Category Archives: Financial Management

Payback Period

Payback Period (ACCA Online)

When a company has enough funds, it always uses its spare money to earn more money. Actually, there are two ways to earn money by spare money, one is loaning money to others and earning interest, the other is earning high payback by investing.

We pay more attention to the later in this article about ACCA. We will introduce you a method to assess investment appraisal for small businesses: Payback Period.

In some small businesses, the proprietors do not spend too much time and energy in creating an analysis of net present value, but use Payback period to evaluate whether a project should be carried out. This method also takes the risk into account. It means that the longer the payback period is, the higher the risk of the project is and the shorter the payback period is, the lower the risk is.
Payback period means how long does the company recovers its initial investment.  For example, when the payback period is 3 years, it means that the enterprise will take 3 years to recover its initial investment if it carries out this project.

Then let me introduce you how to calculate the payback period by 2 cases.
Case One:

LALA Company needs to invest in a project. It is expected to gain 100yuan in cash flow annually. However, if the enterprise wants to get these cash flows, it needs to invest 200yuan in this project. The company invested 200yuan in the project in the beginning and it recovered its initial investment in the second year. The company breaks even in the second year. Seeing that the company can obtain 200yuan after 2 years, the payback period for this project is 2years. So after 2 years, this project begins to gain profit.

 

Case Two:

SASA Company needs to invest in a project. It is expected to gain 100yuan in future cash flow in the first year, 300yuan in the second year and 500yuan in the third year. And the enterprise needs to invest 500yuan in this project in the beginning.

The calculation of the payback period in this project is a little complicated, we will explain it by a form.

It means that the enterprise has gained profit in the third year, but when did it recover its initial investment?

The answer is that the enterprise recovered its initial investment between the second year and the third year. We can calculate the specific payback period. The company has not recovered its initial investment in the second year and it gained -100yuan in the second year. It gained 500yuan cash flow in the third year. So we can get the formula: -100/500=0.2. It means that the company can recover its initial investment after 2years.

After calculation, let us check whether this method is good or bad.

Actually, this method is simple, we can calculate the formula by using excel form. We can get the answer quickly in this method. It is easy to understand.
But there is a disadvantage by using this method:

  • It doesn’t consider the future cash flow. Enterprises can not predict how many cash will flow into the enterprise.

The examiner in ACCA Examination will ask you to master the specific evaluation. If you are interested in this, you can learn it in our network class ACCA F9.

Free Cash flow

  • Free cash flow to firm is cash flow from operations+ interest expense -cash flow from investing activities.
  • Free cash flow to equity is free cash flow-interest expense(net of tax)-net debt borrowing.
  • Once we have calculated the free cash flow to equity we can then establish the dividend cover based on free cash flow to equity. We have learnt how to calculate dividend cover where we take PAT/Dividend paid. But before PAT is profit and it’s subject to manipulation by management so we can use a cash flow approach to do this.

 
There are 2 ways to calculate free cash flow to equity: 

  1. Direct method:
  2. Indirect method:

 
 

Direct method:

 
PATX

Adjustment for non cash itemX

Adjustment for changes in working capitalX

cash flow from investing activitiesX

Adjustment for net debt borrowingX

Free cash flow to equityX

Indirect method:

 
Free cash flowX

interest paid(net of tax)-because in free cash flow we have subtracted the whole taxesX

Adjustment for net debt borrowingX

Free cash flow to equityX

 
 

Free cash flow needs to be assessed not in a single period because sometimes company would spend money into expanding the business in the current year so the current year’s free cash flow would be low but it does benefit the company for the long term.
 
Example Human Ltd

 

The following statement of profit or loss relates to Human Ltd.

  $m
Sales 90
Cost of sales (30)
Gross profit 60
Operating expense (20)
PBIT 40
Interest (10)
PBT 30
Tax@20% (6)
PAT 24

 

During the year loan repayments are expected to amount to $20 million.

Issue of new debt is $69m.

Deprecation charge is $30 million and capital expenditure is $10 million.

Human ltd bought $3 inventory during the year.

Human Ltd ha 100m shares in issue and DPS is $0.03.

Required:

  1. calculate free cash flow to firm
  2. calculate free cash flow to equity
  3. calculate dividend cover using free cash flow to equity method.

Dividend Policy

M&M said dividend policy is not important because:

(dividend irrelevance theory)

  1. There is no tax: when receiving a dividend you don’t need to pay income tax and when you sell a share you don’t need to pay capital gains tax.
  2. There is no transaction cost: this means shareholders can sell a share freely incurring no costs.
  3. Perfect market: this means if company cuts dividend for the year then shareholders know exactly why they are doing this, ie, retain profit and invest in profitable projects to generate a higher return.
 
But the actual world suggests this matters because:

(Traditional theory)

  1. There is tax: when receiving a dividend you need to pay income tax and when you sell a share you need to pay capital gains tax.
  2. There is transaction cost: this means when shareholders sell a share then it incurring costs.
  3. Imperfect market: this means if company cuts dividend for the year then shareholders don’t know exactly why they are doing this and this would make shareholders not happy.

Signaling effect: if company cuts dividend and it suggests company is having cash flow problems.
 
Clientele effect: some shareholders would prefer dividend and hence they buy the shares.
 

There would be other ways besides giving shareholder dividend:

  1. Give them something: for Free, like free flights/free shares.
  2. Given them cash: by repurchasing shares from the market.

How to use APV to appraise your project?

  • We have looked at NPV calculation and we use WACC(weighted average cost of capital) to discount cash flow.
  • WACC has incorporated debt and equity element and one of the arguments for this is future sales, costs incurred have nothing to do with financing but instead they are something to do with operations.
  • So that’s why we developed APV to separate business option from financing.
  • APV is used when you are appraising a project where its financial risk is changed.
  • This means we use cost of equity(ungeared) to discount the basic cash flow including revenue & expenses because they are something to do with business not finance.
  • We can then establish present value of finance effect including issue cost, tax saving on interest and subsidy as well and for these items we use risk free rate/cost of debt to discount because APV doesn’t specify which discount rate we should choose and you can argue that eg, for tax saving on interest we have no idea when tax rate may change and as a result we can use Rf or Kd to discount the cash flow. Here notice you can either use Rf or Kd to discount cash flow and whichever you use your examiner would give you a mark in the exam(although your answer may be different from examiner’s and that’s totally acceptable).

 

Calculation:

APV=Base case NPV + PV of Finance Effect

Business Valuation

  1. Reasons to value a business

    • Efficient Market Hypothesis
    • Go listed
    • M&A a company
  2. Types of valuation methods
    1. Book value approach
      • Tangible assets
      • Intangible assets
    2. Market based approach
      • P/E ratio
      • Dividend yield model
    3. Cash flow based approach
      • dividend valuation model(dividend growth model)

Reasons to value a business

 
The 1st question is why do we need to value a business?

Well, the reasons being:

  • We want to acquire another company so we need to determine how much we are going to pay for them.
  • For listed companies you would notice they have their own share price then we can take it multiply by number of shares giving us total market capitalization then why do we still need to value them?
  • The reason is because we are in a semi market hypothesis so the share price quoted may not include insider information then we need to do extra calculation to verify whether that share price is the value of the company.
  • Other reason includes eg, why we need to value the company would be company may want to go listed onto the stock exchange then how would you determine your share price? Of course you need to value it first then divide by the number of shares and hence you can get share price you are going to quote.
  • Or we would like to merge another company(Co1+Co2=Co1) or acquire another company in order to make it become a subsidiary, eg, creating synergies(1+1>2) so we need to understand how much it’s worth before we purchase it.

 

Efficient Market Hypothesis

 
How quickly share price will react to information?

Weak form -reflect past information

Shareholders can’t just analyze the past information to generate abnormal return.

Semi Strong form -reflect published information

Shareholders can’t just analyze the published information to generate abnormal return.

Strong form -reflect past +published + private information

Shareholders can’t just analyze the inside information to generate abnormal return.

 

Q HJ[EMH]

HJ is about to acquire pc and expect a profit after tax after the acquisition to be $0.096m.

If HJ is not going to announce this to the public then the value of the HJ is $17.44m.

P/E ratio of HJ is 7.5.

 

Required:

Assuming a semi-strong form efficient capital market, calculate and comment on the post acquisition market capitalisation of HJ Co if the expected after-tax savings are made public. (3 marks)
 

Answer:

Value 17.44
Revised value

Changes in PAT X P/E

$0.096mX7.5

0.72
Total value 18.16

 

So if HJ announces the annual tax saving then total market capitalization would increase from 17.44 to 18.16 given shareholders would analyses published information of company to make investment decision either to buy or sell a share.

Non discounting techniques


The idea behind this is to use techniques to evaluate whether the investment proposal is worthwhile.

Techniques would be classified between:

Non-discounting techniques Discounting techniques
Payback period Net present value(NPV)

Other decisions

Asset replacement
Capital rationing
Lease or buy decision
Risks&Uncertainty

Sensitivity analysis
Accounting rate of return(ARR/ROCE/ROI) Internal rate of return(IRR)