JuiceNotes TM

- By FinTree

eBook 5

Corporate Finance

CFA® Level 1 JuiceNotesTM 2017

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Corporate Governance and ESG

LOS a
1 Corporate governance System of internal controls and procedures by which individual
companies are managed.

A framework that defines rights, roles and responsibilities of

various groups

Arrangement of checks and balances a company needs to

minimize and manage the conflicting interests between insiders
and external shareowners.

2 Corporate governance theories

Shareholder Stakeholder
theory theory

Primary focus is the interest of Focus under this theory is

firm’s shareholders broader
Maximization of MV of firm’s It considers conflict of interest
common equity
CG is concerned with the conflict
of interest between managers
and owners e
among several groups such as
shareholders, employees,
suppliers, customers and others.
re
LOS b Primary stakeholders of a
company

Shareholders ç Voting rights

ç Residual interest
ç Ongoing interest in profitability and growth, both increasing the value of their shares
nT

BOD ç Responsibility to protect the interest of shareholders

ç To hire, fire and set the compensation of the firm’s senior managers
ç Monitor financial performance and other ongoing activities.
ç Firm’s executives (most-senior managers) serve on BOD along with directors who are
not otherwise employed by the firm.
ç One-tier - Both executive and non-executive board members serve on a single BOD
ç Two-tier - Non-executive board members serve on a supervisory board that oversees a
management board, made up of company executives.
Senior managers
Fi

ç Compensation - salary, bonus and perquisites

ç Executive bonuses are tied to same measure of firm performance, giving them a
strong interest in financial success of the firm.
Employees ç They have interest in the pay, opportunities for career advancement, training and
working conditions
Creditors ç Providers of debt capital
ç Do not have voting rights
ç Do not participate in the firm’s growth beyond their promised interest and principal
payment
Suppliers ç Ongoing relationship with the firm
ç Typically short-term creditors
ç They have interest in the firm’s solvency and ongoing financial strength
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LOS c Conflict of interest

Principal-agent ª It arises because an agent is hired to act in the interest of the principal but
the agent’s interest may not coincide exactly with those of the principal.
Shareholders ª Shareholders are principals and board members are their agents
and managers ª Managers and directors are dependent on firm for employment
ª They may choose lower level of business risk than the shareholders would
or BOD
since their employment is dependant on firm’s performance.
ª There is an information asymmetry between shareholders and managers
because managers have more and better understanding of the functioning
of the firm. This decreases the ability of the shareholders or non-executive
directors to monitor and evaluate whether managers are acting in the best
interest of the shareholders.

Groups of ª A single shareholder or a group of shareholders may hold a majority of the

votes and act against the minority shareholders.
shareholders ª Some firms have different classes of shares, some with more voting power
than others.
ª In the event of an acquisition, controlling shareholders may be in a
position to get better terms for themselves than minority shareholders.
Creditors and ª Shareholders may prefer more risk than creditors do because creditors
shareholders have a limited upside from good result.
ª The company may raise prices or reduce product quality to increase
Shareholders
profits to the detriment of customers.
and other ª The company may employ strategies that significantly reduce taxes they
stakeholders pay to the government.

LOS d
e
Stakeholder management - Management of company relations with stakeholders
re
Infrastructures

Legal Contractual Organizational Governmental

infrastructure infrastructure infrastructure infrastructure
nT

Legal recourse of Contract that spell Company’s CG Comprises

stakeholders when out rights and procedures regulations to
their rights are responsibilities of including its which companies
violated company and the internal systems are subject.
stakeholders

LOS e Mechanism to manage stakeholder relationships

Fi

Ordinary Requires majority of Majority Candidate with most

resolution votes. Eg. approval voting votes for each single
Voting by Assigning one’s right of auditors, election board position is
proxy to vote to another of directors elected

Proxy is often a Special May require a Cumulative Shareholders can

director, member of resolution supermajority vote. voting cast all their votes to
management or Typically 2/3rd or one single board
shareholder’s 3/4thof votes Eg. candidate or divide
investment advisor mergers, takeovers them among others
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LOS f 1 Board
structure

One-tier Two-tier
board board

Single BOD Two BODs

Internal directors / External directors / Supervisory board Management board

Executive directors Non executive directors
Excludes executive Made up of executive
Senior managers No other relationship directors directors
employed by the firm with the company. Also
termed as independent
Led by company’s CEO
directors
Chairman of the board is
sometimes the CEO

Lead independent director - Ability

to call meetings of independent
directors, separate from meetings
of the full board

2 Board responsibilitiese
Staggered board - Elections for some board positions are held each year
re
ç Selecting senior management, setting their compensation, evaluating their performance
and replacing them as needed.
ç Setting strategic direction.
ç Approving capital structure changes, acquisitions and large investment expenditures.
ç Reviewing company performance and taking necessary corrective steps.
nT

ç Planning for continuity of management and succession of the CEO.

ç Establishing, monitoring and overseeing firm’s internal controls and risk management
system.
ç Ensuring the quality of the firm’s financial reporting and internal audit.

3 Board committees
Fi

Audit Governance Nominations Compensation Risk Investment

committee committee committee committee committee committee

Ÿ Implementation Ÿ CG code Ÿ Proposes Ÿ Recommends Ÿ Informs the Ÿ Reviews and

of accounting Ÿ Implementing code qualified to the board board about reports to the
policies of ethics and candidates for the amounts of appropriate risk board on
Ÿ Effectiveness of policies regarding election to the compensation policy and risk management
internal conflict of int. board to be paid to tolerance of the proposals for
controls Ÿ Monitoring changes directors and organization large
Ÿ Recommending in laws and senior Ÿ Oversees acquisitions,
external auditor regulations managers. enterprise-wide sale or disposal
Ÿ Proposing Ÿ Ensuring company is risk of company
remedies based complying with all management assets or
on audits. laws and regulations process segments
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LOS g Factors that affect stakeholder relationships and CG

1 Activist They pressure companies in which they

shareholders hold significant number shares for changes

Hedge funds have engaged in shareholder activism to

increase the MV of firms in which they hold significant stakes

An activist group may make a tender offer for specific no.

of shares to gain enough votes to take over the company

A threat of hostile takeover can act as an incentive to influence management and

board to pursue policies more in alignment with the interests of shareholders

2 Legal
environment

Common-law system Civil law system

Judges’ rulings become law Judges are bound to rule

in some instances based on enacted laws

Interests of creditors and Rights of creditors are

shareholders are more clearly defined than
considered to be more those of shareholders.
protected in countries with
this system

e Therefore not difficult to

enforce through the courts
re
LOS h Risks of poor CG and benefits of effective CG
When governance is weak and managers are not monitored, they
may choose lower-than-optimal risk, reducing company value

Poor compliance procedures with respect to regulation and

reporting can easily lead to legal and reputational risks
nT

Effective CG can improve operational efficiency by ensuring that management

and board member incentives align their interests with those of shareholders
Alignment of management interests with those of shareholders
leads to better financial performance and greater company value

LOS i Factors relevant to the analysis of CG

Fi

Elements of CG that analysts è Ownership and voting structure

1 è Board composition
have found to be relevant - è Management remuneration
è Composition of shareholders
è Strength of shareholder rights
è Management of long term risks

Dual class One class of shares may be entitled to several votes per share, while another
2
structure - class of shares is entitled to one vote per share
On average, companies with a dual class share structure have traded at a
discount to comparable companies with a single class of shares
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LOS j Environmental and social considerations in investment analysis

ESG integration/investing - The use of environmental, social and governance factors in

making investment decisions

Also termed as sustainable investing, responsible investing

and socially responsible investing

LOS k 1 Usage of ESG in investment analysis

Negative Certain companies and certain sectors are excluded from portfolios.
screening - Eg. mining and oil production sector.

Positive No specific sectors are excluded from portfolios but investors identify
screening - best practices across environmental sustainability.

2
Impact Investing in order to promote specific social or environmental goals.
investing
Investors seek to make profit while at the same time having a
positive impact on the environment

Thematic
investing e
Refers to investing based on a single goal. Eg.
development of clean water resources
re
nT
Fi
 Capital Budgeting
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LOS a
1 Capital budgeting process 2 Categories of capital
budgeting projects
Idea generation
Replacement Replacement
projects to maintain projects for cost
the business reduction
Analyzing project Without detailed Fairly detailed
proposals analysis analysis
New product or
Expansion Projects market
development
Create the firm- wide
Very detailed Detailed analysis
capital budget
analysis

Other projects
Mandatory Projects such as R&D
Monitoring decisions and
conducting a post-audit Without detailed
analysis

LOS b
1 Basic principles of capital
budgeting
e 2 Externalities
re
4 Decisions are based on cash flows, not Positive Negative
accounting income.

4 Consider opportunity costs.

Positive effect on Negative effect on
4 Timing of cash flows is important. sales of a firm’s sales of a firm’s
nT

other product lines. other product lines.

4 Consider cash flows after tax.

4 Ignore financing cost as a cash outflow. Cannibalization - New

Eg. Sales of cars will
increase business of project taking sales from
4 Ignore sunk cost as it is irrelevant for an existing product. Eg.
auto components in
decision making Coke Vs Diet coke
future.
Fi

3 Conventional Unconventional
cash flow cash flow
pattern pattern

Sign on the cash flows

changes only once
Sign on the cash flows
changes more than once } Problem of no IRR
or multiple IRR

0 1 2 3 0 1 2 3

- 1000 500 500 500 - 1000 800 -600 300

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LOS c Selection of capital projects

Unlimited Capital
funds rationing
Independent Mutually exclusive

´ Unlimited ´ Constraints on
select all select only one access to raising capital
projects, if NPV project (with the capital ´ Undertake
>0 highest NPV) ´ Firm can projects with
undertake all highest NPV
profitable
projects

Project sequencing - Investment in a project today creates opportunity to invest in projects in future

LOS d
Discounted Profitability
Payback
NPV IRR payback
period index
period

Time taken to

PV of inflows − PV
of outflows
Rate at which NPV
=0

PV of inflows = PV
of outflows
e
recover initial
investment

Shorter the better

Time taken to
recover initial
investment
considering TVM
PV of inflows
PV of outflows
re
NPV = +ve Poor measure of Poor measure of PI > 1 = Accept
[Accept] profitability profitability PI < 1 = Reject
IRR > WACC =
Accept
NPV = -ve Good measure of Good measure of PI > 1 = +ve NPV
[Reject] liquidity liquidity PI < 1 = −ve NPV
IRR < WACC =
Reject
Doesn’t consider DPB > PB
TVM & CFs after
PB
nT

LOS e Total of
NPV
undiscounted
cash flows
1 (Y-axis intercept)

Crossover rate
Fi

IRR
(X-axis intercept)

WACC

NPV profile
The rate at which NPVs are equal is called as Crossover rate
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2 Calculation of crossover rate on TI BA II Plus Professional

Project A -700 250 450 600

Project B -400 150 300 400

-300 100 150 200

CF0 CF1 CF2 CF3

CPT IRR = 20.61 % (Crossover rate)

3 NPV IRR

Advantages Disadvantages Advantages Disadvantages

ª Direct measure of ª Does not take size ª Measures ª Conflict of rankings
the expected of the project into profitability as a %
increase in the value consideration

ª
of firm

Theoretically the
best method
e
ª Provides information
on margin of safety
that NPV does not
ª

ª
Multiple IRR / No
IRR

Assumes
reinvestment at IRR
re
LOS f Relation between NPV and stock price
nT

A +ve NPV should cause proportionate increase in company’s stock price

Eg. Investment in new project = $300 mln, PV of future CFs = $400 mln
No. of shares outstanding = 50 mln, Market price of share = $25

NPV = $400 mln − $300 mln = $100 mln

Fi

NPV per share = $100 mln/50 mln = $2

Price of share after new project = $25 + $2 = $27
 Cost of Capital
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Preferred
Equity stock Debt

Capital appreciation
Fixed dividend Fixed interest
Variable dividend
Dividend is a function Interest is to be paid
Dividend is a function of profitability irrespective of
of profitability profitability
nd
2 preference in case
Last preference in of liquidity and 1st preference in case
case of liquidity and dividend payment of liquidity and
dividend payment interest payment

LOS a

Capital
component
1

e
Calculation and interpretation of WACC

Amount Component cost

(effective)
Weight Weighted
average
re
Equity 1000 20% 20% 4%

Preferred stock 2000 15% 40% 6%

Debt 2000 10% 40% 4%

Total 5000 100% 14%

nT

Marginal cost of capital = Weighted average cost of capital WACC

2 Costs

Equity Preferred Debt

Fi

stock

Kce Kps Kd x (1-t)

LOS b Impact of taxes on cost of capital

Interest paid on corporate debt is tax deductible
No tax deduction is allowed for payments to common or preferred stockholders
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LOS c How to determine weights in capital structure
The weights in the calculation of WACC should be based on market values not book values

LOS d Cost of Capital / IRR

Marginal
Investment
Cost of
Opportunity
Capital
Schedule

Amount of
capital invested
Optimal
Capital
Budget

LOS e WACC’s role in determining NPV

WACC is appropriate discount rate for projects that have
approximately the same level of risk as the firm’s existing projects
Project with greater than average risk = Discount rate greater than WACC

LOS f Cost of debt e

Project with below-average risk = Discount rate less than WACC
re
True cost of debt is its YTM, not the coupon rate.
If YTM is not available because the firm’s debt is not publicly traded, the analyst can use
matrix pricing to estimate the before-tax cost of debt.

Kd = YTM x (1 - t)
nT

LOS g Cost of preferred Kps = Preference Dividend

stock (perpetual) Price of stock

LOS h Cost of equity

Capital Asset Gordon Growth Bond yield +

Pricing Model Model / Dividend Risk Premium
Fi

discount model

D1 + g PAT Ad hoc approach

Kce = RFR + (Rm - RFR) x β Kce =
P0 Equity

Analysts add a risk

Market Risk Premium Retention Ratio × ROE
premium to the
(MRP) market yield on
firm’s long term debt
DPS
1 − Payout ratio
EPS
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LOS i Beta - measure of systematic risk/market risk

1
Y = a + bx
Covariance (s,m)
Beta =
Dependant variable Variance (m)
Independent variable
Intercept Slope/beta

2 Pure-play method

(Unlever) (Relever) Project beta

Beta of a comparable
Asset beta
company Divide Multiply (Equity beta)
D/E of D/E of
comparable our
company company
1 + D/E ratio
(1 − t)

3 Challenging issues with beta

Ê
of time used and frequency.

Betas exhibit mean reversion tendency (aka beta drift).e

Beta is estimated using historical returns data. The estimate is sensitive to the length
re
Ê Beta of the entire market is 1, therefore all betas have a tendency to move toward 1 and
estimate may need to be adjusted.

Ê The estimate is affected by index chosen.

Ê Beta may need to be adjusted upward for small firms to reflect inherent risk in them.
nT

LOS j Use of country risk premium in estimating cost of equity

Country Risk It is added to MRP (in CAPM) to reflect increased risk

Premium - associated with investing in a developing country

Sovereign Yield of developing country’s govt. bond (denominated in developed

yield spread - country’s currency) − Yield on Treasury bond of similar maturity
Fi

Developing Eg.
country
RFR = 4% Rm = 9%
Sovereign SD of market CRP = 5% Beta = 1.5
CRP = X
yield spread SD of debt
Kce = RFR + (MRP + CRP) x β
Developed Kce = 4 + [(9 − 4) + 5) x 1.5
country
Kce = 19%
Kce = RFR + (MRP + CRP) x β
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LOS k Marginal cost of capital schedule

Break point = Amt. of capital at which cost changes

Weight of the component
Different sources of financing become more
expensive as the firm raises more capital
WACC
The Marginal cost of capital schedule shows
WACC for different amounts of financing

The MCC schedule is shown as graph and

typically has an upward slope

The break points occur when the cost of

one the components of WACC changes
Capital
raised

LOS l Treatment of floatation cost

The correct method to account for floatation costs is to calculate the dollar amount of cost
and increase the initial cash outflow by this amount.

It should not be incorporated directly into the cost of equity because it is not an ongoing
expense and it would lead to increase in WACC which in turn will reduce the NPV

e
re
nT
Fi
 Measures of Leverage
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LOS a
1
Variable Fixed
cost cost

Fixed Variable
cost cost

Low leverage High leverage

2 Leverage refers to the amount of 3 Risks

fixed costs a firm has.
Financial risk Business risk
Operating fixed Financing fixed
cost (OFC) cost (FFC)
Sales risk Operating risk

Degree of
Operating
Leverage
Degree of
Financial
Leverage e Uncertainty about
firm’s sales
Additional
uncertainty
about operating
re
earning

Additional risk borne

∆ operating ∆ net income
by shareholders
earnings > ∆ sales > ∆ operating
because of debt
earnings
financing
nT

LOS b
1 Degree of operating Degree of financial Degree of combined
leverage (DOL) leverage (DFL) leverage (DCL)
Fi

% ∆ EBIT
% ∆ sales
% ∆ EPS
DOL × DFL
% ∆ EBIT
Sales − VC
EBIT % ∆ EPS
EBIT
% ∆ sales
EBT
Highest at low level of
sales Sales − VC
If there’s no FFC,
EBT
DFL=1
If there’s no OFC,
DOL=1
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+10% +10%
2 Sales 1000
Variable 400
cost
Contribution 600 Contribution % ∆ EBIT
1.5 DOL = Or
EBIT % ∆ Sales
Operating
200
fixed cost
DTL = DOL × DFL 3
+15%
EBIT 400
+15%
Interest 200
EBIT % ∆ EAT
EBT 200 2 DFL = Or
% ∆ EBIT
EBT
Taxes 100
EAT 100
+30% +30%

% ∆ Sales = % ∆ Contribution
% ∆ EBT = % ∆ EAT
% ∆ Net income = % ∆ PAT = % ∆ EPS

LOS c

ROE = Net income

e
Effect of financial leverage on ROE

Use of financial leverage increases the risk of default but also

re
Equity increases the potential return for equity shareholders

LOS d LOS e

Breakeven Level of sales a Operating Operating fixed cost

firm must generate breakeven
= Contribution per unit
nT

quantity - to cover its FC & VC

Total OFC + Interest
Breakeven Sales = FC + VC
breakeven = Contribution per unit
sales -
Net income = 0
Units to be sold
OFC + Interest + Des. profit
Contribution - Sales − VC to generate = Contribution per unit
desired profit
Fi

Fixed cost
Breakeven point (in amount) =
Contribution ratio
Contribution
Contribution ratio =
Sales
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Eg. Operating fixed cost = 10,000 Financing fixed cost = 20,000
Selling price = 100 Variable cost = 60 Desired profit = 30,000

Contribution per unit = Selling price − Variable cost

= 100 − 60
= 40

Contribution per unit

Contribution ratio =
Sales per unit
40
=
100
= 40%

OFC
Operating breakeven =
Contribution per unit
10,000
=
40

= 250

OFC + FFC
Total breakeven =
Contribution per unit
10,000 + 20,000
=
40

Breakeven (in amount) =

e
750

OFC + FFC
re
Contribution ratio
10,000 + 20,000
=
40%

= 75,000
nT
Fi
 Dividends and Share Repurchases
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LOS a Types of dividends and their effect on

shareholders’ wealth and company’s ratios

1 Cash dividends 2

Regular Special Liquidating è In theory value of a stock reduces by the

dividend dividend dividend amount of dividend on ex-dividend date.

Consistent Extra/irregular Proceeds of è The payment of cash dividend reduces a

schedule eg. dividend liquidation
quarterly
company’s Assets and MV of its Equity.

Stock Stock Reverse

dividends splits stock splits

Cash dividend decreases asset (cash) and

Division of shareholders’ equity (retained earnings)
Dividends in Combination of
each share into
shares/stocks multiple shares
multiple shares Other things equal, decrease in cash decreases
into one
liquidity ratios and increases debt-to-assets ratio
Retained
earnings decrease

Equity share
capital increases
No. of shares
increase
Price of shares
decrease
Shareholder’s
wealth is
unchanged

A company whose
e
Decrease in retained earnings, increases debt-to-
equity ratio
re
Value of
Total equity stock has fallen
shareholder’s
remains dramatically may
total shares is
unchanged declare Reverse
unchanged
stock split

Stock dividends, stock splits and reverse stock splits have

no effect on company’s leverage ratios or liquidity ratios
nT

LOS b Dividend payment chronology

Declaration Cum-dividend Ex-dividend Holder of Payment

date date date record date date
Fi

Feb. 24 Mar. 13 Mar. 14 Mar. 16 Mar. 31

Settlement cycle in US = T + 3

If a person buys shares on or after ex-dividend date, he will not receive the dividend
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LOS c Share repurchase methods

Open market Tender offer Direct negotiation

Prevailing market price Premium to market price Premium to market price

Gives company the Shareholders may tender Direct negotiation with a

flexibility to choose the their shares according to large shareholder to
timing of the transaction the terms of the offer buyback a block of shares

LOS d Impact of share repurchase on EPS

Profit after tax

EPS = No. of shares outstanding If earning yield > borrowing cost - EPS

EPS
Earning yield =
MPS If borrowing cost > earning yield - EPS
Cost of borrowing = YTM × (1 − t)

LOS e

BV of Assets − BV of Liabilities
e
Impact of share repurchase on BVPS

If BVPS (old) > MPS - BVPS (new)

re
BVPS =
No. of shares outstanding
If MPS > BVPS (old) - BVPS (new)

Eg. (LOS d)
nT

Share price before buyback = $40 Shares outstanding before buyback = 120,000
EPS before buyback = $3 Cost of debt = 9% Tax rate = 30% Planned buyback = 20,000

Earning yield = EPS/MPS After tax cost of debt = 9 × (1 − t)

= 3/40 = 9 × (1 − 0.3)
= 7.5% = 6.3%
Fi

EPS will increase after buyback, because earning yield > after tax cost of debt

Net income − After tax cost of funds

EPS after buyback =
Shares outstanding after buyback
(3 × 120,000) − (20,000 × 40 × 6.3%)
=
(120,000 − 20,000)

360,000 − 50,400
=
100,000

= $3.096
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Eg. (LOS e)

Share price before buyback = $40 Shares outstanding before buyback = 120,000
Book value = $2.4 mln Planned buyback = $800,000

2,400,000
Current BVPS =
120,000
= 20

New BVPS will decrease, because Current BVPS < MPS

No. of shares in buyback = $800,000

$40
= 20,000

New BVPS = Opening BV − Planned buyback

Shares outstanding after buyback

2,400,000 − 800,000
120,000 − 20,000

= 16

Why cash dividend and share repurchase of same amount are

LOS f

e
equivalent in terms of effect on shareholders’ wealth

A share repurchase can be considered as an alternative to cash dividend

re
Assuming the tax treatment is same, share repurchase and cash dividend
have same impact on shareholder’s wealth

Original scenario Cash dividend Share repuechase

5 shares x 100 = 500 20 per share 1 share
nT

Value of shares Value of shares Value of shares

500 400 400
(80 x 5)
Wealth Wealth Wealth
Cash
Cash 100 Cash
0 (20 x 5) 100
Fi
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Working Capital Management

1 What is Working Capital ?

Factory
(700)
Capital
(1000)
Working Capital
Cash
(300)

Accounts
Inventory
Receivable

Factory
2 (700)
Capital
(1000)

Working capital
is still 300
Current liabilities

Accounts Payable
e Amt.

100
Current assets

Inventory
Amt.

100+100
re
Accounts Receivable 100
100 worth of
current assets Cash 100
are funded by
Current
Liabilities
Total 100 Total 400
nT

Working Capital = Current Assets - Current Liabilities

LOS a
1 Sources of liquidity 2 Factors that influence a
company’s liquidity position

Primary Secondary
Fi

sources sources
DI PO
Used in normal day to Used in deteriorating
Drag on Inflows Pull on Outflows
day operations financial conditions
Eg. Uncollected Eg. Paying vendors
è Selling good è Selling assets receivables, sooner than is
è Collecting from AR è Negotiating debts obsolete inventory optimal
è Short-term funding (restructuring)
è Trade credit
è Line of credit
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LOS b Liquidity Activity Higher the better

Ratios Ratios

4 ARTR = Credit Sales / Avg Accounts Receivable

4 Current ratio = CA / CL
4 ITR = COGS / Avg Inventory
4 Quick ratio (acid test ratio) = CA − Inventory/CL
4 WCTR = Sales / Working Capital
4 Cash ratio = Cash + Marketable Sec. / CL
4 APTR = Purchases / Avg Accounts Payable

Lower the better

Accounts payable - 50
LOS c
0 30 50 70

Inventory AR Cash
30 40

Operating cycle (70) = No. of days in Inventory (30) + No. of days in AR (40)

Cash Cycle (20) = Operating cycle (70) − No. of days in AP (50)

LOS d
purchases and pay expenses as they come due.

e
Daily cash position refers to uninvested cash balances a firm has available to make routine

Purpose of managing daily cash position - To have sufficient cash on hand (make sure net daily
cash position never becomes negative) but to avoid keeping excess cash because of interest income
re
forgone by not investing

LOS e 3 mistakes analogy to

remember the formulas
1 Effective earning yield (indicated in red) Bond equivalent yield
nT

(1+3.09%)365/90- 1 j Compounding j No Compounding

k 365 days 90 3.09%
= 13.13% k 365 days
l Investment 365 12.53% l Investment value
Or value as base as base

N = 90/365 Holding period yield

PV = -970
FV = 1000
I/Y = 13.14 % T - bill
970 1000
Fi

3.09
90 days
1 + 3.09% 30
= 3.09%
970

Bank discount yield Money market yield

j No Compounding j No Compounding
90 30/1000 =3% k 360 days 90 3.09% k 360 days
12%
l Face value as 360 12.36% l Investment value
360
base 3 as base
1 − 3%
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3 Every firm should

2 Add on yield 7 % Discount yield 7 % have a written IPS
IPS should have:
100 107 93 100
(investment (face (investment (face g Guidelines about the
value) value) value) value) strategy

g Types of securities
allowed
Interest Interest
Investment value Face value g Persons responsible
for complying with
the guidelines

Most preferred yield for Money market instrument g Limitations on credit

rating of portfolio
Bond equivalent yield securities

LOS f Cost of Trade Credit 3/20 Net 90

PV = −97 FV = 100 N = 70/365 I/Y = 17.21%

0 20 90
97 70 100

e
Cost of borrowing < Cost of annual trade credit = Take the discount
re
If inventory levels are too low, it will result in loss of sales due to stock-outs.

If inventory levels are too high, it will result in more carrying costs.

If credit terms are strict, it will lead to lower sales.

nT

If credit terms are lenient, it will lead to increase in sales but at the cost of longer
average days of receivables. It may also increase bad debts.

LOS g Choices of short term funding

Committed
Fi

Uncommitted Revolving
(regular)

Bank may refuse to lend if Bank charges a fee for Typically for longer terms.
circumstances change. making the commitment.

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