ACCA Paper F9

Financial Management

Core 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 exam • Four compulsory questions • 25 marks each • Balance of calculative and discursive elements in questions

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 stakeholders

Agency 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 organisations

Value 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 analysis

Investment appraisal • ROCE • Payback • Net present value • Internal rate of return

ROCE

Payback

Payback

The 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

Compounding • 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

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

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

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

Annuities and perpetuities

Relevant cash flows • Only consider future, incremental cash flows • Ignore: – ‘sunk costs’ – Committed costs – Depreciation – Interest & dividend payments • Include opportunity costs

• 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 Net present value

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

Internal rate of return

NPV with inflation

Real and money rates

Taxation • 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 allowances

Pro Forma NPV calculation

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 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 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 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 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 = 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 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 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 cycle

Cash 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 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 ratios

Working capital ratios

Managing inventory

Economic order quantity Where: C o = cost per order D = annual demand C h = cost of holding one unit for one year Q = quantity ordered

Inventory 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 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 discounts

Debt factoring

Debt factoring

Invoice discounting

Accounts 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 Management • Return point = lower limit + (⅓ x spread) • Spread = 3[(¾ × transaction cost ×variance of cash flows) ÷ interest rate] ⅓

Cash management

Cash management

Cash management

Financing working capital

Financing working capital

Currency 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 rates

Hedging foreign currency risk • Forward contracts • Money market hedge • Futures • Options

Interest rate risk – the yield curve

Hedging interest rate risk • Forward rate agreements • Interest rate guarantees • Interest rate futures • Interest rate swaps

Macro economic policy

Monetary policy

Fiscal policy

Financial markets

Sources of finance

• Placing • Offer for sale • Offer for sale by tender • Intermediaries’ offer • Rights issue New share issues

Rights 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 right Value 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 • 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 equity

The cost of equity

• The averaging method Estimating growth • Gordon’s growth model

The cost of debt Where: i = the pre-tax interest paid on £100 t = tax rate P 0 = ex-interest market value of £100 nominal of debt

Weighted average cost of capital (WACC)

WACC – 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) • 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

CAPM

CAPM • 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) Where: R j = the required return from the investment R f β j = the risk free rate of return = the beta value of the investment R m = the return from the market portfolio CAPM can therefore be used to calculate a risk adjusted cost of equity

Business risks

Operating gearing • Looking at the cost structure (cause) • Looking at the impact on the income statement (effect)

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

Capital structure and WACC

The traditional view

Modigliani and Miller without tax

Modigliani and Miller with tax

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

CAPM and gearing risk

Financial ratios: Profitability

ROCE

Financial ratios: Investor ratios

Potential 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 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 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 valuations

Asset 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 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 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 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 • 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 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