Financial Management Flashcards

Question

What is Sensitivity analysis ?

Answer 1

The analysis of changes made to significant variables to determine their effect on a planned course of action.

Answer 2

Sensitivity analysis has TWO steps: Step 1 Calculate the NPV of the project based on best estimates. Step 2 For each element of the decision (cash flows, cost of capital), calculate the change necessary for the NPV to fall to zero. The sensitivity can be expressed as a percentage change for an individual cash flow: Sensitivity = (NPV/ PV of relevant cash flow) × 100

Answer 3

a technique that allows more than one variable to change simultaneously.

Answer 4

1. Specify the major variables (e.g. revenue and costs). 2. Specify the relationship between the variables (e.g. revenue minus costs equals profit). 3.Attach probability distributions to each variable and assign random numbers to reflect the distribution (e.g. a 10% probability that costs are $1,000, a 50% probability that they are $10,000 and a 40% probability that they are $12,000). 4. Simulate the environment by generating random numbers for revenue and costs. For example, using random numbers from 00 to 99: assign 00 to 09 to $1,000 cost with 10% probability; assign 10 to 59 to $10,000 with 50% probability assigned to it, and so on. 5. Record the outcome of each simulation (e.g. the profit based on the revenue and costs randomly selected). 6. Repeat the simulation many times to obtain a probability distribution of the possible outcomes (e.g. the probabilities of achieving various profit levels).

Answer 5

Expected value – the quantitative result of weighting uncertain events by the probability of their occurrence. An expected value is calculated as follows: Expected value = weighted arithmetic mean of possible outcomes= ∑xp(x) Where x = value of an outcome P(x) = the probability of outcome x ∑ = sum

Answer 6

This is the length of time it takes the discounted net cash revenue/cost savings of a project to payback the initial investment. Sometimes referred to as the adjusted payback period.

Answer 7

Overtrading often arises from a rapid increase in sales revenue Overcapitalisation results in a relatively low current ratio

Answer 8

1.An increase in dividends (the dividend decision), will reduce the level of retained cash available and increase the need for external finance (the financing decision) to fund capital investment projects (the investment decision). 2.An increase in asset expenditure (the investment decision ),would also increase the need for finance (the financing decision) which may be sourced internally by reducing dividends (the dividend decision). Therefore, directors must decide whether to pay a dividend or retain earnings.

Answer 9

3.1.1 Legal Constraints In most countries, a dividend can only be paid if there is a credit balance in the retained earnings account in the statement of financial position. No distributable reserves means no dividends. If a company has brought forward losses from previous years, the balance on retained earnings may be a debit ("negative"), even if a profit was made in the current year. This restriction on paying dividends for the foreseeable future could damage the company's ability to attract new equity investors to finance its growth. Therefore, some countries allow a debit balance on retained earnings to be written-off against other reserves, allowing the company to resume paying dividends.

Answer 10

3.1.3 Shareholder Expectations Most shares in quoted companies are held by influential institutional investors (e.g. pension funds). Therefore, the directors of quoted companies have to manage investor expectations of dividends carefully. If a large dividend is paid in the current year, this may create expectations of the same, or even higher, in future. If these expectations are not met, key investors may sell their shares. In smaller owner-managed companies, there is no such agency problem. The dividend decision is influenced more by the personal tax position of the owner-managers than sensitivity over expectations.

Answer 11

Signalling In quoted companies, where there is a significant "divorce of ownership and control", investors do not have access to all information about the company’s operations and prospects; they only have what is publicly available. Therefore, public announcements of the level of proposed dividends are signals of company’ strength or weakness. A surprise cut in dividend may be interpreted as a signal of liquidity problems, even if the cut is actually to finance attractive projects. A surprise increase may be taken as a signal of company strength, although some investors may question why the directors have not found suitable strategies for reinvesting surplus cash.

Answer 12

Stability Companies often strive for a stable level of dividends or a constant level of growth. This is done to avoid sharp movements in share price. Companies will try to maintain the level of dividends in the face of fluctuating earnings. This approach is widespread for quoted companies.

Answer 13

Borrowing Covenants A loan agreement may include a clause that limits dividend payments (e.g. to a specified proportion of earnings) to help ensure the loan is more secure. If less cash is paid as dividends, liquidity might be better (though cash can still be consumed on the purchase of non-current assets).

Answer 14

Alternative Dividend Policies 3.2.1 Constant Dividend A constant dividend policy avoids surprises and signals stability to shareholders, but shareholders might be dissatisfied if they receive relatively low dividends if earnings are rising. As the proportion of retained earnings increases, shareholders might question whether the company can find enough suitable investment opportunities. 3.2.2 Constant Growth Constant growth is predictable and favoured by shareholders but again the dividend growth rate might not match the earnings growth rate. 3.2.3 Constant Payout Ratio A constant payout ratio means paying a dividend that is a fixed proportion of each year’s earnings. Although this approach sounds logical, the variability in the absolute amount of dividends creates uncertainty and is rarely adopted by quoted companies.

Answer 15

Residual Dividend Policy Under the residual dividend policy, retained earnings fund all positive NPV projects. Any remaining earnings not needed to support such projects are paid out as a dividend. This links to pecking order theory (i.e. retained earnings are the cheapest source of new finance, so they should be used to fund projects first). A residual dividend policy is likely to lead to fluctuating dividends, so although it may excuse a cut in an otherwise stable dividend pattern, it is not common for quoted companies. 3.2.5 Zero Dividend Policy A high-growth company may find that, in the early years, all surplus cash can be profitably reinvested back into the business – particularly if the company lacks access to external finance. However, at some point, when fewer positive NPV projects are available, the company should start paying dividends.

Answer 16

Difficulties in Raising Finance SMEs are private companies with a limited number of shareholders and, unless those shareholders are wealthy, there is a limit to how much they can invest in the company. Therefore, SMEs have to rely heavily on retained earnings for equity finance, but this source is limited, especially when profits are low. They may have to rely on debt if restricted in the amount of equity they can raise. 4.2.1 Perceptions of Risk and Uncertainty SMEs are often viewed as unattractive investment opportunities because they have high levels of risk and uncertainty attached to them. Larger businesses have a track record, and a long-term relationship with their bankers. New businesses, typically SMEs, obviously do not have a track record. SMEs internal controls are often non-existent or very limited. Larger businesses conduct more of their activities in public than do SMEs. If information is public, there is less uncertainty. A company that is quoted on a stock exchange will be subject to press scrutiny and stock exchange rules that regulate its activities, including publishing accounts that have been audited. Many SMEs do not require audits (or even publish full accounts), and the press is not interested in them. Therefore, they have fewer external controls. The fact that potential investors in an SME have much less information about the business than its managers (i.e. asymmetry of information) contributes to their perception of high risk. Often, SMEs have one dominant owner-manager whose decisions are rarely questioned. They tend to have limited assets to offer as security (see below). 4.2.2 Absence of Security If an SME seeks a bank loan, the bank will look to see what security (collateral) is available for any loan provided. This is likely to involve an audit of the entity's assets. Collateral is important because it can reduce the level of risk a bank is exposed to in granting a loan to a new business. Many SMEs are based in the service sector, where the main asset is likely human capital rather than physical assets. Therefore, the directors may be required to pledge personal assets (e.g. their homes) to secure business loans. 4.2.3 Shares Lack Marketability The equity issued by small companies is unquoted and difficult to buy and sell. Sales are usually on a matched bargain basis, which means that a shareholder wishing to sell has to wait until an investor wishes to buy. This lack of marketability means that small companies may be unable to offer new equity to anyone other than family and friends. 4.2.4 Tax Considerations The tax system may encourage individuals with cash to invest via large institutional investors rather than directly into small companies. In many countries, personal tax incentives are offered on contributions to pension funds. These institutional investors usually invest in larger companies (e.g. listed companies) to maintain an acceptable risk profile and ensure a steady stream of income to meet ongoing liabilities. This reduces the potential flow of funds to small companies, although the government may try to mitigate this effect by offering tax advantages for investment in SMEs. 4.2.5 Funding Gap and Maturity Gap Initial owner finance is nearly always the first source of finance for an SME, whether from the owner or family connections. Many of the assets may be intangible at this stage, making sourcing external financing difficult. The "funding gap" is the difference between the finance available to SMEs and the funding they could productively use. Bank loans may become available at a later stage. However, with small businesses, longer-term loans are often easier to obtain than medium-term loans because the longer-term loans are easily secured with mortgages against property. The fact that medium-term loans are hard to obtain is a well-known feature of SMEs, and many resort to financing medium-term assets with short-term finance such as an overdraft. This is known as the maturity gap as there is a mismatch of the maturity of the assets and liabilities within the business, which is not ideal. Due to the gaps in funding and maturity, an SME may have to take an innovative approach to financing. Possible financing solutions are discussed below.

Answer 17

Financing Solutions Government policies can influence the level of funds available. For example: Tax policy such as higher taxes on dividends (meaning less income for investors) or concessions to encourage companies to invest (e.g. tax-allowable depreciation). Interest rate policy, for example, low rates, meaning borrowing becomes cheaper, and the supply of funds increases as there is less incentive for investors to save. 4.3.1 Venture Capital Venture capitalists are a potential source of financing for an SME. Venture capital is equity capital provided to small and growing businesses. It is usually offered by a wealthy individual, a venture capital firm (e.g. the 3i Group) that manages a venture capital fund, or a high-risk, potentially high-return subsidiary of an organisation with significant cash to invest (e.g. a bank). Typically, a $1m minimum is involved for any one investment. Before investing, the providers look for: a product or products with strong potential (e.g. an innovation); solid management; and potential for high returns. To invest, providers of funds would normally expect: typically, 25% to 49% of the equity; a business plan with medium-term cash flow and profit projections; board representation (to monitor their investment and give advice); a dividend policy which promotes growth (i.e. high reinvestment of earnings); an "exit route" for selling their investment (e.g. proposed time-scale for seeking a market quotation); and the provision of regular management accounting information. Venture capital trusts (VCTs) also serve as a potential financing source. VCTs are listed investment trust companies which invest at least 70% of their funds in a spread of small unquoted trading companies. Many governments give tax incentives to individual investors in VCTs (e.g. Australia, Canada, France, Singapore, the UK and the US). 4.3.2 Private Equity Funds A private equity fund attempts to gain control over a company by putting it through a restructuring programme before either selling to another fund or listing the company on the stock market. The difference between private equity and venture capital is that private equity funds usually seek total control of the target company. In contrast, venture capitalists provide growth finance in return for partial control. Private equity funds do not only target SMEs; they also buy large quoted companies, take them off the stock market, restructure them, and then re-list them on the stock market. 4.3.3 Business Angels Business angels are private individuals (or small groups of individuals) prepared to invest equity (or perhaps debt) into small businesses with considerable potential. Angels are often entrepreneurs who made their fortunes in the high-tech sector, were wise enough to sell before the "dot.com" bubble burst, and now invest in small business as a hobby (although they expect to make gains). Angels not only provide finance, they also offer advice, experience and business contacts. A typical business angel will hold a portfolio of investments and may, for example, add an investment in an entity that makes health drinks to complement existing investments in fitness clubs. Angels receive many applications for finance, and will only be prepared to invest in a business with an innovative product and talented management. 4.3.4 Government Assistance Governments are often keen to support SMEs in raising finance for profitable investments: to avoid lost investment opportunities and national wealth being lower than it could be; to support innovation (an area in which SMEs often excel); and to boost employment. Forms of government assistance include: Providing grants and guaranteeing loans (see Chapter 9). Providing tax breaks or incentives to those willing to take the risk of investing in SMEs. Providing advice. For example, in Scotland, “Business Gateway” is a government-funded organisation which assists those setting up and running a business, including advice on raising finance. Providing equity investment. Many countries have government-backed venture capital organisations willing to invest in the equity of SMEs. This is often done on a matching basis, where the organisation will match any equity investment raised from other sources. For example, “Enterprise Capital Funds” in the UK and the “Small Business Investment Company” programme in the US. The UK Enterprise Investment Scheme (EIS) is an example of a scheme to help SMEs attract equity finance. The EIS scheme encourages private investors to buy shares in unlisted trading companies. Tax relief, at an income tax rate of 30%, is available for investors. Maximum annual tax relief is £1m (£2m if at least £1m is invested in knowledge-intensive companies). Shares must be held for at least three years (otherwise tax reliefs are withdrawn/ withheld). 4.3.5 Crowdfunding Definitions Crowdsourcing – using a large, evolving, relatively open group of people (usually assembled via the internet) to provide goods, services or finance. Crowdfunding – is crowdsourcing, to fund a project. Under crowdfunding, there is no financial intermediary: each individual in the crowd has a direct relationship with the entity funded. Crowdfunding may be appropriate for the early stages of "seed" finance for an SME. The crowdfunding model is driven by: the project initiator who proposes the idea or project to be funded; individuals or groups who support the idea; and a moderating organisation (the "platform") that brings the parties together to launch the idea. Crowdfunding lets people invest in projects or ideas that they believe in or are interested in, so they might be willing to take relatively higher risks and accept relatively lower returns. In addition, the “crowd” aspect means supporters often encourage others to invest. Crowdfunding can be particularly beneficial for SMEs as it allows them to reach out directly to investors who may be happy with the risks associated with funding innovations and technologies often pioneered by SMEs. The main types of crowdfunding are: 1. Donation-based-any crowdfunding campaign without financial returns to the investors or contributors (e.g. fundraising for disaster relief, charities, NPOs and medical bills). It may also be suitable to obtain support from a local community. 2. Reward-based− where entrepreneurs pre-sell a product or service to launch a business concept without incurring debt or issuing equity to outside investors. This is best for businesses with a marketable product and need funding before generating revenues. 3. Equity-based − where investors receive unlisted shares, usually in the company’s early stages, in exchange for the money provided. This is typically best for businesses that can grow and scale quickly.

Answer 18

Convertible - loan notes or preference shares which can be converted into a pre-determined number of ordinary shares. . Convertible loan notes and convertible preference shares: Pay a fixed coupon or dividend until converted. May be converted into ordinary shares: on, or by, a pre-determined date; at a pre-determined rate (the conversion ratio); and at the holder's option. May have a conversion ratio which changes during the loan term to stimulate early conversion. Convertible loan notes require the calculation of "fully diluted" earnings per share (EPS) to indicate what the EPS might be if the debt is converted into equity

Answer 19

Warrant – the investor's right, but not the obligation, to purchase new shares at a future date at a fixed price (the exercise or subscription price). They may be attached to loan notes to make them more attractive. They are an option to buy shares in the issuing company. They may be separated from the underlying debt so the holder of the warrants may sell them rather than keep them (i.e. they are traded independently).

Answer 20

for the issuing company: 1. When initially attached to the loan note, the coupon rate on the loan note will be lower than for comparable straight debt. This is because the investor has the additional benefit of potentially purchasing equity shares at an attractive price. 2. They may make an issue of unsecured debt possible when the company's assets are inadequate to secure the debt. 3. They are a way of issuing equity (albeit with a delay) without the usual negative signal associated with an equity issue.

Answer 21

1. As the loan is for a fixed term, there is no risk of early recall (unlike overdrafts that are repayable on demand). This helps with financial stability. 2. a predetermined repayment schedule makes it easier to budget and plan for loan repayments. This helps cash flow management. 3. Interest will usually be tax deductible; reducing the company’s overall tax liability is cost effective.

Answer 22

Advantages 1. There are many willing providers (often associated with asset manufacturers and therefore offering attractive terms). 2. A lease “matches” finance to the right to use the asset. A company can use assets that might be too expensive to buy outright. 3. Very flexible packages available, some of which include repairs and maintenance. 4. This helps reduce the costs and operational burden of asset maintenance. Disadvantages 1. Over the long term, leasing can be more expensive than outright purchase; cumulative lease payments can exceed the cost of buying the asset. 2. At the end of the lease term, the company typically does not own the asset unless it has an option to purchase it, at an additional cost. 3. Leases can include restrictions on the use of the asset or penalties for early termination. These terms may restrict the company's operational decisions.

Answer 23

Advantages 1. Immediate injection of cash into the business can be used for investment opportunities, debt reduction (interest savings) or working capital requirements. 2. Operational continuity in using the asset without disruption. 3. It may realise a profit on the sale (subject to IFRS requirements). Disadvantages 1. As the company no longer owns the property it will not benefit from any appreciation in its value. 2. The future borrowing capacity of the company will be reduced, as there will be fewer assets to provide security for a loan. 3. The net effect is equivalent to secured borrowing. A right-of-use asset and a lease liability will be recognised. If the right-of-use asset is greater than the carrying amount of the leased asset, gearing (the proportion of debt finance to equity finance) will increase.

Answer 24

Advantages 1. Flexible terms of borrowing and repayment allow businesses to borrow funds as needed up to an approved limit, and repay when cash flow permits. 2. Overdrafts can be established relatively quickly, providing immediate access to cash. 3. Interest paid on the amount of the facility used is more cost effective. Disadvantages 1. Potential uncertainty as banks can withdraw or reduce facilities with little notice: overdrafts are technically repayable on demand. 2. Overdrafts are unsuitable for long-term financing needs and ongoing cash flow issues. 3. Interest rates can be higher than other forms of short-term financing, making overdrafts expensive if used regularly.

Answer 25

Businesses that offer trade credit invoice their customers with payment terms, for example, 30, 60 or 90 days. 1.Trade credit allows a company to delay payment, providing interest-free finance for a period. 2.Extending the time between receipt of goods/services and payment improves cash flow management. 3. Used responsibly (i.e. adhering to terms) can build supplier relationship, potentially leading to more favourable terms and discounts. Disadvantage 1. The loss of settlement (prompt payment) discounts is potentially costly 2. As it is specific to purchases from suppliers, it does not meet other short-term needs (e.g. meeting payroll obligations). 3. Late payments may result in penalties and damage supplier relationships.

Answer 26

it is an acknowledgement of a debt to be paid on a stated date. 1.Bills of exchange provide short-term financing that can help bridge temporary gaps in cash flow. 2. They facilitate payments between parties in different countries, promoting international trade. 3. As negotiable instruments they can be bought, sold or discounted in secondary markets, providing liquidity. Disadvantage 1. There is a risk that the party obligated to pay the bill may not accept it or default on payment, leading to financial losses. 2. The documentation and verification processes involved can be administratively complex. 3. As their main use is trade-related they may not be suitable for all short-term financing needs

Answer 27

short-term unsecured debt issued by high-quality companies. Investors can then trade the paper on the secondary market. It is is appropriate for financing short-term liabilities.

Answer 28

1. It is a cost-effective option as large sums can be raised at lower interest rates than other short-term sources. 2. No security is required; it relies on the creditworthiness of the company. 3. Commercial paper can be issued in various denominations with different maturities to match specific needs. Disadvantage 1. Only available to large companies with investment-grade credit ratings. 2. Concerns about the issuing company can affect the marketability of the paper. 3. Issuers of commercial paper must comply with regulatory requirements that add administrative and legal costs.

Answer 29

A short-term cash injection can help companies in need of working capital. Short repayment terms are typically from three months to one year. Advantage 1. quick access to funds for immediate financial needs is available to most companies (assuming a wellfunctioning banking system). 2. Typically unsecured (i.e. no need to provide collateral). 3.Short-term interest rates are usually lower than long-term interest rates due to lower credit risk on short-term debt. Disadvantage 1. Arrangement fees may be high when expressed as an annual effective cost. 2.If security is required, this can tie up valuable assets. 3.Refinancing risk (rollover risk). Every time a short-term loan matures, the borrower faces the risk that it cannot be easily replaced or refinanced or that interest rates have risen.

Answer 30

1.Trade credit (i.e. obtaining goods or services from suppliers on credit terms). 2. Factoring and invoice discounting (whereby a company effectively raises finance against the security of its outstanding receivables. These forms of short-term financing may be more expensive than a bank overdraft, but the finance available grows as the SME grows 3. Leasing is useful for SMEs as it avoids raising capital to acquire assets. For SMEs, leasing can be cheaper than borrowing because: -Large leasing companies have bargaining power with suppliers, and so the reduced cost of assets can be partially passed on to lessees. -Leasing companies can usually dispose of old assets more effectively than SMEs. -The lease company can reclaim the asset if the lessee defaults on the lease payments, so the agreement has built in security. -The finance cost to a large established leasing company will likely be less than that for an SME. 4. Bank finance, typically an overdraft or longer-term loans secured on major assets, is usually supported by business plans including cash flow forecasts and backed by personal guarantees of the owner-manager of the SME.

Answer 31

Grants and Subsidies Depending on the location and nature of the SME, regional, national or even international grants may be available, either to help start up the business or to contribute towards expansion costs. Subsidies may take the form of government loans offered to SMEs at interest rates below commercial levels. Government Loan Guarantee Schemes: Government loan guarantee schemes exist in various countries to support businesses and stimulate economic activity. Under such schemes, the government act as a guarantor for commercial loans to SMEs.

Answer 32

business angels are wealthy individuals prepared to invest money and time in small companies if they see high growth potential. If prepared to invest in debt, they also may want the opportunity for future equity participation Therefore, convertible debt or debt with warrants may be appropriate.

Answer 33

Supply Chain Finance (SCF) – the use of financial instruments, practices and technologies to optimise the management of the working capital and liquidity tied up in supply chain processes for collaborating business partners. SCF provides short-term credit that optimises working capital for both the buyer and the seller. It generally involves using a technology platform to automate transactions and track invoice approval and settlement processes from initiation to completion.

Answer 34

Peer-to-peer (P2P) lending – a method of debt financing that enables individuals to lend money to small businesses without using an official financial institution as an intermediary. 1. Loans generate interest income for lenders, often exceeding that earned on a bank deposit account. 2. Borrowers have access to finance when banks refuse credit or would charge very high interest rates. 3. By effectively cutting out the middleman (i.e. the formal banking system), interest rates can be relatively attractive to lenders and borrowers.

Answer 35

1. Availability. Finance may be limited if recent or forecast performance is poor and an SME will always find it difficult to raise equity. 2. Cash flow. Debt requires a company to pay out cash in the form of interest; therefore, the company’s ability to generate cash will be relevant. 3. Control. Raising equity can lead to a change in control, but debt will not. 4. Cost. Debt finance is cheaper than equity finance, so if the company can take on more debt, there could be a cost advantage. 5. Ease and cost of issue. Raising equity is more difficult, time consuming and expensive than raising debt. 6. Maturity. In general, the term of the finance should match the term of the need (matching principle). However, the maturity dates of existing debt should also be considered. 7. Risk. Company directors must control the total risk (financial risk and business risk). If business risk rises, the company may seek to reduce financial risk and vice versa. 8. Security and covenants. Debt may require security (is this available?) or covenants (are these acceptable?) to maintain a certain liquidity level. 9. Yield curve. If, for example, the yield curve is getting steeper (see Chapter 2), there is an expectation that interest rates will rise. Therefore, fixed-rate debt may be appropriate if a company wishes to take on more debt.

Answer 36

Variable (floating) interest rate loan notes would automatically adjust their interest payment in line with an agreed market benchmark (e.g. SFOR). Therefore, such variable-rate debt should maintain its value.

Answer 37

Systematic risk is the risk that affects the entire market or a large segment of the market and cannot be eliminated through diversification. It is caused by factors such as changes in interest rates, inflation, recessions, or political instability. This type of risk is also known as market risk and is measured by beta (β) in the Capital Asset Pricing Model (CAPM).

Answer 38

Unsystematic risk is the risk that is specific to a particular company or industry. It can arise from factors such as poor management decisions, product recalls, or labor strikes. Unlike systematic risk, unsystematic risk can be reduced or eliminated through diversification of investments.

Answer 39

A company with high gearing and low interest cover = high financial risk. A company can be geared, but as long as interest cover is strong, lenders may still be confident.

Answer 40

A beta describes a share's degree of sensitivity to changes in the market's returns caused by systematic risk. Typically, beta lies between 0.2 and 1.6: Beta = 1 − Indicates a “neutral” share that is as sensitive as the market to systematic risk. Such shares should earn the market return. Beta > 1 − Indicates an “aggressive” share that is more sensitive than the market. Therefore, if the market in general rises by 10%, the returns from this share are likely to be more than 10%. Beta < 1 − Indicates a “defensive” share that is less sensitive than the market and is likely to rise and fall in value less than the market in general. For example, if a share has a beta of 0.5, if the return on the capital market increases by 10% the share’s expected returns will increase by only 5%.

Answer 41

Myopic management (or managerial myopia) is when managers focus on short-term results at the expense of long-term value. Think of it like being short-sighted — only seeing what’s right in front of you, and ignoring the future.

Answer 42

A Forward Market Hedge is a technique used by companies to protect themselves against foreign exchange rate fluctuations by locking in an exchange rate today for a transaction that will occur in the future. Advantages of Forward Market Hedge: ✅ Locks in a known rate → removes uncertainty ✅ Simple to arrange with banks ✅ No upfront cost (unlike options) ✅ Useful for known amounts and dates ⚠️ Disadvantages: ❌ Can’t benefit from favorable exchange rate movements ❌ Inflexible – fixed date and amount ❌ May incur penalties for cancelling or changing the contract ❌ Not ideal if timing or amount is uncertain

Answer 43

The EAC is the average annual cost of owning and operating an asset, spread evenly over its life, taking the time value of money into account. EAC=Total Present Value of Costs / Annuity Factor for the project’s life Because some machines or projects have different lifespans, and you can't directly compare their total costs or NPVs. EAC helps us make a fair comparison by converting each option's cost into an annual figure.

Answer 44

Payback Period’s biggest weakness is that it ignores cash flows after the payback period. So even if a project has huge profits later, Payback won’t recognize it. It also does not consider time value of money (unless it's discounted payback).

Answer 45

higher gearing = more interest payments, which are fixed costs. This increases the financial risk for equity shareholders because there’s less profit left for them, especially in bad years. Forward contracts eliminate transaction risk (uncertainty over future rates for known payments), but not economic risk (long-term changes in competitiveness due to exchange rates).

Answer 46

A currency future is a standardised, exchange-traded contract to buy or sell a specific amount of a foreign currency at a predetermined price on a fixed future date. These contracts are used primarily for hedging against foreign exchange risk or for speculative purposes.

Answer 47

A currency swap is a long-term agreement between two parties to exchange principal and interest payments in different currencies. It typically involves: 1. An initial exchange of principal amounts at the start, 2. Periodic interest payments exchanged over the life of the swap, and3. A re-exchange of the principal at the end of the agreement. Currency swaps are used to hedge long-term foreign exchange risk and manage exposure to interest rates in different currencies. example: A UK company with a loan in USD enters into a currency swap with a US company that has a loan in GBP. They agree to exchange loan payments (interest and principal), so each company can effectively repay debt in its home currency, avoiding exchange rate risk.

Answer 48

Spot exchange rate – the market exchange rate for buying/selling the currency for immediate delivery. Forward exchange rate – the exchange rate for buying or selling the currency at a specific date in the future.

Answer 49

1. Translation risk - occurs when a company has foreign-denominated assets or liabilities or a foreign subsidiary or branches. 2.Economic risk- The risk that cash flows will be affected by long-term exchange rate movements. 3.Transaction risk - the short-term version of economic risk. It is the risk that the exchange rate changes between the contracting date of a specific export/import and the related receipt/payment of foreign currency.

Answer 50

Translation risk - occurs when a company has foreign-denominated assets or liabilities or a foreign subsidiary or branches.

Answer 51

The risk that cash flows will be affected by long-term exchange rate movements.

Answer 52

This is the short-term version of economic risk. It is the risk that the exchange rate changes between the contracting date of a specific export/import and the related receipt/payment of foreign currency.

Answer 53

1. Invoicing in the company's domestic currency 2.Leading and lagging,- converting domestic currency into foreign currency earlier than needed to pay suppliers ("leading"), if the domestic currency is expected to fall, which may lead to a finance cost (although early settlement discounts may be available); or delaying conversion and paying suppliers late ("lagging"), if the domestic currency is expected to appreciate (although taking longer than the agreed credit period is questionable business practice). 3.Netting when there are both sales/receivables and purchases/payables in a foreign currency, so the net exposure is only on the difference between receivables and payables. 4.Matching of assets and liabilities using foreign currency loans to finance overseas subsidiaries or matching of receipts and payments (i.e. offsetting payments against receipts in a foreign currency) using a foreign currency bank account. 5.Asset and liability management (ALM), in which overseas subsidiaries borrow locally rather than receive finance from the parent.

Answer 54

Money market hedge – a technique to lock in the value of a foreign currency transaction in terms of the organisation's domestic currency using a combination of investing, borrowing and a spot currency exchange.

Answer 55

Forward exchange contracts; Money market hedges; Currency options; Currency futures contracts; Currency swaps.

Answer 56

Gap exposure is the difference between the amounts of interest-sensitive assets and liabilities (i.e. their market prices are vulnerable to changes in interest rates). Negative gap and Positive gap

Answer 57

1.Negative gap − arises when the amount of liabilities maturing at a specific time exceeds the assets maturing simultaneously. This results in a net exposure if interest rates rise by the time of maturity; 2.Positive gap − arises when the amount of assets maturing at a specific time exceeds the amount of liabilities maturing simultaneously. In this situation, the organisation will suffer a loss if interest rates fall by maturity.

Financial Management Flashcards

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