ACCA F9 FINANCIAL MANAGEMENT. Study System Sample Session

Transcription

1 ACCA F9 FINANCIAL MANAGEMENT Study System Sample Session

2 ATC INTERNATIONAL ACCA PAPER F9 FINANCIAL MANAGEMENT STUDY SYSTEM

3 No responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the author, editor or publisher. This training material has been published and prepared by Accountancy Tuition Centre Limited 16 Elmtree Road Teddington TW11 8ST United Kingdom. Editorial material Copyright Accountancy Tuition Centre (International Holdings) Limited, All rights reserved. No part of this training material may be translated, reprinted or reproduced or utilised in any form either in whole or in part or by any electronic, mechanical or other means, now known or hereafter invented, including photocopying and recording, or in any information storage and retrieval system, without permission in writing from the Accountancy Tuition Centre Limited.

4 SESSION 00 CONTENTS CONTENTS Page 1 The Financial Management Function The Financial Management Environment Investment Decisions Discounted Cash Flow Techniques Relevant Cash Flows for DCF Applications of DCF Project Appraisal under Risk Equity Finance Debt Finance Security Valuation and Cost of Capital Weighted Average Cost of Capital and Gearing Capital Asset Pricing Model Working Capital Management Inventory Management Cash Management Management of Accounts Receivable and Payable Risk Management Business Valuation and Ratio Analysis Glossary 1901 Index 2001 (iii)

5 SESSION 00 CONTENTS (iv)

6 SESSION 00 SYLLABUS INTRODUCTION This Study System has been specifically written for the Association of Chartered Certified Accountants fundamentals level examination, Paper F9 Financial Management It provides comprehensive coverage of the core syllabus areas and is designed to be used both as a reference text and interactively with the ATC Learning System to provide you with the knowledge, skill and confidence to succeed in your ACCA studies SYLLABUS AFM (P4) Advanced Financial Management FM (F9) Financial Management MA (F2) Management Accounting Aim To develop the knowledge and skills expected of a finance manager, in relation to investment, financing, and dividend policy decisions. Main capabilities On successful completion of this paper, candidates should be able to: A B C D E F G H Discuss the role and purpose of the financial management function Assess and discuss the impact of the economic environment on financial management Discuss and apply working capital management techniques Carry out effective investment appraisal Identify and evaluate alternative sources of business finance Explain and calculate the cost of capital and the factors which affect it Discuss and apply principles of business and asset valuations Explain and apply risk management techniques in business. (v)

7 SESSION 00 SYLLABUS Financial management function (A) Financial management environment (B) Working capital management (C) Investment appraisal (D) Business finance (E) Cost of capital (F) Business valuations (G) Risk management (H) RATIONALE The syllabus for Paper F9, Financial Management, is designed to equip candidates with the skills that would be expected from a finance manager responsible for the finance function of a business. The paper, therefore, starts by introducing the role and purpose of the financial management function within a business. Before looking at the three key financial management decisions of investing, financing, and dividend policy, the syllabus explores the economic environment in which such decisions are made. The next section of the syllabus is the introduction of investing decisions. This is done in two stages - investment in (and the management of) working capital and the appraisal of longterm investments. The next area introduced is financing decisions. This section of the syllabus starts by examining the various sources of business finance, including dividend policy and how much finance can be raised from within the business. Cost of capital and other factors that influence the choice of the type of capital a business will raise then follows. The principles underlying the valuation of business and financial assets, including the impact of cost of capital on the value of the business is covered next. The syllabus finishes with an introduction to, and examination of, risk and the main techniques employed in the management of such risk. (vi)

8 SESSION 00 SYLLABUS DETAILED SYLLABUS A Financial management function 1. The nature and purpose of financial management 2. Financial objectives and relationship with corporate strategy 3. Stakeholders and impact on corporate objectives 4. Financial and other objectives in not-for-profit organisations B Financial management environment 1. The economic environment for business 2. The nature and role of financial markets and institutions C Working capital management 1. The nature, elements and importance of working capital 2. Management of inventories, accounts receivable, accounts payable and cash 3. Determining working capital needs and funding strategies D Investment appraisal 1. The nature of investment decisions and the appraisal process 2. Non-discounted cash flow techniques 3. Discounted cash flow (DCF) techniques 4. Allowing for inflation and taxation in DCF 5. Adjusting for risk and uncertainty in investment appraisal 6. Specific investment decisions (lease or buy, asset replacement, capital rationing) (vii)

9 SESSION 00 SYLLABUS E Business finance 1. Sources of, and raising short-term finance 2. Sources of, and raising long-term finance 3. Internal sources of finance and dividend policy 4. Gearing and capital structure considerations 5. Finance for Small and Medium-size Entities (SMEs) F Cost of capital 1. Sources of finance and their relative costs 2. Estimating the cost of equity 3. Estimating the cost of debt and other capital instruments 4. Estimating the overall cost of capital 5. Capital structure theories and practical considerations 6. Impact of cost of capital on investments G Business valuations 1. Nature and purpose of the valuation of business and financial assets 2. Models for the valuation of shares 3. The valuation of debt and other financial assets 4. Efficient Markets Hypothesis (EMH) and practical considerations in the valuation of shares H Risk management 1. The nature and types of risk and approaches to risk management 2. Causes of exchange rate differences and interest rate fluctuations 3. Hedging techniques for foreign currency risk 4. Hedging techniques for interest rate risk (viii)

10 SESSION 00 SYLLABUS APPROACH TO EXAMINING THE SYLLABUS The syllabus for Paper F9 aims to develop the skills expected of a finance manager who is responsible for the finance function of a business. The paper also prepares candidates for more advanced and specialist study in Paper P4, Advanced Financial Management. The syllabus is assessed by a three-hour paper-based examination consisting of four compulsory 25-mark questions. All questions will have computational and discursive elements. The balance between computational and discursive content will continue in line with the pilot paper. 15 minutes for reading and planning is given at the start if the examination. During this time candidates may make notes on the question paper but may not write in the answer booklet. Candidates are provided with a formulae sheet and tables of discount and annuity factors. Candidates should bring a scientific calculator to the examination. (ix)

11 SESSION 00 TABLES AND FORMULAE Formula sheet Economic order quantity = 2C C o h D Miller Orr Model Return point = Lower limit + ( 1 / 3 spread) Spread = transaction cost variance of cash flows interest rate 1 3 The Capital Asset Pricing Model E(r i ) = R f + β i (E(r m ) R f ) The asset beta formula β a = ( V + V ( 1 T) ) e V d e β e + Vd ( 1 T) ( V + V ( 1 T) ) e d β d The Growth Model P O = D O ( 1 + g) ( r g) Gordon s growth approximation e g = br e The weighted average cost of capital WACC = The Fisher formula Ve Ve + Vd k e V Ve + Vd d + k ( 1 T) d (1+i) = (1+r) (1+h) Purchasing power parity and interest rate parity ( 1 + h ) c s 1 = s 0 x ( 1 + h ) b ( 1 + i ) c f 0 = s 0 x ( 1 + i ) b (x)

12 SESSION 00 TABLES AND FORMULAE Present value table Present value of 1 i.e. (1 + r) n where r = discount rate n = number of periods until payment Discount rate (r) Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% (xi)

13 SESSION 00 TABLES AND FORMULAE Present value of an annuity of 1 i.e. 1 1 Annuity table + n ( r) r where r = discount rate n = number of periods Discount rate (r) Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% (xii)

14 SESSION 00 EXAM TECHNIQUE EXAM TECHNIQUE Time allocation To allocate your time multiply the marks for each question by 1.8 minutes. i.e. each 25 mark question should take you = 45 minutes. You should also apportion your time carefully between the parts of each question. Do not be tempted to go over the time allocation on each question - remember the law of diminishing returns the longer you spend the lower your efficiency in gaining marks. It is more effective to move onto the next question. Numerical elements Before starting a computation, picture your route. Do this by noting down the steps you are going to take and imagining the layout of your answer. Use a columnar layout if appropriate. This helps to avoid mistakes and is easier for the marker to follow. Use lots of space. Include all your workings and cross-reference them to the face of your answer. A clear approach and workings will help earn marks even if you make an arithmetic mistake. If you later notice a mistake in your answer, it is not worthwhile spending time amending the consequent effects of it. The marker of your script will not punish you for errors caused by an earlier mistake. Don t ignore marks for written recommendations or comments based upon your computation. These are easy marks to gain. If you write good comments based upon calculations which contain errors, you can still receive all the marks for the comments. If you could not complete the calculations required for comment then assume an answer to the calculations. As long as your comments are consistent with your assumed answer you can still pick up all the marks for the comments. (xiii)

15 SESSION 00 EXAM TECHNIQUE Written elements Planning Read the requirements carefully at least twice to identify exactly how many points you are being asked to address. Note down relevant thoughts on your plan. Give your plan a structure which you will follow when you write up the answer. Presentation Use headings and sub-headings to give your answer structure and to make it easier to read for the marker. Use short paragraphs for each point that you are making. Use bullet points where this seems appropriate e.g. for a list of advantages/disadvantages Separate paragraphs by leaving at least one line of space between each. Style Long philosophical debate does not impress markers. Concise, easily understood language scores good marks and requires less writing. Lots of points briefly explained tend to score higher marks than one or two points elaborately explained. (xiv)

16 OVERVIEW Objective To develop a model for the valuation of shares and bonds. To use this model to estimate the cost of equity and the cost of debt. To consider further practical influences on the valuation of securities. SECURITY VALUATION AND THE COST OF CAPITAL EQUITY ANALYSIS Dividend Valuation Model Cost of equity DEBT ANALYSIS Irredeemable debentures Redeemable debentures Semi-annual interest Convertible debentures 1001

17 1 DIVIDEND VALUATION MODEL 1.1 The general model The dividend valuation model states that: the market value of a share or other security is equal to the present value of the future expected cash flows from the security discounted at the investor s required rate of return. A security is any traded investment e.g. shares and bonds. 1.2 Constant Dividend The formula for share valuation can be developed as follows: Ex-div market value at time 0 = Present value of the future dividends discounted at the shareholders required rate of return Ex-div market value is the market value assuming that a dividend has just been paid. Let: Po = Current ex-div market value Dn = Dividend at time n ke = Shareholders required rate of return/company s cost of equity The model then becomes: Po = D1 D2 + (1 + ke) (1+ ke) 2 D3 + (1+ ke) 3... Dn n (1+ ke) If the dividend is assumed to be constant to infinity this becomes the present value of a perpetuity which simplifies to: Po = D ke This version of the model can be used to determine the theoretical value of a share which pays a constant dividend e.g. a preference share or an ordinary share in a zero growth company. 1002

18 1.3 Constant growth in dividends If dividends are forecast to grow at a constant rate in perpetuity, where g = growth rate Po = D0(1 + g) ke g = D1 ke g where Do = most recent dividend D 1 = dividend in one year The formula is published in the exam in the following format: P O = ( 1 + g) ( re g) D O Where re = required return of equity investors = ke 1.4 Assumptions behind the dividend valuation model rational investors all investors have the same expectations and therefore the same required rate of return perfect capital market assumptions, e.g., no transactions costs large number of buyers and sellers of shares no individual can affect the share price all investors have all available information dividends are paid just once a year and one year apart dividends are either constant or are growing at a constant rate. 1.5 Uses of the dividend valuation model The model can be used to estimate the theoretical fair value of shares in unlisted companies where a quoted market price is not known.. However if the company is listed, and the share price is therefore known, the model can be used to estimate the required return of shareholders i.e. the company s cost of equity finance. 1003

19 Illustration 1 Suppose that a share has a current ex-div market value of 80 cents and investors expect a dividend of 10 cents per share to be paid each year as has been the case for the past few years. Using the dividend valuation model the required return of the investors for this share can be determined: Po = 80c = ke = D ke 10c ke 10c 80c ke = 12.5% Investors will all require this return from the share as the model assumes they all have the same information about the risk of this share and they are all rational. If investors think that the dividend is due to increase to 15 cents each year then at a price of 80 cents the share is giving a higher return than 12.5%. Investors will therefore buy the share and the price will increase until, according to the model, the value will be: Po = 15c = 120 cents Alternatively suppose that the investors' perception is that the dividend will remain at 10 cents per share but that the risk of the share has increased thereby requiring a return of 15%. If the share only gives a return of 12.5% (on an 80 cents share price) then investors will sell and the price will fall. The fair value of the share according to the model will be: Po = 10c 0.15 = 66.7 cents 1004

20 1.6 Practical factors affecting share prices The dividend valuation model gives a theoretical value, under the assumptions of the model, for any security. In practice there will be many factors other than the present value of cash flows from a security that play a part in its valuation. These are likely to include: interest rates market sentiment expectation of future events inflation press comment speculation and rumour currency movements takeover and merger activity political issues. The dividend valuation model helps us to understand how a change in these variables should affect the market value of the security. Share prices change, often dramatically, on a daily basis. The dividend valuation model will not predict this, but will give an estimate of the underlying fair value of the shares. 2 COST OF EQUITY 2.1 Shareholders required rate of return The basic dividend valuation model is: Po = D ke This can be rearranged to find ke: ke = D Po If ke is the return required by the shareholders in order for the share value to remain constant then ke is also the return that the company must pay to its shareholders. Therefore ke also equates to the cost of equity of the company. Therefore the cost of equity for a company with a constant annual dividend can be estimated as the dividend divided into the ex-div share price i.e. the dividend yield. The ex-div market value is the market value of the share assuming that the current dividend has just been paid. A cum-div market value is one which includes the value of the dividend just about to be paid. If a cum-div market value is given then this must be adjusted to an ex div market value by taking out the current dividend. 1005

21 Example 1 A company s shares have a market value of $2.20 each. The company is just about to pay a dividend of 20c per share as it has every year for the last ten years. What is the company s cost of equity? Solution 2.2 Dividend with constant growth The model can also deal with a dividend that is growing at a constant annual rate of g. The formula for valuing the share is as seen earlier: Po = D 0 (1 g) ke + g = 1 ked g where Do = most recent dividend D 1 = dividend in one year Rearranged this becomes k e = D0(1 + g) + g Po where g = growth rate (assumed constant in perpetuity). where P o = ex div market value Therefore the cost of equity = dividend yield + estimated growth rate 1006

22 Illustration 2 Do = 12c, Po (ex div) = $1.75, g = 5%. What is the value of ke? ke = 0.12 (1.05) = 12.2% The growth rate of dividends can be estimated using either of two methods. Two methods Extrapolation of past dividends 2.3 Growth from past dividends Gordon s growth model Look at historical growth and use this to predict future growth. If you have specific information about future growth, use that. If dividends have grown at 5% in each of the last 20 years, predicted future growth = 5%. Uneven but steady growth take an average overall growth rate. Discontinuity in growth rate take the most recent evidence. New company with very high growth rates take care! It is unlikely to produce such high growth in perpetuity. No pattern do not use this method (i.e. dividends up one year, down the next). 1007

23 Example 2 A company has paid the following dividends over the last five years. Cents per share 19X X X X X4 145 Estimate the growth rate and the cost of equity if the current (19X4) ex div market value is $10.50 per share. Solution 2.4 Gordon s growth model Gordon s growth model states that growth is achieved by retention and reinvestment of profits. g = br e b = proportion of profits retained r e = return on equity Take an average of r and b over the preceding years to estimate future growth. r e = Profit after tax Shareholders' funds = Profit after tax Net assets b = Retained profit Profit after tax These figures can be obtained from the statement of financial position and income statement. 1008

24 Example 3 A company has 300,000 ordinary shares in issue with an ex-div market value of $2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits of $100,000. Net assets at the year end were valued at $1.06m. Estimate the cost of equity. Solution 1009

25 2.5 Cost of equity and project appraisal Illustration 3 A plc is all equity financed and has 1m shares quoted at $2 each ex div. It pays constant annual dividends of 30c per share. It is considering adopting a project which will cost $500,000 and which is of the same risk as its existing activities. The cost will be met by a rights issue. The project will produce inflows of $90,000 pa in perpetuity. All inflows will be distributed as dividends. What is the new value of the equity in A plc and what is the gain to the shareholders? Ignore tax. ke = = 15% New dividend $ Existing total dividend 300,000 Dividends from the project 90,000 New total dividend 390,000 Value of equity = 390, = $2,600,000 Shareholders gain = $(2,600,000 2,000,000) $500,000 = $100,000 Project NPV = ($500,000) + 90, = $100,000 Therefore, new value of equity = Existing value + Equity outlay + NPV = Existing value + Present value of additional dividends Therefore the NPV of a project serves to increase the value of the company s shares i.e. the NPV of a project shows the increase in shareholders wealth. This proves that NPV is the correct method of project appraisal it is the only method consistent with the assumed objective of maximising shareholders wealth. 1010

26 2.6 Cost of preference shares By definition preference shares have a constant dividend Ke = D Po where D = constant annual dividend Preference dividends are normally quoted as a percentage, e.g. 10% preference shares. This means that the annual dividend will be 10% of the nominal value, not the market value. Example 4 A company has 100,000 12% preference shares in issue (nominal value $1). The current ex-div market value is $1.15 per share. What is the cost of the preference shares? Solution 3 COST OF DEBT 3.1 Terminology of debentures A debenture is a written acknowledgement of a company s debt. A debenture usually pays a fixed rate of interest and it may be secured or unsecured. It may be traded on the bond market and will reach a market price. The terms debenture, bond and loan stock all basically refer to the same thing i.e. traded corporate debt (unlike bank loans which are not traded). The coupon rate is the interest rate printed on the debenture certificate. Annual interest = coupon rate nominal value Nominal value is also known as par or face value. In the exam the nominal value of one debenture is usually $100. Market value (MV) is normally quoted as the MV of a block of $100 nominal value. e.g. 10% debentures quoted at $95 means that a $100 block is selling for $95 and annual interest is $10 per $100 block. Market value (ex-int) is where interest has just been paid. Market value (cum-int) includes the value of accrued interest which is just about to be paid. 1011

27 3.2 Irredeemable debentures Irredeemable debentures are a type of debt finance where the company will never repay the principal but will pay interest each year until infinity. They are also referred to as undated debentures. The market value of undated debt can be calculated using the same logic as the Dividend Valuation Model: MV (ex interest) = present value of future interest payments discounted at the debentureholder s required rate of return For irredeemable debentures the interest is a perpetuity. MV (ex int) = r I where I = annual interest r = return required by debenture holder r = I MV (ex int) = Interest yield The company gets tax relief on the debenture interest it pays, which reduces the cost of debentures to the company known as the tax shield on debt. Illustration 4 Consider two companies with the same earnings before interest and tax (EBIT). The first company uses some debt finance, the second uses no debt. $ $ EBIT Debt interest (10) Profits before tax % $3.30 difference Therefore Effective cost of debt $ Debt interest Less Tax shield (3.30) Effective cost of debt

28 Because of tax relief, the cost to the company is not equal to the required return of the debenture holders. Unless told otherwise, we assume that tax relief is instant (in practice, there will be a minimum time lag of nine months under the UK tax system). Note that if debt is irredeemable then: Cost of debt to the company (also known as the post tax cost of debt) = = Return required by the debenture holders (1 Tc) Interest yield (1 Tc) Where Tc = corporate tax rate as a decimal Kd can be used to denote the cost of debt but care is needed as to whether it is stated pre-tax or post-tax. Example 5 12% undated debentures with a nominal value of $100 are quoted at $92 cum interest. The rate of corporation tax is 33%. Find (a) the return required by the debenture-holders (b) the cost to the company. Solution 1013

29 3.3 Redeemable debentures/dated debentures The cash flows are not a perpetuity because the principal will be repaid. However from the dividend valuation model we can derive the following rule: The cost of any source of funds is the IRR of the cash flows associated with that source. If we are looking at the return from an investor s point of view, interest payments are included gross. If we are looking at the cost to the company, we take the interest payments net of corporation tax. Assume instant tax relief. Assume that the final redemption payment does not have any tax effects. To find the cost of debt for a company find the IRR of the following cash flows: Time $ 0 Market value (ex-interest) x 1 n Post-tax interest (x) n Redemption value (x) The IRR is found as usual using linear interpolation. Example 6 A company has in issue $200,000 7% debentures redeemable at a premium of 5% on 31 December 19X6. Interest is paid annually on the debentures on 31 December. It is currently 1 January 19X3 and the debentures are trading at $98 ex interest. Corporation tax is 33%. What is the cost of debt for this company? Solution 1014

30 Care should be taken not to confuse the required return of the debenture holders with the cost of debt of the company. Required return of the redeemable debenture holder = IRR of pre-tax cash flows from the debenture = Gross redemption yield Gross Redemption Yield is also referred to as the Yield To Maturity (YTM) The cost of debt of the company is then determined by finding the IRR of the market value, net of tax interest payments and redemption value. MV (ex interest) = present value of future interest payments and redemption value discounted at the debenture-holder s required rate of return Example 7 A company has 8% debentures redeemable at a 5% premium in ten years. Debenture-holders require a return of 10%. What is the cost to the company? Corporation tax is 33%. Solution 1015