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Chapter 1: Financial management and financial objectives

Syllabus How examined Past Paper

Purpose of financial management andrelationship to financial and managementaccounting.

-discussion question examiningimportance of shareholder wealthmaximisation

-discuss the relationship betweeninvestment/dividend/financing decisions.

QSX June 2010 part c

Financial objectives and relationship withcorporate strategy

Use of ratio analysis to assessachievement of objectives

NG Dec 2009 part bQSX June 2010 part a,bYNM June 2011 part aBar Co Dec 2011 part b cGWW Co Dec 2012 part c

Stakeholders an impact on corporateobjectives

-Discussion of how to motivatemanagers to achieve objectives.-discussion of conflict betweenstakeholders

Dartig Dec 2008 part eZigto June 12 part a

Financial and other objectives in NFP

organisations

Comparison of objectives of not for

profit and profit seeking organisations.

Bar Dec 2011 part d

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QSX June 2010 Q4

(a)

Year 2008 2009

Dividend yield = dividend /share

price at the start of the year

385/740 = 52% 400/835 = 48%

Capital gain = opening closing

share price(expressed as

monetary amount or percentage)

835 740 = 95c or 128% (100 x95/740)

648 835 = (187c) or (224%)(100 x 187/835)

total shareholder return

= capital gain% + dividend yield

%

or

=(dividend paid+ monetary

capital gain)/opening share price

100 x (95 + 385)/740 = 180%(52% + 128%)

100 x (187 + 40)/835 = 176%(48% 224%)

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(i) The return on equity predicted by the CAPMThe actual return for a shareholder of QSX Co, calculated as total shareholder return, is very different from the

return on equity predicted by the CAPM. In 2008 the company provided a better return than predicted and in2009 the company gave a negative return while the CAPM predicted a positive return.

Year 2008 2009

Total shareholder return 18% -17.6%

ROE predicted by CAPM 12% 8%

Ch13 CAPM capital asset pricing model to calculate a cost of equity and incorporate risk

Because the risk-free rate of return is positive and the equity risk premium is either zero or positive, andbecause negative equity betas are very rare, the return on equity predicted by the CAPM is invariably positive.This reflects the reality that shareholders will always want a return to compensate for taking on risk. In practice,

companies sometimes give negative returns, as is the case here. The return in 2008 was greater than the cost ofequity, but the figure of 10% quoted here is the current cost of equity; the cost of equity may have been differentin 2008.

(ii) Other comments

QSX Co had turnover growth of 3% in 2008, but did not generate any growth in turnover in2009.

EPS grew by 41% in 2008, but fell by 83% in 2009.

Dividends per share also grew by 41% in 2008, but unlike earnings per share, dividend pershare growth was maintained in 2009. It is common for dividends to be maintained when acompany suffers a setback, often in an attempt to give reassurance to shareholders.

There are other negative signs apart from stagnant turnover and falling EPS. The shareholder will be concernedabout experiencing a capital loss in 2009. He will also be concerned that the decline in the price/earnings ratioin 2009 might be a sign that the market is losing confidence in the future of QSX Co. If the shareholder wasaware of the proposal by the finance director to suspend dividends, he would be even more concerned. It might

be argued that, in a semi-strong form-efficient market, the information would remain private. If QSX Co desiresto conserve cash because the company is experiencing liquidity problems, however, these problems are likely to

become public knowledge fairly quickly, for example through the investigations of capital market analysts.

Year 2009 2008 2007

PE=

Closing share price/EPS

$6.48/58.9c = 11 times $8.35/64.2c = 13 times

Dividend cover=

EPS/dividend per share

58.9c/40c = 1.5 times 64.2c/38.5c = 1.7 times 61.7c/37c = 1.7 times

EPS growth =(64.2-58.9)/64.2= -8.3% 4.1%Dividend per share

growth

3.9% 4.1%

Turnover growth nil 3%

(b)

Ch15 dividend growth model : can be used to estimate a cost of equity, on the assumption that the market

value of share is directly related to the expected future dividends from the shares

Historical dividend growth rate = (40/37)05 1 = 004 or 4% per year

0.04054054+0.038961038/2 = 4%Share price using dividend growth model = (40 x 104%)/(10% 4%) = 693c or $693 p.257

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In three years time, the present value of the dividends received from the fourth year onwards can be calculatedby treating the fourth-year dividend as D1 in the dividend growth model and assuming that the cost of equityremains unchanged at 10% per year. Applying the dividend growth model in this way gives the share price inthree years time:

Share price = 70/(01 003) = 1,000c or $1000.

For comparison purposes this share price must be discounted back for three years:Share price = 0751 x 1000 = $751.

The current share price of $648 is less than the share price of $693 calculated by the dividend growth model,indicating perhaps that the capital market believes that future dividend growth will be less than historic dividendgrowth.

The share price resulting from the proposed three-year suspension of dividends is higher than the current shareprice and the share price predicted by the dividend growth model. However, this share price is based oninformation that is not public and it also relies on future dividends and dividend growth being as predicted. It isvery unlikely that a prediction as tentative as this will prove to be accurate.

(c)Investment decisions, dividend decisions and financing decisions have often been called the decision triangleof financial management. The study of financial management is often divided up in accordance with thesethree decision areas. However, they are not independent decisions, but closely connected.

For example, a decision to increase dividends might lead to a reduction in retained earnings and hence a greaterneed for external finance in order to meet the requirements of proposed capital investment projects. Similarly, adecision to increase capital investment spending will increase the need for financing, which could be met in

part by reducing dividends.

The question of the relationship between the three decision areas was investigated by Miller and Modigliani.They showed that, if a perfect capital market was assumed, the market value of a company and its weighted

average cost of capital (WACC) were independent of its capital structure. The market value thereforedepended on the business riskof the company and not on its financial risk. The investment decision, whichdetermined the operating income of a company, was therefore shown to be important in determining its marketvalue, while the financing decision, given their assumptions, was shown to be not relevant in this context. In

practice, it is recognised that capital structure can affect WACC and hence the market value of the company.

Miller and Modigliani also investigated the relationship between dividend policy and the share price of acompany, i.e. the market value of a company. They showed that, if a perfect capital market was assumed, theshare price of a company did not depend on its dividend policy , i.e. the dividend decision was irrelevant tovalue of the share. The market value of the company and therefore the wealth of shareholders were shown to bemaximised when the company implemented its optimum investment policy, which was to invest in all projectswith a positive NPV. The investment decision was therefore shown to be theoretically important withrespect to the market value of the company, while the dividend decision was not relevant.

In practice, capital markets are not perfect and a number of other factors become important in discussing therelationship between the three decision areas. Pecking order theory, for example, suggests that managers donot in practice make financing decisions with the objective of obtaining an optimal capital structure, but on thebasis of the convenience and relative cost of different sources of finance . Retained earnings are the preferredsource of finance from this perspective, with a resulting pressure for annual dividends to be lower rather thanhigher.

NG Dec 2009 part b

NG Co has exported products to Europe for several years and has an established market presence there. It nowplans to increase its market share through investing in a storage, packing & distribution network. The

investment will cost 13 million and is to be financed by equal amounts of equity and debt. The return ineuros before interest and taxation on the total amount invested is forecast to be 20% per year.

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The debt finance will be provided by a65 million bond issue on a large European stock market. The interestrate on the bond issue is 8% per year, with interest being payable in euros on a six-monthly basis.

The equity finance will be raised in dollars by a rights issue in the home country of NG Co. Issue costs for therights issue will be $312,000. The rights issue price will be at a 17% discount to the current share price. Thecurrent share price of NG Co is $400 per share and the market capitalisation of the company is $100

million. (Market value of outstanding shares)

NG Co pays taxation in its home country at a rate of 30% per year. The currency of its home country is thedollar. The current price/earnings ratio of the company, which is not expected to change as a result of the

proposed investment, is 10 times.

The spot exchange rate is 13000 /$. All European customers pay on a credit basis in euros.

(a) Calculate the theoretical ex rights price per share after the rights issue. (4 marks)Amount of equity finance to be invested (euros) = 13m/2 = 65 millionAmount of equity to be invested (dollars) = 65m/13000 = $5 million

The amount of equity finance to be raised (dollars) = 5m + 0312m RI = $5312m

Rights issue price = 400 x 083(100%-17%) = $332 per shareNumber of new shares issued = 5312m/332 = 16 million shares

Current ordinary shares = $100m/400 = 25 million sharesAfter the rights issue = 25m + 16m = 266 million sharesTheoretical ex rights price = ((25m x 4) + (16m x 332))/266 = 105312/266 = $396 per share

(b) Evaluate the effect of the European investment on:(i) the earnings per share of NG Co; and(ii) the wealth of the shareholders of NG Co.Assume that the current spot rate and earnings from existing operations are both constant. (9 marks)

(i) Effect on earnings per shareCurrent EPS = 400/10 = 40 cents per share

(Alternatively, current PAT = MV/PE=100m/10 = $10 millionCurrent EPS = 10m/25m = 40 cents per share)

EPS = Profit distributed to ordinary shareholders/weighted average number of ordinary shareholdersPE = Market value per share/EPSIncrease in profit before interest and tax = 13m x 02 = 2,600,000Dollar increase in profit before interest and tax = 2,600,000/13000 = $2 million

000Increase in PBIT 2,600

Increase in interest 6.5m*8% 520Increase in PBT 2,080Tax 2.08m*30% 624Increase in PAT 1,456 /1.3 = $1,120Current PAT 100m/10 $10,000Revised PAT $11,120

Revised EPS = 11.12m/26.6m(a)=41.8c/share

(ii)Effect on shareholder wealthShare price = $418 per shareThis should be compared to the theoretical ex rights price per share in order to evaluate any change inshareholder wealth.

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The investment produces a capital gain of 22 cents per share ($418 $396(a))In the absence of any information about dividend payments, it appears that the investment will increase thewealth of shareholders.

YNM June 2011 part a

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Bar Co Dec 2011 part b c

4 (a) Theoretical ex rights priceRights issue price = 750 x 08(20% discount) = $600 per shareNumber of shares issued = $90m/600 = 15 million sharesNumber of shares currently in issue = 60 million sharesRI: 1 for 4 basis

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Theoretical ex rights price = ((4 x 750) + (1 x 600))/5 = $720 per share

(b) Financial acceptability to shareholders of buying back bondsThe financial acceptability to shareholders of the proposal to buy back bonds can be assessed bycalculating whether shareholder wealth is increased or decreased as a result.

The bonds are being bought back by Bar Co at their market value of $11250 per bond,rather than their nominal value of $100 per bond. The total nominal value of the bondsredeemed will therefore be less than the $90 million spent redeeming them.

Nominal value of bonds redeemed = 90m x (100/11250) = $80 millionInterest saved by redeeming bonds = 80m x 008 = $64 million per year

EPS will be affected by the redemption of the bonds and the issue of new shares.Revised PBT = 49m (10m 64m interest) = $454 millionRevised PAT (earnings) = 454m x 07 tax = $3178 million. Revised EPS = (3178m/75m) = 4237 cents per share

Current EPS = 100 x (27m/60m) = 45 cents per shareCurrent PE ratio = 750/45 = 167 times

The revised EPS can be used to calculate a revised share price if the PE ratio is assumedto be constant.

PE=Share price/EPSRevised share price = PE constant x EPS revised=167 x 4237 = 708 cents or $708 per

share

This share price is less than the theoretical ex rights price per share ($720) and so the effect ofusing the rights issue funds to redeem the bonds is to decrease shareholder wealth. From ashareholder perspective, therefore, this use of the funds cannot be recommended.

However, this conclusion depends heavily on the assumption that the PE ratio remains constant, asthis ratio was used to calculate the revised share price from the revised earning per share. Inreality, the share price after the redemption of bonds will be set by the capital marketand it is this market-determined share price that will determine the PE ratio, rather than the PEratio determining the share price.

Since the financial risk of Bar Co has decreased following the redemption of bonds, the cost ofequity is likely to fall and the share price is likely to rise, leading to a higher PE ratio. If theshare price increases to above the theoretical ex rights price per share, corresponding to anincrease in the PE ratio to more than 17 times (720/4237), shareholders will experience acapital gain and so using the cash raised by the rights issue to buy back bonds will becomefinancially acceptable from their perspective.

(c)

Current interest coverage ratio = 49m/10m = 49 timesRevised interest coverage ratio = 49m/(10m 64m) = 49m/36m = 136 times

Current debt/equity ratio = 100 x (125m/140m) = 89%Revised book value of bonds = 125m 80m = $45 millionRevised book value of equity = 140m + 90m 10m = $220 millionA loss of $10 million is deducted here because $90 million has been spent to redeem bondswith a total nominal value (book value) of $80 million.Revised debt/equity ratio = 100 x (45m/220m) = 205%Redeeming bonds with a book value of $80m has reduced the financial risk of Bar Co, as shownby the significant reduction in gearing from 89% to 205%, and by the significant increase inthe interest coverage ratio from 49 times to 136 times.

Examiners note: full credit would be given to a revised gearing calculation (196%) that omits theloss due to buying back bonds at a premium to nominal value.

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(d) A key financial objective for a stock exchange listed company is to maximise the wealth ofshareholders. This objective is usually replaced by the objective ofmaximising the companysshare price, since maximising the market value of the company represents the maximum capitalgain over a given period. The need for dividends can be met by recognising that share prices canbe seen as the sum of the present values of future dividends. Maximising the companys shareprice is the same as maximising the equity market value of the company, since equitymarket value (market capitalisation) is equal to number ofissued shares multiplied by share

price. Maximising equity market value can be achieved by maximising net corporate cashincome and the expected growth in that income, while minimising the corporate cost ofcapital. Listed companies therefore have maximising net cash income as a key financial objective.Not-for-profit (NFP) organisations seek to provide services to the public and this requires cashincome. Maximising net cash income is therefore a key financial objective for NFP organisationsas well as listed companies. A large charity seeks to raise as much funds as possible in order toachieve its charitable objectives, which are non-financial in nature.

Both listed companies and NFP organisations need to control the use of cash within a givenfinancial period, and both types of organisations therefore use budgets. Another key financialobjective for both organisations is therefore to keep spending within budget.

The objective of value for money (VFM) is often identified in connection with NFPorganisations. This objective refers to a focus on economy, efficiency and effectiveness. These

three terms can be linked to input (economy refers to securing resources as economically aspossible), process (resources need to be employed efficiently within the organisation) and output(the effective use of resources in achieving the organisations objectives).Described in these terms, it is clear that a listed company also seeks to achieve value for money inits business operations. There is a difference in emphasis, however, which merits carefulconsideration. A listed company has a profit motive, and so VFM for a listed company can berelated to performance measures linked to output, e.g. maximising the equity marketvalue of the company. An NFP organisation has service-related outputs that are difficult tomeasure in quantitative terms and so it focuses on performance measures linked to input,e.g. minimising the input cost for a given level of output.

Both listed companies and NFP organisations can use a variety of accounting ratios in thecontext of financial objectives. For example, both types of organisation may use a target return oncapital employed, or a target level of income per employee, or a target current ratio.

Comparing and contrasting the financial objectives of a stock exchange listed company and a not-for-profit organisation, therefore, shows that while significant differences can be found, there is aconsiderable amount of common ground in terms of financial objectives.

GWW Co Dec 2012 part c

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(c) (i) Calculation of market value of bondThe market value of the bond is the present value of the future cash flows from the bond,discounted at the before-taxcost of debt.Market value of bond = (8 x 5582) + (100 x 0665) = 4466 + 6650 = $11116(ii) Debt/equity ratio (book value basis)D/E = 100 x 250/672 = 372%(iii) Debt/equity ratio (market value basis)Market value of debt = 250 x 11116/100 = $278 million

Market value of equity = 400 x 200/05 = $1600 millionD/E = 100 x 278/1600 = 174%Debt/equity ratio and assessing financial riskFinancial risk relates to the variability in shareholder returns (profit after tax or earnings) that iscaused by the use ofdebt in a companys capital structure. The debt/equity ratio is therefore useful in assessingfinancial risk as it measuresthe relative proportion of debt to equity. Financial risk will increase as the debt/equity ratioincreases, whether the ratiouses a book value basis or a market value basis.In assessing financial risk, however, the debt/equity ratio, like other accounting ratios, needs abasis for comparison. Itis often said that a ratio in isolation has no meaning. In assessing financial risk, therefore, the trendover time in a

companys debt/equity ratio can be considered, a rising trend indicating increasing financial risk. Acomparison can alsobe made with the debt/equity ratios of similar companies, or with sector average debt/equity ratio,in order to assessrelative financial risk.Since financial risk relates to the variability in shareholder returns in the income statement,another commonly used wayof assessing financial risk is the interest coverage ratio, sometimes calculated as interest gearing.

This can be a moresensitive measure of financial risk than the debt/equity ratio, in that it can indicate when acompany is experiencingincreasing difficulty in meeting its interest payments. It should be noted that difficulty in meetinginterest payments canbe a problem even when the debt/equity ratio is low.