A COMPARISON OF SUNK, IRRELEVANT, AND INCREMENTAL COSTS

There are a lot of different ways that companies do their accounting. Some companies might put sunk costs into their books, while other companies might put incremental costs, and others might put irrelevant costs into their books, while others might put all of them. Here is a comparison of sunk, irrelevant, and incremental costs.
The first thing is what are sunk costs? A sunk cost is a cost that has been put into something that ends up not doing what you need it to do and you find something that can replace it for less then what you are going to be into the other thing as far as time and money goes. For example if some one has a program they are working on for their company and it has cost them $2000 this far and they are still trying to get all the bugs out and get it running faster, but then they find a program that they can buy for $2000 and it does everything they need it to do. The company will consider the program they were working on a sunk cost and leave it at that. It is cost that is lost because they found something that they could use without having to put any more money into it.The second thing is what are irrelevant costs? Irrelevant costs are costs that are either positive or negative. They are also costs that might be relevant for some situations but irrelevant to others. For example if one person says that the value of something is one thing it may be relevant right then but in another situation the same thing might be valued at something else making it irrelevant.
The third thing is what are incremental costs. Incremental costs are costs that are occurred that are not expected. For example you might have a project that you have forecasted is going to cost a certain amount but it end up costing you more. The money that you use to pay for the extra money that it is costing you is considered incremental costs.
Now that you know what all of the different terms mean here is a comparison of sunk, irrelevant, and incremental costs. In your company you should look into using all of these costs because they can help you plan for every different situation. It is good to use incremental costs for the sunk costs that you might incur. You can also use incremental costs to supplement some of the incremental costs. For example you might have irrelevant costs because of values going up on certain things that you might be using for projects and you can use incremental costs to cover the amount you spend because of the irrelevant costs.
Depending on the different costs that your company will incur do to all of theses different things will help you to see why you need sunk, irrelevant, and incremental costs as part of your accounting. You just have to compare all of them and decide how much you want to focus on each individual cost. This will help you determine how much money you want to put into different accounts. You will also want to make sure that you pay attention to the different costs so you know if you have a sunk cost that you know when to cut it off. Or if you have incremental costs that you know where you are at and are not spending more money than needed. These are all things that you can do to compare sunk, irrelevant, and incremental costs

DIFFERENCE BETWEEN IRRELEVANT AND INCREMENTAL COSTS?

Businesses experience many different types of costs. There are fixed costs, sunk costs, variable costs, relevant costs, irrelevant costs and incremental costs. Different types of successes and failures bring about each one. So what is the difference between irrelevant and incremental costs? Keep reading and discover what you always wanted to know about business costs.
First, let's start with a definition of both irrelevant and incremental costs.An irrelevant cost is an accounting term that represents a cost, either positive or negative, that does not relate to a situation requiring a management's decision. They are costs that may be irrelevant for some situations, but relevant for others. For example, if one business says that the value of something is X, it might be relevant at that moment, but in another situation the same thing might be valued at Y instead, making it irrelevant. Examples of irrelevant costs include the following: fixed overheads, notional costs, sunk costs and book values.
An incremental cost is an encompassing change that a company experiences within its balance sheet due to one additional unit of production. These are not expected costs. An incremental cost may also be referred to as a "marginal cost." For example, you might have a project that you predicted would cost a particular amount of money, but ends up costing you r more. The money that you used to pay for the extra expenses of the project is an incremental cost. Basically, incremental cost is the overall change that a company experiences by producing one additional unit of products or services.
Finally, we must explain what a sunk cost is, since it is so closely tied into irrelevant and incremental costs. A sunk cost is a cost that has been incurred and cannot be returned. This could include the gym membership that you purchased by never used; equipment that you bought and never installed but can't return; or a computer program has cost your company thousands of dollars to get all the quirks out of it, and then you find a better program that actually works for less money.
Why should you care about these types of costs? Well, knowing about the various types of business costs can help you plan for every situation. They affect each other, as well as sunk costs. Incremental costs can be used for sunk costs of your business. Or incremental costs can be used to supplement irrelevant costs. Let's say you have irrelevant costs because the value of the parts needed to make your product is increasing, making your product more expensive to make and yielding less profit. You might use incremental costs to cover the amount you spend because of the irrelevant costs.
Depending on the type of company that you have, your business will incur different types of costs. But knowing the difference between the costs will help you see why you need irrelevant and incremental costs included in your finance. It's a good idea to compare all of your costs (including sunk costs, incremental costs, relevant and irrelevant costs) and then determine how much you want to focus on each individual cost. Then you can determine how much money you should set aside in different accounts to pay for these costs. For example, if you see that you have a sunk cost, your account for incremental costs may be able to pick up the slack for it until you can eliminate the sunk cost. Keeping a good record of your finances is imperative to running a good business. Doing this will also help you to identify and remedy sunk costs, as well as improve the way you handle irrelevant and incremental costs.

What is a relevant

Commercial organisation usually make decisions with the objective of maximising the present value of future cash flows. In order to ensure that the right opportunities are taken to do this, we need to be able to measure the relevant costs for decision-making. In examination questions (unlike real life) we can assume that future costs and benefits are known with certainty and therefore we only have to apply the principle correctly.

What is a relevant cost or benefit?
A relevant cost or benefit is one that will be affected by the decision. This means that the following can be disregarded as they are irrelevant in the decision-making process:

• Fixed overhead These will be incurred regardless of the decision.
• Notional costs. For example, notional rent - these costs are only a book exercise and do not represent a real cash flow.
• Past or sunk costs. These have already happened, so they cannot be affected by a future decision. It is vital to note that relevant costs are always future costs. book value Similar to sunk costs. For example, the price paid for stock in the past is not a relevant cost to the decision.

Many of the above are included in examination questions and should be rejected by candidates. It is important to state that they are not relevant for decision-making rather than to simply omit them. Marks are often available for this information.

Opportunity costs
A company often has a choice of options. For example, does it choose to use a scarce resource for Contract A instead of Contract B? If it does choose Contract A then Contract B will be deprived of the resource that could have generated a contribution for the company. This is an example of an opportunity cost, a relevant cost for decision-making. By definition, an opportunity cost is one which measures the cost of sacrificing one course of action in favour of another.

In examination questions, the more difficult aspects of a question include opportunity costs. It is important that candidates take their time and employ a logical approach in order to gain maximum marks.

The examination approach
Using the data in the illustration below, we can now apply the above principles in the manner expected by the examiner. It is vital that during the examination your work is clear, cross-referenced, and logical. Markers seek out marks to the best of their ability. However, this is difficult if markers are presented with illegible scribbles and calculations which are not referenced.

Always read the question carefully and make sure that you are comfortable with the requirement. In this illustration you are required to show all the relevant costs in a cost schedule and more importantly you are also required to explain why the costs are relevant. It is logical to deal with each of the costs separately, using the headings given in the illustration. For each cost element, summarise in your own words what the note is telling you before you pronounce a cost as relevant or otherwise.

Illustration
The managing director of Parser Limited, a small business is considering undertaking a one-off contract. She has asked her inexperienced accountant to advise on what costs are likely to be incurred so that she can price at a profit. The following schedule has been prepared:

Costs for special order	Notes	£
Direct wages	1	28,500
Supervisor costs	2	11,500
General overheads	3	4,000
Machine depreciation	4	2,300
Machine overheads	5	18,000
Materials	6	34,000
		98,300

Notes

1. Direct wages comprise the wages of two employees, particularly skilled in the labour process for this job. They could be transferred from another department to undertake the work on the special order. They are fully occupied in their usual department and sub-contracting staff would have to be brought in to undertake the work left behind.
   Sub-contracting costs would be £32,000 for the period of the work. Other sub-contractors who are skilled in the special order techniques are also available to work on the special order. The costs associated with this would amount to £31,300.
2. A supervisor would have to work on the special order. The cost of £11,500 is made up of £8,000 normal payments plus a £3,500 additional bonus for working on the special order. Normal payments refer to the fixed salary of the supervisor. In addition, the supervisor would lose incentive payments in his normal work amounting to £2,500. It is not anticipated that any replacement costs relating to the supervisors' work on other jobs would arise.
3. General overheads comprise an apportionment of £3,000 plus an estimate of £1,000 incrementaloverheads.
4. Machine deprecation represents the normal period cost, based on the duration of the contract. It is anticipated that £500 will be incurred in additional machine maintenance costs.
5. Machine overheads (for running costs such as electricity) are charged at £3 per hour. It is estimated that 6,000 hours will be needed for the special order. The machine has 4,000 hours available capacity. The further 2,000 hours required will mean an existing job is taken off the machine resulting in a lost contribution of £2 per hour (before overheads are charged)
6. Materials represent the purchase costs of 7,500kg bought some time ago. The materials are no longer used and are unlikely to be wanted in the future except for the special order. The complete stock of materials (amounting to 10,000kg), or part thereof, could be sold for £4.20 per kg. The replacement cost of material used would be £33,375.

Because the business does not have adequate funds to finance the special order, a bank overdraft of £20,000 would be required for the project duration of three months. The overdraft would be repaid at the end of the period. The company uses a cost of capital of 20% to appraise projects. The bank's overdraft rate is 18%.

The managing director has heard that for special orders such as this, relevant costing should be used that also incorporates opportunity costs. She has approached you to create a revised costing  based on relevant costing principles.

Required
Produce a revised costing schedule for the special project based on relevant costing principles. Fully explain and justify each of the costs included in the costing schedule.

1. Direct wages
   Summary: There are two options. We can take the workers from their usual department, where it would cost £32,000 to replace them. Or we could hire sub-contractors to do the special order at a cost of £31,300.
   Both of these costs are future costs that will be affected by the decision and are therefore relevant. The choice between the two alternatives is relatively straightforward - either incur a £32,000 cost or a £31,300 cost. As an accountant you will want to minimise costs and will choose to hire the sub-contractors at £31,300.
    
2. Supervisor costs
   Summary: The supervisor's normal salary is £8,000 and this will be paid whether or not we take on the special contract. This is a fixed cost to the business and is unaffected by the decision. However, the £3,500 additional bonus is relevant as it is dependent on the decision to take the special contract. In addition, if we take the special contract we will not have to pay the £2,500 incentive payment. Therefore, the net relevant cost to the business is £3,500 less £2,500 = £1,000.
    
3. General overheads
   Summary: Regardless of the decision, general fixed overhead remain constant. The apportioned rent, rates, power etc, will be incurred whether the special contract is undertaken or not. Therefore, these are not relevant costs and can be ignored for decision-making purposes. However, incremental overheads are extra overheads, incurred as a direct result of undertaking the special project. These could include additional costs for power or premises. They are relevant costs to the project of £1,000.
    
4. Machine depreciation
   Summary: The machine depreciation has been charged at £2,300 which is what the accountant would normally charge for depreciation for this period of time. The accountant will charge this time-baseddepreciation if we use the machine for the special contract and also if we do not. It is only a book value and does not represent a true cash flow to the business. Therefore it is not a relevant cost. However, if we do take the special contract and use the machine, we will incur maintenance costs of £500. These future costs are a direct result of the decision and should be included within the costs.
    
5. Machine overheads
   Summary: Taking the special contact will mean that the machine will run for 6,000 hours and as each hour incurs a running cost of £3, the relevant future cost will be £18,000. In addition, there is an opportunity cost. If we choose to take the contract we will have to choose not to work on an existing job as machine hours are a scarce resource and we only have enough hours free to do one job. Therefore, a relevant cost to the special contract will be the benefit forgone from choosing the special contract over the existing job. This cost if the lost contribution of £2 per hour for 2,000 hours. We will lose £4,000 contribution is we take the special contract. The total relevant cost therefore is £18,000 plus £4,000 = £22,000.
    
6. Materials
   Summary: The 7,500kg of materials is already in stock. We do not know how much it cost and if we did it would not be useful as this is a sunk cost and therefore irrelevant. Neither is the replacement cost of £33,375 relevant as it is not a future cost that will be incurred as a result of the decision (if we already have it we will not need to buy it). However, this would be relevant if the material was in constant use by the company.
   There is an opportunity cost, as we have two courses of action to choose from. We can either use the material for the special contract or we can sell it and receive £4.20 per kg. The relevant cost is 7,500 x £4.20 = £31,500 as this represents the benefit sacrificed by choosing to take the contract rather than selling the materials.
    
7. Overdraft interest
   Summary: If the company chooses to undertake the special project it will incur finance charges for the three month duration. This is a future cost due to the decision being made and therefore should be included as a relevant cost. £20,000 x 18% x 3/12 = £900.

Revised cost schedule for the special contract

Costs for special order	Notes	£
Direct wages	1	31,300
Supervisor costs	2	1,000
General overheads	3	1,000
Machine depreciation	4	500
Machine overheads	5	22,000
Materials	6	31,500
Interest charges	7	900

inflation

Inflation is the term used to describe a rise of average prices through the economy. It means that money is losing its value.

The underlying cause is usually that too much money is available to purchase too few goods and services, or that demand in the economy is outpacing supply. In general, this situation occurs when an economy is so buoyant that there are widespread shortages of labour and materials. People can charge higher prices for the same goods or services.

Inflation can also be caused by a rise in the prices of imported commodities, such as oil. However, this sort of inflation is usually transient, and less crucial than the structural inflation caused by an over-supply of money.

The effects of inflation

Inflation can be very damaging for a number of reasons. First, people may be left worse off if prices rise faster than their incomes. Second, inflation can reduce the value of an investment if the returns prove insufficient to compensate them for inflation. Third, since bouts of inflation often go hand in hand with an overheated economy, they can accentuate boom-bust cycles in the economy.

Sustained inflation also has longer-term effects. If money is losing its value, businesses and investors are less likely to make long-term contracts. This discourages long-term investment in the nation’s productive capacity.

The flip-side of inflation is deflation. This occurs when average prices are falling, and can also result in various economic effects. For example, people will put off spending if they expect prices to fall. Sustained deflation can cause a rapid economic slow-down.

The Reserve Bank is as concerned about deflation as it is about inflation. In New Zealand, however, it has historically been more usual for prices to rise. As Figure 1 shows, there have been only brief periods of deflation in the past 150-odd years, and these have been associated with economic depressions. The graph also shows that, once the economy had become established, New Zealand did not have sustained high inflation until the 1970s and 1980s.

Inflation targeting

In the late 1980s the government gave the Reserve Bank responsibility for keeping inflation low and more stable than it had been. Statutory authority was provided in the Reserve Bank of New Zealand Act 1989, and the specifics were set out in a written agreement between the Governor of the Reserve Bank and the Minister of Finance. This ‘Policy Targets Agreement’ initially called for a reduction of inflation to 0–2 percent increase in the Consumers Price Index (CPI) by 1992. It has been revised several times since, and the current agreement, signed in May 2007, calls for inflation to be kept within 1 to 3 percent a year, on average over the medium term. This means that, as the graph shows, inflation can exceed the 1–3 percent target range in the short term. However, in the medium term it remains within that band, on average, and this means that the very high inflation rates of the 1960s and 1970s – which at times exceeded 18 percent per annum – do not occur.

The effect of this arrangement is clear from Graph 2, in which inflation has remained within a narrow band. The Bank controls inflation through an economic tool known as the Official Cash Rate, covered in a separate sheet.

Measuring inflation

There are various ways of measuring inflation. The one used in the Policy Targets Agreement is the CPI published by Statistics New Zealand. This records the change in the price of a weighted ‘basket’ of goods and services purchased by an ‘average’ New Zealand household. Statistics New Zealand weights and indexes the various items in the basket and forms the ‘all-groups’ index. The percentage change of this index is typically referred to as ‘CPI inflation’, and is usually expressed over both a quarterly and annual period.

The contents of the basket are defined by Statistics New Zealand, which periodically reviews and re-weights them, using data obtained from their annual Household Economic Survey. This is necessary because the basket of goods and services purchased by the average household will change over time.

The Reserve Bank Inflation Calculator

This calculator allows users to input a sum of money and compare its value, in terms of the CPI and other measures for pre-CPI years, between any two quarters from 1862, to the latest quarter for which CPI figures are available.

What is IRR?

The basics

The Internal Rate of Return, or IRR for short, is a measure of your investment performance, and is expressed as percent return per year.  It is essentially equal to the (annualized) interest rate a bank would have to pay you to duplicate the performance of your portfolio.

IRR takes into account the amount of time that has elapsed since making an investment.  For example, if you purchased $1000 worth of stock today, and one year from today its market value is $1200, your gain would be 20%.  Your IRR would also be 20%, because exactly one year would have elapsed since you made the investment.

On the other hand, if you had sold the stock after six months for $1200, although your gain would still be 20%, your IRR would be 44%.   To see why, you must understand that the calculation of IRR "annualizes" your investment return.  In this example, if you were to continue to invest your money with the same degree of success as before, you would take your six-month balance of $1200 and earn another 20% in another six months, giving you $1200 x 1.2 = $1440:  a 44% gain in one year.

The mathematics

When analyzing a complex series of purchases and sales, it is useful to look at your investment activity as a cash flow diagram.  A cash flow diagram is nothing more than a timeline on which arrows are drawn to represent cash transactions.  When you pay cash out (for example, purchasing a stock or making a bank deposit), the cash flow is negative and the arrow is drawn pointing downwards; when you receive cash (for example by selling a stock or making a withdrawal) the cash flow is positive and the arrow points upwards.  The simple example above is represented by the diagram at right.

Mathematically, the IRR is defined as the interest rate r (or "discount rate") that would make the "present value" of the series of cash flows equal to zero.  The "present value" of a particular cash flow is defined as the amount of cash (either positive or negative) divided by (1+r)^t, where t is the time the cash flow occurred relative to the present, expressed in years.  The present value of a series of cash flows is simply the sum of the present values of each individual cash flow.  Applying this to the above example, and using r = 0.44, we would obtain:

	Transaction	cash	t, years	(1+r)t	PV
	initial purchase	-1000	0	1	-1000
	sale after 6 months	+1200	0.5	1.2	+1000
	Total present value:				0

When there are multiple purchases, sales, dividends, etc. the cash flow diagram can become arbitrarily complex.  The general equation can be expressed as follows:

where C_i are the cash flows and t_i the times.  The value of r that solves this equation is the IRR for the series of transactions.

In some circumstances there can be multiple values of r that solve the equation, so that a unique IRR cannot be determined.  The solver utilized in Dan's Portfolio Tracker does not attempt to detect the presence of multiple solutions, but simply returns the first solution found.

Cash-carrying vs. cashless portfolios

In Dan's Portfolio Tracker, cash-carrying portfolios are treated differently from cashless portfolios when calculating IRR.  In a cashless portfolio, every transaction (except stock splits) is treated as a cash flow:  stock purchases are negative, while stock sales and dividends are positive.  In a cash-carrying portfolio, on the other hand, the only cash flows considered are deposits and withdrawals from the cash account.

To see why, think about what happens when a stock is purchased.  When a stock is purchased in a cash-carrying portfolio, the cash required is removed from the cash account, and the portfolio value is unaffected (except for the commission fee).  This is in contrast to a cashless portfolio, in which purchase of a stock increases the portfolio value by the cost of the stock.  In the latter case the portfolio holder would have to put out some cash; in the former, the cash comes from within the portfolio itself.

These implementation details are transparent to the user, however.  All you need to do is decide whether or not to carry a cash balance, and the program will take care of the rest.  If you do decide to maintain a cash balance, however, please remember to make at least one deposit.  The program will allow you to go into debt to make stock purchases, but if there are no deposits at all then there are no cash flows from which to calculate the IRR.

Time Value of Money

Introduction

Time Value of Money (TVM) is an important concept in financial management. It can be used to compare investment alternatives and to solve problems involving loans, mortgages, leases, savings, and annuities.
TVM is based on the concept that a dollar that you have today is worth more than the promise or expectation that you will receive a dollar in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for foregoing spending. For instance, you can invest your dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year.  You can say that thefuture value of the dollar is $1.06 given a 6% interest rate and a one-year period. It follows that the present value of the $1.06 you expect to receive in one year is only $1.
A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced payments or receipts promised in the future can be converted to an equivalent value today.  Conversely, you can determine the value to which a single sum or a series of future payments will grow to at some future date.
You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods, Payments, Present Value, and Future Value.  Each of these factors is very briefly defined in the right-hand column below.  The left column has references to more detailed explanations, formulas, and examples.

GUIDELINES FOR CORPORATE FORECASTING OF EXCHANGE RATES

 GUIDELINES FOR CORPORATE FORECASTING OF EXCHANGE RATES
 Academics and practitioners have sought the determinants of exchange rate changes ever since there were currencies. Many students have learned about the balance of trade and how the more a country exports, the more demand there is for its currency, and so the stronger is its exchange rate. In practice, the story is a lot more complex. Research in the foreign exchange markets have come a long way since the days when international trade was thought to be the dominant factor determining the level of the exchange rate. Monetary variables, capital flows, rational expectations and portfolio balance are all now understood to factor into the determination of currencies in a floating exchange rate system. Many models have been developed to explain and to forecast exchange rates. No model has yet proved to be the definitive one, perhaps because the structure of the worlds economies and financial markets are undergoing such rapid evolution.
 Corporations nevertheless avidly seek ways to predict currencies, in order to decide when and when not to hedge. The models they use are typically one or more of the following kinds: political event analysis, or fundamental, or technical.
 Academic students of international finance, in contrast, find strong empirical support for the role of arbitrage in global financial markets, and for the view that exchange rates exhibit behavior that is characteristic of other speculative asset markets. Exchange rates react quickly to news. Rates are far more volatile than changes in underlying economic variables; they are moved by changing expectations, and hence are difficult to forecast. In a broad sense they are "efficient," but tests of efficiency face inherent obstacles in testing the precise nature of this efficiency directly.
The central "efficient market" model is the unbiased forward rate theory introduced earlier. It says that the forward rate equals the expected future level of the spot rate. Because the forward rate is a contractual price, it offers opportunities for speculative profits for those who correctly assess the future spot price relative to the current forward rate. Specifically, risk neutral players will seek to make a profit their forecast differs from the forward rate, so if there are enough such participants the forward rate will always be bid up or down until it equals the expected future spot. Because expectations of future spot rates are formed on the basis of presently available information (historical data) and an interpretation of its implication for the future, they tend to be subject to frequent and rapid revision. The actual future spot rate may therefore deviate markedly from the expectation embodied in the present forward rate for that maturity. The actual exchange rate may deviate from the expected by some random error.
As is indicated in Exhibit 8, in an efficient market the forecasting error will be distributed randomly, according to some probability distribution, with a mean equal to zero. An implication of this is that today's forecast, as represented by the forward rate, is equal to yesterday's forward plus some random amount. In other words, the forward rate itself follows a random walk. Another way of looking at these errors to consider them as speculative profits or losses: what you would gain or lose of you consistently bet against the forward rate. Can they be consistently positive or negative? A priori reasoning suggests that this should not be the case. Otherwise one would have to explain why consistent losers do not quit the market, or why consistent winners are not imitated by others or do not increase their volume of activity, thus causing adjustment of the forward rate in the direction of their expectation. Barring such explanation, one would expect that the forecast error is sometimes positive, sometimes negative, alternating in a random fashion, driven by unexpected events in the economic and political environment.
Rigorously tested academic models have cast doubt on the pure unbiased forward rate theory of efficiency, and demonstrated the presence of speculative profit opportunities (for example, by the use of "filter rules"). However it is also logical to suppose that speculators will bear foreign exchange risk only if they are compensated with a risk premium. Are the above-zero expected returns excessive in a risk-adjusted sense? Given the small size of the bias in the forward exchange market, and the magnitude of daily currency fluctuations, the answer is "probably not."
 As a result of their finding that the foreign exchange markets are among the world's most efficient, academics argue the exchange rate forecasting by corporations, in the sense of trying to beat the market, plays a role only under very special circumstances. Indeed few firms are actively decide to commit real assets in order to take currency positions. Rather, they get involved with foreign currencies in the course of pursuing profits from the exploitation of a competitive advantage; rather than being based on currency expectations, this advantage is based on expertise in such areas as production, marketing, the organization of people, or other technical resources. If someone does have special expertise in forecasting foreign exchange rates, such skills can usually be put to use without incurring the risks and costs of committing funds to other than purely financial assets. Most finance managers of nonfinancial enterprises concentrate on producing and selling goods; they should find themselves acting as speculative foreign exchange traders only because of an occasional opportunity encountered in the course of their normal operations. Only when foreign exchange markets are systematically distorted by government controls on financial institutions do the operations of trading and manufacturing firms provide an opportunity to move funds and gain from purely financial transactions. Exhibit 9 offers a flowchart of criteria for forecasting and hedging decisions.
 Forecasting exchange rate changes, however, is important for planning purposes. To the extent that all significant managerial tasks are concerned with the future, anticipated exchange rate changes are a major input into virtually all decisions of enterprises involved in and affected by international transactions. However, the task of forecasting foreign exchange rates for planning and decision-making purposes, with the purpose of determining the most likely exchange rate, is quite different from attempting to beat the market in order to derive speculative profits.
 Expected exchange rate changes are revealed by market prices when rates are free to reach their competitive levels. Organized futures or forward markets provide inexpensive information regarding future exchange rates, using the best available data and judgment. Thus, whenever profit-seeking, well-informed traders can take positions, forward rates, prices of future contracts, and interest differentials for instruments of similar riskiness (but denominated in different currencies), provide good indicators of expected exchange rates. In this fashion, an input for corporate planning and decision-making is readily available in all currencies where there are no effective exchange controls. The advantage of such market-based rates over "in-house" forecasts is that they are both less expensive and more likely to be accurate. Market rates are determined by those who tend to have the best information and track-record; incompetent market participants lose money and are eliminated.
 The nature of this market-based expected exchange rate should not lead to confusing notions about the accuracy of prediction. In speculative markets, all decisions are made on the basis of interpretation of past data; however, new information surfaces constantly. Therefore, market-based forecasts rarely will come true. The actual price of a currency will either be below or above the rate expected by the market. If the market knew which would be more likely, any predictive bias quickly would be corrected. Any predictable, economically meaningful bias would be corrected by the transactions of profit-seeking transactors.
 

Example: Hedging with a Forward Contract Janet Fredericks, Foreign Exchange Manager at Murray Chemical, was informed that Murray was selling 25,000 tonnes of naphtha to Canada for a total price of C$11,500,000, to be paid upon delivery in two months' time. To protect her company, she arranged to sell 11.5 million Canadian dollars forward to the Royal Bank of Montreal. The two month forward contract price was US$0.8785 per Canadian dollar. Two months and two days later, Fredericks received US$10,102,750 from RBM and paid RBM C$11,500,000, the amount received from Murray's customer.

The importance of market-based forecasts for a determination of the foreign exchange exposure of the firm is that of a benchmark against which the economic consequences of deviations must be measured. This can be put in the form of a concrete question: How will the expected net cash flow of the firm behave if the future spot exchange rate is not equal to the rate predicted by the market when commitments are made? The nature of this kind of forecast is completely different from trying to outguess the foreign exchange markets

MANAGING ECONOMIC EXPOSURE

 MANAGING ECONOMIC EXPOSURE
6 (a) Economic Effects of Unanticipated Exchange Rate Changes on Cash Flows .
 From this analytical framework, some practical implications emerge for the assessment of economic exposure. First of all, the firm must project its cost and revenue streams over a planning horizon that represents the period of time during which the firm is "locked-in," or constrained from reacting to (unexpected) exchange rate changes. It must then assess the impact of a deviation of the actual exchange rate from the rate used in the projection of costs and revenues.
 

STEPS IN MANAGING ECONOMIC EXPOSURE 1. Estimation of planning horizon as determined by reaction period.  2. Determination of expected future spot rate.  3. Estimation of expected revenue and cost streams, given the expected spot rate.  4. Estimation of effect on revenue and expense streams for unexpected exchange rate changes.  5. Choice of appropriate currency for debt denomination.  6. Estimation of necessary amount of foreign currency debt.  7. Determination of average interest period of debt.  8. Selection between direct or indirect debt denomination.  9. Decision on trade-off between arbitrage gains vs. exchange risk stemming from exposure in markets where rates are distorted by controls.  10. Decision about "residual" risk: consider adjusting business strategy.

Subsequently, the effects on the various cash flows of the firm must be netted over product lines and markets to account for diversification effects where gains and losses could cancel out, wholly or in part. The remaining net loss or gain is the subject of economic exposure management. For a multiunit, multiproduct, multinational corporation the net exposure may not be very large at all because of the many offsetting effects.7 By contrast, enterprises that have invested in the development of one or two major foreign markets are typically subject to considerable fluctuations of their net cash flows, regardless of whether they invoice in their own or in the foreign currency.
 For practical purposes, three questions capture the extent of a company's foreign exchange exposure.
1. How quickly can the firm adjust prices to offset the impact of an unexpected exchange
rate change on profit margins?
 2. How quickly can the firm change sources for inputs and markets for outputs? Or,
alternatively, how diversified are a company's factor and product markets?
 3. To what extent do volume changes, associated with unexpected exchange rate
changes, have an impact on the value of assets?
Normally, the executives within business firms who can supply the best estimates on these issues tend to be those directly involved with purchasing, marketing, and production. Finance managers who focus exclusively on credit and foreign exchange markets may easily miss the essence of corporate foreign exchange risk.

WHAT IS ECONOMIC EXPOSURE

WHAT IS ECONOMIC EXPOSURE?
 PDVSA, the Venezuelan state-owned oil company, recently set up an oil refinery near Rotterdam, The Netherlands for shipment to Germany and other continental European countries. The firm planned to invoice its clients in ECU, the official currency unit of the European Community. The treasurer is considering sources of long term financing. In the past all long term finance has been provided by the parent company, but working capital required to pay local salaries and expenses has been financed in Dutch guilders. The treasurer is not sure whether the short term debt should be hedged, or what currency to issue long term debt in.
This is an example of a situation where the definition of exposure has a direct impact on the firm's hedging decisions.
Translation exposure has to do with the location of the assets, which in this case would be a totally misleading measure of the effect of exchange rate changes on the value of the unit. After all, the oil comes from Venezuela and is shipped to Germany: its temporary resting place, be it a refinery in Rotterdam or a tanker en route to Germany, has no import. Both provide value added, but neither determine the currency of revenues. So financing should definitely not be done in Dutch guilders.
Transactions exposure has to do with the currency of denomination of assets like accounts receivable or payable. Once sales to Germany have been made and invoicing in ECU has taken place, PDVSA-Netherlands has contractual, ECU-denominated assets that should be financed or hedged with ECU. For future sales, however, PDVSA-Netherlands does not have exposure to the ECU. This is because the currency of determination is the U.S. dollar.
Economic exposure is tied to the currency of determination of revenues and costs. Since the world market price of oil is dollars, this is the effective currency in which PDVSA's future sales to Germany are made. If the ECU rises against the dollar, PDVSA must adjust its ECU price down to match those of competitors like Aramco. If the dollar rises against the ECU, PDVSA can and should raise prices to keep the dollar price the same, since competitors would do likewise. Clearly the currency of determination is influenced by the currency in which competitors denominate prices.

The Management of Foreign Exchange Risk

1 (b) What is exchange risk?
Exchange risk is simple in concept: a potential gain or loss that occurs as a result of an exchange rate change. For example, if an individual owns a share in Hitachi, the Japanese company, he or she will lose if the value of the yen drops.
 Yet from this simple question several more arise. First, whose gain or loss? Clearly not just those of a subsidiary, for they may be offset by positions taken elsewhere in the firm. And not just gains or losses on current transactions, for the firm's value consists of anticipated future cash flows as well as currently contracted ones. What counts, modern finance tells us, is shareholder value; yet the impact of any given currency change on shareholder value is difficult to assess, so proxies have to be used. The academic evidence linking exchange rate changes to stock prices is weak.
 Moreover the shareholder who has a diversified portfolio may find that the negative effect of exchange rate changes on one firm is offset by gains in other firms; in other words, that exchange risk is diversifiable. If it is, than perhaps it's a non-risk.
 Finally, risk is not risk if it is anticipated. In most currencies there are futures or forward exchange contracts whose prices give firms an indication of where the market expects currencies to go. And these contracts offer the ability to lock in the anticipated change. So perhaps a better concept of exchange risk isunanticipated exchange rate changes.
 These and other issues justify a closer look at this area of international financial management.
2 SHOULD FIRMS MANAGE FOREIGN EXCHANGE RISK?
 Many firms refrain from active management of their foreign exchange exposure, even though they understand that exchange rate fluctuations can affect their earnings and value. They make this decision for a number of reasons.
First, management does not understand it. They consider any use of risk management tools, such as forwards, futures and options, as speculative. Or they argue that such financial manipulations lie outside the firm's field of expertise. "We are in the business of manufacturing slot machines, and we should not be gambling on currencies." Perhaps they are right to fear abuses of hedging techniques, but refusing to use forwards and other instruments may expose the firm to substantial speculative risks.
 Second, they claim that exposure cannot be measured. They are right -- currency exposure is complex and can seldom be gauged with precision. But as in many business situations, imprecision should not be taken as an excuse for indecision.
 Third, they say that the firm is hedged. All transactions such as imports or exports are covered, and foreign subsidiaries finance in local currencies. This ignores the fact that the bulk of the firm's value comes from transactions not yet completed, so that transactions hedging is a very incomplete strategy.
 Fourth, they say that the firm does not have any exchange risk because it does all its business in dollars (or yen, or whatever the home currency is). But a moment's thought will make it evident that even if you invoice German customers in dollars, when the mark drops your prices will have to adjust or you'll be undercut by local competitors. So revenues are influenced by currency changes.
 Finally, they assert that the balance sheet is hedged on an accounting basis--especially when the "functional currency" is held to be the dollar. The misleading signals that balance sheet exposure measure can give are documented in later sections.
 But is there any economic justification for a "do nothing" strategy?
 Modern principles of the theory of finance suggest prima facie that the management of corporate foreign exchange exposure may neither be an important nor a legitimate concern. It has been argued, in the tradition of the Modigliani-Miller Theorem, that the firm cannot improve shareholder value by financial manipulations: specifically, investors themselves can hedge corporate exchange exposure by taking out forward contracts in accordance with their ownership in a firm. Managers do not serve them by second-guessing what risks shareholders want to hedge.
 One counter-argument is that transaction costs are typically greater for individual investors than firms. Yet there are deeper reasons why foreign exchange risk should be managed at the firm level. As will be shown in the material that follows, the assessment of exposure to exchange rate fluctuations requires detailed estimates of the susceptibility of net cash flows to unexpected exchange rate changes (Dufey and Srinivasulu, 1983). Operating managers can make such estimates with much more precision than shareholders who typically lack the detailed knowledge of competition, markets, and the relevant technologies. Furthermore, in all but the most perfect financial markets, the firm has considerable advantages over investors in obtaining relatively inexpensive debt at home and abroad, taking maximum advantage of interest subsidies and minimizing the effect of taxes and political risk.
 Another line of reasoning suggests that foreign exchange risk management does not matter because of certain equilibrium conditions in international markets for both financial and real assets. These conditions include the relationship between prices of goods in different markets, better known as Purchasing Power Parity (PPP), and between interest rates and exchange rates, usually referred to as the International Fisher Effect (see next section).
 However, deviations from PPP and IFE can persist for considerable periods of time, especially at the level of the individual firm. The resulting variability of net cash flow is of significance as it can subject the firm to the costs of financial distress, or even default. Modern research in finance supports the reasoning that earnings fluctuations that threaten the firm's continued viability absorb management and creditors' time, entail out-of-pocket costs such as legal fees, and create a variety of operating and investment problems, including underinvestment in R&D. The same argument supports the importance of corporate exchange risk management against the claim that in equity markets it is only systematic risk that matters. To the extent that foreign exchange risk represents unsystematic risk, it can, of course, be diversified away -- provided again, that investors have the same quality of information about the firm as management -- a condition not likely to prevail in practice.
 This reasoning is buttressed by the likely effect that exchange risk has on taxes paid by the firm. It is generally agreed that leverage shields the firm from taxes, because interest is tax deductible whereas dividends are not. But the extent to which a firm can increase leverage is limited by the risk and costs of bankruptcy. A riskier firm, perhaps one that does not hedge exchange risk, cannot borrow as much. It follows that anything that reduces the probability of bankruptcy allows the firm to take on greater leverage, and so pay less taxes for a given operating cash flow. If foreign exchange hedging reduces taxes, shareholders benefit from hedging.
 However, there is one task that the firm cannot perform for shareholders: to the extent that individuals face unique exchange risk as a result of their different expenditure patterns, they must themselves devise appropriate hedging strategies. Corporate management of foreign exchange risk in the traditional sense is only able to protect expected nominal returns in the reference currency

Dividend Policy

Dividend policy

 refers to the policy chalked out by companies regarding the amount it would pay to their shareholders as dividend.

With profit making comes the question of utilizing the profit gainfully.

The companies have two options with them:

They can retain these profits within the company They can pay these profits in the form of dividends to their shareholders

The dividend policy to be adopted by the company is based on these two options. Once this is sorted out, a permanent dividend policy can be put into place. These policies shape the attitude of the investors and thefinancial market in general towards the concerned company. The policies are decided according to the current and future financial positions of the company. The preference and orientation of the investors are also taken into account. 

The following are the types of dividend policies:

• Constant Payout Ratio
• Constant Dollar Dividend Policy
• Regular with Extras

The dividend policy acts as a signal for investors for gauging the future earning possibilities as expected by the management of the company. The dividend policies are directed towards attracting investors to their company. This is termed as the clientele effect. The firms that hold back free cash flows are lesser in value than those firms, which allow free cash flows and pay dividends from them. 

There are quite a few impediments to companies paying dividends to their shareholders. Some of these constraints are as follows:

• Consideration of taxes
• Consideration of returns
• Contractual constraints
• Cash flow constraints
• Legal constraints

The dividend policy of a company has a relation with its common stock value. The Dividend Irrelevance Theory propounds that the dividend policy of a firm has no direct bearing on the cost of its capital or its value. The Dividend Relevance Theory, on the other hand, expostulates that the value of the firm is affected by its dividend policy. The Optimal Dividend Policy helps in increasing the value of the firm to the maximum.

A 

Dividend Reinvestment Plan

 (DRIP) provides the investor the opportunity to reinvest dividends obtained from the company back into the company. The firm can repurchase the existent shares or it may issue new shares.

source of finance and use

Long Term Sources of Finance

Long term sources of finance are those that are needed over a longer period of time - generally over a year. The reasons for needing long term finance are generally different to those relating to short term finance.

Long term finance may be needed to fund expansion projects - maybe a firm is considering setting up new offices in a European capital, maybe they want to buy new premises in another part of the UK, maybe they have a new product that they want to develop and maybe they want to buy another company. The methods of financing these types of projects will generally be quite complex and can involve billions of pounds.

It is important to remember that in most cases, a firm will not use just one source of finance but a number of sources. There might be a dominant source of funds but when you are raising hundreds of millions of pounds it is unlikely to come from just one source.

Shares

A share is a part ownership of a company. Shares relate to companies set up as private limited companies or public limited companies (plcs). There are many small firms who decide to set themselves up as private limited companies; there are advantages and disadvantages of doing so. It is possible, therefore, that a small business might start up and have just two shareholders in the business.

If the business wants to expand, they can issue more shares but there are limitations on who they can sell shares to - any share issue has to have the full backing of the existing shareholders. PLCs are different. They sell shares to the general public. This means that anyone could buy the shares in the business.

Merrill Lynch: a merchant bank that engages in large-scale deals to acquire sources of finance.

Some firms might have started out as a private limited company and have expanded over time. There might come a time when they cannot issue any more shares to friends or family and need more funds to continue expanding. They might then decide to become a public limited company. This is called 'floating the business'. It means that the business will have to go through a number of administrative and legal procedures to allow it to be able to offer shares to the general public.

It might be that a business wants to raise £300 million to finance its expansion plans. It might issue 300 million £1 shares in the company. The offering of these shares has to be accompanied by a prospectus which lays out details of the business - what it is involved in, how it is structured, how it will be managed and so on. This is so that prospective investors, people or institutions who might want to buy the shares, can get information about the company before committing to buying shares.

Often a business will employ the services of a merchant bank to help with a share issue. These institutions specialise in arranging large financial deals of this sort. Examples of such institutions are Morgan Stanley, Merrill Lynch, Rothschilds and Goldman Sachs. These institutions may agree to underwrite the share issue. What this means is that if all the shares are not sold, the institution will still provide all the money to the firm issuing the shares.

Once the shares are sold, share owners can buy and sell their shares through the stock exchange. Such buying and selling does not affect the business concerned directly and is one of the main advantages of the stock exchange. You can get more details of how the stock exchange works through our resource on the London Stock Exchange.

There may be times in the development of a plc when it needs to raise more funds. In this case it can issue more shares. Many firms will do this through what is called a 'rights issue'. This occurs where new shares are issued but existing shareholders get the right to purchase new additional shares at a reduced price. If the business is doing well and the new finance is needed for expansion, this can be an attractive proposition for existing shareholders. For the business it is a relatively quick and cheap way of raising new funds.To gain extra finance a business can take out a loan from a bank or other financial institution. A loan is a sum of money lent for a given period of time. Repayment is made with interest. The lender of money needs to know all the business opportunities and risks involved and will therefore want to see a detailed business plan. The lender may also want some form of security should the business run into financial difficulty, and may therefore prefer to provide a secured loan.

Another way of raising short-term finance is through an overdraft facility with a bank. The borrower is given permission to take out more from their account than they have put in. The bank fixes a maximum limit for the overdraft. Interest is charged on the overdraft daily.

Businesses may also qualify for grants. Government and private funds are sometimes made available to businesses that meet certain conditions. For example, grants and loans may be available to firms setting up in rural areas or where there is high unemployment.

A small business can also attract extra finance by taking on a partner or by selling shares. The problem caused by bringing in extra people is that profits have to be shared.

A further way of raising capital that has become popular is that of venture capital. Larger businesses with cash to spare have been putting funds into small- and medium-sized enterprises.

Once a business is up and running there are various ways of financing its expenditures. Expensive items of equipment can be leased. Rather than buying the equipment the business hires it from a leasing company. This saves having to lay out sums of money and the business does not have to worry about having to carry out major repairs itself. Motor vehicles, machines and office equipment are often leased.

Hire Purchase is an alternative way of purchasing items of equipment. With a leased item you use and pay for the item but never own it. With hire-purchase you put down a deposit on an item and then pay off the rest in instalments. When the last instalment has been paid you become the owner of the item.

Another common way in which firms can finance their business in the short term is through trade credit. In business it is common practice to purchase items and pay for them later. The supplier will normally send the purchaser a statement at the end of each month saying how much is owed. The buyer is then given a period of time in which to pay.

Large companies like Argos will raise finance in a variety of different ways. Not only do they raise capital from shareholders, but they also take out loans from banks to finance major capital projects. Capital equipment such as vehicles and computers may be leased. In turn these companies will provide