ACCA Paper F9
description
Transcript of ACCA Paper F9
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ACCA Paper F9ACCA Paper F9
Financial Management
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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
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Format of the examFormat of the exam
• Four compulsory questions
• 25 marks each
• Balance of calculative and discursive elements in questions
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The financial management function
The financial management function
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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
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Corporate strategy and objectives
Corporate strategy and objectives
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Corporate stakeholdersCorporate stakeholders
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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
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Not for profit organisationsNot for profit organisations
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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
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System analysisSystem analysis
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Investment appraisalInvestment appraisal
• ROCE
• Payback
• Net present value
• Internal rate of return
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ROCEROCE
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PaybackPayback
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PaybackPayback
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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
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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
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DiscountingDiscounting
• Discounting is the conversion of future cash flows to their present value
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Annuities and perpetuitiesAnnuities and perpetuities
• An annuity is a constant annual cash flow for a number of years
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Annuities and perpetuitiesAnnuities and perpetuities
• An perpetuity is an annual cash flow that occurs for ever
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Annuities and perpetuitiesAnnuities and perpetuities
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Relevant cash flowsRelevant cash flows
• Only consider future, incremental cash flows
• Ignore:– ‘sunk costs’– Committed costs– Depreciation– Interest & dividend payments
• Include opportunity costs
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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
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Internal rate of returnInternal rate of return
• The rate of interest (discount) at which the NPV = 0
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Internal rate of returnInternal rate of return
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NPV with inflationNPV with inflation
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Real and money ratesReal and money rates
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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
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Writing down allowancesWriting down allowances
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Pro Forma NPV calculationPro Forma NPV calculation
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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
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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
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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
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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
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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
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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
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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
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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
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Cash operating cycleCash operating cycle
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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
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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
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Working capital ratiosWorking capital ratios
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Working capital ratiosWorking capital ratios
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Managing inventoryManaging inventory
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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
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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
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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
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Prompt payment discountsPrompt payment discounts
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Debt factoringDebt factoring
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Debt factoringDebt factoring
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Invoice discountingInvoice discounting
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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
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Cash ManagementCash Management
• Return point = lower limit + (⅓ x spread)• Spread = 3[(¾ × transaction cost ×variance of
cash flows) ÷ interest rate]⅓
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Cash managementCash management
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Cash managementCash management
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Cash managementCash management
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Financing working capitalFinancing working capital
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Financing working capitalFinancing working capital
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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.
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Changes in exchange ratesChanges in exchange rates
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Hedging foreign currency riskHedging foreign currency risk
• Forward contracts
• Money market hedge
• Futures
• Options
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Interest rate risk – the yield curve
Interest rate risk – the yield curve
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Hedging interest rate riskHedging interest rate risk
• Forward rate agreements
• Interest rate guarantees
• Interest rate futures
• Interest rate swaps
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Macro economic policyMacro economic policy
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Monetary policyMonetary policy
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Fiscal policyFiscal policy
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Financial marketsFinancial markets
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Sources of financeSources of finance
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New share issuesNew share issues
• Placing
• Offer for sale
• Offer for sale by tender
• Intermediaries’ offer
• Rights issue
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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
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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
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The cost of equityThe cost of equity
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The cost of equityThe cost of equity
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Estimating growthEstimating growth
• The averaging method
• Gordon’s growth model
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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
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Weighted average cost of capital (WACC)
Weighted average cost of capital (WACC)
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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
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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
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CAPMCAPM
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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)
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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
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Business risksBusiness risks
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Operating gearingOperating gearing
• Looking at the cost structure (cause)
• Looking at the impact on the income statement (effect)
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Financial gearingFinancial gearing
• A measure of risk related to how the company is financed
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Capital structure and WACCCapital structure and WACC
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The traditional viewThe traditional view
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Modigliani and Miller without taxModigliani and Miller without tax
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Modigliani and Miller with taxModigliani and Miller with tax
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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
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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
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CAPM and gearing riskCAPM and gearing risk
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Financial ratios: ProfitabilityFinancial ratios: Profitability
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ROCEROCE
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Financial ratios: Investor ratiosFinancial ratios: Investor ratios
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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
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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
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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
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Asset based valuationsAsset based valuations
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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
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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
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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
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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
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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
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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