Discuss whether financial management theory suggests that Droxfol Co can reduce its weighted average cost of capital to a minimum level.

Droxfol Co has long-term finance provided by ordinary shares, preference shares and loan notes. The rate of return required by each source of finance depends on its risk from an investor point of view, with equity (ordinary shares) being seen as the most risky and debt (in this case loan notes) seen as the least risky. Ignoring taxation, the weighted average cost of capital (WACC) would therefore be expected to decrease as equity is replaced by debt, since debt is cheaper than equity, i.e. the cost of debt is less than the cost of equity. In the traditional view of capital structure, ordinary shareholders are relatively indifferent to the addition of small amounts of debt in terms of increasing financial risk and so the WACC falls as a company gears up. As gearing up continues, the cost of equity increases to include a financial risk premium and the WACC reaches a minimum value. Beyond this minimum point, the WACC increases due to the effect of increasing financial risk on the cost of equity and, at higher levels of gearing, due to the effect of increasing bankruptcy risk on both the cost of equity and the cost of debt. On this traditional view, therefore, Droxfol Co can gear up using debt and reduce its WACC to a minimum, at which point its market value (the present value of future corporate cash flows) will be maximised. In contrast to the traditional view, continuing to ignore taxation but assuming a perfect capital market, Miller and Modigliani demonstrated that the WACC remained constant as a company geared up, with the increase in the cost of equity due to financial risk exactly balancing the decrease in the WACC caused by the lower before-tax cost of debt. Since in a prefect capital market the possibility of bankruptcy risk does not arise, the WACC is constant at all gearing levels and the market value of the company is also constant. Miller and Modigliani showed, therefore, that the market value of a company depends on its business risk alone, and not on its financial risk. On this view, therefore, Droxfol Co cannot reduce its WACC to a minimum. When corporate tax was admitted into the analysis of Miller and Modigliani, a different picture emerged. The interest payments on debt reduced tax liability, which meant that the WACC fell as gearing increased, due to the tax shield given to profits. On this view, Droxfol Co could reduce its WACC to a minimum by taking on as much debt as possible. However, a perfect capital market is not available in the real world and at high levels of gearing the tax shield offered by interest payments is more than offset by the effects of bankruptcy risk and other costs associated with the need to service large amounts of debt. Droxfol Co should therefore be able to reduce its WACC by gearing up, although it may be difficult to determine whether it has reached a capital structure giving a minimum WACC.

Discuss the differences between transaction risk, translation risk and economic risk.

Transaction risk This is the risk arising on short-term foreign currency transactions that the actual income or cost may be different from the income or cost expected when the transaction was agreed. For example, a sale worth $10,000 when the exchange rate is $1.79 per £ has an expected sterling value is $5,587. If the dollar has depreciated against sterling to $1.84 per £ when the transaction is settled, the sterling receipt will have fallen to $5,435. Transaction risk therefore affects cash flows and for this reason most companies choose to hedge or protect themselves against transaction risk. Translation risk This risk arises on consolidation of financial statements prior to reporting financial results and for this reason is also known as accounting exposure. Consider an asset worth €14 million, acquired when the exchange rate was €1.4 per $. One year later, when financial statements are being prepared, the exchange rate has moved to €1.5 per $ and the balance sheet value of the asset has changed from $10 million to $9.3 million, resulting an unrealised (paper) loss of $0.7 million. Translation risk does not involve cash flows and so does not directly affect shareholder wealth. However, investor perception may be affected by the changing values of assets and liabilities, and so a company may choose to hedge translation risk through, for example, matching the currency of assets and liabilities (eg a euro-denominated asset financed by a euro-denominated loan). Economic risk Transaction risk is seen as the short-term manifestation of economic risk, which could be defined as the risk of the present value of a company’s expected future cash flows being affected by exchange rate movements over time. It is difficult to measure economic risk, although its effects can be described, and it is also difficult to hedge against it.

Explain how inflation rates can be used to forecast exchange rates.

Discuss whether the dividend growth model or the Capital asset pricing model should be used to calculate the cost of equity

The dividend growth model calculates the apparent cost of equity in the capital market, provided that the current market price of the share, the current dividend and the future dividend growth rate are known. While the current market price and the current dividend are readily available, it is very difficult to find an accurate value for the future dividend growth rate. A common approach to finding the future dividend growth rate is to calculate the average historic

dividend growth rate and then to assume that the future dividend growth rate will be similar. There is no reason why this assumption should be true.The capital asset pricing model tends to be preferred to the dividend growth model as a way of calculating the cost of equity as it has a sound theoretical basis, relating the cost of equity or required return of well-diversified shareholders to the systematic risk they face through owning the shares of a company. However, finding suitable values for the variables used by the capital asset pricing model (risk-free rate of return, equity beta and equity risk premium) can be difficult.

Discuss the attractions of leasing as a source of both short-term and long-term finance

Operating leasing can act as a source of short-term finance, while finance leasing can act as a source of long-term finance.

Operating leasing offers a solution to the obsolescence problem, whereby rapidly aging assets can decrease competitive advantage. Where keeping up-to-date with the latest technology is essential for business operations, operating leasing provides equipment on short-term contracts which can usually be cancelled without penalty to the lessee. Operating leasing can also provide access to skilled maintenance, which might otherwise need to be bought in by the lessee, although there will be a charge for this service.

Both operating leasing and finance leasing provide access to non-current assets in cases where borrowing may be difficult or even not possible for a company. For example, the company may lack assets to offer as security, or it may be seen as too risky to lend to. Since ownership of the leased asset remains with the lessor, it can be retrieved if lease rental payments are not forthcoming.

In Islamic finance, explain briefly the concept of riba(interest) and how returns are made by Islamic financial instruments

Interest (riba) is the predetermined amount received by a provider of finance, over and above the principal amount of finance provided. Riba is absolutely forbidden in Islamic finance. Riba can be seen as unfair from the perspective of the borrower, the lender and the economy. For the borrower, riba can turn a profit into a loss when profitability is low. For the lender, riba can provide an inadequate return when unanticipated inflation arises. In the economy, riba can lead to allocational inefficiency, directing economic resources to sub-optimal investments.Islamic financial instruments require that an active role be played by the provider of funds, so that the risks and rewards of ownership are shared. In a Mudaraba contract, for example, profits are shared between the partners in the proportions agreed in the contract, while losses are borne by the provider of finance. In a Musharaka contract, profits are shared between the partners in the proportions agreed in the contract, while losses are shared between the partners according to their capital contributions. With Sukuk, certificates are issued which are linked to an underlying tangible asset and which also transfer the risk and

rewards of ownership. The underlying asset is managed on behalf of the Sukuk holders.In a Murabaha contract, payment by the buyer is made on a deferred or instalment basis. Returns are made by the supplier as a mark-up is paid by the buyer in exchange for the right to pay after the delivery date. In an Ijara contract, which is equivalent to a lease agreement, returns are made through the payment of fixed or variable lease rental payments.

Explain the reasons why interest rates may differ between loans of different maturity.

Liquidity preference theoryThis theory suggests that investors prefer to have cash now and so require compensation for lending money. The longer the period for which money is lent, the higher will be the interest rate to compensate the lender for deferring their use of the loaned cash. The higher interest rate for long-term debt over short-term debt will also compensate lenders for increasing risk over time, for example, the increasing risk of default with increasing maturity. Liquidity preference theory can therefore explain why the yield curve is normally upward sloping.Expectations theoryThis theory suggests that the relationship between short-term and long-term interest rates can be explained by expectations regarding interest rate movements. Where future interest rates are expected to rise compared to short-term interest rates, the yield curve will slope upwards. Where future interest rates are expected to fall compared to short-term interest rates, the yield curve will slope downwards.Market segmentation theoryThe reason why interest rates may differ between loans of different maturity could be because the balance between supply and demand differs between markets for loans of different maturity. If demand for long-term loans is greater than the supply, for example, because of a high public sector borrowing requirement, interest rates in the long-term loan market will increase to restore equilibrium between demand and supply. Differing interest rates between markets for loans of different maturity can also explain why the yield curve may not be smooth, but kinked.Fiscal policyGovernments may use fiscal policy to support the achievement of economic objectives. For example, the government or central bank may act to increase short-term interest rates in order to reduce inflation. This can result in short-term interest rates being higher than long-term interest rates, an effect which can be compounded if there is a decrease in the anticipated inflation reflected in long-term interest rates.

Discuss how the capital asset pricing model can be used to calculate a project-specific cost of capital for AMH co, referring in your discussion to the key concepts of systematic risk, business risk and financial risk.

The capital asset pricing model (CAPM) assumes that investors hold diversified portfolios, so that unsystematic risk has been diversified away. Companies using the CAPM to calculate a project-specific discount rate are therefore concerned only with determining the minimum return that must be generated by an investment project as compensation for its systematic risk.The CAPM is useful where the business risk of an investment project is different from the business risk of the investing company’s existing business operations. In such a situation, one or more proxy companies are identified that have similar business risk to the investment project. The equity beta of the proxy company represents the systematic risk of the proxy company, and reflects both the business risk of the proxy company’s business operations and the financial risk arising from the proxy company’s capital structure.Since the investing company is only interested in the business risk of the proxy company, the proxy company’s equity beta is ‘ungeared’ to remove the effect of its capital structure. ‘Ungearing’ converts the proxy company’s equity beta into an asset beta, which represents business risk alone. The asset betas of several proxy companies can be averaged in order to remove any small differences in business operations.The asset beta can then be ‘regeared’, giving an equity beta whose systematic risk takes account of the financial risk of the investing company as well as the business risk of an investment project. Both ungearing and regearing use the weighted average beta formula, which equates the asset beta with the weighted average of the equity beta and the debt beta.The project-specific equity beta resulting from the regearing process can then be used to calculate a project-specific cost of equity using the CAPM. This can be used as the discount rate when evaluating the investment project with a discounted cash (DCF) flow investment appraisal method such as net present value or internal rate of return. Alternatively, the project-specific cost of equity can be used in calculating a project-specific weighted average cost of capital, which can also be used in a DCF evaluation.

Explain why the cost of equity is greater than the cost of debt.

The cost of equity is the return required by ordinary shareholders (equity investors), in order to compensate them for the risk associated with their equity investment, i.e. their investment in the ordinary shares of a company. If the risk of an investment increases, the return expected by the investor also increases. If the risk of a company increases, therefore, its cost of equity also increases.If a company is liquidated, the order in which the claims of creditors are settled is a factor in determining their relative risk. The claims of providers of debt finance (debt holders) must be paid off before any cash can be distributed to ordinary shareholders (the owners). The risk faced by shareholders is therefore greater than the risk faced by debt holders, and the cost of equity is therefore greater than the cost of debt.Interest on debt finance must be paid before dividends can be paid to ordinary shareholders, so the risk faced by ordinary shareholders is greater than the risk faced by debt holders, since the necessity of paying interest may mean that dividends have to be reduced.

Discuss the key elements of a trade receivables management policy.

Credit analysisCredit analysis helps a company to minimise the possibility of bad debts by offering credit only to customers who are likely to pay the money they owe. Credit analysis also helps a company to minimise the likelihood of customers paying late, causing the company to incur additional costs on the money owed, by indicating which customers are likely to settle their accounts as they fall due.Credit analysis, or the assessment of creditworthiness, is undertaken by analysing and evaluating information relating to a customer’s financial history. This information may be provided by trade references, bank references, the annual accounts of a company or credit reports provided by a credit reference agency. The depth of the credit analysis will depend on the potential value of sales to the client, in terms of both order size and expected future trading. As a result of credit analysis, a company will decide on whether to extend credit to a customer.Credit controlHaving granted credit to customers, a company needs to ensure that the agreed terms are being followed. The trade receivables management policy will stipulate the content of the initial sales invoice that is raised. It will also advise on the frequency with which statements are sent to remind customers of outstanding amounts and when they are due to be paid. It will be useful to prepare an aged receivables analysis at regular intervals (e.g. monthly), in order to focus management attention on areas where action needs to be taken to encourage payment by clients.Receivables collectionIdeally, all customers will settle their outstanding accounts as and when they fall due. Any payments not received electronically should be banked quickly in order to decrease costs and increase profitability. If accounts become overdue, steps should be taken to recover the outstanding amount by sending reminders, making customer visits and so on. Legal action could be taken if necessary, although only as a last resort.

Discuss why market value weighted average cost of capital is preferred to book value weighted average cost of capital when making investment decisions

Market values of different sources of finance are preferred to their book values when calculating weighted average cost of capital (WACC) because market values reflect the current conditions in the capital market. The relative proportions of the different sources of finance in the capital structure reflect more appropriately their relative importance to a company if market values are used as weights. For example, the market value of equity is usually much greater than its book value, so using book values for weights would seriously underestimate the relative importance of the cost of equity in the weighted average cost of capital.If book values are used as weights, the WACC will be lower than if market values were used, due to the understatement of the contribution of the cost of equity, which is higher than the cost of capital of other sources of finance. This can be

seen in the case of BKB Co, where the market value after-tax WACC was found to be 9·4% and the book value after-tax WACC is 8·7% (10% x 40 + 8% x 10 + 6·43% x 20/70).If book value WACC were used as the discount rate in investment appraisal, investment projects would be accepted that would be rejected if market value WACC were used. Using book value WACC as the discount rate will therefore lead to sub-optimal investment decisions.As far as the cost of debt is concerned, using book values rather than market values for weights may make little difference to the WACC, since bonds often trade on the capital market at or close to their nominal (par) value. In addition, the cost of debt is lower than the cost of equity and will therefore make a smaller contribution to the WACC. It is still possible, however, that using book values as weights may under- or over-estimate the contribution of the cost of debt to the WACC.

Identify and discuss the factors to be considered in determining the optimum level of cash to be held by a company

The following factors should be considered in determining the optimum level of cash to be held by a company, for example, at the start of a month or other accounting control period.The transactions need for cashThe amount of cash needed for the next period can be forecast using a cash budget, which will net off expected receipts against expected payments. This will determine the transactions need for cash, which is one of the three reasons for holding cash.The precautionary need for cashAlthough a cash budget will provide an estimate of the transactions need for cash, it will be based on assumptions about the future and will therefore be subject to uncertainty. The actual need for cash may be greater than the forecast need for cash. In order to provide for any unexpected need for cash, a company can include some spare cash (a cash buffer) in its cash balance. This is the precautionary need for cash. In determining the optimal level of cash to be held, a company will estimate the size of this cash buffer, for example from past experience, because it will be keen to minimise the opportunity cost of maintaining funds in cash form.The speculative need for cashThere is always the possibility of an unexpected opportunity occurring in the business world and a company may wish to be prepared to take advantage of such a business opportunity if it arises. It may therefore wish to have some cash available for this purpose. This is the speculative need for cash. Building ‘a war chest’ for possible company acquisitions reflects this reason for holding cash.The availability of financeA company may choose to hold higher levels of cash if it has difficulty gaining access to cash when it needs it. For example, if a company’s bank makes it difficult to access overdraft finance, or if a company is refused an overdraft facility, its precautionary need for cash will increase and its optimum cash level will therefore also increase.

Critically discuss the similarities and differences between working capital policies in the following areas: (1) Working capital investment (2) Working capital financing

Working capital investment policy is concerned with the level of investment in current assets, with one company being compared with another. Working capital financing policy is concerned with the relative proportions of short-term and long-term finance used by a company. While working capital investment policy is therefore assessed on an inter-company comparative basis, assessment of working capital financing policy involves analysis of financial information for one company alone. Working capital financing policy uses an analysis of current assets into permanent current assets and fluctuating current assets. Working capital investment policy does not require this analysis. Permanent current assets represent the core level of investment in current assets that supports a given level of business activity. Fluctuating current assets represent the changes in the level of current assets that arise through, for example, the unpredictability of business operations, such as the level of trade receivables increasing due to some customers paying late or the level of inventory increasing due to demand being less than predicted. Working capital financing policy relies on the matching principle, which is not used by working capital investment policy. The matching principle holds that long-term assets should be financed from a long-term source of finance. Non-current assets and permanent current assets should therefore be financed from a long-term source, such as equity finance or bond finance, while fluctuating current assets should be financed from a short-term source, such as an overdraft or a short-term bank loan. Both working capital investment policy and working capital financing policy use the terms conservative, moderate and aggressive. In investment policy, the terms are used to indicate the comparative level of investment in current assets on an inter-company basis. One company has a more aggressive approach compared to another company if it has a lower level of investment in current assets, and vice versa for a conservative approach to working capital investment policy. In working capital financing policy, the terms are used to indicate the way in which fluctuating current assets and permanent current assets are matched to short-term and long-term finance sources. An aggressive financing policy means that fluctuating current assets and a portion of permanent current assets are financed from a short-term finance source. A conservative financing policy means that permanent current assets and a portion of fluctuating current assets are financed from a long-term source. An aggressive financing policy will be more profitable than a conservative financing policy because short-term finance is cheaper than long-term finance, as indicated for debt finance by the normal yield curve (term structure of interest rates). However, an aggressive financing policy will be riskier than a conservative financing policy because short-term finance is riskier than long-term finance. For example, an overdraft is repayable on demand, while a short-term loan may be renewed on less favourable terms than an existing loan. Provided

interest payments are made, however, long-term debt will not lead to any pressure on a company and equity finance is permanent capital. Overall, therefore, it can be said that while working capital investment policy and working capital financing policy use similar terminology, the two policies are very different in terms of their meaning and application. It is even possible, for example, for a company to have a conservative working capital investment policy while following an aggressive working capital financing policy.

Explain the following risks and explain how each of these risks can be managed.

Nature and assessment of business risk Business risk arises due to the nature of a company’s business operations, which determines the business sector into which it is classified, and to the way in which a company conducts its business operations. Business risk is the variability in shareholder returns that arises as a result of business operations. It can therefore be related to the way in which profit before interest and tax (PBIT or operating profit) changes as revenue or turnover changes. This can be assessed from a shareholder perspective by calculating operational gearing, which essentially looks at the relative proportions of fixed operating costs to variable operating costs. One measure of operational gearing that can be used is (100 x contribution/PBIT), although other measures are also used. Nature and assessment of financial risk Financial risk arises due to the use of debt as a source of finance, and hence is related to the capital structure of a company. Financial risk is the variability in shareholder returns that arises due to the need to pay interest on debt. Financial risk can be assessed from a shareholder perspective in two ways. Firstly, balance sheet gearing can be calculated. There are a number of gearing measures that can be used, such as the debt/equity ratio, the debt ratio and financial gearing, and the calculation can be based on either market values or book values. Secondly, the interest coverage ratio can be calculated. Nature and assessment of systematic risk From a shareholder perspective, systematic risk is the sum of business risk and financial risk. Systematic risk is the risk that remains after a shareholder has diversified investments in a portfolio, so that the risk specific to individual companies has been diversified away and the shareholder is faced with risk relating to the market as a whole. Market risk and undiversifiable risk are therefore other names for systematic risk. From a shareholder perspective, the systematic risk of a company can be assessed by the equity beta of the company. If the company has debt in its capital structure, the systematic risk reflected by the equity beta will include both business risk and financial risk. If a company is financed entirely by

equity, the systematic risk reflected by the equity beta will be business risk alone, in which case the equity beta will be the same as the asset beta.

Explain the meaning of the term ‘cash operating cycle’ and discuss the relationship between the cash operatin cycle and the level of investment in working capital. Your answer should include a discussion of relevant working capital policy and the nature of business operations.

The cash operating cycle is the average length of time between paying trade payables and receiving cash from trade receivables. It is the sum of the average inventory holding period, the average production period and the average trade receivables credit period, less the average trade payables credit period. Using working capital ratios, the cash operating cycle is the sum of the inventory turnover period and the accounts receivable days, less the accounts payable days. The relationship between the cash operating cycle and the level of investment in working capital is that an increase in the length of the cash operating cycle will increase the level of investment in working capital. The length of the cash operating cycle depends on working capital policy in relation to the level of investment in working capital, and on the nature of the business operations of a company. Working capital policy Companies with the same business operations may have different levels of investment in working capital as a result of adopting different working capital policies. An aggressive policy uses lower levels of inventory and trade receivables than a conservative policy, and so will lead to a shorter cash operating cycle. A conservative policy on the level of investment in working capital, in contrast, with higher levels of inventory and trade receivables, will lead to a longer cash operating cycle. The higher cost of the longer cash operating cycle will lead to a decrease in profitability while also decreasing risk, for example the risk of running out of inventory. Nature of business operations Companies with different business operations will have different cash operating cycles. There may be little need for inventory, for example, in a company supplying business services, while a company selling consumer goods may have very high levels of inventory. Some companies may operate primarily with cash sales, especially if they sell direct to the consumer, while other companies may have substantial levels of trade receivables as a result of offering trade credit to other companies.

Discuss the circumstances under which the weighted average cost of capital (WACC) can be used as a discount rate in investment appraisal. Briefly indicate alternative approaches that could be adopted when using the WACC is not appropriate.

The weighted average cost of capital (WACC) is the average return required by current providers of finance. The WACC therefore reflects the current risk of a company’s business operations (business risk) and way in which the company is currently financed (financial risk). When the WACC is used as discount rate to appraise an investment project, an assumption is being made that the project’s business risk and financial risk are the same as those currently faced by the investing company. If this is not the case, a marginal cost of capital or a project-specific discount rate must be used to assess the acceptability of an investment project.

The business risk of an investment project will be the same as current business operations if the project is an extension of existing business operations, and if it is small in comparison with current business operations. If this is the case, existing providers of finance will not change their current required rates of return. If these conditions are not met, a project-specific discount rate should be calculated, for example by using the capital asset pricing model. The financial risk of an investment project will be the same as the financial risk currently faced by a company if debt and equity are raised in the same proportions as currently used, thus preserving the existing capital structure. If this is the case, the current WACC can be used to appraise a new investment project. It may still be appropriate to use the current WACC as a discount rate even when the incremental finance raised does not preserve the existing capital structure, providing that the existing capital structure is preserved on an average basis over time via subsequent finance-raising decisions. Where the capital structure is changed by finance raised for an investment project, it may be appropriate to use the marginal cost of capital rather than the WACC.

Hedging against exchange risks—How to do so.

Boluje receives peso income from its export sales and makes annual peso-denominated interest payments to bond-holders. It could consider opening a peso account in the overseas country and using this as a natural hedge against peso exchange rate risk. Boluje Co could consider using lead payments to settle foreign currency liabilities. This would not be beneficial as far as peso- denominated liabilities are concerned, as the peso is depreciating against the dollar. It is inadvisable to lag payments to foreign suppliers, since this would breach sales agreements and lead to loss of goodwill. Foreign currency derivatives available to Boluje Co could include currency futures, currency options and currency swaps. Currency futures are standardised contracts for the purchase or sale of a specified quantity of a foreign currency. These contracts

are settled on a quarterly cycle, but a futures position can be closed out any time by undertaking the opposite transaction to the one that opened the futures position. Currency futures provide a hedge that theoretically eliminates both upside and downside risk by effectively locking the holder into a given exchange rate, since any gains in the currency futures market are offset by exchange rate losses in the cash market, and vice versa. In practice however, movements in the two markets are not perfectly correlated and basis risk exists if maturities are not perfectly matched. Imperfect hedges can also arise if the standardised size of currency futures does not match the exchange rate exposure of the hedging company. Initial margin must be provided when a currency futures position is opened and variation margin may also be subsequently required. Boluje Co could use currency futures to hedge both its regular foreign currency receipts and its annual interest payment. Currency options give holders the right, but not the obligation, to buy or sell foreign currency. Over-the-counter (OTC) currency options are tailored to individual client needs, while exchange-traded currency options are standardised in the same way as currency futures in terms of exchange rate, amount of currency, exercise date and settlement cycle. An advantage of currency options over currency futures is that currency options do not need to be exercised if it is disadvantageous for the holder to do so. Holders of currency options can take advantage of favourable exchange rate movements in the cash market and allow their options to lapse. The initial fee paid for the options will still have been incurred, however. Currency swaps are appropriate for hedging exchange rate risk over a longer period of time than currency futures or currency options. A currency swap is an interest rate swap where the debt positions of the counterparties and the associated interest payments are in different currencies. A currency swap begins with an exchange of principal, although this may be a notional exchange rather than a physical exchange. During the life of the swap agreement, the counterparties undertake to service each others’ foreign currency interest payments. At the end of the swap, the initial exchange of principal is reversed.