Miller Modiliagni

Miller and Modiliagni were two great economists that contributed in a big way in the finance field, both winning Nobel prizes in their day.

Today, the MM proposition 1 that states that under the following assumptions the capital structure is irrelevant to the value of the firm is a framework used by CFOs and companies around the world.

The assumptions under this framework are as follows and can in turn be relaxed to evaluate specific corporate situations and decisions:

1. Perfect and Complete Capital Markets

2. NO Taxes

3. Bankruptcy is NOT costly

4. Capital Structure does NOT affect investment policy and cash flows

5. Symmetric Information (no one has an informational advantage)


Their second proposition is also very powerful and states that the cost of equity increases linearly with the market-value based D/E ration

Two Interesting Behavioral Points of Advice

If you want to know what someone thinks about something, ask what they think others think about this subject.

If you don't want to say what your salary expectations are, just say you heard from a friend that typically for this type of job the salary is so and so.

Some Terminology Related to International Trade

Bill of Exchange - a document used in international trade to pay for goods or services. It is signed by the person promising to pay. The bill of exchange may be payable on demand or at a point in time in the future.

A bill of exchange may be transferable and is similar to a promissory note.

Letter of Credit - this is a letter from a bank guaranteeing the buyers payment will be honored as per the relevant contract. In the event the buyer is not able to make the relevant payment, the bank will be required to pay the remaining outstanding amount due.

In international trade, parties may not know each other and a letter of credit can provide the necessary comfort to the seller that it will receive prompt payment.

Letters of credit are typically negotiable which means they can normally be freely transferable to third parties. 

Financing Options Alternatives to Equity Financing

Overdraft - a form of lending where the bank grants a limit facility and the customer can take advantage of it as necessary. Essentially this is a form of unsecured short term financing. 

Advantages:

1. Typically cheaper than most sources of financing 

2. Interest is payable only on the amounts actually drawn which creates flexibility for the borrower and helps reduce costs. (especially for companies with fluctuating demand for WC) 

Disadvantages:

1. Overdrafts are typically payable on demand which increases the financial risk for the business

2. Longer-term overdrafts may be included in gearing ratios and banks could request security

Debt Factoring - an arrangement where the factor company advances a portion of the A/R to be collected and undertakes the admin functions of collecting the receivables

Advantages:

1. The factor company takes over client invoicing, sales accounting and debt collection and thereby  the client can reduce its own costs on the P&L

2. In certain circumstances the factor company will take over the risk of loss on the receivables, resulting in a transfer of credit risk on the A/R from the corporate to the factor company

3. Frees up capital that can be used to finance growth

4. Focus management time 

Disadvantages:

1. The level of finance is geared to sales volumes. Factoring does not resolve the WC requirements to finance growth since A/R always lag sales volume growth

2. Tends to be expensive relative to bank financing. Typically 2% of invoice value for service charges + bank rates for financing. 

3. May affect reputation with clients especially when clients pay directly to the factor company giving the impression that the company is facing financial troubles. 

Invoice Discounting - in this case a selected portion of the A/R is sold to a buyer at a discount. The Buyer does not undertake any administration of the client's sales ledger. 

1. Allows to raise capital from the A/R 

2. No security required. 

Disadvantages 

1. More expensive than any other source of financing that is likely available

2. Buyers will provide reasonable terms very often only on good quality receivabes 

Other sources of financing:

i. lengthening A/P days i.e. delaying payment

ii. Other loan financing

iii. More efficient inventory management 

iv. Early settlement discounts for customers

Costing approaches in management accounting

Accounting professionals should be aware of the accounting approaches available and their advantages and disadvantages. Below is a short summary:


The two traditional methods of costing are marginal costing and absorption costing. 

Absorption is in line with IFRS and allocates overheads based on the volume of units produced or hours worked.

Marginal costing splits costs strictly between variance and fixed costs. This approach may have the benefits of allowing the analyst to see how the business is likely to behave in certain scenarios such as an increase in certain costs, volume increases or price increases.

There are alternatives, however:

1. Activity Based Costing - a form of absorption costing where the overhead absorption is not based on volumes but instead overheads are allocated to cost pools which are then absorbed based on cost drivers.

2. Target Costing - this is a top-down approach. Whereas the conventional approach is to develop the cost for goods held in inventory based on the cost to produce them and order the inputs, in the target costing approach the company first estimates the market price of the final product and then will subtract the profit margin and take into account investment costs and working capital needs in order to come up with a figure for the true cost.

3. Life Cycle Costing - this is a concept that seeks to track and take into account all the product costs over the lifecycle of the product. For example, an organization that does not take into account lifecycle costing may acquire goods at the lowest possible price but incur subsequently much higher costs later. (e.g. acquire agriculture land cheaper but with certain farming obligations that may have a heavy cost)

4. Total Quality Management (TQM) - this is a structured approach to quality and cost management of an organization focusing on three main elements:

   a) Focus on internal systems to prevent faulty products, production failures etc

   b) Improvement - management needs to persist improvement of the organization processes and not accept the status quo.

   c) Customer orientation - the organization needs to aim to achieve customer needs and expectations and quality should be evaluated from the point of view of the customer.

TQM classifies quality costs under four categories:

I) Prevention costs - costs of any actions by the organization to reduce defective product or failure.
Examples: customer surveys, research of customer needs, quality engineering

II) Appraisal costs - costs associated with checking that the product meets the required quality standards.
Examples: inspection and product testing, product quality audit, process control monitoring

III) Internal failure costs - costs arising from inadequate quality of the organization's processes BEFORE the transfer of ownership to the customer/client actually occurs
E.g. if the plant due to failure produces waste, the cost of getting rid of it and cleaning the facilities can be considered an internal failure cost. Disposal costs of defective products produced is another example.

IV) External failure cost - costs arising when the ownership title for the product is transferred to the customer
E.g. warranty claims, legal claims from the customer for poor quality of service, complaint investigation and processing costs


Prevention and appraisal costs are essentially conformance costs that the organization undertakes to ensure the product meets the requirements and is high quality. The internal and external failure costs on the other hand are non-conformance.

How the Accounting Process Works

First you Collect the accounting information from data sources available.

Once the information is identified, it is posted to the books of prime entry.

These are not double entry and are just lists: sales day book, sales day returns book, purchases day book, purchases returns book, cash book, petty cash book and the journal (includes all other types of items that do not fall into the other books)

The books of prime entry are then entered into the ledger accounts which may be of any number and are in double entry format. e.g. purchase of car for cash will Dr. motor account Cr cash account

The collection of ledger accounts is known as the general ledger or nominal ledger

Separately business entities will maintain lists of individual receivables and payables due from each customer and supplier. These will be known as memorandum balances often referred to also as receivables ledger and payables ledger. These are not to be confused with the receivables and payables ledger control accounts. The memorandum ledgers are also sometimes known as subsidiary ledgers or individual ledgers. They are not part of the double entry system.

The receivables and payables control accounts are part of the double entry system and the general ledger unlike the memorandum (which is not part of the ledger either).

Errors that are NOT revealed by the Trial Balance

The trial balance is a list of all the general ledger balances. Each ledger account part of the general ledger will have either a debit or credit balance. Since the general ledger entries are all double entries, it follows that the resulting balances should also balance.

The trial balance is essentially a control system that helps identify and evaluate errors made. There are however limitations. The following are the types of errors that are not revealed by the trial balance:

1. Error of Omission: no entry at all in a case when there should have been
2. Error of Commission: entry to the wrong individual account. 
3. Error of Principle: entry to the wrong type of account e.g. $100 posted to assets instead of purchases. (both are debit entries)
4. Error of Original Entry: wrong amounts are posted to both credit and debit
5. Error of Reversal: correct amounts are posted to the correct accounts but on the wrong sides
6. Error of Transposition: posting $123 instead of $321 on both sides
7. Compensating errors: two or more erros that compensate each other

The trial balance can still be a useful accounting control system however. The following mistakes are revealed:

1. Posting to one side only
2. Posting both entries to one side only
3. Posting different figures to each side
4. An individual account added up incorrectly
5. Opening balance not brought down
6. Balance in the trial balance is different from balance on the account (extraction error)