FINANCIAL MANAGEMENT TOPICS

8/3/2019 FINANCIAL MANAGEMENT TOPICS

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FINANCIAL MANAGEMENT

Nur Farahin bt Bujang

920123-10-5702

DPP0710/003

Diploma Pangajian Perniagaan

Mr. Johnson

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TABLE OF CONTENTS

1. INTRODUCTION TO FINANCIAL MANAGEMENT

1.1. Financial Management Functions..............................................................................1

1.2. Objective of A Company.............................................................................................3

1.3. Difference of Financial Management

Markets..........................................................4

1.4. Role of the Financial Intermediary............................................................................5

2. WORKING CAPITAL MANAGEMENT

2.1. Funding of Working Capital.......................................................................................7

2.2. Traditional Approach..................................................................................................7

2.3. Conservative Approach...............................................................................................8

2.4. Aggressive Approach...................................................................................................8

2.5. Working Capital Measures.........................................................................................9

2.6. Operating Cycle Formulea........................................................................................10

2.7. Managing Debtors......................................................................................................12

2.8. Managing Creditors...................................................................................................13

3. SOURCE OF FINANCE

3.1. Ordinary Shares.........................................................................................................17

3.2. Preference Share........................................................................................................17

3.3. Debentures..................................................................................................................18

3.4. Types of Debt..............................................................................................................19

3.5. Convenants.................................................................................................................19

3.6. Other Source of Finance............................................................................................20

4. EQUITY

4.1. Method of Raising Equity Finance...........................................................................21

4.2. Dividend Valuation Model With Constant Growth................................................22

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5. DIVIDEND POLICY

5.1. Dividend Irrelevance Theory (MM).........................................................................23

6. INTRODUCTION TO CAPITAL INVESTMENT APPRAISAL

6.1. Investment Appraisal................................................................................................24

6.2. Four Appraisal Methods...........................................................................................24

6.3. ARR Formulae...........................................................................................................24

6.4. IRR

Formulae.............................................................................................................24

6.5. Simple Interest Formulae..........................................................................................24

6.6. Compound Interest Formulae..................................................................................24

7. ADVANCE CAPITAL INVESTMENT APPRAISAL

7.1. Relevant Cash Flows..................................................................................................25

7.2. Real Rate and Money

Formulae.....................................................................................................................25

8. PORTFOLIO THEORY

8.1. PortfolioTheory.........................................................................................................................26

8.2. Factors in the Choice of an

Investment....................................................................26

9. THE CAPITAL ASSET PRICING MODEL

9.1. Measurement of Systematic Risk.............................................................................27

9.2. CAPM Formulae........................................................................................................27

9.3. Problems in CAPM in More

Details.........................................................................27

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TOPIC 1

FUNCTIONS OF FINANCIAL MANAGEMENT

Estimation of capital requirements:

A finance manager has to make estimation with regards to capital requirements of the

company. This will depend upon expected costs and profits and future programmes and

policies of a concern. Estimations have to be made in an adequate manner which increases

earning capacity of enterprise.

Determination of capital composition:

Once the estimation have been made, the capital structure have to be decided. This involves

short- term and long- term debt equity analysis. This will depend upon the proportion of

equity capital a company is possessing and additional funds which have to be raised from

outside parties.

Choice of sources of funds:

For additional funds to be procured, a company has many choices like-

• Issue of shares and debentures

• Loans to be taken from banks and financial institutions

• Public deposits to be drawn like in form of bonds

• Choice of factor will depend on relative merits and demerits of each source and period

of financing

Investment of funds:

The finance manager has to decide to allocate funds into profitable ventures so that there is

safety on investment and regular returns is possible.

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Disposal of surplus:

The net profits decision have to be made by the finance manager. This can be done in two

ways:

• Dividend declaration - It includes identifying the rate of dividends and other benefit

like bonus.

• Retained profits - The volume has to be decided which will depend upon expansional,

innovational, diversification plans of the company.

Management of cash:

Finance manager has to make decisions with regards to cash management. Cash is required

for many purposes like payment of wages and salaries, payment of electricity and water bills,

payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of

raw materials, etc.

Financial controls:

The finance manager has not only to plan, procure and utilize the funds but he also has to

exercise control over finances. This can be done through many techniques like ratio analysis,financial forecasting, cost and profit control, etc.

The management of all the processes associated with the efficient acquisition and deployment

of both short and long term financial resources.

There are 3 key decision:

• Investment

• Capital investment-investment in non current asset

• Financial investment-investment in shares,bonds,etc

• Working capital investment-investment in current asset

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OBJECTIVE OF A COMPANY

The financial management is generally concerned with procurement, allocation and control of

financial resources of a concern. The objectives can be-

• To ensure regular and adequate supply of funds to the concern.

• To ensure adequate returns to the shareholders which will depend upon the earning

capacity, market price of the share, expectations of the shareholders.

• To ensure optimum funds utilization. Once the funds are procured, they should be

utilized in maximum possible way at least cost.

• To ensure safety on investment, funds should be invested in safe ventures so that

adequate rate of return can be achieved.

• To plan a sound capital structure, there should be sound and fair composition of

capital so that a balance is maintained between debt and equity capital.

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DIFFERENCE OF FINANCIAL MANAGEMENT MARKETS

Primary and Secondary Markets:

Primary market Secondary market

The market in which the security or

financial instruments is created.

Role: To raise finance for the issuing

company.

The market in which financial instruments

that have already been issued are traded.

Role: To provide a market for existing

securities hence increasing their

marketability.

Money and capital market:

Money market Capital market

Market concerned with short term financial

instruments.

Markets concerned with long term financial

instruments. It is concerned with the trading

of equity or shares and debt in the form of

long term loans or debentures.

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ROLE OF THE FINANCIAL INTERMEDIARY

Roles of the financial intermediary:

Risk diversification:

This means reducing risk by spreading investment fund over a wide varietyof investment.

Aggregation:

For example banks take small amounts of deposits aggregate them and lend out large sums of

money

Maturity Transformation:

For example banks guarantee depositors their short term deposits while lending over long

term periods

Hedging:Banks help sell financial tool reduce risk such as foreign exchange and interest risk.

Making a market:

Financial institutions help create new market for new financial instruments

Advice:

Financial institutions help provide advice to the private and business sector

While some investors make their own investment decisions and invest directly in CIS

units, many others seek financial and investment advice from an investment professional or

financial intermediary.

Financial intermediaries may include banks, broker-dealers, investment advisers and

financial planners. Because of the important role these parties play in the process of

investment decision making by investors (e.g. by recommending CIS investments to

investors), regulatory authorities may regulate these financial intermediaries in a number of

ways. Regulation may encompass requirements that financial intermediaries meet certain

competency standards such as qualification and training criteria. These criteria may include a

specified level of education, financial or investment experience, professional examinations,

membership of professional or other organizations, and continuing education requirements.

Alternatively, a regulatory authority may not impose specific qualifications on a class

of financial intermediary, but rather may require that the qualifications of the person be

disclosed to potential clients.

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In addition, regulatory authorities may impose specific standards of conduct

requirements on financial intermediaries when providing services to investors. For instance, a

requirement that the financial intermediary make a determination that a particular CIS is a

"suitable" investment based on the investment objectives and financial circumstances of the

investor to whom the recommendation is made.

Some of the standards of conduct requirements imposed on financial intermediaries

may be expressly incorporated in rules or legislation or may arise from a general duty of care

owed to investors due to the fiduciary relationship that exists between the intermediary and

investor. These standards of conduct may be enforceable by a regulatory authority, by a self-

regulatory organization of which the financial intermediary is a member, or through private

litigation against the intermediary for breach of the standard of conduct requirement.

Where there is a "suitability requirement" imposed on a financial intermediary, the

regulatory regime may require that the financial intermediary obtain information from a client

sufficient to make a suitability determination before providing any investment advisory

services and as appropriate thereafter. Relevant information may include the investor's

investment objectives, risk tolerance, investment time horizon, and the relationship of the

proposed CIS investment to the investor's individual portfolio.

Again, the financial intermediary's obligations may vary depending on the

sophistication of the customer and the specific transaction. For example, financial

intermediaries selling CIS units to elderly, retired or firsttime investors may have heightened

obligations with respect to ensuring that a particular CIS product is appropriate for the

investor. On the other hand, the processes that need to be followed when dealing with

institutional clients that have a high degree of financial sophistication may be different.

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TOPIC 2

FUNDING OF WORKING CAPITAL

Short or Long Term

Short term sources of finance are generally cheaper than long term ones. Trade creditors do

not usually carry an interest cost. Short term finance also tends to be more flexible. There is a

danger that the short term funds may not be renewed or maybe renewed on less favourable

terms.

TRADITIONAL APPROACH

Traditionally current assets were seen as fluctuating, originally seasonal agricultural pattern.

Current asset would then be financed out of short term credit, which could be paid off when

not required whilst fixed asset would be financed by long term funds.

The Net Income theory and Net Operating Income theory stand in extreme forms.

Traditional approach stands in the midway between these two theories. This Traditional

theory was advocated by financial experts Ezta Solomon and Fred Weston. According to this

theory a proper and right combination of debt and equity will always lead to market value

enhancement of the firm. This approach accepts that the equity shareholders perceive

financial risk and expect premiums for the risks undertaken. This theory also states that after a

level of debt in the capital structure, the cost of equity capital increases.

Company finance is identified with raising of funds in meeting financial needs

and fulfilling the set objectives of a company. At the outset in the early

years corporate finance was confined to :

• arrangement of funds from financial institutions

• mobilising funds through financial institutions

• looking after the legal and accounting relationship betweena corporate unit and its

sources of funds.

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CONSERVATIVE APPROACH

This approach to the analysis is rather simplistic. In most business a proportion of the current

assets are fixed over time, thus being expressed as permanent. For example certain base level

of stock are always carried, cash balances never fall below are certain level and certain level

of ready credit always extended.

This approach suggests that the estimated requirements of total funds should be met from

long-term sources, the use of short-term funds should be restricted to only emergency

situations or when there is an unexpected outflow of funds.

AGGRESSIVE APPROACH

This where short term finance is used for all fluctuating current assets and most permanent

current asset too. This is likely to decrease interest cost and increase profitability but at the

expense of an increase in the amount of higher risk finance used by the company.

This approach uses more of short-term funds to finance even the permanent current assets.

The following chart gives a summary of the relative costs and benefits of the three different

approaches:

FactorsHedging

Approach

Conservative

Approach

Aggressive

Approach

Liquidity Moderate More Less

Profitability Moderate Less More

Risk Moderate Less More

The risk preferences of the management shall decide the approach to be adopted. The risk-

neutral will adopt the hedging approach, the risk averse the conservative approach and the risk

seekers will adopt the aggressive approach.

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WORKING CAPITAL MEASURES

Operating Cycle:

This is also known as the cash cycle or trading cycle. The operating cycle is the length of time

between the company’s outlay on raw materials, wages and other expenditures and the inflow

of cash from the sale of goods. In a manufacturing business this is the average time that raw

meterials remain in stock less the period of credit taken from suppliers plus the time taken for

producing the goods plus the time the goods remain in finished inventory plus the time taken

for customers to pay for the goods.

Liquidity Ratios:

• Current Ratio

This is a simple measure of how much of the total current assets are financed by

current liabilities. If, for the example measure is 2:1 this means that only a limited

amount of the assets are funded by the current liabilities.

• Quick Ratio

A measure of how well current liabilities are covered by liquid assets. A measure of

1:1 means that we are able to meet our existing liabilities if they all fall due at once.

These liquidity ratios are guide to the risk of cash flow problem and insolvency.

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OPERATING CYCLE FORMULAE

Operating Cycle = Stock Days + Debtor Days + Creditor Days

Calculation of Days:

Stock Days = Raw Material Days + Work-in-Progress Days + Finished Goods Days

Raw Material Days = Raw Material Stock x 365

Purchases*

Work-in-Progress Days = Work-in-Progress x 365

Production Cost*

Finished Goods Days = Finished Goods Stock x 365

Cost of Sales*

*or nearest approximation-depending on available data

Debtor Days = Debtor Balance x 365

Credit Sales

Creditor Days = Creditor Balance x 365

Credit Purchases

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MANAGING DEBTORS

Credit Control:

• ASSESSING CUSTOMER CREDIT RISK

To minimize the risk of bad debts occurring a company should investigate the credit

worthiness of all new customer( credit risk),and should review that of existing

customer from time to time, especially if they request that their credit limit should be

raised. Information about a customer credit rating can be obtained from a variety of

sources. These include:

Bank references

These tend to be fairly standardized in the UK and so are not perhaps as helpful as

they could be.

Trade References

Suppliers already giving credit to the customer can give useful information about how

good the customer is in paying in bills on time.

Published information

The customers own annual accounts and reports will give some idea of the general

financial position of the company and its liquidity

Credit Agencies

Agencies such as Dunn and Bradstreet publish general financial position of many

company, together with a credit rating. They will also produce a special report on a

company if requested.

Company’s Own Sale Record

For an existing customer, the sales ledgers will show prompt a payer the company is

although they cannot show how able the customer is to pay.

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• AGREEING TERMS

Once it has been decided to offer credit to a customer, the company needs to set limits

for both the amount of credit offered and the time taken to repay.

•

COLLECTING PAYMENTAn effective administration system for debtors must be established

Be strict with the credit limit

Send invoices promptly

Systematically review debtors

Chase slow payers

Factoring Work :

This is the outsourcing of the credit control department to a third party. The debts of the

company are effectively sold to a factor (normally owned by a bank). The factor takes on the

responsibility to collect the debt for a fee. The factor offers three services:

Debt Collection and Administration

The factor takes over the whole of the company sale ledgers issuing invoices and collecting

debts.Financing Provision

In addition to the above the factor will advance up to 80% of the value of a debt to the

company, the remainder (minus interest)being paid when the debts are collected. The factor

becomes a source of finance.

Credit Insurance

He factor may take responsibility for bad debt,for this to be the case the factor would dictate

to whom the company was able to offer credit to.This is called without recourse factoring.

Invoice Discounting:

A services also provide by a factoring company. Selected invoice are used as security against

which the company may borrow funds. This is a temporary source of finance repayable when

the debt is cleared. The key advantage of invoice discounting is that it is a confidential

services, the customer need to know about it.

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MANAGING CREDITORS

Creditor Balancing Action:

• Delaying payment to suppliers to obtain a free source of finance

•

Delaying too long may cause difficult for the company• Trade credit is the simplest and most important source of short term finance for many

companies. By delaying payment to creditors companies face possible problems.

• Supplier my refuse to supply in future

• Supplier may only supply on a cash basis

• Loss reputation

• Supplier may increase price in future

Discounts:

Trade Credit is normally seen as free source of finance. What is normally true it maybe that

the supplier may offers a discount early payment. In the case delaying payment is no longer

free, since the cost will be the lost discount.

MANAGING STOCK

Stock is major investment for many companies. In particular, manufacturing companies can

easily carrying stock equivalent to between 50% and 100% of the turnover of the business.

Stock Balancing Action:

Reducing stock to the lowest possible level hence minimizing capital employed to e funded

Ensuring the sufficient stock is held to ensure that stock outs do not arise

Material costs:

Material cost are a major part of a company costs and need to be carefully controlled.There

are 4 type of cost associated with stock

• Ordering cost

• Holding cost

• Stock out cost

• And the purchase cost

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Ordering cost:

The clerical administrative and accounting cost of placing an order.They are usually assumed

to e independent of the size of the order.

Holding cost:

• The opportunity cost of the investment stock

• Incremental storage cost

• Incremental material handling cost

• Incremental insurance costs

• Deterioration snd adolescence

•

Theft,vermin ,damage and evaporation

Stock out Cost:

• Loss contribution through loss of sale

• Loss future contribution through loss of customer

• The cost of emergency orders of material

• The cost of production stopapages

• In efficient organization it is assumed that stock out cost are not suffered. If we

initially assume that the purchase cost is a constant then we need only consider

holding an ordering costs.

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JUST-IN-TIME STOCK MANAGEMENT

An alternative view of stock management is the reduction or elimination of stock, since stock

is seen as waste. The supplier holds the stock until it is needed and delivers just in time for

production.

Implications of jit:

• Total reliance on the supplier for both quality and reliability.

• Long term contracts with supplier to make it worth their while building the factory,

developing the system to service their customer. Harsh penalty clauses for failure as

the cost to the customer of non-performance will be very high.

• Supplier factory ideally located very close to customer.

• Very close working relationship. Supplier workers will often spend time in the

customer factory and vice versa. In to his way the response to problem development

can be immediate.

• Factory design. To operate JIT then delivery trucks need ideally to gain access to each

point on the production line.

• Better factory design can also reduce the work in progress stock.

• Only produce for customer demand hence no finished good stock.

• Emphasis on quality(because of the elimination of the stock buffer).

• Operating JIT successfully can the open up further business oppurtunities.

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CASH MANAGEMENT

Cash balancing action:

• Minimizing the holding of cah an idle asset

• Being able to pay debts as they fall due

Need for cash:

• Transaction motive

This is to manage the daily activities of the firm such as the payment of wages,

expenses

• Precautionary motive

This is to keep money aside in case of any emergencies

• Speculative motive

This is to keep money to take advantage of any opportunities to male quick again

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TOPIC 3

ORDINARY SHARES (EQUITY FINANCE)

• Owning a share confers part ownership of the business

• Shareholder have full right to participate in the business through voting in general

meeting

• Shareholder are entitled payment of dividend out of profit

• Share capital is permanent financing which is not expected to e paid back

• Shareholders are entitled to repayment of capital in the event liquidation but only after

all other claims have been met.

• Ordinary shareholders bear the greatest risk.If there is no profit then dividend does not

have to be paid back.Conversely if the profit high then dividend can be paid.

• Shares are not tax efficient s dividend are post tax as an appropriation of profit

• Shares are marketable if listed .This means it can be traded on a stock exchange.

PREFERENCE SHARES (NON EQUITY)

• Pays affixed dividend ranking before(in preference to)ordinary shareholder

• Hybrid form of finance ranking between debt and equity

• For gearing purposes usually considered to be debt

• Ranks after debt holders but before ordinary shareholders for repayment in the event

liquidation

• No obligation for company to pay dividend

• Dividend are paid out post tax profit which means they are more expensive than debt

for the company.

• Not very popular is the worst of both words ie.

• It is not tax efficient

• It offers no opportunity for capital gain(fixed return)

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DEBENTURE

A debenture is a document that either creates a debt or acknowledges it. In corporate

finance, the term is used for a medium- to long-term debt instrument used by large companies

to borrow money. In some countries the term is used interchangeably with bond, loan stock or

note. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the

company is liable to pay a specified amount with interest and although the money raised by

the debentures becomes a part of the company's capital structure, it does not become share

capital .Debentures are generally freely transferable by the debenture holder. Debenture

holders have no rights to vote in the company's general meetings of shareholders, but they

may have separate meetings or votes e.g. on changes to the rights attached to the debentures.

The interest paid to them is a charge against profit in the company's financial statements.

TYPE OF DEBT

Bank finance:

For companies that are unlisted and for many companies the first port of call for borrowing

money would be the banks. These could be the high street banks or more likely to larger

companies the large number of merchant banks concentrating securitized lending The key

advantage of borrowing from bank is the confidential nature of the arrangement.

A term loan is a business loan with an original maturity of more than one year and a

specified schedule of principal and interest payment. It may not be secured. Term and

condition are negotiable dependent on term amount and the credit rating of the company

wishing to make the borrowing.

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Bonds:

As an alternative to borrowing funds from a bank the company, if listed on the stock exchange

may issue debt to investor over long term. Typical features include:

• The debt is denominated in units of 100 this is the value eventually redeemed on

maturity. It is often the value on issue (the cost to the investor)but the debt maybe

issued at a discount(for less)or even at a premium.

• Interest is paid(normally at a fixed rather than floating rate)on the nominal value of the

loan. For example a 9% bond will pay annual interest of 9.This interest is sometimes

known as the coupon.

• As with all debt it less risky for investor than ordinary shares

• Market rate of bonds will fluctuate depending on the prevailing interest rates

Interest Yield = Interest Paid per annum

Current Market Value of the Debt

COVENANTS

A further means of limiting the risk to the lender is to restrict the action of the directors

through the means of covenants. These are specific requirements or limitation laid down as a

condition of taking on debt financing .The may cause include:

Dividend restriction-limitation on the level of dividends a company is permitted to pay. This

is designed to prevent excessive dividend payment which may seriously weaken the

company’s future cash flows and thereby place the lender at greatest risk.

Financial ratios-specified level below which certain ratio may not fall. Financial reports-

regular accounts and financial reports to be provided to the lender to monitor progress.

Issue of further debt-the amount and type of debt can be issued may be restricted.

Subordinated loan stock (i.e.stock ranking below the existing unsecured loan stock)can

usually still be issued.

OTHER SOURCES OF FINANCE

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Sale and leaseback :

• Selling good quality fixed asset such as high street buildings and leasing them back

over many(25+)years

•

Funds are released without any loss of use of asset• Any potential capital gain on assets is forgone

• A popular means of funding for retail organization with substantial high street

property

Grants:

• Often related to technology job creation or regional policy

• Of particular important to small nd medium sized business (ie unlisted)

• Their key advantage is that they do not need to paid back.

• Remember to European dimension wit grants also available through the European

Union.

Retained earnings:

The single most important source of finance most business use retained earnings as the basis

of their financing needs

Leasing:

If the finance is required for the acquisition of a fixed asset, the company may find it preferable to lease the asset either through a finance lease (for the life of the asset), or an

operating lease (for short term/single use of the asset). The main benefits are:

• The company does not have to raise the finance for acquisition of the asset

• The lease rentals are tax deductible (see investment appraisal for more details)

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TOPIC 4

METHOD RAISNG EQUITY FINANCE

Equity finance are smack and medium sized enterprise (SMEs) and unquoted companies

include:

• Owner finance

• R etained earnings

• Friends and family

• Venture Capital

It is high risk investment

It involves a close working relationship between the venture capital company

and the company receiving the funds

Its neither a short term nor very long term investment.The venture capital

company will be hoping to realize the equity share it has acquired at a profit in

3-5 years either through floatation or by takeover

The venture capitalist will have an exit strategy in place before investing in

shares

Business Angels

These are rich individuals who provide their own money for fresh start up companies

Private Placing

The sale of large block of shares

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DIVIDEND VALUATION MODEL

The dividend valuation model states that the current share price is determined by the future

dividends, discounted at the shareholders required rate of return.

K = The Cost of Equityₑ

This is the rate of return that ordinary shareholders expect to receive on their investment.

Pₒ = The ex div market price of the share

The ex div market price means that new buyers will not receive a recently announced

dividend. The price (cum div) means with a dividend about to be paid.

Price (ex div) = Price (cum div) minus dividend

If the dividend is the same every year (constant), then :

P =ₒ d

K e

Where d = the constant dividend

Growth:

The dividend valuation model with constant growth

P =ₒ dˡ

(K -g)ₑ

K =ₑ dˡ +g

Pₒ

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TOPIC 5

DIVIDEND IRRELEVANCY THEORY (MM) AND THE UNREALISTIC ASSUMPTIONS

The dividend irrelevancy argument starts from the premise that the future earnings and thelevel of risk associated with that company will determine the value of the shares of a company

(shareholder wealth). The way in which the earnings of the company are applied between

dividend payments and retention is unimportant.

MM point out that shareholders can develop their own dividend/retention policies and need to

be dependent on the dividend/retention policy of the company.

If a shareholder wishes to receive their gains in the form of cash rather than through an

increase in share price, then they can create “home-made” dividends by selling a proportion of

the shares, which are held in the company.

If the shareholders received a cash dividend and would prefer the amount to be retained

within the company, they can re-invest the dividend received by acquiring more share in the

company.

Thus it would be illogical for shareholders to value shares in one company more highly than

another on the basis of the dividend policy, which it decides to adopt.

However like the MM theory on gearing their model is based on a number of unrealistic

assumptions.

Unrealistic assumptions:

• There are no taxes

• There are no transaction costs for example;

Investors face no brokerage costs when buying or selling shares

Companies can issue shares without incurring issue costs

• All investos have perfect information, as information is freely available.

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TOPIC 6

INVESTMENT APPRAISAL

The use of decision making techniques to consider the costs and benefits of an investment

over time. We are normally considering an investment in a fixed asset or a project that involve

fixed assets. This decision may be considered the most important made by an organization

because of the long-term impact it will have on profitability.

FOUR SPPRAISAL METHODS

• Payback period

•Accounting cash rate of return (ARR)

• Discounted cash flow-net present value (NPV)

• Discounted cash flow-internal rate of return (IRR)

ARR FORMULAE

ARR = Estimated Average Annual Profit x 100

Average Investment

IRR FORMULAE

IRR = A + NPV A x ( B – A )

NPV A – NPV B

SIMPLE INTEREST FORMULAE

Interest = Principal × Rate × Time

COMPOUND INTEREST FORMULAE

F = P ( 1 + r ) ⁿ

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TOPIC 7

RELEVANT CASH FLOWS

• The incremental after tax cash outflow (investment) for the project

• The resulting subsequent cash inflow associated with project

• Incremental Cash flow are the additional cash flow directly attributed to the proposed

project

• Can be expressed in host currency then result translated into home current

REAL RATE AND MONEY RATE FORMULAE

The "real interest rate" is the rate of interest an investor expects to receive after allowing for

inflation. It is approximately the nominal interest rate minus the inflation rate (this can be

found using the Fisher equation).

Broadly speaking, the formula for the real interest rate is:

Real Interest Rate = Nominal Interest Rate − Expected Inflation.

If, for example, an investor were able to lock in a 5% interest rate for the coming year andanticipated a 2% rise in prices, he would expect to earn a real interest rate of 3%. This is not a

single number, as different investors have different expectations of future inflation. Since the

inflation rate over the course of a loan is not known initially, volatility in inflation represents a

risk to both the lender and the borrower.

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TOPIC 9

PORTFOLIO THEORY

A portfolio:

Is a collection of investment that make up an investors total holding. A portfolio can consist

of any kind of investment, but for simplicity sake, it is usually assumed that it consists

entirely of quoted shares.

Portfolio theory:

Is concerned with how risk involved with investing in only one type of investment can be

reduced through diversification. The theory of risk reduction through diversification applies to

both private investor as well as for companies.Return:

Can be defined as the financial gain that can be obtained by making an investment.

Risk:

Is the possibility that actual returns will be different from expected returns. It is usually

measured as the variance of the outcomes, or the square-root of the variance.

FACTORS IN THE CHOICE OF AN INVESTMENT

Security:

Investments should provide investors with an assurance that at least,

Their capital value will be protected.

Liquidity:

This refers to how quickly an investment can be converted back to cash.

Return:

As defined ealier, the return is the financial gain an investor can obtain by making a financial

investment.

Risk :

This refers to the possibility that investor’s actual returns will be different from expected

returns.

Brokerage Fees:

These are the fees involved when buying and selling securities

Tax:

How will the income from the securitiesbe taxed?

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MEASUREMENT OF SYSTEMATIC RISK Systematic risk reflects market-wide factors such as the country’s rate of economic growth,

corporate tax rates, interest rates etc. since this market-wide factors generally cause returns tomove in the same direction they cannot cancel out. Therefore, systematic risk remains present

in all portfolios. Some investment will be more sensitive to market factors than others and

will therefore have a higher systematic risk.

CAPM FORMULAE

PROBLEMS IN CAPM

Investor hold well-diversified portfolio. When it comes to putting a risk label on securities,

investors often turn to the capital asset pricing model (CAPM) to make that risk judgment.

The goal of CAPM is to determine a required rate of return to justify adding an asset to an

already well-diversified portfolio, considering that asset's non-diversifiable risk.

http://www.investopedia.com/terms/c/capm.asp

http://www.investopedia.com/terms/c/capm.asp

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