Lecture 1: Introduction to Corporate Finance
Unit 2 The Financial Environment
UNIT 2
THE FINANCIAL ENVIORNMENT
FINANCIAL MARKETSA financial market is any mechanism for trading
financial assets or claims. There is no physical market-place,
transactions being conducted via telephone or computer. Its main
financial markets are as follows:(1) The money market channel
wholesale funds, usually less than one year, from lenders to
borrowers. The market is largely dominated by the major banks and
other financial institutions. Referring to short-term lending and
borrowing purposes
(2) The securities or capital market deals with long-dated
securities such as shares and loan stock
(3) The foreign exchange market is a market for buying and
selling one currency against another. Deals are either on a spot
basis (for immediate delivery) or on a forward basis (for future
delivery).The financial markets provide mechanisms through which
the corporate financial manager has access to a wide range of
source of finance and instruments.
Capital markets have two important functions:1Primary Market-
providing new capital for business and other activities. Example
share issuing, or loans.2Secondary Market
trading existing securities
Financial markets promote savings and investment by providing
mechanisms whereby the financial requirements of lenders (suppliers
of funds) and borrowers (users of funds) can be met. Financial
intermediaries (financial institutions) collecting funds from
savers to lend to their corporate and other customers through money
and capital markets, or directly through loans, leasing and other
forms of financing.
The role of financial intermediaries: Re-packaging Finance.
Gathering small amounts of savings from a large number of
individuals and turn them into larger bundles for lending to
businesses.
Risk Reduction. Placing small sums from numerous individuals in
large, well-diversified investment portfolios.
Liquidity Transformation. Bringing together short-term savers
and long-term borrowers.
Cost Reduction. Minimizing transaction costs by providing
convenient and relatively inexpensive services for linking small
savers to larger borrowers.
Are financial markets efficient?
In an efficient stock market, current market prices fully
reflect available information and it is impossible to outperform
the market consistently, except by luck
The measure of efficiency is seen in the extent and speed with
which the market reflects new information in the share
price.Efficient Market Hypothesis (EMH)
Information can be classifies as historical, current or
forecast. Only current or historical information is certain in its
effect on price
Different amounts of financial information are available to
different groups of people
There is unequal access to the information, which may affect a
companys share price
If you are one of the well-informed, this gives you the
opportunity to keep one step ahead of the market Three levels of
market efficiency, EMH:123
The Weak Form of the EMH states that current share price fully
reflect ALL information contained in past price movements. If this
level of efficiency holds, there is no value in trying to predict
future price movement by analyzing trends in past price movements.
Efficient stock market prices will fluctuate more or less randomly,
any departure from randomness being too expensive to determine.
Share price are said to follow a random walkThe semi-strong form of
the EMH states that current market prices reflect not only all past
price movements, but ALL publicly available information. In other
words, there is no benefit in analyzing existing information, such
as that given in published accounts, dividend and profits
announcement, appointment of a new chief executive or product
breakthrough, after the information has been released. The stock
market has already captured this information in the current share
priceThe strong form of the EMH state that current market prices
reflect all relevant information even if privately held. The market
price reflects the true or intrinsic value of the share based on
the underlying future cash flows. The implications of such a level
of market efficiency are clear: no one can consistently beat the
market and earn abnormal returns. Few would go so far as to argue
that stock markets are efficient at this level
You will have noticed that as the EMH strengthens, the
opportunities for profitable speculation reduce. Competition
between well-informed investors drives share prices to reflect
their intrinsic values.
Using the published information
Financial managers and investors need to study the performance
of the shares of their company, both against the appropriate sector
as a whole and also against competitors within the sector. Two
performance statistics that are most commonly reported are the
dividend yield and price:earning ratio.
Dividend yieldPrice:earning (P:E) ratio
This is the gross, or pre-tax, dividends of the companies in the
sector in the last year as a percentage of the total value of the
sector.The P:E ratio is a much-used performance indicator. It is
the share price divided by the current earnings per share.
Taxation and Financial Decisions
Few financial decisions are immune from taxation considerations.
Corporate and personal taxation affects both the cash flows
received by companies and the dividends income received by
shareholders. Consequently, financial managers need to understand
the tax consequences of investment and financing decisions.
Taxation may be important in two key areas of financial
management:(1) Raising Finance. There are clear tax benefits in
raising finance by issuing debt rather than capital. Interest on
borrowings attracts tax relief, thereby reducing the companys tax
bill, while a dividend payment on equity capital does not attract
tax relief. The tax system is thereby biased in favour of debt
finance.(2) Investment in Fixed Assets. Spending on certain types
of fixed asset attracts a form of tax relief termed capital
allowances. This is intended to stimulate certain types of
investment, such as in industrial plant and machinery. The taxation
implications of an investment decision can be very important.
A Financial Health Check using RatiosAccountants and bank
managers have formulated dozens of financial ratios to help
diagnose the financial health of the business, its position,
performance and prospects. (1) Profitability Ratios(a)Profit
margin
(i)
(ii)Gross profit margin
Net profit margin
[b]Return on Capital employed
(2) Activity Ratios(a)
(b)
(c)
(d)Asset turnover
Debtor days
Stockholding period
Supplier credit days
(3) Liquidity and Financing Ratios(a)
(b)
(c)
(d)Current ratio
Quick ratio
Gearing ratio
Interest cover
(4) Investors Ratios(a)
(b)
(c)
(d)(e)
(f)Return on shareholders funds
Dividend per share
Earning per share (EPS)
Dividend cover
Price: Earnings ratio (P:E)
Dividend yield
WORKING CAPITAL MANAGEMENTWhat is Working Capital? The firms
total investment in current assets or assets which it expects to be
converted into cash within a year or less
Net Working Capital = Current Assets Current Liabilities
Frequently when the term working capital is used it is actually
intended to net working capital.
Business needs adequate resources to maintain day-to-day cash
flow (short-term management).
Sufficient liquidity must be maintained in order to ensure the
survival of the business in the long-term as well.
In other words, working capital management is to ensure that
sufficient liquid resources are maintained.
What is Sufficient? Not too much of money but just nice to meet
payment, not too little of money but some of them are used to do
other investment (to earn more money)
A balance between the requirement to minimise the risk of
insolvency (able to pay) and to maximise the return on assets
(fully utilise the available funds)
Working Capital Management The administration of the firms
current assets and the financing needed to support current assets
In short, to maintain the optimum level for current assets and
current liabilities.
The ideal current ratio is generally accepted to be 2:1 (that
is, out of all of the current assets, half is financed by current
liabilities and the other half from long-term liabilities)
The ideal quick ratio is 1:1, these liquidity ratios are a guide
to the risk of cash flow problems and insolvency
However, these ratios also vary according to the nature of the
companys business. For example, does service company have lots of
inventory? What about manufacturing company?
Two situations that should not happen:
(1) Overcapitalisation
Lots of current assets but little bills, excessive working
capital
Too much current assets funds are held to carry current assets,
should have invested elsewhere to get better return
Long-term funds are unnecessarily the tied up
This could be shown through:
Sales/working capital
Liquidity ratios
Turnover period for stock and debtors, too often.
(2) Overtrading
Contrast with overcapitalisation
Where a business tries to do too much too quickly with little
long-term capital
Dangerous will have liquidity problem, does not have enough
capital to provide cash to pay its debts as they fall due
Solutions to reduce the degree of over-trading:
New capital could be injected
Control over stock and debtors
Abandon plans like increase sales and fixed assets purchases,
until build up its capital base with retained profits
Symptoms of over-trading are as follow:
A rapid increase in turnover
A rapid increase in current assets and fixed assets
A small increase in proprietors capital, but increase in trade
creditors, bank overdraft
Decrease in current ratio and quick ratio, increase
debt-to-total-assets ratio. Meaning and consequences of
overtrading: Overtrading is the condition of a business which
enters into commitments in excess of its available short-term
resources. This can arise due to the time lag (between paying for
materials or labour and receiving money from debtors) even if the
company is trading profitably if is has a long cash operating
cycle. The consequences of overtrading will be an increase in the
level of the bank overdraft. When this begins to get dangerously
high then other step tends to be taken to reduce or defer cash
outlays such as delaying payment to creditors and putting off
necessary maintenance or advertising or new expenditure. Ultimately
stocks and production will be reduced so that customer demand
cannot be satisfied.
Cash Conversion Cycle (CCC) Also know as Working Capital Style,
Operating Cash Cycle or Trading Cycle CCC = Stock Turnover in days
+ Debtors collection period Creditors payment period If the
turnover period for stocks and debtors lengthen, or the payment
period to creditors shorten: The operating cycle will lengthen
The investment in working capital will increaseTUTORIALUNIT
2
QUESTION 1
(a) The following information relates to Pearl Bhd.Year ended 30
June
2003(RM000)2004(RM000)
SalesCost of Sales
Purchases
Debtors
Creditors
Raw Material Stocks
Work in Progress
Finished Goods Stocks300240
160
38
24
40
22
48350288
194
43
35
75
39
53
Required:Calculate the projected change in working capital cycle
between 2003 and 2004 positions.
(b) You are the company secretary of Paper Malaysia Bhd a large
manufacturing company. The financial director has recently resigned
following the disclosure of same financial irregularities and you
are temporarily helping to sort out the company finances.
Your examination of the financial position reveals that some 30%
of the total net assets of RM10 million comprise debtors. You
consider from cash flow projections that the company is likely to
be short of funds in the next three months. You also consider that
the management of debtors has been neglected such that too much
cash is locked up in the debtors accounts.
The managing director has asked you to prepare a brief report
for the next Board meeting. The current return on capital is
12%.
QUESTION 2
XY Sdn Bhd
Profit and Loss Account for the year ended 31 December
2002RMRM
Sales
less: Cost of Sales452,000
Opening Inventory125,000
add: Purchases341,000
466,000
less: Closing Inventoy143,000
323,000
Gross Profit129,000
Net Loss3,000
Balance Sheet as at 31 December 2002
RMRM
Current Assets
Debtors163,000
Inventory143.000
306,000
Non-Current Assets (Net Book Value)
Motor Vehicle52,000
Fixture25,000
Freehold premises at valuation280,000
257,000
Total Assets663,000
Capital and Reserves
Ordinary Share Capital100,000
Retained Profits158,000
258,000
Non-Current Liabilities
Loans120,000
Current Liabilities
Trade Creditors145,000
Bank Overdraft140,000
285,000
Bank Overdraft663,000
Required:(a) Calculate the current ratio and quick ratio an
explain why the management of this company should be concerned
about its liquidity position
(b) Explain the term Operating Cash Cycle
(c) Calculate the Operating Cash Cycle for this company (assume
a 360 days year).
QUESTION 3
The following are extracts of Balance Sheet and Income Statement
of Big Shop Sdn Bhd:
2002
RM2003
RM
Current Assets:
Stocks
Debtors
Balance at Bank 1,200
1,000
1,800 1,400
600
1,000
Current Liabilities 3,400 2,300
Owners Equity 4,500 3,500
Sales
Cost of Goods Sold
Net Profit14,000
8,0004,20010,000
6,000
2,800
(a) Calculate the following ratios for each year (assuming a 365
day year):(i) Current ratio
(ii) Quick ratio
(iii) Gross profit margin
(iv) Net profit margin
(v) Debtors collection period (in days)
(15 marks)(b) Using the above calculated ratios, comment on the
profitability and liquidity of Big Shop Sdn Bhd.(5 marks)TOTAL 20
MARKS
QUESTION 4
The following details have been extracted from the accounts of
EmEnO Sdn Bhd for the last three years.2002 (RM000)2002 (RM000)
2004(RM000)
Turnover (Sales)Gross Profit
Net Profit
Fixed Assets
Stock
Debtors
Creditors
Cash at Bank
Bank Overdraft100
3315
64
4
8
5
5
-10334
15
72
4
11
6
-
6108 35.6
15
68
4
15
6
-
5
Required:(a) Calculate, for each of the three years:(i) Gross
profit percentage
(ii) Net profit percentage
(iii) Quick ratio
(6 marks)
(b) Comment briefly on the ratios given and those that you have
calculated in (a) above.
(14 marks)
TOTAL 20 MARKS
QUESTION 5
Deron Sdn Bhd makes a range of products, all of which follow a
similar production process and have the same cost structure. The
products are made in batches that are started at the beginning of
the month and are completed and taken into finished goods stock at
the end of the month. There is no work-in-progress at the end of
any month.Currently sales are RM0.3 million a month and produce a
contribution of 40 sen per RM1 of sales. Variable raw material
costs account for 20 sen per RM1 of sales. Fixed costs are
RM120,000 per month of which RM30,000 is depreciation. The companys
only variable costs are production costs.Currently trade debtors
take one month to pay, trade creditors for raw materials are paid
one month after purchase and the other variable costs are paid
during the month of production. At the end of each month the
company has sufficient raw material stock to meet the following
months production and enough finished goods stock to meet the
following months sales.The company has decided to expand its
production and sales volumes by 50%. To generate the increased
demand, the selling price will be reduced by 10% and trade debtors
will be allowed to pay two months after the sale. Since neither the
usage, nor the cost per product of raw materials and other variable
costs will be affected by the proposed expansion, the contribution
per RM1 of sales will fall to 30 sen. The changes to sales volume,
price and payment period will commence with sales made from 1st
December 2004.
The companys balance at bank at 1st October 2004 is expected to
be RM70,000.
Required:Prepare the companys cash budgets for each of the
months of October 2004, November 2004, December 2004. January 2005
and February 2005.
[Note: To have the necessary finished stock in place fore 1st
December, it will be necessary to increase production during
November, and to have the required raw material stock in place for
1st November it will be necessary to increase purchases during
October.
TOTAL 25 MARKS
PAGE 1Business Finance/4ACC0812/Chandran/1006
