Paper F9 | FINANCIAL MANAGEMENT For Examinations to June 2015

For Examinations to June 2015

ACCA

Paper F 9 |

FINANCIAL MANAGEMENT

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ACCA

PAPER F9

FINANCIAL MANAGEMENT


©2014 DeVry/Becker Educational Development Corp.

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No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the author, editor or publisher.

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ISBN-13: 978-1-78566-043-6

Copyright ©2014 DeVry/Becker Educational Development Corp. All rights reserved.

All rights reserved. No part of this training material may be translated, reprinted or reproduced or utilised in any form either in whole or in part or by any electronic, mechanical or other means, now known or hereafter invented, including photocopying and recording, or in any information storage and retrieval system. Request for permission or further information should be addressed to the Permissions Department, DeVry/Becker Educational Development Corp.

These are condensed notes focusing on key issues for those of you who lead busy, mobile lives or for those of you who want to revise in a more focused fashion.


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CONTENTS

CONTENTS

Syllabus

The financial management function

The financial management environment

Investment appraisal

Business finance

Cost of capital

Working capital management

Business valuations

Risk management

Article – Myopic management

(iv)

0101

0201

0301

0401

0501

0601

0701

0801

0901

1001

1101

1201

Article – Islamic finance

Article – Receivables collection

Article – Optimal capital structure

Article – The capital asset pricing model

Article – Business finance and the SME sector

Analysis of specimen exam

Exam technique

Explanation of formulae sheet

Additional reading


1301

1401

1501

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SYLLABUS

Aim Rationale

To develop the knowledge and skills expected of a finance manager, in relation to investment, financing, and dividend

The syllabus, starts by introducing the role and purpose of the financial management function within a business. Before looking at the three key financial management decisions of policy decisions

Main capabilities investing, financing, and dividend policy, the syllabus explores the economic environment in which such decisions are made.  Discuss the role and purpose of the financial management function

 Assess and discuss the impact of the economic environment on financial management

The next section of the syllabus is the introduction of investing decisions. This is done in two stages – investment in (and the management of) working capital and the appraisal of long-term investments.

The next area examines the various sources of business

 Discuss and apply working capital management techniques

 Carry out effective investment appraisal finance, including dividend policy and how much finance can be raised from within the business. Cost of capital and other factors that influence the choice of the type of capital a  Identify and evaluate alternative sources of business finance business will raise then follows. The principles underlying the valuation of business and financial assets, including the impact of cost of capital on the value of business is covered next.

 Explain and calculate the cost of capital and the factors which affect it

 Discuss and apply principles of business and asset valuations

 Explain and apply risk management techniques in

©2014 business.

DeVry/Becker Educational Development Corp.

The syllabus finishes with an introduction to, and examination of, risk and the main techniques employed in the

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SYLLABUS

CORE TOPICS

Financial management function

Tick when completed

 Stakeholder analysis

 Financial objectives

 Non-financial objectives

 Non-for-profit sector









 Application of DCF techniques:

 capital rationing

 replacement cycles

 lease vs. buy

 Project appraisal under risk

Financial management environment Business finance

 Economic environment

 Financial environment





 Internally generated funds

 Dividend policy

 Debt finance

 Equity issues Investment appraisal

 Gearing (financial and operational)

 Payback period 

 SME finance

 Accounting Rate of Return (ARR) 

 NPV

 IRR

 Relevant cash flows for DCF







 Islamic finance


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Tick when completed























SYLLABUS

Tick when completed

Cost of capital Business valuation

 Asset based valuations

 Earnings based valuations

 Cost of equity

 Post-tax cost of debt

 Weighted Average Cost of Capital

 Theories of capital structure











 Dividend based valuations

Risk management

 Capital Asset Pricing Model

 Foreign currency risk

Working capital management  Interest rate risk

 Level and financing of current assets

 Cash operating cycle

 Overtrading

 Cash management









  Inventory management

 Management of receivables/payables 


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Tick when completed











SYLLABUS regular study of relevant articles in the ACCA “student accountant” magazine

Format of the examination

The syllabus is assessed by a three-hour paper-based examination consisting of section A and section B.

Section A will consist of 20 multiple choice questions from across the syllabus, each worth two marks.

Section B will consist of five compulsory long form questions. Three of these will carry 10 marks and can cover the entire syllabus. Two questions will carry 15 marks and will be taken from the syllabus areas of investment appraisal, sources of finance, cost of capital and working capital management.

15 minutes for reading and planning is given at the start of the examination. During this time candidates may make notes on the question paper but may not write in the answer booklet.

Additional Information

Candidates are provided with a formulae sheet and tables of discount and annuity factors.

Candidates are advised to bring a scientific calculator.

The ACCA Study Guide provides more detailed guidance on the syllabus. Wider reading is also desirable, especially


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THE FINANCIAL MANAGEMENT FUNCTION

Maximisation of shareholder wealth follow a range of non -financial objectives such as reduced pollution, community projects, fair treatment of suppliers etc.

Before we can make any financial management decisions we must first consider what we are trying to achieve i.e. what is the objective(s) of the organisation?

In the end the overall objective of a company may be

“satisficing” i.e. producing satisfactory (rather than maximum) returns for shareholders while taking into account a balanced range of non-financial objectives i.e. Corporate

Social Responsibility.

In the corporate sector the traditional assumption is that our objective is to maximise shareholders’ wealth i.e. maximising the Total Shareholder Return (the sum of dividend yield and share price growth). Theoretically this is achieved by maximising the present value of future cash flows of the company although in practice profit maximisation is often used as a proxy objective.

The agency problem

Unfortunately actual returns may fall even below satisfactory levels if managers/directors follow personal objectives which conflict with shareholders’ objectives. Managers may waste

Stakeholder analysis money on luxurious offices or corporate jets, or engage in reckless mergers and acquisitions simply to be heads of a larger and larger empire. This is known as the “agency problem” and the loss in shareholder wealth due to sub-

This traditional view of the role of business may be viewed as rather narrow. A wider view can be taken by using

“stakeholder analysis” i.e. identifying all groups of people optimal decision is known as “agency costs”. who have some type of involvement in the organisation. clash e.g. society may want cleaner production but this may increase costs and damage shareholder returns. On the other hand shareholders themselves may be ethically and socially


All rights reserved.

Investors need to be active and ensure appropriate corporate governance systems are implemented in order to reduce agency costs to an acceptable level. Unfortunately internal control systems create their own costs.

Of course the shareholders may well be the key stakeholder but other groups should be considered e.g. employees, customers, suppliers and perhaps even society as a whole.

Different groups will have different objectives and they may

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THE FINANCIAL MANAGEMENT FUNCTION

Non for profit sector

Do not assume that the examiner can only ask you about the corporate sector – you may be asked about the objectives of a non-for-profit/public sector organisation e.g. a state school or hospital.

In this sector the traditional profit motive may not exist and therefore some other target must be set. Providing “value for money” if often suggested as an objective in the public sector. This can then be split into the “three E’s” as used by the UK government for performing value for money audits:

 economy; minimising the inputs into the organisation e.g. minimising the cost of running a state university

 efficiency; maximising the output e.g. maximising the number of students who graduate

 effectiveness; success in meeting specified targets e.g. offering a wide range of courses.

Of course the “3 E’s” is far from a perfect system – minimising input costs is likely to compromise effectiveness for example.


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THE FINANCIAL MANAGEMENT ENVIRONMENT

This area of the syllabus is very wide ranging. To help candidates focus on the key issues the examiner published an article, “Market Matters”. efficiency means that relevant information is widely available to all investors at low cost.

An edited version of the article now follows. The original article appeared in the October 2003 issue of the Student

Accountant magazine. efficiency refers to the ability of capital markets to process information quickly and accurately, and arises as a consequence of operational efficiency and informational efficiency.

Capital market efficiency and fair prices

4. Allocational efficiency means that capital markets are able to allocate available funds to their most productive use and arises as a result of pricing efficiency.

For security prices to be fair, the capital markets must be able to process relevant information quickly and accurately.

Relevant information is anything that could affect security prices e.g. previous movements in security prices, newlyMost of the research into market efficiency has been into pricing efficiency.

Forms of pricing efficiency released company financial statements, changes in interest rates or details of sales of their own company’s shares by company directors. We say that a capital market is efficient when we are confident that security prices are fair. A capital In order to decide whether a capital market exhibits pricing efficiency, research must be undertaken into security price market can be efficient when share prices in general are falling (a bear market) or rising (a bull market).

Types of efficiency of securities.



movements and whether it is possible to make abnormal gains by acting on different kinds of information. Most of this research has been based on ordinary share price movements and three forms of efficiency can be described. 1. Operational efficiency requires that transaction costs are low and do not hinder investors in the sale or purchase

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 Weak form efficiency – refers to a market where share prices fully and fairly reflect all past information . In such a market, it is not possible to make abnormal gains

Since in practice it is possible (although usually illegal) to make abnormal gains by using insider information, even well-developed capital markets cannot be described as strong form efficient.

The consequences of market efficiency by studying past share price movements. Research has shown that capital markets are weak form efficient and that share prices appear to follow a “random walk”, the random changes in share prices resulting from the There is no right or wrong time to issue new shares since share prices are always fair. Other considerations than share unpredictable arrival of favourable and unfavourable information on the market.

 Semi-strong form efficiency – refers to a market where share prices fully and fairly reflect all publicly available price must be used to decide on the best time to issue new ordinary shares, such as the number of shares that will need to be issued to raise the required amount of finance, the effect of the new share issue on earnings per share, any dilution of control that might arise, the effect on gearing and financial risk, and so on. information in addition to all past information. In such a market it is not possible to make abnormal gains by studying publicly available information such as the financial press, company financial statements and Another consequence for companies is that it is pointless for company managers to try to manipulate information given to records of past share price movements. Research has shown that well-developed capital markets such as the

London Stock Exchange and the New York Stock

Exchange are semi-strong form efficient.

 Strong form efficiency – refers to a market where share prices fully and fairly reflect not only all publicly available information and all past information, but also all private information



the capital markets in order to present their companies in a more favourable light, since an efficient capital market will see through this as it “fully and fairly reflects all relevant information” in the process of providing fair prices.

A further consequence for both companies and investors is that there are no bargains to be found in capital markets.

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If capital markets are highly efficient, all that managers need to do is to make good financial management decisions (such as investing in all projects with a positive net present value).

This is in order to maximise the market values of their companies and hence to maximise shareholder wealth, which is the primary financial management objective.

The positive consequences of monopoly higher prices in order to support monopoly profits, but they may be offered a reduced product range. Society can also suffer through the inefficient use of economic resources in the production process, a decrease in innovation and product development, and a lack of incentives for a monopoly to reduce managerial and other inefficiencies.

Government regulation of monopoly

There may be situations where monopoly may be desirable, for example when size is necessary for efficient production of a particular product, i.e. through economies of scale.

This has been claimed to be true of utilities such as water distribution and electricity production.

Consumers cannot deal with monopolies and so this regulatory role is usually assumed by governments. The government’s aims can be to stop monopolies arising, to prevent abuse of a dominant position in a particular market, to prevent the creation of price-fixing cartels, and to preserve and maintain competition.

In the UK, these objectives are achieved through the actions of the Office of Fair Trading and the UK Competition

UK governments have felt the need to artificially maintain competition in the markets served by privatised UK utilities, implying that utilities naturally tend towards a monopoly. It has also been suggested that monopoly may be the natural reward for entrepreneurial activity by businesses, or the logical consequence of a focus on shareholder wealth maximisation.

The negative consequences of monopoly

The negative consequences of monopoly are usually felt to outweigh any positive outcomes. Society and the public can suffer as a result of monopoly. Not only do consumers pay



Commission, which are required to monitor, investigate and make binding recommendations in situations where a potential monopoly may arise.

The criteria used to initiate an investigation can be quite broad: UK legislation, for example, considers that a monopoly position may arise when a company has a market

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Product markets and the problem of externalities

Excessive profits can be gained by companies which do not pay the full economic cost for their production processes. For example, a company which causes environmental pollution does not bear the full cost of its inefficient production process, but transfers the cost of cleaning up its waste products as an externality to society as a whole. Externalities are social costs or benefits arising from economic decisions of individual economic agents such as companies.

Governments may need to intervene in product markets to require companies to bear more of the cost of the externalities they produce. In other words, they may adopt green policies.

Interest rate theory

The syllabus also refers to rates of interest and yield curves.

Both interest rate and yield can be seen as the cost of money, i.e. the price of money set by the interaction of the supply of funds and the demand for funds in a particular market.

It is important to recognise that interest rate and yield have different meanings. Interest rate is the percentage return on the nominal amount (face value) of debt issued. Yield can either mean interest rate divided by market price (often referred to as running yield), or it can mean the discount rate that makes the present value of future interest payments and redemption value equal to the current market price (referred to as the gross redemption yield or the yield to maturity).

Green policies can result in increased production costs as companies are required by legislation to reduce the

Consider a bond with a market value of $102.53 that pays 10 per cent per year for three years before being redeemed at par. Its interest rate (or coupon) is 10 per cent. Its running yield is 100  (10/102.53) = 9.75 per cent. Its gross redemption yield (found by linear interpolation) is 9 per cent. environmental impact of their business operations. These increased costs will reduce company profits unless they are passed on to customers through increased prices. If price increases occur, green policies can result in the reduction of externalities and the transfer of their costs from society to consumer.


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The longer the period over which debt is offered, the greater is the risk to the lender that the borrower may be unable to meet interest payments, or be unable to repay the principal amount borrowed. This means that as the time to redemption or repayment increases, the risk of default also increases, and we expect that lenders would require a higher return to compensate for this increased risk. If we consider default risk alone, we would expect long-term debt to be more expensive than short-term debt.

There are other factors to consider in discussing the relative risk and cost of long-term and short-term debt. The important point is that long-term debt is usually expected to be more expensive than short-term debt (i.e. the yield curve slopes upwards), unless other factors arise which act to change the normal state of affairs. Expectations theory, market segmentation theory and liquidity preference theory consider the different costs of debt of differing maturities, and students should consider these as possible explanations of yield curves which do not slope smoothly upwards.


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INVESTMENT APPRAISAL

The examiner believes that the key to creating wealth for shareholders is the selection of appropriate projects.

Cash

Year Project A Project B

(1000)

It is therefore essential that candidates are confident in applying and discussing the following techniques available for project appraisal:

300

2 500

300

4 – Payback period

Payback is defined as the number of years to recover the cash invested in a project. It has some advantages:

6 –

Payback 2 years

300

–

3 years

 it uses cash which is more objective than profits which are distorted by accounting policy

Although project A has a quick payback period it does not appear very attractive if we look over its whole life. Project B has a slower payback but stronger cash flows over its whole life. Remember that the value of a firm depends on its future

 it is easily calculated and understood (although there is no excuse for qualified financial managers to only use simple techniques) cash flow generation – suggesting project B is the better project (although NPV would need to be calculated to ensure the project increases the value of the company)

 it focuses on liquidity which is important particularly in higher risk environments.

Despite these advantages payback has a very large drawback

– it ignores cash flows which occur after the payback point.

This may result in the wrong projects being selected.

Consider the following mutually exclusive projects:



However there is evidence from around the world that many highly qualified financial managers still prefer to select projects using payback period rather than NPV. The reason for this may be “myopia” which literally means shortsightedness bur in finance refers to the problem of short-

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INVESTMENT APPRAISAL that the following factors may encourage managers to suffer from myopia:

 pressure to meet tough short-term targets/budgets

 performance evaluation and bonus systems based upon short run rather than long run results

 high management turnover i.e. managers who change jobs frequently are likely to have a short horizon for decision making at each firm. capital employed in a project – opening investment or the average level of investment over the project’s life. This leads to the following formulae:

ARR =

Annual

Initial average profit investment

 100

Or ARR =

Annual average

Average profit investment

 100

In the exam be prepared to: Average investment measures the average net book value in

 calculate payback period the balance sheet over the investment’s life. It is calculated as:

 explain why it is a poor method of project appraisal

Cost  scrap value

 suggest why it is still used so often in practice.

2

Accounting Rate of Return (ARR)/Return on Capital

Employed (ROCE)/Return on Investment (ROI) financial position. The ratio compares the operating profit

(EBIT) from a project to the level of investment in the project/capital employed. Unfortunately the calculation of profits is subjective and depends on accounting policies.



At a project level the ratio is called ARR. At a company level i.e. total EBIT divided into total capital employed (total assets – current liabilities) it is known as ROCE. However examiners sometimes refer to ROCE even at an individual project level. At a divisional level is can be referred to as

ROI.

This is a percentage measure based upon the financial accounting concepts of income statement and statement of SAMPLE


Whether is it called ARR/ROCE/ROI the technique has several weaknesses:

So how do we calculate NPV? The first step is to identify the relevant costs and revenues associated with the project. The characteristics of costs and revenues relevant for a decision are:

 profits are subjective and have no direct link to the company’s value which depends on cash flows

 future; decisions cannot change the past (past costs are known as sunk costs and are not relevant)

 choice as to the measure of investment in a project i.e. initial or average

 cash flows; the value of a project depends on its cash flows rather than its profits. Depreciation is not a cash cost and is not relevant.

 traditional financial accounting ratios such as ROCE are difficult to interpret in the service sector where the major asset is human capital which is not measured on the balance sheet.

 incremental i.e. the change in costs and revenues caused by the decision

 avoidable e.g. if a contract has already been signed for the rental of equipment then this is an unavoidable/committed cost and not relevant

 ARR is a relative i.e. % measure. Although people like using percentage measures it is not automatically true that a project with the highest ARR will produce the largest increase in shareholder wealth.

Net Present Value (NPV)

Analysis of past exam papers clearly shows that the project appraisal technique most heavily tested is NPV. The reason is simple – NPV shows the absolute $ change in the value of the company caused by the project i.e. the absolute change in the wealth of the company’s shareholders.



 opportunity costs e.g. cannibalisation – when sales of a new product reduce the sales of an existing product due to customers simply switching across.

In the exam you may be given a large volume of information and be required to find the relevant costs and revenues for discounting. Please be aware that there will be marks for explaining why you have excluded any costs and revenues

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Once you have produced your forecast of relevant costs and revenues the next step is to discount everything to present value. Discounting takes into account the time value of money i.e. $ received after one year has less value to us than

$ received today (due to risk, consumption preference and reinvestment opportunity). The discount rate/cost of capital measures the average return required by the company’s investors (both the shareholders and for a geared company, the debt investors) allowable deduction.) The method for calculating capital allowances will be given in the question. Capital allowances themselves are not cash flows but will save tax at the corporate tax rate, creating a cash inflow.

 inflation; note that even if inflation is zero the time value of money still exists (investors still require a positive return on investments) and we must still discount future cash flows to present value. However if inflation exists then the calculations can become more complicated. There are two approaches available: Discounting is performed by using the discount factors and annuity factors published in the exam paper

Present value = future value  discount factor

Total all the present values and you have the NPV.

If NPV is positive the project will increase the value of the company and should be accepted.

Complications:

(1) inflate all the cash flows to produce a “nominal” cash flow forecast. This is basically a forecast of the physical amounts of cash that will enter/leave the company i.e. after the effects of inflation.

These are then discounted using the “nominal” or

“money” discount rate i.e. the return required by investors to compensate for the risk of the project and for inflation.

 taxation; two effects. Firstly tax is paid on the net revenues generated by the project i.e. a cash outflow.

The corporate tax rate will be given in the question.

Secondly a UK company will receive tax allowable deductions on the capital expenditure, known as capital allowances or writing down allowances (paper F9 is under the UK tax system where depreciation is not a tax



(2) use cash flows which have been deflated to today’s purchasing power – known as “real” cash flows. These are discounted using the “real” cost of capital i.e. the return required if inflation was

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To convert a nominal discount rate to an effective discount rate requires a variation on the Fisher formula:

(1+i) = (1+e) (1+h s

)

(3) use cash flows expressed at today’s price levels – known as a cash flow forecast in “current” terms.

Each type of cash flow e.g. revenues, labour costs, materials costs must then be discounted separately at its own discount rate – known as an “effective” rate.

Where i = the money or nominal discount rate e = the effective discount rate h s

= the specific inflation rate of the cash flow.

Each method will produce the same NPV – one of the advantages of NPV is that it is a unique answer. Which method you should use depends on how the data is presented in the question. If you are given the specific inflation rates for different types of cash flow e.g. wage inflation, materials cost inflation then it is usually easiest to use the nominal method. On the other hand if you are told “all cash flows are expressed in real terms” then the real method would be easier. If you are given a cash flow which is an annuity at current price levels then it may be quicker to use the effective method with annuity factors.

 finance costs; what about the cost of financing the project e.g. interest on bank loans? This is a future, incremental cash flow and appears to meet all of the characteristics of a relevant cost for discounting.

However the cost of financing the project is measured in the cost of capital and therefore is already taken into account in the discounting process itself. If you forecast and then discount the financing cash flows associated with the project you are not only wasting your time but

To convert a real discount rate to a nominal discount rate (or vice-versa) requires the Fisher formula (which is given in the exam):

(1+i) = (1+r) (1+h)

Where i = the money or nominal discount rate r = the real discount rate h = the general inflation rate (measured by the CPI –

Consumer Price Index)



you will also understate the NPV by double-counting the finance cost!

The rule – forecast and then discount the operating cash flows from the project (cash from sales, cash for materials, cash paid to workers etc.).

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IRR will lose significant marks. Rule – always show your workings!

Applications of discounted cash flow techniques

The internal rate of return is the discount rate at which NPV

= 0

The method for estimating the IRR is known as interpolation.

Follow these steps:

The syllabus also contains some specific applications of NPV which are more likely to appear in optional questions in section B rather than in the compulsory case study:

(1) calculate the NPV at the company’s cost of capital

(2) if NPV was positive at the cost of capital then test the

NPV at a higher discount rate (simply choose a higher rate). If NPV was negative at the cost of capital then test at a lower rate.

 capital rationing; this is where the company does not have enough cash to finance all available positive NPV projects. The solution depends on whether the projects are divisible i.e. a part of a project can be undertaken, or indivisible. If projects are divisible the key technique is to calculate the following ratio for each project:

NPV

Initial investment

(3) assume a linear relationship between discount rate and

NPV (not technically accurate) and estimate the discount rate at which NPV = 0. Draw a graph of NPV against discount rate if this helps you with the calculations.

Of course if you have a financial calculator (which you are allowed to use in the exam providing it does not have a graphic or word display) this can quickly and accurately calculate the IRR for you. However remember that in ACCA exams the marker wants to see all your workings i.e. they



Examiners sometimes refer to this as a profitability index which is slightly misleading as it uses cash flows rather than profits. It would be better to call it an effectiveness index.

Funds should be allocated to projects with the highest index

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If projects are indivisible i.e. they must be undertaken 100% or not at all, there isn’t any special technique for finding the solution. You must simply use trial and error i.e. test different combinations of projects until the maximum possible NPV is found.

 asset replacement decision; how often should we replace assets such as machinery, computers or company cars? If we replace assets frequently we obviously pay the purchase price more often, but repairs and maintenance costs should be lower and second hand/trade-in values should be higher. If we replace assets less frequently we pay the purchase price less often but will probably have higher repair and maintenance costs and lower scrap values/ To compare different replacement cycles follow the following steps:

 lease vs. buy decisions; one of the most technical areas of the syllabus. Should we make a straight purchase of an asset or obtain it using a lease? Don’t worry too much whether the lease is an operating lease or a finance lease – this is an issue for financial reporting rather than for financial management.

The impact of the UK tax system is relevant in lease vs. buy decisions. If we buy an asset we obtain writing down allowances/capital allowances, which save tax at the corporate tax rate. If we lease an asset we will not receive capital allowances but the lease payments are 100% tax allowable. To analyse a lease vs. buy situation follow these steps:

(1) calculate the present value of operating cash flows (cash from sales, cash paid for labour and materials etc.) at the company’s average cost of cost of capital (1) calculate the present value of the cost of each possible replacement strategy

(2) express the cost of each strategy as an “annual equivalent cost” using the following formula: present va lue of annuity factor

(3) choose the strategy with the lowest annual equivalent cost costs



(2) calculate the present value of cash flows specific to buying the asset (purchase price, tax savings from writing down allowances) at the post-tax cost of debt finance

(3) calculate the present value of cash flows specific to

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(4) compare (2) and (3) and choose the cheaper financing option.

(5) compare the benefit of the asset from (1) to the cheaper finance cost from (4) to find the overall NPV. If overall

NPV is positive then acquire the asset using the cheaper finance, if overall NPV is negative then reject the asset.

 Uncertainty is where probabilities cannot be attached e.g. the residual value of machinery may be uncertain and no meaningful probabilities could be attached to its possible levels. Uncertainty increases with time i.e. more distant cash flows are more uncertain.

Methods of incorporating risk into project appraisal include:

If the question gives you the pre-tax cost of debt e.g. the  Sensitivity analysis i.e. by how much could a project interest rate on a bank loan, then for steps (2) and (3) you should convert it to the post-tax cost of debt which takes into account the tax savings due to interest. Use this formula: variable (such as sales price) change before the NPV hits zero? It could be argued that sensitivity analysis is of limited use as it gives us no idea as to how likely it is that the variable could change by this critical amount.

Post-tax cost of debt = pre-tax cost of debt  (1 – t)

Where t = the corporate tax rate as a decimal

It also ignores inter-relationships between variables i.e. in practice if sales price falls we may expect sales volume to rise.

 Simulation i.e. computer modelling of all possible

If the only discount rate given is the average cost of capital then use that for all steps.

Project appraisal under risk

Exam questions have asked candidates to distinguish between risk and uncertainty. Whilst these are closely related concepts the examiner takes the following definitions:

 Risk can be quantified e.g. it may be possible to attach



outcomes from a project, taking into account the interrelationships between project variables. Models such as

Monte Carlo analysis are useful in that they provide not only the expected NPV of a project but the dispersion of possible values above and below this point i.e. the standard deviation of project NPV. This in turn can be used to estimate the probability of the actual NPV being

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 Probability analysis e.g. attaching a probability distribution to possible levels of demand, to then calculate expected demand, expected sales revenues and, ultimately, expected NPV.

 Risk adjusted discount rates i.e. developing a tailormade cost of equity to model the specific level of business risk attached to the project’s cash flows. More detail on this can be found in the section on cost of capital.

 Use of (discounted0 payback period i.e. it can be argued that relatively short payback projects are relatively low risk However, as mentioned earlier, project selection should not be based on payback period alone as it ignores cash flows after the payback period (such cash flows could be negative).


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BUSINESS FINANCE

If a firm has identified positive NPV projects it must now consider how these projects are to be financed. In reality the method of project finance may affect the cost of capital/discount rate and in turn alter the project’s NPV.

However in paper F9 the topics of project appraisal and project finance are examined quite discreetly – simply evaluate the project using the discount rate given in the question and then suggest the most appropriate method of finance taking into account practical factors.

 “asymmetry of information” – company managers know more about the nature of potential projects than external providers of finance; particularly true for unlisted SME’s. Therefore external providers of finance may view potential projects as being higher risk than is the case, causing external finance to be unnecessarily expensive

However not all companies will have sufficient internally generated funds for several possible reasons:

Internal equity finance

 the project may simply be too large to be financed from internal sources;

 the company is incurring losses;

So where should a company look for project finance? Many candidates immediately suggest a new issue of shares or debt i.e. raising external finance. However a company should not consider external finance if it has internal financing available i.e. re-investment of cash from operations back into the business.

 the company may be reporting profits but still

“burning” cash rather than generating it. This is a common problem for a young, rapidly growing

There are two major advantages of using internally generated funds compared to new external finance:

 there are no issue costs if internal finance is used,



company that might have a lot of cash “locked” in its receivables and/or inventory i.e. poor working capital management. whereas issue costs can be as high as 11% for a new equity issue or 2% for a new bond issue.

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BUSINESS FINANCE

Dividend policy and internal finance Therefore in practice many listed companies tend to pay the same dividend each year, or a slightly higher dividend than the previous year.

Even if positive cash from operations is being generated the shareholders may expect a significant dividend to be paid, restricting the amount of internal finance available. If the company is unlisted then it may be less restricted in dividend policy and may be able to cut the dividend without risking adverse investor reaction.

This may be particularly true for a listed/quoted company that has paid regular dividends in the past. If the company now declares a smaller dividend its shareholders may react If, for whatever reason, internal funds are not available for adversely for the following reasons: financing the project then it is inevitable that external finance must be used. The major choice here is an equity issue or a debt issue. By equity we are referring to a new issue of ordinary shares – companies rarely issue preference shares

 Clientele theory – the firm’s historic dividend policy may have attracted institutional investors to take significant shareholdings in the company e.g. pension because they carry a significant cash cost in the form of dividends which are not a tax allowable deduction.

Debt finance funds like to hold shares in tobacco companies because these shares pay significant cash dividends which provides useful income for servicing the fund’s commitments. If the firm unexpectedly cuts its dividend

Debt can be classified into two main types: this can upset the key shareholders (the firm’s

“clientele”) who may then sell their holdings, causing a fall in share price.

 “Signalling” – there is a risk that the financial markets



 bank loans; with the bank in its traditional role as financial intermediary between lenders and borrowers.

Interest rates may be fixed or floating. will interpret the lower dividend as a signal of company weakness, causing a fall in confidence in the company and with it a fall in share price.

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BUSINESS FINANCE

 fixed charge; where the debt is secured on specific named assets, often fixed assets such as property. The company may not dispose of these assets, they must be held as collateral on the debt.

Equity vs. debt issues  bonds (also known as debentures or loan stock); only available to larger companies who can use “financial disintermediation”. This involves issuing debt directly to investors i.e. cutting out the bank. The company avoids paying a margin to the bank and therefore achieves a lower interest rate (although fees must be paid to an investment bank to guarantee/underwrite the bond issue.) Interest rates on bonds are usually fixed.

Bank loans or bonds may be secured i.e. guaranteed/pledged on assets. There are two main types of security:

Rank upon liquidation

Equity Debt

Last Higher

Servicing of finance

Dividend

Risk to investor

Return required

Discretionary Committed

High

High

Lower

Lower

Cost to company High Lower

Cost of equity > cost of debt

Servicing tax allowable? No Yes

Post-tax cost of debt < pre-tax cost of debt

Speed of issue

Issue costs

Slow

5–11%

Faster

Bonds 1–2%

Bank loan –

 floating charge; where the debt is secured on a class of



Financial gearing assets e.g. current assets. The company may trade with these assets but guarantees to keep them at a certain minimum level. The charge “floats” above the assets but will attach to them in the event of a default upon which inventory, receivables etc. would be liquidated to repay the debt.

With debt being cheaper and faster finance the company may prefer it to an equity issue. Therefore a company may use some level of financial/capital gearing .

However we should not conclude that all companies should

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BUSINESS FINANCE

 quality of assets: if the project has high quality physical assets these can be used to secure debt and achieve low interest rates.

 financial risk; interest on debt is a fixed cost i.e. does not rise and fall with sales. Higher fixed costs creates more volatile profits for shareholders. This higher volatility is known as financial risk. It occurs even at relatively low levels of debt i.e. before default risk becomes significant.

 tax position; a company without taxable profits loses the “tax shield” on debt.

 default/credit risk; at high levels of debt there is risk of default on interest or principal. If the debt holders then put the company into liquidation they are repaid in priority to shareholders who may receive nothing. Even if the company manages to restructure its debts the shareholders will have to suffer the related costs (costs of financial distress).

 restrictive debt covenants; at high levels of gearing the debt investors may require strong conditions to be written into the debt contracts e.g. restricting dividend payments. Control of the company may move away from the shareholders towards the debt investors.

Pecking order theory

For practical, if not theoretical reasons, we can summarise that:

 Internal finance is preferred to external finance;

Therefore we can conclude that the use of debt has both advantages and disadvantages for the company’s shareholders.

 Issuing debt is preferred to issuing equity.

So is there optimal level of financial gearing? Although models of capital structure have been developed (see the later section “ optimal capital structure ”) in practice it is a matter



The resulting hierarchy (internal equity, debt, external equity) is known as “pecking order theory”. of management judgement taking into account factors such as:



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BUSINESS FINANCE

SME finance

Although there is no official definition of an SME it usually refers to unquoted companies. SME are important for various reasons:

 much of the output and employment of many economies is from the SME sector

 SMEs have higher potential growth rates than large mature companies

 SMEs bring economic diversification

 SME’s often have more problems obtaining finance than large companies

You will find detail on SME finance later in the later section

“Business finance and the SME sector”.

Islamic finance

Due to the prohibition on riba Islamic banking has developed a range of alternative methods of providing a return to lenders, Detail on these can be found in the later section

“Islamic finance”.

Be aware of the rising importance of Islamic finance – a system of banking consistent with the principles of Sharia law. Sharia prohibits:

 the payment or acceptance of interest (riba),




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ADDITIONAL READING


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ABOUT BECKER PROFESSIONAL EDUCATION

Becker Professional Education provides a single destination for candidates and professionals looking to advance their careers and achieve success in:

• Accounting

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For more information on how Becker Professional Education can support you in your career, visit www.becker.com.

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Revision Essentials includes:

• ACC A syllabus aim and main capabilities

• Core topics checklist

• Summary of essential facts and theory

• Further reading

• Relevant articles

• Comprehensive analysis of past e x aminations

• Ex aminers' feedback for the last e x am session

• Ex am technique www.becker.com/ACCA | acca@becker.com

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Revision Essentials are not quality assured by ACCA but their content is substantially derived from materials which have been quality assured by ACCA.

Paper F9 | FINANCIAL MANAGEMENT For Examinations to June 2015

For Examinations to June 2015

FINANCIAL MANAGEMENT

Revision Essentials

Copyright ©2014 DeVry/Becker Educational Development Corp. All rights reserved.

For Examinations to June 2015

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Paper F9 | FINANCIAL MANAGEMENT For Examinations to June 2015

For Examinations to June 2015

FINANCIAL MANAGEMENT

Revision Essentials

Copyright ©2014 DeVry/Becker Educational Development Corp. All rights reserved.

For Examinations to June 2015

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