash is invested for longer period before it is received to make another sale transaction. 10.2 Reducing Risks Involved In Foreign Trade 10.2.1 Advance Payment It is insisting foreign customers to pay cash in advance or on delivery.

Financial Management | Page 51 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

10.2.2 Export Factoring Export factoring can be used to reduce risk of foreign trade. Export factoring is same as domestic factoring with the only different is that factor is situated overseas in customerâ&#x20AC;&#x2122;s country. 10.2.3 Bill of exchange Bills of exchange are used primarily in international trade. Bill of exchange is unconditional order by issuer to his/her bank to pay the bearer a specified sum on a specific date written at the face of document. It is not frequently used credit instrument. Unconditional order means it does not require any action by the bearer to cash the bill of exchange. accasupport.com

Bill of exchange can be dishonoured if the issuer does not have sufficient cash balance to accept the bill of exchange. 10.2.4 Letter of Credit (LC) Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. Letter of credit is demanded by supplier from a customer. Bank guarantees to a beneficiary (supplier) to pay specified sum of money on completion of sales in accordance with agreed term and conditions on behalf on his client (customer). accasupport.com

Letter of credit is sent to the supplier, which he/she can use to receive payment and send goods to customer according to term and conditions written on letter of credit. Bill of laden can be used as evidence of transfer of goods to customer. Issuing letter of credit is costly and time-consuming process. However, it is safer way to carry out foreign transaction. Unlike bill of exchange, which can be dishonoured, letter of credit involves guarantee by the bank to pay on behalf of client (customer) even he/she get bankrupt. It is not ideal for urgent sales orders.

Financial Management | Page 52 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

10.2.5 Credit Insurance Credit insurance is risk management product used to used cover the risk of default by foreign customers. It covers the risk of default due to bankruptcy, death, deliberate non-payment etc. accasupport.com

The cost of insurance is called premium. It can be continuous long-term contract or one off transaction insure against specific customer. 10.2.6 Barter Trade Barter trade is receiving goods rather than cash in return for selling goods. Goods are exchanged (despatched) at the same time so it reduces the risk of bad debt. Barter trade does not involve goods in exchange of promise to supply goods. 11 Calculating & Commenting Early Settlement Discounts Early settlement discount is different from trade discount. Early settlement discount is given to reduce finance cost of trade receivables and improve working capital cycle. accasupport.com Early settlement discount is given as percentage of sales. It is given to those who pay early within specified period before usual credit period.

WQZ Co is considering making the following changes in the area of working capital management: accasupport.com

Inventory management It has been suggested that the order size for Product KN5 should be determined using the economic order quantity model (EOQ). WQZ Co forecasts that demand for Product KN5 will be 160.000 units in the coming year and it has traditionally ordered 10% of annual demand per order. The ordering cost is expected to be $400 per order while the holding cost is expected to be $512 per unit per year. A buffer inventory of 5.000 units of Product KN5 will be maintained, whether orders are made by the traditional method or using the economic ordering quantity model. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 53 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Receivables management WQZ Co could introduce an early settlement discount of 1% for customers who pay within 30 days and at the same time, through improved operational procedures, maintain a maximum average payment period of 60 days for credit customers who do not take the discount. It is expected that 25% of credit customers will take the discount if it were offered. It is expected that administration and operating cost savings of $753000 per year will be made after improving operational procedures and introducing the early settlement discount. It is expected that administration and operating cost savings of $753,000 per year will be made after improving operational procedures and introducing the early settlement discount. Credit sales of WQZ Co are currently $876 million per year and trade receivables are currently $18 million. Credit sales are not expected to change as a result of the changes in receivables management. The company has a cost of short-term finance of 55% per year. Required: Calculate and comment on whether the proposed changes in receivables management will be acceptable. Assuming that only 25% of customers take the early settlement discount, what is the maximum early settlement discount that could be offered?

Currently customers take 75 days to repay their debts. accasupport.com

(

)

(

)

Financial Management | Page 54 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Introduction of early settlement discount will result in 25% of customers paying within 30 days. Therefore, it means those customers that take 60 day on average will be 75%.

$12.6m of cash will remain invested in trade receivables and working capital during the year according to revised trade receivable days of 52.5 days.

Reduction in trade receivable turnover from 75 to 52.5 days will result in decrease in trade receivable level by $5.4m ($18m-$12.6m).

As discussed earlier, trade receivables incurs finance cost, decrease in accasupport.com trade receivable level will require less working capital resulting in savings in finance cost.

Cost of early settlement discount is finance cost for the organization rather than admin or selling and distribution expense, because it is given for reducing the cost of financing trade receivables.

accasupport.com

Savings in finance cost of trade receivables per year

$ 297,000

Financial Management | Page 55 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

$ Savings in administration and operating cost per year 753,000 Finance cost of early settlement discount (219,000) Total benefit of early settlement discount per year 831,000 accasupport.com

Maximum Early Settlement Discount Maximum early settlement discount should be the rate at which savings from giving early settlement discount becomes zero. If 25% of credit sales will receive early settlement discount, which is

(

)

Then, maximum early settlement discount that could be offered is

(

)

It is because sales revenue could be lowered by 1,050,000 or 4.8% at max after, which savings will be zero. 12 Discounts from Suppliers ZPS Co places monthly orders with a supplier for 10,000 components that are used in its manufacturing processes. Annual demand is 120,000 components. The current terms are payment in full within 90 days, which ZPS Co meets, and the cost per component is $750. The cost of ordering is $200 per order, while the cost of holding components in inventory is $100 per component per year. The supplier has offered either a discount of O5% for payment in full within 30 days, or a discount of 36% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding components in inventory would increase to $220 per component per year due to the need for a larger storage facility. Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 45% per year. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 56 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Required: Calculate if ZPS Co will benefit financially by accepting the offer of the early settlement discount.

Obtaining early settlement discount will result in savings of $4,500 per year. It is considered as finance income.

Reduction in trade payables will require the use of other source of finance to makeup the short fall in working capital.

Trade payable is usually used as free source of finance because suppliers generally do not charge interest for late payment. Short-term finance will now be used for refinancing working capital, which will give rise to financing (interest) cost.

$ Savings from early settlement discount 4,500 Refinancing cost of working capital (6,657) Net benefit/ cost of early settlement discount (2,157) Increase in financing cost exceeds benefits/savings from early settlement discount. Organization will be better by not taking early settlement discount. accasupport.com

Financial Management | Page 57 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

13 Economic Order Quantity (EOQ) Model 13.1 Optimal or Economic Order Quantity (EOQ) Economic order quantity is the quantity (order size) at which combine cost of inventory ordering and holding is minimized. Diagram: Ordering cost

Total cost

accasupport.com

Holding cost

EOQ

Reorder quantity 13.2 Calculating Economic Order Quantity Formula (given in the formula sheet): â&#x2C6;&#x161; Where Co = ordering cost per order CH = holding cost per unit (for the duration of demand) D = total demand of the period

PKA Co is a European company that sells goods solely within Europe. The recently-appointed financial manager of PKA Co has been investigating the working capital management of the company and has gathered the following information: Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 58 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Inventory management The current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meet production requirements during the next year is 625.000 units. The cost of placing and processing an order is €250, while the cost of holding a unit in stores is €050 per unit per year. Both costs are expected to be constant during the next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week year and that demand is constant throughout the year. Required: Calculate the cost of the current ordering policy and determine the saving that could be made by using the economic order quantity model. accasupport.com

Total cost under current ordering policy:

Ordering inventory in batches of 100,000 units will require 6.25 (625,000/100,000) orders to fulfil annual demand of 625,000 units. However, it is not possible to place 0.25 order in practice.

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It is assumed that always half of the inventory ordered will be held in warehouse, which is the average of inventory getting at lower and higher levels during the year. Each unit will require of holding cost per year.

Financial Management | Page 59 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Inventory usage per week is 12,500 (625,000/50) units. If supplier takes 2 weeks, then inventory should be ordered when 25,000 (12,500 x 2) units remaining in stock to prevent stock outs. However, supplier may delay delivery or unexpected demand can arise during the lead-time. Therefore, organization has kept 10,000 (35,000-25,000) units as buffer (safety) stock for unexpected situation.

Buffer stock is held in the warehouse during whole year. Each unit of buffer of stock will incur holding cost. Therefore, 10,000 units of inventory has incurred

Total cost under EOQ model:

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√

(

)(

)

Financial Management | Page 60 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Orders in smaller quantity than under current ordering policy increased ordering cost by ( ) because of more frequent ordering from 6.25 orders to 25 (625,000/25,000) orders.

(

)

(

)

Ordering as per EOQ resulted in decrease in holding cost of ( ). It is due to reduction in average inventory level.

14 Optimal Reorder Quantity with Bulk Purchase Discount EOQ cannot be used when supplier offers bulk purchase discount for ordering above certain quantity. We must find out economical order size through trial and error. If, supplier offers different discount rate for different order size we have to calculate total cost of purchasing for each order size. Formula:

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ZPS Co places monthly orders with a supplier for 10,000 components that are used in its manufacturing processes. Annual demand is 120,000 components. The current terms are payment in full within 90 days, which ZPS Co meets, and the cost per component is $750. The cost of Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 61 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

ordering is $200 per order, while the cost of holding components in inventory is $100 per component per year. The supplier has offered a discount of 3.6% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding components in inventory would increase to $220 per component per year due to the need for a larger storage facility. Assume that there are 365 days in the year and that ZPS Co can borrow short-term at 45% per year. Required: Calculate if ZPS Co will benefit financially by accepting the offer of the bulk purchase discount. Total purchase cost of current order size at 10,000 units :

Total purchase cost of revised order size at 30,000 units:

Financial Management | Page 62 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

(

)

Savings due to obtaining bulk purchase discount is $6,000 (907,600901,400) per year. 15 Just in Time (JIT) Just in time is modern inventory management philosophy. It means inventory should only be produced or purchase when there is customer available for it. Ideally, inventory level is assumed $0. However, in practice, some butter stock is maintained to meet unexpected demand. 15.1 Benefits JIT reduces inventory-holding costs. However, it increases inventoryordering costs but these are not so high because of application of information technology. Inventory does not generate revenue until it is sold. Cash invested in inventory can be used to earn interest on short-term investments. JIT results in no or little inventory level. accasupport.com

Inventory occupies floor area. Floor area is valuable asset of the organization, which can be used for producing other products. Inventory possesses a risk of theft and deterioration due to dust, water, fire, storm etc. Some kind of inventory is perishable in nature such as groceries and chemicals. Inventory may become obsolete or out of fashion as people tastes and behaviour changes over time. JIT saves cost of inventory obsolesces.

15.2 Limitations JIT is not suitable for organizations operating in health and safety and rescue services sector. Cost of stock outs far more exceeds benefits in such sectors. Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 63 of 108 Chapter 4: MANAGEMENT OF WORKING CAPITAL ELEMENTS

Example: Stock out of life saving drug in a hospital can be disastrous. In this situation, cost of holding inventory is justified against the risk involved in stock outs. Organization may not be able to meet unexpected demand and suffer lost sales from both existing and potential customer. At worst, customer may turn to buy competitors product and may not return. Efficient operation of JIT depends on reliable suppliers, location and distance of organization premises from suppliers and infrastructure available for communication and delivery of goods.

Financial Management | Page 64 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 5:

DETERMINING WORKING CAPITAL NEEDS & FUNDING STRATEGIES Sub S.no 1 2 3 4

Headings Headings (click the cross-ref below for easy navigation) Cash Management Models Funding Working Capital Requirement Level of Investment in Working Capital Symptoms of Overtrading

Pg.no 65 65 65 65

Financial Management | Page 65 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Cash Management Models 1.1 Miller-Orr Model 1.1.1 Benefits 1.1.2 Limitations 1.2 Baumol Model 1.2.1 Benefits 1.2.2 Limitations 2 Funding Working Capital Requirement 2.1 Non-Current Assets 2.2 Permanent Assets 2.3 Fluctuating Assets 2.4 Matching Policy 2.5 Aggressive Working Capital Policy 2.6 Conservative Working Capital Policy 3 Level of Investment in Working Capital 3.1 Length of Working Capital Cycle 3.2 Terms of Trade 3.3 Level of Risk Acceptable to Organization 3.4 Industry in Which Organization Operates 4 Overtrading & Undertrading 4.1 Symptoms of Overtrading 4.1.1 Working Capital to Sales Ratio 4.1.2 Increase in Trade Receivable Turnover Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 66 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

4.1.3 Increase in Inventory Turnover 4.1.4 Increase in Trade Payable Turnover 4.1.5 Overdraft 4.1.6 Liquidity Ratios

Financial Management | Page 67 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 6:

THE NATURE OF INVESTMENT DECISIONS & THE APPRAISAL PROCESS Sub Headings Headings (click the cross-ref below for easy navigation) S.no 1 Capital Investment Process

Pg.no 67

1 Capital Investment Process 1.1 Identifying Investment Opportunities 1.2 Screening Investment Proposals 1.3 Analysing & Evaluating Investment Proposals 1.4 Approving Investment Proposals 1.5 Implementing, Monitoring & Reviewing Investments

Financial Management | Page 68 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 7:

NON DISCOUNTED CASH FLOW TECHNIQUES Sub Headings S.no Headings (click the cross-ref below for easy navigation) 1 Accounting Rate of Return (ARR) 2 Payback Period

Pg.no 68 68

1 Accounting Rate of Return (ARR) 1.1 Benefits & Limitations of ARR 2 Payback Period 2.1 Benefits & Limitations of Payback Period

Financial Management | Page 69 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 8:

DISCOUNTED CASH FLOW (DCF) TECHNIQUES Sub S.no 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Headings Headings (click the cross-ref below for easy navigation) Time Value of Money Present Value (PV) Discount Rate Discounting Annuity Perpetuity Conventional & Non-conventional Cash flows Net Present Value (NPV) Benefits & Limitations of Net Present Value (NPV) Internal Rate of Return (IRR) Benefits & Limitations of Internal Rate of Return (IRR) IRR & Non-Conventional Cash flows Discounted Payback Period Commenting on Investment Proposals Free Cash Flows

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Financial Management | Page 70 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Time Value of Money 1.1 Inflation or Deflation 1.2 Postponing Consumption 1.3 Risk 2 Present Value (PV) 3 Discount Rate 3.1 Inflation Rate 3.2 Interest Rate 3.3 Weighted Average Cost of Capital (WACC) 4 Discounting 4.1 Calculating Discount Factor 5 Annuity 5.1 Calculating Annuity Factor 6

Perpetuity

7 Conventional & Non-conventional Cash flows 8 Net Present Value (NPV) 8.1 Performa for Calculating NPV 9 Benefits & Limitations of Net Present Value (NPV) 9.1 Benefits 9.2 Limitations Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 71 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

10 Internal Rate of Return (IRR) 11 Benefits & Limitations of Internal Rate of Return (IRR) 11.1 Benefits 11.2 Limitations 12 IRR & Non-Conventional Cash flows 13 Discounted Payback Period 14 Commenting on Investment Proposals 15 Free Cash Flows

Financial Management | Page 72 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 9:

ALLOWING FOR INFLATION & TAXATION IN DCF Sub S.no 1 2 3 4 5

Headings Headings (click the cross-ref below for easy navigation) Discounting & Timing Of Cash Flows Capital & Revenue Cash Flows Nominal & Real Cash flows Nominal & Real Discount Rate Cash flows & Discount Rate

Pg.no 73 73 73 73 73

Financial Management | Page 73 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Discounting & Timing Of Cash Flows 2 Capital & Revenue Cash Flows 2.1 Capital Cash Flows 2.2 Initial Investment 2.3 Residual Value 2.4 Tax Savings on Capital Allowance 2.5 With No Delay in Tax Payment 2.6 With Delay in Tax Payment 2.7 Revenue Cash Flows 2.7.1 Sales Revenue 2.7.2 Variable Cost 2.7.3 Project Specific Fixed Cost 2.7.4 Tax Payments 2.7.5 Working Capital Investment 2.8 Financial Cash Flows 3 Nominal & Real Cash flows 4 Nominal & Real Discount Rate 5 Cash flows & Discount Rate

Financial Management | Page 74 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 10:

ADJUSTING FOR RISK & UNCERTAINTY IN INVESTMENT APPRAISAL Sub S.no 1 2 3 4

Headings Headings (click the cross-ref below for easy navigation) Adjusting Risk for Investment Appraisal Risk & Uncertainty Sensitivity Analysis Probability Analysis

Pg.no 74 74 74 74

1 Adjusting Risk for Investment Appraisal 2 Risk & Uncertainty 2.1 Risk 2.2 Uncertainty 3 Sensitivity Analysis 3.1 Benefits 3.2 Limitations 4 Probability Analysis 4.1 Expected Values 4.2 Benefits of Expected Values 4.3 Limitations of Expected Values 4.4 Combine Probability 4.5 Probability of Negative & Positive Outcome 4.6 Probability of Specific Condition Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 75 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 11:

SPECIFIC INVESTMENT DECISIONS Sub S.no 1 2 3 4 5 6 7 8 9

Headings Headings (click the cross-ref below for easy navigation) Lease Types of Lease Buying Lease or Buy Approaches Investment Appraisal Asset Replacement Decisions Capital Rationing Investment Decisions & Capital Rationing Relaxing Capital Rationing

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Financial Management | Page 76 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Lease 1.1 Timing of Lease Rental Payments 1.2 Lessor & Lessee 1.3 Benefits of Lease 1.4 Limitations of Lease 2 Types of Lease 2.1 Finance Lease 2.1.1 Benefits & Limitations of Finance Lease 2.1.2 Benefits for Lessee 2.1.3 Limitations for Lessee 2.2 Treatment of Financial Lease 2.3 Operating Lease 2.4 Benefits & Limitations of Operating Lease 2.4.1 Benefits for Lessee 2.4.2 Limitations for Lessee 2.5 Treatment of Operating Lease 3 Buying Formula: 3.1 Benefits 3.2 Limitations 4 Lease or Buy 5 Approaches Investment Appraisal Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 77 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

6 Asset Replacement Decisions 6.1 Financial Factors to Consider 6.1.1 Efficiency & Economy 6.1.2 Resale Value 6.1.3 Tax Savings 6.2 Non-Financial Factors to Consider 6.2.1 Competitive Advantage 6.2.2 Compatibility 6.3 Equivalent Annual Cost (EAC) 6.4 Benefits 6.5 Limitations 6.6 Equivalent Annual Benefit (EAB) 7 Capital Rationing 7.1 Hard Capital Rationing 7.2 Soft Capital Rationing 8 Investment Decisions & Capital Rationing 8.1 Single Period Capital Rationing 8.1.1 Divisible Projects 8.1.1.1 Non-Postponing Projects Required: 8.1.1.2 Limitations of Profitability Index 8.1.1.3 Postponing Projects

Financial Management | Page 78 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

8.1.2 Non Divisible Projects (Non-Postponing Projects) 8.1.3 Mutually Exclusive Projects (Non-Postponing Projects) 9 Relaxing Capital Rationing 9.1 Outsourcing 9.2 Joint Venture 9.3 Franchise 9.4 Working Capital Management 9.5 Government Grant 9.6 Leasing

Financial Management | Page 79 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 12:

SHORT & LONG TERM FINANCE Sub S.no 1 2 3 4

Headings Headings (click the cross-ref below for easy navigation) Short Term Sources of Finance Long Term Sources of Finance Role of Intermediaries Sources of Finance & Investment Appraisal

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Financial Management | Page 80 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Short Term Sources of Finance 1.1 Account Payables 1.2 Overdrafts 1.3 Short Term Loan 1.4 Operating Lease 2 Long Term Sources of Finance 2.1 Finance Lease 2.2 Retained Earnings 2.3 Equity Finance 2.3.1 Benefits 2.3.2 Limitations 2.4 Ways of Raising Equity Finance 2.4.1 Initial Public Offer (IPO) 2.4.2 Placing 2.4.3 Floatation 2.4.4 Right Issue 2.4.4.1 Pre-Emption Right 2.4.5 Benefits 2.4.6 Limitations 2.4.7 Summary 2.5 Preference Share Capital 2.5.1 Cumulative & Non-Cumulative Preference Shares 2.5.2 Convertible & Non-Convertible Preference Shares 2.5.3 Benefits 2.5.4 Limitations Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 81 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

2.6 Debt Finance 2.6.1 Benefits 2.6.2 Limitation 2.7 Ways of Raising Of Debt Finance 2.7.1 Loan Notes (Bonds or Debenture) 2.7.1.1 Par Value 2.7.1.2 Issue or Redemption at Discount 2.7.1.3 Issue or Redemption at Premium 2.8 Types of Loan Notes 2.8.1 Redeemable Loan Notes 2.8.2 Irredeemable Loan Notes 2.8.3 Convertible Loan Notes 2.8.4 Deep Discount Bonds 2.8.5 Zero Coupon Bond 2.8.6 Summary 2.9 Long Term Bank Loans 2.10 Sale & Lease Back 2.10.1

Benefits

2.10.2

Limitations

3 Role of Intermediaries 4 Sources of Finance & Investment Appraisal 4.1 Risk 4.2 Duration 4.3 Volatility Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 82 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

4.4 Trend

Financial Management | Page 83 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapters13:

INTERNAL SOURCES OF FINANCE & DIVIDEND POLICY Sub S.no 1 2 3 4

Headings Headings (click the cross-ref below for easy navigation) Dividend Policy Factors Affecting level of Dividend Script Dividend Ex-dividend or Cum-divided Share Price

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Financial Management | Page 84 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Dividend Policy 1.1 Miller & Modigliani Theory 1.2 Traditional View 1.3 Tax 1.4 Transaction Cost 1.5 Preference for Dividends 1.6 Clientele Effect 1.7 Signalling Effect 1.8 Financing 2 Factors Affecting level of Dividend 2.1 Liquidity 2.2 Consistency 2.3 Financing Needs 2.4 Legal Restrictions 2.5 Gearing 2.6 Signalling Effect 3 Script Dividend 3.1 Benefits 3.2 Limitations 4 Ex-dividend or Cum-divided Share Price

Financial Management | Page 85 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 14:

GEARING & CAPITAL STRUCTURE CONSIDERATIONS Sub Headings S.no Headings (click the cross-ref below for easy navigation) 1 Evaluating Sources of Finance 2 Theoretical Ex-Right Share Price 3 Calculating Theoretical Ex-Right Share Price 4 Impact of Right Issue on Shareholders Wealth

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Financial Management | Page 86 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Evaluating Sources of Finance 2 Theoretical Ex-Right Share Price 3 Calculating Theoretical Ex-Right Share Price 4 Impact of Right Issue on Shareholders Wealth 4.1 Subscribe 4.2 Renounce 4.3 Lapse

Financial Management | Page 87 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 15:

FINANCE FOR SMALL & MEDIUM SIZED ENTITIES (SMEs) Sub S.no 1 2 3 4

Headings Headings (click the cross-ref below for easy navigation) SMEs (Small & Medium Sized Entities) Sources of Finance for SMEs Islamic Finance Islamic Financial Instruments

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Financial Management | Page 88 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 SMEs (Small & Medium Sized Entities) 2 Sources of Finance for SMEs 2.1 Business Angels 2.2 Venture Capitalist (Joint Venture) 2.3 Leasing 2.4 Borrowing From Family & Friends 2.5 Government Aid 2.6 Bank Loan 3 Islamic Finance 3.1 Riba 3.1.1 Limitations of Riba 3.2 Dain 4 Islamic Financial Instruments 4.1 Murabaha (Trade credit) 4.2 Musharakah (Venture Capital) 4.3 Mudarabah 4.4 Ijarah (Operating Lease) 4.5 Ijarah Thumma Al Bai (Hire Purchase) 4.6 Ijarah-Wal-Iqtina (Finance Lease) 4.7 Musharakah (Joint Venture) 4.8 Sukuk (Debt Finance)

Financial Management | Page 89 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 16:

ESTIMATING COST OF CAPITAL Sub S.no 1 2 3 4 5 6 7 8 9

Headings Headings (click the cross-ref below for easy navigation) Weighted Average Cost of Capital (WACC) Calculating Market Value of Equity & Debt Cost of Equity Systematic Risk & Non Systematic Risk Capital Asset Pricing Model (CAPM) Gearing & Ungearing Betas Benefits & Limitations of CAPM Calculating Cost of Debt Calculating Weighted Average Cost of Capital

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Financial Management | Page 90 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Weighted Average Cost of Capital (WACC) 2 Calculating Market Value of Equity & Debt 2.1 Benefits & Limitations of WACC 2.1.1 Benefits 2.1.2 Limitations 3 Cost of Equity 3.1 Dividend Growth Model (DGM) 3.2 Calculating Growth Rate 3.2.1 Average Growth Rate 3.2.1.1 Limitations 3.2.2 Gordon’s Growth Rate 3.2.2.1 Limitations 3.3 Benefits & Limitations of DGM 3.3.1 Benefits 3.3.2 Limitations 3.4 Assumptions (also limitations) 4 Systematic Risk & Non Systematic Risk 4.1 Systematic Risk 4.2 Non Systematic Risk 5 Capital Asset Pricing Model (CAPM) 5.1 Risk Free Rate of Return 5.2 Market Rate of Return 5.3 Equity Risk Premium (

)

Financial Management | Page 91 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

5.4 Equity Beta

6 Gearing & Ungearing Betas 7 Benefits & Limitations of CAPM 7.1 Benefits 7.2 Limitations 8 Calculating Cost of Debt 9 Calculating Weighted Average Cost of Capital

Financial Management | Page 92 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 17:

RELATIONSHIP B/W COST OF CAPITAL, CAPITAL STRUCTURE & INVESTMENTS Sub S.no 1 2 3 4 5 6

Headings Headings (click the cross-ref below for easy navigation) Financial Risk & Business Risk WACC & Investment Appraisal CAPM & Investment Appraisal WACC & Capital Structure Pecking Order Theory Impact of Sources of Finance on Key Ratios

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Financial Management | Page 93 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Financial Risk & Business Risk 1.1 Financial Risk 1.2 Business Risk 2 WACC & Investment Appraisal 3 CAPM & Investment Appraisal 3.1 Conclusion 4 WACC & Capital Structure 4.1 Traditional View 4.1.1 Assumptions 4.2 Miller & Modigliani (M&M) Theory 4.2.1 Assumptions 4.3 Market Imperfection Theory 4.4 Conclusion 5 Pecking Order Theory 5.1 Retained Earnings 5.2 Debt 5.3 Convertible Debt 5.4 Preference Shares 5.5 Equity 6 Impact of Sources of Finance on Key Ratios 6.1 Profitability Ratios 6.1.1 Return of Investment (ROI) Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 94 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

6.1.2 Return of Equity (ROE) 6.2 Liquidity Ratios 6.3 Current Asset Ratio 6.4 Quick Asset Ratio 6.5 Gearing Ratios 6.5.1 Interest Cover 6.5.2 Debt to Equity Ratio 6.5.3 Debt to Debt Plus Equity Ratio 6.6 Investor Ratios 6.6.1 Dividend Cover 6.6.2 Dividend Yield 6.6.3 Earnings Yield 6.6.4 Earnings Per Share 6.6.5 Price Earnings Ratio 6.6.6 Capital Gain 6.6.7 Wealth Generated

Financial Management | Page 95 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 18:

BUSINESS VALUATION TECHNIQUES Sub S.no 1 2 3 4 5 6 7 8

Headings Headings (click the cross-ref below for easy navigation) Business Valuation Net Assets Valuation Model Price Earnings (P/E) Ratio Method Earnings Yield Valuation Method Dividend Valuation Model (DVM) Valuation of Debt & other Financial Assets Evaluating Financial Performance Preparing Forecast Financial Statements

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Financial Management | Page 96 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Business Valuation 2 Net Assets Valuation Model 2.1 Assets Excluded 2.1.1 Goodwill 2.1.2 Development Expenditure 2.1.3 Contingent Assets 2.2 Assets & Liabilities Included 2.2.1 Brand, Copyright & Patents 2.2.2 Tangible Assets 2.2.3 Contingent Liabilities 2.3 Benefits & Limitations 2.3.1 Benefits 2.3.2 Limitations 3 Price Earnings (P/E) Ratio Method 3.1 Benefits 3.2 Limitations 4 Earnings Yield Valuation Method 5 Dividend Valuation Model (DVM) 5.1 Benefits & Limitations of DVM 5.1.1 Benefits 5.1.2 Limitations 6 Valuation of Debt & other Financial Assets 6.1 Redemption Value Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 97 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

6.2 Redemption Yield 6.3 Floor Value 6.4 Conversion Premium 7 Evaluating Financial Performance 8 Preparing Forecast Financial Statements

Financial Management | Page 98 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 19:

EFFICIENT MARKET HYPOTHESIS Sub S.no 1 2 3

Headings Headings (click the cross-ref below for easy navigation) Features of Efficient Markets Benefits of Efficient Markets Efficient Market Hypothesis

Pg.no 98 98 98

1 Features of Efficient Markets 2 Benefits of Efficient Markets 3 Efficient Market Hypothesis 3.1 Weak Form Efficient 3.1.1 Published Financial Statements 3.1.2 Past Dividend Payments 3.1.3 Past Reputation 3.2 Semi Strong Form Efficient 3.3 Strong Form Efficient

Financial Management | Page 99 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 20:

BASICS OF FINANCIAL RISK MANAGEMENT Sub S.no 1 2 3 4 5 6 7 8

Headings Headings (click the cross-ref below for easy navigation) Direct Vs Indirect Quote Buying & Selling Rate Agreement & Settlement Date Foreign Exchange Risk Types of Foreign Exchange Risk Managing Foreign Exchange Risk Netting Lead & Lag Payment

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1 Direct Vs Indirect Quote 1.1 Direct Quote 1.2 Indirect Quote 2 Buying & Selling Rate 2.1 Direct Quote 2.2 Indirect Quote 3 Agreement & Settlement Date 3.1 Agreement Date 3.2 Settlement Date 4 Foreign Exchange Risk 5 Types of Foreign Exchange Risk 5.1 Transaction Risk 5.2 Translation Risk 5.3 Economic Risk 6 Managing Foreign Exchange Risk 6.1 Hedging 6.1.1 Settlement on Net Basis 6.2 Invoicing in Home Currency 6.3 Matching 7 Netting 8 Lead & Lag Payment Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 101 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 21:

HEDGING TECHNIQUES FOR FOREIGN CURRENCY RISK Sub S.no 1 2 3 4 5 6 7 8 9 10

Headings Headings (click the cross-ref below for easy navigation) Step by Step Solution Spot & Forward rate Inflation Rate Parity Theory Interest Rate Parity Theory Forward Contract Hedge Future Contract Hedge Money Market Hedge Currency Option Currency Swap Derivative

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Financial Management | Page 102 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Step by Step Solution

2 Spot & Forward rate 2.1 Spot Rate 2.2 Forward Rate 3 Inflation Rate Parity Theory 4 Interest Rate Parity Theory 5 Forward Contract Hedge 5.1 Receipt 5.1.1 Scenario 1 (Gain on Forward Contract) 5.1.2 Scenario 2 (Loss on Forward Contract) 5.2 Payment 5.2.1 Scenario 3 (Loss on Forward Contract) 5.2.2 Scenario 4 (Gain on Forward Contract) 5.3 Benefits 5.4 Limitations 6 Future Contract Hedge 6.1 Future Market 6.2 Contract Price 6.3 Contract Size 6.4 Basis Risk 6.5 Tick 6.6 Agreement Date Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 103 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

6.7 Settlement Date 6.8 Benefits 6.9 Limitations 7 Money Market Hedge 7.1 Step By Step Process 7.1.1 Money Market Hedge for Receipt 7.1.2 Money Market Hedge for Payment 7.2 Benefits 7.3 Limitations 8 Currency Option 8.1 Benefits 8.2 Limitations 9 Currency Swap 10 Derivative

Financial Management | Page 104 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

Chapter 22:

HEDGING TECHNIQUES FOR INTEREST RATE RISK Sub S.no 1 2 3 4 5 6 7 8 9 10 11

Headings Headings (click the cross-ref below for easy navigation) Interest Rate Risk Types of Interest Rate Risk Managing Interest Rate Risk Forward Rate Agreements (FRAs) Future Contracts Interest Rate Option Interest Rate Swap Effects of Interest Rate on Performance Factor Affecting Interest Rates Yield Curve Macroeconomic Factors Affecting Interest Rates

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Financial Management | Page 105 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

1 Interest Rate Risk 2 Types of Interest Rate Risk 2.1 Variable Interest Rate Risk 2.2 Basis Risk 2.3 Negative Gap 2.4 Positive Gap 2.5 Fixed Interest Rate Risk 3 Managing Interest Rate Risk 3.1 Matching 3.2 Smoothing 3.3 Hedging 4 Forward Rate Agreements (FRAs) 5 Future Contracts 6 Interest Rate Option 6.1 Cap 6.2 Floor 6.3 Collar 7 Interest Rate Swap 7.1 Switching Between Types of Interest Rate 7.2 Borrow Loan at More Competitive Terms 8 Effects of Interest Rate on Performance Buy Full Financial Management Book (380 Âą) at ACCASUPPORT.COM | NEWSLETTERS | COMMENT | FORUMS | JOBS Management Accounting, Performance Management, Business Analysis, Ebusiness / Ecommerce Guide Free Download

Financial Management | Page 106 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

9 Factor Affecting Interest Rates 9.1 Risk 9.2 Level of Gearing 9.3 Spread on Interest Rate 9.4 Size of Loan 9.5 Flexibility & Marketability 9.6 Liquidity Preference Theory 9.7 Expectation Theory 9.8 Market Segmentation Theory 9.9 Government Policy 10 Yield Curve 11 Macroeconomic Factors Affecting Interest Rates 11.1 Inflation 11.2 Real Return 11.3 Volatile or Stable Economic Conditions 11.4 Monetary Policy 11.5 Foreign Interest Rates 11.6 Balance Of Payments

Financial Management | Page 107 of 108 Chapter 22: HEDGING TECHNIQUES FOR INTEREST RATE RISK

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