EMA 18K : Financial Management

EMA 18K: Financial Management
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Question 1 (a)
Cash inflows earlier
investment 1,200,000.00
Time (years) [42/12] 3.5
Discount rate 4%
Present value factor 0.872
Present value 1,046,079.18
Cash inflows 5000000
Time (years) [60/12] 5
Discount rate 4%
Present value factor 0.822
Present value 4,109,635.53
Cash outflows Loans -2000000
Interest @ 5% for 12
months -100000
Time (years) [6/12] 0.5
Discount rate 4%
Present value factor 0.981
Present value
(2,059,219.42
)
Present value of operating cash
flows
Yea
r Net income PVF@4% Present value
1 3,000,000.00 0.962 2,884,615.38
2 - 0.925 -
3 1,500,000.00 0.889 1,333,494.54
4 1,000,000.00 0.855 854,804.19
5 - 0.822 -
Total 5,072,914.11
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Present value of tax outflows
Year
s Tax payments
PVF@4
%
Present
value
1.5 (556,923.08) 0.943 (525,103.85)
(2884615.38*20%-
100000*20%)
2.5 - 0.907 -
3.5 (266,698.91) 0.872 (232,490.15)
4.5 (170,960.84) 0.838 (143,300.14)
5.5 - 0.806 -
Total (900,894.14)
NPV of
cash
flow
gaps 7,268,515.27
(1046079.18+4109635.53-2059219.42+5072914.11-
900894.14)
Question 1 (b)
Cash inflows earlier
investment 1,200,000.00
Time (years) [42/12] 3.5
Discount rate 6%
Present value factor 0.816
Present value 978,612.41
Cash inflows 5000000
Time (years) [60/12] 5
Discount rate 6%
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Present value factor 0.747
Present value 3,736,290.86
Cash outflows Loans -2000000
Interest @ 5% for 12
months -100000
Time (years) [6/12] 0.5
Discount rate 6%
Present value factor 0.971
Present value (2,039,700.31)
Present value of operating cash flows
Yea
r Net income
PVF@6
%
Present
value
1 3,000,000.00 0.943
2,830,188.6
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2 - 0.890 -
3 1,500,000.00 0.840
1,259,428.9
2
4 1,000,000.00 0.792 792,093.66
5 - 0.747 -
Total
4,881,711.2
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Present value of tax outflows
Year
s Tax payments
PVF@6
%
Present
value
1.5 (546,037.74) 0.916 (500,338.43)
(2884615.38*20%-
100000*20%)
2.5 - 0.864 -
3.5 (251,885.78) 0.816 (205,415.46)
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4.5 (158,418.73) 0.769 (121,879.35)
5.5 - 0.726 -
Total (827,633.24)
NPV of
cash
flow
gaps 6,729,280.98
978612.41+3736290.86-2039700.31+4881711.27-827633.24
Question 1 (c)
The net present value of the cash flow gaps is £7,268,515.27 at the discount rate of 4%.
When the interest rate rises by 2%, the discount rate also increases by 2%. The increase in the
discount rate implies decrease in the present value. Thus, the net present value of the cash flow
gaps declines to £6,729,280.98 when the interest rate rises to 6%. It can be seen that the net
present value reducing on an increase of 2% in the interest rate. However, the net present value is
still positive so the increase in the interest would be acceptable to the board of directors of the
company (Rossi, 2015).
Question 2 (a)
There are various types of foreign exchange risks such as transaction risk, translation
risk, economic risk, risk of netting and matching, and the risk of leading and lagging (Bessis,
2015). In the current case, Factor 14 Plc, which is a British manufacturer, is undertaking
transactions with the Euro zone counties. The company engages in various purchases and sales
transactions with the Euro zone counties. The truncations with the Euro zone countries are
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settled in Euro while the home currency of the company is GBP. Thus, this gives rise to the
transaction exposure to the company. Here, the company has receivables of €200,000 due in next
six months, thus, the company incurring the risk of loss on account of unfavorable changes in the
foreign exchange rates between Euro and GBP. The company has receivables due, thus, if Euro
depreciates against GBP, the company will incur losses. The company can hedge against this risk
by opting to various strategies (Pilbeam, 2018).
There are various alternatives through which the company can hedge the risk of foreign
exchange. The prominent alternatives for such purpose are forward rate agreement, future
contract, option contract, and money market operations (Pilbeam, 2018). Under the forward rate
agreement, the company can enter into an agreement with the bank to receive foreign currency at
the specified rate on the specified date. Further, the future and option contracts of the currencies
are traded on the stock exchange. The future contract provides the company an alternative to fix
the foreign currency rate for the future transaction. For example, in the current case, Factor 14
Plc can enter into sale future contract on Euro for 6 months. Further, option contract also could
be used in the similar fashion to hedge the foreign exchange risk. However, option contract
provides little flexibility as compared to future contract. The option contract is not binding on the
buyer so the buyer gets that flexibility to exercise or get the option lapsed on the date of expiry
(Chance and Brooks, 2015).
Apart from the above, the company can also opt for money market operations. In the
money market operations, the company usages short term lending and borrowing instruments to
create hedge strategy. For instance, in the current case, Factor 14 Plc can lend money in Euro for
6 months. On the date of transaction after six months, the payables in Euro could be settled
against receivables (Chance and Brooks, 2015).
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Question 2 (b)
Applying the concept of interest rate parity theory, forward rates between the foreign
currencies could be calculated. The interest rate parity theory states that the investment
opportunity in two countries must be same and if difference exists, it is due to difference in
foreign exchange rates (Du, Tepper, and Verdelhan, 2018). Thus, the forward rate between Euro
and GBP for 6 months is calculated as below:
Spot rate * (1+interest rate GBP)
(1+interest rate Euro)
0.88* (1+1%/2)/ (1+0.5%/2)
0.8823
Thus, the 6 months forward rate at which the company can take forward cover to hedge
the risk is 0.8823.
Question 2 (c)
In the current case, Factor 14 Plc has receivables of €200,000 thus; the company can
enter into put buy option on Euro. The put option on Euro would give the company the right to
sell Euro after 6 months at the exercise price i.e. 0.88 GBP/ Euro.
The table showing net pay off at different spot rates is given as below:
Exercis
e rate Spot rate Premium
Exercise/
Lapse Pay off
0.88 0.60 0.10 Exercise 0.18
0.88 0.70 0.10 Exercise 0.08
0.88 0.80 0.10 Exercise (0.02)
Lapse
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0.88 0.90 0.10 (0.10)
0.88 1.00 0.10 Lapse (0.10)
0.88 1.10 0.10 Lapse (0.10)
A table showing net receipts in GBP against 200,000 Euros is given as below:
Spot
rate
Receipts in
GBP
0.60 156,000.00 200000*(0.88-0.10)
0.70 156,000.00 200000*(0.88-0.10)
0.80 156,000.00 200000*(0.88-0.10)
0.90 160,000.00 200000*(0.90-0.10)
1.00 180,000.00 200000*(1.0-0.10)
1.10 200,000.00 200000*(1.10-0.10)
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It can be observed that the company would exercise the option contract till the spot rate
remains up to 0.88 (exercise rate). As soon as the spot rate surpasses the exercise rate, the
company would be better off in letting the option lapse. In that scenario, the company would get
money converted at the spot rate rather than exercising the option.
Further, it can be observed that by taking the put option, the company has fixed the
payment at GBP 156000, which means that the company will get at least GBP 156,000 against
Euro 200,000 even if the exchange rate goes down to 0.50. On the other hand, the company
would get opportunity to earn unlimited profits in case the exchange rate rises beyond 0.88
levels.
Question 2 (d)
The company’s decision to hedge the foreign exchange risk shows the apprehensions of
the company about depreciation in Euro against GBP in the coming months. This shows that the
economy of Euro zone is suffering from slow growth and high inflation which is causing the
money power of Euro to decline. However, the company should take hedging position after
analyzing the economic conditions of the foreign country and home country thoroughly.
Question 3 (a)
In the current case, the management is considering a large order of goods emanating from
American Red Cross. The order amount is $30 million and also the buyer (American Red Cross)
is seeking credit terms of more than 30 days, the usual credit period. In this connection, it is
imperative for the management to assess the creditworthiness of American Red Cross so that the
credit risk or the risk of default could be managed. The following methodology should be
adopted by the management for this purpose:
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Market Reputation and Management of Red Cross
American Red Cross has a rich history behind the big empire being built today with
services all around the United States and internationally. The organization was established way
back in 1881 by Clara Barton, one of the honored women with high reputation in the society.
Today, American Red Cross has the most reputed people on the board under the leadership of
person of integrity and high eminence Bonnie McElveen-Hunter. Furthermore, the president of
the United States Mr. Donald J. Trump is the honorary chairman of the organization (Redcross,
2018). The organization follows high standards of ethics to ensure proper governance
mechanism for assuring achievement of the objectives and goals set by it.
Historic Financial Performance and Position
The company works for social causes so there is no profit motive in the business
activities of the company. The financial data depicts that the company is able to generate huge
funds through contributions, donations, and allied business activities. The analysis of major
items of income and expenses is shown in the table given below:
Major Sources of income
2016 ($
millions)
2017 ($
millions)
Contributions 602 661
Products and services revenues 1880 1845
Investment income 85 40
Other revenues 19 93
Total 2586 2639
Operating expenses 2436 2537
Gross income 150 102
Notes: Only major sources of revenues have been considered. Further,
only operating expenses have been considered for analysis.
(Redcross, 2018)
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It could be observed that the total revenues of the company have increased from $2,586
million in the year 2016 to $2,639 million in the year 2017. The operating expenses have also
increased from $2436 million to 2537 million which shows enhancement in the scale of
operations of the company.
Further, for the analysis of buyer’s creditworthiness, it is essential to look into the
working capital and analyze the current assets and current liabilities position (Bluhm, Overbeck,
and Wagner, 2016). The table shown below depicts the relevant data in this connection:
2016 ($
millions)
2017 ($
millions)
Working capital
Cash and cash equivalents 83.34 122.12
Trade receivables 475.62 291.92
Contributions receivable 66.43 69.51
Inventories 38.18 40.71
Other current assets 32.23 37.66
Total 695.8 561.92
Less:
Accounts payable and accrued
expenses 251.74 237.51
Other current liabilities 146.98 130.68
Total 398.72 368.19
Working capital 297.08 193.73
(Redcross, 2018)
The company net working capital in the year 2017 has decreased; however, the company
is still in a good position with net working capital of $193.73 million. The company’s current
ratio is 2.90 times which appears to be healthy and shows that the liquidity position is good.
Further, the cash balance in the company’s accounts of $122.12 shows that it can repay the credit
balance of $30 million without any hassles.
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Further, analysis of long term debt and net assets is also desirable to gauge the proper
understanding of financial position of the company (Bessis, 2015). The table shown below
indicates the relevant data:
Long Term Debt and Net assets
2016 ($
millions)
2017 ($
millions)
Net assets 424.45 249.79
Long Term Debt 572.23 506.87
Total 996.68 756.66
(Redcross, 2018)
The data shows that the long term loans have decreased from $572.23 million to $506.87
million. This shows that the company is repaying the long term debt. The repayment of the
earlier long term debt increases the company’s capacity to repay the proposed credit purchases of
$30 million. The net assets of the company have decreased due to increase in the expenditure
however this should not raise any concerns for the proposed credit transaction.
Therefore, based on the above analysis, it would be concluded that the creditworthiness
of American Red Cross is good. The company’s financial position is good and it does not raise
any basic concern for the proposed credit transaction. However, there it is recommended to the
management of the supplier to opt for credit risk management strategies to provide adequate
safeguard against the credit transaction.
Question 3 (b)
The supplier company can manage the risk emanating from the credit transaction with
American Red Cross by opting various ways such as factoring, letter of credit, and letter of
guarantee. In the factoring arrangement, the company’s debtor can be converted into cash by
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transferring the debtor to a third party called factor (agent). The third party takes over the
responsibility of recovery of outstanding balance from the debtor and it also provides advance
amount to the company. The third party i.e. the factor agent charges certain amount of
commission for this service (Stan and Upton, 2012).
Another option available is letter of credit. The supplier’s management can ask for
irrevocable letter of credit from the buyer. In this case, American Red Cross may be asked to
provide irrevocable letter of credit against the credit transaction of $30 million. In the situation of
inability of American Red Cross to pay back the outstanding amount, the bank issuing letter of
credit would be liable to pay. Thus, the payment of the supplier is secured by taking letter of
credit. The letter of credit must be irrevocable so that it can be cancelled or revoked with the
supplier’s consent only (Stan and Upton, 2012).
Apart from the above, the supplier also has an option to create hypothecation charge on
the inventory being supplied and other assets of the buyer. The hypothecation charge would
provide safety for recovery of the amount due. In the situation of inability of the repayment, the
supplier can exercise the hypothecation charge and realize the assets being hypothecated to
recover the amount.
Question 4 (a)
Financial risk implies the risk associated with the company’s capital structure and
availability of money for funding the assets and meeting the liabilities. Every business needs to
formulate adequate policies for managing and controlling the financial risk. In regards to
Unilever, it has been observed that the financial risk management is an integral part of the
company’s overall business strategy (Unilever, 2017). The company follows modern approach of
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managing the financial risk. At the first step, the risk appetitive is analyzed to and then the risk
analysis is undertaken. The risk appetite is analyzed to understand the level of risk the company
can take and accordingly appropriate risk control policies could be put in place. Based on the gap
between the level of risk and the risk appetite, the company decides measures of risk control and
then they are put in place to manage the risk. Banco Santander also follows the same approach;
however, there are differences in categorization of risk being done by two companies (Banco
Santander, 2017).
Unilever categorizes the risk into categories such as brand preferences, portfolio
management, sustainability, climate change, customer relations, talent, supply chain, systems and
information, economic and political instability, ethical, credit risk, and legal and regulatory
(Unilever, 2017). The risk categorization of Unilever does not follow predetermined categories.
The management undertakes the risk assessment and then categorization is done. However,
Banco Santander seems to be following a standard risk categorization with the categories being
defined as credit risk, trading, market and liquidity risk, operational, compliance, model,
strategic, and capital risk. Therefore, comparing both the companies on risk assessment approach
and risk categorization, Banco Santander seems to be more formal with following standard
approach (Banco Santander, 2017).
In terms of managing the credit risk, Unilever stays risk averse and it assesses the risk
being low. The company apprehends that the risk of default in repayment of the amount due
from the debtors is low as determined on the basis of past experience. Further, the assessment of
credit risk is also undertaken on an overall basis without any sub categorization. On the other
hand, Banco Santander, sub categorizes the credit risk by breaking it down into different
segments. Thus, the credit risk assessment in case of Banco Santander seems to be more
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comprehensive and detailed. However, the reason for this could be that the company considers
the credit risk as the key risk considering its nature of business.
In order to analyze the financial risk in more detail, Banco Santander undertakes the
capital risk analysis separately which Unilever does not do. The analysis of capital risk is
essential for the business; however, it is more essential for Banco Santander as it is in financing
business. On the other hand, one can observe that Unilever undertakes the risk of supply chain
and customer relationship in more detail as these two risks are key risk for its business. So, both
the companies are focused on managing and controlling their key risks in the best way. However,
when it comes on comparing the financial risk management, Banco Santander seems to be ahead
of Unilever. Unilever adopts the traditional ways of controlling the financial risk like it put in
place internal audit and monitoring by the supervisory board. While, Banco Santander put in
place more stringent controls and detailed analysis of finances of the company (Banco Santander,
2017).
Question 4 (b)
Enterprise risk management refers to the standardization of the process of risk
management and control. Enterprise risk management is an overarching or holistic approach to
the risk management which covers all the business activities and processes (Lam, 2014). The
different business activities and processes such as finance, marketing, distribution, supply chain,
human resource, and administration are so aligned that the risk management becomes a simple
and effective process. Further, the enterprise risk management envisages a process which
initiates with identifying the events giving rise to risk and opportunities and it goes through
assessing the magnitude of risk, responding with strategy and concludes with proper monitoring.
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In this regard, it has been observed that both the companies are applying the enterprise
risk management in managing their respective business risks. However, Unilever seems to be
better applying the enterprise risk management. Unilever adopts the thorough process of
identifying the events and circumstances, evaluating the opportunities and then responding with
appropriate Strategy (Unilever, 2017). Banco Santander also undertakes thorough risk
assessment but it appears to be weak in applying the enterprise risk assessment holistically. It has
in place modern risk management models and controlling tools but it does not follow the
enterprise risk management conventionally which may be due to its dynamic nature of business
(Banco Santander, 2017).
On the other hand, Unilever’s risk management approach initiates with assessing the
events and circumstances and then assessing the risk emanating from them. The risk assessment
follows the assessment of opportunity coming in the way. After assessment of opportunities, the
management decides the strategies and based on that, the risk control policies are formulated. For
instance, management has assessed in 2017 that Unilever is exposed to the financial risk of
treasury and pension (Unilever, 2017). Now, the management goes into details of it and finds
that we are exposed to market inertest rate risk. The next step is to identify the opportunity
associated with the risk. The management sees that increase in the market interest rate brings in
opportunity to invest in new bonds and other fixed income bearing securities. Then the
management formulates counter strategy to reduce the risk caused by increase in the market
interest rate. So, the entire process of risk assessment goes sequentially as envisaged by the
enterprise risk management process (Unilever, 2017).
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Based on the above discussion, it could be concluded that both the companies are
applying the process of enterprise risk management; however, Unilever is applying it to the more
extent and more effectively.
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References
Bessis, J., 2015. Risk management in banking. John Wiley & Sons
Pilbeam, K., 2018. Finance & financial markets. Macmillan International Higher Education.
Chance, D.M. and Brooks, R., 2015. Introduction to derivatives and risk management. Cengage
Learning.
Du, W., Tepper, A. and Verdelhan, A., 2018. Deviations from covered interest rate parity. The
Journal of Finance, 73(3), pp.915-957.
Redcross. 2018. American Red Cross home page. [Online]. Available at:
https://www.redcross.org/about-us.html [Accessed on: 04 December 2018].
Redcross. 2018. American Red Cross Annual Report 2017. [Online]. Available at:
https://www.redcross.org/content/dam/redcross/National/pdfs/annual-reports/Annual-Report-
2017.pdf [Accessed on: 04 December 2018].
Banco Santander. 2017. Annual Report of Banco Santander for 2017. [Online]. Available at:
https://www.santander.com/csgs/Satellite/CFWCSancomQP01/en_GB/Corporate/Shareholders-
and-Investors/Shareholders/Shareholder-Reports/Annual-Report.html [Accessed on: 04
December 2018].
Unilever. 2017. Annual Report of Unilever for 2017. [Online]. Available at:
https://www.unilever.com/investor-relations/annual-report-and-accounts/archive-of-unilever-
annual-report-and-accounts.html [Accessed on: 04 December 2018].
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Rossi, M., 2015. The use of capital budgeting techniques: an outlook from Italy. International
Journal of Management Practice, 8(1), pp.43-56.
Bluhm, C., Overbeck, L. and Wagner, C., 2016. Introduction to credit risk modeling. Chapman
and Hall/CRC.
Bessis, J., 2015. Risk management in banking. John Wiley & Sons.
Stan, M. and Upton, M. 2012. Liquidity Risk and Raising Finance. The Open University.
Lam, J., 2014. Enterprise risk management: from incentives to controls. John Wiley & Sons.
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