IMAS CLASS NOTES Fundamentals of Business Economics - PowerPoint Presentation

1. IMAS CLASS NOTESFundamentals of Business EconomicsBA1IMAS1

2. Syllabus structureIMAS2

3. ExaminationObjective test questionsMCQFill in questionsMatch questionsChoose questionsTrue/ False questionsRanking IMAS3

4. Section A Macroeconomic and Organisational Context of Business 25%IMAS4

5. Chapter 1: The Goals and Decisions of OrganisationsWhat is an organisation:-social arrangements for controlled performance of collectives goals.Key words in the defination Collective goals Social arrangements Controlled performanceIMAS5

6. Why do we need OrganisationOrganisations enable people to: Share skills and knowledgeSpecialise andPool resourcesIMAS6

7. Classifying OrganisationsBy Profit Orientation - Profit seeking Organisations - Not-for-profit Organizations (e.g mutual organisation)By Ownership/Control - Public Sector Organisations - Private Sector OrganisationsIMAS7

8. Shareholder wealthMaximising Shareholder WealthThis is reflected in Higher share priceHigher dividend paymentsIMAS8

9. Shareholder’s wealthThree key issues when attempting to measure and increase the Shareholders wealth: Cash is preferable to profitExceeding the cost of capitalManaging both short- and long-term prospects(Supplementary reading illustration on page 10 textbook)IMAS9

10. Measures of financial performanceShort-term:ROCERONAEPSLong-term:Discounting and Investment Appraisal (To Discuss later)IMAS10

11. Share valueThe concept of discounted cash flows can be used to explain how press releases and market rumours can affect the share price.There are many variables that will affect the share price, and they fall into two groups:Factors external to the business.Factors internal to the business.IMAS11

12. Stakeholders “Those persons and organisations that have an interest in the strategy of an organisation”.Stakeholder interest – “an interest or concern that a stakeholder has in an organisation”.Stakeholder influence – “the level of involvement that a stakeholder has in the functions of an organisations”.The degree of interest and influence of different stakeholders vary considerably.IMAS12

13. Stakeholder groupsInternal Stakeholders – intimately connected to the organisation, and their objectives are likely to have a strong influence.(e.g employees, management/directors)Connected Stakeholders – those with a contractual relationship with the organisation. (e.g finance providers, suppliers, shareholders)External Stakeholders – all other outside stakeholders, who have diverse objectives and varying influence on the organisation. (e.g Government, trade unions, pressure groups)IMAS13

14. Stakeholder ConflictThe needs/expectations of the different stakeholders may conflict. For example:Employees Vs Managers – Wages Vs Cost efficiencyCustomers Vs Shareholders – Product quality Vs Profits/dividendsGeneral public Vs Shareholders – Effects on the environment Vs profitsManagers Vs Shareholders – Growth Vs IndependenceSolving these will often involve a mixture of comprise and prioritisation.IMAS14

15. Stakeholder conflict for NFPsNPFs don’t have a dominant stakeholder in most cases and as such they seek to satisfy several different groups at once, without one core objective, such as, profit, to focus on.This makes the decision making for NPFs to be more challenging as they seek to satisfy different stakeholders at once. In most cases they end up trying to quantify all the different issues financially to see if the benefits outweigh the costs (cost-benefit analysis)IMAS15

16. Management ObjectivesThe most important stakeholder conflict is that between shareholders and the managers.The principle agent problem – the problem posed by the agency theory is how can the principal ensure that the agent will behave in such a way as to achieve the aims and intentions of the principal?In a company:Principals – the shareholdersAgents – board of directors/senior managementIMAS16

17. Principal agent problemThe management will have to balance the interest of different stakeholders in the company.On top of that the management may have its own objectives which are in conflict with the shareholders’ interests(profitability). For example:SalariesNon-salary benefits (perks)PowerStatus and PrestigeSafety and SecurityIMAS17

18. Other areas of conflictThe common short term objectives of the management:Sales maximization (Baumol)Growth maximisation (Marris)Satisfying (Simon)IMAS18

19. Other possible areas of conflict‘Fat cat’ salaries and benefits.Mergers and acquisitions.Poor control of the business. (e.g Enron and WorldCom scandals)Short-termismIMAS19

20. How to resolve this conflictAttempts to resolve this conflict can take a number of forms:Corporate governanceA review of the remuneration and bonus schemes given to directors(e.g share options)IMAS20

21. Corporate governance“the system by which companies and other organisations are directed and controlled”Corporate governance is concerned with improving the way companies are governed and run.It seeks to address the principal agent problem.IMAS21

22. Corporate Governance main objectivesTo control the directors by increasing amount of reporting and disclosure.To increase level of confidence and transparency in company activities for all investors and thus promote growth.To increase disclosure to all stakeholdersTo ensure that the company is run in a legal and ethical manner.To build in control at the top that will cascade down the organisation.Corporate governance enables an organisation to relate to its external environment.IMAS22

23. Corporate Governance principlesTypical aspects include:The board of directors should meet on a regular basis.Active responsibilities at board level should be spread over the board (especially the roles of Chairperson and Chief Executive)Directors should have limited contracts.All directors reward and payments should be publicly disclosed.There should be three sub-committees: an audit committee, a nominations committee and a remuneration committee.Greater use should be made of non-executive directors with no direct financial interest in the company, especially on the sub committees.The annual accounts should contain a statement, approved by auditors, that the business is financially sound and is a going concern.IMAS23

24. Chapter 2: The Market SystemSince resources are scarce, it is not possible to make everything everyone would want. As such every society is faced with a fundamental economic problem:What goods and services to produce?In what quantities?Who should make them?Who gets the output?IMAS24

25. How to solve this economic problemThere are three main Economic Systems to solve this problem:A market economy – interactions between supply and demand determines what happens in the economy.A command economy – productions decisions are controlled by a central government.A mixed economy – a combination of the above (Most modern economies are now mixed economies)IMAS25

26. Market forces of Demand and SupplyIn a free market the quantity and price of goods supplied in a market are determined by the interaction between supply and demand.We will look closely at these market forces and see how they determine the price in the market.It is important however to note that these forces at times they don’t always give us the desired results in the market (market failure), In such instances the Government will then have to intervene.IMAS26

27. DemandIndividual demand shows how much of a good or service someone intends to buy at different prices. Market demand shows the total amount of all individual demands in the market.For demand to be effective it has be backed by available money.The key words in the definition of demand is willingness and ability.The main determinant which affects demand is price, and this relationship between price and demand can be shown on a graph, which is referred to as the demand curve (a negative sloping graph, because of the negative relationship between price and demand).For most goods, the lower the price, the higher will be its demand.IMAS27

28. Conditions of demandWhen we were looking at the influence of price on demand, we assumed that other factors were being held constant. These factors are called conditions of demand. We now look at them, with price held constant. The main conditions of demand are:IncomeTastesPrice of other goodsPopulationIMAS28

29. Movements and Shifts of demandWhen the demand of a good or service changes in response to a change in price, this is referred to as a movement in demand:An expansion when the quantity demanded rises.A contraction in demand when the quantity falls.Changes in any of the conditions of demand will create shifts in the demand curve (movement of the whole curve):Increase in demand if the shift is to the right (outward).Decrease in demand if the shift is to the left (inward).Note: Change in price – Movement along the same demand curve.Change in conditions – A shift of the demand curve to create a completely new curve.IMAS29

30. Elasticity of demandElasticity refers to the relationship between two variables and measures the responsiveness of one (dependent) variable to a change in another (independent) variable.Price elasticity of demand shows the responsiveness (sensitiveness) of demand to a change in price.The co-efficient is calculated as follows:- PED = % change in quantity demanded ÷ % change in price.This co-efficient is always negative because of the negative relationship between price and quantity demanded.IMAS30

31. Methods of calculating PEDThere are two ways of calculating PED using the Arc method:Non average arc method – measures % change in price/5 change in quantity using the starting point of price and quantity as the basis for the % calculation.Average arc method – measures % change in price/% change in quantity using the average price and quantity as the basis for the % calculation.Illustration 1 (PED) page 39 in the textbookIMAS31

32. PED Coefficient valuesPerfectly inelastic – 0 – Exist in theoryRelatively inelastic – between 0 and -1 – tea, saltUnit Elasticity - -1 –Relatively elastic – between -1 and infinity – cameras, air travelPerfectly elastic – infinity – Exists in theoryNote The position of the demand curve is important, a curve further from the origin is usually less elastic. The part which is selected on the demand curve is also important, the further down the demand curve the more inelastic the demand becomes.IMAS32

33. Factors that influence PEDProportion of income spent on the good. (small portion-inelastic/ large portion-elastic)Substitutes. (available substitutes-elastic/ no substitutes-inelastic)Necessities. (necessities-inelastic/ luxury-elastic)Habit. (habit/addictive goods are inelastic e.g cigarettes)Time. (short run-inelastic/ long run-elastic)Definition of market. (widely defined-inelastic/narrowly defined-elastic)IMAS33

34. Link between PED and total revenueThe PED can also be calculated by analysing the total revenue (a tool usually used by managers):-If total revenue increases following a price cut, then demand is price elastic (the opposite is true).-If total revenue increases following a price rise, the demand is price inelastic (the opposite is trueIMAS34

35. SupplySupply refers to the quantity of a product that producers would be willing to offer for sale at different prices. (Rational producers aim to make a profit).Market supply is the aggregate supply of all the individual producers in the market.The law of supply states that an increase in price will lead to an increase in the quantity supplied. This relationship between price and quantity supplied can be shown on a graph (Supply curve), which is an upward sloping curve, because of the positive relationship between the variables.IMAS35

36. Conditions of Supply: A decrease in SupplyHigher production cost (maybe caused by an increase the cost of Factors of production).Indirect taxes – makes supply at existing prices less profitable (also contribute to an increase in the cost of production).IMAS36

37. Conditions of Supply: An increase in supplyTechnological innovationsMore efficient use of existing factors of productionLower input prices (e.g cheaper raw material imports)Reduction or abolition of an indirect tax/introduction or increase in subsidiesIMAS37

38. Price elasticity of SupplyThe Price Elasticity of Supply shows the sensitivity of quantity supplied to a change in price, and it is calculated as follows: PES = %change in quantity supplied ÷ %change in priceThe PES will always be positive because of the positive relationship between price and quantity supplied.IMAS38

39. The coefficient of PESIf a change in price leads to a large change in quantity supplied the PES will have a value of more than 1, and supply will be price elastic.If a change in price leads to an equal change in quantity supplied the PES will have a value of 1, and supply will be unit elasticity.If a change in price leads to a smaller change in quantity supplied the PES will have a value of less than 1, and supply will be price inelastic.IMAS39

40. Factors that influence PESTime (short run-inelastic/long run-elastic)Factors of Production (available factors of production-elastic)Stock levels (high stock levels-elastic/ low stock levels-inelastic)Number of firms in the industry (many firms-elastic/ few firms-inelastic)IMAS40

41. Price MechanismIf the demand of consumers and supply plans of sellers are the same then the market is said to be in equilibrium. This is the point where the demand curve intersects with the supply curve, and this is the point where the equilibrium price and equilibrium quantity is determined.IMAS41

42. Excess supply and excess demandAt a price above the equilibrium price, there tend to be a market surplus since sellers will be willing to sell more than what the consumers will be demanding.(reduced orders, returns to suppliers)At a price below the equilibrium price, there tend to be a market shortage since consumers will be demanding more than what the sellers are willing to sell. (Queues, increased orders,)However the market has the ability to correct itself until it gets back to the equilibrium position again. This is what is called the Price Mechanism which can be used in determining the price levels in different scenarios (other markets) e.g Interest rates in the economy, exchange rates.IMAS42

43. Shifts in Supply and DemandPrice can act as a stimulant in a market, by attracting producers to divert resources to that particular market.The equilibrium point is a temporary position which will change if there are changes in any of the conditions of demand or supply. The more inelastic the demand or supply curves the greater the price changes.The long term effects of these changes in the market depend upon the reactions of the consumers and producers.IMAS43

44. Interference with Market PricesThere are cases where by the equilibrium price set by the forces of demand and supply is not the most desirable price. In those cases the government will need to set the prices either above or below the market equilibrium price.IMAS44

45. Minimum Prices (Price Floors)This is a situation where by the gvt sets a minimum price in the market, usually above the equilibrium price. It can do this by providing subsidies to producers or by setting a legal minimum price level (e.g minimum wages). If applied to goods markets this will lead to market surpluses.Effects of minimum prices:Excess supplyMisallocation of resourcesWaste of resourcesIMAS45

46. Maximum Prices (Price Ceilings)This is a situation where by the gvt maximum price controls on certain goods or services either to benefit low income earning consumers or to control inflation. Maximum price controls are set below the equilibrium price in the market. Price ceilings lead to shortages within the market.Effects of maximum prices:Shortages of supplyUnfair/Arbitrary ways of allocating a productCheap quality productsMisallocation of resourcesIMAS46

47. Market failureIn theory market forces are supposed to result in the optimum allocation of resources, however this is not always the case. When markets fail to effectively allocate resources it is called Market Failure.The gvt will then intervene to make sure that the market functions properly.IMAS47

48. Market failure: Public Goods Without the gvt intervention in the market certain goods would not be produced by the private firms, these good are called public goods and the have the following characteristics:Non-excludability (free-rider concept)Non-rivalryIMAS48

49. Market failure: ExternalitiesThese are social costs or benefits (Spill-over effects) that arises from the production or consumption of a product or service and are not borne by the producers or consumers of a product.-Social costs- Negative Externalities-Social benefits- Positive ExternalitiesThe gvt uses indirect taxes, quotas and subsidies to control and regulate externalities.IMAS49

50. Market failure: Merit goodsThese are goods or services which have positive externalities, and they should generally be available to anyone no matter the income earning bracket (eg education, health services).Merit goods are usually underprovided because:Of ignorance of the consumers of the private benefits.Failure of the market to reflect the social benefits.Excessive prices limiting access to these servicesIMAS50

51. Market failure: Demerit goodsIMAS51These are goods which are socially undesirable, degrading because of the perceived effects on the consumers themselves (e.g tobacco, gambling).The gvt usually regulate or ban consumption of demerit goods, by charging high taxes or banning advertising of such products.

52. Market Failure: Unfair Competition (Competition policy)The other form of market failure is that of large businesses. If they go unchecked, market forces may result in powerful companies who can abuse their market power and charge high prices to consumers. The government thus need to intervene.Scope of regulation: There are three aspects:Mergers and acquisitions (Competition and Markets Authority)Restrictive trade practices (Competition and Markets Authority)State created regional monopolies (Specific Industry Regulators)IMAS52

53. Economies of Scale (Increasing returns to scale)Economies of scale are reductions in unit average costs caused by increasing the scale of production in the long run.Diseconomies of scale are an increase in unit average costs caused by increasing the scale of production in the long run. Managers should understand whether economies of scale exist or not in their industry or not, and the extent and nature of such economies. If they exist the firm should take advantage and produce at a lower cost, thus able to charge lower prices than small competitors. This can act as a barrier of entry for other firms as well.However the firm should not grow for growth’s sake as diseconomies of scale will set in.IMAS53

54. When advantages of expanding scale occurs to one firm they are known as internal economies of scale, and the main internal economies are as follows:Technical economiesFinancial economiesTrading economiesManagerial economiesIt is also possible for general advantages to be obtained by all of the firms in an industry, and these are known as external economies of scale. These often occur when an industry is heavily concentrated in one area.The area may develop a reputation of success.Specialised training may be provided locally in accordance to the industry’s needs.Specialist supply of raw materials.Firms in an industry may share their research and development facilities.IMAS54

55. Diseconomies of scaleIf they are specific to one firm they are categorised as internal.Technical diseconomiesTrading diseconomiesManagerial diseconomiesHowever general disadvantages can also arise which will affect all the firms in the industry (external diseconomies).A shortage of labour might lead to higher wages to attract new recruits.Shortage of raw materials might lower output.IMAS55

56. Chapter 3: The Financial SystemThe Financial SystemThis is an umbrella term which covers the following:Financial markets eg stock exchange, money markets.Financial Institutions eg banks, building societies, insurance companies, pension funds.Financial assets and liabilities eg mortgages, bonds, bills and equity shares.IMAS56

57. Financial MarketsAre divided into different types depending on the products being traded:Capital Markets – Stock markets for shares and bond markets.Commodity Markets – trading of commodities eg oil, metals.Derivatives Markets – instruments for the management of risk eg options and future contracts.Insurance Markets – distribution of various risks.Foreign Exchange Markets – trading of foreign exchange.IMAS57

58. Financial IntermediariesWithin each sector in the economy there are times when there are cash surpluses and times when there are deficits.Faced with a desire to lend or borrow, there are three choices:Lenders and borrowers to contact each other directly.Lenders and borrowers use an organised financial market.Lenders and borrowers use financial intermediaries.IMAS58

59. Roles of Financial IntermediariesRisk reductionAggregation (pooling of small individual deposits)Maturity transformationFinancial intermediation (brings together lenders and borrowers)IMAS59

60. Liquidity Surplus and DeficitsThe lack of synchronisation between payments and receipts affects individuals, businesses and governments.IMAS60

61. HouseholdsHousehold’s income comes in many forms. The main ones being Wages and Salaries, Income from investments, property and savings and Social security and Pension fund. The flowing of these incomes tends to be regular but not continuous.Short-termConsumption tents to be continuous and irregular, however some payments match receipts.Households can retain some cash to meet day to day expenditure, use credit cards, save in times when receipts exceed payments. (They do this through the services of financial intermediaries). Medium-termInfrequent purchase of expensive items such as consumer durables, holidays, medical bills. These are usually unrelated to the flows of income.Households can either save before purchasing or borrow and repay over a period of time. (They will be using financial instruments as well). Long-termEven in the long run there may be a mismatch between payments and receipts. Long-term payments include housing property, savings for pensions.The can make use of a different range of specialist mortgages or pension products (to generate income when they retire).IMAS61

62. Finance for BusinessesThere is a wide range of financial instruments which businesses can choose from when they want to raise funds to finance their activities.Short-term instruments should be chosen to finance short term needs.Long-term instruments should be chosen to finance long term needs.When investing surplus funds a balance should also be there between profitability and the periods when the funds will not be needed.IMAS62

63. Short-term and medium-term InstrumentsThese are typically acquired from the money markets and they include:Short-term bank loans and overdraftsBills of exchange (usually 3-6 months)Trade creditLeasing and hire purchaseCommercial paper which are debt securities issued by companiesIMAS63

64. Long-term instrumentsThere are basically 2 forms of long term finance.Equity finance (issue of shares)Debt finance (eg long term commercial paper, preference shares)Its easy for listed companies to secure funding on financial markets but it is extremely difficult for small and starting businesses to secure funds as such governments in different countries are creating initiatives designed to meet the financial needs of these small businesses.IMAS64

65. Financial productsThere are a wide range of contracts and financial instruments issued by financial institutions for lending/borrowing. Issues to consider when choosing the product to use are:Yield(Revenue)/CostRisk (the main determinant of cost/yield)The amount involved/divisibilityThe time period the funds are required/available forLiquidity (how easy is it to sell the asset)Transaction costIMAS65

66. Capital and Money marketsTime to maturity has been used to distinguish between capital and money markets.Capital Markets - matures after more than a year eg equities, bonds and mortgages.Money Markets – matures in less than a year eg Certificates of deposit, Bills of exchange.IMAS66

67. Ordinary Shares (Equity)Ownership of a company is usually conveyed via ordinary shares. Ordinary shareholders have voting rights as well. Shares have a nominal or par value which is usually different from the market value of the shares. Returns – potentially high returns if company is profitable (dividends/increase in value of shares).Risk – carry a high risk.Timescales – long-term since companies usually do not have an intention of buying back shares.Liquidity – for unquoted companies hard to sell but for quoted companies they are liquid.IMAS67

68. Other types of financial productsBondsCertificate of depositMortgagesBills of exchangeCredit agreementsIMAS68

69. Yields on Financial ProductsEquityThe total return to shareholders will include both dividends and growth in share price. Dividend yield = dividends per ordinary share x 100/ market price of the sharesIMAS69

70. Yields on Financial productsBondsThere are different ways of calculating the yield on bonds:The bill rate (coupon rate)This rate does not consider the market value or capital gains/loss on redemption.Running yield(interest yield) = annual interest x 100/market value This rate takes into account the market value of the bond but not the impact of capital gain/loss on redemption.The Gross redemption yield.This gives the overall return to the investor and includes both the interest and capital gains/losses.IMAS70

71. The role of riskThe main determinant of the overall yield to an investor is the perceived risk.Risk determines required return, which determines the market value. Lenders in the financial markets normally demand higher interest rates on loans as the terms (length of time) to maturity increases. The longer the term of security, the higher the Gross Redemption yield.IMAS71

72. Term structure of interest ratesIt is cheaper to borrow on a shorter term than on a long term. This is because the longer the period the higher the risk and as such the lender will ask for higher returns.However most firms still borrow on a long term, the main reasons being:Risk – the long term borrowing can be arranged at a fixed rate for the whole term.The arrangement fees will be higher for short term borrowings.IMAS72

73. The role of credit rating agenciesAnother way of linking risk and yield structures for bonds is through credit rating agencies.If company wants to assess whether a firm that owes them money is likely to default on the debt, they make use of credit rating agencies. They provide this information to potential investors, regulators of investing bodies and the firm.IMAS73

74. Factors usually consideredMagnitude and strength of the company’s cash flows.The size of the debt in relation to the asset value of the firm.The volatility of the firm’s value.The length of time the debt has to run.IMAS74

75. Understanding Interest ratesThough there are many different interest rates, there is a rate which the central bank would lend to the money market, based on the Treasury bill rates. It is called the base rate.IMAS75

76. Real and nominal interest ratesReal interest rate is the rate which is adjusted for inflation while the nominal or money rate is actual interest rate before allowing for inflation.The real interest rate is the most important rate and the one used for decision making.When the nominal rate of interest is higher than the rate of inflation there will be a positive real rate. (borrowers will be losing in real terms but savers will be gaining).And the opposite is true.IMAS76

77. Financial intermediariesThey basically split into 2 types:Deposit-taking institutions (DTIs) eg banks and building societiesNon-deposit-taking institutions (NDTIs) eg insurance companies, pension funds, unit trusts and investment trusts.The deposits in DTIs forms bulk of a country’s money supply, thus DTIs are more important to the government and as such they are subject to more regulation.IMAS77

78. Banks There are 2 main activities for banks: Commercial banking done by retail or commercial banks and Investment banking done by wholesale or investment banks.IMAS78

79. Retail banksRetail/Commercial banksTheir main activities are:Safeguarding customers’ monies – in Deposit (time) accounts, where depositors receive interest for storing their money and Current (sight) accounts, where the interest rate is a bit low and customers can be given chequebook facilities.Transferring Money – Banks can move money between different branches or between different banks through the cheque clearing system. Each bank has an account at the central bank and there is a daily clearing system which is used to transfer net amounts to the different respective bank accounts.Lending money – Banks realises that a small proportion of the deposits was required daily; as such they decided to lend some of it and charge an interest.Facilitating Trade – modern banks provide services which facilitates easier trading eg accepting commercial bills, financial advisory to businesses and provision of foreign exchange.IMAS79

80. Wholesale BanksThe most common of these banks are merchant banks and overseas banks operating in countries other than their own.Merchant Banks:They bring together lenders and borrowers of large sums of money.They operate in high risk areas in industries and commerce, and can at times borrow from each other through the inter-bank market.Advise companies on money management.Negotiate bills of exchange.Underwrite the launching of new shares.Supervising company takeovers on the stock market.Guarantee commercial bills for companies.Overseas banks:Finance overseas trade.International capital movements.International currency transactions.IMAS80

81. Non-bank financial intermediariesThese institutions are not officially authorised by the central bank although they are informally watched. They perform banking tasks eg Building societies (they tend to borrow short and lend long through mortgagesMost building societies have changed into banks in recent years.There has been also a growth of financial conglomerates, where financial institutions are now branching into non-traditional lines of business and diversifying. As such the distinction between banks and building societies has become blurred. Many other financial institutions exist:Investments and unit trusts – invest customers’ savings usually in company shares.Pension funds – accept savings to provide retirement pensions in the future.Insurance companies – invest income into assets such as shares and property.Finance companies – provide medium term credit for businesses and customers, others act as leasing companies.IMAS81

82. Credit creationBanks create credit as a way of making profit. They can do this since not all of the cash that is deposited at the bank is regularly drawn, so they lend some of the cash deposited. Furthermore some of that lent out money is deposited back in the bank again, and this provides more cash reserves.They discovered that at most 10% of the deposited money will be withdrawn leaving the rest for loans and investments (this percentage is known as the cash ratio).The process of credit creation can continue as long as the ratio of cash/liquid assets to total deposits is maintained.Deposit multiplier/Credit multiplier refers to the amount by which total deposits can increase as a result of the bank acquiring additional cash, this amount is the reciprocal of the cash ratio:  Change in total deposits = 1 x the initial cash deposit/cash ratioIMAS82

83. The amount of credit that banks can create depends on two factors:The cash and near cash liquid assets they hold.The size of the credit multiplier.IMAS83

84. Central banksAll countries have a central bank, and these are normally government owned organisations.The main functions of central banks vary a little from country to country, however thee are some common functions for these organisations.IMAS84

85. Main functions of Central BanksBanker to banks (lender of last resort, facilitates transfers between banks)Banker to the government (Accounts for gov dpts, debt management, monetary policy, runs reserves of foreign currency)Supervision of the banking system (Ensures banks have sufficient capital, ensuring that banks have day-to-day cash requirements)Note issueIMAS85

86. Central banks and monetary policyThe Central Bank can alter interest rates by selling or buying bank government stock.The central bank buys and sells treasury bills and commercial bills, and government bonds in the money market.This is known as Open Market Operations.Through this activity the government can either restrict or increase the credit creating abilities of banks.IMAS86

87. Quantitative EasingThe government can control growth in an economy by raising or lowering interest rates.But when interest rates are almost zero, central banks need to adopt different tactics – such as pumping money directly into the economy.This is known as Quantitative Easing or QEThe central bank buys assets, usually government bonds, with the money it has printed or generate electronically. This will increase the amount of cash in the system. This will encourage financial institutions to lend more leading individuals and businesses to spend more, thereby increasing growth the economy.IMAS87

88. Financial MarketsMoney markets (Discount houses)Stock markets (Security markets, Alternative Investment Market, Bonds/Gilts market)IMAS88

89. Financial MarketsMoney markets (Discount houses)Stock markets (Security markets, Alternative Investment Market, Bonds/Gilts market)IMAS88

90. Chapter 4 Macroeconomic and Institutional Context 1: The Domestic EconomyIMAS90

91. The Macroeconomics and the government policy goalsMacroeconomics focuses on the working of the economy as a whole, and it includes issues such as:The total (aggregate) demand for goods and servicesNational OutputThe supply of Factors of ProductionTotal income earned by the owners of Factors of Production (National Income)Money spent on buying the national output (National Expenditure)Government policyIMAS91

92. Government macroeconomic policyThe basic objectives of government:Economic GrowthInflationUnemploymentBalance of paymentsIMAS92

93. Other factors that constraints government policyPrevious policies which cannot be abandoned or altered.Information which is always limited and imperfect.Time lag between the design, implementation and effect of policy.Political limitations.IMAS93

94. The circular flow modelSymbols used in the circular flow model:Y – National incomeC – ConsumptionS – SavingsI – InvestmentT – TaxationG – Government expenditureX – ExportsM – ImportsIMAS94

95. Simple economyIn a simple economy will be having the Firms (Producers) and the Households (Consumers) only, without the government or without trading with other countries.We assume that the households use all their income to buy goods and services. The economy will be equilibrium where consumption (aggregate demand) equals income: Consumption = Income  Assuming also that total expenditure is made up of Consumption therefore: Expenditure = IncomeIMAS95

96. Circular Flow model: Diagram illustrationHouseholds – ConsumptionFirms/Businesses – InvestmentGovernment – Government expenditureForeign Sector - ExportsIMAS96

97. Injections and WithdrawalsIn a realistic model the economy can experience injections and withdrawals:Injections – these are additions to expenditure from outside the circular flow, and they boost the circular flow. They include: Exports, Government Expenditure, and Private sector Investment.Withdrawals – these are leakages of income out of the circular flow. They include: Imports, Taxations and Savings.IMAS97

98. Injections and Withdrawals: EquilibriumEquilibrium: The economy fully using its resources will move towards the position of rest, or equilibrium where planned injections should be equal to planned withdrawals: Injections (J) = Withdrawals (W) OR I + G + X = S + T + MIf injections are more than withdrawals, the level of national income will increase.If withdrawals are more than injections, the level of national income will fall.However this growth or fall does not continue forever.IMAS98

99. Understanding the components of the circular flow of fundsIMAS99

100. ConsumptionThe spending in the circular flow by consumers is called Consumption (C) and the most important determinant of Consumption is the level of income. The extent to which consumption changes with income is called Marginal Propensity to Consume (MPC). MPC = change in consumption/change in income The MPC varies considerably between countries.IMAS100

101. Factors affecting household consumptionIncome – consumption is usually based on current income or expected income.Wealth – at a personal level an increase in wealth leads to an increase in consumption, while at national level a fair distribution of wealth leads to an increase in consumption.Government policy – taxation and government spending also affects consumption.The cost and availability of credit – the cheaper and the greater the availability of credit the more likely consumption will occur.Price Expectations – if price increases are expected in the future this can temporarily increase MPC now.These factors are objective influences, however we other factors which are subjective which depends on an individual behaviour.IMAS101

102. Savings (S)This is the amount of income not spend or residual income after consumption has been determined.IMAS102

103. Factors influencing savingsIncome – both on the individual and national level.Interest rates – if people are saving to earn interest, an increase in the interest rate will mean people will save more since they can now get more income through saving.Inflation – The rational consumers will consider the real interest rates (adjusted for inflation) not the nominal interest rates (unadjusted for inflation) before they consider to save more.Credit – when credit is easily available consumers can acquire as much credit as they are saving.Contractual savings – most saving are contractual and regular such as payments into pension funds.Most savings are done by households and firms, governments save when they run budget surpluses and dis-save when they run budget deficits.IMAS103

104. InvestmentExpenditure on investment covers:Fixed Capital Formation (eg plant, equipment, machinery, roads)The value of physical increase in stocks of Raw materials, Work In Progress and Finished Goods.The Capital Stock of the economy is increased by the amount of Net Investment undertaken in that year. Net Investment is the difference between Total Investment and Replacement Investment (Capital Consumption).IMAS104

105. Factors influencing InvestmentExpectations about future cash flows – anticipated revenue from the output of the investment compared with the anticipated cost of investment.The business cost of capital – the availability and cost of capital as well as risks associated with the cash flows.The state of business confidence – if business are optimistic they will invest more if they are pessimistic they will invest less.Technological innovations – If capital becomes more productive this is likely to increase the level of investment. The Marginal Efficiency of Capital calculates the return on funds invested and should exceed the interest rate for the investment to be worthwhile.Government Policy – Inconsistent and varying economic policies increases business uncertainty and negatively affects investment. On the other hand reduction on corporate tax and improved tax allowances will encourage investment.IMAS105

106. Linkages between the Elements of the circular flowIMAS106

107. The AcceleratorThis principle views investment as a function of changes in national income. When national income rises, desired consumption will increase, and firms will respond by investing in new capital goods to meet this increase in demand.The opposite is true, when there is a decrease in national income will lead to a reduction in investment.IMAS107

108. The MultiplierIt shows a change in national income resulting from a change in planned investment, government spending or exports (effects of injections to the circular flow).  A change in injections can cause a more than appropriate increase in National Income. An initial injection of additional expenditure in the circular flow will lead to a series of additional rounds of expenditure.IMAS108

109. Determinants of the MultiplierEach succeeding round of spending becomes smaller and smaller, as some of the income is lost through withdrawal eg Marginal Propensity to Save (MPS). In a simple economy the only withdrawal will be savings.The value of the multiplier is calculated as follows: K = 1/1-MPC = 1/MPSIMAS109

110. Explaining Trade CyclesThere are a number of explanations for Trade Cycles; however the accelerator and the multiplier effects have also been used to explain the Trade Cycles: Something happens to boost investment eg Innovation, this increase in investment will trigger the multiplier effect leading to rising incomes.The rising income will increase consumption and demand.The high expected demand will trigger the accelerator effect as firms invest more to meet the rise in demand.The extra investment will trigger the multiplier again leading to rising income again.Once the economy starts to grow it will continue to do so, leading to an upward swing in the economy.However this growth does not continue indefinitely, the economy will finally reach full capacity where all Factors are employed. At this point investment will start to drop, and income starts to fall triggering a reverse multiplier. As incomes fall so does consumption and demand, this will lead to a downward swing on the trade cycle.IMAS110

111. Aggregate Supply and DemandMuch of government’s economic policy effort is developed to prevent the twin problems of Inflation and Unemployment. To understand how these problems arises in the market economy we need to first understand the aggregate demand and aggregate supply model.IMAS111

112.  Aggregate Demand (AD) = C + I + G + (X-M)IMAS112AD relates to the level of National Income and the level of Expenditure in the aggregate demand and supply model. It is assumed that AD:Is made up of all the components of expenditure in the economy.Is inversely (negatively) related to pricesMay shift if any one component e.g investment changes through the multiplier effect.Thus the demand curve slopes down from left to right but may shift.

113. Aggregate Supply (AS) -refers to the willingness and ability of producers in the economy, mostly the business sector, to produce and offer for sale goods and services. It is assumed that AS:Is the collection result of decisions made by millions of businesses.Is positively related to prices.It is limited by the availability of resources (eg labour, capital), which means at full employment, output cannot be increased any further.Can only shift in the long run as a result of changes in the cost of production or in the availability of factors of production.Thus the supply curve slopes upwards from left to right and does not shift in short run.IMAS113

114. EquilibriumIMAS114National equilibrium will be where AD curve intersects with AS curve, at this point the total demand for the goods and services in the economy is equal to the total supply of goods and services in the economy.This model shows the changes in either AD or AS on both the national income and price level.The assumption is that the level of employment in the economy in the short and medium run is a function of the level of national income.

115. Changes in AD The AD can shift to the left through government policy when they try to reduce the inflationary pressure; they do this by raising taxes and reducing government spending. However the AD can also shift to the left due to reasons other than government policy such as:A fall in investmentA fall in consumer expenditureA fall in exports due to a major loss of competitiveness, or recession in the country’s major trading partners.On another hand the economy can expand and the AD will shift to the right, this can be caused by factors such as:An investment boomA rapid rise in consumer expenditureA rapid rise in exportsIMAS115

116. Changes in ASIt is a so possible in the long run to have supply side shocks which can reduce the ability or willingness of production in the economy. When this occurs the AS curve will shift to the left, this will cause a rise in prices and a drop in output (this is usually called Stagflation). These supply shock might arise from:A major rise in energy and raw materials prices.A major rise in labour cost.A significant fall in productivity in businesses.On the other hand the supply curve can shift to the right, and this will result in a rise in national income and employment, in addition prices will also drop. This is the opposite of stagflation. These shifts of the supply curve can be caused by: Favourable developments in the economy reducing prices of raw materials and energy.Productivity improvement.Government supply side policies designed to shift the AS curve to the right, e.g Privatisation, Business tax reductions, Labour market reforms.IMAS116

117.  Demand and Supply side policies-Schools of ThoughtIMAS117Different theories exist on how to manage the economy; two of the most important are listed below:

118. The Keynesian view (demand side)Dr Keynes believed that the economy could become stuck at many different equilibrium positions (which doesn’t necessarily mean full employment), as reflected by the Great Depression.He argued that it was the government’s role to move the economy to a better equilibrium position.The government can borrow money to inject in the economy to stimulate economic growth. Future revenue will then be used to finance the debt.On the other hand if the economy is growing too fast, leading to inflation, the government can reduce the amount of money in the circulation through measures such as increasing taxation.He argued for the management of AD in the economy.IMAS118

119. The Monetarist view (supply side)Monetarist revived the earlier classical view, that there is only one equilibrium position in the national economy (where supply is equal to demand).They believed that the economy will move towards that position unless hindered by market imperfections.Thus it becomes the role of the government to free up the economy by removing these imperfections. Once this is done the role of the government should be minimal.Market imperfections include the following:InflationGovernment spending and taxationPrice fixingMinimum wages agreementRegulation of marketsAbuse of monopoly powerThe monetarist’s solutions to economic problems are often described as supply side economics as they focus on improving the supply of factors of production in the economy.The Monetary Policy and Fiscal Policy are primarily concerned with the level of monetary demand in the economy. These policies are aimed at shifting the AD to the right when the problem is unemployment and to shift the AD to the left when the problem is inflation. These policies did not seem so effective so economies are now shifting to Supply Side policies.The objectives of the supply side policies is to shift the AS to the right, this will result in a rising national income and employment at the same time reducing inflationary pressures.IMAS119

120. Supply side policies consist of the following among others:Shifting taxation away from direct to indirect taxation and to reduce marginal rate of taxation, to encourage work and enterprise.Reducing social security payments to encourage the unemployed to seek employment.Emphasis on vocational education and training to improve skills.Reduce the power of Trade Unions so that they do not distort wage prices in the labour market.Deregulation and privatisation to encourage enterprise and risk-taking.IMAS120

121. In the long run these policies proved to be effective; however there are other undesirable consequences which arise from these policies:Taxation system becomes more regressive, putting the poor at a disadvantage.A more unequal distribution of income.Less protection for workers leading to a great degree of uncertainty in the labour market.A fall in the relative and absolute standard of living for those who depend on the social benefits.IMAS121

122. The Trade Cycle and the Government PolicyAggregate demand and supply analysis has shown how the trade cycle of recessions, recoveries and booms followed by further recession might occur and how government policy might be used to deal with these problems.IMAS122

123. RecessionFeatures: - Falling output/income. – High and rising unemployment. – Reduced inflationary pressure. – Improving trade balance as imports fall. – Public finance negatively affected, due to reduced tax income and increased benefit payments.Causes: - Falling domestic AD from lower levels of consumer spending, investment, exports and government expenditure. – World recession.Policy response: - Raise AD by reducing taxation, raising public expenditure, lowing interest rates (This will further increase the need for government borrowing).IMAS123

124. Other Stage of the Trade CycleStagflationRecoveryBoomIMAS124

125.  Trade Cycles (Implications for Businesses)cession and a large upswing during growth phase.Firms which supply the Public sector will be affected by the government spending plans.A firm may reduce their risk due to trade cycles by diversifying geographically.During downturn businesses have bargaining power in the labour market, since there would be high levels of unemployment.Success may also be influenced by being able to determine when to act.If the government adjust interest rates this will affect the firm’s borrowing cost.IMAS125

126. Fiscal and Monetary policy optionsIMAS126

127.  Fiscal Policy OptionsFiscal policy refers to government taxation and spending plans and falls under demand side policies. Government Budget:In the medium to long term the government should achieve a balanced budget. However due to different reasons the government may decide to run either a budget deficit or budget surplus.Government Income ‹ Expenditure = budget deficitGovernment Income › Expenditure = budget surplusGovernment Income = Expenditure = a balanced budgetIMAS127

128. Running a budget deficitIf the government wants to run a budget deficit this has to be financed through borrowing (Public Sector Net Borrowing).This is usually done to promote economic growth and reduce unemployment.The deflationary gap (difference between the actual AD and the required AD to reach full employment) is closed leading to an increase in the income.The government will be injecting more into the economy than what its taking (Expansionary Policy)IMAS128

129.  Running a budget surplusIf AD is above the level which is required to generate full employment, this usually leads to inflation (too much money chasing too few goods). An Inflationary gap will exist in the economy.To control inflation, the government may decide to run a budget surplus to reduce AD. They will be taking money out of the economy (Contractionary policy).IMAS129

130.  Monetary Policy optionsThis refers to the management of money supply in the economy and it is within the context of monetarism. It involves changing interest rates, either directly or indirectly and settling reserves requirements for banks. It can also be Expansionary (increasing money supply by decreasing interest rates), or Contractionary (decreasing the money supply by increasing interest rates).IMAS130

131. Money SupplyThis is the total amount of money in the economy. There are many types of money including:M0 – notes and coin in circulation and balances at the country’s central bank.M4 – notes and coins and all private sector bank/building society deposits.IMAS131

132. Reserve RequirementsBanks operates a fractional reserve system, where they keep just part of the deposits in cash. This proportion of deposits which are retained in cash is known as the reserve asset ratio or liquidity ratio.IMAS132

133. Open market operationsThe government can put some control over money supply by buying and selling its own bonds.IMAS133

134. Interest ratesThe government can use interest rates to control the amount of money supply in the economy.IMAS134

135.  Interest Rate managementThe monetary policy is concerned by managing the monetary environment in the economy, this can be done by affecting either the availability of credit or the price of credit. One instrument used for this is the interest rateIMAS135

136. Effects of increasing interest rates: Domestic economySpending falls since the cost of credit becomes high.Investment falls (as the net return on investment falls).Asset values falls (because of the negative relationship between bond prices and the rate of interest), this will reduce most people’s wealth.The total effect will be the AD curve will shift to the left, and will lower inflationary pressures but at the cost of reduced economic activity and rising unemployment.IMAS136

137. Effects of increasing interest rates: External effectsForeign funds will be attracted into the country.The exchange rate will rise in the short run.In the long run high interest rates will stifle growth, leading to a drop of the local product’s demand on the international markets. This will result in the fall of the exchange rate.IMAS137

138. Effects on BusinessesBusinesses will be affected directly and indirectly. The effects can be in 3 categories:Costs (cost of credit becomes high).Investment decision (a change in interest rates will affect the profitability of investment projects).Sales revenue (sales will drop due to a deflationary effect brought about in the economy, as well as a drop in demand by consumers since some of the goods they buy them on credit). The opposite of these effects are true if Interest rates are dropped.IMAS138

139. Managing interest rate riskFinancial managers face risk arising from changes in interest rates (lack of certainty about amounts and timing of cash payments).Since managers are risk-averse, they look for techniques to manage and reduce these risks.IMAS139

140. Forward rate Agreement (FRA)Aim of FRA is:Lock the company into a target interest rate.Hedge both adverse and favourable interest rate movements.The company enters into a normal loan but independently organises a forward rate agreement with a bank:Interest paid on a loan the normal wayIf interest is greater than the agreed forward rate , the bank pays the difference to the company.If interest is less than the agreed forward rate, the company pays the difference to the bank.IMAS140

141. Interest rate guarantee (IRG)This is an option on a FRA. It allows a company a period of time during which it has an option to buy a FRA at a set price:Decision rules:If there is an adverse movement (an increase in the interest rate) – exercise the option to protect.If there is a favourable movement (a decrease in the interest rate) – allow the option to lapse.IRG are more expensive than FRA, because of the flexibility advantage.The company will use the FRA if they are sure that the interest rates will rise but if it is unsure then it will use the more expensive IRG.IMAS141

142. Interest Rate futuresResult of the future is to:Lock a company into effective interest rateHedge both adverse and favourable interest rate movements.Borrowers can additionally buy options on future contracts. In this case they can enter into the future if needed, but let it lapse if market rates move in their favour.IMAS142

143. TaxationThere are many aims to taxation and their priorities vary with the political complexion of the government. The main aim is to raise revenue; however there are other aims such as to:Change and influence markets (eg on harmful products such as cigarettes)Influence the level of aggregate monetary demand.Finance the provision of Public and Merit goods.Change the distribution of income.IMAS143

144. Types of TaxesIncome tax (e.g Corporate tax, income tax)Expenditure tax (eg VAT, excise and customs duties)Capital tax (eg inheritance and Capital gains)Most taxes are levied by the central government but some by the local government authorities.With direct taxes the person who is receiving the income is the one who pays the tax, with indirect taxes (expenditure taxes) the purchaser who benefits from the goods is the one who pays the tax.IMAS144

145. What percentage of income is paid in tax?Progressive – a large percentage of income is paid in tax as income raises e.g Income tax.Regressive – a smaller percentage of income is paid in tax as income rises e.g VATProportional – the same percentage of income is paid in tax at all income levels.IMAS145

146. Achieving policy objectivesThe above policies can be used to achieve different economic objectives such as recovery from a recession and promote economic growth. IMAS146

147. To Recover from a RecessionCutting Interest (Keynesian demand management).Running a budget deficit (Keynesian response, Monetarists argue that a budget deficit will have a negative effect elsewhere eg high taxation).IMAS147

148.  Enabling long term growthSupply side policies attempt to increase the total quantity of Factors of Production (especially capital) as well as the productivity of these Factors:Increase the availability and quality of labour through – training schemes to increase skills, using income tax and benefits systems to encourage workers to work harder and for longer hours.Encourage Research and Development.Modernisation of Transport systems to enhance distribution networks.Providing smaller firms with assistance.Deregulation of markets.Grants and tax incentives to boost investments.Protectionist measures to reduce imports eg quotasCreating a stable economy to boost confidence.IMAS148

149. Policies to promote economic growthGovernments have always been interested in policies that promote Economic growth, as it raises the standards of living.A necessary condition is that the level of AD are kept sufficiently high (through the fiscal and monetary policies) to maintain a certain level of productive capacity.However the government policies will also seek to encourage AS in order to expand the production in the economy, by increasing the total quantity of Factors of Production available and level of productivity.Some of these supply side policies are Market driven in nature (the government creating a free market e.g reducing the marginal rate of tax).Some of these policies are Interventionist in nature (the government assisting by supporting infrastructure to give firms a stronger foundation from which to conduct business e.g Education and training, sponsoring Research and Development.) IMAS149

150.  UnemploymentIt is not easy to reduce unemployment since we have different causes of unemployment.IMAS150

151. Cyclical unemploymentSometimes known as demand deficient unemployment or Keynesian unemployment.Caused by insufficient demand to create employment for those who want to work, this is known by Keynesians as a deflationary gap and the seek to remove it by boosting demand.Monetarists will address this unemployment through supply side policies, since they argue that this kind of inflation does not really exist.IMAS151

152.  Frictional UnemploymentThis refers to people who are temporarily unemployed as they move from on job to another.Though its not much of a problem it can be reduced by providing better information through job centres and other supply side policies.IMAS152

153. Structural and technological unemploymentCaused by structural changes in the economy, leading to changes in required skills and at time location of where economic activities take place.Boosting aggregate demand would not help much, supply side policies would be more helpful: government funded training schemes, tax breaks for the redevelopment of old industries, grant aid to encourage relocation of industries etc.IMAS153

154. Seasonal unemploymentThis is caused by the seasonal demand for certain goods and services eg farm workers. This can create regional economic problems.IMAS154

155.  Real wages unemploymentThis usually occurs in industries where there are strong unions. By keeping wages artificially high, the number of people employed in the industry is reduced.Monetarist would see this as an example of market imperfection and would address it by reducing the powers of workers union.IMAS155

156.  InflationInflation has a number of causes and solutions.IMAS156

157. Demand-pull inflationThis is caused by high levels of demand compared to the available goods. Too much money chasing too few goods.Demand side policies will focus on reducing aggregate demand by rising taxes, cutting government spending and high interest rates.Monetarists argue that inflation can result from an increase in the money supply, this will increase the purchasing power in economy, boosting demand. If this increase occurs faster than e expansion in goods and services then inflation can rise.The main monetarist tool to reduce such inflation is to reduce the growth of money supply through higher interest rates.IMAS157

158. Cost-push InflationIf the cost of Factors of production increases this usually results in an increase in the price of goods and services as firms tries to maintain their profit margins.This increase can be due to rising Factor prices, rising import prices and increase in indirect taxes.IMAS158

159. Expectations EffectIf anticipated levels of inflation are included in wage negotiations and pricing decisions then it is likely that the expected rate of inflation will arise. This might not be the root cause of inflation but it can contribute to an inflationary spiral.This spiral can be managed by a ‘prices and incomes’ policy where firms agree to limit price rises in response to unions’ agreement to limit wage claims.The government can set price ceilings for both goods and services as well as for wages.IMAS159

160. Macroeconomic and Institutional Context 2: The International EconomyWe are now focusing on the International Economy and International Trade. Balance of Payments: A balance between Exports and Imports.IMAS160

161. Specialisation – enables countries with different skills and resources to specialise in the production of certain goods.Economies of Scale – countries can benefit from serving large markets including those of other countries.Competition – there will be an increase in competition.Lower pricesGreater choices for consumersThe Benefits of International TradeIMAS161

162. Limitations to SpecialisationIn practice it is not easy for countries to fully specialise due to:Factor immobility – in the real world, factors tend to be fairly immobile in the short run.Transport costs – distribution costs may still make products from other countries expensive than the locally produced products.Size of the market – for countries to benefit from Economies of scale, there should be a ready market for its products on the international markets.Government Policies – governments can install barriers to trade for political reasons.IMAS162

163. IMASProtectionismMany countries do not engage in free trade but seek to restrict the flow of imports in their domestic economies.Arguments for ProtectionismTo protect employment.To help infant industries.To protect declining industries to allow structural readjustment.To prevent unfair completion (eg fake products and dumping).To protect the balance of payments.To raise revenue.To maintain security on strategic industries.163

164. Arguments against ProtectionismInefficiency is encouraged.Resources are misallocated.The cost of living is raised.Retaliation may occur.IMAS164

165. The methods of ProtectionThere are two groups of trade barriers – Tariffs and non-tariff barriers (NTBs) which include:Tariffs (taxes charged on imports)QuotasHidden restrictions (eg administrative devices, official persuasion, and public procurement).Subsidies (where the government wants to do export promotion), but these are discouraged by the WTO.IMAS165

166. Trade AgreementIn many parts of the world, governments have created trade agreements and common markets to encourage free trade. However the WTO is against these trade agreements because in most cases they encourage trade among the members only but have high trade barriers for non-members.The different trade agreements are as follows:Bi-lateral and multi-lateral trade agreements – between 2 or more countries to remove tariffs and quotas on most if not all goods.Free trade areas – If the members of a multi-lateral free trade agreement are in the same geographical area then at times its referred to as a free trade area. Customs union – this is a free trade area with a common external tariff.Single markets – this is a customs union with free movement of goods and services as well as free movement of Factors of production.Economic unions – this is a single market with a common currency. The greatest currently being the Eurozone, these are the countries within the European Union which have adopted the Euro.IMAS166

167. Arguments regarding Trading BlocksTheir supporters say they encourage trade creation and low prices within members as restrictions are removed. However opponents state that:Member countries are forced to buy within the block even when there are cheaper resources are available outside.These blocs encourage regional fortress mentality which can lead to conflicts between different regional trading blocs.The blocs can lead to the development of protectionism worldwide yet the WTO is trying to create free trade.IMAS167

168. Balance of PaymentsThis is an account showing the financial transactions of one nation with the rest of the world over a period of time.  The balance of payment is split into three parts:The Current account The Capital AccountThe Financial AccountNote: The accounts are supposed to balance since credits are supposed to be equal to debits. However there are certain cases where there may be deficits or surpluses.IMAS168

169. The Current AccountThis is made up of 2 parts:Visible Trade – This shows the trade in goods.Invisible Trade – This shows the trade in services, investment income (interests, profits and dividends) and transfer of money between individuals and national bodies (eg government transfers to embassies).The Current account balance surplus is generally a good sign. A deficit/surplus on the Current account will be balanced by a surplus/deficit on the combined Capital account and Finance Account.IMAS169

170. The Capital and Financial accountsThese accounts records capital and financial movements by firms, individuals and governments. The balancing item is also included here, which reflects errors and omissions which occur in the collection of data (a positive balancing item shows unrecorded net exports, while a negative shows unrecorded net imports).IMAS170

171. Types of flowsReal foreign direct investment – where investors have some form of control over the business.Portfolio investment – the investor has no control over the enterprise.Financial derivatives – any financial instrument whose underlying value is based on another asset, such as foreign currency, interest rates.Reserve assets – foreign financial assets that are controlled by monetary authorities (Central Banks). E.g gold and foreign currencyIMAS171

172. Equilibrium and disequilibriumThe balance of payments accounts should always balance. Current account + Capital account + Financial account + Balancing item = 0Persistent imbalances in certain sections, such as the visible trade under the current account indicate fundamental disequilibrium.Such disequilibrium will drive governments to undertake policy action to create/restore equilibrium(Increase interest rates or use official reserves). Actions taken to address the balance of payments problems may constrain policies which are designed to achieve other economic objectives such as economic growth.IMAS172

173. Causes of Balance of Payments deficitA structural BOP deficit in the current account is usually due to a high demand for imports coupled with a weak export performance especially in manufacturing products.Import Penetration – where imports are taking a large share of the market or when imports are maintaining their share of growing markets. This can be due to many reasons like growth in consumer spending, imports becoming more competitive, domestic currencies overvalued, foreign currencies may be undervalued. Export Performance – Some of the factors that influence export performance are, the willingness and ability of domestic firms to supply abroad, price competitiveness of exports, some countries have surplus capacity which can be used when income rises.IMAS173

174. IMAS Policies to correct the BOP deficitMany policies have been advocated to restore the balance of payments to equilibrium, usually when deficits have been a regular feature.174

175. Do nothingIf a country is using the floating exchange rate it is claimed that it leads to an automatic correction of the BOP. For example:If imports exceed exports then a BOP deficit occurs.If we are using Sterling, it means that more sterling is being sold to buy imports, than the sterling which is bought to purchase UK exports.This excess supply of sterling over demand for sterling will lead to a weakening of sterling against other currencies.This makes UK exports to be cheaper and imports expensive.As a result export volumes will rise and imports will drop leading to the correction of the BOP.IMAS175

176.  Deliberate Depreciation of the exchange rateDepreciation or devaluation can be done through the buying and selling of foreign currency on the market to induce expenditure switching by consumers. This can occur in two ways:Imports become expensive and hopefully the domestic consumers will switch to local goods.An increase in exports since they become cheaper. However a depreciation or devaluation will not immediately benefit the BOP in practice:There is an initial worsening of the current account since volumes are fixed and prices adjust automatically. However with time goods become more elastic leading to a change in production and consumption patterns.There is also some evidence that following depreciation, exporters maintain their foreign exchange prices rather than lowering them, this will raise their short-run profits at the expense of long-run sales growth.IMAS176

177. IMASDeflationThis is an effective but generally an undesirable policy. Domestic deflation to induce expenditure reduction by consumers.The government through a tight fiscal policy or restrictive monetary policy reduces demand locally.The BOP is corrected because the demand for imports is weakened and even the demand for local products which may lead local firms to switch their resources towards export markets. Although deflation improves the current account it has some costs for the economy.Less demand in the local economy means less supply and a rise in unemployment.The general effect is economic growth will be stifled due to depressed business optimism, lowering investment and under-utilizing resources. Deflation is often used together with depreciation (devaluation).177

178. Import ControlsThese have the effect of causing expenditure switching rather than expenditure reduction. Quotas prevent the purchase of imports and Tariffs increases the prices of imports.However members of the WTO are not allowed to use these kinds of policies.IMAS178

179. Supply side policiesThese policies attempt to improve the efficiency of the supply base of the economy. This is believed to boost the competitiveness of local products on the international market.However there has been little evidence that this has brought about any permanent improvement in the balance of payments.IMAS179

180. GlobalisationGlobalisation is the growing interdependence of countries worldwide.Internationalisation refers to the increasing spread of economic activities across geographical boundaries. Globalisation is a more complex form of Internationalisation, For example:Erosion of trade barriersHomogenising of tastes across different nationsFirms selling same products across marketsGreater harmonisation of laws in different countriesDilution of traditional culturesIMAS180

181. IMASFactors driving GlobalisationImproved communicationPolitical realignment (growth of trade agreements)Growth of Global firms and industriesCost differentialsTrade liberalisation (by WTO)Liberalisation of International capital markets181

182. Impacts of GlobalisationIndustrial relocation (off-shoring)Emergence of growth markets (opening up of new markets)Access to markets and enhanced competitionCross-national business alliances and mergersWidening economic divisions between countriesIMAS182

183. The world Trade organisation (WTO) and The General Agreements on Tariffs and Trade (GATT)After the World War 1 attempts have been made to reduce trade barriers to free trade around the world. Thus the GATT came into being in 1948.In 1995 the WTO based in Geneva replaced GATT and it has a number of roles:To ensure that member countries continue to comply with previous GATT agreements.To negotiate future trade liberalisation agreements.To resolve trade disputes between nations.The WTO has more authority than GATT as it has the power to police and enforce trade agreements. It is also against the development of trading blocs and customs unions.IMAS183

184. The European Union (EU)The EU is an example of a Single market and the Euro zone an Economic union. It has its origins in the Treaty of Rome (1957), and the aims of the treaty were as follows:Elimination of Tariffs and Quotas.Establishment of a common customs tariff and a common commercial policy towards non-members.Removal of barriers of the movement of persons, services and capital.Establishment of common policies on transport and agriculture.The prohibition of business practices that restricts or distort competition.The association of overseas countries in order to increase trade and development.IMAS184

185. Objective Consist of Canada, France, Germany, Italy, Japan, Russia, United Kingdom and United States. Together these countries represent about 65% of the world economy.The agenda of G8 meetings is usually about issues such asGlobal warming.Poverty in Africa.Fair trade policies. AIDS.Macroeconomic management. Energy issues and climate changes.Development issues and creating relations with developing countries.Issues of international concern such as terrorism and organised crime.The G8 does not have any formal resources or powers like other organisation such as the WTO.Check also the Euro Zone Page 216 and the G20 page 218.IMAS185

186. External Analysis of the Macro EnvironmentAn organisation needs to do an external analysis of its external environment within which it operates. There are various factors in this environment which may represent threats or opportunities.The business will have to scan its external environment for factors relevant to the organisations current and future activities.There are a number of strategic management tools that can assist in this process. These include the PESTLE framework which helps in the analysis of the macro and general environment.IMAS186

187. PESTLE anlysisThe PESTEL analysis divides the business environment into four main systems- Political, Economic, Social(and Cultural) and Technical. Others includes Ecological/Environmental and Legal.Some factors affect every industry, but industries will vary in how much they are affected.IMAS187

188. PESTEL approachPolitical influences and events – legislation, government policiesEconomic influences – economic growth, changes in consumer incomes and expenditure, population growthSocial influences – social, cultural, beliefs, values, population shifts, life styles, education, healthTechnological influences – changes in material supply, processing methods and new product development.Ecological influences – impact the organization on its environmentLegal influence – changes in laws and regulations affecting (competition, patents, sale of goods, industrial standards etc)IMAS188

189. Chapter 6: Financial Context of Business 2: International aspectsIMAS189

190. International Money MarketsThese are split into two:International capital marketsThe Foreign exchange marketIMAS190

191. International Capital MarketsThese markets has expanded since 1950 as a result of:Progressive abolition of exchange controls, which were limiting the flow of capital.The growth of MNC, which shop around for favourable financial products.IMAS191

192. Funds on the International Capital MarketsThey fall into three broad categories:Short-term Capital (Eurocurrency) – borrowed usually for working capital purposes.Medium-term Capital (Eurocredit) – borrowed for working capital and investment purposes.Long-term Capital (Eurobonds) – borrowed for investment purposes and for financing mergers and acquisitions. Issued by large companies, governments and supranational institutions and they are denominated in the currency other than that of the borrower (US$ is usually used).IMAS192

193. Foreign Exchange MarketsConcerned with the purchase and sale of foreign exchange. Primarily for four reasons:Finance International tradeCompanies holding and managing a portfolio of currencies as part of their financial management function.Financial Institutions dealing in foreign exchange on behalf of their clients, to benefit from changes in exchange rates.To manage risks associated with echange rate movements.IMAS193

194. Spot and Forward exchange tradingForeign exchange trading may be spot or forward:Spot transactions are undertaken almost immediately and settled within two days.Forward buying involves future delivery date from 3 months onwards. Banks and brokers usually operate in forward markets on behalf of their clients to mitigate the risks of adverse exchange rate movements. (the risks arises if imports or exports are fixed in foreign currency terms)Forward price currency is normally higher (at a premium) or lower (at a discount) than the spot rate.IMAS194

195. Foreign Exchange risksFirms dealing with more than one currency are exposed to risks due to exchange rate movements. Three main aspects to this:Economic risk – long-term movements in exchange rates undermine a firm’s competitive advantage. (Solution: set up a production plant in markets you wish to sell).Transaction risk – time between order being agreed and payment received, the exchange rate can move causing the value of the transaction to be more or less than previously envisage. (Solution: make use of Forward exchange contracts, Futures or Currency Options, see page 236 in the textbook).Translation risk – If a company has foreign assets denoted in another currency, then their value in its home currency will depend on the exchange rate at the time. (This risk is however not realised unless the asset is sold).IMAS195

196. Exchange rate systemsThe exchange rate of a currency is its value expressed in another currency.This exchange rate is very important in the trade of goods and services. When you want to buy goods from another country (eg USA) you will have to change your local country’s currency to that country’s currency (that is into US$).Even when funds are being transferred between people in different countries, foreign exchange is required.IMAS196

197. Exchange rate systems: Floating exchange ratesExchange rates that float are flexible and free to fluctuate in the light of changes which take place in demand and supply.IMAS197

198. Demand for a currency (e.g rand)Demand of the rand comes from a number of sources:It is required to pay for S.A exportsOverseas investors making investments in S.ASpeculators may buy the rand if they feel it is about to increase in valueThe government (The central bank) to manipulate the exchange rateSome currencies are just bought and held as an international medium of exchange (e.g US$)IMAS198

199. Supply of a currency (e.g rand) Supply of the rand comes from a number of sources:S.A residents wishing to buy importsS.A residents making overseas investmentsSpeculators may sell the rand if they feel its value is about to decreaseThe S.A government (Central bank) may sell the rand on the international market to weaken the rand, and improve export performanceIMAS199

200. Impact of different factors on the exchange rateInflation – High inflation weaken a currency as it makes goods expensive thereby dampening exports.Interest rates – An increase in Interest rates (Short term: a rise in the exchange rate) and (Long term: reduce the exchange rate).A trade deficit – A low demand for the rand to buy S.A exports (and at the same time an increase in the supply of the rand to buy imports), thereby leading to the weakening of the rand.Speculation – can influence the exchange rate either up or down.IMAS200

201. Exchange rate systems: Dirty floatingThis is when the government through the central bank intervene in the foreign exchange markets, to buy or sell their own currency and manipulate the exchange rate. This is usually done to make a country’s exports more competitive or to assist in control of inflation.The central bank will:Buy or sell the currency to raise or lower the exchange rate.Alter interest ratesIMAS201

202. Hot moneyDeposits of money can be transferred from one currency to another at short notice, and this will obviously affects the demand and supply of currencies. This is what is referred to as Hot Money, and its affected by the following factors:Relative interest ratesExpectations (appreciation or depreciation of a currency)InflationIMAS202

203. 7ChapterFinancial Context of Business III: Discounting and Investment appraisal

204. Time value of moneyMoney received today is worth more than the same sum received in the future. This happens for several reasons:Potential for earning interestImpact of inflationRisk The time value of money can be expressed in the form of annual interest rates. For investment appraisal this will be termed:Cost of capitalRequired returnDiscount rate

205. Simple interestInterest is paid or received on the principal only P =amount invested r = interest rate per annum as a decimal n = number of years Interest = P x r x nFuture Value = P + (P x r x n)

206. Illustration of simple interest£1,000 is invested for 5 years. The sum earns 10% simple interest each year. How much will accumulate by the end of the fifth year?AnswerFuture value at the end of year 5 = P + (P x r x n) = £1,000 + (£1,000 x 0.1 x 5) = £1,500

207. (b) Compound InterestInterest is paid or received on the principal plus any accumulated interest Formula is given S = value after n years X = amount investedr = annual rate of interest (as a decimal)n = number of years S = X (1 + r)n

208. Illustration of compound interest£1,000 is invested in an account for 5 years. The compound interest rate is 10% per annum. Find the value of the account (to the nearest pound) after 5 years and calculate the interest earned.AnswerValue after 5 years, S = X (1 + r)n = £1,000 (1 + 0.1)5 = £1,611Interest = £1,611 - £1,000 = £611

209. The formula should be used in the exam but it may help to look at the calculation in this way:Year 1: £1,000 + 10% interest = £1,000 x 1.1 = £1,100Year 2: £1,100 + 10% interest = £1,100 x 1.1 = £1,210Year 3: £1,210 + 10% interest = £1,210 x 1.1 = £1,331Year 4: £1,331 + 10% interest = £1,331 x 1.1 = £1,464Year 5: £1,464 + 10% interest = £1,464 x 1.1 = £1,611

210. (c) Interest paid more than once per annumUse the same formula for simple or compound interest but make sure the interest rate used matches the period of payment

211. Illustration of interest paid more than once per annum£500 is borrowed on a credit card charging 1.2% p.c.m. How much is owed after one year?AnswerOne year is 12 months, so 12 periods of compound interest need to be applied.Balance after one year, S = X (1 + r)n = 500 x (1.012)12 = £577, to the nearest £

212. (d) Equivalent annual interest ratesAs mentioned, compound interest is often paid or received more than once a yearIt is useful to convert this period rate to an annual rate of interestThis is called the equivalent annual interest rate or the annual percentage rate (APR) r = period interest rate (as a decimal) n = the number of compounding periods in a year Study text reference 6.4Annual percentage rate = (1 + r) n -1

213. Illustration of equivalent annual interest ratesAn account charges compound interest of 1% per month. Calculate the equivalent annual rate. AnswerAPR = (1.01)12 – 1= 0.1268 or 12.68%Some financing companies can be economic with the truth when describing their products. The APR is usually the best indicator of the true cost.

214. Example 3£500 is invested in an account paying 1.25% interest per quarter. (a) Calculate the fund balance after 5 years. (b) Find the annual percentage rate.

215. (3) Sinking fundsThese have equal sums paid into them each period, e.g. a regular savings accountUse the formula to calculate the amount at the end of the investment periodS = amount at the end of investment periodA = Equal sumR = 1 + interest rate (as a decimal)n = number of periods S = A (Rn – 1) (R – 1)

216. Illustration of sinking funds (part 1)Suppose I pay £1000 a year into an account for 3 years at an interest rate of 10% with all payments made at the end of each year. How much will the fund accumulate to?AnswerValue after 3 years, S = A(Rn - 1) (R – 1) = £1,000 (1.13 – 1) (1.1 – 1) = £3,310

217. Illustration of sinking funds (part 2)How would the answer differ if the funds were paid in at the start of each year?AnswerIn the previous illustration we said that if the payments were made at the end of each year we would have £3,310 by the end of year 3However, if the payments are made at the start of each year they will attract an extra year’s interest and the final sum will be £3,310 x 1.1 = £3,641

218. (4) DiscountingWhen we looked at compound interest we said that the future value after n periods, S = X (1 + r)nHowever, we may know the future value, S, but need to calculate the present value, X. Rearranging the equation we get: S = future sumn = number of periodsr = cost of capital/ discount rate as a decimal (we called this the interest rate previously)Present value, X = S (1 + r)n

219. Illustration of discounting (part 1)Find the present value of £25,000 receivable in 6 years’ time, if the interest rate is 10% pa. (Calculate your answer to the nearest £)SolutionPresent value, X = S (1 + r)n = £25,000 1.16 = £14,112

220. Example 6 Charlie wins a cash prize in a competition. He must choose between Prize A, B or C. The prize details are: Prize A: Receive £20,000 now. Prize B: Receive £27,000 in 3 years’ time. Prize C: Receive £32,000 in 5 years’ time. The bank interest rate is estimated to be 10% pa for the foreseeable future.By finding the present value of each amount, establish which prize is worth the most to Charlie.

221. Answer to example 6 Present value, X = S (1 + r)nPrize A: Present value = £20,000Prize B: Present value, X = £27,000 1.13 = £20,285 (nearest £)Prize C: Present value, X = £32,000 1.15 = £19,869 (nearest £)Prize B is worth most

222. Discounting the quick wayWe already know that present value, X = S (1 + r)nOr we could rewrite this to give X = S x 1 (1 + r)nThis is called the discount factor and can be found in our mathematical tablesThis gives an alternative and quick method of calculating the present value Present value, X = S x Discount Factor (from tables)

223.

224. Illustration of discounting (part 2)Use the present value table to find the present value of £25,000 receivable in 6 years’ time, if the interest rate is 10% pa.SolutionPresent value, X = S x Discount factor 6 years at 10% = £25,000 x 0.564 = £14,100Note: in part 1 of the illustration our answer was £14,112. This is a rounding difference only

225. Example 7 Use the present value tables to rework the answer for example 6

226. AnnuitiesQuestions may require us to calculate the present value of a constant amountAn annuity is a constant amount paid or received for a number of periods Study text reference 6.11

227. Illustration of annuitiesSuppose I expect to receive £1,000 per annum for 3 years, starting in one year’s time, and want to calculate the present value using a discount rate of 5%.AnswerThere are actually three methods available:

228. Method 1One approach would be to discount each cash flow separately and sum the results:Present value, X = S x Discount factor Present value for year 1 amount = £1,000 x 0.952 = £952 Present value for year 2 amount = £1,000 x 0.907 = £907 Present value for year 3 amount = £1,000 x 0.864 = £864 2.723 £2,723The present value of £2,723 is correct but this is a time consuming method, particularly if the annuity continues for a long period

229. Method 2This is a quicker method than method 1. Rather than discounting each cash flow individually we can discount the annuity using a cumulative present value.This is the sum of all of the individual discount factors and can be found from the tables.Using tables this = £1,000 x 2.723 (as seen in method 1) = £2,723 (method 1 gave the same answer) Present value of an annuity = annuity x cumulative present value factor

230. Method 3The cumulative present value factor may not be available from the tables. They are only available for whole numbers from 1% to 20%The calculation is the same as in method 2 but we will need to calculate the cumulative present value factor.The cumulative present value factor is calculated using the formula: (given) PV = £1,000 x = £2,723 (as before) Present value of an annuity = annuity x cumulative present value factor

231.

232. Example 8A new machine will generate an additional £3,333 per annum for the next four years. The first cash flow starts in one year and the discount rate is 5%Calculate the present value of the annuity using the annuity formulaRecalculate the present value of the annuity using the tables(Answers should be rounded to the nearest £)

233. Annuities in advance and delayed annuitiesThe calculation seen will only work for ‘normal’ annuities. This is one that begins in one yearThe calculation must be altered slightly if the annuity is in advance, i.e. begins immediately or is delayed, i.e. begins after year 1

234. Illustration of annuities in advance and delayed annuitiesUsing your the information in example 8, calculate the present value of the annuity using the tables ifThe annuity begins immediatelyThe annuity begins in three years time(Answers should be rounded to the nearest £)

235. AnswerThe first annuity does not need discounting since it is received immediately. The following three annuities are received in years 1 -3 and will be discounted in the normal way using the 3 year cumulative present value factor. PV of the annuity = £3,333 + (£3,333 x 2.723) = £12,409

236. (b) The annuities are received in years 3 -6. When we discount we need to use the cumulative present value factor for year 6 less the cumulative present value factor for year 2. This will give us the correct cumulative present value factor for years 3 -6. PV of the annuity = £3,333 x (5.076 – 1.859) = £10,722

237. (6) PerpetuityA perpetuity is an annuity that continues forever.r = cost of capital/ discount rate Present value of a perpetuity = perpetuity x 1/r

238. Illustration of a perpetuityJo is looking to purchase a perpetuity that guarantees a payment of £10,000 per annum. What is a fair price for the perpetuity, assuming a discount rate of 3% per annum? (Round the answer to the nearest £)AnswerPresent value of the perpetuity = £10,000 x 1/0.03 = £333,333

239. (7) Net present value (NPV)The NPV method is used to appraise investments and involves discounting. NPV = present value of all the cash inflows minus the present value of all the cash outflows.If the NPV is positive we accept the project.

240. Illustration of NPV (part 1)A company is considering investing £100,000 in a project, which is forecast to yield the following net cash flows: Year 1 2 3 4 5 Net cash flow (£000) 40 35 32 25 19Calculate the net present value of this project if the firm has a cost of capital of 10%

241. AnswerProject has a positive NPV of £18,176: acceptTimeCash Flow £000Discount Factor 10%Present Value £0000(100)1(100)1400.90936.362350.82628.913320.75124.0324250.68317.0755190.62111.79918.176

242. Illustration of NPV (part 2)A new project requires £100,000 investment and is expected to generate cash inflows of £35,000 per annum for 5 years. Evaluate the project at a discount rate of 15%.

243. AnswerEach of the cash inflows in years 1 -5 are an annuity. Therefore, the method for discounting annuities should be usedNPV is positive: accept the projectTimeCash Flow (£) Discount Factor 15%Present Value (£)Year 0(100,000)1(100,000)Year 1 -535,0003.352117,32017,320

244. Example 9A machine costs £45,000 and has a residual value of £5,000. It will generate savings of £9,000 per annum for the next 8 years. The company’s cost of capital is 7%. Should the machine be purchased?

245. Answer to example 9Exam tip: Remember to include any residual value in the cash flow for the final yearThe project has a NPV of £11,649: acceptTimeCash Flow (£)Discount Factor 7%Present Value (£)0(45,000)1(45,000)1-79,0005.38948,501814,0000.5828,14811,649

246. (8) Internal rate of return, IRRIRR is another method of appraising investments and involves discountingThe IRR is the discount rate at which NPV is zeroAccept the project if the IRR is more than the company’s cost of capital

247. Cost of Capital %NPV £IRRCompany cost of capitalPositive NPV

248. Estimate of IRRThe process on the previous slide is too time consuming. An estimated IRR is calculated using a three step approach:Step 1: Take a small discount rate r1 and calculate the NPV (NPV1 )Step 2: Take another discount rate r2 and calculate the NPV (NPV2 )Step 3: Use the formula to calculate the IRR (learn)

249. Illustration of IRRA project involves investing £140,000, and will produce the following year-end cash flows: Year 1 2 3 4 Net cash flow (£000) 60 50 45 30 Discount the project at 10% and at 15%, then calculate the internal rate of return of the project

250. AnswerYear Cash Flow (£)Discount Factor 15%Present Value (£)Discount Factor 10%Present Value (£)0(140,000)1(140,000)1(140,000)160,0000.87052,2000.90954,540250,0000.75637,8000.82641,300345,0000.65829,6100.75133,795430,0000.57217,1600.68320,490(3,230)10,125

251. Step 3: Calculate the IRRIRR = 10 + 10,125 x (15 -10) (10,125 –(-3,230)) = 13.79%

252. Example 10Regulus is considering investing in a project and has calculated the following NPVs: At a discount rate of 5% NPV = +£50,000 At a discount rate of 15% NPV = -£27,000 Calculate the IRR of the project and advise Regulus if his normal discount rate is 10%

253. 8ChapterRisk 1 – Summarising and analyzing data

254. Uncertainty and RiskDecision makers face the following problems:all decisions are based on forecastsall forecasts are subject to uncertaintythis uncertainty needs to be reflected in the financial evaluation.The decision maker must distinguish between:risk – quantifiable - possible outcomes are known and the likelihood/probability of each outcome is also known.uncertainty – unquantifiable – outcomes are either not known or cannot be mathematically modelled/quantified.

255. Uncertainty and riskRiskUncertaintyPast experience ProbabilitiesNo experience No probabilitiesSeveral Possible OutcomesProbabilities are usually based on past information. We shall look at how to analyse and sort past information before we look at probability theory.

256. Data analysis techniquesWe will look at the following data analysis techniques to help us produce meaningful information that is useful for decision making.Tabulating data (tallying, frequency distribution tables)Charts and diagrams (pie charts, bar charts, histograms and ogives)Averaging (arithmetic mean, mode, median)Measures of spread (range, variance, standard deviation,coefficient of variation)

257. Presentation of DataRaw data is often collected into groups or classes to make it more meaningful. The method of presentation will be influenced by the type of data:(a) Discrete – this data can only consist of certain values. For example, the number of children in a family(b) Continuous – this data can take any value, including fractions. For example, height and temperature.Continuous data is usually grouped into ranges to make the information more meaningful.

258. Tallying

259. Solution

260. Tallying..The ‘totals’ in the above table are called frequencies and the table is called the frequency distribution of the sample. Thus the frequency of 0 invoices is 3 and so on.The above example was for discrete data, tallying can also be used for grouped data as shown by the following example

261. Example of a grouped frequency distributionTake the following raw data concerning the ages of a group of accountancy students: 19 25 19 32 22 25 27 21 27 21 24 24 24 28 33 23 21 24 18 21 26 18 26 26 29At first sight it is very difficult to assess this information. Are the figures typical? Is this group older than average? Is there a greater spread of ages than expected?It is useful to group the data together into classes.

262. Solution..Age (years) Tally count Number of students18 – 20 1111 421 – 25 1111 1111 11 1226 – 30 1111 11 731 – 35 11 2 Total: 25With the use of a grouped frequency distribution it is easier to understand at least some of the features of the data. We can now see, for example, that most people are in their early twenties.

263. Cumulative frequency distributionsIt is sometimes helpful to develop the idea of frequency further and to look at cumulative frequencies. These are the number of data values up to – or up to and including – a certain point. They can easily be compiled as running totals from the corresponding frequency distribution, as the following will illustrate..

264. (5) Cumulative frequency distributionUsing the data from the previous example (student ages) the cumulative frequency table will be as follows: x Frequency Cumulative frequency 10 < x ≤ 20 7 7 20 < x ≤ 30 15 22 30 < x ≤ 40 3 25

265. Pie ChartsPie charts are a very easily understood way of depicting the percentage or proportional breakdown of a total into various categories. They are so called because the total is represented by a circle, with each component shown as a sector with area proportional to percentage. Overall, the chart looks rather like a ‘pie’ with ‘slices’ in it.Pie charts can be easily drawn using computers

266. Example: Continent of origin of a class of studentsContinent # of men # of women Total Europe 1 2 3 Asia 9 3 12 Africa 6 4 10 America 1 2 3 TOTAL 17 11 28A pie chart can be constructed from this data.

267.

268. Bar chartsBar charts are a simple way of representing actual data pictorially, subject to the following rules:• Distances against the vertical axis are measurements and represent numerical data.• Horizontal distances have no meaning. There is no horizontal axis or scale, there are only labels.*There are 3 types of bar charts: SimpleMultipleCompound/component/stacked

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271.

272. Histograms More specifically, a histogram is a diagram consisting of rectangles whose area is proportional to the frequency of a variable and whose width is equal to the class interval. The x-axis is the variable being measured and the y-axis is the corresponding frequency.

273. 3 step approach to histogramsStep 1: Select the standard class widthStep 2: Draw the classes with standard widths using heights equal to the frequencyStep 3: Draw the remaining classes with heights calculated using the formula: Height of bar =frequency x standard class width actual class width

274. Example 1The following cumulative frequency distribution relates to the weight of some sand bags:Weight of bag Number of bags Cumulative frequency (kg) > 10 ≤ 20 1 1 > 20 ≤ 30 6 7 > 30 ≤ 40 8 15 > 40 ≤ 50 10 25 > 50 ≤ 70 10 35 > 70 ≤ 90 6 41 > 90 ≤ 120 6 47 > 120 ≤ 150 3 50 50

275. Using the frequency distribution from example 1, draw a histogram showing the weight of sand bagsStep 1: The standard class size is 10Step 2: The classes with standard widths can be drawn with heights equal to their frequencyStep 3: The classes 50-70 and 70-90 are double the standard class sizes, so the heights will need to be adjusted to give: Height = number of bags x 1/2 Similarly, the heights for classes 90-120 and 120-150 will need to be adjusted to give: Height = number of bags x 1/3These give the following histogram:

276. 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Weight (kg) 12648102

277. Ogives An ogive is a graph of the cumulative frequency distributionsThe x-axis is the variable being measured and the y-axis is the corresponding cumulative frequencyWith a discrete variable, intermediate x-values have no meaning in reality (recall 1.6 invoices) and so the ogive would consist of a series of discrete points. It is usual therefore not to draw it.With a continuous variable, the intermediate values do have a meaning, and so it makes sense to join the plotted points.This can be illustrated using Example 1 above

278. Example 1 ogive..

279. Averaging dataMeanThis is the weighted averageMost widely understood and useful measureOften just called the ‘average’ 2 methods of calculating the mean, x: (formulae given)Ungrouped/discrete data x = sum of values of x = ∑ x number of values of x n(ii) Grouped data x = ∑ fx x = mid point of class ∑ f f = frequency of class

280. Example 1: Ungrouped dataThe following are the number of rejects per day in a quality control inspection for the last 7 days: 14, 2, 12, 7, 3, 9, 9Q1(a) calculate the meanAnswer: the mean, x = ∑ x n = 14 + 2 + 12 + 7 + 3 + 9 + 9 7 = 8

281. Example 2: Grouped dataEleven units of output from a particular machine were selected and weighed, giving the following results: Weight of unit (kg) Number of units 8 < x ≤ 10 1 10 < x ≤ 12 7 12 < x ≤ 14 3 11Q2(a) Calculate the mean

282. Answer:With grouped data it is often easier to perform calculations in a table: Weight of unit Number of units Midpoint fx f x 8 < x ≤ 10 1 9 9 10 < x ≤ 12 7 11 77 12 < x ≤ 14 3 13 39 ∑f = 11 ∑fx = 125 Mean, x = ∑ fx = 125 = 11.36kg ∑ f 11

283. The value of the middle itemA useful measure if the data is skewedFor ungrouped data: Step 1: Arrange data in ascending or descending order Step 2: For an odd number of items (n) take the middle item i.e. (n+1)/2 For an even number of items (n) average the n/2 and (n+2)/2 items Median

284. Descriptive StatisticsQuestion 1(b) Using the data from Question 1 above calculate the medianAnswerStep 1: Arrange the data in ascending/ descending order 2 3 7 9 9 12 14Step 2: There is an odd number of items (7) and so we will take the middle item = (7 + 1)/ 2 i.e. the 4th item. The median is 9 2 3 7 9 9 12 14

285. For grouped data: the median is the value of the middle item from the ogive. Ogive from Example 1 There are 50 bags in total and so the median can be found by taking the weight of the 25th bag. This is approximately 50 kg.Median..

286. ModeThe value that occurs most often Probably the least useful since unrepresentative of the whole data setFor ungrouped data it is the most frequently occurring item in the listQuestion 1(c): Using the data from Question 1 calculate the modeAnswer: The mode is 9 since it comes up twice in the data set 14, 2, 12, 7, 3, 9, 9

287. For grouped data we estimate the mode using a histogram. This gives a mode of approx. 45 kgs 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Weight (kg) 12648102

288. RangeMeasure of spread most associated with the modeUngrouped data = highest minus lowest valueGrouped data = upper most interval limit minus lowest most interval limitSimple but distorted by extremesE.g. The range of the following distribution 3 7 15 18 21Range = 21 – 3 = 18On its own the range is not particularly useful Measures of Spread

289. (d) Standard deviation, σAverage spread of the data around the meanThe best measure of spread. Not ideal if the data is skewedNote: Variance = standard deviation2Method 1: Ungrouped data (Formula given)

290. Example of standard deviation for ungrouped data Five boxes of finished components are chosen at random and checked for quality control. The following numbers of faulty components were found in each box: 0, 1, 0, 3, 5Question: Calculate the standard deviation

291. Answer:To calculate the standard deviation we must first calculate the mean: Mean, x = (0+1+0+3+5)/5 = 9/5 = 1.8The standard deviation can now be calculated Variance=(0 -1.8)2 + (1 -1.8)2 + (0 -1.8)2 + (3 -1.8)2 + (5 -1.8)2 5 Standard deviation= √(18.8 ÷ 5) = 1.94 (bigger σ = bigger spread)

292. Method 2: Grouped data OR Formula givenExample of standard deviation for grouped dataCalculate the standard deviation for the following data on the losses made from a process production system: Loss (litres) Frequency 0 < x ≤ 10 5 10 < x ≤ 20 17 20 < x ≤ 30 8

293. Descriptive StatisticsAnswer:As with calculating the mean for grouped data, the standard deviation calculation uses mid-points and is neater if done in a table: Loss Frequency Midpoint fx fx2 f x 0 < x ≤ 10 5 5 25 12510 < x ≤ 20 17 15 255 3,825 20 < x ≤ 30 8 25 200 5,000 ∑f = 30 ∑fx = 480 ∑fx2 =8950

294. Start by calculating the mean: x = 480/30 =16 litresWe can now calculate the standard deviation = √8,950/30 – 162= 6.5 litres

295. Coefficient of variation = standard deviation meanUseful when comparing two distributions that have different meansExam tip: The higher the value, the greater the spread

296. 9ChapterInformational Context of Business II: Index Numbers

297. Indices An index is a statistical measure of changes in a representative group of individual data points over time.The data may be derived from any measure, e.g. company revenue, national inflation, employment etc.For example if you wanted to find out how the stock market has fared since the financial crisis of 2008 you can study the JSE All share index and see how much the bourse has grown.Most index figures are averages but they are particularly useful because they relate to a particular fixed point or base period.

298. (1)Simple index numbers All index numbers show the percentage changes over time index = value in any given year x 100 value in base yearThe most common type of indices are price indices. They compare the price in one year to the price in another year, called the base year The index in the base year = 100

299. Example of a simple price indexTurn the following prices into an index series with 2003 as the base year Year 2003 2004 2005 2006 2007 2008 Price £56 £62 £67 £72 £76 £84Answer Index 100 110.7 119.6 128.6 135.7 150.0Sample working 2004: (62 ÷ 56) x 100 = 110.7Sample interpretation In 2004 the price was 10.7% higher than in 2003.

300. (2) Change of base yearOver time a base year may become less meaningfulExam tip: To change to a new base year divide all index numbers by the index number of the new base year and multiply by 100Example of changing the base year Re-base the index calculated in the previous worked example to the Year 2006

301. AnswerYear 2003 2004 2005 2006 2007 2008Price £56 £62 £67 £72 £76 £84Index if 2003 is base year: 100 110.7 119.6 128.6 135.7 150.0Index if 2006 is base year: 77.8 86.1 93.0 100 105.5 116.6Sample working 2003: (100 ÷ 128.6) x 100 = 77.8Sample interpretation The price in 2003 was 77.8% of the price in the year 2006,

302. (3) Splicing the series togetherIf an index has been re-based it can be difficult to make comparisons to earlier years which were measured using the old indexSplicing the series together solves this problemInvolves redefining the base year of an index in a particular year and then restating the index values in previous years so that comparisons can be made

303. Example of splicing a series togetherThe price index below changed its base to 1983 after many years with base 1970. Recalculate it as a single series with base 1983. By how much have prices risen from 1981 to 1985? Year Price index (1970 = 100) 1981 271 1982 277 1983 280 (1983 =100) 1984 104 1985 107

304. Answer Year Price index Single index (1970 = 100) 1981 271 = 271/280 x 100 = 97 1982 277 = 277/280 x 100 = 99 1983 280 100 (1983 =100) 1984 104 104 1985 107 107Now that we have a single series spanning both 1981 and 1985, we can compare the two: 100 x (107/97) = 110So prices have risen by 10 per cent from 1981 to 1985

305. (4) Chain base index numbersThe base year moves forward each year so that each index is measured relative to the previous yearChain-base index= this year’s value x 100 last years valueExample Chain Week Price Chain Index 1 £112 100 2 £117 = 117/112 x 100 = 104 3 £124 = 124/117 x 100 = 106

306. (5) Composite index numbersMost indices cover several items (for example, the Retail Prices Index includes over 650 items).Composite indices reveal the average change in value of a group of items over time.A weighted average of the individual index numbers is calculated to begin with =∑ wx x = individual index ∑w w = weight

307. Question on composite index numbersThree types of bread sold in a shop have the price indices 107.0, 103.6 and 102.9 with weights of 10: 2: 1 (relating to quantities sold). Find the weighted average index AnswerThe weighted average index= (10 x 107) = (2 x 103.6) + (1 x 102.9) (10 +2 + 1)= 106.2

308. (6) Relative price indicesWhen several items are being considered it is important to recognise the importance of the different items within the group. Hence a weighting is usually attached to each item. In the examination the weightings will always be given.The weights could be base year quantities (i.e. Q0) or values (i.e. P0Q0), or current year quantities or values (i.e. Q1 or P1Q1), or they could simply be decided on some other basis that is applicableRelative price index = ∑(w (P1 /P0) X 100 (given) ∑w P1 = price in current year P0 = price in base year w= weight: either base or current year weight

309. Example

310. Solution

311. Solution continued..The base-weighted relative price indices are:

312. Question on relative price indicesItem Price (2007) Price (2008) WeightingMilk 40p per pint 45p per pint 10Meat £6.50 per kg £6.00 per kg 7Caviar £12.40 per jar £14.00 per jar 1Calculate a weighted relative price index for the data above and interpret your answer.

313. Answer P1/P0 W P1/P0 x WMilk 45/40 = 1.125 10 11.250Meat 6.00/6.50 = 0.923 7 6.461Caviar 14.00/12.40 = 1.129 1 1.129 18 18.84Weighted relative price index = 18.84/18 x 100 = 104.7The average price rise of the three items has been 4.7%

314. Choice of weightingAdvantages of base year weightsWeightings can be used for several periodsComparisons can be made between several periodsAdvantage of current year weightsWeights remain up to date and reflect current trends and fashions

315. (9) Quantity indicesCalculated in a similar way to the price indices but changing quantities are measured instead of priceFormula for a weighted relative quantity index = ∑(w (Q1/Q0)) X 100 (given) ∑w where Q1 = the current year quantity and Q0 = the base year quantity

316. Question on quantity indicesA company manufactures two products, A and B. The sales figures over the past three years have been as follows: Year A B Sales (000s) Sales (000s) 2006 386 533 2007 397 542 2008 404 550 Weighting 22 19Using 2006 as a base, compute a weighted relative quantity index for 2007 and 2008, and interpret their values.

317. Answer2006 to 2007 Q1/Q0 W Q1/Q0 x W A 397/386 = 1.028 22 22.616 B 542/533 = 1.017 19 19.323 41 41.939Weighted relative quantity index = 41.939/41 x 100 = 102.29The sales rose by an average of 2.29% from 2006 to 2007

318. 2006 to 2008 Q1/Q0 W Q1/Q0 x W A 404/386 = 1.047 22 23.034 B 550/533 = 1.032 19 19.608 41 42.642Weighted relative quantity index = 42.642/41 x 100 = 104.00The sales rose by an average of 4.00% from 2006 to 2008

319. Inflation One of the most common areas indices are used is in measuring and dealing with inflation.When describing cash flows it is important to clarify whether inflation is included in the figures.Money cashflows: include predicted inflation and other price rises – they are the actual cash flows that take place. If I am awarded a 3% pay rise, then my gross salary will increase by 3% in money termsReal cashflows: have had general inflation taken out of them. If general inflation is 3% per annum, then a 3% pay rise leaves me no better off in real terms – I cannot buy any more goods than before.

320. Consumer Price Index CPIthe CPI measures the average change from month to month in the prices of consumer goods and services.It represents a ‘shopping basket’ containing those goods and services on which people typically spend their money. As the prices of the various items in the basket change over time, so does the total cost of the basket. Movements in the CPI index represent the changing cost of this representative shopping basket.The goods and services contained in the South African CPI basket and their weights can be viewed on the Stats SA website, www.statssa.gov.za The contents of the basket are fixed within each year so that any differences month-on-month are purely because of price changes. The contents of the basket may however be updated annually to reflect changing consumer preferences

321. Adjusting for inflationThere are many situations, business and other, where it is important to make adjustments for inflation.For example, a company may wish to adjust its Revenue figures to reveal the real change in sales, or an employee may wish to adjust his/her salary to hopefully reveal a real increase in income and purchasing power. The government and many employers often use inflation as a guide to pay increases and taxation changes.Investors may want to update their required return to reflect the inflation expectations.

322. Illustration

323. Solution..To compare two sets of index numbers, it is often useful to rebase both sets of figures to the same base. Here rebasing the inflation figures to 2003 will enable the index numbers to be compared directly. To get a wages index in real terms we can then divide the wages index by the rebased inflation index.This shows that wages have gone up by 9% over the two years while inflation by 8.2%.Overall wages have increased in real terms by 0.7%Year200320042005Inflation index (rebased to 2003)100103.6108.2Wages index (money terms) 100106.0109.0Wages index (real terms) 100102.3100.7

324. 10ChapterInformational Context of Business III: Inter-relationships between variables

325. Introduction This chapter focuses on two areas:Regression One of the major applications of statistics is forecasting, e.g. forecasting sales for a given level of advertising spend. Linear regression analysis quantifies the nature of the linear relationship between variablesCorrelation This examines the strength of the relationship between two sets of figures, e.g. sales of umbrellas and rainfall

326. (2) Regression: Linear regression analysisExpresses the relationship between two sets of data using the equation of a straight line, y = a + bxCan be used for forecastingThere are two possible methods Method 1: Draw a scatter diagram and estimate the line of best fit (not directly examinable but it is useful to understand this method) Method 2: Use least squares regression analysis (exam)

327. A scatter graph is drawn showing the sales achieved (£000’s) for different levels of advertising spend (£000)A straight line of best fit is then drawn: y = a + bxThis straight line can then be used to forecast the sales for any given level of advertising spend.Dependent variable = sales (£000)Independent variable = advertising spend (£000)Intercept on y axisGradient

328. Illustration 1: Calculation of the line of best fitUsing the data given below, establish the relationship between the two variables usingLine of best fit (scattergraph)Least squares regression analysisAdvertising Expenditure (£000)Sales (£000)106214756539483281270

329. Method 1

330. Method 2Rather than drawing a graph this method uses formulae to calculate the values of ‘a’ and ‘b’ in the equation of a straight line, y = a + bxWe can then forecast the value of ‘y’ (e.g. sales)for any given value of ‘x’ (e.g. advertising spend)

331. Formulae: (both given) b = n∑xy - ∑x ∑y n∑x2 - (∑x)2 a = y - bxn = number of pairs of data in the sampley and x = mean of y and mean of x

332. AnswerCalculation of b: begin by setting up a tableAdvertising £000 = xSales £000 = yxyx2106262010014751,05019665331836948432813288491270840144∑x = 54∑y = 336∑xy = 3,344∑x2 = 566

333. b = n∑xy - ∑x ∑y n∑x2 - (∑x)2 = 6(3,344) – (54)(336) 6(566) – (54)2 = 1,920 480 = 4.0Calculation of aa = y - bx = 336 - 4 54 = 56 - 36 = 20 6 6

334. Interpolation and extrapolationAs mentioned, the regression equation can be used for predicting the value of y for a given value of xif x is within the range of the original data the prediction is known as interpolation if x is outside the range of our original data the prediction is known as extrapolationin general interpolation is much safer than extrapolation because outside the original range we can not be certain that the relationship between the variables will continue unchanged.

335. Limitations of linear regression analysisAssumes a linear relationship between the variablesOnly measures the relationship between two variablesOnly interpolated forecasts tend to be reliableAssumes historical behaviour of the data continues into the foreseeable future

336. Least squares regression line: y = a + bx y = 20 + 4xThe result should be more precise than method 1Illustration 2: Using the line for forecastingUsing the regression line ‘y = 20 + 4x’ obtained above, predict the average daily sales of a supermarket if the monthly advertising expenditure is: (i) £11,000, and (ii) £100,000In each case, comment on the level of accuracy

337. Answer(i) y = 20 + 4(11) =64, i.e. £64,000 Prediction found by interpolation and some reliance may be placed on this prediction(ii) y = 20 + 4(100) =420, i.e. £420,000 Prediction found by extrapolation, which is less reliable, caution should be exercised when using this forecast.

338. (3) CorrelationRegression analysis attempts to find the relationship between the variables, x and yCorrelation establishes the strength of the relationship between these variablesThere are three different calculations: (a) Pearson’s correlation coefficient (b) Coefficient of determination (c) Spearman’s rank correlation coefficient

339. (a) Pearson’s correlation coefficient, r r = n∑xy - ∑x∑y (given) √(n∑x2 – (∑x)2 )(n∑y2 - (∑y)2 )r = +1 denotes perfect positive linear correlation r = -1 denotes perfect negative linear correlationr = 0 denotes no linear correlation

340. Types of correlationPerfect positive correlationr = +1Perfect negative correlationr = - 1xxxxxxxxxx

341. Types of correlationHigh positive correlation(r is close to +1)High negative correlation(r is close to -1)xxxxxxxxxx

342. Types of correlation No correlation r = 0xxxxxxxxxxxxxxx

343. Illustration of Pearson’s correlation coefficientA new machine has been purchased and management are keen to explore the link between output and cost. Output and cost figures for the last four months are as follows:Calculate the correlation coefficient between these two sets of dataOutput (000s)3456Cost (£000s)67710

344. Answerr = n∑xy - ∑x∑y √(n∑x2 – (∑x)2 )(n∑y2 - (∑y)2 ) = 4(141) − (18)(30) √ (4 x 86) − (18)2(4 x 234 − (30)2) = 24 √(20)(36) = + 0.89xyxyx2y2361893647281649573525496106036100∑x = 18∑y = 30∑xy = 141∑x2 = 86∑y2 =234

345. Spurious CorrelationA high correlation coefficient does not always mean there is always a cause and effect relationship between the data. This is known as spurious correlationE.g.

346. (b) Coefficient of determination, r2 Coefficient of determination is calculated by squaring the correlation coefficient i.e. r2It measures the proportion of changes in y that can be explained by changes in x

347. Illustration of coefficient of determinationUsing the information in the previous illustration calculate, and comment on, the coefficient of determination AnswerFrom the previous illustration, r = 0.89Therefore, the coefficient of determination, r2 = 0.892 = 0.7921This means that 79.21% of the change in cost relating to the machine can be explained by a change in machine output

348. (c) Spearman’s rank correlation coefficient, RUsed when a distribution is given in terms of rank, rather than actual values R = 1 - 6 ∑ d2 n(n2 - 1 ) (given) d = the difference in ranks n = the sample sizeThe rank correlation coefficient can be interpreted in the same way as the ordinary correlation coefficient

349. Illustration of Spearman’s rank correlation coefficientAs part of its recruitment procedures, a company awards applicants ratings from A (excellent) to E (unsatisfactory) for their interview performance and marks out of 100 for a written test. The results for five interviewees are as follows:Calculate the rank correlation coefficient for this data and comment on its valueIntervieweeInterview gradeTest scoreOneA60Two B61ThreeA50FourC72FiveD70

350. AnswerNote: Interviewees one and three share the best interview grade. They therefore share the ranks 1 and 2 giving them 1.5 eachIntervieweeRank of interview gradeRank of test scoredd2One 1.542.56.25Two3300Three1.553.512.25Four4139Five5239∑= 36.50

351. R = 1 - 6 ∑ d2 n(n2 - 1 ) = 1 – (6 x 36.50) 5(25-1) = −0.825There is a strong negative correlation between the interview grade and the test scoreSpearman’s rank correlation coefficient

352. 11ChapterInformational Context of Business IV: Forecasting

353. Introduction to time series analysisA time series is a series of figures recorded over timeTime series analysis is a tool to help forecast the future, particularly salesThe basic idea is to analyse the past to identify a pattern, of say sales, which can then be used to forecast the future

354. (2) Components of a time series (TS)Trend (T): this is a general movement of the time series over a long period of timeSeasonal variation (SV): a recurring pattern, due to repetitive events, over a shorter but fixed time periodCyclical variation (C): recurring patterns over a long time period, not generally fixed in natureRandom variation or residual value (R): unpredictable variations due to random or chance events

355. (3) ModelsCalculation questions tend to focus on the trend and seasonal variation only. These can be combined together in two ways to give the actual results, i.e. the time series: (a) Additive model: TS = T + SV (b) Multiplicative model: TS = T x SV It will be clear as to which one should be usedSome questions also ask for the calculation of the residual (R). In this case, the two equations above should be extended to include R

356. Illustration of residual calculationThe multiplicative model for a time series shows that at a certain time the actual, trend and seasonal variations are 555, 463 and 1.16. Find the residual at this point. (Round your answer to four decimal places).AnswerIn the multiplicative model TS = T x SV x RTherefore, R = TS/ (T x SV) = 555/ (463 x 1.16) = 1.0334 (to four decimal places)

357. (4) Seasonal variationsFor the additive model the seasonal variations will be given as a positive or negative number. The total of the seasonal variations will be zeroFor the multiplicative model the seasonal variations will be given as a percentage or a decimal. The total of the seasonal variations will be four. If this is not the case, any difference should be spread evenly across the seasonal variations

358. Illustration of seasonal variationsUsing the multiplicative model the seasonal variations are found to be 1.04, 1.15, 0.91 and 0.95. They are subsequently adjusted so that their total = 4. What is the new value of the average currently valued at 1.04?AnswerTotal = 1.04 + 1.15 + 0.91 + 0.95 = 4.05, hence we adjust by subtracting 0.05/4 = 0.0125 from each average. The adjusted first average = 1.04 – 0.0125 = 1.0275

359. (5) Forecasting method 1: using least squares regressionStep 1: The forecasted trend can be calculated using least squares regression (as seen in Chapter 7). This is appropriate if there is a linear trendStep 2: Using the appropriate time series model, i.e. additive or multiplicative, an adjustment can be made to the trend for the seasonal variation and the time series can be calculated (Ignore the residual, R, unless stated otherwise)

360. Illustration of forecasting using least squares analysisLeast squares regression was used to calculate the straight line of best fit, y= a + bx, for sales against time.This was found to be y = 13.7 + 1.5x, where y is equal to the sales value and x is the quarterWhat are the forecast sales for quarter 14 if: (a) The seasonal variation is +2.4 for this quarter (b) The seasonal variation is +10% or +0.1 for this quarter

361. AnswerStep 1Using the least squares regression line the trend, T, can be calculated for quarter 14 y = 13.7 + 1.5x y = 13.7 + (1.5 x 14) y = 34.7 This is the forecasted sales trend (T)Step 2An adjustment can be made to the trend to reflect the seasonal variation and the sales can be forecast for quarter 14

362. If the seasonal variation is given as a number (positive or negative) we must use the additive model : Forecast sales for Q14 (TS) = T + SV = 34.7 + 2.4 = 37.1(b) If the seasonal variation is given as a percentage or decimal we must use the multiplicative model: Forecast sales for Q14 (TS) = T x SV = 34.7 x 1.1 = 38.17

363. (6) Forecasting method 2: using moving averages Step 1: The forecasted trend can be calculated using moving averages. This is appropriate if there is no linear trendStep 2: Using the appropriate time series model, i.e. additive or multiplicative, an adjustment can be made to the trend for the seasonal variation and the time series can be calculated (as for method 1) (Ignore the residual, R, unless stated otherwise)

364. Illustration of forecasting using moving averages Using the data below, calculate the trend for the sales of article B as a centred four-point moving average, i.e. complete step 1Answer See next slide. Sales for article B (‘000units)Q1Q2Q3Q4200624.836.338.147.5200731.242.043.455.9200840.048.854.069.1

365. YearQtrSales (Y)4 point moving total8 point moving total4 point moving average (T)2006124.8--236.3--338.1146.7299.837.4750447.5153.1311.938.98752007131.2158.8322.940.3625242.0164.1336.642.0750343.4172.5353.844.2250455.9181.3369.446.17502008140.0188.1386.848.3500248.8198.7410.651.3250354.0211.9438.554.8125469.1226.6-

366. (7) Seasonal adjustmentIf the seasonal variations (SV) are already known, then it is possible to de-seasonalise the actual results (TS) to identify the trend (T) Multiplicative model Based upon: Actual (TS) = Trend x SV Trend = Actual ÷ SV Additive model Based upon: Actual (TS) = Trend + SV Trend = Actual – SV

367. Illustration of seasonal adjustmentUnemployment numbers actually recorded in a town for the second quarter of 20X8 were 2,400. The seasonal variation for this quarter is 0.95. Using the multiplicative model for seasonal adjustment, calculate the seasonally-adjusted figure (in whole numbers) for the quarterAnswerSeasonally adjusted figure, trend = Actual ÷ SV = 2,400 ÷ 0.95 = 2,526