cima f3 study notes 2012-13
DESCRIPTION
notes for f3 cimaTRANSCRIPT
-
CIMAPaperF3FinancialStrategyStudyNotes
HWiseF3
-
CIMAPublishingisanimprintofElsevierTheBoulevard,LangfordLane,Kidlington,Oxford,OX51GB,UK225WymanStreet,Waltham,MA02451,USAKaplanPublishingUK,Unit2TheBusinessCentre,MollyMillarsLane,Wokingham,BerkshireRG412QZ
Copyright2012ElsevierLimitedandKaplanPublishingLimited. Allrightsreserved.
Nopartofthispublicationmaybereproduced,storedinaretrievalsystemortransmittedinanyformorbyanymeanselectronic,mechanical,photocopying,recordingorotherwisewithoutthepriorwrittenpermissionofthepublisher.
PermissionsmaybesoughtdirectlyfromElsevier'sScienceandTechnologyRightsDepartmentinOxford,UK:phone:(+44)(0)1865843830fax:(+44)(0)1865853333email:permissions@elsevier.com.YoumayalsocompleteyourrequestonlineviatheElsevierhomepage(http://elsevier.com),byselectingSupport&ContactthenCopyrightandPermissionandthenObtainingPermissions.
NoticeNoresponsibilityisassumedbythepublisherforanyinjuryand/ordamagetopersonsorpropertyasamatterofproductsliability,negligenceorotherwise,orfromanyuseoroperationofanymethods,products,instructionsorideascontainedinthematerialherein.
British Library Cataloguing in Publication Data AcataloguerecordforthisbookisavailablefromtheBritishLibrary
PrintedandboundinGreatBritain
1213 14 10 9 8 7 6 5 4 3 2 1
ii
-
Contents
Page
Chapter 1 CIMAVerbHierarchystrategiclevelexams 1
Chapter 2 AnIntroductiontoFinancialStrategy 9
Chapter 3 PerformanceMeasurementinFinancialStrategy 31
Chapter 4 LongTermFinance 77
Chapter 5 ShortTermFinanceWorkingCapitalManagement
115
Chapter 6 CostofCapital 139
Chapter 7 CapitalStructure 177
Chapter 8 TheRoleofTreasury 219
Chapter 9 InvestmentAppraisalbasictechniques 231
Chapter 10 InvestmentAppraisalfurthertechniques 263
Chapter 11 InternationalInvestmentAppraisal 293
Chapter 12 BusinessValuation 315
Chapter 13 FinancialandStrategicImplicationsofMergersandAcquisitions
351
Chapter 14 ImplementationandControlProcedures 391
Chapter 15 Howtopreparefortheexam 401
Chapter 16 QuestionsandAnswers 433
iii
-
iv
-
PaperIntroduction
v
chapterIntro
-
How to Use the Materials TheseOfficialCIMAlearningmaterialsbroughttoyoubyElsevier/CIMAPublishingandKaplanPublishinghavebeencarefullydesignedtomakeyourlearningexperienceaseasyaspossibleandtogiveyouthebestchancesofsuccessinyour'FinancialStrategy'exam.
Theproductrangecontainsanumberoffeaturestohelpyouinthestudyprocess.Theyinclude:
ThisStudyTexthasbeendesignedwiththeneedsofhomestudyanddistancelearningcandidatesinmind.Suchstudentsrequireveryfullcoverageofthesyllabustopics,andalsothefacilitytoundertakeextensivequestionpractice.However,theStudyTextisalsoidealforfullytaughtcourses.
Thismainbodyofthetextisdividedintoanumberofchapters,eachofwhichisorganisedonthefollowingpattern:
adetailedexplanationofallsyllabusareas extensive'practical'materials generousquestionpractice,togetherwithfullsolutions anexampreparationsection,includingasuggested
approachonhowtotackethepreseeninformation,bothbeforeandduringtheexam.
Detailedlearningoutcomesexpectedafteryourstudiesofthechapterarecomplete.Youshouldassimilatethesebeforebeginningdetailedworkonthechapter,sothatyoucanappreciatewhereyourstudiesareleading.
Stepbysteptopiccoverage.Thisistheheartofeachchapter,containingdetailedexplanatorytextsupportedwhereappropriatebyworkedexamplesandexercises.Youshouldworkcarefullythroughthissection,ensuringthatyouunderstandthematerialbeingexplainedandcantackletheexamplesandexercisessuccessfully.Rememberthatinmanycasesknowledgeiscumulative:ifyoufailtodigestearliermaterialthoroughly,youmaystruggletounderstandlaterchapters.
vivi
-
Havingworkedthroughthechaptersyouarereadytobeginyourfinalpreparationsfortheexamination.ThefinaltwochaptersofthisStudyTextprovideyouwiththeguidanceyouneed.Theyincludethefollowingfeatures:
Youshouldplantoattemptthesamplepaperjustbeforethedateoftherealexam.Bythisstageyourrevisionshouldbecompleteandyoushouldbeabletoattemptthesamplepaperwithinthetimeconstraintsoftherealexam.
IfyouworkconscientiouslythroughtheofficialCIMAStudyTextaccordingtotheguidelinesaboveyouwillbegivingyourselfanexcellentchanceofexamsuccess.Goodluckwithyourstudies!
Activities.Somechaptersareillustratedbymorepracticalelements,suchascommentsandquestionsdesignedtostimulatediscussion.
Questionpractice.Thetestofhowwellyouhavelearnedthematerialisyourabilitytotackleexamstylequestions.Makeaseriousattemptatproducingyourownanswers,butatthisstagedonotbetooconcernedaboutattemptingthequestionsinexamconditions.Inparticular,itismoreimportanttoabsorbthematerialthoroughlybycompletingafullsolutionthantoobservethetimelimitsthatwouldapplyintheactualexam.
Solutions.Avoidthetemptationmerelyto'audit'thesolutionsprovided.Itisanillusiontothinkthatthisprovidesthesamebenefitsasyouwouldgainfromaseriousattemptofyourown.However,ifyouarestrugglingtogetstartedonaquestionyoushouldreadtheintroductoryguidanceprovidedatthebeginningofthesolution,whereprovided,andthenmakeyourownattemptbeforereferringbacktothefullsolution.
Howtousethepreseeninformationandpreparefortheexam.
Guidanceonhowtotackletheexamitself. Anexamstandardsetofpreseeninformation,with
detailedanalysisandexamplerequirementsandanswers.
Revisionquestions.Theseareexamstandardandshouldbetackedinexamconditions,especiallyasregardsthetimeallocation.
Solutionstotherevisionquestions. Asamplepaperthatyoucanattemptunderexam
conditions,alongwiththerelevantanswers.
vii
-
Icon Explanations
Definition thesesectionsexplainimportantareasofknowledgewhichmustbeunderstoodandreproducedinanexamenvironment.
Key Pointidentifiestopicswhicharekeytosuccessandareoftenexamined.
Supplementary readingidentifiesamoredetailedexplanationofkeyterms,thesesectionswillhelptoprovideadeeperunderstandingofcoreareas.Referencetothistextisvitalwhenselfstudying.
Test Your Understandingfollowingkeypointsanddefinitionsareexerciseswhichgivetheopportunitytoassesstheunderstandingofthesecoreareas.
Illustrationtohelpdevelopanunderstandingofparticulartopics.TheillustrativeexercisesareusefulinpreparingfortheTestyourunderstandingexercises.
Exclamation Markthissymbolsignifiesatopicwhichcanbemoredifficulttounderstand,whenreviewingtheseareascareshouldbetaken.
Study technique
Passingexamsispartlyamatterofintellectualability,buthoweveraccomplishedyouareinthatrespectyoucanimproveyourchancessignificantlybytheuseofappropriatestudyandrevisiontechniques.Inthissectionwebrieflyoutlinesometipsforeffectivestudyduringtheearlierstagesofyourapproachtotheexam.Laterinthetextwementionsometechniquesthatyouwillfindusefulattherevisionstage.
viii
-
Planning
Tobeginwith,formalplanningisessentialtogetthebestreturnfromthetimeyouspendstudying.Estimatehowmuchtimeintotalyouaregoingtoneedforeachsubjectyouarestudying.
Rememberthatyouneedtoallowtimeforrevisionaswellasforinitialstudyofthematerial.Youmayfindithelpfultoread"PassFirstTime!"secondeditionbyDavidR.HarrisISBN9781856177986.Thisbookwillprovideyouwithprovenstudytechniques.Chapterbychapteritcoversthebuildingblocksofsuccessfullearningandexaminationtechniques.ThisistheultimateguidetopassingyourCIMAexams,writtenby apastCIMAexaminerandshowsyouhowtoearnallthemarksyoudeserve,andexplainshowtoavoidthemostcommonpitfalls.Youmayalsofind"TheEWord:Kaplan'sGuidetoPassingExams"byStuartPedleySmithISBN:9780857322050helpful. StuartPedleySmithisaseniorlectureratKaplanFinancialandaqualifiedaccountantspecialisinginfinancialmanagement. Hisnaturalcuriosityandwiderinterestshaveledhimtolookbeyondthetechnicalcontentoffinancialmanagementtotheprocessesandjourneythatwecalleducation. Hehasbecomefascinatedbythewholeprocessoflearningandtheexamskillsandtechniquesthatcontributetowardssuccessintheclassroom. Thisbookisforanyonewhohastositanexamandwantstogivethemselvesabetterchanceofpassing. Itiseasytoread,writteninacommonsensestyleandfullofanecdotes,facts,andpracticaltips. Italsocontainssynopsesofinterviewswithpeopleinvolvedinthelearningandexaminingprocess.
Withyourstudymaterialbeforeyou,decidewhichchaptersyouaregoingtostudyineachweek,andwhichweeksyouwilldevotetorevisionandfinalquestionpractice.
Prepareawrittenschedulesummarisingtheaboveandsticktoit!
Itisessentialtoknowyoursyllabus.Asyourstudiesprogressyouwillbecomemorefamiliarwithhowlongittakestocovertopicsinsufficientdepth.Yourtimetablemayneedtobeadaptedtoallocateenoughtimeforthewholesyllabus.
StudentsareadvisedtorefertothenoticeofexaminablelegislationpublishedregularlyinCIMAsmagazine(FinancialManagement),thestudentsenewsletter(Velocity)andontheCIMAwebsite,toensuretheyareuptodate.
ix
-
Tips for effective studying
(1) Aimtofindaquietandundisturbedlocationforyourstudy,andplanasfaraspossibletousethesameperiodoftimeeachday.Gettingintoaroutinehelpstoavoidwastingtime.Makesurethatyouhaveallthematerialsyouneedbeforeyoubeginsoastominimiseinterruptions.
(2) Storeallyourmaterialsinoneplace,sothatyoudonotwastetimesearchingforitemsaroundyouraccommodation.Ifyouhavetopackeverythingawayaftereachstudyperiod,keeptheminabox,orevenasuitcase,whichwillnotbedisturbeduntilthenexttime.
(3) Limitdistractions.Tomakethemosteffectiveuseofyourstudyperiodsyoushouldbeabletoapplytotalconcentration,soturnoffallentertainmentequipment,setyourphonestomessagemode,andputupyour'donotdisturb'sign.
(4) Yourtimetablewilltellyouwhichtopictostudy.However,beforedivinginandbecomingengrossedinthefinerpoints,makesureyouhaveanoverallpictureofalltheareasthatneedtobecoveredbytheendofthatsession.Afteranhour,allowyourselfashortbreakandmoveawayfromyourStudyText.Withexperience,youwilllearntoassessthepaceyouneedtoworkat.
(5) Workcarefullythroughachapter,makingnotesasyougo.Whenyouhavecoveredasuitableamountofmaterial,varythepatternbyattemptingapracticequestion.Whenyouhavefinishedyourattempt,makenotesofanymistakesyoumade,oranyareasthatyoufailedtocoverorcoveredmorebriefly.
(6) Makenotesasyoustudy,anddiscoverthetechniquesthatworkbestforyou.Yournotesmaybeintheformoflists,bulletpoints,diagrams,summaries,'mindmaps',orthewrittenword,butrememberthatyouwillneedtoreferbacktothematalaterdate,sotheymustbeintelligible.Ifyouareonataughtcourse,makesureyouhighlightanyissuesyouwouldliketofollowupwithyourlecturer.
(7) Organiseyournotes.Makesurethatallyournotes,calculationsetccanbeeffectivelyfiledandeasilyretrievedlater.
x
-
Structure of subjects and learning outcomes
Eachsubjectwithinthesyllabusisdividedintoanumberofbroadsyllabustopics. Thetopicscontainoneormoreleadlearningoutcomes,relatedcomponentlearningoutcomesandindicativeknowledgecontent.
Alearningoutcomehastwomainpurposes:
Thelearningoutcomesarepartofahierarchyoflearningobjectives. Theverbsusedatthebeginningofeachlearningoutcomerelatetoaspecificlearningobjectivee.g.
"EvaluatetheproposedstrategytoexpandintotheNorthAmericanmarket."
Theverb'evaluate'indicatesalevelfivelearningobjective.
Theseverbsareoutlinedinthefirstchapterofthetext.
(a) Todefinetheskillorabilitythatawellpreparedcandidateshouldbeabletoexhibitintheexamination
(b) Todemonstratetheapproachlikelytobetakeninexaminationquestions
xi
-
xii
-
MATHS TABLES AND FORMULAE Present value table Present value of 1.00 unit of currency, that is (1 + r)-n where r = interest rate; n = number of periods until payment or receipt. Periods
(n) Interest rates (r)
1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
Periods
(n) Interest rates (r)
11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065 16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
-
Cumulative present value of 1.00 unit of currency per annum Receivable or Payable at the end of each year for n years
+
rr n)(11
Periods (n)
Interest rates (r) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514
Periods (n)
Interest rates (r) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
-
FORMULAE Valuation models
(i) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value:
P0 = prefk
d
(ii) Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value:
P0 = ek
d
(iii) Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P0 is the ex-div value:
P0 = gk
d
e
1 or P0 = gk
gd
+
e
0 ][1
(iv) Irredeemable bonds, paying annual after-tax interest, i [1 t], in perpetuity, where P0 is the ex-interest value:
P0 = netd
][1
k
ti
or, without tax: P0 = dk
i
(v) Total value of the geared entity, Vg (based on MM):
Vg = Vu + TB
(vi) Future value of S, of a sum X, invested for n periods, compounded at r% interest:
S = X[1 + r]n
(vii) Present value of 100 payable or receivable in n years, discounted at r% per annum:
PV = nr ][1
1
+
(viii) Present value of an annuity of 100 per annum, receivable or payable for n years, commencing in one year, discounted at r% per annum:
PV =
+
nrr ][1
11
1
(ix) Present value of 100 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum:
PV = r
1
(x) Present value of 100 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r% per annum:
PV = gr
1
-
Cost of capital (i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current
ex-div price P0:
kpref = 0P
d
(ii) Cost of irredeemable bonds, paying annual net interest, i [1 t], and having a current ex-interest price P0:
kd net = 0P
ti ][1
(iii) Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0:
ke = 0P
d
(iv) Cost of ordinary (equity) shares, having a current ex-div price, P0, having just paid a dividend, d0, with the dividend growing in perpetuity by a constant g% per annum:
ke = gP
d+
0
1 or ke = g
P
gd+
+
0
0 ]1[
(v) Cost of ordinary (equity) shares, using the CAPM:
ke = Rf + [Rm Rf]
(vi) Cost of ordinary (equity) share capital in a geared entity :
keg = keu + [keu kd] E
DV
tV ][1
(vii) Weighted average cost of capital, k0 or WACC
WACC = ke
+
++
DE
D
DE
E
VV
Vt
VV
Vdk ][1
(viii) Adjusted cost of capital (MM formula):
Kadj = keu [1 tL] or r* = r[1 T*L]
(ix) Ungear :
u = g
+ ][1 tVV
V
DE
E + d
+ ][1
][1
tVV
tV
DE
D
(x) Regear :
g = u + [u d] E
DV
tV ][1
(xi) Adjusted discount rate to use in international capital budgeting (International Fisher effect)
A$/B$ rate Spot
time months' 12 in A$/B$ rate spot Future
A$ rate discount annual1
B$ rate discount annual1=
+
+
where A$/B$ is the number of B$ to each A$
-
Other formulae
(i) Expectations theory:
Future spot rate A$/B$ = Spot rate A$/B$ x rateinterestnominal1
rateinterestnominal1
countryA
countryB
+
+
where: A$/B$ is the number of B$ to each A$, and A$ is the currency of country A and B$ is the currency of country B
(ii) Purchasing power parity (law of one price):
Future spot rate A$B$ = Spot rate A$/B$ x rateinflation1
rateinflation1
countryA
countryB
+
+
(iii) Link between nominal (money) and real interest rates:
[1 + nominal (money) rate] = [1 + real interest rate][1 + inflation rate]
(iv) Equivalent annual cost:
Equivalent annual cost = factorannuityyear
yearsovercostsof
n
nPV
(v) Theoretical ex-rights price:
TERP = 1
1
+N [(N x cum rights price) + issue price]
(vi) Value of a right:
N
priceissuepricerightsex lTheoretica
where N = number of rights required to buy one share.
-
CIMAVerbHierarchystrategiclevelexamsChapter learning objectives
CIMA VERB HIERARCHY
CIMAplacegreatimportanceonthechoiceofverbsinexamquestionrequirements.Itisthuscriticalthatyouanswerthequestionaccordingtothedefinitionoftheverbused.
1
chapter
1
-
1CIMA verb hierarchy strategic level
Instrategiclevelexamsyouwillmainlymeetverbsfromlevels3,4and5.Examinershavecommentedonmanyoccasionsthattheyaskalevel5verbandgetalevel2response.Itisvitalthatthehigherlevelverbsareunderstoodandrespondedto.Veryoccasionallyyouwillalsoseelevel1and2verbsbuttheseshouldnotaccountformorethan510%ofthemarksintotal.
Level 3 APPLICATION
Howyouareexpectedtoapplyyourknowledge
VERBS USED
DEFINITION
Apply
Calculate
Demonstrate
Prepare
Reconcile
Solve
Tabulate
Puttopracticaluse.
Ascertainorreckonmathematically.
Provewithcertaintyorexhibitbypracticalmeans.
Makeorgetreadyforuse.
Makeorproveconsistent/compatible.
Findananswerto.
Arrangeinatable.
CIMA Verb Hierarchy strategic level exams
22
-
Level 4 ANALYSIS
Howyouareexpectedtoanalysethedetailofwhatyouhavelearned.
Level 5 EVALUATION
Howyouareexpectedtouseyourlearningtoevaluate,makedecisionsorrecommendations.
VERBS USED
DEFINITION
Analyse
Categorise
Compareandcontrast
Construct
Discuss
Interpret
Prioritise
Produce
Examineindetailthestructureof.
Placeintoadefinedclassordivision.
Showthesimilaritiesand/ordifferencesbetween.
Builduporcompile.
Examineindetailbyargument.
Translateintointelligibleorfamiliarterms.
Placeinorderofpriorityorsequenceforaction.
Createorbringintoexistence.
VERBS USED
DEFINITION
Advise
Evaluate
Recommend
Counsel,informornotify.
Appraiseorassessthevalueof.
Proposeacourseofaction.
chapter 1
3
-
2Further guidance on strategic level verbs that cause confusion
Verbsthatcausestudentsmostconfusionatthislevelareasfollows:
Level 3 verbs
Giventhatalllevel3verbsinvolveapplication, theverb"apply"israreintherealexam.Oneoftheothermorespecificverbsisusedinstead.
Thisisanumericalrequirementandusuallyinvolvesstartingwithoneofthefigures,adjustingitandendingupwiththeother.
Forexample,inabankreconciliationyoustartwiththerecordedcashatbankfigure,adjustitforunpresentedcheques,etc,and(hopefully!)endupwiththestatedbalanceinthecash"Taccount".
Theverb"todemonstrate"canbeusedintwomainways.
Firstlyitcouldmeantoprovethatagivenstatementistrueorconsistentwithcircumstancesgiven.Forexample,theFinanceDirectormayhavestatedinthequestionthatthecompanywillnotexceeditsoverdraftlimitinthenextsixmonths.TherequirementthenasksyoutodemonstratethattheDirectoriswrong.Youcoulddothisbypreparingacashflowforecastforthenextsixmonths.
Secondlyyoucouldbeaskedtodemonstratehowastatedmodel,framework,techniqueortheorycould be usedintheparticularscenariotoachieveaspecificresultforexample,howaprobabilitymatrixcouldbeusedtomakeaproductiondecision.Ensureinsuchquestionsthatyoudonotmerelydescribethemodelbutuseittogeneratethedesiredoutcome.
Level 4 verbs
Toanalysesomethingistoexamineitindetailinordertodiscoveritsmeaningoressentialfeatures.Thiswillusuallyinvolvebreakingthescenariodownandlookingatthefinedetail,possiblywithadditionalcalculations,andthensteppingbacktoseethebiggerpicturetoidentifyanythemestosupportconclusions.
The verb "to apply"
The verb "to reconcile"
The verb "to demonstrate"
The verb "to analyse"
CIMA Verb Hierarchy strategic level exams
4
-
Forexample,ifaskedtoanalyseasetoffinancialstatements,thentheendresultwillbeasetofstatementsabouttheperformanceofthebusinesswithsupportingevidence.Thiscouldinvolvethefollowing:
Themainerrorstudentsmakeisthattheyfailtodrawoutanythemesandconclusionsandsimplypresentthemarkerwithacollectionofuninterpreted,unexplainedfactsandfigures.
Todiscusssomethingisverysimilartoanalysingit,exceptthatdiscussionusuallyinvolvestwoormoredifferentviewpointsorargumentsasthecontext,ratherthanasetoffigures,say.Todiscussviewpointswillinvolvelookingattheirunderlyingarguments,examiningthemcritically,tryingtoassesswhetheroneargumentismorepersuasivethantheotherandthenseekingtoreachaconclusion.
Forexample,ifaskedtodiscusswhetheraparticulartechniquecouldbeusedbyacompany,youwouldexaminetheargumentsforandagainst,makingreferencetothespecificcircumstancesinthequestion,andseektoconclude.
Toprioritiseistoplaceobjectsinanorder.Thekeyissuehereistodecideuponthecriteriatousetoperformtheordering.Forexample,prioritisingtheexternalthreatsfacingafirmcouldbedonebyconsideringthescaleoffinancialconsequences,immediacy,implicationsfortheunderlyingbusinessmodelandsoon.
Themainmistakestudentsmakeisthattheyfailtojustifytheirprioritisationwhyisthisthemostimportantissue?
(1) Youcouldbreakdownyouranalysisintoareasofprofitability,liquidity,gearingandsoon.
(2) Undereachheadinglookatkeyfiguresinthefinancialstatements,identifyingtrends(e.g.salesgrowth)andcalculatingsupportingratios(e.g.margins).
(3) Trytoexplainwhatthefiguresmeanandwhytheyhaveoccurred(e.g.whyhastheoperatingmarginfallen?)
(4) Startconsideringthebiggerpicturearetheratiospresentingaconsistentmessageordotheycontradicteachother?Canyouidentifycommoncauses?
(5) Finallyyouwouldthenseektopullallthisinformationtogetherandinterpretittomakesomehigherlevelcommentsaboutoverallperformance.
The verb "to discuss"
The verb "to prioritise"
chapter 1
5
-
Level 5 verbs
Toevaluatesomethingistoassessitwithaviewtoplacingavalueonit. Inmanyrespects"evaluate"shouldbeseenasahigherlevelversionof"analyse"and"discuss"andcouldincludequalitativeandquantitativefactorswithinyourcriteria.Yourresultingargumentswillneedtobeprioritisedandweighedagainsteachothertoformaconclusion.
Forexample,supposeyouareaskedtoevaluateaproposedstrategyinpaperE3.Atitssimplestyouranswercouldcontainaseriesofargumentsforandagainstthestrategy.Eachargumentshouldbediscussedtoassessitsimportance.Theargumentscanthenbeweighedupagainsteachothertoformaconclusion.Youarethusevaluatingthefactorswithineachargumentandthenevaluatingtheargumentsagainsteachother.
Withsuchquestionsmanystudentsstruggletogenerateenoughpointsorarguments.Partofthesolutionistoproducementalchecklistswhenstudyingthepaperconcerned.Thesegivecriteriatouseforvaluingthematterathand.Withtheaboveexampleonstrategyevaluation,criteriacouldincludeanyofthefollowing:
Useofsuchachecklistwillensureyouhaveenoughpointstopass.
Insomequestionsyoumayhavetodomorepreliminaryworkbeforeyoucanevaluate.Forexample,ifaskedtoevaluateafirm'sapproachtochangemanagementyouwouldstartbyidentifyingwhattypeofapproachtheyaretaking(referencingtodifferentmodelsofchangemanagement)beforeyoucanevaluateit.
The verb "to evaluate"
Arethereanyusefulcalculationse.g.NPV,impactonprofit? Doesthestrategyresolveanymajorthreatsfacedbythefirm? Doesthestrategycapitaliseonthefirm'sstrengthsordo
weaknessesneedresolvingfirst? Doesthestrategyenhancethefirm'scompetitivestrategy? Doesthestrategyleadtoabetter"fit"withtheenvironment? Whataretherisksandaretheyacceptable? Whataretheimplicationsfordifferentstakeholdersandwoulditbe
acceptabletothem? Whataretheresourceimplicationshowfeasibleisthestrategy?
CIMA Verb Hierarchy strategic level exams
6
-
Allthreelevel5verbsinvolveamixtureofidentifyingrelevantissues,analysingthem,evaluatingthemandthenfinishingwithsomeformofconclusion.Somewritersseethisasathreestepapproach:
Thedifferencebetweenthelevel5verbsliesinwherethemainemphasisisinthesethreesteps.With"advise"and"recommend"theexaminerwillbelookingformoredetailinstep3.Recommendationsinparticularcouldinvolveformulatingaplanofactionthatincludesbothshortandlongertermaspects.
The differences between the verbs "to evaluate", "to advise" and "to recommend"
(1) What?Identifyrelevantissues.
(2) So what?Whyaretheissuesrelevant?Howsignificantarethey?
(3) What now?Whatresponseisrequiredbythefirmbeingconsidered?
chapter 1
7
-
CIMA Verb Hierarchy strategic level exams
8
-
AnIntroductiontoFinancialStrategyChapter learning objectives
Lead Component
A1:Discusspotentialstrategicfinancialobjectives,andtherelationshipsamongandconstraintsontheelementsoffinancialstrategy.
(a) discussthepotentialstrategicobjectivesofanorganisation.
(b) discusstheinterrelationshipsbetweendecisionsconcerninginvestment,financinganddividends.
(c) discusstheimpactofinternalandexternalconstraintsonfinancialstrategy,includingtheimpactofregulationonbusinesscombinations.
9
chapter
2
-
Indicative syllabus content
Thefinancialandnonfinancialobjectivesofdifferentorganisations(e.g.valueformoney,maximisingshareholderwealth,providingasurplus).
Thethreekeydecisionsoffinancialmanagement(investment,financinganddividend)andtheirlinks.
Benefitsofmatchingcharacteristicsofinvestmentandfinancinginthelongerterm,(e.g.incrossborderinvestment)andinshorttermhedgingstrategies.
Considerationsintheformulationofdividendpolicyanddividenddecisions,includingmeetingthecashneedsofthebusiness.
Externalconstraintsonfinancialstrategy(e.g.funding,regulatorybodies,investorrelations,strategy,andeconomicfactors).
Developingfinancialstrategyinthecontextofregulatoryrequirements(e.g.priceandservicecontrolsexercisedbyindustryregulators)andinternationaloperations.
An Introduction to Financial Strategy
1010
-
1Overview of Chapter
2The Importance of Financial Strategy to the Organisation
Anorganisation'sfinancialmanagersmustplantheircoursesofactiontoachievetheorganisation'sfinancialobjectives.Decisionsthattheymusttakeinclude:
ThisChapterfirstdefinessomeofthekeytermswhichwillbeusedthroughoutthesyllabus,andthenlooksatthemaindecisions(financingdecision,investmentdecisionanddividenddecision)indetail.
Fromwhichsourcesshouldfundsberaised? Shouldproposedinvestmentsbeundertaken? Howlargeadividendshouldbepaid? Howshouldworkingcapitalbecontrolled,e.g.shoulddiscountsbe
offeredtodebtorsforpromptpayment?
chapter 2
11
Definitions of key terms
-
3Financial Strategy and Overall Corporate Strategy
Eachlevelofabusinesscanhaveitsownstrategy.Threelevelsarecommonlyidentified:
Corporate strategy Thisconcernsthedecisionstobemadebyseniormanagementsuchastheparticularbusinessthatthecompanyisin,andwhethernewmarketsshouldbeenteredorcurrentmarketswithdrawnfrom.
Business strategyThisconcernsthedecisionstobemadebytheseparatestrategicbusinessunitswithinthegroup.Eachunitwilltrytomaximiseitscompetitivepositionswithinitschosenmarket.
Operational strategyThisconcernshowthedifferentfunctionalareaswithinastrategicbusinessunitplantheiroperationstosatisfythecorporateandbusinessstrategiesbeingfollowed.Weareofcoursemostinterestedinthedecisionsfacingthefinancefunctions.
Financialstrategywillbeimportantateachlevelinthishierarchy.Forexample,investmentdecisionsandfinancingdecisionsmaybeimportantatallthelevels(althoughalargenumberofcompaniesmanagefinancingcentrally).Dividenddecisionswillbemadeatthecorporatelevelonly.
4Objectives Financial objectives of profit seeking organisations
Decisionstobemadedependontheultimateobjectivesofanorganisation.
Academicstudieshaveshownthatorganisationsoftenhavemany,sometimesconflicting,objectives.
Itisgenerallyacceptedthattheprimarystrategicobjectiveofacommercialcompanyisthelongtermgoalofthemaximisation of the wealth of the shareholders.
An Introduction to Financial Strategy
12
-
However,anorganisationhasmanyotherstakeholderswithbothlongandshorttermgoals,suchas:
Equityinvestors(ordinaryshareholders) Thecommunityatlarge Companyemployees Companymanagers/directors Customers Suppliers Financeproviders Thegovernment
Objectives and economic forces
Whensettingthecompany'sfinancialstrategythefinancialmanagerisoftenconstrainedbybothinternalandexternalfactors.
Forexample,significantexpansionandanincreaseindividendsmaynotbefeasibleiftheentityhasalackofskilledstaff,andmaybecomeuneconomicifinterestratesaresettorise(thusincreasingtheamountpayabletobanksandotherdebtfinanceproviders).
chapter 2
13
Internal and external constraints on financial strategy
Examples of stakeholder objectives
The effect of interest rate and inflation changes
Definition of stakeholders
-
Stakeholder conflicts
Facedwithabroadrangeofstakeholders,managersarelikelytofindtheycannotsimultaneouslymaximisethewealthoftheirshareholdersandkeepalltheotherstakeholderscontent.
Inpractice,themainstrategicobjectivemaybeinterpretedasachievingthemaximumprofitpossible,consistentwithbalancingtheneedsofthevariousstakeholdersintheentity.
Suchapolicymayimplyachievingasatisfactoryreturnforshareholders,whilst(forexample)establishingcompetitivetermsandconditionsofservicefortheemployees,andavoidingpollutingtheenvironment.
Performance and progress indicators (PIs)
Inordertoachievetheoverallobjectivecompaniesshouldsetspecifictargets,financialandnonfinancial,inordertobothcommunicatedirectionandmeasureperformance,forexample:
Financial
Profitabilitye.g.annual10%improvementinearnings,orearningspershare.
Cashgeneratione.g.annual10%improvementinoperatingcashflow.
Nonfinancial
Marketsharee.g.fourproductsoutofsixaredominantinthemarket.
Customersatisfactione.g.complaintstoreducefrom5%to2%.
Thesetargetscanbeusedtodirectmanagers'attentiontowardskeystakeholderrequirements,toensurethattheorganisationbalancestheneedsofitsdifferentstakeholdersandminimisestheconflictbetweenthedifferentstakeholdergroups.
An Introduction to Financial Strategy
14
More on financial and non financial objectives
Conflicts of objectives between managers and shareholders
-
Objectives of notforprofit organisations
Organisationssuchascharitiesandtradeunionsarenotruntomakeprofitsbuttobenefitprescribedgroupsofpeople.Forexample,theprimaryobjectiveofacharityistopursuewhatevercharitableobjectivesitwassetupfor.
Sincetheservicesprovidedarelimitedprimarilybythefundsavailable,secondaryobjectivesaretoraisethemaximumpossiblefundseachyear(netoffundraisingexpenses),andtousethefundsefficientlytomaximisethebenefitgenerated.
Performance and progress indicators Public sector
Publicsectorentitiesareoftenappraisedaccordingtothe"valueformoney"(VFM)thattheygenerate.
Valueformoneymaybedefinedas"performanceofanactivityinsuchawayastosimultaneouslyachieveeconomy,efficiencyandeffectiveness."(CIMAOfficialTerminology2005)
Thismeansmaximisingbenefitsforthelowestcostandhasthreeconstituentelements:
Economyisameasureofinputstoachieveacertainserviceorlevelofservice.
Effectivenessisameasureofoutputs,i.e.services/facilities.
Efficiencyistheoptimumofeconomyandeffectiveness,i.e.themeasureofoutputsoverinputs.
5The Key Decisions of Financial Management
Threekeydecisionsoffinancialmanagementthatcanbeidentifiedare:
Thesethreeareasareverycloselyinterlinked.
Investmentwhatprojectsshouldbeundertakenbytheorganisation? Financehowshouldthenecessaryfundsberaised? Dividendshowmuchcashshouldbeallocatedeachyeartobepaid
asareturntoshareholders?
chapter 2
15
More detail on VFM
Financial objectives in the public sector
-
Investment decision
Financialmanagershaveresponsibilityfortheallocationoffinancialresourcestoachievetheorganisation'sobjectives.Animportantpartoftheirjobistounderstandtheshort,mediumandlongtermcapitalrequirementsforinvestmentinfixedassetsandworkingcapitalthatfitswiththeoverallstrategy.
Whilstfinancialmanagersareunlikelytobesolelyresponsibleforthefinalchoiceofcapitalinvestmentprojectstobeundertaken,theywillbeactivelyinvolvedintheevaluationofpossibleinvestmentopportunities.
Finance decision
Forbothfixedassetandworkingcapitalinvestment,thefinancialmanagermustdecideonthemostappropriatetypeandsourceoffunding.
Thiswillincludesuchconsiderationsas:
theextenttowhichrequirementscanbefundedinternally,fromtheorganisation'soperations.Thiswillinvolveconsiderationsofdividendpolicyandtaximplications
ifnew,externallyprovided,financeisrequired,whetheritshouldbeintheformofequityordebtfinance.Thismayaffectthelevelofgearing(theratioofdebttoequityfinance)whichcanhaveimplicationsforreturnsrequiredbytheprovidersofcapital
theextenttowhichworkingcapitalshouldbefinancedbylongtermfinanceorshorttermcredit.
Dividend decision
Whendecidingonthetypeofinvestmentandleveloffinanceneeded,thefinancialmanagermusthaveregardforthepotentialeffectsontheriskandlevelofdividendspayabletoshareholders.Iftheshareholdersarenothappywiththeirreturn,theywillbereluctanttoinvestfurther,whichinturnwillaffectthefundingavailableforfutureinvestment.
An Introduction to Financial Strategy
16
More detail on the financing decision
More detail on the investment decision
-
Thedividenddecisionthushastwoelements:
Thelevelandregulargrowthofdividendsrepresentasignificantfactorindeterminingaprofitmakingentitysmarketvalue,thatis,thevalueplacedonitssharesbythestockmarket.
theamounttobepaidout,and theamounttoberetainedtosupportthegrowthoftheentity(notethat
thisisalsoafinancingdecision).
Links between the three key decisions
Itisclearfromthediscussionsabovethatthethreeareasarecloselyinterrelated.
Investmentdecisionscannotbetakenwithoutconsiderationofwhereandhowthefundsaretoberaisedtofinancethem.Thetypeoffinanceavailablewill,inturn,dependtosomeextentonthenatureoftheprojectitssize,duration,risk,capitalassetbacking,etc.
Dividendsrepresentthepaymentofreturnsontheinvestmentbacktotheshareholders,thelevelandriskofwhichwilldependupontheprojectitself,andhowitwasfinanced.
Debtfinance,forexample,canbecheap(particularlywhereinterestistaxdeductible)butrequiresaninterestpaymenttobemadeoutofprojectearnings,whichcanincreasetheriskoftheshareholders'dividends.
6Dividend Policy
Onelongstandingquestionincorporatefinanceis:Isshareholders'wealthaffectedbyacompany'sdividendpolicy?
Noticethatthequestionisnotaskingwhetherdividendsmatterofcoursetheydo(asweknowfromthedividendvaluationmodel)whatthequestionasksiswhetherthechosenpolicymatters.Examplesofsuchpoliciesmayinclude:
(i) payingaconstantannualdividend(ii) payingoutaconstantproportionofannualearnings(iii) increasingdividendsinlinewiththeannualrateofinflation,etc(iv) payingoutwhat'sleftafterfinancingallfutureinvestmenttheresidual
policy.
chapter 2
17
-
Fouraspectstoconsiderinrelationtothepaymentofdividendsare:
Dividend irrelevancy
M&M'sdividendirrelevancytheorysaysthatthepatternofdividendpayoutshouldbeirrelevant.AslongascompaniescontinuetoinvestinpositiveNPVprojects,thewealthoftheshareholdersshouldincreasewhetherornotthecompanymakesadividendpaymentthisyear.
(1) ModiglianiandMiller's(M&M)dividendirrelevancyargument.(2) Theclienteleeffect.(3) Thebirdinthehandargument.(4) Thesignallingeffectorinformationcontentofdividends.
Clientele effect
Thisanalysisarguesthat,intherealworld,therearedifferentialtaxtreatmentsofdividendsandcapitalgains,andtherearetransactioncostsonsharedealings.
Asaresult,shareholdersareconcernedastohowtheirreturnisdeliveredtothembythecompany.Thuscompaniesshouldfollowaconsistentdividendpolicysoastoensurethattheygathertothemaclienteleofshareholderswholikethatparticularpolicy.
Thustheargumenthereisthattheactualdividendpolicythatacompanyfollowsisunimportantbut,havingdecidedonaparticularpolicy,itshouldthenkeeptoit.
The birdinthehand argument
Thisanalysisputsforwardaverysimpleargument.Someinvestorsmayfindcapitalgainsmoretaxefficientthandividends,andsomeinvestorswillavoidtransactioncostsiftheirreturnsaredeliveredintheformofcapitalgainsratherthandividendsdespiteallthis,investorsgenerallyhaveastrongpreferencefordividends.
Thereasongivenisthatadividendiscertainandinvestorspreferacertaindividendnow,tothepromiseofuncertainfuturedividends(arisingoutofretainingandreinvestingearnings).
An Introduction to Financial Strategy
18
M & M's Dividend Irrelevancy Theory
-
The signalling effect
Thistheoryholdsthatinvestorsread'signals'intothecompany'sdividenddecisionandthatthesesignalssayasmuchaboutthecompany'sfuturefinancialperformanceastheysayaboutitspastfinancialperformance.
Thusmanagementwillnotnecessarilyreducethedividendpersharejustbecauselastyear'sperformancewaspoor,iftheybelievethatnextyear'sperformancewillbegood.
Ifthistheoryiscorrect,andinvestorsdoindeedreadsignalsintothedividenddecision,thenthedividenddecisionbecomesimportant:itbecomesimportantforthecompanynottogivethewrongsignal.
How to reconcile these differing views of dividend policy in the real world
Giventhesecontrastingviews,howaremanagerstodecideonthedividendpolicythattheyshouldpursue?
Theansweristhat,intherealworld,likesomuchelseincorporatefinance,managershavetomakeajudgementaftertakingmanyvaryingfactorsintoaccount.
Inthisprocesstheywillconsider:
Howevertheywillalsotakeintoaccountarangeofotherfactors,suchas:
(1) Whatdividendsareourshareholdersexpecting(i.e.theclienteleeffect)?
(2) Whatdividenddidwepaylasttime(i.e.wemustnotpaylessthanthatbecauseofthesignalthatitmightgive)?
(3) Isitlegaltopayoutadividend?(4) Isthecashavailabletopayoutadividend?(5) Dowehaveaminimumgearingratioimposedonthecompanyasa
financialcovenantinadebtagreement?(6) Whatisthetaximpactforshareholdersofpayingdividends?(7) Whatinvestmentopportunitiesdoesthecompanyface?
chapter 2
19
More details on signalling
-
(8) Howdifficult/expensiveisittoraiseexternalfinance?(9) Whathasbeentherateofinflation(andsowhatdividendincreaseis
neededtomaintainthepurchasingpoweroflastyear'sdividends)?(10)Whathasbeenthecapitalgain/lossinthesharepriceoverthelast
year?
An Introduction to Financial Strategy
20
Scrip / bonus dividends and share repurchase
-
7Exam style questions
Quotation1
'Thedirectorsofallbusinessesmustconsiderthewishesofallpotentialstakeholdersforwhosesupporttheyarecompetingnotjustownersbutemployees,suppliers,customers,lenders,regulatorsandthecommunityinwhichtheirbusinessoperates.'
Quotation2
'Stakeholdertheoryisincompatiblewithbusinessanditsobjectivesandshouldbefirmlyresisted.'
Required:
Discuss the opposing arguments in the two quotations given above, and explain how these views might be reconciled.
Publicsectororganisationsdonothavetherequirementtoproduce'profit'inthesamesenseastheprivatesector.However,theyareexpectedtoworkwithinbudgetsandrecogniseaspectsoffinancialmanagementfamiliartotheprivatesector.
Thefollowingarefourexamplesofdifferencesbetweenthepublicandprivatesector:
(1) Acompanythatoperatesachainofprivatehospitalsusesadiscountrateof16%toevaluateitsinvestmentdecisionsandgenerallyexpectsanaccountingrateofreturnof25%.Agovernmentfundedhospitaltrustisrequiredtoachieveareturnofonly6%onassets.
(2) Privatesectorcompaniesaremovingtowardsamoreflexibleapproachtobudgeting.Organisationsinthepublicsectoraremovingintheoppositedirectioni.e.towardsamorerigidapproachtobudgeting,enforcedbytheTreasury(uptothreeyears).
(3) Publicsectorpayissubjecttogovernmentcontrolsandhasformanyyearsfailedtokeeppacewithinflation.Marketforcesdeterminewagesandsalariesintheprivatesector.
chapter 2
21
Test your understanding 1 Stakeholders
Test your understanding 2 Public v private sector objectives
-
Required:
Discuss the causes and consequences of the three scenarios outlined above, using examples to illustrate your answer where appropriate.
Note:Overseascandidatesmayuseexamplesoforganisationsintheirowncountry.
DIVSplcisalargeinternationalcompanywithwidespreadinterestsinadvertising,mediaandvariousconsultancyactivitiesassociatedwithsalespromotionandmarketing.Inrecentyearsthecompany'searningsanddividendpayments,inrealterms,havegrownonaverageby15%and12%peryearrespectively.Thecompanyislikelytohavesubstantialcashsurplusesinthecomingyear,butanumberofinvestmentopportunitiesarebeingconsideredforthesubsequenttwoyears.Theseniormanagersofthecompanyarereviewingtheirlikelyfundingrequirementsforthenexttwotothreeyearsandthepossibleconsequencesfordividendpolicy.
Atpresentthecompanyhasadebt:equityratioof1:5,measuredinmarketvalueterms.Itdoesnotwanttoincreasethisratioatthepresenttimebutmightneedtoborrowtopayamaintaineddividendinthefuture.
Theseniormanagersofthecompanyarediscussingarangeofissuesconcerningfinancialstrategyingeneralanddividendpolicyinparticular.
Required:
Assume you are an independent financial advisor to the board of DIVS plc. Write a report to the board which discusses the following issues:
(i) The repurchase of some of the company's shares in the coming year using the forecast surplus cash, the aim being to reduce the amount of cash needed to pay dividends in subsequent years. Other implications of share repurchase for the company's financial strategy should also be considered.
An Introduction to Financial Strategy
22
Test your understanding 3 Dividend policy and financing
-
(25 marks)
(ii) The advisability of borrowing money to pay dividends in years 2 and 3.
(iii) The likely effect on the company's cost of equity if the company decides on share repurchase and / or further borrowing.
chapter 2
23
-
Test your understanding answers
Asensiblestartingpointistolistthevariousstakeholdersandshowhowtheirinterestsmayconflict,beforereconcilingthetwostatements.
Afirmisacollectionofcontributors,allofwhomhaveastakeinitsongoingsuccessandsurvival.Inanarrowsense,theirrespectiveinterestsareboundtoconflictifpushedtothelimit.
Ifpushedtothelimit,mostoftheseaimsarelikelytobankruptthebusiness.Ifshareholders'aimsarepursuedneglectingallelse,itrequiresscrewingdownwagesandconditionstominimallevels,rackinguppricestotakemaximumadvantageofshorttermopportunities,neverpayingsuppliersuntilthreatenedwithlegalaction,andsoon.
Suchbehaviourisnotjustantisocial,itisantisurvival.Itwillattractcriticalattentionfromthegovernmentandotherbodies,resultinginpenalties,finesandongoingscrutinywhichwilldamagethefirm'sreputationandmarketpositionirretrievably.
TheSWMaimisnotashorttermprofitmaximisingaim.Itaimstocreatesustainableandpermanentvalueforowners.Itisthoroughlyconsistentwithtreatingcustomersandemployeeswellandbuildingupanimageasarespectedcontributortosociety.
Itisthuseasytoreconcilethetwostatementsfirmsthattreattheirstakeholdersbadlyareunlikelytosurviveintothelongterm.To'considerthewishesofallpotentialstakeholders'doesnotrequiremaximisingeveryone'sparticularinterestsbutstrikingabalancebetweenthemtotheultimateandongoingbenefitofall.Thisissimplygoodbusiness.
Ownerswantmaximumdividendsandshareprice. Lenderswantmaximumsecurityfortheirinvestment. Managerswantmaximumpayandotherformsofremuneration. Otheremployeeswantmaximumpayforminimumeffortplus
optimalhealthandsafetystandards. Customerswantmaximumqualityatminimumpriceplus
maximumcredit. Supplierswantminimumsettlementdelay. Governmentwantsmaximumtaxtake. Societywantsmaximumenvironmentalsafeguards,contributions
tocharityandlocalcommunityprojects.
An Introduction to Financial Strategy
24
Test your understanding 1 Stakeholders
-
(1) Rates of return
Theprivatesectorcompanyhasahigherrequiredrateofreturn,andusesmoremeasuresoffinancialsuccessthanthepublicsectorentity.
Causes
Theprivatesectorentityhasaprimaryobjectivetoincreaseshareholderwealth,soithastomeasurefinancialperformancecarefully.
Itsrequiredrateofreturnishigherbecausetheinvestorsintheprivateentityperceiverisktobehigh.Publicsectorentitiesfacelowerrisksincetheyaresupportedbygovernments.
Thecostoffinanceforthepublicsectorentity(providedbythegovernment)willbelower,sincethegovernmentcanusuallyborrowmoneyverycheaply.Thismeansthattherequiredreturncanbelower.
Consequences
Thepublicsectorentitywillbemoreinclinedtoundertakerelativelylowreturnprojectswhichtheprivatesectorentitywillreject.Therefore,"unprofitable"treatmentswillstillbeundertakeninthepublicsector.
Theprivatesectorentitywillperformanarrowrangeoftreatmentsveryefficiently.Thepublicsectorentitywillofferamuchbroaderrangeoftreatments.
Thelowerrequiredreturninthepublicsectorwillgivelessincentivetoreducecosts,sothepublicsectorentitymaybelessefficientthantheprivatesector.
Privatesectorentitieshavemoreflexiblebudgetingproceduresthanpublicsectorentities.
Causes
Publicsectorentitiestendtobelarger,andhavemorebureaucraticstructures.Hence,publicsectorbudgetingcanbeamuchmorecomplexprocess.
(2) Budgets
chapter 2
25
Test your understanding 2 Public v private sector objectives
-
Thepublicsectorisexpectedtolookfurtherintothefuture(3years)whereasaprivatesectorbudgetmayonlylastfor1year.
Privatesectorentitieshaveaflexibleapproachtofinancing(effectivelyanyprojectcanbeundertakenifthefinancecanbefound).Publicsectorentitiesareallocatedfinancebygovernmentandthereforehaveanobjectivetoworkwithinthisimposedconstraint.Flexibilityisthereforelessimportantinapublicsectorentity.
Thegovernmentlikestobeabletocompareperformanceofdifferentpublicsectorentities,sooftenastandard,rigidmethodofbudgetingisproposedtoenablecomparisonstobemadeeasily.
Consequences
Privatesectorentitiesfinditeasiertoadaptquicklytorealworldfactorswhichimpactthem.
Privatesectorentitiestendtohaveamoreflexible,"cando"culture.
Publicsectorbudgetstendtocontainmorebudgetaryslack,becausethebudgethasoftenbeensetwellinadvanceandthennotamendedtoreflectnewfactorswhichcometolight.
Publicsectorpaylagsbehindthatintheprivatesector.
Causes
Publicsectorjobsecuritytendstobebetter,sopayisnottheonlyattractionofholdingapublicsectorjob.
Also,publicsectorpensionstendtobegovernmentfunded,finalsalaryschemes.Intheprivatesector,finalsalaryschemesarebecominglessprevalentasfirmsstruggletoaffordthem.
Thegovernmentoftentriestocontrolinflationbykeepingpublicsectorpayrisesundercontrol.Alowpayriseforpublicsectorworkerscanbeusedasasignaloffinancialprudence.
Publicsectorstaffarepaidrelativelylittleasabonusorincentivepayment.Mostofthepaytendstobeabasicsalarydeterminedbyaverydetailedpayscale.
(3) Pay
An Introduction to Financial Strategy
26
-
Consequences
Publicsectormoraleandmotivationisoftenlowerthanintheprivatesector.
Goodqualitystaffareoftenattractedtoprivatesectorroleswherethestaffarebetterrewarded.
Thelackofbonusesinthepublicsectorsometimesstiflescreativityanddiscouragestheuseofinitiative.
Report
To:BoardofDirectors,DIVSplc
From:Independentfinancialadvisor
Date:XX/XX/XX
Re:Dividendpolicyandotherfinancingissues
Youarecurrentlyconsideringthecurrentandfuturepositionofthecompanyasregardsdividendpaymentsandfinancingoverthenexttwotothreeyears,inthelightofyourcurrentcashsurplusandtheinvestmentopportunitiesavailabletoyoufromnextyear.
Thisreportaddressesthefollowingissues:
Youarelikelytohavesubstantialcashsurplusesinthecomingyear.Yourfirstdecisionistodecidehowmuchtodistribute,bearinginmindbothyourinvestmentfinancingrequirementsinthefutureandthepossiblereactionsofshareholdersandothermarketplayers.Inthecurrentclimate,itisexpectedthat'spare'cash,inexcessofthatrequiredforspecificprofitableinvestmentopportunities,shouldbereturnedtotheshareholderstodowithastheywish.
theimplicationsofsharerepurchasetoreducefuturedividendpayments
borrowingfundstofinancedividends thepossibleeffectsoncostofequityifeitherorbothoftheabove
actionsaretaken.(i) Sharerepurchase
chapter 2
27
Test your understanding 3 Dividend policy and financing
-
Youhavesomeinvestmentopportunitiesopentoyouinthenearfuture.Whetherornotyouhavetoretainsomeofthecurrentsurpluscashtofundthesewilldependupontheextenttowhichyouexpecttheretobesparefundsgeneratedinthenexttwoorthreeyears.
Oncetheamounttobedistributed(ifany)hasbeendecidedupon,youthenneedtodecidewhethertoreturnittoalltheshareholdersasadividend,ortosomeofthemintheformofasharerepurchase.Thelatteroptionwillresultinonlyasmallnumberofshareholderslikelytobethelargeinstitutionalinvestorsreceivingcash,althoughtheirproportionateholding,andthereforeentitlementtofuturedividends,willbereduced.Othershareholderswillhavetosellshares,incurringtransactioncosts,to'manufacture'dividendsshouldtheyneedthem.
Itshouldbenotedthatasharerepurchaseisadministrativelymorecomplexinthatitrequirespriorapprovalfromageneralmeetingofshareholders(assumingtheArticlesofAssociationprovidethatitcanhappenatall).ItisalsonolongerpossibleforinstitutionstoreclaimtaxonthedistributionintheUK.
Thetwotypesofdistributionwillalsoaffectsharepricesdifferently.Whenadividendisdeclared,thevalueofthesharesfallsfromcumdivtoexdiv,theshareholdershavinghadsomeoftheircapitalinvestmentrealisedascash.
Intheory,ifthesharerepurchaseismadeatcurrentmarketprice,asharerepurchaseshouldleavetheindividualsharepriceunchangedtherehasbeenareductionintotalmarketvalueinproportiontothetotalnumberofsharesinissue.
ItshouldalsobenotedthatasharerepurchasewouldresultinahigherfutureEPSfigurethanifanormaldividendhadbeenpaid.Howeverthisshouldnotaffectthemarket'sperceptionofthehealthofthecompany,asitispurelyaresultofthesameearningsbeingspreadoverasmallernumberofshares.
Overall,itwouldappearthatthereisnoparticularlystrongargumentforasharerepurchaseinpreferencetoadividendpaymenttoallshareholders.Whilstyoumayseethisasameansofreducingfuturedividendpayments,itislikelythattheremainingshareholders,whowouldbeholdingagreaterproportionofsharesthanpreviously,wouldexpectahigherdividendpershare.Ifthisexpectationisnotmet,sharepricesmaybeaffectedadversely.
An Introduction to Financial Strategy
28
-
Ifitisdecidedtodistributeanamountinthecurrentyearthatcannotbemaintained(withplannedgrowth)infutureyearsoutofoperationalcashflows,thenadditionalfundswillneedtobeborrowed.
Thiswillraisethecompany'sgearinglevelabovethecurrent1:5debt:equityratio,withtwoconsequences.First,thecompanywillbefundedbyagreaterproportionofcheapfinance,particularlyasdebtinterestistaxdeductible.Second,shareholdersmayperceiveagreaterriskasbeingattachedtotheirdividends,asmoreoftheearningsareattributedtofixedinterestpayments.Itisaquestionoffindingtheoptimumbalancebetweenthesetwoeffects.
Theprobableeffectofincreasingthegearinglevelwillbe,asdiscussedin(ii)above,toincreasetherequiredreturnby(costof)equity.Borrowingwilldirectlyaffectthegearinglevel,byincreasingthedebtelement.
Thepaymentofadividendorasharerepurchasewillalsoincreasethegearinglevel,byloweringthevalueoftheequity(asdiscussedin(i)above,adividendresultsinalowersharepricewiththenumberofsharesbeingmaintainedasharerepurchaseresultsinamaintainedsharepricewithalowernumberofshares).
Thusbothactionsmayresultinahighercostofequity.
Overallrecommendations
ItisadvisedthatanysurpluscashoverandabovetheneedsofallpositiveNPVinvestmentsshouldbepaidoutintheformofadividend.This'residual'dividendpolicymayleadtofluctuatingdividends,however,andinstitutionalinvestorsgenerallypreferasteadydividendpatternyouwillneedtokeepacarefuleyeonyoursharepricetoensureitisnotbeingadverselyaffectedinthelongterm.
Shouldyouneedtoborrowinthefuture,youshouldfindthistoyouradvantage,asyourcurrentgearinglevelisquitelow,andthebenefitsofcheaperdebtshouldoutweighanyincreaseincostofequity.
(ii) Borrowingtopaydividends
(iii) Effectoncostofequity
chapter 2
29
-
An Introduction to Financial Strategy
30
-
PerformanceMeasurementinFinancialStrategyChapter learning objectives
Lead Component
A2:Evaluatethestrategicfinancialstrategiesandobjectivesofanorganisationandtheextentoftheirattainment.
(a) identifyanorganisation'sobjectivesinfinancialterms.
(b) evaluatetheattainmentofanorganisation'sfinancialobjectives.
(c) evaluatecurrentandforecastperformancetakingaccountofpotentialvariationsineconomicandbusinessfactors.
(d) evaluatealternativefinancialstrategiesforanorganisation,takingaccountofassessmentoftheorganisationbyfinanciersandotherstakeholders,includinglikelychangestosuchassessmentinthelightofdevelopmentsinreporting.
31
chapter
3
-
Indicative syllabus content
Thefinancialobjectivesofanorganisationandeconomicforcesaffectingitsfinancialplans(e.g.interest,inflationandexchangerates).
Assessingattainmentoffinancialobjectives. Useoffinancialanalysisintheexternalassessmentofa
company(e.g.inassessingcreditworthinessandcompliancewithfinancingcovenants).
Modellingandforecastingcashflowsandfinancialstatementsbasedonexpectedvaluesforeconomicvariables(e.g.interestrates)andbusinessvariables(e.g.volumeandmargins)overanumberofyears.
Analysisofsensitivitytochangesinexpectedvaluesintheabovemodelsandforecasts.
Assessingtheimplicationsforshareholdervalueofalternativefinancialstrategies,includingdividendpolicy.(Note:ModiglianiandMillerstheoryofdividendirrelevancywillbetestedinbroadterms.Themathematicalproofofthemodelwillnotberequired,butsomeunderstandingofthegraphicalmethodisexpected).
Thelendersassessmentofcreditworthiness. Currentandemergingissuesinfinancialreporting(e.g.
proposalstoamendorintroducenewaccountingstandards)andinotherformsofexternalreporting(e.g.environmentalaccounting).
Performance Measurement in Financial Strategy
3232
-
1Overview of Chapter
Performance evaluation
Investors(bothshareholdersandlenders)willoftenappraisetheperformanceofanorganisation,toassesswhethertheorganisationrepresentsagoodinvestment.Ifitisshownthattheorganisation'sperformanceisdeclining,theshareholdersmaydecidetoselltheirshares,andthelendersmightchangetheirassessmentoftheorganisation'screditworthiness.
Inanexamquestion,youmightalsobeaskedtouseratioanalysistoassesswhetheranentityhasmetitsobjectives.
Toappraiseperformance,itisnecessarytofirstcalculateratiosunderthefollowingheadings:
profitabilityratios, liquidityratios(essentiallytheworkingcapitalratioscoveredinthelater
Chapter'ShortTermFinanceWorkingCapitalManagement'), gearingratios, stockmarketratios.
chapter 3
33
-
WiththeexceptionoftheliquidityratioscoveredinthelaterChapter'ShortTermFinanceWorkingCapitalManagement',thecalculationoftheseratiosiscoveredinthisChapter.
However,aswellasperformingthecalculations,itwillalsobeimportanttocommentontheratios,anytrends,andanylikelyfuturedevelopments,soyouwillfinddetailedexplanationsofhowtointerprettheratiosthroughoutthisChapter.
2Limitations of ratio analysis
Anyanalysisofratioscalculatedfrominformationinthefinancialstatementsofanentitycanhelpustobetterunderstandtheperformanceofthatentity.However,itisimportanttounderstandthefollowinglimitationsoftheanalysis:
ratiosarealwaysbasedonhistoricinformation,theyarenotforwardlooking
inisolation,aratiofigureisuseless.Inordertointerpretthefigure,somesortofcomparison(withprioryears,budgetsorsimilarbusinesses)isnecessary
theyshowthepositionatasinglepointintime.Someanalysisovertimeisuseful,orperhapsaverage,ratherthanyearend,figuresshouldbeused
the'ideal'levelforaparticularratiowillvarywiththetypeofindustry.Forexample,inthefurnitureretailingindustry,profitmarginstendtobemuchhigherthaninthefoodretailingindustry
differentaccountingpoliciesmightdistortsomeratios,makingitdifficulttocomparedifferentbusinesses
thebasicratiofiguresneedtobeinterpretedcarefully.Forexample,anentitywithhighlevelsofreceivableswillappeartohavegoodliquidityratios,wheninfactitmaybestrugglingtocollectoverduedebts.
3Profitability Ratios
Severalprofitfigures(grossprofit,operatingprofit,netprofit)canbeidentifiedinatypicalincomestatement.
Eachmaybeusedtoevaluatetheprofitabilityofthebusiness.
Performance Measurement in Financial Strategy
34
Definitions of different profit figures
Rationale for analysing profitability
-
Therearetwomeasurescriticaltoanyanalysisofprofitability:
Return on capital employed (ROCE)
Returnoncapitalemployed(ROCE)isameasurementthatisfrequentlyusedintheanalysisoffinancialstatements.
Itshowstheoverallperformanceoftheentity,expressedasapercentagereturnonthetotalinvestment.Itmeasuresmanagementsefficiencyingeneratingprofitsfromtheresourcesavailable.
ROCEisexpressedasapercentage,andiscalculatedasfollows:
whereCapitalemployed=Thetotalfundsinvestedinthebusiness,i.e.shareholders'funds+longtermdebt,ortotalassetslesscurrentliabilities.
Return on equity (ROE)
ROEgivesanindicationastohowwellthecompanyhasperformedinrelationtoitsshareholders,themostimportantstakeholder.
ROEisexpressedasapercentage,andiscalculatedasfollows:
whereEquity=Thebookvalueofshareholders'funds
ItisusefultocomparetheROEtotheROCEtomeasuretheamountofthereturnunderlyingthebusinessthatpertainstotheshareholder.Note,however,thattheyarenotdirectlycomparable,ROEbeingbasedonnetprofitandROCEbasedonoperatingprofit.
(1) Return on Capital Employed (ROCE)
(2) Return on Equity (ROE)
OperatingprofitROCE = 100
Capitalemployed
NetprofitROE= 100
Equity
chapter 3
35
Activity ratios
Profit margin calculations
-
Return on capital employed further analysis
WhentryingtoanalyseROCE,itcanbeusefultobreakitdownasfollowsintotwocomponentratios:
ROCE = Operating profit margin Asset turnover
Therelationshipbecomesclearwhenweputtheratiocalculationsintotheformula:
AnalysingthecomponentratiosmaythrowsomelightonthecauseofachangeinROCE.
Forexample,afallinROCEcouldbecausedby:
Operatingprofit Operatingprofit Revenue 100= 100
Capitalemployed Revenue Capitalemployed
generatinglowersalesfromthecompany'scapital(lowerassetturnover),and/or
generatingalowerprofitmarginonthesaleswhichhavebeenachieved(loweroperatingprofitmargin).
Acompanyisconsideringtwofundingoptionsforanewproject.ThenewprojectmaybefundedbyGBP10mofequityordebt.Belowaretheforecastfinancialstatementsreflectingbothmethodsoffunding.
Balance sheet extract
Equity DebtGBPm GBPm
Longtermliabilities(10%debentures) 0.0 10.0
CapitalSharecapital(50pence) 11.0 3.5Sharepremium 4.0 1.5Reserves 5.0 5.0
20.0 10.0
Performance Measurement in Financial Strategy
36
Example 1
-
Income Statement extract
Corporationtaxischargedat30%.
Required:
GBPmRevenue 100.0Grossprofit 20.0Lessexpenses(excludingfinancecharges)
(15.0)
Operatingprofit 5.0
(a) Calculate the operating profit margin and the asset turnover.
(b) Calculate Return on Capital Employed and Return on Equity, and compare the financial performance of the company under the two funding methods.
(c) What is the impact on the company's performance of financing by debt rather than equity?
Interpretation of profitability ratios
Ingeneralterms,highlevelsofprofitabilityaredesirable.
AnentitywithhighprofitmarginsandahighROCEisusuallyperceivedtobeperformingwell.Similarly,iftheratiosgrowovertime,thisisusuallyperceivedtobepositive.
Theidealvaluefortheprofitabilityratioswillvaryfromindustrytoindustry,sobesuretocomparethefigurestopreviousyearsandtoothersimilarbusinessesifpossible.
4Financial Gearing
chapter 3
37
Rationale for analysing gearing
Definition of gearing
-
Gearingisthemixofdebttoequitywithinafirm'spermanentcapital.Therearetwoparticularlyusefulmeasures:
Capital gearing a measure of capital structure
Therearetwokeymeasuresofcapitalgearing:
Thecalculationofcapitalgearingcanbedoneinanumberofdifferentways.Inanexam,makesurethatyoushowyourworkings,andusethesameformulaconsistently.
What do debt and equity contain?
Debt
Allpermanentcapitalchargingafixedcharge(interest)maybeconsideredtobedebt.Thisincludesdebenturesandloansnaturally.Itmayincludebankoverdraftifsignificantandconsideredpartofthepermanentfinancing.Similarly,cashandcashequivalentsshouldbedeductedwhencalculatingdebtingearingcalculationsifthecashisregardedasa'permanent'cashbuffer.
Equity
Allordinarysharecapitalandsharepremiumtogetherwithreserves(theyrelatetotheordinaryshareholders).
A note on preference shares:
Preferencesharesshouldbetreatedinthefollowingwayiftheyareirredeemable,treatasequityand,ifredeemable,treatasdebt.
(1) Capitalgearingastatementoffinancialposition(balancesheet)measure.
(2) Interestcoveranincomestatementmeasure.
DebtCapitalgearing= 100
Equity
Debt 100Debt+Equity
Performance Measurement in Financial Strategy
38
Market value and book value of equity and debt
-
Interest cover
Theinterestcoverratioindicatesthenumberoftimesprofitswillcovertheinterestchargethehighertheratio,thebetter.
Theinterestcoverratioisusedbylenderstodeterminethevulnerabilityofinterestpaymentstoadropinprofit.
Asanalternativetotheformulashownhere,investorsoftenuseEBITDAratherthanprofitbeforeinterestandtaxintheformula,becauseEBITDAisabetterapproximationtothecashgeneratedbythebusiness(andavailabletopayinterestwith).
Interestcover=
Profitbeforeinterestandtax
Interestpayable
Balance sheet (statement of financial position) for X Co
USDmNoncurrentassets(total) 23.0Currentassets(total) 15.0TOTAL ASSETS 38.0EquityandLiabilitiesOrdinarysharecapital 10.0Ordinarysharepremium 4.0Preferencesharecapital(irredeemable) 1.5Reserves 1.5NoncurrentliabilitiesDebenture10% 8.0CurrentliabilitiesTradecreditors 8.0Bankoverdraft 5.0TOTAL EQUITY & LIABILITIES 38.0
chapter 3
39
Example 2
The debt ratio
-
X Co Income Statement Extract
Required:
USDmOperatingprofit(PBIT) 4.0FinanceCharges (1.0)
Profitbeforetax(PBT) 3.0Tax@30% (0.9)
Netprofit 2.1
(a) Calculate the interest cover and the capital gearing ratio for X Co.
(b) Comment on the results of your calculations in part (a).
Interpretation of gearing ratios
Statement of financial position
Ahighproportionofdebtfinanceintheentity'scapitalstructureisseenasbeingriskybytheentity'sshareholders(whichcausesthemtodemandhigherreturnsontheirequitysee'CapitalStructure'Chapterformoredetails).
However,itisdifficulttogiveanypracticalguidanceastowhata'safe'levelofgearingmightbe.Comparethegearingratiotoprioryearsandbudgets,andtothegearingratioofsimilarentities,toassesswhetheritlookstoohigh.
Also,considerinparticularthelevelofnoncurrentassetsonthebalancesheetwhichcouldbeusedforsecurity.Ahighlevelofnoncurrentassets(muchhigherthanthecurrentvalueofdebtfinance)indicatesthatpotentiallytheentityshouldbeabletoraisemoredebtfinancequiteeasily.
Performance Measurement in Financial Strategy
40
Operating and financial leverage
-
Income statement
Aninterestcoverratiolessthan1indicatesthattheentityishavingtroubleservicingitsdebtfinance.Thehighertheratioisabove1,theeasieritshouldbefortheentitytocontinuepayingitsinterest,sothelessriskytheentityappearstobe.
However,notethatalackofcash,ratherthanalackofprofit,isusuallythereasonwhyacompanyfailstomeetitsinterestobligations.ThisiswhyanalystsoftensubstituteEBITDA(orevencashflow)intotheformulainsteadofprofit,togiveamoreusefulmeasureofcover.
5Stock Market Ratios
Investorswillwishtoassesstheperformanceofthesharestheyhaveinvestedin(againstcompetingentitiesinthesamesector,againstthemarketasawhole,andovertime).
Thereareanumberofratioswhichwillbeofspecificinteresttoinvestors(bothdebtinvestorsandequityinvestors).
Earnings per share (EPS)
Beforewecancalculateanyratiosweneedtocalculateakeymeasureofreturn,theEarningspershare(EPS).
whereEarnings=Profitdistributabletoordinaryshareholders,i.e.afterinterest,taxandanypreferencedividend.
EarningsEPS=
Numberofordinarysharesinissue
chapter 3
41
More details on EPS
Market price per share
-
P/E ratio
TheP/Eratioisameasureofgrowthitcomparesthemarketvalue(ameasureoffutureearnings)tothecurrentearnings.
or,alternatively,Totalmarketcapitalisation/Totalearnings.
ThehighertheP/Eratio,thegreaterthemarketexpectationoffutureearningsgrowth.Thismayalsobedescribedasmarketpotential.
Earnings yield
TheP/Eratioisthereciprocal(inmaths,anumberorquantitydividedinto1)oftheearningsyield.
or,alternatively,Totalearnings/Totalmarketcapitalisation.
Themarketpricewillincorporateexpectationsofallbuyersandsellersoftheentitysshares,andsothisisanindicationofthefutureearningpoweroftheentity.
Dividendpayout rate
Thecasheffectofpaymentofdividendsismeasuredbythedividendpayoutrate.
or,alternatively,Totaldividend/Totalearnings.
TherelationshipbetweentheaboveinvestorsratiosisusuallythatanentitywithahighP/Eratiohasalowdividendpayoutratioasthehighgrowthentityneedstoretainmoreresourcesintheentity.AmorestableentitywouldhavearelativelylowP/Eratioandhigherdividendpayoutratio.
Whenanalysingfinancialstatementsfromaninvestorspointofviewitisimportanttoidentifytheobjectivesoftheinvestor.Doestheinvestorrequirehighcapitalgrowthandhighrisk,oralowerrisk,fixeddividendpaymentandlowcapitalgrowth?
Currentshareprice P/Eratio=
EPS
EPS Earningsyield=
Currentshareprice
Dividendpershare Payoutrate=
EPS
Performance Measurement in Financial Strategy
42
-
Dividend yield
Thisistherelationshipofthedividendpaidtothecurrentmarketvalueofashare.
or,alternatively,Totaldividend/Totalmarketcapitalisation.
However,thedividendrepresentsonlypartoftheoverallreturnfromashare.
Theotherpartofthereturnisthecapitalgainfromanincreaseinthevalueoftheshare.Thecapitalgainfromasharemaywellbefarmoresignificantthanthedividend.
Dividendpershare Dividendyield=
Currentshareprice
Dividend cover
Dividendcovermeasurestheabilityoftheentitytomaintaintheexistinglevelofdividendandisusedinconjunctionwiththedividendyield.
or,alternatively,Totalearnings/Totaldividend.
Thehigherthedividendcoverthemorelikelyitisthatthedividendyieldcanbemaintained.
Dividendcoveralsogivesanindicationofthelevelofprofitsbeingretainedbytheentityforreinvestmentbyconsideringhowmanytimesthisyearsdividendiscoveredbythisyearsearnings.
EarningspershareDividendcover =
Dividendpershare
LilydaleCohas5mordinarysharesinissue.Itsresultsfortheyearare:
USD000Profitbeforetax 750Tax (150)
Profitaftertax(PAT) 600Ordinarydividendproposed (150)
Retainedprofit 450
chapter 3
43
Example 3
-
Themarketpricepershareiscurrently83centscumdividend.
Required:
Calculate the following ratios:
(a) Price/earnings ratio
(b) Dividend payout rate
(c) Dividend yield, and
(d) Dividend cover.
6The use of published accounts for ratio analysis
Whenexternalstakeholders,suchaspotentialinvestorsandlenders,trytoassesstheperformanceofanentity,themostreadilyavailablesourceofinformationisthepublishedaccountsoftheentity.
Intryingtointerprettheratioscalculatedfromthepublishedaccountsfigures,itisimportanttounderstandthelimitationsofthepublishedfigures.
Limitations of published accounts figures for ratio analysis
Publishedaccountsarehistoricrecords,notforwardlooking.However,theOperatingandFinancialReview(OFR),whichcompaniesareencouragedtopresentaspartoftheirpublishedaccounts,willcontainthedirectors'viewofthecompany'sprospects.
Theincomestatementispreparedusingtheaccrualsconcept,soitisdifficulttorelatethefigurestotheentity'scashposition.Howevertheinclusionofthecashflowstatementinthepublishedaccountshelpstogiveanimpressionofthecashposition.
Thepublishedaccountshavehistoricallycontainedonlyfinancialinformation.Inrecentyearsentitieshavebeenencouragedtoreportonwiderissues(suchasenvironmentalandsocialissues),sousersoftheaccountsareabletoseeafullerviewoftheentity'sperformance.
Performance Measurement in Financial Strategy
44
The lender's assessment of creditworthiness
More on recent developments in financial reporting
-
7Forecasting Profits, Cash Flows and the Balance Sheet Planning
Allbusinessesneedtoplan.Theyneedtoidentifyexactlywhattheirbusinesswilllooklikefinanciallyshouldtheychoosetogoaheadwithaparticularstrategy.
Objective of planningtoallowanorganisationtoinfluenceitsownfuturebythinkingandactinginadvance.
Averypopularexamrequirementistocalculateaforecastincomestatement,balancesheetand/orcashflow.
Forecasting income statement and balance sheet values
Thisisaverysimpleprocess.Forexample,ifsalesarecurrentlyUSD10mandgrowthisforecasttobe5%,futuresalescanbeforecastas:
Tax adjustments
Thisisthemainsourceofdifficultyinmanyquestions.Thetaxshouldnotbechargeddirectlyontheaccountingprofits.Instead,thefirm'sdepreciationshouldbeaddedbackandthenthecapitalallowancesdeductedtogivetaxableprofit,towhichthetaxratecanbeapplied.
Year1:USD10mx1.05Year2:USD10mx(1.05)2
USD10.5mUSD11.025m
FallowCo'sdepreciationonitsplantandmachinerynextyearwillbeEUR2monastraightlinebasis.Fortaxpurposes,taxdepreciationallowancescanbeclaimedatarateof25%p.a.(reducingbalancebasis).Thecurrentbookvalue,andtaxwrittendownvalue,oftheplantisEUR10m.TheexpectedaccountingprofitforthecomingyearisEUR8m.Corporationtaxis30%.
Required:
Calculate the expected tax charge for next year.
chapter 3
45
Example 4 Tax adjustments
Guidance for forecasting financial statements
-
GSDLtdisaprivateUKcompanyownedbythetwofamiliesthatstartedthebusinessin20X0.ThecompanyproducesorganicfoodproductsfordistributioninthedomesticUKmarketusingfoodproductsfromUKfarms.Thecompanyisexperiencingaperiodofrapidgrowth,withrevenueexpectedtoriseby15%ineachofthefollowingfiveyears.
Thecompanyishopingtoretainaprofitmargin(profitbeforeinterestandtaxesdividedbyrevenue)of30%throughoutthenextfiveyears.Theratioofworkingcapitaltorevenueisexpectedtoremainconstant,whereworkingcapitalisinventoriesplustradereceivableslesstradepayables.
Interestispaidontheoverdraftandbankloanat6%perannum.Interestonthebankloanandoverdraftiscalculatedonthebalanceoutstandingatthebeginningoftheyear.Corporationtaxispaidoneyearinarrearsatarateof30%,witha100%taxallowanceforcapitalexpenditureintheyearinwhichitisincurred.Inarrivingatoperatingprofit,depreciationischargedat25%onareducingbalancebasisbasedonyearendbalances.
ExtractsfromthemanagementaccountsofGSDLtdon31December20X4areasfollows:(N.B.thecurrencyofGSDistheBritishPoundGBP,or)
Balance sheet as at 31 December 20X4
mProperty,plantandequipment 15Workingcapital 9
24
Sharecapital(50pordinary) 10Retainedearnings 4Longtermborrowings(bankloan) 8Shorttermborrowings(overdraft) 1Currenttaxpayable 1
24
Performance Measurement in Financial Strategy
46
Illustration 1 Exam style forecasting question
-
Income statement for the year ended 31 December 20X4
Capitalexpenditureplansareforexpenditureonproperty,plantandequipmentof10min20X5,10min20X6and7mineachofyears20X7to20X9.Nodisposalsofproperty,plantandequipmentareexpectedinthisperiod.
Shareholdersexpectayearonyearincreaseindividendsof5%.Anyfundsdeficitintheyearwillbefundedbyoverdraftandanysurplusfundsusedtoreducetheoverdraft.However,withtheincreaseddemandsonthefundsofthebusinesstofinancegrowth,thedirectorsareconcernedthattheymayexceedtheoverdraftlimitof1.5m.Theymay,therefore,needtonegotiateanincreaseinthebankloan,althoughthebankhasindicatedthatitwouldnotacceptgearinghigherthan70%basedonbookvalueswheregearingisdefinedaslongandshorttermborrowings(includingoverdraft)dividedbyequity.Theshareholdershaveindicatedthattheydonotwishtoinjectanyadditionalcapitalintothebusiness.
Required:
Construct the balance sheet, income statement and a cash flow analysis of the company for each of the years 20X5 and 20X6 and advise the company on the extent of any additional funding requirement in that period. In your answer, round figures to the nearest 1,000.
RevenueProfitbeforeinterestandtaxesDividendpaidin20X4
45.0m13.5m
50pashare
Solution: 20X4 20X5 20X6
Income statements k k kRevenue(15%increasepa) 45,000
51,750
59,513
Profitbeforeinterestandtax(30%ofrevenue) 13,500 15,525 17,854Interestonbankloan(6%8m) (480) (480)Interestonoverdraft(6%openingbalance,seebelow)
(60)
(157)
Profitbeforetax 14,985 17,217Tax(W1) (3,371)
(4,322)
Profitaftertax 11,614
12,895
chapter 3
47
-
20X5 20X6Cash flow analysis k kProfitbeforeinterestandtax 15,525 17,854Addbackdepreciation(W2) 6,250 7,188Deductincreaseinworkingcapital(W3) (1,350)
(1,553)
Cashflowfromoperations 20,425 23,489Interestpaidonbankloan(6%8m) (480) (480)Interestpaidonoverdraft(6%openingbalance)
(60) (157)
Dividendspaid(5%increasepa) (10,500)(11,025)Taxpaid(W1) (1,000) (3,371)Capitalexpenditure (10,000)
(10,000)
Netcashflowfortheyear (1,615) (1,544)Cashb/f (1,000)
(2,615)
Cashc/f (2,615)
(4,159)
20X5 20X6
Balance sheets k kProperty,plantandequipment(W2) 18,750 21,562Workingcapital(20%revenue) 10,350
11,903
29,100
33,465
Sharecapital 10,000 10,000Retainedearnings(W4) 5,114
6,984
15,114 16,984Longtermborrowings(bankloan) 8,000 8,000Shorttermborrowings(overdraft,fromcashflowanalysis)
2,615 4,159
Currenttaxpayable 3,371
4,322
29,100
33,465
Performance Measurement in Financial Strategy
48
-
Workings20X5 20X6
(W1)Taxexpense k kProfitbeforeinterestandtax 15,525 17,854Addbackdepreciation(W2) 6,250 7,188Deductcapitalallowances (10,000)(10,000)Interestonbankloan (480) (480)Interestonoverdraft(6%openingbalance) (60)
(157)
Taxableprofit 11,235
14,405
Taxexpenseat30% 3,371 4,322
20X5 20X6(W2)Property,plantandequipment k k
Balanceb/f 15,000 18,750Capitalexpenditure 10,000
10,000
Nettotal 25,000 28,750Depreciationat25% (6,250)
(7,188)
Balancec/f 18,750
21,562
20X5 20X6
(W3)Movementsinworkingcapital k k kWorkingcapitalb/f 9,000Workingcapitalc/f(9/4551,750) 10,350
Increaseinyear 1,350Workingcapitalb/f 10,350Workingcapitalc/f( 9/45 59,513) 11,903
Increaseinyear 1,553
chapter 3
49
-
Advicetothecompany
Theoverdraftlimitis1.5m,whereastheaboveforecastsshowaforecastoverdraftofapproximately2.6mattheendof20X5and4.2mattheendof20X6,ifthelongtermbankloaniskeptconstant.Thisisnotacceptable,sothecompanymustapproachthebankandseektoincreasethebankloanbytheexcess4.2m1.5m=2.7m.Forecasttotalborrowingsat31December20X6are12.2m.
Forecastequityat31December20X6is17.0m.
whichisabovethebankslimit.Someamendmentstothecompanysplansarenecessary,asdiscussedinthenextExample.
20X5 20X6(W4)Retainedearnings k k
Balanceb/f 4,000 5,114Profitfortheyear 11,614 12,895Dividends (10,500)
(11,025)
Balancec/f 5,114
6,984
Theforecastgearingratioat31December20X6is
12.2100%=72%,17.0
FollowingonfromtheforecastingIllustrationabove(regardingGSDLtd).
Required:
Discuss the interrelationships between financing, investment and dividend strategies with reference to the liquidity requirements of GSD Ltd. Include in your discussion how each could be adapted to meet the companys liquidity requirements in the years 20X5 and 20X6 and provide a recommendation.
Performance Measurement in Financial Strategy
50
Example 5 Exam style forecasting question continued
-
8Exam style questions
ThedirectorsofABC,aconglomeratelistedonastockexchange,areappraisingoneoftheirwhollyownedsubsidiaries,XYZ,withaviewtodisinvestment.Thesubsidiaryisprimarilyinvolvedinthemanufactureanddistributionofcarcareproducts.
FinancialdataforXYZareshowninthetablebelow.
Required:
(10 marks)
(15 marks)
(Total: 25 marks)
(a) Calculate five ratios for each of the two years 20X1 and 20X2 which you consider to be appropriate for the evaluation of the subsidiary's gearing, profitability and liquidity over the twoyear period. Your selection of ratios should ensure measurement of the company's performance in all three areas.
(b) Prepare a report for the management of ABC. This report should discuss the following:(i) the performance of the subsidiary during the past two
years, using the ratios calculated in part (a) to guide your comments
(ii) the limitations of the type of historical analysis you have just provided
(iii) suggestions for the parent company's future course of action in respect of the subsidiary, including comment on an appropriate procedure for valuing the company
(iv) other, nonfinancial information which would be useful to the directors of ABC before they make any decision.
chapter 3
51
Test your understanding 1 Ratio analysis
-
Summary accounts for XYZ
Balance sheet (statement of financial position) at 31 December
Extracts from the income statements for the years ended 31 December
20X2 20X1$000 $000
Noncurrentassets(plant&equip) 2,650 2,255Otherlongtermassets(Note1) 750 675
Cashandmarketablesecurities 195 162Receivables 765 476Inventoryandworkinprogress 1,250 893Othercurrentassets 150 91
Totalassets 5,760 4,552
Shareholders'funds 2,520 1,726
Longtermdebt 2,250 1,976Otherlongtermliabilities(Note2) 275 206
Currentliabilities 715 644
Totalequity&liabilities 5,760 4,552
20X2 20X1$000 $000
Turnover 6,575 5,918Costofgoodssold 5,918 5,444Otherexpenses 658 592Otherincome 23 20
Earningsbeforefinancechargesandtax 22 (98)FinanceCharges 395 339Taxonordinaryactivities(Note3) (120) (149)
Netloss (253) (288)
Performance Measurement in Financial Strategy
52
-
Notes:
Other financial information
(1) Otherlongtermassetsaremotorvehiclesandofficeequipment.(2) Otherlongtermliabilitiesarefinanceleases.(3) Thetaxshowninthe20X1profitandlossextractwillberecovered
in20X2.
$000Depreciation20X2 175Netrealisablevalueofinventory 1,091Netrealisablevalueofplantandequipment 3,907Inventoryandworkinprogressat1January20X1 850Receivablesat1January20X1 435
STRisawellestablishedmarketingconsultancyinacountrywithalowinterestrate.STRisasuccessfulbusinesswhichhasexperiencedrapidgrowthinrecentyears.Thereare20million$1ordinarysharesinissue.Theseordinarysharesarequotedonarecognisedstockexchangeand40%areownedbythefoundersofthebusiness.Dividendswere40centspersharein20X3andgrewby5%perannumbetween20X3and20X6.Thispatternisexpectedtocontinuebeyond20X6.Dividendsarepaidintheyearinwhichtheyaredeclared.
Extractsfromthefinancialstatementsforthepastthreeyearsareasfollows:
Additional information:
20X4 20X5 20X6$million$million$million
Profitbeforetax 21.6 24.4 26.7Taxexpense 7.7 2.6 4.3Netcashgeneratedafterdeductinginterest,taxandnetcapitalexpenditure,butexcludingordinarydividends
19.2 (7.1) 18.8
Theopeningcashbalancein20X4forcashandcashequivalentswas$6million
Theopeningbookvalueofequityin20X4was$60million
chapter 3
53
Test your understanding 2 Forecasting and ratio analysis
-
Thedirectorshavenoticedthebuildupofcashandcashequivalents.Theyareconcernedthatthismightnotbeinthebestinterestoftheshareholdersandcouldhaveanadverseeffectontheshareprice.Variousproposalshavebeenmadetoreducethelevelofcashandcashequivalents.
Required:
(3 marks)
(10 marks)
(7 marks)
(5 marks)
(Total for part (c) = 12 marks)
(Total: 25 marks)
Longtermborrowingsremainedat$50millionthroughoutthethreeyearsandtheannualgrossinterestcostontheborrowingswas$1million
Therewereanumberofdisposalsofnoncurrentassetsin20X4andanexceptionallyhighlevelofcapitalexpenditurein20X5.
(a) Calculate the following financial information for STR for each of the years 20X4 to 20X6:
Closing cash balance
Closing book value of equity.
(b) Analyse and discuss the financial performance of the entity from the viewpoint of both the lenders and shareholders, referring to the information calculated in part (a) above and making appropriate additional calculations. Up to 6 marks are available for calculations.
(c) (i) Discuss the comparative advantages and disadvantages
of a share repurchase versus a oneoff dividend payment.
(ii) Advise the directors of STR on alternative financial strategies that they could consider that would reduce the level of surplus cash.
Performance Measurement in Financial Strategy
54
-
(a) YouareanewlyappointedFinanceManagerofanEducationalInstitutionthatismainlygovernmentfunded,havingmovedfromasimilarpostinaserviceentityintheprivatesector.Theobjective,ormissionstatement,ofthisInstitutionisshowninitspublicitymaterialas:
Toachieverecognizedstandardsofexcellenceintheprovisionofteachingandresearch.
TheonlyfinancialperformancemeasureevaluatedbythegovernmentisthattheInstitutionhastoremainwithincashlimits.ThecashallocationeachyearisdeterminedbyarangeofnonfinancialmeasuressuchasthenumberofresearchpublicationstheInstitutionsstaffhaveachievedandofficialratingsforteachingquality.
However,almost20%oftotalcashgeneratedbytheInstitutionisnowfromtheprovisionofcoursesandseminarstoprivatesectorentities,usingeitheritsownoritscustomersfacilities.Thesecustomersarelargelyunconcernedaboutresearchratingsandteachingqualityastheyrelatemoretoacademicawardssuchasdegrees.
TheHeadoftheInstitutionaimstoincreasethepercentageofincomecomingfromtheprivatesectorto50%overthenext5years.Shehasaskedyoutoadviseonhowthemanagementteamcanevaluateprogresstowardsachievingthisaimaswellasmeetingtheobjectivesetbythegovernmentfortheactivitiesitfunds.
Required:
Discuss the main issues that an institution such as this has to consider when setting objectives. Advise onwhether a financial objective, or objectives, could or should be determined and whether such objective(s) should be made public.
(9 marks)
chapter 3
55
Test your understanding 3 Objectives / performance appraisal
-
Required:
Choose two of each type of measure, explain their purpose and advise on how they could be used by the Educational Institution over the next 5 years to assess how it is meeting the Head of the Institutions aims.
(16 marks)
Note: A report format is not required in answering this question.
(Total 25 marks)
(b) Thefollowingisalistoffinancialandnonfinancialperformancemeasuresthatwereinuseinyourpreviousprofitmakingentity:
Financial NonfinancialValue