Notes ACCA P aper F9 Financial Management For exams in 2012
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ExPress Notes ACCA F9 Financial Management
Contents
About ExPress Notes
3
1.
Financial Management Function
7
2.
Financial Management Environment
11
3.
Working Capital Management
13
4.
Investment Appraisal
21
5.
Business Finance
39
6.
Cost of Capital
45
7.
Business Valuations
53
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ExPress Notes ACCA F9 Financial Management
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ExPress Notes ACCA F9 Financial Management
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ExPress Notes ACCA F9 Financial Management
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ExPress Notes ACCA F9 Financial Management
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ExPress Notes ACCA F9 Financial Management
Chapter 1
Financial Management Function
KEY KNOWLEDGE The Nature and Purpose of of Financial Financial Management The main purpose of financial strategy is to ensure that financial resources are available to the organization in support of its overall corporate objectives, which include financial objectives. Management accounting is a set of tools and disciplines measuring corporate performance and to facilitate decision-making; it is designed and implemented in coordination with the company’s strategy.
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ExPress Notes ACCA F9 Financial Management
KEY KNOWLEDGE Financial Objectives and the Relationship with Corporate Strategy In pursuing its financial objectives, the firm must ensure that those objectives are congruent – i.e. consistent – with its overall corporate strategy.
KEY KNOWLEDGE Stakeholders and Impact on Corporate Objectives Stakeholder groups
Shareholders: A s owners of the business, they rank supreme, as reflected in US/UK models of corporate governance; Lenders: Important if the business relies heavily on providers of loan capital (banks, bondholders); Directors: The executive directors or senior management of the business are central since they have “hands-on” power and can serve their own interests (giving rise to agency risk); Employees: Often referred to as a company’s “most valuable asset”; they must be motivated and adequately compensated; Customers: No customers, no business! How influential they are or how carefully management needs to listen to their concerns depends on the type of business activity and the competitive environment;
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ExPress Notes ACCA F9 Financial Management
Conflicting stakeholder interests Conflicting interests can exist between various stakeholder groups. Management must examine the degrees of stakeholder influence and actively manage the relationship with relevant stakeholders. Agency theory Agency theory addresses the risk that management will not act in the best interest of the shareholders, but will make decisions that will serve its own interests. Examples of self-serving management behavior could include: (a) artificially boosting corporate profits in the short-term in order to earn bonuses; (b) paying too much to acquire another company for reasons of prestige or in order to “build empires”; (c) rejecting opportunities, such as takeover bids, or restructuring initiatives, that might jeopardize their positions (an orientation to maintaining the “status quo”). Influencing managerial behavior In order to cause managers to behave in a way consistent with stakeholder interests, rewards and bonus schemes need to be carefully designed. This can be seen as the “internal” dimension to corporate governance. The other dimension -- “external” – comes in the form of regulation. Scope of strategic performance measures in private sector
Shareholder value measurements focus on creation of shareholder value as fundamental aim of profit oriented companies. Long-term wealth maximization is not always consistent with the “artificial” inflation of
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ExPress Notes ACCA F9 Financial Management
Accounting Capital Employed = Total Assets – Current Liabilities = Total Non-Current Assets, net + Working Capital
Disadvantage: ROI/ROCE increases as investment centre’s fixed assets grow older, thus a ROI improvement over time (or a better ROI compared to another division) may be partly attributable to the age of the assets used. Consequently, gross value of fixed assets may be used in measuring performance based on ROI.
Earnings Per Share (EPS) Net income less any preferred dividends divided by the number of shares outstanding. Return on Equity Net income divided by shareholders’ equity.
KEY KNOWLEDGE Financial and Other Objectives in Non‐for‐Profit Organisations Profit and Not-for-profit organisations Profit-seeking organizations exist ultimately to create wealth for their owners. Non-profit (or not-for-profit) organizations are created to accomplish a pre-defined mission, such as the delivery of a service; they are expected to do so in an economical manner.
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ExPress Notes ACCA F9 Financial Management
Chapter 2
Financial Management Environment
The economic environment for business The general economic environment, and in particular the influence of governments – through its monetary and fiscal policies – has a far-reaching impact on most businesses.
The impact of macro-economics Businesses must also take macro-economic factors into account:
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ExPress Notes ACCA F9 Financial Management
(d) Trade policy: to what degree is any protectionism likely to stay in place? Again, actively keeping up with reading on these issues will be the best way to prepare for this section of the exam.
The nature and role of financial markets and institutions Financial markets and institutions have achieved such a degree of global integration that shocks in one part – as shown with the onset of the financial crisis in 2008 – can have systematic implications across all markets.
Stock markets A stock exchange is an organized and regulated market place which permits:
(i)
Companies to raise capital through the issuance of new shares or debentures (collectively known as securities); the proceeds of such issuances go to the company issuing them -- this is called the “primary market”; and
(ii)
Investors to buy and sell already-issued securities – called the “secondary market”.
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ExPress Notes ACCA F9 Financial Management
Chapter 3
Working Capital Management
START The Big Picture
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ExPress Notes ACCA F9 Financial Management
Raw m aterials aterials received Receipt of cash Payment to supplier
Sale of goods
Conversion into finished goods
The above diagram shows the operating cash flows for a typical manufacturing company converting raw materials into finished goods for sale. The company needs its own cash to pay the supplier and can only recover this from the sale of the finished goods. The cash invested in inventories and receivables represents a cost to the company. This is most directly obvious in opportunity cost terms: the cash could be earning interest, reducing interest-bearing debt, or ultimately find its way into shareholders’ pockets as a dividend payment. The presence of payables indicates that cash payments (outflows) are delayed; this is beneficial to the company as long as it is not overdue on its payments, as late payment
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ExPress Notes ACCA F9 Financial Management
Turnover ratios
(1) Trade debtors (receivables) Trade Debtors x 365 Sales (2) Inventory turnover Inventory x 365 COGS (3) Trade creditors (payables) Trade Payables x 365 COGS
Economic Order Quantity (EOQ) Within a company, there is a natural temptation to accumulate buffer stocks (raw materials and semi-finished goods) so that production is never interrupted. Similarly, in order to avoid stock-outs, sales managers will insist on maintaining a plentiful
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ExPress Notes ACCA F9 Financial Management
The total cost function is as follows: Total cost = Purchase cost + Ordering cost + Holding cost which can be expressed algebraically as follows: TC
= PxD
+ C x D/Q
+ H x Q/2
It is this total cost function which must be minimized. Recognizing that:
PD does not vary; Ordering costs rise the more frequently one places (during the year); and Holding costs rise the fewer times one places orders (due to larger quantities being ordered each time),
It follows that there is a trade-off between the Ordering and the Holding costs. The optimal order quantity (Q*) is found where the Ordering and Holding costs equal each other, i.e. C x D/Q = H x Q/2 Rearranging the above and solving for Q results in
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ExPress Notes ACCA F9 Financial Management
Assessing the creditworthiness of customers When assessing the creditworthiness of (potential) clients, companies can use the approach typically employed by banks, referred to (originally) as the 3 C’s of credit, later expanded to the 5 C’s. They are (1) Character: Focuses on the reputation of the principals/decision makers at a company; credit checking agencies and bank references assist to this end; (2) Capacity: Examines the company’s cash flow generation in the context of management’s ability to perform competently and reliably in meeting their obligations, based on an examination of their track record (either directly or via the experiences of others). Financial statement analysis is a major part of the exercise here (and in the next point); (3) Capital: Identifies and assesses the financial “staying power” and resources of the
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ExPress Notes ACCA F9 Financial Management
A company granting settlement discounts must ensure that the benefits of doing so will outweigh the costs.
EXAMPLE Redwood Co. currently gives payment terms of 3 months to its customers. If it shortens this to one month by offering a 2% settlement discount, calculate what the impact will be if sales of USD 5m remain unchanged and all customers elect to take advantage of the discount. The company’s cost of capital is 15%.
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ExPress Notes ACCA F9 Financial Management
Deductions Another phenomenon which results in significant write-offs of receivable is the practice of “deductions” in which a customer pays less than the full amount of the invoice, giving a reason for withholding the difference. This amounts to a renegotiation of the original invoice and is often accepted as a “fait accompli” by the supplier. A company managing its receivables diligently will have the following: (1) A (1) A monitoring system that clearly “flags” late payers, known as an aging system. This includes identifying properly the practice of deductions mentioned above; (2) A (2) A follow-up system that assigns responsibility to specific staff doing the follow-up; this includes an elevating of difficult cases to more senior and/or more experienced staff to handle;
