OUM Business School

BBPW3103

Financial Management I

Copyright Open University Malaysia (OUM)

BBPW3103
FINANCIAL
MANAGEMENT I
Assoc Prof Dr Yusnidah Ibrahim
Faudziah Zainal Abidin
Norlida Abd Manab
Rusmawati Ismail
Zaemah Zainuddin

Copyright Open University Malaysia (OUM)

Project Directors:

Prof Dato Dr Mansor Fadzil

Prof Dr Wardah Mohamad
Open University Malaysia

Module Writers:

Assoc Prof Dr Yusnidah Ibrahim

Faudziah Zainal Abidin
Norlida Abd Manab
Rusmawati Ismail
Zaemah Zainuddin
Universiti Utara Malaysia

Moderators:

Assoc Prof Loo Sin Chun

Lillian Kek Siew Yick
Azlina Abd Aziz
Open University Malaysia
Assoc Prof Dr Abu Hassan Md Isa
Curtin University of Technology Sarawak Malaysia

Reviewed by:

Norbaini Abdul Halim

Open University Malaysia

Developed by:

Centre for Instructional Design and Technology

Open University Malaysia

First Edition, April 2009

Second Edition, December 2013 (rs)
Copyright Open University Malaysia (OUM), December 2013, BBPW3103
All rights reserved. No part of this work may be reproduced in any form or by any means without
the written permission of the President, Open University Malaysia (OUM).

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Table of Contents
Course Guide

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Topic 1

Introduction to Finance
1.1 Finance
1.2 Roles of a Finance Manager
1.3 Objectives of Financial Management
1.3.1 Maximising Profit
1.3.2 Maximising Shareholders Wealth
1.4 Agency Problems
1.5 Types of Business Organisations
1.6 Financial Market
Summary
Key Terms

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Topic 2

Analysis of Financial Statements

2.1 Annual Report and Users of Financial Statements
2.2 Income Statement
2.3 Balance Sheet
2.3.1 Assets
2.3.2 Liabilities
2.3.3 Owners Equity or Shareholders Equity
2.3.4 Summary of Basic Accounting
2.4 Statement of Retained Earnings
2.5 Cash Flow Statement
2.5.1 Preparing Cash Flow Statement
2.5.2 Differentiating Cash Resources and Usage
2.6 Financial Ratio Analysis
2.6.1 Income Statement
2.6.2 Balance Sheet
2.7 Liquidity Ratio
2.7.1 Net Working Capital
2.7.2 Current Ratio
2.7.3 Quick Ratio

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Topic 3

TABLE OF CONTENTS

2.8

Asset Management Ratio

2.8.1 Account Receivable Turnover
2.8.2 Average Collection Period
2.8.3 Inventory Turnover
2.8.4 Average Inventory Sales Period
2.8.5 Fixed Asset Turnover
2.8.6 Total Asset Turnover
2.9 Leverage Ratio
2.9.1 Debt Ratio
2.9.2 Debt-equity Ratio
2.9.3 Equity Multiplier
2.9.4 Interest Coverage Ratio
2.10 Profitability Ratio
2.10.1 Gross Profit Margin
2.10.2 Net Profit Margin
2.10.3 Operating Profit Margin
2.10.4 Return on Assets
2.10.5 Return on Equity
2.10.6 Earnings Per Share
2.11 Market Value Ratio
2.11.1 Price Earnings Ratio
2.11.2 Dividend Yield Ratio
2.12 Conducting a Complete Ratio Analysis
2.12.1 DuPont Analysis
2.12.2 Summarising All Financial Ratios
2.13 Weaknesses of Financial Ratios
Summary
Key Terms

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Time Value of Money

3.1 Concept of Compounding and Future Value
3.1.1 Time Line
3.1.2 Compound Interest
3.1.3 Calculation of Future Value using Schedule/Table
3.1.4 Graphical Illustration of Future Value
3.2 Concept of Discounting and Present Value
3.2.1 Calculation of Present Value
3.2.2 Calculation of Present Value (Principal) Using
Schedule/Table
3.2.3 Graphical Illustration of Present Value
3.3 Future and Present Values of a Single Cash Flow

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Topic 4

3.4

Future and Present Values of a Series of Cash Flow

3.4.1 Annuity
3.4.2 Non-uniform Cash Flow
3.4.3 Perpetuity
3.5 Compounding and Discounting More than Once a Year
3.6 Continuous Compounding and Discounting
Summary
Key Terms

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Valuation of Securities
4.1 Valuation
4.1.1 Definition of Value
4.1.2 Valuation Process
4.1.3 Basic Model of Valuation
4.2 Bonds
4.2.1 Characteristics of Bonds
4.2.2 Rating of Bonds
4.2.3 Types of Bonds
4.3 Valuation of Bonds
4.3.1 Basic Valuation of Bonds
4.3.2 Value of Bonds and Required Rate of Return
4.3.3 Payment of Interest Twice a Year
4.4 Yield to Maturity
4.5 Relationship between Value and Yield to Maturity
4.5.1 Changes to Required Returns
4.6 Ordinary Shares
4.6.1 Characteristics of Ordinary Shares
4.7 Valuation of Ordinary Shares
4.7.1 Valuation of Ordinary Shares One Holding
Period
4.7.2 Valuation of Ordinary Shares Multiple Holding
Periods
4.7.3 Required Rate of Return for Ordinary Shares
4.8 Preference Shares
4.8.1 Characteristics of Preference Shares
4.9 Valuation of Preference Shares
4.9.1 Expected Rate of Return for Preference Shares
Summary
Key Terms

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Topic 5

Topic 6

TABLE OF CONTENTS

Risk Analysis
5.1 Definition of Risk and Return
5.2 Use of Statistics to Determine Risk and Return
5.2.1 Random Variable
5.2.2 Probability and Its Distribution
5.2.3 Mean (Expected Return)
5.2.4 Variance and Standard Deviation
5.2.5 Coefficient of Variation
5.2.6 Covariance
5.2.7 Correlation Coefficient
5.3 Measuring the Expected Return and Risk of Investing
in One Security
5.4 Reducing Risk Through Diversification
5.4.1 Principle of Systematic and Unsystematic Risk
5.4.2 Measuring the Expected Return and Risk of
Security Portfolio
5.4.3 Capital Asset Pricing Model
5.4.4 Measuring Systematic Risk (Beta)
5.4.5 Security Market Line
Summary
Key Terms

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Criteria of Capital Budgeting

6.1 Capital Budgeting
6.2 Payback Period
6.2.1 Calculation of Payback Period
6.2.2 Application of Payback Period
6.2.3 Advantages and Disadvantages of Payback
Period
6.3 Net Present Value
6.3.1 Calculation of Net Present Value
6.3.2 Application of Net Present Value
6.3.3 Advantages and Disadvantages of Net Present
Value
6.4 Profitability Index
6.4.1 Calculation of Profitability Index
6.4.2 Application of Profitability Index
6.4.3 Advantages and Disadvantages of Profitability
Index

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6.5

Topic 7

Topic 8

Topic 9

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Internal Rate of Return

6.5.1 Calculation of Internal Rate of Return
6.5.2 Application of Internal Rate of Return
6.5.3 Advantages and Disadvantages of Internal Rate
of Return
Summary
Key Terms

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Cash Flow of Capital Budgeting

7.1 Guidelines in Estimating Cash Flow for Capital
Budgeting
7.2 Initial Outlay
7.3 Operating Cash Flow
7.4 Terminal Cash Flow
7.5 Application of Cash Flow for Capital Budgeting in
Decision Making
Summary
Key Terms

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Cost of Capital
8.1 Definition for Cost of Capital
8.1.1 Financing Policy and Cost of Capital
8.2 Determining the Cost of Capital for Each Component
of Capital Resources
8.2.1 Cost of Debt
8.2.2 Cost of Preference Shares
8.2.3 Cost of Ordinary Shares
8.3 Weighted Average Cost of Capital
Summary
Key Terms

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Financial Planning
9.1 Financial Planning
9.2 Cash Budget
9.3 Pro Forma Income Statement
Summary
Key Terms

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Topic 10

TABLE OF CONTENTS

Working Capital Management

10.1
Importance of Working Capital Management
10.1.1
Net Working Capital
10.1.2
Current Assets
10.1.3
Permanent Current Assets
10.1.4
Temporary Current Assets
10.2
Strategies of Working Capital Management
10.2.1
Moderate Approach
10.2.2
Aggressive Approach
10.2.3
Conservative Approach
10.3
Types of Short-term Financing
10.3.1
Spontaneous Financing
10.3.2
Negotiated Financing
10.4
Cash Conversion Cycle
10.5
Management of Marketable Securities
10.5.1
Factors in Choosing Marketable Securities
10.5.2
Types of Marketable Securities
10.6
Balance between Risk-return in Cash Management
10.7
Management of Account Receivable
10.7.1
Account Receivable
10.7.2
Credit Policy
10.7.3
Credit Control
10.7.4
Balance between Risk-return in Management
of Account Receivable
10.8
Inventory Management
10.8.1
Types of Inventory
10.8.2
Objective of Inventory Management
10.8.3
Cost Related to Inventory
10.8.4
Economic Order Quantity Model (EOQ)
10.8.5
Balance between Risk-return in Inventory
Management
Summary
Key Terms

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Answers

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Attachments

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COURSE GUIDE

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COURSE GUIDE

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COURSE GUIDE DESCRIPTION

You must read this Course Guide carefully from the beginning to the end. It tells
you briefly what the course is about and how you can work your way through
the course material. It also suggests the amount of time you are likely to spend in
order to complete the course successfully. Please keep on referring to the Course
Guide as you go through the course material as it will help you to clarify
important study components or points that you might miss or overlook.

INTRODUCTION
BBPW3103 Financial Management I is one of the courses offered by the Faculty of
Business and Management at Open University Malaysia (OUM). This course is
worth 3 credit hours and should be covered over 8 to 15 weeks.

COURSE AUDIENCE
This course is offered to all students taking the Bachelor of Business
Administration programme. This module aims to impart an overview of
currency risk in international economic activities.
As an open and distance learner, you should be able to learn independently and
optimise the learning modes and environment available to you. Before you begin
this course, please confirm the course material, the course requirements and how
the course is conducted.

STUDY SCHEDULE
It is a standard OUM practice that learners accumulate 40 study hours for every
credit hour. As such, for a three-credit hour course, you are expected to spend
120 study hours. Table 1 gives an estimation of how the 120 study hours could be
accumulated.

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COURSE GUIDE

Table 1: Estimation of Time Allocation of Study Hours

Study Activities

Study
Hours

Briefly go through the course content and participate in initial discussion

Study the module

60

Attend three to five tutorial sessions

10

Online participation

12

Revision

15

Assignment(s), Test(s) and Examination(s)

20

TOTAL STUDY HOURS

120

COURSE OUTCOMES
By the end of this course, you should be able to:
1. Explain the concepts and theories in key areas of finance;
2. Analyse financial information and enhance conceptual understanding of the
financial decision making process;
3. Examine the financial tools used by financial managers and investors in
analysis and decision making;
4. Analyse the interrelationships among the areas of finance in allowing firms,
financial managers and investors to achieve their investment and financing
goals efficiently; and
5. Apply the strategies of working capital management in managing short-term
obligations.

COURSE SYNOPSIS
This course is divided into 10 topics. The synopsis for each topic is presented
below:
Topic 1 introduces the topic of finance, the role of the finance manager in
companies as well as the main objective of companies to maximise the
shareholders' wealth. Besides that, the types of business entities, agency
problems and financial institutions will also be discussed. This topic also
discusses the main financial market, that is the money market and capital market.
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Topic 2 discusses the usage of financial ratio analysis such as the liquidity ratio,
asset management, leverage, profitability, and market value ratio. Besides that,
this topic also discusses on the DuPont analysis and the overall financial analysis.
Topic 3 exposes students to the basic concept for time value of money, which is
the concept of present value and future value. You will learn the application and
formula for the time value of money for single cash flow and net cash flow,
annuity, perpetuity and derivation cash flow. The discussion will also include
compounding and discounting methods that occur more than once a year and
compounding and discounting that occurs continuously.
Topic 4 discusses the valuation of bonds and the valuation of ordinary shares.
The topic of discussion will touch on the characteristics of bonds, ratings of
bonds, types of bonds, valuation of bonds, yield upon maturity and the
connection between the value and yield upon maturity. The discussion topic will
also focus on characteristics of ordinary shares, dividend valuation models in
ordinary shares, characteristics of preference shares and valuation of preferences
shares.
Topic 5 introduces you to the relationship between the risk and return from the
financial theories perspective. The discussion comprises the definition of risk and
return from the investors' perspective, the usage of statistics in ascertaining the
level of risk and return and the measurement of risk and return. The basic
principles of systematic and unsystematic risks and the CAPM Model (model
that explains the relationship between risk and return) are also discussed.
Topic 6 discusses the four techniques of capital budgeting, which are the payback
period, net present value, profitability index and internal rate of return.
Topic 7 explains how the cash flow for capital budget is estimated and applied in
decision making for long-term investments. The calculation of initial outlay,
operating cash flow and terminal cash flow are also explained.
Topic 8 discusses the cost of capital. The discussion topic touches on the
definition for cost of capital, cost of long-term debt, cost of ordinary shares, cost
of preference shares and weighted average cost of capital.
Topic 9 discusses financial planning, cash budget and pro-forma income
statement.
Topic 10 explains the working capital management, management of marketable
securities, account receivables and inventory.

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COURSE GUIDE

TEXT ARRANGEMENT GUIDE

Before you go through this module, it is important that you note the text
arrangement. Understanding the text arrangement will help you to organise your
study of this course in a more objective and effective way. Generally, the text
arrangement for each topic is as follows:
Learning Outcomes: This section refers to what you should achieve after you
have completely covered a topic. As you go through each topic, you should
frequently refer to these learning outcomes. By doing this, you can continuously
gauge your understanding of the topic.
Self-Check: This component of the module is inserted at strategic locations
throughout the module. It may be inserted after one sub-section or a few subsections. It usually comes in the form of a question. When you come across this
component, try to reflect on what you have already learnt thus far. By attempting
to answer the question, you should be able to gauge how well you have
understood the sub-section(s). Most of the time, the answers to the questions can
be found directly from the module itself.
Activity: Like Self-Check, the Activity component is also placed at various
locations or junctures throughout the module. This component may require you to
solve questions, explore short case studies, or conduct an observation or research.
It may even require you to evaluate a given scenario. When you come across an
Activity, you should try to reflect on what you have gathered from the module and
apply it to real situations. You should, at the same time, engage yourself in higher
order thinking where you might be required to analyse, synthesise and evaluate
instead of only having to recall and define.
Summary: You will find this component at the end of each topic. This component
helps you to recap the whole topic. By going through the summary, you should
be able to gauge your knowledge retention level. Should you find points in the
summary that you do not fully understand, it would be a good idea for you to
revisit the details in the module.

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Key Terms: This component can be found at the end of each topic. You should go
through this component to remind yourself of important terms or jargon used
throughout the module. Should you find terms here that you are not able to
explain, you should look for the terms in the module.
References: The References section is where a list of relevant and useful
textbooks, journals, articles, electronic contents or sources can be found. The list
can appear in a few locations such as in the Course Guide (at the References
section), at the end of every topic or at the back of the module. You are
encouraged to read or refer to the suggested sources to obtain the additional
information needed and to enhance your overall understanding of the course.

PRIOR KNOWLEDGE
Learners of this course are required to pass BBAW2103 Financial Accounting
course.

ASSESSMENT METHOD
Please refer to myINSPIRE.

REFERENCES
Emery, D. R., Finnerty, J. D., & Stone, J. D. (1997). Principles of financial management
(1st ed.). Upper Saddle River, NJ: Prentice Hall Inc.
Gitman, L. J. (2008). Principles of managerial finance (12th ed.). Massachusetts:
Addison Wesley.
Lasher, W. R. (2008). Practical financial management (5th ed.). Mason, Ohio: SouthWestern Thomson Learning.
Martin, J. D., Petty, J. W., Scott, D. F. Jr., & Keown, A. J. (1998). Basic financial
management (8th ed.). New Jersey: Prentice Hall Inc.

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COURSE GUIDE

TAN SRI DR ABDULLAH SANUSI (TSDAS)

DIGITAL LIBRARY
The TSDAS Digital Library has a wide range of print and online resources for
the use of its learners. This comprehensive digital library, which is accessible
through the OUM portal, provides access to more than 30 online databases
comprising e-journals, e-theses, e-books and more. Examples of databases
available are EBSCOhost, ProQuest, SpringerLink, Books24 7, InfoSci Books,
Emerald Management Plus and Ebrary Electronic Books. As an OUM learner,
you are encouraged to make full use of the resources available through this
library.

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Topic

Introduction to
Finance

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Identify the areas of finance and its importance to businesses;
2. Explain the four main activities of finance managers in a company;
3. Discuss the main objective of financial management, that is to
maximise the wealth of the shareholders;
4. Examine the relationship in agency problems;
5. Elaborate on the three types of business organisations, which are the
sole proprietors, partnerships and companies; and
6. Explain the characteristics of financial market.

INTRODUCTION
This topic introduces the area of finance and discusses the role of finance
managers in companies. Besides that, the main objective and mission of the
company in maximising the wealth of the shareholders as well as the different
types of business entities will also be discussed. The next subject will enable you
to discover problems that might affect the agencies due to the existence of two
different parties that is the manager and the owner in achieving their separate
objectives. At the end of this topic, the financial institutions will be discussed in
general.

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TOPIC 1

1.1

INTRODUCTION TO FINANCE

FINANCE

As you have known, nearly all rational individuals and organisations will try to
obtain profit or money and thereafter, spend or invest the money for specific
purposes. Finance is closely related to these processes, institution, market and
instruments that are involved in the transfer of money between individuals and
businesses.
Finance can be defined as an art and science in managing money. Financial
decisions are made based on basic concepts, principles and financial theories.
These decisions can be divided into three main categories, such as the following:
(a)

Investment decisions related to assets;

(b)

Financing decisions related to liabilities and equity shareholders; and

(c)

Management decisions related to operating decisions and daily financial

decisions of the company.

Businesses are involved in numerous dealings and each day, the finance manager
will face a variety of questions such as:
(a)

Should the company carry out the project?

(b)

Will the investment be successful?

(c)

How to fund the investment?

(d)

Which is the best funding decision? Getting a loan from a bank or issuing
shares?

(e)

Does the company have enough cash to fulfil its daily operations?

(f)

What is the level of inventory that needs to be kept?

(g)

To which customer should the company offer credit?

(h)

What is the optimal dividend policy?

(i)

Should the takeover be continued?

The success or failure of a business depends on the quality of the financial

decision made. Each decision made will have important financial implications.
It is very important for those who do not have vast experience in the area of
finance such as marketing managers, production managers and human resource
managers to understand finance in order for them to perform their duties and
responsibilities better.

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INTRODUCTION TO FINANCE

For example, marketing managers should understand how marketing decisions

can influence and be influenced by the levels of inventory, surplus capacity and
the availability of funds. Meanwhile, accountants should understand how
accounting data can be used in corporate planning and also as a guide to
investors for investing. Therefore, financial implications exist in almost all the
business decisions and managers from other departments should be concerned
with the financial status and issues of the departments and the organisation as a
whole.

ACTIVITY 1.1
Explain the best way for a finance manager to establish good
relationship with the managers from other departments to ensure the
financial status of the company is always within control. What are the
advantages and disadvantages of this bilateral relationship?

1.2

ROLES OF A FINANCE MANAGER

SELF-CHECK 1.1

If you were assigned as a finance manager, what are the main

responsibilities that you will face in straightening the financial position
of your organisation?

Finance manager plays an important role in the operations and success of a

business. The responsibility of a financial manager is not only to obtain and use
the funds but also to ensure that the funds value and companys profit be
maximised. Besides that, a finance manager must make several important
decisions especially in the investment of companys assets and how these assets
can be financed. Meanwhile, the accountant must also think of the best way to
manage the companys resources such as employees, machines, buildings and
equipments. When assets of the company are managed efficiently, the value of
the company can be maximised. Figure 1.1 shows the four main roles of a finance
manager.

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TOPIC 1

INTRODUCTION TO FINANCE

Figure 1.1: Four main roles of a finance manager

(a)

Making Decisions in Short-term and Long-term Investments and Financing

A company that grows rapidly will show a sudden increase in sales.
This increase in sales will require additional investments in the form
of inventory and fixed assets such as industrial plant and equipments.
Therefore, the finance manager must determine the type and quantity of
assets that must be bought in the short term and long term. At the same
time, the finance manager must also think of the best way to fund the
investment in assets. For example, does the company have adequate funds
to purchase the assets? Would the company require loans or equities? What
are the implications of having short-term or long-term debts?

(b)

Making Financial Planning and Forecasts

A finance manager is supposed to make plans for the companys future.
Therefore, the finance manager must cooperate with managers from other
departments to enable the overall companys strategic planning to be
implemented together.

(c)

Dealings in Financial Market

One of the roles of the finance manager is dealing in the money market and
the capital market. Finance managers must be updated in the developments
of the financial market to enable financing decisions to be made efficiently
and effectively.

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(d)

INTRODUCTION TO FINANCE

Control and Coordination

A finance manager should interact and cooperate with other managers
to ensure that the company is operating efficiently. The control and
coordination conducted by the finance manager is important, especially in
large companies that have many departments to enable the organisations
objectives to be achieved together.

1.3

OBJECTIVES OF FINANCIAL
MANAGEMENT

Making effective financial decisions requires a person to understand the

objectives this must be achieved in the company. What are the key objectives in
the decision making process? What are the decisions that must be achieved by
the management that can provide impact to the owners of the company? In this
case, the objective of the finance manager is to achieve the objectives of the
companys owners, which are its shareholders.

SELF-CHECK 1.2
Why is the objective of a company to maximise the shareholders
wealth and not maximise profit?

1.3.1

Maximising Profit

Some parties state that the objective of a company is to maximise profit. To

achieve that objective, the finance manager must only take actions that are
expected to contribute in generating profits. Therefore, for every alternative
action that can be made, the finance manager will choose the action plan that can
generate the highest profit.
The companys profit is measured by the earnings per share, that is the profit of
each ordinary share. The earning per share is obtained by dividing the net profit
with the number of ordinary shares issued.
Earnings Per Share

Net Profit
Ordinary Shares Issued (Units)

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INTRODUCTION TO FINANCE

However, to maximise profit is not an accurate objective and is rarely used as a

companys objective due to these three reasons:
(a)

Cash Inflow and Outflow

In calculating companys profit, all expenses whether in cash (rent, utilities
and others) or non-cash (bad debts, depreciation, loss on asset disposal) will
be taken into account to be matched with the current income in the
accounting period.
This does not illustrate the cash flow obtained during that period. To obtain
a true picture of the companys return, items that do not involve cash flow,
especially depreciation, bad debts and loss on assets disposal must be
added again to the net profit.

(b)

Timing of Returns
The objective of maximising profits disregards the timing of returns from a
project. Assuming the company can carry out either project A or project B,
as follows:
Project

Profits
Year 1

Year 2

Project A

RM100,000

Project B

RM 100,000

Both the projects show the same profit. If we follow the objective of
maximising profits, both projects are equally good. However, this is
incorrect. In actual fact, Project A is the better project as the returns or the
amount of RM100,000 is received earlier compared to Project B. Thereafter,
this amount can be invested to obtain additional returns. For example, if
we deposit RM100,000 received through Project A in a bank that gives an
interest rate of 5 percent, this amount will become RM105,000 after one year
(RM100,000 1.05). This shows that this amount will exceed the RM100,000
that is obtained through Project B.
(c)

Risks
The objective of maximising profits also disregards risks. Risk is defined as
the probability of a result being different from what is expected. One basic
concept in finance states that there exists a relationship between risks and
returns. High returns can only be achieved by bearing higher risk.

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INTRODUCTION TO FINANCE

A lot of financial decisions made by finance managers involved the

relationship between risks and returns. The higher the risks, the higher the
expected returns from the action taken. For example, a company that keeps
low inventory stock will expect higher returns even with a possibility of
running out of inventory stock. Therefore, in making decision, the manager
will look at the relationship between risks and returns and make decision
based on the assumption that the companys objective is to maximise
shareholders wealth. The owners of the company will then evaluate the
decisions made and this evaluation will be reflected by changes of share
prices in the market.
Companies that balance the profits and risks can be seen as consistent with
the objective in maximising the shareholders wealth. By defining the
companys objective in the aspect of the shares market value, it will reflect
the managements efforts in optimising between risks and profits. The
manager should find the combination between profits and risks that can
maximise shareholders wealth.

1.3.2

Maximising Shareholders Wealth

The objective of a company in the financial context is to maximise the value of

the company for its owner that is by maximising the shareholders wealth.
Shareholders wealth is reflected by the companys share price in the market.
This objective is more appropriate compared with just maximisation of profits as
it takes into account the impacts of all financial decisions. Shareholders will react
to poor investment decisions by causing the companys share price to fall and in
contrary, they will react to good investment decisions by increasing the
companys share price.
Maximising shareholders wealth means that the management is supposed to
maximise the present return value that is expected to be received by its
shareholders in the future. It is measured by the ordinary share prices market
value. The share price reflects the share value according to the opinion of the
owners. It takes into account the uncertainties or risks, timing and other
important factors to the owners.
Therefore, all problems related to the objective in maximising profits can be
overcomed when the manager prioritised the objective in maximising
shareholders wealth. This objective also enables the decision scenario to be made
by taking into account any complications and difficulties in the real business
world. Finance managers must prioritise the companys shareholders as they are
the actual owners of the company.
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ACTIVITY 1.2
In your opinion, besides investing money, what are the roles and
responsibilities of shareholders in the company's operations? Are they
only interested in profit taking or in having absolute authority in the
companys operations?

EXERCISE 1.1
1. Financial theories assumed that the main objective of a company is
to maximise the shareholders ___________ which means
maximising the __________________ of the companys ordinary
shares.
2. _____________________ is the short-term objective that disregards
several factors such as risks and timing of cash flow.
3. Company managers that are effective:
A.

disregard the requirements of shareholders.

B.

might make decisions that are different from the interest of

shareholders.

C.

are aware of the risks and returns in achieving the objective of

financial management.

D.

are not aware of the requirements of the shareholders.

E.

B and C.

4. Maximising
shareholders
_________________

wealth

means

A.

companys cash value.

B.

companys investment value.

C.

companys profits.

D.

market value of companys ordinary shares.

maximising

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INTRODUCTION TO FINANCE

AGENCY PROBLEMS

The relationship of agency occurs when one or more individuals (principal) hire
another individual (agent) to perform services on behalf of the principal. In the
relationship of agency, the principal normally entrusts the decision making
authority to the agent. In financing, the important relationship of agency is
between the shareholders (as the actual owners of the company) with the
manager.
The objective in maximising shareholders wealth can determine how the
financial decisions should be made. However, in practice, not all decisions made
by the manager are consistent with that objective. The companys efforts in
maximising shareholders wealth are obstructed by social obligations. Problems
also arises when more attention are given to the managers interest than the
shareholders interest. Therefore, there might be deviations from the objective in
maximising shareholders wealth and the real objective pursued by the manager.
This is known as agency problems. The differences in objective occur because of
the separation of ownership and control in the company.
The separation of ownership and control has caused managers to pursue their
own selfish objectives. They would no longer maximise the owners objective but
instead, the manager adopts a self-sufficient attitude or only attempt to obtain a
moderate level of achievement, and at the same time, tries to maximise their own
interest. They are more focused on their own position and job security. They will
try to limit or minimise the risks borne by the company as unsatisfactory
outcome might result in them being terminated or the company becoming
bankrupt.
To avoid or minimise agency problems, the companys owners will have to bear
the costs of agency and to control the actions of the managers. The company will
offer various incentives to motivate the managers to act in the best interest of the
shareholders. Among steps that can be taken include provide compensation or
incentives based on the companys achievement, threats of termination and
threats of company takeover by another company due to administrative
weaknesses.

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SELF-CHECK 1.3
State the differences that might exist between the objectives of the
companys managers with the board of directors or shareholders.

1.5

TYPES OF BUSINESS ORGANISATIONS

SELF-CHECK 1.4

A business incorporated can be in the form of sole proprietor,

partnership or company. If you plan to start a business, which type of
business would you choose? Why?

Three important types of business organisations are:

(a)

Sole Proprietorship
Sole proprietorship is a business owned by one individual. The establishing
of a sole proprietor business is simple; an individual only needs to start its
businesss operation. However, the business must be registered and acquire
a business licence from the Registrar of Businesses.
The capital resources are normally acquired from the owners savings,
loans from family members and friends or from the bank. The owner owns
all the assets and bears all the business liabilities. The liabilities of a sole
proprietor are unlimited. This means that if the business fails to pay its
debts to its creditors, the owner will have to use its own property to settle
the business debts.

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11

The advantages and disadvantages of sole proprietorship are explained in

Table 1.1.
Table 1.1: Advantages and Disadvantages of Sole Proprietor Businesses
Advantages
Business is simple to establish.
Cost to establish the business is low.
Business is not governed by several
regulations.
Profit of the business is not taxable.
Income is only subject to personal
tax.
The financial status can be kept
confidential.

(b)

Disadvantages
Rather difficult for organisations of
sole proprietors to obtain huge
capital.
Business owners have unlimited
liabilities on the business debts.
The existence of sole proprietors is
not permanent. It will end upon the
death of the business owner.

Partnership
Partnership is a business operated by two or more partners. The
partnership can be made in writing or verbally. If the partnership is made
verbally, the Partnership Act 1961 will be relevant.
There are two types of partnership:
(i)

General partnership

(ii)

Limited partnership

In general partnership, all partners have unlimited liabilities. This means

that if the business fails to pay its debts to its creditors, all partners must
settle those debts by using their own personal property. The liabilities
obligation might be according to the percentage of ownership among the
partners.

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In limited partnership, there would be several partners with liabilities

limited to the capital invested into the business. However, there must be at
least one partner with unlimited liability. Partners with limited liability
might contribute only the capital and are not involved in managing the
business.
From taxation aspect, profits from partnerships will be taxed based on
the individual income tax. A partnership can be dissolved if one of the
partners retreats, passes away or becomes bankrupt.
The advantages and disadvantages of partnership businesses are explained
in Table 1.2.
Table 1.2: Advantages and Disadvantages of Partnership Businesses
Advantages

Disadvantages

A partnership is easily formed and

the cost of formation is low.
More capital can be acquired
compared to the sole proprietor
business.
Profits from business will only be
subject to personal tax.
Partnership combines a variety of
expertise and skills of the partners.
Businesss risks and liabilities can
be shared among the partners.

(c)

Partnership can be dissolved

upon the death, withdrawal or
bankruptcy of one of the partners.
The decision making process will
be rather difficult compared to the
sole proprietor as it must be
referred with consent obtained
from the other partners.
Partners have unlimited liabilities.
Personal assets can be claimed by
creditors to settle business debts.
Business risks must be borne by
all partners. A mistake made by
one partner will bind the other
partners.

Company
Company is a business entity that exists separately from its owners. Under
the Companies Act 1965, a company is a legal entity under the aspect of the
law, can own assets, bear liabilities, have authority to sue other parties and
can be sued by other parties. To incorporate a company, registration must
be made with the Registrar of Companies and is governed by the
companies act, such as the preparation of Memorandum of Understanding
and Articles of Association documents.

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A company can be incorporated as a private limited company (Sendirian

Berhad) or public limited company (Berhad). For a private limited
company, the number of shareholders are limited to 50 people only while
the number of shareholders for a public limited company is unlimited.
The liabilities of shareholders or the owner of the company is limited, that
is if the company suffered losses, the owners liability is limited to the total
capital invested into the business. There is segregation between the
ownership with management in the public limited company. The owners of
the company are the shareholders but the management of the company are
the people paid with salaries to manage the company.
The advantages and disadvantages of company businesses are described in
Table 1.3.
Table 1.3: Advantages and Disadvantages of Company Businesses
Advantages

Disadvantages

Owners have liability limited to the

capital contributed.
Can grow more easily as it has the
opportunity to enter the financial
market.
Ownership
transfered.

can

be

easily

The lifetime of the business is

continuous. Business does not end
with the death of the owner.

The incorporation of a company

business is difficult. The business is
governed by several regulations.
Require larger capital to start the
business.
Being taxed twice; that is the
companys profits are subject to
corporate tax while dividends
distributed to owners are subject to
personal tax.

Easier to obtain bigger capital.

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EXERCISE 1.2
1. One disadvantage of a company business is being _______________
on profits and _________________ that are paid to the shareholders.
2. A partnership can be dissolved when one of the partners
_____________ or ________________.
3. ________________ is the distribution of company's profits to the
owners.
4. Agency problem is the potential conflict that arises between a
principal and an agent. In finance, the relationship of agency is
between ____________ and ____________.
A.

owner, manager

B.

manager, accountant

C.

shareholder, creditor

D.

owner, creditor

5. Which type of the organisation below exposes all its owners to

unlimited liability?
A.

Limited partnership

B.

Sole proprietor

C.

Company

D.

A and B

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1.6

INTRODUCTION TO FINANCE

15

FINANCIAL MARKET
SELF-CHECK 1.5

What do you understand by the term financial market? Provide two

types of the main financial markets in the country and explain their
respective functions.

Business firms, individuals and government bodies need to obtain funds.

Assuming Tenaga Nasional Berhad (TNB) expects an increase in electricity
demands in the northern Peninsular Malaysia and TNB decides to build a new
electrical plant. As TNB does not have huge funds to finance the construction of
the plant that cost RM2 billion, TNB is forced to obtain the funds from the
financial market. It is the same for Mr. Haron, the owner of a supermarket who
plans to open a new supermarket. He needs to think of the best way to fund that
project. TNB and Mr. Haron can obtain the financing of their projects from the
financial market.
Financial market is the intermediary that connects the capital depositors with
borrowers in the economy. There are two main financial markets:
Money market; and
Capital market.
The main characteristic that differentiates the money market from the capital
market is the maturity period of the traded securities.
(a)

Money Market
Money market is the market that deals with the selling and buying of shortterm securities that have maturity periods of one year or less. Securities in
the money market usually have low default risk. Default risk means risk of
losses that must be borne by the securities holders if the securities issuers
delay or are unable to make their interest and/or principal payments issued
by them. Money markets securities can be easily sold by the securities
holders due to the short-term maturity period and low risk. These securities
usually do not require assets as collateral because of its low default risk.
Among the securities in money markets are government treasury bills,
commercial notes, deposit certificates and bankers acceptance.

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(b)

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INTRODUCTION TO FINANCE

Capital Market
Capital market is the market that deals with the selling and buying of longterm securities that have maturity periods of more than one year. These
securities are more risky compared to the securities in the money markets
due to its long term nature. It is a source for long-term funding and is
commonly used by companies to make capital investments. The default
risks are also higher due to its longer maturity period. Several main
securities available in the capital market are bonds, preference shares and
ordinary shares.
These long-term securities are traded in two types of markets, the main
market and the ACE market.
Main Market

ACE Market

Objective

For established companies with

track record

An alternative market for

companies with growth
potential

Mode of
Listing

(a) Profit Test

No minimum operating track

record or profit requirement

Uninterrupted profit
after tax (PAT) of
three to five full
financial years (FY),
with aggregate of a least
RM20 million; and
PAT of at least RM6
million for the recent full
FY.
(b) Market Capitalisation Test
A total market
capitalisation of at least
RM500 million upon
listing; and
Incorporated and
generated operating
revenue for at least one
full FY prior to
submission.

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(c)

INTRODUCTION TO FINANCE

17

Infrastruture Project
Corporation Test
Must have the right to
build and operate an
infrastructure project in
or outside Malaysia,
with project costs of not
less than RM500 million;
and
The concession or
licence for the
infrastructure project has
been awarded by a
government or a state
agency, in or outside
Malaysia, with
remaining concession or
licence period of at least
15 years.

Public
Spread

At least 25% of the company's

share capital; and
Minimum of 1000 public
shareholders holding not less
than 100 shares each.

Bumiputera
Equity
Requirement*

Allocation of 50% of the public

spread requirement to
Bumiputera investors on best
effort basis

At least 25% of the

company's share capital;
and
Minimum of 200 public
shareholders holding not
less than 100 shares each.
No requirement upon initial
listing
Allocation on best effort basis
of 12.5% of the enlarged
issued and paid-up share
capital to Bumiputera
investors
within one year after
achieving Main Market
profit track record; or
five years after being
listed on ACE Market,
whichever is the earlier

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Sponsorship

INTRODUCTION TO FINANCE

Not applicable

Engage a Sponsor to
assess the suitability for
listing
Sponsorship is required
for at least three years
post listing

Core
Business

An identifiable core business

which it has majority ownership
and management control

Core business should not be

holding of investment in other
listed companies

Core business should not be

holding of investment in other
listed companies
Management
Continuity
and
Capability

Continuity of substantially the

same management for at least
three full FY prior to submission
For market capitalisation test,
since the commencement of
operations (if less than three full
FY)

Financial
Position and
Liquidity

Sufficient level of working

capital for at least 12 months;

Continuity of substantially the

same management for at least
three FY prior to submission
or since its incorporation (if
less than three full FY)

Sufficient level of working

capital for at least 12 months

Positive cashflow from the

operating activities for listing
via profit test and market
capitalisation test; and
No accumulated losses based
on its latest audited balance
sheet for listing via profit test

Moratorium
on Shares

Promoters' entire shareholdings

for six months from the date of
admission
Subsequent sell down with
conditions for companies listed
ubder Infrastructure Project
Corporation test

Promoters' entire
shareholdings for six months
from the date of admission.
Subsequently, at least 45%
must be retained for anotehr
six months and thereafter,
further sell down is allowed
on a staggered basis over a
period of three years

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Transaction
with Related
Parties

INTRODUCTION TO FINANCE

19

Must be based on terms and

conditions which are not
unfavourable to the company

Must be based on terms and

conditions which are not
unfavourable to the company

All trade debts exceeding the

normal credit period and all nontrade debts, owning by the
interested persons to the
company or its subsidiary
companies must be fully settled
prior to listing

All trade debts exceeding the

normal credit period and all
non-trade debts, owning by
the interested persons to the
company or its subsidiary
companies must be fully
settled prior to listing

* Companies with MSC status, BioNexus status and companies with predominantly
foreign-based operations are exempted from the Bumiputera equity requirement.

ACTIVITY 1.3
Visit the Bursa Malaysia website at www.bursamalaysia.com/market
to obtain additional information on the said financial market.

EXERCISE 1.3
1. New ordinary shares are sold by a company in the ___________
market and investors sell and buy financial securities in the
_______________ market.
A.

money; first level

B.

second level; capital

C.

first level; second level

D.

international; domestic

2. The price of ordinary shares is determined by __________.

A.

Bursa Malaysia.

B.

the government.

C.

companys management.

D.

individuals who buy and sell shares.

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3. The objective of the financial market is to __________.

A.

reduce the price of bonds.

B.

allocate savings efficiently.

C.

increase the price of shares.

D.

provide job opportunities for stock brokers.

4. Assume you own IBM shares, but you are not allowed to enter the
companys headquarter at any time you feel like doing so. If then,
in what sense are you considered an owner of the IBM Company?
5. Explain why each one of the following might not be appropriate as
a companys objective:
(a)

Increasing market shares.

(b)

Minimising costs.

(c)

Reducing price to overcome competition.

(d)

Increasing profit.

6. Which type of compensation will make the manager act in

accordance with the interests of the shareholders? Discuss.
(a)

Fixed salary.

(b)

Salary linked to the companys profit.

(c)

Salary that is partly paid with company shares.

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INTRODUCTION TO FINANCE

21

Financial management is influenced by financial decisions that can be

divided into three main sections. These are the investment decisions,
financing decisions and management decisions.

Every decision made must be relevant to the countrys current economic

situation and this is the companys financial managers responsibility.

A financial manager must be smart and be able to obtain and use the funds to
enable the value of the company to be maximised to attract investors.

The manager is responsible for making main decisions in investment and

short-term and long-term financing, financial planning and forecasting,
control and coordination with the other managers to ensure the company
operates efficiently and must also understand the financial market issues.

The companys objective is to maximise the shareholders wealth. This

objective is more appropriate compared to maximising profit as it takes into
consideration the uncertainties or risks, timing and other factors that are
important to the companys owner.

The agency problems that occur due to the separation of internal controls of
the company show that there are differences in objectives between the
manager and the companys actual objective and this can interfere with the
administration of the company.

The owner must find alternatives to control the managers actions by offering
various incentives and reimbursements. This internal problem arises without
taking into consideration whether the organisation is a sole proprietor,
partnership or company.

The financial market, which are the money market and the capital market had
set up a forum or platform where the funds suppliers and funds borrowers
can conduct financial assets transactions. It is the medium that connects the
capital depositors with the borrowers in the economy.

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Agency problems

Primary market

Capital market

Profit maximisation

Company

Secondary market

Financial market

Sole proprietorship

Money market

Wealth maximisation

Partnership

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Topic

Analysis of
Financial
Statements

LEARNING OUTCOMES
By the end of this topic, you should able to:
1. Explain the importance of financial statements to different groups of
users;
2. Prepare the statement of retained earnings and cash flow statement;
3. Calculate the ratio for liquidity, asset management, financial
leverage, profitability and market value;
4. Evaluate a companys performance based on financial ratios and the
DuPont analysis; and
5. Explain the weaknesses of financial ratio analysis.

INTRODUCTION
Financial statement is a data summary on asset, liability and equity as well as
income and expenditure of a business for a specific period. Financial statement is
used by financial managers to evaluate the companys status and for planning
the companys future.
In this topic, you will learn about the four main financial statements, which are
the income statement, balance sheet, statement of retained earnings and cash
flow statement. In the beginning, you will be exposed to the basic format of each
financial statement. Subsequently, you will learn how to prepare each of the
financial statement. Understanding of the financial statements is important as
these financial statements will assist in evaluating the companys performance.

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TOPIC 2

ANALYSIS OF FINANCIAL STATEMENTS

Financial analysis is an evaluation of the companys financial achievements for

the previous years and its prospect in the future. Normally the evaluation will
involve analysis of the companys financial statements. Information from the
financial statements is used to identify the relative strengths and weaknesses of
the company compared to its competitors and providing indication on areas that
needs to be investigated and improved.
Finance manager use the financial analysis for the companys future planning.
For example, shareholders and potential investors are interested in the level of
returns and risks of the company. Creditors are interested in the short-term
liquidity level and the ability of the company to settle its interests and debts.
They will also emphasise on the profitability of the company as they want to
ensure that the companys performance is good and will be successful. Therefore,
the finance manager must know the entire aspects of the financial analysis that
are being focused by several parties having their own interests in evaluating the
company.
Beside the finance manager, the management also uses the financial analysis to
monitor the companys achievement from time to time. Any unexpected changes
will be examined to identify the problems that need to be dealt with.

2.1

ANNUAL REPORT AND USERS OF

FINANCIAL STATEMENTS
SELF-CHECK 2.1

Who are the users of financial statements? What type of information is

required by them?

Companies are required to report their business financial status at the end of
each accounting period in the annual report.

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ANALYSIS OF FINANCIAL STATEMENTS

25

Annual reports usually contain messages from the chairman, financial statements
and notes explaining the practices and policies adopted in reporting the
companys accounts (see Figure 2.1).

Figure 2.1: Information in the annual report

There are two types of information in an annual report. The first section is the
message from the chairman. It reports the companys achievement throughout
that year and discusses on new developments that will affect the companys
future operations. The second section will report on the basic financial statements
such as the income statement, balance sheet, statement of retained earnings and
cash flow statement.
Financial statements illustrate the operations and financial status of a company.
Detailed data are prepared for past two or three years together with a summary
of the main statistics for the past five or ten years. Normally, financial statements
are followed by notes explaining in detail the items found in the statements.
These notes explain the policies or accounting practices that are used in the
preparation of the financial statements. For example, further notes on inventory
might explain the method of inventory recording being adopted by the company.
Several groups of users are interested in the information contained in the
financial statements. They examine the statements in detail and interpret the
information according to their own interests. The objective of the analysis is

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ANALYSIS OF FINANCIAL STATEMENTS

the evaluation on the specific aspect of the companys performance. The

information required by the user depends on the type of intended decision. We
can divide the users of financial statements into two groups (see Figure 2.2).

Figure 2.2: Two groups of users of financial statements

Now, let us look into the groups one by one.

(a)

Internal users include the managers and other officers that operate the
business. They are responsible in planning the strategies and operations of
the company. Therefore, they use the financial statements to obtain
information on the overall companys performance.

(b)

External users of the company are not directly involved in the operations of
the company. They comprise of users who have direct interest in the
company (such as shareholders, investors and creditors) and users who
have indirect interest in the company (such as customers, tax agent and
labour organisations).

Shareholders and potential investors use financial statements to help them to

interpret what will happen to the company in the future. Short-term creditors will
look at the companys liquidity, while long-term creditors look at the ability of the
company to settle the interests and payment of the long-term principal debts.
The Companies Act 1965 stipulates that at least four of the following financial
statements must to be included in the annual reports, which are:
(a)

Income statements;

(b)

Balance sheet;

(c)

Statement of retained earnings; and

(d)

Cash flow statement.

Let us look at these financial statements and the relationship between each of
them based on the financial statements of Company FAZ as an example.
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2.2

ANALYSIS OF FINANCIAL STATEMENTS

27

INCOME STATEMENT
SELF-CHECK 2.2

What are the uses of income statement to the financial operations of a

company?

Income statement measures the operating performance of a company for a

specific period, normally for a period of one year ending at a specific date,
usually at 31 December.
Monthly statements are also prepared for the usage of the management who
required more frequent information to enable more prudent decisions to be made.
Yearly quarter statements are also prepared for shareholders of public companies.
Income statements provide information to evaluate the firms performances. To
measure a firms performance, several important aspects in the income statement
must be given priority:
(a)

Sales figure can be compared with the firms sales for the previous year and
the expected sales in the future. This information can be used for the firms
future planning.

(b)

Gross profit/gross loss can be compared with the sales figure to show
profit from the products/services sold.

(c)

Firm expenditures can be compared with the firms expenditures for the
previous year to see which policy can be adopted to reduce costs.

Table 2.1 is the income statement of Company FAZ for year ended 31 December
2012. This statement starts with sales revenue that is the sales value in ringgit
throughout the accounting period. Cost of goods sold is deducted from the sales
revenue to obtain gross profit of RM70,000. This total is the amount obtained
from sales to cover the financial operating costs and tax.

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Table 2.1: Income Statement

Company FAZ
Income Statement
for the Year Ended 31 December 2012
RM
170,000
100,000

Sales
Less: Cost of goods sold
Gross profit
Less: Operating expenditure
Sales expenses
Administrative and general expenses
Depreciation expenses
Total operating expenditure

70,000
8,000
15,000
10,000
33,000

Profit before interest and tax

Interest

37,000
7,000

Profit before tax

Tax (40%)

30,000
12,000

Profit after tax

Less: Dividend for preference shares

18,000
1,000

Net profit (or profit available for ordinary shareholders)

17,000

Earnings per share = Net profit/Total ordinary shares

0.17

All the operating expenditures such as sales expenses, general and administrative
expenses and depreciation expenses will be listed and totalled to obtain the total
operating expenditure. This total will then be deducted from the gross profit to
obtain profit from operations of RM37,000. Profit from operations is the profit
obtained from activities of manufacturing and selling of products; it does not
take into account the financial costs and tax. Profit from operations is also known
as profit before interest and tax.
Thereafter, the financial cost that is the interest expenses of RM7,000 will be
deducted from the profit from operations to obtain the profit before tax of
RM30,000. After deducting tax, we will obtain profit after tax (or profit before
preference shares) of RM18,000.

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Any dividends for preference shares must be deducted from the profit after tax
to obtain net profit. This total is also known as profit available to the ordinary
shareholders and is the total obtained by the company on behalf of ordinary
shareholders throughout the specific period. Normally, reports on earnings per
share are provided at the last section of the income statement. Earnings per share
show the total obtained by the company throughout the specific period for each
ordinary share. In year 2012, Company FAZ obtained RM17,000 for the ordinary
shareholders or RM0.17 for each share issued (total ordinary shares is 100,000).
Earnings per share are often referred as the bottom line to show that earnings
per share are the most important item in the income statement compared to the
other items (see Figure 2.3).

Figure 2.3: Companys objectives are to increase earnings and maximise profit

SELF-CHECK 2.3
If you are one of the preference shareholders in Company FAZ, how
would the information contained in the companys financial statements
be useful to you?

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2.3

ANALYSIS OF FINANCIAL STATEMENTS

BALANCE SHEET
SELF-CHECK 2.4

Explain in detail the difference among asset, liability and equity.

Balance sheet is a statement that summarises the status of a company at a specific

point of time. Balance sheet shows the accounts for assets, liabilities and equities.
It balances the companys assets (what it owns) with its financing, either debts
(provided by creditors) or equity (provided by owner). The balance sheet of
Company FAZ as at 31 December 2011 and 31 December 2012 is shown in Table 2.2.
Table 2.2: Balance Sheet
Company FAZ
Balance Sheet
As at 31 December 2011 and 2012
31-12-2012

31-12-2011

RM

RM

40,000
60,000
40,000
60,000

30,000
20,000
50,000
90,000

Total current assets

200,000

190,000

Long-term assets
Land and building
Machines and equipment
Fixtures and fittings
Vehicles
Others (including lease)

120,000
85,000
30,000
10,000
5,000

105,000
80,000
22,000
8,000
5,000

Less: Accumulated depreciation

250,000
130,000

220,000
120,000

Fixed assets, net

120,000

100,000

TOTAL ASSETS

320,000

290,000

Assets
Current assets
Cash
Marketable securities
Account receivables
Inventory

Total fixed assets

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ANALYSIS OF FINANCIAL STATEMENTS

Liabilities and Equities

Current liabilities
Account payable
Notes payable
Tax accrual

70,000
60,000
10,000

50,000
70,000
20,000

Long-term debts

140,000
60,000

140,000
40,000

Total liabilities

200,000

180,000

10,000

10,000

12,000
38,000
60,000

12,000
38,000
50,000

Total equities

120,000

110,000

TOTAL LIABILITIES AND EQUITIES

320,000

290,000

Total current liabilities

Equities
Preference shares
Ordinary shares, RM10 par value,
4,500 shares
Paid-up capital above par
Retained earnings

2.3.1

Assets

Assets are valuable economic resources owned by the business. It can be used
in several activities such as manufacturing, usage and exchange. Assets have
service potential or will bring economic benefit in the future. Assets have the
capability to provide services or generate benefit to the business entity that owns
it. In businesses, services or economic benefit will generate cash inflow (receiving
cash) to the business.
Assets can be categorised into current assets and long-term assets. Assets are listed
in the balance sheet according to its liquidity level from the most liquid to the less
liquid. Therefore, current assets are arranged first, followed by fixed assets.
(a)

Current Assets
Current assets are assets that can be converted into cash in the shortest
period, which is within a year or less. The current assets for Company FAZ
comprised of:
(i)

Cash;

(ii)

Marketable securities;

(iii) Account receivables; and

(iv) Inventory.

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Cash is the most liquid of current assets. Marketable securities such as

government bills or deposit certificates are short-term investments that are
highly liquid. Marketable securities can sometimes be seen as a form of
cash due to its high liquidity. Account receivables are debts owed by
customers who bought goods by credit from the company. Inventory
comprised of raw materials, work in process and finished goods held by the
company.
Other current assets which are not in Company FAZs balance sheet are
prepaid expenses (prepayment). Prepaid expenses are expenses that have
been paid in advance by cash but the benefits from the expenses have not
been received. Examples of prepaid expenses are prepaid rental, prepaid
insurance and office supplies.
(b)

Long-term Assets
Long-term assets are assets that are held by the company for a rather long
period, which is more than a year. Long-term assets are categorised into
fixed assets, other long-term assets and intangible assets. The long-term
assets of Company FAZ only comprised of fixed assets.
Fixed assets are land and buildings, machines and equipment, fixtures and
fittings and vehicles. Usually, a company will report the total fixed asset
that is the original cost of all the fixed assets owned by the company. From
that total, the company will deduct the accumulated depreciation for all
fixed assets to obtain net fixed assets. All fixed assets must be depreciated
except for land. This is because the value of land will always increase, while
the values of other fixed assets such as machines and equipment, as well as
vehicles will decrease when the life span of the asset increases.
Other long-term assets comprise of long-term investments (such as bonds
and shares) prepaid expenses and account receivables that involve a period
of more than a year.
Besides current assets and fixed assets, a business might show intangible
assets in its balance sheet. Intangible assets are long-term assets that cannot
be physically seen and usually provide a competitive advantage to the firm.
Examples of intangible assets are patents, franchise licences, licences,
trademarks, copyrights and goodwill. Although these assets cannot be
physically seen, it is recorded using the same method as the other fixed
assets. This means that the assets will be recorded at its original cost and
this cost will be amortised throughout its lifetime. Among the intangible
assets that are famous are the patent of Polaroid, the franchise of McDonald
and the trademark of Colonel Sanders Kentucky Fried Chicken.
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33

ACTIVITY 2.1
If you used a private vehicle to conduct the companys business, would
that vehicle be considered a companys asset? Discuss with your tutor.

2.3.2

Liabilities

Most businesses have been in situations where they need to take loans to finance
the businesss assets or to buy assets such as raw materials on credit. Liabilities
are claims made by creditors on the company assets. In other words, liabilities
are debts and obligations of a company. Liabilities comprise of current liabilities
and long-term liabilities.
If a situation occurs where the company is unable to pay its business liabilities,
the creditors can force the company to be liquidated. In this situation, the
creditors claims must be settled first before the company can settle the claims of
the shareholders.
(a)

Current Liabilities
Current liabilities are short-term debts, or debts that will mature within the
period of one year or less. Company FAZs current liabilities are:
(i)

Account payable;

(ii)

Notes payable; and

(iii) Tax accrual.

Account payable is the obligation of the company towards its suppliers
when the company purchases raw materials and finished goods on credit.
Notes payable is a written obligation of Company FAZ. The obligation is
with the bank for the loan to purchase vehicles for the usage of the
company. The company also has tax accrual, that is the tax that must be
paid to the government but still outstanding.
Other current liability that is not in the balance sheet of Company FAZ is
deferred income. Deferred income is cash that had been received from
customers but the services or products paid had not been provided.
Examples of deferred income are deferred rental and deposit from
customers.

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(b)

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ANALYSIS OF FINANCIAL STATEMENTS

Long-term Liabilities
Long-term liabilities are the responsibilities or obligations that mature in a
period of more than a year. These claims might be in the form of bonds,
long-term notes payable and lease.
Bonds are a type of fixed income securities that are issued by companies.
Notes payables are a type of credit transaction that involves a written
agreement between the company and creditors. Mortgage loans are longterm loan that use the assets (such as land and buildings) as a mortgage for
the loan. Notes payable can also be mortgaged with the other assets as a
security for the loan. A lease is a contractual agreement between the lessor
and the lessee. The lessor gives the right to the lessee to use the asset for a
specific period and will impose charges for usage of the asset.

2.3.3

Owners Equity or Shareholders Equity

Owners or shareholders claim towards the assets are known as owners equity
or shareholders equity. In the balance sheet of Company FAZ, the owners
equity comprised of:
Preference shares;
Ordinary shares;
Paid up capital above par; and
Retained earnings.
(a)

Preference shares are securities that provide fixed return dividend to its
holders. Preference shareholders do not have ownership in the company.

(b)

Ordinary shares are securities that reflect the ownership of the company.
Ordinary shareholders are the real owners of the company. They will
receive returns in dividends that will be paid to them in cash or shares
(bonus issues).

(c)

There will be situations where the par value (stated value) is not equal to
the market price of the ordinary shares at the time of issue. Cash earnings
from the issuance of shares might be equal, more or less than the par value.
When this situation occurs, the company will record the issuance of shares
at the par value in the Ordinary Shares account and the difference between
the par value and the shares selling price (surplus earnings) will be
recorded in a separate account known as Paid-up Capital Above Par.

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(d)

ANALYSIS OF FINANCIAL STATEMENTS

35

Retained earnings are the total accumulated earnings since incorporation

that had not been distributed to the shareholders as dividend but was reinvested into the company. It is important to remember that retained
earnings are not cash but are earnings that have been used to finance the
companys assets.

2.3.4

Summary of Basic Accounting

Assuming that a newly started business was self-financed by the businesss

owner. This means that all the companys assets belong or are claimable by the
businesss owner.
This relationship can be shown by the equation as follows:
Assets = Owners Equity
However, businesses are normally financed by the businesses owners and
creditors. Therefore, claims on the assets are equal to the claims by the creditors
(liabilities) added with the claims by the owner of the business (owners equity)
towards the assets. This relationship can be shown in the equation as follows:
Assets = Liabilities + Owners Equity
The equation above is known as the summary of basic accounting where the total
assets must be equal to the total liabilities plus owners equity. Owners equity is
equal to total assets less total liabilities. This is because the assets of a business
are financed by either the creditors or the owner. To determine the owners
portion (owners equity), we must deduct the creditors portion (liabilities) from
the assets. The balance will be the claim of the owner on the businesss assets. As
the creditors claims would be given priority over the owners claims upon
liquidation, the owners claims are also known as residual equity.

ACTIVITY 2.2
By using the summary of basic accounting, connect the relationship
among cash, account payable, account receivable, retained earnings,
marketable securities and ordinary shares.

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EXERCISE 2.1
Answer each of the following questions.
1. Balance sheet is the statement on the financial status of a company
for a specific period.
(a)

True

(b)

False

2. Income statement is the statement that attempts to measure the

result of a companys operating decisions at specific point of time.
(a)

True

(b)

False

3. Fixed assets are items that cannot be converted into cash within a
period of one year.
(a)

True

(b)

False

4. Investments in financial securities are considered as current assets.

(a)

True

(b)

False

5. Which is FALSE?
A.

Assets = Liabilities + Owners Equity

B.

Assets Liabilities = Owners Equity

C.

Assets + Liabilities = Owners Equity

D.

Assets Owners Equity = Liabilities

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ANALYSIS OF FINANCIAL STATEMENTS

6. Mark on each of the accounts listed below as follows:

(a)

In column (1), state the appropriate statement whether the

account is in the Income Statement (IS) or the Balance Sheet
(BS)

(b)

In column (2), state whether the account is a current asset

(CA), fixed asset (FA), current liabilities (CL), long term
liabilities (LTL), shareholders equity (SE), income (I) or
expenditure (EX).

Account
Account payable
Account receivable
Accrual
Building
General expenses
Interest expenses
Sales expenses
Operating expenses
Administrative expenses
Tax
Preference shares dividends
Sales revenue
Long-term loans
Inventory
Cost of goods sold
Paid-up capital above par
Notes payable
Retained earnings
Equipments
Ordinary shares
Preference shares
Marketable securities
Depreciation
Accumulated depreciation
Land
Cash

(1) Statement
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________
____________

(2) Type of Account

___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________
___________________

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ANALYSIS OF FINANCIAL STATEMENTS

7. Use the relevant items listed below to prepare the income statement
for Company PC for period ending 31 December 2011.
Items
Account receivable
Accumulated depreciation
Cost of goods sold
Depreciation expenses
General and administrative expenses
Interest expenses
Preference shares dividends
Sales revenue
Sales expenses
Shareholders equity
Tax Rate = 30%

Value as at 31 December 2011

(RM 000)
3,500
2,050
2,850
550
600
250
100
5,250
350
2,650

8. Use the relevant items from the list below to prepare the balance
sheet for Company ODC as at 31 December 2011.
Item
Account payable
Account receivable
Accrual
Building
General expenses
Depreciation expenses
Sales revenue
Long-term loans
Inventory
Equipments
Cost of goods sold
Machines
Paid-up capital above par
Notes payable
Retained earnings
Ordinary shares (at par)
Preference shares
Marketable securities
Accumulated depreciation
Land
Cash

Value at 31 December 2011

(RM 000)
2,200
4,500
550
2,250
3,200
450
3,600
4,200
3,750
2,350
25,000
4,200
3,600
4,750
2,100
900
1,000
750
2,650
2,000
2,150

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2.4

39

ANALYSIS OF FINANCIAL STATEMENTS

STATEMENT OF RETAINED EARNINGS

Statement of retained earnings shows how the retained earnings account in the
balance sheet is adjusted between two dates of the balance sheet. Statement of
retained earnings will adjust the net profit generated throughout the period and
any dividends paid, with the changes in the retained earnings in the beginning
and ending of the year. Table 2.3 shows the statement of retained earnings for
Company FAZ for the year ended 31 December 2012.
The statement shows that the company started with a retained earnings of
RM50,000 on 31 December 2011 or 1 January 2012 and profit after tax of
RM18,000 (data obtained from the income statement). From this total, the
company had paid dividends of RM1,000 for preference shares and dividends of
RM7,000 for ordinary shares. Therefore, the retained earnings had increased by
RM10,000 from RM50,000 as at 1 January 2012 to RM60,000 as at 31 December
2012.
Table 2.3: Statement of Retained Earnings
Company FAZ
Statement of Retained Earnings
for the Year Ended 31 December 2012
Retained earnings, 1 January 2012
+ Net profit (throughout year 2012)
Dividends paid (throughout year 2012)
Preference shares
Ordinary shares

RM50,000
18,000
RM1,000
7,000

Retained earnings, 31 December 2012

2.5

8,000
RM60,000

CASH FLOW STATEMENT

Cash flow statement shows how the activities in a company such as operating,
investing and financing activity can influence the status of cash and marketable
securities. Cash flow statement is the statement that summarises the cash flow
throughout a specific period, normally for the current year ended. Data from the
balance sheet and income statement are used to prepare the cash flow statement.

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ANALYSIS OF FINANCIAL STATEMENTS

Cash flow statement can assist the finance manager to:

Evaluate the companys capability to generate positive cash flow in the
future; and
Evaluate the companys capability to settle debts, pay dividends and provide
loans.
(a)

Operating Activities
Operating activities refer to the activities that are directly related to the
production of products, sales and services of the company such as the sales
and purchases of goods/services, rental income, fees income, wages and
salaries of employees, utility expenses and rental expenses.

(b)

Investing Activities
Investing activities refer to the activities that are related to the buying and
selling of long-term assets such as the sale and purchase of fixed assets,
selling of investments, buying of stocks and bonds (investing) and loans to
other entities.

(c)

Financing Activities
Financing activities refer to the activities that are related to the current
liabilities and long-term liabilities as well as owners equity such as
repayment of loans, short-term and long-term loans and shares buyback.

ACTIVITY 2.3
What will affect the status of cash and marketable securities of a
company? Discuss this with your tutor.

2.5.1

Preparing Cash Flow Statement

Data obtained from the balance sheet together with the net profit, depreciation
and dividends obtained from the income statement can be used to prepare the
cash flow statement. You can do this by using the following three steps:
Step 1

Classify the data into one of these three components:

(a)

Cash flow from operating activities;

(b)

Cash flow from investing activities; and

(c)

Cash flow from financing activities.

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ANALYSIS OF FINANCIAL STATEMENTS

Step 2

List the data according to the arrangement in Table 2.4. All resources
and net profit including depreciation are positive cash flow, which is
the cash flowing in; while all usages, any losses and dividends payable
are negative cash flow, which is the cash flowing out. Obtain the total
for the items in each component.

Step 3

Add the total from each component to obtain the increase (or decrease)
of net cash and marketable securities. To check whether you had
prepared the statement correctly, ensure that the value is equal to the
changes in cash and marketable securities for the relevant year by
looking at the opening and closing balances of cash and marketable
securities in the balance sheet.
Table 2.4: Components and Data Sources that Must be Included into the
Cash Flow Statement
RM
Cash Flow from Operating Activities
Net profit (Net loss)
Depreciation and other non-cash charges
Changes in all current assets
(except cash and marketable securities)
Changes in all current liabilities
(except notes payable)

IS
IS
BS
BS

Cash flow from operating activities

Cash Flow from Investing Activities
Changes in total fixed assets
Changes in the companys interest

xx

BS
BS

Cash flow from investing activities

Cash Flow from Financing Activities
Changes in notes payable
Changes in long-term loans
Changes in shareholders equity
(other than retained earnings)

Cash flow from financing activities

xx

BS
BS
BS
xx

Increase (or decrease) in cash and marketable securities

XX
Data Sources
BS = Balance Sheet
IS = Income Statement
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ANALYSIS OF FINANCIAL STATEMENTS

Example of Cash Flow Statement: Company FAZ

The cash flow statement of Company FAZ for year ended 31 December 2012 is
shown in Table 2.5. Based on this cash flow statement, the company had enjoyed
an increase of RM50,000 in cash and marketable securities for the year 2012
(refer to Table 2.5). The cash of the company increased by RM10,000, while the
marketable securities increased by RM40,000 between the two dates.
Table 2.5: Cash Flow Statement of Company FAZ
Company FAZ
Cash Flow Statement
as at 31 December 2012
RM
Cash Flow from Operating Activities
Net Profit
Depreciation
Decrease in account receivable
Decrease in inventory
Increase in account payable
Decrease in tax accrual

RM

18,000
10,000
10,000
30,000
20,000
(10,000)

Cash flow from operating services

Cash Flow from Investing Activities
Increase in total fixed assets

78,000

(30,000)

Cash flow from investing activities

Cash Flow from Financing Activities
Decrease in short-term notes payable
Increase in long-term loan
Changes in shareholders equity
Dividends paid

(30,000)

(10,000)
20,000

(8,000)

Cash flow from financing activities

Net increase in cash and marketable securities

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43

Let us now discuss Step 1 in greater details.

(a)

Cash Flow from Operating Activities

The operating activities in the cash flow statement show that the profit after
tax of Company FAZ is RM18,000 for year 2012. Depreciation expenses of
RM10,000 deducted from the income statement had been added back into
the cash flow statement as it is not cash outflow.
Account receivable had decreased by RM10,000 which means that the
company had collected credit accounts from its customers. Inventory had
also decreased from RM90,000 in year 2011 to RM60,000 in year 2012,
representing cash resources of RM30,000 to the company. In the liabilities
section, notice that the account payable had increased by RM20,000. This
means that the company had increased its debts from the suppliers and this
represents cash inflow. Tax accrual had decreased by RM10,000 indicating
that the company had used RM10,000 to pay tax.

(b)

Cash Flow from Investing Activities

Fixed assets of Company FAZ had increased by RM30,000 between
31 December 2011 and 31 December 2012. This increment reflected the cash
outflow used to buy additional assets.

(c)

Cash Flow from Financing Activities

Notes payable for Company FAZ had decreased by RM10,000 indicating a
cash outflow as the company paid its short-term loans. Long-term liabilities
increased by RM20,000 indicating a cash inflow. The company obtained
loans to acquire additional cash.

2.5.2

Differentiating Cash Resources and Usage

Before we can prepare the cash flow, we must classify the cash flow from
operating, investing and financing activities into cash resources or usage.
Table 2.6 lists the basic cash resources and usage.

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ANALYSIS OF FINANCIAL STATEMENTS

Several issues can help you to classify between cash resources and usage as
shown in Table 2.6.
Table 2.6: Cash Resources and Usage
Cash Resources
Decrease in asset
Increase in liability
Net profit
Depreciation
Sale of shares

(a)

Cash Usage
Increase in asset
Decrease in liability
Net loss
Payment of dividends
Shares buyback

Decrease in the asset account is a cash inflow resource while increase in the
asset account is a cash usage or cash outflow.
Company bought new assets with cash. Therefore, any increase in the asset
items between the two dates of the balance sheets will indicate that cash
outflow had occurred. Any decrease in the asset items will indicate cash
inflow as the company had sold the assets to obtain cash.

(b)

Increase in the liability account and owners equity is a cash inflow resource
and a decrease in the liability account is cash usage.
The company might use cash to settle its liability and claims on the assets.
Therefore, any decrease in the liability items, preference shares or ordinary
shares between the two dates of balance sheets indicates cash outflow. To
obtain additional cash, the company can take loans. Hence, any increase in
the liability items, preference shares or ordinary shares indicates cash
inflow.

(c)

Depreciation is a cash flow resource as it is not a cash expense (non-cash

charges). Non-cash expenditures are all expenses deducted from sales in
the income statement but actually do not involve any cash outflow
throughout the period. Depreciation and amortisation are examples of noncash expenses.

(d)

Direct changes in the retained earnings are not included in the cash flow
statement as these items affect the retained earnings and are shown as
profit after tax (or loss after tax) and cash dividends.

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ANALYSIS OF FINANCIAL STATEMENTS

Table 2.7 shows changes in the balance sheet items of Company FAZ between
31 December 2011 and 31 December 2012.
Table 2.7: Changes in the Balance Sheet Items
Company FAZ
Changes in the Balance Sheet Items between 31 December 2011
and 31 December 2012
Classification
Resource
Usage

31-12-11

31-12-12

Changes

RM
30,000
20,000

RM
40,000
60,000

RM
+10,000
+40,000

RM

50,000

40,000

10,000

10,000

90,000
220,000
(120,000)

60,000
250,000
(130,000)

30,000
+30,000
10,000

30,000

50,000
70,000
20,000
40,000

70,000
60,000
10,000
60,000

+20,000
10,000
10,000
+20,000

20,000

10,000
12,000

10,000
12,000

0
0

38,000
50,000

38,000
60,000

0
+10,000

Assets
Cash
Marketable
securities
Account
receivable
Inventory
Total fixed assets
Less:
Accumulated
depreciation
Liabilities
Account payable
Notes payable
Tax accrual
Long-term loan
Equities
Preference shares
Original shares at
par
Paid-up capital
Retained earnings
TOTAL

RM
10,000
40,000

30,000
10,000

10,000
10,000
20,000

10,000
100,000

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ANALYSIS OF FINANCIAL STATEMENTS

From Table 2.7, we find that:

(a)

Account receivable decreased by RM10,000 and this is considered as a cash

resource as when debts are collected, the company obtains cash.

(b)

Inventory decreased by RM30,000 and this is considered a cash resource as

the company obtains cash from the product sold.

(c)

Total fixed assets increased by RM30,000 and this is considered as cash

usage as the company uses the cash to buy fixed assets.

(d)

Increase in account payable and long-term loans of RM20,000 are

considered cash sources as the company increases its debt with suppliers.

(e)

Notes payable and tax accrual decreased by RM10,000 and this is

considered as cash usage as the cash is used to settle debts to the creditors
and tax to the government.

These types of classifications (based on Table 2.6) are made on every item in the
balance sheet. The result of these classifications will be totalled to obtain the total
cash resources and total cash usage. If these classifications are done correctly, the
total cash resources will be equal to the total cash usages.

ACTIVITY 2.4
All sorts of support and loan assistance had been provided by the
government through organisations such as Perbadanan Usahawan
Nasional Berhad (PUNB) to encourage the participation of Bumiputeras
in the field of entrepreneurship. Many have grabbed this opportunity to
be involved in their own businesses covering various economic sectors
but not all of them succeeded. What is your opinion on this matter?

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EXERCISE 2.2
1. In the Cash Flow Statement, you will see that both interest expenses
and dividends paid are in the section of financing activities.
(a)

True

(b)

False

2. Depreciation expense is one of the items that will be deducted from

the net profit to determine the cash flow from operating activities.
(a)

True

(b)

False

3. Profit from the sale of fixed assets will be deducted from the net
profit to ascertain the cash flow from operating activities.
(a)

True

(b)

False

4. Payment to suppliers for the purchase of materials will be included

into the cash flow statement in the section of cash from financing
activities.
(a)

True

(b)

False

5. Information included in the cash flow statement are obtained

from_______________.
A.

income statement

B.

balance sheet

C.

income statement and balance sheet

6. Interest expenses are regarded as _________________ in the income

statement and ___________ in the cash flow statement.
A.

operating expenses; item from operating activity

B.

financing expenses; item from financing activity

C.

operating expenses; item from financing activity

D.

financing expenses; item from operating activity

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7. Hugo Enterprise begun the year 2010 with retained earnings of

RM92,800. Throughout year 2010, the company obtained profit of
RM37,700 after tax. From this amount, preference shareholders
were paid dividends of RM4,700. At the end of year 2010, retained
earnings of the company total RM104,800. 14,000 units of ordinary
shares were issued throughout year 2010.
(a)

Prepare the retained earnings statement for the year ended

31 December 2010 (ensure that you calculate and include the
total dividends of ordinary shares paid in the year 2010).

(b)

Calculate the earnings per share for year 2010.

(c)

How much dividend per share was paid by the company to

the ordinary shareholders for the year 2010?

8. Profit after tax of year 2011 for Company Ceria is RM186,000. The
closing balance for retained earnings for year 2011 and 2010 were
RM812,000 and RM736,000 accordingly. How much dividend did
the company pay in the year 2010?
9. Classify each of the following items as funds resource (R), usage
(U), or neither one (N).
Item

Changes (RM)

Cash Flow

Cash

+1,000

________________

10,000

________________

Account payable
Notes payable

+5,000

________________

20,000

________________

Inventory

+2,000

________________

Fixed assets

+4,000

________________

Account receivable

7,000

________________

Long-term loans

Net profit

+6,000

________________

Depreciation

+1,000

________________

Share buyback

+6,000

________________

Cash dividend

+8,000

________________

+10,000

________________

Sale of Share

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10. Use the data from the balance sheet and several items from the
income statement of Suresh Corporation to prepare the Cash Flow
Statement for year ended 31 December 2011.
Suresh Corporation
Balance Sheet
as at 31 December 2011
Assets
Cash
Marketable securities
Account receivable
Inventory
Total current assets
Total fixed assets
Less: Accumulated depreciation
Net fixed assets
Total Assets
Liabilities
Current liabilities
Account payable
Notes payable
Wages accrual
Total current liabilities
Long-term loans
Owners Equities
Ordinary shares
Retained earnings
Total shareholders equity
Total liabilities and
shareholders equities

RM
15,000
18,000
20,000
29,000
82,000
295,000
147,000
148,000
230,000

RM
10,000
12,000
18,000
28,000
68,000
281,000
131,000
150,000
218,000

16,000
28,000
2,000
46,000
50,000

15,000
22,000
3,000
40,000
50,000

100,000
34,000
134,000

100,000
28,000
128,000

230,000

218,000

Data from Income Statement (2011)

Depreciation expenses
RM16,000
Net Profit
RM14,000

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ANALYSIS OF FINANCIAL STATEMENTS

FINANCIAL RATIO ANALYSIS

SELF-CHECK 2.5

What is the relevance in calculating the financial ratios for short-term

and long-term operations? Should its value be in accordance with the
average performance of the industry? Please explain.

Financial ratio analysis involves the calculation of several ratios that will enable
the manager to evaluate the performance and financial status of the company by
comparing its financial ratios with the financial ratios of other companies. These
ratios are divided into five groups or categories, which are:
(a)

Liquidity Ratio
Liquidity ratio refers to the companys ability to fulfil its short-term
maturity claims or obligations.

(b)

Asset Management Ratio

Asset management ratio refers to the efficiency of the company to use its
assets and how fast specific accounts can be converted into sales or cash.

(c)

Leverage Ratio
Leverage ratio refers to the level of debt usage or the ability of the company
to fulfil its financial claims such as interest claims.

(d)

Profitability Ratio
Profitability ratio refers to the effectiveness of the company in generating
returns from investments and sales, for example, gross profit margin, net
profit margin, operating profit margin, return from assets and returns from
equity.

(e)

Market Value Ratio

Market value ratio refers to the ability of the company to create market
values in excess of its investment costs. Liquidity, asset management and
leverage ratios measure the companys risk, while profitability ratio
measures the companys returns.

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51

Within the short-term period, liquidity, asset management and profitability ratios
are important to the management of the company as these ratios provide critical
information on the companys short-term operations. If a business is unable to
sustain within the short-term period, it would be pointless to discuss its longterm prospects.
Before preparing the ratio analysis, the finance manager must consider the
following issues:
(a)

One ratio is unable to give complete information on the status of the

company. This means that several categories of ratios must be looked at
simultaneously before any conclusion can be made.

(b)

Comparisons between the financial ratios of one company with other

companies in the industry must be made at the same point of time. Industry
average is not a figure that must be achieved by a company. There are
many companies that had been managed efficiently but the performance of
their financial ratios is much higher or lower than the performance of the
industry average. The obvious difference between the financial ratios of the
company and the industry average is an indication to the analysts to check
on the ratio further.

(c)

Use the financial statements that have been audited. This will show the
actual status of the company.

(d)

Use the same method to evaluate items in the financial statement that will
be compared. For example, to record inventory, a company might use
different accounting methods such as the first-in-first-out, first-in-last-out
or moving average method. Choose only one of these methods for
comparison purposes. Different methods will provide different ratio values.
Therefore, actual evaluation cannot be done.

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Financial statements of the company are the main input for the manager who
intend to prepare the ratio analysis for its company. Each example of the ratios
that will be discussed in the next section will be based on the financial
information extracted from the income statement and balance sheet of Company
ABC (refer to Table 2.8 and Table 2.9).
Table 2.8: Income Statement for Company ABC
Company ABC
Income Statement
for the Year Ended 31 December 2011 and 2010

Sales
Less: Cost of goods sold
Gross profit
Less: Operating expenses
Sales expenses
Administrative and general expenses
Lease expenses
Depreciation expenses
Total operating expenses
Profit before interest and tax (operating profit)
Less: Interest expense
Profit before tax
Less: Tax (29%)
Profit after tax
Less: Preference shares dividend
Profit available for ordinary shareholders
Earnings per share

2011
RM
307,400
208,800
98,600

2010
RM
256,700
171,000
85,700

10,000
19,400
3,500
23,900
56,800
41,800
9,300
32,500
9,425
23,075
1,000
22,075

10,800
18,700
3,500
22,300
55,300
30,400
9,100
21,300
6,177
15,123
1,000
14,123

0.29

0.18

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Table 2.9: Balance Sheet

Company ABC
Balance Sheet
as at 31 December 2011 and 31 December 2010
2011

2010

RM

RM

36,300
6,800
50,300
28,900

28,800
5,100
36,500
30,000

Net Fixed Assets

122,300
237,400

100,400
226,600

Total Assets

359,700

327,000

38,200
7,900
15,900

27,000
9,900
11,400

Long-term loans

48,300
102,300

62,000
96,700

Total liabilities

164,300

145,000

20,000
19,100

20,000
19,000

Paid-up capital above par

Retained earnings

42,800
113,500

41,800
101,200

Total equities

195,400

182,000

Total liabilities and shareholders equities

359,700

327,000

Assets
Current Assets
Cash
Marketable securities
Account receivable
Inventory

Total current assets

Liabilities and Equities

Current liabilities
Account payable
Notes payable
Accruals

Total current liabilities

Equities
Preference shares
Ordinary shares, RM2.50 par value,
100,000 shares issued 2011: 76,262;
2010: 76,244

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Income Statement

The income statement for Company ABC for the year ended 31 December 2010
and 31 December 2011 are shown in Table 2.8. The income statement shows the
operating performance of the company for a specific period.

2.6.2

Balance Sheet

Balance sheet shows the overall value of various assets and claims on these assets
at a specific point of time. For Company ABC, the balance sheet shows the assets,
liabilities and equities as at 31 December 2011 and 31 December 2010 as shown in
Table 2.9.

2.7

LIQUIDITY RATIO

Liquidity refers to the ability of asset to be converted easily into cash without
affecting the value of the asset. Liquidity ratios refer to the ability of the company
to discharge its claims or short-term obligations by cash and assets that can be
converted into cash in a short period. Liquidity is important in operating the
business activities. A poor liquidity status is an early indication that the company
is facing fundamental problems. The liquidity ratios are shown in Figure 2.4.

Figure 2.4: Liquidity ratio

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ANALYSIS OF FINANCIAL STATEMENTS

Net Working Capital

Net working capital is the difference between total current assets with total
current liabilities. It measures the funds (cash and items that can be easily
converted into cash) that are owned by the company in managing its daily
operating activities. The higher the value of the working capital the better, as this
shows that the company is able to settle its short-term debts with surplus funds
for its daily operating activities.
Net working capital of Company ABC for the year 2011 is calculated as follows:

Net working capital

Current assets Current liabilities

RM122,300 RM62,000
RM60,300

(2.1)

Industry average RM42,700

Based on the calculation above, the net working capital of Company ABC is
higher than the industry average. This shows that Company ABC is able to settle
its short-term debts and has higher surplus funds than the other companies in the
industry to manage its daily operations.

2.7.2

Current Ratio

Current ratio measures the ability of the company to fulfil its short-term loans
using its current assets. The higher the value of this ratio, the better the liquidity
status of the company. This shows that the company is able to settle short-term
debts using its current assets.
Current ratio is obtained by dividing the current assets with the current
liabilities. The current ratio of Company ABC (year 2011) is as follows:

Current ratio

Current Assets
Current Liabilities
RM122,300
RM62,000
1.97

Industry average

2.05

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The current ratio of Company ABC is 1.97 which is lower compared to the
industry average of 2.05. This shows that for every ringgit of current liability, the
company only has RM1.97 current assets for its payment compared to the other
companies in the industry that has RM2.05 to settle their current liabilities.
However, the current ratio of the company is not too low for concern.
Current ratio of 2.0 times is acceptable; however, this acceptance depends on the
type of industry. For example, current ratio of 1.0 is satisfactory for industries
such as utilities that have a rather stable business but it is unsatisfactory for
industries like the manufacturing line due to their business volatility.
The current ratio can be related to the net working capital;
(a)

If the current ratio is equal to 1.0, the net working capital is zero.

(b)

If the current ratio is less than 1.0, the net working capital is negative.

(c)

If the current ratio is more than 1.0, the net working capital is positive.

2.7.3

Quick Ratio

Quick ratio measures the ability of the company to pay its short-term loans
quickly. Quick ratio is a liquidity test that is more stringent compared to the net
working capital and current ratio. This is because quick ratio only takes into
consideration the cash and assets that can easily be converted into cash.
Inventory is not included with the other liquid assets due to the longer period for
the inventory to be converted into cash. Expenses prepaid are also not included
as it cannot be converted into cash. Therefore, it cannot be used to settle the
current liabilities.
Quick ratio is obtained when the most liquid current assets (cash, marketable
securities and account receivables) are divided with current liabilities. The higher
the quick asset ratio compared with the current liabilities, the better the liquidity
level of the company to settle its short-term loans quickly.

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57

The calculation of quick ratio for Company ABC (year 2011) is as follows:
Quick ratio

Current assets (Inventory + Prepayments)

Current liabilities
RM122,300 RM28,900
RM62,000

(2.3)

1.51 times
Industry average 1.43 times
The quick ratio of Company ABC is 1.51 times, it is higher compared to the
industry average of 1.43 times. This means that the liquidity level of the company
is better compared to the other companies in the industry. For every ringgit of
current liability, the company has RM1.51 cash and assets that can be easily
converted into cash to pay its short-term debts immediately. This is better
compared to other companies in the industry that only has RM1.43 to pay their
short-term debts immediately.

EXERCISE 2.3
1. The following data is taken from the financial statements of
Company Fazrul:
2009
RM640,000
380,000
30,000
40,000
70,000
150,000
10,000
300,000
120,000

Sales
Cost of sold goods
Cash
Marketable securities
Account receivable
Inventory
Prepayment items
Net fixed assets
Current liabilities

2008
RM560,000
360,000
26,000
52,000
62,000
140,000
10,000
260,000
140,000

Based on the data above, calculate the following liquidity ratios for the
years 2008 and 2009:
(a)

Net working capital

(b)

Current ratio

(c)

Quick ratio

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2.8

ANALYSIS OF FINANCIAL STATEMENTS

ASSET MANAGEMENT RATIO

Asset management ratio measures the efficiency of the management in using the
assets and specific accounts to generate sales or cash.
Ratios that can be used to measure the efficiency in asset management are shown
in Figure 2.5.

Figure 2.5: Asset management ratio

2.8.1

Account Receivable Turnover

Account receivable turnover measures the ability of the company to collect debts
from its customers. It provides the total of account receivables collected
throughout the year. The higher the ratio, the better it is an indication that:
(a)

The company can collect debts from its customers quickly;

(b)

The company has low bad debts; and

(c)

The company can use the funds for future investments.

Account receivable turnover is the net credit sales revenue (if unavailable,
use the total sales) divided by the account receivables (or average account
receivable).

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Account receivable turnover

ANALYSIS OF FINANCIAL STATEMENTS

59

Credit sales
Account receivable
RM307,400
RM50,300

(2.4)

6.11 times
Industry average 8.24 times
The account receivable turnover for the company is unsatisfactory compared to
the industry average. This may indicate the inefficiency of the credit department
in credit collection.

2.8.2

Average Collection Period

Average collection period shows the average days taken by the company to
collect the account receivable. Assuming there are 360 days in a year. The
comparison between the average periods with the companys credit term could
measure the efficiency of the company in collecting debts from its customers.
Average collection period of Company ABC is as follows:
360
Account receivable turnover
360
6.11

(2.5)

58.92 days
Industry average

44.3 days

The average collection period of Company ABC is 58.92 days which is

unsatisfactory compared with the performance of the industry average of
44.3 days. On average, Company ABC takes 58.92 days to collect its account
receivables while other companies in the industry only takes an average of
44.3 days to collect debts from their customers.
If the credit period for Company ABC is 30 days, the average collection period of
58.2 days is unsatisfactory. This means, on average, the customers did not settle
their payments within the period specified. This could also indicate that the
credit management or credit department is inefficient or both. If the collection

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period extends for several years without changes to the credit policy, the
company must take action to expedite the collection of account receivables.
However, if the companys credit period is 60 days and the average collection
period is 58.92 days, this shows a practical collection period.
The average collection period can also be calculated using formula 2.6.
Average collection period

Account receivables
Yearly sales/360
RM50,300
RM307,400/360

(2.6)

58.92 days

2.8.3

Inventory Turnover

Inventory turnover measures the efficiency of inventory management. It shows

the number of times the inventory can be sold in a year. The higher the inventory
turnover, the better, as it is an indication that the company is able to sell its
inventory quickly and reduce the chances of obsolete inventory.
Inventory turnover is obtained by dividing the cost of goods sold with inventory.
The calculation of inventory turnover for Company ABC is shown as follows:
Inventory turnover

Cost of goods sold

Inventory
RM208,800
RM28,900

(2.7)

7.22 times
Industry average 6.6 times
Inventory turnover for Company ABC of 7.22 times is much better if it is
compared with the industry average of 6.6 times. This means that the company
can sell its inventory 7.22 times in a year compared to the other companies in the
industry that can only sell their inventory 6.6 times in a year. This might be
because the company does not keep surplus inventory. Surplus inventory is not
productive and it is an investment that does not provide any return.

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61

If the company holds a high inventory, the funds that could be invested
elsewhere would be held by the inventory. Furthermore, the transportation and
holding cost of the inventory will be high and the company is at risk of goods
becoming damaged or obsolete. However, the company might lose sales if it is
unable to fulfil the customers demands due to low inventory keeping. Therefore,
the manager must be efficient in managing its inventory.
Several issues that must to be considered in calculating inventory turnover.
(a)

Notice that the cost of goods sold and not sales (as might be done by some
companies) is used as the numeric figure as inventory is recorded at cost.

(b)

The usage of sales as the numeric figure is not appropriate as it will

increase the value of inventory turnover.

(c)

Remember that for comparison, the company must ensure that the method
of inventory recording must be similar between the company and the
industry.

(d)

The inventory turnover can be changed into number of days when it is

divided by 360 days (average number of days a year). This ratio is known
as the average inventory sales period as discussed in the next section.

2.8.4

Average Inventory Sales Period

The average inventory sales period shows the number of days taken to make one
round of inventory sales. A high average inventory sales period is less
satisfactory as this indicates that the company takes a longer time to sell its
inventory.
For Company ABC, the average inventory sales period is 50 days as calculated
below:

360
Inventory turnover
360
7.22

(2.8)

49.86 days
Industry average

55.30 days

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The average inventory sales period for Company ABC of 49.86 days is better
compared to the industrial performance of 55.30 days. This indicates that the
company takes shorter time to sell its inventory compared to the other companies
in the industry.
This ratio can also be calculated using the following formula:
Inventory
Cost of goods sold/360
RM28,900
RM208,800/360

(2.9)

49.83 days
Industry average

2.8.5

55.30 days

Fixed Asset Turnover

Fixed asset turnover shows the efficiency of the company in using its fixed assets
to generate sales. The higher the ratio, the better it is because it indicates efficient
asset management.
This ratio is obtained when the sales is divided by the net fixed assets. The
calculation of fixed asset turnover for Company ABC is as follows:
Fixed asset turnover

Sales
Net Fixed Assets
RM307,400
RM237,400

(2.10)

1.29 times
Industry average 1.35 times
The fixed asset turnover ratio for Company ABC is lower compared to the other
companies in the industry indicating that the asset management of the company
in generating sales is less efficient compared to the other companies. This might
be because the company has lots of fixed assets or unsatisfactory sales.

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ANALYSIS OF FINANCIAL STATEMENTS

Total Asset Turnover

The total asset turnover shows the efficiency of the company in using all its assets
to generate sales. Usually, the higher the ratio, the more efficient the usage of the
assets. This ratio might be the most frequent ratio referred by management as it
can show the overall efficiency of the companys operations.
Total asset turnover of Company ABC is as follows:
Sales
Total assets
RM307,400
RM359,700

(2.11)

0.85 times
Industry average 0.75 times
This performance is more satisfactory compared to the industry average.
However, analysts must be careful in using the fixed asset turnover and total
asset turnover ratio because the calculation of these ratios uses the historical costs
of the assets.
Some companies may have old assets or new assets. Therefore, it might not be
appropriate to compare the fixed asset ratio. Companies that owned new fixed
assets normally will show lower fixed asset turnover. Therefore, the difference in
the performance of the asset turnover might be due to the costs of the assets and
not the efficiency of the managements operations.

ACTIVITY 2.5
The economic and technology status of the country will influence the
operations of a business. To ensure that the company stays competitive
and is expanding, what effective actions can be taken?

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EXERCISE 2.4
The following data was taken from the financial statements of Fazrul
Company. Based on the data below, calculate the asset management
ratios for the years 2008 and 2009. Assume that there are 365 days in a
year.
2009
RM640,000
380,000
30,000
40,000
70,000
150,000
10,000
300,000
120,000

Sales
Cost of goods sold
Cash
Marketable securities
Account receivables
Inventory
Prepayment items
Net fixed assets
Current liabilities

(a)

Account receivables turnover

(b)

Average collection period

(c)

Inventory turnover

(d)

Average inventory sales period

(e)

Fixed asset turnover

(f)

Total asset turnover

2008
RM560,000
360,000
26,000
52,000
62,000
140,000
10,000
260,000
140,000

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65

LEVERAGE RATIO

Leverage ratio measures a companys level of debt funding and the ability of the
company to fulfil its financial demands such as interest claim. Leverage ratios are
shown in Figure 2.6.

Figure 2.6: Leverage ratio

Leverage occurs when a company is being funded by debt. Debt include all
current liabilities and long-term liabilities. Debt is also one of the main sources of
funding. It provides tax advantage as interest is a tax deductible item. The costs
of debt transactions are also lower as debts are easier to obtain compared to the
issuance of shares. Usually, the more debt in relation to total assets, the higher
the financial leverage of the company.
Leverage ratios can be divided into two groups:
(a)

Ratios to evaluate the debt level used by the company such as debt ratio,
debt-equity ratio and equity multiplier; and

(b)

Ratios to see the ability of the company in fulfilling its claims or obligations
to the creditors such as interest coverage ratio.

Normally, analysts would focus their attention on the long-term loans as the
company is bound by interest payments for a longer period and at the end of that
period, the company must repay the principal amount of the loan. As creditors
claims must be settled first before any earnings can be distributed to the
shareholders, potential shareholders will usually look at the debt level and the
ability of the company to repay the companys debts.

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Creditors will also focus on the leverage ratios as the higher the debt level, the
higher the probability of the company being unable to settle the debts of all its
creditors. Therefore, the management of the company must prioritise on the
leverage ratio as it attracts attention from several parties that are concerned with
the debt level of the company.

2.9.1

Debt Ratio

Debt ratio measures the percentage of total assets that are financed by debts.
Creditors prefer lower debt ratio as the lower the debt ratio, the higher the
protection for their losses upon liquidation. Unlike the preference of creditors for
a lower debt ratio, the management might choose a higher leverage to increase
earnings. This is because they do not like to issue new equity as they fear the
degree of control in the company will reduce. The higher the debt ratio, the
higher the percentage of assets being funded by debts.
The debt ratio of Company ABC is:
Debt ratio

Total liabilities
100
Total assets
RM164,300
100
RM359,700
45.7%

Industry average

40.0%

The debt ratio of the company is 45.7% and this is higher than the industry
average of 40%. Potential creditors might be reluctant to provide additional loans
to the company as they worry that the company would not be able to settle the
interest and principal payment, due to its rather high debt ratio.

2.9.2

Debt-equity Ratio

Debt-equity ratio measures the total long-term debts for each ringgit of equity.
The lower the ratio, the better it is because it shows that the total equity owned
by the company exceeds the long-term debts.

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The debt-equity ratio of Company ABC is:

Debt-equity ratio

Long-term liabilities
Shareholders equity
RM102,300
100
RM195,400

(2.13)

52.4%
Industry average

50%

The debt-equity ratio of the company is higher compared to the industry average.
This shows that the percentage of long-term debt relative to the amount of equity
of the company is higher compared to the industry average. The higher the ratio
indicates that the company relies on long-term creditor-supplied funds than
owner-supplied funds.

2.9.3

Equity Multiplier

Equity multiplier shows the asset ownership for each ringgit of equity. Debt ratio
and equity multiplier provides the same information but in different approach.
Debt ratio of 40% means that the company is being funded by 40% debts. Based
on the balance sheet identity:
Asset = Liability + Equity
From this information, we know that the company is being funded by 60%
equity. Equity multiplier is 100/60 = 1.67 times. Therefore, when the debt ratio of
Company ABC is 45.7%, thus the equity multiplier is 100/54.3 = 1.84 times.
In general,

Equity multiplier

1
1-Debt ratio
Total asset
Total equity
RM359,700
RM195,400

Industry average 1.67 times

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The equity multiplier of the company is higher compared to the industry

average. This shows that the funding of the companys assets via equity is higher
compared to the other companies in the industry.

2.9.4

Interest Coverage Ratio

Creditors and other parties would know the companys ability to make interest
payments periodically by using the current operations income. Interest coverage
ratio is used to decide the number of times the company can repay all its interest
expenses with the current income. This ratio is obtained by dividing the
operations profit with interest expenses.
Interest coverage ratio of Company ABC is:
Profit before interest and tax
Interest expenses
RM41,800
RM9,300

(2.15)

4.49 times
Industry average

4.3 times

Interest coverage ratio of 4.49 times is more satisfactory compared to the industry
average performance of 4.3 times. This indicates the interest expenses margin
with current income.
Interest coverage ratio can also be calculated by using the following formula:
Interest coverage ratio

Net profit

Interest expenses Tax expenses

Interest expenses

RM22,100 RM9,300 RM9,400

RM9,300
4.39 times

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EXERCISE 2.5
The summary balance sheet and income statement of Adiy Corporation
are as shown below:
Adiy Corporation
Balance Sheet
Assets:
Cash
Account receivable
Inventory
Net fixed assets

RM150,000
450,000
600,000
1,800,000

Liabilities and Equities:

Account payable
Notes payable
Long-term liabilities
Equities

Income Statement
Sales (all credit)
RM6,000,000
Cost of goods sold
3,000,000
Operating expenses
750,000
Interest expenses
750,000
Tax
420,000
Net Profit
1,080,000

150,000
150,000
1,200,000
1,500,000

Calculate the financial ratios for Adiy Corporation based on the

information given above. Assume that there are 365 days in a year.
(a)

Debt ratio

(b)

Interest coverage ratio

(c)

Return on asset

(d)

Average collection period

(e)

Total asset turnover

2.10

PROFITABILITY RATIO

The profitability ratio measures the effectiveness of the company in generating

returns from investments and sales. It is used as a sign to determine the
businesss efficiency and effectiveness in achieving its profit objective.
Profitability ratios are shown in Figure 2.7.

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Figure 2.7: Profitability ratio

2.10.1

Gross Profit Margin

Gross profit margin measures the profit for each ringgit of sales that can be used
to pay the sales and administration expenditures. The higher the gross profit
margin, the better the status of the company as this shows lower expenditures or
costs involved in implementing sales activities.
Gross profit margin can be obtained by dividing the gross profit with sales. It
shows the balance percentage for each ringgit of sales after the company had
paid all the costs of goods.
Gross Profit Margin

Gross Profit
100
Sales
RM98,600
100
RM307,400

(2.17)

32.1%
Industry average

30%

Gross profit margin of 32.1% is higher compared to the industry average of 30%.
This shows that the purchasing management and cost of the company are better
compared to the industry average. The company generates 32.1 cents gross profit
after deducting all costs of goods for each ringgit of sale.

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71

Net Profit Margin

Net profit margin measures the ability of the company to generate net profit from
each ringgit of sale after deducting all expenditure including the cost of goods
sold, sales expenditures, general and administrative expenditures, depreciation
expenses, interest expenses and tax. The higher the net profit margin, the better
the status of the company as this shows an efficient purchasing management
with low purchasing costs.
Net profit margin is calculated by dividing the profit after tax with sales. Hence,
the net profit margin of Company ABC is as follows:
Net profit margin

Profit after tax

100
Sales
RM23,100
100
RM307,400

(2.18)

7.5%
Industry average 6.4%
The net profit margin for the company of 7.5% is higher compared to the
industrys performance of 6.4%. This shows that the management of purchasing
and related purchasing costs are better compared to the industry average. The
company had managed to generate 7.5 cents net profit for each ringgit of sale
compared to the industry average that only managed to generate 6.4 cents for
each ringgit of sale.

2.10.3

Operating Profit Margin

The operating profit margin measures the efficiency of operations in reducing

costs and increasing returns before interest and tax. A higher operating profit
margin is better as it indicates that the company is able to operate efficiently. The
operating profit margin of Company ABC is:
Operating Profit Margin

Operating Profit
100
Sales
RM41,800
100
RM307,400
13.6%

Industry average 10%

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The operating profit margin of company ABC is better compared to the industry
average. This shows that the company is more efficient in its operations and
control of its operating expenditures to generate higher earnings before interest
and tax.

2.10.4

Return on Assets

Return on assets or return on investment measures the effectiveness of the

company in using its assets to generate profit. The higher the ratio, the better the
status of the company as it indicates the managements efficiency in using its
assets to generate profit.
Return on Assets

Profit after tax

100
Total Asset
RM23,100
100
RM359,700

(2.20)

6.42%
Industry average

4.8%

Return on assets of the company is better compared to the industry average that
only contributes 4.8%. This shows that the company is better in managing its
assets to generate profit compared to the other companies in the industry.

2.10.5

Return on Equity

Return on equity measures the efficiency of the company in generating profit for
its ordinary shareholders. The higher the ratio, the better as the company is able
to generate high profit for its owners.
Return on equity

Profit after tax

100
Shareholders Equity
RM23,100
100
RM195,400
11.8%

Industry average 8%

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Return on equity of the company is 11.8% and this is more satisfactory compared
to 8% for the industry average. This shows that the management of the company
is more efficient compared to the industry average. The calculation of return on
equity will be discussed further when we discuss the DuPont analysis.

2.10.6

Earnings Per Share

Earnings per share calculate the net profit that is generated from each ordinary
share. This information is often given priority by the management and investors
as it is regarded as an important indication of the companys success. Therefore,
the bigger the value of this ratio, the better the status of the shareholders.
Earnings per share is obtained by dividing the net profit with the number of
shares issued.

Earnings per share

Profit available to ordinary shareholders

Number of ordinary shares issued
RM22,100
76,262

(2.22)

RM0.29
Industry average RM0.26
The company obtained RM0.29 for each unit of shares issued compared to the
industry average of only RM0.26. The value of this difference is small and in
practice, this value represents the actual amount that will be distributed to the
shareholders.

2.11

MARKET VALUE RATIO

SELF-CHECK 2.6

Provide the differences between price earnings ratio and dividend

yield ratio.

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Market value ratio measures the ability of the company to generate market
values in excess of its investment costs. This aspect is very important as these
market value ratios are directly related to the objective of the company, that is to
maximise shareholders wealth and value of the company. Therefore, it can be
said that the value of market value ratio influences the markets reaction and
investors confidence towards the ability of the companys management in
generating profit efficiently and effectively.
Market value ratios are shown in Figure 2.8.

Figure 2.8: Market value ratio

2.11.1

Price Earnings Ratio

Price earnings ratio shows the total ringgit that the investor is willing to pay for
each ringgit of profit reported by the company. The level of price earnings ratio
shows the degree of confidence of the investors towards the future performance
of the company. The higher the price earnings ratio, the higher the confidence of
the investors towards the companys future.
Price earnings ratio can be obtained when the market price per share is divided
by the earnings per share. To calculate the price earnings of Company ABC, we
assumed that the market price for the companys share is RM3.23.
Price earnings ratio

Market price per share

Earnings per share
RM3.23
RM0.29

(2.23)

11.1
Industry average 1.25

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The ratio shows that the degree of confidence of the investors towards
the company is significantly higher compared to the industry average as the
investors are willing to pay 11.1 times more for each companys share compared
to 1.25 for each share in the industry average.
You can see this price earning ratio in share prices section in the newspaper.
However, newspapers provide current price ratio instead of the latest profits.
Investors prioritise more on the price relative to future earnings.

2.11.2

Dividend Yield Ratio

There are investors who will buy ordinary shares to receive dividends. Others
will be more interested in the growth of their share market value. Dividend yield
ratio measures the rate of return in the form of dividends received from a share
investment. Assume that Company ABC practices a stable dividend policy and
pays dividends of RM0.15 per share. This means that the investors will receive
return from dividends of 4.6%.
A lot of companies try to maintain paying a stable dividend and, if possible, they
will try to increase the dividends so that investors will receive more returns from
their share holdings. There are companies that pay small dividends and there are
those that do not pay any dividends to their shareholders. This is because they
put in more effort to expand their businesses by retaining and reinvesting the
profit obtained.
Dividend yield

Dividend per share

Market price per share
RM0.15
100
RM3.23

(2.24)

4.6%

EXERCISE 2.6
1. _________ is the ability of the company to fulfil its current
liabilities obligations by using its current assets.
2. Current ratio is similar to _________ divided by ___________.
3. _________ is included in the calculation of current ratio but
excluded from the calculation of the quick ratio.

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EXERCISE 2.6

4. Inventory turnover is obtained by dividing _________ by _________.

5. Ratio of total liabilities to ____________ is used to ascertain the level
of debt in the capital structure.
6. Return on equity is obtained when _________ is divided by
_________.
7. Price earnings ratio is equal to _________ per share divided by
_________ per share.
8. X-Cell and N-Hance are two companies operating in the same
industry. The financial information for both companies as at
31 December 2010 are as follows:

Total assets
Total liabilities
Total equities
Net sales
Interest expenses
Tax expenses
Net profit
Earnings per share
Market price per share of ordinary shares
Dividends per share for ordinary shares

X-Cell
RM3,000,000
1,800,000
1,200,000
3,700,000
90,000
240,000
380,000
5.60
35.00
2.40

N-Hance
RM1,600,000
960,000
640,000
1,880,000
38,000
100,000
180,000
2.10
26.50
0.50

For each of the company, calculate the following ratios:

X-Cell

N-Hance

(a)

Return on assets

_______________ _______________

(b)

Return on equity

_______________ _______________

(c)

Net profit margin

_______________ _______________

(d)

Total asset turnover

_______________ _______________

(e)

Debt ratio

_______________ _______________

(f)

Equity multiplier

_______________ _______________

(g)

Interest coverage ratio

_______________ _______________

(h)

Price earnings ratio

_______________ _______________

(i)

Dividend yield ratio

_______________ _______________

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CONDUCTING A COMPLETE RATIO

ANALYSIS

As stated above, one ratio is not sufficient to evaluate all aspects of the
companys financial status. Therefore, the manager must conduct a complete
ratio analysis to cover all aspects of liquidity, asset management, leverage,
profitability and market value ratio.
The two approaches that can be conducted are:
(a)

DuPont Analysis looks at the main sections that contribute to the

companys financial performance.

(b)

Summary of financial ratio analysis looks at all the financial aspects of the
company to identify sections that require further investigations or
improvements.

2.12.1

DuPont Analysis

DuPont analysis is used by finance managers to evaluate the financial status of a

company. The DuPont analysis combines the income statement and the balance
sheet to become two measurements of profitability.
(a)

Return on assets; and

(b)

Return on equity.

The first step in DuPont analysis is to show the DuPont formula:

Return on assets Net profit margin Total assets turnover
Profit after tax
Sales
Sales
Total assets
7.5% 0.85 times
6.4%

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In the DuPont formula, the net profit margin measures the profitability of sales,
while the total asset turnover shows the efficiency of management in using assets
to generate sales.
The value of return on asset is calculated by using the DuPont formula is the
same as the value of return on assets calculated directly parting section 2.10.4.
However, the DuPont formula allows the company to evaluate its return on asset
by separating it into two different components that is the profit on sales and
efficiency in asset management.
The second step in DuPont analysis is to connect the return on asset with return
on equity. This relationship is shown below.
Return on equity

Return on assets Equity multiplier

Profit after tax Total assets
Total asset
Total equity
6.4% 1.84 times
11.8%

When the values for return on asset and equity multiplier are replaced in the
formula above, the result is 11.8%, the same as calculated directly in topic 2.10.5.
However, the DuPont analysis has the advantage of allowing the manager to
evaluate the return on equity by looking at three separate components, which are:
(a)

Profit on sales;

(b)

Efficiency of asset management; and

(c)

Effect of using debts in funding assets.

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If the DuPont analysis is extended, the return to the owner can be evaluated by
looking at each important dimension as shown in Figure 2.9.

Figure 2.9: Extended DuPont analysis

From Figure 2.9, we found that the return on equity for Company ABC (11.8%) is
higher compared to the industry average (8%). This higher return on equity is
influenced by the companys higher return on asset compared to the industry
and less influenced by the pattern of funding as illustrated by the equity
multiplier. (Return on asset of the company is 6.41%, while the return on asset
of the industry is only 4.8%. The difference in equity multiplier between the
company and the industry is quite marginal, 1.84 times for the company and
1.67 times for the industry).
The difference in returns between the company and the industry is influenced by
the difference in net profit margin compared to the difference in total assets
turnover. The difference in profit margin between the company and industry is
significant. (7.5% for the company and 6.4% for the industry) compared to the
difference in total assets turnover (0.85 times for the company and 0.75 times for
the industry).

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Net profit margin of the company is influenced by the higher operating profit
margin compared to the gross profit margin. Therefore, the higher return on
equity for the company is due to the management efficiency in managing its
operations.

2.12.2

Summarising All Financial Ratios

The performance of Company ABC is measured based on five groups of ratio,

which are:
(a)

Liquidity;

(b)

Asset management;

(c)

Leverage;

(d)

Profitability; and

(e)

Market value.

The companys financial ratios can be compared with the ratios of other
equivalent companies, or with the industry average at one point of time. These
comparisons provide explanations on the relative financial status and
performance of the company compared to the relative performance of its
competitors. This analysis uses industry average as a benchmark or standard of
comparison.
When the industry average cannot be obtained, comparisons are usually made
with other companies in the same industry. This benchmark is assumed to be the
suitable value for a company in the same industry. The assumption here is for the
companies in the same industry to have an almost identical financial ratio. If the
ratio of a company shows a significant difference with the standard ratio, then
further investigation must to be done to find the cause of that difference.
For evaluation, a companys financial ratio is compared to the industrys ratios
one by one, and then classified as satisfactory or unsatisfactory, depending upon
the direction and how far it has diverted from standard.

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Table 2.10 summarises the comparison between Company ABCs financial ratios
with the industry average for the year 2011.
Table 2.10: Summary of Ratio Analysis for Company ABC Compared with the
Industry Average for Year 2011
Company ABC

Industry Average

Notes*

Liquidity Ratio
Current ratio
Quick ratio

1.97 times
1.51 times

2.05 times
1.43 times

US
US

Asset Management Ratio

Account receivable turnover
Average collection period
Inventory turnover
Average inventory sales period
Fixed asset turnover
Total asset turnover

6.11 times
58.92 days
7.22 times
49.86 days
1.29 times
0.85 times

8.24 times
44.3 days
6.6 times
55.30 days
1.35 times
0.75 times

US
US
S
US
US
S

Leverage Ratio
Debt ratio
Debt-equity ratio
Interest coverage ratio

45.7%
52.4%
4.49 times

40.0%
50%
4.3 times

US
S
S

Profitability Ratio
Gross profit margin
Net profit margin
Return on assets
Return on equity
Earnings per share

32.1%
7.5%
6.42%
11.80%
RM0.29

30%
6.4%
4.8%
8.0%
RM0.26

S
S
S
S
S

Market Value Ratio

Price earnings ratio
Dividend yield ratio

11.1
RM0.046

1.25
RM0.50

US
US

*S = Satisfactory

US = Unsatisfactory

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From Table 2.10, we can summarise that:

(a)

Liquidity
The companys achievement in current ratio and quick ratio are much
different compared with the industry. Overall, the companys liquidity is
rather satisfactory.

(b)

Asset Management
The companys inventory management is quite satisfactory. The company
might face problems with its account receivables as the collection period for
the company is higher compared to the industry. Therefore, attention has to
be given to the management of account receivables.

(c)

Leverage
The level of the companys debts is higher than that of the industry average.
However, the ability of the company to pay interests is better compared to
the industry.

(d)

Profitability
Profitability, relative to the investors (as seen in the return on asset and
return on equity ratios) of the company is better compared to the industry.
This is the same with the gross profit margin and net profit margin.

(e)

Market Value
The companys shares were sold at the higher price earnings ratio than the
industry. This is the same for dividends yield ratio which is smaller
compared with the industry.

2.13 WEAKNESSES OF FINANCIAL RATIOS

Financial ratio is an important tool in financial analysis but when the users apply
the financial ratios, they must take into consideration the weaknesses related to
these financial ratios. Among the weaknesses are:
(a)

The accuracy of the financial ratio depends on the accuracy of the data
found in the financial statements.

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(b)

In using the financial ratio for industrial comparison purposes, the users
must take into consideration that the industry ratio is only a rough
estimate. This is due to the difficulty to obtain the entire similar firms in the
same industry.

(c)

Financial ratio is a relative measurement and does not show the actual size
of the firm.

(d)

Financial ratio is used to measure the status of the firm but it cannot show
the issues that had caused the situation.

ACTIVITY 2.6
Visit the following websites to obtain additional information regarding
the topics discussed in this topic.
http://www.ppkm.net/
Description: Persatuan Pasaran Kewangan Malaysia was established
with the objective to provide an organisation for individuals who are
actively engaged in the foreign exchange and financial markets in
Malaysia.
http://www.finpipe.com/equity/finratan.htm
Description: Introduction to Financial Ratio Analysis
http://www.investopedia.com/university/ratios/
Description: Steps and explanations on the calculations of Financial
Ratio Analysis
http://www.credit-to-cash-advisor.com/Document.asp?lid=120
Description: Detailed explanation on DuPont Analysis. It also includes
a convenient web calculator.

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EXERCISE 2.7
1. When ratio comparisons show an obvious change in the financial
status of a company, the manager should investigate the matter
further.
(a)

True

(b)

False

2. In the DuPont Analysis, return on equity is the result of

multiplying three other ratios: net profit margin, total asset
turnover and return on asset.
(a)

True

(b)

False

3. Net profit divided by total asset is ___________ ratio.

A.

return on equity

B.

current ratio

C.

gross profit margin

D.

return on asset

4. Dividend yield ratio is:

A. total money distributed to shareholders.
B. dividends paid to shareholders divided by retained earnings.
C. dividends per share divided by price per share.
D. retained earnings divided by sales.

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5. Use the following information to calculate the net profit.

Return on asset

= 2%

Total asset turnover = 0.5 times

Cost of goods sold

= RM105,000

Gross profit margin = 30%

6. Calculate the return on equity based on the information below:
Sales

= RM100,000

Net profit

= RM3,000

Total assets

= RM150,000

Total liabilities = RM75,000

7. Listed below are several transactions made by Fima Corporation
along with the financial ratios.
For each of the transactions, state whether there is an increase,
decrease or no change to the ratio listed next to the related
transaction.
Transactions

Financial Ratios

(a)

Selling of inventory on credit

Current ratio

(b)

Issuing ordinary shares to collect cash

Return on equity

(c)

Issuing long-term bonds for cash

Debt ratio

(d)

Declaring and paying cash dividends for

ordinary shares

Dividend yield

(e)

Collecting account receivable

Account receivable turnover

(f)

Making cash loans by issuing long-term

notes payable

Return on assets

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8. The finance manager of Lily Corporation provided the following

financial information to you to prepare the company's financial
analysis.
Lily Corporation
Balance Sheet as at 31 December 2010

Cash
Account receivable
Inventory
Total current liabilities
Total fixed asset
Accumulated
Depreciation
Net fixed asset

Total asset

Sales
Cost of goods sold
Gross profit
Operating expenditure
Operating profit
Interest expenses
Profit before tax
Tax
Net Profit

RM
1,000
8,900
4,350
15,675
35,000

Account payable
Accrual account

RM
9,000
6,675

Total current asset

Long-term loans

14,250
4,125

Total liabilities

19,800

Ordinary shares
Retained earnings
Total equity

1,000
15,200
16,200

Total liability and equity

36,000

13,250
21,750

36,000

RM
100,000
87,000
13,000
11,000
2,000
500
1,500
420
1,080

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Based on the financial information above, calculate the following

financial ratios:
(a)

Current ratio

__________________

(b)

Quick ratio

__________________

(c)

Average collection period __________________

(d)

Inventory turnover

__________________

(e)

Fixed asset turnover

__________________

(f)

Total asset turnover

__________________

(g)

Debt ratio

__________________

(h)

Interest coverage ratio

__________________

(i)

Gross profit margin

__________________

(j)

Operating profit margin

__________________

(k)

Net profit margin

__________________

(l)

Return on asset

__________________

(m) Return on equity

__________________

9. Complete the balance sheet for Company Amri based on the

following information. Assume that there are 360 days in a year.
Gross profit margin

= 38.7%

Inventory turnover

= 6 times

Average collection period = 31 days

Sales

= RM720,000

Current ratio

= 2.35 times

Total asset turnover

= 2.81 times

Debt ratio

= 49.4%

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Assets

Current asset
Cash

Company Amri
Balance Sheet
RM
Liability and Owners Equity
Current liabilities
8,005 Account payable

Marketable securities

Notes payable

Account receivable

Accruals

Inventory
Total current assets

RM

28,800

18,800

Total current liabilities

159,565
Long-term liabilities

Total fixed assets

Accumulated depreciation
Net fixed asset

Total liabilities
50,000
Shareholders equity
Preference shares
Ordinary shares
Paid-up capital
Retained earnings

Total assets

2,451
30,000
6,400
90,800

Total equity
Total liabilities and equity

Financial ratio analysis is suitable to be used when the company wants to

interpret the financial statements of the company.
Liquidity ratios such as net working capital, current ratio and quick ratio
enables the measurement of the companys ability to fulfil its short-term
maturity claims.
Asset management ratios measure the companys efficacy in using the assets.
Examples of this ratio include account receivable turnover, average collection
period, inventory turnover, average inventory sales period, fixed asset
turnover and total asset turnover.

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Leverage ratio measures the level a company is being funded by debt or the
ability of a company to fulfil its financial claims such as interest claims.
Profitability ratio measures the effectiveness of the company in generating
returns from investment and sales; for example gross profit margin, net profit
margin, return on assets and return on equity.
Market value ratio such as price earnings ratio and dividend yield ratio,
measures the ability of a company to create values in the market exceeding its
investment costs. This aspect is very important as these ratios are directly
connected with the companys objective that is to maximise shareholders
wealth and value of the company.
The DuPont analysis is used by finance managers to evaluate the financial
status of the company by measuring the two important ratios, which are
return on assets ratio and return on equity ratio while the approach on
summarising the financial ratio analysis is to show all aspects of the
companys overall financial status to identify sectors that require further
investigation.

Annual report

Income statement

Asset management ratio

Leverage ratio

Balance sheet

Liquidity ratio

Cash flow statement

Market value ratio

DuPont analysis

Profitability ratio

Financial ratio analysis

Statement of retained earnings

Financial statement

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Topic

Time Value of
Money

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Apply the concept of compounding and discounting in determining
future value and present value of money;
2. Differentiate between an ordinary annuity and an annuity due;
3. Calculate the present value of a perpetuity; and
4. Calculate the future and present value of money for non-annual
compounding periods.

INTRODUCTION
The public generally assume time as very precious and must be managed
efficiently. They place the value of time on par with various valuable objects and
one of the globally accepted proverb is time is money. From the financial
management perspective, this proverb is a phrase that can be measured and
proven quantitatively by using financial mathematics. In fact, this quantitative
proof has been developed as one of the basic principles in financial decisions
known as the concept of time value of money.

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CONCEPT OF COMPOUNDING AND

FUTURE VALUE
SELF-CHECK 3.1

If you were given two choices either an offer of RM1,000 in the

beginning of the year or an offer of RM1,000 at the end of the year,
which offer will you choose?

Rationally, you will certainly choose the offer at the beginning of the year as
the value of money makes this alternative more profitable. The concept of
compounding is one of the main concepts of time value of money. The concept of
compounding, in brief, explains that RM1 today is more valuable than RM1 in
the future. This is because RM1 today can be invested to generate interest and
subsequently multiply to become more than RM1 at the end of the investment
year.
Among the reasons why time value of money makes this alternative more
valuable are:
(a)

In general, individuals are more interested in the present usage than

postponing the usage to the future.

(b)

During the inflation periods caused by uncontrollable development in the

economy, the real purchasing power of RM1 now is more that the real
purchasing power of RM1 in the coming years.

(c)

Capital that is obtained now can be invested productively to generate a

higher return in the future.

3.1.1

Time Line

The drawing of time line in Figure 3.1 can ease the understanding of the concept
of time value of money especially for complex problems. Time is divided into
several periods of valuation that is shown along the horizontal line and the
calculation of the period begins from left to right. Time 0 (t0) refers to the present
time or the starting of the first period, time 1 (t1) refers to the end of the first
period or the starting of the second period, time 2 (t2) refers to the end of the
second period or the starting of the third period and so forth.

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Figure 3.1: Time line

3.1.2

Compound Interest

There are two types of interest: simple interest and compound interest. Simple
interest is the interest that will be paid or accepted based on the principal
amount. On the other hand, compound interest refers to the interest that will be
paid not only on the principal amount but also on any interest payable not
withdrawn throughout its period (accumulated interest).
In this topic, we will focus our discussion on compound interest as in the
calculation for time value of money, only compound interest is considered.
Example 3.1
If you had invested RM100 in the savings account in a bank with the interest
rates of 10% per year, how much returns will you receive at the end of the first
year? Roughly, you will obtain RM110. These returns can be calculated as
follows:
Returns (F) = Total principal (P) + Total interest (i)
= Total principal (P) + [Total principal (P)

Interest (i)]

= RM100 + RM10 (10%)

= RM100 + 10
= RM110
F1 = P + P(i)
= P(1 + i)
If the stated returns are not withdrawn from the savings account, and the banks
interest rates for the second and third year remained unchanged, how much
return will you receive at the end of the second and third year?

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F2 = P (1+i)2
= F1 (1+i)
= RM100 (1 + 0.1)2
= 121
F3 = RM121 + RM12.10
= RM133.10 that is
= F2 +F2 (i)
= F2 (1+i)
= P2 (1+i)2 (1+i)
= P (1+i)3
When the savings period is extended to tn, the total amount in period (n) is:
Fn = P (1+i)n

(3.1)

The complete time line for savings of RM100 at an interest rate of 10% per year is
as follows:

EXERCISE 3.1
1. Salmah deposits RM100 in the savings account at Affin Bank with
an interest rate of 5% per year for 5 years. How much would
Salmah have in the savings account at the end of the 5-year period?
2. Assume that Ah Seng deposits RM5,000 in the savings account at
CIMB at the interest rate of 10% per year for 2 years. How much
would Ah Seng have in the savings account at the end of the second
year?

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3.1.3

Calculation of Future Value Using Schedule/Table

TIME VALUE OF MONEY

Calculation of future value using the formula of Fn = P (1+i)n with the value of n
being more than one sometimes takes a rather long time. Therefore, the usage of
a financial schedule that is the schedule of Future Value Interest Factor (FVIFi,n)
helps to save time in terms of calculations.
Equation 3.2 shows that the future value (FVn) is equivalent to the principal at
the point of time equal to 0 or the original principal amount (PV0) multiply with
the future value factor stated in the schedule of Future Value Interest Factor
(FVIFi,n). This schedule is enclosed in Attachment A.
FVn = PV0 (FVIFi,n)

(3.2)

As a basic guide on the usage of the financial schedule, please refer to the extract
on the schedule of Future Value Interest Factor (FVIFi,n) in Table 3.1 to solve
examples 3.2 and 3.3.
Example 3.2
You deposited RM2,000 in the savings account in a bank at a yearly interest rate
of 5% for the period of one year. Upon the completion of one year, how much
will you receive?
FVn = PV0 (FVIF i,n)
= RM2,000 (FVIF 5%, 1)
= RM2,000 (1.0500)
= RM2,100
Example 3.3
Assume you deposited RM2,000 in the savings account in your bank at a yearly
interest rate of 5% for the period of four years. Upon the completion of four
years, how much will you receive?
FVn = PV0 (FVIF i,n)
= RM2,000 (FVIF 5%, 4)
= RM2,000 (1.216)
= RM2,432

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Table 3.1: Extract from the Future Value Interest Factor (FVIF i, n) Schedule

It must be remembered that sometimes a different answer might exist by using

manual calculation compared to the calculations using the schedule. This is due
to the usage of different numbers of decimal points. However, the difference is
not significant and both answers are acceptable.

EXERCISE 3.2
Use the schedule of Future Value Interest Factor (FVIFi,n) in
Attachment A to calculate the answers for the questions below.
1. Assume that you keep RM5,555 in the savings account at Affin
Bank with an interest rate of 15% per year for 5 years. How much
will you obtain at the end of the 5 year period?
2. If you keep RM4,321 in the savings account at Maybank with an
interest rate of 7% per year for 2 years, how much will you obtain at
the end of the 2 years period?

3.1.4

Graphical Illustration of Future Value

There are three basic elements which will influence the future value, these are:
(a)

Principal (amount that was borrowed or invested);

(b)

Time period (the number of periods or frequency of interest payments); and

(c)

Interest rate payable (if the money was borrowed) or interest receivable (if
the money was invested).

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To show how the interest rate influences the future value of an investment, we
must assume that the principal and the time period are constant. Therefore, any
changes to the future value are caused only by the interest rates. For example,
you intend to deposit RM100 at Bank A, B and C that offer different interest rates
of 8%, 10% and 12%. Compounded annually how much will the future value of
your deposit be in 3 years from now?
Based on the formula
FVn=PV0(FVIFi,n)
The future value of deposit in Bank A that offers an interest rate of 8% is:
FV0.083 = RM100(FVIF8%,3)

= RM100(1.26)

= RM126.00

The future value of deposit in Bank B that offers an interest rate of 10% is:
FV0.13 = RM100(FVIF10%,3)

= RM100(1.331)

= RM133.10

Meanwhile, the future value of deposit in Bank C that offers an interest rate of
12% is:
FV0.123 = RM100(FVIF12%,3)

= RM100(1.405)

= RM140.50

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The examples above can also be applied on either the principal value or the time
period by assuming that the other variables are constant. You will discover that
the future value has a positive correlation with the time period (n) and the
interest rate (i) as shown in Figure 3.2.

Figure 3.2: Relationship among interest rate, time period and future value for RM100

ACTIVITY 3.1
As a bank manager, what are your strategies in attracting more people
to deposit and invest in your bank?

3.2

CONCEPT OF DISCOUNTING AND PRESENT

VALUE
SELF-CHECK 3.2

In your opinion, how is the concept of discounting and present value

different from compounding and future value?

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The second concept that is related with the time value of money is the concept of
cash flow discounting. This concept is used to ascertain the present value (PV0)
or principal value for a sum of money in the future (FV0) that is discounted at an
interest rate known as rate of return (i) for the valuation period (t).
The process to determine the present value is the reverse process of determining
the future value. The relationship between these two processes is illustrated in
the time line as shown in Figure 3.3.

Figure 3.3: Comparison between future value and present value

3.2.1

Calculation of Present Value

The process of discounting is the reverse process of compounding. The present

value (principal) can be found with a small variation to the basic formula of
calculating the future value (formula 3.1).
Example 3.4
Assume you expect to receive RM2,500 a year from now. How much is the
present value for RM2,500 if the discount rate or rate of return is 8% per year?

FVn

PV0 (1 i)n

RM2,500 PV0 (1 0.08)1

PV0

RM2,500
1.08
RM2,314.81

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How much must you invest if you expect to receive of RM2,500 in the period (a)
2 years and (b) 3 years at a discount rate of 8% per year?

FV2

PV0 (1 i)2

RM2,500 PV0 (1 0.08)2

PV0

RM2,500
(1 0.08)2
RM2,143.35

FV3

PV0 (1 i)3

RM2,500 PV0 (1 0.08)3

PV0

RM2,500
(1 0.08)3
RM1,984.58

The present value of RM2,500 at a rate of 8% in period 1, 2 and 3 years are as

follows:

If the discounting period is extended to tn, the principal amount that must be
invested is

PV0 =

FVn

(3.3)

(1+i)n
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Or
PV0 = FVn [1/(1+i)n]

EXERCISE 3.3
1. You want RM1,100 in your account a year from now. How much
investment must you make now if the interest rate offered by the
bank is 10%?
2. Seri Sdn Bhd offers a low risk security that promises a payment of
RM3,000 at the end of 2 years period with an offer of 15% interest
rate per year. What is the present value for RM3,000?

3.2.2

Calculation of Present Value (Principal) using

Schedule/Table

Similar to the future value factor, the present value factor can also be obtained by
using a schedule that is the Present Value Interest Factor (PVIFi,n) as attached in
Attachment B. This schedule helps to simplify the calculation of present value
especially in complex problems. Equation 3.4 shows that the present value (PV0)
is equal to the future value amount (FVn) multiply with the present value interest
factor (PVIFi,n).
PV0 = FVn (PVIF i,n)
(3.4)

As a basic guide on the use of the financial schedule, please refer to the extract on
the schedule of Present Value Interest Factor (PVIFi,n) in Table 3.2 to solve
examples 3.5 and 3.6.
Example 3.5
Assume you expect to receive RM3,999 in 3 years time. How much is the present
value for RM3,999 if the discount rate or rate of return is 9% per year?
PV0 = FVn (PVIF i,n)
= RM3,999 (PVIF 9%,3)
= RM3,999 (0.772)
= RM3,087.23

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Example 3.6
You intend to accumulate RM5,713 in a bank savings account in 4 years. How
much savings must you deposit now if the interest rate offered by the bank is
10% per year?
PV0 = FVn (PVIF i,n)
= RM5,713 (PVIF 10%,4)
= RM5,713 (0.683)
= RM3,901.98
Table 3.2: Extract of Present Value Interest Factor Schedule (PVIF i, n)

It must be remembered that sometimes you might come up with a different

answer by using manual calculation compared to the calculations using the
schedule. This is due to the different numbers of decimal points used. However,
the difference is not obvious and both answers are acceptable.

EXERCISE 3.4
Use the schedule of present value interest factor to help you solve the
questions below:
1. Assume that you are given the opportunity to purchase a low risk
security that promised a payment of RM127.63 at the end of 5 years
with an interest rate of 5% per year. How much is the present value
for RM127.63?
2. You plan to accumulate RM6,213 in a bank savings account 5 years
from now. How much savings must you deposit now if the interest
rate offered by the bank is 12% per year?

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3.2.3

Graphical Illustration of Present Value

TIME VALUE OF MONEY

To show how the interest rate influences the present value (principal) of an
investment, we must assume that the future value and the time period are
constant. Therefore, any changes to the present value are caused only by the
interest rates.
Example 3.7
You intend to obtain a return of RM1,000 within 3 years in banks A, B and C that
offer different compounding interest rates of 8%, 10% and 12%. What is the
principal value that you should make?
The principal value for Bank A that offers an interest rate of 8% is:
PV8%,3 = RM1,000 (PVIF 8%,3)
= RM1,000 (0.7938)
= RM793.80
The principal value for Bank B that offers an interest rate of 10% is:
PV10%,3 = RM1,000 (PVIF10%,3)
= RM1,000 (0.7513)
= RM751.30
The principal value for Bank C that offers an interest rate of 12% is:
PV12%,3 = RM1,000 (PVIF12%,3)
= RM1,000 (0.7118)
= RM711.80
The examples above can also be applied either in the future value or time period
by assuming that the other variables are constant. You will find that the present
value has a negative relationship both with the time period (n) and interest rates
(i) as shown in Figure 3.4. This graph explains that the principal value of
RM1,000 that will be received in the future will decrease when the acceptance
period is extended. The rate of decrease for present value is higher with the
increase in discount rates or interest rates.

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Figure 3.4: Relationship between interest rate, time period and future value for RM100

3.3

FUTURE AND PRESENT VALUES OF A

SINGLE CASH FLOW

Single cash flow is a cash flow that only occurs once throughout the period of
valuation. Both the concepts of compounding and discounting that were
explained earlier have used the examples of single cash flow.
The examples stated clearly show that the future value of an amount of single
cash flow invested presently will increase from time to time with the existence of
specific interest rates. In reverse, a sum value of single cash flow that has been
determined in the future will decrease when time approaches zero (see Figure 3.5).

Figure 3.5: Single Cash Flow: Future value and present value

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3.4

TIME VALUE OF MONEY

FUTURE AND PRESENT VALUES OF A

SERIES OF CASH FLOW

The concepts of future value and present value are not limited to the process of
compounding and discounting single cash flow only. These concepts can be
applied to a series of cash flow.
A series of cash flow means that there are a series of receiving or payments of
cash that occur throughout the valuation period. There are several categories of
series cash flow which are annuity, derivation cash flow and perpetuity.

3.4.1

Annuity

Annuity is a series of payment or receiving of the same amount at the same

intervals throughout the period of valuation. Therefore, a cash flow of RM5 each
month for one year is an annuity. While a cash flow of RM5 that is swap
alternately with a cash flow of RM10 each month for a year is not an annuity.
Annuity has a clearly stated starting point and an ending, in other words,
annuity cash flow would not be indefinite. Normally, annuity occurs at the end
of each period and this annuity is known as ordinary annuity. However, in some
cases, annuity occurs at the beginning of the period and this type of annuity is
called annuity due.
(a)

Future Value of Ordinary Annuity

Ordinary annuity is annuity that occurs at the end of each period as shown
in Figure 3.6.

Figure 3.6: Time line of ordinary annuity

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The finance manager often makes future planning for the company but he
usually does not know how much investment or savings that must be saved
continuously to accumulate the sum of money required in the future. The
future value of annuity is the number of annuity payments at a specific
amount (n) that will increase at a specific period based on a specific interest
rate (i).
Example 3.8
You had deposited RM100 at the end of each year for 3 years continuously
in the account that pays a yearly interest of 10%. How much is the future
value of this annuity?
The solution can be illustrated by the following time line:

First step:

Calculate the future value for t1, t2 and t3.

Second step:

Total the three future values to get the future value annuity
(FVA).

First step:
F1 = RM100(1+0.1)1
= RM100 (1.1)
= RM110
F2 = RM100(1+0.1)2
= RM100 (1.21)
= RM121
F3 = RM100 (no increase in the future value as the deposit was made at
the end of the third year).
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Second step:
FVA3 = F1 + F2 + F3
= RM110 + RM121 + RM100
= RM331
The steps shown in the example above takes time to do even though it is a
simple example. In cases where the calculation for future value of annuities
are for a period of 20 or 30 years, it will be slow with complicated
calculations. Therefore, we can simplify the calculations by using the
following formula:

FVA n =A

(1+i)n 1
i

(3.5)

FVAn = A(FVIFAi,n )

(3.6)

Equation 3.5 is used to solve the future value problems that involve
ordinary annuity is by manual calculation. While equation 3.6 is the
solution formula for ordinary annuity using schedule. Annuity future value
schedule can be obtained in Attachment C.
Example 3.9
Danon Company deposited RM5,000 at the end of each year for a period of
3 years consecutively in an account that pays a yearly interest of 10%. What
is the future value of this annuity?
(i)

Manual solution

FVA n

A [ (1 + i)n
i

1]

RM5, 000 [(1 + 0.10)3 1]

0.10
RM16, 550

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Solution using schedule

FVA n = A (FVIFA i, n )
= RM5, 000
= RM5, 000 (3.310)

= RM16, 550
The time line for future value of ordinary annuity of RM5,000 for 3 years at
a rate of 10% per year is as follows:

(b)

Future Value of Annuity Due

Sometimes we face a situation where the payment of annuity is at the
beginning of a period, for example, the beginning of each month or year.
This type of annuity is known as annuity due where it is different from
ordinary annuity as ordinary annuity is paid at the end of a period.
Annuity due occurs more frequently in future value annuity problems than
present value annuity (PVA). Figure 3.7 shows the time line for annuity
due.

Figure 3.7: Time line for annuity in advance

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The equation of annuity due can be formulated with a little alteration to the
ordinary annuity equation that is by multiplying the equation of ordinary
annuity with (1 + i). This alteration is made because the cash flow for
annuity due occurs at the beginning of a period.
(i)

Manual equation

FVA n

(1 + i) n 1
(1 + i)
i

(3.7)

(ii)

Equation using schedule

FVAn = A (FVIFA i,n) (1 + i)

(3.8)

Example 3.10 helps you to differentiate between ordinary annuity and

annuity due.
Example 3.10
Danon Company deposited RM5,000 at the beginning of each period for 3
years consecutively in the account that pays yearly interest of 10%. How
much is the future value for that annuity?
(i)

Solving manually
FVA n

(1 + i)n 1
(1 + i)
i

RM5, 000

[1 + 0.10)3 1] (1 + 0.10)
0.10

RM18, 205

(ii)

Solving using schedule

FVA n

A (FVIFAi, n ) (1 + i)
RM5,000 (3.310) (1.10)
RM18,205

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The time line for future value annuity due of RM5,000 for 3 years at an
interest rate of 10% per year is as follows:

From the solution above, we found that the future value for annuity due
(RM18,205 in example 3.10) is higher compared to the future value for
ordinary annuity (RM16,550 in example 3.9). This is because for annuity
due, the deposit is deposited in the beginning of the period and therefore
generates more interest compared to the ordinary annuity where the
deposit is deposited at the end of the period.

EXERCISE 3.5
Solve the questions below by using the manual formula or schedule
(FVIFAi,n).
1. Assume that you deposit RM100 into the bank at the beginning of
the year for 3 years in the savings account that gives 5% interest
rate. How much can be obtained at the end of the third year?
2. Mr Yeoh deposits RM10,000 into the bank on 31 December each
year for 5 years at an interest rate of 10%. How much can he obtain
at the end of the fifth year?

(c)

Present Value of Ordinary Annuity

Payment of annuity promises a return rate (investment in bonds) and cash
flow (cash flow resulting from investment in equipment and plant).
Therefore, it is important for a finance manager to know the value of the
investment at the present time.

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As an example, a finance manager finds an annuity that promises four

yearly payments of RM500 starting from the current year. How much must
be paid by the finance manager to obtain this annuity? The principal
amount that must be paid by the finance manager is the present value of
ordinary annuity.
The present value of ordinary annuity (PVAn) can be obtained by using the
manual equation (equation 3.9) or by using the financial schedule in
Attachment D (equation 3.10). Both the equations below refer to the present
value annuity (PVA n) equivalent to the annuity cash flow multiply by the
present value annuity factor.
(i)

Manual equation
PVA n = A

(ii)

[ 1 [1/(1 + i)n ]
i

(3.9)

Equation using schedule

PVAn = A (PVIFAi,n)

(3.10)

Example 3.11
Taming Company expects to receive RM3,000 at the end of each year for
3 consecutive years. How much is the present value of this annuity if it is
discounted at the rate of 6% per year?
(i)

Solution via manual equation:

PVA n =A

[1[1 / (1+i)n ]
i

=RM3,000

[1 [1 / (1+i)3 ]
0.06

=RM8,019.04
(ii)

Solution via equation using schedule

PVAn = A (PVIFAi, n)
= RM3,000 (PVIFA6%,3)
= RM3,000 (2.673)
= RM8,019
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The time line for present value ordinary annuity of RM3,000 for 3 years at a
discounted rate of 6% per year is as follows:

(d)

Present Value of Annuity Due

The concept of forming equation for present value of annuity due is as per
the future value of annuity due where it is based on a small alteration to the
ordinary annuity equation that is by multiplying equation 3.9 and 3.10 with
(1 + i).
PVA n = A

1 [1/(1 + i)n
i

(1 + i)

(3.11)

Example 3.12 can help you to differentiate between ordinary annuity with
the annuity due for present value.
Example 3.12
Taming Company expects to receive RM3,000 at the beginning of each year
for 3 consecutive years. How much is the present value of this annuity if it
is discounted at the rate of 6% per year?
(i)

Manual solution:

PVAn

[1/(1 + i)n
i

RM3,000

[1

(1 + i)

[1/(1 + 0.063)3 ]
(1 + 0.06)
0.06

RM8,500.18

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(ii)

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Solution using schedule:

PVA n

A (PVIFA i,n ) (1 + i)
A (PVIFA6%,3 ) (1 + 0.06)
RM3,000 (2.673) (1.06)
RM8,500.14

The time line for present value annuity due of RM3,000 for 3 years at a
discounted rate of 6% per year is as follows:

As per the difference between ordinary annuity and annuity due for
future value, the solution for present value of annuity due (RM8,500 in
example 3.12) is also higher compared to the present value of ordinary
annuity (RM8,019 in example 3.11). This is because in annuity due, the
deposit is deposited in the beginning of the period and therefore generates
interest longer compared to ordinary annuity.

EXERCISE 3.6
You are offered an annuity payment of RM100 at the end of each year
for 3 years and is deposited into the bank. The interest rate offered is
5% per year. How much is the present value of that annuity payment?

3.4.2

Non-uniform Cash Flow

There are many decisions in the financial field, for example involving capital
budgeting and dividend payments contain a mixture of cash flow or cash flow
that is irregular. The calculation of future value and present value of an irregular
cash flow is a combination concept of determining money value for single cash
flow and also annuity.
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Future Value of Non-uniform Cash Flows

The calculation for future value of non-uniform cash flow involves the
determination of future value for each of the cash flows and subsequently
totalling all that future values. The formula in equation 3.12 shows the
future value (FVn) is obtained by adding each of the cash flow (Pt) that is
adjusted with the exponent (n t) that is the number of periods in which
the interest is obtained.
Exponent is used in this formula because the last cash flow happens at the
end of the last period. Therefore, interest is not obtained for it. The sigma
symbol ( ) is the mathematical symbol for a total of a series of value.
(i)

Manual equation
n

Pt (1 + i)nt

FVn

(3.12)

t 1
If solution by using the schedule is chosen, you can use the formula in 3.2,
3.6 or 3.8 according to the suitability of the cash flow. This is because the
calculation of future value of irregular cash flow is a combination concept
of determining the value of money for single cash flow and also annuity.
Example 3.13
Bikin Fulus Company made a decision to deposit RM2,000 at the end of the
first and second year, withdrawing RM3,000 at the end of the third year
and depositing RM4,000 again at the end of the fourth year. How much is
the future value of these cash flows at the end of the fourth year if the
annual interest rate is 10% per year?
(i)

Solution via manual formula

n

Pt (1 + i)n

FVn

t 1

(RM2,000)(1.10)4 1 + (RM2,000)(1.10)4 2 + ( RM3,000)(1.10)4

+ (RM4,000)(1.10)4-4
RM5,782

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Example 3.13 can be illustrated by using the time line as follows:

(ii)

Solution by using schedule

Step 1:
Find the future value of annuity for RM2,000 for 2 years (end of second
year).
RM2,000 (FVIFA10%, 2)

= RM2,000 (2.10)
= RM4,200

Step 2:
Find the future value of RM4,200 at the end of fourth year.
RM4,200 (FVIFA10%, 2)

= RM4,200 (1.21)
= RM5,082

Step 3:
Find the future value at the end of fourth year for the withdrawal of
RM3,000 that occurred at the end of third year.
RM3,000 (FVIFA10%, 1) = RM3,000 (1.10)
= RM3,300

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Step 4:
The present value cash flow is obtained by adding the result of Steps 2
and 3 with the final cash flow of RM4,000. As RM4,000 occurs at the
last period, there is no interest earnings from it.
FV4 = RM5,082 + (RM3,300) + RM4,000
= RM5,782
(b)

Present Value of Non-uniform Cash Flows

Similar to the concept in determining the future value of derivation cash
flow, the present value of irregular cash flows is also a combination concept
of present value of single cash flow and annuity.
Manual equation:
n

PV0

Pt [1/(1 + i)t ]

(3.13)

t 1

If solution by using the schedule is chosen, you can use the formula in
present value of single cash flow, present value of ordinary annuity or
present value of annuity in advance according to the suitability of the type
of cash flow stated in the problem.
Example 3.14
Buat Pitih Company expects to receive RM1,000 at the end of the first and
second year, RM2,000 at the end of the third year and RM4,000 at the end of
the fourth year. How much is the present value of the cash flow if the
yearly interest rate is 10% per year?
(i)

Solution via manual formula

n

PV0

Pt (1 + i)t

t 1

[RM1,000][1/(1.10)1 ] [RM1,000][1/(1.10)2 ]
[RM2,000][1/(1.10)3 ] [RM4,000][1/(1.10)4 ]
RM5,970.22

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The time line for example 3.14; present value for derivation cash flow is as
follows:

(ii)

Solution via schedule

Step 1:
Find the present value for annuity of RM1,000 for 2 years.
RM1,000 (PVIFA10%, 2) = RM1,000 (1.736)
= RM1,736
Step 2:
Find the present value for RM2,000 that occurs at the end of third year.
RM2,000 (PVIF10%, 3)

= RM2,000 (0.751)
= RM1,502

Step 3:
Find the present value for RM4,000 that occurs at the end of fourth year.
RM4,000 (PVIF10%, 4)

= RM4,000 (0.683)
= RM2,732

Step 4:
The present value cash flow is obtained by adding all the previous results
earlier (figure bolded).
PV0 = RM1,736 + RM1,502 + RM2,732
= RM5,970

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117

Perpetuity

Perpetuity is a series of cash flow that involves the same amount for each period
continuously. In other words, perpetuity is an annuity that has an infinity period.
An example of perpetuity is the payment of dividends for preference shares.
The concept for future value of perpetuity is illogical and cannot be used in
making financial decisions as the concept do not predict the period ending point
while future value is something that can be expected. Instead, the concept for
present value of perpetuity can be applied in making financial decisions. For
example, the use of this concept to determine the present value for preference
shares and present value for pensions.
From the formula of present value of annuity, we know that:
PVA n = A

[ 1 [1/(1 + i)n ]
i

(3.14)

Try to imagine what will happen if the value of n increases. The value of (1 + i)n
will also increase. This will cause 1/(1 + i)n to become smaller. When (n)
approaches infinity, the value of (1 + i)n will become extremely big, while the
value of 1/(1 + i)n will approach zero.
The situation above can be summarised as follows:
PV p = P/i

(3.15)

Based on this equation, the present value of perpetuity is equivalent to the

payment of annuity amount (P) divided by the interest rate (i). Solution by
schedule and scientific calculator cannot resolve the present value of perpetuity.
This is because schedule PVIFA does not contain the value for infinity; similarly
scientific calculators too do not have an infinity key. Hence, it must be
calculated manually in stages.

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Figure 3.18 shows the position of variables in equation 3.15.

Figure 3.18: Present value of perpetuity

Example 3.15
Sukehati Company issued securities that promised a payment of RM100 per year
at the yearly interest rate of 8% to the holders of that security. How much is the
present value for this cash flow?
PVp = P/i
= RM100/0.08
= RM1,250
The financial schedule does not provide the factor for present value of perpetuity
because perpetuity involves an infinity period. Therefore, the solution for
perpetuity cases can only depend on manual calculations.

EXERCISE 3.7
Consider the perpetuity that pays RM100 per year, with an interest rate
of 10%. How much is the present value of this perpetuity?

3.5

COMPOUNDING AND DISCOUNTING

MORE THAN ONCE A YEAR

The practice of compounding or discounting interest more than once a year is also
known as intrayear compounding or discounting. For example, compounding or
discounting twice a year, three times a year, four times a year or each month. The
frequency of compounding or discounting several times in a year is a normal
practice in making financial decisions.
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When the frequency of compounding or discounting for future value or present

value is more than once a year, the time period will become (n m), the interest
rate must also be divided with the said frequency (i/m). The purpose is to adjust
the changes in the period and interest rate to enable both the variables to change
consistently. Therefore, a little alteration must be made to the formulas that had
been learned previously.
The formula for manual solution is:
FV = PV

(1 + i/m)nm

(3.16)

FV = Future value
PV = Present value
i

= Interest rate

m = Frequency of compounding or discounting in a year

n

= Number of years

While the solution by schedule is as follow:

FV = PV x (FVIF i/m,nm)

(3.17)

Example 3.16
The future value of RM1 now after 6 years, using the interest rate of 10% per year
with different compounding frequencies.
Presumed Compounding

nm

i/m

FVnm

Once a year

1=6

0.1/1 = 0.1

RM1.772

Twice a year

2 = 12

0.1/2 = 0.05

RM1.796

Four times a year

4 = 24

0.1/4 = 0.025

RM1.809

Every month

12 = 72

0.1/12 = 0.0083

RM1.817

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Example 3.17
The present value of RM1 received in 6 years from now, discounted at the
interest rate of 10% per year with different discounting frequencies.
Presumed Discounting

nm

i/m

PV0

Once a year

1=6

0.1/1 = 0.01

RM0.564

Twice a year

2 = 12

0.1/2 = 0.05

RM0.557

Four times a year

4 = 24

0.1/4 = 0.025

RM0.553

Every month

12 = 72

0.1/12 = 0.0083

RM0.550

The conclusion that can be made based on examples 3.16 and 3.17 are:
(a)

The higher the frequency of compounding, the higher the future value of
cash flow; and

(b)

Higher the frequency of discounting, the lower the present value of cash
flow.

3.6

CONTINUOUS COMPOUNDING AND

DISCOUNTING

Before this, you were only exposed to situations where the interest is compounded
or discounted at specific discrete intervals whether yearly or twice a year, monthly
and so forth. However, in some cases of time value of money, interest must be
compounded or discounted continuously or at each micro-second.
Referring to formula 3.16, FV = PV (1 + i/m)nm, we cannot divide the value (i)
with infinity and multiply (n) with infinity. Instead, we use the term (e) that is
e ~ 2.71828. The value e is an antilog to 1 and same as pi ( ) with value of 3.142,
which cannot be represented by one exact value but only as an estimated value.
The new formula for future value and present value that is compounded and
discounted continuously is as follows.
Future value:

FVn = PV0 (e in)(3.18)

Present value: PV0 = FVn (e in)

(3.19)

The estimate number for the symbol e in equation 3.18 and 3.19 is 2.72 (or more
accurately, 2.71828183).

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Example 3.18
What is the future value for RM100 that is invested now for 6 years with an
interest rate of 8% per year and compounded continuously?
Manual solution:
FVn = PV0 (ein)
= RM100 (2.72(0.08)(6))
= RM161.61
Example 3.19
What is the present value of RM161.61 that will be received in 6 years from now
that is discounted continuously at an interest rate of 8% per year?
PVn = FVn (ein)
= 161.61 (2.72 (0.08)(6)
= RM100

EXERCISE 3.8
1. What is the future value for RM260 that is invested now for 3 years
at the interest rate of 10 % per year and compounded continuously?
2. What is the present value for RM200 that will be received 5 years
from now and discounted continuously at the interest rate of 6%
per year?
3. Mr Sarbat plans to invest RM3,000 a year in the Pension Investment
Scheme for a period of 15 years. Mr Sarbat wants to know the result
of the RM3,000 investment at the beginning of each year compared
with the end of each year. Calculate the value differences between
the two types of cash flow if the interest rate is 8% per year.

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4. Mas Joko Company is considering an investment on a new machine

that involves a total purchase and assembly cost of RM30,000. The
usage of this new machine is expected to generate a yearly cash
flow for 5 consecutive years: end of first year RM4,000, end of
second and third year RM5,000, end of fourth year RM6,000 and
end of fifth year RM8,000. If the company requires a yearly 18%
rate of return on its investment, is it reasonable for the company to
continue with its investment?
5. Compute the present value for a series of indefinite yearly
payments of RM180, assuming that the interest rate is:
(a)

5 % per year

(b)

10 % per year

6. You have just won a puzzle contest where you were offered
two choice of prizes that is whether to accept RM60,000 today or
RM12,000 at the end of each year for 5 consecutive years. If the cash
flow is discounted at a yearly rate of 12% and compounded twice a
year, which prize would you choose?
7. Mrs Aimi plans to get a loan for a total of RM6,000 at the interest
rate of 10% from a kind-hearted money lender. The money lender
agrees to receive a sum of payment for the same amount at the end
of each year for 4 years. What is the size of payment that Mrs Aimi
must give to the money lender each year?
8. What is the present value for RM400 that will be received in 7 years
from now and discounted continuously at the interest rate of 10%
per year?

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This topic explains the key conceptual and computational aspects of the time
value of money. It is important to understand the role of time value of money
when assessing the value of the expected cash flow streams associated with
investment alternatives either based on compounding to find future value or
discounting to find present value.
What you have learned in this topic will enhance your understanding in
various areas of financial management including the valuation of bonds and
shares as well as determining the value of a new project.

Annuity

Future value

Annuity due

Ordinary value

Cash flow

Perpetuity

Compound interest

Present value

Compounding

Simple interest

Discounting

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Valuation of
Securities

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Define the term value as used in different context;
2. Describe the characteristics and types of bonds;
3. Calculate the value of a bond and yield to maturity of a bond;
4. Assess the relationships that exist in bond valuation; and
5. Calculate the value of ordinary shares based on zero growth,
constant growth rate and differential divided growth.

INTRODUCTION
Valuation is a very important concept in finance. The process of valuation takes
into consideration specific factors that can influence the value. This topic
discusses the general concept of valuation and the process of bonds valuation.
The topic of discussion will touch on the characteristics of bonds, rating of bonds,
types of bonds, evaluation of bonds, rate of yield upon maturity and the
correlation between value and rate of yield upon maturity.
In Topic 4, you will be exposed to the basic concept of valuation. In this topic, we
will discuss the intrinsic value or economic value that has been identified as
present value of cash flow that is expected to be generated in the future by an
investment or asset.

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Subsequently, we will continue with the discussion related to the valuation of

financial assets with focus on the valuation of shares. In this topic, we will
discuss two types of shares that are ordinary shares and preference shares. As
you are aware, the objective of a finance manager is to maximise the value of the
companys ordinary shares. Therefore, you must understand how to identify the
value of shares.

4.1

VALUATION
SELF-CHECK 4.1

Explain the difference between book value, liquidated value, market

value and intrinsic value.

Valuation on an asset is a subjective matter. Every individual have different

perceptions on the value of specific asset. The valuation term is also used in
different contexts. There are individuals that value assets by referring to the
companys balance sheet. The value obtained with this method is known as book
value. However, if valuation is made based on the price of the same asset found
in the market, then the value obtained by this method is known as market value.
When a business is in the process of liquidation and most of the assets will be
auctioned by offering a lower price to ensure that it can be sold, and then this
sales price will be known as liquidation value. Assets can also be valued based
on the benefit that can be obtained from the assets. This value is called the
intrinsic value or economic value.

4.1.1

Definition of Value

There are several definitions of value that is used in different contexts.

(a)

Book Value
Book value is the value of an asset as stated in the balance sheet of the
company. It is also known as historical value. For example, you purchase a
business premise two years ago at a price of RM100,000. The book value is
the actual value that was paid for the asset at the time it was bought, that is
RM100,000. This value may not be the same with the current market value.
Assets such as machines and vehicles will have depreciation in value and
the book value is the price of the asset at the time it was purchased minus
its accumulated depreciation.
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(b)

Liquidation Value
Liquidation value is the value that will be obtained when an asset is sold
separately and not as part of going concern. For example, if the company is
no longer in operation and needs to be liquidated, then, the assets will be
sold separately and the sales price is the assets liquidation value.

(c)

Market Value
Market value is the value of assets available in the market as determined by
forces of demand and supply in the market. For example, the market value
of ordinary shares that is found in Bursa Malaysia is the sale and purchase
value that is agreed among the investors through an intermediary such as
brokers.

(d)

Intrinsic Value
Intrinsic value is also known as economic value and is the sum of all the
potential cash flows that will be obtained from the asset after discounting at
the rate of return required by the investors. The amount obtained is
regarded as the fair value based on the amount, time and risk level of all
the expected cash flow. This value is normally compared with the market
value. If the intrinsic value is higher than market value, then in the opinion
of the investors, the asset was undervalued. However, if the intrinsic value
is lower than market value, it will be regarded as overvalued. If the market
is efficient, the intrinsic value and the market value will be the same as the
value of the securities traded will always depict all general information
available.

4.1.2

Valuation Process

The valuation process is a process to determine the value of an asset at a specific

period by using the technique of time value of money. As has been stated, the
intrinsic value of an asset is sum of expected cash flows that discounted at a rate
of return required by the investors. There are three main factors that influence
the value of an asset, these are:
(a)

Total Cash Flow (Return)

The value of an asset depends on the total cash flow that is expected. To
obtain this return value it does not only involve a yearly cash flow but also
a single cash flow for a specific period. For example, you as an investor,
expect that you will obtain a dividend of RM0.30 per share every year for a
period of 5 years if you invest in the shares of Antah Company.

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(b)

Timing
To estimate cash flow, you must know the timing for each cash flow. For
example, you will make an investment after you expect that you will obtain
RM2,000 in year 1, RM4,000 in year 2 and RM5,000 in year 3.

(c)

Required Rate of Return

The risk level can have direct effect on the value. Generally the higher the
risk of the cash flows, the lower the value. According to the CAPM model,
the higher the risk that is measured by beta ( ), the bigger the return (k).
The higher the risk means the bigger the rate of return and the lower the
risk means the smaller the rate of return. The determination of the rate of
return required by investors takes into consideration the investors attitude
towards risk and the investors perception on the level of risk for the asset.
Figure 4.1 shows the basic factors to determine the value of assets.

Figure 4.1: Basic factors in determining the value of assets

General rules on cash flow and valuation:

(a)

From the aspect of amount the higher the amount of cash flow, the better.

(b)

From the aspect of timing the sooner it is received, the better.

(c)

From the aspect of risk the lower the level of risk, the better.

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4.1.3

Basic Model of Valuation

VALUATION OF SECURITIES

The valuation process is the process in giving value to an asset by calculating the
present value of all the expected cash flows from the asset. It uses the rate of
return required by the investors as the discount rate.
There are three basic steps in the valuation process:
(a)

Estimating the amount and timing of cash flows that would be received
(CFt).

(b)

Determining the rate of return required by investors (k).

(c)

Calculating the intrinsic value of the assets that is, the present value of all
the cash flows that will be obtained from asset (V).

In the earlier topic you have learnt, that the present value is obtained from the
following formula:

Pn

F
1

(1 i)n

by replacing:
(a)

Pn1 to Vn1;

(b)

Fn to CFt; and

(c)

i to k;

we obtain this formula:

Vt

CFt
(1 k)t

If the valuation period is more than a year (t > 1), the formula above can be
expanded as follows:

V0

CF1

CF2
1

(1 k)
n

(1 k)

...

CFn
(1 k)n
(4.1a)

CFt

t=1 (1

k)t

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Where:
CFt = Cash flow expected to be received at time t.
V0 = Intrinsic value/present value of asset that will generate cash flow from
period 1 to n.
k

= Required rate of return (rate of discount)

= Period cash flow is expected to be received.

Formula 4.1a measures the present value for future cash flow and it is the basis
for the valuation process. It is very important as all the formulas in this unit are
based on this equation.

ACTIVITY 4.1
If you intend to buy land in Putrajaya, what is the value that you will
use? Why do you use that value?

EXERCISE 4.1
1. What is meant by valuation and why is it important for a finance
manager to understand this valuation process?
2. What are the three main elements in the valuation process of
assets?

4.2

BONDS

Bonds are long-term guarantee notes issued by borrowers. The bondholders will
receive interest at a fixed rate for a determined period. On the maturity date, the
bondholder will receive the interest and principal amount. The payment of fixed
interest on each period is the basic concept of annuity that we had discussed in
the earlier topic.
Figure 4.2 shows the concept of bonds in graphics. Based on the example in
Figure 4.2, these bonds have a maturity period of 5 years. It pays interest of
RM100 each year and has a face value of RM1,000.

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Figure 4.2: Concept of bond in graphics

4.2.1

Characteristics of Bonds

Bonds are fixed claims on the company and failure to fulfil this claim by issuers
can lead to the firms bankruptcy.
(a)

Claims on Assets and Earnings

Bondholders have priority in claims on the earnings and companys assets
compared to preference shareholders and ordinary shareholders. If the
company fails to settle the interest, the bondholders can classify the issuing
company as insolvent or incapable of paying debts and force the company
into bankruptcy.

(b)

Par Value
Par value or face value is the value stated on the bond document. It is the
amount that will be paid back to the bondholders on maturity date.
Usually, the bonds par value in the US is USD1,000 per unit, while in
Malaysia, its par value is RM100 per unit.

(c)

Coupon Rate
Coupon rate refers to the percentage of par value that will be paid to the
bondholders (investors) as interest based on the frequency that has been
specified. This rate is fixed throughout the lifespan of the bond and the
amount of interest payable is the same for each period.

(d)

Indenture
Indenture is a legal contract between the trustees who represents the
bondholders with the company that issued the bond. Indenture specifies
the terms and conditions related to the issuance of the bonds.

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Rating of Bonds

The issuance of bonds is given rating based on the potential risks that are related
to the said bonds. Ratings are valuation or grading done by specific agencies to
determine the quality of the bond in the aspect of default. If the rating of a bond
is high, this means that the possibility of default is low.
In Malaysia, there are two rating agencies, which are the Rating Agency Malaysia
Berhad (RAM) and the Malaysian Rating Corporation Berhad (MARC). Both
these agencies play important roles in the ratings of all bonds and commercial
notes issued, especially in the private debt security market.
The valuations by RAM are stated in alphabet symbols. For long-term loans that
is more than a year, the valuation of AAA indicates a high level of credit trust
while loans level between AA and BBB is generally regarded as a prudent
investment grade. Long-term loans rated as BB or lower are classified as
speculative grade.
The valuations by MARC are stated in symbols and symbols with numerical. For
long-term loans, its valuation is within the range of AAA D. For short-term
loans, its valuation is within the range of MARC-1 MARC-4.
Ratings are done via the financial ratio analysis and cash flow analysis by looking
at the capability of the company to fulfil its specific obligations in bonds. Besides
that, other factors will also provide positive effects on the ratings of bonds. For
example, the level of funding with equity, operations that are profitable, low
level of variables in previous returns and the size of the company.
Valuation given on a bond will influence the returns required by the investors.
The lower the ratings of the bond, the higher the rate of return that is required for
the bond and vice versa. Therefore, the finance manager must be aware of the
ratings given as it will have an effect on the rate of return that must be paid to the
investors.

ACTIVITY 4.2
Visit the websites of RAM at http://www.ram.com.my and MARC at
http://www.marc.com.my and see how the financial securities are
rated by both these agencies.

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4.2.3

Types of Bonds

VALUATION OF SECURITIES

Bond is the general term for debt security. It is issued in various types with
different characteristics. Therefore, there are several names for bonds. Among
them are:
(a)

Mortgage Bonds
Mortgage bond is a secured bond backed by tangible assets such as
buildings and land. Normally, the secured value imposed is higher than the
value of the bond issued. If the company that issued the bond is unable to
repay its loan on the maturity date, the secured assets will be sold to repay
the loan to the investors via a trust fund.

(b)

Debentures
Debentures refer to the long-term loans that are not secured with assets but
depend on the ability of the company that issued the bonds to obtain earnings.
This type of bond has a higher risk to the investors compared to secured
bonds. Therefore, the rate of return that is required by the investors is also
higher. This type of bond provides an advantage to the issuing company as no
property is charged. This enables the company that issued the bonds to
maintain its opportunity to borrow additional loans in the future.

(c)

High Yield Bonds

High yield bonds refer to the bonds that pay interest only if the issuing
company has surplus earnings. It is normally issued via the restructuring of
a company that fails to repay its debts. Upon the date of maturity, the
issuers still have to pay the face value of the said bonds.

(d)

Convertible Bonds
Convertible bonds refer to the bonds that can be converted by its holders to
ordinary shares at the price and conversion ratio that has been determined
by the issuing company when the bonds were issued. With this, the
investors are given the right to convert its status from creditor to owner
when the right of conversion is exercised.

(e)

Zero Coupon Bonds

Zero coupon bonds are bonds that do not pay interest and were issued at a
price lower than the par value. The bondholders will receive returns as a
result of the price differences during purchase compared to its face value
that will be paid at the date of maturity.

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(f)

Euro Bonds
Euro bonds are bonds that were initially issued in the European countries
using the American currency (USD) by foreign companies. Now, any bonds
that are issued in a country using a currency different from its own are known
as euro bonds. For example, bonds issued in Europe or Asia by American
companies but the interest and principal are payable in the value of the
American dollar.

(g)

Foreign Currency Bonds

Unlike euro bonds, foreign currency bonds are issued in the financial
market of a country using its own countrys currency by debtors or issuing
company of a foreign country.

ACTIVITY 4.3
Visit the following website http://rmbond.bnm.gov.my to obtain more
information regarding bonds in Malaysia. Based on the information
obtained, list the types of bonds that are found in our country and
compare them with the types of bonds that had been discussed.

SELF-CHECK 4.2
List the types of bonds and its characteristics.

4.3

VALUATION OF BONDS

In section 4.1.2 Valuation Process, we had discussed the three main factors that
influence the value of assets, which are the total cash flow, timing and required
rate of return. In the valuation of bonds, three important elements that influence
the valuation are (see Figure 4.3):
(a)

Amount and Timing of Cash Flow that Will be Received by Investors

This refers to the payment of annual interest and face value or principal
amount.

(b)

Maturity Date of Bond

This refers to the date that the bond issuer must pay the face value of the
bond to the bondholders.
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(c)

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Rate of Return Required by Investors

This rate of return takes into consideration the valuation of risk levels on
cash flow and the investors attitude toward risks taking. This is also a form
of return to the investors due to the opportunity cost faced by the investors.

Figure 4.3: Valuation of bonds using the time line

SELF-CHECK 4.3
What are the three important elements that influence the valuation
process of bonds? Explain.

4.3.1

Basic Valuation of Bonds

Bond value is the total present value of payments that must be paid by the issuer
to the bondholders from now until maturity period. In section 4.1.3 Basic Model
of Valuation, we had learned that the basic formula for valuation of assets is:

Vb

CF1

CF2
1

(1 k)
n

(1 k)

...

CFn
(1 k)n

CFt

t 1 (1

k)t

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We also know that bond has a maturity date and it also pays interest at a rate that
is constant for a fixed period. Therefore, the formula for valuation of bonds is
obtained by modifying the formula above to be as follows:

Vb

i
1

(1 k b )

(1 k b )

(1 k b )

...

i
(1 k b )

M
n

(1 k b )n

(4.2)

Or
n

Vb
t=1

I
(1 k b )

M
t

(1 k b )n

(4.2a)

As bond pays interest at a fixed rate for a fixed period, we can also use the
schedule for present value interest factor of annuity (PVIFA) to calculate the
value of bonds. The formula for valuation of bonds using the PVIFA schedule is
obtained by modifying the basic formula of present value annuity. The following
is the formula for valuation of bonds using the PVIFA schedule.

Vb =I (PVIFAkb, n ) + M (PVIFkb, n )

(4.2b)

Where:
Vb

= Intrinsic value or present price of bond

= Coupon payment

= Period of bond till maturity

kb

= Rate of return required for the bond

= Par value or face value of bond

PVIF

= Interest factor of present value

PVIFA = Interest factor of present value annuity

Example 4.1
Bond A has 10 years maturity period. The coupon rate is 10% per year and the
interest is paid every year. The par value of bond is RM1,000. The returns
required for the bond is 8% per year. What is the value of this bond?
Step 1:

Estimate the amount and timing of expected cash flow.

Step 2:

Determine the rate of return required to evaluate the cash flow risk of
the bond in the future. Assume that the rate of return required is 10%.
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Step 3:

Calculate the intrinsic value of the bond that is the present value of
interest that is expected to be received in the future and the payment
of the principal on date of maturity, discounted at the rate of return
required by the investors.

VALUATION OF SECURITIES

Value of the bond is:

Vb

100
(1.08)

100

100

(1.08)

92.59

85.73

(1.08)
79.37

100
(1.08)4

73.53

...

100

1,000
10

(1.08)

68.03

63.01

(1.08)10
58.38 54.02

50 46.32 463.18
RM1,134.16
Or
Vb = PV (coupon payment) + PV (par value)
= I (PVIFAkb,n) + M (PVIFkb, n)
= 100 (PVIFA 8%, 10) + 1,000 (PVIF8%,10)
= 100 (6.710) + 1,000 (0.463)
= 671 + 463
= RM1,134
(Note: The difference between the answers that are calculated using
the formula and schedule PVIFA is small and is caused by the decimal
point. Both the answers are acceptable.)
The calculation result above can be illustrated through Figure 4.4. We
found that the intrinsic value or actual value for the bond is
RM1,134.21. If the rate of return required is 8%, then the price is
reasonable. If the market price of the bond is sold at a higher price
than RM1,134.21, then in the perspective of the investors it is
expensive. Instead, if the market price is less than the actual value of
the bond, then it is a good investment.

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Figure 4.4: Calculating the value of bond using the time line

4.3.2

Value of Bonds and Required Rate of Return

When the required rate of return is different from the bonds coupon rate, the
value of the bond will be different from the par value. The changes to the
required returns are caused by:
(a)

Changes in the economic situation that causes the cost of long-term funds
to change as well; or

(b)

Changes in companys risks.

The increase in the long-term funds cost or risk will increase the required rate of
return. Instead, the decrease in long-term funds cost or risk will reduce the
required rate of return.
There are three different situations that can be used to show the relationship
between the required rate of return and the value of the bond.
(a)

Required Rate of Return is Larger than the Coupon Interest Rate (kb> i)
Example 4.2
Bond A has a maturity period of 10 years with the coupon interest rate of
10% per year and interest payable every year. The face value is RM1,000.
The required return for this bond is 12% per year.

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Vb = PV (coupon payment) + PV (par value)

= I (PVIFAkb,n) + M (PVIFkb,n)
= 100 (PVIFA12%,10) + 1,000 (PVIF12%,10)
= 100 (5.650) + 1,000 (0.322)
= RM887.00
V = Present value of bond
M = Face value/Par value
V < M
In this situation, the value of the bond (Vb) is smaller than par value,
M (Vb < M). If this bond is traded, its transaction will be at a price lower
than par value. Therefore, it can be called a transaction at a discounted
price.
(b)

Required Rate of Return is Lower than the Coupon Interest Rate (kb< i)
Example 4.3
Bond A has a maturity period of 10 years with the coupon interest rate of
10% per year and interest payable every year. The face value is RM1,000.
The required return for this bond is 8% per year.
Vb = PV (coupon payment) + PV (par value)
= I (PVIFAkb,n) + M (PVIFkb,n)
= 100 (PVIFA8%,10) + 1,000 (PVIF8%,10)
= 100 (6.7101) + 1,000 (0.4632)
= RM1,134.21
In this situation, the value of bond (Vb) is larger than par value (Vb > M). If
this bond is traded, its transaction will be at a price higher than par value.
Therefore, it can be called a transaction at a premium price.

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(c)

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139

Required Rate of Return is Same Value with Coupon Interest Rate (kb = i)
Example 4.4
Bond A has a maturity period of 10 years with the coupon interest rate of
10% per year and interest payable every year. The face value is RM1,000.
The required return for this bond is 10% per year.
Vb = PV (coupon payment) + PV (par value)
= I (PVIFA kb, n) + M (PVIF kb, n)
= 100 (PVIFA 10%, 10) + 1,000 (PVIF 10%, 10)
= 100 (6.1466) + 1,000 (0.3855)
= RM1,000.16

In this situation, the value of bond (Vb) is the same with the par value (Vb=M). If
this bond is sold or purchased, its transaction is at the same price with the par
value. Therefore, it can be called a transaction at par value.
Table 4.1 shows the conclusion on the relationship between the values of bond
with the required rates of return. The value of bond has a inverse relationship
with the required rate of return that is, if the investors require higher returns, the
value of the bond will decline.
Table 4.1: Value of Bond at Different Required Rates of Return
Required Rate of
Return, kd(%)

Coupon Interest Rate,

i (%)

Value of Bond, Vb

Status

(RM)

12

10

887.00

Discount

10

10

1,000.00

Par Value

10

1,134.21

Premium

As in examples 4.2 to 4.4, when investors required a return of 12% compared to

the coupon rate of 10%, the value of bond will fall below par, which is to RM887
and is sold at a discount. On the other hand, the decrease in the required rate of
return that is 8% compared to the coupon rate of 10% will cause an increase in
the value or price of the bond to RM1,134.21 and it is sold at premium price.
When the required rate of return is the same as the coupon rate, the value of the
bond is the same with par value.
The current interest rate is used as the basis to the rate of return required by the
investors. Therefore, it has a inverse relationship with value or price of bond.
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4.3.3

Payment of Interest Twice a Year

VALUATION OF SECURITIES

The valuation process of bonds that pay interest twice a year is the same with
the concept of calculating interest that is compounded more than once a year.
The discussion on interest compounded more than once a year was covered in
Topic 3.
The formula for interest compounded more than once a year is as follows:

PV=

FV
(1+i/m)nm

In the formula:
PV = Present value
FV = Future value
i

= Interest rate

m = Frequency of compounding or discounting

n

= Period

To calculate the value of bonds that pay interest twice a year,

(a)

Change the annual interest (I) to interest twice a year by dividing (I) with 2;

(b)

Change the number of maturity period, n, to every 6 months by

multiplying n with 2 (n 2); and

(c)

Change annual required rate of return, kb, to each half yearly by dividing
kb into 2 (kb/2).

Therefore, the valuation formula for bonds with coupon payments of twice a
year is:
2n

Vb

t 1 (1

I/2
k b /2)

M
t

(1 k b /2)2n

(4.3)

or
Vb = I (PVIFAkb/2,2n) + M (PVIFkb/2,2n)

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Where:
I

= Coupon rate

Par value

n = Period
kb = Required rate of return
Example 4.5
Maya Enterprise Company had issued bonds that have a maturity period of
8 years with a coupon rate of 8% that is payable every 6 months. The par value of
the bond is RM1,000. If the required rate of return is 10%, what is the value of the
bond?

Vb

I
(PVIFA kb/2,2N ) M(PVIFkb/2,2N )
2
RM80
(PVIFA10%/2,8 2 ) RM1,000(PVIF10%/2,8 2 )
2
RM40(PVIFA 5%,16 ) M(PVIF5%,16 )
RM40 (10.8378) RM1,000 (0.4581)
RM891.61

ACTIVITY 4.4
Do not invest your money until you have fully understood all the
information related to investment. Give your opinion on this
statement.

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EXERCISE 4.2
1. Calculate the value of a bond that has a maturity period of 12 years
with a face value of RM1,000. The coupon rate is 8% and the
required rate of return is 13%.
2. Calculate the value of a bond that has a maturity period of 8 years
with a par value of RM1,000. The coupon rate of 12% is payable
twice a year and the required rate of return is 10%.
3. How do coupon payments of more than once a year affect the value
of the bond?

4.4

YIELD TO MATURITY

Every individual who invests has a minimum expected rate of return from each
investment. This is known as the required rate of return and is different for every
investor. The finance manager will only be attracted to high rates of return. This
is because the present price of bonds reflects the rate of return that is expected to
be received by investors.
Yield to maturity or YTM is the rate or return that will be obtained by the
investors if the bond is hold until maturity. This expected rate of return is also
known as yield to maturity if the investors hold the bonds until its maturity
period. Therefore, when we refer to bonds, the terms expected rate of return and
yield to maturity are used interchangeably.
Yield to maturity is the discount rate that equals the present value for all interest
payments and principal payment of bond with the present value of bond. It can
be calculated using the basic formula for valuation of bonds (formula 4.3b).
Vb = I (PVIFAkb,n) + M (PVIFkb,n)

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143

This discount rate can also be calculated using the PVIF schedule by a method of
trial and error. Through this trial and error method, different discount rates, k,
will be applied in the formula for valuation of bonds until the present value of
the bond cash flow is similar to market value. If this rate is located between the
rates found in the schedule, the interpolation method will be used to obtain the
exact value. To explain this concept in detail, let us look at Example 4.6.
Example 4.6
Orlid Bhd issued bonds that have a par value of RM1,000 with a coupon rate of
10% per year and a maturity period of 10 years. The present price of the bond is
RM1,080. As the price of the bond is higher than the par value (P0 > M), then the
rate of yield to maturity is smaller than the coupon interest rate (k < I). This
shows that the rate that must be found must be lower than 10%. To begin the
process of looking for the discount rate, the rate of 9% will be used.
RM1,080 = I (PVIFAk,n) + M (PVIFk,n)
= 100 (PVIFA9%,10) + 1,000 (PVIF9%,10)
= 100 (6.4177) + 1,000 (0.4224)
= RM1064.17
When we use the discount rate of 9%, the value of bond obtained, that is
RM1,064.17, is lower than the market value, that is RM1,080. To increase the
value we are searching for, the rate of discount must be decreased to 8%.
RM1,080 = I (PVIFAk,n) + M (PVIFk,n)
= 100 (PVIFA8%,10) + 1,000 (PVIF8%,10)
= 100 (6.7101) + 1,000 (0.4632)
= RM1,134.21
When we use 8% as the discount rate, the value of bond obtained is more than its
market value. This shows that the rate of yield to maturity is between 8% and 9%
as illustrated in Table 4.2.
Table 4.2: Searching for the Value of Bond by Using the Trial-and-Error Method
Rate

Value

8%

RM1,134.21

YTM

RM1,080.00

9%

RM1,064.17

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Next, use the interpolation method to obtain the rate of yield to maturity more
accurately.
Step 1:

Calculate the difference between the value of bond at the rate of 8%

and 9%.
Difference in Value = RM1,134.21 RM 1,064.17
= RM70.04

Step 2:

Calculate the difference between the value required that is the rate of
yield to maturity with the value of the bond at a discount rate that is
lower, that is 8% (disregard the symbol of minus or plus).
Difference in Value = RM1,134.21 RM1,080.00
= RM54.21

Step 3:

Divide the value obtained in Step 2 with the result obtained in Step 1.
Ratio obtained = RM54.21/RM70.04
= 0.774

Step 4:

Add to the value calculated with the rate of discount that is lower and
multiply it with the gap in discount rate to obtain the rate of yield to
maturity.
Rate of yield to maturity = 8% + [0.774
Rate (%)

Value (RM)

1,134.21

YTM

1,080.00

Value (RM)
1,134.31
1,064.17

Difference

YTM 8%

(9% 8%)] = 8.774%

RM54.21

RM70.04

54.21
(9% 8%)
70.04

8% (0.774 1%)
8.774%

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Besides the interpolation method, you can also use the estimation method to
calculate the rate of yield to maturity by using the following formula:
i
YTM

M P0
n
M P0
2

(4.4)

Where:
i

= Coupon rate

M = Par value
P0 = Market value of bond
n = Number of years for bond until maturity
Furthermore, by using equation 4.4, you can obtain the rate of yield to maturity
as follows:
100
YTM

1,000 1,080
10
1,000 1,080
2

0.0885
8.85%
Through this estimation method, we find that the rate of yield to maturity is
8.85%. This answer is not as accurate as when we use the trial-and-error method
and interpolation method that is 8.774%.

EXERCISE 4.3
Bond A has a par value of RM1,000 and pays interest of RM82 per year.
The maturity period for Bond A is 5 years and the present market price
is RM720. How much is the yield to maturity for Bond A? Use the trialand-error method as well as the estimation method to obtain the yield
to maturity.

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4.5

VALUATION OF SECURITIES

RELATIONSHIP BETWEEN VALUE AND

YIELD TO MATURITY

When the required rate of return is different from the coupon interest rate, and it
is assumed constant until the maturity period, the market value of bond will
approach the par value when it is closer to the maturity period.
Figure 4.5 shows the movement of the bond value based on the calculation from
Table 4.1. The required rates of return of 12%, 10% and 8% are assumed constant
throughout the 10 years for bond maturity and the par value is assumed the
same that is RM1,000.
(a)

When the required rate of return is the same as the coupon rate of the bond,
that is 10%, the value of bond and is remain constant or maturity period,
that is RM1,000.

(b)

When the required rate of return is 12%, value of the bond increases from
RM887 to RM1,000 when time passes and approaches the maturity period.

(c)

Finally, when the required rate of return is 8%, the premium value of the
bond decreases from RM1,134.21 to RM1,000 on maturity period.

This shows that when the required rate of return is assumed constant until
maturity, the value of the bond will reach par value of RM1,000 on maturity date.

Figure 4.5: Period until maturity and the value of bond

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147

Changes to Required Returns

As shown in Figure 4.5, the value of bonds has an inverse relationship with the
changes to the required rate of return of an investor. Generally, the increase in the
interest rate will cause a decrease in the value of bond. Instead, a decrease in the
interest rate will cause an increase in the value of the bond. This shows that, the
higher the rate of return required by an investor, the lower the value of the bond.
This is because the increase in interest rate will cause the bondholders to experience
loss in market value, the bond investors will be exposed to the risk of interest rate.
Therefore, the bondholders are always aware of the increase in interest rate. The
shorter the maturity period of the bond, the lower the response of market value
on the changes to the required rate of return. In summary, a shorter maturity
period will have lower interest rate risk compared to long-term bonds with the
assumption that the coupon rate, par value and frequency of interest payment
are the same.
Table 4.3 shows the value of the bond with different required rate of return and
different maturity period (summary of examples 4.2 and 4.3).
(a)

When the required rate of return decreased from 10% to 8%, the value of
bond with a maturity period of 10 years will increase by RM134.21,
meanwhile the value of bond with a period of maturity of 5 years will only
increase by RM79.87.

(b)

When the required rate of return increased from 10% to 12%, the value of
the bond with a period of maturity of 10 years will decrease by RM113.
Meanwhile, the value of the bond for 5 years will decrease by RM72.18.
Table 4.3: Effect of Bonds Maturity Period on Different Required Rate of Return
Required Rate of
Return
(%)

Value of Bond
10 Years
(RM)

Value of Bond
5 Years
(RM)

1,134.21

1,079.87

10

1,000.00

1,000.00

12

887.00

927.82

Based on the table and explanation above, it is clear that the changes to interest
rate has a bigger effect on the bonds with a longer maturity period compared to
bonds that have shorter maturity period.

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EXERCISE 4.3
1. Yield to maturity (YTM) is _______________.
A.

low for bonds with high risk

B.

returns are required on bonds

C.

similar with bonds coupons rate

D.

fixed throught the lifetime of bond

2. The discount rate used to value bonds is ________________.

(i)

coupon rate of the said bond

(ii)

interest rate in the market

(iii) rate determined by the company

(iv) fixed rate for the entire lifetime of the bond
A.

i.

B.

ii.

C.

i and ii.

D.

iii and iv.

3. Bonds were sold at _________ when the interest rate (coupon) is

more than the required rate of return; sold at _________ when the
interest rate is lower than the required rate of return; and were sold
at _________ when the interest rate is the same with the required
rate of return.
A.

premium; discount; same with par value

B.

premium; same with par value; discount

C.

discount; premium; same with par value

D.

same with par value; premium; discount

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EXERCISE 4.3

4. Which of the following statements is true?

A.

Short-term bonds have higher interest rate risk compared to

long-term bonds.

B.

Long-term bonds have higher interest rate risk compared to

short-term bonds.

C.

All bonds have the same interest rate risk.

D.

None of the above statements are true.

5. Choose the false statements regarding bonds.

(i)

Mortgage bond is a bond that is secured with property where

the value of the property usually exceeds the value of bond.

(ii)

Indenture is a type of bond with low level of priority claim.

(iii) Euro bond is a bond that is issued in one country using the
currency of the bond issuers' original country where the
principal and interest payments are according to the original
countrys currency.
(iv) Par value is the value of cash flow that is expected to be
received by the bondholders every year.
A.

iv only.

B.

i and ii only.

C.

ii and iv.

D.

i, iii and iv.

6. How much is the value of a bond with a par value of RM1,000, pays
interest of RM80 per year and matures in a period of 11 years?
Assume that the required rate of return is 12%.
7. Indah Air Berhad issued bonds that will mature in a period of 10
years. These bonds pay interest twice a year at a rate of 8% and the
par value of the bond is RM1,000. If the yearly required rate of return
each year by investors is 6%, what is the present market value of the
said bond?

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EXERCISE 4.3
8.

Bonds with a par value of RM1,000 were issued by KEE Company

and have another 15 years before reaching the maturity period.
The coupon rate promised is 5% per year, paid twice a year. The
market interest rate of bonds with similar risk level with this
companys bond is 6%. What is the present market value of this
bond?

9.

Ms Nadia bought bonds with a par value of RM1,000 at a price of

RM950 per share. These bonds pay a coupon rate of 9% per year,
paid yearly and will mature in another 2 years. Calculate the
yield to maturity for this bond.

10.

Company X has issued bonds with a par value of RM1,000 and a

maturity period of 3 years. The yearly coupon rate offered is 10%.
Rating Agency Malaysia Berhad (RAM) has given a rating of
AAA to the bonds of Company X.
(a)

If the required rate of return is 13%, what is the market

value of this bond?

(b)

If the bonds were sold at the price of RM975.98, what is its

yield to maturity (YTM)?

11.

What is meant by the yield to maturity of bonds?

12.

As a risk averse investor, would you choose, the long-term bonds

or short-term bonds to protect the effect of interest rate on bonds?

4.6

ORDINARY SHARES

Ordinary shares are securities that represent ownership in the company.

Bondholders can be portrayed as the creditors, while ordinary shareholders are
the actual owners of the company. The more ordinary shares held by an investor,
the bigger its portion of ownership in the company. Ordinary shareholders are
also known as equity owners.

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Ordinary shares do not have maturity period; it will remain forever as long as the
company is still in operation. It is the same from the aspect of dividend payment,
it is unlimited. Before dividends are paid, it must be announced earlier by the
companys board of directors. If the company goes bankrupt, the ordinary
shareholders, who are the owners of the company, cannot make any claims on
the assets before the claims by the creditors (including bondholders) and
preference shareholders are fulfilled.

4.6.1

Characteristics of Ordinary Shares

Before making valuation on ordinary shares, it is necessary for us to understand

first the characteristics of ordinary shares.
(a)

Claim on Earnings
As owners of the company, ordinary shareholders have rights on surplus
earnings, after the interest for bondholders and dividends for preference
shareholders have been paid. The earnings received, can either be direct or
indirect. Here, direct earnings come in the form of cash dividends, while
indirect earnings is in the form of retained earnings. Retained earnings are
indirect earnings because the earnings obtained are not distributed to the
ordinary shareholders but are used for re-investment with the hope of
increasing the value of the company.
Receiving surplus earnings has advantages and disadvantages to the
ordinary shareholders. The advantage is that there is no limit to the
earnings receivable. The disadvantage of receiving surplus earnings is that
shareholders might not receive anything if all the earnings were used to
fulfil the claims of creditors and preference shareholders. When the
company experiences deterioration in earnings, the ordinary shareholders
will have to bear the effects.

(b)

Claims on Earnings and Assets

If liquidation occurs, the ordinary shareholders will be the last to claim the
earnings and assets of the company after the claims of bondholders and
preference shareholders.

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(c)

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Voting Rights
Ordinary shareholders have rights to choose the board of directors of the
company. Ordinary shares are the only securities that grant the rights to
vote and the right to approve changes to the memorandum of incorporation
to its holders. Voting is conducted at the companys annual meeting. It can
be done individually or via a proxy. Most voting however is done by proxy.
Proxy means giving the right to a third party to vote on behalf of the party
who is unable to attend the annual general meeting of the company.
The voting procedures involve two methods, which are majority voting and
collective voting. Majority voting is the voting where each share owned
grants one right to vote to the shareholder and each position in the board of
directors will be voted separately. Therefore, the majority shareholders
have the opportunity to select all the members of the board of directors.
Through collective voting, each share grants a voting right equivalent to the
number of positions contested. Shareholders can choose to use all their
rights to vote a particular candidate or divide it among several selected
candidates. This method gives a chance to the minority shareholders to
appoint members of the board of directors who will represent them.

(d)

Pre-emptive Rights
Pre-emptive rights allows the shareholder to maintain the ownership in
hand if the company intends to issue new shares. Certificates will be sent to
the existing shareholders to purchase a predetermined number of shares at
a specific price and time period. Shareholders have the choice to exercise
those rights, leave it until the end of the period or sell them in the open
market.

(e)

Limited Liability
If liquidation of the company occurs, the liability of the ordinary
shareholders is only limited to the total investments in the company.

SELF-CHECK 4.4
State five basic characteristics of ordinary shares.

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VALUATION OF ORDINARY SHARES

SELF-CHECK 4.5

What is the main purpose of companys owners in selling their

companys shares in the share market?

Similar to how bonds are valued, the value of ordinary shares is also equivalent
to the present value of all cash flow that will be received by shareholders.
However, ordinary shareholders are not promised with fixed income or specific
payment upon maturity period such as bonds and preference shares. Ordinary
shareholders will receive returns in two forms, which are:
(a)

Dividends profits that are distributed to shareholders; or

(b)

Capital gain the difference between the selling price and the purchase
price of shares.

Dividends receivable depend on the profit of the company and the decision of
management to pay dividends or to retain earnings for the purpose of
reinvestment. The amount of dividend receivable is also not the same; it depends
on the companys profit and the rate of growth.
In general, the growth of the company has direct implication on the dividends
payable and the value of shares. The growth of the company can be achieved
through various ways. For example, through loans, issuance of new shares or by
merger with companies that are bigger and more solid. Normally, a company
will experience growth by the using new funding such as the issuance of bonds
and ordinary shares.
The growth of the company can also be achieved by internal growth; by retaining
a portion or all of the companys profit for the purpose of reinvestment.
Retaining profit is a form of investment by the existing ordinary shareholders.

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To illustrate more clearly on the internal growth, assume that the return on
equity of Meru Company is 18%. If the management decides to pay all the profits
as dividends to the shareholders, this means that there will be no internal growth
for the company. If the company retains all its profits, then the shareholders
investments in the company will grow in the same amount of profit retained,
which is 18%. If the company only retains 50% of its profits for investment
purposes, then the growth of the company will also be half that is 9%. In general,
this relationship can be concluded as follows:
g = ROE

r
(4.5)

Where:
g

= Rate of growth of earnings in the future and internal growth of

shareholders investment in the company

ROE = Return on equity (profit after tax/total equity)

r

= Percentage of profit retained by company

Therefore, if the company retains 25% of its profit, then the value of shares will
increase to 4.5%.
g = 0.18

0.25

= 0.045 or 4.5%

4.7.1

Valuation of Ordinary Shares One Holding

Period

In the previous topic, we had been informed that the value of ordinary shares is
the same with the present value of all cash flows that will be received by the
shareholders. For investors who hold ordinary shares for one period, for example
one year, the value of the share is equivalent to the present value of the
dividends receivable in the period of one year (D1) and the selling price of the
shares at the end of the period (P1). This is because both the cash flows occur at
the same time that is at the end of the period.

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The process of valuation ordinary shares involves three steps:

Step 1:

Assume the cash flow that is expected to be received in the future,

which is the amount of dividend and the selling price of the shares at
the end of the period;

Step 2:

Estimate the cash flow required by investors by taking into

consideration the risk of expected cash flow; and

Step 3:

Discount the dividend that is expected to be received and the price of

shares at the end of the period at the present value with the rate of
return required by the investors.

Example 4.7
Assume an investor plans to buy shares in Meru Company. It expects that the
dividend payable will be RM0.15 at the end of the year. It believes that the shares
can be sold at the price of RM2.40 after one year of holding. What is the value of
Merus shares if the required rate of return is 12%?
By using the basic formula of present value and following the steps above, the
value of the shares is:

Fn
(1 i)n
RM0.15
1

(1 0.12)

RM2.40
(1 0.12)1

RM0.13 RM2.14
RM2.27

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The formula above can be summarised as follows:

Vcs

Present value of dividends received in year 1 (D1 )

Present value of selling price received in year 1 (P1 )
D1
(1 k cs )1

P1
(1 k cs )1

Where:
Vcs = Present value of ordinary shares
D1 = Cash dividend that is expected to be received at the end of the period
P1 = Price of shares that is expected at the end of the period
Kcs = Required rate of return for the shares

4.7.2

Valuation of Ordinary Shares Multiple Holding

Periods

Ordinary shares do not have maturity period and is usually held for several
years. Therefore, its valuation is more complex from what we have discussed in
the previous topic. The expected cash flows will be different throughout the
holding period. Dividends received throughout the holding period are also not
fixed. This means that the cash flows are discounted for an uncertain period or
until infinity.
If the holding period is more than one or infinity, with a little modification to
formula 4.2, the valuation model of ordinary share is as follows:

Vcs

D1
(1 k cs )1
t

D2
(1 k cs )2

...

Dn
(1 k cs )n

D
(1 k cs )

Dt
t
1 (1 k cs )
(4.7)

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Dividends are a part of the companys earnings. When the earnings of a company
fluctuate throughout its period of operations, the risk will increase and this will
then influence the price of the companys shares. To reduce the risk assumed by
investors, the company normally pays dividends based on the long-term growth
of the company. The valuation model for ordinary shares above can be applied in
three levels of growth, which are:
(a)

Zero Growth
Zero growth means that dividends are not expected to experience any
growth but at the rate of g = 0. This means that the dividends receivable in
the future is the same with the dividends that were received the previous
year that is D1 = D2 = = Dn. Therefore, the value of ordinary shares
experiencing zero growth can be stated as follows:

Vcs

D1
(1 k cs )1

D2
(1 k cs )2

...

Dn
(1 k cs )n

(4.8)

When D1 = D2 = = Dn, this shows that the cash flow is perpetuity as the
cash flow obtained is the same amount for an uncertain period.
With zero growth, the value of ordinary shares is the same with the present
value of perpetuity for D1. By using the basic formula of perpetuity as a
guide, equation 4.8 can be summarised as follows:

Vcs =

D1
k cs

(4.9)

Example 4.8
Rias Company has been operating for a long time in the fast food industry.
Lately, the company had paid dividends of RM0.20 per share to its ordinary
shareholders. Based on the sales and current earnings of the company, the
management expects the dividends to maintain in the future. If the required
rate of return is 12%, what is the value of shares for Rias Company?
Vcs

D1
k cs
RM0.20
0.12
RM1.67

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(b)

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Constant Growth Rate

Although the model of zero growth can be applied to several companies,
most of the companies will experience an increase in earnings and
dividends from time to time. Some will expect to experience growth with
fixed dividends or constant dividends. If the growth is constant, dividends
that will be receivable in the following year (Dt) is equivalent to:
D1 = Dt-1 (1+g)

or

Dt = D0 (1+g)t

Where:
Dt

= Dividend for period t

Dt1 = Dividend that was paid in the previous year

g

= Dividends rate of growth

By using formula 4.10, we can find the dividend for any given year.
D1 = D0 (1+g)
D2 = D1 (1+g)
= D0 (1+g) (1+g)
= D0 (1+g)2
D3 = D2 (1+g)
= D0 (1+g)2 (1+g)
= D0 (1+g)3
D4 = D3 (1+g)
= D0 (1+g)3 (1+g)
= D0 (1+g)4

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By using the basic method to estimate the dividends in the future, we can
obtain the present value of the shares (Vcs) by using formula 4.6.
Step 1:

Find the cash flow that is expected to be received in the future

(dividend);

Step 2:

Calculate the present value for all dividend payments; and

present value of dividends that are expected to be received in
the future.

As the growth (g) is constant, equation 4.6 can be modified as follows:

Vcs

D 0 (1 g)
(1 k cs )

D0 (1 g)2
(1 k cs )2

...

D 0 (1 g)t
(1 k cs )t

(4.11)

Subsequently, the equation above can be simplified to the following

equation if the holding period is infinity:

Vcs =

D1
k cs

(4.12)

Formula 4.12 is better known as the Gordon Model, named after Myron J.
Gordon, the person who created and popularised the formula. Formula 4.12
is used to find the present value of ordinary shares that experience a
constant rate of growth. In theory, the required rate of return (kcs) must be
bigger than the value of the rate of dividend growth (g). If the required rate
of return is lower than the rate of dividend growth, you will obtain a
negative dividend and the value of the shares cannot be determined. In a
real situation, if the investor expects the dividend will increase at a higher
rate, then the required rate of return will also be higher than the rate of
dividend growth.
Example 4.9
BBB Company paid dividends of RM0.20 at the end of last year and is
expected to pay cash dividends every year starting from now until forever.
The rate of growth for each year is 10% while the rate of return is 15%.
Step 1:

Find the dividends that will be received

D1 = D0 (1+g)
= 0.20 (1+0.10)
= RM0.22
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Step 2:

VALUATION OF SECURITIES

Find the present value of the shares

Vcs

D1
k cs g
0.22
0.15 0.10
RM4.40

(c)

Differential Dividend Growth

Companies expand according to the product lifecycle that is being
transacted. Sometimes there are companies that will experience faster
growth in the beginning compared to the overall economic situation. Then
there is a possibility that it will grow parallel with the economic growth
and finally, its growth will be slower than the economic growth.
Companies facing this kind of situation are known as companies with
inconstant growth or fluctuating growth. Figure 4.6 shows the illustration
of inconstant growth compared with constant growth and zero growth.

Figure 4.6: Illustration of dividend growth rate

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Figure 4.6 shows the dividend for a company that experienced inconstant
growth. Dividends are expected to increase by 25% for the first three
years, after which, the growth rate is expected to fall to 6% a year for a
rather long period. The value of shares for this company is the same with
the present value of the dividends that are expected in the future, as shown
in equation 4.6. It also involves three steps:
(i)

Calculate the present value of dividends for the entire period of

inconstant growth;

(ii)

Calculate the share price at the end of the inconstant period of

growth, which is at the point it changes to constant growth, next
discount this price at present value; and

(iii) Add the present value obtained from step 1 and step 2 to obtain the
intrinsic value, Vcs.
Example 4.10
By using the illustration in Figure 4.6, calculate the present value of
ordinary shares that experienced inconstant growth. Assume the following
five information are given:
Kcs = Rate of return required by investors (12%)
n

= Period of inconstant growth (3 years)

gs = Rate of dividend growth throughout the period of inconstant growth

(25%)
gn = Fixed rate (6%)
D0 = Amount of the last final paid by the company (RM0.20 per share)
Calculations:
Step 1:

Calculate the expected dividend at the end of each year

throughout the period of inconstant growth. The rate of
inconstant growth, gs, for the period of three years is 25%.
D1 = D0 (1+g)
= RM0.20 (1+0.25)
= RM0.25

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D2 = RM0.25 (1+0.25)
= RM0.3125
D3 = RM0.3125 (1+0.25)
= RM0.3906
Step 2:

The price of shares is the present value of dividend from year 1

to infinity; therefore, it is required to obtain the value of
dividend at year 4, D4, by using the constant growth rate of
gn = 6%.
D4 = RM0.3906 (1+0.06)
= RM0.414
Next, we use the formula for constant growth rate to find the
price at year 3 that is the present value of dividend from year 4
to infinity.
P3

D4
k cs g n
RM0.414
0.12 0.06
RM6.90

Step 3:

Discount the cash flow for year 1 to 3 and the present value of
dividend at year 4 at the required rate of return, kcs = 12%, to
obtain the intrinsic value for ordinary shares.

Vcs

RM0.25(PVIF12%,1 ) RM0.3125(PVIF12%,2 )
RM0.3906(PVIF12%,3 ) RM6.90(PVIF12%,3 )
RM0.223 RM0.249 RM0.278 RM4.911
RM5.66

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The valuation process above can be shown by using a time line as

seen in Figure 4.7.

Figure 4.7: Process of finding the value of company shares that experienced inconstant
dividend growth

The value of RM6.90 stated in Figure 4.7 is the second cash flow
at year 3. The shareholders can sell it at year 3 at the price of
RM6.90 or in other words, it is the present value of dividend
cash flow from year 4 to infinity.

4.7.3

Required Rate of Return for Ordinary Shares

As explained, the expected rate of return for bonds is the return that is expected
to be received by the bondholders on the investments. The expected rate of
return for ordinary shares is the rate of return expected by ordinary shareholders
on their investment. Finance managers use the expected rate of return for
ordinary shares to evaluate the effect of ordinary shares towards the companys
new funding costs.
The rate of return is calculated based on the value or price of shares and
dividends that are received. The equation of share valuation can still be used to
estimate the expected rate of return for ordinary shares. However, this equation
must be modified as the value required is the required rate of return or the rate of
return used to discount cash flow.

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The expected rate of return is also shown for the three aspects of growth:
(a)

Zero Growth
To find the expected rate of return for dividends that experience no growth,
we can use formula 4.13.

Vcs

D
k cs

(4.13)

As we are looking for the value for the rate of return, the formula above can
be modified as follows:

K cs

D
Vcs

(4.14)

Example 4.11
Cergas Maju Company has just sold its ordinary shares at the price of
RM2.30 per share. Last year, the company paid dividends of RM0.25. Based
on the economic situation and the current developments in the company,
the management expects that the company will not experience growth for a
long period of time. What is the expected rate of return for the shares of
Cergas Maju Company?

K cs

D
Vcs
RM0.25
RM2.30
10.87%

(b)

Constant Growth Rate

To find the expected rate of return for dividends at a constant growth rate,
we can use formula 4.15.

Vcs

D1
K cs

(4.15)

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As we are looking for the value for the required rate of return, the formula
above can be modified as follows:

K cs

D1
Vcs

(4.16)

From the equation above, the required rate of return for ordinary
shareholders is equivalent to the rate of return for dividend added with the
growth factor. Even though the rate of growth (g) is applied to the rate of
growth for dividend of the company, assume that the value of shares is also
expected to increase at the same rate. This is because (g) represents the
percentage of annual rate of growth for the value of shares. In other words,
the rate of return required by investors is determined by dividends received
including capital gain, as reflected by the expected percentage rate of
growth in the share price.
Example 4.12
The ordinary shares for Maju Jaya Company were recently sold at the price
of RM3.38. The company has just paid dividends of RM0.30 per share and is
expected to experience constant growth of 8.5%. If you purchase these
shares in the market, what are the returns that you would expect to receive?
K cs

D1
Vcs

RM0.30 (1 0.085)
0.085
RM3.38
0.1813 or 18.13%

ACTIVITY 4.5
Based on the formula g = ROE
the value of ordinary shares?

r, what are the factors that influence

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EXERCISE 4.5
1. What are the two forms of returns that will be obtained by ordinary
shareholders on their investments?
2. Litar Company is expected to pay dividends of RM0.18 to its
companys ordinary shareholders next year and the growth rate is
fixed, that is at 5% per year. The market price of shares is estimated to
value at RM4.25 at the end of next year. If the required rate of return is
11%, what is the present value of the share? If you own shares in Litar
Company, will you sell the shares? Why?
3. TAB Company has just paid dividends of RM0.50 to its
shareholders. The company expects dividends to experience a
remarkable growth rate of 15% for the period of 3 years from now
and subsequently will experience a constant growth rate of 4%. The
rate of return required by investors is 12%. What is the price of TAB
Companys shares?
4. What do you understand by the rate of return expected by
investors?
5. Ordinary shares of Mesra Company had just been sold at the price
of RM2.30 per share. The company expects to experience a constant
growth rate of 10.5% and the dividend at the end of the year is
expected to be RM0.25.
(a)

What is the expected rate of return for the shares of Mesra

Company?

(b)

If the required rate of return is 17%, will you buy those

shares?

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PREFERENCE SHARES
SELF-CHECK 4.6

Why are preference shares less popular compared to ordinary shares?

Preference shares are also known as hybrid securities as they have characteristics
of bonds and ordinary shares. Table 4.4 lists down the similarities and differences
between preference shares with ordinary shares and bonds.
Table 4.4: Similarities and Differences of Preference Shares with Bonds
and Ordinary Shares
Item

Bond

Preference Shares

Ordinary Shares

Dividend

Bondholders
receives interest at a
fixed rate and
period.

Payment of dividend is
at a fixed rate and
period.

Payment of dividend is
unlimited but must be
declared first by the
board of directors of the
company.

Claims
on
earnings
and
assets

Has priority claims

on the earnings and
assets compared to
preference shares
and ordinary shares.

Has priority claims on

the earnings and assets
compared to ordinary
shares, but only after the
claims of bonds had
been settled.

If liquidation occurs,
the ordinary
shareholders have the
last claim on the
earnings and assets
after bondholders and
preference shares.

Maturity
period

Bonds have maturity

period.

Preference shares do not

have maturity period.
Ownership remains as
long as the company is
in operation.

Ordinary shares do not

have maturity period.
Ownership remains as
long as the company is
in operation.

Voting
rights

Bondholders do not
have the right to
vote the members of
the board of
directors.

Preference shareholders
have voting rights to
protect their interest.

Ordinary shareholders
have voting rights as
owners of the company

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4.8.1

Characteristics of Preference Shares

VALUATION OF SECURITIES

Before we discuss how preference shares are valuated, we must first understand
the characteristics of preference shares.
(a)

Issuance of Several Classes of Preference Shares

Normally, a company will issue several classes of preference shares that
have different characteristics and different degree of priority in the aspect
of assets claim if liquidation occurs.

(b)

Claims on Assets and Earnings

Preference shares have priority in the aspect of claims on assets and
earnings compared to ordinary shares. For companies that issue several
classes of preference shares, priority of claims will be specified based on the
characteristics of preference shares. Therefore, in the aspect of risks, the risk
of preference shares are lower compared to the risks of ordinary shares but
higher compared to the risks of bonds.

(c)

Cumulative Dividends
If there are dividends in arrears, the company must pay those dividends
first before the payment of dividends for ordinary shares are declared. This
characteristic is to protect the interest of preference shareholders.

(d)

Provision for Protection

The provision for protection is a provision that is normally included in the
issuing conditions of preference shares. It is for the purpose of protecting
the interest of preference shareholders. For example, provide voting rights
and if there is failure in paying dividends or by barring the dividend
payment of ordinary shares if the payment for sinking funds is not made.

(e)

Convertible Preference Shares

Convertible preference shareholders have the option to change their
existing preference shares to several units of ordinary shares according to
the ratio prescribed when the shares were issued. This is an attraction to
investors and can also reduce the cost to the issuer of preference shares.

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169

Redeemable Preference Shares

Companies that issue preference shares would normally provide a method
for the purpose of redeeming the preference shares issued. If there is no
redemption method, the company will not benefit from the reduction of
interest rates. When interest rates decrease, the company will redeem the
preference shares that are currently available and issue new preference
shares at a lower rate.
There are two methods for the redemption of preference shares that are
normally used, these are:
(i)

Provision for Call Option

This method enables the issuing company to buy back the preference
shares at a price that had been specified and within a period that had
been specified.

(ii)

Provision for Sinking Funds

This method requires the issuing company to separate a sum of
money periodically for the purpose of redeeming preference shares.
The amount that has been accumulated will be used to buy back the
preference shares by using the call option or any other cheaper
methods.

ACTIVITY 4.6
Dividend of preference shares must be paid before the dividend of
ordinary shares at the amount and period specified. In your opinion,
should this dividend be categorised as a liability to the company such
as debts? Why?

4.9

VALUATION OF PREFERENCE SHARES

SELF-CHECK 4.7

Preference shares enable its holders to receive fixed dividends. How

are fixed dividends paid?

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As explained, the owners of preference shares generally receive fixed dividends

from its investment at each period. It does not have maturity period or in other
words, it is perpetuity. Just like the valuation of ordinary shares, the valuation
process of preference shares also involve three steps. These steps are as follows:
(a)

Assume the amount and timing of the cash flow that will be received from
the investment of the preference shares;

(b)

Calculate the risk level of cash flow that is expected to be received and then
determine the rate of return required by the investors; and

(c)

Calculate the intrinsic value of preference shares by discounting all the cash
flow that is expected to be received by using the required rate of return.

As preference shares do not have maturity period, the dividends are expected to
be received continuously until infinity. Therefore, the formula to calculate the
value of preference shares is as follows:
Value of Shares =

Annual Dividends
Required Rate of Return
(4.17)

D
Vps =
k ps
Example 4.13
The annual dividend that is expected to be received is RM0.36 per share. The rate
of return required by investors is 7%. Calculate the value of these preference
shares.

Vps

RM0.36
0.07
RM5.14

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Expected Rate of Return for Preference Shares

The purpose of finding the expected rate of return for preference shares is the
same with the purpose of finding the expected rate of return for ordinary shares
and bonds, which is to evaluate the effect of preference shares on the new
funding costs for the company. To calculate the expected rate of return for
preference shareholders, formula 4.17 needs to be modified as follows:

k ps

D
Vps

(4.18)

Example 4.14
Cher Mate Company sold its preference shares at the price of RM5.50 and pays
dividends of RM0.25 per share. What is the expected rate of return if you
purchase the shares at market price?

k ps

D
Vps
RM0.25
RM5.50
4.54%

ACTIVITY 4.7
1. There are several types of investments such as shares, real estate,
bonds, equities and unit trust. Which is more suitable for you or are
you the type of person who will only create savings in the banks?
2. You can get more information on shares in Malaysia through the
Bursa Malaysia website at http://www.klse.com.my.

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EXERCISE 4.6
1. Ordinary shareholders are ____________.
(i)

owners of the company

(ii)

managers of the company

(iii) creditors of the company

A.

i.

B.

i,ii.

C.

ii,iii.

D.

i,ii,iii.

2. Everything below has an effect on the value of ordinary shares

except:
A.

par value.

B.

risk-free rates.

C.

growth of dividends in the future.

D.

dividends in the future.

3. If an investor believes that a share is ____________, he should

____________ the share to receive more profit.
A.

devalued; buy

B.

undervalued; sell

C.

correctly valued; buy

D.

correctly valued; sell

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EXERCISE 4.6
4. Preference shares mean __________________
(i)

priority over ordinary shares in the aspect of claims on assets.

(ii)

priority over ordinary shares in the aspect of dividend

payments.

(iii) priority over ordinary shares in the aspect of voting rights.

A.

i.

B.

i, ii.

C.

ii, iii.

D.

i, ii, iii.

5. Preference shares have characteristics similar to bonds because they

___________.
A.

have a fixed monthly rate.

B.

have a fixed dividend amount.

C.

represent the ownership of the company.

D.

all of the above.

6. Why is preference share stated as hybrid security?

7. What is the value of preference shares if the dividend rate is 16% of
its par value of RM10? The required rate of return is 12%.
8. You own 150 units of preference shares of Mapa Company. These
shares had just been sold at the price of RM3.85 per share and the
annual dividend is RM0.35.
(a)

What is the expected rate of return?

(b)

If the required rate of return is 18%, will you sell or buy these
shares?

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EXERCISE 4.6
9.

Maju Company had just paid dividends of RM1.32. If the growth

rate is expected at 7% perpetually and the rate of return required
by investors is 11%, what is the price of Maju Companys shares?

10.

Chips Computer Sdn. Bhd. had just paid dividends for ordinary
shares of RM1.15. For the next two years, the company is
expected to experience high growth as high as 15% and 13% for
the third year and consequently with a fixed rate of 6%. The
required rate of return for the companys shares is 12%. Calculate
the value of shares for Chips Computer Sdn. Bhd.

11.

Recently, Tenun Company had just issued its ordinary shares at

the price of RM4.05 per share. Dividend of RM0.24 per share is
expected to be paid at the end of this year and is expected to
experience a fixed growth rate of 7% per year. What is the
required rate of return for these shares?

12.

Last year, Primax Company paid dividend of RM0.40, and this

year the dividend is expected to experience a growth rate of 10%.
The company had just paid dividend of RM0.44. Through a new
technique in producing its products, Primax expects to obtain
high achievement in the short term that is, at 25% per year for the
first 3 years. After this, the growth is expected to return to normal
for a long period, that is 10% perpetually. If investors required
15% rate of return, what is the price of the company's shares
today?

13.

If Cabin Company pays dividends as much as RM1 per year for

its preference shares and the required rate of return is 12%, what
is the value of these preference shares?

14.

What is the rate of return required for preference shares if the

dividends payable every year is RM0.15 with a par value of
RM4.00? These shares had just been sold at the price of RM5.

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TOPIC 4

VALUATION OF SECURITIES

175

Valuation is a very important process in finance. This is because in finance,

the value of an asset is measured based on the factors of timing and risk, and
not based on the historical value.
Understanding the concept of value and having skills in valuations are very
important to assist the manager in making financial decisions for the
company. It is in accordance with the objective of the company to maximise
the shareholders wealth.
Bonds, which is one of the long-term sources in funding, is becoming more
important in the capital market.
In the valuation of bonds, you will obtain the intrinsic value, which is the
actual value or true value of an asset and this value is emphasised in finance.
This value will then be compared to the selling price of the bonds in the
market.
If the selling price of the bond in the market is higher than the intrinsic value,
the bond is said to be overvalued and if the reverse occurs, the bond is said to
be undervalued.
The yield to maturity (YTM) can also be a basis in making investment
decisions as it is the rate of return that can be expected if you hold a bond
until its maturity date. This rate will then be compared with the rate of return
required by investors. If this rate is higher than the required rate of return,
then the investment is a good one.
The ordinary and preferences shares are sources of long-term funding.
Ordinary shares is a more important source of funding and the usage is wider
than preference shares.

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TOPIC 4

VALUATION OF SECURITIES

The objective of valuating ordinary shares and preference shares is the same
with the objective of valuating bonds, that is to find the intrinsic value or true
value of shares to assist in the decision making on funding or investing.
The valuation process of ordinary shares requires you to make estimates on
dividends for the coming years in advance.
Dividend is an important component in the valuation of ordinary shares and
preference shares because it is a cash flow that must be discounted to obtain
the share value.
The rate of return that is expected concerns the returns to be received from
the investment in ordinary shares and preference shares. Knowing the
expected rate of return receivable is also important as it influences the
funding and investment of the company.

Book value

Liquidation value

Bond

Market value

Capital gain

Maturity period

Constant growth rate

Ordinary shares

Coupon rate

Par value

Differential dividend growth

Pre-emptive rights

Dividends

Preference shares

Expected rate of return

Required rate of return

Indenture

Yield to maturity

Intrinsic value

Zero growth

Limited liability

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Topic Risk Analysis

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Define risk and return;
2. Apply statistics measures in determining risk and return of an
investment;
3. Measure the expected return and the riskiness of an individual
investment;
4. Differentiate between systematic risk and unsystematic risk;
5. Explain how diversifying investments affects the riskiness and
expected return of a portfolio; and
6. Apply Capital Asset Pricing Model (CAPM) in determining an
investors required rate of return on an investment.

INTRODUCTION
The modern portfolio theory was introduced by Harry Markowitz in the year
1952. According to this theory, risk and return cannot be separated. The higher
the risk the higher the expected return. In 1964, this theory analysis has been
further developed by William F. Sharpe to form another theory that is very
useful in the field of finance that is, the Capital Asset Pricing Model (CAPM).
In this topic, you will learn the risk and return from the perspective of capital
contributors or shareholders. According to the research on the habits of investors
that were conducted by Markowitz, capital contributors will make valuation on
returns before making investment. Subsequently, they will make analysis on the
changes in returns as a measurement of risk.

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TOPIC 5

RISK ANALYSIS

Generally, as rational capital contributors, shareholders will do their best to

maximise returns and at the same time, try to minimise risk. Therefore, it is the
responsibility of the finance manager analyse of risk and return before making
any financial decisions. This is important to ensure that the company can
maximise its value including the wealth of shareholders.

5.1

DEFINITION OF RISK AND RETURN

Generally, risk means the possibility of facing something that is uncertain in the
future. From the perspective of financial management, risk is the probability of
changes to the returns received by an investor in a specific period. Assets that
have higher possibility of losses is said to have higher risk compared to assets
that have lower possibility of losses. Return is defined as the profit level received
by investors during the period of its investment. The actual return from an
investment comprised of two main components, which are:
(a)

Expected return; and

(b)

Unexpected return

Expected return is the return based on the information available as well as

information that can be expected by the investors. Unexpected return is created
from information that is beyond the expectation of investors.
In an efficient capital market environment, in theory, return can be completely
expected. However, in practice, the actual return value may be different from the
expected return due to the existence of unexpected return.
Unexpected return comprised of systematic return and unsystematic return
components. Systematic return exists as a result of systematic risk, while
unsystematic return exists as a result of unsystematic risk. Systematic and
unsystematic risks will be explained further in later topics.
As a smart investor, you will have to analyse risk-return before making
investment decisions. This analysis is to determine the minimum rate of return
that is appropriate in balancing the risk level that you are willing to accept. The
minimum rate of return is also known as nominal rate of return or required rate
of return.

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RISK ANALYSIS

179

The return that is required by an investor might be the same or different

compared to another investor. The rate of return is normally used as a guide by
investors on whether to buy or sell the financial asset in the market. A rational
investor will normally buy the financial asset if the expected rate of return is
higher or equal to the required rate of return and vice versa.

SELF-CHECK 5.1
Explain the relationship of risk and return in investments.

5.2

USE OF STATISTICS TO DETERMINE RISK

AND RETURN

As a basic step in understanding how return and risk are measured as well as
interrelated, you must first know several important terms in statistics such as
random variable, probability and its distribution pattern, mean, variance, standard
deviation, coefficient of variation, covariance and correlation coefficient.

5.2.1

Random Variable

The value of random variable is a statistic data that is difficult to predict

accurately. The value of random variable can only be estimated as the real value
is difficult to obtain. For example, you can only estimate the value of a
companys profit based on several methods. One of these methods is based on
the profit obtained from previous years.

5.2.2

Probability and Its Distribution

As the value of random variable is something that is uncertain, hence the concept
known as probability is used to measure the possible value of random variable.
The concept of probability is a statistics term that is used to predict the
occurrence of an uncertain occurrence. In other words, probability is the
numerical figure that measures the relative frequency of an occurrence in a
specific period. Based on probability, you can make a rather effective decision
that can be adopted.

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RISK ANALYSIS

The concept of probability outlines several of the following issues:

(a)

Probability cannot be in negative form.

(b)

The total overall probabilities are equal to 1 or 100 percent.

(c)

The value 0 shows the probability of a specific occurrence that definitely

would not occur.

(d)

The value 0.1 shows the probability of a specific occurrence occurring is

10%.

(e)

The value 1 shows the probability of a specific occurrence that would

definitely occur.

The risk of an investment is usually measured based on the total dispersion of

random variables in the probability distribution. In general, probability
distribution is categorised into two types of distribution, which are the discrete
distribution and continuous distribution.
The discrete probability distribution is a distribution that has a matching
probability value and random variables value that are limited. While the
continuous probability distribution is a calculation of probability value that is
related with the random variables with the assumption that it will create an
unlimited numbers of possibility or infinity return. In other words, continuous
distribution can be formed when you are able to fully determine every matching
value of the probability and return of an investment.
Example 5.1
Nusa Company is currently considering two alternative investments, which are
the project to rear fish (PRF) and project to rear sheep (PRS). The following are
the discrete probability distribution of returns for both investment alternatives:
Probability

PRF Returns (RM)

PRS Returns (RM)

0.25

8,000

2,000

0.25

12,000

18,000

0.50

10,000

10,000

Based on the prediction by Nusa Company, both the investment alternatives

showed that the opportunity to obtain the estimated return of RM10,000 is higher
as it stated a higher probability percentage. Figure 5.1 displays the above
information in the form of a bar chart.
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RISK ANALYSIS

181

Figure 5.1: Discrete probability distribution for the prediction of returns for PRF and PRS

If Nusa Company can predict the matching of probability and return

continuously for both projects, the outline of probability distribution and return
from both projects can roughly be illustrated in Figure 5.2.

Figure 5.2: Continuous probability distribution for the prediction of returns for
PRF and PRS

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RISK ANALYSIS

From the aspect of its concept, the steeper the probability distributions graph on
investment return, the riskier the said investment. A steep graph shows that the
probability distribution gap of return is bigger. The probability distribution gap
is the difference or variation between the estimated highest return and the
estimated lowest return. The smaller the differences in value, the lower the
estimated risk and on the other hand, the higher the gap the higher the risk of an
investment.
Figure 5.1 shows that the probability distribution gap of return for PRS is bigger
(RM18,000 RM2,000 = RM16,000) compared to PRF (RM12,000 RM8,000 =
RM4,000). Meanwhile, Figure 5.2 shows that the probability distribution of return
for PRS is flatter compared to the probability distribution of return for PRF.
Therefore, you can conclude that PRS is riskier compared to PRF.

5.2.3

Mean (Expected Return)

Expected return is the mean for random variable. Mean is the arithmetic average
of probability for all the possibilities in the value of random variables. Mean is
obtained when the experiments are repeated several times and the results of
these experiments are obtained that is the weighted average probability for all
the outcomes are determined.
n

X t Pt

(5.1)

rt Pt

(5.2)

t1

or
n

r
t1

Where:

= Mean of return or expected return in Ringgit value

= Mean of return or expected return in percentage value

= Sum
t 1

Pt

= Probability of obtaining returns

Xt

= Return in Ringgit (usually based on previous returns)

rt

= Return in percentage of (usually based on previous returns)

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5.2.4

RISK ANALYSIS

183

Variance and Standard Deviation

Variance is a measure of dispersion or distribution of all possible result around

the mean (expected value). In other words, it is the square of standard deviation.
Standard deviation is the measurement of dispersion around the expected value
of a probability distribution or its frequency, which is the square root of variance.
Both are measurements for risk that take into consideration systematic risk and
unsystematic risk.
Variance:
2

r )2 Pi

(5.3)

(ri r)2 Pi

(5.4)

(ri
i=1
n
i=1

Where:
2

= Variance
= Standard deviation

5.2.5

Coefficient of Variation

Coefficient of variation is a standard deviation ratio on expected return. It is a

standard measurement of risks for each unit of return. Coefficient of variation is
used as the comparison basis for two investments in financial assets.
It is used if a situation arises where the financial asset of A produces return that
is higher than the financial asset of B but at the same time, the financial asset of A
has higher risk compared to the financial asset of B. The higher the value of CV,
the higher it will be for the level of risk for each unit of return.
CV

(5.5)

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5.2.6

Covariance

RISK ANALYSIS

The use of covariance can explain to you the relationship of returns among the
financial assets that can be compared. In other words, covariance measures how
far two random variables are different from each other.
(a)

The value of positive covariance shows that one of the random variables
states a value of more than mean, while the other random variable is also
inclined towards the value of more than mean.

(b)

The value of negative covariance shows that one of the random variables
states a value of more than the mean, while the other random variable will
incline towards the value of less than mean.

(c)

The value of zero covariance shows that no pattern had been formed
between the two variables. The covariance for the two random variables (r1,
r2) is usually written as Cov (r1,r2) of sr1r2.
n

Cov (r1 , r2 )

Pi (ri1

r1 ) (ri2

r2 )

(5.6)

i=1

5.2.7

Correlation Coefficient

Correlation coefficient is used to measure the relationship movement magnitude

between two variables that is, the movement of returns on financial assets that
are being analysed. It is obtained by dividing the covariance with the result of
multiplying the standard deviation. The value of correlation coefficient is
between the range of -1 and +1 only. Normally, it is written as Corr (r1,r2) or the
symbol Rho (r).

Corr (r1 , r2 )

Cov (r1 , r2 )
r1 , r2

(5.7)

(a)

Perfect Negative Correlation [Corr (r1, r2) = 1.0]

Correlation 1.0 explains two variables moving in opposite directions and
with the same magnitude. The combination of investment in these two sets
of financing is said to reduce risk.

(b)

Perfect Positive Correlation [Corr (r1, r2) = +1.0]

Correlation +1.0 explains two variables moving in the same directions and
with the same magnitude. The combination of investment in these two sets
of financing would not be able to reduce risk.
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(c)

RISK ANALYSIS

185

Positive Correlation
Positive correlation, for example +0.4 explains two variables moving in
the same direction but at different magnitudes. The combination of these
variables created lower risk compared to cases of perfect positive
correlations but is higher compared to cases of perfect negative correlations.

5.3

MEASURING THE EXPECTED RETURN AND

RISK OF INVESTING IN ONE SECURITY

Before the investment risk in a security can be determined, you must first
calculate the expected return by using the equation 5.1 or 5.2. The investment risk
in one security is known as specific risk. Specific risk is measured using the
variance formula (equation 5.3) and subsequently the formula for standard
deviation (equation 5.4) for the investment return of an asset.
Example 5.2
Economic
Situation

(a)

Probability
(P)

Rate of Return (r) for

Financial Asset
A

Weak

0.20

12%

6%

Moderate

0.50

14%

14%

Strong

0.30

16%

19%

Expected Return or Mean Return

Financial Asset A
r = {(0.20

12%) + (0.50

14%) + (0.30

16%)}

14%) + (0.30

9%)}

= 14.2%
Financial Asset B
r = {(0.20

6%) + (0.50

= 13.9%

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(b)

TOPIC 5

RISK ANALYSIS

Variance
Financial Asset A
2

= [0.20 (12% 14.2%)2] + [ 0.50 (14% 14.2%)2] + [0.30 (16% 14.2%)2]

= 1.96%

Financial Asset B
2

= [0.20 (6% 13.9%)2] + [ 0.50 (14% 13.9%)2] +[0.30 (19% 13.9%)2]

= 20.29%

(c)

Standard Deviation
Financial Asset A

[0.20 (12% 14.2%)2 ] [ 0.50 (14% 14.2%)2 ] [0.30(16% 14.2%)2 ]

1.4%
Financial Asset B

[0.20 (6% 13.9%)2 ] [ 0.50 (14%

13.9%)2 ] [0.30 (19% 13.9%)2 ]

4.50%
Based on the calculation above, Financial Asset A produces an expected return
that is larger (14.2%) compared to B (13.9%). From the aspect of risks, it is found
that the Financial Asset B is riskier (4.50%) compared to the Financial Asset A
(1.41%). Therefore, the choice of Financial Asset A is better.

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RISK ANALYSIS

187

EXERCISE 5.1
1. Layar Gemilang Company plans to introduce a new fishing boat
model. The estimated return depends on the degree of market
acceptance on this new fishing boat model.
Market Acceptance

5.4

Probability

Estimated Return (%)

Very discouraging

0.05

Not encouraging

0.10

Moderate

0.40

20

Encouraging

0.25

30

Very encouraging

0.20

40

(a)

Calculate the expected return.

(b)

Calculate the standard deviation of return.

(c)

Calculate the coefficient of variation of return and interpret

its result.

REDUCING RISK THROUGH

DIVERSIFICATION

Diversified investments or a combination of several securities in the capital

market refers to the security portfolio. Among the objectives of portfolio is to
avoid the burden of risk in investing in only one asset. The total investment risk
of the portfolio (which is a combination of systematic and unsystematic risks) is
distributed at the minimum level to obtain the maximum return. The reduction
of total risk can be described with the help of Figure 5.3.

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RISK ANALYSIS

Figure 5.3: Effects of diversification on systematic risks and unsystematic risks

5.4.1

Principle of Systematic and Unsystematic Risk

Systematic risk is a risk that cannot be diversified. It is a risk that has an overall
effect on all financial assets in the capital market. Systematic risk is related to
market risk that is, the rise and fall of a countrys internal and external markets,
interest rate risks and the risk of purchasing power. These risks cannot be
eliminated by diversification in investments.
Unsystematic risk or risk that can be diversified is a risk that only has effect on
the financial assets of specific companies or group of related companies. This risk
is unique or different among the companies (depends on the nature of the
business). It comprises of business risk (operations) of the company and financial
risk of the company. These risks can be distributed or reduced by diversification
in investments.

SELF-CHECK 5.2
What is the principle of systematic and unsystematic risk?

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5.4.2

RISK ANALYSIS

189

Measuring the Expected Return and Risk of

Security Portfolio

The expected rate of return for investment in the security portfolio is the
weighted average expected return on the financial assets held in the portfolio.
n

rport

i=1

w1 r1

w 2 r 2

(5.8)

w n rn

Where:
rport1. = Expected rate of return for portfolio.

r1

= ra Expected rate of return for asset (1)

W1

= Weight for financial asset (1) in the portfolio

r2

= rb Expected rate of return for financial asset (2)

W2

= Weight for financial asset (2) in the portfolio

rn

= r n Expected rate of return for financial asset (n)

Wn

= Weight for financial asset (n)

The portfolio risk refers to the variability of expected returns or average returns
from investments in the portfolio. The effects from diversification caused the
portfolio risk to become smaller compared to the risk of individual assets
(portfolio components). The total reduction of risk (through diversification)
depends on the correlation of an asset return with other assets return in the
portfolio that is measured with the coefficient correlation.
portf.
n

P n (rportf. in a specific economic situation

rportf. for all securities in the portf.)2

i=1

(5.9)

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RISK ANALYSIS

For data based on time series, the portfolio formula for standard deviation is
modified as follows:
Example 5.3
Investment portfolio is made up of 50% of Financial Asset A, 25% of Financial
Asset of B and the remaining 25% of Financial Asset C.
Economic
Situation

(a)

Rate of Return (r) for Financial Asset (%)

Probability (P)

Strong

.45

11

16

21

Weak

.55

Expected Return for Each Financial Asset

Financial Asset A
R A = {(0.45 11%) + (0.55
= 9.90%

9%)}

Financial Asset B
R B = {(0.45 16%) + (0.55
= 9.95%

5%)}

Financial Asset C
R C = {(0.45 21%) + (0.55
= 9.45%

(b)

0%)}

Expected Return for the Portfolio of Financial Asset of A, B and C

rport1. = {[0.50

9.9%] + [0.25

9.95%] + [0.25

9.45%]}

= 9.8%

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(c)

RISK ANALYSIS

Variance
Expected portfolio return during a strong economic situation:
= {[0.50

11%] + [0.25

16%] + [0.25

21%]}

= 14.75%
Expected portfolio return during a weak economic situation:
= {[0.50

9%] + [0.25

5%] + [0.25

0%]}

= 5.75%
2
portf.

= {[0.45

(14.75% - 9.8%)2] + [0.55

(5.75 9.8)2]}

= 20.05%
(d)

Standard Deviation
portf

{[0.45 (14.75% 9.8%)2 ] [0.55 (5.75 9.8)2 ]}

= 11.026 + 9.02
= 4.477%

EXERCISE 5.2
Amin plans to form an investment portfolio that comprised of 40%
investment in share X, 35% investment in share Y and the remaining
25% in share Z.
Economic
Situation

Probability (P)

Rate of Return (r) for Shares

X

Strong

0.48

10%

15%

20%

Weak

0.52

10%

6%

1%

Calculate:
(a)

Expected return for each share.

(b)

Expected return for investment portfolio of share X, Y and Z.

(c)

Standard deviation for the investment portfolio.

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5.4.3

Capital Asset Pricing Model

RISK ANALYSIS

Capital Asset Pricing Model (CAPM) is a principle that explains how the price of
capital assets can be determined based on the reaction of investors in choosing a
portfolio in the capital market. Choosing a portfolio depends on the attitude of
the investor towards risk and return. Most investors, in general, are conservative
and possess risk averse attitude. They ensure that every Ringgit they had
invested is able to generate profit. This group of investors is only willing to pay
the amount that is lesser than the value of expected return.
In the capital market, there are many combinations of assets that have uncertain
risk-return levels. Therefore, investors have a chance to choose and diversify the
investment combinations or portfolio that consist of risky and non-risky assets.
Non-risky asset refers to asset that has a standard deviation equals to zero. In
other words, the actual return is the same as the expected return. In reality, there
would not be any asset that is totally free from risk. However, there are assets
with very low risks. For example, treasury bills issued by the government.
Although these treasury bills are not totally risk-free but because their returns are
guaranteed by the government, they are categorised as non-risky assets.
According to the CAPM concept, an investor will choose any combination of
assets that are risky and non-risky in an efficient portfolio along the capital
market line (CML). The reason for choosing this portfolio is to create a situation
of an optimum risk-return replacement. CML is a straight line graph that is
tangent with the efficient frontier curve (refer to Figure 5.4).

Figure 5.4: Capital Market Line

This graph explains the connection between the value of rate of return and
standard deviation. At Y axis, the straight line is known as CML, starting from
the point marked rf, which is the return of risk-free asset and subsequently, it
touches the efficient frontier curve (that is the market portfolio known as M).
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193

The market portfolio is the portfolio that contains all securities in the market. The
overall unsystematic risks in the market portfolio has been distributed or
reduced to the lowest level. The balance is the systematic risks. The possibility of
these systematic risks to be distributed is very slim or in theory it is categorised
as risks that cannot be distributed. M is the risky portfolio that is the best to be
chosen compared to the other risky portfolios in the efficient frontier curve but in
reality it is not possible for you to own a portfolio containing all the securities in
the market.
The entire portfolio along the CML is a combination of risk-free assets and risky
portfolio that will produce the same risk and return in investments if made in
risk-free assets and market portfolio M. When CML is formed, it is up to the
investors to choose any combination of investments on the CML. This is because
based on the gradient of the CML, any of the combinations will provide the same
risk-return.
The gradient of the CML can measure the amount of expected return for a unit of
total risky investment. The formula is as stated in equation 5.10.

Gradient of CML

rm

rf

(5.10)

Equation rm rf is known as market risk premium. Market risk premium

measures the reward offered by the market on the willingness of investors to
accept an average total of systematic risks during the period of investment. As
unsystematic risks can be distributed by diversification of investments, therefore
there would be no reward for the willingness of the investors to bear these risks.

5.4.4

Measuring Systematic Risk (Beta)

Assume you had successfully chosen one of the portfolios that could reduce the
total risks to the minimum level on the CML efficient frontier line. This portfolio
comprised of a combination of risky assets A, B, C, D and one non-risky asset.
Each of these risky assets has a combination of systematic and unsystematic
risks. Therefore, when this portfolio is formed, the unsystematic risk can be fully
distributed. The result, the only systematic risk left accumulated is due to the
combination of systematic risk from each of the risky assets of A, B, C and D.

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RISK ANALYSIS

You can measure the systematic risk by using the coefficient beta ( ) that is the
relative shares diversifiable index. The following are the indicators that are used
to interpret the results of beta multiplier:
(a)

= 0.0: Securities without risk (risk-free assets).

(b)

= 0.5: The level of securities risk is half of the market risk.

(c)

= 1.0: Securities have the same level of risk as the average market
risk.

(d)

= 2.0: The level of securities risk is twice the average market risk.

The systematic risk for each risky asset portfolio is the total risk that contributes
to the risky market portfolio. Therefore, the systematic risk of the asset influences
the return that is expected in the market. However, how do you know how much
is the return payable on the willingness to receive a certain amount of systematic
assets risk?
Total expected return for a unit of risk that is stated above actually can be
measured by the CML gradient that had been learned previously. Therefore, you
are able to determine the risk premium for a risky asset, for example asset A
using equation 5.11.
Risk premium for A = (Systematic risk) (CML gradient)
{[Corr (A, M)]

A}

rm

rf

(5.11)

Equation 5.11 above can be modified to determine the beta for asset A
(equation 5.12)

Cov(A, M)
A

(5.12)

M2

After each of the beta multiplier for the risky assets portfolio had been calculated,
you will determine the beta for the entire investment portfolio. Your calculation
is based on equation 5.13.
n

(5.13)

Wi Bi

portf.
i =1

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Example 5.4
Assume you have determined the beta multiplier including the weighted
investment for each of the risky financial assets. Based on this information, you
can then calculate the portfolio beta multiplier for the investment of assets X, Y
and Z.

portfolio x,y,z

Securities

% Portfolio

Beta

25

1.20

20

0.90

55

0.80

= {[ (1.20) (0.25)] + [ (0.90) (0.20)] + [(0.80) (0.55)]}

= 0.92

5.4.5

Security Market Line

Prior to this you have seen the graph that forms the CML that is the illustration
that connects the rate of return value with the measurement of overall risks
(standard deviation). Now you will learn the relationship between rates of return
with the measurement of systematic risk (beta). This relationship is illustrated by
the security market line (SML) graph shown in Figure 5.5. In theory, SML will
fluctuate from time to time depending on the changes in the estimation of
inflation, risk aversion and beta shares.

Figure 5.5: Security market line

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Equation 5.14 is the basic formula for CAPM where the expected return for risky
asset A is the sum return for risk-free assets and risk premium for risky assets A.
This equation shows how SML connects the expected returns for risky asset A
with the beta of risky asset A.
rA

rf

(rm

(5.14)

rf )A

Assume that there is an investment portfolio that comprised of all the securities
in the market. This type of portfolio is known as market portfolio where the
expected return for this portfolio is stated as rm. As this portfolio represents all
the securities in the market, then it is certain that this portfolio has an average
systematic risk that is bm = 1.0. The SML gradient for market portfolio is:
rm

rf

rm

rf
1

rm

rf

(5.15)

Example 5.5
First Portfolio
Assume the portfolio comprised of investments in security X (where its beta is 1.5
and the expected return is 18%) and risk-free security (where rf is 7%). 30% of
the investment is invested in security X, while 70% is invested in the risk-free
security.
Therefore,
rportf. = {[(0.30) (0.18) + (0.70) (0.07)]}
= 10.30%
portf.

= {[(0.30) (1.5) + (0.70) (0)]}

= 0.45

Reward to risk ratio can be calculated based on the following formula:

SML gradient =

rx rf
x

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For security X, the reward to risk ratio is

RISK ANALYSIS

197

(18 7)
1.5

= 7.33%
(meaning that security X has a reward to risk ratio of 7.33%)
Example 5.6
Second Portfolio
Assume the portfolio comprised of investments in security Y (where its beta is 1.1
and the expected return is 14%) and risk-free security (where rf is 7%). 30% of
the investment is invested in security Y, while 70% is invested in the risk-free
security.
Therefore,
rportf. = {[(0.30) (0.14) + (0.70) (0.07)]}
= 9.10%
portf.

= {[(0.30) (1.1) + (0.70) (0)]}

= 0.33

Reward to risk ratio can be calculated based on the SML gradient:

=

ry

rf
y

(14 7)
1.1

= 6.36%
(meaning the security has a reward to risk ratio of 6.36% which is less than the
7.33% offered by security X)

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Figure 5.6: SML gradient for portfolio X and Y

Figure 5.6 shows the graph position that draw the combination points of expected
returns and beta for security X that is higher compared to security Y. This situation
explains that the return offered by the first portfolio is higher compared to the
return offered in the second portfolio at any level of systematic risk that is
measured by beta.

SELF-CHECK 5.3
What is your financial planning after your retirement? How do you
ensure that your savings are enough to provide for your old age?

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RISK ANALYSIS

EXERCISE 5.3
1. You are considering two alternatives in buying shares from either
Company A or Company B. The share broker had prepared an
estimated return for both these shares as stated below.
Shares Company A

Shares Company B

Probability

Return (%)

Probability

Return (%)

0.05

0.05

15

0.15

30

0.05

35

0.25

25

0.20

20

0.25

15

0.20

30

0.30

20

0.50

25

(a)

Draw a bar chart for the shares in Company A and Company

B.

(b)

Calculate the range of probability distribution for the return

of shares in Company A and Company B.

(c)

Determine which of the shares is riskier.

2.
Economic Situation

Probability

Estimated Return (%)

Shares X

Shares Y

Strong

0.6

14

Moderate

0.4

12

50 percent from the total capital was invested in shares X and the
remaining 50 percent was invested in shares Y.
(a)

Calculate the expected return for each security.

(b)

Calculate the expected portfolio return for shares X and shares

Y.

(c)

Calculate the standard deviation for the portfolio of shares X

and shares Y.

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3. What will happen to the portfolio investment risks of shares S and

shares L if the correlation multiplier for return of both these shares
changed from a positive value to a negative value?
4. Recently, Jacob Company is considering a project that has a beta of
1.40. Currently, the risk-free rate is 6% and the return for market
portfolio is 11%. It is expected that this project will generate an
annual rate of return of 12%.
(a)

By using the CAPM formula, calculate the required rate of

return on the investment in this project.

(b)

Based on the answer in (a), is it feasible for Jacob Company to

invest in this project?

(c)

What is the required rate of return on the investment in this

project if the rate of return for the market portfolio increased
by 10 percent?

5. What is the risk status for a share if the beta for this share is less
than 1.0?
6. The management of Danun Company is considering two choices for
the best investment portfolio that is (1) combination of financial
assets A and B (2) combination of financial assets A and C. The
investment planned is 50 percent for each asset component in each
portfolio.
The following are the estimated returns for all the three types of
financial assets:
Year

Expected Return (%) of Financial Assets

A

2003

12

16

12

2004

14

14

14

2005

16

12

16

(a)

What is the expected return for each portfolio?

(b)

What is the standard deviation for each portfolio?

(c)

Which portfolio should Danun Company choose?

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7. The estimated beta for the shares in Emas Company is 1.3. The riskfree rate is 8 percent and the estimated market return is 16 percent.
(a)

Based on the CAPM formula, what is the required rate of

return for investors who invest in the shares of Emas
Company?

(b)

What is the premium value of the market risk?

8. The following information is the probability distribution for the

returns of share V and share W.
Probability

Expected Returns (%)

Share V

Share W

0.1

0.2

0.3

0.4

Based on the information above, calculate:

(a)

Expected returns for each share.

(b)

Variance for each share.

(c)

Standard deviation for each share.

(d)

Covariance between the returns of share V and share W.

(e)

Correlation between the returns of share V and share W.

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Mesra Company has two choices in investment portfolio.

First Choice

Second Choice

Invest 40% in share N and 60%

in risk-free security.

Invest 50% in share M and

50% in risk-free security.

Expected return for share N is

13% and for risk-free security
is 6%.

Expected return for share M is

16% and for risk-free security
is 6%.

Beta for share N is 1.25.

Beta for share N is 1.4.

Based on the information above, calculate:

10.

(a)

Expected portfolio return, portfolio beta and reward to risk

ratio for both investment alternatives; and

(b)

Which portfolio should be chosen by Mesra Company?

Share A has a beta of 1.2 and expected return of 20%. Meanwhile,

share B has a beta of 0.80 and expected return of 13%. If the riskfree rate is 5% and the market premium risk is 12%, which share is
said to be overpriced or underpriced?

In this topic, you have been exposed to the basic knowledge on risk and
return from the perspective of an investor. Based on this knowledge, it is
hoped that you will be able to apply it to ascertain the risk and return of an
investment in a security as well as in a portfolio.
The importance of return and risk can also be analysed from the viewpoints
of financial managers and financial markets.
They assess the return and risk of all major decisions to make sure that the
best return is being earned for a given level of risk or that risk is being
minimised for a given level of return which is also known as efficient
portfolio.

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Beta

Portfolio

Capital asset pricing model (CAPM)

Return

Capital market line

Risk

Coefficient of variation

Risk-free assets

Correlation coefficient

Security market line

Covariance

Standard deviation

Diversification

Systematic risk

Expected return

Unexpected return

Market risk

Variance

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Topic

Criteria of
Capital
Budgeting

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Determine the acceptability of a new project based on the payback
period, net present value, the profitability index and the internal rate
of return; and
2. Explain the advantages and disadvantages of each capital budgeting
technique.

INTRODUCTION
Capital budgeting is a process where firms plan the investments in long-term
assets or activities that have long-term financial implications. It involves a
substantial cash withdrawal and the cash inflow is for a long period in the future.
Just like other decisions making process, capital budgeting involves the
considerations and valuation of available alternatives. Among the important
matters that must be given attention in the valuation process of capital budgeting
projects are the appropriate use of techniques and accurate estimation of cash
flow as inputs to the techniques that will be used.

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205

CAPITAL BUDGETING
SELF-CHECK 6.1

In your opinion, what are the criteria to be considered in capital

budgeting? Explain.

Capital budgeting refers to the technique used for analysing whether an

investment in an asset or long-term project is profitable or not profitable. These
techniques are often mentioned as the criteria of capital budgeting. There are four
basic techniques in capital budgeting; which are:
(a)

Payback period technique;

(b)

Net present value technique;

(c)

Profitability index; and

(d)

Internal rate of return technique.

6.2

PAYBACK PERIOD

The payback period technique involves the use of payback period criteria as
the basis in decision making. The payback period, normally referred with the
acronym PBP, is the time period taken by a project to regain the sum of money
invested at the beginning of the project.

6.2.1

Calculation of Payback Period

Examples 6.1 to 6.3 show how the payback period (PBP) is obtained.

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Example 6.1
Project A has the following cash flow. What is the PBP of this project?
Year

Cash Flow (RM)

Cumulative Cash Inflow (RM)

100,000

20,000

20,000

20,000

40,000

30,000

70,000

30,000

100,000

30,000

130,000

The negative cash flow of RM100,000 at year 0 equals the total that was invested,
or the cash outflow as the money has been spent on this project. Observe that in
year 4, the cumulative cash inflow is RM100,000, matching the cash outflow
(initial capital) at year 0. Therefore, the PBP for Project A is 4 years, that is the
time where the total sum obtained matches the total sum withdrawn.
Example 6.2
When PBP is between two different time periods, we can assume that the
distribution of cash flow is uniform. In this situation, we can use the linear
interpolation to estimate the PBP for the project assessed.
The project of purchasing a grinding machine has a cash flow as follows:
Year

Cash Flow (RM)

Cumulative Cash Inflow (RM)

200,000

50,000

50,000

50,000

100,000

70,000

170,000

70,000

240,000

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Based on the above cash flow, the PBP for this project is found to be within
3 years to 4 years because to achieve PBP, the cash inflow must be equal to the
cash outflow at the beginning of this project that is RM200,000. At the third year,
the cumulative cash inflow of RM170,000 is still short of RM30,000 (RM200,000
RM170,000) to achieve the PBP. By estimating that the cash flow distribution is
uniform, the calculation of PBP for the project of purchasing a grinding machine
is as follows:

RM30,000
70, 000

PBP

3 years

PBP

3.43 years

*Note: RM30,000 is the remaining balance that needs to be recovered

For projects that generate cash flow in the form of annuity, you can use
formula 6.1 to calculate the PBP.
PBP

IO

IO
ACF

(6.1)

= Initial Outlay

ACF = Annual Cash Flow

Example 6.3
Suppose there is a project that involves a cash outflow of RM700,000 and it is
expected to produce a cash inflow of RM200,000 every year throughout the
lifetime of the project, which is 5 years. By using formula 6.1, the PBP of this
project is:
PBP

RM700,000
RM200, 000
3.5 years

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By using the cash flow schedule, we can also obtain the same answer, which is
PBP = 3.5 years.

6.2.2

Year

Cash Flow (RM)

Cumulative Cash Inflow (RM)

700,000

200,000

200,000

200,000

400,000

200,000

600,000

200,000

800,000

200,000

1,000,000

Application of Payback Period

After knowing what is meant by PBP and how it is calculated, the next step is to
use this technique in making decisions, whether to accept or reject a capital
budgeting project.
If a comparison is made between two projects with different PBP, the project
with the lower PBP value is better as the company will regain its invested capital
faster. Therefore, the company will have the opportunity to use that cash for
other investing purposes. Besides that, a shorter PBP shows that the period
where the company is exposed to investment risks is also shorter.
In deciding whether to accept or reject a project, the company must compare the
PBP of the project with the targeted PBP set by the company. This technique
proposed that a project will be rejected if the PBP of that project is longer than the
targeted PBP and vice versa, that is, the project should be accepted if the PBP of
that project is less than the targeted PBP.
By referring to example 6.1, if the company involved had set the targeted PBP for
the project at 3 years, the PBP technique proposed that project A to be rejected as
the PBP of project A of 4 years exceeded the targeted PBP of 3 years.

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The criteria for accepting or rejecting a capital budgeting project can be

summarised as follows:
(a)

Accept project if PBP

(b)

Reject project if PBP > targeted PBP

targeted PBP

What is important is to evaluate whether the PBP of the project is less or more
than the targeted PBP. The manager need to calculate the PBP of the project
accurately as it is important to ensure whether the PBP of the project is higher or
lower than the targeted PBP. To evaluate whether the PBP of the project is higher
or lower than the targeted PBP, we only need to determine whether the
cumulative cash inflow of the targeted PBP is higher or lower than the initial cash
outflow.
Example 6.4
Suppose that the targeted PBP for the project in example 6.2 is 4 years. Should the
company purchase the grinding machine?
Solution
The cumulative cash inflow at year 4, which is at the targeted PBP, is RM240,000.
As this total is more than the initial cash outflow of RM200,000, therefore it can
be concluded that the PBP of the grinding machine is higher than the targeted
PBP. Based on the PBP technique, the grinding machine should be purchased.

EXERCISE 6.1
1. You are considering the following two projects:
Project A
Requires an initial investment of RM250,000 and this project will
generate cash inflow of RM100,000 at the end of the second and
third year and RM150,000 at the end of the fourth year.
Project B
Requires an initial investment of RM400,000 and this project will
produce cash inflow of RM125,000 every year for five years.
Based on the PBP technique, should these projects be accepted if the
targeted payback period is 3 years?
2. Calculate the payback period for a project that involves the initial
cash outflow of RM1 million and an annual cash inflow of RM100,000
for the first five years and RM200,000 for the next five years.

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6.2.3

CRITERIA OF CAPITAL BUDGETING

Advantages and Disadvantages of Payback Period

The main advantages of using the PBP technique are as follows:

(a)

PBP is easy to calculate and understand.

(b)

PBP uses the cash flows and not accounting profits as the basis of
calculation. The use of cash flow as the basis of calculation is more accurate
as it shows the income and cost involved and also clearly shows the time
when the cash flow occurs.

(c)

The criteria of PBP is an indication of the liquidity for the project. A shorter
PBP shows that the period where the funds are tied to a project is shorter.

(d)

The criteria of PBP also takes into account the risk of a project. A cash flow
that is distant has higher uncertainties. Therefore, the company should
focus on a lower PBP to reduce risk that may be faced by the company.

SELF-CHECK 6.2
State the advantages and disadvantages of Payback Period (PBP) in
capital budgeting.

However, the PBP technique has two main disadvantages, which are:
(a)

PBP Does Not Take into Account the Concept of Time Value of Money
The cumulative cash inflow is obtained by totalling the cash flow at
different times without making any adjustments to the time value of
money. An analysis that does not take into account the time value of money
concept, implicitly assumes that the opportunity cost of the funds is 0.
Further explanation on this disadvantage is shown in the following
example.
Example 6.5
Year

Project A

Project B

100,000

100,000

60,000

40,000

40,000

60,000

30,000

30,000

10,000

10,000

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Referring to the above schedule, both these projects have the same PBP that
is in the second year. This means that both these projects should be given
the same priority if PBP is applied.
Based on the concept of time value of money, we know that project A is
better than project B because it produces an extra cash flow of RM20,000
(RM60,000 RM40,000) in the first year compared to project B. This extra
cash flow can be reinvested to generate returns. As PBP does not take into
account the time value of money, the use of this technique is limited.
Therefore, the finance manager should not merely depend on the PBP
technique in making major investment decisions.
However, this disadvantage can be overcome by using a discounted
payback period technique. A discounted payback period technique
determines the period that is required to regain the sum of money invested
but the cash inflow is discounted to the present value before making
decision on whether to accept or reject a project.
(b)

PBP Does Not Take into Account the Cash Flows After the Payback Period
One of the disadvantages of the PBP technique is that it disregards the cash
flow after the payback period. Thus, long-term projects cannot be valued
accurately. This disadvantage can be shown in the example.
Example 6.6

Year

Cash Flow (RM)

Project A

Project B

100,000

100,000

50,000

50,000

50,000

40,000

40,000

40,000

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Based on PBP, project A is better than project B because the PBP for project A is
shorter than project B (2 years compared to 4 years). If the targeted PBP is not
more than 2 years, the PBP technique would accept project A and reject project B
even though project B generates cash flow after the targeted PBP. By not taking
into account the cash flow after the payback period, the company may disregard
another better and more profitable investment merely because it does not fulfil
the targeted PBP.

EXERCISE 6.2
1. Most companies use the payback period as a guideline for making
decisions in capital investments because of the following reasons
except:
A.

It provides implicit consideration on the timing of cash flow.

B.

Identifies cash flow that will be obtained after the payback

period.

C.

Measures the exposure to risks.

D.

Simple calculation.

E.

A and C.

2. The main disadvantage(s) of the payback period technique is

____________.

6.3

A.

it cannot be used as an indicator of risk

B.

it disregards cash flow after the pay back period

C.

it does not take into account the time value of money

D.

B and C

NET PRESENT VALUE

Net present value is a technique for making decisions in capital budgeting that is
based on the criteria of net present value, simplified as NPV. It is one of the
techniques of discounted cash flow as it uses the cash flow that has been adjusted
for the time value of money.

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213

Calculation of Net Present Value

Net Present Value (NPV) is the difference between the present value of cash
inflow with the present value of cash outflow in a project. As the cash outflow for
a capital budgeting project usually occurs at the beginning of a project, the
formula for NPV is stated as follows:

NPV

CF1

CF2
1

(1 k)
n

CFt

t 1

1 k

(1 k)
t

...

CFn
(1 k)n

I0

I0

Where:
I0

= Initial cash flow

CFt = Cash flow for period t

k

= Cost of capital

= Project lifetime

The cost of capital is the required rate of return for a firm, from a particular new
capital budgeting project in order to maintain the value of the firm.
Example 6.7
Year

Cash Flow (RM)

200,000

40,000

80,000

100,000

100,000

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A project has a cost of capital of 15% and the cash flow is as follows:
Calculation:

NPV

RM40, 000
(1 0.15)

RM80, 000
(1 0.15)

RM100, 000
(1 0.15)

RM100, 000

(1 0.15)4

RM200, 000

can also be written as PVIF15%,n, the formula above can also be

(1 0.15)n
solved using the present value schedule.

As

NPV = 40,000(PVIF15%,1) + 80,000 (PVIF15%,2) + 100,000 (PVIF15%,3) +

100,000 (PVIF 15%,4) 200,000
NPV = 40,000 (0.870) + 80,000 (0.756) + 100,000 (0.658) + 100,000 (0.572) 200,000
= RM34,800 + RM60,480 + RM65,800 + RM57,200 RM200,000
= RM18,280
The table below summarises the calculation of present value.
Year
(1)

Cash Flow (RM)

(2)

Discounting Factor
PVIF15%,n (3)

Present Value (RM)

(2) (3)

40,000

0.870

34,800

80,000

0.756

60,480

100,000

0.658

65,800

100,000

0.572

57,200

Present value cash inflow

Initial cash outflow
Net present value

218,280
(200,000)
RM18,280

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Example 6.8
If a project has a cash inflow that is in the form of annuity, the calculation for
NPV is easier and simpler as you can use the present value factor annuity in your
calculations.
Suppose a project involves the initial investment cost of RM 1 million. It is
expected to produce a cash flow of RM 250,000 per year for 5 years. If the cost of
capital for this project is 12%, the NPV for this project is:
NPV = RM250,000 (PVIFA 12%,5) RM1,000,000
= RM250,000 (3.605) RM1,000,000
= RM901,250 RM1,000,000
= RM 98,750

6.3.2

Application of Net Present Value

NPV of a project shows the amount of increase or decrease in the value of a firm
that is caused by the investment in the project. NPV that is equivalent to zero
shows that the value of the firm is maintained. A positive NPV will increase the
value of the firm while a negative NPV will decrease the value of the firm.
Based on the explanation above, a project should be accepted if the NPV is
positive and should be rejected if the NPV is negative. Therefore, the project in
Example 6.7 should be accepted, while the project in Example 6.8 should be
rejected.
The criteria for rejecting/accepting an investment decision based on this
technique of net present value can be summarised as follows:
(a)

If the projects that are evaluated are independent projects, accept the
projects that have NPV 0.

(b)

If the projects that are evaluated are mutually exclusive projects, accept the
projects that have the highest NPV and NPV 0

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6.3.3

Advantages and Disadvantages of Net Present

Value

CRITERIA OF CAPITAL BUDGETING

The advantages of the NPV technique are as follows:

(a)

It uses the cash flow and not accounting profits.

(b)

It takes into account the timing of cash flow by using the discounted cash
flow or the concept of time value of money.

(c)

It takes into account all the cash flows of the project.

(d)

The criteria of NPV is in accordance with the concept of owners wealth

where, in theory, NPV of a project represents the explicit measurement of
the increase or decrease of a firms value and owners wealth. Therefore,
the NPV technique is the best technique in the perspective of financial
theory.

Disadvantages of the NPV technique are as follows:

(a)

The calculation of NPV is rather complex compared to PBP because it

requires an in-depth understanding of the concept and calculation of
present value.

(b)

The calculation of NPV requires information on the cost of capital for the
project that is sometimes difficult to ascertain.

ACTIVITY 6.1
What is the relationship between the cost of capital and NPV?

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EXERCISE 6.3
1. You are required to evaluate three projects that have a cash flow
estimation as shown in the table below.
Cash Flow (RM)
Year

Project A

Project B

0
1
2
3
4
5
6
7
8
9
10

26,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000
4,000

500,000
100,000
120,000
140,000
160,000
180,000
200,000

Project C
100,000
0
0
0
30,000
40,000
0
60,000
70,000

If the cost of capital for these projects is 10%, should you make
investments in these projects if you use the NPV technique?
2. The opening of a mini market involves a cost of RM300,000 as the
initial capital. It is expected that the mini market will generate a
cash flow of RM20,000 every year for a period of five years. At the
end of the fifth year, the mini market can be sold to generate a cash
flow of RM400,000. What is the NPV if the cost of capital is
equivalent to 10%?
3. When the cost of capital increases, the NPV of the project will
________________.

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TOPIC 6

6.4

CRITERIA OF CAPITAL BUDGETING

PROFITABILITY INDEX

The technique of profitability index or PI uses the criteria that is known as

profitability index as the evaluation basis for capital budgeting projects.

6.4.1

Calculation of Profitability Index

Just like the NPV, the Profitability Index (PI) uses a discounted cash flow as the
evaluation basis. Therefore, it is grouped in the criteria of discounted cash flow.
PI is defined as the present value per Ringgit of investment and is a type of
benefit-cost ratio.
Formula for PI is as follows:
n

PI

CFt
t
1 (1 k)
I0

(6.2)

The PI calculation requires an input similar to the calculation of NPV. If we

return to the project in example 6.8, we will find that the project PI is 0.90125,
which is RM901,250 divided by RM1,000,000.

6.4.2

Application of Profitability Index

In principle, a project is profitable if its benefit exceeds its cost. The general rule
for Profitability Index (PI) is that the project should be accepted if the PI is the
same with or more than 1. As we have discussed, the value of the firm will
increase if the NPV is positive. Observe that a positive NPV is the same with the
situation where the PI is more than 1. In accordance to this, the value of the firm
will increase if the PI is more than 1. Therefore, the PI technique encourages the
project to be accepted if the PI is more than one and rejected if the PI is less than 1.

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219

In summary, the criteria for acceptance/rejection are as follows:

(a)

Accept the project if PI

(b)

Reject the project if PI 1

(c)

If PI = 0, the project will have no effect on the wealth of the company.

Therefore, the acceptance or rejection of the project will not have any effect
on the company.

6.4.3

Advantages and Disadvantages of Profitability

Index

In summary, the PI has advantages and disadvantages that are almost the same
with the NPV technique. Its disadvantage compared to the NPV is that it does
not measure the total increase in wealth, as measured by the NPV.
It also has an advantage where it is used together with the NPV to make
decisions in situations where the investment capital of the firm is limited.

EXERCISE 6.4
Calculate the PI for the projects in question 1 of Exercise 6.3.

6.5

INTERNAL RATE OF RETURN

SELF-CHECK 6.3

If the NPV for a project at a discount rate of 15% is (RM350,000), the

IRR for this project is more than 15%. Is this statement true or false?

This technique uses the criteria known as the internal rate of return as the
evaluation basis in capital budgeting project.

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6.5.1

Calculation of Internal Rate of Return

CRITERIA OF CAPITAL BUDGETING

The internal rate of return (IRR) of a project is defined as the rate of discount that
equates the present value of cash inflow with the initial cash flow, or the rate of
discount when the NPV is equal to zero.
It is calculated using the following mathematical equation:
NPVIRR

CFt

n
t 1 (1

I0

IRR)t

The manual calculation of IRR involves a process of trial and error and linear
interpolation. Example 6.9 shows the calculations involved in using the above
equation.
Example 6.9
Two projects have the following cash flows:
Cash Flows (RM)

Year

Project A

Project B

100,000

1,000,000

50,000

250,000

40,000

250,000

30,000

250,000

10,000

250,000

250,000

IRR for Project A is:

NPVA, IRR

50,000

40,000
1

(1 IRR)

(1 IRR)

30,000
2

(1 IRR)

10,000
3

(1 IRR)4

100,000 0

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Manually, you would have to use the trial-and-error method, where you would
include a discount rate (k) and determine whether NPV is equal to 0 or not. You
might have to do this process several times until you obtain k when NPV is equal
to 0. (Whenever possible, you should try until you obtain a positive number and
a negative number). There is a bigger possibility that it would involve a linear
interpolation where the IRR is not a whole number. Calculators and certain
computer packages can be used to help calculate the IRR that is not a whole
number.
Suppose after several trials, you finally tried k = 14%
NPVA,14% = 50,000(0.877) + 40,000(0.769) + 30,000(0.675) + 10,000(0.592) 100,000
= RM780
Based on this NPV value, and the inverse relationship between k and NPV, it is
clear that you should try a discount rate higher than 14%. Suppose you tried 15%.
NPVA,15% = 50,000(0.870) + 40,000(0.756) + 30,000(0.658) + 10,000(0.572) 100,000
= RM800
As the NPVA,14% is positive and NPVA,15% is negative, we know that the IRR is
between 14% and 15%.
Rate (%)

Value (RM)

14%

780

NPV

15%

800

To get the estimated IRR for Project A, you can perform the linear interpolation
as follow:
14%

780
15% 14%
780 800

14% 0.49%
14.49%

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For project B, the calculation of IRR is easier because you can use the function of
present value annuity to simplify your calculations. This is because the cash
inflow for years 1 to 5 is uniform that is at RM 250,000.
You can get the IRR by using the following equation:

250,000 (PVIFAIRR,5 )

NPVB,IRR

1,000,000

PVIFAIRR,5

1,000,000
250,000
4

Refer to the schedule of present value annuity (see row period 5) you will get 8%.
Through the trial-and-error method, you will find that the IRR for Project B is
between 7% and 8% as shown in the following table.
Rate (%)

Value (RM)

7%

25,000

NPV

8%

1,750

To obtain the estimated IRR, you can perform the linear interpolation as follows:

= 7% +

25,000
(25,000 + 1,750)

(8%

7%)

= 7% + 0.94%
= 7.94%
The calculation of IRR is much easier if you use a financial calculator. There are
special functions to calculate the IRR and you only have to enter the information
into the schedule above.

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6.5.2

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223

Application of Internal Rate of Return

IRR is the expected rate of return that will be obtained by a firm if a project is
accepted. Meanwhile the cost of capital, k, is the required rate of return from the
project to maintain its value. If the IRR of the project is higher than k, then the value
of the firm will increase and vice-versa, the value of the firm will fall when the IRR is
lower than k. The value of the firm will not change if the IRR is equal to k.
In summary, the criteria for acceptance and rejection of a project based on the
IRR are as follows:
(a)

If the projects evaluated are independent projects, accept the project that
have IRR cost of capital.

(b)

If the projects evaluated are mutually exclusive projects, accept the project
with the highest IRR and between the projects that have at least an IRR
equal to the cost of capital.

Referring to the projects in example 6.9, if the cost of capital is 14%, project A will
be accepted while project B will be rejected.

EXERCISE 6.5
1. When the net present value is negative, the internal rate of return is
_____________ the cost of capital.
A.

bigger than

B.

bigger than or equal to

C.

less than

D.

equal to

E.

cannot be identified without cash flow

2. The internal rate of return is the _______________.

A.

rate of discount that produces a positive NPV

B.

rate of discount that is equal with the present value of cash

inflow with the present value of cash outflow

C.

rate of discount that produces a negative NPV

D.

rate of discount that produces a positive payback period

E.

A and D

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3. Voltex Company is considering a new project. This project will

involve an initial investment of RM1,200,000 and will produce
RM600,000 cash flow every year for 3 years. The IRR of this project
is
A.

14.5%

B.

18.6%

C.

23.4%

D.

20.2%

4. Project M has the following cash flows:

C0 = 2,000

C1 = 500

C2 = 1,500

C3 = 1,455

What is the IRR value for project M?

6.5.3

A.

10%

B.

18%

C.

28%

D.

None of the rates above

Advantages and Disadvantages of Internal Rate

of Return

After understanding what is IRR and how it is applied, now we will look at the
advantages and disadvantages of IRR.
The advantages of IRR are as follows:
(a)

Just like the criteria of PBP and NPV, IRR uses the cash flow and not
accounting profits as the basis for calculations.

(b)

Just like the criteria of NPV, the IRR takes into account the time value of
money in its calculations.

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(c)

CRITERIA OF CAPITAL BUDGETING

225

In a lot of situations, the IRR technique provides a solution that is parallel

with the NPV technique. The IRR technique is acknowledged to be the best
technique in the perspective of financial theory. This is because when a
project has IRR more than k, its NPV is also more than 0.
(i)

If k > IRR, NPV < 0 ; project should be rejected.

(ii)

If k < IRR, NPV > 0; project should be accepted.

(iii) If k = IRR, NPV = 0; project should be accepted.

The disadvantages of IRR are as follows:
(a)

The calculation of IRR is more complicated compared to NPV.

(b)

The calculation of IRR requires information on the cost of capital of the

project which is rather difficult to ascertain.

(c)

Decisions are difficult to make when IRR is multiple, which is a situation

where the solution of the mathematical equation for IRR gives more than
one answer. This situation will be faced in the consideration of projects that
are unconventional. Conventional projects are defined as projects where the
cash outflow only happens in the beginning of the project, while in the
following years, the project will generate cash inflows. The signal for this
cash flow has the following pattern: + + + + +. For projects that are
unconventional, the cash outflow can occur in the middle of a series of cash
inflows, for example, projects that have the following cash flow pattern: +
+ - + + - + +. The number of IRR for such projects is the same with the
number of the cash flow direction change, in this example, its number is 5.

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EXERCISE 6.6
1. Multiple internal rate of return (multiple IRR) happens because of
_____________.
(a)

differences in the timing of cash flow for the project

(b)

differences in the size of the project investment

(c)

differences in the assumption of the rate of re-investment

(d)

differences in the annual cash flow pattern of the project

2. A project has an initial cash outflow of RM10,000 that produces a

single cash flow of RM16,650 in year 1. If the cost of capital is 12%,
calculate the:
(a)

Payback period

(b)

Net present value

(c)

Profitability index

(d)

Internal rate of return

3. A project has an initial cash outflow of RM10,000 and produces a

cash inflow of RM2,146 every year for the next ten years. If the cost
of capital is equal to 12%, calculate the:
(a)

Payback period

(b)

Net present value

(c)

Profitability index

(d)

Internal rate of return

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4. A project has the initial cash outflow of RM10,000 and produces cash
inflow of RM3,000 at the end of the first year, RM5,000 at the end of
the second year and RM7,500 at the end of the third year. If the cost
of capital is equal to 12%, calculate the:
(a)

Payback period

(b)

Net present value

(c)

Profitability index

(d)

Internal rate of return

5. Bina Company is evaluating two projects of constructing two

different luxury apartments in two towns in the state of Kedah. The
initial investment for both projects are the same, that is RM160,000.
The required rate of return for these projects is 10%. The following is
the estimated annual cash flow for the first 6 years.
Year

Mergong Project (RM)

Sik Project (RM)

40,000

30,000

40,000

35,000

40,000

35,000

40,000

30,000

40,000

40,000

40,000

51,000

Based on the above information, you are required to make an

analysis for the decision on capital budgeting based on these
techniques:
(a)

Payback period

(b)

Net present value

(c)

Profitability index

6. List one advantage and one disadvantage that is unique for each of
the following capital budgeting evaluation techniques:
(a)

Payback period

(b)

Net present value

(c)

Internal rate of return

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There are four main types of techniques in capital budgeting, which are PBP
technique, NPV technique, PI technique and IRR technique.
The payback period (PBP) is the number of years required to regain the
project costs. By using this technique, the project will be accepted if its PBP is
less than the targeted PBP.
The net present value (NPV) is the difference between the present value of
cash inflows with the present value of cash outflow. By using this NPV
technique, the project will be accepted if its NPV is more than 0.
The NPV technique is the best technique in the perspective of financial theory
because NPV measures the increase in the firms value and the owners
wealth that is affected by the evaluated project.
The profitability index (PI) is the ratio of present value of cash inflows
throughout the project with the initial outflow. Based on the PI technique,
this project will be accepted if the PI is more than 1.
The internal rate of return is the rate of discount where the NPV is equal to
zero. Based on the IRR technique, a project will be accepted if its IRR is more
than k.
One of the main disadvantages of IRR is the problem of multiple IRR, which
is a situation where the solution of the mathematical equation gives more
than one answer.
The techniques of NPV, PI and IRR are categorised as discounted cash flow
techniques (DCF techniques).

Annual cash flow

Internal rate of return

Capital budgeting

Net present value

Cost of capital

Payback period

Discounting factor

Present value

Initial outlay

Profitability index
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Cash Flow of
Capital
Budgeting

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Apply the guidelines in estimation of cash flow;
2. Explain the initial outlay;
3. Describe the operating and terminal cash flow; and
4. Apply capital budgeting technique in decision making.

INTRODUCTION
Several main techniques for capital budgeting discussed in Topic 6 required an
estimated cash flow in its calculations. Without the estimated cash flow, we
cannot apply these techniques. Therefore, it is important for us to understand
that a wrongly estimated capital budgeting cash flow will produce an inaccurate
decision that may result in a decrease in the owners wealth instead of increasing
the owners wealth.
This topic will discuss the estimation for cash flow of capital budgeting by
looking at three types of cash flow during the time it occurs. You will then find
that this separation is appropriate due to the uniqueness of the cash flows
involved at that time. Subsequently, we will analyse the items that must be taken
into account in estimating each type of these cash flows. Finally, we will apply
what we had learned in the decision making of capital budgeting.

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7.1

CASH FLOW OF CAPITAL BUDGETING

GUIDELINES IN ESTIMATING CASH FLOW

FOR CAPITAL BUDGETING
SELF-CHECK 7.1

State several guidelines that assist in estimating the cash flow for
capital budgeting.

To make more accurate decisions on capital budgeting, the finance manager

needs to consider several important guidelines. Generally, cash flow of capital
budgeting must fulfil the following characteristics:
(a)

It is an Additional Cash Flow

Cash flow for capital budget only involves the cash flow components that
changes as a result of the evaluated project. Suppose that Project A will
cause the cash sale revenue of the firm to increase from RM1 million to
RM1.5 million. In the estimation of cash flow for capital budget of Project
A, we will only take into account the inflow of RM0.5 million and not the
entire RM1.5 million. This is because we should only consider the effect of
the project. In this example, the concept of incremental cash flow is quite
obvious. However, in some situations, we may be confused if we are not
careful. The guidelines to decide whether the cash flow is an incremental
cash flow or not, compare the cash flow if the investment in the related
project is made with the cash flow without that project.

(b)

It Takes into Account the Effects of Taxation

Another important characteristic for cash flow of capital budgeting is that it
must take into account the cash flow after tax. It is obvious that tax imposed
on earnings is an expense that must be paid. Therefore, it should be taken
into account at the beginning of the calculation. This characteristic is
emphasised as we always disregard the effect of taxation although it
influences the total cash inflow and outflow of a project. Imagine if the
taxation rate of 30% is imposed and we expect to receive as much as RM1
million. We have to realise that in reality, we are not enjoying RM1 million
but only RM700,000.

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(c)

CASH FLOW OF CAPITAL BUDGETING

231

It Does Not Take into Account the Effect of Financing

Investment in capital assets involves a sum of financing, whether from
external sources or internal sources. Each of these sources would surely
involve cost. In estimating cash flow of capital budgeting, these costs are
not taken into account. Suppose our investment involves financing from the
bank, where the interest charged is RM30,000 per year. In estimating the
cash flow of capital budgeting, we do not take into account this cost. This
is because, as observed in the topic on cost of capital, the effect of this
financing had been taken into account when the cost of capital is used to
discount the cash flow. If it is taken into account in the calculation of cash
flow, the effect of this financing is taken into account twice. This method
can also differentiate the investment decisions from the financing decisions.

Several other guidelines that can assist in the estimation for cash flow of capital
budgeting are:
(a)

Disregard Sunk Cost

Sunk cost is the cost that has been spent that does not influence the decision
on accepting/rejecting a project. An example of sunk cost is the cost of
building a research laboratory that had been completed before the project
of producing a new product was considered. Based on the concept of
additional cash flow, sunk cost should not be taken into account in the
calculation for cash flow of capital budgeting, especially the initial cash
flow.

(b)

Do Not Disregard Opportunity Cost

Opportunity cost can be defined as the cash flow that could had been
obtained if the project under consideration was not implemented. For
example, the rental income from the factory that had been stopped because
of that project. Based on the concept of additional cash flow, this cost
should be taken into account as cash outflow due to the decrease in the
firms cash flow as a result of executing the project.

(c)

Do Not Disregard Side Effect

Side effect is the effect of accepting the project on the other sections of the
firm. For example, the effect of a project in producing a new product on the
production level of the other products. The effect might be cash outflow or
cash inflow, depending on whether its effect is positive or negative. We
need to take into account the side effects as it is in accordance with the
concept of additional cash flow. The failure to identify the side effects can
cause the project that is expected to be profitable, to be actually
unprofitable and resulting in negative effects to the firms value.

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After we have identified several of the important guidelines in estimating cash

flow of capital budgeting, the next step is to identify the types of cash flow
according to the time it occurs. There are three types of cash flow based on the
time it occurs, which are:
(a)

Initial Outlay (IO);

(b)

Operating Cash Flow (OCF); and

(c)

Terminal Cash Flow (TCF).

Figure 7.1 shows the three cash flows based on time line.

Figure 7.1: Time line showing the types of cash flow for capital budgeting

7.2

INITIAL OUTLAY
SELF-CHECK 7.2

What do you understand by initial outlay?

Initial outlay (IO) of a capital budget project refers to the total cash outflow that
is expected to occur at the beginning of an investment to enable an asset or
project to operate smoothly. As shown in Figure 7.1, IO is the cash flow at time 0.
The acronym IO is often used to represent initial outlay.
Among the main items that are involved in the estimation of IO are:
(a)

Cost of purchasing, installing and transporting the new assets;

(b)

Changes to the net working capital of the firm due to the investment made;
and

(c)

Sale revenue after tax for the old assets that must be sold if the project is
accepted.
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233

The calculation of IO depends on:

Whether or not it involves all items stated above; and

The taxation system being enforced.

Let us now discuss the items in the estimation of IO.

(a)

Cost of Purchasing, Installing and Transporting the New Assets

As discussed in section 7.1, we must be careful not to include the sunk cost,
for example the cost of setting up the laboratory that was made before the
decision for the capital budgeting was made. To simplify, only the cost that
must be spent to enable the project to be operational will be taken into
account.

(b)

Changes to Net Working Capital

Net working capital (NWC) is equivalent to the current assets deducted by
current liabilities. A capital budgeting project can have effect on the level
of NWC held by the firm. For example, the opening of a new factory is
expected to increase the level of account payable by RM500,000 (due to the
increase of purchases of raw materials and other on credit), the level of
account receivable by RM800,000 (due to the increase in credit sales), the
level of inventory by RM400,000 and also the level of short-term loans by
RM100,000.
These increases that are not balanced between the current assets and
current liabilities will cause the level of net working capital to change,
whether to increase or decrease. In summary, the changes in NWC are
represented by the following equation:
NWC = Current Assets Current Liabilities

(7.1)

In the above example, the changes in the level of net working capital are
calculated as follows:
Account receivable
Inventory
Short-term loans
Account payable
NWC

800,000
400,000
100,000
500,000
600,000

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The level of net working capital has increased by RM600,000. The level
of NWC will decrease if NWC has a negative value. Observe that the
negative symbol is used for the increase in current liabilities and its the
same when there is a decrease in the current assets.
As the increase in net working capital involves a sum of cash that is tied
to the firm, it is assumed as the cash outflow while the decrease in net
working capital involves the release of cash and is considered as cash
inflow.
The change in NWC is one of the important items in the estimation of IO as
this change usually occurs when the project is started.
(c)

Revenue from Sale of Old Assets, After Tax

For replacement projects where the new assets are bought to replace old
assets, the revenue from the sale of old assets must be taken into account as
one of the cash inflows in the calculation of IO as this replacement usually
occurs at the beginning of the project.

In some taxation systems, capital gain, which is the profit obtained from selling
the capital assets, will be taxed. Meanwhile, the losses that occurred from the sale
of capital assets will be tax savings. Therefore, we must take into account the
effect of taxation in the calculation of IO via the calculations of the revenue from
sales, after tax.
It must be noted that:

Tax is imposed on the components of disposal gains only and not the entire
revenue from the sale of the assets; and

Disposal gain is the surplus of selling asset new its book value.

The following equations will help us to understand and calculate the sales
revenue of the old assets after tax:
(a)

Sales revenue after tax = Selling price Increase in Tax

(b)

Tax in

= Tax rate (disposal gain)

(c)

Disposal gain

= Selling price Book value

(d)

Book value

= Original price Accumulated depreciation

(e)

Annual depreciation

Original cost
Economic life of the asset
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The calculation of depreciation above assumes that the asset is depreciated

according to the straight line method and is similar to capital allowance.
Now we will look at how the sales revenue of the assets after tax and the changes
in net working capital are handled via examples 7.1 and 7.2.
Example 7.1
Project A involves the replacement of an old grinding machine with a new
grinding machine. The old grinding machine was bought at a price of RM250,000
three years ago and has a lifetime of 5 years. What is the sales revenue of the
asset after tax if this old machine can be sold at a price of RM120,000 now and the
marginal tax rate is 30%?
Solution:
Step 1: Obtain the book value of the old machine
Book Value of old machine = Original price Accumulated depreciation
= RM250,000 RM150,000*
= RM100,000
* Assumption:
Asset is depreciated in a straight line.
Annual depreciation is equivalent to RM50,000 per year that is
Accumulated depreciation is RM150,000 (RM50,000

(RM250,000)
5

3 years)

The following calculation can also be used to obtain the book value of the old
machine:
Book value of old machine = Annual depreciation
= RM50,000 per year

Surplus lifetime
2 years

= RM100,000
Step 2: Obtain the capital gain for the old machine
Capital gain = Selling price Book value
= RM120,000 RM100,000
= RM20,000
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Step 3: Obtain the effect of taxation

= RM20,000

0.3

= RM6,000
Step 4: Calculate the sales revenue after tax for the old machine
= Selling price Increase in tax
= RM120,000 RM6,000
= RM114,000
Observe that in cases of capital losses, we will obtain a tax saving, where to
calculate the assets sales revenue after tax, we must add the tax saving to the
selling price of the asset.
In summary, the formula for sales revenue of asset after tax is as follows:
Sales revenue after tax = Selling price Increase in Tax
= Selling price [Tax rate (Selling price Book value)]

Example 7.2 shows the calculation of Initial Outlay (IO).

Example 7.2
Teguh Company plans to purchase a new cement mixing machine to replace the
old machine. The old machine was purchased 6 years ago at a price of RM200,000
and was depreciated using the straight line method to the scrap value equivalent
to zero, throughout its lifetime of 10 years.
If the company plans to replace this old machine, it can be sold at a price of
RM120,000. The price of the new machine is RM300,000 while the transportation
cost is RM20,000 and the installation cost is RM10,000. To meet this new level of
productivity, the raw materials inventory must be increased by RM20,000 and
the account payable will increase by RM10,000. The marginal tax rate of the
company is 30%. Based on this information, calculate the initial outlay.

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Solution:
* Changes in NWC

= Inventory Account payable

= RM20,000 RM10,000
= RM10,000 (outflow)

** Sale revenue after = Selling price Increase in Tax

tax for old machine
= RM120,000 RM12,000 ***
= RM108,000 (inflow)
*** Increase in Tax

= Tax rate (Selling price Book value)

= 0.3 [RM120,000 Unexpired lifetime
(Annual depreciation)]
= 0.3 [RM120,000 4 (RM20,000)]
= 0.3 (RM40,000)
= RM12,000

Initial outlay

= (300,000 + 20,000 + 10,000 + 10,000 108,000)

= RM232,000

ACTIVITY 7.1
Observe in Example 7.2, the sales revenue of the old machine after tax
had been deducted in the process of obtaining the initial outlay. Why?

EXERCISE 7.1
The purchase price of a new machine is RM35,000, the delivery cost
is RM3,000 and the installation cost is RM3,000. The lifetime of this
machine is 5 years. The old machine was bought at a price of RM15,000
and can be sold at RM17,000. This machine has a book value of
RM10,000. As a result of using the new machine, inventory had
increased by RM5,000. The taxation rate imposed is 30%. What is the
initial investment for this replacement project?

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7.3

CASH FLOW OF CAPITAL BUDGETING

OPERATING CASH FLOW

The operating cash flow for a capital budgeting project refers to the additional
cash inflow that is expected to occur in the beginning of the first year until the
end of the project lifetime, due to the investment made in the said project. As
shown in Figure 7.1, OCF is the cash flow from time 1 to n. The acronym OCF is
often used to represent operating cash flow.
Among the items that must be taken into account in the estimation of OCF are as
follows:
(a)

Change in sales revenue;

(b)

Change in cash operating costs; and

(c)

Change in taxation.

A capital budgeting project can cause changes to any one of the items above or all
of them at once. A development project, for example, has a higher possibility of
involving the changes to all the items above, while a manufacturing automation
project has a higher possibility of only involving a reduction in the cash
operation cost and taxation. The increase in revenue is a cash inflow while the
increase in cost and taxation are cash outflows. Generally, OCF can be stated in
the following equation:
OCF n = S n E n T n

(7.2)

Where:
S n = Increase in the sales revenue for year n
E n = Increase in the cash expenditure for year n
T n = Increase in taxation for year n
As E n only involve cash expenditure, the changes in depreciation, which is
a type of non-cash expenditure, is not taken into account in its calculation.
However, as a tax deduction item, the change in depreciation will influence the
changes to tax (assume that this depreciation is equal to capital allowance).
Therefore, it is important for the calculation of OCF. Suppose, the investment
in project A causes an increase in the annual depreciation by RM50,000. Even
though this RM50,000 does not involve cash flow, it can save on tax by
RM50,000
Rate of tax. This savings must be taken into account in the
calculation of OCF for this project.

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There are several formulas to calculate OCF. By using formula 7.2, we can expand
that formula as follows:
OCFm =
=

Sn En Tn
Sn En t ( Sn En Dn)

= ( Sn En) (1+t) + t( Dn)

(7.3a)

= ( Sn En Dn) (1 t) + Dn

(7.3b)

(7.3c)

NIn + Dn

Where:
Sn

= Increase in the sales revenue for year n

Dn = Increase in depreciation for year n

En

= Increase in cash expenditure for year n

Tn

= Increase in taxation for year n

NIn = Increase in net income for year n

t

= Tax rate
Dn is calculated as follows:
Dn = New depreciation amount Old depreciation amount

The equation 7.3b states that the cash flow for year n is equivalent to the increase
in net income (NI) plus the increase in depreciation. This can be explained quite
easily; because the calculation of net income (NI) involves the deduction of
depreciation (D), a non-cash cost, therefore to calculate OCF, this depreciation is
added back. You will see how these equations are used via Example 7.3.

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Example 7.3
We return to the project that is being considered by Teguh Company in Example
7.2. To estimate the operating cash flow of this project, we need to obtain the
information for the effect of this project on the level of sales, operating
expenditure and also the depreciation expenses.
The following information has been obtained:
(a)

The new machine will be used for 4 years and is depreciated using straight
line to the scrap value of zero.

(b)

At the end of year 4, this machine is expected to be sold at the price of

RM70,000. With this replacement, the company expects to increase the sales
revenue by RM50,000 per year.

(c)

At the same time, the cash expenditure will reduce by RM5,000 per year.

Based on the information above and the information provided in Example 7.2,
calculate the OCF for this project.
Solution:
Step 1: Collect all the related information.
S = RM50,000
E = RM5,000
Step 2: Calculate the changes in depreciation
Depreciation of old machine = RM20,000
Depreciation of new machine =

RM300,000 RM20,000 RM10,000

4

= RM82,500
D = RM82,500 RM20,000
= RM62,500

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Step 3: Calculate the OCF

OCF = ( Sn En Dn) (1 t) + Dn
= [RM50,000 (RM5,000) RM62,500] (1 0.3) + RM62,500
= (RM50,000 + RM5,000 RM62,500) (0.7) + RM62,500
= RM57,250

EXERCISE 7.2
The purchase price of a new machine is RM35,000, the delivery cost
is RM3,000 and the installation cost is RM3,000. The lifetime of this
machine is 5 years. The old machine was bought at the price of
RM15,000 and can be sold at the price of RM17,000. This machine has a
book value of RM10,000.
The usage of this new machine will reduce the wages cost by RM9,000,
Employees benefit by RM1,000 per year, the defect cost reduced from
RM8,000 to RM3,000. However, the maintenance cost will increase by
RM4,000 per year. The depreciation of the old machine is RM2,000 per
year. Assume that the taxation rate is 30%, how much is the annual
additional cash flow after tax?

7.4

TERMINAL CASH FLOW

Terminal cash flow for a capital budgeting project refers to the total cash flow
related to the termination of that project. As shown in Figure 7.1, it is referred to
as TCF. The acronym of TCF is normally used to represent terminal cash flow.
What are the items involved at the time a project is terminated? One of it is the
disposal price for the assets. The following are among the several important
items that form the TCF:
(a)

Sales Revenue After Tax of New Assets

As discussed above, we expect that the assets which had been used can be
sold and this will produce cash flow to the firm. The effect of taxation must
be taken into account in estimating cash inflow as a result of selling that
asset. Supposing, an asset in the project can be sold at the price of
RM100,000. Assuming there is no salvage value. The cash flow after tax can
be calculated as follows:
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Cash flow after tax = Selling price Increase in Tax

= Selling price (Tax rate

Disposal gain)

= RM100,000 0.3 (RM100,000)

= RM70,000
Observe that for asset with its salvage value of zero, the following formula
can be used:
Cash flow after tax = Selling price (1 Marginal tax rate)
(b)

Other Expenditure Related with Project Termination

The termination of a project involves a clean-up cost, moving cost or
refurbishment cost. All these involve cash flow at that time. These
expenditures are calculated as expenditures that are tax deductible.
Therefore, we must obtain these expenditures after taxes by using the
following equation:
Expenditure after tax = Expenditure (1 Marginal tax rate)
Suppose a project is expected to involve expenditure of RM250,000 for
clean-up works. If the tax rate is 30%, the clean-up expenditure after tax is
RM175,000, which is 0.7 RM250,000.

(c)

Regaining the Original Level of Net Working Capital

Normally, the changes to the level of working capital are maintained
throughout the lifetime of the project to provide for the requirement in the
operations of that project. Therefore, the increase only occurs in the
beginning of the project, which has been taken into account in the
calculations of IO. When the project is terminated, the company will return
to its original position before the project was implemented. The level of net
working capital is also expected to return to the original level. If at the
beginning of the project, the level of net working capital had increased, then
at the time of the project termination, this level of net working capital will
decrease to return to its original position. On the other hand, if the level of
this net working capital had decreased in the beginning of the project, then
this net working capital will increase at the time of the project termination
to return to its original position. Regaining the net working capital level
involves a cash flow, whether in or out depending on whether this level has
increases or decreases.

Suppose in the beginning of the project, the level of net working capital has
increase to RM200,000. You need to take into account the regaining of this level
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that will involve a cash inflow of RM200,000 in estimating the terminal cash flow.
This is because the level of net working capital is expected to decrease by
RM200,000.
Look at Example 7.4 to understand the terminal cash flow more clearly.
Example 7.4
Use the example of Teguh Company (Example 7.2) that is evaluating the
replacement of an old grinding machine with a new grinding machine. To assist
this company in making a decision whether or not this replacement should be
made, we need to calculate the TCF of this project. No other information will be
given besides those that had already been included in Examples 7.2 and 7.3.
Based on that information:
TCF is:
Sales revenue after tax of new machine [RM70,000 (1-0.3)] RM49,000
Other termination expenditures
Regaining the level of net working capital (decrease)

(0)
RM10,000

TCF

RM59,000

ACTIVITY 7.2
Explain the differences that exist among the concept of initial outlay,
operating cash flow and terminal cash flow.

7.5

APPLICATION OF CASH FLOW FOR

CAPITAL BUDGETING IN DECISION
MAKING

After the three types of cash flow have been estimated, we can now use the
capital budgeting techniques that were discussed in Topic 6. Look at Example 7.5
to understand how cash flows are estimated and used in capital budgeting.

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Example 7.5
We want to make a decision on whether the project of replacing a grinding
machine that is being considered by Teguh Company in Examples 7.2, 7.3 and 7.4
should be accepted or not. State your decision based on the PBP and NPV
techniques if the cost of capital used is 12% and the targeted PBP is 3 years.
Solution:
Estimation for cash flow of capital budgeting can be obtained as follows:
IO

= RM232,000

OCF = RM48,250
TCF = RM94,000

(a)

PBP Technique
The following cash flow schedule is used:
Time

Cash Flow

Cumulative Cash Flow

232,000

48,250

48,250

48,250

96,500

48,250

144,750

142,250

The cumulative cash flow for year three is RM144,750. As this total is less
than the initial cash outlay, which is RM232,000, it can be summarised that
the PBP of this project is higher than the targeted PBP. Based on the PBP
technique, this project should be rejected.

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245

NPV Technique
Based on the issues that we have learned in Topic 6, the following equation
can be used to obtain the NPV for this project:
NPV

CF
1 K

CF2
1 K2

...

CFn
1 Kn

RM48,250 PVIFA12%,4
RM48,250 3.037
RM206,319

I0

RM94,000 PVIF12%,4

RM94,000 0.636

RM232,000

RM232,000

RM232,000

RM25,680.75

The NPV value of this project is RM25,680.75. The negative NPV value will
decrease the value of the firm. Therefore, this project should be rejected.

EXERCISE 7.3
1. Koska Clothing Company intends to replace its old weaving
machine which had been fully depreciated. Two models are being
considered:
Item
Price
Lifetime
Additional cash flow after tax
(per year)

Model 190-4

Model 360-6

RM190,000

RM360,000

4 years

6 years

RM87,000

RM120,000

The cost of capital for Koska is 14% while the marginal tax rate is
20%. Which model should be chosen based on the information
above?

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2. Matasashita Company, which is a main manufacturing company of

electrical components, is considering replacing its current machine
with a more sophisticated machine. The following are information
on the old machine and new machine:
Old Machine

New Machine

Cost

RM100,000

RM135,000

Selling price

RM85,000

Lifetime

5 years

5 years

Usage period

2 years

RM18,000

RM34,000

Installation cost

RM5,000

Decrease in yearly wages

RM1,200

Increase in yearly maintenance

expenses

RM4,000

Sales revenue per year

Additional information:

Depreciation using the straight line method

Corporate tax is 20%

Cost of capital is 10%

(a)

You are required to calculate:

(i)

Book value of old machine

(ii)

Tax from sale of the old asset

(iii) Initial investment

(iv) Net operating cash inflow
(v)
(b)

Net present value (NPV)

Should the company replace the old machine with the new
machine?

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3. By using the information given below, compute the initial cash

outlay.
Purchase price of new machine

RM8,000

Delivery expenses

2,000

Market value of old machine

2,000

Book value of old machine

1,000

Decrease in inventory if new machine is installed

1,000

Increase in account receivable if new machine is

installed
Tax rate

500
34%

4. You are considering whether or not to replace the current meter with
a new meter. The old meter can be sold at the price of RM500. It
involves a cost of RM300 per year to operate. The new meter costs
RM4,000 and has a lifetime of 10 years. It also involves a cost of
RM140 per year to operate. If the cost of capital is 12% with taxation
disregarded, should the old machine be replaced?
5. Depreciation is not important in the calculation of cash flow for
capital budgeting. Is this statement true or false? Provide
explanations.

Estimating the cash flows is one of the most important process and the most
complicated in decision making on capital budgeting.
The concept of additional cash flow after tax is used to ascertain the cash flow
of capital budgeting.
Among the important issues that can be used as a guide in estimating the
cash flow for capital budgeting are the sunk cost, opportunity cost and side
effects.

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Capital budgeting projects normally involve changes to the level of net

working capital (NWC). These changes must be taken into account in the
calculation of cash flow for capital budgeting as an imbalance increase
between the current asset and current liability will cause the level of net
working capital to change.
Increase in NWC must be taken into account in the calculation of initial cash
outlay and in the calculation of terminal cash flow.
Cash flow for capital budgeting can be classified into three, which are initial
outlay (IO), operating cash flow (OCF) and terminal cash flow (TCF).
Among the main items that are involved in the estimation of initial outlay are
the purchasing cost, installation and transportation cost incurred by new
assets, changes to the net working capital level of the firm and sales revenue
after tax of the old assets that must be sold if the project is accepted.
Among the main items that must be taken into account in the estimation of
operating cash flow are the changes to sales revenue, changes to cash
operating cost and changes in taxation. Operating cash flow can be seen as an
increase in the net income plus the increase in depreciation.
Among several important items that form the terminal cash flow is the sales
revenue after tax of the new asset, other expenses related to the termination
of the project and regaining the original level of net working capital.

Initial outlay

Opportunity cost

Net working capital

Sunk cost

Operating cash flow

Terminal cash flow

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Cost of Capital

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Apply the principles in determining the cost of capital;
2. Calculate the cost of debts, cost of ordinary shares and cost of
preference shares; and
3. Determine a companys weighted average cost of capital (WACC).

INTRODUCTION
In Topics 4 and 5, we have discussed the relationship between the rate of return
with the risk in a security and the valuation process of bonds and shares. Next,
we will discuss cost of capital. Cost of capital is connected with the financing
decision and investment decision. It is the rate that must be achieved in an
investment before the shareholders wealth can be increased. The cost of capital
is often used interchangeably with the required rate of return by a company, the
rate of discount to evaluate new investments and opportunity cost of funds. Even
though its name is different, the concept remains the same.
In this topic, we will discuss the principle in determining the cost of capital of a
company and its rationale from the aspect of its usage and calculation. To obtain
the overall cost of the company or the weighted average cost of capital, we must
first obtain the cost for each capital resources, which are the cost of debts, cost of
preference shares and cost of ordinary shares.

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8.1

COST OF CAPITAL

DEFINITION FOR COST OF CAPITAL

Cost of capital is the minimum rate of return that must be obtained by the
company from its investments. It is for the purpose of guaranteeing the required
rate of return for the bond holders and the shareholders of the company. In other
words, cost of capital holds the role as the main liaison between the decisions of
long-term investment by the company with maximising the shareholders
wealth. It is very important to ascertain whether the investment proposal will
increase or decrease the share price or the value of the company. If the risk is
constant, a project with a higher rate of return than the cost of capital will
increase the value of the company while a project with a lower rate of return than
the cost of capital will decrease the value of the company.
The rate of return required by investors is defined as the minimum rate of return
required to attract the interest of investors to buy or hold a security. The rate of
return is the return from the investment that pays the cost of capital and is also
an incentive to attract investors.
There are two factors that differentiate between the rate of return with the cost of
capital, which are taxation and the types of transactions involved. When a
company borrows funds for the purpose of buying assets, the interest expenses is
deducted from the earnings before tax. This means that the cost of debt of the
company will reduce. The second factor that differentiates the cost of capital with
the required rate of return is the cost of transaction involved when the company
increases its funds by issuing securities. The cost of this transaction is known as
the floatation cost and this cost increases the companys overall costs.

SELF-CHECK 8.1
What is the role for cost of capital in the operations of a company?

8.1.1

Financing Policy and Cost of Capital

The financing policy of a company refers to the policy that has been specified by
the management in the financing of investments. In this topic, we will assume
that the company has a preset financial policy. The combination of financing that
is often used comprised of debts and equity.

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The cost of capital, which is the combined cost of all the company's financing
resources (debt and equity) is known as the weighted average cost of capital. It is
the average cost after tax for each capital resources that is used by the company
to finance its project. Weight refers to the percentage of usage for each resources
from the total overall financing. Most companies will make an effort to maintain
the optimal financing combination of debt and equity or better known as the
target capital structure.

SELF-CHECK 8.2
To maintain the market value of a company, the required rate of return
must be the same as the cost of capital.
How far do you agree with the statement above?

8.2

DETERMINING THE COST OF CAPITAL FOR

EACH COMPONENT OF CAPITAL
RESOURCES
SELF-CHECK 8.3

How do you think total cost of capital for the company is computed?

A company has various financial instruments or securities to attract new

investments. A company can increase its capital by borrowing (issuing bonds to
investors) or issuing ordinary shares or preference shares. The entire total of a
companys capital depends on the returns that are required by the investors. To
determine the total cost of capital, a company must determine the three capital
resources, which are debts, preference shares and ordinary shares. The cost of
capital for each financing resource is obtained by getting the required rate of
return for investors by taking into account the floatation cost and taxation
impacts.

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8.2.1

Cost of Debt

COST OF CAPITAL

The cost of capital for debts is obtained by getting the rate of return for debt by
taking into account the floatation cost and taxation impacts. In Topic 4, you have
learned that the rate of return required by investors is the minimum returns
anticipated by the investors in an investment.
There are three important steps in the calculation for cost of debt, which are:
Step 1: Calculate the net value of debt (NPb) by taking into account the floatation
cost.
NPb = Market value (P0) Floatation cost
Step 2: Calculate the rate of return for debt that is required by investors. The
rate of debt return can be obtained by using the trial-and-error method or the
estimation method as explained in section 4.4, Topic 4.
By using the trial-and-error method, the different rates of discount kb, will be
applied in the following formula (Formula 4.2b in Topic 4):
NPb = I (PVIFAkb,n) + M (PVIFkb,n)
The formula to calculate the rate of return by using the estimation method is as
follows:
i
kb

M NPb
n
M NPb
2

Step 3: Calculate the cost of capital by taking into account the effect of taxation.
Cost after tax = Cost of return (kb) Tax savings (kb T)
= k b kb T
= kb (1 T)

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Example 8.1
Indah Company has sold bonds that have a maturity period of 20 years with a
coupon rate of 9%. The par value is RM1,000. The bond is sold at the price of
RM980 with a floatation cost of 2% based on the par value (2% x 1,000). What is
the cost of debt for Indah Company?
Calculation:
(a)

First Step, Calculate the Net Value of Bond

NPb = RM980 RM20
= RM960

(b)

Second Step, Calculate the Rate of Return for the Bond

You can use the trial and error method or the estimation method to obtain
the required rate of return.
(i)

Trial-and-error Method
The bond is sold at a discount, where the selling price is lower than
the par value (RM980 < RM1,000). Therefore, the required rate of
return is higher than the coupon rate (k > I). To begin the calculation
process, you can try using the rate of 10%.
NPb = I (PVIFAk,n) + M (PVIFk,n)
= 90 (PVIFA10%,20) + 1,000 (PVIF10%,20)
= 90 (8.514) + 1,000 (0.149)
= RM915.26
From the calculations above, we find that the share value at the rate of
10% is RM915.26. This means that the cost of capital is between 9%
and 10%.
Next, we use the interpolation method to obtain the rate of returns.
Rate (%)

Value (RM)

Value (RM)

1,000

1,000

NPb

960

10

915.26

Difference

RM40

RM84.74

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kb

COST OF CAPITAL

9%

40.00
84.74

(10% 9%)

9.47%
(ii)

Estimation Method
You can also use the estimation method to obtain the required rate of
return by using the equation (Formula 4.4 in Topic 4) as follows:
i
kb

M NPb
n
M NPb
2

90

RM1, 000 RM960

20
RM1, 000 RM960
2

9.4%

(c)

Calculate the capital cost of debt by taking into account the effect of
taxation. Assume that corporate tax is 34% per year.
(i)

Trial-and-error Method
The required rate of return is 9.47% that is the cost of debt before
taking into account the tax. Therefore, the capital cost of debt (cost of
debt) is as follows:
Cost of debt after tax = 9.47% (1 0.34)
= 6.25%

(ii)

Estimation Method
As the interest on debt is tax deductible, therefore it can reduce the
cost of capital for the company. The cost of debt by using the
estimation method is:
Cost of debt after tax = 9.4% (1 0.34)
= 6.2%
The estimation method gives the answer of 6.2% while the trial-anderror method gives a more accurate answer of 6.25%.

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EXERCISE 8.1
Maju Indah Company plans to issue bonds that have a maturity period
of 10 years with a par value of RM1,000 and pays an interest of RM55
every 6 months. These bonds are sold at the net amount of RM840.68
after taking into account the additional costs involved. If the rate of
corporate tax is 25%, what is the cost of debt after tax?

8.2.2

Cost of Preference Shares

Preference shares have the rights to receive fixed dividends before earnings are
distributed to the ordinary shareholders. As preference shares are in the form of
ownership, therefore the net profit from sales is expected to be held for an
unlimited period of time. The dividends for preference shares are normally in the
form of amounts (RM) per year such as RM4 per year. There are also dividends
in the form of annual percentage rate where it is represented by a percentage
based on the par value of shares. For example, the dividend for preference shares
is 8% of the par value of RM5, which is RM0.40.
The cost of preference shares (kps) is the rate of return for preference shares,
which is the ratio of dividends for preference shares (Dps) compared to the net
earnings from sales of preference shares (Nps). Net earnings are the selling price
of preference shares minus the floatation cost.
To obtain the cost of preference shares (kps), we can use the formula (Formula 4.18
in Topic 4) as follows:

k ps

D ps
NPps

As the dividends of preference shares are paid from the cash flow after tax,
therefore the adjustment on tax is not required.

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Example 8.2
Calculate the cost of preference shares for Indah Company based on the
information as follows:
Selling price

= RM8.70 value per share

Cost of issuance and sale of shares = RM0.50 per share

Annual dividends

= RM0.87

Calculation
(a)

Net price (NPps) = RM8.70 RM0.50

= RM8.20

(b)

Kps

RM0.87
RM8.20

= 10.6%

EXERCISE 8.2
Jaya Financial Company has preference shares in its capital structure
that pays a dividend of RM0.35 and is sold at the price of RM2.50. The
cost of issuing and selling the preference shares is RM0.60 per share. If
the rate of corporate tax is 34%, what is the cost of preference shares
after tax?

8.2.3

Cost of Ordinary Shares

The cost of ordinary shares is the rate of return that is required by investors for
ordinary shares. The determination for the cost of ordinary shares is unique due
to two factors, which are:
(a)

First, it is difficult to estimate as the returns to ordinary shareholders are a

surplus after the payment of interest for bonds and dividends for
preference shares.

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(b)

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257

Second, there are two sources of financing for ordinary shares, which are
the retained earnings and the issuance of new ordinary shares. Both these
sources are different from the aspect of floatation cost. The use of retained
earnings does not involve floatation cost while the sale of new ordinary
shares involves floatation cost.

There are two methods that you can use to determine the cost of retained
earnings or the rate of return that is required by ordinary shareholders, which are:
(a)

Constant Growth Valuation Model or the Gordon Model

The cost of ordinary shares is the returns required by the existing
shareholders on their investments. The valuation model for constant
growth or better known as the Gordon Model assumes that the value of
shares (P0) is equal to the present value of all dividends in the future (D1).
(Refer to Topic 4: Valuation of Shares) Therefore, the value of ordinary
shares is obtained by using the formula (Formula 4.12 in Topic 4) as
follows:

P0

D1
k cs

Where:
P0 = Value of ordinary shares
D1 = Current dividends
kcs = Required rate of return
g

= Rate of dividend growth

To find the cost of ordinary shares or the rate of return for ordinary shares,
the formula above can be modified as follows:

K cs

D1
P0

As the dividends of ordinary shares are paid from earnings after tax,
therefore there is no adjustment on tax.

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COST OF CAPITAL

Example 8.3
The following is the financial information on Tuah Company.
Price of ordinary shares (H0) = RM5.00
Expected dividends (D1) = RM0.40
Rate of growth (g) = 5%
kcs =

0.40
0.05
5.00

= 0.13 or 13%
(b)

Use of Capital Asset Pricing Model (CAPM)

The CAPM Model shows the relationship between the returns required or
the cost of ordinary shares (kcs) with the systematic risk that is measured by
beta ( ).
The CAPM equation is as follows:
kcs = krf + (km krf)

Where:
kcs = Cost of ordinary shares for security j
krf = Risk-free rate
km = Rate of market returns
j

= Beta of security j

Based on the equation above, we can estimate the use cost for retained
earnings as one of the components of capital as shown in example 8.4.
Example 8.4
Assume that the risk-free rate of Indah Company is 7%, the rate of market
return is 11% and the ordinary shares for the company have a beta of 1.5.
What is the cost of retained earnings?
Kcs = 7% + (11% 7%) 1.5
= 7% + 6%
= 13%

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(c)

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259

Cost of Issuing New Ordinary Shares

The cost of issuing new ordinary shares (kcs) is obtained by taking into
account the effect of floatation cost or sales cost. Normally, new ordinary
shares are sold at a price that is lower than the current market price.
Therefore, the net value of the new shares after sale will be lower. The cost
of ordinary shares (kcs) is calculated by using the valuation model for
constant growth, but at net price (NPcs). Net price is obtained by deducting
the floatation cost from the selling price. Therefore, the formula to obtain
the cost of issuing new ordinary shares is as follows:
k cs

D1
NPcs

The cost of issuing new ordinary shares is usually higher than the cost of
existing shares and is usually higher than any other types of long term
financing cost. As the dividend is paid from the cash flow after tax, there
will be no adjustment for tax.
Example 8.5
Based on the financial information of Indah Company below, calculate the
cost of issuing new ordinary shares.
Expected dividends (D1)

= RM0.40

Current market price (P0)

= RM5.00

Floatation cost

= RM0.25 per share

Rate of dividend growth

= 5%

Sale of new ordinary shares = RM4.70

Solution:

K cs

RM0.40
0.05
RM4.45
0.14 or 14%

ACTIVITY 8.1
Why must we calculate all the costs for capital resources before
calculating the overall cost of capital?

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EXERCISE 8.3
1. Ordinary shares of Tunas Damai Company were recently sold at the
price of RM5 per share. The dividend for next year is RM0.18 per
share. Investors expect the dividend to increase at the rate of 9% per
year in the future.
(a)

What is the internal cost of equity of the company?

(b)

The sale of new ordinary shares is expected to involve an

issuing cost of RM0.50 per share. What is the cost of the new
ordinary shares?

2. Differentiate between the internal equity of the company with new

ordinary shares.
3. What is the cost that can be connected with the internal equity of the
company?
4. Explain two approaches that can be used in the calculation for the
cost of ordinary shares.

8.3

WEIGHTED AVERAGE COST OF CAPITAL

After the cost for each capital resources had been determined, the next step is to
calculate the overall cost of capital for the company. The overall cost of capital
takes into account all individual costs of financing resources used. It is better
known as the weighted average cost of capital (WACC).
There are three main steps in determining WACC, which are:
(a)

Calculate the cost for each capital resource (cost of debt, cost of preference
shares and cost of ordinary shares);

(b)

Calculate the combined financing or capital structure that is the weight of

each resource that is used from the overall total financing of the company
(the capital structure is usually predetermined by the company); and

(c)

Calculate the WACC.

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Therefore, the calculation for weighted average cost of capital (WACC) is as

follows:
WACC = (wb

kb) + (wps

kps) + (wcs

kcs)

(Note: wb + wps + wcs = 1)

Where:
Wb = Weightage of debt
Kb

= Cost of debt after tax

Wps = Weightage of preference shares

Kps = Cost of preference shares
Wcs = Weightage of ordinary shares
Kcs = Cost of ordinary shares
Example 8.6
Based on the financial information of Indah Company, calculate the WACC.
Cost of debt (kb)

= 6.25%

Cost of preference shares (kps)

= 10.6%

Cost of retained earnings (kcs)

= 13%

Cost of new ordinary shares (kcs) = 14%

Capital resources
Long-term loans
Preference shares
Ordinary shares

Ratio/Weightage
40%
10%
50%
100%

Therefore, the weighted average cost of capital (WACC), if the company uses the
retained earnings is:
WACC = (0.40

6.25%) + (0.1

10.6%) + (0.5

13%)

= 2.5% + 1.06% + 6.5%

= 10.6%
If the company issues new ordinary shares, then the weighted average cost of
capital is:
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WACC = (0.40

COST OF CAPITAL

6.25%) + (0.1

10.6%) + (0.5

14%)

= 2.5% + 1.06% + 7%
= 10.56%

EXERCISE 8.4
1. Match the following information with the statements provided.
(a) Cost of capital
(b) Dividend valuation
model
(c) Capital financing
(d) Floatation cost
(e) Optimal capital
structure
(f) Weighted average
cost of capital

1. Additional expenditure that is involved in

the issuance of a security.
2. The result of cost multiplying for each item
in the capital structure with the financing
ratio in the entire capital structure and the
results are added together.
3. The result of adding the best among the
debts, preference shares, retained earnings
and new ordinary shares.
4. Determining the value of shares by taking
into account the present value of dividends
that are expected to be received in the
future.
5. The company's alternative cost of financing
structure.
6. It is found in the balance sheet under longterm liabilities and equity.

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2. Maju Company is determining the optimal capital structure based on

the information below:
Capital Resource

Percentage of Financing (%)

Long-term debt

35

Preference shares

10

Ordinary shares

55

The company can issue bonds that have a maturity period of 20 years
with a face value of RM1,000. The coupon rate for the bonds is 9%
and is sold at the price of RM980. The cost of issuing the bonds is 2%
from the face value of the bonds.
Preference Shares:
The company found that it can issue preference shares at the price of
RM6.50 per share with the annual dividend payment of RM0.80. The
cost involved in issuing and selling shares is RM0.30 per share.
Ordinary Shares:
The ordinary shares of the company are sold at the present price of
RM4 per share. The dividend that is expected to be paid at the end of
next year is RM0.50. The growth rate of dividends is constant, that
is at 8% every year. The company must pay the floatation cost of
RM0.10 per share.
Corporate tax is 40%.
(a)

Calculate the cost for each of the capital resources.

(b)

Calculate the weighted average cost of capital (WACC).

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3. The information below is the total financing for each capital resource
of Jati Company.
Capital Resources

Total Financing (RM)

Long-term debt

40,000

Preference shares

20,000

Ordinary shares

40,000

The cost of debt before tax is 9.37%, the cost of preference shares is
10%, the cost of ordinary shares is 13% and the marginal cost of tax is
34%. What is the weighted average cost of capital (WACC) for the
company?
4. How does the tax rate of the company affect the cost of capital?
5. What is the effect of floatation cost on the issuance of a security?

The cost of capital is also known as the rate of return that is required by the
company.
The rate of discount and the opportunity cost of fund is the minimum rate of
return required by the company for its investments. Usually, it comprised of
three main components of capital resources, which are debt, preference
shares and the ordinary equities of the company that consist of retained
earnings and new ordinary shares.
The cost of capital is influenced by the combination of financing and usually
the company will try to maintain the optimal financing combination or better
known as target capital structure.
To obtain the cost of capital for the entire financing of the company, firstly
you must determine the cost of capital for each component of the capital
resources, which are cost of debt, cost of preference shares and cost of
ordinary equity. Next, determine the overall cost of capital or the weighted
average cost of capital, which is the combination of all financing resources by
taking into account the financing combination.
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Capital structure

Debt

Cost of capital

Equity

Cost of debt

Floatation cost

Cost of ordinary shares

Optimal capital structure

Cost of preference shares

Weighted average cost of capital

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Topic

Financial
Planning

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Explain the importance of cash budget and pro forma income
statement in financial management; and
2. Prepare cash budget and pro forma income statement.

INTRODUCTION
Topic 9 discusses the importance of financial planning, preparation of cash budget
and preparation of pro forma income statement. This topic also discusses the
importance of working capital management and the types of short-term financing.
Besides that, this topic will focus on the basis of cash management. It explains the
cash conversion cycle and its components, and the types of marketable securities
that are found in the market. It also touches on the management of account
receivable that is a part of the current asset of the company or the working capital
of the company. Finally, it discusses the management of current asset with the
lowest level of liquidity, which is the inventory.

9.1

FINANCIAL PLANNING
SELF-CHECK 9.1

Financial planning that is practical and effective is very important in the

operations of a company. Who is responsible to plan and implement
these guidelines? Is it the responsibility of one individual or through
collective discussions?

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Before understanding the income statements even further, we need to look at the
guidelines for preparing the financial planning correctly. Generally, a financial
plan that is correct and complete should have the following criteria:
(a)

Objective, strategy and operational plans that are clear;

(b)

Assumptions that are used in the preparation of financial plans;

(c)

Budgets that are classified according to the period and type;

(d)

Projects financing that are classified according to the type and time period;
and

(e)

Pro forma financial statement throughout the planning period.

After having some image on the initial steps of preparing a financial plan, the
next step is to understand the method of preparing a cash budget.

9.2

CASH BUDGET
SELF-CHECK 9.2

What do you understand by a cash budget?

Efficient cash management involves the forecast of cash requirements in the

future. One of the normal methods used to estimate the cash requirements in the
future is by preparing a cash budget.
Cash budget is a summary of the receipt and payment of cash that is expected for
a short period of time. Normally, it is prepared for a planning period of six
months or one year. It can show how the cash flow is planned for a specific time,
whether it is a cash inflow or cash outflow.
Besides that, cash budget is very important to the company as the sales and profit
obtained cannot ensure that the company will have enough cash to fulfil its
financial obligations. Instead, the cash budget can assist the company to know
the cash status of the company in the effort to ensure that the cash flow of the
company is strong and stimulating. The following are several terms that are often
used in cash budget.

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(a)

Cash Receipts or Cash Inflow

Receiving of cash is the entire cash inflow for the financial period given. For
example, cash sales and collection of account receivables.

(b)

Payment of Cash or Cash Outflow

Payment of cash is the entire cash outflow for the financial period given.
For example, purchase of equipments, wages and salaries, rental, payment
of interests, dividend, taxes and capital expenses. Depreciation and other
non-financial charges are not included in the cash budget.

(c)

Changes in Net Cash

Changes in net cash can be obtained as a result of comparison made between
cash inflow with cash outflow and with the opening balance of cash flow for
that period (see Figure 9.1). Besides that, the additional financing cost that is
predicted at the beginning of the period that is, the interest will also be taken
into account.

(d)

Cash Surplus or Additional Financing Requirement

The amount of cash surplus or additional financing requirement depends on
the changes of net cash and the targeted balance determined by the company.
A positive amount shows that the company has cash surplus while a negative
amount shows that the company requires additional financing.

Figure 9.1: Comparison of changes in net cash flow

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Example 9.1
The example below shows how a cash budget is prepared. The following are
several information and assumptions for preparing the cash budget of Nuri
Company.
(a)

Cash budget will be prepared for the months of March, April and May. The
information required are as follows:
(i)

Actual sales for January and February.

(ii)

Sales forecast for the months of March, April and May.

(iii) Cash sales are 25% and the balance are credit sales. For credit sales,
80% of it will be collected in the next month and 20% will be collected
two months after the sale.
Month

Sales (RM)

January

45,000

February

65,000

March

60,000

April

90,000

May

85,000

(b)

The purchase of raw materials is predicted at 60% of sales and the payment
will be made a month later.

(c)

Office and warehouse rentals are RM4,500 per month.

(d)

Payments of wages are RM5,000 per month.

(e)

The company will pay insurance premiums of RM2,800 in the month of

March.

(f)

The purchase of a new asset involving a cost of RM25,000 will be made in

the month of March.

(g)

Opening cash balance for the month of March is RM15,000.

(h)

The cash balance that the company intends to hold every month is
RM10,000.

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Solution
Step 1: Complete the schedule of cash received for the months of March to May.
Jan
45,000
33,750

Total sales
Credit sales (75%)

Feb
65,000
48,750

Collections:
Cash sales (25%)
80% from last months sales
20% from last two months sales
Total cash inflow

Mar
60,000
45,000

Apr
90,000
67,500

May
85,000
63,750

15,000
39,000
6,750

22,500
36,000
9,750

21,250
54,000
9,000

60,750

68,250

84,250

Step 2: Complete the schedule of cash payment for the months of March to May

Total purchase of raw materials

Credit purchase of raw materials

Feb
39,000
39,000

Payment a month after purchase

Rental
Wages
Insurance premiums
Purchase of new asset
Total cash outflow

Mar
36,000
36,000

Apr
54,000
54,000

May
51,000
51,000

39,000
4,500
5,000
2,800
25,000

36,000
4,500
5,000

54,000
4,500
5,000

76,300

45,500

63,500

Step 3: Prepare the cash budget

Table 9.1: Cash Budget
Total cash receipt
Total cash payment
Changes in cash
Opening balance
Closing cash balance (without loans)
Cumulative cash balance
Minimum balance required
Financing requirement (repayment)
Closing cash balance

Mar
60,750
76,300
(15,550)
15,000
(550)
(550)
10,000
10,550

Apr
68,250
45,500
22,750
10,000
32,750
32,750
10,000
(10,550)

May
84,250
63,500
20,750
22,200
42,950
42,950
10,000

10,000

22,2200

42,950

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Next, we will make the following financial forecast for the purpose of forming a
series of pro forma financial statements:
(a)

The company can estimate the level of account receivables, inventory,

account payable and other accounts in the future to fulfil the requirement
for loans and expected profits.

(b)

The finance officer can make detail evaluation on the actual financial
statements that had been planned and from thereon make adjustments.

(c)

The finance manager and creditors can evaluate in advance the level of the
companys profitability and the overall achievement of the company.

ACTIVITY 9.1
Budget is a forecast and forecast is often not accurate. What is the way
to ensure that the forecast in the estimation of the companys cash flow
achieves the objective without any contradiction or error?

EXERCISE 9.1
1. What is the appropriate time period for cash budget?
2. One of your duty as an employee of Zitroe Company is to prepare
the cash budget for the period from 1 January to 30 June 2011.
Please prepare the following:
(a)

Forecasted Cash Received Schedule

(b)

Forecasted Monthly Cash Payment Schedule

(c)

Cash budget from January 1st until June 30th 2011.

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Use the information below to assist you in preparing that budget.

(i)

80% are credit sales; 80% of credit sales will be collected in the
next month; 15% will be collected 60 days after sales and 4%
more will be collected 90 days after sales. The company had to
bear 1% of credit sales as uncollectible debt (bad debt).

(ii)

Purchases made every month are 65% of sales forecasted for

the next month. Payment for these purchases will only be
made one month after purchase.

(iii) The company intends to maintain a minimum cash balance of

RM300,000. The cash balance on 1 January is RM300,000.
(iv) The company expects the delivery of a new machine in the
month of April. Payment of RM400,000 will be made after
delivery had been done.
(v)

Payment for tax of RM500,000 will be made in the month of

March and June.

(vi) Rental of RM100,000 per month. Other cash expenditure is 3%

of sales.
(vii) The depreciation expenses are RM150,000 per month.
(viii) Labour expenses are 10% of sales for the next month.
(ix) The companys Board of Directors intends to maintain the
dividend payment of RM450,000 that will be made in the
month of June.
(x)

Sales in the month of October are RM3,000,000 and RM2,000,000

in the months of November and December 2010.

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(xi) Sales forecast for the first seven months in the year 2011 is as
follows:
Month

Sales (RM)

January

3,000,000

February

5,000,000

March

5,000,000

April

6,000,000

May

3,000,000

June

2,000,000

July

2,000,000

(xii) The company will make interest payments in the month of

June for RM310,000.

9.3

PRO FORMA INCOME STATEMENT

Pro forma income statement provides the forecast on the total profitability that
can be obtained by the company throughout a specific time period. There are two
main steps in preparing a pro forma financial statement, which are:
(a)

Preparing Sales Forecast

Brigham (1995), defines sales forecast as a forecast on the unit and amount
of sales in the future. Sales forecast is the main pre-condition activity in the
process of financial planning. Several sources are needed to make this
forecast (see Figure 9.2). Sales forecast must at least be based on:
(i)

Any sales trend expected for the company which will be repeated in
the coming years; and

(ii)

Any factor or occurrence that may have a significant effect on the

sales trend of the company.

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Figure 9.2: Factors that influence sales forecast

As a result of this information, the finance manager can make an estimated

cash inflow and outflow that are related with the sales and inventory
operations. Besides that, this information can also assist the finance
manager in determining the assets used and the amount that is required to
finance the forecasted production level.
(b)

Forecasting Financial Variables

Financial variables are the items from expenditure, current assets and
fixed assets, liabilities and equity (Scott, Keown et al., 1996). After you have
successfully estimated the increase in sales, determine the effect of this
increase in sales on these financial variables.

Generally, these variables should change according to the changes in sales. For
example, if sales increase, then surely its expenditure, especially the costs will
change; will increase with the increase in sales. Assets must also be increased as
more assets, whether current assets or fixed assets, are needed to support the
increase in sales and those financial variables.
The process of preparing a pro forma financial statement is as follows:
Step 1
Prepare the sales forecast.

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Step 2
Determine the production schedule and requirements for materials, labour and
expenditure.
(a)

Determine the Total Units that will be Produced

Total unit that will be produced depends on the opening inventory, sales
forecast and the targeted closing level of inventory
Expected unit sales
+ Closing inventory
Opening inventory
= Production requirement

(b)

Determine the Production Cost Per Unit

Cost per unit

= Material + Labour + Overhead

Total product cost = Number of units to be produced x Cost per unit

Calculate the cost of goods sold

(c)

(i)

Estimated sales unit

(ii)

Cost of goods sold = Sales unit x Cost per unit

Calculate the Closing Inventory

RM xxxx
xxx

Opening inventory
+ Total production cost
= Total inventory for sale

xxxx

Cost of goods sold

xxx

= Closing inventory

xxxx

Step 3
Calculate other expenditures
(a)

Administration and general expenses

(b)

Interest expenses

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Step 4
Prepare the pro forma income statement
RM xxxx
xxx

Sales revenue
Cost of goods sold
Depreciation

xxx

= Gross profit

xxxx

Administration and general expenses

xxx

= Operating profit (profit before interest and tax)

xxx

Interest expenses

xx

= Earnings before tax

xxx

Tax

xx

= Earnings after tax

xxx

Dividend of ordinary shares (cash)

= Increase (decrease) in retained earnings

xx
xxx

Example 9.2
By using the information in Example 9.1, prepare a pro forma income statement
for Nuri Company for the month of May. The following are the additional
information:
Total fixed assets

= RM300,000

Depreciation

= 10% from the total fixed assets

Inventory as at 30 April = RM20,000

Inventory as at 30 May = RM40,000
Tax rate

= 30%

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Nuri Company
Pro forma Income Statement
for the month of May
(RM)
Sales revenue
Cost of goods sold
Opening inventory
Purchases (60% 85,000)
Closing inventory
Cost of goods sold
Gross profit
Operating expenditure
Office and warehouse rental expenses
Wages expenses
Operating expenditure
Operating profit before interest and tax
Tax
Earnings after tax

(RM)
85,000

20,000
51,000
71,000
(40,000)
(31,000)
54,000
4,500
5,000
(9,500)
44,500
(13,350)
31,150

ACTIVITY 9.2
An auditor has detected an obvious difference in the net cash flow from
the accounting files of your company for the last two years period.
There is a possibility that it might be due to a recording error or there is
discrepancy by the companys employees. What action should be
taken?

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EXERCISE 9.2
1. What is the use of a pro forma income statement?
2. State four sections that are found in the cash budget.
3. Based on the information below, prepare a pro forma income
statement for Tulip Company for the year 2011.
Sales forecast

$10,000,000

Cost of goods sold

60% of sales

Administration and sales expenses

$100,000 per month

Depreciation expenses

$140,000 per month

Interest expenses

$120,000

Tax rate

34%

Rate of dividend payments

50%

You have been exposed to the importance of financial planning via the
preparation of pro forma income statement and cash budget in Topic 9.
Companies can make evaluations and detailed adjustments to maximise
profit through the comparisons of cash inflow with cash outflow.
Cash budget is a summary of the receipt and payment of cash that is expected
for a short period of time.
Terms that are used in cash budget are as follows:

Cash receipt;

Payment of cash;

Changes in Net Cash; and

Cash Surplus.

A pro forma income statement provides the forecast on the total profitability
that can be obtained by the company throughout a specific time period.

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Cash budget

Financial planning

Cash inflow

Net cash

Cash outflow

Pro forma income statement

Cash surplus

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Topic

10

Working Capital
Management

LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe the importance and strategies of working capital
management;
2. Explain the types and sources of short-term financing;
3. Evaluate the efficiency of a firms management of its working
capital based on cash conversion cycle;
4. Elaborate on the importance of marketable securities;
5. Assess the factors that influence the management of accounts
receivable; and
6. Identify costs that are related to inventory and explain how
inventory management decisions are made.

INTRODUCTION
Working capital management refers to the management of current assets and
current liabilities that are required for the daily operations of the company. It
involves the determination of working capital policy and the implementation of
this policy in the daily operations.
Working capital policy comprised of the working capital level and how the
working capital should be financed. For example, a firm needs to make a decision
on how much cash that needs to be kept in the accounts and the inventory level
that needs to be maintained. Besides that, a firm also needs to make decisions on
whether to finance its current assets with short-term fund, long-term funds or a
combination of both.

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Working capital management is more obvious in small or medium size

companies. This is because small and medium size companies have limited
alternative financing compared to larger companies. The financing resources are
focused on trade credit and bank loans. Therefore, the finance managers of small
and medium size companies are more inclined to use short-term fund resources
to fulfil their financing requirements.

10.1

IMPORTANCE OF WORKING CAPITAL

MANAGEMENT
SELF-CHECK 10.1

What is difference between current assets and current liabilities?

Working capital is required for the daily operations of the company. Efficient
working capital management is important to ensure that the firm does not have
any liquidity problems that will effect the operations of the company. At the
same time, efficient working capital management also means that the company
was successful in conducting its business without too much funds being tied up
in the form of current assets.
Current assets and current liabilities are the main items in the daily operations.
Most of the managements time is focused on the working capital management
such as:
(a)

Controlling the cash inflows and outflows;

(b)

Preparing credit facilities to customers; and

(c)

Always ensuring adequate stock.

10.1.1

Net Working Capital

Net working capital is the difference between current assets and current
liabilities.
Net working capital = Current assets Current liabilities

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To have a better understanding of the concept of net working capital, look at

Example 10.1.
Example 10.1
ASSETS

RM

Current assets
Fixed assets

376,600
203,800

LIABILITIES AND EQUITY

Current liabilities
Long-term debts
Owners equity

580,400

RM
162,700
94,000
323,700
580,400

Based on the above summary balance sheet of Endah Company Sdn. Bhd., the
net working capital for Endah Company Sdn Bhd is:
Net working capital = Current assets Current liabilities
= RM376,600 RM162,700
= RM213, 900
This shows that Endah Company has the ability to fulfil its short-term financial
claims whenever required. In other words, the net working capital can be used as
a measurement of the companys liquidity.

10.1.2

Current Assets

Current assets comprise of cash and assets that can be converted into cash in a
period not more than one year. Current assets are also known as liquid assets as
it is easily converted into cash in a short period of time. Current assets comprise of:
(a)

Cash
Money in hand or bank.

(b)

Marketable Securities
Marketable securities are short-term investments that can be converted into
cash in a short period of time.

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(c)

Account Receivables
Account receivables exist when the company makes sales by credit.
Normally, the credit period given is short and customers are expected to
settle their debt within the date predetermined. When payments have been
made, the account receivables will convert to cash.

(d)

Inventory
Commercial goods that will be sold to customers.

To fully understand the approach used in working capital management, we

categorised the current assets of the company into permanent current assets and
temporary current assets.

10.1.3

Permanent Current Assets

Permanent current assets are investment in the current assets that are expected to
be permanently held by the company for a period of more than one year. The
company will keep emergency or safety stocks as inventory to fulfil unexpected
requirements.

10.1.4

Temporary Current Assets

Temporary assets are assets that are held by the company for only a short period
of time, which is less than a year. This situation is more obvious for seasonal
businesses where at certain times; the expected sales are more than the sales in
normal situations.
For example, when the festive season is approaching, companies that sell clothes
will increase their inventory to fulfil the demand that will normally increase. This
increase in inventory is only temporary because after the festival, the inventory
level will return to its normal level.
After the current assets had been categorised into permanent current assets and
temporary current assets, the next question will be related to the sources of
capital financing that are used to finance the investment in these assets. To match
the financing with the investments, the sources of financing also have to be
categorised into permanent financing source and temporary financing source.

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ACTIVITY 10.1
Try to obtain the annual reports of several companies and refer to their
balance sheets. Calculate the average percentage of current assets
compared to the total assets of the companies. What can you summarise
from the results of your calculations?

10.2

STRATEGIES OF WORKING CAPITAL

MANAGEMENT
SELF-CHECK 10.2

State the difference between permanent financing and temporary

financing.

The net working capital management is especially drawn-up to explain the level
of investments that are suitable for current assets. Working capital management
involves financial decisions making that are simultaneously and interrelated with
investments in current assets together with the financing of these assets. One of
the methods used in working capital management is the matching of the assets
lifetime with the financing period used. This method is known as the hedging
principle. The hedging principle is also known as the matching principle or the
principle of self-liquidating debt.
The hedging principle matches the cash flow characteristics of an asset with the
maturity period of financial source that is used to finance that asset. How is this
hedging principle implemented? There are three approaches that can be used to
implement this principle, which are:
(a)

Moderate approach;

(b)

Aggressive approach; and

(c)

Conservative approach.

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Moderate Approach

Through this moderate approach (see Figure 10.1), the permanent current assets
are financed by permanent financing and temporary current assets are financed
by temporary financing. Permanent financing is long-term financing such as
equities and bonds that have a maturity period of more than one year.
Temporary financing involves short-term debt. This type of financing can be
stated as a negotiated financing that has a short maturity period. For example,
bank loans, overdrafts and commercial papers.

Figure 10.1: Moderate approach

10.2.2

Aggressive Approach

Through this aggressive approach (see Figure 10.2), the company uses more
temporary financing to finance the temporary assets and permanent assets.
Therefore, the company is exposed to higher risk as a result of the fluctuating
interest rates and the inability of the company to pay its short-term debts in a
short period of time due to the low level of net working capital. However, this
approach can increase the returns due to the reduction in financing cost that is
temporary.

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Figure 10.2: Aggressive approach

10.2.3

Conservative Approach

Through this conservative approach (see Figure 10.3), the permanent current
assets and a part of the temporary current assets are financed by permanent
financing. A company that practices this approach has a high level of net
working capital. Therefore, it can fulfil its short-term claims at the predetermined
time. However, this approach will cause the company to be exposed to long-term
financing cost.

Figure 10.3: Conservative approach

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EXERCISE 10.1
1. What are the main components of current assets and why are these
components also known as liquid assets?
2. How are the assets and liabilities of a company classified for the
purpose of capital management?
3. What is meant by hedging principle?

TYPES OF SHORT-TERM FINANCING

10.3

SELF-CHECK 10.3
List examples of short-term financing. Why is short-term financing
important for a company?

Current liabilities and short-term liabilities are debts or responsibilities of the

company that must be settled within the period of a year or less. In summary,
short-term financing is very important to ensure the smooth running of the daily
operations of the company so that it would not be disrupted due to shortage of
cash.

10.3.1

Spontaneous Financing

Spontaneous financing exists due to the daily activities of the company. For
example, when the companys sales increases, the inventory must also be
increased and these additional purchases are usually financed by trade credit.
Spontaneous financing can also exist as a result of the differences in timing
between the actual cash flow with the cash flow that should have occurred. For
example, a company had obtained the services of companys employee for the
period of 1 to 15 January but payments were only made on 16 January.

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The main sources for spontaneous financing are:

(a)

Trade Credit
Trade credit is the credit facility offered by suppliers to customers. For
suppliers, trade credits will be recorded in the balance sheet at the current
assets section (account receivable). While for the customers, trade credits
are located in the current liabilities section (account payable).
This financing source is obtained based on the trust by the suppliers to
customers. The cost of trade credit cannot be obtained directly, as the
suppliers usually would not charge any interest on the trade credits offered.
However, when the suppliers offer discount, customers will bear a higher
effective cost if the discounts were not taken.
Example 10.2
Endah Company Sdn Bhd has made a purchase on credit from the supplier
for RM800 on the terms of 3/10 net 30. If the company made the payment
within 10 days, it will pay only RM776 because the cash discount of RM24
would be deducted from the invoice.
In summary, the company is assumed to have made a loan of RM776 for the
period of 20 days with the interest payment of RM24. Therefore, with the
assumption of 365 days a year, the annual cost borne by Endah Company
Sdn Bhd as a result of foregoing the discount offered can be estimated as
follows:

Annual cost

RM24

365

RM776

20

0.564 or 56.5%
Based on the calculation above, Syarikat Endah Sdn Bhd had to bear the
annual cost of 56.4% if it did not accept the discount offer of 3/10 net 30.
(b)

Accruals
Accruals exist when there is a delay in payment. For example, the
employees salaries will only be paid at the end of each month and also the
employees salaries deduction (EPF and SOCSO) by the employer will only
be made on the 20th of the month. Financing sources through accruals do
not involve any costs. It is free to the company as long as it does not affect
the credibility of the company.

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Negotiated Financing

The sources of negotiated financing are often obtained formally from financial
institutions. It has to undergo various procedures that have been predetermined.
In this topic, we will focus on the facilities provided by commercial banks, which
are overdrafts and short-term loans only. Other financing sources that will be
discussed are commercial papers and factoring.
(a)

Overdraft
Overdraft is a credit facility provided by banks to its customers. It is
channelled through the customers current accounts, where the customer is
allowed to withdraw money in excess of the balance in its current account.
However, there is a limit set on the withdrawal. For example, Endah
Company Sdn. Bhd. received an overdraft facility for RM50,000. This means
that the company can use the funds provided by the bank until the balance
in its account reaches RM50,000.
Overdraft facilities are very useful to a company that wishes to take the
cash discount offered by the supplier. The cost that needs to be borne by the
customer who uses the overdraft service is the interest that is applied based
on the negative balance of the customers current account.

(b)

Bank Loans
Besides overdrafts, banks will also provide services for short-term loan
facilities. To understand this negotiated financing via bank loans, see
Example 10.3.
Example 10.3
Endah Company Sdn Bhd has obtained a bank loan of RM200,000 for a
period of 3 months at the rate of 15% per year. At the end of the period,
Endah Company Sdn Bhd repaid the principal together with its interest.
Before making calculations for the effective cost of the loan, the interest
amount must be ascertained in advance.
Interest

RM200,000

0.15

1
4

RM7,500

Effective cost

RM7,500
RM200,000 1
4
0.15 or 15%
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If you look at the example, the effective cost of 15% is the same with the rate
of the bank loan. However, there are two characteristics in the cost of shortterm loan that will make its value higher than the nominal interest rate.
These characteristics are the compensating balance and the discounted
interest.
(i)

Compensating Balance
The compensating balance is the amount that must be kept in the bank
account and remained as a balance throughout the loan period. The
requirement for this compensating balance makes the actual amount
received by the borrower to be less by the compensating balance amount.
However, the interest is still calculated based on the entire loan.
By using Example 10.3 and several additional information, we can see
the effect of the compensating balance on the effective cost of the
loan. The bank that provides the loan imposed the condition for
compensating balance to be 10% of the total loan. Assuming that
Endah Company Sdn Bhd does not have the balance as required by
the compensating balance. Calculate the effective cost of this loan.
To obtain the effective cost of this loan, we need to obtain the value for:

Interest amount;

Compensating balance; and

Value of net loan

These information can be calculated as follows:

Interest amount = RM200,000

15%

Compensating balance = RM200,000

1 = RM7,500
4
10% = RM20,000

Net loan = RM200,000 RM20,000 = RM180,000

Effective cost

RM7,500
RM180,000 1
4
0.1667 or 16.7%

Based on the calculation above, the effective cost of the loan is higher
compared to the value before there was a compensating balance.

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Discounted Interest
Through this characteristic, the borrower must pay interest when the
loan amount is withdrawn. This means that the payment of interest
has been settled in advance before the loan can be used. This
condition makes the net amount obtained by the loan to be less than
the amount borrowed. However, the effective cost still increases as the
interest is made based on the entire loan.
By using Example 10.3, the calculation of interest, net amount and the
effective cost for Endah Company Sdn Bhd are as follows:
Interest amount = RM200,000

15%

1 = RM7,500
4

Net loan

= RM200,000 RM7,500 = RM192,500

Effective cost

RM7,500
RM192,500 1
4

= 0.15584 or 15.6%
From the explanation above, it is clear that the condition of
compensating balance and discounted interest will increase the cost of
the company doing the borrowing.
(c)

Commercial Papers
In Malaysia, the use of commercial papers is not widespread. Commercial
papers are promissory notes for short-term debt that are issued by
companies with strong financial standing. The issuance of this instrument is
based on the confidence of investors toward the companys ability to repay
the loan at the date that has been predetermined.
Commercial papers are issued at a discounted price where the selling price
is the face value after deducting interest. The cost involved in the issuance
of commercial papers comprised of all the expenditures that are directly
involved in the issuance of this security. For example, a company that
issues commercial papers will obtain the services of a merchant bank to sell
it to the investors. All these expenditure must be taken into account in
estimating the effective cost of financing through commercial papers.

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Example 10.4
Endah Company Sdn Bhd will issue commercial papers that have a value of
RM20 million with a maturity period of 6 months. The interest rate for these
commercial papers is 10%. The cost involved in issuing these commercial
papers is RM50,000.
The calculation of the effective cost is as follows:
Interest amount = RM20 million

10%

year

= RM1 million
Total cost

= Interest + Issuing cost

= RM1 million + RM50,000
= RM1.05 million

Net loan

= RM20 million RM1 million

= RM19 million

Effective cost

RM1.05
RM19 million

= 0.1105 or 11%
(d)

Factoring
Factoring is a transaction that involves the purchase of account receivables
or the invoices from supplier companies by the factoring companies.
Financial institutions that conduct these factoring activities are known as
factor. It comprised of takeover and administration of account receivables
as well as the activity of collecting debt.
The cost of financing that is counted by factoring is the total financing and
expenditure involved such as the factoring fee (1% to 3% from the invoice
value), interest on deposit and reserves (a small percentage that is held by
factor). The balance value of the invoice payable by factor will only be
settled to the company when the entire account receivables have been
collected.

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Example 10.5
Endah Company Sdn Bhd has factorised the account receivable totalling
RM200,000. The credit period of the company is 60 days. The factoring fee is
3.5% of the invoice value while the reserves are at 7.5%. The interest rate
that is charged on the deposit is 12% per year. When the deposit is received,
the fees and interest must be settled. Based on previous practice of the
company, it will give cash deposit of 60% of the invoice value.
The following is the effective cost of financing through factoring:
Deposit

= RM200,000

60% = RM120,000

Reserves

= RM200,000

7.5% = RM15,000

Fees

= RM200,000

3.5% = RM7,000

Interest

= (RM120,000 RM15,000 RM7,000)

12%

12

= RM1,960
Net amount

= RM120,000 RM15,000 RM7,000 RM1,960

= RM96,040

Effective cost =

RM7,000 RM1,960
RM96,040 2 12

= 0.5598 or 55.98%
Based on the calculation above, the effective cost of this financing is 55.98%
and the company obtains a deposit of RM96,040 for the period of 2 months
at the cost of RM8,960 (fees and interest). If all the account receivable can
be collected successfully, the balance of RM80,000 including reserves of
RM15,000 will be given by the factor to Endah Company Sdn Bhd.

ACTIVITY 10.2
A telecommunication company in our country is facing losses of
millions of Ringgit due to the burden of their bad debts from customers
who refuse to settle the payment of their bills. Several notices and
summon letters had been sent yet the customers are still ignoring them.
What is the way to solve this dilemma?

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EXERCISE 10.2
1. The following are the total loan by Zie-zam Company throughout
the year.
Month

Total (RM)

January

12,000

February

13,000

March

9,000

April

8,000

May

9,000

June

7,000

July

6,000

August

5,000

September

6,000

October

5,000

November

7,000

December

9,000

(a)

Calculate the average total loans of Zie-zam Company.

(b)

Calculate the annual loan costs of the company at the interest

rate of 15%.

2. Z-tron Company has obtained a loan from the bank for RM10,000
for a period of 90 days at the interest rate of 15% payable on the
maturity date of the loan. Assume that there are 360 days in a year.
(a)

How much is the total interest (in Ringgit) that must be paid
by Z-tron Company for this loan?

(b)

Calculate the effective cost for this loan.

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3. Commercial papers are usually sold at a discounted rate. Fang

Company has just sold its commercial papers that had been issued
for a period of 90 days at the face value of RM1 million. The
company receive as much as RM978,000.
(a)

What is the effective annual interest rate that must be paid to

finance the commercial papers?

(b)

If the brokers fee is RM9,612 and had been paid at the

beginning of the issuance of these commercial papers, how
much is the annual effective rate that must be paid by the
company?

4. D-ban Company Berhad intends to get an advance from the

factoring account for RM100,000 and will mature in a period of
30 days. The factor holds 10% of the total account that will be
factorised (reserves). There is also a 2% fee on factoring and a
prepayment interest rate of 15% per year.
(a)

Calculate the maximum amount (in RM) of the interest that

must be paid.

(b)

What is actual amount that will be obtained by the company?

(c)

What is the annual cost factor (in percentage) for this

transaction?

10.4

CASH CONVERSION CYCLE

SELF-CHECK 10.4

What will happen if the cash conversion cycle exceeds the period that
had been set?

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The cash conversion cycle refers to the time period taken from the payment for the
purchase of raw materials to the receipt of cash from the sale of goods. Figure 10.4
shows the three main components in the cash conversion cycle, which are:
(a)

Cash/Inventory Conversion Period

The average time period taken to convert raw materials into finished goods
and selling them.

(b)

Account Receivable Collection Period

The average time period taken to obtain cash from credit sales.

(c)

Deferred Payment Period

The time period taken from the purchase of raw materials and labour until
the payment of cash for these items.

Figure 10.4: Cash conversion cycle

Example 10.6
Now, we will look at an example on how the calculation for cash conversion
cycle is made. Jaya Jati Company manufactures office fittings such as tables and
chairs. The following are the cash dealings of the company:
(a)

Purchase of raw materials on credit for the production of tables and chairs
and the company is given a period of 30 days to make payment.

(b)

Employees will be paid at the end of the month (that is after 30 working
days).

(c)

The customers of the company will purchase the goods on credit.

Therefore, the account receivables will exist when sales are made.

(d)

The payment for raw materials and wages must be made at the date
promised. As the cash from the credit sales have not been received, the
company has to finance the cash flow with short-term loans.

(e)

The cash cycle will be complete when cash from the credit sales are
received. Subsequently, the cash will be used to pay the short-term loans
that were taken to pay for the raw materials and wages of employees.

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Sales of Jaya Jati Company are RM1,500,000, while the average inventory is
RM350,000. Account receivables are RM85,750. Assume that there are 360 days in
a year.
Based on the information, the cash conversion cycle for Jaya Jati Company can be
calculated as follows:
Step 1: Calculate the cash conversion period
Inventory conversion period

Inventory
Sales/360
RM350,000
RM1,500,000/360
84 days

Step 2: Calculate the account receivable conversion period

Account receivable
conversion period

Account receivable
Sales/360
RM85,750
RM1,500,000/360
21 days

Step 3: Calculate the deferred payment period

Based on the information above, the deferred payment period is 30 days
(items a and b).
Step 4: Calculate the cash conversion cycle period
Cash conversion cycle = 84 days + 21 days 30 days
= 75 days
Based on the calculation above, Jaya Jati Company:
(a)

Requires 84 days to convert the raw materials into finished goods (office
chairs and tables);

(b)

Has 21 days to obtain cash from the sales made on credit; and

(c)

Has 30 days to make payment on the purchase of raw materials and

utilisation of labour.
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Therefore, the time period between the withdrawal of cash (payments that were
made for the purchase of raw materials and utilisation labour) and the receiving
of cash from the sales is 75 days.

EXERCISE 10.3
1. What is meant by cash conversion cycle?
2. Explain three components in the cash conversion cycle.
3. U-Tany Companys ventures in a teakwood furniture business. Its
supplier, Mr Chong had been given a 20-day period to settle his
payments for the inventory ordered.
Sales

RM450,000

Average inventory

RM50,000

Account receivables

RM15,000

Based on the information above, calculate the:

(a)

Inventory conversion period

(b)

Account receivable conversion period

(c)

Deferred payments period

(d)

Cash conversion cycle period

Assume that there are 360 days in a year.

10.5

MANAGEMENT OF MARKETABLE
SECURITIES
SELF-CHECK 10.5

The companies owners would sometimes use the surplus funds of the
company to insert in marketable securities to obtain some returns. Is
this a wise action?

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Marketable securities is a short-term financial instrument that provides returns to

the investors. Marketable securities are also known as cash equivalent as these
securities can be converted into cash in a short period of time.
Companies that have surplus funds can temporarily invest these funds in
marketable securities. By doing this, the company can convert the securities into
cash in a short period of time and obtain some return from the investment.

10.5.1

Factors in Choosing Marketable Securities

Marketable securities can be valued based on these factors:

(a)

Default Risk
The probability of the interest and principal cannot be repaid in the amount
promised at the specific time.

(b)

Liquidity/Marketability
Liquidity/marketability refer to the ability of the security to be converted
into cash in a short period of time.

(c)

Taxation
Interest that is obtained from the marketable security which is not financed
by the federal government will be taxed.

(d)

Returns
The criteria of returns involve evaluation of risk and interest for each factor
stated above.

10.5.2

Types of Marketable Securities

The following are several types of marketable securities that are found in the
market:
(a)

Treasury Bills
Treasury bills are short-term securities that are issued by the Central Bank
of Malaysia (Bank Negara Malaysia) with a maturity period of 91 days,
182 days or 365 days. This bill is offered on discount basis. Therefore,
investors will not receive interest payments. The return received is the
difference between the purchase price and the face value of the bill. It is
also risk-free as it is guaranteed by the government.

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(b)

Commercial Papers
Commercial papers are short-term promissory notes that are issued by
large companies to obtain additional capital. These promissory notes are
issued without guarantee and the maturity period for this instrument is
between 30 days to 270 days. Just like treasury bills, these commercial
papers have a face value and are sold at a discounted price.

(c)

Bankers Acceptance
Bankers acceptance is a draft (instruction to pay) that is issued by exporters
to obtain payment for goods that are sold to customers who have accounts
with the said bank. Normally, the financing period of these bills is between
30 days to 200 days. Bankers acceptance can be traded in the money market
where the rate of discount is determined by the market.

(d)

Negotiable Certificate of Deposit

Negotiable certificate of deposit is a receipt that is issued by the commercial
bank or merchant bank as a savings evidence for a sum of money that is
kept and the certificate investor has the right to obtain the specific interest
rates.
This certificate can only be issued by commercial banks or merchant banks
that have permission from the Central Bank of Malaysia (Bank Negara
Malaysia) with the minimum amount of RM50,000 to RM1 million for a
period between 3 months to 36 months. The interest rate charged is
determined by the bank issuing the said certificate. This certificate can be
negotiated in the money market or between an individual with another
individual.

EXERCISE 10.4
1. State four criteria that are used in choosing marketable securities.
2. List three types of marketable securities that are found in Malaysia.

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301

BALANCE BETWEEN RISK-RETURN IN

CASH MANAGEMENT
SELF-CHECK 10.6

Explain the difference among the balance between risk-return in cash

management, management of account receivables and management of
inventories.

Cash management involves a balance between risk and rate of return. Cash that
is insufficient will cause the risk of liquidity or insolvency to the company such
as the failure to fulfil liabilities at the predetermined time. A cash holding that is
too high will reduce the companys returns as cash is an asset that does not have
any return.
Therefore, the management must look at the effect of risk and rate of return of
the company in determining the optimal holding level of cash and marketable
securities. Decisions on the level of risk that will be taken by the company depends
on the decision that has been determined by the companys management.
Cash management has the purpose of achieving the following objectives:
(a)

Company has sufficient cash to fulfil the requirements of its transactions;

and

(b)

Cash surplus must be at the minimum level as cash does not have any return.

ACTIVITY 10.3
By taking an example of a prospectus from one of the public limited
companies that is listed on the main board in Bursa Malaysia, provide
review on the cash budget and income statement of that said company.

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EXERCISE 10.5
Give the definition for the following terms:
(a)

Liquid assets

(b)

Cash

(c)

Marketable securities

10.7

MANAGEMENT OF ACCOUNT RECEIVABLE

In this section, you will be expose with the management of account receivable.

10.7.1

Account Receivable

Account receivable exists when sales were made on credit. It is a promise from
the customers to make payment on the purchases that were made in a period that
has been mutually agreed upon.
The importance of managing the account receivable can be determined by
looking at the percentage of the companys sales that were made on credit or the
total account receivable for the company.
The total account receivable for a company at a specific time is determined by the
following two factors:
(a)

Credit sales level of the company; and

(b)

Average collection time.

Changes in any one of these factors will cause a change in the total account
receivable for the company. Therefore, the account receivable for a company at a
specific time can be determined as follows:
Account receivable = Credit sales per day

Average collection time

To further strengthen your understanding on the calculation of account

receivable, refer to the example.

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Example 10.7
Rania Company is a company that manufactures plastic goods. It has an annual
sales of RM250,000 per year. All sales were made on credit and the credit terms is
2/15 net 30. Based on previous experience, 60% of the companys customers will
take the discount and pay on the 15th day. In the meantime, the other 40% will
make payments on the 30th day. Assuming that there are 360 days in a year,
calculate the total account receivable for Rania Company.
Account receivable = Credit sales per day
=

RM250,000
360

Average collection time

[(0.6) (15) (0.4) (30)]

= RM14,583.33
This means that the average account receivable for Rania Company at a specific
time is RM14,583.33.

EXERCISE 10.6
1. What is meant by account receivable?
2. Provide two factors that influence the total account receivable.

10.7.2

Credit Policy

The credit policy of a company is the procedure that has been set by the
management in managing the account receivable. Generally, the credit policy of a
company comprised of credit terms, credit standards and collection policies.
(a)

Credit Terms
Credit terms refer to the terms that are made for the credit sales of the
company. It is normally written as x/y net z which means that the customer
is entitled to get a discount or reduction in price for x% of the purchase
price if the payment is made within the period of y days. If the customer
does not want to take that discount, it has z days to make full payment.
Assuming the credit terms of 2/10 net 30. This means that customers will
get a 2% discount from the invoice price if payment is made within 10 days
of the invoice date. Customers who do not take this discount will have to
make payment within 30 days.
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You can refer to Figure 10.5 to get a graphical illustration of credit terms.

Figure 10.5: Credit terms period

There are two things that form the credit term, which are:
(i)

Credit Period
Credit period refers to the time period given to customers to make
payments for credit purchases. A longer credit period can increase
sales and account receivable. A shorter credit period decreases sales
and account receivable.

(ii)

Cash Discount
Cash discount is the reduction in price that is offered to the customers
who made early payments. The purpose of giving cash discounts to
customers is to encourage early payments, attract new customers and
also to increase the sales.
Figure 10.6 shows two components that are involved in determining
cash discounts.

Figure 10.6: Components in determining cash discounts

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Example 10.8 can help you to understand the credit terms of a company
more clearly.
Example 10.8
On 2 February 2001, U-Pen Company made credit sales amounting to
RM85,000 based on the terms 3/15 net 30. If the customers pay within the
period of 15 days, which is until 17 February, they will get a discount of 3%.
The discount amount can be calculated as follows:
Discount = Percentage of discount
= 3%

Selling price

RM85,000

= RM2,550
Total payments if discount is taken:
= (Invoice price)
= RM85,000

( 1 Discount percentage)

(1 0.03)

= RM82,450
Customers who do not take the discount are given 30 days to settle the
payment at the invoice price of RM85,000.
(b)

Credit Standards
Customers who intend to deal in credit must fulfil the credit standards that
had been determined by the company. Credit standards can be seen as a
minimum qualification test that must be fulfilled by customers to obtain
credit. The determination of credit standards will affect the risk and rate of
return.
(i)

Strict Credit Standard

Reduces sales, returns and financing cost for account receivables; and

(ii)

Loose Credit Standard

Increases sales, returns and the financing cost for account receivables.

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The application of the credit standards can be seen via an analysis of the
customers credit applications conducted by companies via the 5C system.
This system is a subjective value measurement method that is widely used
among credit managers.
This method measures the credit quality that comprised of five main
sections, which are:
(i)

Capacity/Capability
The capacity factor refers to the capacity or capability of the customer
to make payments as predetermined. Valuation can be made based
on the consideration of business practice including the customers
previous records, especially those related to the pattern and trend of
payments.

(ii)

General Economic Conditions

The general economic conditions refer to the development in local
or general economy that may influence businesses that are being
conducted by the customers. The economic conditions may indirectly
affect the ability of the customers in fulfilling their obligations.

(iii) Capital
The capital factor refers to the overall financial status of the
customers. For the purpose of credit evaluations, emphasis is made on
the ratio related to the customers ownership status such as the debt
equity ratio, liquidity ratio and interest coverage ratio.
(iv) Character
Character refers to the enthusiasm shown by the customers in
fulfilling their promise to make payments as mutually agreed.
An experienced credit officer can make accurate estimates on the
enthusiasm and sincerity of a customer based on information such as
the customers previous record with suppliers, banks and background
information regarding the business owned by the customer.
(v)

Collateral
Collateral refers to any fixed assets that are pledged for the credit
facilities. Finance managers will evaluate the collateral based on the
value and the marketability of the asset pledged.

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Collection Policies
Although most customers will make payments within the time period set,
there are those who had to delay payment unintentionally due to financial
problems.
The following are the methods normally used to collect account receivable
that had exceeded the payment period set:
(i)

Sending reminder letters.

(ii)

Making telephone calls.

(iii) Personal visits.

(iv) Forwarding the accounts to collection agency.
(v)

Legal action.

(vi) Including those accounts as bad debt account.

EXERCISE 10.7
1. Describe the components of credit policy.
2. Explain the meaning of credit term 3/15 net 40.
3. List five factors that are evaluated in the usage of the 5C system.

10.7.3

Credit Control

The next discussion involves another important aspect in the management of

account receivable, which is the evaluation on the effectiveness of the credit
policy set. The optimal credit policy is unique to a company as it is determined
by the operating feature of that company itself. There are two common methods
used by companies to control account receivable, which are:
(a)

Average Period Method

The average collection period refers to the average period that is required to
collect cash from the sales made on credit.

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Example 10.9
E-Zet Company sells goods on credit with the terms of 2/15 net 40. Based
on previous experience, customers who will take the discount and make
payments on the 15th day are 70% and the rest will pay on the 40th day.
The credit sales of the company are RM80,000. Assume that there are
360 days in a year.
Based on the information above, the average collection period can be
calculated as follows:
Period collection period = 0.7 (15 days) + 0.3 (40 days)
= 22.5 or 23 days
If the annual sales are RM80,000, therefore the average credit sales per day
are as follows:
Average credit sales per day =

RM80,000
360

= RM222.22
Average account receivable = Credit sales per day
Period

= RM222.22

Average Collection

23

= RM5,111.11
(b)

Ageing Schedule Method

The ageing schedule is a schedule that lists all the account receivables of
customers based on the age of that account. This schedule provides
information on the percentage of account receivables that have yet to be
collected and also the percentage that exceeded the credit period for a
specific period.

Example 10.10 shows how the ageing schedule assists the management in
controlling the companys account receivables. Both company NZJ and company
ZBZ had offered credit terms of 4/15 net 30 days to customers who deal on
credit. The total account receivables for both of these companies are RM4,000,000.
The following is the ageing schedule for both companies:

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Example 10.10
Age of Account
(Days)

NZJ Company

ZBZ Company

Account Value

% from Sales

Account Value

% from Sales

015

2,400,000

60%

1,400,000

35%

1630

1,000,000

25%

1,200,000

30%

3145

600,000

15%

800,000

20%

600,000

15%

4,000,000

100%

More than 45

0
4,000,000

100%

The ageing schedule above shows that 15% of the customers from NZJ Company
had exceeded the credit period that has been set while 35% of customers from
Company ZBZ had failed to pay within the period set.
Both these companies need to look at the credit policy that was set to identify the
problems faced in credit management of the company.

10.7.4

Balance between Risk-return in Management

of Account Receivable

As in management of cash and marketable securities, management of account

receivables is also important as it has an effect on risk and the rate of return for
the company. The balance between risk and the rate of return is a decision that
must be made by the management in managing the account receivable of the
company.
The management of account receivable starts from the decision on whether the
company should sell by credit or not. In relation to this, the company will set
specific policies in managing the account receivable which is normally known as
companys credit.
A loose credit policy normally will increase sales and this will bring a higher rate
of return. However at the same time, this policy will also increase the risk of bad
debts for the company. The increase in this risk will have a negative effect on the
rate of return for the company.

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On the other hand, a strict credit policy will reduce the sales of the company.
However, this policy will reduce the risk of bad debts and will indirectly have a
positive effect on the rate of return for the company. Therefore, in choosing a
specific credit policy, the management of the company must take into account the
effect of the credit policy on the overall risk level and the rate of return of the
company.

ACTIVITY 10.4
You were shocked to receive a tax claim of RM2 million for the business
period of the last three years. Before this, you had expected your
business to be given tax exemption by the government but you do not
have any written documents regarding this matter. This tax must be
settled in full without any instalment payments and you must inform
this issue to the members of the board of directors. What will be your
next course of action?

EXERCISE 10.8
1. Biru Company offers the term of 3/10 net 30 to all the customers
who purchase its goods. Assume that 60% of its customers take
the discount while the rest pays on the 30th day. The annual sales
of Biru Company is RM500,000. Calculate the average account
receivables of Biru Company with the assumption that there are
360 days in a year.
2. Kiki Grocery Store ordered goods totalling RM3,000 every 3 months.
The credit term sets by the supplier is 2/10 net 30. If the company
takes the discount offered by the supplier, calculate the savings that
can be obtained in a year. Assume that there are 360 days in a year.
3. Mrs Latifah buys supplies for her bakery for RM3,500 from Zarina
Supplier Company with the credit term of 2/15 net 30 on 15 June
2011. What is the payment amount made by Mrs Latifah if she
makes payment on 27 June 2011?

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INVENTORY MANAGEMENT

In this subtopic, we will discuss the inventory management in detail.

10.8.1

Types of Inventory

Before starting the discussion on inventory, we need to understand the types of

inventory that are normally held by companies. Generally, inventory is divided
into four categories as follows:
(a)

Raw Materials
Raw materials are the basic items that are bought by the company to be
used in the manufacturing process to produce finished goods. Raw
materials are the main materials in the production of the final product. For
example, timber is used to make furniture.

(b)

Supplies
Supplies are goods that are used in the manufacturing process or the
operations of a business. However, supplies are not the main items in
finished goods. It is the supplementary items that are used in the
production of final product.

(c)

Goods in Process
These are goods undergoing the manufacturing process. They are halfcompleted goods that are at a specific production stage and must undergo
the next production process.

(d)

Finished Goods
Finished goods are goods that have completed the manufacturing process
and are ready for sale.

The type of inventory held by a company depends on the operations of that

company.

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SELF-CHECK 10.7
By using the example of Kentucky Fried Chicken Restaurant, complete
the types of inventory below.
1. Raw materials

______________________

2. Supplies

______________________

3. Goods in process

______________________

4. Finished goods

______________________

10.8.2

Objective of Inventory Management

Generally, the objective of inventory management is to prepare sufficient

inventory to enable the company to operate efficiently and productively. To
achieve this objective, the inventory management, particularly, involves two
questions, which are:
(a)

How much inventory must be held (bought) at a specific period of time?;

(b)

When is the appropriate time to reorder inventory?

10.8.3

Cost Related to Inventory

Management must identify the costs that are related to inventory in its efforts to
minimise the costs. The costs that are related to inventory are:
(a)

Carrying Cost of Inventory

Carrying cost of inventory is the cost of keeping inventory from the
moment it is stored by the company until it is sold. Among the carrying
costs of inventory are warehouse cost, depreciation cost, insurance and tax,
and capital tied to the inventory.
The carrying cost of inventory has a direct connection with the average
inventory. This means that the carrying cost of inventory will increase with
the increase in the average inventory held.
The average inventory depends on the frequency of orders made. The
following is the formula to obtain the average inventory.
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313

Number of units per order (Q)

2
S/N
2

Figure 10.7 shows how the average inventory is obtained graphically.

Figure 10.7: Average inventory

The formula and Figure 10.7 assumed that when inventory is ordered, the total
inventory kept is equal to 0 (all inventory ordered had been completely sold).
Example 10.11:
Intoll Company sells 150,000 (S) units of computer per year. The inventory is
ordered four times per year (N) and each order (Q) is 37,500 units. The purchase
price (P) is RM3.50 per unit. The cost of capital to finance the inventory is 10%
of the average inventory value. Warehouse cost is RM3,500 insurance cost is
RM1,000, and depreciation cost is RM500.
Average inventory A

37, 500
2
18,750

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By using the information that the inventory purchasing price is RM3.50 per unit,
the average value of inventory is:
Average Value of Inventory = (P)(A)
= (RM3.50) (18,750 units)
= RM65,625

The next step is to identify the costs involved in holding the inventory. Based on
the information given, the costs involved are financing costs, warehousing costs,
insurance costs and depreciation costs.
Total carrying cost of inventory (TCC)

= (RM65,625 0.10) + RM 3,500 +

RM1,000 + RM500
= RM11,562.50

The percentage cost of carrying inventory can be calculated as follows:

% of carrying inventory

Total carrying cost

Average value of inventory
RM11,562.50
RM65,625
0.17619 or 17.62%

(b)

Ordering Cost of Inventory

The ordering cost of inventory or TOC is the cost involved in the process of
preparing an order to obtain inventory. Examples of ordering costs are cost
of telephone calls, cost of preparing paperwork, delivery cost and handling
cost.

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The ordering cost of inventory is a constant cost. Ordering cost is fixed for
specific order without taking into account the size of the order made. The
total ordering cost can be calculated as follows:

Total ordering cost (TOC) Fixed cost for an order

F

Sales units per year

2 (Average inventory)

S
2A

Where:
F = Fixed cost for an order
S = Sales unit per year
A = Average inventory
Example 10.12
If S = 150,000 units, A = 18,750 units and F = RM500, what is the total
ordering costs?

Total ordering cost (TOC) 500

150,000
2(18,750)

RM2,000
(c)

Annual Total Inventory Cost

Total inventory cost or TIC consists of all the costs related with inventory,
which are the carrying costs of inventory and the ordering cost of
inventory.
Based on the previous calculation example, the total inventory cost can be
calculated as follows:
Total inventory cost (TIC) = TCC + TOC
= RM11,562.50 + RM2,000
= RM13,562.50

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Economic Order Quantity Model (EOQ)

This section will answer the first question which was raised in achieving the
objective of inventory management, which is: How much inventory must be held
at a specific period of time?
The Economic Order Quantity Model which is also known as EOQ Model is the
method used to ascertain the optimal order quantity of inventory for a company.
Figure 10.8 shows the EOQ Model graphically.

Figure 10.8: Economic Order Quantity Model (EOQ)

Figure 10.8 shows that the cost of carrying inventory increases with the increase
in average inventory (please refer to the TCC line; Total Carrying Cost). This
means that a high order quantity will increase the carrying cost of inventory
that must be borne by the company. Therefore, costs that are related with this
inventory activity such as insurance, tax and storage will increase with the
increase in average inventory.
The ordering cost will decrease when the order quantity of inventory increases.
This is because a bigger order size will reduce the frequency of the orders. This
can be seen in the figure above which shows that the TOC (Total Ordering Cost)
curve will decrease when the order quantity increases.

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The total carrying cost and ordering cost are the total inventory cost (please refer to
the TIC curve; Total Inventory Cost). The minimum level at the TIC curve (as shown
by the dotted line) is the EOQ level which is the optimal order quantity of inventory
for the company. In Figure 10.8, we found that the TCC curve (total carrying cost
curve) and the TOC curve (total ordering cost curve) also crosses at this level. This
shows that at EOQ level, the total carrying cost and the total ordering cost are the
same. Therefore, also at this level, the total inventory cost is at the minimum level.
The EOQ level can be calculated by using the following formula:

EOQ

2(F)(S)
(C)(P)

Where:
EOQ = Economic order quantity
F

= Fixed cost in ordering

= Annual sales (units)

= Carrying cost (percentage of inventory value)

= Purchase price per unit of inventory

The usage of EOQ Model is based on several assumptions, which are:

(a)

Sales are equal throughout the year.

(b)

Sales can be predicted accurately.

(c)

Order made will be received according to schedule.

(d)

Storage cost and ordering cost are constant.

Example 10.13
The sales of Zulia Company is 50,000 units per year. The percentage of storage
cost is 20% of inventory value. The purchase price is RM15 per unit and the
ordering cost for each order is RM1,500. Based on the information given, the
EOQ level is as follows:
S = 50,000 units per year
C = 20% or 0.2
P = RM15
F = RM1,500

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EOQ

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2(1,500) (50,000)
(0.2)(15)
7,071 units

This means that Zulia Company will order 7,071 units each time an order is
made. Therefore, the orders will be made seven times per year (50,000/7,071).
The total cost involved with the order level of 7,071 units are:
TIC = TCC + TOC
= (C) (P) (Q/2) + (F)(S/Q)
= (0.2) (15.00)(7,071/2) + (RM1,500)(50,000/7,071)
= 10,606 + 10,606
= 21,212
Therefore, the total inventory cost at EOQ quantity is RM21,212 and the total
carrying cost (TCC) and ordering cost (TOC) is the same at RM10,606.
The second question to be answered in fulfilling the objective of inventory
management is:
When is the appropriate time to reorder inventory?
The appropriate time to reorder inventory is known as the reorder point. The
reorder point refers to the inventory level where the next order needs to be made.
The determination of the reorder level is important to avoid problems in shortage of
inventory or depleted inventory. Three factors that influence the reorder point are:
(a)

Safety Stock
Safety stock is the surplus stock that is held by the company to overcome
the problem in shortage of stock. When the total stock reaches the safety
stock level, the company will make a new order. Figure 10.9 shows the
effect of safety stock on the reorder point (the effect of lead time and goods
in transit on the reorder point is not taken into account).

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Figure 10.9: Effect of safety stock on the reorder point

(b)

Receiving Order Lead Time

Lead time refers to the time period taken from the time the order is made
until the time the inventory is received by the company. Figure 10.10 shows
the effect of lead time on the reorder point (the effect of goods in transit on
the reorder point is not taken into account).

Figure 10.10: Effect of lead time and safety stock on the reorder point

The reorder point can be calculated using the following formula:

Reorder point

Sales
52 weeks

lead time

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Example 10.14
D-Dee Company sells 130,000 units of inventory per year. Assume that the sales
are constant throughout the year. Therefore, the usage of inventory per week is
2,500 units (assume that there are 52 weeks in a year). If the lead time is 3 weeks,
the calculation of the reorder point is as follows:
Reorder point = 2,500

3 weeks

= 7,500 units
(c)

Goods in Transit
Goods in transit are goods that have been ordered but have yet to be
received. Goods in transit exist when the lead time or the time taken when
one order was made until the time it is received is longer than the time
between one order and the next order. Let us look at an example of how
goods in transit are taken into account in determining the reorder point.
Figure 10.11 shows the effect of safety stock, lead time and goods in transit
on the reorder point.

Reorder point

Sales
52 weeks

lead time

Goods in Transit

Figure 10.11: Effect of safety stock, lead time and goods in transit on the reorder
point

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Example 10.15
Assume that a company takes 3 weeks to wait for a new order to be received and
the weekly usage is 2,500 units. The order quantity is 2,000 units and the time
between orders is 2 weeks. The inventory level when new orders must be made
is as follows:
Reorder point = (3

2,500) 2,000

= 7,500 2,000
= 5,500 units
In the example above, the company needs to reorder inventory at the level
of 5,500 units after taking into account the stock lead time for the order of
7,500 units to be received and the goods in transit of 2,000 units that would
arrive.

EXERCISE 10.9
1. Explain the objectives of inventory management in general.
2. What is the use of the EOQ Model?
3. Explain the assumptions that are made to enable the usage of the
EOQ Model.

10.8.5

Balance between Risk-return in Inventory

Management

As discussed earlier, the management of cash and marketable securities as well

as account receivable involved a balance between risk and rate of return. The
same consideration must be noted by finance managers when managing the
companys inventory.
Inventory management cannot be separated from the management of account
receivable as both are closely related to one another. Changes in sales will have
effects on account receivable and inventory. Therefore, management must take
into account the relationship between both these items before making any
decision that involves account receivable and inventory.

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The next example that will be discussed will show how the holding level of the
companys inventory will affect the risk and the rate of return of the company. A
grocery store must make investments in inventory. It cannot operate if there is
absolutely no inventory to sell. Therefore, the store owner must make estimation
on the level and type of inventory that will be sold in its store. The risk that may
be faced by the store owner is the risk of losing its customers. For example,
holding inventory that is too low will cause the store to be always out of stock
and regular customers will have to go to another store.
To overcome this problem in shortage of inventory or depleted inventory, the
storekeeper will start to purchase lots of inventory. Must remember that a higher
inventory will involve higher costs and this will bring an overall negative effect
on the rate of return of the company. Therefore, the store owner must determine
the minimum inventory holding level to be parallel with its acceptable risk level
and the required rate of returns.

ACTIVITY 10.5
Please visit the following websites to obtain additional information on
the topics discussed in this topic.
http://www.vainteractive.com/inbusiness/editorial/finance/ibt/cash_bud.html
Description: Valuation of cash budget as well as an interactive web
calculator.
http://www.learningforlife.fsu.edu
Description: Basis to financial planning.
http://www.businesstown.com
Description: Introduction and definition of Pro forma Income Statement.
http://www.financeprofessor.com/fin402/notes/shorttermfinance.html
Description: Detailed explanation on short-term finance management.

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EXERCISE 10.10
1. The following are the information obtained on Bertam Company:
Annual sales

= 20,000 units

Purchase price per unit = RM1.50

Carrying cost

= 15% from the inventory value

Ordering cost

= RM5

Lead time

= 2 weeks

(a)

Calculate the economic order quantity for Bertam Company.

(b)

Calculate the total inventory cost for Bertam Company at the

EOQ level.

(c)

Calculate the reorder point for Bertam Company.

2. The following are the information obtained on Keat Company.

Annual sales

= 100,000 units

Purchase price per unit

= RM2.50

Economic order quantity (EOQ) = 35,000

Delivering period of inventory

= 15 days

Carrying cost

= 10% of inventory value

Assume that there are 365 days in a year.

Based on the information given, determine the:
(a)

Reorder point for inventory.

(b)

Average inventory level.

(c)

Annual carrying cost.

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This working capital management comprised of the balance of risk-return in

management of cash, management of account receivable and management of
inventory in ensuring that the level of profit returns are in accordance with
the budget made.
Account receivables exist when sales are made on credit. Account receivables
at a specific period are influenced by the credit sales level of the company
and the time period required in collecting cash from those credit sales.
Inventory management involves a balance between risk and the rate of
return.
Inventory must be managed wisely as it is an investment by the company
that is tied up and cannot be used for other purposes.

Account receivable

Economic order quantity (EOQ)

Accruals

Factoring

Aggressive approach

Marketable securities

Bank loans

Moderate approach

Bankers acceptance

Negotiable certificate of deposit

Cash conversion cycle

Negotiated financing

Commercial papers

Net working capital

Conservative approach

Overdraft

Credit control

Spontaneous financing

Credit policy

Trade credit

Credit terms

Treasury bills

Current assets

Working capital management

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Answers
TOPIC 1: INTRODUCTION TO FINANCE
Exercise 1.1
1. wealth; price
2. Maximising profit
3. D
4. D

Exercise 1.2
1. taxed twice; dividends
2. withdraws; dies or becomes bankrupt
3. Dividend
4. A
5. B

Exercise 1.3
1. C
2. D
3. B
4. Separation of ownership and management means that you cannot be
interacting with the manager whenever you want. However, you are the coowner of the company; you share the success or failure of the company via
dividends payment by the company and the price of the shares traded; you
can vote in the election of the board of directors who control and appoint the
management.

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ANSWERS

5. (a)

Increasing the market share is not appropriate as a company objective if

it means lowering the price until it is detrimental to the company.
Increasing market share can be a part of the companys management
strategy but it must be remembered that market shares is not an
objective on its own. The owner of the company wants the management
to maximise the value of their investments.

(b)

Minimising cost might also be against the objective of maximising the

value of the company. For example, assume that the company accepts a
large order for its product. The company must be willing to pay wages
for overtime and bear the additional costs to fulfil that order only if it
can sell the additional product at a price in excess of these costs.

(c)

Lowering prices to compete with rivals may result in the company

selling the goods at a price lower than the price needed to maximise
shareholders wealth. Again, in certain situations, this strategy can be
accepted but it must not be regarded as the ultimate objective of the
company. It must be valued by taking into consideration its effect on
the value of the company.

(d)

Increasing profit is not appropriate as a companys objective. This

objective might be achieved in one year compared to the other years.
Which years profit should be maximised? Increasing investment in the
company can also increase profit, even though the increase in the profit
is not justifiable with the additional investment. In this situation, the
additional investment increases profit but reduces the shareholders
wealth.

6. (a)

Fixed salary means that compensation (in the short term) does not
depend on the achievement of the company.

(b)

Salary that is related to the profit of the company will bind the
managers compensation with the success of the company. However,
profitability is not the appropriate method to measure a companys
success. We had already discussed earlier that the objective to maximise
profit is only a short-term objective that does not look at the long-term
prospects of the company.

(c)

Salary that is partially paid by company shares means that the manager
will obtain the highest returns when the shareholders wealth are
maximised. Therefore, this compensation will lead the manager to act in
accordance with the interest of the owners.

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327

TOPIC 2: ANALYSIS OF FINANCIAL STATEMENTS

Exercise 2.1
1. (b)

False

2. (b)

False

3. (a)

True

4. (b)

False

5. C
6.
Account
Account payable
Account receivable
Accrual
Building
General expenses
Interest expenses
Sales expenses
Operating expenses
Administrative expenses
Tax
Preference shares dividends
Sales revenue
Long-term loans
Inventory
Cost of goods sold
Paid-up capital above par
Notes payable
Retained earnings
Equipments
Ordinary shares
Preference shares
Marketable securities
Depreciation
Accumulated depreciation
Land
Cash

(1)
Statement

(2)
Type of Account

BS
BS
BS
BS
IS
IS
IS
IS
IS
IS
IS
IS
BS
BS
IS
BS
BS
BS
BS
BS
BS
BS
IS
BS
BS
BS

CL
CA
CL
FA
EX
EX
EX
EX
EX
EX
EX
R
LTL
CA
EX
SE
CL or LTL
SE
FA
SE
SE
CA
EX
FA (contra account)
FA
CA

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ANSWERS

7.
Company PC
Income Statement
for the Year Ended 31 December 2011
Sales
Less: Cost of goods sold
Gross profit
Less Operating expenditure
Sales expenses
Administrative and general expenses
Depreciation expenses
Total operating costs
Profit before interest and tax
Interest expenses
Profit before tax
Tax (30%)
Profit after tax
Less: Preference shares dividend
Net profit (or profit available for ordinary
shareholders)
Earnings per share

RM5,250,000
2,850,000
RM2,400,000
RM350,000
600,000
550,000
RM1,500,000
RM900,000
250,000
RM650,000
195,000
RM455,000
100,000
RM355,000
RM 0.17

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329

8.
Company ODC
Balance Sheet
as at 31 December 2011
Assets
Current assets

Cash
Marketable securities
Account receivable
Inventory

RM2,150,000

Total current assets

RM11,150,000

750,000
4,500,000
3,750,000

Fixed assets
Land
Building
Machines
Equipments

RM2,000,000
RM2,250,000
4,200,000

2,350,000

Total fixed assets

RM10,800,000

Less: Accumulated depreciation

Fixed assets, net
Total Assets

2,650,000
8,150,000
RM19,300,000

Liabilities and Equities

Current liabilities

RM2,200,000
4,750,000
550,000

Account payable
Notes payable
Accruals

Total current liabilities

RM7,500,000
4,200,000
RM11,700,000

Long-term loans
Total liabilities
Equities
Preference shares
Ordinary shares
Paid up capital
Retained earnings

Total equities
Total liabilities and equities

Copyright Open University Malaysia (OUM)

RM1,000,000
900,000
3,600,000
2,100,000
RM7,600,000
RM19,300,00

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ANSWERS

Exercise 2.2
1. (b)

False

2. (b)

False

3. (a)

True

4. (b)

False

5. C
6. D
7. (a)
Hugo Enterprise
Statement of Retained Earnings
for the year ended 31 December 2010
Retained Earnings, 1 January 2010
+ Net Profit (throughout year 2010)
Dividends paid (throughout year 2010)
Preference shares
Ordinary shares
Retained Earnings, 31 December 2010

(b)

Earnings per share

(c)

Dividends per share =

RM92,800
37,000
RM4,700
21,000

25,700
RM104,800

RM37,700 RM4,700
= RM2.36
14,000
RM21,000
= RM2.36
14,000

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8. Dividends paid = RM736,000 + RM186,000 RM812,000

= RM110,000
9.
Items
Cash

Changes
(RM)

Cash Flow

+1,000

10,000

+5,000

Long-term loans

20,000

Inventory

+20,000

Fixed assets

+4,000

Account receivable

7,000

Net profit

+6,000

Depreciation

+1,000

Share buyback

+6,000

Cash dividend

+8,000

+10,000

Account payable
Notes payable

Sale of Share

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ANSWERS

10.
Suresh Corporation
Changes in balance sheet items
between 31 December 2011 and 31 December 2012
2011

2012

Changes

Assets
Cash
15,000 10,000 +5,000
Marketable securities
18,000 12,000 +6,000
Account receivable
20,000 18,000 +2,000
Inventory
29,000 28,000 +1,000
Total fixed assets
295,000 281,000 +14,000
Less: Accumulated depreciation 147,000 131,000 (16,000)
Liabilities
Account payable
Notes payable
Wages accrual
Long-term loans
Equities
Preference shares
Retained earnings
TOTAL

16,000
28,000
2,000
50,000

15,000
22,000
3,000
50,000

+1,000
+6,000
1,000
0

100,000 100,000
14,000 28,000

0
+6,000

Resource

Usage

5,000
6,000
2,000
1,000
14,000
16,000

1,000
6,000

1,000
6,000
RM29,000 RM29,000

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333

Suresh Corporation
Cash Flow Statement
For the Year Ended 31 December 2012
Cash Flow from Operating Activities
Net Profit
Depreciation
Increase in account receivable
Increase in inventory
Increase in account payable
Decrease in accrual

RM14,000
16,000
(2,000)
(1,000)
1,000
(1,000)

Cash flow from operating activities

RM27,000

Cash Flow from Investing Activities

Increase in total fixed assets

(14,000)

Cash flow from investing activities

Cash Flow from Financing Activities
Decrease in short-term notes payable
Dividends paid

RM6,000
(8,000)

Cash flow from financing activities

(2,000)
RM11,000

Net increase in cash and marketable securities

Exercise 2.3
1.

Fazrul Company
2009
(a) Net working capital

2008

RM180,000

RM150,000

(b) Current ratio

2.5 times

2.07 times

(c)

1.17 times

1 time

Quick ratio

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ANSWERS

Exercise 2.4
Fazrul Company
2009

2008

(a) Account receivable turnover

9.14 times

9.03 times

(b) Average collection period

39.9 days

40.4 days

(c)

2.54 times

2.57 times

(d) Average inventory sales period

144.27 days
= 144 days

142.02 days
= 142 days

(e)

Fixed asset turnover

2.13 times

2.15 times

(f)

Total asset turnover

1.07 times

1.02 times

Inventory turnover

Exercise 2.5
(a)

Debt ratio = 50%

(b)

Interest coverage ratio = 3 times

(c)

Return on asset = 36%

(d)

Average collection period = 27 days

(e)

Total asset turnover = 2 times

Exercise 2.6
1. Liquidity
2. current asset; current liability
3. Inventory
4. cost of goods sold; inventory
5. total asset
6. net profit; owners equity
7. share price; earnings

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8.
X-Cell

N-Hance

(a) Return on assets

12.67%

11.25%

(b) Return on equity

31.67%

28.13%

(c)

10.27%

9.57%

(d) Total asset turnover

1.23 times

1.18 times

(e)

Debt ratio

60%

60%

(f)

Equity multiplier

2.5 times

2.5 times

(g) Interest coverage ratio

7.89 times

8.37 times

(h) Price earnings ratio

6.25

12.62

(i)

6.86%

1.89%

Net profit margin

Dividend yield ratio

Exercise 2.7
1. (a)

True

2. (b)

False

3. D
4. C
5. Net profit = RM6,000
6. Return on equity = 4.0%
7. Fima Corporation
(a)

Current ratio increased.

(b)

Return on equity decreased.

(c)

Debt ratio increased.

(d)

Dividend yield increased.

(e)

Account receivables turnover decreased.

(f)

Return on asset decreased.

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336

ANSWERS

8. Lily Corporation
(a)

Current ratio = 0.91 times

(b)

Quick ratio = 0.63 times

(c)

Average collection period = 32.5 days

(d)

Inventory turnover = 20 times

(e)

Fixed asset turnover = 4.60 times

(f)

Total asset turnover = 2.8 times

(g)

Debt ratio = 55%

(h)

Interest coverage ratio = 4.0 times

(i)

Gross profit margin = 13%

(j)

Operating profit margin = 2%

(k)

Net profit margin = 1.08%

(l)

Return on asset = 3%

(m) Return on equity = 6.7%

9. Amri Company
Marketable securities

= RM16,000

Account receivable

= RM62,000

Inventory

= RM73,560

Total fixed asset

= RM146,663

Net fixed asset

= RM96,663

Total asset

= RM256,228

Notes payable

= RM20,300

Total current liabilities

= RM67,900

Long-term liabilities

= RM58,677

Total liabilities

= RM126,577

Total equity

= RM129,651

Total liabilities and equity = RM256,228

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TOPIC 3: TIME VALUE OF MONEY

Exercise 3.1
1. RM127.63
2. RM6,050

Exercise 3.2
1. RM11,171.10
2. RM4,974.55

Exercise 3.3
1. RM1,000
2. RM2,268.43

Exercise 3.4
1. RM100.06
2. RM3,522.77

Exercise 3.5
1. RM330.96
2. RM61,050

Exercise 3.6
RM272.30

Exercise 3.7
RM1,000

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ANSWERS

Exercise 3.8
1. RM346.06
2. RM149.4
3. FVOA = RM3,000 (FVIFA8%,15)
= RM3,000 (27.1521)
= RM81,456.30
FVAD = RM3,000 (FVIFA8%,15) (1.08)
= RM3,000 (29.32)
= RM87,972.80
The difference: RM6,516.50
4. PV1 = RM4,000 (PVIF18%,1) = RM3,390.00
PV2 = RM5,000 (PVIF18%,2) = RM3,591.00
PV3 = RM5,000 (PVIF18%,3) = RM3,043.00
PV4 = RM6,000 (PVIF18%,4) = RM3,094.80
PV5 = RM8,000 (PVIF18%,5) = RM3,496.80
Total PV

= RM16,615.60

RM16,615.60 RM30,000

= RM13,384.40

Therefore, Mas Joko Company should not continue with its investment.
5. (a)
(b)

RM180/5%

= RM3,600

RM180/10% = RM1,800

6. PVOA = RM12,000 (PVIFA6%,10)

= RM12,000 (7.3601)
= RM88,321.20
The second choice should be chosen (RM88,321.20) as the present value is
more compared to the first choice (RM60,000).

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339

7. PMTA = PVA/(PVIFA10%,4)
= RM6,000/3.170
= RM1,892.74
8. PV = RM400 (2.72) (0.10) (7)
= RM198.55

TOPIC 4: VALUATION OF SECURITIES

Exercise 4.1
1. Assists in making investment/financing decisions
2. (a)

Amount and timing of future cash flow

(b)

Cash flow risk

(c)

Attitude of investors towards risks

Exercise 4.2
1. Vb = 80 (PVIFA13%,12) + 1000 (PVIF13%,12)
= 80 (5.918) + 1000 (0.231)
= 473.44 + 231
= RM704.44
2. Vb = 60 (PVIFA5%,16) + 1000 (PVIF5%, 16)
= 60 (10.838) + 1000 (0.458)
= 650.28 + 458
= RM1108.28
3. The value of bond will be higher as the time period (t) for the payment is
shorter and the present value of the bond will increase. Therefore, the value
of the bond will also increase.

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ANSWERS

Exercise 4.3
Trial-and-error method = 16.96% @ 17%
Estimation method

= 16.01%

Exercise 4.4
1. B
2. B
3. A
4. B
5. C
6. Vb = 80 (PVIFA12%,11) + 1000 (PVIF12%,11)
= 80 (5.9377) + 1000 (0.2875)
= 475.02 + 287.5
= RM762.52
7. Vb = 40 (PVIFA3%,20) + 1000 (PVIF3%,20)
= 40 (14.8775) + 1000 (0.5537)
= 595.1 + 553.7
= RM1148.8
8. Vb = 25 (PVIFA3%,30) + 1000 (PVIF3%,30)
= 25 (19.5004) + 1000 (0.4120)
= 487.51 + 412
= RM899.51
9. RM950 = 90 (PVIFA11%,2) + 1000 (PVIF11%,2)
= 90 (1.7125) + 1000 (0.8116)
= RM965.75

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341

RM950 = 90 (PVIFA12%,2) + 1000 (PVIF12%,2)

= 90 (1.6901) + 1000 (0.7972)
= RM949.3
= 11% + 965.75 950
= 965.75 949.3
= 11.96%
10.

Vb = 100 (PVIFA11%,3) + 1000 (PVIF11%,3)

(a)

= 100 (2.3612) + 1000 (0.6931)

= RM929.22
RM975.98 = 100 (PVIFA11%,3) + 1000 (PVIF11%,3)

(b)

= 100 (2.4437) + (0.7312)

= RM975.57
YTM

= 11%

11.

The rate of discount that equalise the present value for all interest and
capital payment for the bonds with the present value of the bond.

12.

Short-term bond.

Exercise 4.5
1. (a)
(b)

dividends
capital gains

2. VCS =

0.18
0.11 0.05

= RM3.00
Yes, the shares will be sold as the actual value of these shares is lower than
the market price and it will be profitable.

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342

3. D1 = 0.50 (1 + 0.15) = 0.575

D2 = 0.575 (1 + 0.15) = 0.661
D3 = 0.661 (1 + 0.15) = 0.760
D4 = 0.760 (1 + 0.4) = 0.790
P3 =

0.79
0.12 0.04

9.875

Vcs = 0.575(PVIF12%,1) + 0.661(PVIF12%,2) + 0.760(PVIF12%,3) + 9.875(PVIF12%,3)

= RM8.61
4. The rate of return is the return, calculated as a percentage of investment that
is expected to be received by investors. For ordinary shares, it is the rate of
dividend yield added with the rate of yield from capital gain.
5. (a)

Kcs =

0.25
2.30

+ 0.105

= 0.2137
= 21.37%
(b)

Yes. As the expected return (21.36%) is higher than 17%, therefore the
shares should be bought.

Exercise 4.6
1. A
2. A
3. A
4. B
5. B
6. Because it has similarities with the characteristics of ordinary shares and
bonds.
7.

VPS =

0.16
= RM1.33
0.12
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ANSWERS

8.

9.

0.35
3.85

343

(a)

K ps =

(b)

Sell as the expected rate of return is lower than the required rate of
return.

VCS =
=

9.09%

D
K cs g
1.32
0.11 0.07

= RM33
10.

D1

= D0 (1 + g)
= 1.15 (1 + 0.15)
= 1.32

D2

= 1.32 (1 + 0.15)
= 1.52

D3

= 1.52 (1 + 0.13)
= 1.72

D4

= 1.72 (1 + 0.06)
= 1.82

P3

1.82
0.12 0.06

= RM30.33
VCS = 1.32(PVIF12%,1) + 1.52(PVIF12%,2) + 1.72(PVIF12%,3) + 30.33(PVIF12%,3)
= 1.32 (0.8929) + 1.52 (0.7972) + 1.72 (0.7118) + 30.33 (0.7118)
= 1.18 + 1.21 + 1.22 + 21.59
= RM25.20

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344

11.

KCS =
=

D
+g
P0

0.25
4.05

+ 0.07

= 0.1317
= 13.17%
12.

D1

= 0.44 (1 + 0.25)
= 0.55

D2

= 0.55 (1 + 0.25)
= 0.688

D3

= 0.688 (1 + 0.25)
= 0.859

D4

= 0.859 (1 + 0.1)
= 0.945

P4

0.945
=

0.15 0.10

= RM18.90
Vcs = 0.55(PVIF15%,1) + 0.688(PVIF15%,2) + 0.859(PVIF15%,3) +
18.9(PVIF15%,3)
= 0.55 (0.8696) + 0.688 (0.7561) + 0.859 (0.6575) + 18.9 (0.6575)
= 0.478 + 0.520 + 0.565 + 12.427
= RM13.99

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ANSWERS

13.

14.

VCS =

D
P0

D
kp

D2

= RM8.33

kP

=
=

D2

345

1
0.12
0.15
5

= 3%

TOPIC 5: RISK ANALYSIS

Exercise 5.1
(a)

Value of expected return = 24%

(b)

Standard deviation of return = 11.47%

(c)

Variance multiplier of return = 0.48; There is a 0.48% risk for each 1% return)

Exercise 5.2
(a)

Value of expected return for shares x = 10%

Shares y = 10.32%
Shares z = 10.12%

(b)

Expected return of portfolio = 10.14%

(c)

Standard deviation of portfolio = 3.95%

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ANSWERS

Exercise 5.3
1. (a)

(b)

Shares of Company A

Shares of Company B

Range of A return = 30% 5% = 25%

Range of B return = 35% 15% = 20%

(c)

2. (a)

Shares A are riskier as it has a bigger range of return and it also shows a
flatter probability distribution.
Expected return for shares X = 10.8%; shares Y = 9%

(b)

Expected return for portfolio = 9.9%

(c)

Standard deviation for portfolio = 0.73%

3. The risks for portfolio shares K and L will reduce.

4. (a)

Required rate of return = 13%

(b)

12% > 13%; therefore Jacob Company should not invest in this project.

(c)

The required rate of return = 27%

5. These shares have a lower level of risk than the average securities risk in the
capital market.

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6. (a)

Average expected return of portfolio AB = 14%

Average expected return of portfolio AC = 14%

(b)

Standard deviation of portfolio AB = 0%

Standard deviation of portfolio AC = 2%

(c)
7. (a)
(b)
8. (a)

Portfolio AB should be chosen

Required rate of return = 18.4%
Premium value of market risks = 8%
E(rv) = (0.1)(0) + (0.2)(6) + (0.3)(7) + (0.4)(5)
= 0 + 1.2 + 2.1 + 2.0 =5.3%
Expected return of shares V = 5.3%
E(rw) = (0.1)(3) + (0.2)(4) + (0.3)(5) + (0.4)(6)
= 0.3 + 0.8 + 1.5 + 2.4 = 5%
Expected return of shares W = 5%

(b)

2
v

= (0.1)(0 5.3)2 + (0.2)(6 5.3)2 + (0.3)(7 5.3)2 + (0.4)(5 5.3)2

= 2.809 + 0.098 + 0.867 + 0.036 = 3.81

Variance of shares V = 3.81

2

= (0.1)(3 5)2 + (0.2)(4 5)2 + (0.3)(5 5)2 + (0.4)(6 5)2

= 0.4 + 0.2 + 0 + 0.4 = 1

Variance of shares W = 1
(c)

3.81 = 1.95%

Standard deviation of shares V = 1.95%

w

1 = 1%

Standard deviation of shares W = 1%

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ANSWERS

348

(d)

covvw = (0 5.3)(3 5)(0.1) + (6 5.3)(4 5)(0.2) + (7 5.3)(5 5)(0.3) +

(5 5.3)(6 5)(0.4)

= 1.06 0.14 + 0 0.12

= 0.8
Covariance between the return of shares V and W = 1.04
(e)

AZ

= 0.8/(1.95

1) = 0.8/1.95 = 0.410

Correlation between the return of shares V and W = 1.09

9.

(a)
Alternative I
Expected return of portfolio
Beta portfolio
Risk reward ratio

(b)
10.

Alternative II

8.8%
0.5
5.6%

11%
0.7
7.14%

Therefore, alternative II should be chosen

Required return for shares A = 19.4%

Required return for shares B = 14.6%
20% > 19.4% = underpriced
13% < 14.6% = overpriced

TOPIC 6: CRITERIA OF CAPITAL BUDGETING

Exercise 6.1
1. The cash flow for project A is stated in the following table:
Year

Cash Flow (RM)

0
1
2
3
4

250,000
0
100,000
100,000
150,000

Cumulative Cash Inflow (RM)

0
100,000
200,000
350,000

Project A should be rejected as the cumulative cash inflow at the end of the
third year, which is at the targeted payback period is less than the initial cash
outflow showing that this projects PBP is more than 3 years.
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349

For project B, we can immediately calculate the PBP as follows:

PBP = RM400,000/RM125,000
= 3.2 years
Project B should also be rejected as its PBP is more than 3 years, which is the
targeted PBP.
2. The cumulative cash flow for this project at the end of the fifth year is
RM500,000. To regain the capital of another RM500,000, the time period that
will be taken is calculated as follows:
RM500,000/RM200,000 = 2.5 years
Therefore, the project PBP is calculated as follows:
PBP = 5 years + 2.5 years
= 7.5 years

Exercise 6.2
1. B
2. D

Exercise 6.3
1. The NPV for project A is calculated as follows:
NPVA = 4,000 PVIFA10%,10 26,000
= 4,000 (6.1446) 26,000
= 24,578 26,000
= RM1,422
Investment A should not be made as the NPV < 0.

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ANSWERS

The NPV for project B is calculated as follows:

NPVB = 100,000 PVIF10%,1 + 120,000 PVIF10%,2 + 140,000 PVIF10%,3 +
160,000 PVIF10%,4 + 180,000 PVIF10%,5 + 200,000 PVIF10%,6 500,000
= 100,000 (0.909) + 120,000 (0.8264) + 140,000 (0.7513) +
160,000 (0.683) + 180,000 (0.6209) + 200,000 (0.5645) 500,000
= 629,192 500,000
= RM129,192
Investment B should be made as the NPV > 0.
The NPV for project C is calculated as follows:
NPVc = 30,000 PVIF10%,4 + 40,000 PVIF10%,5 + 60,000 PVIF10%,7 +
70,000 PVIF10%,8 100,000
= 30,000 (0.6830) + 40,000 (0.6209) + 60,000 (0.5132) +
70,000 (0.4665) 100,000
= 108,773 100,000
= RM8,773
Investment C should be made as the NPV > 0
2. The NPV for this project can be obtained as follows:
20,000 PVIF10%,5 + 400,000 PVIF10%,5 300,000
= 20,000 (3.7908) + 400,000 (0.6209) 300,000
= 324,176 300,000
= RM 24,176
3. When the cost of capital increases, the NPV for the project will decrease.

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Exercise 6.4
PIA = 24,578/26,000
= 0.945
PIB = 629,192/500,000
= 1.258
PIC = 108,773/100,000
= 1.088

Exercise 6.5
1. C
2. B
3. C
4. C

Exercise 6.6
1. D
2. (a)

PBP = M10,000/RM 16,650

= 0.6 years

(b)

NPV = (RM16,650/0.893) RM10,000

= RM14,866 RM10,000
= RM4,866

(c)

PI

= (RM16,650/0.893)/RM10,000
= RM14,866/RM10,000
= 1.49

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352

(d)

ANSWERS

RM16,650/(1 + IRR) RM10,000 = 0

Therefore,
10,000 (1 + IRR) = 16,650
IRR = (16,650/10,000) 1
= 1.67 1
= 0.67
= 67%

3. (a)

PBP = RM10,000/RM2,146
= 4.7 years

(b)

NPV = RM2,146 (PVIFA12%,10) RM10,000

= RM2,146 (5.65) RM10,000
= RM12,124.9 RM10,000
= RM2,125

(c)

PI

= RM2, 146 (PVIFA12%,10)/RM10,000

= RM12,124.9/10,000
= 1.21

(d)

RM2,146 (PVIFAIRR,10) RM10,000 = 0

Therefore,
RM2,146 (PVIFAIRR,10) = RM 10,000
(PVIFAIRR,10)

= 10,000/2,146

(PVIFAIRR,10)

= 4.66

From the PVIFA table, we found that the IRR is 17%.

4. (a)

It is clear that PBP is between two and three years because the
cumulative cash inflow in the second year is RM8,000 while the
cumulative cash inflow for the third year is RM15,500.
PBP = 2 + (RM2,000/RM7,500)
= 2.26 years
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(b)

353

NPV = 3,000 (PVIF12%,1) + 5,000 (PVIF12%,2) + 7,500 (PVIF12%,3) 10,000

= 3,000 (0.893) + 5,000 (0.797) + 7,500 (0.712) 10,000
= RM12,004 RM 10,000
= RM2,004

(c)

PI

= 12,004
= 10,000
= 1.2004

(d)

3,000 (PVIFIRR,1) + 5,000 (PVIFIRR,2) + 7,500 (PVIFIRR,3) RM10,000 = 0

We use the trial-and-error method to get the IRR.
In question 3(b), when we use the discount rate of 12%, the NPV is
RM2,004. This means that the IRR is higher than 12%.
Assuming we use the discount rate of 20%.
NPV = RM3,000(PVIF 20%,1) +RM5,000(PVIF20%,2) +
RM7,500 (PVIF20%,3) RM10,000
= RM3,000 (0.833) + RM5,000 (0.694) +
RM7,500 (0.579) RM10,000
= RM10,311.50 RM10,000
= RM311.50
The NPV is still positive.
Try to change the calculation of the NPV by using a higher discount
rate, suppose 24%
NPV = RM3,000(PVIF 24%,1) +RM5,000(PVIF24%,2) +
RM7,500 (PVIF24%,3) RM10,000
= RM3,000 (0.806) + RM5,000 (0.650) + RM7,500 (0.514)
RM10,000
= RM9,523 RM10,000
= RM477
The NPV is negative.
It is clear that the IRR is between 20% and 24%.
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ANSWERS

Using the interpolation linear,

IRR

20%

311.50
(24% 20%)
311.50 402.00

21.75%
5. (a)

PBP for Mergong is:

PBP M = RM160 million/RM40 million
= 4 years
PBP for Sik is more than 4 years because the cumulative cash inflow at
the end of year 4 is RM130 million less than the initial investment.
Based on the PBP technique, the Mergong project will be accepted while
the Sik project is rejected.

(b)

NPVM = RM40 million (PVIFA10%,6) RM160 million

= RM40 million (4.355) RM160 million
= RM174.2 million RM160 million
= RM14.2 million
NPVS = RM30 million (PVIF10%,1) + RM35 million (PVIF10%,2) +
RM35 million (PVIF10%,3) + RM30 million
(PVIF10%,4) + RM40 million (PVIF10%,5) + RM50
million (PVIF10%,6) RM160million
= RM30 million (0.909) + RM35 million (0.826) + RM35
million (0.751) + RM30 million (0.683) + RM40 million
(0.621) + RM51 million (0.564) RM160 million
= RM156.56 million RM160 million
= RM3.44 million
Based on the NPV technique, Mergong project will be accepted because
its NPV is positive while Sik project will be rejected because its NPV is
negative.

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(c)

355

PIM = RM40 million PVIFA10%,6/RM160 million

= RM174.2 million/RM160 million
= 1.09
PIS = [RM30 million PVIF10%,1 + RM35 million PVIF10%,2 +
RM35 million PVIF10%,3 + RM30 million PVIF10%,4 +
RM90 million PVIF10%,5]/RM160 million
= RM158.85 million/RM160 million
= 0.99

Based on the PI technique, the Mergong project will be accepted because its
PI is more than 1 while the Sik project will be rejected because its PI is less than
1.
6. (a)

(b)

(c)

Payback Period:
Advantages:

It is easy to calculate and there is no need to

estimate the cash flow after the targeted TBB.

Disadvantages:

It does not take into account the time value of

money.

Net Present Value:

Advantages:

Its measurement is in accordance with the owners

wealth

Disadvantages:

Its calculation is more complex as the entire cash

flow and cost of capital must to be estimated.

Internal Rate of Return:

Advantages:

It takes into account the concept of time value of

money

Disadvantages:

Its calculation is more complicated than NPV and

there is a possible problem on multiple IRR.

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ANSWERS

TOPIC 7: CASH FLOW OF CAPITAL BUDGETING

Exercise 7.1
Initial investment:
Price of new machine:

RM35,000

Delivery and installation cost:

RM6,000

Change in net working capital:

RM5,000

Sales revenue after tax of old machine*:

IO:

(RM14,900)
RM31,100

*selling price increase in tax

= RM17,000 0.3 (price book value)
= RM17,000 0.3 (RM17,000 RM10,000)
= RM17,000 RM2,100
= RM14,900

Exercise 7.2
The additional annual cash flow after tax = ( Sm Em Dm ) (1 t) + Dm
Sm = 0
Em:
Decrease in wages

RM9,000

Decrease in employees benefit

RM1,000

Decrease in defect cost

RM5,000

Increase in maintenance cost

RM4,000

Em

RM11,000

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357

Dm:
Depreciation of new machine

RM8,200

(RM35,000 + RM30,000 + RM3,000)/5 years

Depreciation of old machine

RM2,000

T = 30%
Therefore,
The additional annual cash flow after tax
= [0 ( RM11,000) RM6,200] (1 0.3) + RM6,200
= RM9,560

Exercise 7.3
1. NPV190-4 = RM87,000 (PVIFA14%,4) RM190,000
= RM87,000 (2.91) RM190,000
= RM253,170 RM190,000
= RM63,170
NPV360-6 = RM120,000 (PVFA14%,6) RM360,000
= RM120,000 (3.89) RM360,000
= RM466,800 RM360,000
= RM106,800
The model that should be chosen is Model 360-6 because its NPV is higher
than the NPV for Model 190-4. However, you will learn that the analysis
based on NPV is not accurate in this case because the comparison made
involved assets with different lifetime. The EAA technique will be
recommended in cases such as this.

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2. (a)

ANSWERS

(i)

Book value of old machine:

= Annual depreciation

Balance of lifetime

= (RM100,000/5 years)

3 years

= RM60,000
(ii)

Tax from sale of old assets:

= Tax rate

Capital gain

= 0.4 (selling price book value)

= 0.4 (RM85,000 RM60,000)
= RM10,000
(iii) Initial Investment (IO):
Cost of new machine
Installation cost
Selling price of old assets
Effect of tax from sale of old assets
IO

RM135,000
RM5,000
(RM85,000)
RM10,000
RM65,000

(iv) Net operating Cash Inflow (OCF)

= ( Sm Em Dm) (1 t) + Dm
Sm = RM54,000 RM18,000
= RM36,000
Em :
Decrease in wages
Increase in maintenance cost
Em Em
Dm
Depreciation of new machine
[(RM 135,000 + RM 5,000)/3 years]
Depreciation of old machine
[RM 100,000/5 years]
Dm
t = 40%

RM1,200
RM4,000
RM3,000

RM46,667
RM20,000

RM26,667

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359

Therefore,
OCF = [RM36,000 (RM3,000) RM26,667] (1 0.4) + RM26,667
= RM34,067
(v)

NPV = RM34,067 (PVIFA10%,5) RM65,000

= RM84,827 RM65,000
= RM19,827

(b)

Yes, the company should replace the old machine with the new
machine because the NPV of this replacement is positive.

3. The initial cash outflow, IO:

Cost of new machine
Delivery cost
Sales revenue after tax of old assets
[RM2,000 increase in tax]
[RM2,000 0.34 (RM2,000 RM1,000)]
Change to net working capital
[ RM1,000 + RM500]
IO

RM8,000
RM2,000
RM1,660

RM500
RM11,160

4. To make a decision on whether to replace the old meter with the new meter,
we need to calculate the NPV for this replacement project. The steps that
need to be taken are as follows:
(i)

Calculate the IO, OCF and TCF

Price of new meter
Sale revenue of old meter
IO

RM4,000
RM500
RM3,500

Operating cash flow (OCF) = ( Sm Em Dm ) (1 t) + Dm

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ANSWERS

However when no tax is imposed, students should observe that Dm is

not relevant for calculation of OCF as its relevancy in the analysis of
capital budget is only from the aspect of tax savings. This is proven
when t is replaced by the value 0:
OCF

= ( Sm Em Dm) + Dm
= Sm Em

Sm

=0

Em

= RM 140 RM500 = RM360

OCF1-10 = 0 (RM360)
= RM360
TCF
(ii)

=0

Calculate the NPV at the cost of capital, which is 12%

NPV = RM360 (PVIFA12%,10) RM3,500
= RM360 (5.65) RM3,500
= RM1,466
As the NPV value is negative, the decision that should be made is to not
make the said replacement.

5. This statement is false because although the depreciation in itself is not cash
but as a tax deductible expense, it affects the tax for the capital budget
project. Tax is a cash flow item.

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TOPIC 8: COST OF CAPITAL

Exercise 8.1
RM 840.68

= 55 (PVIFA7%,20) + 1000 (PVIF7%,20)

= 55 (10.594) + 1000 (0.258)
= RM840.67

k=7

= 14%

Cost of debt = 14% (1 0.25) = 10.5%

Exercise 8.2
Cost of preference shares = RM0.35 = 18.42%
= RM1.90

Exercise 8.3
1. (a)

(b)

0.18
0.09
5
12.6%
0.18
0.09
4.50
13%

0.126

0.13

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362

ANSWERS

2. The capital equity can be increased either by retained earnings in the

company or by issuing new ordinary shares. Both are funds that are invested
by ordinary shareholders.
3. Opportunity cost.
4. Dividend growth model and capital asset pricing model (CAPM).

Exercise 8.4
1. (d)
2. (f)
3. (e)
4. (b)
5. (a)
6. (c)
2. (a)

Debt:
980 20 = 90 (PVIFA 10%,20) + 1000 (PVIF 10%,20)
960

= 90 (8.5136) + 1000 (0.1486)

= 914.8

Interpolation:
= 9

980 960
980 914.8

= 9 + 0.307
= 9.307%

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363

Preference shares:
Kp =

RM 8
RM 65

3%

Ordinary shares:
Ks =

5.07
40 1

0.08

= 12.69%
(b) WACC = 9.307 (1 0.4) (0.35) + 12.69 (0.1) + 21 (0.55)
= 1.95 + 1.27 + 11.55
= 14.77%
3. WACC = 9.37% (1 0.34) (0.4) + 10% (0.2) + 13% (0.4)
= 9.67%
4. Interest is a tax deduction item. Therefore, the cost of debt becomes lower
because it takes into account the taxes.
5. The floatation cost will cause the cost of capital for each capital component
that is issued to become higher.

TOPIC 9: FINANCIAL PLANNING

Exercise 9.1
1. The time period that is suitable for preparing the cash budget is 3 months or
6 months.
2. Cash Budget for Zitroe Company.

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ANSWERS

(a)

Forecasted Cash Received Schedule

364

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(b)

Forecasted Monthly Cash Payment Schedule

ANSWERS

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365

Cash Budget, 1 January 30 June 2011

ANSWERS

(c)

366

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367

Exercise 9.2
1. Pro forma financial income statement is used by the finance manager and the
creditors to make initial evaluation on the level of the companys overall
profitability and achievements.
2. Four sections that are found in the cash budget:
(a)

Section I consists of all cash received and cash inflow

(b)

Section II consists of all cash outflow or cash withdrawal.

(c)

Section III is the change in net cash that is obtained from the
comparison of cash outflow and cash inflow.

(d)

Section IV provides information on cash surplus or the required

financing to support cash deficit. This amount is determined by the
change in net cash and the targeted cash balance by the management.

3. Pro forma Income Statement

Tulip Company
Pro forma Income Statement
For the year ended 31 December 2010
Sales

RM10,000,000
6,000,000

Cost of goods sold

RM4,000,000

Gross profit
Depreciation expenses

1,680,000

Administration and sale expenses

1,200,000

Operating profit (EBIT)

Interest expenses

RM1,120,000
120,000

Profit before tax

RM1,000,000

Tax (34%)
Net income

340,000
RM660,000

Less Dividend
Increase in retained earnings

330,000
RM330,000

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ANSWERS

TOPIC 10: WORKING CAPITAL MANAGEMENT

Exercise 10.1
1. The main components of current assets include cash, marketable securities,
account receivable and inventory. These assets are liquid assets as they are
easily converted into cash in a short period of time without any obvious loss
of value.
2. For working capital management, assets are divided into permanent assets
and temporary assets. While liabilities are categorised into permanent
financing, temporary financing and spontaneous financing. This classification
is suitable to apply the principle of interest protection in the working capital
management.
3. The principle of interest protection matches the cash flow generation aspect
of an asset with the maturity period of the financing source that was used to
obtain the asset.

Exercise 10.2
1. (a)

Average loans

= [(RM12,000 + RM13,000 + RM9,000 + RM8,000 +

RM9,000 + RM7,000 + RM6,000 + RM5,000 +
RM6,000 + RM5,000 + RM7,000 + RM9,000)/12)]
= RM96,000/12 = RM8,000

(b)
2. (a)
(b)
3. (a)

Annual cost of loans = RM8,000

Interest

0.15 = RM1,200

= (RM10,000

0.15)

(90/360) = RM375

Effective cost for 90 days = RM375/RM10,000 = 3.75%

Annual effective interest rate

= [(RM1,000,000 RM978,000)/
RM978,000 (360/90)]
= 9.0%

(b)

Annual effective interest rate

= [(RM1,000,000 RM978,000 +
RM9,612)/(RM978,000
RM9,612)) (360/90)]
= 0.0512

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369

4. (a)
Account book value
Less; Reserves (10% RM100,000)
Less: Fees (2% RM100,000)
Total available for advance
Interest on advance = (0.16/12

RM100,000
10,000
2,000
RM88,000
88,000)

= RM1173.33
(b)

Revenue from advance = RM1173.33

Annual effective cost

(c)

Annual effective
factoring cost

= (RM1,173/RM86,827)

12 = 16.21%

= [(Interest + Factoring cost) + revenue] 12

(RM1,173 + RM2,000)/RM86,827] 12
= 43.85%

Exercise 10.3
1. The cash conversion cycle refers to the time period taken from the time
payment is made on the purchase of raw materials to the time cash is
received from the sales made.
2. The three components in the cash conversion cycle are:
(a)

The cash conversion period is the time period taken to convert raw
materials into finished goods which will be sold.

(b)

The account receivable collection period refers to the average time

period taken to convert account receivable into cash.

(c)

Deferred payment period refers to the average time taken beginning

from the purchase of raw materials and labour until the payment of
cash is made on the purchase of raw materials and labour.

3. (a)

Inventory conversion period

RM50,000
RM450,000/360
40 days
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(b)

ANSWERS

Account receivable conversion period

=

RM15,000
RM450,000/360

= 12 days

(c)

Deferred payment period

= 20 days

(d)

Cash conversion cycle period

= 40 + 12 20
= 32 days

Exercise 10.4
1. Four criteria that are taken into account in choosing the marketable securities
are:
(a)

Default risk

(b)

Marketability or liquidity risk

(c)

Tax

(d)

Returns

2. Three types of marketable securities found in Malaysia

(a)

Treasury Bills

(b)

Negotiable Certificate of Deposit

(c)

Investment Certificate by Government of Malaysia

Exercise 10.5
1. (a)

(b)

Liquid Assets
Assets that can be converted into cash in a short period of time (less
than a year). For example, cash and marketable securities.
Cash
Banknotes and coins that are owned by a company in its petty cash,
cash register or in its bank accounts.
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(c)

371

Marketable Securities
The short-term investments (less than one year period) which are
conducted in the money market that can be immediately converted into
cash.

Exercise 10.6
1. Account receivable is the account that is formed when sales are made on
credit where it is a promise from the customer to make payment on the
purchase within an agreed time period.
2. The two factors that influence the total of account receivable are:
(a)

The credit sales level of a company; and

(b)

Average collection time.

Exercise 10.7
1. The three components of credit policy.
(a)

Credit terms

(b)

Credit standards

(c)

Collection policies

2. Credit term 3/15 net 40 means that the customer who pays within the first
15 days are eligible to get a discount of 3%, while customers who do not take
this discount will have a period of 40 days to make payment.
3. The five factors that are evaluated in the usage of the 5C system:
(a)

Character

(b)

Capacity

(c)

Capital

(d)

Collateral

(e)

Conditions

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ANSWERS

Exercise 10.8
1. Average account receivables for Biru Company
= Average collection period
= {(0.6) (10) + (0.4) (30)}
= 18 days

Daily sales

(RM500,000/360)

RM 1,389

= RM25,002
2. Savings obtained in a year:
= (RM3,000) (0.02) (Four orders per year)
= RM240
3. Amount that needs to be paid on 27 June 2011
= RM3,500 (0.02) (RM3,500)
= RM3,430

Exercise 10.9
1. Generally, inventory management is for the purpose of preparing sufficient
inventory for the operations of the company and to control the costs related
to inventory to be at the minimum level.
2. The EOQ Model is a method that is used to determine the order quantity that
is optimal for a company. This level is also the level where the inventory cost
is at the minimum level.
3. Assumptions that are made to enable the usage of the EOQ Model:
(a)

Sales are constant throughout the year

(b)

Sales can be forecasted accurately

(c)

Orders made will be received on schedule

(d)

Carrying cost and receiving cost are constant

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373

Exercise 10.10
1. (a)

Economic Order Quantity for Bertam Company

S

= 20,000 units

= 0.15

= RM1.50

= RM5

EOQ =

(2) (5) (20,000)

0.15 (1.50)

= 942.809 ~ 943
(b)

Total inventory cost for Bertam Company at the EOQ level

Total inventory cost = Total carrying cost and Total ordering cost
= (C) (P) (Q/2) + (O) (S/Q)
= (0.15) (RM1.50) (943/2) +
(RM5) (20,000/943)
= 106.088 + 106.045
= 212.133

(c)

The reorder point for Bertam Company

20,000/52 weeks = 384.615 or 385 (Sales per week)
If the orders take 2 weeks to be received, the company needs
770 (385 2) units of inventory for the period of 2 weeks.

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2. (a)

ANSWERS

Inventory reorder point

Sales/365

15 days = (100,000/365

15 days)

= 4109.6 units
(b)

Average inventory level

EOQ/2 = 35,000/2 = 17,500 units

(c)

Annual carrying cost

= (C) (P) (Q/2)
= (0.10) (RM2.50) (35,000/2)
= RM4,375

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Financial Schedule for Future Value Interest Factor {FVn = PV0 (FVIFi,n)}

ATTACHMENT A

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Financial Schedule for Present Value Interest Factor {PV0 = FVn (PVIFi,n)}

ATTACHMENT B

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Financial table for Future Value Interest Factor Annuity{FVAn = A (FVIFAn)}

ATTACHMENT C

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Financial Table for Present Value Interest Factor Annuity {PVAn = A (PVIFAi,n)}

ATTACHMENT D

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OR
2.

Fill in the Print Module online evaluation form available on myINSPIRE.

Thank you.
Centre for Instructional Design and Technology
(Pusat Reka Bentuk Pengajaran dan Teknologi )
Tel No.:

03-27732578

Fax No.:

03-26978702

Copyright Open University Malaysia (OUM)

Copyright Open University Malaysia (OUM)