Professional Documents
Culture Documents
BFD Book - Dec 2021
BFD Book - Dec 2021
CFAP-04
BFD
DEC 2021 EDITION
Page | 0
ABOUT THE AUTHOR
• Ammar Ahmed is a Chartered Accountant (Pakistan), Qualified in 2012, Member since 2013
(Articles from AFF)
• He is a CFA Level 3 candidate and obtained highest grades in both levels 1 & 2
• He attended On-campus Finance & Leadership Program at LUMS and is an Alumni of LUMS
• He has been teaching CA Final / CFAP subjects (AAFR, BFD & AARS) since 2012 with
excellent results. 3000+ students passed their respective paper and 400+ became qualified
Chartered Accountants. His students also achieved distinctions in AAFR, MAC and AARS.
• He taught CFA students from 2014 to 2017. 100+ students passed their paper and 50+
students became qualified CFAs
• He is a member of the Technical Advisory Group of the Accounting Standard’s Board and a
former member of ICAP’s Accounting Standard’s Committee and Chairman of IFRS 15
committee
• He has served more than 7 years in Industry and has worked in Senior Management / Head
of Department roles in the Financial Analysis, Financial Planning & Strategy divisions at one
of the largest Multi-national companies
Page | 1
TABLE OF CONTENTS
Chap Title Page Corresponding Chap Corresponding Chap #
# # # in Study Text in Brigham (T&P)
1 Basic Concepts of Financial 5 Chapter 2
Management
2 Cost and Value of Equity 9 Chapter 13 Chapter 7
Page | 2
ANALYSIS OF PAST PAPERS & QUESTIONS TO BE SOLVED IN CLASS
S 14 W 14 S 15 W 15 S 16 W 16 S 17 W 17 S 18 W 18 S 19 W 19 W 20 S 21
Area
Marks %
Chap 2 9 1%
Chap 3 0%
Chap 4 40 16 17 14 23 25 11%
Chap 5 34 22 26 27 42 25 21 16%
Chap 6 18 17 16 17 42 21 6%
Chap 7 18 20 24 21 17 20 17 25 23 24 23 20 25 19%
Chap 8 14 17 20 16 19 6%
Chap 9 & 10 17 10 17 17 19 15 17 15 16 18 17 12%
Chap 11 33 32 15 30 49 24 22 17%
Chap 12 10 15 16 19 6 5%
Chap 13 0%
Chap 14 25 23 4%
Chap 15 17 19 20 12 3%
Questions marked in green will be solved in class
Note: Winter 2020 & Summer 2021 complete papers solved in dedicated sessions.
Page | 3
ANALYSIS OF PAST PAPERS & QUESTIONS TO BE SOLVED IN CLASS
S 08 W 08 S 09 W 09 S 10 W 10 S 11 W 11 S 12 W 12 S 13 W 13
Area
Marks %
Chap 2 12 13 2%
Chap 3 20 2%
Chap 4 38 15 14 16 14 17 24 15 13%
Chap 5 15 15 16 24 15 20 19 20 23 14%
Chap 6 18 25 20 13 15 19 12 10%
Chap 7 20 21 13 25 20 42 20 30 43 25 22%
Chap 8 18 17 24 20 12 17 20 20 12%
Chap 9 & 10 17 10 32 12 20 14 14 11 7 11%
Chap 11 14 17 39 23 15 18 22 12%
Chap 12 21 2%
Chap 13 0%
Chap 14 0%
Chap 15 0%
Page | 4
CHAPTER 1: BASIC CONCEPTS OF FINANCIAL MANAGEMENT
Discounting
Present valuing monetary amounts to be received in future to account for the Time value of money
𝐶𝐹
(1 + 𝑑)𝑛
Future valuing
Compounding monetary amounts received in the past to account for Time value of money
𝐶𝐹 𝑥 (1 + 𝑑)𝑛
Compounding
If the discount rate or rate of return for an annual period is 20%, the return for half year will not be 10% and
return for a quarter will not be 5%. Instead it will be calculated using the formula:
1 − (1 + 𝑑)−𝑛
𝐶𝐹 𝑥
𝑑
𝐶𝐹
𝑑
- Finite number of periodic cashflows with a constant growth: Annuity with growth
1 + 𝑑 −𝑛
1 − (1 + 𝑔)
1𝑠𝑡 𝐶𝐹 ×
𝑑−𝑔
Page | 5
CHAPTER 1: BASIC CONCEPTS OF FINANCIAL MANAGEMENT
- Infinite number of periodic cashflows with a constant growth: Perpetuity with growth
1𝑠𝑡 𝐶𝐹
𝑑−𝑔
- Annuity in advance:
1 − (1 + 𝑑)−𝑛+1
𝐶𝐹 𝑥 (1 + )
𝑑
- Perpetuity in advance:
𝐶𝐹
𝐶𝐹 +
𝑑
Capital
In financial management, “capital” includes all funds available for long term investment whether debt or equity.
Value
Value means the intrinsic worth of an asset. It may be different from the price of a security quoted in the stock
market. Value of an item may vary from person to person, whereas price is the same for all.
Page | 6
CHAPTER 1: BASIC CONCEPTS OF FINANCIAL MANAGEMENT
Example 1: Discounting
Today is 1st January 2021. Calculate the PV of following cashflows assuming that the discount rate is 10% p.a.
- Rs 10m to be received on 31-Dec-2021
- Rs 15m to be received on 31-Dec-2023
- Rs 20m to be received on 30-June-2022
- Rs 30m to be received on 30-Sep-2024
Example 4: Compounding
Mr X is in the business of giving out loans on half yearly interest at the rate of 9.54% per half year. On 1st Jan
2021, he gave out loans worth Rs 100,000 each to two people Mr A and Mr B both for a period of 1 year.
- Mr A failed to pay the 1st half yearly interest. He repaid the complete loan together with all interest due at
the end of the year.
- Mr B paid both half yearly interests together with principal on time.
Page | 7
CHAPTER 1: BASIC CONCEPTS OF FINANCIAL MANAGEMENT
Example 8: Perpetuity
Today is 1st January 2021. Calculate the PV of following cashflows assuming that the discount rate is 10% p.a.
a) Rs 10m to be paid each year for the foreseeable future starting the end of 2021
b) Rs 15m to be paid each year for the foreseeable future starting the end of 2021 and growing at 4% p.a
c) Rs 25m to be paid each year for the foreseeable future starting the end of 2023 and growing at 5% p.a
d) Rs 5m to be paid each quarter for the foreseeable future starting the end of Q1 2022 and growing at 1% p.q
e) Rs 12m to be paid each year for the foreseeable future starting the beginning of 2021 and growing at 3% p.a
Page | 8
CHAPTER 2: COST & VALUE OF EQUITY
Ke = D o
Po
Ke = Do (1 + g) + g
Po
Growth rates
1. Historic growth => Do = D-n (1+g)n [Solve for g]
2. Gordon growth => g = ROE x rate of retention
CAPM
CAPM is a measure of the cost of equity. Its formula is based on the concept that the unsystematic risk can be
diversified by investing in various securities. The risk that diversified shareholder’s face is the systematic or
market risk. It assumes that all shareholders are well diversified
Understanding beta:
If an investment is riskier than the average market then the βe > 1.
Page | 9
CHAPTER 2: COST & VALUE OF EQUITY
If an investment is less risky than the average market then the βe < 1.
If an investment is risk free then βe = 0.
Alpha factor
Alpha is an abnormal return on an equity security. In other words, it is the return over and above the Ke
computed by CAPM.
Exhibit 1: Beta Equity of listed companies w.r.t PSX 30-index as of 19th June 2020 (Googleable numbers)
Company Name Beta
Amreli Steels Limited 1.09
Engro Fertilizers Limited 0.54
Fauji Cement Company Limited 1.04
Fauji Fertilizer Bin Qasim Limited 1.03
Hascol Petroleum Limited 1.13
K-Electric Limited 0.99
Maple Leaf Cement Factory Limited 1.1
National Bank of Pakistan 0.9
Oil & Gas Development Company Limited 1.01
Pakistan State Oil Company Limited 1.14
Pakistan Telecommunication Company Ltd 0.66
Sui Northern Gas Pipelines Limited 1.18
Sui Southern Gas Company Limited 1.11
The Bank of Punjab 1.1
The Hub Power Company Limited 1.04
Exhibit 2: One Year T-Bills Yield - Risk free rate of interest (Googleable numbers)
Page | 10
CHAPTER 2: COST & VALUE OF EQUITY
Page | 11
CHAPTER 2: COST & VALUE OF EQUITY
Example 6: CAPM
X Co is currently paying a return of 20% on equity investment. If the return on Govt. Gilts is currently 7% and the
average return on the KSE 100 index is 15%, what is the beta of X Co and what does this tell us about the
volatility of B’s returns compared to those of the market on average?
Page | 12
CHAPTER 3: COST & VALUE OF DEBT AND THE WACC
Simple / Straight Loans
Kd = I (1 – T) / Po
Po = I (1 – T) / Kd
Convertible debt
The same IRR approach as above is followed with exception only that redemption value of equity or the conversion
proceeds (whichever is higher) is taken.
Preference shares
- May be redeemable or irredeemable, cumulative or non-cumulative, participating or non-participating
- Return on preference shares is generally not deductible for tax purposes
- Computation of cost and value of redeemable preference shares is similar to calculations for debt
- Computation of cost and value of irredeemable preference shares is similar to calculations for equity
Irredeemable debt
Same computation as simple loans
Page | 13
CHAPTER 3: COST & VALUE OF DEBT AND THE WACC
Foreign debt
- Cost of capital is currency sensitive
- Use forecasted Foreign exchange rates to convert Forex into PKR
- Exchange rate could be forecasted using either the Inflation rates (Purchasing Power Parity) or Interest rates
(Interest rate parity)
IRP: Current exchange rate x (1 + interest rate Pakistan) / (1 + interest rate Foreign country)
Credit rating
- A quantified assessment of the creditworthiness of a borrower
- Credit rating for companies and governments is generally done by a credit rating agency such as Standard &
Poor's, Moody's or PACRA. These rating agencies are paid by the entity that is seeking a credit rating
- Credit rating agencies typically assign letter grades to indicate ratings. For example, S&P has a credit rating
scale ranging from AAA (excellent) to C and D.
- Ratings can generally be divided into two grades: Investment Grade and Speculative grade (Junk bonds)
- Individuals are generally assigned credit scores (instead of credit rating) based on their track record
Tax deductibility
- Interest is generally tax deductible
- Return on preference shares is generally not deductible for tax purposes
- Tax deductibility is irrelevant if the company is in irrecoverable tax losses or fully under the FTR regime
Page | 14
CHAPTER 3: COST & VALUE OF DEBT AND THE WACC
Fixed income investments
- Fixed income securities are a type of debt instrument that provides returns in the form of regular, or fixed,
interest payments and repayments of the principal when the security reaches maturity.
- The instruments are issued by governments, corporations, and other entities to finance their operations.
- Management of Fixed income securities is a wide subject included in specific Financial management studies
such as CFA & Financial Engineering but are not included within the course of CA Pakistan
WACC = Sum of WX
Sum of W
Page | 15
CHAPTER 3: COST & VALUE OF DEBT AND THE WACC
Example 1: Simple Loan
Compute the Cost debt assuming Tax rate is 30% and loan obtained in Rs 100m.
a) Rs 10m is payable as Interest on an annual basis
b) Rs 2m is payable as Interest on a quarterly basis
c) Rs 4m is payable as Interest on a half yearly basis
Page | 16
CHAPTER 3: COST & VALUE OF DEBT AND THE WACC
of 1-Jan-2022 assuming that the Gross yield on bonds of similar credit rating and maturity at that date is KIBOR +
1%. Tax rate is 30%. KIBOR FCST for the next 3 years is as follows: Current: 8%, Yr 1: 9%, Yr 2: 9.5%, Yr 3: 10%.
Page | 17
CHAPTER 4: BASIC INVESTMENT APPRAISAL
ROCE / ROI
This is also known as accounting rate of return (ARR).
ROCE = Average annual profits before interest and tax × 100%
Initial capital costs or avg. capital costs
Decision rule:
If the expected ROCE for the investment is greater than the target or hurdle rate then the project should be
accepted.
Ignore:
• sunk costs
• committed costs
• non-cash items
• allocated costs
Payback
The payback period is the time a project will take to pay back the money spent on it.
Decision rule:
• only select projects which pay back within the specified time period
• choose between options on the basis of the fastest payback
Cashflows:
Only relevant cash flows and opportunity cost of scarce resource as discussed above are considered.
Page | 18
CHAPTER 4: BASIC INVESTMENT APPRAISAL
Inflation:
• Inflation must be accounted for on a cumulative basis for each year if real cash flows are to be translated
into nominal cashflows.
• In exam, generally prefer to use nominal cashflows and discount rate.
Tax:
• Tax outflows are shown when tax is actually paid, which is usually one year in arrears.
• Tax savings on tax allowable non-cash expenses e.g. tax depreciation, tax amortisation and tax provision
for employee benefits are reduced from tax outflow.
Working capital
• Take initial WC at year 0
• Take investment as at i.e. take differential WC each year
• Recover WC as positive cashflow at the end of the project life
Discount rate
• Should reflect the gearing and financial risk of the company after project
• Should reflect business risk of the project
• Should reflect project specific cost of debt and cost of equity
Decision rule
• if the NPV is positive – the project is financially viable
• if the NPV is zero – the project breaks even
• if the NPV is negative – the project is not financially viable
IRR
The IRR represents the discount rate at which the NPV of an investment is zero. It assumes reinvestment at IRR
rate.
IRR of Perpetuity
IRR of a perpetuity = Annual inflow × 100
Initial investment
Two IRRs
One weak point of the IRR is that there may be two IRRs if negative cashflows occur at different times in a project.
Suppose a firm is considering expenditure of Rs 1.6 million to develop a mine. The mine will produce a cash flow
of Rs 10 million at the end of Year 1. Then, at the end of Year 2, Rs 10 million must be expended to restore the
land to its original condition. The IRR for the investment can be formulized as:
NPV = -1.6 + 10/(1+IRR) – 10/(1+IRR)2
Page | 19
CHAPTER 4: BASIC INVESTMENT APPRAISAL
−𝑏±√𝑏2 −4𝑎𝑐
This curvilinear function can be solved to get IRR by curvilinear equation [Formula = 2𝑎
]. When solved,
we find that NPV is 0 when IRR is 25% and also when IRR is 400%. Therefore, the IRR of the investment is both
25% and 400%.
MIRR
MIRR assumes that cash flows are reinvested at the cost of capital. Since reinvestment at the IRR is generally not
correct, the MIRR is generally a better indicator of a project’s true profitability.
Terminal value of inflows / PV of costs = (1 + MIRR)n
Targeted NPV
All cashflows other than target cashflows are discounted and then divided by annuity factor to compute equal
targeted cashflow or put into equation to compute unequal target cashflows.
Where:
EBIT = PBT + interest expense + accounting depreciation – economic depreciation + R&D written off + Goodwill
written off.
Capital employed = Capital employed per SFP + R&D written off + Goodwill written off.
Profitability index
It is a measure of relative profitability of a project: PI = NPV or PV of inflows
Initial outlay Initial outlay
Sensitivity analysis
Brigham defines it as “Sensitivity analysis measures the percentage change in NPV that results from a given
percentage change in an input with other variables held at their expected values”. This change is calculated as:
Sensitivity margin = NPV × 100%
PV of post-tax relevant cash flows
Page | 20
CHAPTER 4: BASIC INVESTMENT APPRAISAL
Expected value
When there are a number of possible outcomes for a decision and probabilities can be assigned to each, then an
EV may be calculated. The EV is the weighted average of all the possible outcomes, with the weightings based on
the probability estimates. The EV is not the most likely result. It may not even be a possible result, but instead it
finds the long-run average outcome.
The formula for calculating an EV is: EV = Σpx
Scenario analysis
Begin with the base-case scenario, which uses the most likely set of input values. We then specify a worst-case
scenario (low unit sales, low sales price, high variable costs) and then a best-case scenario and then compare the
results.
Decision trees
Decision Trees are tools to help between choosing several courses of action. There two types of signs used to
make a decision tree. A square represents a decision point and a circle represents possible event occurring on
adopting a particular course of action.
Exam technique
• Work backwards. First calculate NPV at each end event point.
• Then calculate Expected NPV at each event point.
• For decision points simply take higher NPV from the off shoots.
• Finally calculate the NPV for the project as a whole.
Page | 21
CHAPTER 4: BASIC INVESTMENT APPRAISAL
Example 1: ROCE
A project requires an initial investment of Rs 800,000 and then earns net cash inflows as follows:
Year 1 2 3 4 5 6 7
Cash inflows 100 200 400 400 300 200 150
In addition, at the end of the seven year project the assets initially purchased will be sold for Rs 100,000.
Determine the project’s ROCE using:
(a) initial capital invested
(b) average capital invested.
Example 6: NPV
An organisation is considering a capital investment in new equipment. The estimated cash flows are as follows.
Year 0 1 2 3 4 5
Rupees (240,000) 80,000 120,000 70,000 40,000 20,000
The company’s cost of capital is 9%. Calculate the NPV of the project to assess whether it should be undertaken.
Example 7: IRR
A business undertakes high risk investments and requires a minimum expected rate of return of 17% p.a. on its
investments. A proposed capital investment has the following expected cash flows:
Year 0 1 2 3 4
Rs (50,000) 18,000 25,000 20,000 10,000
Calculate the IRR and appraise the project.
Example 8: MIRR
Projects A and B have the following cash flows:
Year 0 1 2
A (Rs 1,000) Rs 1,150 Rs 100
B (Rs 1,000) Rs 100 Rs 1,300
Their cost of capital is 10%. What are the projects’ IRRs, MIRRs, and NPVs? Which project would each method
select?
Page | 22
CHAPTER 4: BASIC INVESTMENT APPRAISAL
Example 9: EVA
ABC Limited’s Profit before tax is Rs 283.8 and interest expense is Rs 88.0. Tax rate is 40%. Its ROCE is 12.5% &
WACC is 15%. Calculate EVA.
Required: Evaluate if X limited should invest in the Project if its WACC is 10%.
Page | 23
CHAPTER 4: BASIC INVESTMENT APPRAISAL
Example 13: Bailout payback period
A company is considering a new project requiring a capital outlay of Rs.150,000. The objective of the investment
is to bailout as soon as the initial investment is recovered. Calculate the Bail-out payback period using the following
projections.
Page | 24
CHAPTER 5: ADVANCED INVESTMENT APPRAISAL & WACC
Leverage
Financial leverage denotes the sensitivity of PBT to change in PBIT. It is affected by the amount of int. expense.
Financial leverage = PBIT .
PBT – [Pref. dividend/(1-T)]
Operating leverage denotes the sensitivity of PBIT to change in contribution/sales volume. It is affected by the
amount of fixed costs.
Operating leverage = Contribution
PBIT
Total leverage denotes the sensitivity of PBT to a change in contribution/sales volume. It is affected by both the
amount of fixed costs and interest expense.
Total leverage = Contribution or FL x OL
PBT – [Pref. dividend/(1-T)]
Vg = Vu
KEg = KEu + D/E (KEu – KDg)
WACCg = WACCu
Vg = Vu + DT
KEg = KEu + (1 – T) D/E (KEu – KDg)
WACCg = WACCu [1 – DT / (D+E)]
Page | 25
CHAPTER 5: ADVANCED INVESTMENT APPRAISAL & WACC
Types of M&M scenarios
- No change in total capital – ungeared to geared / geared to ungeared
- No change in total capital – geared to geared
- Change in total capital – ungeared to geared / geared to ungeared
- Change in total capital – geared to geared
Limitations of M&M
- Agency costs
- Bankruptcy costs
- Amended formula: Vg = Vu + DT – PV of Bankruptcy costs – PV of Agency costs
Conversion of beta
ßa = ße × Ve + ßd × Vd (1 – T) .
Ve + Vd(1 – T) Ve + Vd(1 – T)
Note: First part of the formula is developed using the Hamada equation.
Exam steps
• Take Be of industry. Ungear Be using industry gearing % and tax % to convert to beta asset of the industry.
• Use this beta asset and regear using gearing % and tax % for the project to get beta equity of the project
• This beta equity is then used in CAPM.
Page | 26
CHAPTER 5: ADVANCED INVESTMENT APPRAISAL & WACC
Investment decision:
Base case NPV xxx
Financing decision:
PV of issue costs xxx
PV of tax shield on debt xxx
PV of subsidised loan benefit xxx
APV xxx
Issue costs
• Issue costs are calculated at gross.
• Tax effects are taken on debt issue costs only
• Any discount on issue of shares for project is ignored
Subsidised loan
• It is quite often the case that govt. etc issues subsidised loans for development oriented projects.
• Benefit of a subsidised loan with bullet repayment = Loan amount x (Kd – Subsidised loan cost %) x (1 – tax
rate %) x Relevant Annuity factor at Rf / Kd (pre-tax).
• If the loan is irredeemable, benefit only for the term of the project is considered
• If tax is payable in arrears, discount tax effects by one year delay
• If the subsidized loan is to be repaid in instalments, the benefit of subsidised loan is given to be computed in
ACCA books as:
Annual repayment = Loan amount (including issue costs)
Annuity factor at actual loan %
PV of loan subsidy = [Loan amount – (Annual repayment x annuity factor at Kd %)] x (1 – tax rate %)
Page | 27
CHAPTER 5: ADVANCED INVESTMENT APPRAISAL & WACC
• The above method is slightly faulty and better approach is to make two tables and compare.
Technicalities in Cashflows
- Future exchange rates are estimated using the PPP or IRP
- Tax treaties and impact of local vs foreign taxes
- Restriction on dividend repatriation and repatriation taxes
- Transfer pricing between local and foreign entity
Market details:
– Market size – Selling price – Market growth rate – Market share
Investment costs:
– Investment required – Residual value of investment
Operating costs:
– Variable costs – Fixed costs – Taxation – Useful life of plant.
(2) Specify the relationships between variables to calculate an NPV. For example:
Sales revenue = market size × market share × selling price.
Net cash flow = sales revenue - (variable costs + fixed costs + taxation), etc.
Page | 28
CHAPTER 5: ADVANCED INVESTMENT APPRAISAL & WACC
The results of a simulation exercise will be a probability distribution of NPVs.
Instead of choosing between expected values, decision makers can now take the dispersion of outcomes and the
expected return into account.
The probability of the project having for example, a positive NPV, or an NPV above a particular amount, can
then be calculated.
Merits of simulation
- It includes all possible outcomes in the decision-making process.
- It is a relatively easily understood technique.
- It has a wide variety of applications (inventory control, component replacement, corporate models, etc).
Drawbacks of simulation
- Models can become extremely complex and the time and costs involved in their construction can be more th
an is gained from the improved decisions.
- Probability distributions may be difficult to formulate.
Advantages of APT
• Permits several economic factors to influence individual stock returns
• Does not assume that all investors hold the market portfolio (a CAPM requirement not met in practice)
Disadvantages of APT
Difficult to implement since APT does not tell what factors influence returns and does not indicate how many
factors should appear in the model.
Page | 29
CHAPTER 5: ADVANCED INVESTMENT APPRAISAL & WACC
Example 1: Leverage
ABC co. currently has a contribution of Rs 100,000. Its fixed costs are 40,000 and interest expense is 20,000. It
proposes to change its business dimensions and reduce its fixed costs to 30,000 while increasing gearing and
interest expense to 30,000. Determine whether the company’s new business dimension would have a higher or
lower leverage.
Example 2: M&M
ABC co. is entirely equity financed. Its cost of equity is 15% and market value of equity is Rs. 100,000. It proposes
to change its capital structure by obtaining debt amounting to Rs 30,000 and repaying existing equity. The cost of
this debt is 10%. Tax rate is 30%. Calculate the new WACC and value of the company.
What would be a suitable discount rate for the new investment if Hubbard were to be financed in each of the
following ways?
(a) Entirely by equity.
(b) By 30% debt and 70% equity.
(c) By 40% debt and 60% equity.
Example 4: APV
A company operating in the insurance industry is considering whether to diversify by investing in a project in the
transport industry. The company has a gearing ratio of 30% debt and 70% equity, and its equity beta is 0.90. Its
debt capital is risk-free. The transport industry has an average equity beta of 1.30, and firms in the transport
industry on average have a gearing ratio of 40% debt to 60% equity. The risk free rate of return is 5% and the
expected market return is 8%. Tax is paid in arrears at 30%. The cashflows of the project will be:
Year 0: (Rs 600,000)
Year 1 – 3: Rs 250,000
Calculate Base case NPV.
Example 5: APV
The investment in above example would be financed by Rs 400,000 new equity and Rs 200,000 new debt. Issue
costs are 5% for equity and 2% for debt. The risk free rate is 5%. Tax is paid in arrears at 30%.
Calculate PV of issue costs.
Example 6: APV
The finance required for a planned investment is $2m (net of issue costs). Issue costs are 3%. And the finance
raised will also have to cover the issue costs. What are the issue costs and what sum will need to be raised
altogether?
Page | 30
CHAPTER 5: ADVANCED INVESTMENT APPRAISAL & WACC
Example 7: APV
Rs 400,000 is to be borrowed for 3 years and repaid in equal instalments. The risk-free rate is 10% and all debt is
assumed to be risk free. Calculate the present value of the tax relief on the debt interest if the tax rate is 30%.
Assume that tax is delayed 1 year.
Example 8: APV
ABC Limited plans to invest in electricity production unit. To encourage ABC, the Govt. of Pakistan has issued a
loan at 5%. Market cost of debt is 10%. The loan amount to Rs 180,000 with 2% issue costs. The project term is 5
years. Calculate the PV of loan subsidy assuming:
(a) No repayment is made over 5 years
(b) Annual repayment is made over 5 years
Example 8: APV
Rounding plc is a company currently engaged in the manufacture of baby equipment. It wishes to diversify into
the manufacture of snowboards. The company’s equity beta is 1.27 and is current debt to equity ratio is 25:75,
however the company’s gearing ratio will change as a result of the new project.
Firms involved in snowboard manufacture have an average equity beta of 1.19 and an average debt to equity
ratio of 30:70.
Assume that the debt is risk free, that the risk free rate is 10% and that the expected return from the market
portfolio is 16%. The new project will involve the purchase of new machinery for a cost of $800,000 (net of issue
costs), which will produce annual cash inflows of $450,000 for 3 years. At the end of this time it will have no
scrap value. Corporation tax is payable in the same year at a rate of 33%. The machine will attract writing down
allowances of 25% pa on a reducing balance basis, with a balancing allowance at the end of the project life when
the machine is scrapped.
The issue costs are 4% on the gross equity issued and 2% on the gross debt issued. Estimate the adjusted
present value of the project.
Page | 31
CHAPTER 5: ADVANCED INVESTMENT APPRAISAL & WACC
• Corporate tax rate in Pakistan is 35% whereas tax rate in USA is 30%. There is a double tax treaty between
the countries. Tax depreciation is allowed on straight line basis in USA. Interest income and expense is
declared / claimed in USA Tax Returns. Interest income is taxed @ 20% in USA.
• Inflation rate in the USA is 4% and in Pakistan is 10% per annum.
• Current exchange rate is PKR 100 = USD 1.
Required: Calculate Net Present Value of the Project in PKR
Required: Compute the required return on ABC’s shares in accordance with the APT model.
Page | 32
CHAPTER 6: PORTFOLIO THEORY & CAPITAL MARKETS
Return
Return = capital gain + dividend
value at year start
Risk
• Risk is the variability of returns of the investment
• Risk is measured by SD = √∑ Probability (Return – Avg. return)2
Portfolio
• Risk is eliminated by making a portfolio (combination of investments having a co-relation of less than +1)
• This increases the return and / or decreases the risk and gives better result than individual securities
Return of a portfolio
Return of a portfolio = %XRX + %YRY
Risk of a portfolio
Risk of a portfolio = √(%𝑋 . 𝑆𝐷𝑋)2 + (%𝑌 . 𝑆𝐷𝑌)2 + 2 (%𝑋 . 𝑆𝐷𝑋)(%𝑌 . 𝑆𝐷𝑌)𝐶𝑜 − 𝑟𝑒𝑙𝑎𝑡𝑖𝑜𝑛 𝑋𝑌
Co-relationXY = Co-varianceXY
SDX SDY
Indifference curves
Every investor has a different risk attitude and corresponding return requirement. But all investors require higher
return for higher risk.
a
B
These are investor’s satisfaction curves. The investor is indifferent between different points at a curve. This is
called an “Indifference curve” (IDC). However, IDC A is preferable to IDC B.
Page | 33
CHAPTER 6: PORTFOLIO THEORY & CAPITAL MARKETS
Attitude to risk
Different cashflows may have different utility to an investor. An investor may be risk averse, risk seeking or risk
neutral. Their IDCs are as follows:
Risk averse
Neutral
Risk seeker
Page | 34
CHAPTER 6: PORTFOLIO THEORY & CAPITAL MARKETS
• Portfolio theory assumes that all investors have same expectations. This means that all investors will want to
invest in portfolio M. Therefore, nobody would wish to hold any other security. Hence, M would include all
listed securities. This portfolio of all listed securities is called market portfolio.
• The equation of capital market line = Rf + (Rm – Rf) x SD of portfolio .
SD of Market portfolio
Beta Equity
Beta Equity of security X = Covariance of X returns with market returns
Variance of market returns
Sharpe ratio
= RX – Rf
SDX
Beta Debt
- Beta Debt can be computed using the above formula for Beta Equity and placing Covariance of Returns of
the debt with market returns in the numerator.
- However, more frequently Beta Debt is computed using CAPM equation:
Pre-tax Yield on Debt = Rf + (Rm – Rf) Beta Debt
Page | 35
CHAPTER 6: PORTFOLIO THEORY & CAPITAL MARKETS
Example 1: Return
Investment Value at start of year Value at end of year Dividend
A 1000 900 300
B 800 1200 200
C 700 1000 250
Evaluate which of the above securities provided the highest return during the year?
Determine the risk and return of the portfolio if the co-relation between the returns of A and B is:
(a) 0.9 (b) 0.5 (c) – 0.2
Example 5: Beta
A share has SD of 15% and a co-relation of 0.72 with market returns. The SD of the market is 21%. Find Beta?
Page | 36
CHAPTER 6: PORTFOLIO THEORY & CAPITAL MARKETS
Solution with Matrix approach:
X Y Z Total
X %X. SDX. %X. SDX. %X. SDX. %Y. SDY. %X. SDX. %Z. SDZ.
Correlation XX Correlation XY Correlation XZ
Y %X. SDX. %Y. SDY. %Y. SDY. %Y. SDY. %Y. SDY. %Z. SDZ.
Correlation XY Correlation YY Correlation YZ
Z %X. SDX. %Z. SDZ. %Y. SDY. %Z. SDZ. %Z. SDZ. %Z. SDZ.
Correlation XZ Correlation YZ Correlation ZZ
Total
X Y Z Total
X 20% x 8 x 20% x 8 x 1 20% x 8 x 30% x 10 x 0.1 20% x 8 x 50% x 11 x -0.2
= 2.56 = 0.48 = -1.76 1.28
Y 0.48 30% x 10 x 30% x 10 x 1 30% x 10 x 50% x 11 x 0.9
=9 = 14.85 24.33
Z -1.76 14.85 50% x 11 x 50% x 11 x 1
= 30.25 43.34
Total 68.95
Variance = 68.95
SD = 8.3 %
Page | 37
CHAPTER 7: BUSINESS VALUATION
Purpose of valuation
- To establish terms of takeovers and mergers, etc.
- To value companies entering the stock market
- For tax purposes (e.g. capital gains tax)
Asset-based measures
Book values
• It’s based on historic cost value
DVM
Po = Do (1 + g)
Ke – g
Page | 38
CHAPTER 7: BUSINESS VALUATION
FCF for equity
• FCF for firm (computed as above) – interest payments – principal repayment.
• These are FCF for equity and represent returns to shareholders only.
• Discount the above FCFs at Ke to determine value of equity.
• This value is calculated as follows:
➢ FCFo (No growth to perpetuity)
Ke
➢ FCFo (1 + g) (constant growth to perpetuity)
Ke – g
Multiples Method
Value of company = Benchmark number (e.g. Earnings or Revenue) x Industry Multiple (e.g. 5x, 7x etc.)
PE Multiples method
PE Ratio = Price per share / EPS
Value of company = Total earnings × Suitable PE ratio
Yield Benchmarks
Value of company = Benchmark number (e.g. Earnings or Dividend) ÷ Industry Yield (e.g. 15%, 20% etc.)
Earnings yield
Earnings yield = EPS / Price per share
Value of company = Total earnings / Suitable earnings yield
Dividend yield
Dividend yield = DPS / Price per share
Value of company = Total dividends / Suitable dividend yield
Page | 39
CHAPTER 7: BUSINESS VALUATION
Past paper analysis:
Page | 40
CHAPTER 7: BUSINESS VALUATION
Example 1: Venture Capitalist
Mr. Aay, a famous scientist, has started a Robotics Manufacturing Unit in Pakistan. However, due to financial
difficulties, he has approached Bee Investment Limited [a venture capitalist] to buy & finance the project on the
following terms.
a) Bee would purchase 100% capital and would immediately repay existing O/D facility of PKR 50M. There is no
other debt.
b) After 5 years, Bee would exit the venture in the following manner:
• 20% of the shares would be purchased by Mr. Aay at a discount of 10% on market price.
• 80% of the shares would be offered to the public under IPO. IPO costs of PKR 5M would be borne by Bee.
c) Mr. Aay would remain the CEO of the Unit but would take no remuneration.
d) During the time before exiting, Bee would finance any cash deficit arising in the business on yearly basis. In
case of surplus cash availability during any particular year, 50% of the amount would be paid out as dividend
to Bee.
Required: Calculate the maximum price that Bee Limited would be willing to pay to acquire the unit.
Page | 41
CHAPTER 8: CERTAIN FINANCIAL DECISIONS
Lease versus buy
Concept
• Once the decision is made to acquire an asset, a decision still needs to be made as to how to finance it.
• The choices that we will consider are either to lease or buy the asset.
• The NPVs of the financing cash flows for both options are found and compared.
• The finance decision is considered separately from the investment decision.
• The operating costs and revenues from the investment will be common in each case.
• Only the relevant cash flows arising as a result of the type of finance are included in the NPV calculation.
Leasing
The relevant cash flows are:
• the lease payments
• tax relief on the lease payments
• other cashflows differing from the buying alternative
Buying
The relevant cash flows would be:
• the purchase cost
• any residual value
• any associated tax implications due to tax depreciation
• other cashflows differing from the leasing alternative
Do not include the interest payments or the tax relief on them, as this is dealt with via the discount rate.
Discount rate
• Opportunity cost of funds used to finance the buying are used as Discount rate
• Normally in a question these funds come from a loan so post tax Kd is usually used as a discount rate
• If those funds come from Equity or Current business funds, Ke or WACC, may respectively used
Other considerations
• Who receives the residual value in the lease agreement?
• Any restrictions associated with the leased equipment, e.g. leases may restrict a firm’s borrowing capacity.
• Any additional benefits associated with lease agreement, e.g. maintenance or other support services.
Page | 42
CHAPTER 8: CERTAIN FINANCIAL DECISIONS
• Calculate the EAC for each strategy
• Choose the strategy with the lowest EAC.
• EAC uses real cashflows and real discount rate. It cannot be applied using nominal cashflows.
• The formula used for EAC is: EAC = PV of costs .
Annuity factor (AF)
Capital rationing
Shareholder wealth is maximized if a company undertakes all possible positive NPV projects. Capital rationing
occurs where there are insufficient funds to do so. There are two causes of this:
Divisible projects
• If a project is divisible, any fraction of the project may be undertaken
• Returns from the project are expected to be generated in exact proportion to the amount of investment
• Calculate the PI for each project
• The profitability index (PI) = NPV .
Investment
• Rank the projects according to their PI
• Allocate funds according to the projects’ rankings until they are used up.
Page | 43
CHAPTER 8: CERTAIN FINANCIAL DECISIONS
Linear programming and Shadow price concept
Linear programming is performed to identify best strategy in cases where more than one constraint applies. It is
applied in following steps.
Slack: The amount of constrained resource left after producing in the best mix.
Critical resource: It is the resource which is fully consumed at best mix i.e. its slack = zero
Shadow price / Dual value: Additional benefit that can be earned after adding one further unit of critical resource.
It gives the premium that may be paid for this further unit of critical resource.
Page | 44
CHAPTER 8: CERTAIN FINANCIAL DECISIONS
Example 1: Lease vs Buy
A firm has decided to acquire a new machine to neutralize the toxic waste produced by its refining plant. The
machine would cost Rs 6.4 million and would have an economic life of five years. Tax depreciation is provided at
25% pa. Taxation at 30% is payable on operating cash flows, one year in arrears. The firm intends to finance the
new plant by means of a five year fixed interest loan at a pretax cost of 11.4% pa, principal repayable in five years’
time. As an alternative, a leasing company has proposed a finance lease over five years at Rs 1.42 million pa
payable in advance. Scrap value of the machine under each financing alternative will be zero. Evaluate the two
options for acquiring the machine and advise the company on the best alternative.
The truck could be purchased for Rs 1,200,000. At the end of four years the company has been guaranteed a
trade-in price of Rs 200,000. The service and maintenance costs under a suppliers maintenance contract will be
Rs 100,000 per annum, payable at the end of each year. The truck would be depreciated both for tax and
internal accounting purposes on the straight line basis over four years.
The company could borrow money from a bank at a nominal interest rate of 12% per annum. The company's
weighted average before tax cost of capital is 20%, and its weighted average after tax cost, 16%. If the truck is
purchased outright, the funds would be financed using bank loan.
The corporation tax rate is 30%, but the company has not paid any tax for the last two years. It is anticipated
that the company will not pay any tax for the next two years because of trading losses. However, large profits
will be earned during year 2. The company will then continue to earn profits for a number of years. Accumulated
losses can be carried forward for tax purposes. The amount of profits in year 2 are expected to be well in excess
of the accumulated losses. Tax is paid one year after the date of reporting profits.
Required: Which is the less expensive alternative, to purchase or to lease the forklift truck?
Rent. The annual rental charge will be Rs 500,000 for next year payable in advance, and includes servicing the
machine. In addition, the charge per photocopy made will be Rs 2.15 payable annually in arrears.
Lease. Under the terms of the proposed lease, three lease payments of Rs 250,000 would be due, one at the
beginning of each of the next three years. At the end of the third year, Drifter Ltd would be entitled to purchase
the photocopying machine for a nominal amount of Rs 10,000. The annual servicing charge would be Rs 60,000,
both during and after the lease period, payable annually in arrears. The servicing charge would include the cost
of the first 50,000 photocopies each year. The charge for each additional copy would be Rs 0.55.
Purchase. The machine could be purchased at the start of next year for Rs 650,000, payable at the beginning of
the year. Annual servicing charges and costs of additional copies would be as for the leasing alternative.
Page | 45
CHAPTER 8: CERTAIN FINANCIAL DECISIONS
The finance director of Drifter Ltd expects that all costs except lease payments will increase in the future at an
annual compound rate of 5%. Whichever alternative is selected, the company will continue to insure the
photocopying machine. The premium for next year is expected Co be Rs 15,000. The finance director estimates
that the remaining useful life of the machine is 5 years at the end of which time it will have no scrap or resale
value. The company presently makes about 80,000 photocopies per annum and this level is expected to
continue over the next five years.
Drifter Ltd obtains corporation tax relief at 30% on its costs one year after the costs arise. A 100% first-year tax
allowance is available on photocopying machinery. Drifter Ltd has a money cost of capital, net of tax, of 10% per
annum.
You are required to: Prepare calculations for the finance director of Drifter Ltd showing whether the photocopying
machine should be rented, leased or purchased
Bench X Bench Y
Sale price per unit of bench Rs 1000 Rs 1100
Wood required per unit 2 KGs 3 KGs
Labor required per unit 5 Hours 4 Hours
Page | 46
CHAPTER 9: CURRENCY RISK, COMMODITY RISK & HEDGING
Exchange rates
It is the price of one currency relative to another currency
Quotes
• The exchange rate may be expressed as a direct quote or an indirect quote.
• Direct quote is the number of domestic currency units needed to buy one unit of foreign currency. E.g. Rs
170/$1.
• The indirect quote the number of foreign currency units needed to buy one unit of domestic currency.
$0.00588/Rs 1.
Spot rate
• Spot rate is the exchange rate on currency for immediate delivery
• The Rs to $ spot rate may be quoted as follows: Rs 170 - Rs 170.5 (Direct) or $ 0.00588 - $ 0.00586 (Indirect).
• In direct quote, the first rate is bid price (buying rate) and the second is the offer price (selling rate).
• In indirect quote, vice versa.
Transaction risk
• The risk of an exchange rate changing between the transaction date and the subsequent settlement date.
• Associated with exports/imports.
Economic risk
• Risk of long-term effects of changes in exchange rates on the value of a company (PV of future cash flows).
• Looks at how changes in exchange rates affect competitiveness, directly or indirectly.
• Reduced by geographic diversification.
As an example, Is a Pakistani company, which is not engaged in any form of foreign trade and therefore not
involved in any transactions denominated in a foreign currency, exposed to currency risk?
The answer is YES! One of the Pakistani firm’s competitors could be foreign (e.g. Bangladeshi), or could import its
product from another country. Hence if, for example, the PKR strengthened against the BKT, the Pakistani firm’s
competitors would gain an advantage; they could charge a lower price for their product and therefore potentially
take market share from the Pakistani company but still receive the same value in BKT.
Translation risk
• Risk of changes in exchange rates and its effect on the translated value of foreign assets and liabilities (e.g.
foreign subsidiaries).
• Gains/losses usually unrealised so many firms do not hedge.
Hedging strategies
Invoice in home currency
• Insist that all foreign customers pay in your home currency and that your company pays for all imports in your
home currency.
• The rate risk has not gone away; it has just been passed onto the customer.
Page | 47
CHAPTER 9: CURRENCY RISK, COMMODITY RISK & HEDGING
• It is achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic
approach.
Matching
• When a company has receipts and payments in the same foreign currency due at the same time, it can simply
match them against each other.
• It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions.
Decide to do nothing?
• The company would ‘win some, lose some’.
• Theory suggests that, in the long run, gains and losses net off to leave a similar result to that if hedged.
• In the short run, however, losses may be significant.
• One additional advantage of this policy is the savings in transaction and administrative costs.
Forward contracts
Characteristics
• The forward market is where you can buy and sell a currency, at a future date for a predetermined rate
• The forward exchange rates are quoted at a premium or at discount from the spot rates.
• For direct quotes: Add premium; Less discount
• For indirect quotes: Less premium; Add discount
Advantages
• It is over the counter (OTC) – tailor made and so can be matched exactly to the future sums involved.
• Simple and easy to understand.
Disadvantages
• Binding contract for delivery, even if commercial circumstances change – e.g. a customer is late paying.
• Eliminates exposure to upside as well as downside movements.
For receipt
• There is an asset in forex, set up a liability by borrowing in forex and converting to Rupee today.
Page | 48
CHAPTER 9: CURRENCY RISK, COMMODITY RISK & HEDGING
• Required forex borrowing = Receipt in forex / (1 + interest on borrowing in forex)
• Convert the forex borrowed into local currency = forex amount x buying rate
• Receipt in local currency = Local currency x (1 + interest on deposit in local currency)
Implications
• Interest rate parity implies that a money market hedge should give the same result as a forward contract.
• Money market hedges may be feasible for currencies where forward contracts are not available.
• This approach has obvious cash flow implications which may prevent a company from using this method, e.g. if
a company has a considerable overdraft it may be impossible for it to borrow funds now.
Futures contracts
For receipt
• Step 1: Choose the first contract to expiry after the conversion date.
• Step 2: Calculate the currency requirement in contract currency units (Use current spot rate if required).
• Step 3: Divide by the contract size to determine number of contracts.
• Step 4: Sell forex futures or buy local currency futures
• Step 5: Close the position by taking inverse action once the exposure period is over.
• Step 6: Calculate the difference in buying and selling rates. Difference = Sale price - Buy price
• Step 7: Calculate profit/loss = Difference x no. of contracts x value of each contract
• Step 8: Add/(less) the profit/(loss) to the receipt.
For payment
• Step 1: Choose the first contract to expiry after the conversion date.
• Step 2: Calculate the currency requirement in contract currency units (Use current spot rate if required).
• Step 3: Divide by the contract size to determine number of contracts.
• Step 4: Buy forex futures or sell local currency futures
• Step 5: Close the position by taking inverse action once the exposure period is over.
• Step 6: Calculate the difference in buying and selling rates. Difference = Sale price - Buy price
• Step 7: Calculate profit/loss = Difference x no. of contracts x value of each contract
• Step 8: Less/(add) the profit/(loss) to the payment.
Forex swaps
• In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then reswap them
at the end of the period at an agreed swap rate.
• The swap rate and amount of currency is agreed between the parties in advance. Thus it is called a ‘fixed
rate/fixed rate’ swap.
• The main objectives of a forex swap is to hedge against forex risk for a long period.
Illustration
Suppose that ABC Limited, a Pakistani construction company, wins a contract to construct a bridge in Argentina.
The bridge will require an initial investment now, and will be sold to the Argentinean Government in one year’s
time. The Government will pay in pesos. The problem is the company’s exposure to currency risk. They know how
much will be received in one year’s time in pesos but not in Rupees as the exchange rate changes daily.
Page | 49
CHAPTER 9: CURRENCY RISK, COMMODITY RISK & HEDGING
The Company can enter into a forex swap. Instead of taking out a loan in pesos it can:
(a) Swap Rupees today for the pesos required to cover the initial investment, at an agreed swap rate.
(b) Take out a loan in Rupees today to buy the pesos.
(c) In one year’s time arrange to swap back the pesos obtained in (a) for Rupees at the same swap rate.
Currency swaps
Characteristics
• A currency swap allows the two counterparties to swap interest rate commitments on borrowings in different
currencies.
• In effect a currency swap has two elements:
– An exchange of principal in different currencies, which are swapped back at the original spot rate – just like a
forex swap.
– An exchange of interest rates – the timing of these depends on the individual contract.
• The swap of interest rates could be ‘fixed for fixed’ or ‘fixed for variable’.
Illustration
Warne Co is an Australian firm looking to expand in Germany and is thus looking to raise €24 million. It can borrow
at the following fixed rates: A$ 7.0%, € 5.6%. Euroports Inc is a French company looking to acquire an Australian
firm and is looking to borrow A$40 million. It can borrow at the following rates: A$ 7.2%, € 5.5%.
The current spot rate is A$1 = €0.6. Show how the currency swap would work in the circumstances described,
assuming the swap is only for one year and that interest is paid at the end of the year concerned.
Now
• Australian company borrows A$40m at 7.0% from bank and French company borrows €24m at 5.5% from
Bank.
• Then, the companies exchange principals. Australian company pays A$40m to French company and receives
€24m from it.
At end of year
• Australian company pays A$2.8m interest to bank and French company pays €1.32m interest to its bank.
• Then, the companies exchange interest. Australian company pays €1.32m to French company and receives
A$2.8m.
• Finally the companies swap back principal. Australian company pays €24m to French company and receives
A$40m from it
Calculation
Interest costs Warne Co Euroports Inc
Without swap €1.344m (24 × 5.6%) A$2.88m (40×7.2%)
With swap €1.320m (as above) A$2.80m (as above)
Saving €24,000 A$80,000
Currency options
Characteristics
• A currency option is a right, but not an obligation, to buy or sell currency at an exercise price on a future date.
• If there is a favourable movement in rates the company will allow the option to lapse.
• A call option gives the holder the right to buy the underlying currency.
Page | 50
CHAPTER 9: CURRENCY RISK, COMMODITY RISK & HEDGING
• A put option gives the holder the right to sell the underlying currency.
• Options are more expensive than the forward contracts and futures.
• A European option can only be exercised on the expiry date whilst an American option can be exercised at any
time up to the expiry date.
• Two types of currency options are available:
– Cash options contracting for delivery of the underlying currency.
– Options on currency futures (Double derivative)
A typical pricing schedule for the US$/€ currency option on the Philadelphia exchange is as follows.
Here, the options are for a contract size of €125,000 and prices (both strike price and premia) are quoted in US$
(cents) per €1. So to buy a call option on €125,000 with an expiry date of July and at a strike price of €1 = $1.17
would cost 1.55 cents per euro, or $1,937.50. Similarly, the premium on a June put at a strike price of 11,500 (€1
= $1.15) would cost 0.64 cents per euro, or $800.
• The decision as to which exercise price to choose will depend on cost, risk exposure and expectations. If you
have to choose in the exam then one approach is to consider the cost implications only for calculation purposes.
Using the above schedule in example 5, the lowest net cost of each option will be given as follows:
The lowest cost would involve using call options with a strike price of 115.
Calculations
Step 1: Determine the type of contract – call or put
Step 2: Determine number of contracts.
Step 3: Decide on the exercise price, if necessary.
Step 4: Buy calls/puts option contracts as required –
Step 5: Determine option premium – usually payable upfront. Include the opportunity cost of funds, i.e. assume
the company will have to borrow the cost of the options between now and conversion date.
Step 6: On the settlement date compare the option price with the prevailing spot to determine whether the option
would be exercised or allowed to lapse.
Page | 51
CHAPTER 9: CURRENCY RISK, COMMODITY RISK & HEDGING
Step 7: Determine net cash flows.
Calculations
Step 1: Convert all currency flows to a common (‘base’) currency using spot rates
Step 2: Clear the overlap of any bilateral indebtedness.
Step 3: Convert back into original currencies.
Step 4: Use the simplified figures for:
A Settlement
B Setting up appropriate hedging tools
Currency Swaptions
• Swaptions are Options to swap.
• These are hybrid derivative products that integrate the benefits of swaps and options.
• Currency swaptions are rare in practice
• The purchaser of a currency swaption has the right, but not the obligation, to enter into a currency
swap at some future date on terms agreed today.
• An up-front premium is payable.
• Some of the more complex swaptions used in practice include Cross-currency Bermudan swaptions which
have an embedded option in a cross currency swap. However such complex instruments are not in syllabus.
Page | 52
CHAPTER 9: CURRENCY RISK, COMMODITY RISK & HEDGING
Example 1: Forward
An Australian firm has just bought some machinery from a US supplier for US$250,000 with payment due in 3
months’ time. Exchange rates are quoted as follows:
A$1 = US$ Spot 0.7785 - 0.7891 Three months forward 0.21 - 0.18 cents premium
Determine the amount payable if a forward contract is used.
Solution: AUD 321,999
Solution:
(a) Payment: €179,622 ; Receipt: €575,545
(b) Payment: €175,230 ; Receipt: €549,139
Example 3: Futures
It is 15 October and a treasurer has identified the need to convert euros into dollars to pay a US supplier $12
million on 20 November. The treasurer has decided to use December Euro futures contracts to hedge with the
following details:
• Contract size €200,000.
• Prices given in US$ per Euro
• Tick size $0.0001 or $20 per contract.
He opens a position on 15 October and closes it on 20 November. Spot and relevant futures prices are as follows:
Date Spot Futures price
15 October 1.3300 1.3350
20 November 1.3190 1.3240
Calculate the financial position using the hedge described.
Solution: Euro 9,022,745
Example 4: Futures
It is 4 May and the treasurer of a Swiss company has identified a net receipt of US$2 million on 10 June. The
treasurer has decided to use June US dollar – Swiss Franc futures contracts to hedge with the following details:
• New York Board of Trade (NYBOT) options and futures exchange.
• Contract size $200,000
• Prices given in Swiss francs per US dollar
Page | 53
CHAPTER 9: CURRENCY RISK, COMMODITY RISK & HEDGING
• Tick size CHF 0.0001 or CHF20 per contract
She opens a position on 4 May and closes it on 10 June. Spot and relevant futures prices are as follows:
Date Spot Futures price
4 May 1.2160 1.2200
10 June 1.2750 1.2760
Calculate the financial position using the hedge described.
Solution: SFr 2,438,000
Example 8a
Pongo plc is a UK based import export company. It has an invoice, which it is due to pay on 30 June, in respect of
$350,000. The company wishes to hedge its exposure to FX risk using FX options with an exercise price of $1.50.
The current $/£ spot rate is 1.5190 – 1.5230. On LIFFE contract size is £25,000.
Exercise price ($/£) June contracts
Calls Puts
1.50 6.80 12.40
Option premiums are given in cents per pound.
Assume that it is now the 31 March and that UK £ interest rates are 12%. Calculate the cash flows in respect to
the payment if the spot rate is: 1.4810 – 1.4850 on the 30 June
Page | 54
CHAPTER 9: CURRENCY RISK, COMMODITY RISK & HEDGING
Example 8b
Using the circumstances described in the above example, suppose Pongo plc is also due to receive $275,000 from
a US customer on 30 September. LIFFE quotes for September option contracts are as follows:
Exercise price ($/£) September contracts
Calls Puts
1.50 8.00 13.40
Calculate the cash flows in respect to the receipt if the spot rate is 1.5250 – 1.5285 on the 30 September.
Midmarket spot rates are $1 = £0.50; $1 = €0.75; $1 = CHF1.25. Establish the net external indebtedness that would
require external hedging and the net intra-group settlement required.
The investment will be made after 1 year and will cost 800m Escudos and then yield an amount of 1500m Escudos
after a further 2 years. Aay cannot borrow Escudos directly and is therefore considering two possible hedging
techniques:
• Entering into a 3 years forward contract for 1200m escudos at 30 Escudos / USD. The forward processing fee
is Escudos 0.1m and is payable upfront.
• Entering into a Currency Swaption with a one year maturity allowing the option for a 2 years swap for the
800m escudos initial investment at 20 Escudos / USD. The swaption premium is 0.5% of contract value and is
payable upfront in Escudos.
The currency spot rate is 20 Escudos / USD and WACC of Aay is 10%. Inflation in the USA is 5% and in Chile is 25%.
Using Purchasing Power Parity theory, determine whether Aay should hedge its exposure using a forward contract
or a Currency swaption.
Page | 55
CHAPTER 9: CURRENCY RISK, COMMODITY RISK & HEDGING
Calculate the effectiveness of using futures hedge if on 30th April the spot rate is Rs 5,500 per maund and the
futures price is Rs. 5,400 per maund. Bee Limited’s WACC is 15%.
Page | 56
CHAPTER 10: INTEREST RATE RISK & HEDGING
Interest rate risk
Firms are exposed to interest rate movements in two ways:
• The cost of existing borrowings may be variable. This risk can be eliminated by using fixed rate products.
• There may be a need for future borrowings/deposits. Interest rates may change before such borrowing/deposit.
• The second type of risk is our focus.
Borrowing
1. Buy FRA (pay FRA, receive KIBOR)
2. Select relevant FRA
3. Calculate saving = Principal x (KIBOR @ settlement - FRA rate) x m/12 x 1 .
1 + (KIBOR x m/12)
4. Effective borrowing rate = Actual interest - Saving
Loan
Lending
1. Sell FRA (pay KIBOR, receive FRA)
2. Select relevant FRA
3. Calculate saving = Principal x (FRA rate - KIBOR @ settlement) x m/12 x 1 .
1 + (KIBOR x m/12)
4. Effective deposit rate = Actual interest + Saving
Deposit
Underlying assets
The underlying of an IRF is a debenture.
• Selling futures thus equates to issuing debentures and hence borrowing money.
• Buying futures equates to buying debentures or depositing funds.
Futures price
Interest rate futures prices are stated as (100 – the expected market reference rate), so a price of 95.5 would
imply an interest rate of 4.5%.
Page | 57
CHAPTER 10: INTEREST RATE RISK & HEDGING
Borrowing
1. Sell IRFs (Thus at settlement close position by buying IRF)
2. Select IRF with maturity right after start of borrowing period
3. Calculate no of contracts = Loan amount / Contract value x Term of loan / Term of contract
4. Gain = no of contracts x contract value x contract term/12 x change in interest %
5. Deduct gain from actual interest cost
6. Calculate effective interest rate
Lending
1. Buy IRFs (Thus at settlement close position by selling IRF)
2. Select IRF with maturity right after start of lending period
3. Calculate no of contracts = Deposit amount / Contract value x Term of deposit / Term of contract
4. Gain = no of contracts x contract value x contract term/12 x change in interest %
5. Add gain to actual interest income
6. Calculate effective interest rate
Concept
An interest rate swap is an agreement whereby the parties agree to swap a floating stream of interest payments
for a fixed stream of interest payments and via versa. There is no exchange of principal
Swaps can be used to hedge against an adverse movement in interest rates. Say a company has a $200m floating
loan and the treasurer believes that interest rates are likely to rise over the next five years. He could enter into a
five year swap with a counter party to swap into a fixed rate of interest for the next five years. From year six
onwards, the company will once again pay a floating rate of interest.
Total gain
Total arbitrage gain = Diff in fixed rate risk premium - Diff in floating rate risk premium
Hedging
Step 1: Identify the type of loan with the biggest difference in rates.
Step 2: Identify the party that can borrow this type of loan the cheapest
Step 3: Write the actual rates and target rate first.
Step 4: Make fixed party pay KIBOR / KIBOR
Step 5: Remaining would be balancing
Step 6: Calculate the net cost and savings:
Interest payable on loan (%)
Swap - receive %
Swap - pay (%)
Net cost (%)
Page | 58
CHAPTER 10: INTEREST RATE RISK & HEDGING
• The ‘bid rate’ that they are willing to pay in exchange for receiving KIBOR.
• The difference between these gives the bank’s profit margin.
• Its method is same as above direct swap except that variable party pays ask rate and fixed party pays bid rate.
Options on IRFs
Borrowing
1. Buy on option to sell IRFs (Put option)
2. Select option with maturity right after start of borrowing period
3. Select the exercise price with lowest payment i.e. loan interest plus cost is the lowest
4. Calculate no of contracts = Loan amount / Contract value x Term of loan / Term of contract
5. Calculate premium = % pa x m/12 x no of contracts x contract value
6. Decide whether to exercise or lapse the option
Lending
1. Buy on option to buy IRFs (Call option)
2. Select option with maturity right after start of lending period
3. Select the exercise price with highest receipt i.e. deposit interest minus cost is the highest
4. Calculate no of contracts = Deposit amount / Contract value x Term of deposit / Term of contract
5. Calculate premium = % pa x m/12 x no of contracts x contract value
6. Decide whether to exercise or lapse the option
7. Gain = no of contracts x contract value x contract term/12 x diff in interest %
(E.g. if you have a call option at 91 and the market rate is 92, you can buy a thing worth 92 for 91, you make a gain
of 1%)
8. Add gain and deduct option premium from actual interest income
9. Calculate effective interest rate
Page | 59
CHAPTER 10: INTEREST RATE RISK & HEDGING
Example 1: FRA
Enfield Inc’s financial projections show an expected cash deficit in two months time of $8m, which will last for
approximately three months. It is now the 1st November 2006. The treasurer is concerned that interest rates may
rise before the 1st January 2007. Protection is thus required for two months. The treasurer can lock into an interest
rate today for a future loan. The company takes out a loan as normal, i.e. the rate it pays is the going market rate
at the date the loan is taken out. It will then receive or pay compensation under the separate forward rate
agreement to return to the locked in rate. Suppose a 2 – 5 FRA at 5.00 – 4.70 is agreed. The agreement starts in
2 months time and ends in 5 months time. The FRA is quoted as interest rates for borrowing and lending – the
borrowing rate is always the highest. Calculate the interest payable if in two months’ time the market rate is (a)
7% or (b) 4%.
Example 2: FRA
ARF Co. needs to borrow $10 million in six month’s time for a period of six months. To avoid adverse interest rate
movements it buys a 6v12 FRA for which the fixed rate is 5.74%. If the reference interest rate is 5% at the start of
the loan, calculate the settlement payment on the FRA.
Example 3: IRF
Global Inc wishes to borrow €9,000,000 for one month starting in 5 weeks’ time. Euribor is currently 3% and the
treasurer of Global decides to fix the rate by selling IRFs at 96.90. The market rate subsequently rises by 25 basis
points to 3.25%. As soon as the loan is agreed, the treasurer closes out Global’s position by buying a matching
number of contracts at 96.65.
(a) Calculate the number of contracts required (Note: one 3month contract is for €1,000,000)
(b) Demonstrate that, in this case, the gain on the futures contracts exactly matches the extra interest on the loan.
Example 4: IRF
A company is going to borrow £2,000,000 in two month’s time for a period of three months. It fears that the
current interest rate will rise from its current level of 5%. It is decided to use £500,000 3month interest rate futures
to hedge the position. The current price is 94.90. In two months time the interest rates have risen to 7% and the
futures price is 92.90. Calculate the cash flow that results from the profit or loss on the futures.
Example 5: Swaps
Company A wishes to raise $10m and to pay interest at a floating rate, as it would like to be able to take advantage
of any fall in interest rates. It can borrow for one year at a fixed rate of 10% or at a floating rate of 1% above
KIBOR. Company B also wishes to raise $10m. They would prefer to issue fixed rate debt because they want
certainty about their future interest payments, but can only borrow for one year at 13% fixed or KIBOR + 2%
floating, as it has a lower credit rating than company A.. Calculate the effective swap rate for each company –
assume savings are split equally.
Example 6: Swaps
Company X wishes to raise $50m. They would prefer to issue fixed rate debt and can borrow for one year at 6%
fixed or KIBOR + 80 points. Company Y also wishes to raise $50m and to pay interest at a floating rate. It can
borrow for one year at a fixed rate of 5% or at KIBOR + 50 points. Calculate the effective swap rate for each
company – assume savings are split equally.
Page | 60
CHAPTER 10: INTEREST RATE RISK & HEDGING
The bank is currently quoting 12 month swap rates of 4.90 (bid) and 4.95 (ask). Show how the swap via the
intermediary would work.
IRFs have a term of 6 months and contract size of Rs 50m. Show how a hedge using Options on Interest rate
futures would work using KIBOR rates and Interest Rate Future prices given below:
Date KIBOR March maturity future June maturity future
1-Jan 7.00% 92.00 91.00
31-Mar 8.50% 91.00 90.50
IRFs have a term of 6 months and contract size of Rs 50m. Show how a hedge using Options on Interest rate
futures would work using KIBOR rates and Interest Rate Future prices given below:
Date KIBOR March maturity future June maturity future
1-Jan 7.00% 92.00 91.00
30-June 8.50% 91.00 90.50
Page | 61
CHAPTER 10: INTEREST RATE RISK & HEDGING
premium of €50,000, commencing in three months’ time and with a maturity date the same as the floating rate
Euro loan. Explain what is meant by a swaption, and illustrate under what circumstances this proposed swaption
would benefit Noswis. The time value of money may be ignored.
Solution
The swaption offers a swap from floating to fixed rate for the remaining 3 years of the loan. The fixed rate is 0.3%
above the current floating rate payable by Noswis. The premium payable of €50,000 is 2.5% of the total value of
the loan or 0.83% per year over the remaining 3 year period. If interest rates rise during the next nine months
by more than 0.3% the swaption is likely to be exercised. For the swaption to be beneficial to Noswis, the
average floating rate payable by Noswis without the swap over the three year period would have to exceed
9.33% (8.2% + 0.3% + 0.83%).
Page | 62
CHAPTER 11: DIVIDEND & FINANCING DECISIONS
Dividend irrelevancy theory
In an efficient market, dividend irrelevancy theory suggests that, provided all retained earnings are invested in
positive NPV projects, existing shareholders will be indifferent about the pattern of dividend pay-outs. But there
are certain points against dividend irrelevance:
• Reductions in dividend can convey ‘bad news’ to shareholders (dividend signalling).
• Changes in dividend policy, particularly reductions, may conflict with investor liquidity requirements
• Changes in dividend policy may upset investor tax planning
• Companies attract a certain clientele of shareholders precisely because of their preference between income
and growth (Clientele effect)
Value of a right
‘Ex-right price’ minus ‘issue price’
However, there can be other basis for evaluation of different financing options given below.
Page | 63
CHAPTER 11: DIVIDEND & FINANCING DECISIONS
Comparison of Financing Cost
The financing side will usually have no impact on operating cash flows of the project. This means that the cashflows
will remain the same and thus the alternative providing a lower cost (discount rate) will yield the highest NPV.
There can be more than one ways of doing of comparing the financing costs:
Comparison of outflows
Where the period of calculation is limited by the question, for example the data is available for only 2 years or the
examiner has asked to restrict computation to 1 year, the cash outflows under each alternative are compared.
Again, there can be more than one ways of doing so depending on the question:
Comparison of market value or shareholder benefit using Dividend or Earnings based techniques
As discussed above, different financing options generally do not impact operating cashflows. It follows therefore
that once WACC under different alternatives is calculated it does not make sense to compute an NPV. Since NPV
if calculated using the same cashflows for each scenario, it would be best at the lowest rate.
However, market value or shareholder value under different alternatives could be different if Dividend or Earning
based techniques are used. In this case you could use:
a) DVM to account for differing dividends and thus giving different Ke under each option; or
b) PE based valuation to reflect different earnings and PE under different alternatives.
Page | 64
CHAPTER 11: DIVIDEND & FINANCING DECISIONS
Example 1: Dividend irrelevancy
X limited has in issue 5 million shares having market value of Rs 50 each. The dividend proposed for the current
year is Rs 5 per share. The company can invest cash surpluses at 10% pa at the same level of risk as current
operations. Compute the effect on shareholder’s wealth of the following options:
(a) continuing with the current dividend
(b) retaining an extra Rs 10 million and investing it at 10%
(c) paying out normal dividend and raising an additional Rs 10 million for investment at 10% by right issue
(b) Al-Ghazali Pakistan Limited (AGPL) is a listed company whose shares are currently traded at Rs. 80 per share.
AGPL’s Board has approved a proposal to invest Rs. 600 million in a project which is expected to commence on 31
December 2012. There are no internal funds available for this investment and the company would have to finance
the project from the profit for the year ending 31 December 2012 and through right issue. AGPL has a share capital
consisting of 20 million shares of Rs. 10 each and its profit for the year ending 31 December 2012 is projected at
Rs. 250 million. The annual return on 1-year treasury bills, the standard deviation of returns on AGPL’s shares and
the estimated correlation of returns with market returns are 7.5%, 8% and 0.8 respectively. The current market
return is 12.9% with a standard deviation of 5%.
Required:
Using MM Theory of Dividend Irrelevance, estimate the price of AGPL’s shares as at 31 December 2012, if the
company declares:
(i) 20% dividend
(ii) Nil dividend (05 marks)
(c) Justify the MM Theory of Dividend Irrelevance, based on your computation in (b) above. (05 marks)
Additional WC of 10,000 and additional capex of 20,000 is required to increase sales by 50%. Calculate how much
debt financing is required for increasing sales as proposed.
Sales 100,000
PBT Margin 40%
Tax 30%
Dividend pay-out % 50%
Normal accrued expenses 10,000
Normal prepaid expenses 5,000
Normal working capital 15,000 [Excluding accruals prepayments]
Normal yearly capex 30,000
Page | 65
CHAPTER 11: DIVIDEND & FINANCING DECISIONS
Additional WC of 10,000 and additional capex of 20,000 is required to increase sales by 50% next year. In addition,
accruals and prepayments will each grow by 10%. Calculate how much additional debt financing would be required
next year to fulfil financing needs assuming that the normal working capital and capex needs would not change.
Page | 66
CHAPTER 12: WORKING CAPITAL MANAGEMENT
WORKING CAPITAL
Cash cycle
Cash cycle = Inventory turnover period + Debtors receivable period – Payables payment period
Over-capitalisation
If there are excessive inventories, accounts receivable and cash, and very few accounts payable, there will be an
over-investment in current assets and the company will be over-capitalised.
Overtrading
Overtrading happens when a business tries to do too much too quickly with too little long-term capital. Symptoms
include rapid increase in sales with high volume of current assets financed by short term capital.
INVENTORY MANAGEMENT
Inventories are managed by balancing the costs of inventory shortages against those of inventory holding.
Relevant costs of inventory to be considered include holding cost, ordering cost and shortage costs.
Page | 67
CHAPTER 12: WORKING CAPITAL MANAGEMENT
Inventory levels
• Re-order level = maximum usage x maximum lead time
• Maximum inventory level = re-order level + re-order quantity – (minimum usage x minimum lead time)
• Buffer safety inventory = re-order level – (average usage x average lead time)
• Average inventory = buffer safety inventory + re - order amount / 2
Assessing creditworthiness
The main points to note are as follows.
• New customers should give two good references, including one from a bank.
• Credit ratings might be checked through a credit rating agency.
• A new customer's credit limit should be fixed at a low level and only increased later
• For large value customers, a file should be maintained of available financial information
• Send a member of staff to visit the customer concerned
Factoring
Factoring is an arrangement to have debts collected by a factor company, which advances a proportion of the
money it is due to collect.
Invoice discounting
Invoice discounting is the sale of trade debts at a discount. Invoice discounting enables the company from which
the debts are purchased to raise working capital.
Page | 68
CHAPTER 12: WORKING CAPITAL MANAGEMENT
CASH MANAGEMENT
Organisations hold cash for the transaction, precautionary or a speculative motive.
Cash forecasts
Cash forecasts show the expected receipts and payments during a forecast period and are a vital management
control tool.
Baumol Model
Similar to EOQ model, but here the procured asset is Cash and not inventory
EOQ = √ (2COD/CH)
Short-term investments
Temporary surpluses of cash can be invested keeping in mind liquidity, profitability and safety.
• Deposits with a financial institution
• Invested in longer term traded debt instruments
• Invested in shares of listed companies
• Money market lending
• Government securities (PIBs T-bills etc.)
Page | 69
CHAPTER 12: WORKING CAPITAL MANAGEMENT
Example 1: WC cycle
Wines Co buys raw materials from suppliers that allow Wines 2.5 months credit. The raw materials remain in
inventory for one month, and it takes Wines 2 months to produce the goods. The goods are sold within a couple
of days of production being completed and customers take on average 1.5 months to pay. Calculate Wines's cash
operating cycle.
Example 2: EOQ
The demand for a commodity is 40,000 units a year, at a steady rate. It costs $20 to place an order, and 40c to
hold a unit for a year. Find the order size to minimise inventory costs, the number of orders placed each year, the
length of the inventory cycle and the total costs of holding inventory for the year
The required rate of return on investments is 20%. Assume that the 25% increase in sales would result in additional
inventories of $100,000 and additional accounts payable of $20,000. Advise the company on whether or not to
extend the credit period offered to customers, if:
(a) All customers take the longer credit of two months
(b) Existing customers do not change their payment habits, and only the new customers take a full two months
credit
Page | 70
CHAPTER 12: WORKING CAPITAL MANAGEMENT
Example 7: Receivables Management
A company offers its goods to customers on 30 days' credit, subject to satisfactory trade references. It also offers
a 2% discount if payment is made within ten days of the date of the invoice. Calculate the cost to the company of
offering the discount, assuming a 365 day year.
The current debt collection period is one month, and the management consider that if credit terms were eased
(option A), the effects would be as follows.
Present policy Option A
Additional sales (%) – 25%
Average collection period 1 month 2 months
Bad debts (% of sales) 1% 3%
The company requires a 20% return on its investments. The costs of sales are 75% variable and 25% fixed. Assume
there would be no increase in fixed costs from the extra revenue; and that there would be no increase in average
inventories or accounts payable. Which is the preferable policy, Option A or the present one?
Page | 71
CHAPTER 12: WORKING CAPITAL MANAGEMENT
(c) Quantities sold/to be sold on credit
May June July Aug Sept Oct Nov Dec
1,000 1,200 1,400 1,600 1,800 2,000 2,200 2,600
(d) Production quantities
May June July Aug Sept Oct Nov Dec
1,200 1,400 1,600 2,000 2,400 2,600 2,400 2,200
(e) Cash sales at a discount of 5% are expected to average 100 units a month.
(f) Customers settle their accounts by the end of the second month following sale.
(g) Suppliers of material are paid two months after the material is used in production.
(h) Wages are paid in the same month as they are incurred.
(i) 70% of the variable overhead is paid in the month of production, the remainder in the following month.
(j) Corporation tax of $18,000 is to be paid in October.
(k) A new delivery vehicle was bought in June. It cost $8,000 and is to be paid for in August. The old vehicle was
sold for $600, the buyer undertaking to pay in July.
(l) The company is expected to be $3,000 overdrawn at the bank at 30 June 20X5.
(m) No increases or decreases in raw materials, work in progress or finished goods are planned over the period.
(n) No price increases or cost increases are expected in the period.
On average:
(a) Accounts receivable take 2.5 months before payment
(b) Raw materials are in inventory for three months
(c) Work-in-progress represents two months’ worth of half produced goods
(d) Finished goods represent one month's production
(e) Credit is taken as follows:
(i) Direct materials 2 months
(ii) Direct labour 1 week
Page | 72
CHAPTER 12: WORKING CAPITAL MANAGEMENT
(iii) Variable overheads 1 month
(iv) Fixed overheads 1 month
(v) Selling and distribution 0.5 months
Work-in-progress and finished goods are valued at material, labour and variable expense cost.
Compute the working capital requirement of Corn Co assuming the labour force is paid for 50 working weeks a
year
Page | 73
CHAPTER 13: DECISION MAKING - MANAGEMENT ACCOUNTING
Relevant costing
Relevant costs are future cash flows arising as a direct consequence of a decision.
• Relevant costs are future costs
• Relevant costs are cash flows
• Relevant costs are incremental costs
Labour
If the labour has an alternative use the relevant costs are the variable costs of the labour and plus the contribution
forgone.
Materials
Opportunity costs
Benefit sacrificed by choosing one opportunity rather than the next best alternative.
Outsourcing
The relevant costs/revenues are the differential costs between the two options.
Page | 74
CHAPTER 13: DECISION MAKING - MANAGEMENT ACCOUNTING
Pricing for special orders
Special orders may arise when a business has a regular source of income but also has some spare capacity or when
a business has no regular source of income and does one-off projects.
A minimum price for a special order covers the incremental costs of producing and selling the item and the
opportunity costs of the resources consumed in making and selling the item.
Page | 75
CHAPTER 13: DECISION MAKING - MANAGEMENT ACCOUNTING
Example 1: Relevant costing
Bronty Co is considering whether to undertake some contract work for a customer. The machinery required for
the contract would be as follows.
(a) A special cutting machine will have to be hired for three months for the work (the length of the contract). Hire
charges for this machine are $75 per month, with a minimum hire charge of $300.
(b) All other machinery required in the production for the contract has already been purchased by the organisation
on hire purchase terms. The monthly hire purchase payments for this machinery are $500. This consists of $450
for capital repayment and $50 as an interest charge. The last hire purchase payment is to be made in two months’
time. The cash price of this machinery was $9,000 two years ago. It is being depreciated on a straight line basis at
the rate of $200 per month. However, it still has a useful life which will enable it to be operated for another 36
months. The machinery is highly specialised and is unlikely to be required for other, more profitable jobs over the
period during which the contract work would be carried out. Although there is no immediate market for selling
this machine, it is expected that a customer might be found in the future. It is further estimated that the machine
would lose $200 in its eventual sale value if it is used for the contract work.
What is the relevant cost of machinery for the contract?
(a) Material B is used regularly by O ' Reilly Ltd, and if units of B are required for this job, they would need to be
replaced to meet other production demand.
(b) Materials C and D are in inventory as the result of previous over-buying, and they have a restricted use. No
other use could be found for material C, but the units of material D could be used in another job as substitute for
300 units of material E, which currently costs $5 per unit (of which the company has no units in inventory at the
moment).
What are the relevant costs of material, in deciding whether or not to accept the contract?
Page | 76
CHAPTER 13: DECISION MAKING - MANAGEMENT ACCOUNTING
Example 4: Make or Buy decisions
Shellfish Co makes four components, W, X, Y and Z, for which costs in the forthcoming year are expected to be as
follows.
A sub-contractor has offered to supply units of W, X, Y and Z for $12, $21, $10 and $14 respectively. Should
Shellfish make or buy the components?
The contract requires 3,000 kg of material K, which is a material used regularly by the company in other
production. The company has 2,000 kg of material K currently in stock which had been purchased last month for
a total cost of $19,600. Since then the price per kilogram for material K has increased by 5%. The contract also
requires 200 kg of material L. There are 250 kg of material L in stock which are not required for normal production.
This material originally cost a total of $3,125. If not used on this contract, the stock of material L would be sold for
$11 per kg.
The contract requires 800 hours of skilled labour. Skilled labour is paid $9.50 per hour. There is a shortage of
skilled labour and all the available skilled labour is fully employed in the company in the manufacture of product
P. The following information relates to product P:
$ per unit
Selling price 100
Skilled labour costs 38
Other variable costs 22
Required: Prepare on a relevant cost basis, the lowest cost estimate that could be used as the basis for a quotation.
Page | 77
CHAPTER 13: DECISION MAKING - MANAGEMENT ACCOUNTING
Example 8: Further processing decisions
A company produces 3 products A, B and C from Processes A, B and C respectively. All processes take input from
Process X. Other relevant information is as follows.
A B C Total
Output volume (KGs) 10,000 15,000 13,000 38,000
Normal loss @ 50% conversion stage 5% of input 3% of input 4% of input
Sales price per KG 4,500 5,000 5,500
Variable cost of conversion per completed unit (PKR) 2,100 2,200 2,500
Other variable production costs* 200,000
Other fixed production costs* 150,000
* Allocated to process A, B and C based on output volume of each process
The output of Process X can be sold at PKR 3000 per KG at a direct cost to sell of PKR 500 per KG. Lost units from
any of the processes can be sold at PKR 2000. There is no loss in Process X.
The sales price per unit is $14 per Mash and $11 per Sauce. During July the available direct labour is limited to
8,000 hours. Sales demand in July is expected to be as follows.
Mash 3,000 units
Sauce 5,000 units
Required: Determine the production budget that will maximise profit, assuming that fixed costs per month are
$20,000 and that there is no opening inventory of finished goods or work in progress.
The organisation has existing inventory of 250 units of X and 200 units of Z, which it is quite willing to use up to
meet sales demand. All three products use the same direct materials and the same type of direct labour. In the
next year, the available supply of materials will be restricted to $4,800 (at cost) and the available supply of labour
to $6,600 (at cost).
Required: Determine what product mix and sales mix would maximise the organisation's profits in the next year.
Page | 78
CHAPTER 13: DECISION MAKING - MANAGEMENT ACCOUNTING
Example 11: Limiting factor decisions
MM manufactures three components, S, A and T using the same machines for each. The budget for the next year
calls for the production and assembly of 4,000 of each component. The variable production cost per unit of the
final product is as follows.
Only 24,000 hours of machine time will be available during the year, and a sub-contractor has quoted the following
unit prices for supplying components: S $29; A $40; T $34.
Required: Advise MM
What is the production mix which will maximise total contribution and what would be the total contribution?
Although additional labour can be made available at short notice, the company wishes to make use of 1,200 hours
of Grade A labour and 800 hours of Grade B labour which has already been assigned to working on the contract
next month. The total variable cost per unit is $120 for X and $100 for Y.
Claire Speke wishes to minimise expenditure on the contract next month. How much of X and Y should be supplied
in order to meet the terms of the contract?
Page | 79
CHAPTER 13: DECISION MAKING - MANAGEMENT ACCOUNTING
at $15 a roll and the heavy gauge at $20 a roll. There is an unlimited market for the standard gauge but outlets for
the heavy gauge are limited to 13,000 rolls a year. The factory operations of each process are limited to 2,400
hours a year. Other relevant data is given below.
Required: Calculate the allocation of resources and hence the production mix which will maximise total
contribution
Page | 80
CHAPTER 14: TRANSFER PRICING
Transfer Price
A transfer price is the price at which goods or services are transferred from one department to another or from
one member of a group to another. Transfer prices are a way of promoting divisional autonomy without
prejudicing the measurement of divisional performance or discouraging overall corporate profit maximisation.
General rules
• Minimum: Supplying division's Marginal cost + Opportunity cost. Opportunity cost is higher of the following:
a) Maximum contribution forgone by supplying division by not selling goods externally
b) Maximum contribution forgone by supplying division in not using the same for next best alternative
• Maximum: Lowest market price at which the receiving division could purchase the goods or services
externally, less any internal cost savings in packaging and delivery.
Page | 81
CHAPTER 14: TRANSFER PRICING
Example 1: Fair inter-division transfer price
The Sole Division makes rubber soles for both football boots and work boots and sells these soles to other boot
manufacturers. The Boot division manufactures leather uppers for football boots and attaches these uppers to
rubber soles. During its first year the Boot Division purchased its rubber soles from outside suppliers so as not to
disrupt the operations of the Sole Division. Strike management now wants the Sole Division to provide at least
some of the soles used by the Boot Division. The table below shows the contribution margin for each division
when the Boot Division purchases from an outside supplier.
What would be a fair transfer price if the Sole Division sold 10,000 soles to the Boot Division?
Page | 82
CHAPTER 15: VARIANCE ANALYSIS
BASIC STANDARD COSTING:
Standard costing is used when entity produces standard units of product or service that are identical to all other
similar units produced. Standard costing is most suited to mass production and repetitive assembly work.
USES: Pre-determined estimated unit cost used for stock valuation & control. It may be used both in absorption
costing & marginal costing. Also used for performance measurement and control reporting
TYPES OF STANDARDS:
Basic:
The material total variance is the difference between what the output actually cost and what it
should have cost, in terms of material. It can be divided into the following two sub-variances:
► The material price variance is the difference between what the material did cost and what it
should have cost.
FORMULA: (Actual Price per unit – Standard price per unit) Actual Quantity
► The material usage variance is the difference between the standard cost of the material that should
have been used and the standard cost of the material that was used.
FORMULA: (Actual Quantity used – standard quantity used for actual production) Standard price per
unit
Page | 83
CHAPTER 15: VARIANCE ANALYSIS
Example 1:
A unit of product A123 has a standard cost of five liters of material A at $3 per liter. In a particular
month, 2000 units of product A123 were manufactured. They used 10,400 liters of material A, costing
$33,600.
Solution:
TOTAL MATERIAL VARIANCE:
Standard cost for Actual production (2000 x 15) 30,000
Actual cost 33,600
Variance 3,600 Adverse
The variance is adverse as the material actual cost is higher than budgeted.
The material usage variance is adverse because more material is used than expected, and this has added
to costs.
The standard may take into account the effect of normal loss.
Example 2:
A company makes a standard product. Each finished product contains 450g of raw material and there is an
expected loss of 5% of material input. Standard cost is $4 per kg.
Actual results:
6000 units were produced and 3240 kgs of raw material has been consumed.
Solution:
The standard cost of material allowing for normal wastage of 5% is 450g * 100/95 = 500g
Page | 84
CHAPTER 15: VARIANCE ANALYSIS
POSSIBLE CAUSES OF MATERIAL VARIANCES:
The total cost variance for direct labour is difference between the standard and actual labour cost for
the units produced. It is divided in further three variances.
► Direct Labour Rate Variance: This is the difference between the actual cost of the direct labour ( hours
paid for) and what the hours should have cost (the actual hours at standard rate)
FORMULA: (Actual rate – standard rate) Actual Hours paid for
► Direct labour efficiency variance: This is the difference between the actual hours worked and the
standard hours required to make the quantity of units produced
FORMULA: (Actual hours worked – standard hours for actual production) standard rate per hour
FAVORABLE: Where labour has taken less hours than required as per standard to make the required units. And
variance is adverse where labour has taken more hours to complete the task.
Example 2: A company produces and sells one product only, the Thing, the standard cost for one unit being as
follows.
Solution:
Labour rate variance
4,200 hours should have cost (× $6) 25,200
Page | 85
CHAPTER 15: VARIANCE ANALYSIS
but did cost 24,150
Rate variance 1,050 (F)
This idle time variance may be favorable (where idle time is less than expected) or may be adverse (where idle
time is more than expected)
Example 3:
Product X: Standard:
Standard time per unit is 1.8 hours @ $15
Actual results:
Output 1000 units
Hours paid 1950
Hours worked 1910
Labour cost $27,300
Solution:
Idle time variance (1950 – 1910) 15 600 A
Labour Efficiency ratio (1800 – 1910) 15 1650 A
Page | 86
CHAPTER 15: VARIANCE ANALYSIS
POSSIBLE CAUSES OF LABOUR VARIANCES:
The variable production overhead total variance is the difference between what the output should
have cost and what it did cost, in terms of variable production overhead.
FORMULA: (Actual rate per hour – standard rate per hour) Actual hours worked
Important to note: The formula is same as that of labour rate except that in labour rate variance actual
hours paid are taken instead of actual hours worked.
► The variable production overhead efficiency variance is the difference between the standard cost of the
hours that should have been worked for the number of units actually produced, and the standard cost of the
actual number of hours worked.
FORMULA: (Actual Hours worked – standard hours for actual production) standard rate of variable overhead
per unit
The cause of variable overhead efficiency variance is same as that of the labour efficiency variance.
Page | 87
CHAPTER 15: VARIANCE ANALYSIS
FIXED OVERHEAD VARIANCES:
Fixed production overhead total variance is the difference between fixed production overhead
incurred and fixed production overhead absorbed. In other words, it is the under– or over absorbed
fixed production overhead. It is further subdivided:
► Fixed production overhead expenditure variance is the difference between the budgeted fixed production
overhead expenditure and actual fixed production overhead expenditure.
► Fixed production overhead volume variance is the difference between actual and budgeted
production/volume multiplied by the standard absorption rate per unit.
► Fixed production overhead volume efficiency variance is the difference between the number of hours that
actual production should have taken, and the number of hours actually taken (that is, worked) multiplied by
the standard absorption rate per hour.
► Fixed production overhead volume capacity variance is the difference between budgeted hours of work
and the actual hours worked, multiplied by the standard absorption rate per hour.
Point to note: If actual hours are greater than budgeted, there is an increase in capacity. More products can be
produced and this will increase profit therefore this is a favorable variance.
The Efficiency Variance is same in hours as the efficiency variance for labour and variable production overhead.
However, it is valued at the fixed production overhead rate per hour.
The Capacity Variance is an hours worked variance. It is difference between budgeted hours and actual hours
worked and it is priced at the fixed production overhead rate per hour.
Total Fixed
Overhead Cost
Variance
Volume Expenditure
Variance Variance
Efficiency Capacity
Variance Variance
EXAMPLE:
A company produces and sells one product only, AMX.
Standard cost - Fixed production overhead $50
Page | 88
CHAPTER 15: VARIANCE ANALYSIS
The fixed overhead included in the standard cost is based on an expected monthly output of 900 units.
Fixed production overhead is absorbed on the basis of direct labour hours.
During April the actual Fixed production overhead $47,000.
Find all fixed overhead variances.
Solution:
Fixed overhead expenditure variance $
SALES VARIANCES:
Sale variances are used to reconcile actual profit with budgeted profit and give an indication to management to
assess performance.
► Sales Price Variance: The sales price variance measures the effect on expected profit of a selling price
different to the standard selling price. It is calculated as the difference between what the sales revenue
should have been for the actual quantity sold, and what it was.
Formula : (Actual selling price – standard selling price) Actual Qty Sold
► Sales Volume Variance: The sales volume variance measures the increase or decrease in expected profit as a
result of the sales volume being higher or lower than budgeted. It is calculated as the difference between
the budgeted sales volume and the actual sales volume multiplied by the standard profit per unit.
Formula : (Actual qty sold – standard qty sold) Standard Margin per unit*
Page | 89
CHAPTER 15: VARIANCE ANALYSIS
*We use standard margin in case of marginal costing. Where absorption costing is used it will be replaced by
standard profit per unit.
Example:
A company budgets to sell 7,000 units of product ABC. The standard sales price is $ 50 per unit and standard
cost is $ 42.
Actual sales were 7,200 units, which sold for $351,400.
Solution:
Sales Price Variance:
7,000 units at $50 360,000
7,200 did sell for 351,400
Variance 8,600 A
Adverse as actual sales revenue was less than the expected revenue.
Where standard costing is used for products which contain two or more items of direct material, the material
usage is further subdivided into two variances:
► Material Mix Variance: The material mix variance measures how much of the total usage variance is
attributable to the fact that the actual combination or mixture of material that was used was more
expensive or less expensive than the standard mixture for the material.
o The material mix variance indicates the effect on profits of having an actual material mix that is
different from standard mix.
Page | 90
CHAPTER 15: VARIANCE ANALYSIS
o Favorable: Where the actual mix of materials used is cheaper than the standard mix.
► Material Yield Variance: It is the difference between the actual yield from a given input and the yield
that the actual input should have given in standard terms.
o This variance indicates the effects on costs of the total material input yielding more or less
output than expected.
A mix variance and yield variance are only appropriate in the following situations:
► Where proportions of materials in a mix are changeable and controllable;
► Where the usage variance of individual materials is of limited value because of the variability of the
mix, and a combined yield variance for all the materials together is more helpful for control.
In particular, sales mix variances are only of use if there is some kind of link between the products in question.
► Complementary products, such as pancake mix and lemon juice
► Substitute products, such as branded and 'own-label' goods
► Same products, different sizes
► Products produced within a limiting factor environment
NOTE: It would be totally inappropriate to calculate a mix variance where the materials in the 'mix' are discrete
items. A chair, for example, might consist of wood, covering material, stuffing and glue. These materials are
separate components, and it would not be possible to think in terms of controlling the proportions of each
material in the final product. The usage of each material must be controlled separately.
If a company sells more than one product, it is possible to analyze the overall sales volume variance into a sales
mix variance and a sales quantity variance.
► The sales mix variance occurs when the proportions of the various products sold are different from
those in the budget.
► The sales quantity variance shows the difference in contribution/profit because of a change in sales
volume from the budgeted volume of sales.
NOTE: It is calculated in the same manner as the material mix and yield variance. The only difference is as
follows:
The sales mix variance is calculated as the difference between the actual quantity sold in the standard mix and
the actual quantity sold in the actual mix, valued at standard profit margin per unit.*
The sales quantity variance is calculated as the difference between the actual sales volume in the budgeted
proportions and the budgeted sales volumes, multiplied by the standard profit margin.*
* Where an organization uses standard marginal costing instead of standard absorption costing then
standard contribution rather than standard profit margin is used in the calculations.
Page | 91
CHAPTER 15: VARIANCE ANALYSIS
Planning and Operational Variances:
A planning and operational approach to variance analysis divides the total variance into those variances which
have arisen because of inaccurate planning or faulty standards (planning variances) and those variances which
have been caused by adverse or favorable operational performance, compared with a standard which has been
revised in hindsight (operational variances).
► Planning variance: A planning variance (or revision variance) compares an original standard with a
revised standard that should or would have been used if planners had known in advance what was going
to happen.
► Operational Variance: An operational variance (or operating variance) compares an actual result with
the revised standard.
S
Planning variance is uncontrollable variance in the sense that control action by management cannot eliminate
weaknesses in planning. Planning variances arise because the original standard and revised more realistic
standards are different and have nothing to do with operational performance. In most cases, it is unlikely that
anything could be done about planning variances: they are not controllable by operational managers but by
senior management.
Operational variance may be controllable variances. By comparing actual results with more realistic revised
standards provide management with useful control information.
Advantages of using planning and operational Disadvantages of using planning and operational
variances variances
Managers are only held accountable for the Managers will be tempted to manipulate the
operational variances, this lead to more realistic results of standards by revising the standards and
performance evaluation. classify most of the variances as being caused due
to planning errors instead of operational
performance
Planning variances can be used to update standard It takes time and efforts to prepare revised
costs and revise budgets. standards and make revised budgets accordingly.
Provide more realistic information to control
operational variance.
Page | 92
CHAPTER 15: VARIANCE ANALYSIS
Market Size and Market Share Variances:
Sales volume variance can be analyzed in the following manner:
► the planning variance for sales volume is called a market size variance
► the operational variance for sales volume is called a market share variance
However these variances are calculated without revising the sales budget. This is because of the fact that the
sales budget is based on estimates;
► There will be an estimate of market size and estimated amount of sales in the market segment which
can turn out differently later on
► Within the market size, the entity budget will specify the market share captured
It is called operational sales volume variance as this aspect can be controlled by the entity.
Example:
A company set the following sales budget:
Total size of market 200,000 units
Expected market share 25%
Standard contribution per unit $40
At the end of the year it was estimated that the actual size of the market during the year had been 260,000
units.
Actual sales in the year were 61,000 units.
Solution:
Market size variance :
Total budgeted market size 200,000
Actual market size 260,000
Difference 60,000
Budgeted market share 25%
Page | 93
CHAPTER 15: VARIANCE ANALYSIS
Market share variance 160,000 A
Operating Statements:
An operating statement is a regular report for management which compares actual costs and revenues with
budgeted figures and shows variances.
The common format is one which reconciles budgeted profit to actual profit. Sales variances are reported first,
and the total of the budgeted profit and the two sales variances results in a figure for 'actual sales minus the
standard cost of sales'. The cost variances are then reported, and an actual profit calculated.
Page | 94
CHAPTER 15: VARIANCE ANALYSIS
Example 1: Basic variance analysis
Following data relates to ABC Limited for the Month of January 2022.
Calculate basic variances under Absorption Costing system.
Actual Standard
Production & Sales (Units) 11,000 10,000
Selling price (Rs) 1,450 1,500
Page | 95
CHAPTER 15: VARIANCE ANALYSIS
Example 3: Sales mix & yield variances, market share and market size variances
Following data relates to B Limited for the month of Jan 2022. Calculate sales variances.
Budgeted
Budgeted profit Actual profit Actual market sales
Product market sales
PKR PKR Units
Units
A 300,000 400,000 100,000 110,000
B 700,000 750,000 150,000 145,000
C 500,000 450,000 200,000 130,000
Page | 96