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					UOW/MBA/FM                                      ARTICLES      Page   1


                                 UNIVERSITY OF WALES

                                                     &

           MANAGEMENT DEVELOPMENT INSTITUTE OF SINGAPORE



SUBJECT                       FINANCIAL MANAGEMENT

LECTURER                      Manek

COURSE                        MASTER OF BUSINESS ADMINISTRATION




                                          ARTICLES

For restricted use during the class room discussion only.
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Lecturer: Manek                                   Page   1    Page   1
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        Financial Management — Basic Concepts
Business Finance is the first stage at which you are tested on issues relating to corporate finance
and financial management.

Remember that the finance section of Business Finance serves as a foundation stone for
Corporate Finance &International Finance paper in year 3, and the two examination papers are
quite closely related. Many of the topics which form part of the syllabus for Business Finance, for
example, investment appraisal techniques, are re-examined in CIF paper at a more advanced
level. By working hard and preparing well for Business Finance, you should find that you are
                                                                                           rd
building a solid foundation of knowledge which you will use again later in the 3 year
examinations.

It is helpful to gain an understanding of the meaning of financial management to start by breaking
the relevant sections of the Business Finance syllabus down into key topic areas. The topics can
actually be drafted as a series of questions:

    •   What are the aims/objectives of the organisation?

    •   What external economic factors might affect our success and/or our definition of
        objectives?

    •   How is the business to be funded?

    •   What techniques can we use to ensure that funds are invested wisely?

    •   How does working capital management affect the financial success of the organisation?

Financial management can thus be viewed as the process of developing a long term perspective
on the funding and management of funds for all organisations. The longer term strategic
emphasis contrasts, perhaps, with the traditionally perceived role of the management accountant.
The traditional view of the management accountant has been as the person responsible for
ensuring that systems are put in place and information provided to management, which serves to
ensure the attainment of longer term financial objectives.

The dividing line between financial management and management accounting, at least in the
context of Business Finance, is best understood by way of an example. The syllabus contains a
section on financial objectives, which requires candidates to understand the nature and type of
financial objectives which might be pursued by both profit and non-profit seeking organisations. In
defining objectives, for example, the maximisation of growth of earnings per share, an
organisation is making a strategic choice. Strategies and tactics will be selected which best serve
the achievement of the specified objective. Identification of the appropriate financial strategies is
the responsibility of the financial manager/finance director. This does not mean that the
management accountant can ignore the issue of corporate objectives, because the objectives will
affect the type of information which the management accountant will be excepted to provide.
Hence the management accountant and the financial manager work together, linking short term
and medium term information, to ensure achievement of the desired objectives.

If a question on financial objectives were to appear in Sections A or B of the paper, the emphasis
in the question would be entirely different. It is useful to remember this point; the boundary
between financial management and management accounting is not clear cut, but the aspects of a
topic which are emphasised differ greatly.


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At this stage it is useful to look in more detail at the financial management aspects of Business
Finance, by looking in turn at each of the financial management questions which define the key
topic areas.



What are the aims/objectives of the organisation? As already indicated above, the financial
management perspective on this topic is a long term strategic one. Specification of alternative
objectives is reasonably straightforward, although the need to acknowledge the requirements of
different interest groups needs to be recognised. In the context of Business Finance, you can
expect that questions on this area of the syllabus will simply ask you to define and explain
alternative organisational objectives and comment, with examples, on the factors which might
affect their successful achievement. For example, a publicly quoted company may declare that its
primary objective is the maximisation of shareholder wealth, but it must also recognise that it
cannot totally ignore the needs/desires of its staff. Providing good staff facilities and services will
potentially increase costs, thereby reducing earnings. The objective of profit or wealth
maximisation is thus modified to meet the needs of different interest groups, and questions may
require comment on this problem.



What external economic factors might affect our success and/or our definition of
objectives? Your understanding of the basic theories of economics was tested earlier. In
Business Finance it is intended that you apply the theories to specific business situations. For
example, if government economic policy is such that interest rates are kept at a high level, and a
currency is thus highly valued, what effect might this have on a business? Alternatively, if a
government responds to economic problems by printing lots more money, what will happen to the
economy and to business? The key issue for Business Finance candidates is the link between
economics and business — economics is not just a set of theories, but a collection of policies
which can significantly affect a business’ success. The theoretical arguments about the pros and
cons of various economic viewpoints will not be examined: the focus is on the impact of policies
on the business environment. One important point to note here is that as the European Union and
the Euro approaches, the role of EU economic policy cannot be ignored.



How is the business to be funded? The mix of sources of funding available to business of
different sizes, and the advantages and disadvantages of the various alternatives is seen as a
core part of the syllabus for Business Finance. As with economic issues, however, it is expected
that candidates will be able to take the theories and relate them to specific business situations. It
is unlikely that questions will simply require candidates to, for example, list five sources of long
term finance for a publicly quoted company. Instead questions will be set in a context, similar to
that of question 1 on the June 1998 paper. In answering this question many candidates proved
that they could write out long lists of finance sources, which appeared to have been learned by
rote from a manual/textbook. The well prepared candidates thought about the list that they had
learned, and only wrote about the sources of finance appropriate to the business in the question.
Almost as many marks are earned for relevance in an exam answer as are given for general
content. Remembering this can save you time in the examination hall. Look at the size and type
of business described in the question, and suggest only those sources of funds which are
relevant.




Lecturer: Manek                                Page   3                              Page   3
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What techniques can we use to ensure that money is invested wisely? There is perhaps an
assumption, based on past examination papers, that an intrinsic part of the finance element of
Business Finance is a question on discounted cash flow analysis. Certainly DCF is central to
investment decision making, but it is not the only appraisal technique available. Indeed research
suggests that, in practice, many firms use payback or ROCE in preference to the more complex
net present value approach when making investment decisions. In examination questions
candidates will be expected to be able to undertake calculations using any/all of payback, ROCE,
NPV and IRR, and critically comment on the various approaches. No particular approach will be
given precedence in the setting of exam questions, and lease versus buy decisions will also be
examinable. Note also that the effects of risk, tax and inflation may be incorporated into
questions, as these issues are regularly tested in paper 14 at a more advanced level.

The need to apply criteria for the selection of investments clearly arises because companies do
not have an unlimited supply of funds. When capital is rationed it becomes important to ensure
that the money available is used in the most effective manner. This means that candidates must
also understand how to compare projects when capital is rationed: what alternative ranking
systems are available and which is the preferred option? Capital rationing is just one part of the
larger question of how investments should be appraised, and so in an examination it would
account for just a few marks in the context of a broader question on investment decisions.



How does working capital management affect the financial success of the company?
Investing money wisely assumes that there is money available to invest, but this will not be the
case if working capital is ineffectively managed. An understanding of the importance of tight
working capital management to the long term survival of a business is a core theme in financial
management. The syllabus for Business Finance details a number of aspects of working capital
management, covering cash, debtors, stock and creditors. Debtors, stock and credit control are
regarded as financial management topics to be examined in Sections A or B of the paper. Cash
management may appear in any of Sections A, B or C.

Note that cash flow patterns can be viewed from either a long term or a short term perspective. In
the financial management part of the examination paper, the emphasis in questions on cash flow
will be in respect of the longer term management of flows, which ensure the continued ability to
trade; for example avoidance of the problem of over-trading. In the management accounting
section of the paper, the emphasis is shorter term, requiring, say, the preparation of a cash
budget which details the forecast monthly cash flows over a six month time scale.

Examination questions will test candidates’ understanding of these topics, and simply saying, for
example, that cash flow can be improved by reducing debtors or taking on more trade credit will
not be adequate to achieve high marks. The implications of the alternative choices must also be
considered. Increasing trade credit can lead to a loss of goodwill from suppliers, or the forfeiting
of early payment discounts, and these disadvantages must be compared to the gains derived
from improved cash flow. It is also very useful to remember that many small companies often
seek outside finance which is unnecessary, by requesting funds which could be raised by
improvements to the internal management of working capital. Looking at internal sources of
finance (which may be relatively low cost) should always pre-empt applications to external
financial institutions.

This idea links working capital management back to the topic of sources of funds, and
demonstrates how good financial management forms a type of control loop. Managers set their
objectives (subject to external influences) and then seek to raise the required level of funding. If


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the funding mix is correct and good investment decisions are made, then the business should
flourish. If sales are inadequate, or growth is very rapid, then cash flow can become a problem,
and objectives need to be re-defined and the whole process re-commences. Working capital
management completes the circle of financial management.


Non-financial objectives

Few people would argue with the idea that commercial businesses aim to make profits, and that
decisions in these businesses are focused around how best to achieve this objective. The desire
to be profitable need not, however, be all embracing, and in practice it can be seen that
companies are likely to pursue a wide range of objectives, which are both financial and non-
financial in nature. This article seeks to explain how such diversity of objectives might arise,
discuss examples of non-financial objectives, and consider the implications for company owners
and society in general.
It is useful to remember that although a company is a separate entity in the legal sense, in reality
it is made up of a collection of individuals and interest groups, all of whom have personal
objectives to fulfil. Management will constantly be trying to balance the return to these groups
e.g., shareholders or employees, and discussion on corporate objectives really comes down to a
compromise which takes account of what the different groups are seeking. Consequently some
objectives may be financial in nature, such as a rise in earnings per share, whilst others will be
non-financial e.g., shorter working hours, or an increase in the level of waste recycling in a
manufacturing process.

A useful starting point for analysing non-financial objectives, is to specify the variety of interest
groups which may seek to influence company objectives, because they are affected by a
company's operations. The list includes:

    •   Equity investors
        In other words the owners of the business, who will be looking for a financial return on
        their investment.

    •   Creditors
        This group will want to ensure that the business maintains the liquidity level required to
        repay its debts on time.

    •   Customers
        Who will be concerned about product/service quality and price.

    •   Employees
        Improved working hours and conditions of work will be important to this group, and so
        they may have a mix of financial and non-financial concerns.

    •   Managers
        Whose personal objectives may to some extent conflict with those of the owners. For
        example, a manager may seek to increase staff levels, as a way of increasing his
        personal status, but this may be lead to reduced profits.

    •   The community at large
        Communities are affected by company activities in a number of ways such as the use of



Lecturer: Manek                               Page   5                              Page   5
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        land in a local area, the potential for pollution from effluents, commercial sponsorship of
        community projects and the impact of business activity on local transport systems.

        Faced with such a broad range of interest groups, managers are likely to find that they
        cannot simultaneously maximise profits and the wealth of their shareholders whilst also
        keeping all the other parties happy. In this situation, the only practical approach is to try
        and work to satisfy the various objectives rather than maximise any individual one.
        Adopting such a strategy means, for example, that the company might earn a satisfactory
        return for its shareholders, whilst at the same time paying reasonable wages to satisfy
        employees, and avoiding polluting the environment, hence being a "good citizen." As a
        result, profit is no longer the sole corporate objective, and the pursuit of non-financial
        objectives has begun to be increasingly important, as part of a portfolio of corporate
        objectives which spread right out into the community of which they are a part.



Non-financial objectives
The range of possible non-financial objectives which might be pursued is broad, and the list
below is not comprehensive, but may be viewed as indicative of the aims of a typical business at
the start of the twenty first century.
Non-financial objectives might include:

    •   Growth of sales;

    •   Diversification;

    •   Survival;

    •   Contented workforce;

    •   Leaders in technology development;

    •   Product/service quality;

    •   Environmental protection.

Clearly some of the objectives listed are specific to the interests of one particular group of people,
and the extent to which they are pursued is dependent upon the bargaining power of that group.
For example, employees may want to reduce working hours or raise the hourly rate of pay, but if
management do not face a problem in recruiting staff to work under existing contract terms, it
may be very difficult to persuade management to pursue objectives which serve the interests of
staff. In one sense, the "controlling influence" is always the equity investors. Pursuit of alternative
goals, relating to employees, the environment or whatever, will incur costs and reduce profits.
Equity investors will be conscious of this trade off, and if they think that they are losing too much
as a consequence, investors will sell shares and the market value of the firm will fall. Managers
need to remember that the interests of shareholders are paramount, but those interests will be
tempered by the influences and objectives of other parties.

The recent furore over the Millennium Dome in London is evidence of this. A large proportion of
the finance for the Dome came from commercial sponsorship, from companies such as Roche,
Boots, BSkyB and Mars, and low attendance figures at the Dome have led these sponsors to
threaten non-payment of their last tranche of funding, unless something is done to improve visitor

Lecturer: Manek                                Page   6                              Page   6
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numbers. The reason behind the commercial sponsorship is ultimately that it buys publicity for the
companies concerned - it is a form of advertising. If the adverts do not draw in the customers,
raising corporate profits, then the money has not been well spent. The mix of objectives for the
sponsoring companies is quite subtle; on the one hand they like the public relations benefits that
come from being associated with a large public project such as the dome, but at the same time
they want a commercial return on their investment. In some texts, sponsorship of community
projects in this way is termed "corporate social responsibility", whereby the company recognises
that its stakeholders extend well beyond the shareholders and out into the wider community.
Regardless of the terminology, the fact is that companies now need to acknowledge some
commitment to meeting the objectives of parties other than just the equity investors.

In a large number of instances, the willingness of management to pursue wider objectives is a
matter of goodwill on their part, combined with strong bargaining power on the part of the outside
parties. In other cases, non- financial objectives are "forced" upon companies via legislation. For
example, the furniture company Ikea is very environmentally conscious. This reflects Ikea's
Scandinavian origins, but at the same time it also reflects the fact that EU legislation, and the
Kyoto Protocol are forcing companies to become more environmentally conscious. For example,
Ikea banned the use of HFCs and CFCs in its products some years ago. The ban might indicate a
strong environmental conscience on the part of the company, or it may simply indicate an
anticipation of legislation that would ban such products anyway. Nonetheless, regardless of the
reason behind the ban, its very existence indicates that Ikea is typical of the many companies
which pursue non-financial as well as financial objectives.

Shareholder impact of non-financial objectives

The impact of the pursuit of non-financial objectives upon shareholder wealth is not clear cut.
There are many writers who would argue that companies which pursue a wide range of objectives
find that they create for themselves a very positive public image, and this serves to increase
shareholder wealth. Others would argue that community type projects simply add to costs and
thus erode profit, thereby reducing shareholder wealth. In reality, the truth probably lies
somewhere between these two extremes. Carefully selected projects, particularly those which are
community related, may well serve as a form of indirect advertising, and raise the corporate
profile and associated shareholder wealth. Other projects may simply represent a gesture of
goodwill, on which no return is either sought or earned.

For example, suppose that a company decides to pursue an image of high product quality as a
secondary objective. The aim is clearly non-financial in nature, but it will involve spending money
on quality control and management projects which could add to costs and reduce profits. There is
substantial research evidence from people like Juran, which suggests that "quality is free". In
other words, the gains from higher sales levels and reduced costs of warranty claims exceed the
costs of the investment in quality improvements. Where this is the case, then the shareholders
actually gain from the fact that the company has chosen to pursue a non-financial objective.

In other cases, the shareholder impact will be much more difficult to identify. Some companies
have a very good reputation in terms of the facilities which they provide for employees. Such
provision clearly costs money, and absorbs funds which could be used elsewhere within a
business, and so it might be easy to take the view that pursuit of the objective of employee
welfare is detrimental to shareholders. In fact, it may work that such policies serve to reduce staff
turnover rates and increase productivity. It is quite possible for the aggregate benefits from such a
policy to exceed the costs, so that shareholders see profits rise over the longer term. As with
many things, whether a strategy has a positive or negative effect depends upon the time frame
within which it is being judged.


Lecturer: Manek                               Page   7                              Page   7
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Not for profit organisations

This category of organisation includes public sector bodies such as the National Health Service or
local councils, charitable bodies e.g., Oxfam, and other organisations whose purpose is to serve
the broader community interests, rather than the pursuit of profit. In broad terms, such
organisations seek to serve the interests of society as a whole, and so they give non-financial
objectives priority of place.

It is reasonable to argue that they best serve society's interests when the gap between the
benefits they provide, and the cost of that provision is greatest. This is commonly termed value
for money, and it is not dissimilar to the concept of profit maximisation, but for the fact that public
welfare is being maximised rather than profit.

In practice it is incredibly difficult to quantify, for example, the benefits from an operation such as
the UK's National Health Service. How does one put a value on a life which has been prolonged
by "x" number of years, or on the easing of pain which is brought about by the replacement of an
arthritic joint? The benefits extend beyond factors which can be measured in purely financial
terms. Nonetheless, financial criteria can be used to appraise the extent to which such
organisations offer value for money, and hence make good use of the funds provided to them.

Value for money may be described as " getting the best possible combination of services from the
least resources." This means maximising the benefits for the lowest possible cost, and is usually
accepted as requiring the application of economy, effectiveness and efficiency. Economy
measures the inputs that are required to achieve a certain level of outputs. Effectiveness
measures the extent to which a service achieves its declared objectives/goals. Efficiency
combines the other two measures to show the ratio of inputs : outputs. When an operation is
efficient it will produce the maximum number of goods/services relative to the inputs required for
their production. The three "Es" are the fundamental prerequisite of achieving Value For Money,
and their importance cannot be over-emphasised.

The major difficulty for public sector bodies lies in precisely how to measure the achievement of
the non-financial objectives. Value for money as a concept assumes that there is a yardstick
against which to measure success i.e., achievement of objectives. In reality, the indicators of
success are open to debate. For example, in the Health Service is success measured in terms of
fewer patient deaths per hospital admission, shorter waiting lists for operations, average speed of
patient recovery? etc., etc. As long as objectives are difficult to specify, so too will it remain
difficult to specify where there is value for money. Comparative performance measures are
useful, but care must be taken not to read too much into limited information.

Conclusion

We have seen that the pursuit of non- financial objectives is associated with all types of
organisations, including what might typically be described as the commercial organisation. To
seek non-financial objectives is not to ignore the financial , but merely to acknowledge that no
single aim is of overriding importance. At the same time, non- financial objectives do not
necessarily conflict with the financial, and can in fact serve to prosper the interests of
shareholders. A strong public image, and good publicity must be important too, for example the
Nationwide Building Society in sponsoring the Nationwide Football League, but it would be naive
to believe that Nationwide did not also think that the associated publicity would also bring in
business. The difficulty lies in reaching the right balance, which keeps shareholders happy but
also allows other interest groups to believe that a company also has their interest at heart as well.
The good manager must learn to be good at juggling.


Lecturer: Manek                                Page   8                              Page   8
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SHAREHOLDER VALUE
What exactly is it? How do we achieve it? Should we report it in the
financial statements? What are companies doing about it? Some answers
are put forward for your considerations…


 Introduction
The term "value" has gained increasing usage in the business literature in recent years For
example, business managers and management accountants will make reference to the value
chain and value-added activities, auditors are familiar with the concept of value for money and the
preparation of value added statements was recommended but rejected some years ago It seems
that we have come a long way since Oscar Wilde remarked that a cynic is one who knows the
price of everything, and the value of nothing

This short article is about shareholder value This term began to feature prominently in the 1980s
and was, in many respects, popularised by Alfred Rappaport in his book Creating Shareholder
Value (Free Press, 1986) He reiterated the proposition that the appropriate goal for commercial
organisations is to maximise shareholder value via dividends and increases in the market price of
the company’s shares While this principle is widely accepted - corporate mission statements often
proclaim this to be the primary responsibility of management - there is substantially less
agreement about how this is to be accomplished and whether shareholder value metrics should
be reported in the annual financial statements Some interesting material has recently been
published in this regard and is covered in this article structured around the following questions:

· What is shareholder value?

· How do we achieve it?

· Should we report shareholder value in the financial statements?

· What are companies doing about it?

 What is shareholder value?
The fundamental assumption of shareholder value is that a business is worth the net present
value of its future cash flows over a defined timeframe, discounted by the cost of capital
appropriate for the business This assumption is well supported by modern corporate finance
theory What is important is that a company adhering to shareholder value principles concentrates
on cash flow rather than profits Secondly, it always puts the shareholder first in terms of company
goals This seems to conflict with conventional wisdom that customer satisfaction/loyalty is the
most important goal However, a company that fails to deliver value to customers is acting against
the long-term interests of shareholders The corollary would be to offer products and services
without regard to profit: customers would be delighted but shareholder value would be destroyed.

 How do we achieve it?
The corporate goal of creating shareholder value is determined by seven value drivers,
highlighted in Table 1 below These seven macro level factors vary between industries but the
assumption is that improvement in any of these value drivers leads to an increase in shareholder


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value These value drivers can be classified into three categories; operating, investing and
financing that represent the major functions of any business

Operating decisions such as product mix, pricing, advertising and levels of customer service are
impounded primarily in three value drivers – sales growth, operating profit margins and corporate
tax rates The first two drive the amount of cash coming in to the business whereas the corporate
tax rate drives the amount of cash going out Investment decisions are defined in terms of fixed
asset and working capital investment In addition to these, there is the weighted average cost of
capital (WACC) which is the rate of return demanded by investors – in relation to both debt and
equity – based on the risk associated with the business and its capital structure For management,
the insight offered by a ‘value’ focus is that the use of capital is not ‘free’ Rather, it is invested in
the expectation of earning a return and this required return defines the company’s cost of capital
The company creates shareholder value only if it generates returns in excess of its cost of capital
Therefore, the seventh value driver is the planning horizon over which a particular strategy can be
expected to deliver competitive advantage For example, a company may depend on a product
that is expected to hold its place in the market for, say, five years After that, a new product will be
needed So, the planning or competitive advantage period is five years.

The major benefit of using shareholder value comes from linking management decisions to value
through the planing horizon and the key value drivers For example, in some companies, sales
growth will destroy value because of the additional working capital requirements and fixed asset
investment Value can also be destroyed through acquisition In fact, value can be destroyed even
though reported accounting profits and EPS are positive

Thus far we have simply re-iterated a commonly held view that creating shareholder value has
been central to the objective of firms since the foundation of corporate enterprises As a
perspective, it has become enshrined in principles of corporate financial reporting We have also
stressed the importance of cash flow in terms of valuing firms What is new, in terms of emphasis,
is the realisation that management only creates value Management can only create value for
shareholders if the company consistently, over the long term, generates a return on capital, which
is greater than its cost Management creates value by developing a strategy that builds on the
business’s competitive advantage In addition, management is required to implement that
strategy, to recognise and manage the risk inherent in that strategy and to identify future sources
of potential advantage, including market trends

Should we report shareholder value in the financial statements?

Why should companies report on shareholder value creation? One simple answer is that financial
statements are supposed to be useful to investors (and other users) and an important
characteristic of useful information is its long-term, future-orientation Currently, financial
statements, prepared in accordance with accounting standards, are focussed on past events and
historical financial performance and provide little information about future-orientated matters
Relying only on financial statements for decision-making purposes has been likened to driving a
car using the rear view mirror!

Admittedly, companies now produce an Operating and Financial Review (OFR), but surveys
show that companies have been slow to respond to the challenge of providing forward-looking
information Yet, investor surveys confirm both investors’ desire for more forward-looking
information in a company’s annual report and the importance to their investment decisions of
strategic matters and key drivers of future performance Thus, if management is entrusted with the
responsibility of creating value through their strategic initiatives then, surely, they should report on
their progress However, there are crude assumptions and extreme computational difficulties
associated with the shareholder value calculations In such circumstances, it is reasonable to

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argue that investors (actual and potential) look for softer, more qualitative evidence that
management has set its sight on creating shareholder value In other words, management should
report more transparently to investors on the chosen strategy and the key indicators of successful
implementation of that strategy Since this information may be unaudited, management credibility
will become a crucial factor

This is the thrust of the 1999 discussion paper by the ICAEW Their proposals are intended to
provide a framework for explaining a company’s strategy, and the progress that the company is
making towards achieving that strategy The proposals create an important link between external
financial reporting and the internal management practices and could be described as forming part
of an integrated performance measurement system Interestingly, the proposals relate to all
companies whose shareholders are remote from management The recommended disclosures
help to address shareholder value considerations They relate both to the company as a whole
and, to each significant business activity of the company, in respect to:

· Strategy

· Markets and competitive positioning

· Key performance indicators and ‘value’ based measures of performance

I have no doubt in suggesting that the recommended levels of disclosure will come as a surprise
to many managers of Irish companies I would venture to suggest that some managers may be
unable to comply with these recommendations simply because they have not been required to
think in such dimensions! If managers choose to disclose a new measure, it is important to
articulate why that measure is important and why it affects "value" The outlined proposals are
viewed as providing a practical framework for the introduction of a more forward looking
perspective into annual financial reports Many of the recommendations are based on practices
observed in other countries

 What are companies doing about it?
Based on illustrations provided in the discussion paper from corporate reports, it is obvious that
some companies have already (voluntarily) provided the disclosures suggested For example,
some companies provide clear statements about the company’s objectives, business philosophy,
the long-term targets management has set itself and the strategic direction pursued in each of the
business segments In addition, performance against target is reported for a period of years
Moreover, a large variety of performance measures (financial and non-financial) are highlighted
Anyone curious about reporting performance measures and indicators could usefully look at the
interesting disclosures contained in the 1999 report of our own Revenue Commissioners!

 Conclusion
We focused on shareholder value that may be described as a perspective which acknowledges
that management is primarily responsible to shareholders Shareholder value is created only by
management and so, it is reasonable to suggest that management should report both why their
strategies are expected to lead to the creation of value over the long term and their own view of
actual performance Such information will benefit individual shareholders and firms, and facilitate
the Stock Exchange in allocating scare capital resources Really, there is nothing radically new
about these proposals which may, in time, be referred to as strategic financial reporting They are
attempting to address the criticism: "when I get my accounting report I am either happy or sad,
but rarely wiser"!


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Capital investment appraisal
Organisations operate in a dynamic environment. They must therefore continually make changes
in different areas of their operations in order to meet the challenges that the dynamic nature of
the environment brings and also in order to survive and prosper. It is believed that continuous
change could improve the way things are done, thereby putting the organisation at an advantage
over their competitors. Most changes involve capital expenditure, which can invariably involve
large sums of money. The expenditure might involve replacing existing fixed assets with
something more efficient and up to date or to acquire an entire business.

The decision to go ahead with any capital expenditure of a significant amount could necessitate
spending a large sum of money. Managers must give careful thought to every step that they need
to take before a final decision is made on whether or not to invest money on such a project. Most
investments will have one form of return or another. The question to address is whether or not the
future returns will be sufficient to justify the sacrifices the investing entity would have to make.

The intention of this article is to demonstrate how organisations justify capital investments using
different appraisal techniques. It is hoped that the reader will supplement the knowledge gained
from it with that gained elsewhere.

The article will be of interest to students taking paper 8, Managerial Finance, at the certificate
level and also to those taking Paper 9, Information for Control and Decision-Making at the
professional level.

Strategic needs
Before an organisation goes out to appraise an investment opportunity a strategic need for the
project must exist. The strategic need will determine, amongst other things, aspects such as
which of the many investment opportunities before the entity will best help to meet their strategic
objectives, how much to commit to the project and when to undertake the investment. The
organisation may use SWOT and PEST analysis in order to be able to provide answers to these
and similar questions.

Basic information
To appraise an investment project, the appraiser must have information about the following
relevant areas:
1 Cost of investment project.

2 Estimated life of project.

3 Estimated net cash inflows from project.

4 Estimated residual value of project at the end of its life if applicable.

5 Cost of capital.

6 Taxation implications of project.

7 Inflation rates and effect on project.

Anyone who has had to plan for a future activity/event should understand that the future is never
certain. Bearing this in mind, one must try to predict the future by drawing from past experience

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and using available information either from published statistics or from other sources. Some of
the data required about the project would have to be estimated taking into consideration all
available information. The accuracy of these estimated data would have a consequential effect on
the final result of the decision, as such care must be taken in making these estimates.



Methods of investment appraisal
When the decision-maker has at his/her disposal basic information about the project as stated
above, he/she is then ready to use one or more of the four main methods used in appraising
investment projects.


Payback method
The payback method is used to determine how long it will take for future cash inflows from the
project to equal the initial cost of the project. The method as the name implies establishes the
payback period of each project. As the method stands, the shorter the payback period the better.
It is often argued that industries where products get outdated quickly such as fashion and
computers will prefer to use the payback method. The reason being that it is critical that the initial
cost of the project is recovered quickly. In any case, most organisations have a set of standard
payback periods for each investment project. They will in most cases compare the payback
period from each investment project with the pre-determined payback period. Any project that
falls short of the standard payback period will be rejected.
Evidence has shown that apart from this fact, managers will prefer to use the method as an initial
screening process because it is easy to use and understand by them. One important
disadvantage of the method is that it ignores the time value of money. It also ignores profitability
of the project but stresses the importance of liquidity. Whether this is an advantage or not will
depend on the area of interest to the individual concerned.

Accounting Rate of Return (ARR)
This method ARR is also referred to by some other names such as Return on Investment (ROI),
Return on Capital Employed (ROCE). The most important thing to remember about this method is
that it establishes rates of return on projects. There are different ways of determining a rate of
return. For the purposes of this article, we will use Average Accounting Profits divided by Average
Capital Employed multiplied by 100. That is:

APR =                         Average accounting profits           x 100
                              Average capital employed
           Where:
Average accounting profits = Profits over the life of the project
                              Life of the project
and
Average capital employed = Initial cost of project + Scrap value
                                                2
When there are two or more investment projects, rates of return are compared. A project, which
has a higher rate, will be recommended, as this is an indication that it will give a higher return to
the investing entity compared with the one with a lower rate.


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Discounted Cash Flow (DCF) methods
The Net Present Value (NPV) and Internal Rate of Return (IRR) are the two investment appraisal
methods under DCF. Let us now describe and comment upon the two methods.


Net Present Value (NPV) Method

Of all the investment appraisal methods, NPV is often argued to be the most superior. This is
because it takes into account the time value of money. The method assumes that a pound today
is worth more than a pound this time next year. It works under the assumption that if one is owed
a pound and the borrower offers a choice of either giving the pound now or in a year’s time, the
more rational option for the lender is to take the pound now. Provided the lender does not keep
the pound under his mattress at home, it will be worth more than a pound in a year’s time. The
reverse is true if the borrower has the option to pay either now or in a year’s time, the borrower
would choose to pay in the future as the pound he/she pays in the future will be worth less than
what he/she would have paid now. It stresses that future cash flows should be expressed in terms
of what they are worth now when cash is expended on the project. The present values of these
future cash flows can then be compared with what we are spending now on the project. In other
words, the NPV is saying that one should compare like with like, which of course is a fair
statement. By setting the future cash inflows from the project without discounting them against
the initial capital cost, one is not being realistic and fair.

When present values of cash outflows and inflows are compared, if the result gives a positive
NPV, then the project should be recommended. In a mutually exclusive situation, that is, when
you can only undertake one project and not two projects at the same time, if two projects were to
give positive NPVs, then the project with the higher NPV is the one to recommend.



Internal Rate of Return (IRR) method

Often an entity would want to establish its internal rate of a project for various reasons e.g., for
decision-making purposes. By IRR we mean a rate that will be used to discount future cash
inflows to make the total of the present values equal the cost of the project. The attempt being
made under IRR is to find a rate that will equate the NPV of a project to be zero. The IRR
therefore is the maximum rate of discount that will be used to finance a project without making a
loss from it. Again in a mutually exclusive situation, the project that has the highest IRR is the one
to recommend. The reason being that the IRR is showing the highest rate that can be used to
finance a project without incurring a loss from it. Students often suggest to the author that the IRR
should be called the break-even rate. His reply to them is often, if this makes you understand IRR
you should use that term for it.

In order to find the IRR manually, this is done by the trial and error approach. By this we mean
using a discount rate which gives a positive NPV and another rate which gives a negative NPV.
Then apply the formula:
IRR = A + a x (B – A)
          a+b
Where:


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A = The lower discount rate which gives the positive NPV

B = The higher discount rate which gives the negative NPV

a = The value of the positive NPV

b = The value of the negative NPV

Please note that a and b should be added together as the negative sign in b is ignored.

Now let us demonstrate these various methods using a case from a fictitious company we shall
call AICO Plc.

Case

Senior management of AICO Plc have identified that there is a strategic need for a replacement
machine to be acquired in one of their production departments. They have to make a choice
between two models of the machine — model 1 is called Super and model 2 is called Deluxe.
They are unsure as to which of the two models they should buy. They have given you the
following profiles of the two models. They want you to use the four investment appraisal
techniques discussed above. You are required to recommend which of the two models is better
under each appraisal technique and to explain briefly why you have recommended one in place
of the others under each technique. You are told that funds are only available for only one model.
Super             Deluxe
Cost              £500,000 £800,000
Net cash inflow   £        £
Year
1                 250,000   150,000
2                 100,000   200,000
3                 100,000   250,000
4                 50,000    100,000
5                 150,000   100,000
6                 100,000   250,000
Scrap value       20,000    80,000
The cost of capital is 12% and AICO depreciates all its fixed assets on the straight-line basis. By
cost of capital is meant what it costs to raise the required finance for the project.




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Payback method

Super Model
Cost              £500,000
Year              Cash inflows   Accumulated Cash inflows
1                 250,000        250,000
2                 100,000        350,000
3                 100,000        450,000
4                 50,000         500,000
Payback Period    = 4 years
Deluxe Model
Cost              £800,000
Year              Cash inflows   Accumulated Cash inflows
1                 150,000        150,000
2                 200,000        350,000
3                 250,000        600,000
4                 100,000        700,000
5                 100,000        800,000
Payback           = 5 years
By comparing four years for the super model with five years for the deluxe model, one would
recommend AICO Plc to buy the former, as its payback period is shorter than the latter.



The Accounting Rate of Return
The information provided by AICO plc is based on hypothetical cash flows. This information is
insufficient for establishing the ARR of the two models; therefore it will be necessary to calculate
the annual depreciation figures for the two machines. To arrive at the annual accounting profits
will necessitate a deduction from each year’s net cash inflows — the annual depreciation figure.

Super model
Depreciation per annum = Cost less scrap value
                       Life of machine
                       = £500,000 less 20,000
                                6 years
                       = £80,000 per annum
Deluxe model
Depreciation per annum = £800,000 less 80,000
                                6 years
                       = £120,000 per annum
Now that we have calculated the annual depreciation for each machine, let us establish the
annual accounting profit or loss for each machine.



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Super model
                        Cash inflow less      Depreciation    =Accounting Profit/(Loss)
Year
1                       250,000     –         80,000          = 170,000
2                       100,000     –         80,000          = 20,000
3                       100,000     –         80,000          = 20,000
4                       50,000      –         80,000          = (30,000)
5                       150,000     –         80,000          = 70,000
6                       100,000     –         80,000          = 20,000
Total accounting profit                                       270,000
Therefore the average accounting profit       = £270,000 /6
                                              = £45,000
Average Capital Employed                      ={ £500,000 + 20,000} / 2
                                              = £260,000
ARR                                           = 45,000 x 100
                                              260,000
                                              = 17·30%
Deluxe Model
Year                     Cash inflow   less   Depreciation    = Accounting Profit/(Loss)
1                        150,000       –      120,000         = 30,000
2                        200,000       –      120,000         = 80,000
3                        250,000       –      120,000         = 130,000
4                        100,000       –      120,000         = (20,000)
5                        100,000       –      120,000         = (20,000)
6                        250,000       –      120,000         = 130,000
Total accounting profits                                      330,000
Average accounting profit                     = £330,000 /6
                                              = £55,000
Average capital employed                      = {£800,000 + 80,000} / 2
                                              = £440,000
Therefore ARR                                 = £55,000 x 100
                                              £440,000
                                              = 12·50%
Using ARR, clearly the super model with a 17·30% will be recommended instead of the deluxe
model, which has a lower rate of return of 12·50%.

Net Present Value

When using the NPV method the present value table is required in order to find out the present
value factors of the pound at different rates over different time periods. Your examination
question paper has often in the past provided the table for candidates’ use with the examination
questions. There is no indication that this will not continue. However the figures in the table can
be calculated if a table is unavailable.

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Super model
              Cash flows           PV factors Present values
Year
0             (500,000)          x1             (500,000)
1             250,000            x 0·893        223,250
2             100,000            x 0·797        79,700
3             100,000            x 0·712        71,200
4             50,000             x 0·636        31,800
5             150,000            x 0·567        85,050
6             100,000 + 20,000   x 0·507        60,840
              N. P. V.                          51,840
Deluxe model
Year   Cash flows           PV factors   Present values
0      (800,000)          x1             (800,000)
1      150,000            x 0·893        133,950
2      200,000            x 0·797        159,400
3      250,000            x 0·712        178,000
4      100,000            x 0·636        63,600
5      100,000            x 0·567        56,700
6      250,000 + 80,000   x 0·507        167,310
       N. V. P.                          (41,040)
Under the NPV method super has a positive NPV of £51,840 whilst deluxe has a negative NPV of
£41,040. Any project with a negative NPV should not be undertaken at all. On the basis of this
super model will be recommended but not deluxe model.

Internal Rate of Return (IRR)
Under NPV we have used 12% discount rate and arrived at both a positive and negative NPV
respectively for the two machines. We need to use a higher rate for the Super model to arrive at a
negative NPV and a lower rate for Deluxe model to arrive at a positive NPV. Remember that the
higher the IRR the better. Let us now use 20% for Super model and 4% for Deluxe model.
Super Model
Year   Cash flows           PV factors   Present values
0      (500,000)          x1             (500,000)
1      250,000            x 0·833        208,250
2      100,000            x 0·694        69,400
3      100,000            x 0·579        57,900
4      50,000             x 0·482        24,100
5      150,000            x 0·402        60,300
6      100,000 + 20,000   x 0·335        40,200
       N. P. V.                          (39,850)
Now that we have a negative NPV for Super model we can now use the IRR formula we had
earlier to establish IRR for this model.

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IRR = A +         a x (B – A)
                  a–b
      = 12 +      51,840 x (20-12)
                  51,840 + 39,850
      = 12 +      51,840 x 8
                  91,690
    = 12 + 4·52
IRR = 16·52%
Now let us turn our attention to the second machine, but first we need to find a positive NPV for
this machine. We have stated earlier that we will use 4%, let us use that straight away.

Deluxe Model
Year   Cash flows           PV factors   Present values
0      (800,000)        x   1            (800,000)
1      150,000          x   0·962        144,300
2      200,000          x   0·925        185,000
3      250,000          x   0·889        222,250
4      100,000          x   0·855        85,500
5      100,000          x   0·822        82,200
6      250,000+80,000   x   0·790        260,700
       N. P. V.                          179,950




Therefore IRR = 4 +          179,950 x (12–4)

                             179,950+41,040
               =4+           179,950 x 8
                             220,990
               = 4 + 6·51
IRR            = 10·51%
The Deluxe module has an IRR of 10.51%. As this is lower than the super model’s 16.52%, once
again super model will be recommended.

Conclusion
It can be seen that all four methods of investment appraisal have consistently recommended the
Super model. This has happened because the example was designed to do so. A real life
exercise on investment appraisal will probably not be as easy and straightforward as this.




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        Evaluation techniques for capital budgeting                                   – article 2

 Investment involves the sacrifice of current consumption opportunities in order to obtain the
 benefit of future consumption possibilities. The commitment of funds to capital projects gives rise
 to a management decision problem, the solution of which, if incorrectly arrived at, may seriously
 impair company profitability and growth.
The proper use of evaluation techniques and criteria should enable management to make more
effective decisions which result in future success. The purpose of investment appraisal is to
evaluate whether or not the current sacrifice is worthwhile.

Capital investment decisions have certain characteristics which are not always present in other
management decisions, and as a result, special techniques are required to ensure that only the
best information is available to the decision maker.

These characteristics are:

    •    a significant outlay of cash;

    •    long term involvement with greater risks and uncertainty because forecasts of the future
         are less reliable;

    •    irreversibility of some projects due to the specialised nature of, for example, plant which
         having been bought with a specific project in mind may have little or no scrap value;

    •    a significant time lag between commitment of resources and the receipt of benefits;

    •    management’s ability is often stretched with some projects demanding an awareness of
         all relevant diverse factors;

    •    limited resources require priorities on capital expenditure;

    •    project completion time requires adequate continuous control information as costs can be
         exceeded by a significant amount.




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Factors to consider with capital projects

When considering any capital investment project there are six factors to be examined:

    •   the initial cost of the project;

    •   the phasing of the expenditure;

    •   the estimated life of the investment;

    •   the amount and timing of the resulting cash flow;

    •   the effect, if any, on the rest of the undertaking;

    •   the working capital required.

There are different/multiple objectives for a company, for example, survival. These can change in
priority at different stages of a company’s life cycle, but the one overriding objective is
maximisation of owner’s wealth. Stated differently, it is the present value of future cash flows.
Therefore, all investment opportunities should eventually be viewed in financial terms.

Evaluation techniques

There are a number of methods for evaluating capital expenditure projects but no matter what
method is used it is important to realise that the information used for the evaluation has to be
properly screened as it can materially affect the evaluation.

Some of the methods available are:

    •   accounting rate of return (ARR or ROCE or ROI);

    •   payback or discounted payback;

    •   discounted cash flow — net present value (NPV);

    •   internal rate of return (IRR).

Each of these methods will be described in turn and an example given of the calculations
involved. Then the acceptance criterion for each will be stated:

    •   when there is only one project under consideration; and

    •   when there are two mutually exclusive projects under review.




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Calculations are performed for Project A only. Space is left for you to duplicate the calculations
for Project B. Answers for Project B appear at the end of the article for your reference.

 Project                    A                  B

                            £                  £

 Capital expenditure 75,000                    75,000

 Accounting profit/(loss)

 Year 1                     30,000             43,000

 Year 2                     30,000             6,000

 Year 3                     20,000             25,000

 Year 4                     (10,000)           (1,000)

 Year 5                     (10,000)           (13,000)

 TOTAL PROFIT               60,000             60,000

Equipment estimated resale value at the end of 5 years will be:
 Project                        A                   B
                                £                   £
 Resale value                   5,000               5,000
Depreciation is calculated on the straight line method.

Solution


The Accounting Rate of Return (ARR) model uses ACCOUNTING PROFIT/LOSS.

For Payback and the Discount methods i.e., NPV or IRR models accounting profits/losses must
be converted to CASHFLOWS.

ACCOUNTING RATE OF RETURN — calculates the average annual profits as a percentage of
the cost of the project.

ROCE/ARR/ROI = average annual profits * 100
            average investment 1

Average investment equals initial investment plus residual value (if any) divided by 2.




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    •   Advantages
        - uses readily available accounting information.
        - more readily understood by managers.

    •   Disadvantages
        - deals with accounting profit, rather than cash flow.
        - different methods for calculating depreciation/stock values.
        - fails to take account of time value of money.

    •   Acceptance
        - One project
        - accept if above management’s acceptable return cut-off point.
        - Mutually exclusive projects
        - whichever offers the highest return.




Cash flows
Firstly, convert accounting profits to cashflows. This is done by adding the annual depreciation
charge to the profit/loss each year. Remember straight line depreciation equals:
                                     cost less residual value
                                  number of years expected use
                                     Project                Project
                                     A                      B
                                     £                      £
 Capital expenditure                 75,000

 Residual value                      5,000
Total depreciation chargeable 70,000
 No. of years expected use           5

 Annual depreciation                 £14,000




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            Project A
 Year      Profit after depreciation                                        Profit after
 depreciation                              Cash flow
           £                               £
 1          30,000                         44,000

 2          30,000                         44,000

 3          20,000                         34,000

 4          (10,000)                       4,000

 5          (10,000)                       4,000
             60,000                     130,000




Payback
The length of time which is required for a stream of cashflows (proceeds) from an investment to
recover the original cash outlay. An assumption can be made that cash flows accrue evenly
throughout the year in the case of payback occurring some part way through a year.

         Project A
 Year    Net cash inflow             Cumulative cash inflow
         £                           £
 1       44,000                      44,000

 2       44,000                      88,000

Project A’s outlay was £75,000. Of this only £44,000 was got back in year 1 and another £44,000
was got back in year 2. Therefore, payback took place somewhere between years 1 and 2. After
the first year £31,000 was still needed. £44,000 was received in year 2 so payback equals:




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     Payback method

     •   Advantages
         — simple to use and understand;
         — useful when liquidity is important when early recovery of funds is required;
         — promotes a policy of caution;
         — favoured by risk averse people.

     •   Disadvantages
         — disregards total contribution;
         — cash flows after payback are ignored;
         — fails to take account of the time value of money;
         — fails to take account of the magnitude of cash flows during the payback period.

     •   Acceptance
         — One project
         — accept as long as within management’s acceptable payback period;
         — Mutually exclusive projects
         — whichever pays back first.

Payback is usually expressed with no adjustment to the cashflows for the time value of money. It
is proper and consistent with the other cashflow methods to express payback as a discounted
payback figure. Therefore, Project’s payback period is 2.166 years.




Discounted cash flow
These methods use the technique of discounting to take into account the time value of money.
This refers to the fact that money can now be invested for a period of time and earn a return.

In capital budgeting we are concerned with finding the value now, i.e., its present day value, of a
sum to be received in the future given the interest rate to be X%. The discount factor can be
found using a calculator but it is normal to use discount tables which give the rate to be applied
each year.

Net present value — calculates the present value of the future cash flows generated by the
project and compares this present value of the cash inflow with the present value of any outflows.
If the PV of the cash inflow is greater than the PV of the cash outflow the project will have a
positive net present value (NPV).

A positive NPV indicates that the investment earns more for the firm than it has to pay for its
funds.

                                          Project A
 Year                CF                   DF           PV
                     £                    15%          £

 1                   44,000               0.869        38,236

 2                   44,000               0.756        33,264

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 3                     34,000            0.657       22,338

 4                     4,000             0.571       2,284

 5                     4,000             0.497       1,988
 5                     5,000             0.497     2,485


 Total of present values                                100,595

 Less initial outlay                      75,000

 Net present value                       25,595




     •   Advantages
         — uses cash flow information;
         — takes into account both the magnitude and timing of cash flows;
         — maximises shareholder wealth.

     •   Disadvantages
         — cost and time involved in gathering information and making calculations may not be
         merited;
         — although uses DCF the results can conflict with what IRR recommends.

     •   Acceptance
         — One project
         — accept if NPV positive;
         — Mutual exclusive projects — whichever offers the highest NPV.
Internal rate of return — is the discount rate used by the company which gives a zero NPV. At
this point the PV of the cash inflows will exactly equal the PV of the cash outflow.
IRR can be solved by using — linear interpolation or — graphs.

Linear interpolation — calculate two NPVs, choosing a discount rate which will make one positive
and one negative.

— using the following formula:




where:
     •   lower is the lower rate of return;
     •   pos is the amount of the positive NPV;
     •   neg is the amount of the negative NPV;
     •   higher is the higher rate of return.


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                                       Project A

    Year                              Net cash flow            Lower discount                        Present
    value                 Higher discount          Present value

                          £            15%           £                35%             £

    1                     44,000       0.869         38,236           0.741           32,604

    2                     44,000       0.756         33,264           0.549           24,156

    3                     34,000       0.657         22,338           0.406           13,804

    4                     4,000        0.571         2,284            0.301           1,204

    5                     4,000        0.497         1,988            0.223           892

5                         5,000        0.497            2,485         0.223       1,115


    Total of present values                          100,595                          73,775

    less initial outlay                 75,000                        75,000
Net present value                                       25,595              (1,225)

    IRR = 15% +           ( 25,595 * (35 - 15) = 34.09%

                          ( 25,595 + 1,225)

        •   Advantages
            — takes into account both the magnitude and timing of cash flows.

        •   Disadvantages
            — in some cases there may be more than one IRR e.g., if there are net cash outflows in
            more than one period, and the outflows are separated by one or more periods of net cash
            inflows;
            — although uses DCF the results can conflict with what NPV recommends.

        •   Acceptance
            — one project — accept if IRR is above management’s return cut-off point;
            — mutually exclusive projects — whichever offers the highest IRR.



Project B answers:
    ARR/ROCE/ROI      30%              Accept A or B
    Payback                            1.90 years          Accept A
    Discounted payback                 2.40years           Accept A
    NPV                                £25,681             Accept B
    IRR                                34.47%              Accept B




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Surveys of practice

Drury presents a table of “Evaluation techniques used by UK companies”. In the table,
reproduced below, payback is the most frequent method used by evaluators at present, as
evidenced by all researchers quoted and also over time as evidenced by Pike and Wolfe at three
points in time from 1975 through to 1986.

Table 1: Evaluation techniques used by UK companies




* Pike and Wolfe’s survey focused on the largest UK companies, whereas McIntyre and
Coulthurt’s survey focused on medium sized companies. The study by Drury et al is based on the
replies of 300 UK manufacturing companies with an annual sales turnover in excess of £20
million.

Pike and Wolfe’s research also highlights that the discounted cash flow methods are rapidly
increasing in popularity, none more so than NPV which has increased in use by 2.125 times over
the survey periods.



Points to note
NPV questions can be set in two contexts:

    •   profit situation (take highest or most positive NPV);

    •   cost reduction situation (take lowest NPV).
Conversion of cashflows back to accounting profits is done by deducting the depreciation from
the cashflow figure.
                                              £
  Cash flow                                   44,000
  Depreciation                                14,000
  Accounting profit                           30,000
For such a calculation to be performed the depreciation charged per annum would have to be
given in the question.




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                               The Importance Of Working Capital

Manchester United may be kings of Europe, but how good are the treble winners at managing
their working capital?

Many organisations that are profitable on paper are forced to cease trading due to an inabilty to
meet short-term debts when they fall due. In order to remain in business it is essential that an
organisation successfully manages its working capital. Too often however, this is an area which is
ignored. This article will look at the items which comprise working capital, and using live
examples will consider the level of working capital required by businesses operating in different
industries. We will also look at the problems faced by small businesses before reviewing some of
the ways in which an organisation can improve its management of working capital.

1. What is working capital?

The definition of working capital is fairly simple, it is the difference between an organisation’s
current assets and its current liabilities. Of more importance is its function which is primarily to
support the day-to-day financial operations of an organisation, including the purchase of stock,
the payment of salaries, wages and other business expenses, and the financing of credit sales.

As Diagram 1 indicates, working capital comprises a number of different items and its
management is difficult since these are often linked. Hence altering one item may impact
adversely upon other areas of the business. For example, a reduction in the level of stock will see
a fall in storage costs and reduce the danger of goods becoming obsolete. It will also reduce the
level of resources that an organisation has tied up in stock. However, such an action may
damage an organisation’s relationship with its customers as they are forced to wait for new stock
to be delivered, or worse still may result in lost sales as customers go elsewhere.

Extending the credit period might attract new customers and lead to an increase in turnover.
However, in order to finance this new credit facility an organisation might require a bank
overdraft. This might result in the profit arising from additional sales actually being less than the
cost of the overdraft.

Management must ensure that a business has sufficient working capital. Too little will result in
cash flow problems highlighted by an organisation exceeding its agreed overdraft limit, failing to
pay suppliers on time, and being unable to claim discounts for prompt payment. In the long run, a
business with insufficient working capital will be unable to meet its current obligations and will be
forced to cease trading even if it remains profitable on paper.

On the other hand, if an organisation ties up too much of its resources in working capital it will
earn a lower than expected rate of return on capital employed. Again this is not a desirable
situation.

2. The working capital cycle

The working capital cycle is summarised in Diagram 1. As the diagram illustrates, stock is
purchased on credit from suppliers and is sold for cash and credit. When cash is received from
debtors it is used to pay suppliers, wages and any other expenses. In general a business will
want to minimise the length of its working capital cycle thereby reducing its exposure to liquidity
problems. Obviously, the longer that a business holds its stock, and the longer it takes for cash to
be collected from credit sales, the greater cash flow difficulties an organisation will face.



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In managing its working capital a business must therefore consider the following question. “If
goods are received into stock today, on average how long does it take before those goods are
sold and the cash received and profit realised from that sale?” The answer will depend upon a
number of factors that we will consider later in this article. For now we will turn our attention to
calculating the length of a business’s working capital cycle.

Dublin Ltd has provided the following information based upon the year to 31 January 1999.
Credit sales        £1,200,000
Credit purchases    £650,000
Average stock       £80,000
Average debtors     £200,000
Average creditors   £54,000



With the help of a few simple ratios we can calculate the length of Dublin's working capital cycle
as follows:

We can use the stock days ratio to calculate the average length of time that goods remain in
stock:
Average stock       *365 days = 80,000*365 = 45 days

Credit purchases                 650,000
The average time taken by Dublin Ltd to pay suppliers may be calculated as follows:



Average creditors *365 days = 54,000*365 = 31 days

Credit purchases                  650,000
Whilst the average time taken for cash to be collected from a credit sale is calculated as:
Average debtors *365days = 200,000*365 = 61 days

Credit sales                  1,200,000
The working capital cycle for Dublin Ltd can be summarised as follows:
Stock received today is held for   45 days
Less:
Credit period offered by suppliers 31 days

                                     14 days
Add:
Credit period offered to customers 61 days

Length of working capital cycle
                                     75 days



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The longer the cycle the greater the level of resources tied up in working capital. In the above
example, if Dublin could reduce its stock turnover and debtors collection periods each by just five
days, its investment in working capital would fall as follows:
Stock £71,000
Debtors £184,000
A saving of £25,000

3. Problems faced by small businesses

Although working capital problems can be experienced by businesses of any size, it is usually
small businesses which have most problems, especially during their start up phase. We can
illustrate this with the aid of a detailed example.

William Miller has recently started a business producing pine dining furniture. The furniture is
produced by himself and two employees and is then sold to a national chain of furniture retailers.
The retail chain insists on a two month credit period. However, since the business is new,
suppliers require immediate payment for raw materials. Wages and other expenses are paid as
incurred. At the end of each month, Miller has no stock remaining. The opening in cash balance
in January was £1,000.

Miller has provided the following forecast figures from which he would like you to construct a cash
budget and profit and loss account.
    Sales Purchases of     Wages and
           raw materials   other expenses
    £      £               £
Jan 10,000 5,000           3,000
Feb 10,000 5,000           3,000
Mar 20,000 10,000          4,500
Apr 30,000 15,000          6,000
Table 1 contains the forecast cash budget, profit and loss account and summary of working
capital for the business and illustrates the problems faced by many small businesses. The
forecast profit and loss account shows that William Miller is running a profitable business
(£18,500 profit during the four months), with monthly sales increasing threefold during the period
under review. However, due to the credit terms offered to his customers, and the payment terms
required by his suppliers, Miller has severe cash flow problems highlighted by the cash deficit of
£30,500 at 30 April. Consequently the business has a weak working capital position, with net
current liabilities of £18,500.

For small businesses that are starting up or expanding, the problems faced by William Miller are
not uncommon. As sales increase, businesses are required to acquire more raw materials to
produce enough goods to meet the increase in demand, whilst workers are required to work
longer hours necessitating the payment of overtime wages. However, the cash from credit sales
may not be received for several weeks, whilst suppliers and employees require immediate
payment. In this situation a business is heavily dependent upon its bank overdraft and loans. In
the long term, if the business survives, the problem will be reduced through negotiating better
credit terms with customers and suppliers.
Table 1


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4. The optimum level of working capital

As a guide many text books suggest that to be safe an organisation requires a 2:1 ratio of current
assets to current liabilities. That is for every £1 of current liabilities, £2 of current assets is
required to ensure that the organisation does not run into cash flow problems. However, this is
much too simplistic, and the required level of working capital will vary from industry to industry.
We can illustrate this point with reference to Table 2 which shows a breakdown of the working
capital for three public limited companies (plc) operating in different industrial sectors. The figures
are taken from recently published annual reports.

Each of our plcs is profitable and is considered successful in its field. However, it is apparent from
Table 2 that only Manchester United plc meets the 'suggested' current ratio of 2:1. Indeed Tesco
appears to be in real trouble with only 35 pence of current assets and 13 pence of 'quick' assets
for every £1 of current liabilities. Worse still, if we consider the ratio of cash to current liabilities,
Tesco has only one pence of cash coverage for every £1 of current liabilities suggesting severe
liquidity problems. Yet Tesco is the largest supermarket chain in the UK with over 600 stores and
an annual profit on ordinary activities before taxation in excess of £800 million.

Airtours also falls well short of the suggested current ratio of 2:1, although its quick assets ratio of
1:1 is satisfactory. These figures illustrate that the 2:1 ratio is inappropriate, and the amount of
working capital required by an organisation will vary depending upon the nature of its business
and the industry in which it operates.

Let us consider the figures shown in Table 2 in more detail starting with Tesco.

Although Tesco's level of working capital appears low, let us look at the nature of its business.
Each day throughout the UK and Europe, millions of customers will purchase their groceries from
Tesco paying for their goods in cash before they leave the store.

Most items sold by Tesco have a shelf life of only a few days. As market leader Tesco can rely on
regular deliveries of stock from suppliers at fairly short notice. In addition the use of forecasting
techniques will enable managers to reliably predict daily sales levels. All of these factors enable
Tesco to operate with relatively low levels of stock.

Since almost all sales are on a cash rather than credit basis, the level of debtors is also low. In
addition, the company is able to invest surplus cash balances in short-term investments (usually
on the money markets), hence maximising the return to its investors.

Turning our attention to current liabilities, Tesco will purchase most of its stock on credit resulting
in trade creditors in its 1998 annual accounts of £826million. Indeed most stock will have been
sold and realised a profit before Tesco even pays its suppliers. Few organisations are in such a
fortuitous position. Other creditors will include corporation tax and dividends, amounts which
Tesco will know with certainty when they are to be paid.

We can see that due to the nature of its business, and in particular an abundance of cash sales,
few debtors, low levels of stock, and most purchases being for credit, cash flow is not likely to be
a problem, and hence Tesco is able to operate with negative working capital.

If we turn our attention to Airtours, customers will usually pay for their holidays well in advance of
departure ensuring that cash flow is not a problem whilst also minimising the incidence of bad
debts. Unlike Tesco, Airtours sales are seasonal with most cash being received during the period
January to June. However, expenses will be incurred throughout the year and careful planning is
necessary to ensure that Airtours is able to meet its current liabilities as they fall due.


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Being a tour operator, stock levels are relatively low. Debtors mostly comprise amounts paid in
advance in respect of hotel accommodation and balances owing from customers for holidays.
Whilst creditors compromise amounts owing for accommodation and advance payments made by
customers.

We can see from Table 2 that like Tesco, Airtours can operate with a lower current ratio than the
suggested 2:1, however due to the seasonal nature of its business, sound budgeting and
forecasting is essential to ensure that liabilities can be met even during the close season.

Turning to Manchester United we can see little evidence of any working capital problems at 31
July 1997, with the company having a current ratio of 2:1. In addition the company has 79 pence
of cash for every £1 of current liabilities. This is not surprising if we consider the nature of
Manchester United’s business. During the period August to May cash flow is not likely to be a
problem since almost every week over 50,000 fans will crowd into Old Trafford to watch their
team play. Many of these fans pay for their seats in advance, purchasing a season ticket before
the season commences. In addition the club will receive cash from sponsors, television
companies and the sale of merchandise. However, as with Airtours, business is seasonal and
careful planning is necessary to ensure that all liabilties are met as they fall due.

A review of the club’s working capital at 31 July shows that stock and debtors are relatively small,
with the majority of working capital comprising short-term investments and cash, reflecting the
cash received from season ticket sales.

From our review of Table 2 we can see that the optimum level of working capital will vary
depending upon the industry in which an organisation operates and the nature of its transactions.




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5. Managing working capital

Having discussed what comprises working capital, let us now consider some of the methods that
can be employed to assist in its management. We will review each of the key elements that
comprise working capital in turn.

(a) Stock

The cost of holding stock is relatively easy to measure and will include:

    •    storage;

    •    security;

    •    losses due to theft, obsolescence, and goods perishing.

For example, consider a retail outlet selling home computers. Three years ago it acquired fifty
state of the art PCs at a cost of £1,000 each. At the time each computer could be sold for £1,300
resulting in a profit of £300 per machine. Unfortunately today fifteen of these models remain in
stock. Not only are they taking up valuable space, but due to rapid advances in technology they
can only be sold for £300 each. If this outdated stock is sold, the overall position on this
transaction is:
                                               £
Sales of 35 computers at £1,300 each           45,500
Sale of 15 computers at £300 each              4,500

Total sales revenue
                                            50,000
Cost of sales (50 computers at £1,000 each) (50,000)

Profit
                                               —
When we take into account administration and storage costs this transaction will actually result in
a loss to the organisation.

We can therefore see the importance of not holding excessive levels of stock.

What is less easy to quantify is the cost of not holding sufficient levels of stock to meet the
demand from customers. For example, if an organisation has insufficient stock to meet demand, it
will initially result in lost sales. In the longer term it may also damage a business’s goodwill, with
long-standing customers turning to other, more reliable suppliers.




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For most organisations the difficulty is determining the optimum level of stock.This will depend
upon a number of factors including:

    •   the average level of daily sales (adjusted for seasonal variations);

    •   the lead time between ordering goods and their delivery;

    •   the reliability of suppliers;

    •   the type of good and the danger of their perishing or becoming obsolete;

    •   the cost of re-ordering stock;

    •   storage and security costs;

    •   other factors such as rumours of a shortage or an increase in price.

It is essential that systems are in place to ensure that stock levels are reviewed regularly and
where necessary appropriate action taken.

(b) Debtors

Too often, especially during their start-up period, businesses concentrate on generating sales and
pay little attention to the collection of money from debtors. As a result although sales exist on
paper, the cash generated by these sales takes too long to materialise and cash flow problems
occur (as our William Miller example illustrates). Additionally, the longer a debt is outstanding the
greater the likelihood it will become bad.

With this in mind an effective credit control policy is necessary. This should include the following:

    •   Before allowing credit, an organisation should check the credit rating of potential
        customers, where necessary seeking references from a third party. Often this will involve
        using the services of a credit agency such as Dunn and Bradstreet.

    •   Based upon the results of a credit check, credit limits can be set. Once the credit limit is
        reached it cannot be exceeded without the authorisation of senior management.

    •   Credit customers should be informed in writing of the normal credit period (for example
        30 days after the invoice date).

    •   A small cash discount is often used as an incentive to encourage early payment by
        debtors. For example, many firms offer a discount of 2.5% of the invoice value for
        payment within seven working days of the invoice date.

    •   It is essential that an organisation maintains accurate records detailing all transactions
        with customers and the amounts owing. An aged debtors’ list detailing the length of time
        that a debt has been owing is useful since it highlights those debts which management
        needs to concentrate on.

    •   An organisation should issue regular statements (normally monthly), and where
        necessary these should be followed up with reminders and phone calls/letters.



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Effective credit control will ensure that disputes are settled quickly without damaging the
relationship with a customer, whilst at the same time reducing the occurrence of bad debts.
However, such a system is often expensive and time consuming to set up, hence many
organisations, especially those which have only recently commenced trading, utilise debt
factoring.

Debt factoring involves an organisation passing responsibility for the management and collection
of its trade debtors to a third party.The organisation ‘sells’ its invoices to a factor company and in
return the factor immediately advances cash equal to between 50 and 85% of the total invoice
value. The balance of the invoice value, less a charge for the factoring service, is paid when the
debts are collected. In addition the factor is responsible for the administration of an organisation’s
debtors, and can offer protection against bad debts.

The advantage of factoring is that it enables an organisation to concentrate upon generating
sales and leaves the collection of cash to a third party. Most importantly it reduces the cash flow
problems often experienced by new businesses by giving access to cash immediately rather than
having to wait 30 or more days. Again our William Miller example highlights the problems
experienced by small businesses, factoring would immediately solve Miller’s cash flow problem.
However, factoring is expensive and in the long term it may be cheaper for an organisation to
establish its own debtor management systems.

Invoice discounting is becoming increasingly common. Like debt factoring the business
immediately receives cash representing a proportion of the total invoice value. Unlike debt
factoring the business retains responsibility for the management of its credit control system.

When deciding the credit period offered to customers an organisation must consider several
factors. A longer credit period (for example 45 days compared to 30 days offered by competitors)
may generate additional sales, however these must be compared against the additional costs
incurred by the business. These costs might include an increase in bad debts, higher
administration costs and bank overdraft charges. If the profits arising from the additional credit
period are less than the costs incurred, the credit period should be reviewed.



(c) Trade creditors

The practice of businesses extending trade credit to one another is probably the most important
source of short-term funding available to most organisations. At first glance trade credit appears
to represent a short-term interest free loan which enables a higher level of trade than if everything
was paid for immediately in cash.

However, if we take a closer look at trade credit we can see that there are costs associated with
it. Most suppliers offer customers a discount for early payment. Thus a supplier might allow 30
days’credit on all sales. However, in order to encourage early settlement of debts, customers
paying within seven days are offered a cash discount equating to 2.5% of the invoice total. On an
invoice of £10,000 (excluding VAT) this would equate to a saving of £250 (£10,000*2.5%).

Even if an organisation has an overdraft it may still be beneficial to take advantage of a cash
discount. For example, Alanis purchases £5,000 of goods from Celine. Celine offers all customers
the option of either 30 days’ credit or a 1.5% discount if cash is received within 5 days. If Alanis
takes the cash discount she will incur an overdraft on which interest is charged at 20% per
annum. Is the cash discount beneficial to Alanis?



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If     Alanis     takes             the        cash        discount         she          will        save:
£5,000*1.5% = £75

However, she will incur an overdraft for 25 days (30 – 5 days) which will cost:
£5,000*[20%*25/365] = £68.49

In this example Alanis will benefit by £6.51 if she pays the invoice within five days.

Another cost of trade credit, which is often ignored, is its impact upon the creditworthiness of a
business. If a business consistently exceeds the credit period imposed by suppliers, in the long
term its credit rating will be damaged. In the worst case scenario, suppliers will be forced to take
legal action and may even withdraw their credit facility, requiring cash on delivery.

Whilst trade credit is undoubtedly a useful facility, it is important that businesses do not become
too dependent upon it.

(d) Cash and bank balances

Liquidity problems often arise because inflows and outflows of cash do not coincide. For example,
a small tour operator is likely to find itself awash with cash from January to June as customers
book and pay for their summer holidays. Whilst from July to December sales and hence cash
balances will be lower. However, business expenses such as wages and salaries, heat and light,
rent and rates, and loan interest will remain more or less the same throughout the year. It is
therefore essential that businesses plan ahead to ensure that sufficient cash is available to meet
expenses in the off-peak period.

As demonstrated in Table 1, the preparation of a cash budget will indicate the flow of receipts
and payments in and out of the business and will forecast periods of surplus and deficit cash
balances thereby reducing the level of uncertainty. If a large surplus is forecast, cash can be
invested in an interest earning account until it is required. If a deficit is forecast, our business can
arrange a bank overdraft or loan. However, wherever possible overdrafts and loans should be
avoided due to their high cost

6. Summary

During the course of this article we have looked at the items which make up working capital and
considered how organisations can improve their management of working capital. We have seen
that the ideal level of working capital is difficult to calculate and will vary from one organisation to
another depending upon the industry in which they operate. What is essential is that a business
avoids both the situation of too little or too much working capital.

Too little working capital is known as over-trading, and is common when a business is starting up
or is experiencing a period of rapid growth. As we saw in our Willam Miller example, the level of
sales might grow very quickly, but inadequate working capital is available to support this growth.
The situation will then arise whereby a business may be profitable on paper but has insufficient
funds available to pay debts as they become due. In the short term this situation can be solved
through a combination of measures including:
    •   obtaining an increased overdraft facility;
    •   negotiating a longer credit period with suppliers;
    •   encouraging debtors to pay faster.
However, in the long term a business is unlikely to survive without a combination of:
    •   new capital from shareholders/proprietor;

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    •   better control of working capital;
    •   the building up of an adequate capital base through retained profits.
Almost as bad is too much working capital or over-capitalisation. Poor management of working
capital will result in excessive amounts tied up in current assets. Such a scenario will lead to a
business earning a lower than expected return.

It must be remembered that the shorter an organisation’s working capital cycle, the faster cash,
and hence profits, from credit sales will be realised. In order to achieve this an organisation must
regularly review its working capital, taking action where necessary.




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            Working Capital Management – article 2

Working capital management is a core area of the managing finances syllabus. As such it should
form a key element of the study programme when preparing for the your examination.

Working capital is defined as, the excess of current asset over current liabilities. The composition
and size of the various elements comprising current assets will vary depending on the type of
industry, size of organisation and time of year. In addition, the relationship of current assets to
current liabilities will vary considerably from one industry to another.

Efficient and effective working capital management is vital for the survival and prosperity of any
organisation. To survive, a firm must remain solvent. Poor working capital management could
result in the organisation not having enough cash to pay obligations as they fall due. This may
place the business in danger of failure.

Current assets commonly comprise:

    •   Stocks

    •   Debtors

    •   Cash

Current liabilities commonly comprise payments due within one year:

    •   Creditors

    •   Taxation

    •   Bank overdraft

The theoretical lower limit is a current assets to current liabilities ratio of 1:1. The higher the ratio
(excess of current assets to current liabilities) the better the organisation is positioned to meet its
financial commitments as they fall due.

There is a general consensus that a current assets to current liabilities ratio of 2:1 is financially
sound. This can vary considerably however, from industry to industry. Prudence would suggest
that a manufacturing company should be closer to 2:1 whereas a services company could
operate successfully close to the lower level of 1:1.

Consequently, it is important in assessing the current assets to current liabilities ratio to consider
the type of business and the industry norm, rather than automatically expecting a target ratio of
2:1.

Cash operating cycle

The working capital (cash operating) cycle refers to the average period elapsing from the
payment for purchases and other production expenditure (cash outflow) to the eventual cash
receipt from the sale of finished goods (cash inflow).


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Diagrammatically the cash operating cycle can be shown as in Figure 1.

The length of the cash operating cycle can be calculated as in Figure 2.

Figure 2: calculating the cash operating cycle

Debtors days:
   Average debtors
   _______________               x 365 = days
   Credit sales
Stockholding days:
   Average stocks
   _______________
   Cost of sales
                                 x 365 = days
Less creditors:
   Average creditors
   _______________
   Credit purchases
   Net cash operating cycle = x 365 = (days)




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Figure 3: operating cycle example

Operator Ltd (a distributor of calculators) sample data
Y/E 31/12/1998

           Sales                                 £133,000
           Cost of sales
                                                 £100,000
           Opening stock
                                                 £40,000 (1/1/1998)
           Closing stock                         £50,000 (31/12/1998)
           Purchases on credit                   £110,000
           Debtors                               £24,000
           Creditors
                                                 £11,000

Notes:
(i) Operator Ltd intends to extend its product range in 1999. This is expected to increase sales
by 10%.

(ii) The gross margin on these additional sales is expected to remain at current levels (i.e.,
£33,333/£133,333 = 25%)

(iii) To facilitate the business expansion, stock levels are expected to increase by £6,000
effective almost immediately.

(iv) The expansion is expected to lead to an immediate increase in the average period credit
extended to customers of 5 days.

(v) Creditors days are not expected to change.

(vi) The increased investment will be financed via an increased bank overdraft at a cost of 12%
p.a.




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Figure 4: operating cycles to the nearest day

                                                  Current            cash Amended cash
                                                  operating cycle         operating cycle
Debtor days
Average debtors x 365 =            £24,000        x    365 =    66   days 71 days (an increase
Sales                              £133,333                               of 5 days)
Stock days (Note 1)
Average stocks x 365 =             £45,000        x    365 = 164 days 186 days (Note 2 & 3)
Cost of sales                      £100,000
Less creditors days
Average creditors x 365 =          £11,000        x 365     = (37 days)    (37 days) (no change)
Credit purchases                   £110,000
                                                            = 193 days     220 days
Net operating cycle

This represents an increase of 27 days (i.e., a 14% increase)

Note 1: Current average stock = {£40,000 + £50,000} /2= £45,000


Note 2: The stock increase is immediate, therefore, the average stock will become £50,000 +
£6,000 (increase) = £56,000
Cost of sales will become £100,000 x 1.1 = £110,000

Note 3: £56,000 x 365 = 186 days
£110,000

Figure 5: additional investment required

                                Current investment             Proposed investment
                                in working capital             in working capital
Stocks                          £50,000                        £56,000 (increase of £6,000)
Debtors                         £24,000                        £28,530 (Note 1)
Less creditors                  (£11,000)                      (£11,759) (Note 2 & 3)
Net working capital             £63,000                        £72,771
This represents an increased investment of £9,771 which, if financed by a bank overdraft at 12%,
will have an incremental finance cost of £1,173.
Note 1: Debtors almost immediately increase by an average of 5 days.
The new debtors level will be approx:
Sales x 71 = £133,333 x 1.1 x 71 = £28,530
        365                   365
Note 2: Creditors days remain unchanged at 37 days.
So the new creditors level will be approx:
Purchases x 37 = £116,000 x 37 = £11,759
             365              365
Note 3: Credit purchases will be:
Cost of sales £100,000 x 1.1 = £110,000
+ increase in stocks      = £6,000
Total credit purchases      £116,000

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Figure 6: the impact of the proposed change on profit

Sales will increase by 10%

£133,333 x 10% = £13,333

The margin on sales is 25%
So additional profit will be £13,333 x 25% =                 £3,333

Less the incremental finance cost of the
additional working capital investment (from Figure 5) = (£1,173)

Net Marginal Profit
Therefore, the change is beneficial to Operator Ltd          £2,160
as it improves profit by approximately £2,160



Analysis of the cash operating cycle

The objectives of working capital management are twofold:

(a) the determination of optimum investment in stock, debtors and cash appropriate to the
industry type and size of business;

(b) the acquisition of optimum (minimum cost) working capital finance.

The length of the operating cycle has significant implications for working capital finance
requirements. The longer the cycle time, the greater the required finance. The greater the
required finance, the higher the finance cost needed to sustain the investment in current assets.
The optimum level of working capital is, therefore, an amount which does not strain liquidity yet
avoids excessive surplus cash.

It is important to appreciate that care needs to be exercised in attempting to reduce the operating
cycle time so that it does not lead to a reduction in profits. For example, significantly reducing
stocks to reduce the stockholding period could, if not properly managed, result in costly stockouts
and a subsequent loss of sales and customer goodwill. If debtors were pressed for earlier
payment they might opt to purchase from a competitor who offers longer credit terms. Therefore,
reducing the operating cycle too far can have dangerous consequences.




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The example in Figure 3 may help to clarify the calculations involved in a simple cash operating
cycle analysis.

The company may wish to consider:
(a) the impact of the proposed expansion on the cash operating cycle (Figure 4). (b) the
incremental investment in working capital (Figure 5).
(c) the impact of the proposal on profit (Figure 6).

Figure 4 sets out detailed calculations of the existing cash operating cycle which is 193 days.
The changes resulting from the increase in activity are then factored into a revised cash operating
cycle calculation. The revised cycle time is 220 days. Consequently, the increase in sales
combined with the anticipated changes in working capital are expected to lengthen the operating
cycle time by 27 days.

Figure 5 shows the expected impact of the longer cycle time on the investment in working capital.
Currently the net investment in working capital is £63,000. The longer cycle time is expected to
lead to the net working capital investment increasing to £72,771 (an increase of £9,771). Make
sure you follow the calculation for each of the elements comprising the revised net working capital
investment of £72,771 in Figure 5.

Figure 6 rounds out the evaluation by assesing the impact of the changes in terms of financial
benefits and costs. This analysis shows a marginal improvement in profit of £2,160, making the
expansion financially viable.

Summary

With any change in working capital management, it is vital to comprehensively review the
consequences, particularly the financial benefits and costs.

Reducing the operating cycle

When considering techniques to reduce the operating cycle it is

always important to attempt to review the implications and ensure that the expected benefits
exceed the expected costs.



Selected techniques could include:

(a) Reducing the raw material stock holding period

 l Introduction of J IT (J us t in tim e ) s tock m a na ge m e nt s ys te m s .
 Re ducing the va rie ty of pa rts a nd com pone nts us e d a nd, cons e que ntly, the va rie ty of s tock to
hold.


(b) Reducing the production time
 Re de s ign of the fa ctory la yout to fa cilita te a smoother flow through the production process.
 Introduction of TQ M (Tota l Q ua lity Ma na ge m e nt) philos oph y. This s hould re duce or e lim ina te
the level of rejects and costly rectification work.


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       P rovide re le va nt s ta ff tra ining a nd de ve lopm e nt focus e d on continuously seeking
improvements in performance and efficient practices.
 Inve s t in the on going re vie w of product a nd proce s s de s ign to e ns ure only va lue a dding
activities are undertaken in the manufacturing or service processes.
 Introduction of a utomated processes where appropriate.


(c) Reduce finished goods stockholding periods
 If pos s ible , ope ra te a J IT philos ophy of only m a nufa cturing to orde r thus re ducing finis he d
goods stock levels to zero.
 Re gula r re vie w of s tock turnove r by finis hed stock item with a view to eliminating slow or
obsolete stock lines.


(d) Improved credit control procedures
 Efficie nt inte rna l controls to e ns ure tha t a ll dis pa tche s a re invoice d without de la y.
 Atte m pt to m ove cus tom e rs onto e fficie nt pa ym e nt methods to reduce the length of time from a
customer initiating payment to the eventual receipt of cleared funds.
 P rom pt lodge m e nt of pa ym e nts re ce ive d from cus tom e rs to re duce tota l floa t tim e .
 Fa ctoring or invoice dis c ounting to re duce the pe riod from making a credit sale to the eventual
receipt of payment.


(e) Management of creditors

Progressive companies have come to realise that there are significant benefits in developing a
mutually beneficial relationship with their suppliers rather than attempting to delay payment
beyond the agreed credit period. It is still possible however, to implement procedures which
ensure that maximum benefit is achieved from efficient creditor management.

Effective and efficient management of creditors could involve the following:

    •   Availing of allowed credit periods.

    •   Only availing of early settlement discounts if the benefits exceed the cost.

    •   Avoiding the cost of frequently changing suppliers by operating prudence in the initial
        selection process.

These are only some of the techniques which could be employed in an effort to improve efficiency
and increase profits.



Conclusion

Careful management of working capital is vital for the survival and prosperity of an organisation.

The mix and relative size of current assets and current liabilities varies considerably from industry
to industry.



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Any proposed change in working capital should be comprehensively investigated to ensure the
expected benefits exceed the expected costs of such a change.

Great care must be taken when attempting to reduce the working capital cycle as this policy can
often have dangerous consequences if not managed properly.




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Debtor management
One year after The Late Payment of Commercial Debts (Interest) Act 1998 was passed, market information
specialists, Experian, recently reported that British companies are now taking two days longer to settle their
bills with suppliers than before the legislation was introduced. The average time taken to pay for credit
purchases by British companies is now 74 days. Although the 1998 legislation enables companies
employing fewer than 50 staff to levy an 8% interest charge above the base rate on late-paying larger
clients, few have done so in fear of alienating the enterprises on whom they frequently so heavily rely. The
study also found that most large businesses now insist on a 60-day payment period. Reliant upon cash from
trade debtors to pay suppliers, wages and other costs, the failure to receive the amounts owing from credit
customers on the due dates creates enormous problems for businesses in paying their own way. This article
reviews the major considerations at each stage of the credit management process and concludes with an
illustration of how factoring can benefit companies suffering from late-paying customers.

Assessing the credit worthiness of customers

Before extending credit to a customer, a supplier should analyse the five Cs of credit worthiness, which will
provoke a series of questions. These are:

    •    Capacity — will the customer be able to pay the amount agreed within the allowable
         credit period? What is their past payment record? How large is the customer's
         busiCapital — what is the financial health of the customer? Is it a liquid and profitable
         concern, able to make payments on time?

    •    Character — do the customers’ management appear to be committed to prompt
         payment? Are they of high integrity? What are their personalities like?

    •    Collateral — what is the scope for including appropriate security in return for extending
         credit to the customer?

    •    Conditions — what are the prevailing economic conditions? How are these likely to
         impact on the customer’s ability to pay promptly?

Whilst the materiality of the amount will dictate the degree of analysis involved, the major sources of
information available to companies in assessing customers’ credit worthiness are:

    •    Bank references. These may be provided by the customer’s bank to indicate their
         financial standing. However, the law and practice of banking secrecy determines the way
         in which banks respond to credit enquiries, which can render such references
         uninformative, particularly when the customer is encountering financial difficulties.

    •    Trade references. Companies already trading with the customer may be willing to
         provide a reference for the customer. This can be extremely useful, providing that the
         companies approached are a representative sample of all the clients’ suppliers. Such
         references can be misleading, as they are usually based on direct credit experience and
         contain no knowledge of the underlying financial strength of the customer.

    •    Financial accounts. The most recent accounts of the customer can be obtained either
         direct from the business, or for limited companies, from Companies House. While subject
         to certain limitations (encountered in paper 1), past accounts can be useful in vetting
         customers. Where the credit risk appears high or where substantial levels of credit are

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         required, the supplier may ask to see evidence of the ability to pay on time. This
         demands access to internal future budget data.

    •    Personal contact. Through visiting the premises and interviewing senior management,
         staff should gain an impression of the efficiency and financial resources of customers and
         the integrity of its management.

    •    Credit agencies. Obtaining information from a range of sources such as financial
         accounts, bank and newspaper reports, court judgements, payment records with other
         suppliers, in return for a fee, credit agencies can prove a mine of information. They will
         provide a credit rating for different companies. The use of such agencies has grown
         dramatically in recent years.

    •    Past experience. For existing customers, the supplier will have access to their past
         payment record. However, credit managers should be aware that many failing companies
         preserve solid payment records with key suppliers in order to maintain supplies, but they
         only do so at the expense of other creditors. Indeed, many companies go into liquidation
         with flawless payment records with key suppliers.

    •    General sources of information. Credit managers should scout trade journals, business
         magazines and the columns of the business press to keep abreast of the key factors
         influencing customers' businesses and their sector generally. Sales staff who have their
         ears to the ground can also prove an invaluable source of information.

Credit terms granted to customers

Although sales representatives work under the premise that all sales are good (particularly, one may add,
where commission is involved!), the credit manager must take a more dispassionate view. (S)he must
balance the sales representative's desire to extend generous credit terms, please customers and boost sales,
with a cost/benefit analysis of the impact of such sales, incorporating the likelihood of payment on time and
the possibility of bad debts. Where a customer does ‘survive’ the credit checking process, the specific
credit terms offered to them will depend upon a range of factors. These include:

    •    Order size and frequency — companies placing large and/or frequent orders will be in a
         better position to negotiate terms than firms ordering on a one-off basis.

    •    Market position — the relative market strengths of the customer and supplier can be
         influential. For example, a supplier with a strong market share may be able to impose
         strict credit terms on a weak, fragmented customer base.

    •    Profitability — the size of the profit margin on the goods sold will influence the
         generosity of credit facilities offered by the supplier. If margins are tight, credit advanced
         will be on a much stricter basis than where margins are wider.

    •    Financial resources of the respective businesses — from the supplier's perspective, it
         must have sufficient resources to be able to offer credit and ensure that the level of credit
         granted represents an efficient use of funds. For the customer, trade credit may represent
         an important source of finance, particularly where finance is constrained. If credit is not
         made available, the customer may switch to an alternative, more understanding supplier.

    •    Industry norms — unless a company can differentiate itself in some manner (e.g.,
         unrivalled after sales service), its credit policy will generally be guided by the terms


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        offered by its competitors. Suppliers will have to get a ‘feel’ for the sensitivity of demand
        to changes in the credit terms offered to customers.

    •   Business objectives — where growth in market share is an objective, trade credit may
        be used as a marketing device (i.e., liberalised to boost sales volumes).

The main elements of a trade policy are:

    •   Terms of trade — the supplier must address the following questions: which customers
        should receive credit? How much credit should be advanced to particular customers and
        what length of credit period should be allowed? (See Example 1 for an illustration of a
        typical credit policy decision faced by a company).

    •   Cash discounts — suppliers must ponder on whether to provide incentives to encourage
        customers to pay promptly. A number of companies have abandoned the expensive
        practice of offering discounts as customers frequently accepted discounts without paying
        in the stipulated period.

    •   Collection policy — an efficient system of debt collection is essential. A good
        accounting system should invoice customers promptly, follow up disputed invoices
        speedily, issue statements and reminders at appropriate intervals, and generate
        management reports such as an aged analysis of debtors. A clear policy must be devised
        for overdue accounts, and followed up consistently, with appropriate procedures (such as
        withdrawing future credit and charging interest on overdue amounts). Materiality is
        important. Whilst it may appear nonsensical to spend time chasing a small debt, by doing
        so, a company may send a powerful signal to its customers that it is serious about the
        application of its credit and collection policies. Ultimately, a balance must be struck
        between the cost of implementing a strict collection policy (i.e., the risk of alienating
        otherwise good customers) and the tangible benefits resulting from good credit
        management.

Example 1
Henman Limited manufactures a tennis racket, which sells for £50. The variable unit costs of
production are £26, while unit fixed costs (an apportionment of the total fixed costs incurred) are
£10. Net profit per unit is therefore £14. Currently Henman has a turnover of £750,000, which has
been stable for three years. To increase sales, the directors of Henman Limited are always
considering whether to liberalise their credit policy and allow all customers more time to pay. At
present, the average debtor collection period is 30 days. The two options available to the
directorate are to either increase the collection period to 40 days (this would increase sales by
£85,000) or, to raise the collection period to 50 days, which would raise turnover by £95,000. The
cost of capital (before tax) of Henman Limited is 20%. Which credit policy should Henman offer its
customers?




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Evaluation of credit policies
                                                           40 days              50 days
                                                           £                    £
Debtors £835,000 x 40/365                                  91,507
£845,000 x 50/365                                                               115,753
Current debtors £750,000 x 30/365                          61,644               61,644
Increase in debtors                                        29,863               54,109
No. of additional units sold
£85,000/£50                                                1,700
£95,000/£50                                                                     1,900
                                                           £                    £
Cost of additional debtors (at 20%)                        (5,973)              (10,822)
Increase in contribution
1,700 x £24                                                40,800
1,900 x £24                                                                     45,600
Increase in profits                                        34,827               34,778

The analysis shows that a ten-day liberalisation of the current 30-day credit policy will
increase profits by slightly more than the twenty-day extension. However, the results are
very close and subject to any inaccuracies in the estimates utilised.
Problems in collecting debts

Despite the best efforts of companies to research the companies to whom they extend credit, problems can,
and frequently do, arise. These include disputes over invoices, late payment, deduction of discounts where
payment is late, and the troublesome issue of bad debts. Space precludes a detailed examination of debtor
finance, so this next section concentrates solely on the frequently examined method of factoring.

Factoring — an evaluation

Key features

Factoring involves raising funds against the security of a company's trade debts, so that cash is received
earlier than if the company waited for its credit customers to pay. Three basic services are offered,
frequently through subsidiaries of major clearing banks:

    •   sales ledger accounting, involving invoicing and the collecting of debts;

    •   credit insurance, which guarantees against bad debts;

    •   provision of finance, whereby the factor immediately advances about 80% of the value of
        debts being collected.

There are two types of factoring service. Non-recourse factoring is where the factoring company
purchases the debts without recourse to the client. This means that if the client’s debtors do not
pay what they owe, the factor will not ask for his money back from the client.



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Recourse factoring, on the other hand, is where the business takes the bad debt risk. With 80%
of the value of debtors paid up front (usually electronically into the client’s bank account, by the
next working day), the remaining 20% is paid over when either the debtors pay the factor (in the
case of recourse factoring), or, when the debt becomes due (non-recourse factoring). Factors
usually charge for their services in two ways: administration fees and finance charges. Service
fees typically range from 0.5 – 3% of annual turnover. For the finance made available, factors
levy a separate charge, similar to that of a bank overdraft.



Advantages

    •   provides faster and more predictable cash flows;

    •   finance provided is linked to sales, in contrast to overdraft limits, which tend to be
        determined by historical balance sheets;

    •   growth can be financed through sales, rather than having to resort to external funds;

    •   the business can pay its suppliers promptly (perhaps benefiting from discounts) and
        because they have sufficient cash to pay for stocks, the firm can maintain optimal stock
        levels;

    •   management can concentrate on managing, rather than chasing debts;

    •   the cost of running a sales ledger department is saved and the company benefits from
        the expertise (and economies of scale) of the factor in credit control
.
Disadvantages

    •   the interest charge usually costs more than other forms of short-term debt;

    •   the administration fee can be quite high depending on the number of debtors, the volume
        of business and the complexity of the accounts;

    •   by paying the factor directly, customers will lose some contact with the supplier.
        Moreover, where disputes over an invoice arise, having the factor in the middle can lead
        to a confused three-way communication system, which hinders the debt collection
        process;

    •   traditionally the involvement of a factor was perceived in a negative light (indicating that a
        company was in financial difficulties), though attitudes are rapidly changing.

Example 2
Connors plc is a small engineering company with annual credit sales of £2m. Recently, the
company has witnessed increasing problems in its credit control department. The average
collection period for debtors has risen to 55 days, even though the stated policy of the business is
for payment within 30 days. Moreover, 1% of sales are annually written off as bad debts. Connors
plc has entered into negotiations with a factor who is prepared to make an advance to the
company equivalent to 80% of trade debtors, based on the assumption, that in the future,
customers will adhere to the 30 day payment period. The interest rate for the advance will be


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11% per annum. Trade debtors are currently financed at 12%, through a bank overdraft. The
factor will take over the credit control procedures of the company. This will not only lead to an
annual saving of £15,000, but will also eliminate all bad debts. The factor will, however, make a
2% charge of sales revenue for the provision of this service. Should Connors plc take advantage
of the opportunity to factor its trade debts?
Two of the ways of tackling such a question are presented. The first compares the cost of the
current credit policy with that prevailing if the factoring agreement were employed.

Cost of existing credit policy                         £
Cost of debtors (50/365 x £2m x 12%)                   32,877
Bad debts written off (1% x £2m)                       20,000
                                                       52,877

                                                       Cost of factor
Factor charges (2% x £2m)                              40,000
Factor finance charges
[30/365 x (80% x £2m) x 11%]                           14,466
Overdraft charges
[30/365 x (20% x £2m) x 12%]                           3,945
                                                       58,411
Less: Cost savings                                     15,000
 Net cost of factor agreement                          43,411




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Net saving from factoring agreement (52,877 – 43,411) 9,466
Secondly, cost-benefit analysis can be used to consider the proposed change in credit policy.
Cost-benefit analysis of engaging a factoring company
Costs
Factor charges (2% x £2m)                                             (40,000)


Benefits
Credit control department savings                       15,000
Bad debts saved (1% x £2m)
Net savings in finance charges                          20,000
(50/365 x 12% x £2m)
– [(30/365 x 80% x £2m x 11%)
+ (30/365 x 20% x £2m x 12%)]                           14,466         49,466
Net benefit from factoring                                               9,466

Connors plc would benefit from entering into an agreement with the factoring company.


Conclusion

Working capital management is of critical importance to all companies. Ensuring that sufficient
liquid resources are available to the company is a pre-requisite for corporate survival. Companies
must strike a balance between minimizing the risk of insolvency (by having sufficient working
capital) with the need to maximize the return on assets, which demands a far less conservative
outlook. In this paper, one of the elements of the working capital equation, debtor management,
has been considered. Students should ensure that they can not only tackle computation-type
questions, but also be able to discuss the numerous facets of operating a credit management
policy.




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                     How Capital Structure Affects A Company's Cost Of Capital?

The term capital structure refers to the mix of different types of funds which a company uses to
finance its activities. Capital structure varies greatly from one company to another. For example,
some companies are financed mainly by shareholders’ funds whereas others make much greater
use of borrowings. In this article we consider some of the arguments that have been put forward
in answer to the question “Are some capital structures better than others?”

Firstly we must decide what we mean by a ‘good’ capital structure. This would be a capital
structure which results in a low overall cost of capital for the company1, that is a low overall rate
of return that needs to be paid on funds provided. If the cost of capital is low, then the discounted
value of future cash flows generated by the company is high, resulting in a high overall company
value. The objective is therefore to find the capital structure that gives the lowest overall cost of
capital and, consequently, the highest company value.

Secondly, to simplify the problem, the only variation in capital structure we will consider is in the
overall amount of borrowings which firms use. We will ignore the differences between the
numerous types of debt and hybrid instruments that are available and focus purely on the ratio of
debt to equity funds in the company’s capital structure. The question can then be rephrased as
“Does borrowing affect a company’s cost of capital, and is there an optimal level of borrowing
which will minimise the cost of capital and maximise the company’s value?”

In summary, then, we will assume that companies are financed by just two types of funds,
shareholders funds (equity) and borrowings (debt), and we will consider the effect on the cost of
capital of varying the proportion of debt in the capital structure.

Effects of borrowing
Suppose our company is financed entirely by ordinary shares (equity). What would be the effects
of issuing some debt capital? The main advantage of borrowing is that debt has a cheaper direct
cost than equity. There are two distinct reasons for this:
   i.   debt is less risky to the investor than equity (low risk results in a low required return); and

  ii.   interest payments are allowable against corporate taxation, whereas dividends are not.

However, borrowing has two distinct disadvantages. Firstly it causes shareholders to suffer
increased volatility of earnings. This is known as financial leverage. For example, if a firm is
financed entirely by equity, a 10% reduction in operating earnings will result in a 10% reduction in
earnings per share. But if the firm is financed by debt as well as equity, a 10% reduction in
operating earnings causes a greater reduction in earnings per share than 10%, because debt
interest does not reduce in line with operating earnings.

The increased volatility to shareholders’ returns resulting from financial leverage causes
shareholders to demand a higher rate of return in compensation. In other words, any borrowing at
all will cause the cost of equity capital to rise, off-setting the cheap direct cost of debt.

The second disadvantage of borrowing is that if the company borrows too much, it increases its
bankruptcy risks. At reasonable levels of gearing this effect will be imperceptible, but it becomes
significant for highly geared companies and results in a range of risks and costs which have the
effect of increasing the company’s cost of capital.

In summary then, we have identified two distinct advantages of borrowing and two distinct
disadvantages (Figure 1). There are other advantages and disadvantages, but for the moment let

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us just focus on these four effects. To what extent do the disadvantages offset the advantages?
In the discussion that follows we will look at the effects of the firm’s weighted average cost of
capital, or WACC (Figure 2).
            Figure 1: Two advantages and two disadvantages of borrowing
Advantages                                 Disadvantages
1. Cheap direct cost because debt is       1. Financial leverage causes shareholders to
less risky to the investor                 increase their cost of capital
2. Cheap direct cost because interest is
                                           2. Bankruptcy risks if borrowings are too high.
a tax deductible expense.




Effect of borrowing on WACC: traditional view

The so-called traditional view of capital structure states that when a company starts to borrow, the
advantages outweigh the disadvantages. The cheap cost of debt, combined with its tax
advantage, will cause the WACC to fall as borrowing increases.



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However, as gearing increases, the effect of financial leverage causes shareholders to increase
their required return (i.e., the cost of equity rises). At high gearing the cost of debt also rises
because the chance of the company defaulting on the debt is higher (i.e., bankruptcy risk). So at
higher gearing, the WACC will increase.

The result is that we should be able to identify a minimum WACC and an optimal gearing, as
shown on the graph in Figure 3.




                                            Example 1

Suppose that when a company has no borrowings its cost of equity capital (Ke) is 20%
per annum. Its WACC is of course also 20% because there is no debt. Now suppose it
borrows at an after-tax cost (K d) of 10% per annum to a proportion of debt to equity of
3:7. Suppose the cost of equity rises because of financial leverage to 22%. What is the
WACC?


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Solution
WACC = 7/10 x 22% + 3/10 x 10% = 18.4%. The WACC has been lowered by
borrowing.


                                        Example 2
Now suppose the company borrows more so that the proportion of debt to equity is 1:1.
Suppose the cost of equity rises to 27%. Suppose also that because of default risk, the
average cost of the company’s debt is now 12%. What is the WACC?
Solution
WACC = 1/2 x 27% + 1/2 x 12% = 19.5%. The WACC has started to rise again,
indicating that the borrowing is at an above-optimal level.
The main problem with the traditional view is that there is no underlying theory to show by how
much the cost of equity should increase because of financial leverage or the cost of debt should
increase because of default risk. The figures we have used in the calculations are entirely
subjective. Although it is more or less realistic, the traditional view remains a purely descriptive
theory.

Modigliani and Miller’s theory (1958)

In contrast to the traditional view, Modigliani and Miller (MM) set out to show what ought to
happen to the cost of capital when a company increases or decreases borrowing. The approach
for normative theories of this type is to state a set of assumptions and then to deduce the logical
conclusions. The effect of relaxing some of the assumptions can then be examined.

In order to demonstrate a workable theory, MM’s 1958 paper made a number of simplifying
assumptions which are common in the theory of finance: they assume that the capital market is
perfect; there are therefore no transactions costs and the borrowing rate is the same as the
lending rate and equal to the so-called risk free rate of borrowing; taxation is ignored and risk is
measured entirely by volatility of cash flows.

If the capital market is perfect, MM argue, then all companies with the same business risk and the
same expected annual earnings should have the same total value, regardless of capital structure,
because the value of a company should depend on the present value of its operations, not on the
way it is financed.

It follows from this that if all such companies have the same expected earnings and the same
value, they must also have the same WACC, regardless of capital structure, because WACC is
simply the rate of return that links earnings with value (see the numerical illustration below).
Hence, for any individual company, WACC will be the same at all levels of gearing. In other
words, there is no optimal level of gearing and no minimum WACC — one capital structure is as
good as another.

MM offered a number of formal proofs of their theory. To gain a further understanding of the
theory, consider the assumptions on which it is based.

Although perfect capital market assumptions are unrealistic, most of them do not pose serious
problems for the theory. However, there are two assumptions which need to be highlighted
because they have a significant effect on the result.



Lecturer: Manek                               Page   57                              Page   57
Year 2010.
UOW/MBA/FM                                  ARTICLES                               Page   58
    1. It is assumed there is no taxation: this is a serious problem because one of the key
       advantages of debt is the tax relief on interest payments.

    2. Risk in Modigliani and Miller’s theory is measured entirely by variability of cash flows.
       They ignore the possibility that cash flows might cease because of bankruptcy. This is
       another significant problem for the theory if borrowing is high.

Making these assumptions means that from Figure 1 there is only one advantage of borrowing
(debt is cheaper because it is less risky to the investor) and one disadvantage (the cost of equity
increases with borrowing because of financial leverage).

Modigliani and Miller show that these effects cancel out exactly. The use of cheap debt gives
shareholders a higher rate of return, but this higher return is precisely what they need to
compensate for the increased risk from financial leverage (Figure 4). The graph of cost of capital
against gearing (as measured by debt/equity ratio) is shown in Figure 5.




Lecturer: Manek                              Page   58                             Page   58
Year 2010.
UOW/MBA/FM        ARTICLES    Page   59




Lecturer: Manek   Page   59   Page   59
Year 2010.

				
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