Module B Corporate Financing. Capital structure. Reference: LP Chapter 14.

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1 Module B Corporate Financing Capital structure Reference: LP Chapter 14

2 MB Capital structure Content 1. Gearing 2. Effect on shareholders wealth 3. Capital structure decision 4. The FRICT framework 5. Summary

3 MB Capital structure 1. Gearing Gearing is the amount of debt finance a company uses relative to its equity finance. Debt finance tends to be relatively low risk for the debt holder as it is interest-bearing and can be secured. The cost of debt to the company is therefore relatively low. The greater the level of debt, the more financial risk (of reduced dividends after the payment of debt interest) to the shareholder of the company, so the higher is their required return. Financial gearing measures the relationship between shareholders' funds and prior charge capital. Operational gearing measures the relationship between contribution and profit before interest and tax.

4 MB Capital structure 1. Gearing Ratios Ability to raise debt when: The company is in a healthy competitive position. Cash flows and earnings are stable. Profit margins are reasonable. Operational gearing is low. Bulk of the company's assets are tangible. Liquidity and cash flow position is strong. Debt-equity ratio is low. Share prices are low.

5 MB Capital structure 2. Effect on shareholder wealth a) If the returns on capital in excess of the interest payable on debt, financial gearing will raise the EPS. b) Gearing will, however, increase the variability of returns for shareholders and increase the chance of corporate failure. EPS as an evaluation of a finance plan One measure of gearing uses earnings per share The indifference points between any two methods of financing can be determined by solving for operating profit

6 MB Capital structure 2. Effect on shareholder wealth Example: EPS and financing option (Answer) A company has 10,000 million shares in issue and wants to raise $5,000m to fund an investment by either: a) issuing and selling 2,500m shares at $2 each or b) issuing $5,000m 10% loan stock at par The income tax rate is 40%. In order to calculate the indifference point between issuing equity shares and issuing debt, we use the above equation. OP = 2,500

7 MB Capital structure 2. Effect on shareholder wealth Example: EPS and financing option (Answer) Proof: Issues equity Issues debt $m $m Operating profit 2,500 2,500 Interest (500) Profit before tax 2,500 2,000 Tax (1,000) (800) Earnings after tax 1,500 1,200 Number of shares 12,500 10,000 Earning per share $0.12 $0.12 At a level of operating profit above $2,500 million, it will be better to issue debt, as every $ extra of earnings will be distributed between fewer shareholders. At a level of operating profit below $2,500 million, it will be better to issue equity, as the loss of each $ will be by more shareholders.

8 MB Capital structure 2. Effect on shareholder wealth Effect on other ratios when EPS falls due to debt If EPS falls because of an increased burden from increased gearing, an increased P/E ratio will indicate that the market views positively the projects that the increased gearing will fund. a) To maintain levels of dividend cover by a reductions in dividend. b) To maintain dividend levels, in which case dividend cover will fall, indicating an increased risk that the company will not be able to maintain the same dividend payments in future years, should earnings fall. If the additional debt finance is to be used to generate good returns in the longterm, the dividend yield might fall significantly in the short-term, but increase in the market price reflecting market expectations of enhanced long-term returns.

9 MB Capital structure 2. Effect on shareholder wealth Example: Gearing Summarised statement of financial position of Rufus: Assets less current liabilities 150 Debt capital (70) Share capital (10 million shares) 20 Reserves 60 $m 80 80

10 MB Capital structure 2. Effect on shareholder wealth Example: Gearing The company's profits in the year just ended are as follows: $m Profit from operations 21 Interest 6 Profit before tax 15 Taxation at 16.5% 4.5 Profit after tax (earnings) 10.5 Dividends 6.5 Retained profits 4

11 MB Capital structure 2. Effect on shareholder wealth Example: Gearing The company is now considering an investment of $25 million. This will add $5 million each year to profits before interest and tax. a) There are two ways of financing this investment. One would be to borrow $25 million at a cost of 8% per annum in interest. The other would be to raise the money by means of a 1-for-4 rights issue. b) Whichever financing method is used, the company will increase dividends per share next year from 65c to 70c. c) The company does not intend to allow its gearing level, measured as debt finance as a proportion of equity capital plus debt finance, to exceed 55% as at the end of any financial year. In addition, the company will not accept any dilution in earnings per share.

12 MB Capital structure 2. Effect on shareholder wealth Example: Gearing Assume that the rate of taxation will remain at 16.5% and that debt interest costs will be $6 million plus the interest cost of any new debt capital. a) Produce a profit forecast for next year, assuming that the new project is undertaken and is financed (i) by debt capital or (ii) by a rights issue. b) Calculate the earnings per share next year, with each financing method. c) Calculate the effect on gearing as at the end of next year, with each financing method. d) Explain whether either or both methods of funding would be acceptable.

13 MB Capital structure 2. Effect on shareholder wealth Example: Gearing (Answer) If the project is financed by $25 million of debt at 8%, interest charges will rise by $2 million. If the project is financed by a 1-for-4 rights issue, there will be 12.5 million shares in issue.

14 MB Capital structure 2. Effect on shareholder wealth Example: Gearing (Answer) Finance with debt Finance with rights issue $m $m Profit before interest and tax (+ 5.0) Interest Taxation (16.5%) Profit after tax Dividends (70c per share) Retained profits Earnings (profits after tax) $12.6m $14m Number of shares 10m 12.5m Earnings per share $1.26 $1.12

15 MB Capital structure 2. Effect on shareholder wealth Example: Gearing Answer: Assets less current liabilities (150 + new capital 25 + retained profits) Finance with debt Finance with rights issue $m $m Debt capital (95) (70) Share capital Reserves Debt capital Debt capital plus equity finance ( ) ( ) Gearing 53% 39%

16 MB Capital structure 2. Effect on shareholder wealth Example: Gearing Answer: Either financing method would be acceptable, since the requirements for no dilution in EPS would be met with both rights issue and borrowing, and the requirement for the gearing level to remain below 55% is (just) met even if the company were to borrow the money.

17 MB Capital structure 3. Capital Structure Decisions The Traditional View The cost declines initially and then rises as gearing increases. The optimal capital structure will be the point at which WACC is lowest.

18 MB Capital structure 3. Capital Structure Decisions The Modigliani-Miller (MM) Model a) In the absence of tax, a company's capital structure would have no impact upon its WACC. b) The tax relief on interest payments (the tax shield) lowers the cost of debt and hence the weighted average cost of capital. As a result MM claimed that as debt finance is increased the WACC would continue to fall, up to gearing of 100%. The lower a company's WACC, the higher the NPV of its future cash flows and the higher its market value.

19 MB Capital structure 3. Capital Structure Decisions Market Imperfection In practice, the existence of bankruptcy risk, agency costs and tax exhaustion prevent the levels of debt (100%) as advocated by MM. Pecking Order Theory Companies will prefer retained earnings to any other source of finance, and then will choose debt, and last of all equity. The order of preference will be: retained earnings straight debt convertible debt preference shares equity shares

20 MB Capital structure 4. The FRICT framework The FRICT framework, (Flexibility, Risk, Income, Control and Timing) is a useful tool for analysing capital structure issues that arise when a firm raises long-term finance and is faced with several alternatives. Flexibility How many financing options does the firm have? Risk How much additional financial risk can the firm afford? Income Can obligations be met as they fall due? Control If debt finance were raised, would the covenants imposed be too restrictive? Timing Will one alternative that is available today be less accessible in the future?

21 MB Capital structure 5. Summary Other capital structure considerations include: understanding the advantages and disadvantages of share issues as a source of funds long run viability of the company managerial conservatism lending and rating agency attitudes borrowing capacity/availability maintenance of control of the company by management, rather than by lenders asset structure of the company growth rate of the company profitability of the company taxation costs.

22 Module B Corporate Financing Working capital management Reference: LP Chapter 8

23 MB Working capital management Content 1. Working Capital Management 2. Objectives of Working Capital Management 3. Cash Operating Cycle 4. Working Capital Requirement 5. Working Capital Liquidity Ratios 6. Inventory Management (Refer to LP: JIT Procurement) 7. Receivables Management 8. Payables Management 9. Cash Forecasting 10. Cash and Treasury Management 11. Working Capital Funding Strategy (Refer to LP)

24 MB Working capital management 1. Working Capital Management Net Working Capital (NWC) = Current Assets - Current Liabilities The size of NWC has a direct effect on the liquidity of a business. Working capital management manages the relationship between current assets and current liabilities so cash flows and returns are acceptable. Effective working capital management ensures the firm s ability to operate and that it has sufficient cash available to meet its short and long-term requirements (servicing debt and covering operational expenses) 2. Objectives of Working Capital Management Liquidity (minimize the risk of insolvency) Profitability (maximize the return on assets) Consideration on the level of working capital depends on firms attitude (Conservative / Aggressive / Moderate approaches) and industry norms, production process, management-specific issues.

25 MB Working capital management 3. Cash Operating Cycle Cash operating cycle is the period of time that elapses between the point when cash starts to be spent on the production of a product and the collection of cash from a purchaser.

26 MB Working capital management 3. Cash Operating Cycle Example: A company buys raw materials from suppliers on 75 days' credit. The raw materials remain in inventory for 30 days and it takes the company 60 days to produce its goods. The goods are sold within 10 days of completion of production and customers take on average 45 days to make payment. Activity Time (Days) Average time that raw materials remain in inventory 30 Period of credit taken from suppliers (75) Time taken to produce the goods 60 Time goods remain in finished inventory 10 Time taken by customers to pay for the goods 45 Cash operating cycle 70 Financing is required for 145 days in total but 75 of these days are financed by the period of time taken to pay suppliers.

27 MB Working capital management 3. Cash Operating Cycle Ways to manage the length of cash operating cycle Inventory minimise the holding of raw materials and finished goods ensure production processes are efficient Just-in-time procurement (Please refer to LP) Receivables Early settlement discounts (the benefit of interest cost of overdraft should exceed the cost of discount allowed) Factoring Invoice discounting Payables Trade credit from suppliers (without a loss on goodwill/ discount) Careful consideration before taking early settlement discounts

28 MB Working capital management 4. Working Capital Requirement Example: The following data relate to Corn, a manufacturing company. Sales revenue for the year $1,500,000 Costs as percentages of sales % Direct materials 30 Direct labour 25 Variable overheads 10 Fixed overheads 15 Selling and distribution 5

29 MB Working capital management 4. Working Capital Requirement Example: On average a) Debtors take 2.5 months before payment b) Raw materials are in inventory for three months c) Work-in-progress represents two months worth of half-produced goods d) Finished goods represent one month's production e) Credit is taken as follows (i) Direct materials: 2 months (ii) Direct labour: 1 week (iii) Variable overheads: 1 month (iv) Fixed overheads: 1 month (v) Selling and distribution: 0.5 months Work-in-progress and finished goods are valued at material, labour and variable expense cost.

30 MB Working capital management 4. Working Capital Requirement Example: Compute the average working capital requirement of Corn assuming the labour force is paid for 50 working weeks a year. Working capital is defined for the purpose of this exercise as inventories (raw materials, work in progress and finished goods) plus receivables minus current liabilities.

31 MB Working capital management 4. Working Capital Requirement Example: Answer (a) The annual costs incurred will be as follows: $ Direct materials 30% $1,500, ,000 Direct labour 25% $1,500, ,000 Variable overheads 10% $1,500, ,000 Fixed overheads 15% $1,500, ,000 Selling and distribution 5% $1,500,000 75,000

32 MB Working capital management 4. Working Capital Requirement Example: Answer (b) The average value of current assets will be as follows: $ $ Raw materials 3/12 $450, ,500 Work-in-progress Materials (50% complete) 1/12 $450,000 37,500 Labour (50% complete) 1/12 $375,000 31,250 Variable overheads (50% complete) 1/12 $150,000 12,500 81,250 Finished goods Materials 1/12 $450,000 37,500 Labour 1/12 $375,000 31,250 Variable overheads 1/12 $150,000 12,500 81,250 Receivables 2.5/12 $1,500, , ,500

33 MB Working capital management 4. Working Capital Requirement Example: Answer (c) Average value of current liabilities will be as follows: Materials 2/12 $450,000 75,000 Labours 1/50 $375,000 7,500 Variable overheads 1/12 $150,000 12,500 Fixed overheads 1/12 $225,000 18,750 Selling and distribution 0.5/12 $75,000 3,125 Answer (d) Working capital required is ($(587, ,875)) = 470,625 $ 116,875

34 MB Working capital management 5. Working Capital Liquidity Ratios Liquidity Current Ratio = Current assets / Current liabilities Quick Ratio = (Current Assets Inventories) / Current Liabilities Periods (days) AR Settlement Period = (Trade Receivable / Credit Sales Revenue) x 365 Finished Goods(FG) Holding Period = (Avg. FG Inv./ Cost of Sales) x 365 Raw Materials(RW) Holding Period = (Avg. RW Inv./ Annual Purchase) x 365 Production/ WIP Period = (Avg. WIP/ Cost of Sales) x 365 AP Payment Period = (Avg. Trade Payable / Cost of Sales) x 365 Efficiency Sales/ Net Working Capital = Sales Revenue/(Current Assets - Current Liabilities)

35 MB Working capital management 5. Working Capital Liquidity Ratios Symptoms of Overtrading a) Rapid increase in sales revenues b) Fast and dramatic increase in the volume of current assets (and possibly noncurrent assets) c) Rate of increase in inventories and accounts receivable is greater than the rate of increase in sales revenues d) Only a small increase in shareholders' equity with most of the increase in assets financed by short-term credit, mainly trade accounts payable (payment period likely to lengthen) and bank overdraft (often reaching or exceeding the agreed facility) e) Some ratios alter dramatically, for example the proportion of total assets financed by shareholders' equity falls and the proportion financed by credit rises and the current and acid test ratios fall f) The business might be illiquid (i.e. current liabilities are greater than current assets).

36 MB Working capital management 6. Inventory Management Motives for holding inventory a) Transaction motive (i.e. purchase in bulk to obtain trade discount) b) Precautionary motive (i.e. inventory is held in case the business receives a sudden customer order or a risk regarding future deliveries of inventory arises) c) Speculative motive (i.e. inventory has been bought to hedge against future price rises) Costs relating to inventory Purchase/production cost of inventory: Production Cost (PC) x Demand (D) Holding/carrying/storage cost: Holding Cost (HC) x Order Quantity (Q) / 2 Ordering/procuring cost: Order Cost (OC) x Demand (D) / Order Quantity (Q) Shortage/stock-out costs (SC) Total Cost = (PC x D) + (HC x Q/2) + (OC x D/Q)

37 MB Working capital management 6. Inventory Management Economic Order Quantity (EOQ) Optimal ordering quantity for an item of inventory that will minimise costs. Total Cost = (PC x D) + (HC x Q/2) + (OC x D/Q) Partial differentiate the total cost curve with respect to Q and set to 0 then solve for Q, i.e. Assumptions: Ordering cost is constant. Rate of demand is known, and spread evenly throughout the year. Lead time is fixed. Purchase price of the item is constant i.e. no discount is available Replenishment is made instantaneously, the whole batch is delivered at once. Only one product is involved.

38 MB Working capital management 6. Inventory Management Economic Order Quantity (EOQ) with Discount Where a bulk discount is available and the required order quantity is greater than the EOQ, the EOQ will be determined through the following steps: Step 1 Step 2 Step 3 Step 4 Step 5 Calculate EOQ, ignoring discount. If this is below the level for discount, calculate the total annual Inventory cost (i.e. OC + HC). Recalculate total annual inventory costs using the order size required to just obtain the discount. Compare the cost of Step 2 and Step 3 to the saving from the discount and select the minimum cost alternative. Repeat for all discount levels until the maximum saving in cost is achieved and the ordering quantity will be the ultimate EOQ.

39 MB Working capital management 6. Inventory Management Economic Order Quantity (EOQ) with Discount Example: Demand = 30,000; Unit Cost = $120; Order Cost = $2,500; Holding Cost = 20% of Unit Cost = $120 x 0.2 = $24 The supplier offers to give 2% discount for ordering at least 2,500 units. Should the firm take the offer? Without Offer With Offer Order Quantity EOQ = 2,500 5,000 Number of order per year (D/Q) 12 6 Inventory cycle (52 weeks/ no. of order) 4.33 weeks 8.67 weeks Total Cost = HC+OC (ignore product cost) $60,000 $73,800

40 MB Working capital management 6. Inventory Management Re-Order Level Uncertainties in demand and lead times taken to fulfil orders mean that inventory will be ordered once it reaches a re-order level (ROL). Inventory levels might fluctuate with this system. The x points show the ROL at which a new order is placed, with the number of units ordered each time being the EOQ.

41 MB Working capital management 6. Inventory Management Re-Order Level Use of a re-order level builds in a measure of safety inventory and minimises the risk of the organisation running out of inventory. The average annual cost of such a safety inventory is: Quantity of safety inventory (units) holding cost per unit per annum Inventory Level: Maximum inventory level = ROL + ROQ (min. usage min. lead time) Minimum inventory level = ROL (avg. usage avg. lead time). Average inventory = Minimum inventory level + ROL/2 Annual stock-out cost = Cost of one stock-out Expected number of stock-outs per order Number of orders per year

42 MB Working capital management 6. Inventory Management Example: Re-Order Level Maximum consumption = 2000 Units per Week Normal Consumption = 1500 Units Minimum Consumption = 1000 Units Delivery Time = 8 to 10 weeks Re-order Level = 20,000 Units Minimum Level = 20,000 - (1,500 X 9) = 20,000 13,500 = 6,500 units

43 MB Working capital management 7. Receivables Management A balance between profit improvement from sales obtained by allowing credit and the cost of the credit allowed to customers. The cost of offering credit is the interest charged on an overdraft to fund the period of credit, or the interest lost on the cash not received and deposited in the bank. Decisions involved in receivables management: 1. Assessment of creditworthiness (new customer check/ rating agency) 2. Managing accounts receivable (aging/ utilisation report) 3. Extending additional credit (Example 1) 4. Collection of receivables (collection procedure) 5. Offering early settlement discounts (Example 2) 6. Monitoring bad debts risk 7. Receivables Financing: Factoring / Invoice Discounting (Example 3) 8. Further consideration on foreign trade (LC/ Trade Insurance)

44 MB Working capital management 7. Receivables Management Example 1: Extending Additional Credit The management of a company are considering a change of credit policy that will increase the average collection period from 1 to 2 months. The relaxation in credit is expected to produce an increase in sales in each year amounting to 25% of the current sales volume. The company's products sell at a contribution ratio of 15% and current sales are $240m. The required rate of return on investments is 20%. Assuming that the 25% increase in sales would result in additional inventories of $10m and additional accounts payable of $2m, advise the company on whether or not to extend the credit period offered to customers if: a) all customers take the longer credit of two months. b) existing customers do not change their payment habits and only the new customers take the extended credit.

45 MB Working capital management 7. Receivables Management Example 1: Extending Additional Credit Answer (a): The additional investment required, if all accounts receivable take two months' credit is as follows: Average accounts receivable after the sales increase (2/12 $300m) 50 Less current average accounts receivable (1/12 $240m) (20) Increase in accounts receivable 30 Increase in inventories 10 Less increase in accounts payable (2) Net increase in working capital investment 38 $m

46 MB Working capital management 7. Receivables Management Example 1: Extending Additional Credit Answer (a) (Cont d): Increase in sales revenue is $60m and at a contribution ratio of 15%, this is an increase in contribution of $9m. The change in credit policy is justifiable if the rate of return on the additional investment in working capital exceeds 20%. The return on extra investment if all accounts receivable take two months' credit is: $9m/ $38m = 23.7% > 20%, Good to go!!

47 MB Working capital management 7. Receivables Management Example 1: Extending Additional Credit Answer (b): The additional investment required, if only new customers take two months' credit is as follows: Average accounts receivable after the sales increase (2/12 $60m) 10 Increase in accounts receivable 10 Increase in inventories 20 Less increase in accounts payable (2) Net increase in working capital investment 18 The return on extra investment if only new customers take two months' credit is: $9m/ $18m = 50.0% > 20% Good to go!! $m

48 MB Working capital management 7. Receivables Management Example 2: Offering Settlement Discounts A company has annual credit sales of $30m with two months being the usual credit period given to customers. Not all customers, however, adhere to the policies as evidenced by the actual receivables ageing record as follows: Actual credit term % of customers 2 months 60 3 months 40 Average collection period is therefore = (2 0.6) + (3 0.4) = 2.4 months

49 MB Working capital management 7. Receivables Management Example 2: Offering Settlement Discounts The company's management decide to offer a 15% discount for payments made within 14 working days (assuming one year = 350 working days) of the invoice being raised and to reduce the maximum time allowed for payment to one month. It is estimated that 80% of customers will take the discount and the remainder will use the existing credit terms. If such a scheme is offered to customers, sales will increase by 20% (at a contribution margin of 30%) and bad debts will be reduced from 10% to 6% of credit sales. The company requires a 25% per annum return on investment. Is implementation of the early settlement discount scheme worthwhile in financial terms?

50 MB Working capital management 7. Receivables Management Example 2: Offering Settlement Discounts Answer: Without discount $m With discount $m Benefits Contribution earned 9 $30m x 1.2 x 30% 10.8 Costs Discount given - $30m x 1.2 x 0.8 x 15% (4.32) Bad debts ($30m x 10%) (3) $30m x 1.2 x 6% (2.16) Cost of working capital invested ($30m x 2.4/12 x 25%) (1.5) $30m x 1.2 x 0.8 x 14/350 x 25% $30m x 1.2 x 0.2 x 3/12 x 25% (0.29) (0.45) Net benefits The company should not adopt the early settlement discount scheme, as it results in a net decrease in benefits of $0.92 million.

51 MB Working capital management 7. Receivables Management Example 3: Factoring A company makes annual credit sales of $200m. Credit terms are one month, but its debt administration has been poor and the average collection period has been two months with 2% of sales resulting in bad debts which are written off. A non-recourse factor would take on the task of debt administration and credit checking, at an annual fee of 6% of sales receipts. The company would save $8m a year in administration costs. The factor would also provide an advance of 75% of invoiced debts at once at an interest rate of 3% above the current base rate which is at 10% and the remaining 25% is payable in normal credit term. The company normally obtains an overdraft facility to finance its debtors at a rate of 2% over base rate. Assuming constant monthly turnover, should the factor's services be accepted?

52 MB Working capital management 7. Receivables Management Example 3: Factoring Answer: Benefits $m Cost $m Savings in cost of finance ($200m x 2/12 x 0.12) 4 Bad debts avoided ($200m x 0.02) 4 Savings Administration costs 8 Factoring charges ($200m x 0.06) 12 Cost of finance from the factor ($200m x 0.75 x 1/12 x 0.13) 1.63 Cost of finance from the bank ($200m x 0.25 x 1/12 x 0.12) The factoring services should be accepted as there is a net benefit of $1.87 million.

53 MB Working capital management 8. Payables Management To seek satisfactory credit terms from suppliers, getting credit extended during periods of cash shortage, and maintaining good relations with suppliers. Costs of making maximum use of trade credit include the loss of suppliers' goodwill, and loss of any available cash discounts for the early payment of debts. The cost of taking advantage cash discounts can be calculated by comparing the saving from the discount with the opportunity cost of investing the cash.

54 MB Working capital management 8. Payables Management Example: Early Payment Discount A company has annual credit purchases of HK$20m from its major supplier. The credit terms are payment must be made in 60 days of the invoice without discount but a cash discount of 4% will be given if payment is made within 10 days of the invoice. The company's required return on investment is at 15% per annum. Is the cash discount of 4% worth undertaking from a financial viewpoint?

55 MB Working capital management 8. Payables Management Example: Early Payment Discount Answer: Taking discount $m Early payment ($20m x 0.96) 19.2 Refusing discount Payment made 20 Return earned ($20m x 0.15 x 50/365) (0.41) It is cheaper to accept the discount.

56 MB Working capital management 9. Cash Forecasting Cash flow forecasts show the expected receipts and payments during a forecast period and are a vital management control tool, especially during times of recession. Motives for companies to hold cash a) Transaction Motive b) Precautionary Motive c) Speculative Motive Cash Flow Problems Continual losses being incurred Inflation Non-current assets/ working capital increase in time of growth Seasonal or cyclical sales A single non-recurring item of expenditure

57 MB Working capital management 10. Cash and Treasury Management Example: Baumol model (Optimal Cash Holding Level) The Baumol model uses an equation of the same form as the EOQ formula and, similarly to the EOQ, costs are minimised when: Drawback of Baumol model: a) It is difficult to predict amounts required over future periods with much certainty in reality. b) There is no buffer inventory of cash allowed for and there may be costs associated with running out of cash. c) There may be other normal costs of holding cash which increase with the average amount held.

58 MB Working capital management 10. Cash and Treasury Management Example: Baumol model A company requires $480,000 of cash over each period of one year for the foreseeable future and is considering two alternatives: Option (1) Taking up a bank loan of $480,000 at once for a one-year period at an interest rate of 12% per annum on the initial balance. Option (2) Sale of existing securities which will incur a transaction fee of $1,000 based on the Baumol model (the return from the securities investment is currently at 15% per annum) Any fund/cash not in use will be placed in a call deposit at 9% per annum. Which of the two options is financially better to undertake?

59 MB Working capital management 10. Cash and Treasury Management Example: Baumol model Answer:

60 MB Working capital management 10. Cash and Treasury Management Example: Baumol model Answer: Total costs per annum under each option ($) Option 1 Option 2 Interest payable ($0.48m x 0.12) 57,600 Lost return on investment ($0.48m/2) x 0.09 (21,600) $ $ Ordering cost ($1,000 x 4) 4,000 Holding cost ($0.48m/2) x ,000 Return on investment ($126,491/2) x 0.09 (5,700) Total cost 36,000 34,300 Option (2) should be chosen, as its total cost is marginally lower than option (1).

61 MB Working capital management 10. Cash and Treasury Management Miller-Orr Model Miller-Orr model manages to achieve a fair degree of realism. Since the cash balance is likely to meander upwards or downwards. Miller-Orr model does no attempt to manage cash balances but imposes limits to this meandering. a) The cash balance held should always be close to a normal level / return point (RP). b) If the cash balance increases and reaches an upper limit (UL), firms should buy/invest sufficient securities to utilise the excess cash and bring cash balance back to the RP. c) If the cash balances decreases and reaches a lower limit (LL), firms should sell/dispose of sufficient securities to bring the balance back to the RP.

62 MB Working capital management 10. Cash and Treasury Management Miller-Orr Model Upper Limit = Lower limit + 1 Spread Lower Limit is to be set by management Example: Lower limit = $8,000; Variance = 4,000,000 (Standard Deviation = 2,000) Transaction cost = $50; Interest Rate = 0.025% per day Spread = $25,303 Upper Limit = Lower limit + Spread = $8,000 + $25,303 = $33,303 Return Point = Lower limit + 1/3 Spread = $16,433

63 MB Working capital management

64 MB Working capital management

65 MB Working capital management

66 Module B Corporate Financing Financial Market Reference: LP Chapter 16

67 MB Financial Market Content 1. Financial markets 2. Money markets and capital markets 3. The banking structure in Hong Kong 4. Cash management in Hong Kong 5. The mainland China banking environment 6. International financial institutions 7. The efficient market hypothesis 8. Financial markets in Hong Kong 9. Other current capital market trends

68 MB Financial Market 1. Financial markets Financial markets facilitate the buying and selling of financial assets (i.e. debt and equity financial instruments) to allow participants to achieve their desired portfolio mix of risk and return. Financial intermediary links those with surplus funds (for example, lenders) to those with funds deficits (for example, potential borrowers) therefore providing aggregation and economies of scale, risk pooling and maturity transformation.

69 MB Financial Market 1. Financial markets Financial intermediaries serve three important purposes in the working of the financial markets. 1) Aggregation (collect together small deposits and can lend large amounts) 2) Maturity transformation (collect short-term deposits and can lend long term) 3) Risk reduction (can reduce risk cheaply for small investors by investing in a portfolio of equity shares which they could not afford to own individually)

70 MB Financial Market 2. Money Market and Capital Market Money Market

71 MB Financial Market 2. Money Market and Capital Market Capital markets are markets for trading in long-term finance, in the form of longterm financial instruments such as equities and corporate bonds. International capital markets has built up which allows very large companies to borrow long-term or short-term. Eurobonds: bonds denominated in a currency that often differs from that of the country of issue. They are long-term loans raised by international companies or other institutions and sold to investors in several countries at the same time. Investor subscribing to a bond issue will be concerned about the following factors: Security Marketability Anonymity The return on the investment.

72 MB Financial Market 3. The Banking Structure in Hong Kong Three-tier system of deposit-taking institutions Licensed banks: operate current and savings accounts, and accept deposits of any size and maturity from the public and pay or collect cheques drawn by or paid in by customers. Restricted licence banks: principally engaged in investment banking and capital market activities. Deposit-taking companies: engage in a range of specialised activities, including consumer finance and securities business. Local representative offices: liaison work between the bank and its customers in Hong Kong.

73 MB Financial Market 4. Cash management in Hong Kong Real Time Gross Settlements (RTGS) System: large-value interbank payments are settled on a continuous, deal-by-deal basis through the banks' settlement accounts with the settlement institution of the system. Settling one by one during the day, systemic settlement risks arising from end-of-day netting are eliminated. Payment-versus-Payment (PvP) is a mechanism for settling a foreign exchange transaction to ensure that payments in the two currencies involved are settled simultaneously.

74 MB Financial Market 5. The mainland China banking environment China Banking Regulatory Commission (CBRC) regulates the banking industry: a) Formulation of supervisory rules and regulations. b) Authorisation of establishment, changes, termination and business scope of the banking institutions. c) Conduct of on-site examination and off-site surveillance of the banking institutions, and taking of enforcement actions against rule breaking behaviours. d) Conduct of fit and proper tests on the senior managerial personnel of the banking institutions. e) Compilation and publication of statistics and reports on the overall banking industry. f) Provision of proposals on the resolution of problem deposit-taking industry in accordance with relevant regulations. g) Administration of the supervisory boards of the major State-owned banking institutions

75 MB Financial Market 6. International financial institutions International Monetary Fund (IMF) IMF supports its membership by providing: policy advice to governments and central banks based on analysis of economic trends and cross-country experiences; research, statistics, forecasts, and analysis based on tracking of global, regional, and individual economies and markets; loans to help countries overcome economic difficulties; concessional loans to help fight poverty in developing countries; and technical assistance and training to help countries improve the management of their economies.

76 MB Financial Market 6. International financial institutions International Monetary Fund (IMF) supports its membership by providing: policy advice to governments and central banks based on analysis of economic trends and cross-country experiences; research, statistics, forecasts, and analysis based on tracking of global, regional, and individual economies and markets; loans to help countries overcome economic difficulties; concessional loans to help fight poverty in developing countries; and technical assistance and training to help countries improve the management of their economies. World Bank provide low-interest loans, interest-free credits and grants to developing countries for a wide array of purposes that include investments in education, health, public administration, infrastructure, financial and private sector development, agriculture and environmental and natural resource management.

77 MB Financial Market 7. The efficient market hypothesis 1. Weak form efficiency implies that prices reflect all relevant information about past price movements and their implications. 2. Semi-strong form efficiency implies that prices reflect past price movements and publicly available knowledge. 3. Strong form efficiency implies that prices reflect past price movements, publicly available knowledge and inside knowledge. The efficient market hypothesis is the hypothesis that the stock market reacts immediately to all the information that is available. Therefore, a long-term investor cannot obtain higher than average returns from a well-diversified share portfolio.

78 MB Financial Market 7. The efficient market hypothesis The definition of efficiency a) Allocative efficiency: allow funds to be directed towards firms which make the most productive use of them b) Operational efficiency: transaction costs are kept as low as possible. Transaction costs are kept low where there is open competition between brokers and other market participants. c) Informational processing efficiency: the market prices of all securities reflect all the available information.

79 MB Financial Market 7. The efficient market hypothesis Features of efficient markets It has been argued that the UK, Hong Kong and US stock markets are efficient capital markets, in which: a) share prices change quickly to reflect all new information about future prospects b) no individual dominates the market c) transaction costs of buying and selling are not so high as to discourage trading significantly d) investors are rational e) there are low, or no, costs of acquiring information

80 MB Financial Market 7. The efficient market hypothesis Impact of efficiency on share prices Share prices should vary in a rational way: a) If a company makes an investment with a positive net present value (NPV), shareholders will get to know about it and the market price of its shares will rise in anticipation of future dividend increases. b) If a company makes a bad investment shareholders will find out and so the price of its shares will fall. c) If interest rates rise, shareholders will want a higher return from their investments, so market prices will fall.

81 MB Financial Market 7. The efficient market hypothesis Implications for the corporate treasurer/financial manager If the market is strongly efficient, there is little point in financial managers attempting strategies that will attempt to mislead the markets: a) There is no point in trying to identify a correct date when shares should be issued, since share prices will always reflect the true worth of the company. b) The market will identify any attempts to window dress the accounts and put an optimistic spin on the figures. c) It is pointless for the company to try to change the market's view by issuing different types of capital instruments.

82 MB Financial Market 8. Financial markets in Hong Kong Securities traded on Hong Kong's equity and debt markets

83 MB Financial Market 8. Financial markets in Hong Kong Securities traded on Hong Kong's equity and debt markets

84 MB Financial Market 8. Financial markets in Hong Kong Derivatives markets

85 MB Financial Market 9. Other current capital market trends The Basel rules The Basel rules (Basel II and Basel III together) have two main objectives. a) To require banks to maintain a minimum amount of capital, mainly equity capital, in relation to the size and amount of their risky assets. (Most bank assets have some element of risk. Only assets such as cash do not.) b) To require banks to maintain a minimum amount of liquid assets to meet their potential need for liquidity. Minimum liquidity requirements for banks were introduced by Basel III.

86 MB Financial Market 9. Other current capital market trends Implications of the Basel rules The rules require banks to increase their equity capital, which means that banks return on equity is likely to fall. The liquidity requirements also mean that banks have to hold more short-term (and lower-yielding) liquid assets. resulted in a substantial fall in the profitability. Many banks are also still trying to recover from the effects of the global recession, and may have many loans on their balance sheets which they will eventually need to write off as irrecoverable. Banks appear reluctant to lend. When they do lend, the interest rate is usually much higher than the low official short-term interest rates available to banks from their central bank. Small and medium-sized business enterprises (SMEs) may be very difficult to obtain bank loans for new investment.

87 MB Financial Market 9. Other current capital market trends Dodd-Frank Act To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes. One requirement of the Act may have extensive implications for global financial markets is a requirement for standard financial derivatives such as interest rate swaps and credit default swaps to be traded on a formal derivatives exchange rather than over-the-counter. It should still be possible to negotiate derivative deals over the counter with a bank, but the objective of the Dodd-Frank Act is to encourage greater standardisation of derivatives and more exchange-based trading in derivatives.