F9 - Definitions

Question 0

What is the residual theory (in respect of dividend policy)?

Answer 0

The residual theory argues that the timing of dividends is irrelevant – that a smaller dividend now will result in more retention and therefore more growth, leading to a larger dividend in the future.

Therefore, dividends themselves are important but the pattern of them is not.

Question 1

What is the dividend irrelevancy theory?

Answer 1

The theory by M&M argues that in a perfect capital market (no tax, no transaction costs, no market imperfections) shareholders are indifferent between getting dividends or capital growth as they are only concerned about increasing their wealth

and are unconcerned about whether that comes in the form of dividend or capital growth.

and that therefore the level of dividends is irrelevant.

Question 2

What is Ijara - (lease) under Islamic finance?

Answer 2

Ijara is effectively the same as lease finance.
The bank allows the customer to use the asset for a fixed period at a fixed price. (Or variable lease rental payment)

The bank is responsible for major maintenance, and the lessee is responsible for general maintenance

Question 3

What is Musharaka - (venture) Islamic finance?

Answer 3

Essentially venture capital

Musharaka is a relationship between two or more parties who contribute the capital of a business.

They share profits in pre-agreed ratios, but they shares losses strictly in proportion to the capital invested.

Finance providers can choose but don’t have to participate in management

Question 4

What is a forward exchange rate?

Answer 4

A forward rate is an exchange rate quoted today to apply to conversion of a fixed amount on a fixed future date.

Question 5

What is meant by leading and lagging?

Answer 5

Leading is paying early and lagging is delaying payment – depending on the expected movement in the exchange rates.

Question 6

What is meant by interest rate parity?

Answer 6

Interest rate parity assumes that the exchange rate between two currencies depends on the relative interest rates in the two countries.

Interest rate parity is a method of predicting foreign exchange rates based on the hypothesis that the difference between the interest rates in the two countries should offset the difference between the spot rates and the forward foreign exchange rates over the same period.

F0 = S0 x ((1+ic)/(1+ib))

Where F0 = forward rate
S 0= current spot rate
i c= interest rate in country c
i b= interest rate in country b

Question 7

What is meant by purchasing power parity

Answer 7

Purchasing power parity assumes that the exchange rate between two currencies depends on the relative inflation rates – that identical goods must cost the same.

Question 8

What is the payback method of appraisal ?

Answer 8

The payback period is the time a project will take to pay back the money spent on it. It is based on expected cash flows and provides a measure of liquidity.

Payback period = initial investment/annual cash flow

Decision rule —> only projects within specified time period
——> choose options with fastest payback

• -> +avg
• simple
• used in certain situations (quick changing technology)
• improving investment condition

—> -avg

• Ignore returns after payback period
• ignore timing of cash flow
• subjective
• ignore project profitability

Question 9

What are the three Es that explains Value For Money (VFM)?

Answer 9

Economy - Minimising the cost of inputs required to achieve a defined level of output. Focuses on cost and cost control

Efficiency - ratio of outputs to inputs - achieving a high level of output in relation to the resources put in (input driven) or proving a particular level of services at a reasonable input cost (output driven) - focuses on systems and methods

Effectiveness - whether outputs are achieved that match the predetermined objectives - focuses on achieving targets

Question 10

What is overtrading or undercapitalisation ?

Answer 10

Overtrading or undercapitalisation refers to the situation where a company is over-reliant on short-term finance to support its operations/expansion i.e. Capital base is too small. This is risky because short-term finance may be withdrawn relatively quickly if accounts payable lose confidence in the business.

So there is insufficient capital to meet liabilities as they fall due.

Question 11

What is mudaraba - (partnership) under Islamic finance ?

Answer 11

This is effectively equity finance

Profits are shared between partners in proportions agreed in contract. Finance providers don’t help to run the business.

Losses are borne by the owners of the capital but not by the agent managing the business.

Question 12

What is Sukuk - (debt) under islamic finance?

Answer 12

These are certificates (similarly to debentures) are issued to the finance providers, and are linked to a specific tangible assets. The certificates transfers the risk and rewards of ownership ie:

The Sukuk holder is a partial owner of the asset. The managers of the business manage the asset on behalf of the Sukuk holders. The Sukuk holder has a rights to profits in relation to the underlying asset and will bear their share of any losses.

Question 13

What is murabaha - (credit) under Islamic finance?

Answer 13

Agreement between buyer (the business) and supplier (the bank who will have taken physical ownership of the asset), whereby assets are purchased on a differed of instalment basis.

Returns are made by the supplier in the form of markup paid by the buyer in exchange for the right to pay after the delivery date.

Repayment period can be extended but bank can’t charge penalties nor charge extra mark-up.

Question 14

Give details of the features of betas in risk?

Answer 14

• returns must reflect the level of risk faced by investors
• for a well diversified investors, systematic risk has two parts

Business risk - from business activities
Finance risk - from the level of gearing in the business

Therefore two types of betas;

Asset betas: this reflects an ungeared business as it only reflects business risk therefore purely systematic risk.

Equity betas: this reflects both business and financial risk typical of a geared business financial structure.

Three steps to calculating a risk adjusted cost of equity (return)

1. Find appropriate asset beta (if not provided - DEGEAR given beta)
2. Regear asset beta to convert it to an equity beta based on gearing level of company needed the risk adjusted cost of equity
3. Use CAPM to calculate ke

Question 15

What are the principle of Islamic finance?

Answer 15

Islamic finance rest on the application of Islamic, or shariah, law. The charging or receiving or interest riba is forbidden.

Main principles

• wealth must be generated from legitimate trade and asset based investment (using money to make money is forbidden)
• investment should be socially and economically beneficial to wider society beyond pure return.
• risk should be shared
• activities such as gambling, alcohol and sale of certain foods should be avoided

Question 16

What are the symptoms of overtrading?

Answer 16

Symptoms of overtrading are as follows.

(a) There is a rapid increase in turnover.
(b) There is a rapid increase in the volume of current assets and possibly also non-current assets.

Inventory turnover and accounts receivable turnover might slow down, in which case the rate of increase in inventories and accounts receivable would be even greater than the rate of increase in sales.

(c) There is only a small increase inproprietors’ capital (perhaps through retained profits).

Most of the increase in assets is financed by credit, especially:

(i) Trade accounts payable - the payment period to accounts payable is likely to lengthen
(ii) A bank overdraft, which often reaches or even exceeds the limit of the facilities agreed by the bank

(d) Some debt ratios andliquidity ratios alter dramatically.
(i) The proportion of total assets financed by proprietors’ capital falls, and the proportion financed by credit rises.
(ii) The current ratio and the quick ratio fall.
(ii) The business might have a liquid deficit, that is, an excess of current liabilities over current assets. This list of signs is important; you must be aware of why businesses run into financial difficulties. In the

Question 17

What are four main reasons for differences in the interest rate quoted on loans?

Answer 17

• The risk
• The duration of the loan
• The size of the loan
• General interest rates (due to factors in the economy)

Three theories ——->

—-> Liquidity preference means investors prefer cash now to later and want compensation in the form of a higher return for being unable to use their cash now. Long-term interest rates therefore not only reflect investors’ assumptions about future interest rates but also include a premium for holding long-term bonds.

—-> Expectations theory states that the forward interest rate is due only to expectations of interest rate movements. When interest rates are expected to fall, short-term rates might be higher than longterm rates, and the yield curve would be downward sloping.

—–> The market segmentation theory of interest rates suggests that the slope of the yield curve will reflect conditions in different segments of the market. This theory holds that the major investors are confined to a particular segment of the market and will not switch segment even if the forecast of likely future interests rates changes.
O

Question 18

What is the difference between ‘risk’ and ‘uncertainty’?

Answer 18

Risk is the situation where there are several possible outcomes and probabilities can be assigned to the outcomes. Thus risk is quantifiable.

Uncertainly is the situation where there are several possible outcomes but where probabilities can not be assigned. Uncertainty is unquantifiable.

Question 19

Sensitivity analysis

Answer 19

Sensitivity = (NPV / present value of flow under consideration) x 100

Sensitivity analysis assesses how responsive the project’s NPV is to changes in the variables used to calculate that NPV. One particular approach to sensitivity analysis, the certainty-equivalent approach, involves the conversion of the expected cash flows of the project to riskless equivalent amounts.

Sensitivity analysis is one method of analysing the risk surrounding a capital expenditure project and enables an assessment to be made of how responsive the project’s NPV is to changes in the variables that are used to calculate that NPV. The NPV could depend on a number of uncertain independent variables.

• Selling price
• Sales volume
• Cost of capital
• Initial cost
• Operating costs
• Benefits

Question 20

Futures

Answer 20

Futures are like a forward contract in that :

• The company’s position is fixed by the rate of exchange in the futures contract
• It is a binding contract
• can be traded on the futures exchange
• settled in 3 monthly cycle.

Question 21

Options

Answer 21

Similarly to forwards but with one difference
- they give the right but not the obligation to buy or sell currency at some point in the future at a predetermined rate.

• can exercise option if beneficial to do so or lapse spot rare more favourable or no longer need to exchange currency.

Question 22

Three foreign currency risk?

Answer 22

—–> Translation risk

This Is the risk that the organisation will make exchange losses when the accounting results of its foreign branches or subsidiaries are translated into the home currency. Translation losses can result, for example, from restating the book value of a foreign subsidiary’s assets at the exchange rate on the statement of financial position date.

—–> Transaction risk

This Is the risk of adverse exchange rate movements occurring in the course of normalinternational trading transactions. This arises when the prices of imports or exports are fixed in foreign currency terms and there is movement in the exchange rate between the date when the price is agreed and the date when the cash is paid or received in settlement.

—–> Economic risk

This refers to the effect of exchange rate movements on the internationalcompetitiveness of a company and refers to the effect on the present value of longer term cash flows. For example, a UK company might use raw materials which are priced in US dollars, but export its products mainly within the EU. A depreciation of sterling against the dollar or an appreciation of sterling against other EU currencies will both erode the competitiveness of the company. Economic exposure can be difficult to avoid, although diversification of the supplierandcustomer base across different countries will reduce this kind of exposure to risk.

Question 23

Common types of reward schemes include:

Answer 23

• remuneration linked to:

• minimum profit levels
• economic value added (EVA)
• turnover growth

•executive share option schemes (ESOP).