CPA FRM - Module 3: Financing and evaluating investments | KnowledgEquity

At the end of this module, you should be able to:

• explain the various forms of short-term and intermediate-term financing

• explain the various forms of long-term debt and equity financing

• explain and analyse various business types and identify appropriate sources of funding

• analyse and discuss an organisation’s ability to access funding

• identify and apply the capital budgeting techniques used in project evaluation

• explain why investment decisions should be analysed using the net present value (NPV) method, and apply it to various investment project scenarios

• analyse and discuss the impact of inflation and the adjusted present value approach on the capital budgeting process.

https://www.cpaaustralia.com.au/-/media/corporate/allfiles/document/cpaprogram/subject-outline-financial-risk-management.pdf?la=en&rev=d5a482895eb54ad984bd53cc45c1bebc

Part A: Sources of funds for business

A.1. Short- and intermediate-term financing

• Short term: matures in less than one year

• Intermediate term: matures between one to five years

A.1.1 Promissory notes (commercial papers)

• unconditional promise

• carries the issuers name only

• specific sum of money (that you are able to access)

• payee (or bearer) entitled

• issued at a discount to face value

• negotiable (tradable)

• promissory notes 약속 어음: a financial instrument that contains a written promise by one party (the note's issuer or maker) to pay another party (the note's payee) a definite sum of money, either on demand or at a specified future date. https://www.investopedia.com/terms/p/promissorynote.asp#:~:text=A%20promissory%20note%20is%20a,at%20a%20specified%20future%20date.

• commercial paper 신종 기업 어음: a common form of unsecured, short-term debt issued by a corporation. Commercial paper is typically issued for the financing of payroll, accounts payable, inventories, and meeting other short-term liabilities. Maturities on most commercial paper ranges from a few weeks to months. (고정 이율의 기업 어음과는 달리 기업과 투자자 사이에 금리를 자율 결정하는 어음, 略 CP) https://www.investopedia.com/articles/investing/070313/introduction-commercial-paper.asp

A.1.2 Negotiable certificates of deposit

• issued by banks

• certificate issued in exchange for a deposit

• deposit plus interest is paid to bearer on future date

• traded in the market

• only bears the name of the issuing bank

• negotiable certificates of deposit 양도성 예금 증서: CDs with a minimum face value of $100,000. They are guaranteed by banks, cannot be redeemed before their maturation date, and can usually be sold in highly liquid secondary markets. Along with U.S. Treasury bills, they are considered a low-risk, low-interest security. https://www.investopedia.com/terms/n/ncd.asp#:~:text=Negotiable%20certificates%20of%20deposit%20are,risk%2C%20low%2Dinterest%20security.

A.1.3 Bills of exchange & bank bills

• borrower: draws up the bill of exchange

• acceptor: promises to pay sum nominated

• discounter: initially lends funds at a discount

• bearer: receives nominated sum at maturity so at maturity

• borrower: repays face value on a set day

• bill of exchange 환어음: a written order used primarily in international trade that binds one party to pay a fixed sum of money to another party on demand or at a predetermined date. Bills of exchange are similar to checks and promissory notes—they can be drawn by individuals or banks and are generally transferable by endorsements. https://www.investopedia.com/terms/b/billofexchange.asp

• bank bill 은행 어음: an unconditional written order by one party addressed to a Bank to pay a fixed sum - the bill's face value - at a fixed time to the Bank. A Bank Bill is a bill of exchange. Two types of Bill of Exchange facilities are available: Bill Discount and Bill Acceptance. https://www.stgeorge.com.au/corporate-business/business-finance-solutions/bank-bill-facilities#:~:text=A%20Bank%20Bill%20is%20an,Bill%20Discount%20and%20Bill%20Acceptance.

A.1.4 Other short and intermediate instruments:

• bank overdrafts: accessible to companies and organisations at any time, up to a specified amount

• fully drawn advances: a specific amount for a specific asset

• term loans

• trade finance: tends to be used by small to medium sized organisations, and mostly for international transactions

• leasing

• hire purchase

• overdraft 마이너스 통장: allows the account holder to continue withdrawing money even when the account has no funds in it or has insufficient funds to cover the amount of the withdrawal. https://www.investopedia.com/terms/o/overdraft.asp#:~:text=The%20overdraft%20allows%20the%20account,a%20set%20amount%20of%20money.

• fully drawn advance: a term loan in which the borrower receives the principal upon initiation of the loan and agrees to repay the principal with interest according to a predetermined amortization schedule.

• term loan 대출: a loan from a bank for a specific amount that has a specified repayment schedule and either a fixed or floating interest rate. https://www.investopedia.com/terms/t/termloan.asp

• trade finance 무역금융: an umbrella term which covers many financial products that banks and companies utilize to make trade transactions feasible. Trade finance represents the financial instruments and products that are used by companies to facilitate international trade and commerce. Trade finance makes it possible and easier for importers and exporters to transact business through trade.

• lease 임대차 계약: a contract outlining the terms under which one party agrees to rent property owned by another party. https://www.investopedia.com/terms/l/lease.asp

• hire purchase 할부 구입: an arrangement for buying expensive consumer goods, where the buyer makes an initial down payment and pays the balance plus interest in instalments. With hire purchase agreements, the ownership of the merchandise is not officially transferred to the buyer until all the payments have been made. https://www.investopedia.com/terms/h/hire-purchase.asp

CBF corporation sells its accounts receivable to We Collect Ltd with no option to sell-back any debts not collected. What is this an example of?

1. Full-recourse factoring

2. Non-recourse factoring

3. Partial-recourse factoring

4. Working capital financing

2. Non-recourse factoring

• 'recourse': the legal right to demand compensation or payment

• There is no requirement for CBF to buy back the debt - We Collect Ltd bears all the risk (so there is 'no recourse').

• In this situation, the price paid for the initial sale is likely to be lower (i.e. more highly discounted) than for full recourse factoring, because of the increased risk to We Collect Ltd.

A.2. Long-term debt financing

A.2.1 Bonds

• government & state government or corporate

• coupon payment: fixed or variable - based on face value

• can be listed on the stock exchange

• price can vary from the face value

Foreign bonds

• issued by a borrower to investors in a country other than the borrower's home country (e.g. investor is in Australia and chooses to issue bonds in Japan)

• denominated in the investors currency

A.2.2 Euro market /Euro bonds:

Eurocurrency market

• banks making loans and accepting deposits in a non-native currency

• not to be confused with the euro currency (e.g. AUD deposit in a UK bank)

Euro bond market

• fixed interest bonds

• underlying currency is not native to the issuers home currency

• 'Bearer' bonds

• e.g. AUD-denominated bond issued in the UK

A.2.3 Asset-backed securities

• car loans, mortgages

A.2.4 Debentures

• secured loan; secured by a fixed charge (on a particular asset) or floating charge (of a number of assets)

• normally fixed interest rate & maturity date

• tend to have a trustee to make sure that the rights of the debenture holders are not violated by the company (requires a trust deed)

A.2.5 Unsecured notes

• rank after debentures; in the event a company wounds up, debenture holders would be paid first before unsecured notes holders

A.3. Equity financing

where you try and get shareholders or investors to invest into your company

• primary market: raising money (e.g. IPO)

• secondary market: buying and selling of shares - does not provide funds to the company concerned

A.4. Debt versus equity—the Global Financial Crisis and European sovereign debt crisis

A.5. Financial risk management and the role of the board of directors

A.6. Summary of financial instruments and products

Ways to raise capital

1. Primary issue

2. Rights or pro-rata issues

3. Placements (if they want to avoid preparing prospectus again > target certain investors who will invest to raise additional funding, at least $500,000)

4. Dividend reinvestment plans

5. Employee share-ownership schemes

6. Company-issued options

7. Partly paid shares

Hybrid type of instruments

• have a characteristics of both debt and equity

• lower risk to investors

• 'tier one' capital under Basel III (measures the risk profile of different types of capital that a bank may have)

• fully franked distributions

Examples:

• Convertible notes: right to convert that debt into equity

• Preference shares: rank below debtors and rank higher than ordinary shareholders

• Exchangeable notes

Part B: Funding for specific types of business structures

B.1. Funding for sole traders and partnerships

• difficult to source capital

• sale of assets

• external loans

• line of credit

• government grants

B.2. Funding for private companies and other small and medium-sized enterprises

Private companies & SMEs

• greater access to equity capital

• venture capital

Public companies

• listed or unlisted

• fundraising from public

Part C: Capital budgeting techniques

You've recently landed your dream job, with a salary of $120,000 a year.

Based on this salary, your total tax payable would be around $36,000.

Would you rather,

1. pay your tax bill in monthly instalments - twelve payments of $3,000 a month, or

2. pay $36,000 in one go at the end of the tax year?

it's preferable to have the money in your hands to today - this way, you could invest it any interest until the day you have to pay the tax

investment decisions factors

• time value of money

• risk affects required rate of return (generally speaking the cost of debt < cost of equity)

present value of a single cash flow:

• to calculate a present value, we have to take the future value and bring it back to 'today's value'

• e.g. if you know you will pay $115.7625 in 3 years, what is this actually worth to you today if interest rates are 5%?

PV0 = FV0 / (1 + r)^n

= $115.7625/ (1 + 5%)^3 = $100

Investment evaluation

When making capital budgeting decisions. at which step would you undertake the net present value (NPV) analysis?

1. generating investment proposals - ideas

2. estimating future cash flows for proposals - initial investment and subsequent cash flows

3. evaluating future cash flows

4. selecting project to proceed with

5. re-evaluating projects

so what what things can go wrong:

• cash flow estimations

• discount rate used

• investment horizon

Evaluation techniques

1. accounting rate of return (ARR): annual profits

2. payback period: how long will it take before you get back your initial investment

3. net present value (NPV): discounts future cash flows into the present

4. Internal rate of return (IRR): rate of return that discounts future cash flows into into today and the net present value becomes zero

C.1. Accounting rate of return

ARR = average annual profit / initial cash outlay

Simple but has disadvantages:

• profit fluctuates a lot from year to year - how many years do we average it by?

• have not considered the time value of money (100K in five years is not the same as a 100K today)

• subjective benchmark

• accrual earnings, not cash

C.2. Payback period

Almost fresh Pty Limited (AM) is a supermarket chain. Currently AM operates two discount supermarkets in Brisbane, and would like to expand their business. They have two options:

A. purchase a pre-existing supermarket and rebrand it

B. develop a new supermarket from scratch

AM will only undertake projects with a maximum of a three-year payback period. The relevant cash flows associated with each options are...

But at what point in Year 3 is the cash outlay for option A paid back?

$50,000 (negative cumulative position at end of year 2) divided by $75,000 (cash inflow in year 3)

= $50,000/$75,000 = 0.67 year

A = 2.67 years

$100,000 (negative cumulative position at end of year 3) divided by $125,000 (cash inflow in year 4)

= $100,000/$125,000 = 0.80 year

B =3.80 years

Answer: A, faster payback, and within maximum payback period

Limitations:

• cash flows not discounted, so no account for time value of money

• how is the maximum payback period (e.g. 3 years) determined?

• assumes linear receipt/payment of cash flows during the year

• what about the size and timing of cash flows after the payback period?

What does it mean for a company if it invests in a project which has a zero NPV?

1. the company's value will remain the same

2. the company's discount rate is greater than the project IRR

3. the company's discount rate is smaller than the project IRR

4. the sum of the cash inflows equals the sum of the cash outflows

1. when you discount the future cash flows they are equal to the initial investment.

Positive NPV generates value; negative NPV destroys value;

2 & 3, IRR is the discount rate that applies when the NPV = 0. So the company discount rate would equal the project IRR

4. the sum of the present value of cash inflows equals the sum of the present value of cash outflows

C.3. Net present value

• taking the cash outflows from a project and deducting the initial investment

Organisations choose either

• their project with the highest positive net present value, or

• their project with the lowest negative present value

A business plans to spend $600,000 on a new project which has a WACC of 7%.The project is expected to generate the following cash flows:

Year 1 = $120,000

Year 2 = $200,000

Year 3 = $300,000

What is the discount factor for year 1, 2 and 3?

Discount factors = (1 + rate)^n

What is the NPV?

Should you approve this project?

No, NPV = -68K, the project will destroy the organisational value

C.4. Internal rate of return

Return (or growth) generated by a specific project.

The discount rate when the NPV = 0.

• use excel formula or trial and error

C.5. Net present value and internal rate of return methods compared

Mutually exclusive projects

CPF corporation has two potential projects, which are mutually exclusive:

What is the lowest common duration for the two projects?

• 9 years

• 11 years

• 20 years (4 years x 5 years)

• 30 years

Cafe Allblack wants to upgrade its existing coffee machine with one that is more efficient and can increase turnover of coffee sales and profits. It is considering two different coffee machines:

• Machine A will cost $60,000 and has a life of 3 years

• Machine B will cost $50,000 and has a life of 2 years

The following incremental cash flows are expected for each machine.

Using a discount rate of 10%, which machine should Cafe Allblack purchase?

Mutually exclusive projects with different lives:

1. common terminal date

2. constant chain of replacement

What is the lowest common multiple lifespan?

• Machine A lasts for 3 years x 2 years = 6 years

• Machine B lasts for 2 years x 3 years = 6 years

Constant chain or replacement:

Caffe AllBlack wants to upgrade its existing coffee machine:

• Machine A will cost $60,000 and has a life of 7 years

• Machine B will cost $50,000 and has a life of 4 years

The following incremental cash flows are expected:

What is each machine's NPV using a discount rate of 10% and the constant chain of replacement method?

• Step 1 calculate the NPV of each project over its estimated life

• Step 2 convert these NPVs into an equivalent annual annuity (EAA) series

EAA = NPV/ PV annuity factor

• Step 3 convert the EAA series for each project into a perpetuity or indefinitely

perpetuity = EAA / k

• Machine A: 12676 / 0.1 = 126757

• Machine B 14226 / 0.1 = 142265

Part D: Additional issues in capital budgeting

D.1. Estimating cash flows

D.2. Inflation and capital budgeting

Inflation

• the fall in purchasing value of money )due to increasing prices)

Fisher equation:

(1 + r) = (1 + a) x (1 + p)

r = nominal interest rate

a = real interest rate

p = expected rate of inflation

• real: the current year (underlying) prices/costs - requires real discount rate

• nominal: future year (stated) prices/costs - requires nominal discount rate

D.3. Adjusted present value approach

D.4. A word of caution