financial management subject guide
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Financial managementJ. Dahya, R.E.V. Groves
AC3059,2790059
2011
Undergraduate study inEconomics, Management,Finance and the Social Sciences
This subject guide is or a Level 3 course (also known as a 300 course) oered as
part o the University o London International Programmes in Economics, Management,
Finance and the Social Sciences. This is equivalent to Level 6 within the Framework or
Higher Education Qualifcations in England, Wales and Northern Ireland (FHEQ).
For more inormation about the University o London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
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This guide was prepared for the University of London International Programmes by:
J. Dahya, Bacc., Macc, Lecturer in Accounting and Business Finance, Cardiff Business School,University of Wales, Cardiff.
R.E.V. Groves, B.Com., MSc, PhD, FCA, Sir Julian Hodge Professor of Accounting, CardiffBusiness School, University of Wales, Cardiff.
It was updated in 2008 by Professor Groves.
This is one of a series of subject guides published by the University. We regret that dueto pressure of work the authors are unable to enter into any correspondence relating to,or arising from, the guide. If you have any comments on this subject guide, favourable orunfavourable, please use the form at the back of this guide.
The University of London International Programmes
Publications OfficeStewart House32 Russell Square
London WC1B 5DNUnited Kingdom
Website: www.londoninternational.ac.uk
Published by: University of London
University of London 2008
Reprinted with minor revisions 2011
The University of London asserts copyright over all material in this subject guide except whereotherwise indicated. All rights reserved. No part of this work may be reproduced in any form,
or by any means, without permission in writing from the publisher.We make every effort to contact copyright holders. If you think we have inadvertently usedyour copyright material, please let us know.
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Contents
i
Contents
Introduction ............................................................................................................ 1
Aims and objectives ................................. ................................. ................................ ..... 1
Learning outcomes ................................. ................................. ................................. ..... 2
Syllabus ............................... ................................ ................................. ........................ 2
Studying financial management .......................................... ................................. ......... 2
Reading advice ............................... ................................. ................................. ............ 3
Online study resources ................................. ................................. ................................. 4
How to use the subject guide .................................. ................................. ..................... 5
Solutions to learning activities .......... ................................. ................................. .......... 6
Examination advice ............................... ................................. ................................ ....... 6
Summary ................................. ................................. ................................. ................... 7
Abbreviations ................................ ................................. ................................. ............. 7
Chapter 1: Introduction to financial management ................................................ 9
Aims of the chapter ............................. ................................. ................................. ....... 9
Learning outcomes .............................. ................................. ................................. ........ 9
Essential reading ................................ ................................. ................................. ...... 10
Further reading ............................. ................................. ................................ ............. 10
Key tasks of financial management ........ ................................ ................................. .... 10
Financial environment ............................... ................................ ................................. . 10
Organisational forms of business ... ................................. ................................. ........... 11
Corporate objectives ................................ ................................. ................................ .. 11
Role of managers ................................... ................................ ................................. ... 12
Conflicts of interest and their resolution ............................................ .......................... 12
Corporate governance ............................ ................................. ................................. .. 13
Financial management and risk ............................................................. ...................... 13
Financial management and accounting ..... .................................. ................................ 13
Financial management and taxation ............................... ................................. ........... 14
A reminder of your learning outcomes ............................. ................................. ........... 14
Practise questions ............................. ................................ ................................. ......... 14
Problems .............................. ................................ ................................. ..................... 15
Chapter 2: Basic investment appraisal methods .................................................. 17
Aims of the chapter .......................... ................................. ................................. ........ 17Learning outcomes ................................. ................................. ................................ .... 17
Essential reading ............................. ................................. ................................. ......... 17
Further reading ............................... ................................. ................................. .......... 17
Time value of money ............................. ................................. ................................. .... 18
Future value and compounding .......................................... ................................. ........ 18
Present value and discounting ............................... ................................. .................... 18
Interest rates, discount rates and real rates ............................... ................................. . 19
Basic investment appraisal techniques ............................... ................................. ........ 19
Application problems some considerations ............................. ................................. . 21
What-if questions .............................. ................................. ................................. ..... 25The examination ................................. ................................. ................................. ...... 26
A reminder of your learning outcomes ................................................ ......................... 26
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59 Financial management
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Sample examination questions ................................. ................................. .................. 26
Practise question 2.1 ................................... ................................. .............................. 26
Problems ............................. ................................. ................................. ..................... 27
Chapter 3: Introduction to risk and return ........................................................... 29
Aims of the chapter ............................... ................................. ................................ .... 29
Learning outcomes ................................ ................................. ................................. .... 29
Essential reading .................................. ................................. ................................. .... 29Further reading ............................... ................................. ................................ ........... 29
Introduction ...............................................................................................................29
Rate of return: a review ............. ................................. ................................. ............... 30
Calculating expected return, variance and standard deviation ....... ............................... 31
Risk and diversification .......................................................... ................................. .... 33
Market risk versus unique risk ................................ ................................. .................... 35
A reminder of your learning outcomes ................................................ ......................... 35
Practise questions ............................... ................................. ................................. ...... 35
Problems ................................ ................................. ................................. .................. 36
Chapter 4: Capital budgeting risk and return .................................................. 37Aims of the chapter ............................ ................................. ................................. ...... 37
Learning outcomes .............................. ................................ ................................. ....... 37
Essential reading ................................ ................................ ................................. ....... 37
Further reading .................................. ................................. ................................ ........ 37
Introduction ............................... ................................. ................................. .............. 37
Measuring market risk .................................. ................................. ............................. 38
Measuring beta ................................ ................................. ................................. ........ 38
Portfolio betas .................................. ................................. ................................ ......... 39
Risk and return ............................................................ ................................. .............. 39
Capital asset pricing model ........................................... ................................. ............. 40Project returns and the opportunity cost of capital ................................................... .... 41
Capital budgeting and project risk ................................. ................................. ............ 42
A reminder of your learning outcomes ............................. ................................ ............ 43
Practise questions .................................. ................................ ................................. .... 43
Problems ............................. ................................. ................................ ...................... 43
Chapter 5: Sources of funds ................................................................................. 45
Aims of the chapter ............................... ................................. ................................ .... 45
Learning outcomes ................................ ................................. ................................. .... 45
Essential reading ............................. ................................ ................................. .......... 45
Capital markets .............................. ................................. ................................. .......... 46
Efficient market hypothesis .................... ................................. ................................ .... 46
Tests of the efficient market hypothesis ......................... ................................. ............. 47
Anomalies, fads, insider trading and doubts concerning efficiency ....... ......................... 48
Implications of capital market efficiency .............. ................................ ........................ 48
London capital market .......................................................... ................................. ..... 49
Share capital ................................ ................................. ................................. ............ 50
Methods of raising share capital ................................. ................................. ............... 50
Rights issues, share prices and shareholder wealth .................... ................................. . 51
Other sources and types of equity ............................... ................................ ................ 52
Retained earnings ............................... ................................ ................................. ....... 53
Long-term debt finance ...................... ................................. ................................. ...... 53
The issue of loan capital ................................ ................................. ............................ 54
Hybrid capital .............................. ................................. ................................ .............. 54
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The attitude of investors and managers to the financing decision .......................... ....... 54
A reminder of your learning outcomes ............................. ................................. ........... 55
Practise questions .................................. ................................ ................................. .... 55
Problems ............................. ................................. ................................. ..................... 55
Chapter 6: Cost of capital and valuation of a business........................................ 57
Aims of the chapter ............................... ................................ ................................. .... 57
Learning outcomes ................................ ................................. ................................ ..... 57Essential reading .................................. ................................. ................................ ..... 57
Further reading .............................. ................................. ................................. ........... 57
The value of economic assets debt .................................. ................................. ........ 58
The value of economic assets equity ........................................................... .............. 59
The required return on investment .............................. ................................. ............... 60
The capital asset pricing model (CAPM) ............................. ................................ ......... 61
The cost of retained earnings ..................... ................................. ................................ 61
Valuation of warrants ............................... ................................. ................................. 62
The reasons for capital gearing ................................... ................................ ................ 62
Capital gearing and risk ............................................................. ................................. 63The relationship between the level of capital gearing and the cost of capital the
traditional view ................................. ................................. ................................ ........ 63
The relationship between the level of capital gearing and the cost of capital the
Modigliani and Miller view ............................ ................................. ............................ 64
Weighted average cost of capital (WACC) ... ................................. ............................... 65
Valuation on the basis of the businesss earnings ................................ ........................ 65
Other approaches to share and business valuation ................................... ................... 66
A reminder of your learning outcomes .............................. ................................. .......... 70
Practise questions ............................. ................................. ................................. ........ 70
Problems .............................. ................................. ................................. .................... 71
Chapter 7: Dividend policy ................................................................................... 73
Aims of the chapter ........................... ................................. ................................ ........ 73
Learning outcomes .................................. ................................ ................................. ... 73
Essential reading .............................. ................................. ................................. ........ 73
Further reading ................................ ................................. ................................. ......... 73
Introduction .............................. ................................. ................................ ................ 73
Dividend policy and shareholder wealth .... ................................. ................................. 74
Dividend irrelevancy argument ...................................... ................................. ............. 74
Traditional view of dividends .............................. ................................. ........................ 74
Information content of dividends .................................. ................................. ............. 75
Clientele effect ............................... ................................. ................................. .......... 75Share repurchase ................................. ................................. ................................. ..... 76
Scrip dividends .............................. ................................. ................................. ........... 76
Determining dividend policy in practice ............................... ................................ ........ 77
A reminder of your learning outcomes ................................. ................................ ........ 77
Practise questions ................................ ................................. ................................. ..... 77
Problems ....................................................................................................................79
Chapter 8: Financial analysis, methods and uses, and financial planning ............ 81
Aims of the chapter ........................ ................................ ................................. ........... 81
Learning outcomes .............................. ................................. ................................. ...... 81
Essential reading ................................ ................................. ................................. ...... 81Further reading ............................. ................................. ................................ ............. 81
Statement analysis .............................. ................................. ................................ ....... 81
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Cash based ratios ........................................................ ................................ ............... 82
Practical applications ............................. ................................. ................................. ... 83
Financial planning introductory comments .............................. ................................. 88
Financial planning process ................................................. ................................. ........ 88
Technical aspects of financial planning ........................... ................................. ............ 88
Planning outputs .................................. ................................. ................................. .... 89
A reminder of your learning outcomes ................................. ................................. ....... 90Practise questions ................................. ................................ ................................. ..... 91
Problems ....................................................................................................................91
Chapter 9: Short-term finance and asset management ...................................... 93
Aims of the chapter .............................. ................................ ................................. ..... 93
Learning outcomes ............................... ................................. ................................ ...... 93
Essential reading ................................. ................................. ................................ ...... 93
Further reading .............................. ................................ ................................. ............ 93
Long- versus short-term finance ........................................ ................................. ......... 94
Trade credit ....................................................... ................................. ........................ 94
Debt factoring .............................. ................................. ................................. ............ 94Bank borrowing .................................. ................................ ................................. ....... 95
Specialist finance ................................ ................................ ................................. ....... 96
Leasing ................................. ................................ ................................. .................... 96
Evaluation of sources of finance ............................................................. ..................... 96
Management of short-term assets .......................................................... ..................... 99
The management of cash ............................................... ................................. ............ 99
The management of trade debtors ............................. ................................ ............... 100
The management of stock-in-trade ............................. ................................. .............. 101
Working capital and the problem of overtrading ................................................. ....... 102
A reminder of your learning outcomes .............................. ................................ ......... 104
Practise questions ............................. ................................. ................................ ....... 104
Problems .............................. ................................. ................................ ................... 105
Chapter 10: Treasury management and international aspects of
financial management ....................................................................................... 107
Aims of the chapter .......................... ................................. ................................ ....... 107
Learning outcomes ................................. ................................ ................................. .. 107
Essential reading ............................. ................................. ................................. ....... 107
Further reading ............................... ................................. ................................. ........ 107
Introduction ............................. ................................. ................................ ............... 108
Why should financial managers of firms be concerned with options and other
financial instruments? ................................. ................................. ............................. 108Calls and puts .......................... ................................ ................................. ............... 108
What the value of a call option depends upon ...................................... ..................... 109
Option valuation model ....................... ................................. ................................. ... 110
Using options to allow the expansion or abandonment of real assets ......................... 111
Options on financial assets .............. ................................ ................................. ........ 112
Why do companies hedge? .............................................. ................................. ........ 112
International financial management ................................................... ....................... 113
Interrelationships between variable affecting exchange rates ....................... .............. 114
Exchange risk exposure ............................. ................................. ............................... 116
Management of foreign exchange exposure .................. ................................ ............ 116A reminder of your learning outcomes ............................................... ........................ 119
Practise question ............................... ................................. ................................. ..... 119
Problems ..................................................................................................................120
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Chapter 11: Mergers, corporate restructuring and off-balance sheet funding .. 121
Aims of the chapter ......................... ................................ ................................. ........ 121
Learning outcomes ............................... ................................. ................................. ... 121
Essential reading ................................. ................................. ................................. ... 121
Further reading .............................. ................................. ................................. ......... 121
Introduction ................................. ................................. ................................. .......... 122
Merger waves ................................ ................................ ................................. .......... 122Motives for individual mergers ............................... ................................. .................. 123
Economic theories of mergers ..................... ................................ .............................. 123
Management motives ............................... ................................. ............................... 126
Takeover tactics ....................................................... ................................. ................ 127
Takeover defences ........................................ ................................. ........................... 129
Glamorous defence tactics .............................................. ................................. ......... 129
Company restructuring ............................. ................................ ................................ 130
Divestments .............................................................................................................130
Off-balance sheet funding ............................... ................................. ......................... 131
Leasing ....................................................................................................................131A reminder of your learning outcomes ............................................... ........................ 132
Practise questions .............................. ................................. ................................. ..... 132
Problems ..................................................................................................................133
Appendix 1: Review questions ........................................................................... 135
Question 1 ...............................................................................................................135
Question 2 ................................. ................................. ................................. ............ 135
Question 3 ................................. ................................. ................................ ............. 136
Question 4 ................................ ................................. ................................. ............. 137
Question 5 ................................ ................................. ................................ .............. 137
Question 6 ................................ ................................ ................................. .............. 138
Question 7 ................................ ................................. ................................. .............. 138
Question 8 ............................... ................................. ................................. .............. 139
Appendix 2: Suggested solutions to review questions ..................................... 141
Solution to Question 1 ............................................ ................................. ................. 141
Solution to Question 2 ............................................ ................................. ................. 142
Solution to Question 3 ............................................ ................................. ................. 143
Solution to Question 4 .................................. ................................. ............................ 145
Solution to Question 5 ............................................ ................................. ................. 146
Solution to Question 6 .................................. ................................. ............................ 147
Solution to Question 7 .................................. ................................. ............................ 149
Solution to Question 8 ............................................ ................................. ................. 150
Appendix 3: Sample examination paper ........................................................... 151
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Notes
59 Financial management
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Introduction
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Introduction
59 Financial management is a Level 3 course (also known as a 300
course) offered on the Economics, Management, Finance and the SocialSciences (EMFSS) suite of programmes.
Financial management is part of the decision-making, planning and
control subsystems of an enterprise. It incorporates:
the treasury function, which includes the management of working
capital and the implications arising from exchange rate mechanisms
due to international competition
the evaluation, selection, management and control of new capital
investment opportunities
the raising and management of the long term financing of an entity
the need to understand the scope and effects of the capital markets fora company, and
the need to understand the strategic planning processes necessary to
manage the long and short term financial activities of a firm.
The management of risk in the different aspects of the financial
activities undertaken is also addressed.
Studying this course should provide you with an overview of the problems
facing a financial merger in the commercial world. It will introduce you to
the concepts and theories of corporate finance that underlie the techniques
which are offered as aids for the understanding, evaluation and resolution
of financial managers problems.
This subject guide is written to supplement the Essential and
Further reading listed for this course, not to replace them. It makes no
assumptions about prior knowledge other than that you have passed
the course 25 Principles of accounting(or its predecessor, course
19 Elements of accounting and finance). This course may not be
taken with 92 Corporate finance. The aim of the course is to provide
an understanding and awareness of both the underlying concepts and
practical application of the basics of financial management. The readings
and the subject guide should also help to build in your mind the ability to
make critical judgements of the strengths and weaknesses of the theories,
just as it should be helping to build a critical appreciation of the uses andlimitations of the same theories and their possible applications.
Aims and objectives
This course is designed to:
place financial management as a clear part of the decision making,
planning and control subsystems of an enterprise
provide an overview of the problems facing a financial merger in the
commercial world
introduce the concepts and theories of corporate finance that underlie
the techniques
which are offered as aids for the understanding, evaluation and
resolution of financial managers problems.
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59 Financial management
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Learning outcomes
At the end of this course, and having completed the Essential reading
and activities, you should be able to:
discuss the theoretical models underpinning the practices in financial
management
apply the techniques derived from the models and theories in financialmanagement
explain the long and short-term financial needs of a business
describe the techniques used for the selection and management of long
and short-term assets
discuss and give examples of the wider aspects of financial
management so as to include international considerations and the need
to communicate decisions made to other members of a management
team.
The above provides a broad checklist for you to refer to as you work
through the guide.
Syllabus
A critical perspective of the topic of finance, the role of financial managers
and the place of financial markets within the business environment in
developed and developing economies. Topics will be set in both national
and international contexts.
Sources and methods of raising finance including venture capital, public
offerings, private placements and project finance.
A critical review of the different forms of finance such as equity, debt
and their derivatives and incorporating critical consideration of theircosts individually and in combination. Valuation methods for costing the
different elements of capital such as the Capital Asset Pricing Model and
the Arbitrage Pricing Model. Theories of capital gearing, dividend policy
and corporate restructuring and refinancing. Mergers and acquisitions.
Evaluation of risk measurement theories and methods and their
application to both sources of finance and to investment appraisal.
Investment appraisal techniques in the certain and uncertain world, with
and without constraints.
Analytical tools, techniques and methods for analysing financial reports
incorporating an assessment of their relevance for evaluation and planning
purposes. Strategic considerations of financial planning and control,models and methods, for management of corporate liabilities and assets.
Consideration of theories and techniques for management of short term
funds including treasury and currency management.
An introduction to risk management including hedging, futures, options
and derivatives and their uses in both long and short term situations.
Studying financial management
This subject guide highlights the key theoretical and practical issues
relating to financial management.
The topics to be covered in this subject can be divided into six elements:
the theories and techniques of appraisal and management of long-term
investments under conditions of both certainty and risk
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Introduction
3
the various sources of long-term funds, the methods used to raise them,
their individual costs and the effect of gearing in the corporate financial
mix
the valuation models used to derive capital costs, incorporating
theoretical and empirical aspects of investors behaviour both
individually and as a capital market, noting differences in capital
market operations and effects between developed and developing
capital markets
the analytical tools necessary for corporate evaluation, valuation,
prediction and planning
short-term funds, their sources and management, both nationally and
internationally
general elements of corporate financial activity such as mergers
and acquisitions, risk management, treasury management using the
currency and futures markets.
From the practical viewpoint, these elements of financial management
can be condensed to the three broad areas of the provision, allocation
and control of a businesss financial resources to enable it to achieve its
objectives. The financial manager must be able to identify and quantify
the amount of capital required for investment, whether this is in fixed or
current assets. To do this, the manager will use financial planning models
to determine the quantity of funds required. Where, why, and how the
funds are obtained is all part of the financial managers function just as
deciding to what use the funds should be put. Having decided upon the
capital mix on the one hand, and the selection of the investments on
the other, the financial manager must then fulfil the control function of
this role thus ensuring that the planning goals are achieved. Overall, the
financial manager has a wide and very important role.
Reading advice
Essential reading
You need to purchase or have regular access to the following
textbook:
Brealey, R.A., S.C. Myers and A.J. MarcusFundamentals of Corporate Finance .
(McGraw-Hill Inc, 2007) fifth edition (Intl) [ISBN 9780073012384].
This textbook gives a good introduction to the subject, but on its own is
insufficient since it does not provide the depth of discussion and analysis
required for an undergraduate degree course. It is therefore necessary to
read the appropriate chapters in one of the additional texts listed below
to provide this depth. These texts tend to be reflective of the corporate
finance perception of the subject matter rather than the more applied view
of financial management. This has to be born in mind. In the text it will be
referred to in this subject guide as BMM.
Detailed reading references in this subject guide refer to the editions of the
set textbooks listed above. New editions of one or more of these textbooks
may have been published by the time you study this course. You can use
a more recent edition of any of the books; use the detailed chapter and
section headings and the index to identify relevant readings. Also check
the virtual learning environment (VLE) regularly for updated guidance on
readings.
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Further reading
Please note that as long as you read the Essential reading you are then free
to read around the subject area in any text, paper or online resource. You
will need to support your learning by reading as widely as possible and by
thinking about how these principles apply in the real world. To help you
read extensively, you have free access to the VLE and University of London
Online Library (see below).
Other useful texts for this course include:
Brealey, R.A., S.C. Myers and F. AllenPrinciples of Corporate Finance.
(McGraw-Hill, 2008) ninth edition (Intl) [ISBN 9780073368696].
For those of you who are studying on your own who find difficulty with
the recommended basic text of BMM another text is offered, but note that
it does not cover the subjects to the same depth and rigour required. This
supplementary primer is:
Atrill, P.Financial Management for Decision makers. (FT Prentice Hall
Europe, 2005) fourth edition [ISBN 9780273702498].
Online study resources
In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you forget your login details at any point, please email: uolia.support@
london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
Self-testing activities: Doing these allows you to test your own
understanding of subject material.
Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
Past examination papers andExaminers commentaries : These provide
advice on how each examination question might best be answered.
A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, workcollaboratively to solve problems and discuss subject material.
Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
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Introduction
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Recorded lectures: For some courses, where appropriate, the sessions
from previous years Study Weekends have been recorded and made
available.
Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
Feedback forms.
Some of these resources are available for certain courses only, but weare expanding our provision all the time and you should check the VLE
regularly for updates.
Making use of the Online Library
The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
How to use the subject guide
This subject guide is divided into 11 chapters, plus appendicies. Somechapters in the subject guide are self-contained; others lead into one or
more following chapters. Complete whichever chapter you are studying
and the associated work before moving on.
A suggested order for your studying is as follows:
For each chapter, read the aims and/or introduction and the learning
objectives to appreciate the scope of the material to be covered.
Carefully read the suggested chapters in Brealey, Myers and Marcus,
with the aim of gaining an initial understanding of the topics.
Read the remainder of the chapter in the subject guide. You may then
approach the Further reading suggested in Brealey, Myers and Allen.
The subject guide material is aimed to identify the scope of your
studying of this topic as well as attempting to reinforce the basic
messages set out in Brealey, Myers and Marcus. Therefore you should
pay careful attention to the examples in both the texts and the subject
guide to ensure you achieve that basic understanding. By taking notes
from Brealey, Myers and Marcus and then from any other books you
should have obtained the necessary material for your understanding,
application and later revision.
Pay particular attention to the practise questions and the examples
given in the subject guide. The material covered in the examples and in
working through the exercises is both complementary to the textbookand important in your preparation for the examination.
Ensure you have achieved the listed learning outcomes.
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59 Financial management
6
Attempt the problems at the end of each chapter, and if you have the
time attempt those at the end of the Brealey, Myers and Marcus chapters.
Check you have mastered each topic before moving on to the next.
At the end of your preparations, attempt the Sample examination
questions at the end of the subject guide. Then compare your answers
with the suggested solutions, but do remember that they may well
include more information than the Examiner would expect in anexamination paper, since the guide is trying to cover all possible
angles in the answer, a luxury you do not usually have time for in an
examination.
Solutions to learning activities
Solutions to certain learning activities is provided online in the VLE at
http://emfss.elearning.london.ac.uk/
This is indicated in the subject guide as: See VLE for solution
Examination adviceImportant: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations
for relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow
those instructions.
The examination paper will normally be made up of two sections each
containing four questions. One section will include data handling andnumerical analysis type questions each requiring analysis, composition
and presentation. Each question will also have a small section requiring
a written answer which may be a discussion of the theory used in the
application, or a request for interpretation of your results or something
related to the problem or theory used. The other section will contain
essay or report-style questions requiring written answers. You will need to
answer four questions with a minimum of one question from each section.
Remember when sitting the examination to maximise the time spent
on each question and although, throughout, the subject guide will give
you advice on tackling your examinations, remember that the numerical
type questions on this paper take some time to read through and digest.
Therefore try to remember and practise the following approach. Always
read the requirement(s) of a question first before reading the body of the
question. This is appropriate whether you are making your selection of
questions to answer, or when you are reading the question in preparation
for your answer.
In the question selection process at the start of the examination, by
reading only the requirements, which are always placed at the end of a
question, you then only read material relevant to your choice, you do
not waste time reading material you are not going to answer. Secondly,
by reading the requirements first, your mind is focused on the sort of
information it should be looking for in order to answer the question,
therefore speeding up the analysis and saving time.
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Introduction
7
Remember, it is important to check the VLE for:
up-to-date information on examination and assessment arrangements
for this course
where available, past examination papers and Examiners
commentaries for the course which give advice on how each question
might best be answered.
Summary
Remember this introduction is only a complementary study tool in your
efforts with this subject guide. Its aim is to give you a clear understanding
of what is in the subject guide and how to study successfully.
Systematically study the next eleven chapters along with the listed texts
for your desired success.
Good luck and enjoy the subject!
Abbreviations
AIM Alternative Investment Market
APM Arbitrage Pricing model
ARR Accounting rate of return
BMA Brealey, Myers and Allen
BMM Brealey, Myers and Marcus
CAPM Capital asset pricing model
CME Capital market efficiency
EMH Efficient market hypothesis
EPS Earnings per shareIRR Internal rate of return
ISE International Stock Exchange of the UK and the
Republic of Ireland
NPV Net present value
MM Modigliani and Miller
MPT Modem portfolio theory
PA Peter Atrill
PE Price earnings ratio
PI Profitability indexPP Payback period
WACC Weighted average cost of capital
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Notes
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Chapter 1: Introduction to financial management
9
Chapter 1: Introduction to financial
management
Aims of the chapterThis chapter is clearly one of the most important in the subject guide
because it deals with the fundamentals of financial management. Without
a clear understanding of the fundamentals the remainder of this subject
will not be easy to grasp. As with any subject area, a knowledge of the
background, the environment to which the subject relates, is important as
it helps to put everything learnt later into appropriate perspective.
The chapter starts by looking at the key tasks of financial management.
Since knowledge of the financial environment is vital to managers this
comes next before the review of the differing organisational forms of
business that are in use.
An outline of corporate objectives follows because these form the basis of
much of the theory that is covered in this subject. The roles of financial
managers come next, to be followed by a discussion of some of their
conflicts of interest and how they might be resolved. One area of major
interest is the corporate governance debate on how the relationship
between owners and controllers should be systemised to maximise the
corporate gain.
Brief descriptions of how risk is treated in financial management theory,
and how accounting is linked in with financial management, are included
and the chapter is concluded with a note of the direction and importance
of taxation in todays financial decisions.The course 25 Principles of accounting, if studied carefully and fully,
should have meant you already have all this background knowledge. If
that is true, then perhaps only a quick review of this subject matter is
necessary, but if the practise questions and problem(s) here and in the
Essential text cause you any problems, then a more detailed and careful
review of your prerequisite course may be needed.
Learning outcomes
By the end of this chapter, and having completed the Essential reading and
activities, you should be able to:
describe the general financial environment in which corporations
operate
explain the importance and roles of financial markets
list/outline the roles financial managers can have within an
organisation
outline such things as taxation, accounting information and form of
business and their implications for financial management
give examples of the various objectives a company may have and why
the main objective is deemed to be shareholder wealth maximisation
explain and give examples of how the influence of risk will permeate allaspects of financial management, the theories presented, the appraisal
and selection, the changes suggested, and the control methods used.
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59 Financial management
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Essential reading
Brealey, R.A., S.C. Myers and A.J. MarcusFundamentals of Corporate Finance .
(McGraw-Hill Inc, 2007) Chapters 1, 2 and 3.
Further reading
Brealey, R.A., S.C. Myers and F. AllenPrinciples of Corporate Finance. (McGraw-
Hill, 2008) Chapter 1.
Atrill, P.Financial Management for Decision makers. (FT Prentice Hall Europe,
2005) Chapters 1 and 2.
Key tasks of financial management
There are five key tasks undertaken in financial management:
financial planning
investment project appraisal
financial decisions capital market operations
financial control.
Financial planning provides the means, through plans and projections, to
evaluate the proposed courses of action. Similarly financial control deals
with the ways and means by which the plans are achieved. The next two
tasks, investment project appraisal and financing decisions are seen by
some, including Brealey and Myers, as the two most important tasks.
Investment project appraisal is the assessment and evaluation of the
relative strengths of a companys investment propositions. The financing
decisions involve the identification and choice of the sources of funds
which will provide the cash to be invested into the selected projects. Part
of the finance function is dealing with the capital market since a large
part of the finance is obtained through the capital market, not least those
funds provided by the equity owners, the ordinary shareholders.
This function does not just deal with the raising of funds but also with
the ongoing relationship between the company and the market place;
information disseminated to the capital markets affects the markets
perception of the company and the price of the companys shares, and thus
wealth of the shareholder.
Financial environment
The economic and social background of a country is a major influence on a
firm, on its structure and on its objectives and operations. Firms in socialist
or communist countries have different structures and objectives from those
that operate in capitalist economies. Countries that are still developing
may not have a public market place (i.e. a stock market) in which the
shares in a company can be traded. Different phases of the trade cycle
have different implications for financial operations. In depressed times,
interest rates payable on loans will be higher, trading conditions much
more risky and so returns to shareholders may be lower or non-existent.
In the capitalist economies of developed countries where there are
stockmarkets, the owners of the shares in trading companies will expectreturns on those shares. The quality and amount of that return, the
dividend, will be one of the elements influencing the price at which the
share is quoted in the market. Potential owners of shares as well as existing
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Chapter 1: Introduction to financial management
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owners of shares are interested in the quoted price of a companys share
and in the return obtainable from that investment. How and why those
returns and share prices can be influenced will be covered later. The extent
of a countrys capital markets, of which the stockmarket is but a part, vary
enormously from the very large, very sophisticated, very structured markets
such as London and New York to some of the very small nascent markets in
some developing countries in Africa and the Middle East.
Each country has its own sets of laws and regulations which provide the
parameters for the structure of the entity and how it can operate on a
daily basis.
Organisational forms of business
Businesses established for profit-making purposes generally are
organised into one of two forms: incorporated and un-incorporated.
The incorporated firm are the companies or corporations, while the un-
incorporated are either proprietorships or partnerships.
The corporation or company is a legal entity of unlimited life, independent
of its owners. The owners of a company, its shareholders, have limited
liability for the debts and obligation of the company. The liability being
limited to the par or nominal value of the shares or equity held. With
ownership usually comes some form of control through voting rights, but
this does not extend to managerial control of day to day operations. For
that, management, by way of directors, have to be appointed to act as the
shareholders agents. Therefore, in theory, ownership and management are
likely to be separate, unless of course managers are also major shareholders.
The unincorporated form of business make up the majority of the numbers
of businesses, though not the majority in terms of value or employment.
These businesses are generally sole proprietorships or partnerships. The
liability of the owners of these entities is unlimited. They are managedby the owners and do not have a separate legal entity even though they
may have a separate trading name. Ownership and management risks
are intertwined which makes raising very large sums of capital almost
impossible. If the owner/partners want the entity to continue to grow then
usually a change in form for the entity will be necessary. In this subject
guide we will be viewing financial management from the perspective of
a corporate entity, but much of what is covered is also relevant to the
unincorporated business.
Corporate objectives
Generally we assume that a companys objective is to increase the value of
the shareholders investment in the firm. We also assume that all managers
act to further that objective. Shareholder wealth maximisation is the
normative objective of a company that underlies financial management
theory.
In practice, a company has many stakeholders, employees, customers,
government, creditors, lenders as well as shareholders. As groups they
have their objectives for the company and as individuals they have their
own objectives for their stake in the company. Some of these individual
objectives may be at slight variance with the others, for example,
customers want the company to provide the product with the highest
quality and lowest price, but this may not result in high profits and share
price maximisation. Corporate objectives are determined by a relatively
small group of senior management, probably the directors. These can
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be influenced by a number of things with an outcome which may not be
shareholder wealth maximisation, and which can be allowed to vary with
circumstances and over time. It is often argued in the UK financial press
that though companies may be trying to increase shareholder wealth it is
not with a long-term perspective but is only short-term oriented.
Activity 1.1
Consider the stakeholders of a business as described earlier.
Try to list what you believe are the major objectives of each group. There may be two,
three or more for each group.
Then try to rank each groups objectives in order of importance.
Now draft your reasons for your rankings.
Next assume you are the Board of Directors and you are required to publish the
companys objective(s).
Which one(s) would you list and why? Do they all directly or indirectly lead to
shareholder wealth maximisation?
Your lists could be based upon the company(s) you know or work for. Do not be surprisedby the differences and variations, and do not forget the power of the financial market
place in steering you towards your final selection.
See VLE for solution
Role of managers
A company is a complex organisation made up of many employees each
with their own objectives. In theory, the manager is expected to act in
furtherance of the goals of the owners. The financial manager is expected
to act as the intermediary who will undertake the tasks of financial
management. That is, the manager, using the evaluation, planning andcontrol techniques and systems, will attempt to maximise the return
from the optimal selection of investments so as to satisfy the providers of
finance from whom (s)he has obtained the cheapest and best combination
of funds via the capital markets. However, managers may not be owners.
Conflicts of interest and their resolution
One of the major disadvantages of the corporate form is the separation
of management and ownership. This separation can create costs which
have been called the costs of agencysince management is deemed to
be the agent of the owners (the principals).Agency theoryattempts to
explain this situation and how conflicts between principal and agent canarise, as well as possible ways in which the costs of any such conflict can
be minimised. It is argued that agents will tend to pursue their own goals
and the greater the deviation of those goals from the corporate goals, the
greater the agency costs. Therefore incentives should be provided to try
to ensure convergence of goals between principal and agent (e.g. share
option schemes). Systems should be used to monitor and ensure control of
agents, for example use of annual reports, the setting up of an appropriate
governance structure which restricts, minimises and hopefully enables
the removal of management, and in particular directors, who abuse their
powers and who are therefore not attempting to ensure the company
achieves its goals.
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Chapter 1: Introduction to financial management
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Corporate governance
The essence of the corporate governance debate is the effects of the
particular relationship between directors and shareholders. The greater
the separation between the two, the greater the potential for abuse and
also the greater the possibility of suboptimal behaviour by managers
as viewed by shareholders. At present in the UK there is a voluntary
system of governance in place. The framework has evolved through,
or been impacted upon, by six key reports starting with the Cadbury
report in 1992. The various recommendations of these reports have been
incorporated into the combined code which is included in the Listing
Rules of the London Stock Exchange as an appendix. The rules require
a company to make a disclosure statement in its annual report about its
compliance with the combined code. Though not legally enforceable,
the regulations require compliance and provide for penalties. Different
corporate structures, business, legal and social environments require
different governance requirements and systems. All this is important
because it highlights the differences between the normative theory and the
practical application.
Financial management and risk
Since financial management is concerned with making decisions, and
decision making is concerned with the future and the future is uncertain,
risk must be a major factor in all aspects of financial management. Risk
may be defined as the extent to which what we estimate will happen in
the future may or may not happen. If there is only one single possible
outcome, there is no risk. If there are many possible outcomes and many
of them are very different from our estimate of the outcome, then there is
a lot of risk.
Broadly speaking, both theory and practice show us that risk and return
are correlated. We seek higher expected returns for investing in riskier
projects. Where we perceive little risk (e.g. an investment in government
securities), we are prepared to accept relatively small returns.
Activity 1.2
Choose a few practical situations where a business faces the effect of risk,
(e.g. projecting next years sales budget or evaluating a new investment proposal).
Try to identify the causes of that riskiness.
Then think of ways to try to measure it and ways to control it.
See VLE for solution
Financial management and accounting
Financial management is not the same as, or even a branch of,
accounting.
Accounting has been defined as:
the process of identifying, measuring and communicating
economic information to permit informed judgements and
decisions by users of the information. (American Accounting
Association).
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Given this definition, it is clear that financial managers will be major users
of accounting information.
Those who work as financial managers may very well have a background
in accounting. In many small businesses one person combines the roles
of accountant and financial manager. Despite these facts, the role of the
accountant and that of financial manager are distinctly different. The
accountant is concerned with the provision of information: financial
managers use information supplied by the businesss accounting system
and other sources to help them to make financing and investment
decisions.
Financial management and taxation
Virtually all decisions taken by financial managers have tax effects. In the
UK, for example, the tax treatment of loan interest is different from that
of dividends paid to shareholders. Therefore the decision between raising
funds from shareholders and from lenders has tax implications. Returns
from investments made by the business (i.e. profits) are taxed. It is not
one of the objectives of this course to turn you into an expert on the UKtax system. It is important, however, that you have a broad appreciation of
the major aspects of the UK tax system, which has much in common with
the tax systems which prevail in other of the worlds countries.
Activity 1.3
Think of similarities and differences between the UK tax systems and another country you
are familiar with. Are there any major differences in the corporate taxation system?
A reminder of your learning outcomes
By the end of this chapter, and having completed the Essential reading andactivities, you should be able to:
describe the general financial environment in which corporations
operate
explain the importance and roles of financial markets
list/outline the roles financial managers can have within an
organisation
outline such things as taxation, accounting information and form of
business and their implications for financial management
give examples of the various objectives a company may have and why
the main objective is deemed to be shareholder wealth maximisation explain and give examples of how the influence of risk will permeate all
aspects of financial management, the theories presented, the appraisal
and selection, the changes suggested, and the control methods used.
Practise questions
1. Consider what objectives might be important to a company other
than shareholder wealth maximisation. Describe these objectives and
show how there may or may not be consistency between the different
objectives. Discuss the implications of your findings.
2. How might a managers objectives differ from those of the company?What are the implications for corporate policies in order to ensure
congruence between the sets of objectives?
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Chapter 1: Introduction to financial management
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Problems
In BMM, attempt the following problems:
Chapter 1, p.23, numbers 2, 5, 7, 8 and 9
Chapter 2, pp.44 and 45, numbers 4, 10 and 17
Chapter 3, p.65, numbers 2, 3 and 4.
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Notes
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Chapter 2: Basic investment appraisal methods
17
Chapter 2: Basic investment appraisal
methods
Aims of the chapterLike the topics in the first chapter of this guide, the topics in this chapter
are integral to the subject as a whole since these basic techniques of time
value of money and discounting are used in numerous other aspects of
financial management. So carefully learn these concepts, and the process
as well as the principles and the pros and cons concerning them.
This chapter defines and explains the time value of money concept
and applies it to problems of investment appraisal in a certain world.
The relaxation of the assumption of certainty occurs in the following
two chapters. Here we concentrate on the basics since the technique
can be and is used in long-term and short-term investment appraisal,
in evaluation of financing methods, valuing monetary assets, risk
management etc.
We start by describing the time value of money and then explain the
concept and approach to the computational methodology used in a
practical example of investment appraisal and selection. The net present
value (NPV) is described very fully both in principle and application and
in how the decision rules are derived. Different sets of circumstances are
introduced to show how the NPV approach can cope with the situations
met in an imperfect world, (e.g. taxation, inflation, different interest rates,
repeat investments, mutually exclusive investments, capital rationing).
Alternative methods of appraisal are also described, such as internal
rate of return and pay-back. The major problem of an imperfect world
and uncertain outcomes is dealt with later in Chapters three and four.
Learning outcomes
By the end of this chapter and having completed the Essential reading and
activities, you should he able to:
describe and apply the time value of money in project evaluation,
whether it be future or present value oriented
defend the use of NPV as the method of appraisal against other
suggested methods
prepare evaluations of investment proposals and state which decision
rule is appropriate in the specific set of circumstances.
Essential reading
Brealey, R.A., S.C. Myers and A.J. MarcusFundamentals of Corporate Finance .
(McGraw-Hill Inc, 2007) Chapters 4, 7, 8 and 9
Further reading
Brealey, R.A., S.C. Myers and F. AllenPrinciples of Corporate Finance. (McGraw-
Hill, 2008) Chapters 2, 3, 6 and 7.Atrill, P.Financial Management for Decision makers. (FT Prentice Hall Europe,
2005) Chapters 4 and 5.
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Time value of money
Money (i.e. cash) has a different value over time; holders of money can
either spend the money on consumption now or delay the consumption
by investing the money until it is required for consumption. The reward
for the delay in spending is the interest received by investing. The amount
of interest is dependent upon the amount of time and the rate of interest.
The further into the future a consumer has to wait, the greater the interest
compensation required. So if one knows of a certain future receipt of
cash then there must be a certain value today, which we call the present
value, which will be its equivalent. By receiving today an amount of cash
equal to the present value, the recipient would be indifferent between the
future receipt and todays receipt. The difference between the two receipts
is the time value, the compensation for the passage of time. The present
value of a future amount is also known as the discounted value.
Future value and compounding
Whenever someone makes an investment, he or she expects to earn areturn which can take the form of interest when the investment is in some
form of monetary asset. If the interest earned is reinvested rather than
withdrawn then the total amount invested grows at a compound rate.
At the end of the life of the investment (at maturity) it will have a value F
the future or maturity value. IfP is the amount invested today at r%
with compound interest for tyears then the future value will beF.
F=P(1 + r)t
Present value and discounting
The converse of compounding is discounting. This uses as its basis thesane algebraic relationship but in the opposite way. The aim of discounting
is to determine the present value of a future amount (i.e. todays amount)
which, if invested at the rate of interest r, would achieve the future
value predicted. With prospective new investments we can predict the
incremental cash flows which will occur because of the investment, but
as these predictions are all in money terms of differing values they must
all be converted into a value at a common date (i.e. today, the day of the
investment). Therefore we need to convert all cash flows into present
values, todays values. So if we predict receiving Fin tyears time during
which r is rate of interest then P is the present value of F, derived thus:
tt
r
F
r
FP
)1(
1
)1( +=
+
=
Notet
r)1(
1
+
is the discount factor.
Using a computer, a table of discount factors for all combinations ofr
and t has already been prepared. This can be found at the back of all
reputable texts. You should familiarise yourself with the compounding and
discounting formulae and procedures and where they are used. Apply this
knowledge to annuity payments or receipts. Remember an annuity is a
constant annual amount and so the annuity factor for any year is the sum
of the annual discount factors up to and including that year.
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Chapter 2: Basic investment appraisal methods
19
Interest rates, discount rates and real rates
An interest rate is the proportionate return on an investment
appropriate for the risk level of the investment. So it could be the return
on a bond, a companys investment or the required return a company
has to pay on its loan etc. The expression discount rate is often used
synonymously with interest rates because the discount factor is derived
using an interest rate. Similarly, because companies use a mixture of
capital types to fund their investments, that mixture has an average cost
which the company has to service. Any investments made from that mix
of capital must generate flows and in the evaluation of those flows we
use the discounting process. We can use the expressions cost of capital,
opportunity cost of funds, as alternatives to discount rate since the
discounting factor is derived using the cost of capital.
You must learn the difference between real and nominal interest rates.
(The terms, money and actual interest rates, are also used to mean
nominal rate). The nominal rate is the rate to be found in the market
place. The real rate is the rate of interest that would persist if there were
no inflation or deflation.
(1 + real rate)(1+ infation rate) = (1 + nominal rate)
(1+ r)(1+ i) = (1+ n)
N.B. Note the short cut sometimes used to derive the nominal rate (r+ i)
= n. Do remember this is only an approximation and will usually lead to
over-valuing the present value of the future flows.
Remember that different items of operating expenditure and revenues
may have their own specific inflation rates and, when undertaking an
investment appraisal, all cash flows prior to discounting should be quoted
in actual or money flows for the specific period. All individual and specific
inflation rates will have been separately accounted for (e.g. the degree ofinflation may have been different from year to year or between say wages
and materials). The discount factor used should only incorporate the
inflation rate relevant to the capital providers who have to be serviced and
repaid from the investment.
Activity 2.1
What is the time value of money? How is it different from the real and actual rates of
interest of a risky investment?
See VLE for solution
Basic investment appraisal techniques
Using BMM learn how to compute the net present value (NPV) for
an investment, as well as an investments internal rate of return
(IRR). Likewise learn how to compute the payback period (PP) and
the accounting rate of return (ARR). The decision rules for each
appraisal method should be learnt for the range of different types of
decisions a manager might face, simple go/no go, selection between
mutually exclusive projects and so on. See BMM sections 7.1 and 7.2.
Activity 2.2
Solve self-tests in BMM, numbers 4.1, 4.3, 4.4, 4.5, 4.8 and 4.14.
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You must remember:
that long term projects under consideration should be consistent with
the long term corporate plan
that the estimated cash inflows from the project when discounted
to a common date, the present, exceed the estimated outflows, also
discounted to the present
that the theory in this section assumes certainty of knowledge andforecasting this is relaxed in the next chapter
that, in practice, businesses do not wholeheartedly follow the
theoretically correct route of using the net present value approach
(NPV) all the time.
You should learn the process of identifying, analysing and estimating the
investment flows, remembering the projections should be in cash not profit
flows, unless ARR is being used. Profit flows will need adjustment to cash
if only profit estimates are given. You should learn the theory behind the
four main analytical techniques with emphasis on why NPV is superior to
IRR, PP and ARR. The amount and timing of the net cash flows of a project
are crucial to the viability of an investment.
Given below is an example of two mutually exclusive investments, A and
B, with an explanation of why only NPV will give the correct signal to
management. Assuming an annual cost of capital of 15% and estimated
net actual annual cash flows as stated, then the four methods will give
conflicting results. Each method has its own set of decision rules.
Project Time periods (years)
0 1 2 3 4 Total
A (25,000) 5,000 12,500 12,500 12,500 17,500
B (10,000) 5,000 10,000 (1,000) - 4,000
NPV() IRR (%) Payback (Years) ARR(%)
A 4,166* 22 2.6 35*
B 1,251 24* 1.5* 26.7
Separately using each evaluation method the pairs of values for projects
A and B are shown above. Using the NPV approach A will have an NPV
of 4,166 and B an NPV of 1,251. The decision rule is to select the
investment with the higher NPV regardless of the size of the original
investment. Therefore A will be preferred to B, which is why it is marked
with an asterisk (*). Under each of the evaluation methods and using the
appropriate decision rule the preferred choice can be made. It is marked
with an asterisk (*) in each case.
Using the payback approach would suggest B is preferred as it has the
shorter payback period. If one only used ARR, then A is preferred since it
has the higher rate. Since neither method is the correct one, it is by chance
one gives us the appropriate selection. The main reason for disregarding
the outcomes under these two methods is that neither payback nor
ARR take into account the pattern of flows (i.e. the time value of the
cashflows). Also payback does not take into account the post payback
flows which, in the case of A, are considerable, while for B they are less so
and it even has a net outflow in one period. From the textbooks note the
rationales presented for the still considerable use of payback by managersin practice. See BMM p.202 and PA pp.14043.
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59 Financial management
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An alternative way of acquiring the services of an asset is to lease it rather
than buy it. The same principles of evaluation should be applied to the
incremental cash flows arising as a result of taking out a lease in order to
see whether it is a better way of funding the asset as opposed to buying it.
Worked example 1
A business is considering an investment in equipment which requires an initial outlay of
10 million. The investment will be allowed a 20% writing down allowance (depreciation)
on a straight line basis for tax purposes. It is estimated the equipment will be sold at the
end of the project, the end of the fourth year for 3 million. Any tax received on a loss, or
paid on a gain, arising from the sale of the equipment would occur in the fifth year.
The incremental revenues and costs and the annual price rises incorporated in the
estimates arising from the investment are as follows:
million
Years 1 2 3 4
Sales 30 40 50 4
Wages (4% p.a. increases) 10 11 15 16
Materials (20% p.a. increases) 7 13 17 19
Other costs (5% p.a. increases) 10 11 12 13
Book depreciation 2 29 2 37 2 46 1 49
Net trading surplus 1 3 4 5
Increases in working capital 1 0.5 0.5 (2.0)
The business estimates that the average annual inflation rate will be 4.5% p.a. during
the five years and the businesss real after tax opportunity cost of capital is 10% p.a. The
corporate tax rate for each of the five years is 30% payable a year in arrears.Required:
Compute the NPV, IRR, Payback and ARR for the project.
Solution to Worked example 1
First compute the depreciation for tax purposes. Obviously one uses the tax regime
requirements appropriate to the country in which one is investing.
Writing down allowance computation (straight line)
Tax allowance
Outlay 10
Year 1 (20%) 2 2
8
Year 2 (20%) 2 2
6
Year 3 (20%) 2 2
4
Year 4 Sale 3
Year 4 1 Loss on sale 1
(The same approach can be used for reducing balance based allowances.)
Then compute the tax payments or receipts based upon the taxable profits. This may
require a transfer of tax depreciation for book depreciation (in this case they are similar).
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Chapter 2: Basic investment appraisal methods
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Tax computation (million)
Years
1 2 3 4
Net trading surplus 1 3 4 5
Add book depreciation 2 2 2 1
Trading surplus (adjusted) 3 5 6 6
Less tax depreciation 2 2 2 1
Taxable profit 1 3 4 5
Tax (30%) 0.3 0.9 1.2 1.5
Tax is paid in year following the year in which the profits were earned, i. e. tax on year 1s
profits of 0.3 paid at end of year 2.
Cost of capital (discount rate) (i)
The actual or money rate is the rate to use. Then:
(1+i) = (1 + 0.1)(1 + 0.045)
= (1 + 0.1495)Thus i = 0.15 (i.e. 15%)
(Some authors and businesses use the quick way and get an approximate value by
summing the real and inflation rates. Here: 10% + 4.5% = 14.5% = 15%. You should
use the theoretically correct method given above unless an approximation is called for.)
To calculate the NPV
million
Year 0 1 2 3 4 5 Total
Outlay (10.0) (10.0)
Trading surplus
(adjusted) 3.0 5.0 6.0 6.0 20.0
Working capital
change (1.0) (0.5) (0.5) 2.0
S