ACCA Paper F9ACCA Paper F9

Financial Management

Core areas of the syllabusCore areas of the syllabus

• Financial management function

• Financial management environment

• Working capital management

• Investment appraisal

• Business finance

• Cost of capital

• Business valuations

• Risk management

Format of the examFormat of the exam

• Four compulsory questions

• 25 marks each

• Balance of calculative and discursive elements in questions

The financial management function

The financial management function

The financial management function

The financial management function

• (1) Raising finance

• (2) Investing funds raised – this includes

• allocating funds and

• controlling investments

• (3) Dividend policy – returning gains to shareholders

Corporate strategy and objectives

Corporate strategy and objectives

Corporate stakeholdersCorporate stakeholders

Agency theoryAgency theory

• Agency relationships occur when one party, the principal, employs another party, the agent, to perform a task on their behalf

• Objectives of principals and agents may not coincide

• Problem of goal congruence

Not for profit organisationsNot for profit organisations

Value for moneyValue for money

• Effectiveness– A measure of outputs– e.g. number of pupils taught

• Efficiency– A measure of outputs over inputs– e.g. Average class size

• Economy– Being effective and efficient at the lowest

possible cost

System analysisSystem analysis

Investment appraisalInvestment appraisal

• ROCE

• Payback

• Net present value

• Internal rate of return

ROCEROCE

PaybackPayback

PaybackPayback

The time value of moneyThe time value of money

• Money received today is worth more than the same sum received in the future because of:– The potential for earning interest– The impact of inflation– The effect of risk

CompoundingCompounding

• Compounding calculates the future value of a given sum of money

F = P (1 + r)n

where F = future value after n periods

P = present or initial value

r = rate of interest per period

n = number of periods

DiscountingDiscounting

• Discounting is the conversion of future cash flows to their present value

Annuities and perpetuitiesAnnuities and perpetuities

• An annuity is a constant annual cash flow for a number of years

Annuities and perpetuitiesAnnuities and perpetuities

• An perpetuity is an annual cash flow that occurs for ever

Annuities and perpetuitiesAnnuities and perpetuities

Relevant cash flowsRelevant cash flows

• Only consider future, incremental cash flows

• Ignore:– ‘sunk costs’– Committed costs– Depreciation– Interest & dividend payments

• Include opportunity costs

Net present valueNet present value

• All future cash flows are discounted to their present value and then added

• A positive result indicates the project should be accepted

• A negative result and the project should be rejected

Internal rate of returnInternal rate of return

• The rate of interest (discount) at which the NPV = 0

Internal rate of returnInternal rate of return

NPV with inflationNPV with inflation

Real and money ratesReal and money rates

TaxationTaxation

• Two tax effects to consider:– Tax payments on operating profits– Tax benefit from capital allowances and a

possible tax payment from a balancing charge on asset disposal

Writing down allowancesWriting down allowances

Pro Forma NPV calculationPro Forma NPV calculation

Working capital in NPV questions

Working capital in NPV questions

• Working capital is treated as an investment at the start of the project

• Any increases during the project are treated as a relevant cash outflow

• At the end of the project the working capital is ‘released’ – an inflow

• The working capital requirement may be given as a % of (usually) sales

Lease versus buy decisionLease versus buy decision

• Compare the present value cost of leasing with the present value cost of borrowing to buy

• Leasing cash flows:– Rental payments (usually in advance)– Tax relief on the rental payments

• Buying cash flows:– Asset purchase– Writing down allowances

Replacement decisionsReplacement decisions

• Used when the assets of a project need replacing periodically

• Choose the option with the lowest equivalent annual cost

• The optimum replacement cycle is that period which has the lowest EAC

Capital rationingCapital rationing

• Insufficient funds to undertake all positive NPV projects

• Mutually exclusive projects – choose the project with the highest NPV

• Divisible projects – calculate the profitability index

• Indivisible projects – trial and error

Risk in investment appraisalRisk in investment appraisal

• Risk = probabilities of different outcomes can be estimated

• Expected values

p = probability of each outcome

x = the cash flow from each outcome

• Payback used in addition to NPV

• Risk adjusted discount rates

Uncertainty in investment appraisal

Uncertainty in investment appraisal

• Uncertainty = probabilities of different outcomes cannot be estimated

• Sensitivity analysis

• Minimum payback period

• Assess the worst possible situation

• Obtain a range by assessing the best and worst possible situations

Sensitivity analysisSensitivity analysis

• Calculate how much one input value must change before the decision changes (say from accept to reject)

• The smaller the margin the more sensitive is the decision to the factor being considered

Working capitalWorking capital

• The capital available for conducting the day-to-day operations of the business

• All aspects of both current assets and current liabilities need to be managed to:– Minimise the risk of insolvency– Maximise the return on assets

Cash operating cycleCash operating cycle

Cash operating cycleCash operating cycle

• The length of the cycle = Inventory days + Receivable days – Payables days

• The amount of cash required to fund the operating cycle will increase as either:– The cycle gets longer– The level of activity or sales increases

Cash operating cycleCash operating cycle

• Reduce cycle time by:– Improving production efficiency– Improving finished goods and / or raw

material inventory turnover– Improving receivable collection and

payables payment periods

Working capital ratiosWorking capital ratios

Working capital ratiosWorking capital ratios

Managing inventoryManaging inventory

Economic order quantityEconomic order quantity

Where:

Co = cost per order

D = annual demand

Ch = cost of holding one unit for

one year

Q = quantity ordered

Inventory management systemsInventory management systems

• Bin systems– Action taken if inventory falls outside a

preset maximum and minimum

• Periodic review– Inventory levels reviewed at fixed intervals

• Just in time– Aims for elimination of inventory– Finished goods made to order– Raw material inventory is delivered to point

of use when needed

Accounts receivableAccounts receivable

• Have a credit policy

• Assess credit worthiness

• Control credit limits

• Invoice promptly and collect overdue debts

• Follow up procedures

• Monitoring the credit system

• Offer discounts

Prompt payment discountsPrompt payment discounts

Debt factoringDebt factoring

Debt factoringDebt factoring

Invoice discountingInvoice discounting

Accounts payableAccounts payable

• Simple and convenient source of short term finance

• Normally seen as ‘free’ but:– Supplier may offer a discount for prompt

payment– Undue delays in payments can result in:

• Supplier refusing to supply in future• Loss of reputation and goodwill• Supplier increasing price in future

Cash ManagementCash Management

• Return point = lower limit + (⅓ x spread)• Spread = 3[(¾ × transaction cost ×variance of

cash flows) ÷ interest rate]⅓

Cash managementCash management

Cash managementCash management

Cash managementCash management

Financing working capitalFinancing working capital

Financing working capitalFinancing working capital

Currency riskCurrency risk

• Transaction exposure – the risk of the exchange rate changing between the transaction date and the settlement date.

• Translation exposure – the change in the value of a subsidiary due to changes in exchange rate.

• Economic exposure – the loss of competitive strength due to changes in exchange rates.

Changes in exchange ratesChanges in exchange rates

Hedging foreign currency riskHedging foreign currency risk

• Forward contracts

• Money market hedge

• Futures

• Options

Interest rate risk – the yield curve

Interest rate risk – the yield curve

Hedging interest rate riskHedging interest rate risk

• Forward rate agreements

• Interest rate guarantees

• Interest rate futures

• Interest rate swaps

Macro economic policyMacro economic policy

Monetary policyMonetary policy

Fiscal policyFiscal policy

Financial marketsFinancial markets

Sources of financeSources of finance

New share issuesNew share issues

• Placing

• Offer for sale

• Offer for sale by tender

• Intermediaries’ offer

• Rights issue

Rights issuesRights issues

• Existing shareholders have the right to subscribe to new share issues in proportion to their existing holdings

• Theoretical Ex-rights price (TERP)TERP = Value of existing shares + proceeds from issue

No. of shares in issue after the rights issue

• Value of a rightValue of a right = TERP – issue price

Value of a right per existing share = Value of a right .

No. of shares needed to have a right

Estimating the cost of capital - The dividend valuation model

Estimating the cost of capital - The dividend valuation model

• The current share price is determined by the future dividends, discounted at the investors required rate of return

• Assumes:– Dividends will be paid in perpetuity– Dividends are constant or growing at a

fixed rate

The cost of equityThe cost of equity

The cost of equityThe cost of equity

Estimating growthEstimating growth

• The averaging method

• Gordon’s growth model

The cost of debtThe cost of debt

Where:

i = the pre-tax interest paid on £100

t = tax rate

P0 = ex-interest market value of £100 nominal of debt

Weighted average cost of capital (WACC)

Weighted average cost of capital (WACC)

WACC – the calculationsWACC – the calculations

The steps:

1.Calculate weights for each source of capital

2.Estimate the cost of each source

3.Multiply the weights for each source of capital by its cost

4.Sum the results

Capital asset pricing model (CAPM)

Capital asset pricing model (CAPM)

• Total risk comprises systematic risk and unsystematic risk– Systematic risk = market wide factors such

as the state of the economy– Unsystematic risk = company / industry

specific factors

• By holding a diversified portfolio, investors can almost eliminate unsystematic risk

CAPMCAPM

CAPMCAPM

• Investors should only be compensated for systematic risk

• CAPM uses the β value of a share to measure its systematic risk and from that predicts the return an investor should require

β = 0 = risk free investment

β = 1 = the market portfolio (avg risk)

Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

Where:Rj = the required return from the investment

Rf = the risk free rate of return

βj = the beta value of the investment

Rm = the return from the market portfolio

CAPM can therefore be used to calculate a risk adjusted cost of equity

Business risksBusiness risks

Operating gearingOperating gearing

• Looking at the cost structure (cause)

• Looking at the impact on the income statement (effect)

Financial gearingFinancial gearing

• A measure of risk related to how the company is financed

Capital structure and WACCCapital structure and WACC

The traditional viewThe traditional view

Modigliani and Miller without taxModigliani and Miller without tax

Modigliani and Miller with taxModigliani and Miller with tax

Gearing levels in practiceGearing levels in practice

• Problems with high levels of gearing:– Bankruptcy risk– Agency costs– Tax exhaustion– Effect on borrowing capacity– Risk tolerance of investors– Breach of Articles of Association– Increases in the cost of borrowing as

gearing levels rise

CAPM and gearing riskCAPM and gearing risk

• When using betas in project appraisal, the impact of gearing of the finance used must be borne in mind

CAPM and gearing riskCAPM and gearing risk

Financial ratios: ProfitabilityFinancial ratios: Profitability

ROCEROCE

Financial ratios: Investor ratiosFinancial ratios: Investor ratios

Potential problemsPotential problems

• ROCE– Uses profit, not maximisation of

shareholder wealth

• EPS– Does not represent actual income

• ROE– Sensitive to gearing levels

• Dividend yield– Ignores capital growth

Dividend irrelevancy theoryDividend irrelevancy theory

• Theory: shareholders do not mind how their returns are split between dividends and capital gains

• Reality: Market imperfections due to:– Dividend signalling– The clientele effect– Taxation– Liquidity requirements

• Conclusion: companies tend to adopt a stable dividend policy

Business valuationsBusiness valuations

• Valuations are subjective and are a compromise between buyer and seller

• Methods exist to get a starting point for negotiations– Dividend valuation model (covered

previously)– Asset based valuations– Price-earnings ratio model– Discounted cash flow basis

Asset based valuationsAsset based valuations

Asset based valuationsAsset based valuations

• Problems:– You’ll usually get a value considerably

lower than the market value of all the company’s shares which reflect goodwill

– The company is usually being bought for its future income potential, not its assets

Price-earnings ratio modelPrice-earnings ratio model

Using an adjusted P/E multiple from a similar quoted company (or industry average):

Value of company = Total earnings × P/E ratio

Value per share = EPS × P/E ratio

Problems:• Finding a similar quoted company• Identifying required adjustments (if any)• Marketability discount to reflect that the

shares aren’t quoted

Discounted cash flow basisDiscounted cash flow basis

• Calculate a company-wide NPV using:– Details of all future company cash flows– The company discount rate

• Problems– It relies on estimates of both cash flows

and discount rates– It assumes discount rate and tax rates are

constant through the period– It does not evaluate further options

Market efficiency – Weak formMarket efficiency – Weak form

• Share prices reflect all known publicly available past information about companies and their shares.

• Impossible to predict future share price movements from historical patterns

• Share prices follow a random walk

Market efficiency – Semi-strong form

Market efficiency – Semi-strong form

• Share prices reflects historical information about companies and respond immediately to other current publicly-available information.

• Evidence suggests most leading stock markets are semi-strong efficient

Market efficiency – Strong formMarket efficiency – Strong form

• Share prices reflects all information about companies including information that has not yet been made public.

• Publication of new information does not impact on the share price

• It is unlikely that strong-form exists in reality