SUMMARY OF SLIDES FIN 722.docx

8/10/2019 SUMMARY OF SLIDES FIN 722.docx

1/114

SUMMARYOF SLIDES

FIN 722


2/114

LESSON 23

EXAMPLE

A firm has 100 shares outstanding and the par value of share is Rs.100. The company intends to pay all

of its earnings in dividends. The cash flow for year 1 & 2 to be paid as dividend is rs.10,000 that meansRs.100 dividend per share.

The other option is to pay a dividend of Rs. 110 after first year and Rs. 89 after second year as dividend.

Assuming 10% required rate of return.

What is the value of the firm with new dividend policy?

Solution

Po = D1/(1 + R)1+ D2/ (1+R)

2

that is:

= 100 /1.10 + 100/(1.10)

2

= 173.55

Now if the second option is adopted, then value of firm is:

Po= D1/(1 + R)1+ D2/ (1+R)2

= 110 /1.10 + 89*/(1.10)2

= 173.55

*why it is 89lets see.

We have only Rs. 10,000 of cash flow for dividend payout. but under later option we need a cash flow

of

110 x 100 = 11,000 - a deficit of Rs 1000.

Suppose we seek a loan to bridge this deficit. In the next year we need to pay dividend, return the loan

and to pay interest on loan (assume 10% Rate)

Loan repayment and interest will be Rs. 1100 and the balance amount left for dividend will be

20,0001,100 = 8,900 which equals Rs 89 per share dividend.

DIVIDEND RELEVANCE:

As a mean of resolving the uncertainty early, investors prefer dividend income rather than non-

dividend paying.

Liquidity preference

Time value of money


3/114

FINANCIAL SIGNALING:

Image of the company improved by paying dividend.

None payment of Dividend adversely effect companys image.

Dividends have impact on share prices because it indicate the firms profitability as well.

Accounting earnings may not be a influencing factor as compared to increase in dividend.

TAXATION ON CAPITAL GAINS VS DIVIDENDS:

In Pakistan no tax levied on Capital Gain but tax is paid on Dividend.

RESIDUAL DIVIDEND POLICY

Debt Equity Ratio of 0.50firm wishes to maintain it. After tax profit rs.1,000. If no dividend is paid,

equity will increase. It means that firm will seek loan to maintain D/E Ratio. for example, after tax profit

of Rs.1000/- the firm must borrow Rs.500 in order to maintain D/E of 0.50.The first thing would be to determine the funds that can be generated without selling additional

shares.

Residual Dividend Policy

Sr.

No. After Tax

Earning

New

Investment

Additional

Debt

Retained

Earning

Additional

Stock

Dividends Debt/Equity

1 2,000.00 6,000.00 2,000.00 2,000.00 2,000.00 - 0.50

2 2,000.00 5,000.00 1,500.00 2,000.00 1,000.00 - 0.50

3 2,000.00 4,000.00 1,250.00 2,000.00 500.00 - 0.50

4 2,000.00 3,000.00 1,000.00 2,000.00 - - 0.50

5 2,000.00 2,000.00 666.67 1,333.33 - 666.67 0.50

6 2,000.00 1,000.00 333.33 666.67 - 1,333.33 0.50

7 2,000.00 - 2,000.00

CONCLUSION


4/114

A firm must endeavor to establish a dividend policy that maximizes shareholders wealth.

Mostly it is believed that if a firm does not have investment opportunities on its plate, it should return /

distribute funds to shareholders.

It is not necessary to pay out everything but firm may wish to stabilize the dividends.

There must be preference for dividend.

It appears realistic to have some value associated with modest dividend as compared to nothing.

FINANCIAL PLANNING & FORECAST

BUDGETS FUNCTIONS AND PREPARATION OF BUDGET

CASH BUDGETS:

- SALES FORECAST

- DIRECT COST FORECAST / ESTIMATE

- OTHER RECEIPT & DISBURSEMENT

- NET CASH FLOW

CASH FLOW STATEMENT ACCOUNTING:

INDIRECT METHODIAS DEFINITION

PARTS OF CASH FLOW

ANALYZING CASH FLOW

- FORECAST FINANCIAL STATEMENTS

PLANNING PROCESS:Identify objectives or targets

Develop Courses Of Action To Achieve Objectives

Evaluate every alternative

Choose a course of actionstrategy to achieve

Implement a plan

Lead to controlling

CONTROL PROCESS

Plans put to operationlast stage of planning

-Actual results are recorded

-Actual results are compared with actual

-Feedback is prepared

-Two types of Feed back

-Negative Feed back

-Positive Feed back

-Feedback is used to change the strategy

-Feedback & feed forward control

WHAT SORT OF CORRECTION CAN BE MADE


5/114

CHANGE THE STRATEGY OR COURSE OF ACTION:

If something went wrong with strategy, the course of action is fine tuned or changed to ensure

future actual results conform to original plan.

DO NOTHING:

If the results are in line with the planned, no action is required.

CHANGE THE PLAN:

Targets or plan itself is revised rather than changing strategy. For example the targeted profit is

scaled down.

BUDGET AS PLANNING & CONTROLLING TOOL

Budget:

Transform yours objectives into monetary values.

BUDGET PREPARATION PROCESS

BUDGET POLICY & DETAILS

Budgeting committee

Budgeting period

Time

Communicating to all

DETERMINING THE LIMITING FACTOR

(either capacity or sales forecast)

LESSON 24

SALES BUDGET PREPARATION

Sale forecast & Production budget

OTHER ANCILLARY POLICY ISSUES DETERMINATION

Finished goods level

Materials ending inventory

Production cost budget

FUNCTIONAL BUDGETSNEGOTIATION

MASTER BUDGET OR CORPORATE BUDGET

FINALIZATION OF BUDGET & IMPLEMENTATION

CONTROLLING STAGE

VARIANCE ANALYSIS

Difference between actual and budgeted numbers is known as variance.

INVESTIGATION


6/114

PURPOSE & OBJECTIVES OF BUDGET

Path to achieve the corporate objectives

Compel Planning

Increased Responsibility AccountingEnsures Control

Increased Coordination

Source of Motivation

CASH BUDGETS

A statement that incorporates both inflows and outflows.

Based on the timings of each component.

COMPONENTS OF CASH BUDGET

Non-cash items are not considered.

Every item involving cash is included and considered.Example: Depreciation is a non-cash items.

Accruals are not taken into cash budgets.

Profits and losses are not related to cash budgets.

Above all the essence of cash budget is the timing of occurrence of every line item.

EXAMPLE

M/S Hi Land Ltd is in the process of preparing cash budget for the 1stquarter of 2007. The following

information is available:

Opening cash balance is Rs. 2,000/-

Forecast sales are Rs 50,000/- each for Nov. 06 to Jan. 07 and Rs. 65,000 per month for Feb. & Mar. 07.

80% sales is on credit basis and 20% on cash.Debtors pay after two months from the sale date.

Materials cost will be Rs. 34,000/- for Nov. & Dec. 07 & Rs. 35,000/-, Rs. 36,000/- & Rs. 37,000/- for Jan

to Mar. 07 respectively.

Creditors are paid after one month.

Electricity bill is paid in following month. Dec to Mar. expense is estimated at Rs. 6,000 per month.

Recurring expense will be Rs. 4,000 per month for Nov. & Dec. 06 and Rs. 6,000, Rs 9000 & Rs. 12,000

for Jan. to Mar. 07 and are paid in the month of incurrence.

A new assets will be purchased in Jan 07 for Rs. 12,000/-. payment will be made in Feb. 07.

An old assets will be disposed off in January for Rs. 1,000/- and the receipt will hit the bank on first of

February 07.

Required:

Prepare the cash budget for the first quarter of year 2007 and provide your feedback to the

management.

SOLUTION CASH BUDGET


7/114

Nov-06 Dec-06 Jan-07 Feb-07 Mar-07

INFLOWS Rs.

TOTAL SALES 50,000.00 50,000.00 50,000.00 65,000.00 65,000.00

SALES - CREDIT 80% 40,000.00 40,000.00 40,000.00

SALES - CASH 20% 10,000.00 13,000.00 13,000.00

SALES INFLOW 50,000.00 53,000.00 53,000.00

OTHER RECEIPTS

SALE OF ASSET - 1,000.00 -

TOTAL INFLOWS 50,000.00 54,000.00 53,000.00

OUTFLOWS MATERIALS COST 34,000.00 34,000.00 35,000.00 36,000.00 36,000.00

CREDITORS PAYMENT 34,000.00 35,000.00 36,000.00

ELECTRICITY 6,000.00 6,000.00 6,000.00

RECURRING EXP 6,000.00 9,000.00 12,000.00

CAPITAL PAYMENTS - 12,000.00 -

TOTAL INFLOWS 46,000.00 62,000.00 54,000.00

NET CASH FLOW 4,000.00 (8,000.00) (1,000.00)

OPENING CASH 2,000.00 6,000.00 (2,000.00)

ENDING CASH 6,000.00 (2,000.00) (3,000.00)

CASH FLOW STATEMENT

This statement is governed by International Accounting Standard 07.


8/114

Purpose of Cash Flow Statement is to provide information about the inflows and outflows of cash and

cash equivalents.

Cash And Cash Equivalent has two characteristics:

The inflows and outflows are grouped into three categories.

both readily convertible into cash

without loss of value

CASH FLOW STATEMENT IS DIVIDED INTO THREE CATEGORIES

OPERATING ACTIVITIES

INVESTING ACTIVITIES

FINANCING ACTIVITIES

PURPOSE OF CASH FLOW STATEMENT

To identify and assess the ability to generate future net cash flow from operations to pay debt, interest

and dividends

External financing requirements.

To see the effects of cash & non cash investing and financing transactions.

Assess the reasons for differences between income and associated cash receipts and payments.

METHODS OF PREPARING CASH FLOW STATEMENT

COMPLIANCE OF IAS 07:

DIRECT METHODBENCHMARK

INDIRECT METHODALLOWED ALTERNATIVE

EXAMPLE: INDIRECT METHOD

HI LAND LIMITED

INCOME STATEMENT

For the year Ended December 31, 2005 Rs.

SALES 290,000.00

Less COST OF SALES 174,000.00

GROSS MARGIN 116,000.00


9/114

Less OPERATING EXP

Administrative Exp 45,000.00

Selling & Marketing 20,900.00

Depreciation 13,000.00

Less Interest Exp 15,400.00

Gain on Sale of Land 2,500.00

Profit before taxes 24,200.00

Provision for taxes 9,700.00

Net Income 14,500.00

HI LAND LIMITED

BALANCE SHEET

AS ON DECEMBER 31, 2005

2005 2004

Fixed Assets

Land 148,400.00 100,000.00


10/114


11/114


12/114

Gain on Sale of Land (2,500.00)

Operating profit before working capital changes 25,000.00

Change in working capital

Increase in Inventory (22,000.00)

Increase in Accounts Receivable (19,000.00)

Decrease in Prepaid Expenses 1,500.00

Decrease in Accounts Payable (6,000.00)

Increase in Accrued Liabilities 4,500.00

Decrease in Amortization of Bond Premium (600.00)

Cash Generated from operations (16,600.00)

LESSON 25

CASH FLOW STATEMENT

Three segments of preparing Cash Flow Statement:

OPERATING ACTIVITIES

INVESTING ACTIVITIES

FINANCING ACTIVITIES

HI LAND LIMITED

BALANCE SHEET

AS ON DECEMBER 31, 2005

2005 2004

Fixed Assets

Land 148,400.00 100,000.00

Buildings 465,000.00 415,000.00


13/114

Less: Accumulated Depreciation (217,000.00) (205,000.00)

396,400.00 310,000.00

Intangible Assets:

Patents 5,000.00 6,000.00

CURRENT ASSETS

Inventory 175,000.00 153,000.00

Accounts Receivable 109,000.00 90,000.00

Prepaid Expenses 15,500.00 17,000.00

Cash & Bank 50,000.00 55,000.00

349,500.00 315,000.00

Investment - Land - 27,500.00

TOTAL ASSETS 750,900.00 658,500.00

CURRENT LIABILITIES

Accounts Payable 69,000.00 75,000.00

Accrued Liabilities 24,500.00 20,000.00

93,500.00 95,000.00

Long Term Liabilities:

Bonds 200,000.00 200,000.00

Premium on Bonds 29,400.00 30,000.00


14/114

229,400.00 230,000.00

TOTAL LIBILITIES 322,900.00 325,000.00

SHAREHOLDERS' EQUITY

Share Capital 335,500.00 255,500.00

Retained Earnings 92,500.00 78,000.00

Total Equity 428,000.00 333,500.00

TOTAL LAIBILITIES & EQUITY 750,900.00 658,500.00

HI LAND LIMITED

CASH FLOW STATEMENT

For the Year Ended December 31, 2005

(INDIRECT METHOD)

A CASH FLOW FROM OPERATING ACTIVITIES Rs.

Net Income 14,500.00

Adjustment for Non-Cash items:

Add Depreciation and Amortization 13,000.00

Gain on Sale of Land (2,500.00)

Operating profit before working capital changes 25,000.00

Change in working capital


15/114


16/114

NET INCREASE/(DECREASE) IN CASH EQUIVALENTS (5,000.00)

CASH AND CASH EQUIVALENTS AT THE BEGINING OF THE PERIOD 55,000.00

CASH AND CASH EQUIVALENTS AT THE END 50,000.00

Cash Budget Vs. Cash Flow

Cash Budget Pre Operations

Cash Flow Statement Post Operations

WORKING CAPITAL MANAGEMENT

These activities are in sequence:

How much inventory to procure?

Payment to creditors and expenses borrow?

Production of goods/ Manufacturing

Sales credit extension period / Cash sales

Collection of funds and application

OPERATING AND CASH CYCLE

OPERATING CYCLE:

The time between receiving the raw materials and collection of amount against credit sales

from debtors is called Operating Cycle.

CASH CYCLE:

The time period between cash payment and cash receipts.

EXAMPLE:

We buy inventory on credit on Jan. 01, 2006 worth Rs. 10,000/-. settle the creditor on Feb. 01. After amonth (on march 01) a debtor buys the finished goods for Rs. 14,000/- and pays after 1.50 months (on

15thApril 2006.

The period from the date of acquisition of inventory Jan. 01, 06 to the date of receipt of cash from

debtor15thApril 2006 is known as operating cycle.

Normally operating cycle is expressed in days. In this example, the length of Operating Cycle is 105

days.

Operating Cycle can be divided into two components:


17/114


18/114

A/R TURNOVER = CREDIT SALES/AVG AR 6.39 TIMES

(ASSUMED ALL SALES ON CREDIT)

RECEIVABLE PERIOD = 365 DAYS / AR TURNOVER 57.13 DAYS

OPERATING CYCLE= Inventory Period +AR Period

168.41 = 111.28 Days + 57.13 Days

CASH CYCLE:

Payable Turnover = COS /Avg. Payable

= 9.37 Times

AP Period = 365 days / AP Turnover = 38.95 Days

Cash Cycle = Operating CycleAccounts Payable period

129.46= 168.41Days - 38.95 Days

Recap

Two types of Cash Flow:

Pre-Operation Cash Budget

Post- OperationCash Flow Statement

Difference between Cash Budget & Cash Flow Statement

Statutory Requirement:

Cash Flow Statement: Statutory obligation to prepare CFS in order to compliance with IAS 07.

On the other hand, there is no statutory obligation to prepare Cash Budget.

Format:

Cash Budget based on estimated data. CFS based on actual data. Benchmark is direct method.

Normally CFS also prepare through indirect method.

LESSON 26


19/114


20/114

High level of investment in current assets.

Support any level of Production and Sales.

High liquidity level.

Avoid short-term financing to reduce risk, but decreases the potential for maximum value

creation because of the high cost of long-term debt and equity financing.

Borrowing long-term is considered less risky than borrowing short-term.

This approach involves the use of long-term debt and equity to finance all long-term fixed

assets and permanent assets, in addition to some part of temporary current assets.

The firm has a large amount of net working capital. It is a relatively low-risk position.

The safety of conservative approach has a cost.

Long-term financing is generally more expensive than Short term financing.

AGGRESSIVE WORKING CAPITAL POLICY

Low level of investment

Support low level of Production & Sales Activity.

More short-term financing is used to finance current assets.

Firm risk increases, due to the risk of Fluctuating Interest Rates, but the potential for higher

returns increases because of the generally low-cost financing.

Borrowing short-term is considered more risky than borrowing long-term.

This approach involves the use of short-term debt to finance at least the firm's temporary

assets, some or all of its permanent current assets, and possibly some of its long-term fixed

assets. (Heavy reliance on short term debt).

The firm has very little Net Working Capital. It is more risky.

MODERATE WORKING CAPITAL POLICY

This approach tries to balance Risk, Profitability and liquidity.

Temporary current assets that are only going to be on the balance sheet for a short time should

be financed with short-term debt, Current liabilities.

And Permanent Current Assets and Long Term Fixed Assets that are going to be on the balance

sheet for a long time should be financed from long term debt and equity sources.

The firm has a moderate amount of net working capital. It is a relatively amount of risk

balanced by a relatively moderate amount of expected return.

In the real world, each firm must decide on its balance of financing sources and its approach to

working capital management based on its particular industry and the firm's risk and return

strategy.

PROFITABILITY AND WC POLICIES

Ranking of Working Capital Policies with regard to Return on Investment:

ROI = NET PROFIT / TOTAL ASSET

OR

ROI = Net profit / (Cash + Receivables + Inventory) + Fixed Assets

While moving from policy Conservative to Aggressive, the profitability will increase.


21/114

As the inventory will decrease the return on investment will increase as suggested by the above

equation.

Under Aggressive policy, profitability is greater than Conservative.

LIQUIDITY & PROFITABILITY

lenders prefer a company having:

Large excess of current assets over current liabilities.

Whereas the owners prefer a high return.

Current assets have the advantage of being liquid, but holding them is not very profitable.

Accounts Receivable earns no return.

Inventory earns no return until it is sold.

Non-current assets can be profitable, but they are usually not very liquid.

Firms are usually faced with a trade-off in their working capital management policy.

They seek a balance between liquidity and profitability that reflects their desire for profit and

their need for liquidity.

RISK & RETURN OF CURRENT LIABILITIES

A firm's working capital is financed from:

Long-term borrowing

Short-term borrowing,

Spontaneous

The choice of the firm's working capital financing depends on manager's desire for profit

versus their degree of risk aversion.

The balance between the risk and return of financing options depends on the firm, its financial

managers, and its financing approaches.

OPTIMAL LEVE OF CURRENT ASSETS

A firm's optimal level of current assets is reached when the optimal level of

Inventory

Accounts Receivable

Cash or Cash equivalent

and other current assets is achieved.

PROJECTING THE ALL THREE POLICIES

CONSERVATIVE = A


22/114

MODERATE = B

AGGRESSIVE = C

LIQUIDITY PROFITABILITY RISK

HIGH A C C

NOR B B B

LOW C A A

THE CHART TELL US TWO THINGS

Profitability varies inversely with Liquidity;

Increased Liquidity can be achieved at the expense of (decreased) Profitability.

Profitability & Risk have same direction;

In order to have greater Profitability, we need to take greater Risk.

CONCLUSION

Optimal level of each current asset will depend on the managements attitude towards Risk &Return.

LESSON 27

CLASSIFICATION OF WORKING CAPITAL

Classification by Component:

Like Cash, Receivables, Inventory, Investments (Short Term)

Classification by Time:

Like Temporary Current Assets & Permanent Current Assets

Temporary Working Capital

-is the amount of current assets that varies with short term seasonal requirements.


23/114

Permanent working capitalis the amount of investment in current assets that is required to support

the minimum long term needs.

CURRENT ASSETS FINANCING

Short Term & Long Term Investment Mix:

A trade off between risk and profitability is required when we are faced with current assets

financing decisions.

It is assumed that a company has a definite policy vis--vis payment to creditors, taxes And

expenses. The reason being that a firm cannot stretch these outflows by a reasonable time

period.

Short Term & Long Term Investment Mix:

In other words, creditors / accounts payable and accruals are dormant decision variables when

it comes to current asset financing.

These current liabilities are known as spontaneous financing.

Residual policy have different approaches for financing.

How mix develop to finance temporary current assets and permanent current assets?

Hedging approach to Current Assets Financing

Each asset will be offset with a financing instrument having same maturity.

Temporary current assets should be financed with short term debts.

Permanent portion of current assets (and all non current assets) should be financed with long

term loans and equity.

NEXT PAGE


24/114

GRAPHICAL VERSION OF HEDGING POLICY

Only short term variations would be financed through short term loans.

If we finance this portion through long term loans, then we will pay interest on loan when actually

funds are not needed.

Short term loan/financing is flexible.

Short term loans shall only be employed in the period of seasonal lessened activity.

We pay off the loan liability when not needed to avoid interest cost.

Borrowing and payment of short term loans can be arranged to correspond to the expected cavariations.

On Eid, (increased activity) inventory will increased and that increase shall be financed through short

term borrowing.

Inventory will squeeze due to increased sales and receivables will expand.

That cash used to pay off the loan (and creditors) now comes through collection of accounts

receivable.

Short term loan to support seasonal need would generate necessary cash to repayment in normal

course of operation.

This is known as Self-Liquidating Principle.

Short Term Vs Long Term Financing

Under uncertainty, net cash flow will not exactly match the maturity of debt.

This aspect is of crucial importance when it comes to risk and profitability trade off.

What should be the Margin of Safety to allow for adverse variation in expected cash flow?


25/114


26/114

Firm finances a part of seasonal fund requirements less accounts payable on long term basis.

If cash flow estimates do not deviate far from actual, it will pay interest on debt (shaded area) when

actually funds are not needed.

Higher the long term financing line, more Conservative Policy and higher cost.

AGGRESSIVE POLICY

The company must arrange renewal of short term debt. It involves risk.

The greater portion of permanent current assets is financed with short term debt, more

aggressive policy it is.


27/114

Expected margin of safety regarding short term and long term financing can be positive,

negative or neutral.

Margin of safety can be increased by more financing in the liquid assets.

Risk of cash insolvency can be reduced by stretching the maturity schedule of debt or carrying

larger amounts of current assets.

WORKING CAPITAL POLICIES

Aggressive Policy

Conservative Policy


Guiding force:

Management attitude (Planning Process)

Vision about money market, business etc.

LESSON 28


Factors affect working capital management

Profitability

LiquidityRisk

Management attitude

Interest cost

Long term

Short term

DETERMINING W-C REQUIREMENTS: EXAMPLE

The following information pertains to M/S No-one Limited:

Estimated Turnover Rs. 1,000,000/-

Direct cost:

Direct materials 25%

Direct labor 20%

Variable overheads 10%

Fixed overheads 10%

Selling & admin 5%

WORKING CAPITAL REQUIREMENTS


28/114

Credit terms are as under:

Direct Materials 2 Months

Direct Labor 1 Month

Variable Overheads 1.5 Months

Fixed Overheads 2 Months

Selling & Admin. 1 Month

Average duration/turnover:

Accounts receivables take 2 months before realization.

Raw materials are in stock for 4 months.

WIP represents one month production 50% complete.

Finished good represents 1.5 months production.

WIP & FG are valued at material, Labor & VOH Cost.

Compute the working capital requirements of the company.

WORKING CAPITAL REQUIREMENTS

Estimated Turnover 1,000,000.00

1 Annual Cost Of Cost Items: % Of Turnover Annual Cost

Direct Materials 25 250,000.00

Direct Labor 20 200,000.00

Variable Overheads 10 100,000.00

Fixed Overheads 10 100,000.00

Selling & Admin 5 50,000.00

2 Average Value Of Current Assets Period

Raw Materials

4 months in

stock 83,333.33

Work in Process 22,916.67

Direct materials 50% complete 10,416.67

Direct labor 50% complete 8,333.33


29/114

Variable overheads 50% complete 4,166.67

Finished Goods 68,750.00

Direct materials

1.5 month

production 31,250.00

Direct labor

1.5 month


Variable overheads

1.5 month


Accounts Receivable 2 166,666.67

Gross Working Capital 341,666.67

3 Average Value Of Current Liabilities

Direct materials 2 41,666.67

Direct labor 1 month 16,666.67

Variable overheads 1.5 months 12,500.00

Fixed overheads 2 month 16,666.67

Selling & admin 1 month 4,166.67

91,666.67

4 Net Working Capital=

Current Asset - Current Liabilities

341,666.67-

91,666.67 250,000.00


30/114

3

Average Value Of Current

Liabilities

Direct materials 2 41,666.67

Direct labor 1 month 16,666.67

Variable overheads 1.5 months 12,500.00

Fixed overheads 2 month 16,666.67

Selling & admin 1 month 4,166.67

91,666.67

4

Net Working Capital=341,666.67-

91,666.67 250,000.00Current Asset - Current Liabilities

OVERTRADING

It occurs when a company tries to do too much with too little long term capital.

In other words, a firm is trying to satisfy huge level of sale or productions from lowest level of

inventory.

This liquidity problem emerges from the situation when a firm does not have enough cash flow topay off the debt.

INDICATIONS

Rapid increase in Turnover/Sales, current assets (and may be in fixed assets)

Payments to creditors are stretched.

More reliance on short term finances.

Proportion of assets financed by equity is decreased and vice versa.

Liquidity Deteriorates.

Results in negative Net Working Capital.

Debt equity ratio changes significantly.

How to get ride off Over Trading?

Injected fresh capital

Revised strategy in short run -trimming unnecessary plans.

Control over Inventory and Debtors.

Individual Component of Working Capital:

Cash


31/114

Inventory

Receivable

CASH MANAGEMENT

Motive to hold cash:

TRANSACTION MOTIVE

PRECAUTIONARY MOTIVE

SPECULATIVE MOTIVE

How much cash or cash equivalents a company should hold?

Holding too much cash or near cash items has a cost in terms of Loss of Earnings

Liquidity and profitability trade off is of crucial importance to a financial manager.

CASH FLOW PROBLEMS

Growth

Seasonal business: Like on Eid and Religious occasions, the business activity increases.

Capital expense or one-off expenditure.

Loss Making

HOW TO IMPROVE CASH FLOW

Float:

Decreasing the receipt Float.Deferring Capex and developmental work.

Early recovery of cash flows.

Liquidate Short Term Investments.

Deferring payments to creditors.

Rescheduling loan payments.

Planning is of vital importance especially rolling cash budgets.

Investing Surplus Cash Flow

Important factors:

Liquidity

Profitability

Safety


32/114

Maturityearly liquidation penalty?

INVENTORY APPROACH TO CASH MANAGEMENT

Two types of costs involved in cash holding:FIXED COST

To raise loans or capital.

VARIABLE COST

Opportunity cost, surrendering the return by investing money.

ECONOMIC ORDER QUANTITY

Q=2FS/I

Where:

S= Amount of consumption or demand in each period

F= Fixed cost of obtaining new funds

I = Interest cost of holding cash

Q= Optimal cash holding level

EXAMPLE

Liquid Limited has a fixed cost at present of Rs.10,000 to seek fresh finances. Per cash budget, the cash

requirements for the next 4 periods of a year each would be Rs. 100,000. The interest cost of fresh

finances will not be less than 14%. Interest on deposits at present is 8%.

How much finance should the firm raise at a time?

SOLUTION

HOLDING COST =14% - 8% = 6%

OPTIMUM LEVEL OF Q

= (2 x 10,000 x 100,000 / 0.06)

= 182,574

This is for 182,574/100,000 = 1.83 years. In other words, this amount is enough for almost two years.

(Almost. 1.83 is rounded off)


33/114

DRAWBACKS OF EOQ APPROACH

You cant predict future cash requirements with certainty.

There are many cost associated with running out of cash which are not considered.

There may be some other cost of holding cash which increase with the average amount held.

LESSON 29

MILLER-ORR MODEL OF CASH MANAGEMENT

There would be some upper limit or lower limit of cash balance movement.

Miller-Orr Model tries to establish optimal cash holding between the upper and lower limits of cash

balance movements.

MILLER-ORR MODEL

When cash balance reaches point A, the upper limit.

Company will invest the surplus to bring down the cash balance to return point.

When cash balance touches down point B, the lower limit.

The company would liquidate some of its investment to bring the balance back to return point.

How the upper and lower limits are determined?

Spread

Spread is the difference between lower limit and upper limit.

Variations depends on three factors:


34/114

Variance of Cash Flow

Transaction Cost

Interest Rate

Steps to be followed to use MILLER-ORR MODEL

Determine lower limit for the cash balance. This may be zero.

Calculate cash flow variance on daily basis. This sample size may be of 100-days period

Observe the interest rates and note the transaction costs

Calculate the upper limit and return point.

EXAMPLE: MILLER ORR MODEL

Minimum cash balance is Rs. 100,000/-

Daily cash flow variance is Rs. 2,000,000/-.

Transaction cost of selling & buying securities is Rs. 500/-.

Interest rate is Rs.9% per annum.

Required: Work out the upper limit and return point using miller model.SOLUTION

Spread = 3(3/4 x ((TC x V)/I)1/3

Where:

TC = Transaction Cost

V = Cash Flow Variance

I = Interest

Putting values:

= 3(3/4 x ((500 x 2,000,000)/(0.09/365)1/3

Spread = 42,855.12

Now we can calculate the Upper Limit and Return Point:

Upper Limit = Min Cash Balance + Spread

= 100,000 + 42855.12

= 142,855.12

Return Point = Min Cash Balance + 1/3 x Spread

= 100,000 + (42855.12)x 1/3

= 114,285.04

DECISION

If cash balance reaches 142k buy securities worth of (142114 =28k)


35/114

And if cash balance fall to 100k, sell securities worth 14k to get back to Return Point.

MANAGEMENT OF INVENTORY

There are three types of Inventories:

Raw materials inventory

Work in process inventory

Finished good inventory

SIZE OF ORDER

CONTROL OVER INVENTORY

EOQ is used to determine the optimum size of stock purchase in order to reduce the inventory

costs.

DISCOUNTS

If discounts are available on stock purchase, then EOQ would not be considered. Need to work

out net benefit.

INVENTORY COSTS

HOLDING COST

ORDERING COSTSHORTAGE COST

HOLDING COST CONSISTS OF:

Investment in stocks

Warehousing cost

Handling cost

Insurance cost

Pilferage cost

ORDERING COST

Delivery cost

SHORTAGE COST CONSISTS OF:

Contribution from lost sales

Increased cost of emergency stock


36/114


37/114

b) Order Per Year:

= Annual Demand / Economic Order Size

= 80,000 / 1900 = 42.10 Orders

c) Stock Cycle will be:

= 365 / 42

= 9 Days (Rounded Off)

RE-ORDER LEVEL

Re-order level is the stock level (in kg) when replenishment order should be made.

Time period involved between placing an order and receiving the order. This is known as Lead Time.

Placing order after the stock runs out may result in loss of sales and loss of cash flow.

Placing order to late and too soon have costs.

SAFETY STOCK

Safety Stock:Inventory stock held in reserve as a cushion against uncertainty in usage and/or lead

time.

Price BreaksDiscounts & EOQ:

Business always tries to save cost in order to increase profitability. When a vendor offers discounts

(Price breaks) for buying a specific quantity which is not in line with the EOQ, then business has to

consider the net saving.

Increase in order size does increase inventory costs but if that cost is off-set by the purchase cost

beyond that increase, then EOQ is not financially feasible.

EXAMPLE: PRICE BREAKS

Demand of a raw material is 80,000 kg per year. the ordering cost is Rs. 90/- per order. Material is priced

at Rs. 100 per kg. Holding cost per kg is estimated at 2% of purchase price. The vendor offer 5%

discount if the minimum order size is 5000kg. What do you suggest to the firm?

Solution:

EOQ = (2 x 90 x 80,000)/2% (100) = 2683 Units

A- NO DISCOUNT

Purchase Cost = 80,000 x 100 = 8,000,000.00

Holding Cost = 80,000 x (2% x 100) = 160,000.00

Order Cost = 42.10 X 90 = 3,789.00

Total Cost = 8,163,789.00


38/114

Per Kg Cost = 963789/80000 = 102.05 /Kg

B- When Discount is 5% on Qty order of 5000 Units:

Total Orders Annual Demand / 5000

=80,000 /5,000

= 16 Orders

Purchase Cost = 80,000 x (100-5%) = 7,600,000.00

Holding Cost = 80,000 x (2% x 95) = 152,000.00

Ordering Cost = 16 x 90 = 1,440.00

Total Cost = 7,753,440.00

Cost Per Kg = 913440/80000 = 96.42 / Kg

SAVING UNDER OPTION B:

Per unit price before discount = 102.05

Per unit price after discount = 96.42

Per unit saving = 5.63

Annualized saving = 80,000 x 5.63 = 450,400

STOCKOUTS

STOCKOUTS:The situation when a firm runs out of stock which results in shutdown of slow down of

production / sales.

In order to avoid stock out situation, a safety stock level should be procured and maintained.

LESSON 30

EXAMPLE: STOCK OUT

Five Star Limited consume 100,000/- kg per year. each order is for 5000 kg and stock out is 2000 units.

The stock out probability acceptance level is set to 10%. per unit stock out cost is Rs. 5/-. Holding cost is


39/114

estimated at Rs. 2/- per kg. being an inventory manager, determine stock out cost and amount of safety

stock to be kept on hand.

STOCKOUT COST =

= AC / Q x S x Sc x Ps

Where:

AC = Annual Consumption

Q = Order Quantity

S = Stock out in Unit

Sc = Stock out Unit Cost

Ps = Accepted Probability of Stock out

Plugging values, we get

= 100000/5000 x 2000 x 5 x 0.10

= 20,000/-

SAFETY STOCK LEVEL

Let X = Safety Stock

Then,

Stock out Cost = Carrying Cost x Safety Stock

= 20,0000 = 2 * X

X = 20,000 /2

= 10,000 UNITS

ECONOMIC ORDER POINT

EOP is the level of inventory that signals the time to place re-order of materials using EOQ amount.

Safety stock is considered in the calculations.

EOP = SL + F S x EOQ x L

WhereS= Consumption Per Period

L= Lead Time

F= Stock out Acceptance Factor

EOQ = Economic Order Quantity

ECONOMIC ORDER POINT


40/114

S = 2000 Units

EOQ = 60 Units

L = 1/4 Month

F= 1.10 (This Represents The Stock out level of say, 10%)

EOP = SL + F S x EOQ x L

= 2000 x 1/4 + 1.10 2000 x60 x 1/4

= 691 Units

Financial managers must try to establish inventory level that results in greater savings.

QUESTION: A company is in process of re-visiting its inventory policy. The current inventory turns over

18 time per year. Variable costs are 75% of sales value. If inventory levels are increased the company

anticipates additional sales and less of an incidence of inventory stock outs. the rate of return is 14%.

Actual and estimated sales & inventory levels are as under:

SALES TURN OVER

750,000 18

810,000 15

890,000 12

960,000 8

REQUIRED: Work out the level of inventory that results in highest saving.

SOLUTION: INVENTORY COST SAVING

Sales Turn Avg. Opportunity Additional Net


41/114


42/114

Very sensitive issue. Greater probability of Stock outs. May turn the overall benefits to losses.

May not be feasible for every business. Some business may maintain some inventory items on

JIT and others on EOQ etc.

DEBTORS MANAGEMENT

Significant funds are invested in debtors.

Debtors are important factor / element of Cash Cycle.

Interest cost is associated with offering credit to debtors.

Debtors are measure in days.

Investment in debtors

CREDIT CONTROL POLICY: COMPONENTS

Extending credit to customers requires careful planning and to devise policy and procedures.

Credit policy set up requires dealing with:

Terms of Sale

Credit AnalysisCollection Policy

Lets discuss each component in detail.

1. TERMS OF SALE

There are three factors underlying terms of sale:

Credit period to be granted

Cash discount & Period of discount

Credit instrument

CREDIT PERIOD:

Credit period will vary from firm to firm, industry to industry and business to business.

normally the range is 30 to 120 days.

If cash discount is offered then period is divided into two components:

Net Credit Period

Cash Discount Period

Credit period begins from the invoice date. This represents the dispatch of goods to buyer.

Many terms are used:

ROG= RECEIPT OF GOODS

2/10, NET 30

2/10, EOM

CREDIT PERIOD

Factors influencing credit period:

Buyers Inventory Period

Buyers Operating Cycle

Operating Cycle can be divided into two parts:


43/114

Inventory Period

Accounts Receivable Period

Inventory Period:

The period of time it takes to procure, produce and sell the inventory to the debtors.

Accounts Receivable Period:

The time to receive the cash from the debtors.

Main Points to keep in view

If sellers credit extension period exceeds the buyers inventory period, then seller is not only

financing the buyers inventory purchases but also a part of the receivable as well.

If sellers credit extension period exceeds the buyers operating cycle, then seller is effectively

financing the buyers need beyond the purchase and sale of sellers merchandise.

The other factors that merit consideration are:

Perishability

Collateral

Size of the account

Competition

Customer Type

TERMS OF SALE:

There are three factors underlying terms of sale:

Credit Period to be granted

Cash Discount

Credit Instrument

LESSON 31

CASH DISCOUNTS

For Example: Cost of Credit

The sale terms are 2/10 net 30 for a transaction in the amount of Rs. 100,000/-.

If buyer gives up discount, he pays Rs. 100,000/- on 30thday, and will loose Rs. 2,000/- (100,000 x

2%).

Look, foregoing Rs 2,000/- may look small but lets annualize it and express it in %age:

2,000/98,000 = 0.020408 or 2.0408%


44/114


45/114


46/114

Existing Annual Sales Rs. 2.00 M

Required Rate of Return is 15%.

25% increase in sales will result in additional investment of Rs. 150,000 in stocks and additional

creditors of Rs. 40,000/-

Advise the firm whether to change the existing policy if:

The existing customers take two month credit period, and

Only new customers only take two month credit.

Solution: Debtors Management

Sale Price 12.00

Variable Cost 10.20

Sales 2,000,000.00

Return 15.00

Contribution Margin 1.80

Contribution /Sale Ratio 15.00

Increase 1.20

Inc. In Stock 150,000.00

Inc. In Creditor 40,000.00

Particulars Amount in Rs.

Extra contribution 15.00


47/114

Increase in sales - 20% 400,000.00

Increase in cont. margin 60,000.00

A ALL CUSTOMERS TAKE TWO MONTHS CREDIT

Total turnover after 20% increase 2,400,000.00

Avg. debtors - 2 months 400,000.00

Existing debtors 1 month 166,666.67

Increase in debtors 233,333.33

Increase in stocks 150,000.00

Less: increase in creditors 40,000.00

Net increase in working capital 343,333.33

ROI ON EXTRA INVESTMENT 17.48

B ONLY NEW CUSTOMERS TAKE 2 MONTH CREDIT

Increase in sales 400,000.00

Increase in debtors 66,666.67

Increase in stock 150,000.00

Less: increase in creditors 40,000.00

Increase in net working capital 176,666.67

ROI ON EXTRA INVESTMENT 33.96

In both cases new policy look favorable and financially viable.

DISCOUNTS


48/114

Evaluate the Discounts.

More precisely, we must work out what level of discount can be offered to debtors for early

payment.

The other aspect would be to know the effect of this discount of the sales, ACP and Profit.

This example deals a situation where early payment does not effect the sales.

EXAMPLE DISCOUNT NOT EFFECTING VOLUME

A company has decided to offer 2% discount to customers if they pay the invoice within 10 days. The

current sales level is Rs. 10 million and existing terms are 2 month. This discount offering is only

intended to reduce the credit terms. The company has estimated that around 75% of customers will

avail this opportunity.

Required: If the ROI is 18%, what will be effect of % discount?

Solution: Debtors Management

Sale 10,000,000.00

Discount offered 0.02

Discount validity days 10.00

No of customer to avail discount 0.75

Existing collection time - days 2.00 month

New collection time - days 1.00 month

Return on investment 0.18

A) UNDER NO DISCOUNT POLICY

Existing volume of Debtors

=10,000,000/12 x 2 1,666,666.67

B) UNDER DISCOUNT POLICY 622,146.12

i)

75% customers will avail 2% Discount and will pay

in 10 days

=10,000,0000 x 75% x 10/365 205,479.45

ii) 25% customer will pay after 2 months


49/114


50/114

ROI 0.15

Existing Bad Debt 0.02 COS Var. 0.80

COS % 0.70 COS Fix. 0.2

New Bad Debt Level 0.03 Inc. in Sales 0.2

Var. COS 0.56

C/S 0.44

Existing sales 2,100,000.00

Cost of sales 1,470,000.00

Gross profit 630,000.00

Bad debt 31,500.00

Net profit 598,500.00

Variable Cost of sales COS=1470000 x Variable Portion of 80% 1,176,000.00

Cont Margin = 2,100,000 - 1,176,000 924,000.00

C/S ratio = 924,000 / 2,100,000 0.44 or 44%

Increase in Contribution Margin Sales=2,100,000 x Inc. 20%x C/S Ratio 0.44 184,800.00

Increase in Bad Debts= Sales 2.1m X Increase (1+0.2)xBad Debt 0.03

- BD=31,500 44,100.00

Increase in Profit 140,700.00


51/114

Intended investment in debtors (New Sales (2.1 million + 20%) /12) x 2 420,000.00

Existing investment in debtors = 2.1million / 12 175,000.00

Additional investment required 245,000.00

Cost of Additional Investment = 245,750 x ROI 15% 36,750.00

Net Benefit =140700 - 36750 103,950.00

LESSON 32

Factoring

A firm may employ a specialized entity to manage account receivables.

This specialized entity is called Factor.

Main function of a factor is to collect the accounts receivables on behalf of seller but may also

involve in invoicing and sales accounting.

Factor makes advance payments to seller in return for commission of certain %age of total debt.

This is often referred as Factor Financing.

In case of action against defaulters, factor initiate action.

Factor also take over the risk of loss in case of bad debt.

This type of factoring is known as Non-Recourse.

Significant positive effect on cash cycle.

Ensuring early payments to vendors and benefit of obtaining early payment discounts.

Optimum stock level can be maintained.

Financing (Factor) is directly linked to level of sales/accounts receivables.

Reduction in collection expense and staff payroll costs.

May prove much expensive


52/114

May have adverse effect on customers loyalty. (Factors attitude may be harsh with customers) and

may tarnish companys image.

Example: Factoring

A company is considering to seek the services of a factor because of poor collection of debtors

which has pushed up the ACP from 30 days to 45 days coupled with bad debt of 1% of annual

sales. Sales are Rs.1.80 Million.

With factoring in place, the company will save Rs. 25,000 per year on account of debtors

administration and collection costs, bring down ACP to 30 days but will cost 2% of sales.

Factor will provide 80% on invoice value of sales and will charges 11% interest. Rest 20% shall be

paid after 30 days. The company can obtain short term loan @ 10%. Sales are assumed evenly

spread over the months.

Required: Evaluate the Policy?

Debtors Management

Solution: Factoring

Cost Data

Credit Sales Annual 1,800,000.00

Current ACP Days 45.00

Cost of Short Financing 0.10

Bad Debts (1%) 0.010

Factor Financing (80%) 0.800

Factor Financing Days 30.000

Factor Fee (2%) 0.0200

Factor Financing Charge 0.110 or 11%


53/114

Existing Cost Components

Current Annual Cost 22,191.78 =Sales 1.8Million x 45/365 x 10%

Bad Debts 0.1% 18,000.00 = 1.8M x 1%

Administration Cost 25,000.00

Total Existing Cost 65,191.78

Cost of Factoring

Factor Financing Cost 13,019.18 = (1.8Million x 80%) x 30/365 x 11%

Factor will provide 80% Finance, 20% will be through Short Term Financing:

Short Term Financing Cost 2,958.90 = (Sale 1.8M x 20%) x 30/365 x 10%

Cost of Factoring 36,000.00 = Sales (1.8M) x 2% Factor Fee

Total Cost of Factoring 51,978.08

Net Saving 13,213.70

Solution

We need to work out the total cost of employing factor and saving thereof. In this case the comparison is between the existing cost of debtor administration and cost of

factoring.

If the later is less than the former, then we will accept or implement the new policy, otherwise

not.

It is Current Cost Vs Factor Cost

CREDITORS MANAGEMENT OR

MANAGEMENT OF CREDITORS

Example: Creditors Management

A vendor has offered credit terms of 2/15, net 50 to M/s ABC Limited. The company can investin Short Term Securities @ 24%. The average creditors level is Rs. 100,000.

Evaluate the offer from vendor.

Example: Creditors Management

If ABC Ltd refuses discount and pay after 50 days, then interest cost will be:

= ( D /100D ) x 365/ T 21.28


54/114

= 2/( 1002 ) x 365 / 35

D = Days in terms when Discount is valid

T= Reduction in days if Discount availed

Discount 2% 2

Discount Validity Days 15

Reduction in days is discount taken 35

Total Days 50

Average Creditors 100,000.00

Short Investment Return 24

Accept Discount

Saving will be 2% of Avg. Creditors 2,000.00

Discount is Declined

ABC can invest the money in Short Securities

For 35 days to earn @ 24% 2,301.37

Benefit of Rejection is > Discount

It is better to Decline the Discount.

Mergers and Acquisitions

Combination of two business for increasing the value of business through Synergiesin the formof Acquisition or Merger.

A process of accruing an other company.

Acquisition is also known as takeover. (Purchase Merger)

Mergers may be termed as Amalgamation. (Also consolidation Mergers)

Two businesses become single entity after Merger or Acquisition.

We will use combination for both Mergers and Acquisitions.


55/114

Vertical Mergers

Purpose of Combinations

Main purpose of combinations is to cultivate Synergies.

Synergy is a force that creates enhanced cost efficiencies when two business Merge.

The increase in efficiency of production as the number of goods being produced increases. Typically,

a company that achieves economies of scale lowers the average cost per unit through increased

production since fixed costs are shared over an increased number of goods.

Sources of Synergies are as under:

- Scale of Economies

- Staff Reduction/Cost Cutting

- Financial Strength

- Market/Distribution Network

- Acquisition of New Technology

Synergy from Operational Economies

Horizontal Combination:

When two companies in similar business combine horizontal combination, to reduce cost and

increase profit / value due to large economies of scale.

In other words both companies are in Direct Competition and have same product line but may or

may not have same markets

Vertical Mergers:

This may be eliminating backward or forward Integration. This type of Mergers increase value by the

middleman/level.

LESSON 33

COMPLIMENTARY RESOURCES


56/114

Economies of scales can also be cultivated when companies have complimentary strengths and utilizing

both under a new / combined platform.

Financial Synergy

Growth of the Business.

From a shareholders point of view, theres no gain in merger when operating economies are

absent.

Even if there are no value addition achieved, yet there is increase in value due to lower risk.

If the future cash flow stream of two companies is not positively correlated then combining the two

will reduce the variability of cash flow or

Will bring stability in cash flow thus may increase the value by having cheaper financing available.

(Lenders and creditors like to have stable cash flow that signals the ability of company to settle its

short term and long term obligations).

Other Synergies of Mergers

Skilled Human Resources

Surplus Cash

Market Power:

Mergers may enable a firm to monopolize the market.

Organic Growth:

Mergers are far faster way of expanding businesses.

Why Mergers Fail?

Over-Optimistic Estimate of Economies

Ignore Human Integration

Expertise

Lack of Communication

Expertise:

The experts involved are expert in finance and skilled in designing combination strategy and are so

involved in pre-acquisition issues that they dont find any time for behavioral aspect of unified

workforce.

CORPORATE CULTURE

The two firms may appear identical in every respect, yet the culture is different and people may not be

learning to work together.


57/114

Cultural Differencethat stand un-resolved by the new management will leave adverse effects on

communication, decision-making, productivity and inter-se relationship among people.

CORPORATE CULTURE

Inadequate Planning

Lack of Communication

Human Resource Department must be involved in Mergers and Acquisition issue.

TALENT DEPARTURE:

Studies have shown that 5075% of managers leave the merged entity within 3 years.

LOSS OF CUSTOMERS:

Especially sales/marketing employees may take good customers with them when they depart.

POWER POLITICS:

Power struggle and clashes between the groups of management for seeking power adversely

effect the health of Merger.

Mergers and Acquisition Process

Identifying Potential Targets

Business Due Diligence

Information required for appraisal of Target:

Human Resources

- Management and Expertise/Talent

- Employees and terms of employment

- Benefits Pension & Bonus

All this is required to compare the existing employee terms, remuneration, benefits and talent with the

new ones from Target Company.

Sales & Market Network

Historic sale volumes product-wise, region-wise with market share

- Details of customers & locations

- SWOT analysis, major competitors and their market share


58/114

-Marketing strategy

Production and Capacity

- Total capacity and current utilization

- Future extension possibilities

- Capital investment required for Modernization.

Technology

- Existing technical skills

- Research & Development and stage of development

Financial Information

o Accounting Policies

o Details of Assets

o Financial Analysis over the period

o Details of Loans & Overdrafts

o

Agreement of Foreign Exchange Covenants

o Details of others modes of debts like Leases

o Tax History & Computations

o Tax liabilities

o Details of dividend & liability

Cultural Due Diligence

Steps involved in culture due diligence

Readiness of company to change

Developing contents of change

Injection of new values

Freezing

LESSON 34

CULTURAL DUE DELLIGENCE

Steps involved in culture due diligence

Readiness Of Company To Change


59/114

Contents of Change, Change Agent

Change Management

Implementation and Feedback

Methods of Mergers

1- By Transfer of Assets

2. By Transfer of Shares

These two methods of acquisition can be summarized in following table.

Transfer of Shares Transfer of Assets

Acquisition

X takes over Z

X acquires shares in Z from the

existing shareholders of firm Z

for cash. Z becomes subsidiary

of X and transfer trade and

assets to holding company X.

X acquires trade and assets of Z

for cash. Firm Z stands

liquidated, proceeds are

received by shareholders of old

firm Z.

Merger

A & B merge to

form C

C acquires share in A & B for

new shares of C.

A & B become subsidiary of

firm C and may transfer trade

and assets to new holding

company.

C acquires assets and trade

from A & B in return for sharesof new company C. Original

companies are liquidated.

Acquisition

Methods & Mode of Consideration

Share & Asset Purchase:

Share Purchase:

It is a complicated option because all of the liabilities need to be owned by the predator

company. There might be some hidden liabilities.


60/114

Asset Purchase:

Only identified assets are acquired and Predator is well aware or can work out the market

value of assets.

There may be other reasons for not using shares as consideration.

Dilution:

Existing major shareholders may not wish to dilute their %age for control issue primarily.

Valuation of shares:

Difficulty in valuation of unquoted shares.

Debt/Equity Ratio:

If theres a surge in equity base after a merger, it may be an uphill task to bring back the

optimal D/E ratio.Valuation of Shares

After the target to acquire has been identified, then the predator must decide how much to pay.

Shares valuations are needed for may reasons:

- For entering stock market

- To establish terms of Acquisitions

- For tax purposes

- To value of shares held by directors

Income Based Methods:

- Present value method

- Dividend Valuation

- Price Earning Ratio

Asset Based Methods:

- Replacement cost method

- Book value method

- Break up value


61/114


62/114

When comparing with other firms we must ensure that the company is of equal size and is in same

business line.

We can use dividend yield approach for valuation of shares in Merger & Acquisition.

Dividend yield:

Div. Yield = Annual Dividend / Share Price x 100

For valuation of unquoted shares, the formula is as under:

Share Value = Annual Dividend / Div Yield

Price Earning Ratio:

This is another important measure to value shares.

P/E Ratio is = Price Per Share / EPS

Or

Value Per Share = EPS x Suitable P/E Ratio

A High P/E Ratio may be due to:

The company may be experiencing consistent Growth over the recent past years.

Based on some future expectations.

High Security Shares.

Low P/E Ratio may be due to:

Low profit & losses mix in recent past

Expected future losses

Low security

Difficulties in using this method:

A firm may not have exact similar size company and growth prospects.

P/E ratio is based on past data, where as future earnings are center point of target company in

Merger & Acquisitions.

Example: P/E Ratio of Share Valuation

Income Statement of Target Limited

For the year ended 31 December 2004

Rs.


63/114

Profit before tax 890,000

Less: Income tax 360,000

Profit after tax 530,000

Less: Preference dividend 100,000

Ordinary dividend 200,000

Retained Profit for the year 230,000

Other Information:

Outstanding shares are 300,000 @ Rs. 10 each.

P/E ratio of another company in the same industry and of same size is 8.

Required:

You are required to value share of target limited using P/E ratio method.

Solution:

Work out EPS of Target Ltd for the year in question:

EPS = Profit After TaxPreference Dividend

Outstanding shares

EPS = 530,000100,000 / 300,000

EPS = 1.433

Share Value = EPS x P/E Ratio

Share Value = 1.433 x 8

= Rs. 11.47 Per Share

Asset Based Share Valuation:


64/114

Asset-Based Methods typically involve restating both assets and liabilities to their current values to

arrive at a net asset value.

Even with Asset-based Models, value remains a function of expected benefits to the owners.

Replacement Cost:

This is the total cost of setting up whole business from scratch.

But one thing is still missing

On going business value known as goodwill.

Therefore, it is not a pure Asset Based Method.

Break Up Value:

This is the minimum price of assets based on balance sheet.

This is made on ongoing basis.

Break up value needs to be adjusted for expected costs like Redundancy, Legal and Liquidation

Costs.

LESSON 35

Hybrid Methods

Mix of Asset Based & Income Method

Process for Public Take Over:

Evaluation:

Predator company appoints experts.

Legal consultants, Banks, Accountants and Stock Brokers.

Direct BID:

Decision regarding contact with target firm, approach before the BID or hostile takeover.

Purchase of certain % age of shares of target.

Establish an offer and communicate target includes offer document, offer validity , Predator may revise

offer if declined by target.

Acquisition of Private Company

Limited consultancy services from expert are required. Internal evaluation is normally enough.

Detailed investigation is conducted before the transaction.

Offer price is negotiated by both parties.

Finalization of deal By entering into a contract.

Payment of price finishes the deal.

Anti-Takeover Tools


65/114

A target company may employ such tools and tactics as to foil the takeover bid. This resistance is

achieved in following ways:

Poison Pill:

Target company grants right to existing shareholder to acquire new shares at attractive price.

This effectively dilute the shareholdings and interest of predator.

In an other way the target company may give handsome dividends to existing shareholders

(other than predator) to exchange their shares for cash at a price well above the offer price by

predator.

The target company may offer a debt security in lieu of shares.

Pac Man:

The target company may make a reverse offer to predator company. It is not used widely.

White Knight:

Target company may seek a friendly predator (other than original predator) potentially capable

of bidding high and acquiring.

A target company can acquire another company may by large or under performing to decrease

attractiveness to predator.

Shark Repellents:

Target may modify its charter to stop the takeover. For example, it would need to have 90% votes to

approve merger.

Disposal of Assets:

A target company may dispose off assets that are of prime interest to acquirer or to further extent

liquidate all its assets leaving nothing for the acquirer.

Severance Pay:

Management may enter into agreement with senior personnel to pay them a certain hand some

amount if theres change in companys control.

Political Pressure and action can stop the take over.

Case StudyValuation of Company

Target Limited

Balance Sheet

As on December 31, 2005

$


66/114

Fixed Assets

At Cost less Acc. Depreciation 2,300,000.00

Current Assets

Raw materials 400,000.00

Finished goods 650,000.00

Accounts receivable 1,349,000.00

Cash & bank 1,000.00

2,400,000.00

Current Liabilities

Accounts payable 1,280,000.00

Short term loan 980,000.00

2,260,000.00

Net Current Assets 140,000.00

Total Assets 2,440,000.00

Capital

Issued common stock 2,050,000.00

Retained earnings 390,000.00

2,440,000.00

History of Profit 2005 2004 2003 2002 2001

Net Income 260,000.00 190,000.00 210,000.00 185,000.00 150,000.00


67/114

Dividend 135,000.00 135,000.00 115,000.00 110,000.00 110,000.00

Retained Income 125,000.00 55,000.00 95,000.00 75,000.00 40,000.00

Other Information

Replacement Value

Fixed assets 2,600,000.00



Sales Value

Fixed assets 2,200,000.00



Bad debts (above current level) 50,000.00

Avg. Industry beta 0.95

Avg. P/E ratio 9.00

Risk free rate 8%

Market risk premium 5%

Predator's WACC 17%

Predator's P/E ratio 15.00


68/114

Solution

1 Balance sheet value $

Un-adjusted value 2,440,000.00

Bad debts (50,000.00)

B/S value of Target 2,390,000.00

2 Replacement Cost Value

B/S adjusted value (as above) 2,390,000.00

Increase in fixed assets value =2600000 - 2300000 300,000.00

Increase in stock value =475,000 - 400,000 75,000.00

Increase in finished goods value =700,000 - 650,000 50,000.00

2,815,000.00

3 Break up value

B/s adjusted value (as above) 2,390,000.00

Decrease in sales value

Fixed assets (100,000.00)

Finished goods (100,000.00)

Raw materials (20,000.00)

2,170,000.00


69/114

4 DIVIDEND MODEL

Po = D1 / (Ke -g)

We need to calculate g & Ke

g = r x b

r = Profit / Capital Employed

r = 260,000 / 2,440,000 0.106557377 or 10.65%

b = Retention of Earnings

= 125,000 / 260,000 0.480769231 or 48.07%

g = r x b 0.051229508 or 5.12%

Ke, using CAPM

Ke = Rf + b (Rm)

Ke = 8 + 0.95(5) 0.1275 or 12.75%

Po = 135,000 x ( 1 + .0274)/(.1275 - 0.0274) 1,860,693.18

g can be calculated as under:

= 110,000 (1+g)4 = 135,000


70/114

g = (135,000/110,000)1/4 -1 0.0525 or 5.25%

Po = 135,000 x ( 1 + .0525)/(0.1275 - 0.0525) 1,894,500.00

P/E earnings basis of valuation

Profit x P/E multiple of similar company

=260,000 x 9 2,340,000.00

Analysis of each Valuation Method

Balance Sheet Value:

Assets are based on historical cost adjusted for arbitrary accounting convention like depreciation. Historical Costs are not representative of actual worth of assets.

Not logical to use this method.

Replacement Cost Basis

More appropriate for valuation of manufacturing concern than service industry.

Assets subject to rapid technological change are difficult to value under this method.

Break Up Value

The value return by this method means that the owner can realize the amount on piecemeal basis

by disposing off assets individually.

Not based on going concern basis.

Going concern value is normally well above the value returned by this method.

Dividend Valuation Method

Assume Constant Growth:

Companys value is determined by discounting future estimated cash flow.Price Earning Method of Valuation

It is very difficult to find a company of the similar size.

P/E self is a problem and history can be used.


71/114

LESSON 36

Corporate Reorganization and Capital Reconstruction

Divestment:

Business not only acquire assets but also dispose off subsidiaries, division and SBU (Strategic BusinessUnit) or even individual assets.

The process of disposing off inefficient assets is known as Divestment or Disinvestment.

If the asset is returning less than the groups/firms hurdle rate, then it shouldbe disposed off.

The decision to divest should be evaluated like decision to invest.

Example

For example, if a division of a group is earning 12% as compared to group return of 18%, then it

should be disposed off. However, the cost of asset and price available for sale must be compared and evaluated before the

decision to sell.

For example, if an asset or group of assets costing Rs 100,000 is earning 12% or 12000 and could be

sold for 60,000.

The group hurdle rate is 18%.

Comparing 12,000 with 80,000, then ROCE is 15% (12,000/80,000) and is under group hurdle rate of

18%, therefore, it can be disposed off.

However, if the offer price of asset in question is 50,000, the ROCE is 24%, well above the groups

rate of return of 18% and should not be disposed off.

Disinvestment or divestment may be in the form of un-bundling or de-merger.

Management buyouts are another type of mergers and takeovers but also, on other hand, is anexample of divestment.

There are many versions of MBO:

Management Buyout:

Executives of the firm with the help of institutional financing buy the business from the current owner.

Significant sources are pooled by the executives.

Leveraged Buyout:

Executives with the help of external investors buy the firm from the existing owners.

Employee Buyout:

This is not confined to executives, but all the employees contribute in funds pool.


72/114

Management Buy-In

The executives from outside business acquire the business.

Spin Out:

Executives and employees do participate in buyout but the company may also retain some %age ofownership.

The common thing in all these variations is that existing managers have substantial role in term of

control and become the owner of the business.

Advantages of Buy-Outs

It is better to sell a loss making unit/asset than to liquidate.

Going concern transfer of firm protects interest of various stakeholders.

Employees do not loose their jobs

Vendors continue to supply (may be less than the previously)Govt. keeps on receiving taxes in different ways

Better for existing managers to have their own business.

Managers become owners of a established business.

Factors to be considered while preparing of Proposal:

Readiness of parent company to dispose off the assets/SBU.

Managers will be exposing themselves to high risk.

They must evaluate the financial feasibility of this take over.

They must look for the long term potential of the business and future extension requirements.

Managers Own Assessment:

Managers must look For the expertise and skill required for the success for the buy-out. All the

functional areas should be evaluated.

Price to be paid:

Their own resources pool and the gap to be covered by external financing.

Example

Management Buy-Out

Following information pertains to a proposed management buyout:

Share Capital:

Management 60% 300,000


73/114

Banks 40% 200,000

10% Preference Shares 1,000,000

Loans 1,200,000

Sort Term Loans (8%) 600,000

Long Term Loans 600,000

Total Capital 2,700,000

Long term loan of 600,000 are payable in next 5 years in equal installments. The loan is secured

against fixed assets. Interest on loan is 11% pa.

The assets to be acquired have a book value of Rs 2.30 million but the agreed price is Rs 2.40 million. This company is a part of large group and has been registering a turnover growth of 8% but its

business is not compatible with its group.

Required:

Highlight the factor to be considered and financial appraisal of this buyout.

The difference between the book value of company and the purchase price is not wide apart.

Total of Rs 2.70 million will be raised. out of which Rs 2.40 million will be paid and only Rs 300,000 is

left for working capital.

Gearing will be very high. Equity is Rs 300,000 whereas debt is Rs 2.400 million (including

preference shares). High interest cost and return on equity will be too risky.

However, buyout team will bag 60% of return for a investment of Rs 300 k. A very high reward.

Keeping in view the gearing level it will be almost impossible to seek further loans, and if the

company is successful in seeking loan, then its pricing will be too high.

Financial Commitments:

3.6959 is the value of annuity factor for 5 years at 11%.

Loan repayments; annual payments of loans including interest will be

600,000 / 3.6959 = 162,342

Redeemable Preference Shares

These share will be paid after 10 years and on average Rs 100,000 shall be provided every year.

Preference dividend of Rs 100,000 needs to be paid every year.

Running finance expenses would be Rs 48,000 per annum assuming full loan utilization.

Priority claim of around Rs 400,000 will be needed on the above items.

Other Requirements


74/114

For working capital and fixed assets.

Keeping in view steady growth in sales the lenders will require increased profit and stable cash flow.

Cash flow will be burdened due to high gearing but MBO has no other option mentioned in

question.

Capital Reconstruction Schemes

Companies in financial distress (normally) undertake capital Reconstruction/Restructuring schemes

to improve capital mix and the timing of availability of funds.

The following are the main Reconstruction reasons:

a) To reduce net of tax cost of borrowing

b) To satisfy loans

c) To improve D/E ratio

d) To improve companys image

e) To tidy up the balance sheet

f)

Financial Distress

Financial Distress

Causes of Financial Distress

A. Industry Level Factors

1. Competition

Entry / exist barriers

Bargaining power of suppliers

Bargaining power of customers

Substitute products availability

Competition and rivalry among companies

2. Industry Shocks

Adverse shocks to industrys products, costs or overheads, sustained over time will lead to push

the marginal / weak industry out of industry. Like Bird flue etc

Most will embrace bankruptcy.

3. Industry Deregulations:

When an industry is de-regularized it can induce financial distress within industry.

Economic structure of the industry also changes. Deregulation increases the cost of monitoring and controlling managers.

Inexperience of management may push new entrants towards financial distress.

B. Firm Level Causes Of Financial Distress:

1. Ownership and Governance Structure

Experience and skill of management


75/114

2. Leverage

Both operating and financial risk

3. Operating Risk

C. Macro Level Factors:

1. Recession:

It narrows the margin between cash flow and debt service.

Lower cash flow / income will increase probability that cash flow constraints will have to be

eliminated at costly means.

2. Monetary policy:

Monetary policy significantly effect the nations liquidity.

When the state bank buys Govt. securities / bills, it creates expansionary maneuver, it adds to

reserves of the banks which create more loans. Short term interest rate falls. Selling of securities leads to contraction effect.

Bank reserves decrease and loans are not created. Short term interest rates increase.

LESSON 37

Effects of Financial Distress

The risk of incurring the costs of financial distress has a negative effect on a firm's value which offsets

the value of tax relief of increasing debt levels and tax depreciation relief.

Relationship between stakeholder damaged:

Even if a firm manages to avoid liquidation its relationships with

Vendors/creditors/suppliers

Customers

Bankers

Employees may be seriously damaged.

Suppliers providing goods and services on credit are likely to reduce the generosity of their terms, or

even stop supplying altogether, if they believe that there is an increased chance of the firm not

being in existence in a few months' time.

Employees may become de-motivated because of insecurity and uncertainty.

Management become short-term oriented. Always caught up in day-to-day matters like liquidity,

and cash flow rather than long term.

Customers may develop close relationships with their suppliers, and plan their own production on

the assumption of a continuance of that relationship. If there is any doubt about the longevity of


76/114

a firm it will not be able to secure high-quality contracts. In the consumer markets customers

often need assurance that firms are sufficiently stable to deliver on promises.

Transaction cost goes very high and restructuring costs may be high for a financially distressed

company attempting to restructure the loans.

Factors influencing the Risk of Financial Distress

Variability of cash flow:

The sensitivity of the company's revenues to the general level of economic activity.

If a company is highly responsive to the ups and downs in the economy, shareholders and lenders may

perceive a greater risk of liquidation and/or distress and demand a higher return in compensation

for gearing compared with that demanded for a firm which is less sensitive to economic events.

The proportion of fixed to variable costs.A firm which is highly operationally geared, and which also takes on high borrowing, may find

that equity and debt holders demand a high return for the increased risk.

The liquidity of the firm's assets.

o

Financial analysis may be used to view some of the indicators of the financial distress. Important

ratios to be considered include:

Liquidity Ratios

Debt Equity Ratios

Asset Utilization Ratios

Types of Reorganizations

Conversion of Debt to Equity:

In order to improve equity base. When the company has relied heavily on short term finances for short

term expansion and has caught up in working capital problem.

When the holders of convertible securities exercise their right.

Conversion of Equity to Debt:

Preference shares are converted to say debt security.

From a legal point of view converting Preference shares to debt security constitute reduction of

share capital

Conversion of Equity from one form to another:


77/114

Eliminating or reducing reserves by issuing bonus shares.

This also involves sub-division of shares to smaller units.

It needs to be carried out in accordance with articles of the company.

This may involve converting Preference share to ordinary shares.

Converting Debt from one form to another:

To improve security, flexibility and reducing cost of borrowing.

General Conditions and Re-organization Process:

Assumptions:

Company is incurring losses.

Needs immediate capital injections.

Assets and liabilities are out of line with market value.

Process:

Revaluation of assets (Bring them to market value)

Write of the debit balance on profit and loss account.

To determine whether new capital / finances are needed?

if yes, through which source (Shares / Loans)

General Conditions and Re-organization Process:

Determine the amount required to be injected.

Negotiating with stakeholders.

- Vendors / Suppliers

To seek stretched credit period.

May reduce their claim if they calculate to get less than their claims in case of liquidation on

the hope to have better situation in future.

They may be offered some stake in the company.

Banks:

May request rescheduling of loans, and may get fresh loan at higher interest rates.

Ordinary Shareholders:

Normally they get nothing in case of winding up or liquidation. They must be given some stake

in the company if further finances are required.

Preference Shareholders:

May accede to new scheme when they are offered some increase in dividend rate.

Foreign Exchange Risk Management

Foreign Exchange Market:


78/114

A market where currencies are traded / exchanged with other currencies.

Major players are banks, who also trade in on behalf of their customers as well.

Several large & small buyers and sellers.

Significant transactions are conducted using telephone / electronically.

There are others brokers / agents and companies as players.

How to determine and quote the Rates?

Forex Market

Foreign exchange market is highly competitive.

This rate is primarily determined through the interaction of demand and supply.

Interest or deposit of different currencies.

The exchange rate is the price of one currency quoted in another currency.

Two type of currencies involved:

o

Base Currencyo Variable Currencies

Forex Market

In Forex market the rate are quoted in terms of a base currency to several other variable currencies.

When a dealer express rate as US $ / PKR, the this mean the rate of number of PKR to 1 US $.

For example, US $ / PKR = 60, means that we need to exchange Rs. 60 (PKR) to get one dollar.

Conversely, a rate expressed as PKR/US $ refers to a rate of number of US $ to 1 PKR.

In this case we need to express the rate in terms of dollar. How many dollars we will surrender to

get 1 Rupee= US$ 0.016667 to get 1 PKR.

Bid & Offer Price

Banks and Forex dealers quote two rates for a single pair of currency.

BID Price

Offer Price

Bid Price (Lower price)

A price at which the dealer will sell the variable currency.

Offer price (Higher price)

A price at which the dealer will buy the variable currency.

A dealer/bank may express PKR/US $ as

0.01666 - 0.01679

At $ 0.01666, dealer will sell us $ in exchange for PKR

At $ 0.01679, dealer will buy us $ In exchange for PKR

The difference between Bid & Offer is called Spread

This represents the income of dealer. For small sum the spread will be high but very small for high

sum.


79/114

Spot Rate & Forward Rate:

Currency can be bought and sold using spot and forward.

Spot Rates: It means trading now. Now normally is up to two days.

Forward Rates:Buying or selling forward means trading now and settling claim at a future date.

LESSON 38

Example

Rates for PKR/US$ are quoted as follows:

Spot 0.0166530.016660

1 month 0.0166480.016655

3 months 0.0166320.016641

6 months 0.0166060.016617

Today is 4thJanuary. A Pak company has to pay US$ 245,000 to a supplier at the end of week 1 of

April and want to fix exchange rate now.

What forward rate can be obtained for a currency transaction and what would the cost to Pak

company?

Solution

That rate will be 0.016632

The cost to the company will be:

245,000/0.016632 = PKR 14,730,299.38

For foreign currency rates calculation there are two factors underlined:

Demand and Supply of currency involved

Interest Rates of currencies

Foreign Exchange Risks

Foreign Exchange Risk is divided into 3 categories:

1 ) Transaction Exposure

2 ) Translation Exposure


80/114

3 ) Economic Exposure

1 ) Transaction Exposure :

Gains / losses made on settlement of buying-selling contracts of goods, import-export transactions,

investment in foreign currency instruments, deriving dividend from abroad.

The risk involved is normally covered through hedging contracts.

2 ) Translation Exposure:

It arises from the accounting side when businesses are required to consolidate their group results in

the compliance of local financial reporting laws.

3 ) Economic Exposure:

It is difficult to Pre-determine the dollar effect of economic effect because of the unexpected nature

of change.

A subsidiary in the country X whose currency devalues unexpectedly has two effects on the value of

the firm.

i) Adverse effect on value as every dollar of profit will have less worth when repatriated to homecountry.

ii) there may be positive effect in terms of cheaper exports adding cash flow contributions of parent

company.

How to reduce the Translation Exposure?

Translation Exposure:

This translation exposure can be hedged by

Date post:	02-Jun-2018
Category:	Documents
Upload:	muhammad-salim-ullah-khan
View:	222 times
Download:	0 times

SUMMARY OF SLIDES FIN 722.docx

Documents