Part1 sources of business finance

一、Dividend ：Dividends and share price growth are the two ways in which wealth can be provided to shareholders.

theory:

The dividend valuation model:

P₀ = D₀ (1+ g)/(r_e – g)

Where:

P₀ = the ex-div share price at time 0 (ie the current ex div share price)

D₀ = the time 0 dividend (ie the dividend that has either just been paid or which is about to be paid)

r_e = the rate of return of equity (ie the cost of equity)

g = the future annual dividend growth rate.

The Gordon growth model: 

g = bR

where b is the proportion of earnings retained and R is the rate that profits are earned on new investment.

Modigliani and Miller’s dividend irrelevancy theory. 

This theory states that dividend patterns have no effect on share values

Dividend payment policies:

Constant dividends, Constant growth, Constant pay-out ratio, Dividends as residuals, No dividend:

二、The capital asset pricing model

The CAPM assumes that investors hold fully diversified portfolios.

The formula for the CAPM, which is included in the formulae sheet, is as follows:

E(ri ) = Rf + βi(E(rm) – Rf)

Where：
E(ri) = return required on financial asset     Rf = risk-free rate of return   βi = beta value for financial asset  E(rm) = average return on the capital market

Asset betas, equity betas and debt betas

三、Proxy companies and proxy betas

Ungearing equity betas

Assuming the debt beta is zero, the asset beta formula becomes:

Regearing the asset beta

Summary of steps in the calculation

The steps in calculating a project-specific discount rate using the CAPM can now be summarised, as follows:

1. Locate suitable proxy companies.

2. Determine the equity betas of the proxy companies, their gearings and tax rates.

3. Ungear the proxy equity betas to obtain asset betas.

4. Calculate an average asset beta.

5. Regear the asset beta.

6. Use the CAPM to calculate a project-specific cost of equity.

Using the CAPM in investment appraisal

portfolio beta= βp = (W1β1) + (W2β2)

W1 and W2 are the market value weightings of each business area
β1 and β2 are the equity betas of each business area.、

四、small and medium-sized enterprises

raising finance difficult

• SMEs often have a limited track record in raising investment and providing suitable returns to their investors

• SMEs often have non-existent or very limited internal controls

• SMEs often have few external controls. For instance they are unlikely to be abiding by the rules of any stock exchange and due to their size they are unlikely to attract much press scrutiny. Indeed, in the UK many SMEs are no longer required to have their annual accounts audited

• SMEs often have one dominant owner-manager whose decisions may face little questioning

• SMEs often have few tangible assets to offer as security.

五、Analysing the suitability of financing alternatives

Recommendation of a suitable financing method

hen recommending a financing method, consideration should be given to a number of factors.

Cost – Debt finance is cheaper than equity finance and so if the company has the capacity to take on more debt, it could have a cost advantage.

Cash flows – While debt finance is cheaper than equity finance, it places on the company the obligation to pay out cash in the form of interest. 

Risk – The directors of the company must control the total risk of the company and keep it at a level where the shareholders and other key stakeholders are content.

Security and covenants – If debt is to be raised, security may be required.

Availability – The likely availability of finance must also be considered when recommending a suitable finance source.

Maturity – The basic rule is that the term of the finance should match the term of the need (the matching principle).

Control – If debt is raised then there will be no change in control.

Costs and ease of issue – Debt finance is generally both cheaper and easier to raise than equity and, hence, a company will often raise debt rather than equity. Raising equity is often difficult, time-consuming and costly.

The yield curve – Consideration should be given to the term structure of interest rates. 

六、 Introduction to Islamic finance

The main principles of Islamic finance are that:

-Wealth must be generated from legitimate trade and asset-based investment. (The use of money for the purposes of making money is expressly forbidden.)

-Investment should also have a social and an ethical benefit to wider society beyond pure return.

-Risk should be shared.

-All harmful activities (haram) should be avoided.

The following activities are prohibited:

--Charging and receiving interest (riba).

--Investments in businesses dealing with alcohol, gambling, drugs, pork, pornography or anything else that the Shariah considers unlawful or undesirable (haram).

--Uncertainty, where transactions involve speculation, or extreme risk. This is seen as being akin to gambling.

--Uncertainty about the subject matter and terms of contracts – this includes a prohibition on selling something that one does not own. 

The permitted

--Murabaha is a form of trade credit for asset acquisition that avoids the paymentof interest.

--Ijara is a lease finance agreement whereby the bank buys an item for a customer and then leases it back over a specific period at an agreed amount. 

--Mudaraba is essentially like equity finance in which the bank and the customer share any profits

--Musharaka is a joint venture or investment partnership between two parties.

--Sukuk is debt finance. A conventional, non-Islamic loan note is a simple debt, and the debt holder's return for providing capital to the bond issuer takes the form of interest

七、Business finance

The main sources are:

1. bank loans and overdrafts

2. leasing/hire purchase

3. trade credit

4. government grants, loans and guarantees

5. venture capitalists and business angels

6. invoice discounting and factoring

7. retained profits.

How much capital is needed

• for investment in non-current assets

• to sustain the company through initial loss-making periods

• for investment in current assets.

Cash-flow forecasts are an essential tool in planning capital needs

八、Cost of capital gearing and CAPM

The cost of equity is the relationship between the amount of equity capital that can be raised and the rewards expected by shareholders in exchange for their capital. The cost of equity can be estimated in two ways: 

1. The dividend growth model

2. The capital asset pricing model (CAPM)

There are two main components of the risk suffered by equity shareholders:

1.The nature of the business.

2.The level of gearing.

 the rate of return required by shareholders (the cost of equity) will also be affected by two factors:

1. The nature of the company’s operations.

2. The amount of gearing in the company.

Project appraisal 1 – pure equity finance

1. A new investment can be appraised using the cost of equity only if equity alone is being used to fund the new investment.

2. The gearing does not change.

3. The nature of the business is unchanged.

Project appraisal 2 – same business activities, a mix of funds and constant gearing

1. Conventional theory：when there is only equity, the WACC starts at the cost of equity

2. Modigliani and Miller (M&M) without tax：M&M were able to demonstrate that as gearing increases, the increase in the cost of equity

3. Modigliani and Miller (M&M) with tax：Debt, because of tax relief on interest, becomes unassailably cheap as a source of finance.

Project appraisal 3 - different business activities, a mix of funds and changing gearing

E(ri) = Rf + ßi(E(rm) – Rf)

九、Optimum capital structure

Market value of a company = Future cash flows / WACC

It is essential to note that the lower the WACC, the higher the market value of the company.

mixture of equity and debt 

issue more debt to replace expensive equity; this reduces the WACC, but

more debt also increases the WACC as:

• gearing

• financial risk

• beta equity

• keg WACC.

Part2  business and asset valuations

一、Interest rate risk

Behavioural finance attempts to explain how decision makers take financial decisions in real life, and why their decisions might not appear to be rational every time and, therefore, have unpredictable consequences. 

There are three broad approaches to share valuation:
1. Assets-based.: net realisable value is likely to be the most useful because it presents the sellers with the lowest value they should accept.2. Income-based: P/E ratio method 

3. Cash flow-based:The dividend valuation model (or growth model) suggests that the market value of a
share is supported by the present value of future dividends.

Part3 Risk management techniques

Hedging techniques for interest rate risk

Traditional and basic methods of interest rate risk management,including

1. Matching and smoothing

   Matching: equires a business to have both assets and liabilities with the same kind of interest rate.

   Smoothing: interest rate risk management the loans or deposits are simply divided
   

2. Asset and liability management
   

3. Forward rate agreements: in four months’ time for a period of three months FRA 4-7

The interest rate derivatives that will be discussed are:

- Interest rate futures

    rule for interest rate futures is: 

• Depositing: buy futures then sell

• Borrowing: sell futures then buy

- Interest rate options

Options are like insurance policies

- Interest rate caps, floors and collars

A cap involves using interest rate options to set a maximum interest rate for borrowers.

A floor involves using interest rate options to set a minimum interest rate for investors

A collar involves using interest rate options to confine the interest paid or earned within a pre-determined range

- Interest rate swapsments 

allow companies to exchange interest payments on an agreed notional amount for an agreed period of time

二、Foreign currency risk and its management

1. Economic risk. The source of economic risk is the change in the competitive strength of imports and exports.

2.Translation risk. This affects companies with foreign subsidiaries

3.Transaction risk. This arises when a company is importing or exporting. 

-Invoice. Arrange for the contract and the invoice to be in your own currency.

-Netting AR and AP

-Matching

-Leading and lagging

-Forward exchange contracts

-Money market hedging

Part3 Working capital

Reducing investment in foreign accounts receivable

1.  Forfaiting:  involves the purchase of foreign accounts receivable from the seller by a forfaiter

2. letter of credit:  reducing the investment in foreign accounts receivable and can give a business a risk-free method of securing payment for goods or services.

   There are a number of steps in arranging a letter of credit:

   -Both parties set the terms for the sale of goods or services

   -The purchaser (importer) requests their bank to issue a letter of credit in favour of the seller

   -The letter of credit is issued to the seller’s bank, guaranteeing payment to the seller once the conditions specified in the letter have been complied with. Typically the conditions relate to presenting shipping documentation and dispatching the goods before a certain date.

   -The goods are dispatched to the customer and the shipping documentation is sent to the purchaser’s bank

   -The bank then issues a banker’s acceptance

   -The seller can either hold the banker’s acceptance until maturity or sell it on the money market at a discounted value

3. countertrade :goods or services are exchanged for other goods or services instead of for cash.

4. Export credit insurance : protects a business against the risk of non-payment by a foreign customer. 
   

5. Export factoring: provides the same functions in relation to foreign accounts receivable as a factor covering domestic accounts receivable and therefore can help with the cash flow of a business.

   
   

Part4 Effective investment appraisal 

一、

1. The effect of inflation on cash flows

2.Real and nominal costs of capital

(1 + i) = (1 + r)(1 + h)

3. Nominal cash flows

4. Real cash flows are found by deflating nominal cash flows by the general rate of inflation

二、equivalent annual costs and benefits

1.  steps:

Step 1 – Calculate the net present value (NPV) of cost for each potential replacement cycle

Step 2 – For each potential replacement cycle an equivalent annual cost is calculated

The decision – The replacement cycle with the lowest equivalent annual cost may then be chosen, although other factors may also have to be considered.