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F9 Financial Management Tuition Note

ACCA F9 FINANCIAL MANAGEMENT

Tuition Note

For exams in June2015

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© Lesco Group Limited, April 2016

All rights reserved. No part of this publication may be reproduced, stored in a

retrieval system, or transmitted, in any form or by any means, electronic,

mechanical, photocopying, recording or otherwise, without the prior written

permission of Lesco Group Limited.

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Content

CHAPTER1 INTRODUCTION .................................................................................................... 5

OBJECTIVES ..................................................................................................................................... 5 STAKEHOLDERS ................................................................................................................................. 6 3 KEY DECISIONS ............................................................................................................................... 6 TREASURY DEPARTMENT ..................................................................................................................... 7 NON-PROFIT MAKING ORGANIZATION ................................................................................................... 8

CHAPTER2 FINANCING DECISION ........................................................................................... 9

SOURCE OF FINANCE ........................................................................................................................ 10 Debt finance (Cheaper but more risky) .................................................................................. 10 Equity finance (more expensive but less risky) ....................................................................... 10 Others ..................................................................................................................................... 10

SME (SMALL & MEDIUM SIZED COMPANIES FINANCE) ......................................................................... 19 Problems of Financing ............................................................................................................ 19 Ways to solve the above problems ........................................................................................ 20

COST OF CAPITAL ............................................................................................................................ 21 Cost of equity ......................................................................................................................... 21 Cost of debt ............................................................................................................................ 27 Weighted average cost of capital (WACC).............................................................................. 31

GEARING THEORY ........................................................................................................................... 34 Traditional theory ................................................................................................................... 34 Perking Oder Theory ............................................................................................................... 37 Yield curve .............................................................................................................................. 38

CHAPTER3 INVESTMENT DECISION ....................................................................................... 40

PAYBACK PERIOD ............................................................................................................................. 41 ACCOUNTING RATE OF RETURN (ARR) ................................................................................................ 44 DISCOUNTING ................................................................................................................................ 47 COMPOUNDING.............................................................................................................................. 48 ANNUITY ....................................................................................................................................... 49 PERPETUITIES ................................................................................................................................. 51 DISCOUNT WITH INFLATION ............................................................................................................... 52 NET PRESENT VALUE (NPV) .............................................................................................................. 54

Basic NPV theory .................................................................................................................... 54 Comment on NPV ................................................................................................................... 55 Other NPV Decisions .............................................................................................................. 57 Risks &Uncertainty ................................................................................................................. 67 Internal rate of return (IRR) .................................................................................................... 72

CHAPTER4 WORKING CAPITAL MANAGEMENT ..................................................................... 74

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WORKING CAPITAL MANAGEMENT OVERVIEW ...................................................................................... 74 WORKING CAPITAL FINANCING POLICY ................................................................................................. 74 FACTORS AFFECTING WORKING CAPITAL FINANCING POLICY ...................................................................... 77 WORKING CAPITAL IN DETAIL ............................................................................................................. 82

Receivables management: ..................................................................................................... 82 Inventory management .......................................................................................................... 87 Cash management ................................................................................................................. 91

OVERTRADING ............................................................................................................................... 98 Payables management ......................................................................................................... 101

CHAPTER 5 DIVIDEND POLICY ............................................................................................ 102

CHAPTER 6 BUSINESS VALUATION ...................................................................................... 104

REASONS TO VALUE A BUSINESS ....................................................................................................... 105 Efficient Market Hypothesis ................................................................................................. 106

TYPES OF VALUATION METHODS ....................................................................................................... 108 Book value approach ............................................................................................................ 108 Market based approach ....................................................................................................... 111 P/E ratio ................................................................................................................................ 112 Dividend yield basis .............................................................................................................. 113 Cash flow based approach ................................................................................................... 115 Dividend valuation (growth) model ..................................................................................... 116

CHAPTER7 RISK MANAGEMENT ......................................................................................... 120

EXCHANGE RATE ........................................................................................................................... 120 EXCHANGE RATE PREDICTION THEORIES: ............................................................................................ 121

PPPT (purchasing power parity theory) ............................................................................... 121 Interest rate parity theory (IRPT) ......................................................................................... 123 Summary international fisher effect (1+m)=(1+r)(1+i)......................................................... 125

FOREIGN EXCHANGE RATE RISK ......................................................................................................... 126 Transaction risk: ................................................................................................................... 126 Economic risk: ...................................................................................................................... 127 Translation risk: .................................................................................................................... 127 Hedging techniques relating to foreign exchange rate risk: ................................................ 129 Internal hedging techniques for FOREX change: .................................................................. 130 External hedging techniques for FOREX change: ................................................................. 132

CHAPTER8 PERFORMANCE MANAGEMENT ........................................................................ 141

RATIO ANALYSIS ............................................................................................................................ 141

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Chapter1 Introduction

Objectives

Primary Objectives of the organization is to maximize shareholders wealth by

maximizing dividend payment or capital gain.

There are other objectives like:

Maximization of Sales growth (units)

Maximization of Cash generation/liquidity

Minimization of risk

Maximization of Customer Satisfaction

Maximization of Employee Welfare

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Stakeholders

When considering setting/achieving objectives (both long and short term) the company

must take into account the interests of other stakeholders. Stakeholders are:

Shareholders

Fund lenders

Customers

Suppliers

Employees

3 key decisions There are 3 key decisions for financial management:

Investment decision

Financing decision

Dividend policy decision

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Treasury department

These works would be delegated to treasury department.

Their role is to make the above decision +working capital management +risk

management and taxation management.

The structure of the treasury department would be centralized or decentralized.

Advantages of a specialist centralized treasury department

* Avoids having a mix of cash surpluses and overdrafts in different local bank accounts

and facilitates bulk cash flows, so that lower bank charges can be negotiated.

* Larger volumes of cash are available to invest, giving better short-term investment

opportunities

* Any borrowing can be arranged in bulk, at lower interest rates than for smaller

borrowings.

* Foreign currency risk management is likely to be improved in a group of companies. A

central treasury department can match foreign currency income earned by one

subsidiary with expenditure in the same currency by another subsidiary. In this way, the

risk of losses on adverse exchange rate changes can be avoided without the expense of

forward exchange contracts or other 'hedging' (risk-reducing) methods.

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Advantages of decentralized cash management

* Sources of finance can be diversified and can be matched with local assets.

* Greater autonomy can be given to subsidiaries and divisions because of the closer

relationships

they will have with the decentralized cash management function.

* The decentralized Treasury function may be able to be more responsive to the needs

of individual operating units.

Non-profit making organization

The objective of non-profit making organization is to meet with their established

goals, e.g., protecting environment.

We must follow 3Es’ to do this: economy; efficiency; effectiveness.

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Chapter2 Financing decision

In this session we are going to look at right hand side of the accounting

equation which is LIABILITY+EQUITY and this refers to financing decision

made by the company, i.e., decision to raise money.

We will start off by looking at source of finance and basically there are two ways of

financing, i.e., debt finance and equity finance.

After that we would have a look at the cost of capital for equity and debt finance and of

course when sum up these together it would give us the weighted average cost of

capital (WACC).

Company’s value would have something to do with the WACC and we are then going to

talk about capital structure theory as well.

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Source of finance

Debt finance (Cheaper but more risky)

Loan

Preference shares

Bank loan-secured bank loan

-unsecured bank loan

Debenture (tradable)

Convertible loan stock

Equity finance (more expensive but less risky)

Public listing (IPO)/Bonus issue/Right issue

Private equity- venture capital/ business angel

Others

Retained Earnings

Payables

Operating lease

Finance lease

Islamic finance

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*How to issue shares?

1. Offer for sale: Sell shares to general public

Financial institution (issuing house)-share issues would be typically be underwritten

(guarantee to sell them all by them)

But this is expensive

2. Offer for sale by tender People would bid for shares-price paid +no of sahres willing to buy

The benefit of this is to maximize receipt from sale

But it’s very expensive-set up/admin

It’s not underwritten

Usually: Privatization of nationalized asset

3. Placing Financial institution (bank) sells shares to people.

The benefit is that the sale can be quick.

It’s cheap from an administration point of view.

But you have to find suitable investors to buy large quantity but if this is impossible

then it would be expensive if you find those small investors.

It would be loss of control since large quantity of shares are bought by them

It would normally be a discount on share price.

4. Listing IPO [initial public offering]-issue shares on stock exchange and taken up by

shareholders.

It’s expensive

5. Bonus issue This is where company would issue “Free” shares to existing shareholders.

Normally, the accounting entry would be:

DR share premium, CR share capital

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6. Right issue For the listed companies where the shares are marketable, they can of course have a

right issue to the existing shareholders.

If you own more shares then you will have more rights to buy more shares at a cheaper

price.

If it is taken up, then it will not affect proportional shareholdings if they have taken up.

But for small companies, the current shareholders may have limited funds.

Advantages:

1, cheap

2, seldom fail

3, doesn't need external approval.

From a shareholder’s perspective, what are the choices he has with regards to

rights issue?

1, take up the right

2, sell the right/ do nothing

But these options are based on the theoretical ex right price calculation (TERP)

TERP= (MV of shares before right issue +proceeds of right issue)/no of rights

in total after right issue

Shares Price Share X Price

3(old) $8(old) $24

1(new) $6.4(new) $6.4

4 $30.4

So TERP=$30.4 =$7.6/share

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Calculation:

Issue price: usually at a discount to market price

Issue quantity: funds required/issue price

Terms of issue: compare the number of shares currently in issue to the issue

quantity, eg, 1 for 6 right issue / 2 for 7 rights issue

Q Bow Ltd Bow plc has a current market price of $8.00 per share and wishes to raise $1,280,000

via a rights issue at a 20% discount to market price. There are currently 600,000

shares in issues.

If a shareholder currently owns 3,000 shares, calculate the effect on his wealth under

each of the following options.

Required:

(a)Calculate:

(i) The offer price;

(ii) The issue quantity;

(iii) The terms of the issues;

(iv) The theoretical ex-rights price; and

(v)The value of a right.

(b)Calculate the wealth he has in these following options.

Option1: Sell Rights/Do nothing

Option 2: Fully Subscribe

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Answer:

(a)

(i) Offer price=$8X80%=$6.4

(ii) $1,280,000 =200,000shares

$6.4

(iii) Terms of issue: 200,000 for 600,000 so it’s 1 for 3 right issue.

(iv)

Shares Price ShareXPrice

3(old) $8(old) $24

1(new) $6.4(new) $6.4

4 $30.4

So TERP=$30.4 =$7.6/share

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(v) [mnemonic: IT]

Issue price: 6.4

TERP : 7.6

Right: 1.2

The TERP of 7.6 has been split between issue price of 6.4 and right value of 1.2.

they would pay a maximum premium of 1.2 to have this right because they can buy at

6.4 which would then worth 7.6 later on.

They are not willing to pay more than this because it would be 7.6 after the right issue

and they can buy it from the open market directly if the value is greater 1.2.

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(b) mnemonic: “HA”

Option1: Sell Rights/Do nothing

Have (3,000shares left)X$7.6(TERP) $22,800

Action(sell rights) 3,000 (rights)X$1.2(value of right)

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$1,200

$24,000

Ie, if you own 10% of shares but you don’t take up right issue so that your

shareholding will go down.

Option 2: Fully Subscribe

Have (3,000shares +3,000/3)X$7.6(TERP) $30,400

Action(buy shares) 3,000 (rights)X$6.4

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($6,400)

$24,000

TERP assumes the money eaised is invested in projects with NPV=0 and So if NPV>0

then you will increase your wealth cuz TERP is sightly higher.

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*Islamic Finance

RIBA (Interest) is not allowed.

Islamic financial instrument:

Fixed income mode:

1. Murabaha (Loan)

Instead of borrowing money from a conventional bank to buy something, people would

sign a Murabaha contract with the Islamic bank that the bank would buy something

from the seller and sells to that person with all profit, costs being disclosed.

2. Ijara (Lease)

This is like a lease but:

1. The asset you lease must be tangible;

2. The lessor bears all risks and rewards of the asset.

3. Sukuk (Debt finance)

Instead of just getting interest and principal from the loan issuer, with Sukuk that

person would also have a right to share profit and cash flow from the asset and the

underlying asset would belong to that person as well.

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Equity Mode: 1. Mudaraba (Equity):

The investor and management set up a company and investor is responsible for money

invested in the business whilst management is responsible for the running of the

business. Any profit made would be distributed on a pre-determined ratio according to

Mudaraba contract and the investor would bear the losses only.

2. Musharaka (Joint venture):

Two or more investors would set up a company and invest their money into the

business. Any profit made from the business would be distributed on a pre-determined

ratio or capital contribution; Losses incurred would be distributed under capital

contribution of each party.

Advantages and disadvantages of using Islamic finance:

Advantages:

Because uncertainty, risk or speculation is not allowed and hence this reduce the risk of

losses

Excessive profit is not allowed under Mudaraba contract and only reasonable markup is

allowed.

And because interest is not allowed and hence reduces the risk that company collapses

and hence bank would have a smaller risk to collapse.

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Disadvantages:

There is no particular standard on those Islamic financial instrument product and hence

the transaction cost dealing with each transaction would be high.

Islamic banks cannot minimize their risks in the same way as conventional banks as

hedging is prohibited.

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SME (Small & Medium Sized Companies Finance)

Problems of Financing

Mnemonics: “MICE”

Marketability of shares

Their shares are not marketable and hence it’s difficult to sell the shares to public to

raise finance.

Lack of information

SME’s tends to have a weak internal control system and their information is not made

public and hence make finance for SMEs difficult.

Cost

Since SMEs are more risky and hence the cost of financing would be higher.

Existing condition

Since SMEs may not have enough good quality assets to secure the borrowing and

hence make the financing more difficult.

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Ways to solve the above problems

Business Angel

Someone who would bring knowledge and money to help the SMEs.

Venture Capital

Someone who enjoy high risky SMEs investment with the aim of listing it or selling it to

others.

Schemes

SMEs would enjoy some investment schemes provided by government to save tax etc.

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Cost of capital

We need to establish cost of debt, cost of equity and finally summarizing them to be

weighted average cost of capital (WACC).

Cost of equity

We can use DIVIDEND VALUATION MODEL, CAPITAL ASSET PRICING MODEL to

calculate the cost of equity.

DIVIDEND VALUATION MODEL

It assumes we will receive dividend from company forever

From the formulae: Po=Dividend P.A.

Ke

We can get ke= D

Po

Ke = cost of equity

Po = the ex-div market price of the share

d = is a constant dividend p.a.

dividend would stay constant or it would grow each year.

So let’s consider the situation where there is no growth of dividend.

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Apple Ltd

1,

The ordinary shares of Apple Ltd are quoted at $5 per share ex div. A dividend of 40p

per share has just been paid and there is expected to be no growth in dividends.

Required:

What is the cost of equity?

Answer:

1,Ke=D 40p x100=8%

Po= 500p

2,

The ordinary shares of Apple Ltd are quoted at $2 per share. A dividend of 15p is about

to be paid. There is expected to be no growth in dividends.

Required:

What is the cost of equity?

Answer:

2, Ke=D 15p x100=8.1%

Po= (200-15) p

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