ACCA F9 Key Point Notes - June 2010

ACCA F9 Financial Management Key Point Notes June 2010

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________________________________________________________________________ Sunil Bhandari – IAT Ltd

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Key PointNotes

June 2010

ACCAF9

Financial Management

Tutor:Sunil Bhandari

Tutor Contact DetailsMobile: 07833 096979E-mail: viawww.IntelligentAccountancyTutorsLtd.co.uk

These notes are not intended to cover the whole syllabus, but target key examinable areas.

Copyright to Intelligent Accountancy Tutors Ltd


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Use of these Key Point Notes

These notes have been written as an aid to assist studentspreparing for the ACCA F9 June 2010 Exam. They accrue forthe topics tested in the past exams.

It is of paramount importance that they are used with an upto date Revision Kit (KAPLAN, BPP or CIMA). A combinationof using the notes and question practice is the best way toprepare for the forthcoming exams.


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Index

Chapter Number Chapter Name Page NumbersPreliminaries 5-11

Chapter One Financial Objectives 13-20

Chapter Two Dividend policy 21-23

Chapter Three Cost of Capital 25-28

Chapter Four Bonds-Yields & MarketValue

29-30

Chapter Five Risk Adjusted WACC 31-34

Chapter Six CAPM 35-43

Chapter Seven Capital Structure 45-48

Chapter Eight Project Appraisal 49-62

Chapter Nine Business Valuations 63-64

Chapter Ten Sources of Finance 65-71

Chapter Eleven Ratios 73-75

Chapter Twelve Working Capital 77-80

Chapter Thirteen Inventory Control 81-83

Chapter Fourteen Receivables& Payables 85-87

Chapter Fifteen Cash Management 89-92

Chapter Sixteen Foreign Currency Risk 93-99

Chapter Seventeen Interest Rate Risk 101-108


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Exam Technique

First 15 minutes

Read the questions carefully

Recognise the topic being tested (eg NPV, Rights Issueetc)

Rank the questions according to your ‘strongest’ to‘weakest’

Next 180 minutes

Attempt the questions in your ranked order.

Stay within your time allocation both on each part ofthe question and on the question itself.

If the written elements are unrelated to thecomputations-try front load as they represent ‘easier’marks.

Try to attempt all parts to all the questions.

If in doubt about how to compute a value-make areasonable estimate and move on.


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General

Numerical Questions

State formula

Show method

Explain as you go

Make assumptions if in doubt

Written Questions

Check format – report / essay/ listed points

Headings / subheadings / columnar

Simple short paragraphs-essays and reports

Use ‘numbered’ points for most questions-simplesentence approach.


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Tips

These will be posted on my website sometime in lateApril/early May 2010.


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Chapter One

Financial Objectives

1 Primary Financial Objective

1.1 For profit making business “Maximise Shareholder(S/H)Wealth”

1.2 To Measure S/H wealth

Value of Equity (Ve) =Number of issued Equity/OrdinaryShares X Current Market Price (Po)

1.3 To find Po:

Given in the Question if it is a listed company(seebelow)

Compute Using:-

Asset Valuation Models Dividend Valuation Model(DVM) Earnings Based Models Discounted Cash Flow Approach(DCF)

1.4 Check the question very carefully for the size of thecompany is it:-

Listed* Private Company

* Market value exist on a stock exchange


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2 Indicators

2.1 Financial indicators pointing towards maximising S/Hwealth include:-

Earning per share(EPS) Dividend per share(DPS) Return on Capital Employed(ROCE) Return on Shareholder Capital(ROSC) Profit after tax Revenue

2.2 Non-Financial Indicators include:

Market Share Customer Satisfaction Quality Measures

The above are all Key Performance Indicators (KPI’s)that need to be measured and reviewed on a regularbasis by the board of directors. (Board)

3. External Factor Affecting Ve & Po

3.1 The Board cannot control all aspects that effectVe and/or Po. Two major external factors are:-

Economic Variables Regulators


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3.2 Economic Variables

3.2.1 Interest Rates- If they fall:-

Stimulate demand and revenue Lower the cost of debt and improve profits Investors switch to share market for better

returns

3.2.2 Inflation Rates- If it rises:-

Costs rise causing a drop in profits Cause interest rates to rise. Devalues the home currency

3.2.3 Foreign Exchange Rate(FOREX)- If it rises:-

Reduce cash receipts for exporters Lowers the cost for importersDiscourage exporting

3.2.4 Gross Domestic Product- If it falls:-

Reduce demand and revenue Cause interest rates to fall to stimulate demand

3.2.5 General Taxation –If it rises:-

Damage company profits Not encourage investment by companies

Important to relate your comments to the effect uponPo & Ve.


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3.3 Agency Problem

3.3.1 S/H are the owners of the company and expecttheir directors (agents) to take decisions to maximiseS/H wealth. The agency problem occurs when directorstake decisions that DO NOT lead to maximising S/Hwealth.

3.3.2 Examples of decisions that ‘may’ damage S/H wealth:

Directors pay Taking high risk business decisions Non-payment of dividends Using debt finance (against the wishes of the

S/H)

3.3.3 Solutions to this problem include:

Company Law Corporate Governance (eg UK Combined Code) Share Options (ESOPS)

3.3.4 ESOPS

This provides a way of rewarding Directors bygranting them options to buy shares in their companyat a fixed price. They can buy the shares in future(normally 1 year) at the fixed price which usually istoday’s price.Hence, directors are encouraged to takedecisions to maximise future share prices. Thisbenefits both the directors and the shareholders.


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4 The Three Key Decisions

4.1 To maximize S/H wealth the board must take

Investment Finance Dividend

4.2 Investment

4.2.1 Allocate cash for:-

Organic Growth (Projects) Acquisitions

4.2.2 Must always consider how investmentsimpact upon:-

Company Liquidity Future Profits and Asset values Business Risk Profile i.e. effect upon

variability of the cash flows and profits.

4.3 Finance

4.3.1 To finance investments the board have todecide the best balance of equity and debt.

4.3.2 They will consider:-

Cash available within the company Access to new sources of finance Impact on KPI’s like gearing

ratio(Debt:Equity) Cost of Finance (WACC or Ko)


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4.4 Dividends

4.4.1 The Board needs to establish a dividend policy –see Chapter 2

4.5 The three decisions are interlinked.

Example: New projects need new finance but mustgenerate cash to service the finance providersincluding paying dividends to the shareholders.


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5 Objectives of Not-For-Profit- Organisations (NFP’S)


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Chapter Two

Dividend Policy

1 Introduction

To maximise S/H wealth the Board should establish adividend policy-the payment pattern to the equity investors.

2 Theories

Several theories have been put forward to assist:-

2.1 Residual – If spare cash exists at the end of the year paydividend.

2.2 Pattern – Be consistent with dividend payments. Either

a) Pay the same dividend per share (DPS) each year.b) Maintain the payout ratio (DPS/EPS)c) Maintain the same year-on-year growth rate in

dividends. The latter links into the Po via thedividend valuation model (DVM)

Po= Do (1+g)(re-g)


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2.3 Irrelevancy

In a perfect capital market providing the directors caninvest in projects with a positive NPV no dividendsare required. The Ve will rise and the S/H can sell sharesto create the cash the need(Manufacture Dividends).

3 Practical Considerations

There are many to consider:

Availability of Cash What dividends to S/H want (clientele effect)? Signalling effect –payment of dividends indicates a

healthy company Retaining cash is a key source of Finance. Dividend growth should be greater than inflation Tax impact upon S/H Effect the dividend will have on dividend

cover(EPS/DPS) Number of investment opportunities will restrict

dividend payments. Risk-paying now is safer than promising to pay next

year Is the dividend within the company law regulations?

4 Alternatives to Cash Dividends

4.1 Scrip Dividends

4.1.1 The S/H will receive extra shares instead of cash on apro rata basis.

4.1.2 This will allow the S/H to sell extra shares for cash andthe gain will be subject to CGT.


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4.1.3 The effect will:-

a) Increase the issued equity capitalb) Dilute EPS and Po valuesc) Create pressure for the board to pay more total

dividends in the future as more shares are in issue

4.2 Share Buy Back

4.2.1 If the board has “one off” period of excess cash, theycould consider a share buy back.

i.e. Buy back shares at Po and cancel them.

4.2.2 Considerations:-

a) Allowable under company law.b) Increase gearing as Ve may fall.c) Tax implications for the S/H(CGT)d) Reduced number of shares will cut supply for

trading purposes.e) Less dividend pressure on the board in future.f) Criticism-is this the best use of company cash.


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Chapter Three

Cost of Capital

1 Weighted Average Cost of Capital (WACC)

Ke=Cost of EquityKd=Should be “Kd(1-t)”=Cost of DebtVe=Market Value of EquityVd=Market Value of Debt

2 Market Values

2.1 Ve=Total Number of Issued Shares X Po

2.2 Vd=Total Book value of the Debt X Po

$100

2.3 Alternative Presentations

a) Ratio (Vd:Ve) e.g. 1:4b) Gearing Percentage e.g. 35%

Hence Vd=35,Ve=65For WACC equation


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3 Cost of Equity (Ke)

3.1 The minimum return required by the S/H to compensatefor the risks they face from the equity investment.

3.2 CAPM

Ke=Rf+ (Rm-Rf)βe

where Rf=Risk free returnRm=Return on the market portfolio(Rm-Rf)=Equity Risk Premiumβe=Risk measure for the risks being

faced by the S/H

3.3 DVM

Where Po=Ex Dividend Share Priced1=The DPS at Time 1do=The DPS at Time 0g =Constant annual future growth rate

in the DPS

4 Cost of Debt (Kd (1-t))

Depends upon the type of Debt

Also note:-

a) Kd=Called Yield(the minimum return of the lender)b) “Kd (1-t)”=Cost of Debt*

* This is part of the cost of capital computation.


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4.1 Non traded debt (Bank Loans)

Kd is the Interest rate on the loan(i.e. the yield) “Kd (1-t)”=Interest Rate X (1-t)

4.2 Traded Bonds

4.2.1 These are issued and traded in blocks of $100or £100.Do all computations per block of “100”.

4.2.2 Undated Bonds-the process is:-

a) Establish the Kd(Yield) Given in the question Kd(Yield)= Ints

Po

b) “Kd (1-t)”= Yield X (1-t)

4.3.3 Redeemable Bonds-the process is via IRR computation

Time $To Po (X) Take two guesses at

the Kd(1-t) likeT1-Tn Ints x (1-t) X 10% & 1% and

Perform IRR computationTn Capital Repayment X

5 Uses of the WACC

5.1 The Ko is the money or nominal cost of capital to use inproject DCF approaches. It can be used:-

a. To compute the NPV as the discount rate.b. Compare with the project IRR.

IRR>WACC-Accept


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5.2 The WACC is useable if the new project underconsideration:-

a) Is a core activity –same as the company’snormal activities

b) Does not alter the capital structure of thecompany (Vd:Ve)

5.3 In all the past F9 exam questions, it has been very clearwithin the question details that the conditions exist touse the WACC. If the WACC can’t be used then the RiskAdjusted Cost of Equity per Chapter 5 may be used.

6 What if’s?

6.1 Extend the WACC formula for all extra methods ofcompany finance. So you could have a WACC with:-

Equity Preference Capital Bank loans Traded Bonds

6.2 For Preference Capital

> Kp=D.P.SPo

> Vp= No of issued X Market price perPreference shares share (PO)


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Chapter Four

Bonds –Yields and Market Values

1 Bonds

Debt which is issued in blocks of “100” and trades on thestock exchange.

2 Market Value

2.1 The market value is Po/$100 and can be established viathe DVM

“The present value of future cash flows received by theinvestor and discounted at the yield(Kd)”

2.2 Undated Debt

Po= IntsYield

2.3 Redeemable Bonds

Time $ Yield% PV

Ti-Tn Ints X X X

Tn Capital X X XRepayment*

Po = XX


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2.4 Convertible Bonds

Replace the * Capital repayment with the share value ifhigher than the cash repayment.

2.5 Bank loans market value is the book value.

3 Yield (the minimum return required by the lender)

3.1 Yield is the minimum return of a lender. Practically wewould expect:-

RF<Inter-Bank rate(LIBOR)<Yield required by the lender

3.2 Undated Bonds

Yield = IntsPo

3.3 Redeemable Bonds

Time $

To Po (X) Take two guesses atthe yield say 10% &

T1-Tn Ints X 1% and perform IRRcomputation

Tn Capital Repayment X

3.4 Bank Loans

Yield=Interest Rate on the loan


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Chapter Five

Risk Adjusted Cost of Equity

1 Uses

When the company wants to assess a project that is non-core.

2 Process

a. Take the Proxy Company Beta equity and degear via

b. Repeat the above for other Proxy Company Betas.Then average all the βa

c. Re-gear βa to find the project βe

d. Put the Project βe into CAPM

Project Ke =Rf + (Rm-Rf) Project βe

Note:(Rm-Rf) is the Equity Risk Premium.


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3 Concerns

Will the project finance truly have no effect upon thecompany’s gearing?

Proxy company βe:-

a) Does it exist?b) Does the proxy company specialise in the non-

core field or does it have many different businessactivities

c) If we are not listed-how do we gear up the βa


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4 Examiners Article


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Chapter Six

CAPM

1 CAPM Equation

Minimum return = Rf+ (Rm-Rf) β

There are several uses of the CAPM equation:-

To find the company’s Ke(Chapter 3) Risk Adjusted Ke (Chapter 5) Assist a stock market investor to buy or sell equities

2 CAPM & Buy/Sell Equities

2.1 Single Equity

Take/Find βe Put into CAPM

Minimum Return = Rf+(Rm-Rf)βe

Forecast a return for the investment (could usepast returns)

Forecast exceeds/equalsminimum return-Buy or Keep the share


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2.3 Combining Equities (portfolio)

a) Created a weighted average portfolio Beta

i.e (Cash in Share (1)/Total Cash in Equities X β1) + (CashIn Share (2)/Total Cash in Equities X β2 )

b) Put into CAPM

Minimum Return = Rf+(Rm-Rf)Weighted Average β

c) Forecast exceeds/equalsminimum return-Buy or keep the portfolio.

3 Meaning of a βe

3.1 A βe is the measure of risk being faced by equityshareholders

3.2 βe can be split into:-

Systematic Business Risk-measured by βasset Financial Risk

3.3 Systematic risk is how market factors effect thatinvestment. Market factors are:-

Macroeconomic variables Political factors

The measure is relative to the benchmark of themarket portfolio.


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3.4 CAPM assumes that the investor eliminated theunsystematic risk.


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4 Criticisms of CAPM


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5 Examiners Articles


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Chapter Seven

Capital Structure

1 Introduction

How should the company decide the mix ofequity and debt capital?

2 Practical Issues

If the company uses Debt capital funding it shouldconsider:-

Credit Rating of the company Rate of interest it will pay Market conditions- access to Debt capital Forecast Cash Flows-to service and repay the debt. Level of Tangible Assets on which secure the loans. Interest will lead to tax savings i.e Tax Shield Constraints on the level of debt from

a) Articles Of Associationb) Loan Agreements.

Effect upon the company gearing ratio

Debt/Equity+Debt OR Debt/Equity

Will the debt providers exercise influence over thecompany?

The chance of bankruptcy.


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3 Theories of Optimal Capital Structure

3.1 Common Ground-both major views accept two facts:-

a) Yield<Ke

b) Gearing causes Ke to rise

3.2 Traditional View

Key Points:-

1) Ke rises due to financial risk caused by gearing.2) Kd is initially uneffected by gearing but rises at “high”

gearing levels due to the perception of the possibility ofbankruptcy.


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3) Ko (WACC) -trade off of Ke and Kd. Point X is theoptimum gearing level where WACC is lowest.

4) Once point X is reached via trial and error it must bemaintained.

3.3 MM and Tax

Key points:-

1) Assumption behind the model:-

All debt is risk free Only corporation tax exists Debt is issued to replace Equity All types of debt carry one yield, the risk free

rate Full distribution of profits Perfect Capital Market


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2) MM concluded companies should gear up to themaximum levels.

4 Pecking Order Theory


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Chapter Eight

Project Appraisal

1 Accounting Rate of Return (ARR)

1.1 Average Annual Post Depreciation Profit X 100Investment

1.2 Investment is:-

a) Initial Investmentb) (Initial Investment +Scrap Value)

21.3 Decision rule is:-

ARR> Target return-accept the projectOR

Take the project with the highest ARR

1.4 Limitations and Strengths


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2 Payback

2.1 Time it takes the project to payback it’s initialinvestment.

2.2 General Approach:-

Time Cash Flows Cumulative Cash flowsTo (X) (X)T1 X (X)T2 X (X)T3 X XT4 X -T5 X -

2.3 Annuity and Perpetuity cash flows

Payback period=Initial OutflowAnnual Inflows


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3 Net Present Value (NPV)

3.1 NPV is the increase in S/H wealth arising from theproject.

3.2 Two formats to considerFormat (A)


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Format B

Time CF R% PV$’000

To (X) 1.0 (X)T1-Tn X X XT2-Tn X X X

NPV $XXX

3.3 Incremental Cash Flows

Result from/caused by the project Include opportunity cash flows Ignore:-

Non-Cash Flows Sunk Costs Interest /Dividend payments

3.4 Financial Maths Required:-

1) Compounding

Eg: Inflation is 5% paReal cash flow at time 7 is $250

Money cash flow =$250 x 1.057= $352

2) Discounting (tables)

Eg: Cash flow at T5 is $390.r=10%pa

PV=$390 x 0.621 =$242

3) Annuity (tables)

Eg: Cash flow from T1-T9 is $400 pa r=5%PV =$400 x 7.108 = $2843


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4) Delayed Annuity

Eg: Cash flow T3-T5 =$300 par=10%

PV=$300 x (AF1-5 –AF1-2)=$300 x (3.791-1.736)=$617

5) Perpetuity

Eg:Cash flow is $500 pa from T1 each year forever.r= 4%

PV= $500 x 1r

=$500 x 1 = $12,5000.04

6) Delayed Perpetuity

Eg: Cash flow is $600 from T4-Tperp

r= 5%PV=$600 x (1/r –AF1-3)

=$600 x (1/0.05-2.723)= $10,366

7) Perpetuity with Growth

Eg: Cash Flow at time 1 will be $120 and then itwill grow at 3% pa.r=12%

PV= $120 x 1(r-g)

PV=$120 x 1 = $1,333(0.12-0.03)

8) Delayed Perpetuity with Growth

Eg: As for (7) above but $120 is cash flow at T5.


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PV= $120 x Effective Discount Rate.

Effective Discount Rate=

1 x DF4 at 12%(r-g)

1 x 0.636(0.12-0.03)

= 7.067

PV =$120 x 7.067 = $848

3.5 Inflation- Factors to consider:

a) ‘h’ is symbol for inflationb) ‘r’ is symbol for real –excludes inflationc) ‘i’ is symbol for money/nominal –includes inflationd) Two approaches are possible

3.6 Include Inflation

Money cash flows can be:- Given in the question Computed via

Real CF x (1+h)n

Money cost of Capital can be Given in the question WACC (see earlier chapter) Computed via

Money rate=Real Rate x (1+general ‘h’)


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Exclude Inflation

Not yet tested by the examiner at F9 Cash flows are REAL Discounted at REAL Cost of Capital

3.7 Working capital-think of as a project bank account:-

i. Invest at To

ii. Adjust each yeariii. Close at end of the project.

Eg: Project needs WC at end of each year as follows:

T0 T1 T2 T3

- 300 350 375RelevantCF’s

(300) (50) (25) 375

3.8 Taxation-relevant cash flows to be included in the NPVcomputation.(RTQ re timings of tax flows!!!)

1) Operating Flows x Tax rate

2) Tax saved on Capital allowances or Tax AllowableDepreciation(TAD):-

a) TAD-straight line.eg: CAPEX is $1m.Scrap value at T4=$200K.TADis 4 years and tax rate is 30% (No delay)

Tax saved= [($1000-$200)] x 30% =$60 paT1-T4 4

b) TAD-Reducing Balanceeg: Asset is bought at T0 (1/1/09)cost$1m.Sold at T4 for $200k.TAD is 25% reducing


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balance. Tax is 30% (1 year delay).

Time Tax saved$’000

T2 $1000 x 25% x 30% 75T3 75 x (100% -25%) 56T4 56 x75% 42T5 Bal Figure 6730% x (1000-200) 240

4 Internal Rate of Return (IRR)

4.1 The cost of capital that gives an NPV=Nil

4.2 Approach-Take the following example:

NPV@ 10% =$200KNPV@ 20% = ($15K)

IRR= 10+ (200/200-(-15)) x (20-10) =19.30%

4.3 Decision Rule

IRR>Project Cost of Capital-Accept

4.4 PROS CONS

*Easier to explain *Will mislead if comparing*Simple decision rule projects

* If cash flows are non-regular (-, +, +, +,-)IRR computed above isincorrect


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5 Capital Rationing

5.1 A restriction of cash preventing the company fromaccepting all projects with a positive NPV

5.2 Causes:

Hard Soft

External constraint on Internal within theRaising cash.Eg:- Credit CompanyCrunch Crisis Eg:- Capex Budget

5.3 Period –only single period is examinable i.e. cash mayBe restricted at T0 or T1.

5.4 Divisible projects –can invest in proportions of a projectfrom 0% to 100% maximum.

Approach:-

1)Compute Project NPV’s2)Compute Profitability Index(PI) =

NPVCash Invested at critical period

3) Rank-High to Low PI

5.5 Non-Divisible –take all or none of any project.

Approach:-

1)Compute Project NPV’S2)Take best combination of projects that

maximiseThe total NPV but spend less than or equal to cashavailable in the critical period.


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6 Asset Replacement

6.1 If assets have to be replaced on a periodic basis,Equivalent Annual NPV is the method to use.

6.2 Process

a) Compute the NPV for each replacement cycle.

b) E.A.NPV = NPV

Annuity Factor for life of the project @cost of capital

c) As (b) will give negative values, take the leastexpensive.

7 Accruing for Risk or Uncertainty within NPV

Several methods, the best are:-

7.1 Certainty Equivalents-Reduce cash flows by C.E factorprior to discounting .Example:-

Time $’000 C.E Factor Adj CF RF%T0 (1000) 1.0 (1000) 1.0T1 700 0.90 630 XT2 900 0.85 765 X

7.2 Probabilities –One project cash flow may beuncertain.

Example Sales in year 1$’000 P2000 0.701000 0.30

1.0


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Sales in T1 for NPV=

(2000 X 0.70)+ (1000 X 0.30) =$1700K

7.3 Risk adjusted Cost of Equity –See Chapter 5

7.4 Sensitivity Analysis-What if?

NPV X 100% For Cash flowsPV of the cash flowthat is uncertain

IRR-Cost of Capital X 100% For the Cost of capitalCost of Capital

Lower the sensitivity % the higher the risk

7.5 Discounted Payback

Payback using discounted cash flows

Format

Time D.C.F Cumulative D.C.FT0 (X) (X)T1 X (X)T2 X (X)

T3 X XT4 X -T5 X -


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8 Post Completion Audit (PCA)

9 NPV and S/H wealth

9.1 As stated earlier, NPV represents the change in S/Hwealth arising from the project. It is the only methodthat can be directly related to the primary objective offinancial management.

9.2 The NPV is effectively the change in the marketcapitalisation of the company and the movement in itsshare price. It relies upon markets being efficient(see chapter 9) to reflect the project data within the newmarket price.


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Appendix – Capital Rationing Question

HIJ is a private transport and distribution entity. It isconsidering three investment opportunities, which are notmutually exclusive. HIJ is no cash reserves ,but couldborrow a maximum of $30 million at the present time at agross interest rate of 10%.Borrowing above this amountmight be possible, but at much higher rate of interest.

The initial capital investment required, the NPV and theduration o each project is as follows:

InitialInvestment

$million

NPV$million(after

tax)

Durationyears

Project A 15.4 2.75 6Project B 19.0 3.60 7Project c 12.8 3.24 Indefinite

Notes:

1) The projects are not divisible and cannot be postponed.2) The discount rate considered appropriate for all three

investments is 12% net of tax.3) HIJ pays corporate tax at 30%4) Assume cash flows, other than the initial investment,

occur evenly throughout the duration of theinvestments.

Required:

(a) (i) Calculate the profitably index and equivalent annualannuities for all three projects ,explain the usefulnessof these methods of evaluation in the circumstances


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here, and recommend which project(s) should beundertaken. (10marks)

(ii) Explain the differences between ‘hard’ and ‘soft’capital rationing and which type is evident in thescenario here. Discuss, briefly, the advisability of thedirectors of HIJ limiting their capital expenditure inthis way. (5 marks)

(iii) You later discover that the discount rate used wasnominal but the cash flows have been calculated inreal terms.

Explain, briefly, how the calculation for NPV should beadjusted and what effect the changes might have andon your recommendation. You are not required to doany calculations for this section of the question.

(4 marks)


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Chapter Nine

Business Valuations

1 Equity

1.1 To value equity /ordinary shares on a per share basistwo primary methods exists.

1.2 DGM/DVM

Po is the present value of future dividends discounted atthe cost of equity(re or Ke)

Po= Do (1+g)(re-g)

1.3 P/E Model

PO =EPS X P/E Ratio

P/E Ratio may have to come from a proxy company.

2 Others

2.1 Preference shares

PO = Drp


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2.2 Traded Debt-Undated

PO per $100 = Intsrd

2.3 Traded debt –Redeemable

PO per $100:-

Time $ rd PV

T1-Tn Ints X X XTn Capital Repayment X X X

PO X

3 Efficient Market Hypothesis (EMH)

3.1 EMH explains how stock market prices change to reflectdata /information. The market can be efficient at 3levels:-

Weak Semi-Strong Strong

3.2 Weak –the prices reflect only historic/past data.

3.3 Semi-Strong-prices include past data +publicannouncements.

3.4 Strong-prices reflect past, public and insider (secret)data.

3.5 Most of the world’s stock markets are closer tosemi strong.


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Chapter Ten

Sources of Finance

1 Introduction

Where and how do companies raise long term capital.

2 Equity –General Factors

2.1 Ordinary shares of the company with voting rights.

2.2 Carry the greatest risk but also the best possiblereturns.

2.3 Could be traded on the stock exchange if company islisted.

2.4 “A Stock Exchange Listing”


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3 Equity- Raising New Capital

3.1 Retained Earnings-First source of cash. Hold back thepayment of dividends. Will effect the dividend policyand can raise a small amount of cash.


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3.2 Rights Issue-Pro Rata issue to existing S/H.

3.2.3 From the exam questions will need to obtain orcompute:-

a) Po just before the rights issue (Cum Rightsprice)

b) Issue Price

c) Ex Rights Price-price directly after the shareissue (TERP)

For Example: 1 for 3 rights issue at 550p andcum rights is 600p

No £3 at 600p 18.001 at 550p 5.504 £ 23.50

TERP =£ 23.50/4 =£5.88

d) Value of the right

£ 5.88- £5.50 =38p

3.2.4 Shareholder can sell the rights to anothershareholder at the value of the rights.

3.3 Placing- Sell a large batch of new shares toinstitutions.

3.4 Prospectus- Sell shares to investors at a fixed priceafter issuing a prospectus.


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3.5 Tender- Request investors to tender for the sharesat a price they would want to pay. The board thenestablishes final price.

4 DEBT

4.1 Loans provided to the company on a long term basis.

Debt holders will:-

a)Interest paid from pre-tax profits

b) Security via Fixed charged Floating charge Securitisation of future income.

c) Covenants-restrict company activity in areassuch as:

Dividend payments Issues of further debt

4.2 Bank Loans

4.2.1 Funds come from one bank or group of banks.

4.2.2 Terms & Conditions depend upon marketconditions and credit rating.

4.3 Traded Bonds

4.3.1 Loan is split into blocks of $100 and issue on themarket.

4.3.2 Can be undated or redeemable.

4.3.3 Bond has a yield and market value (Chapter 4)


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4.4 Other Types of Debt

a) Convertible Bonds-Debt that can be convertedto shares, normally at redemption.

b) Eurobonds-Rare large foreign currency loan inthe home country. Used by MNC’s and minimumvalues normally $1m.

c) Mezzanine Loan-Loan used in MBO’s. Loan thatcarries high interest but normally only paid ifprofits are made.

d) Grants-Free government finance providingconditions are met.

5 Leases


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5.2 Lease Vs Buy Evaluation

3 Step approach

1.Ascertain the post tax cost of debti.e Pretax % X (1-t)

2. NPV of the lease cash flows using (1)Lease cash flows are:

Payments/Rental Tax savings caused by rentals.

3. NPV of buy cash flows using (1)Relevant flows are:-

Capital Cost Scrap value Tax saved on Capital allowances or Tax

allowable depreciation.


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6 The role of Treasury Function

6.1 Treasury functions mainly exist in Large MNC.

6.2 Roles include:-

Managing the groups cash resourcesLiaise with the banks.Advising on Heading strategies for:-

Forex Risk Interest Rate Risk

Establishing source of Finance and cost of capitalfor the group.

Deciding upon investment policy.


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Chapter Eleven

Ratios

1. Ratios-You must Learn!!!!

1.1 Investor

EPS = PAT less Preference DividendsNo of ordinary shares in issue

P/E = Po

EPS

Dividend Cover= EPSDPS

Payout Ratio = DPSEPS

Dividend Yield = DPSPo

1.2 Gearing

Capital Gearing= Debt or Debt X 100Equity Debt+Equity

NB Preference shares are generally treated as debt.

Interest Cover = Operating ProfitInterest


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1.3 Profitability

ROCE = Operating Profit X 100Equity +Debt

ROE = PAT X 100Equity

Margin = Operating Profit X 100Turnover

1.4 Liquidity

Current Ratio= C.AssetsC.Liabilities

Quick/Acid Test = (C.Assets-Inventory)Ratio C.Liabilities

Inventory Days= Inventory x 365COS or purchases

Receivables Days= Trade Receivables x 365Sales

Payables Days = Trade Payables x 365COS or Purchases

2 Important

Learn the ratios State on answer book, substitute the relevant

figures from the question and compute the ratio. Comment on each ration in a sensible manner.


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Be ready to change the ratios around

Eg: C.Ratio is 1.25:1.C.Assets are $260K andC.Liabilities are made up of bank overdraft andpayables. Payables are $108K.What is the value ofthe bank overdraft?

Solution

CA=1.25($260K)CL=1.00(?)

CL=$260K=$208K$1.25

Bank O/D=$208K-$108K=$100K


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Chapter Twelve

Working Capital


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Chapter Thirteen

Inventory Control

1

INVENTORY MANAGEMENT

Economic Order Qty(EOQ) Just In Time(JIT)-Optimise stock order quantity -Nil/minimumand Re-order level stock

-Minimises stock associatedcosts

No discounts With discounts


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EOQ

Assumptions Demand is known

Purchase price isconstant(No discounts)

Lead time isconstant(No Stock outs)

Re-order level =demand in leadtime

All costs are knownand constant

Graphs

Q

Q/2

ROL

0

TIME

£ Total relevant Variablecosts holding

costs

Fixed ordercosts

EOQ Q

Co=Fixed cost perorder

D=Annual Demand

CH=Variable holdingcost per unit.

EOQ + DISCOUNTS

Method

1) Calculate the EOQusing the formula,ignoring anypotential discounts.This is the startingpoint.

2) If, and only if, theEOQ calculated in1) would result in adiscountedpurchase price,recalculate the EOQusing the formulataking into accountthe relevantdiscount.

3) Finally, calculatethe total annualcost using the EOQcalculated in 2)AND the totalannual costordering inquantities higherthan the EOQ butwhere greaterdiscounts areavailable.


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Forecast Sales qtys

(2)

Demand Driven

(1) No Finished (3)

Goods inventory

Close Linkwith suppliers

(7)

No or Ltd JITRaw material Production (4)Inventory(6) NO WIP(5)

JIT(Factors)


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Chapter Fourteen

Receivables and Payables

1 Receivables

1.1 Receivables management is the balance between:-

liquidity (hold a lower balance) profitability(offer more credit)

1.2 Factors to consider when offering credit.

Do competitors offer credit? Industry norms Check the credit rating of both new and existing

customers Set realistic credit limits

1.3 To collect cash from receivables efficiently:-

Invoice promptly State terms on the invoice Send out monthly statements Call customers to chase payment Consider legal proceedings as a last resort.

1.4 Factoring companies offer “contracted out” receivablesmanagement.

Receivables administration/collection of cash. Advances of cash Insurance cover for “bad” debts.

All the above have costs & fees attached.


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1.5 Recourse- Services can be offered with or withoutrecourse. If without recourse, the factoring company willsuffer any bad debts should they arise.

1.6 Invoice discounting-this is where cash can be raisedusing certain receivables balances as security.Customers are not aware of the transaction. The debt ispaid off when the receivables settle their debt.

1.7 Offering early settlement discounts to customers.

Eg Receivables normally pay in 45 days a settlementdiscount of 1.0% is offered for payment within 30days. Bank overdraft rate is 20%pa

Solution

Assume sale of $100

Discount is $ 1.00 = 0.01$99.00

Effectively, Annual value is:-

365 = 24.33(45-30)

(1+0.01)24.33-1 x 100

=27.4%

Discounts costs the company 27.4 % but save20%.Hence, don’t offer these terms.


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1.8 Changes of Policy

Prepare all computations on an annual basis Show incremental relevant cash costs and savings

when changing from old to new policy.

2 Payables

2.1 Again balancing act:-

Maximise use of free credit Not to over extend and lead to:-

a) Costs/Chargesb) Supplier withdrawing supplyc) Supplier going out of business.

2.2 Taking early settlement discount offered by suppliers –same approach as receivables as per 1.7.


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Chapter Fifteen

Cash Management

1 GENERAL

Motives to hold cash Transactions-Day to Day payments Precautionary-To cover “rainy day” Speculative-Possible investment

opportunities

Business may have Surpluses Deficits

SurplusesConsider: -

Amount Time Access Return Risk

Investments Deposits Building society

a/c’s Inter bank

market Gilts Aim London SE Futures

Deficits

Uses: -1. Extend trade

payablesfinance.

2. Bank facils.

3. Factoringco’s.


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2 CASH BUDGETS-LAYOUT

January February March

Receipts

Cash sales

Receipts from debtors

Sale of assets

Payments

Cash purchases

Payments to creditors

Expenses

Purchase of assets

Tax

Dividends

Interest

Net cash inflow/(outflow)

Balance b/f

Balance c/f


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Exam Technique

Proforma (as above)

Copy in easy figures.

Workings for others e.g. receivables receipts, payablespayments.

Total & tidy!!

3 CASH MODELS

Aim is to optimise the amount of cash held in the longterm.

3.1 Baumol Model

The “inventory control” model of cash.

£

Max Bal

Spread

Min Bal

Time


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3.2 Spread comes from EOQ formula:

3.3 Miller Orr

A model to cope with the daily variances in the use of cash.

£

Max Bal

SPREADReturnPoint

One thirdof spread

Min Bal

Time

Sell Investments andReplenish cash

Formulae are:


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Chapter Sixteen

Foreign Currency Risk

1. Translation Exposure

This is a Financial Reporting risk. The change in the valueof an asset /liability caused by a change in the spotexchange rate.

1.1 Example-ABC plc has a US subsidiary worth $10m.

2008 - at $1.50 £6.67m

2009 - at $1.75 £5.71m

Loss to equity (£0.96m)

Funded by a $10m loan.

2004 - at $1.50 £6.67m

2005 - at $1.75 £5.71m

Gain to equity £0.96m

1.2 Not a cash risk, only due to financial reporting!!!!

2. Transaction Exposure

Change in the value of the spot rate over the short term(less than a year) causing a cash gain or loss.

2.2 Must hedge!!


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3. Economic Exposure

Longterm change in the spot rates effecting project cashflows .Risk can be reduced by Global Diversification.

4. SPOT and Forward Rates

4.1 Typical presentation of SPOT and Forward Rates.

(Bid) (Offer)$1.5000 - $1.5555 / £

£0.6429 - £0.6667 / $(Bid) (Offer)

4.2 Picking the correct rate –Good Method

Spot and Forward rates presented as FX/Homecurrency

If “we” are Receiving Forex

Use the right hand rate

5. Internal Hedges for Transaction Risk

5.1 Invoice in home currency

All transactions in home currency

Transfer risk to the other party

Only useable rarely-if “we” have monopoly power.

Reciprocal andcross over!!!!!


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5.2 Foreign currency bank account

Held in the main currencies ($, Euro)

Pool all transactions in same FX

Liking have 3 bank accounts with 3 cheque books!!

5.3 Leading and Lagging

Watcher / predictor of spot rate changes

Leading – accelerate exchange

Lagging – delay the exchange

Used a lot by Importers who have to sell their homecurrency

5.4 Netting

Match all FX transactions in the same FX occurring onthe same day

Eg: 30 June we expectReceive $200KPay ($50k)Net Rec $150k


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6. External Hedges for Transaction Risk

6.1 Forward Market

“Fix the rate today that will apply on a set future date”

Technique: -

1. Net the future transactions in same FX and samedate. Ascertain if “buying” or “selling” the £.

2. Forward contract, X months, atGiven as a ‘spread’

3. Exchange FX at the forward rate(Remember ifreceiving FX use the right hand rate)

6.2 Money Market Hedge

“The exchange will take place today at the known spotrate”.

Technique

Home AbroadToday Today’s Spot

£Answer FX

X

1+ints home

Future Date

£ Answer FX

FX

÷ 1+ ints foreign


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7. Pros & Cons

Pros ConsForward Market

Fixed Rate, certainty Easy Cheap Tailored(Any size of

transaction)

Inflexible/contract Lose out on the

upside potential orgain

Must ensure FXreceipts arrive

MMH Convert today Cheap Tailored Flexible

Complicated May not apply for FX

receipt as borrowingmay not be possibleabroad

8. Predicting Future Exchange Rates

Best long term prediction model is PPPT

S0=Spot TodayS1=Spot 1 years timehc=annual inflation rate foreignhb=annual inflation rate base/home country

In the short term use IRPT

F0=Forward/future spot ratei=interest rate


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Practical Factors influencing the Spot Rate

1. Political stability-strengthens home currency value2. Economic growth-strengthens home currency

value3. Commodity pricing-oil is priced in dollars4. Trader activity-buying & selling of currencies5. Central bank action acting as a trader in FX6. Changing interest rates-protect the value of the

home currency.

9 Derivatives (written questions only at F9)

9.1 Futures

This is a method of hedging which is trying to fix thefuture spot rate at a value approximately equal to thecurrent spot rate.

“Futures exchange rates” are always similar to spotrates and this is a key factor.

Hedge is based upon:-

1) Find the direction of the change in the spot rate thatwould cause a transaction loss.

2) Use the Futures market and effectively “spread bet” onthe futures rate moving in directions that cause a loss.

3) If:-a) Spot rate moves in the direction to cause a

transaction loss, a profit will be made on thefutures market, hence two will cancel out.

b) Spot rate moves in the direction to cause atransaction profit, a loss will be made on thefutures market, hence two will cancel out.


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It’s not a perfect hedge due to basis risk and “odd”contract sizes.

9.2 Options

If “we” could take the current spot rate and use it inthe future, there would be no transaction risk.

With an option:-

1) Take a contract to give us the option (right)toexchange in the future at approx current spotrate.

2) Pay a non-refundable premium3) Future-use the option rate if spot rate has

move unfavourably. Otherwise the optionlapses.

Think of an insurance policy-very similar


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Chapter Seventeen

Interest Rate Risk

1What are the issues?

We have loan finance We have depositsand interest rates are earning a variableset at a variable rate on a interest rateregular basis(more likely exam questions)

Cover an interest Cover an interestRate rise rate fall

Note

1) Interest rate relationship:-

Yield on Govt Stock<Interbank Rates<Rates set by(see yield curves) lender(as above)

2) F9 syllabus requires students to discuss:

a) How to fix rates.b) How to create a ceiling on interest rates.


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2 How to fix the Interest Rate

Forward rate agreements(FRA)

Purchased from a Pros Consmerchant bank - easy - contract

- flexible size (≥ $1m)- cheap

Contract that fixes futureinterest rates for a set period

eg FRA 3-9 @ 4% pa

Fix start 3 Fixed RateMonths from Fix stops 9 monthsnow from now


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Interest rate future

Fixing the interest rate can be achieved by using futures.One of the main markets that is used is the UK LIFFE(London International Financial Futures Exchange).

The hedge is achieved by effectively ‘betting’ on the futuresmarket that its interest rate will change. The bet is alwayson the downside (ie those with loans are betting that rateswill increase). Also, the futures interest rate is derived fromthe market interest rates.

If the downside occurs, the company will have to pay moreon its loans as the market rate has risen, but would havemade a profit on the futures market. If rates go down, loaninterest will fall but a loss will be made on the futuresmarket. In both cases, the effective interest rate is fixed.

Futures are complicated by a number of factors.

Contract sizes

Margins / deposits payable at the start of thehedge(Refundable)

Speculators – who dominate the market and caneffect the future rates.


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Overview Illustration-to enhance understanding.

Concerned ints rate will go up

T Now T 6 months

LOAN = £10m Ints = 6% p.a.

Ints = 4% p.a. LIFFEInts = 6.2% p.a.

LIFFE Ints = 4.1%

Bet that thiswill rise.

Win on the bet Pay more ints.

Match up!!!!!


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3 How to set Ceiling Rates

Interest rate guarantee(IRG)

Purchased froma merchant bank for Covers the adversea fee side of interest rate

changes, but at a cost!!!

Contract that capsthe future interestrate for a setperiod

eg IRG 3-9 @ 4% pa at cost of 0.1% of loan

Cap stops 9 Capped Rate Non –refundableCap starts in months from now Fe3 months time


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Interest Rate Option

The future and options market provides a product that cancap interest rates for borrowers like an IRG. The hedge is toeffectively have the ‘right to bet’ on an interest rate increaseas shown on the futures market.

As an example, suppose that today is 30 June and thefollowing data is available on September LIFFE options.

Strike price(SP)%

Interest ratecap

(100 – SP)%

Call optionspremium

%

Put optionspremium

%\\

93.75 6.25 1.29 0.2394.25 5.75 0.69 0.7794.75 5.25 0.16 1.33

If a company wished to protect itself against an interest rateincrease above, say, 5.75%, it would purchase a put option.A premium of 0.77% would be payable now. If the marketinterest rates started to rise, the company would have topay more interest on its loans. However, interest rates onthe futures market will also rise and should this exceed5.75%, the business will exercise its put option. The cashreceived from this should cover most of the extra interestpaid on the loan.

Contract sizes and a standard length of three monthscomplicate interest rate options.


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4. Yield Curves

The shape of the yield curve is influenced by:

Liquidity Preference Theory – the longer cash isloaned /invested with any entity the greater thereturns are needed for not having access to the cash.


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Expectations Theory- the yield curve reflects moneyinterest rates which incorporates predicted inflationrates.

ACCA F9 Key Point Notes - June 2010

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