Cash & Treasury Management

Question 1

Early settlement discounts (paying suppliers early)

Answer 1

1. sufficient cash/sufficient access to cash (overdraft limit)
2. Establish the annual equivalent interest rate of the discount
3. Compare #2 with the normal cost of money to the business.
   * Examples of cost of money
   - interest rate on an overdraft facility the business is using
   - interest rate on a deposit account the business is using (this measures the interest that the business won’t be able to receive because it’s using the cash for paying early
4. Annual equivalent interest rate of the discount > cost of money = accept discount and pay early

Question 2

Early settlement discounts (offering to clients)

Answer 2

1. Will receiving cash early be an advantage?
2. Establish the cost of offering the discount (using annual equivalent interest rate of the discount)
3. Compare #2 with the interest rate that could be generated by the organization
   * Examples of interest rate generated
   - interest rate earned from a deposit account
   - reduction in bank overdraft interest resulting from lower overdraft balances
4. Annual equivalent interest rate of the discount < interest rate = offer the discount

Question 3

comparing budget with actual

Answer 3

1. Is the difference significant?
2. Do we know the cause of the difference?
3. Will the difference right itself anyway?
4. Will the difference recur?
5. Is the cause controllable?

Question 4

liquidity

Answer 4

the availability of cash or assets which can easily be turned into cash

Question 5

The Bribery Act 2010

Answer 5

Offences:

1. active bribery
   - offering, promising, or giving a bribe
2. passive bribery
   - requesting, agreeing to receive, or accepting a bribe
3. bribery of a foreign public official in order to obtain/retain business, or an advantage in the conduct of business
4. failing to prevent bribery on behalf of a commercial organisation

Question 6

banks

Answer 6

• banks operating in the banking system provide each other with liquidity as they are regularly making large volumes of payments to each other
• source of liquidity is very important for possible “cushioning” if customers lose confidence in the bank and demand their deposits back
• if banks cannot borrow from other banks, issue short-term securities (paper “certs”) to Bank of England for finance.
• this paper certs will be traded in the London money markets

Risk:

• Banks are generally seen as low risk to risk free (in terms of loss of capital value)
• However, in light of the world banking crisis that took place in 2008/2009, it is possible that a bank can fail
• There is a small element of risk–liquidation risk of the bank itself, if the above happens.

Advantages:

• amounts deposited and borrowed can be very flexible
• time period of loans doesn’t have to rely on the time period of the deposit
• the risk to the depositor is normally regarded as being low
• interest payable on the loan and the interest received for the deposit will be based on established market rates, providing a fair deal for borrower and depositor

Types of banks:

• retail “High Street” banks
• investment/merchant banks (dealing with major company financing, investment advice and share issues)
• Bank of England (UK’s Central Bank)

Question 7

Bank of England

Answer 7

Functions:

• banker to the Government
• banker to other banks
• responsible for note printing, gold, and foreign currency reserves
• helps to influence interest rates in the economy (short-term interest rates are set by the Bank with the aim of controlling the inflation rate)

Operational Standing Facilities:
-The Bank of England lends overnight funds to banks in order to alleviate short-term technical or operational problems that may cause imbalances between banks

Open Market Operations (OMOs):

• the Bank of England can add or drain funds from the banking system by
  1. Outright purchases or sales of securities from or to banks
  2. Funds are provided using repo (repurchase) agreements, in which the Bank buys securities from the banks, with a simultaneous agreement to sell them back at a later date
• long-term arrangements where funds are offered monthly with an interest rate indexed to Bank Rate
• normally have maturities of 3 or 6 months

Discount Window Facility
-banks can borrow gilts from the bank, against a wide range of types of security

Question 8

Types of UK money markets
(secured)

(short-term = 3 or 6 months)

Answer 8

1. treasury bills
   - 91 day certificates issued to provide short-term Government funding
   - Issuer of security: UK Government
2. gilts
   - short for gilt-edged stock
   - Government securities (i.e. certificates issued in return for long-term Government borrowing
   - Issuer of security: UK Government
3. local authority bills of exchange
   - short-term bills issued by local authorities (e.g. County Councils, Metropolitan Councils in the UK)
   - can be sold in the market (at a discount) before the debt is due to be paid so that the person/institution that buys it will receive the money on the due date.
   - Issuer of security: local authorities
4. certificates of deposit (CDs)
   - short-term certificates issued by the banks for deposits received
   - Issuer of security: banks
5. bills of exchange
   - short-term bills, normally guaranteed by banks (often merchant banks)
   - Issuer of security: companies
6. corporate bonds and commercial paper
   - debt certificates (higher risk than bills)
   - Issuer of security: companies

Question 9

Types of money markets

unsecured

Answer 9

1. Interbank market
   - major sterling money market
   - involves banks and other large institutions lending to each other
   - lending over short periods of time
   - no certificates issued for these loans

Question 10

IOU

Answer 10

• usually an informal document acknowledging debt.
• not a negotiable instrument
• does not specify repayment terms such as the time of repayment.
• IOUs usually specify:
  1. the debtor
  2. the amount owed
  3. sometimes the creditor
• IOUs may be signed or carry distinguishing marks or designs to ensure authenticity.
• In some cases, IOUs may be redeemable for a specific product or service rather than a quantity of currency, constituting a form of scrip.

Question 11

Secured money markets

Answer 11

• IOU certificates are issued by reputable institutions (governmental & commercial), when raising money
• the institution agrees to pay a fixed interest rate on the certificates, which can then be sold as an investment in the money markets before the maturity (repayment) date.
• Whoever has the certificate when it matures will receive the face value of that certificate from the issuer

Question 12

monetary policy

Answer 12

-a process where the central bank increases or decreases the money supply in the economy which in turn affects the rate of inflation

• long-term overall objectives of an effective monetary policy:
  1. maintain price stability, as defined by the inflation target set by the Government
  2. achieve the economic goal of a stable level of employment
  3. achieve economic growth measured in terms of GDP (Gross Domestic Product)
  4. avoid the economy slipping into recession

Question 13

fiscal policy

Answer 13

• the use by the UK Government of how much it spends and how it applies taxes to help control the economy
• the direct and indirect effects of this policy can impact on personal spending, capital expenditure, exchange rates, & deficit levels

Question 14

GDP (Gross Domestic Product)

Answer 14

• the market value of goods and services produced by a country over a given period of time
• the total value of what a country produces
• if it’s stable or increasing, Government economic and monetary policy is working
• if not, the country may be entering into recession and the Government policy will be open to criticism

Question 15

Recession

Answer 15

• the situation in which GDP has fallen over two successive quarters
• not good for business liquidity
• cash inflows are restricted in 2 ways:
  1. customers may fall behind in paying invoices or even become insolvent so that the amounts owing become irrecoverable debts
  2. reduced demand for products is likely to reduce revenue from sales

Question 16

bank rate

Answer 16

• rate paid on reserve balances held by commercial banks at the Bank of England overnight
• rate applied to lending by the Bank to commercial banks for their savers and borrowers

Question 17

Quantitative Easing

Answer 17

-The central bank (Bank of England) “prints money” by digitally creating funds/reserves which it then uses to purchase high quality assets, mainly government bonds and/or gilts (Government Stock) from private sector institutions.

• Effects:
  1. Interest rates are lowered
  2. More money is pumped into the economy
  3. With #2, it makes it easier for banks to lend money to people and businesses, hopefully increasing growth and stimulating the economy

-Quantitative Easing is not normally considered by governments to boost economic growth because it would rapidly increase the money supply, resulting in high inflation.

Question 18

Effect of rising interest rates

Answer 18

• Cost of borrowing will increase
• increase in interest charges
• investment in the business is discouraged
• an interest rate rise is often associated with an inflation rise.
• a rise in overhead costs & costs of raw materials
• currency value will tend to rise in the short-term
• exports are less competitive because your currency value is high/expensive
• cheaper raw materials (imports)

-the return from investments will be greater as interest rates rise

Question 19

Effect of fall in interest rates

Answer 19

• Cost of borrowing will decrease
• decrease in interest charges
• investment in the business is encouraged
• increase in borrowing from banks
• The inflation rate will stabilise or even fall
• price stability or even a fall in the costs of raw materials and overheads

Question 20

Effects on “supply & demand”

Answer 20

Exchange rates

• Reason why exchange rates between currencies move: one currency is seen as more attractive
• Examples:
  1. The strength of the national economy
  2. Increase in national interest rates
• When a currency becomes stronger, the businesses that operate in that currency will find it hard to export. Imports would be cheaper.

Commodity prices

• increase: Demand increases or supply diminishes
• Change in prices:
  1. businesses that sell the commodity will be more valuable
  2. Organisations that buy and use the commodities will feel the costs

Question 21

Types of short-term finance

company needs money

Answer 21

1. bank overdraft
2. factoring
3. invoice discounting

Question 22

Types of long-term finance

company needs money

Answer 22

1. bank loans
2. lease
3. capital financing

Question 23

bank overdraft

Answer 23

• an arrangement (facility) between a bank and a customer which allow the customer to borrow money on a current account up to a limit
• available to personal and business clients
• Features:
  1. interest is calculated on a daily basis
  2. the interest is charged at an agreed APR rate (usually a fixed percentage above the bank’s base rate) monthly or quarterly, but only on the amount that is borrowed
  3. interest is only charged on the amount that is borrowed
  4. likely, there is an arrangement fee that the customer has to pay (on top of interest), based on a percentage of the overall limit
  5. the overdraft facility is agreed for a set time period (often 6 or 12 months). It can be reviewed by the bank at any time and renewed with an appropriate limit to reflect activity on the current account
  6. a business overdraft is nowadays a committed overdraft (granted for a fixed period of time….only repayable on demand if the borrower becomes insolvent)
• Advantages:
  1. very flexible - the borrower only borrows what is needed for the short-term. Could even be repaid in less than the agreed term
  2. the borrower only pays interest on what is borrowed
  3. the limit may be raised by the bank on request with the minimum of formality if the borrower needs extra working capital, or consolidated into a term loan if the borrowing becomes “hard core”
• Disadvantages:
  1. repayable on demand, but only if it is not a committed overdraft
  2. May not be renewed after the term ends
  3. it can be more expensive in terms of interest rates, compared with fixed-rate finance (the interest rate is likely to be set at a set percentage over bank base rate and so could rise to a high level if base rate goes up)
  4. if applicable, arrangement fee is charged annually
  5. business overdrafts for small and medium-sized businesses will normally need to be secured

Question 24

factoring

Answer 24

-the factoring company is often a subsidiary company of a bank (hence, such services are often offered by banks as part of a financing package

• Features:
  1. a financial arrangement in which a business sells its sales invoices (a.k.a. debts) for cash to a factoring company
  2. the factoring company carries out the debt management that include credit checks and debt chasing when they are due
  3. a percentage of the value of the sales invoices is paid into the bank account of the business within 24 hours (typically 85%)
  4. the remainder (typically 15%) is paid to the business when the invoices are due, less the factoring company’s charges
• Advantages:
  1. turns unpaid invoices into immediately available working capital
  2. it helps to reduce time and cost spend on credit control/debt collection (e.g. savings on administration costs of updating the sales ledger)
  3. some factoring companies do provide debt insurance cover (non-recourse factoring)
  4. Secures more cash than an overdraft based on outstanding invoices (usually 50%)
• Disadvantages:
  1. costs money
  2. security may be required
  3. could endanger trading relationships & damage goodwill (customers might prefer to deal with the business, not a factor company)
  4. Alerts customers that there may be cash flow problems in the business
  5. with a non-recourse factoring service, the company loses control over decisions about granting credit to its customers
  6. factoring company may impose constraints on the way you do business
  7. ending a factoring arrangement could be difficult
• SOPL:
• factoring fees will be recorded as an expense
• any irrecoverable debts will be written off (if it’s recourse factoring)
• Gearing:
• no impact

Question 25

invoice discounting

Answer 25

• Features:
  1. factoring without the debt management service: sales ledger function of processing and pursuing debts
  2. The debt management is handed by the business
• Advantages:
  1. it turns unpaid invoices into immediately available working capital
  2. it enables the seller to maintain better contact with its customers
• Disadvantages:
  1. the cost
  2. the need to maintain an efficient sales ledger & credit control function
  3. security may be required

Question 26

bank loan

Answer 26

-a contractual agreement for a specific sum, loaned for a fixed period, at an agreed interest rate

• types of bank loan:
  1. business loans
  2. commercial mortgages
• business loan:
  1. loan amounts can range from £1,000 -£250,000
  2. a loan can be granted for up to 10 years, but a normal term would be for 5 years
  3. If the company is getting a loan to purchase an asset, the loan term should not exceed the life of the asset being purchased. Normally the same as the asset’s useful life.
  4. repaid in regular instalments
  5. bullet business loan: the capital amount borrowed is repaid in full at the end of the loan period
  6. interest rates can be:
• fixed for the period of the loan. This would often result in incurring more costs than an overdraft or a variable rate loan, ending up in the company paying more for the asset than it would have cost for cash
• variable (at a fixed percentage over the bank base lending rate)
• variable (at a fixed percentage over LIBOR)
• capped (the bank will guarantee a maximum rate and will carry the risk if the market interest rates rise above the “capped” limit
  7. an arrangement fee is charged at the beginning of the loan
• SOFP:
• The loan will be a long-term liability
• SOPL:
• interest and repayment charges will be debited
• Advantages:
  1. repayments can be scheduled to suit the life of the asset. It may have the option to pay back the loan early
  2. repayments may be delayed if required. If the loan is for an asset from which the income generated will be subject to a delay, sometimes one can arrange a repayment holiday
  3. regularity of repayments helps the business in its financial planning processes
  4. interest rates can be lower than interest rates for overdraft borrowing or other finance options
  5. Interest is deducted before tax
• Disadvantages:
  1. The level of gearing will initially increase
  2. (For high gearing) This may hamper/limit the ability to raise further short-term finance, since high gearing is risky
  3. Penalties may be charged for early repayment
  4. Committed to paying interest during the loan term
  5. The bank may impose certain restrictions/covenants which will limit the freedom of action of the management of the company. Example: restrictions on dividend payments or other forms of finance taken out by the business
  6. security is likely to be required to cover the loan. Which means that charge may be placed on asset or asset(s), depending on the loan terms

Question 27

LIBOR

Answer 27

• London Interbank Offered Rate

- LIBOR linked loans are for larger amounts (£500,000 and above)

Question 28

commercial mortgage

Answer 28

• a loan for up to 25 years to cover the purchase of property
• an arrangement in which the property is used as security for borrowing
• banks can provide finance for the purchase of commercial property, normally up to 70% of its market value
• interest may be paid:
  1. at a fixed rate at the beginning of the mortgage
  2. at a variable rate in line with market rates during the lifetime of the mortgage
  3. at a capped rate
• Advantage:
  1. it is repayable over a long period of time
  2. the interest costs are lower than an overdraft

Question 29

bonds

Answer 29

• type of capital financing
• a.k.a. loan stock or debentures
• convertible loan stock: a secured loan stock that can be directly converted to ordinary equity shares at a later date
• Procedure:
  1. The company issues bonds at an interest rate for a fixed term
  2. at the end of the term, the company will repay the bond holders the original value in full
  3. in the meantime, during the period before the bond maturity date, the stock can be bought and sold at any time at the market price on the stock markets
• Interest rate:
• it’s usually a fixed rate of interest
• however, in recent years, companies have issued floating rate debentures
• interest will be paid to the bondholders at a specified date
• Finance position:
  1. SOFP:
• the bond issued by the company is recorded as a non-current liability
  2. SOPL:
• interest paid is debited as finance cost
• Security:
• secured or unsecured
• Advantages (issuer of bonds):
  1) cheaper to raise than a new issue of equity
  2) repayment of bond is deferred until the bond maturity date
  3) debenture-holders may be satisfied by a lower return
• Advantages (bond holders):
  1) cheaper than equity
  2) suffer less risk
• Disadvantages (issuer of bonds):
• if the company issuing the bond is already highly financed by debts–having a high gear ratio–, then the bond-holders may require a higher return
• the company issuing the bonds may be committed to the fixed interest payments and will therefore have less flexibility than with equity
• if the company defaults on interest payments, the debenture-holders would have the power to appoint a receiver to run the company
• Gearing:
• the gearing of the company issuing the bonds will increase
• future financing may be affected, as future lenders will consider the level of debt already in existence
• Liquidity (bond holders):
• it depends on the terms of the investment
• it may be possible to redeem the investment early if the money is required, but there is a risk of incurring early redemption charges/penalties (usually a couple of months interest). However, the capital amount is safe
• it may also be possible to sell the bond before maturity

Question 30

corporate bonds

Answer 30

bonds issued by large companies quoted on the stock markets

Question 31

zero coupon bonds

Answer 31

• bonds issued at a substantial discount to their face value

- on the redemption date, the issuer of the bond will repay the face value

Question 32

overdraft interest

Answer 32

average overdraft x average annual interest rate

Question 33

overdraft arrangement fee

Answer 33

• fixed percentage arrangement fee charged as a percentage of the overdraft limit
• may also have to pay a fixed percentage renewal fee when the overdraft is renewed

Question 34

mortgage

Answer 34

• a legal document signed by a borrower pledging his/her property to a lender
• if the borrower fails to repay, the lender is given the legal right to sell the property in order to get the money back

Question 35

guarantee

Answer 35

a document signed by Person A which states that if Person B does not pay up, Person A will have to do so instead

Question 36

fixed charge

Answer 36

a document signed by a company borrower which states that if it defaults on a loan, the bank can sell company property specified in the document to repay the debt

Question 37

floating charge

Answer 37

a document signed by a company which states that if the company does not pay up to the bank on demand, the bank can sell or claim from the company’s floating assets which happen to be in the company’s possession when the claim is made

Question 38

fixed and floating charge

Answer 38

• a combination of both fixed and floating charges

- a charge over all of the company’s assets

Question 39

loan to value

Answer 39

loan amount / value of asset x 100

Question 40

types of investments of surplus funds

Answer 40

• Short term:
  1. money market interbank deposits
  2. certificates of deposit
  3. treasury bills
  4. bank deposit accounts
• Long term:
  1. gilts/gilt-edged securities
  2. shares
  3. land, gold, commodities

Question 41

interbank market

Answer 41

• made up of short-term, unsecured, money-market deposits based by banks with each other
• treasurers place deposits with their bank on “money market” accounts. These accounts are consolidated with other liquid funds held by the banks and are placed on the interbank market
• Risk: low (the banks are generally seen as a good risk…the interbank market is essential to the Bank of England for implementing its monetary policy and for the fixing of bank lending rate)
• Return: higher than the rates for bank deposit accounts as investment amounts are higher
• Liquidity: vary according to the type of account; the higher the liquidity the lower the interest rate

Question 42

types of money market deposits

Answer 42

1. call accounts
   * access to funds: immediate
   * interest rate: lower than the rate for the same amount invested for a longer time period
   * minimum balance: £50,000
   * No maximum balance
2. fixed term deposits
   * access to funds: fixed term (from overnight to 5 years)
   * interest rate: the longer the period, the higher the interest rate
   * minimum balance: £250,000 (overnight to 6 days); £50,000 (7 days to 5 years)
   * No maximum balance
3. notice deposits
   * access to funds: give advance notice of either 1 or 2 weeks (or 1, 3, or 6 months)
   * the notice gives the bank more certainty and is reflected in an increased return on deposit, in the form of an increased interest rate
   * if no notice to the bank, then penalty interest charges will be incurred
   * interest rate: the longer the period, the higher the interest rate
   * minimum balance: £50,000
   * No maximum balance

Question 43

certificates of deposit

Answer 43

• tradeable securities issued by banks or building societies
• certifies a sum of money (normally a minimum of £50,000) has been deposited and will be repaid on a set date

Process:

• repayment can range from 7 days to 5 years, but is often 6 months later
• the certificates can be bought and sold on the market (at a discount)
• whoever holds the CD on the repayment date will receive the amount stated on the certificate

Risk:
-low risk investments when they are from a reputable bank, but are more risky than treasury stock

Return:

• Offer a good rate of interest
• The holder of the CD at maturity has the right to take the deposit with interest
• If the holder does not want to wait until the maturity date, the CD can be sold in the money market. Usually it’s sold at a discount.

Liquidity:

• It’s very liquid as it can be bought and sold any time, at the current market rate
• The market in CDs is large and active; they are an ideal method for investing large cash surpluses

Question 44

treasury bills

Answer 44

• tradeable certificates issued by the UK Debt Management Office, backed by the Government…they use this to finance short-term cash requirements
• Issued at regular intervals when investors are invited to apply to buy bills in the new issue
• maturity date of less than one year. Most of them are 3-months (91 days)

Process:

• the bills are sold to banks and other dealing institutions at a discount
• the eventual holder will be repaid in full (at face value) on the due date

Risk:

• In general, low risk investments (since they are guaranteed by the government of the country of issue). However, the risk is dependent on the government’s economy.
• They reflect the credit rating of the country
• If issued by a government and denominated in the domestic currency, they should be risk free

Return:

• Treasury bills are fixed dated. They may be negotiable but this results in incurring costs.
• investors pay less than face value to buy them, since they are redeemable at face value
• yields are lower than for many other short-term investments, to reflect the low risk
• Also, treasury bills will expose the company to price movement which will reflect the change in market interest rates. For example: if the company holds the bills for 91 days, & at the end of the 91 days find out that the market interest rates have risen, the return on the treasury bills may be below market rates. The inverse is true, if interest rates fall

Liquidity:

• very liquid
• can convert bills to cash quickly through a broker or a bank
• there is a large & active secondary market in treasury bills in the UK

Question 45

bank deposit accounts

Answer 45

• deposits of smaller amounts (typically less than £50,000)
• these accounts are offered by individual banks and other financial institutions
• form: fixed, term, notice, or immediate access
• interest rate: fixed or variable
• can be operated online
• Risk: low (banks are generally seen as risk free from the perspective of the loss of capital value)
• However, in light of the world banking crisis that happened in 2008/2009, there is a risk of loss of capital value if the deposit is not covered by a government backed guarantee scheme

-FSCS: the UK Government’s Financial Services Compensation Scheme guarantees repayment of deposits of up to £85,000 if the financial institution fails (for small businesses & private individuals whose turnover is up to £6.5M)

• Return: low (the amount invested and the risk level are low). Calculate the interest, add them and deduct the investment from the interest to find your return.
• substantially less than could be earned on other investments
• interest rates will vary depending on the amount deposited and the liquidity required; the higher the liquidity, the lower the interest rate
• initial investment is guaranteed
• Vital to match the maturity of the deposit to the date that the funds will be needed to maximize the return
• Liquidity: Not so liquid/flexible (if one wants to receive the agreed return).
• However, the funds could be available immediately, for a fee (a.k.a. penalty interest charges), if required, even though the company would achieve a lower return than expected.

Question 46

commercial paper

Answer 46

• short-term lending to first class quoted commercial companies
• securities issued by the companies through a bank take the form of loan notes (value £100,000 and above)
• maturities are mainly between 7 days & 3 months

Question 47

gilts/gilt-edged securities

Answer 47

• Government stock to help fund Government debt
• titles are either “Treasury” or “Exchequer”
• prices of stock are reported daily in the financial press
• Interest rate (a.k.a. coupon): mostly at a fixed interest rate; some are index-linked
• Risk:
• more or less risk-free because it is issued on behalf of the Government and so carries a state-owned risk profile (it is extremely unlikely that the government will default on the debt)
• however, if they are sold prior to the redemption date, then the value of the investment may vary
• however, there is still a risk if interest rates rise to a higher level than was expected by the market. This causes the value of the investment to reduce
• Return:
  1. interest yield
• annual return for the investor based on the stock price and the coupon rate stated on the gilt
  2. redemption yield
• takes into account the change in price of the stock (fluctuations of falling and rising in stock value) as it reaches the redemption date
  3. Exposed to the volatile market prices. A rise in interest rates could make the market price of the stock fall. However, the actual interest received by the existing holders of the stock would be unaffected
• Liquidity:
• very liquid as they can be sold at any time
• they can be sold “second hand” in the stock markets
• provide a regular income
• however, they are normally held for the long-term because it a very low risk investment
• maturity periods:
  1. shorts (up to 5 years)
  2. mediums (5-15 years)
  3. longs (more than 15 years)
• Trading process:
  1. normally quoted in terms of £100 (but can be traded in any amount). £1 of stock = £1 on maturity date
  2. While waiting for the gilts to mature, those with a higher coupon than prevailing rates will trade for more than £1, and those with a lower coupon will trade at a lower price
  3. the gilts price will return to £1 per £1 of stock at the maturity date

Question 48

shares

Answer 48

-listed (UK Stock Exchange) or unlisted (foreign-recognised Stock Exchange or alternative market)

• two main markets:
  1. the Main Market (well-established and large)
  2. Alternative Investment Market (smaller and more recently established companies trade here)
• Risk:
• high risk, depending on the type of shares being purchased (prices can fluctuate according the market sentiment; shares/investment can become worthless if the company goes into liquidation). Also high risk due to the lack of control over business decisions made by those running the company
• the risk associated with a particular share depends upon the risk associated with the market in general…as well as the risk associated with the particular company
• risk factor can be reduced by
  1. investing in a portfolio of shares with different risk profiles
  2. investing in managed funds (which invest in a wide range of shares in a particular area/field)
• Return:
• high returns can be achieved with the right portfolio of shares held for a reasonable time period
• the return achievable cannot be identified with any certainty at the time of investment because of the volatile market prices. Share prices may increase but equally they could fall.
• therefore, they are often held for the long term (as their value will generally increase over time, in line with the stock market indices; the return may be even negative if it’s held for the short term and the shares fall in value)
• costs of dealing with shares can be high (offset against return received from capital gain and dividend income)
• Dividends may or may not be paid, depending on how profitable the company is, as well as the amount of cash it has at hand.
• Liquidity:
• most shares can be sold at very short notice to realise cash (a few days)
• if the shares are from a company not listed in the FTSE100 index, selling the shares may be difficult. This would affect the liquidity
• however, sometimes they yield a loss instead of a profit, depending on the stock market indices at the time the company wishes to sell
• therefore, the company needs to be prepared to take the price offered at the point they wish to sell
• Hence, shares are normally viewed as being a long-term investment
• Unlisted shares:
• shares of private companies where ownership is in private hands
• not normally available as an investment
• exception: purchased by another company carrying out a merger or an acquisition

Question 49

investment in land

Answer 49

• yield:
• rent per year/ property value x 100
• Risk:
• Land is deemed to be a high risk investment as the land values have been volatile in the recent years, making the return unknown & sometimes causing some investors to face capital loss.
• commercial property in some areas can fall significantly in value
• planning permission to build on the land could be refused
• There is also a risk of the loss of rental from tenants of the land (income from lease property is only guaranteed if the tenant remains in occupation and solvent)
• risk of not being able to sell the land/property at the required speed
• risk of not fully realising the initial investment at the end of the the desired period
• Return:
• High potential return as there is a possible capital appreciation but it would be unquantifiable or can’t be forecasted with any certainty at the time of purchase (capital values have historically risen over time)
• there is no annual income from the land unless it can be rented out.
• rent received from a tenant may be higher than the interest paid on the same amount invested in a deposit account
• extra costs will be incurred if the company wants to build on the land. E.g. legal, planning fees, advertising, etc.
• the value of the land could either deteriorate or increase, depending on whether the planning permission to build on the land is refused or permitted, respectively
• Liquidity:
• usually seen as a long-term investment because it’s not so liquid
• selling property can take an extremely long time
• the land/property can be put up for sale at any time
• not being able to find a buyer, particularly in a time of economic recession
• the investment can only be realised once the land is sold, and speed of this will depend upon the economic environment at the time of sale

Question 50

investment in gold

Answer 50

-buying and taking responsibility for the storage of the physical metal (bullion) in the form of gold bars or coins

• Risk:
• a commodity seen as a safe store of value in times of market and economic uncertainty
• however, high risk in the short-term (significantly volatile market value)
• 2 ways of gold investment:
  1. in physical metal form as bullion (either gold bars or coins)
  2. in electronic form as an ETF
• 2 types of gold ETFs:
  1. physical (owns and arranges for the storage of the gold – safer but more expensive)
  2. synthetic [uses derivatives (financial contracts) to replicate the performance of the gold index –riskier option]
• an ETF is a much less risky investment in terms of physical security
• a physical ETF is less risky than a synthetic ETF
• Return:
• does not provide any income
• however it does increase in capital value over time (although this is becoming unpredictable)
• there are likely to be insurance and storage costs each year
• Liquidity
• very liquid (can be sold in physical form through a bullion dealer or in ETF form through a stock broker
• unpredictable gold prices
• more suitable for long-term investment

Question 51

investment in commodities

Answer 51

-tradeable resources, invested in the form of ETFs

• Risk:
• very high
• a thorough investigation, including a site visit, will need to be carried out on the company in question to analyse profits and profile
• Liquidity:
• if the shares are from a company not listed in the FTSE100 index, selling the shares may be difficult. This would affect the liquidity

Question 52

ETF

Answer 52

• Exchange Traded Funds
• a type of Exchange Traded Product (ETP)
• shares that are based on trading contracts
• shares which track the performance of a gold price index

Question 53

interest rates, yields, selling price, market price

Answer 53

1. yield on investments (from value of interest to percentage)
   * calculation: interest (£) / market price (£) x 100
2. yield on investments (from interest rate to percentage)
   * calculation: interest rate (don’t change to decimal form) / market price (£) x 100
3. dividend yield per share in percentage
   * calculation: [dividend per share (pence)] / [market price of share (pence)] x 100
   * dividend per share = total dividend / (“share capital” / “nominal value of share”)
4. dividend yield per share in value
   * (dividend value / share capital value) x nominal value per share
5. selling price per share
   * number of shares x share price at the time one bought = total share value
   * total share value (+ profit or - loss) = total sales value of shares
   * total sales value of shares / number of shares
6. investment amount required for a given return
   interest (£) / interest rate (don’t change to decimal) x 100
7. market price of stock
   * must have the interest receivable value, investment amount & interest percentage
   - calculate the value of interest per nominal value block
   - calculate the nominal value blocks: interest value / value of interest per nominal value block
   - calculate the market price: investment amount / nominal value blocks
   * if it’s irredeemable bonds, you only need to have the required rate of return, interest receivable value, & interest percentage:
   - calculate the value of interest per nominal value block
   - rate of return = the value of interest per nominal value block / stock market price

Question 54

bearer certificates/bearer bond certificates

Answer 54

• the name of the owner is not recorded on the cert
• the cert belongs to whoever is holding it at the time
• high security risk due to their easy conversion into cash

Question 55

equity shares

Answer 55

• a.k.a. ordinary shares
• carry the main risks and rewards of the company
• investments by individual investors
• injection of capital
• Investors: directors and outside investors
• Companies won’t always give out all its profit in the form of dividends (they might save some in the reserves for rainy days)
• aids in lowering the company’s gearing position which, in turn, aids in times where the company wants to raise additional finance
• SOPL: no entry as this is injection of capital (with no interest payable)
• SOFP: an increase in the Equity section
• Gearing: there will be a reduction as Equity will increase. However, there will not be a reduction in external borrowing.
• risks:
  1. if the company loses money and/or becomes insolvent, the value of the shares may be partially or fully lost
  2. last to receive repayment of investments (if the business becomes insolvent). Other liabilities will be paid off first. May not even receive any payment (if the business situation is bad).
  3. If shares are offered to new investors, existing shareholders will experience a dilution of control & possibly earnings. This may cause discontent
  4. the risk associated with a particular share depends upon the risk associated with the market in general…as well as the risk associated with the particular company
• rewards:
  1. shares take a share of the profit (in the form of dividends)
  2. this dividends come after deducting all the business’ expenses, finance costs, tax, and preference shares (if any)
  3. value of the dividends interest rate fluctuates, depending on the profitability of the business. If high profit, high dividends could be paid. If losses are made, then the ordinary shareholder may not be able to receive any dividend
  4. have voting rights (directors’ control of the company may be weakened by the outside investors, if shares are issued to them)

Question 56

preference shares

Answer 56

• they have a fixed percentage rate of dividend
• no voting rights & no control at company meetings
• dividends are paid in preference to ordinary shareholders’ dividends
• if the company becomes insolvent, preference shareholders would have their investments repaid first, before the ordinary shareholders
• SOPL: dividends are considered interest payable
• SOFP: long-term liability
• Gearing: gearing position will increase as external borrowing will increase in relation to Equity
• Advantage:
• Annual dividend payments are the only cash outflows
• Disadvantage:
  1. The level of gearing would initially increase
  2. This would hamper/limit the ability to raise further short-term finance

Question 57

Types of interest rates

Answer 57

• Capped:
• the bank will guarantee a maximum rate and will carry the risk if the market interest rates rise above the upper “capped limit”
• Simple interest:
• a rate banks commonly use to calculate the interest rate they charge borrowers
• formula: Principal x interest rate x loan term in years
• Simple interest (principal + interest):
• formula: A = P(1 + rt)
• interpretation of formula symbols:
  1. A = Total Accrued Amount (principal + interest)
  2. P = Principal Amount
  3. r = Rate of Interest per year in decimal; r = R/100
  4. t = Time Period involved in months or years

-Compound interest:
*formula: P x (1 + r/n)^(nt)
*interpretation of formula symbols:
1. P = principal amount
2. r = interest rate in decimal form
3. n = compounding frequency (number of times per year)
4. t = overall length of time the interest is applied (expressed using the same time units as r)
​

Loans:

1. Fixed rate
   * interest rate that remains the same for the period of the loan
   * calculated on the amount which is outstanding/reducing
2. Variable rate
   * an interest rate that has a fixed percentage added to the agreed indicator (usually the bank base lending rate/LIBOR). As the agreed indicator fluctuates, this interest rate will also fluctuate in line with it.
   * advantage: borrowers can benefit if the base interest rates declines during the period of the loan (usually in tougher economic times.)
   * disadvantage: the borrower may be forced to pay more interest, if base interest rates rise.
3. Flat rate (principal)
   * interest rate is based on the total amount borrowed (principal) over the whole period of the loan and ignores any repayments made
   * Example: a £5000 loan with a flate rate of 10% will charge interest of £500 per annum every year until maturity, even if some of the capital is repaid.
   * Calculation:
   - work out the total interest by comparing the principal borrowed with the total amount repaid over the period of the loan
   - divide the total interest by the number of years of the loan
   - express the result as a percentage of the principal borrowed
   * Formula: (interest rate) x (initial amount borrowed) x (number of years)
   * the interest rate itself can be fixed or variable
   * advantage: company may benefit from fall in interest rate (probably for variable)
   * disadvantage: would not be beneficial if interest rates rise (probably for variable). The interest rates does not take into account the reducing balance of the loan…..this results in paying more.
4. Annual Percentage rate (APR)…..reducing balance
   * takes into account factors such as the reducing balance of a loan over time and the added fees and interest costs on an annual basis
   * higher than the flat rate
   * based on a compound interest rate

• formula: APR = {[(Interest + Fees) / Loan amount} / Number of days in loan term} x 365 x 100
• formula: 100[(1+ interest/principal) ^ (365/days in loan term)-1]
• formula: APR = [(1 + r) / n]^n - 1 where r = period rate; n = number of compounding periods
• Fixed APR:
• the interest rate applied to the principal amount borrowed does not change.
• The APR calculated based on the interest rate will also be fixed. There is no variation of the rate, and so the amount paid per year for borrowing that money remains the same.
• Variable APR:
• A variable APR is subject to change because the interest rate applied to the principal varies from time to time. It depends on the movement of the bank base lending rate.
• The variable nature means that once there is an upward surge in interest rate, the borrower pays more.
• advantages: interest calculated on the reducing balance. For variable rate, it is beneficial if interest rates fall
• disadvantages: For fixed rate, it would not be beneficial if the interest rates fall (because interest rate is fixed for the loan). For variable rate, it would not be beneficial if the interest rates rise

Investments

1. Fixed rate
   * fixed based on principal
   * risk: if the investor fixes interest at a low rate and then finds that the rates rise
2. Variable rate
   * fixed percentage added to the bank base lending rate/LIBOR
   * risk: no risk…no danger in being caught out by a general interest rate rise
   * variable rates will introduce variability in the return, although it’s likely to reflect market rates
3. Bonus rate
   * an introductory extra percentage paid on an investment
   * usually for the first year of the deposit
   * the interest rate will fall after the period of the bonus

Question 58

factors to consider when deciding how to invest short-term cash surplus

Answer 58

1. Maturity
   * a short-term investment will involve investing the money for a specified time period. Will also involve receiving interest & the capital payment at a specified future date
   * One should make sure that the investment’s maturity date should be no longer than the duration of the cash surplus
   * There will be a risk of interest loss or capital value if cash is required before the maturity of the investment & as a result, the investment is “cashed in” early
2. Risk versus Return
   * One should investigate the risk of the investment.
   * Risk is:
   - the possibility that the investment might fall in value
   - the possibility of not receiving the eventual payment of interest or repayment of capital
   * Generally the higher the risk, the higher the return of the investment
3. Liquidity
   * One should investigate how easy can the investment be “cashed in” without any significant loss of value or interest, when deciding of the possible types of investment
   * All short-term investments are less liquid than cash in a bank current account, but some are more liquid than others. E.g.many savings accounts or deposit accounts are reasonably liquid, as a depositor can withdraw cash immediately without penalty or for the loss of only several days’ interest.

Question 59

FTSE100

Answer 59

• Financial Times Stock Exchange 100 index
• a share index of the 100 companies listed on the London Stock Exchange with (in principle) the highest market capitalisation.
• The index is maintained by the FTSE Group, a subsidiary of the London Stock Exchange Group.

Question 60

current account in the bank as an investment

Answer 60

Risk:
*low as a bank account is a very safe investment

Return:
*very low, as the interest rate is very low

Liquidity:
*high, as money can be withdrawn at any point

Question 61

local authority stock

Answer 61

• Higher risk than government stock
• the market for such stock is smaller than the market for central government stock
• debt security issued by a local authority to raise funds for infrastructure projects