CIMA Study Systems 2006: Management Accounting-Financial Strategy (CIMA Study Systems Strategic Level 2006)

CIMA’S Ofﬁcial Study System Strategic Level Management Accounting – Financial Strategy John Ogilvie Christine Parkins...

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CIMA’S Ofﬁcial Study System

Strategic Level

Management Accounting – Financial Strategy John Ogilvie Christine Parkinson

AMSTERDAM BOSTON HEIDELBERG PARIS SAN DIEGO SAN FRANCISCO

LONDON NEW YORK SINGAPORE SYDNEY

OXFORD TOKYO

CIMA Publishing An imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP 30 Corporate Drive, Burlington, MA 01803 First published 2005 Copyright © 2005, Elsevier Ltd. All rights reserved No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder except in accordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road, London, England W1T 4LP. Applications for the copyright holder’s written permission to reproduce any part of this publication should be addressed to the publisher Permissions may be sought directly from Elsevier’s Science and Technology Rights Department in Oxford, UK: phone: (44) (0) 1865 843830; fax: (44) (0) 1865 853333; e-mail: [email protected]. You may also complete your request on-line via the Elsevier homepage (http://www.elsevier.com), by selecting ‘Customer Support’ and then ‘Obtaining Permissions’

British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN 0 7506 6715 X For information on all CIMA publications visit our website at www.cimapublishing.com

Important Note A new edition of the CIMA Ofﬁcial Terminology is due to be published in September 2005. As this is past the publication date of this Study System the page reference numbers for ‘Management Accounting Ofﬁcial Terminology’ contained in this Study System are for the 2000 edition. You should ensure that you are familiar with the 2005 CIMA Ofﬁcial Terminology (ISBN 0 7506 6827 X) once published, available from www.cimapublishing.com Typeset by Newgen Imaging Systems (P) Ltd, Chennai, India Printed in Great Britain

Contents

The CIMA Study System Acknowledgements How to use your CIMA Study System Study technique Management Accounting – Financial Strategy Syllabus Transitional arrangements

1 Formulation of Financial Strategy 1.1 Introduction 1.2 Objectives of proﬁt-making entities 1.2.1 Financial objectives 1.2.2 Non-ﬁnancial objectives 1.2.3 Agency theory 1.2.4 Shareholder value analysis 1.3 Objectives of not-for-proﬁt organisations 1.3.1 The three ‘E’s 1.4 Public and private – similarities and differences 1.5 Assessing attainment of ﬁnancial objectives 1.5.1 Financial performance indicators 1.5.2 Non-ﬁnancial performance indicators 1.6 The three key decisions of ﬁnancial management 1.6.1 Investment decisions 1.6.2 Financing decisions 1.6.3 Dividend decisions 1.7 Policies for distribution of earnings 1.7.1 Practical dividend policies 1.7.2 Theory of dividend irrelevance 1.7.3 Scrip dividends 1.7.4 Share repurchases 1.8 The impact of internal and external constraints on ﬁnancial strategy 1.8.1 Internal constraints 1.8.2 External constraints 1.9 Developing ﬁnancial strategy in the context of regulatory requirements 1.9.1 Corporate Governance and the Cadbury Report 1.9.2 The Greenbury Report 1.9.3 The Hampel Report 1.9.4 Regulatory bodies 1.9.5 The regulation of takeovers and the competition commission iii

xi xi xi xiii xiv xix 1 1 1 2 3 3 4 5 7 8 10 10 11 12 12 12 13 13 14 16 18 18 19 19 20 20 20 21 22 22 24 2005.1

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1.10 Major economic inﬂuences 1.10.1 Interest rates 1.10.2 Term structure of interest rates 1.10.3 Inﬂation 1.10.4 Exchange rates 1.11 Modelling and forecasting cash ﬂows and ﬁnancial statements 1.11.1 Forecasting cash ﬂows 1.11.2 Forecasting ﬁnancial statements 1.11.3 Sensitivity analysis 1.12 Current and emerging issues in ﬁnancial reporting 1.12.1 IFRS 1 ﬁrst time adoption of IFRS 1.12.2 IFRS 2 Share-based payment 1.12.3 Reporting environmental issues 1.12.4 Reporting of social issues 1.12.5 Inclusion of forecasts in the annual report 1.12.6 Reporting of human capital 1.13 Summary Readings

45

Revision Questions

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Solutions to Revision Questions

53

2 Financial Management 2.1 Introduction 2.2 The ﬁnance function 2.2.1 Evaluating key success factors in the management of the ﬁnance function 2.3 The treasury function 2.3.1 The role of the treasury function 2.3.2 Cost centre or proﬁt centre 2.4 Financial markets 2.4.1 Money market 2.4.2 Capital or securities market 2.4.3 The foreign exchange market 2.4.4 Derivatives markets 2.5 Share price volatility 2.5.1 Technical analysis or chartism 2.5.2 Fundamental analysis 2.5.3 Random Walk Theory 2.6 The efﬁcient market hypothesis 2.6.1 Weak form 2.6.2 Semi-strong form 2.6.3 Strong form 2.6.4 Implications of EMH for ﬁnancial managers 2.7 Investor ratios 2.7.1 Market price per share 2.7.2 Earnings per share 2005.1

26 26 27 30 30 31 31 32 35 36 36 36 38 40 42 42 43

59 59 59 60 60 61 61 62 62 63 64 64 64 65 65 65 65 66 66 66 67 67 67 68

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Readings Revision Questions Solutions to Revision Questions

3 Sources of Long-term Finance 3.1 Introduction 3.2 Shareholders’ funds 3.2.1 Ordinary shares 3.2.2 Preferred and deferred ordinary shares 3.2.3 Preference shares 3.2.4 Reserves 3.3 Raising share capital – the stock market 3.3.1 New issues 3.3.2 Rights issues 3.3.3 Share splits and bonus issues 3.4 Debt ﬁnance 3.4.1 Debentures 3.4.2 Debt yields 3.4.3 Convertibles 3.4.4 Warrants 3.5 Medium-term ﬁnancing 3.5.1 Term loans 3.5.2 Mezzanine ﬁnance 3.5.3 The lender’s assessment of creditworthiness 3.5.4 Leasing 3.5.5 Lease-or-buy decisions 3.6 Financing of small businesses 3.6.1 Venture capital 3.6.2 Business ‘angels’ 3.6.3 Government assistance 3.7 Summary Readings Revision Questions Solutions to Revision Questions

68 69 69 69 70 71 71 72 72 74 74 75 77 79 85 85 85 85 86 87 87 87 88 89 94 95 95 96 98 99 100 100 100 101 101 104 108 109 110 110 111 113 117 123 2005.1

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2.7.3 The price/earnings ratio 2.7.4 Earnings yield 2.7.5 Dividend-payout rate 2.7.6 Dividend yield 2.7.7 Dividend cover 2.7.8 Book value per share 2.8 Working capital management strategies 2.8.1 The investment decision 2.8.2 The ﬁnancing decision 2.8.3 Multinational working capital management 2.9 Summary

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4 Capital Structure and Cost of Capital 4.1 Introduction 4.2 Measuring gearing 4.2.1 Capital gearing 4.2.2 Interest cover 4.2.3 Leverage 4.3 Cost of capital 4.3.1 Cost of equity 4.3.2 Cost of debt 4.3.3 Cost of preference shares 4.4 Weighted average cost of capital 4.4.1 Assumptions in the use of WACC 4.5 Marginal cost of capital 4.6 The traditional theory of gearing 4.7 Modigliani and Miller’s theories of gearing 4.7.1 Limitations of MM theory 4.8 Cost of capital and adjusted cost of capital 4.8.1 Adjusted present value 4.8.2 Adjusted cost of capital – Modigliani and Miller 4.9 Risk and reward 4.10 Portfolio theory 4.10.1 Systematic risk and unsystematic risk 4.11 The capital asset pricing model 4.11.1 Measuring beta values 4.11.2 The security market line 4.12 Using the CAPM as an investment tool 4.13 MM, CAPM and geared betas 4.13.1 Ungearing beta 4.13.2 Geared equity beta 4.14 Use of CAPM in investment appraisal 4.14.1 Limitations of CAP-M 4.15 Arbitrage pricing model 4.16 Summary Readings Revision Questions Solutions to Revision Questions

5 Business Valuations 5.1 Introduction 5.2. Asset-based valuations 5.2.1 Choice of valuation base 5.2.2 Merits of asset-based valuations 5.3 Earnings-based valuations 5.3.1 P/E ratio valuation 5.3.2 Earnings yield valuation

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Readings Revision Questions Solutions to Revision Questions

6 Mergers, Acquisitions and Buyouts 6.1 Introduction 6.2 Terminology and types of merger 6.2.1 Terminology 6.2.2 Types of merger 6.3 The reasons for merger or acquisition 6.4 Defences against takeover 6.4.1 Before the bid 6.4.2 After the bid 6.5 Methods of payment for an acquisition 6.5.1 Cash 6.5.2 Share exchange 6.5.3 Other types of ﬁnance 6.5.4 Earn-out arrangements 6.6 The post-merger or post-acquisition integration process 6.6.1 Impact on ratios or performance measures 6.6.2 Acquirer’s post-acquisition share price 6.6.3 Example of share valuation, its effects and reasons for acquisition 6.7 Reasons why mergers and acquisitions fail

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5.4 Dividend-based valuations 5.4.1 Dividend yield 5.4.2 Dividend growth model 5.4.3. Problems of dividend-based valuations 5.4.4 Capital asset pricing model 5.5 Cash-based valuations 5.5.1 Discounted cash ﬂow 5.5.2 Shareholder value analysis 5.6 Business valuations and efﬁcient markets 5.7 Intellectual capital 5.7.1 Forms of intellectual capital 5.7.2 The components of intellectual capital 5.7.3 Valuing intellectual capital 5.7.4 Comparative indicators 5.8 The impact of changing capital structure 5.9 Recognition of the interests of different stakeholder groups in company valuations 5.9.1 Liquidation 5.9.2 Re-ﬁnancing 5.9.3 Mergers and acquisitions 5.10 Summary References

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6.8 Management buyouts 6.8.1 Financing MBOs 6.8.2 Evaluation by investors and ﬁnanciers 6.9 Reconstruction 6.9.1 Effect on the share price of a listed company 6.10 Summary Readings Revision Questions Solutions to Revision Questions

7 Investment Appraisal Techniques 7.1 Introduction 7.2 Accounting rate of return 7.3 Payback 7.3.1 Discounted payback 7.4 Discounting techniques 7.4.1 Net present value 7.4.2 Internal rate of return 7.4.3 Modiﬁed internal rate of return 7.4.4 Discussion of techniques 7.5 Capital rationing 7.5.1 Single-period capital rationing 7.5.2 Single-period rationing with mutually exclusive projects 7.5.3 Single-period rationing with indivisible projects 7.6 Annual equivalent cost 7.6.1 Asset replacement cycles 7.7 Summary Revision Questions Solutions to Revision Questions

8 Advanced Investment Appraisal Techniques 8.1 Introduction 8.2 Taxation 8.2.1 Depreciation and capital allowances 8.3 Inﬂation 8.4 Working capital 8.5 Identiﬁcation of a project’s relevant costs and beneﬁts 8.6 Linking investment in IS/IT with strategic, operational and control needs 8.6.1 Beneﬁts of a formal strategy 8.6.2 IS, IT and IM strategy 8.6.3 Content of information systems strategy 8.6.4 Cost–beneﬁt analysis 8.6.5 Evaluating system performance 2005.1

249 249 250 251 252 252 253 257 265 275 275 276 278 279 279 279 280 283 284 285 286 287 288 288 290 291 293 297

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Readings Revision Questions Solutions to Revision Questions

9 Financing and Appraisal of Overseas Operations 9.1 9.2 9.3 9.4

9.5 9.6 9.7 9.8

Introduction Financing overseas operations – a global strategy The effect of restrictions on remittances The Euromarkets 9.4.1 Eurocurrency markets 9.4.2 Eurobonds The effect of taxation 9.5.1 Double taxation relief International capital budgeting APV method Summary Revision Questions Solutions to Revision Questions

Preparing for the Examination Revision technique Planning Getting down to work Tips for the ﬁnal revision phase

316 316 319 320 320 321 321 322 324 326 326 329 330 330 330 330 332 332 333 334 334 337 343 349

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8.7 Adjusting for risk 8.7.1 Sensitivity analysis 8.7.2 Decision trees 8.7.3 Certainty equivalents 8.7.4 The discount rate 8.7.5 Adjusted discount rate 8.7.6 Capital asset pricing model 8.8 Evaluating and reporting investment opportunities 8.9 Adjusted present value 8.10 Assessing investments as options on future cash ﬂows 8.10.1 The abandonment option 8.10.2 Timing options 8.10.3 Strategic investment options 8.10.4 Valuing options 8.11 Project implementation and control 8.11.1 The investment cycle 8.11.2 Post-completion auditing 8.11.3 Beneﬁts of post-completion auditing 8.11.4 Organisation of PCA 8.11.5 Role of post-appraisal in project abandonment 8.12 Summary

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Format of the examination Structure of the paper Types of question Allocation of time Weighting of subjects

Case-study Questions Solutions to Case-study Questions Scenario Questions Solutions to Scenario Questions

Index

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The CIMA Study System

Acknowledgements Every effort has been made to contact the holders of copyright material, but if any here have been inadvertently overlooked the publishers will be pleased to make the necessary arrangements at the ﬁrst opportunity.

How to use your CIMA Study System This Management Accounting – Financial Strategy Study System has been devised as a resource for students attempting to pass their CIMA exams, and provides: ● ● ● ●

A detailed explanation of all syllabus areas; extensive ‘practical’ materials, including readings from relevant journals; generous question practice, together with full solutions an exam preparation section, complete with exam standard questions and solutions

This Study System has been designed with the needs of home-study and distancelearning candidates in mind. Such students require very full coverage of the syllabus topics, and also the facility to undertake extensive question practice. However, the Study System is also ideal for fully taught courses. The main body of the text is divided into a number of chapters, each of which is organised on the following pattern: ●

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Detailed learning outcomes. expected after your studies of the chapter are complete. You should assimilate these before beginning detailed work on the chapter, so that you can appreciate where your studies are leading. Step-by-step topic coverage. This is the heart of each chapter, containing detailed explanatory text supported where appropriate by worked examples and exercises. You should work carefully through this section, ensuring that you understand the material being explained and can tackle the examples and exercises successfully. Remember that in many cases knowledge is cumulative: if you fail to digest earlier material thoroughly, you may struggle to understand later chapters. Readings and activities. Some chapters are illustrated by more practical elements, such as relevant journal articles or other readings, together with comments and questions designed to stimulate discussion. xi

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Question practice. The test of how well you have learned the material is your ability to tackle exam-standard questions. Make a serious attempt at producing your own answers, but at this stage do not be too concerned about attempting the questions in exam conditions. In particular, it is more important to absorb the material thoroughly by completing a full solution than to observe the time limits that would apply in the actual exam. Solutions. Avoid the temptation merely to ‘audit’ the solutions provided. It is an illusion to think that this provides the same beneﬁts as you would gain from a serious attempt of your own. However, if you are struggling to get started on a question you should read the introductory guidance provided at the beginning of the solution, and then make your own attempt before referring back to the full solution.

Having worked through the chapters you are ready to begin your ﬁnal preparations for the examination. The ﬁnal section of this CIMA Study System provides you with the guidance you need. It includes the following features: ● ●

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A brief guide to revision technique. A note on the format of the examination. You should know what to expect when you tackle the real exam, and in particular the number of questions to attempt, which questions are compulsory and which optional, and so on. Guidance on how to tackle the examination itself. A table mapping revision questions to the syllabus learning outcomes allowing you to quickly identify questions by subject area. Revision questions. These are of exam standard and should be tackled in exam conditions, especially as regards the time allocation. Solutions to the revision questions. As before, these indicate the length and the quality of solution that would be expected of a well-prepared candidate.

If you work conscientiously through this CIMA Study System according to the guidelines above you will be giving yourself an excellent chance of exam success. Good luck with your studies!

Guide to the Icons used within this Text Key term or deﬁnition Equation to learn Exam tip to topic likely to appear in the exam Exercise Question Solution Comment or Note 2005.1

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Passing exams is partly a matter of intellectual ability, but however accomplished you are in that respect you can improve your chances signiﬁcantly by the use of appropriate study and revision techniques. In this section, we brieﬂy outline some tips for effective study during the earlier stages of your approach to the exam. Later in the text we mention some techniques that you will ﬁnd useful at the revision stage.

Planning To begin with, formal planning is essential to get the best return from the time you spend studying. Estimate how much time in total you are going to need for each subject that you face. Remember that you need to allow time for revision as well as for initial study of the material. The amount of notional study time for any subject is the minimum estimated time that students will need to achieve the speciﬁed learning outcomes set out earlier in this chapter. This time includes all appropriate learning activities, for example, face-to-face tuition, private study, directed home study, learning in the workplace, revision time, etc. You may ﬁnd it helpful to read Better exam results by Sam Malone, CIMA Publishing, ISBN: 075066357X. This book will provide you with proven study techniques. Chapter by chapter it covers the building blocks of successful learning and examination techniques. The notional study time for Strategic level Financial Strategy is 200 hours. Note that the standard amount of notional learning hours attributed to one full-time academic year of approximately 30 weeks is 1,200 hours. By way of example, the notional study time might be made up as follows: Hours Face-to-face study: up to Personal study: up to ‘Other’ study – e.g. learning in the workplace, revision, etc.: up to

60 100 1140 200

Note that all study and learning-time recommendations should be used only as a guideline and are intended as minimum amounts. The amount of time recommended for face-to-face tuition, personal study and/or additional learning will vary according to the type of course undertaken, prior learning of the student, and the pace at which different students learn. Now split your total time requirement over the weeks between now and the assessment. This will give you an idea of how much time you need to devote to study each week. Remember to allow for holidays or other periods during which you will not be able to study (e.g. because of seasonal workloads). With your study material before you, decide which chapters you are going to study in each week, and which weeks you will devote to revision and ﬁnal question practice. Prepare a written schedule summarising the above – and stick to it! The amount of space allocated to a topic in the study material is not a very good guide as to how long it will take you. For example, ‘Summarising and Analysing Data’ has a weight of 25 per cent in the syllabus and this is the best guide as to how long you should spend on it. It occupies 45 per cent of the main body of the text because it includes many tables and charts. 2005.1

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Study technique

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It is essential to know your syllabus. As your course progresses you will become more familiar with how long it takes to cover topics in sufﬁcient depth. Your timetable may need to be adapted to allocate enough time for the whole syllabus.

Tips for effective studying 1. Aim to ﬁnd a quiet and undisturbed location for your study, and plan as far as possible to use the same period of time each day. Getting into a routine helps to avoid wasting time. Make sure that you have all the materials you need before you begin so as to minimise interruptions. 2. Store all your materials in one place, so that you do not waste time searching for items around the house. If you have to pack everything away after each study period, keep them in a box, or even a suitcase, which will not be disturbed until the next time. 3. Limit distractions. To make the most effective use of your study periods you should be able to apply total concentration, so turn off the TV, set your phones to message mode, and put up your ‘do not disturb’ sign. 4. Your timetable will tell you which topic to study. However, before diving in and becoming engrossed in the ﬁner points, make sure you have an overall picture of all the areas that need to be covered by the end of that session. After an hour, allow yourself a short break and move away from your books. With experience, you will learn to assess the pace you need to work at. You should also allow enough time to read relevant articles from newspapers and journals, which will supplement your knowledge and demonstrate a wider perspective. 5. Work carefully through a chapter, making notes as you go. When you have covered a suitable amount of material, vary the pattern by attempting a practice question. Preparing an answer plan is a good habit to get into, while you are both studying and revising, and also in the examination room. It helps to impose a structure on your solutions, and avoids rambling. When you have ﬁnished your attempt, make notes of any mistakes you made, or any areas that you failed to cover or covered only skimpily. 6. Make notes as you study, and discover the techniques that work best for you. Your notes may be in the form of lists, bullet points, diagrams, summaries, ‘mind maps’, or the written word, but remember that you will need to refer back to them at a later date, so they must be intelligible. If you are on a taught course, make sure you highlight any issues you would like to follow up with your lecturer. 7. Organise your paperwork. There are now numerous paper storage systems available to ensure that all your notes, calculations and articles can be effectively ﬁled and easily retrieved later.

Management Accounting – Financial Strategy Syllabus To be ﬁrst examined in May 2005

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Syllabus outline The syllabus comprises: Topic A Formulation of Financial Strategy B Financial Management C Business Valuations and Acquisitions D Investment Decisions and Project Control

Study Weighting 20% 30% 25% 25%

Learning aims Students should be able to: ● ● ●

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understand and apply contemporary thinking on strategic ﬁnancial management, understand and utilise appropriate tools for strategic ﬁnancial management, evaluate strategic ﬁnancial management options in light of the needs of management and the policy of the enterprise, characterise and describe the enterprise’s ﬁnancial strategy and use that characterisation to develop optimal ﬁnancial strategy for all stages of the life-cycle, and assess and evaluate proposed strategies.

Assessment strategy There will be a written examination paper of three hours, with the following sections. Section A – 50 marks A maximum of four compulsory questions, totalling 50 marks, all relating to a single scenario. Section B – 50 marks Two questions, from a choice of four, each worth 25 marks. Short scenarios will be given, to which some or all questions relate.

Learning outcomes and syllabus content A – Formulation of ﬁnancial strategy – 20% Learning outcomes On completion of their studies students should be able to: (i) identify an organisation’s objectives in ﬁnancial terms and evaluate their attainment; (ii) discuss the interrelationships between decisions concerning investment, ﬁnancing and dividends; (iii) identify and analyse the impact of internal and external constraints on ﬁnancial strategy (e.g. funding, regulatory bodies, investor relations, strategy, and economic factors); (iv) evaluate current performance, taking account of potential variations in economic and business factors; (v) recommend alternative ﬁnancial strategies for an organisation. Syllabus content ● The ﬁnancial and non-ﬁnancial objectives of different organisations (e.g. value for money, maximising shareholder wealth, providing a surplus). 2005.1

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The three key decisions of ﬁnancial management (by which we mean investment, ﬁnancing, dividend) and their links. Beneﬁts of matching characteristics of investment and ﬁnancing, for example, in crossborder investment. Identifying the ﬁnancial objectives of an organisation and the economic forces affecting its ﬁnancial plans, for example, interest, inﬂation and exchange rates. Assessing attainment of ﬁnancial objectives. Developing ﬁnancial strategy in the context of regulatory requirements (e.g. price and service controls exercised by industry regulators) and international operations. Modelling and forecasting cash ﬂows and ﬁnancial statements based on expected values for economic variables (e.g. interest rates) and business variables (e.g. volume and margins) over a number of years. Analysis of sensitivity to changes in expected values in the above models and forecasts. Identifying ﬁnancing requirements ( both in respect of domestic and international operations) and the impacts of different types of ﬁnance on the above models and forecasts. Assessing the implications for shareholder value of alternative ﬁnancial strategies, including dividend policy. Note: Modigliani and Miller’s theory of dividend irrelevancy will be tested in broad terms. The mathematical proof of the model will not be required, but some understanding of the graphical method is expected. Current and emerging issues in ﬁnancial reporting (e.g. proposals to amend or introduce new accounting standards) and in other forms of external reporting (e.g. environmental accounting).

B – Financial management – 30% Learning outcomes On completion of their studies students should be able to: (i) identify and describe optimal strategies for the management of working capital and satisfaction of longer term ﬁnancing requirements; (ii) identify and evaluate key success factors in the management of the ﬁnance function and its relationship with other parts of the organisation and, where necessary, with external parties; (iii) discuss the role and management of the treasury function. Syllabus content ● Working capital management strategies. (Note: No detailed testing of cash and stock management models will be set since these are covered at the Managerial level.) ● Types and features of domestic and international long-term ﬁnance: share capital (ordinary and preference shares, warrants), long-term debt (bank borrowing and forms of securitised debt, e.g. convertibles) and ﬁnance leases, and methods of issuing securities. ● The lender’s assessment of creditworthiness. ● The lease or buy decision (with both operating and ﬁnance leases). ● The operation of stock exchanges (e.g. how share prices are determined, what causes share prices to rise or fall, and the efﬁcient market hypothesis). (Note: No detailed knowledge of any speciﬁc country’s stock exchange will be tested.) ● The capital asset pricing model (CAPM): calculation of the cost of equity using the dividend growth model (knowledge of methods of calculating and estimating dividend 2005.1

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C – Business valuations and acquisitions – 25% Learning outcomes On completion of their studies students should be able to: (i) calculate values of organisations of different types, for example, service, capital intensive; (ii) identify and calculate the value of intangible assets (including intellectual property); (iii) identify and evaluate the ﬁnancial and strategic implications of proposals for mergers, acquisitions, demergers and divestments; (iv) compare and recommend alternative forms of consideration for, and terms of, acquisitions; (v) calculate post-merger or post-acquisition value of companies; (vi) identify and evaluate post-merger or post-acquisition value enhancement strategies; (vii) discuss and illustrate the impact of regulation on business combinations; (viii) evaluate exit strategies. Syllabus content ● Valuation bases for assets (e.g. historic cost, replacement cost and realisable value), earnings (e.g. price/earnings multiples and earnings yield) and cash ﬂows (e.g. discounted cash ﬂow, dividend yield and the dividend growth model). ● The strengths and weaknesses of each valuation method and when each is most suitable. ● Recognition of the interests of different stakeholder groups in mergers, acquisitions and company valuations. ● Application of the efﬁcient market hypothesis to business valuations. ● Selection of an appropriate cost of capital for use in valuations. ● The impact of changing capital structure on the market value of a company. (Note: An understanding of Modigliani and Miller’s theory of gearing, with and without taxes, will be expected, but proof of their theory will not be examined.) ● Forms of intellectual property and methods of valuation. 2005.1

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growth will be expected), the ability to gear and ungear betas and comparison to the arbitrage pricing model. The ideas of diversiﬁable risk (unsystematic risk) and systematic risk. (Note: use of the two-asset portfolio formula will not be tested.) The cost of redeemable and irredeemable debt, including the tax shield on debt (numerical questions on the cost of convertible debt will not be tested). The weighted average cost of capital (WACC): calculation, interpretation and uses. Criteria for selecting sources of ﬁnance, including ﬁnance for international investments. The effect of ﬁnancing decisions on balance sheet structure and on ratios of interest to investors and other ﬁnanciers ( gearing, earnings per share, price–earnings ratio, dividend yield, dividend cover gearing, interest cover). Management of the ﬁnance function and relationships with professional advisors (accounting, tax and legal), auditors and ﬁnancial stakeholders (investors and ﬁnanciers). The role of the treasury function in terms of setting corporate objectives, liquidity management, funding management, currency management. The advantages and disadvantages of establishing treasury departments as proﬁt centres or cost centres, and their control.

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The reasons for merger or acquisitions (e.g. synergistic beneﬁts). Forms of consideration and terms for acquisitions (e.g. cash, shares, convertibles and earn-out arrangements), and their ﬁnancial effects. The post-merger or post-acquisition integration process (e.g. management transfer and merger of systems). The implications of regulation for business combinations. (Note: Detailed knowledge of the City Code and EU competition rules will not be tested.) The function/role of management buy-outs, venture capitalists. Types of exit strategy and their implications.

D – Investment decisions and project control – 25% Learning outcomes On completion of their studies students should be able to: (i) analyse relevant costs, beneﬁts and risks of an investment project; (ii) evaluate investment projects (domestic and international) taking account of potential variations in business and economic factors; (iii) recommend methods of funding investments, taking account of basic tax considerations; (iv) evaluate procedures for the implementation and control of investment projects; (v) recommend investment decisions when capital is rationed. Syllabus content Identiﬁcation of a project’s relevant costs (e.g. infrastructure, marketing and human resource development needs), beneﬁts (including incremental effects on other activities as well as direct cash ﬂows) and risks (i.e. ﬁnancial and non-ﬁnancial). ● Linking investments with customer requirements and product/service design. ● Linking investment in IS/IT with strategic, operational and control needs (particularly where risks and beneﬁts are difﬁcult to quantify). ● Calculation of a project’s net present value and internal rate of return, including techniques for dealing with cash ﬂows denominated in a foreign currency and use of the weighted average cost of capital. ● The modiﬁed internal rate of return based on a project’s ‘terminal value’ (reﬂecting an assumed reinvestment rate). ● The effects of taxation (including foreign direct and withholding taxes), potential changes in economic factors (inﬂation, interest and exchange rates) and potential restrictions on remittances on these calculations. ● Recognising risk using the certainty equivalent method (when given a risk free rate and certainty equivalent values). ● Adjusted present value. (Note: The two-step method may be tested for debt introduced permanently and debt in place for the duration of the project.) ● Capital investment real options (i.e. to make follow-on investment, abandon or wait). ● Project implementation and control in the conceptual stage, the development stage, the construction stage and initial manufacturing/operating stage. ● Post completion audit of investment projects. ● Single period for capital rationing for divisible and non-divisible projects. (Note: Multiperiod rationing will not be tested) ●

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MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY

Students who have passed the Financial Strategy paper under the Beyond 2000 syllabus will be given a credit for the Financial Strategy paper under the new 2005 syllabus. For further details of transitional arrangements, please contact CIMA directly or visit their website at www.cimaglobal.com.

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THE CIMA STUDY SYSTEM

Transitional arrangements

xix

Mathematical Tables

MANAGEMENT ACCOUNTING – PERFORMANCE EVALUATION

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xxi THE CIMA STUDY SYSTEM

THE CIMA STUDY SYSTEM

xxii

MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY P9

Formulae Valuation models (i) Irredeemable preference share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value: P0 d kpref (ii) Ordinary (Equity) share, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value: P0 d ke (iii) Ordinary (Equity) share, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P0 is the ex-div value: P0

d1 ke g

or

P0

d0[1 g] ke g

(iv) Irredeemable (Undated) debt, paying annual after tax interest, i(1 t), in perpetuity, where P0 is the ex-interest value: i[1 t] kd net or, without tax: P0

P0 i kd (v) Total value of the geared ﬁrm, Vg with taxes (based on MM): Vg Vu TB where TB is the value of tax shield. (vi) Future value of S, of a sum X, invested for n periods, compounded at r % interest: S X[1 r ] n (vii) Present value of £1 payable or receivable in n years, discounted at r % per annum: PV

1 [1 r ]n

(viii) Present value of an annuity of £1 per annum, receivable or payable for n years, commencing in one year, discounted at r % per annum:

冤

冥

1 PV 1r 1 [1 r ]n

(ix) Present value of £1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r % per annum: PV 1r

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1 PV r g

Cost of capital (i) Cost of irredeemable preference capital, paying an annual dividend d in perpetuity, and having a current ex-div price P0: kpref d P0 (ii) Cost of irredeemable debt capital, paying annual net interest i(1 t ), and having a current ex-interest price P0: i[1 t] Kd net P0 (iii) Cost of ordinary (Equity) share capital, paying an annual dividend d in perpetuity, and having a current ex div price P0: ke d P0 (iv) Cost of ordinary ( Equity) share capital, having a current ex div price, P0, having just paid a dividend, d0, with the dividend growing in perpetuity by a constant g % per annum: d0[1 g] d ke 1 g or ke g P0 P0 (v) Cost of ordinary (Equity) share capital, using the CAPM: ke Rf [Rm Rf ]␤ (vi) Cost of ordinary (Equity) share capital in a geared ﬁrm, (No tax): V keg k0 [k0 kd] D VE (vii) Cost ordinary (Equity) share capital in a geared ﬁrm, (With tax) VD[1 t] VE (viii) Weighted average cost of capital, k0: keg keu [keu kd]

k0 keg

冤V V V 冥 k 冤V V V 冥 E

E

D

d

D

E

D

(ix) Adjusted cost of capital (MM formula) kadj keu[1 tL]

or r* r[1 T *L]

In the following formulae to calculate Beta, ␤u is used for an ungeared ␤, and ␤g is used for a geared ␤: (x) ␤u from ␤g , taking ␤d as zero, (No tax): ␤u ␤g

冤V V V 冥 E

E

D

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THE CIMA STUDY SYSTEM

(x) Present value of £1 per annum, receivable or payable, commencing in one year, growing in perpetuity at a constant rate of g% per annum, discounted at r % per annum:

xxiii

THE CIMA STUDY SYSTEM

xxiv

MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY P9

(xi) ␤u from ␤g, taking ␤d as zero, ( With tax):

冤V

␤u ␤g

冥

VE V E D[1 t]

Other formulae (i) Interest Rate Parity (International Fisher Effect) For indirect quotes Forward rate US$ £ Spot US$ £ 1 nominal US interest rate 1 nominal UK interest rate (ii) Purchasing Power Parity (Law of one price)

Forward rate US$ £ Spot US$ £ 1 US inflation rate 1 UK inflation rate (iii) Link between nominal (money) and real interest rates

[1 nominal (money) rate] [1 real interest rate][1 inﬂation rate] (iv) Equivalent annual cost Equivalent annual cost

PV of costs over n years n year annuity factor

(v) Theoretical ex-rights price TERP

1 [(N rights on price) Issue price] N1

(vi) Value of a right Rights on price Issue price N1 Theoretical ex rights price Issue price or N Value of a right

where N number of rights required to buy one share.

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1

LEARNING OUTCOMES After completing this chapter you should be able to: 䉴

identify an organisation’s objectives in ﬁnancial terms and evaluate their attainment;

䉴

discuss the interrelationships between decisions concerning investment, ﬁnancing and dividends;

䉴

identify and analyse the impact of internal and external constraints on ﬁnancial strategy;

䉴

evaluate current performance, taking account of potential variations in economic and business factors;

䉴

recommend alternative ﬁnancial strategies for an organisation;

䉴

discuss and illustrate the impact of regulation on business combinations.

1.1 Introduction In this chapter we identify the ﬁnancial and non-ﬁnancial objectives of different organisations; the three key decisions of ﬁnancial management and their links; economic forces affecting ﬁnancial plans; regulatory requirements; modelling and forecasting of cash ﬂows and ﬁnancial statements; dividend policy, and current and emergency issues in ﬁnancial reporting.

1.2 Objectives of proﬁt-making entities Strategy: A course of action, including the speciﬁcation of resources required, to achieve a speciﬁc objective. (Management Accounting: Ofﬁcial Terminology, 2000) Financial strategy is the aspect of strategy which falls within the scope of ﬁnancial management, which will include decisions on investment, ﬁnancing and dividends. 1

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Strategic ﬁnancial management: The identiﬁcation of the possible strategies capable of maximising an organisation’s net present value, the allocation of scarce capital resources among the competing opportunities and the implementation and monitoring of the chosen strategy so as to achieve stated objectives. (Ofﬁcial Terminology, 2000) The deﬁnitions above both indicate that strategy depends on objectives. For a proﬁtmaking entity the main strategic objective is to optimise the wealth of the proprietors, which means achieving the maximum proﬁt possible consistent with balancing the needs of the various stakeholders in the entity, including shareholders, fund lenders, customers, suppliers, employees and government (in terms of taxation and legal constraints on operations). The health of the entity also depends on a proper balance being achieved between long-term projects and short-term opportunities, a major constraint against the latter being that they must not be taken where there is a signiﬁcant risk that they will damage long-term viability. If all these factors can be effectively balanced the result should be the achievement of the overriding strategic ﬁnancial management objective of maximising shareholder value.

1.2.1 Financial objectives For a proﬁt-making entity the main strategic objective is to optimise the wealth of the proprietors. In other words, the objective is assumed to be to maximise shareholder wealth. In practice, this may be interpreted as achieving the maximum proﬁt possible consistent with balancing the needs of the various stakeholders in the entity. Stakeholders Stakeholders: Groups or individuals having a legitimate interest in the activities of an organisation, generally comprising customers, employees, the community, shareholders, suppliers and lenders. The various stakeholder groups may have different interests in the activities of an organisation: ● ● ● ● ●

●

Shareholders – maximisation of wealth from their investment. Fund lenders – receipt of interest and capital repayments by the due date. Customers – a continuous trading relationship with suppliers. Suppliers – to ensure that they are paid in full by the due date. Employees – to maximise rewards paid to them in salaries and beneﬁts, and continuity of employment. Government – may have the broad objectives of sustained economic growth and maintaining levels of employment.

Economists, and many accountants, believe that cash ﬂow is the main criterion to judge a company’s performance. Cash is a fact, whereas proﬁt can be manipulated by accounting policies. Companies have in fact gone out of business because of a back of funds, even though they were proﬁtable. In reality, shareholder wealth is based on the present value of future cash ﬂows. Managers in practice may have broader objectives – perhaps undertaking any ﬁnancing, investment, or dividend decision that will achieve satisfactory returns rather than those that 2005.1

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may optimise returns. Alternatively, objectives may be more related to achievement of a level of: sales, earnings per share, dividend per share, or survival. Shareholder wealth may be measured by the return that shareholders receive from their investment, represented partly by the dividend received each year and partly by the capital gain from the increase in the value of the shares over that period.

FORMULATION OF FINANCIAL STRATEGY

1.2.2 Non-ﬁnancial objectives A company may also have a number of important non-ﬁnancial objectives, which may be related to: ● ● ● ●

customer satisfaction; welfare of employees; welfare of management; the environment.

For example, in its annual report for 2004, J. Sainsbury plc, stated the following objectives which recognised in some detail the interests of other stakeholders. Our objective is to meet our customers’ needs effectively and thereby provide shareholders with good, sustainable ﬁnancial returns. We aim to ensure all colleagues have opportunities to develop their abilities and are well rewarded for their contribution to the success of their business. Our policy is to work with all of our supplies fairly, recognising the mutual beneﬁt of satisfying customers’ needs. We also aim to fulﬁl our responsibilities to the communities and environments in which we operate. Contrast this with the all-embracing objective of International Power plc in its annual report for 2002: Our objective is to enhance shareholder values through the viable growth of our business in a socially responsible manner.

The general thrust of this objective features in various sections of the company’s annual report but it is not quantiﬁed and it might be useful to consider how its achievement might be measured. In both the examples given above, the lack of quantiﬁcation of the objectives would make it difﬁcult for shareholders to challenge their achievement in an Annual General Meeting.

1.2.3 Agency theory A possible conﬂict can arise when ownership is separated from the day-to-day management of an organisation. In larger companies, the ordinary shares are likely to be diversely held, and so the actions of shareholders are likely to be restricted in practical terms. The responsibility of running the company will be with the board of directors, who may only own a small percentage of the shares in issue. The managers of an organisation are essentially agents for the shareholders, being tasked with running the organisation in the shareholders’ best interests. The shareholders, however, have little opportunity to assess whether the managers are acting in the shareholders’ best interests. Agency theory: Hypothesis that attempts to explain elements of organisational behaviour through an understanding of the relationships between principals (such as 2005.1

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shareholders) and agents (such as company managers and accountants). A conﬂict may exist between the actions undertaken by agents in furtherance of their own self-interest, and those required to promote the interests of the principals. (Ofﬁcial Terminology, 2000) Investor relations Where ownership is separated from the day-to-day management of an organisation, managers may be motivated to behave in ways that are not optimal to the shareholders of the organisation: ●

●

●

Shareholders can spread their risk by unresting in a number of companies. Managers have personal and ﬁnancial capital invested in the company and so may be averase to investing in a risky investment. Shareholders wealth will be maximised by investing in projects with positive net present values. Managers may be more interested in short-term payback than net present value as the investment criterion, in order to help further their own promotion prospects. Managers of companies that are subject to a takeover bid often put up a defence to repel the predator. While arguing this action is in the shareholders best interests, Shareholders of acquired companies often receive large gains in the value of their shares. The managers of the acquired company often lose their jobs or status.

Goal congruence The general term covering the possible conﬂicts of interest within a company, and the various methods by which attempts are made to overcome such obstacles to goal congruence, is called agency theory. In its broadest sense the term relates to economic models which provide comparisons of information systems. Goal congruence: In a control system, the state which leads individuals or groups to take actions which are in their self-interest and also in the best interest of the entity. (Ofﬁcial Terminology, 2000) It is evident that an important element within companies is the extent to which all members of the management team and their staff work together to achieve the strategic objectives of that company. An aspect of agency theory aims to demonstrate that while various kinds of contract exist, formal and informal (such as job descriptions, departmental responsibilities and ofﬁce and factory rules), these can only be effective in helping to make a company successful if there is general acceptance of them in practice, and a concerted effort by all concerned to strive in the same direction, that is, to achieve genuine goal congruence.

1.2.4 Shareholder value analysis Traditionally, managers of limited liability companies have used ﬁnancial measures such as proﬁt margin and return on assets to assess progress, and have used discounted cash-ﬂow measures to assess the viability of projects or investments. Shareholder value analysis (SVA) is used to bring these three measurement systems into line, and starts from the view that the main objective of the directors of a company is to maximise the wealth of the shareholders. Coca-Cola, Monsanto, Unilever and Tate and Lyle have all used SVA to measure ﬁnancial performance. 2005.1

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An assumption of SVA is that the value of a business is the net present value of future cash ﬂows, discounted at an appropriate cost of capital. Financing and investment decisions should be evaluated on their ability to maximise value for the shareholders. The inference is that the decision made will be reﬂected in the share price. Seven key value drivers have been identiﬁed that have the greatest impact on share price:

FORMULATION OF FINANCIAL STRATEGY

● ● ● ● ● ● ●

sales growth rate (per cent); proﬁt margin (per cent); cash tax rate (per cent); working capital/sales (per cent); capital expenditure/sales (per cent); cost of capital (per cent); value growth duration period (years).

The ‘value growth duration period’ represents the future period for which the company has a foreseeable competitive advantage. SVA is used to indicate the amount of economic value created in a period. It does so by measuring and managing cash ﬂows of the business that take account of risk and the true value of money. The cash ﬂows used in SVA are the net proﬁts after tax, plus non-cash items, less any investments in working capital and ﬁxed assets. These are known as the ‘free’ cash ﬂows. Free cash ﬂow: Cash ﬂow from operations after deducting interest, tax, dividends and ongoing capital expenditure, but excluding capital expenditure associated with strategic acquisitions and/or disposals. (Ofﬁcial Terminology, 2000) A major difﬁculty is calculating those future cash ﬂows. This problem can be partly resolved by breaking the value of the business into two constituent parts, such that the value of the business equals the present value of free cash ﬂows during the normal planning horizon, plus a residual value. The residual value represents the present value of free cash ﬂows after the normal planning horizon. Nevertheless, it is still difﬁcult to establish a reliable estimate for the residual value. You will ﬁnd a comprehensive article on shareholder value analysis in the Readings section of this chapter.

1.3 Objectives of not-for-proﬁt organisations As a general rule, books on ﬁnancial management, and modern corporate ﬁnance theories, are written in the context of the proﬁt-seeking segment of the private sector. Note that the very survival of such enterprises depends on their being able to identify and satisfy needs and to offer the prospect of an adequate ﬁnancial return. Those which can hold out such a prospect are able to attract the funds necessary to grow their businesses, while those which cannot must inevitably shrink. Financial management involves not only heeding that discipline but also translating it into a criterion for the allocation of resources within the enterprise. In this context, the expression ‘an adequate return’ describes a situation in which the value of outputs (to customers or, in more upmarket situations, ‘clients’) exceeds the value of inputs of all kinds: not just bought-in goods and services and labour, but also capital. It would be easy to overlook the fact that these proﬁt-seeking enterprises (even if we include privately owned businesses as well as publicly quoted ones) represent only a minority of economic activity. The majority comprises a wide variety of enterprises which are usually 2005.1

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FORMULATION OF FINANCIAL STRATEGY

referred to as ‘not for proﬁt’. In the private sector, you might think of: ● trades unions, trade associations, employers’ organisations and federations thereof (such as the Confederation of British Industry); ● professional bodies, such as the Chartered Institute of Management Accountants; ● housing associations (currently accounting for over 4 per cent of UK housing stock, and building 50,000 units a year), friendly societies, clubs and cooperatives; ● charities; ● religious organisations, such as the Church of England. It is enlightening to ask which of the business imperatives do not apply to such organisations. Can they operate without identifying and satisfying needs? To operate, can they do without adequate investment in resources, and hence the need to attract funds? Is it conceivable that they could do so if the value of their outputs is perceived as being less than the value of inputs? The answers to all these questions must be in the negative. In a way, the expression ‘not-for-proﬁt’ is somewhat misleading: if proﬁt is the legitimate reward for the commitment of funds, why should any organisation which requires long-term funding not seek a proﬁt (albeit under a different name, for example, surplus of income over expenditure, and with an intention that it be ploughed back)? So it is with the public sector, of which central government (currently responsible for over 40 per cent of UK gross domestic product) is the most prominent example. Activities in this sector should not be insulated from the application of ﬁnancial disciplines. Would it make sense, for example, for: ● ●

the Civil Service College to use a different criterion from CIMA Mastercourses? a National Health trust hospital to use a different criterion from a private hospital?

If the rate of return sought by enterprises in the public sector were to be lower than that sought in the private sector, then the result would inevitably be that the public sector would grow (ﬁnanced by taxation or borrowing) while the private sector would shrink. In short, the criterion used in resource allocation should be the same across all sectors: the value of outputs should exceed the value of inputs. At this point, however, the distinguishing feature of the ‘not-for-proﬁt’ organisations begins to emerge. It is that their customers are not synonymous with their clients. Accountancy institutes use funds supplied by their members to develop their specialism for the beneﬁt of employers and the public. Charities and religious organisations use the cash from donors to alleviate suffering or promote a belief. The government takes money from those in employment to give it to those out of work, or from the healthy to give to the sick. All of these redistributions are noble in themselves, but they lack the direct link between consumption and price. It is a well-known economic ‘law’ that as the price of a service at the point of delivery tends towards zero, so demand for it tends towards inﬁnity. Consequently, organisations whose income comes from a source other than paying customers are frequently plagued by an excess of demand over supply. There are variations on the customer/client theme, as follows: ●

Some organisations have elaborate transfer pricing arrangements, which could allow internal customers to relate cost to value, by reference to: – benchmarks derived from prices prevailing in the market economy, for example, the Civil Service College’s charges can be compared with those of a private institution; – the prices quoted by quasi-competitive units within the organisation, as with the National Health Service.

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7

In some cases, the clients (e.g. the passengers travelling on some railway routes in Britain) will contribute towards the cost but the taxpayer meets the balance in the form of a subsidy. In other cases, the primary function is a regulatory one, and fees are charged to those being regulated, for example, Companies House.

FORMULATION OF FINANCIAL STRATEGY

●

MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY

To various degrees, however, managers in such organisations see their role in terms of rationing their limited resources. Speciﬁcally, many are uncomfortable with the concept of value, and retreat into choosing between costs. Resources are assumed to be ﬁnite, and the task is seen as trading-off within one time-frame, for example the current ﬁscal year. On a small scale, for example, a church council’s decisions could include choosing between a toilet for the disabled or paying for a missionary to go to a far-off land. On a large scale, the UK government makes a political assessment of what it can raise in taxation and borrowings, and this becomes the total that it can ‘afford’ to spend. Choices have to be made and confrontation (in this case between spending ministries: Health/Education/Defence, etc.) is inevitable. Lower down the scale, departments use the term virement (signiﬁcantly, a term which is unknown in the private sector) to refer to the need to get permission to offset an overspend on one account against an underspend in another. Managers in the public sector are well aware of the trends, but see considerable obstacles to going with the tide. The stance of national government is to seek stability through rigid planning. The problems with plans is that, in a rapidly changing environment, they are so quickly overtaken by events: ﬂexibility and adaptability are required today. The UK Treasury’s ‘cash limit’ approach to ﬁnancial management, for example, is tactical and shorttermist, and – in the absence of any countervailing strategic control – inhibits adaptation.

1.3.1 The three ‘E’s The public sector is usually credited with having drawn attention to the distinctions between: ●

●

●

economy, which is generally thought of in terms of doing things as cheaply as possible, and is therefore associated with the operational level of control; efﬁciency, which is generally thought of in terms of productivity (the ratio of output to input) and is therefore associated with the tactical level of control; effectiveness, which is generally thought of in terms of doing the right things, and is therefore associated with the strategic level of control.

The ﬁrst two are much in evidence in public-sector management-control systems. An agency such as the Civil Service College will measure the number of students, the number of courses, the ratio of lecturers to students, and so on. It will also seek its customers’ assessments of the standard of, for example, its lecturing and catering, and compare them with preset targets. In the language of strategic ﬁnancial management, these are answers to the question ‘How well did we do what we chose to do?’. You should also be aware, by now, of the dangers of concentrating on what can be measured. Note, for example, that it is possible to measure crime detection, but it is not possible to measure crime prevention; it is possible to measure the extent to which the sick are cured, but not the extent to which sickness is prevented. People can be rewarded on the basis of measurables, but it should come as no surprise if they then skimp on the immeasurables: you get what you measure. Measuring performance is but a part of monitoring progress: assessing potential and changes therein are at least as important. 2005.1

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Disturbingly, the third (and, arguably, the most important) ‘E’ – effectiveness – is the least in evidence. Where the word ‘strategy’ is used, it usually means a 3-year budget. Zero variances (and hence zero feedback) are expected. Health-service purchasers tend to talk, for example, of ‘delivering’ a strategy as though it were a result – a destination rather than the route thereto. This stems, perhaps, from the top-down style which we have seen is still the norm: top management decides what is to be done, middle management has some choice as to how it is done, the vast majority are seen as responsible for doing it. In other words, the emphasis is on tactics, in the form of leadership from behind: ‘Carry on doing what you have been doing but do it cheaper/faster/more accurately, etc.’ Partly, this is cultural, reﬂecting an antipathy towards uncertainty, risk and surprises. When publicsector investments go awry (e.g. investments in information technology not producing the expected beneﬁts) they tend to be reported in terms of wasting public money. The same outcome in the private sector might be seen as the risk inevitably associated with pushing out the boundaries.

1.4 Public and private – similarities and differences The public sector is as affected by managerial trends as the private sector. Authority has been delegated, but there is a consequent need for strategic accountability. As in a group of companies, strategy is not just something which exists within one single business, but is also concerned with the relationship between the businesses and the centre. The language of strategy in general, and ﬁnancial management in particular, is therefore necessary and is developing. Consequently, the decision-support techniques used in the private sector are largely also applicable in the public sector. Take the UK Civil Service College, for example. Given the trend towards generalism, and the reputation of the service for generalism, it might see an opportunity to mount a course for private-sector delegates. But what outlays would be involved, and would they be matched by income? The college is known to research and develop relevant management techniques: again, costs and beneﬁts need to be matched. Its report stresses that its greatest assets are ones – the knowledge and commitment of its staff – not shown on its balance sheet. It is important that such assets are recognised, cost-effectively enhanced, employed to deliver good value for taxpayers’ money, and suitably monitored. In corporate strategy terms, it is possible to quantify the cash ﬂows from the rest of the public sector to the college, obtain its net present value, and then compare with the cost of the nextbest alternative, for example, using a private-sector provider (or, possibly, to compare with the price which could be obtained on disposal). So, subject only to a willingness by those in authority to quantify their judgements, ﬁnancial management is, on the whole, equally applicable to the not-for-proﬁt sector generally and the public sector in particular. It is worth stressing perhaps, that – in common with the private sector – it is never possible to say whether or not value has been maximised. We do not know what we do not know: speciﬁcally, we do not know what opportunities have been missed. This is not a problem for those familiar with devolved authority, as it is the only approach compatible with empowerment: you cannot tell an explorer what to ﬁnd, or identify what he/she has not found! Some bridge is usually required, from the known to the unknown, for example, to relate the value of a unit to the costs of its tangible assets, and

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to consider what ‘intangibles’ explain the difference. This will often act as a very good attention-directing tool, but recognise it as holding up a mirror: in reality, value is not a function of cost. The health sector provides other examples. Investments in medical equipment represent decisions to trade in purchasing power now in the expectation of beneﬁts later. These beneﬁts may take the form of increased throughput (and hence reduced waiting lists) or the meeting of needs which would otherwise go unsatisﬁed. These beneﬁts are not measurable, because it is not possible to measure something which has not yet happened; they are judgmental. But this does not mean that they are not quantiﬁable and hence capable of evaluation. The main obstacle is usually an unwillingness on the part of those in authority (e.g. politicians) to express value judgements, perhaps because they fear such judgements ‘being taken down and used in evidence against them’. For the avoidance of doubt, it is worth stressing that values are equally subjective in the private sector. No one pretends that they can measure the effectiveness of a proposed investment in advertising: they forecast the improvement after assessing the likely reactions of competitors, direct customers and ultimate consumers. The management accountant fulﬁls a vital role in being able to synthesise these judgements together with others (e.g. the volume–cost relationship and the cost of capital) to identify the optimum level of investment they imply. The forecast outcome is logged, so as to provide a benchmark by which to monitor progress. Of course, there are differing degrees of difﬁculty – discomfort, even – in making value judgements in the public sector. Currently and foreseeably, the health sector is providing many examples. Thanks to results of research in pharmaceuticals, for example, previously incurable illnesses are being dealt with, and people are living longer. Demand for drugs, etc., is correlated with age, so demand continues to increase. With a progressively smaller proportion of the population in employment, the ﬁnancial pressures are substantial. How does one make an informed choice as to the transfer of funds between the well and the unwell? What value does one put on curing an illness, or saving a life? These are societal matters, the discomfort being one of the reasons they are placed ﬁrmly in the public sector, rather than being left to the ‘survival of the ﬁttest’ philosophy associated with the competitive struggle for existence that we call the market economy. In the UK, this is being addressed by reforms characterised by the creation of the internal market. The main feature is the separation of purchasers (representing a particular geographical area) from the providers (hospitals and other healthcare facilities). The providers are competing among themselves for the purchasers’ funds, the idea being that those offering the best value for money will gain an increasing share of the available funds. In the early days, at least, various ‘rules of the game’ have been laid down, most notably (from a strategic ﬁnancial management point of view) in the area of pricing. Given that the health service is still one large (but hybrid) business, formula-based transfer pricing is to be expected. The rules are very simple: price must equal cost, and cost must equal total cost, including a target return on capital employed. Those who framed the rules seem to have been thinking in terms of there being one objectively veriﬁable cost of an activity (which is valid only when looking backwards) but prices have to be established in advance. The demand for sophisticated yet pragmatic costing systems will, consequently, be high for some considerable time to come, as providers seek costs which signal good value for money for the business they seek to attract, and poor value for those they wish to repel.

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1.5 Assessing attainment of ﬁnancial objectives Traditionally, managers have focused on ﬁnancial measures of performance and progress. Increasingly, organisations in both the private and public sectors are using non-ﬁnancial indicators to assess success across a range of criteria, which need to be chosen to help an organisation meet its objectives. We discuss a number of common ﬁnancial and non-ﬁnancial indicators below.

1.5.1 Financial performance indicators ●

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Cash generation. Poor liquidity is a greater threat to the survival of an enterprise than is poor proﬁtability. Unless the organisation is prepared to fund growth with high levels of debt, cash generation is vital to ensure investment in future proﬁtable ventures. In the private sector the alternative to cash via retained earnings is debt. In the public sector this choice has not been available in the past, and all growth has been funded by government. However, in the face of government-imposed cash limits, local authorities and other public-sector institutions are beginning to raise debt on the capital markets, and are therefore beginning to be faced with the same choices as private companies. Value added. This is primarily a measure of performance. It is usually deﬁned as sales value less the cost of purchased materials and services. It represents the value added to a company’s products by its own efforts. A problem here is comparability with other industries – or even with other companies in the same industry. It is less common in the public sector, although the situation is changing and many public-sector organisations – for example, those in the health service – are now publishing information on their own value added. Proﬁtability. Proﬁtability may be deﬁned as the rate at which proﬁts are generated. It is often expressed as proﬁt per unit of input (e.g. investment). However, proﬁtability limits an organisation’s focus to one output measure – proﬁt. It overlooks quality, and this limitation must be kept in mind when using proﬁtability as a measure of success. Proﬁtability as a measure of decision-making has been criticised because: – it fails to provide a systematic explanation as to why one business sector has more favourable prospects than another; – it does not provide enough insight into the dynamics and balance of an enterprise’s individual business units, and the balance between them; – it is remote from the actions that create value, and cannot therefore be managed directly in any but the smallest organisations; – the input to the measure may vary substantially between organisations. Nevertheless, it is a well-known and accepted measure which, once the input has been deﬁned, is readily understood. Provided the input is consistent across organisations and time periods, it also provides a useful comparative measure. Although the concept of proﬁt in its true sense is absent from most of the public sector, proﬁtability may be used to relate inputs to outputs if a different measure of output is used – for example: surplus after all costs, to capital investment. Return on assets (RoA). This is an accounting measure, calculated by dividing annual profits by the average net book value of assets. It is therefore subject to the distortions inevitable when proﬁt, rather than cash ﬂows, is used to determine performance. Distorting factors for interpretation and comparison purposes include depreciation

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1.5.2 Non-ﬁnancial performance indicators ●

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Market share. A performance indicator that could conceivably be included in the list of ﬁnancial measures, market share is often seen as an objective for a company in its own right. However, it must be judged in the context of other measures such as proﬁtability and shareholder value. Market share, unlike many other measures, can take quality into account – it must be assumed that if customers do not get the quality they want or expect then the company will lose market share. Gaining market share must be seen as a long-term goal of companies to ensure outlets for their products and services, and to minimise competition. However, market share can be acquired only within limits if a monopoly situation is to be avoided. It is a measure that is becoming increasingly relevant to the public sector – for example universities and the health service. Health providers must now ‘sell’ their services to trusts established to ‘buy’ from them. Those providers which are seen to fail their customers will lose market share as the trusts will buy from elsewhere (within certain limits). Customer satisfaction. This can be linked to market share. If customers are not satisﬁed they will take their business elsewhere and the company will lose market share and go into liquidation. Measuring customer satisfaction is difﬁcult to do formally, as the inputs and outputs are not readily deﬁned or measurable. Surveys and questionnaires may be used but these methods have known ﬂaws, mainly as a result of respondent bias. It can of course be measured indirectly by the level of sales and increase in market share. The UK Citizen’s Charter was designed to help ‘customers’ of public services gain satisfaction, and provided for redress if they do not – for example, ticket refunds for the late running of trains. Competitive position. The performance of a business must be compared with that of its competitors to establish a strategic perspective. A number of models and frameworks have been suggested by organisational theorists as to how competitive position may be determined and improved. A manager needing to make decisions must know by whom, by how much, and why he is gaining ground or being beaten by competitors. Conventional measures, such as accounting data, are useful but no one measure is sufﬁcient. Instead, an array of measures is needed to establish competitive position. The most difﬁcult problem to overcome in using competitive position as a success factor is in collecting and acquiring data from competitors. 2005.1

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policy, stock revaluations, write-off of intangibles such as goodwill, etc. A further defect is that RoA ignores the time value of money, although this may be of minor concern when inﬂation is very low. RoA may not adequately reﬂect how efﬁciently assets were utilised: in a commercial context, taking account of proﬁts but not the assets used in their making, for whatever reason, would overstate a company’s performance. In the public sector, the concept of proﬁt is absent, but it is still not unrealistic to expect organisations to use donated assets with maximum efﬁciency. If depreciation on such assets were to be charged against income, this would depress the amount of surplus income over expenditure. Other points which may affect interpretation of RoA in the public sector are: – difﬁculty in determining value; – there may be no resale value; – are for use by community at large; – charge for depreciation may have the effect of ‘double taxation’ on the taxpayer.

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The public sector is increasingly in competition with other providers of a similar service both in the private and public sectors. For example, hospitals now have to compete for the funds of health trusts. Their advantage is that it is easier to gain access to data from such competitors than it is in the private sector. Risk exposure. Risk can be measured according to ﬁnance theory. Some risks – for example, exchange-rate risk and interest-rate risk – can be managed by the use of hedging mechanisms. Shareholders and companies can therefore choose how much risk they wish to be exposed to for a given level of return. However, risk can take many forms, and the theory does not deal with risk exposure to matters such as recruitment of senior personnel or competitor activity. Public-sector organisations tend to be risk-averse because of the political repercussions of failure and the fact that taxpayers, unlike shareholders, do not have the option to invest their money in less (or more) risky ventures.

1.6 The three key decisions of ﬁnancial management The practical applications of ﬁnancial management can be grouped into three main areas of decisions – investment decisions, ﬁnancing decisions and dividend decisions – which reﬂect the responibilities of acquiring ﬁnancial resources and managing those resources.

1.6.1 Investment decisions Investment decisions are those which determine how scarce resources in terms of funds available are committed to projects, which can range from acquisition of plant to the acquisition of another entity. Investing in ﬁxed assets usually carries the need for supporting investment in working capital, for example, stocks and debtors, less creditors, an aspect often not properly taken into account by management. Investment to enhance internal growth is often called ‘internal investment’ as compared with acquisitions, which represent ‘external investment’. The other side of the investment coin is disinvestment, which means the preparedness to withdraw from unsuccessful projects, and the disposal of parts of an entity which no longer fit with the parent entity’s strategy. Such decisions usually involve one very special element – the right timing for the action to be taken. Disinvestment decisions can also be involved in reconstructions, where an entity has to alter its capital structure, possibly to survive as a result of heavy losses.

1.6.2 Financing decisions Financing decisions relate to acquiring the optimum ﬁnance to meet ﬁnancial objectives and seeing that ﬁxed and working capital are effectively managed. The ﬁnancial manager must possess a good knowledge of the sources of available funds and their respective costs, and should ensure that the entity has a sound capital structure, that is, a proper balance between equity capital and debt. Such managers also need to have a very clear understanding of the difference between proﬁt and cash ﬂow, bearing in mind that proﬁt is of little avail unless the entity is adequately supported by cash to pay for assets and sustain the working capital cycle. Financing decisions also call for a good knowledge of evaluation of risk: excessive 2005.1

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The opportunity cost of ﬁnance In making ﬁnancial decisions, the manager must always be aware of the opportunity cost aspect involved. Thus, if a company wishes to raise money by means of an issue of ordinary shares, the terms must be made attractive enough to make it worth while for the investor to forgo the opportunity cost of investing in the next-best investment project. Also if a company wishes to maintain or improve its share price, it must pay satisfactory dividends and show good long-term growth prospects, otherwise it will lose out because its investors will ﬁnd it more satisfactory to sell out and not forgo the opportunity cost of alternative equities. In setting a price for anything – whether it be for a company’s product or services, or the rate of interest to be paid for borrowings or to receive on loans, or the cost of equity capital – it is important to be fully aware of what the market requires and what the market will bear.

1.6.3 Dividend decisions Dividend decisions relate to the determination of how much and how frequently cash can be paid out of the proﬁts of an entity as income for its proprietors. The owner of any proﬁt-making organisation looks for reward for his or her investment in two ways: the growth of the capital invested and the cash paid out as income. For a sole trader this income would be termed drawings and for a limited liability company the term is dividends. The dividend decision thus has two elements: the amount to be paid out and the amount to be retained to support the growth of the entity, the latter being also a ﬁnancing decision; the level and regular growth of dividends represent a signiﬁcant factor in determining a proﬁtmaking company’s market value, that is, the value placed on its shares by the stock market. The three types of decision are interrelated, the ﬁrst two pertaining to any kind of entity, while the third relates only to proﬁt-making organisations. Thus it can be seen that ﬁnancial management is of vital importance at every level of business activity, from the sole trader to the largest multinational corporation. It is instructive to think this point through by taking the case of the sole trader. He (she) has to invest capital in a shop, ﬁttings and equipment and in the purchase of stock and sustaining debtors (working capital); he has to have sources of capital to ﬁnance his investment such as his own capital and bank borrowings; and he has to make dividend decisions to determine how much can be reasonably withdrawn from the business to ensure that it will remain sufﬁciently liquid and, if desired, capable of growth.

1.7 Policies for distribution of earnings Dividend policy is one of a company’s ﬁnancing decisions. How should a company divide its earnings between payments to shareholders and retention for future investments if the aim is to increase the market value of the ﬁrm? Using internally generated funds is often thought to be a ‘free’ form of ﬁnance. This is of course not the case, and it is important to remember that these funds do have a cost, that is, an opportunity cost, normally taken as the weighted average cost of capital. 2005.1

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debt carries high risk for an entity’s equity because of the priority rights of the lenders. A major area for risk-related decisions is in overseas trading, where an entity is vulnerable to currency ﬂuctuations, and the manager must be well aware of the various protective procedures – such as hedging – which are available.

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In deciding a company’s dividend policy the following factors should be considered: ●

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Liquidity. In order to pay dividends, a company will require access to cash. Even very proﬁtable companies might sometimes have difﬁculty paying dividends if resources are tied up in other forms of asset, especially if bank overdraft facilities are not available. Repayment of debt. Dividend payout may be made difﬁcult if debt is scheduled for repayment and this is not ﬁnanced by a further issue of funds. Restrictive covenants. The Articles of Association may contain agreed restrictions on dividends. In addition, some forms of debt may have restrictive covenants limiting the amount of dividend payments or the rate of growth which applies to them. Rate of expansion. The funds may be needed to avoid overtrading. Stability of proﬁts. Other things being equal, a company with stable proﬁts is more likely to be able to pay out a higher percentage of earnings than a company with ﬂuctuating proﬁts. Control. The use of retained earnings to ﬁnance new projects preserves the company’s ownership and control. This can be advantageous in ﬁrms where the present disposition of shareholdings is of importance. Policy of competitors. Dividend policies of competitors may inﬂuence corporate dividend policy. It may be difﬁcult, for example, to reduce a dividend for the sake of further investment, when competitors follow a policy of higher distributions. Signalling effect. This is the information content of dividends. Dividends are seen as signals from the company to the ﬁnancial markets and shareholders. Investors perceive dividend announcements as signals of future prospects for the company. This aspect of dividend policy is assuming increasing importance, and there have been numerous instances reported in the press where companies have paid an increased dividend when ﬁnancial prudence suggests that they should be paying no dividend at all.

Having taken into account the above factors, companies will formulate standard dividend policies, three of which are discussed below.

1.7.1 Practical dividend policies Constant payout ratio There are important links between dividends and proﬁts. In company law, for instance, the prohibition of paying dividends other than out of proﬁts is seen as an important protection for creditors (including lenders, who may well specify a maximum proportion of proﬁts which can be declared as dividends while their loans remain in force). This is reinforced by the accounting concept which deﬁnes proﬁt as what you could afford to distribute, and still be as well off as you were. Such links encourage a backward-looking approach to dividend policy, with some boards of directors publishing an objective to maintain a certain dividend cover, that is, to declare dividends which represent a constant percentage of proﬁts after tax. In a stable state, one would expect some symmetry in the ﬁgures, for example, a company whose proﬁts after tax represented a 10 per cent per annum return might choose to plough half back into the business, and look forward to a 5 per cent per annum growth in its proﬁts (and earnings per share) and hence dividends. This forms the basis of the idea that the value of a company is a multiple of its past proﬁts. The reality, however, is not one of a stable state. One very speciﬁc shock to the system has been the instability of the unit of measure (money). Should dividends be related to the proﬁts calculated under the historical cost convention, or after making an adjustment to exclude the inﬂationary element? Ought they to be 2005.1

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Stable policy – signalling Some boards of directors think not in terms of maintaining dividend cover, but in terms of maintaining a trend in the absolute level of payout. Their starting point for deciding this year’s dividend is what was paid last year, what rate of increase it represented on the previous year, and whether they feel that this rate can be repeated, taking into account considerations of liquidity. Rightly or wrongly, the dividend decision is seen as a powerful signal to the market of the directors’ conﬁdence in the future of the enterprise, and this does appear to be supported by evidence that unexpected dividend cuts have been followed by a reduction in share prices. The danger, of course, is that this can become a game, in which directors seek to give the signal they think will have the most favourable effect on the share price. Some even argue that the aim must not be to surprise the market, which leads to the suggestion that the dividend should be what the analysts are predicting. In pure economic terms, companies should pay zero dividends when they have sufﬁcient positive net present value projects to utilise all their after tax proﬁts and pay out 100 per cent of after tax proﬁts when they have no such investment possibilities. Whatever the theoretical rationale, boards – in the UK at least – would not countenance such potentially huge variation in dividends payouts that such a policy would imply. In the UK, the practice of maintaining a particular rate (sometimes real, sometimes nominal) of growth of dividends has been very popular, and seemed to work well as long as things were stable, cyclical or at least predictable. As the rate of change has speeded up, however, its limitations have become more obvious and more serious. In particular, the unexpectedly severe downturn in the UK in the early 1990s presented boards with a dilemma: given sharply reduced proﬁts, what should be preserved – dividend growth or dividend cover? Some fund managers made it clear that they preferred dividends to retentions. Some boards responded, to the point of declaring dividends in excess of their proﬁts after tax. One chairman talked about the need to ‘reward shareholders for their loyalty’. As a general rule, however, ﬁnancial journalists took the opposite view, based on their perception of dividends as just another outlay, like wages or advertising or plant and machinery. Companies in ﬁnancial difﬁculties, they argued, should cut dividends and increase investment. Such comments give the impression that their authors mistakenly see ﬁnancial management as being about trade-offs within one time-frame (i.e. the short term). The reality is that it is about trade-offs between different time-frame. Residual dividend policy Strategic ﬁnancial management does focus on the creation of value and, as we have seen, is principally concerned with forecast cash ﬂows. The question is what cash is needed, not for some irrelevant aim of maintaining a quantum of assets evaluated at unconsumed historical cost, but for the strategies which are in place. Those strategies will have been evaluated by discounting the said cash ﬂows at the cost of capital, and the dividend decision should, logically, be subject to the same discipline. 2005.1

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inﬂuenced by translation gains and losses (usually taken direct to the reserves ﬁgure on the balance sheet)? Bear in mind that ‘well-offness’ is measured by reference to the cost of unconsumed tangible assets. No allowance is made for the intangible assets (such as quality, reputation and pace of innovation) which are so crucial to survival in a rapidly changing environment. Intriguingly, what the accountant calls an asset, for example, an old-fashioned piece of plant, can actually be a strategic liability.

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To the extent, that is, that the company has opportunities to invest for a return in excess of the cost of capital, it should retain funds within the business. If, on the other hand, it has funds in excess of its identiﬁable viable investment opportunities, it should return them to its shareholders for investment elsewhere. This would mean much more volatile levels of dividend, of course, but that was what equity capital was originally meant to be about. The idea of a share being more like a bond, i.e. carrying an entitlement to a steady, or steadily increasing, stream of dividends, is relatively new. It may be coincidence, but it has come to prominence as the proportion of shares owned by institutions has grown. In the 1950s, two-thirds of UK listed company shares were owned by individuals; by 1990, two-thirds were owned by institutions. At this stage, it is worth noting that, rather than transferring wealth from the company to the shareholders in the form of dividends, it is possible to return capital to them by ‘buying back shares’, i.e. the company makes an offer to all members, or goes out into the market to buy its own shares. This does not happen very often but does allow shareholders to choose: they can take the cash, or have a larger interest in the company. The effect on the entity is the same as paying a dividend, but the tax situation may make it possible to beneﬁt (at least some) shareholders at the expense of the tax authorities.

1.7.2 Theory of dividend irrelevance To appreciate the theory advanced by Modigliani and Miller (MM) in 1961 regarding dividend policy and the hypothesis of dividend irrelevance, we need to understand MM’s fundamental principle of valuation: ‘that the price of each share must be such that the rate of return (dividends plus capital gains per dollar invested) on every share will be the same throughout the market over any given interval of time.’ This principle is supported by three basic assumptions: 1. In ‘perfect’ capital markets no buyer, seller or issuer of securities is large enough for their transactions to signiﬁcantly affect the current ruling price. Information regarding the ruling price is available to all without cost, and no brokerage fees, transfer taxes or other transaction costs are incurred in the trading of securities. In addition, no tax differentials exist either between dividends or retentions of proﬁt or between dividends and capital gains. 2. All investors will behave ‘rationally’ in that they will prefer more wealth to less, and they are indifferent as to whether any given increment of their wealth is in the form of cash payments (dividends) or an increase in the market value of their holdings (capital gains). 3. ‘Perfect certainty’ carries the implication of complete assurance on the part of every investor as to the future investment programme and future proﬁts of every company. With this assurance there is, among other things, no need to distinguish between stocks and bonds as sources of funds for this analysis, which is itself based on an analytical framework set up to examine the effects of differences in dividend policy on the current price of shares in an ideal economy, characterised by the three assumptions of perfect capital markets, rational behaviour and perfect certainty. Important aspects of this theory arising from the above assumptions, or developed from them, include the following: ●

In a tax-free world, shareholders will not differentiate between dividends or capital gains, the value of a company and therefore the price of its shares being based only on the earnings capacity of its assets and investments, that is, on the worth of the projects in which the company has invested its funds.

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The so-called ‘clientele effect’ shows that a company with a particular pattern and stability of dividend proﬁle will attract stockholders having a similar preference for that type of proﬁle. Thus, since shareholders’ expectations are being met, the price of shares will be unaffected by changes in dividend policy. If retentions are insufﬁcient to allow a company to take up all its worthwhile investments, the shortfall caused by a dividend can be offset by obtaining further funds from other external sources. MM argue that although there will be a loss in value of existing shares as a result of using external ﬁnance instead of retentions, such loss will be exactly offset by the amount of the dividend paid; as a result a company should be indifferent as to whether it pays a dividend and obtains external funding or retains more of its proﬁts. Thus, the effect of dividends on share price is exactly compensated for by other sources of ﬁnancing. MM recognise that dividends can in some way affect share prices, but suggest that the positive effects of dividend increases on such prices relate not to the dividend itself but to the ‘informational content’ of dividends in regard to future earnings. This information leads to shareholders pushing up the share price on the basis of their expectations as to future earnings. From these arguments it seems reasonable to assume that if a company does not have sufﬁcient worthwhile projects to use up retentions, it should distribute these surplus funds to its shareholders, who will then be able to invest in other companies which do have satisfactory investments to which these extra funds can be applied.

Within the considerable limitations of the assumptions made, which are discussed below, MM do present some interesting, if contentious, arguments as to why dividends are irrelevant to the value of any particular company. Has MM’s theory any practical relevance today? Arguably we can answer positively in that: ●

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it sets out a number of issues which provide useful background in developing an approach to dividend policy, for example, concerning ‘informational content’ of dividends; since legalisation of share buy-backs in the UK, a number of companies have shown interest in, and a few have acted upon, the concept of returning surplus funds to shareholders, signifying that this may prove to be the better way of ensuring their more proﬁtable use.

In a perfect world, which in the interests of clarity MM explicitly assumed, their theory would seem unexceptional. In the real world, however, we need to recognise some imperfections: ●

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Use of the accounting model for purposes beyond its design speciﬁcation. As mentioned above, retention of proﬁts is likely to result in the company reporting earnings per share growth. Paying dividends and raising capital would not. If that earnings per share ﬁgure is seen as a measure of performance, or is used for determining rewards, this could have considerable signiﬁcance. Transaction costs. It costs money to pay a dividend, and it costs money to raise capital. To eliminate one transaction by reducing the size of the other would clearly avoid wasteful administration costs. Taxation is never neutral, and the declaration of a dividend can affect the attribution of value as between shareholders and the tax-gatherers. Whether companies need be concerned about the tax ultimately borne by their shareholders – in respect of dividends and/or the buying and selling of shares – is a moot point. Some are adopting policies which appeal to a particular clientele, that is, category of investor; others are passively 2005.1

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watching the steady decline of the individual shareholder, and the growth of the tax-exempt fund. Barring a change of policy, the UK market is polarising: individuals are being encouraged to invest in National Savings and tax-exempt individual savings accounts (ISAs); share ownership increasingly appeals only to pension funds and the like. The inefﬁciency of the market. A dividend is certain, being tangible cash-in-hand and discretionary income, whereas the market price is subject to all sorts of extraneous inﬂuences and therefore more uncertain. Note, accordingly, how increasing the dividend is a predictable response to a threat of a takeover, the presumption being that it will have the effect of increasing the share price. Supporters of the efﬁcient market hypothesis would like to think that prices equate with the net present value of projected cash ﬂows and are therefore fair as between buyers and sellers, but it would be perverse to argue that directors have a responsibility for the bargains struck between consenting shareholders, that is, for ensuring that reality ﬁts the hypothesis! It would be more rational to argue that they should concentrate on creating wealth, and recognise that the question of its distribution as between stakeholders is far from being within their control.

1.7.3 Scrip dividends Companies sometimes offer shareholders a choice between a cash dividend and additional shares worth the same, or approximately the same amount. The dividend paid in shares is referred to as a scrip dividend and is often offered when the directors feel they must pay a dividend but would prefer to retain cash funds within the business. The presumption is that the retained funds will be invested in projects which can reasonably be expected to earn an adequate return. As with bonus or scrip issues directors rarely highlight the fact that once the reserves are capitalised in this way, they become undistributable. To see how scrip dividends work, imagine a company with 100 million shares in issue, the directors of which decided to declare a dividend of 12p per share. In the ‘normal’ course of events this would mear a cash outﬂow of £12 million to the shareholders. Assuming, for the sake of illustration, that the company’s shares had been trading at around 360p ex div., the board might offer an alternative of one new share for every 30 held. There would be rules as to fractional entitlements, of course, but in simple terms someone who held, say, 3,000 shares could receive a divident of £360, or 100 shares’ worth – at the contemporary share price – £360. From the point of view of the individual shareholder: ●

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if he (or she) had been thinking of buying some more shares, and felt that the price was unlikely to fall below 360p in the near future, he would welcome the opportunity of obtaining some without having to pay the usual commissions, etc.; if he had no wish to increase his holding, he could simply take the dividend as originally declared; if he had no ﬁrm views, he could take part dividend and part shares.

1.7.4 Share repurchases The decline in scrip dividend offers in recent years has coincided with an increase in the number of companies returning capital to investors through share repurchase schemes, or in some cases by making a special dividend payment. 2005.1

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return of surplus cash to investors; to reduce the company’s cost of capital; to enhance earnings per share in the hope of also increasing market price per share; to prevent, or reduce the likelihood of, unwelcome takeover bids; to adjust the gearing of the company to a higher level, closer to the company’s optimal capital structure; to reduce the amount of cash needed to pay future dividends.

The ability of UK companies to repurchase shares was introduced in the Companies Act 1981. The process requires approval of the shareholders, and any shares repurchased must be cancelled. There are also further rules imposed by the Stock Exchange and the Takeover Code, which control the use of share repurchases. The majority of recent share repurchases, and special dividends, have been as a result of companies having surplus cash in excess of their operational requirements. Shares may be repurchased by: ● ● ●

purchase on the open market; individual arrangement with institutional investors; a tender offer to all shareholders.

An individual arrangement with institutional investors tends to be the most popular approach as it is the quickest, most efﬁcient means of returning surplus cash. Often therefore, only a small group of shareholders will participate in a share repurchase, whereas all shareholders will participate in a special dividend. A further consideration in the return of surplus cash concerns the possible tax implications for investors. A share repurchase may lead to a capital gains tax liability for participating investors, while a special dividend would normally attract an income tax liability. A share repurchase may suggest a failure of management to identify projects that will generate returns above the company’s cost of capital. Returning capital to shareholders gives the shareholders the opportunity to generate higher returns for themselves by investing elsewhere. It can also be difﬁcult to determine a price for the share repurchase that is fair to all parties.

1.8 The impact of internal and external constraints on ﬁnancial strategy 1.8.1 Internal constraints Two of the main internal constraints on ﬁnancial strategy are funding and gearing. Traditionalists claim that capital structure can be planned and managed to maximise the value of the ﬁrm. Modigliani and Miller claim that the value of an ungeared company cannot be more than the value of a geared company except for the present value of the tax shield and the costs of ﬁnancial distress. These issues are dealt with in Chapter 4. The main argument in favour of gearing, that is, introducing debt into the capital structure is that the interest payments attract tax relief. The argument against debt is that it introduces ﬁnancial risk into the company. Financial managers have to formulate a policy that balances the effect of these opposing features, such as the state of the economy, government 2005.1

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The repurchase of a company’s shares may be carried out for a number of reasons:

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economic policy, and sources of ﬁnance and their cost cannot be ignored when determining capital structure policy.

1.8.2 External constraints Major external constraints include: ● ● ● ●

●

Government regulation (this is discussed in Section 1.9). Regulatory bodies (Regulation is discussed in Sections 1.9.4 and 1.9.5). Major economic inﬂuences (these are discussed in Section 1.10). Accounting concepts: Detailed knowledge of accounting procedures will not be examined in this volume. However, discussion may be required on current and emerging issues in ﬁnancial reporting (relevant topics are discussed in Section 1.12). Sources of ﬁnance and their cost when determining capital structure policy (these are discussed in Chapters 3 and 4).

1.9 Developing ﬁnancial strategy in the context of regulatory requirements The ﬁnancial manager must have a proper understanding of those aspects of legislation which impact upon entities. Such legislation will include the Companies Acts, health and safety regulations, laws relating to consumer protection and consumer rights, laws relating to contract and agency, employment law and laws relating to protection of the environment. You should be aware of the meaning of tax havens, which are used by large organisations – usually multinational corporations – to defer payment of tax on funds earned prior to them being remitted to the parent company’s host country or used for investment purposes. Such havens will be expected to impose only low rates of tax on income earned by resident subsidiaries or low withholding taxes on dividends remitted, to have satisfactory ﬁnancial services able to provide adequate support facilities and to possess political and currency stability. Understanding the implications of regulation on takeover and merger activities is required although you will not need detailed knowledge of the City Code on takeovers and mergers.

1.9.1 Corporate Governance and the Cadbury Report Statutory control of corporate governance has been with us for a long time, and has increased over time, but has generally lagged behind the demonstrable need for it. It is impossible to legislate against crime, for example, fraud, but there is a case for spelling out the ‘rules of the game’. The theory which underpins current UK legislation is based on the idea that a board of directors represents the interests of the shareholders, but in practice it is often dominated by executive managers. The trends towards share options and pay schemes related to high proﬁts have opened up a risk that courses of action which are good for the directors can have an adverse effect on the long-term health of the enterprise. Among the issues of particular concern at the moment are: ●

creative accounting designed to circumvent limits on directors’ powers as deﬁned in Articles of Association (e.g. the inclusion of brands on the balance sheet, avoiding the need for prior approval of acquisitions);

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the inability of shareholders to stop directors investing in uneconomic projects (often funded by rights issues, the arithmetic of the process meaning that the best they can do is sell their rights in the market); the question of where the loyalties of auditors lie. The practice of valuing intangibles and then auditing them has now been outlawed by the Institute of Chartered Accountants, but many auditors are helping to devise schemes of off balance sheet ﬁnance, so as to avoid limitations on directors in listing agreements and banking covenants – suggesting they are servants of the management rather than shareholders, bankers and creditors.

The philosophical question is whether legislation and regulation should spell out the broad principles and trust directors and auditors to follow its spirit, or provide a detailed set of rules which should be followed to the letter. What we have at present is claimed to be the former, but there are many who say it is not working satisfactorily. The chairman of the Accounting Standards Board has urged directors and auditors to follow the spirit, otherwise there would be detailed regulation. The implicit message is that this would result in more bureaucracy and political intervention. The central recommendation of the Cadbury Committee’s report in 1991 was that the boards of all listed companies should comply with the ‘Code of Best Practice’ set out in its report, and this is to be underpinned by a Stock Exchange listing requirement for a ‘statement of compliance’. Objectively veriﬁable items should be reviewed by the auditors. Among the items covered in the code are: ● ● ● ● ●

● ● ●

regularity and comprehensiveness of board meetings; separation of powers at the top of the organisation; availability of advice to all directors; inclusion of ‘independent’ non-executive directors; limit of 3 years for executive directors’ contracts (unless overridden by general meeting), disclosure of total emoluments, and control via a remuneration committee; appointment of an audit committee; report on the effectiveness of internal controls; assertion of ‘going concern’ status, with supporting assumptions as necessary.

Detailed knowledge of corporate governance issues is not required for the Financial Strategy syllabus. Students are expected to have a general understanding of the key principles. Overseas candidates will be able to comment on regulation in their own country as an alternative to the UK examples given in this Study System.

1.9.2 The Greenbury Report There have been further developments since the Cadbury Report. The main recommendations of the Greenbury Committee’s report have become requirements for Stock Exchange listing: ●

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The remuneration committee should consist entirely of non-executive directors with no personal interest other than as shareholders in the matter to be decided. An annual report should be provided for shareholders, approved by the shareholders at the annual general meeting. Full details of the directors’ remuneration should be disclosed. 2005.1

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A number of non-mandatory recommendations were also made, which included: ● ●

bonuses should partly comprise shares or options; directors’ contracts should be for terms of one year or less, in order to avoid large pay-offs.

1.9.3 The Hampel Report The Hampel Committee was set up to develop issues raised in the Cadbury and Greenbury reports. The report, issued in 1998, proposed combining the best practices, principles and codes of all three reports into a single code. The Stock Exchange subsequently issued a combined code on corporate governance, and amended the listing rules to make compliance with the code obligatory for listed companies. Among the key recommendations of the Hampel Report are: ● ●

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The primary duty of the directors is to enhance the shareholders’ investment. Non-executive directors should comprise at least one-third of the membership of the board. The roles of chairman and chief executive should generally be separate. All directors should submit themselves for re-election at least once every 3 years. A remuneration committee should be established, composed of independent, nonexecutive directors. A business presentation is recommended at the annual general meeting, with a questionand-answer session. A resolution should be proposed at the annual general meeting relating to the annual report and accounts. An audit committee should be established, composed of at least three non-executive directors, at least two of these being independent. Directors should report on internal control. The accounts should contain a statement describing how corporate governance principles are applied.

1.9.4 Regulatory bodies Where a market is not competitive, or is in the early stages of becoming so – as is the case with privatised utilities in the UK – there is a need for regulators whose role is to try to balance the interests of the various stakeholders. Customers need to be protected by limiting the extent to which entities can use a monopoly position to create excessively high added value for the beneﬁt of shareholders, employees, and, through taxation, the state. Even so, the regulator still needs to ensure that prices will provide sufﬁcient margins to allow for necessary investment. Similar situations can exist overseas, especially where countries are at an early stage of competition development. Here the state will often control the rate of development by licensing ‘private’ entities, while delegating to regulators a number of powers relating to business operations. Important issues for regulating in the UK and overseas are the prevention of ‘cross-subsidy’, that is, the transferring or ofﬂoading of portions of overhead costs from lower- to higher-margin products, the limitation of non-price barriers affecting the entry of new competitors, and assuring reasonable quality of product in relation to price. Non-price barriers could include trade restrictions, or restricted access to supplies or distribution channels. 2005.1

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In an international environment, ﬁnancial managers need to know about issues in other countries. However, examination questions will usually allow overseas candidates to comment on institutions in their own country as an alternative to the UK examples which may be given in the question.

Exercise 1.1 Explain the objectives and main activities of a regulatory authority.

Solution The starting point for establishing a regulatory regime is a clear set of government objectives. The regulatory rules should then be designed so that they both meet government objectives and can readily be understood by both regulator and the regulated industry. These objectives may be classiﬁed under three headings: ● ● ●

the protection of customers from monopoly power; the promotion of social and macroeconomic objectives; the promotion of competition.

Where participants in a regulated market are judged to possess signiﬁcant market power, and where there is no other protection for customers, methods for protecting customers in a speciﬁc sector by controls on prices and on quality of service will need to be considered. A particular focus here will be on price or tariff controls. Social objectives cover a variety of possible government objectives, including the availability and affordability of services in particular areas and to particular groups such as the disabled or customers in rural areas. It is often difﬁcult to achieve these objectives (which may be speciﬁc) from wider government macroeconomic objectives. These can include policy on employment, pricing (and inﬂation) and investment, and may be particularly important in developing countries. The ﬁrst step in designing effective regulations to promote competition is to identify where potential barriers to entry might exist, and their relative importance. Once the market segments in which there is scope for competition have been identiﬁed, steps will be needed to assist its development. 2005.1

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Regulators and their relationship to the regulated is a tricky area. Regulators rarely have statutory rights to enforce decisions and can usually only advise government. Their responsibilities may also only extend to the regulated portion of a company’s business; if the company has interests in a deregulated area the regulator has to take steps to ensure the correct allocation of costs. In the UK, examples of institutions covered by this section of the syllabus are the regulators of privatised industries. Examples include Oftel (telecommunications), Ofgas (gas) and Ofwat (water), plus organisations such as the Competition Commission (which is not strictly a regulator, rather a watchdog). Understanding the purpose of these organisations, and the inﬂuence they may have on government and company decisions, is necessary. Detailed knowledge of the procedures of the various organisations will not be expected in your examination.

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Other regulatory options may also be considered, including: ●

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Prohibiting cross-subsidy. To enforce this it will be necessary to require the company to make available to the regulator separate accounts for separate businesses. Removal of the right to compete in deﬁned activities. An alternative to requiring separation or prohibiting cross-subsidy is to prohibit the regulated company from competing in the activity in which competition is to be promoted. Creation of a regulation prohibiting discrimination. The established company can prevent the loss of its most valuable customers to a new competitor by offering special terms of service. A rule to prevent this may therefore be appropriate. Regulation may be enforced by a number of means: legislation, licences, industry codes of practice, government department versus independent regulator.

The need for these, and the effectiveness of current controls, will depend very much on the technical characteristics of the particular service offered.

1.9.5 The regulation of takeovers and the competition commission The syllabus does not require detailed knowledge of the regulation of takeovers or the operations of the UK Competition Commission. However, some understanding of the implications of regulation is useful, as often companies use a reference to the competition authorities as a defence against takeover. UK takeovers are regulated in three ways, two of them formal and the third informal. UK mergers are considered by the competition authorities under the Enterprise Act 2002. Any UK mergers which do not fall under the EC Merger Regulation (ECMR), and which meet the jurisdictional tests in the Enterprise Act 2002, fall to the UK authorities: Ofﬁce of Fair Trading (OFT), Competition Commission (CC) and, in the case of public interest considerations and, for the time being, mergers between water and sewerage companies, the Secretary of State for Trade and Industry (SoS). The public interest considerations relate to national security and media mergers. The latter covers newspapers, broadcasting and cross-media mergers. Generally, mergers can only be considered by the UK competition authorities if the turnover in the UK of the enterprise being taken over exceeds £70m or the merger creates or increases a 25 per cent share in a market for goods or services in the UK or a substantial part of it. There is no general requirement to notify mergers to the UK competition authorities. The OFT investigates all mergers in the ﬁrst instance and, with the exception of public interest cases, decides whether or not they should be referred to the CC for further investigation. The test is whether the OFT believes a merger has resulted or may be expected to result in a substantial lessening of competition. At this stage there are three ways in which a merger may be treated: ● ● ●

it may be referred to the CC for further investigation; it may be cleared; or undertakings may be sought in lieu of a reference to the CC.

Where a merger is referred to the CC, they are required to determine whether it has resulted or may be expected to result in a substantial lessening of competition and to take the action it considers reasonable and practicable to address any adverse effects of the merger that they have identiﬁed. 2005.1

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● ●

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ﬁnal decisions on mergers taken by the SoS rather than the OFT and the CC; mergers considered against a broader public interest test rather than the new test of whether they result in a substantial lessening of competition; a worldwide assets-based criteria for determining whether a merger is subject to merger control procedures rather than a UK-based turnover test.

Section 58 of the Fair Trading Act 1973 requires proprietors of newspapers circulating in the UK to obtain the Secretary of State’s (Department of Trade & Industry) prior written consent to acquire a controlling interest in another newspaper or newspaper assets if the total sales (i.e. paid-for circulation) of all the newspapers concerned (the proprietor’s existing titles plus those to be acquired) is 500,000 or more copies per day of publication. The second mode of regulation is under the competition policy of the European Union, set out in Articles 81 (formerly Article 85) and 82 (formerly 86) of the Treaty of Rome. Article 82 prohibits the abuse of a dominant ﬁrm position insofar as it may affect trade between member states. The ECMR provides that a merger that creates a dominant position, as a result of which competition would be signiﬁcantly impeded, shall be declared incompatible with the common market. The Regulation applies to all mergers with a ‘Community Dimension’, deﬁned in terms of turnover levels. The ECMR was designed to provide ‘one-stop’ merger control to avoid the risk of mergers being investigated under two or more jurisdictions. National authorities may not normally apply their own competition laws to mergers falling within the ECMR. The third control on takeovers is operated by the Takeover Panel, formed in 1968 to counter the perceived inadequacy of the statutory mechanisms for regulating the conduct of both parties in the takeover process. The Panel consists of representatives from City and other leading business institutions, such as the CBI, the Stock Exchange and the ICAEW accounting body, thus representing the main associations whose members are involved in takeovers, whether as advisers, shareholders or regulators. The Panel promulgates and 2005.1

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All CC reports are published. Companies can also obtain conﬁdential guidance or informal advice from the OFT on whether or not a potential merger would be likely to be referred. For public interest cases, the SoS will decide whether to clear a merger, refer it to the CC, or seek undertakings in lieu of a reference following receipt of advice from the OFT and, in the case of media mergers, from OFCOM. The SoS will also decide whether to make an adverse public interest ﬁnding following receipt of the CC’s report. In making these decisions, the SoS must accept the views of OFT and CC as to jurisdiction and whether there is an anti-competitive outcome. For a merger situation raising deﬁned public interest issues, but which falls below the turnover and share of supply tests, the SoS may issue a special intervention notice allowing the competition authorities to consider those issues. As with other public interest cases, the SoS will make any decision on reference to the CC and on an adverse public interest ﬁnding. The public interest considerations relating to media mergers came into force on 29 December 2003 when they were inserted into the Enterprise Act by the Communications Act 2003. A special regime exists for mergers between water and sewerage companies. These are currently considered under the Water Industry Act 1991, with changes to be made through the Enterprise Act and the Water Act. A key change will be that the OFT and the CC will replace the SoS as relevant authorities in water mergers. Those mergers completed, notiﬁed to the OFT by means of the statutory merger notice, or referred to the CC before 20 June 2003, are considered under the Fair Trading Act as follows:

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administers the Takeover Code, a set or rules with no force of law, but which reﬂects what those most closely involved with takeovers regard as best practice. It does, however, have some sanctions to enforce its authority, such as public reprimands, which damage the reputation of violators of the Code, perhaps leading to the collapse of the bid and, for ﬁnancial advisers, to long-term loss of business. The Panel’s ultimate sanction is to request its members to withdraw the facilities of the City from offenders, although this is extremely rare. Source: Department of Trade and Industry. (www.dti.gov.uk/cp/ukmergerguide.htm)

1.10 Major economic inﬂuences In this section we review some of the major economic forces affecting an organisation’s ﬁnancial plans, such as interest rates, inﬂation and exchange rates.

1.10.1 Interest rates In the UK, short-term interest rates are set by the Bank of England’s Monetary Policy Committee. A rate of interest is the price of money which is lent/borrowed. It is expressed as a percentage of the sum, calculated on an annual basis. For example, if someone buys a gilt, and thus lends money to the government, they will receive interest. In this case it is calculated on the purchase price. Thus there is an inverse relationship between the price of gilts and the rate of interest. Let us assume that a £100 stock pays £10 annually to the holder as interest. If someone bought the stock and held it until maturity, after (say) a year they are effectively receiving 10 per cent interest. However, if the £100 nominal value stock is bought for less than its face value at, say, £97, the purchaser is really receiving 10.31 per cent, that is, £10 on an outlay of £97. Furthermore, if the government needs to sell more stock in order to ﬁnance its publicsector borrowing requirement, the price might fall to £95. However, this effectively means that a higher rate of interest is paid by the borrower (and received by the buyer). It is 10.52 per cent, that is (£10 £95). Generally, the longer the time period of a loan, the higher the rate of interest given/charged because of the greater risk and uncertainty involved. However, because some borrowers are safer than others, two loans for the same length of time might carry different interest rates. For example, normally a bank loan to a low-risk, blue-chip plc would receive a lower rate of interest than a loan to a high-risk sole trader. A central rate of interest It is clear that there is no such thing as the rate of interest because there are many rates of interest, which reﬂect varying risk. However, there has always been a central rate around which the others vary and to which governments have paid great attention. This has usually been the rate at which the Bank of England would lend to the money market, based on Treasury bill rates. In the post-war period until 1971 this key central rate was called bank rate and was ﬁxed by the Bank of England. It was replaced by minimum lending rate which was set at _21 per cent above the weekly Treasury bill lender rate, so that it reﬂected market conditions. However, in 1981 this rate was abolished and so there is no ‘ofﬁcial rate’. Nevertheless, the bank base rate has become a key indicator. It moves to reﬂect changes in the money market which are 2005.1

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1.10.2 Term structure of interest rates One of the primary considerations in evaluating debt is the likely movement in interest rates. This will affect the relative costs of long- and short-term debt, as well as increasing or decreasing the preference for ﬁxed interest rates. In practice, long-term rates will normally be higher than short-term rates, owing to the additional risk borne by the lender. Hence an interest premium is required to attract investors to longer-term securities. This effect may be magniﬁed or reversed by investors’ expectations of future rates, an anticipated rate rise producing higher longer-term rates. This difference between long- and short-term rates is known as term structure. The term structure of interest rates is shown by the yield curve. Figure 1.1 shows an upward-sloping, or normal, yield curve showing long-term rates to be higher than those available in the short term. The yield curve will normally be upwardsloping in order to compensate investors for tying up their money for longer periods of time. In extreme cases, this may justify a company borrowing, using short-dated stock which is replaced regularly – although the level of transaction costs makes this unlikely. Sometimes the yield curve will be downward, or inverse, with short-term interest rates higher than long-term rates, as shown in Figure 1.2. In the UK, the Bank of England

Figure 1.1

Term structure of interest rates

Figure 1.2

Inverse yield curve 2005.1

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triggered by the Bank of England’s behaviour in that market. For example, if the Bank of England wants higher rates of interest and sells more bills, thereby pushing prices down, this will have a ripple affect and base rates will rise too (causing further ripples).

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Monetary Policy Committee meets monthly to set interest rates. Their inﬂuence is directed primarily towards short-term interest rates, as a means of managing inﬂation in the economy. Short-term interest rates might be increased to combat inﬂation. If, however, interest rates are expected to fall in the future once the risk of inﬂation has been countered, long-term interest rates may be lower than short-term rates, and the yield curve would therefore be downward sloping. Factors that inﬂuence term structure In general terms, an increasing term structure results from two factors: ● ●

increased risk of longer debt; anticipated general interest-rate rises.

More detailed analysis is required, however. Below are listed formal theories as to why interest rates increase with time. Expectations theory This states that the forward interest rate is due solely to expectations of interest-rate movements. If an individual wishes to borrow for two years, two obvious possibilities present themselves: (a) borrow for 2 years at an agreed rate; (b) borrow for 1 year and reﬁnance for the second year (i.e. pay off the ﬁrst loan by taking out a second). In option (a), the interest paid on the loan will be based on the current interest rate and the forward rate for one year. In option (b), the individual will consider the current interest rate and the expected interest rate for year two. Thus, the choice between the options hinges on whether the forward rate for year two is higher or lower than the expected rate. From the lender’s point of view, if the expected rate was higher they would only lend short, preferring to renegotiate at the end of 1 year and take advantage of the anticipated rate rise. A similar argument could be made if the expected rate was lower than the forward rate. Thus, for long- and short-dated debt to coexist, expected future rates and forward rates must be equal. Thus, the term structure of interest rates arises purely from investor expectations. Liquidity preference theory The problem with the expectations theory is that it ignores risk. If the expected rate for year two is the same as the forward rate, then an individual needing to borrow for 2 years would choose a 2-year loan since this eliminates the uncertainty of the actual interest rate to be paid in year two. Thus, borrowers will aim to borrow for the period for which they need funds. If lenders wish to lend for only one year there will be a shortage of long funds and an excess of short funds. This will lead to a premium on forward rates – that is, lenders will get a bonus for lending for two years and borrowers will have to pay extra if they insist on a 2-year loan. In this case the term structure of interest rates would again be upward-sloping but now this would be because of the liquidity preference of lenders and borrowers. Market segmentation It has been argued that demand for capital funds in practice can be segmented, particularly on a time basis. Thus, for example, companies tend to ﬁnance 2005.1

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Real interest rates The real interest rate puts interest rates in the context of inﬂation. When the rate of interest is higher than the rate of inﬂation, as in 1992–93, there is a positive real rate. This means that borrowers are losing in real terms but savers are gaining. Conversely, when the rate of inﬂation is higher than the rate of interest (e.g. 1980), the real rate of interest will be negative. In such a case borrowers gain and savers lose. The relationship between real and nominal rates of interest is given by the formula originally considered by Fisher: (1 nominal rate) (1 real rate) (1 inﬂation rate) If the nominal rate of interest is 7 per cent and the rate of inﬂation is 2 per cent, the real rate of interest is calculated as: 1 + real rate = 1 + nominal rate = 1.07 = 1.049 1 + inflation rate 1.02 Thus, the real rate is 4.9 per cent. The effects of interest rate changes Changes in interest rates affect the economy in many ways. The following consequences are the main effects of an increase in interest rates: ●

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Spending falls – expenditure by consumers, both individual and business, will be reduced. This occurs because the higher interest rates raise the cost of credit and deter spending. If we take incomes as fairly stable in the short term, higher interest payments on credit cards/mortgages, etc., leave less income for spending on consumer goods and services. This fall in spending means less aggregate demand in the economy and thus unemployment results. Asset values fall – the market value of ﬁnancial assets will drop, because of the inverse relationship (between bonds and the rate of interest) explained earlier. This, in turn, will reduce many people’s wealth. It is likely that they will react to maintain the value of their total wealth and so may save, thereby further reducing expenditure in the economy. This phenomenon seems to ﬁt the recession of the early 1990s when the house-price slump deepened the economic gloom. For many consumers today a house, rather than bonds, is their main asset. Foreign funds are attracted into Britain – a rise in interest rates will encourage overseas ﬁnancial speculators to deposit money in Britain’s banking institutions because the rate of return has increased relative to that in other countries. Such funds could be made available as loans to British ﬁrms by the banking sector. The exchange rate rises – the inﬂow of foreign funds raises demand for sterling and so pushes up the exchange rate. This has the beneﬁt of lowering import prices and thereby bearing down on domestic inﬂation. However, it makes exports more expensive and possibly harder to sell. The longer-term effect on the balance of payments could be beneﬁcial or harmful depending on the elasticity of demand and supply for traded goods. This is discussed in detail in a later chapter. 2005.1

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stocks with short-term funds and equipment with long-term funds. This leads to different factors affecting long- and short-term rates and a lack of a clear trend in the yield curve, characterised by irregularities such as humps and dips.

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Inﬂation falls – higher interest rates affect the rate of inﬂation in three ways. First, less demand in the economy may encourage producers to lower prices in order to sell. This could be achieved by squeezing proﬁt margins and/or wage levels. Second, new borrowing is deferred by the high interest rates and so demand will fall. Third, the higher exchange rate will raise export prices and thereby threaten sales which in turn pressurises producers to cut costs, particularly wages. If workers are laid off then again total demand is reduced and inﬂation is likely to fall.

1.10.3 Inﬂation Inﬂation is deﬁned simply as ‘rising prices’ and shows the cost of living in general terms. The effects of inﬂation If the rate of inﬂation is low, then the effects may be beneﬁcial to an economy. Businessmen are encouraged by fairly stable prices and the prospect of higher proﬁts. However, there is some argument about whether getting inﬂation below 3 per cent to, say, zero, is worth the economic pain (of, say, higher unemployment). There is agreement, though, that inﬂation above 5 per cent is harmful – worse still if it is accelerating. The main arguments are that such inﬂation: ●

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distorts consumer behaviour – people may bring forward purchases because they fear higher prices later. This can cause hoarding and so destabilise markets, creating unnecessary shortages. redistributes income – people on ﬁxed incomes or those lacking bargaining power will become relatively worse off, as their purchasing power falls. This is unfair. affects wage bargainers – trades unionists on behalf of labour may submit higher claims at times of high inﬂation, particularly if previously they had underestimated the future rise in prices. If employers accept such claims this may precipitate a wage–price spiral which exacerbates the inﬂation problem. undermines business conﬁdence – wide ﬂuctuations in the inﬂation rate make it difﬁcult for entrepreneurs to predict the economic future and accurately calculate prices and investment returns. This uncertainty handicaps planning and production. weakens Britain’s competitive position – if Britain’s inﬂation exceeds her competitors’, then it makes exports less attractive (assuming unchanged exchange rates) and imports more competitive. This could mean fewer sales of British goods at home and abroad and thus a bigger trade deﬁcit. For example, the decline of Britain’s manufacturing industry can be partly attributed to the growth of cheap imports when they were experiencing high inﬂation in the period 1978-83. redistributes wealth – if the rate of interest is below the rate of inﬂation, then borrowers are gaining at the expense of lenders. The real value of savings is being eroded. This wealth is being redistributed from savers to borrowers and from creditors to debtors. As the government is the largest borrower, via the national debt, it gains most during inﬂationary times.

1.10.4 Exchange rates The exchange rate of a currency is a price. It is the external value of a currency expressed in another currency, for example £1 $1.60. A more complex measure expresses the value in terms of a weighted average of exchange rates as an index number. These are currencies 2005.1

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The foreign exchange market This market enables companies, fund managers, banks and others to buy and sell foreign currencies. Capital ﬂows arising from trade, investment, loans and speculative dealing create a large demand for foreign currency, particularly sterling, US dollars and Euros. Typical deals are in Euros, and £300 billion is traded daily in London, the world’s largest foreign exchange centre. London beneﬁts from its geographical location, favourable time intervals (with USA and the Far East in particular) and the variety of business generated there – insurance, commodities, banking, Eurobonds, etc. Foreign exchange trading may be spot or forward. Spot transactions are undertaken almost immediately and settled within two days. However, forward buying involves a future delivery date from three months onward. Banks and brokers, on behalf of their clients, operate in the forward market to protect the anticipated ﬂows of foreign currency from exchange rate volatility. The forward price of a currency is normally higher (at a premium) or lower (at a discount) than the spot rate. Such premiums (or discounts) reﬂect interest rate differentials between currencies and expectations of currency depreciations and appreciations. As the foreign exchange market has grown, so other instruments such as futures and options have been developed to protect foreign exchange commitments. Currency futures involve the trading of forward transactions other than for currencies themselves, while currency options enable buyers (at a premium paid to the writer of the option, usually a bank) to guarantee a buying (or selling) price for a currency at a future speciﬁed date.

1.11 Modelling and forecasting cash ﬂows and ﬁnancial statements 1.11.1 Forecasting cash ﬂows Cash ﬂow forecasts are vital to the management of cash. They show, over periods varying between a single day, a week, a month, a year or even longer, the expected inﬂows and outﬂows of cash through the company. They help to show cash surpluses and cash shortages. 2005.1

FORMULATION OF FINANCIAL STRATEGY

of a nation’s main trading partners in manufactured goods and are collected in a representative basket. This is known as the effective exchange rate and shows the relative importance of the country as a competitor in export markets. A fall in the index shows a depreciation of a currency relative to the total basket of currencies on which the index is based. However, it is possible that that currency may be appreciating against some currencies in the basket whilst depreciating against others. A fall in the index simply shows that there is an overall depreciation, whereas a rise in the index would show an overall appreciation. The exchange of currencies is vital for trade in goods and services. British ﬁrms selling abroad will require foreign buyers to exchange their currency into sterling to facilitate payment. Similarly, British importers will need to pay out in foreign currencies. Also, when funds are transferred between people in different countries, foreign exchange is required. Today, the sale and purchase of currencies for trading purposes is dwarfed by the lending and borrowing of funds. The internal and external values of a currency are different. The former refers to the purchasing power of a currency at home. Inﬂation lowers the internal value. The external value is not affected by domestic inﬂation directly, but it changes with variations in other nations’ exchange rates. These variations reﬂected the demand for and supply of currencies on foreign exchange markets. In turn these tend to reﬂect trade performance.

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32

STUDY MATERIAL P9

Management can therefore use cash budgets to plan ahead to meet those eventualities; arranging borrowing when a deﬁcit is forecast, or buying short-term securities during times of excess cash. Remember that there will be differences between the cash ﬂow forecast for a period and the forecast income statement for that period. This is because the cash budget is concerned with cash payments and cash receipts, while the income statement is concerned with income earned and expenses consumed in a period. Areas where the two statements may show different amounts include: ●

●

●

●

the cash budget will record budgeted cash receipts from customers, while the income statement will show forecast revenue for the period; the cash budget will record budgeted cash payments to suppliers, while the income statement will show forecast cost of sales, which will reﬂect opening stock, plus purchases, less closing stock; the cash budget shows the budgeted cash payments for expenses such as wages, electricity and rates. The income statement will record the expenditure expected to be consumed in the period, reﬂecting any accounts or prepayments; the cash budget will reﬂect the cost of purchasing a ﬁxed asset at the expected date of purchase and the proceeds at the date of sale. The income statement will record a depreciation charge for the consumption of the asset and a proﬁt or loss on disposal.

1.11.2 Forecasting ﬁnancial statements In an examination you may be required to model annual cash-ﬂow forecasts and other ﬁnancial statements using expected changes in values, based on data for a base year. The example below demonstrates such an approach. Example 1.A Lavinia Products plc manufactures toys and other goods for children. It has been trading for 3 years. The shares in the company are owned by ﬁve people, all of them employed full time in the business. The company is doing well and now needs additional capital to expand operations. Assume that you are a consultant working for Lavinia Products plc. You have been assigned to the company to advise on its objectives and ﬁnancial situation. As well as being provided with ﬁnancial statements for the year to 31 December 2006, the company’s accountant gives you the following information: 1. Sales and costs of sales are expected to increase by 10 per cent in each of the ﬁnancial years ending 31 December 2007, 2008 and 2009. Operating expenses are expected to increase by 5 per cent each year. 2. The company expects to continue to be liable for tax at the marginal rate of 33 per cent. Assume tax is paid or refunded twelve months after the year end. 3. The ratios of debtors to sales and creditors to cost of sales will remain the same for the next three years. 4. The ﬁxed assets are land and buildings which are not depreciated in the company’s books. Capital allowances on the buildings may be ignored. All other assets used by the company (machinery, cars, etc.) are rented. 5. Dividends will grow at 25 per cent in each of the ﬁnancial years 2007, 2008 and 2009, as per the company’s objectives. 6. The company intends to purchase new machinery to the value of £500,000 during 2007 although an investment appraisal exercise has not been carried out. It will be depreciated straight line over 10 years. The company charges a full year’s depreciation in the ﬁrst year of purchase of its assets. Capital allowances are available at 25 per cent reducing balance on this expenditure. 7. Additional stock was purchased for £35,000 at the beginning of 2007. The value of stock after this purchase is likely to remain at £361,000 for the foreseeable future. 8. No decision has been made on the type of ﬁnance to be used for the expansion programme. However, the company’s directors think they can raise new medium-term secured debt if necessary. 9. The average P/E ratio of listed companies in the same industry as Lavinia Products plc is 15. 2005.1

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● ● ●

FORMULATION OF FINANCIAL STRATEGY

The company’s objectives include the following: to earn a pre-tax return on the closing book value of shareholders’ funds of 35 per cent per year; to increase dividends per share by 25 per cent per year; to obtain a quotation on a recognised stock exchange within the next 3 years.

A summary of the ﬁnancial statements for the year to 31 December 2006 is shown below. LAVINIA PRODUCTS PLC Summarised income statement for the year to 31 December 2006 Revenue Cost of sales Gross proﬁt Operating expenses Interest Tax liability Net proﬁt

£000 (1,560 1,(950) (1,610 1,(325) 1,0(30) 1,0(84) 1,0171

Dividends declared

1,5068

Summarised balance sheet at 31 December 2006 £000 £750

Non-current assets (net book value) Current assets: Inventory Receivables Cash and bank

326 192 1,350 1,318 £000

Capital and reserves Ordinary share capital (ordinary shares of £1) Retained proﬁts to 31 December 2005 Retentions for the year to 31 December 2006 Total ﬁnancing Non-current liabilities 10% debenture redeemable 2020 Current liabilities Trade creditors Other creditors (including tax and dividends)

500 128 103 731 300 135 1,0 152 1,318

Requirements Using the information in the case: (a) prepare forecast income statements for the years 2007, 2008 and 2009, and calculate whether the company is likely to meet its stated ﬁnancial objective (return on shareholders’ funds) for these 3 years; (b) prepare cash-ﬂow forecasts for the years 2007, 2008 and 2009, and estimate the amount of funds which will need to be raised by the company to ﬁnance its expansion. Notes: 1. You should ignore interest or returns on surplus funds invested during the 3-year period of review. 2. This is not an investment appraisal exercise; you may ignore the timing of cash ﬂows within each year and you should not discount the cash ﬂows. 3. Ignore inﬂation.

Solution (a) Income statements for the year to 31 December

Revenue

.2006 .£000 1,560

(2007 ((£000 (1,716

(2008 ( £000 (1,888

33

(2009 ( £000 (2,076 2005.1

STUDY MATERIAL P9 Cost of sales Gross proﬁt Operating expenses Depreciation Interest on debt Proﬁt before tax Tax Proﬁt after interest and tax

FORMULATION OF FINANCIAL STRATEGY

34

(,(950) (1610 (.(325)

(1,045) 00671 00(341) 00;(50) (1,,(30) 00250 (1,, (58) (1,192

(1,(30) (1255 (1,(84) 1,171

(1,150) 00738 0( (358) (1,,(50) (1 ,(30) 00300 (1, (85) (1,215)

(1,264) 00812 0( (376) (1,,(50) (1 ,(30) 00356 (1,(111) (1,245)

Notes: 1. Revenue and direct costs are increased by 10 per cent and operating expenses by 5 per cent per annum from 2006 onwards. 2. Tax is calculated as: Proﬁt before tax Add depreciation Capital allowances Taxable proﬁt Tax at 33%

£000 255 125) ,255

£000 250 50 (125) ,175.

£000 300 50 (((94) ,256)

£000 356 50 ( (70) )336)

,284

,158.

.285.

)111)

Other relevant information 2006 Dividends Dividends payable (£000) DPS (%) Percentage increase Percentage payout Earnings Proﬁt retained (£000) EPS (pence) Percentage increase Value of equity (£000) 500,000 shares at PE of 15

68 13.6 49 103 34.2

2008

2009

85 17.0 25 44

106 21.2 25 49

133 26.6 25 54

107 38.4 12.4

109 43.1 12.1

112 49.0 13.8

2,565

2,880

3,232

3,675

£000

£000

£000

£000

Shareholders’ funds Ordinary share capital Retained earnings

500 2,231

500 2,338

500 2,447

500 2,559

Shareholders’ funds

2,731

2,838

3,947

1,059

Proﬁt before tax ROSF (%) ROCE (%) (b) Cash-ﬂow forecasts for

2005.1

2007

255 34.9 31.0

250 29.8 27.0

300 31.7 29.0

356 33.6 31.0

2007 £000

2008 £000

2009 £000

Inﬂows Cash from sales

1,697

1,867

2,053

Outﬂows Payments for purchases Operating expenses Working capital Machinery Tax payments Dividends paid Interest Total outﬂows

1,031 341 35 500 84 68 1,030 2,089

1,135 358

1,248 377

58 85 1,130 1,666

85 106 1,230 1,846

Net cash ﬂow Opening balance Cumulative cash balance

(392) (3350 ---(342)

201 (((342) ---(141)

207 (((141) ---(166

MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY

Calculation of cash from sales and payments for purchases Assuming, as per the question, that the ratio of debtors to sales and creditors to cost of sales remains the same (12.3 and 14.2 per cent respectively) the calculations are as follows:

Sales Opening debtors Less closing debtors (12.3% of sales) Cash received Purchases Opening creditors Less closing creditors (14.2% of CoS)

2007 £000 1,716 192 3(211) 1,697

2008 £000 1,888 211 3(232) 1,867

2009 £000 2,076 232 3(255) 2,053

1,045 135 3(149) 1,031

1,150 149 3(164) 1,867

1,264 164 3(180) 2,053

An IAS 7 format is also acceptable. 2007 £000 290 (30) (((68)

2008 £000 374 (30) (((85)

2009 £000 428 (30) (106)

Net cash inﬂow

192

259

(292

Tax paid Investing activities: ﬁxed assets Net cash outﬂow Net cash ﬂow before ﬁnancing

(84) (500) (584) (392)

(58) ((((–((((( (((58) 201)

(85) ((((–(((( (((85) 207)

Net cash inﬂow from operating activities Interest paid Dividends paid

Net cash inﬂow from operating activities for 2007 Gross proﬁt (before depreciation) Less operating expenses Increase in debtors Increase in creditors Increase in stocks

£000 671 (341) (19) 14 (((35) (290(

1.11.3 Sensitivity analysis Sensitivity analysis tests the effect of varying the projected value of important variables. When forecasting cash-ﬂows and ﬁnancial statements, it is essential that uncertainties in estimates of costs and beneﬁts are taken into account by, at the very least, undertaking a sensitivity analysis. Signiﬁcant variables may include: ● ● ● ●

sales volumes levels of productivity costs of materials labour costs.

Sensitivity tests should be well designed; it is not sufﬁcient to show the implications of an arbitrary variation around a particular cost or beneﬁt. Some indication of the likely range of variation is needed.

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FORMULATION OF FINANCIAL STRATEGY

The company will need to raise a minimum of £342,000 plus interest payments – which at 12 per cent would be £41,000 in the ﬁrst year. A total of approximately £400,000 will therefore need to be raised.

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STUDY MATERIAL P9

1.12 Current and emerging issues in ﬁnancial reporting In July 2001 the Inernational Accounting Standards Board (IASB) announced its technical agenda which can be summarised as follows: Four key high-priority projects ● Accounting for share-based payments ● Business combinations ● Performance reporting ● Accounting for insurance contracts Applying international accounting standards ● New guidance on ﬁrst-time application of International Financial Reporting Standards (IFRS) ● Disclosure and presentation of ﬁnancial institutions’ activities Improvements projects ● Amendments to IAS 39 Financial Instruments: Recognition and Measurement ● Improvements (e.g. eliminating inconsistencies and reducing elements of choice). The four high-priority projects are all controversial to some degree. A major issue in business combinations accounting is the future of the pooling of interests/merger method of accounting, permitted by both IAS and UK accounting standards, but which has been recently abolished in the US. Performance reporting has been, and continues to be, a major problem in both practical and conceptual terms for reasons which include the following: ● ● ●

●

●

Problems of deﬁnition of gains, revenue, income, losses. Tension between economic and accounting deﬁnitions of income. Decision-usefulness and fair-value accounting: dealing with the consequences in the income statement. Complexity of income statements which cover operational and ﬁnancial gains and losses, and recognised but not realised gains and losses on operational and ﬁnancial assets and liabilities. Establishing a bottom line.

1.12.1 IFRS 1 ﬁrst time adoption of IFRS This standard applies to all entities adopting IFRSs as the basis of their reporting. The objective of the IFRS is: ●

to ensure that an entity’s ﬁrst IFRS ﬁnancial statements, and its interim ﬁnancial reports for part of the period covered by those ﬁnancial statements, contain high quality information that: (a) Is transparent for users and comparable over all periods presented: (b) provides a suitable starting point for accounting under International Financial Reporting Standards; and (c) can be generated at a cost that does not exceed the beneﬁts to users.

1.12.2 IFRS 2 Share-based payment Share-based payment is an issue that has concerned standard-setters around the world for at least a decade. It was debated at length during the 1990s in the USA where the problem is 2005.1

MANAGEMENT ACCOUNTING – FINANCIAL STRATEGY

What is the issue? Share option schemes are frequently used as a means of rewarding employees. They may also be used as a means of buying-in goods or services from parties outside the company. Such schemes can become very complicated, especially if the options are dependent in some way on company or employee performance. In some cases, share schemes of various types are used as a means of replacing substantial parts of remuneration in the form of regular salary, or indeed as a complete substitute for remuneration. In the case of risky business start-ups (particularly in high-tech industries) employees may agree to work for little or nothing, being rewarded instead either by shares in the company at start-up (at which point the shares are likely to be worth little or nothing) or by options to purchase shares at a minimal price at some future date. Employees in such cases voluntarily take on a risk, in the hope of material reward in future. The advantage to the start-up company is obvious: it obtains the advantages of highly skilled labour without having to pay for it. If the business fails, the value of the stock or options will never materialise and the employees bear the opportunity cost of their services which, in the event, have been supplied for no return. If the business prospers the shares gain in value, the options are exercised, and, in some cases, the employees gain huge rewards for the risk they have run. A simple example, set in the context of an established business, will illustrate the issue. Example 1.B Company A, a listed company, rewards its senior employees from time to time by granting share options. On 1 January 20X3 it grants each member of a group of senior employees an option on 10,000 shares, at an exercise price of the market value of the shares on 1 January 20X3 ($3.50), the option to be exercised no earlier than 1 January 20X6. Three years later, on 1 January 20X6 the market value of one share is $4.50. Senior employee B decides to exercise the option. He pays A $35,000 (10,000 shares @ $3.50) and receives 10,000 shares in exchange. Employee B has thus gained a beneﬁt with a current value at 1 January 20X6 of $10,000 (current value of shares $4.50 10,000 $45,000 less the $35.000 just paid). Whether or not B chooses to realise his gain immediately by selling the shares at $4.50 each is entirely up to him; hence-forth, for as long as he owns the shares, he bears all of the risks and rewards of ownership, just like any other equity shareholder in a listed company. Accounting for this transaction appears straightforward: $10,000 to be credited to share capital, being the nominal value of shares issued; $25,000 to share premium account; a debit of $35,000 to cash for the amount received from the employee. However, beyond these simple entries there is the question of the $10,000 beneﬁt to the employee, which can be viewed as representing delayed remuneration for his services over the 3-year period. Applying the accruals concept, remuneration should be matched against the revenue which the services of the employee have helped to create. So, in this case, should there not be an additional debit of $10,000 to the income statement over the 3 years in order to reﬂect the cost of these services? The arguments for and against its inclusion are as follows. For ● The $10,000 represents remuneration and so should be properly reﬂected as an expense; the means by which the remuneration is paid is irrelevant. ● If the company does not fully reﬂect remuneration for services to employees the performance statement will be incomplete, and users will neither be able to properly assess the stewardship of management nor to make fully informed economic decisions. 2005.1

FORMULATION OF FINANCIAL STRATEGY

particularly pressing due to the large number of company executives who are paid in the form of shares or share options. The Financial Accounting Standards Board in the US was only partially successful in addressing the problem; a standard was issued but compliance was voluntary. In 2000, the G41 group of standard setters issued a discussion paper whose proposals would require companies to account fully for the costs of share-based payment. The IASB announced during 2001 that it would be undertaking a project to produce a standard on the subject. In February 2004 it issued IFRS 2 Share-based payment.

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38

STUDY MATERIAL P9 ●

If costs of employment are fully reﬂected in some companies (because they are paid via regular salaries) and not in others (because rewards are wholly or partly in shares or share options) then the performance statements between companies will not be comparable. (Remember: comparability is one of the four key qualitative characteristics of ﬁnancial statements identiﬁed by the IASC in its Framework).

Against The $10,000 does not represent an outﬂow of economic beneﬁts from the company. The gain arises because of the company’s share price performance, and is receivable by the employee independently of any action by the company. ● The $10,000 does not represent an expense within the terms employed by the conceptual framework. Losses (which include expenses) ‘are decreases in ownership interest not resulting from distributions to owners’. The $10,000 is not a decrease in ownership interest. ● If $10,000 is debited to the company’s performance statement, what should happen to the related credit? It is doubtful whether it fulﬁls the characteristics of either a liability or ownership interest. ●

Up till now there has been limited guidance on accounting for share-based payment. There is a standard in the US but, because of adverse responses from interested parties, its adoption for share-based payments is voluntary.

IFRS 2’s response to the problem The IFRS should be applied to all share-based payment transactions, and it identiﬁes three principal types: 1. Equity-settled share-based payment transactions. This category would include the transaction in Example 1B above. 2. Cash-settled share-based payment transactions. This is where the provider of services or goods (i.e. in most cases the employee) is rewarded in cash, but the cash value is based upon the price of the company’s shares or other equity instruments. 3. Transactions where one of the parties involved can choose whether the provider of services or goods is rewarded in cash (value based on equity prices) or in shares. The underlying assumption of the IFRS is that the issue of share options and grants of shares to employees and others creates a ﬁnancial instrument which must be accounted for. Recognition. Where payment for goods and services is in the form of shares or share options the transaction should be recognised in the ﬁnancial statements. There should be a charge to proﬁt and loss account when the goods or services are consumed. Where the payment is equity-settled (type 1 above) the corresponding credit should be to equity. Where the payment is cash-settled (type 2 above) the corresponding credit should be to liabilities. Measurement. The transaction should be measured at the fair value of the shares or options issued. Measurement can be direct, that is, at the fair value of the goods or services received, or indirect, that is, by reference to the fair value of the equity instruments granted. In this latter case, fair value should be measured at the date of grant.

1.12.3 Reporting environmental issues Protecting the environment is a key issue affecting everyone. Pressures are placed on businesses to ensure that the environment suffers minimum damage as a result of their products, processes or services. Businesses are using recyclable materials, monitoring pollution levels and taking other environmentally sound measures to comply with customer demand for ‘green’ products. Indeed, as writers suggest, the work of the accountant is changing so as to encompass environmental issues. 2005.1

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●

● ● ● ●

Dealing with environmental taxes. France, for example, charges businesses for air and water pollution and reinvests those taxes in pollution control. Investment appraisal will have to take environmental factors into account. Costing new pollution controls. Reporting on the feasibility of replacing materials for environmental purposes. Estimating the impact of ‘green’ consumer preference.

This general trend is extending to the annual ﬁnancial report; companies are reporting information about their actions with regard to maintaining the environment. Such disclosures include: ● ● ●

level of toxic waste, energy usage and noise; policies regarding environmental care; comment on actions the company has taken, for example in choice of raw materials or product policies.

The annual report is traditionally a vehicle for ﬁnancial information about the company. However, the users of the annual report represent a wide audience which extends beyond the shareholders and investors. Companies therefore view the annual report as a public relations document and report much voluntary information regarding their products, policies and so on and this now includes information about their actions towards preserving the environment. Indeed some companies are almost obliged to report on environmental issues. Generally, the trend in environmental reporting by companies has been slow and on an ad hoc basis. Some companies make a company policy statement only, others may make a company policy statement and a statement of what action has been taken to implement the policy, not necessarily quantiﬁed. Finally, some companies may report physically audited measurements, such as water pollution, emissions or depletion of non-renewable resources, plus reporting on indirect effects such as the environmental impact of suppliers and the impact resulting from the disposal of a product, and consideration of stakeholders from an environmental point of view. A powerful force in the demand for environmental information from companies arises from the ethical investment movement and the Green Alliance. Furthermore, the green movement headed by groups such as Greenpeace and Friends of the Earth is making the public aware of environmental issues and forcing companies to care. The situation is inconsistent. International bodies such as the United Nations, as well as the UK’s Confederation of British Industries, have addressed the main issues. However their proposals have been complex and impractical for implementation by industry and standard-setting bodies. Environmental issues are major concerns, and regulations issued by governments and international bodies are helping to ensure that environmental care is increasing. At present there are no mandatory requirements to publish results of environmental audits but some environmental bodies require that companies publish a summary of ﬁgures on pollution emissions, waste production, consumption of raw materials, energy and water, noise and a presentation of the company’s environmental policy. EC proposals set standards for environmental issues, such as emission levels for pollution. It is also seeking a requirement for publication of these levels and targets. 2005.1

FORMULATION OF FINANCIAL STRATEGY

This will include:

39

FORMULATION OF FINANCIAL STRATEGY

40

STUDY MATERIAL P9

As environmental regulations increase and demands from the public, consumers and investors become more onerous, companies will suffer the cost of these actions. Contingent liabilities relating to the results of environmental audits, other clean-up measures, environmental disasters and other litigation due to noise or waste policies need to be disclosed in the ﬁnancial statements. The current situation is not wholly satisfactory and there is much ground to cover: ●

●

●

●

Not all companies currently report environmental information; some companies may report environmental issues one year and none at all in another year. As disclosures are of a voluntary nature there is a danger that the information may be incomplete and therefore unreliable. The importance of disclosure of information varies according to particular industries. Chemical, oil, steel and other high-polluting industries are seen as being more responsible for reporting on environmental issues. The use of environmental issues appears to be more of a public relations exercise rather than an obligation.

However, adequate disclosure is of limited reliability unless it is adequately audited. There is at present no obligation to carry out an environmental audit. If such audits are carried out they are conﬁdential, are not carried out to agreed standards, and the audit reports do not have to be published.

1.12.4 Reporting of social issues The present nature of environmental reporting is a product of lobby groups, government and international pressures on companies and individuals to be aware of, and take care of, the environment. However, this is not a new concept. Accounting theorists have always questioned the role of ﬁnancial reports. Currently, they communicate ﬁnancial information resulting from historic transactions entered into by the company. This relates primarily to the exchange of goods and services and excludes movements in human capital, the effects on the social environment and details of future ﬁnancial position and performance. The theory of socio-economic accounting is the process of ordering, measuring and disclosing the impact of exchanges between a ﬁrm and its social environment. This involves looking at social resources and the exchanges between a company and society. Society is seen as a number of subsystems with which the company will interact. Interaction with the economic system is currently reported in the ﬁnancial reports. Social accounting seems to extend the reporting function beyond this system to include: ●

●

●

The physical environment. The company will utilise physical resources such as coal, gas and agricultural products but the social cost of this use is currently not reported. The meteorological and biological environment. In its use of energy and the production of goods the ﬁrm will cause changes in the surrounding atmosphere and natural environment. The sociological environment. The way in which a ﬁrm attracts human resources, and uses those resources, will affect local society.

The activities of a company may lead to an increase in social resources. For example, the provision of employment in an area may result in a social beneﬁt. 2005.1

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● ● ● ●

pollution: air, water, noise; depletion and destruction of animal resources; soil erosion and deforestation; unemployment and idle resources.

Social reporting would include a social income statement, recording social costs and beneﬁts to different areas of society, and a social balance sheet disclosing staff assets, organisational assets, the use of public goods, ﬁnancial and physical assets. One of the most important papers to be produced on the subject was The Corporate Report (UK), published in 1975. It reviewed the objectives and role of the ﬁnancial statements as the IASB has done in its Framework. The Corporate Report went further in advocating the publication of supplementary reports to meet the needs of other users. These were: ●

●

●

●

Statement of corporate objectives. The statement could take many forms but would include all stakeholders’ objectives The employment report, intended to give information on the number and details of employees, wage rates, the type of work and training. Statement of future prospects. The Corporate Report acknowledged that it was difﬁcult to report on issues in this area. Yet it would provide vital information to all users. Value-added reports, showing the development of resources throughout the organisation and the interdependency of all parties (employees, government, capital providers, not just proﬁt for shareholders). A typical value-added statement shows the split of turnover between the interested parties: ABC Group: value-added statement for the year ended 31 December 20X1 $ Revenue X Less: bought-in materials and services (X) Value added X Applied to Employees Wages, pensions and other beneﬁts X Government Corporation tax X Providers of capital Interest on loans X Dividends X Retained by the company for future growth and capital expenditure Depreciation X Retained earnings ‘X‘ Total allocated funds ‘X ‘

The provision of such information would be costly. There would be a need for independent review or audit, further adding to the cost. The incorporation of this additional information in the annual report would become truly widespread only if encapsulated in regulation. 2005.1

FORMULATION OF FINANCIAL STRATEGY

On the other hand, if the activities of a company lead to the depletion of social resources this is termed a social cost. Social costs include:

41

FORMULATION OF FINANCIAL STRATEGY

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1.12.5 Inclusion of forecasts in the annual report Why not require enterprises to include forecasts in their annual report? There has been discussion within the accounting profession on the issue of including forecast information in the annual report. A suggestion is that the primary statements should include an additional column for forecast budgets. This information is available within the management information system. However, the implications for companies including this information are profound. If the company included an optimistic forecast and those forecasts were not met then the market’s perceptions would be that management was incompetent, with resultant effects on the company’s share price. If, on the other hand, the forecast was too pessimistic then again this would have adverse effects on the company’s share price and would result in undervaluation of the company. Furthermore, if the company outperformed the forecast, perceptions may be that this was due to luck rather than management efforts. Some authors have stated, however, that these potential effects would force budgets to be realistic. Annual reports would include management’s analysis of the forecasts and so produce a new type of reporting. It would also force management to consider the effects of decisions. The analysis of the ﬁnancial report and information for decision-making would be more relevant from a user’s point of view. Those who do not wish to include forecasts cite commercial reasons. Forecasts would have to include commercial plans and so provide valuable information to competitors. However, if this was a mandatory obligation, competitors would of course have to provide that information as well. Provision of additional information would be costly. Costs include not only the ﬁnancial costs of obtaining the information but also costs to the ﬁrm from action taken on the information by investors, customers and suppliers.

1.12.6 Reporting of human capital The difference between the market value of an entity and shareholders’ funds in the balance sheet can be due to factors such as staff with good management skills, the existence of certain technical skills within the company and know-how. These human resource factors are not quantiﬁed in the ﬁnancial statements at present but are, all the same, recognised by the markets involving a company. An asset is deﬁned by the IASC Framework as ‘… a resource controlled by the enterprise as a result of past events and from which future economic beneﬁts are expected to ﬂow to the enterprise’. Certainly the skills and talents of employees and management will contribute to the generation of future beneﬁts to the company. The problem arises as to how to value the human resource factors. The wages and salaries paid to management and employees for their skills are expensed in the year. However, if the view was taken that human resources were an ‘asset’ of the business, the costs would be capitalised in the balance sheet and depreciated or charged to the income statement in line with the income they generate. Valuation of the ‘asset’ would be in line with other methods used in the balance sheet: historical cost, replacement cost, economic value. The historical cost method would involve capitalising all costs associated with recruiting, selecting, employing, training and developing an employee and then amortising these costs over the expected useful life of the asset. Problems arise with this method. The value of the asset’s ability to generate beneﬁts to the ﬁrm does not necessarily correspond to the historical cost and amortisation. Furthermore, 2005.1

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1.13 Summary This chapter has aimed to provide an overview of ﬁnancial strategy. We discuss the main groups into which ﬁnancial management decisions can be classiﬁed: investment, ﬁnancing and dividends. We explain how ﬁnancial strategy is applicable to, and equally important in, organisations which do not seek distributable proﬁts, emphasising that the key factor is the assessment of the value of the output of an entity and especially the excess of that value over the cost of inputs, whether it be in the private or the public sector. Dividend payments have been shown to be irrelevant to shareholder wealth in perfect capital markets. When market imperfections – such as taxes, transaction costs and imperfect information – are considered, the situation is less clear. Companies tend to adopt stable and consistent dividend policies, in order to attract a clientele of investors whose personal taxation position suits that particular policy. Unexpected ﬂuctuations in the dividend payment tend to be avoided because of the informational content of the dividend which is being signalled to the market. We discuss the impact of economic and regulatory constraints on ﬁnancial strategy. We have illustrated in detail an approach to modelling and forecasting cash ﬂows and ﬁnancial statements and identiﬁed some current and emerging issues in ﬁnancial reporting.

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different companies will incur differing costs for training and development, for example, therefore hampering comparisons. The replacement cost method estimates the cost of replacing the existing human resources, that is, what costs would be incurred to bring new staff to the level of competence of existing staff. Again, however, this value does not equate with the value of future beneﬁts the asset will generate. Also, as with other physical assets there may not be an equivalent replacement for a given human asset. Finally, estimating the replacement costs would be very subjective. An economic value for a human asset could be obtained using an adjusted discounted future wages method. Discounted future wages are adjusted by an efﬁciency factor to measure the effectiveness of human capital of a company. There are many other non-monetary methods of valuing human resources of a company and these would involve much subjectivity.

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Readings

The article by Paul Nichols compares the concepts of cash-ﬂow return on investment, economic value added and cash value added. He revisits the ‘proﬁt is an opinion; cash is a fact’ argument of a couple of decades ago, and concludes that management will have to relearn how to manage the fact of cash, and that the ability to manage and manipulate proﬁt is no longer sufﬁcient. The second article considers the trend towards corporate social responsibility reporting.

Unlocking shareholder value Paul Nichols, Management Accounting, October 1998. Reproduced with permission. I get paid to make the owners of the company increasingly wealthy with each passing day. Everything else is just ﬂuff. Former Coca-Cola CEO, Roberto Giozueta Our traditional mindset has always somehow perceived business as buying cheap and selling dear. The new approach deﬁnes a business as the organisation that adds value and creates wealth. Peter Drucker, Harvard Business Review, February 1995

Since the start of limited liability companies, corporate accountants have been measuring the success of their organisations by using traditional measurements – proﬁt margin, return on assets, return on equity etc. At the same time, when judging the viability of individual projects or investments, they have used discounted cash ﬂow measurements – NPV, IRR etc. And while they were adopting this dual approach the investor was using yet a third set of measurements – EPS, P/E etc. It was surely only a matter of time before something happened to bring the three different measurement systems into line: for both management and investors to judge the success of a company by the same criteria that they judged investments. That catalyst was the publication in 1986 of Alfred Rappaport’s Creating Shareholder Value. This book started a major change in the way both management and shareholders view performance. At the same time it was the starting point for an acceleration in the activity of consultants, each developing their own version of the best way of judging performance in this new world. All the consultants follow a similar thought process: 1. Proﬁt has become to some extent a discredited measure – to quote Price Waterhouse’s Proﬁt is an opinion; cash is a fact. Arguably, decades ago there was little difference between cash ﬂow and proﬁt. However, as the world has become more complex and accounting 45

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rules and practices have had to match this complexity, so a gulf has developed between the two. Inevitably (?) this has led to many accounting entries being made on the basis of management judgement. Acquisitions, goodwill adjustments, pension funding, depreciation policies, deferred-tax accounting etc. have taken us down the judgement route. No longer is proﬁt judged by the auditor to be correct. It is now only true and fair. 2. If proﬁt cannot be trusted then cash, the fact rather than the opinion, needs to be measured. Rappaport argued (and all the consultants agree) that there are ﬁve drivers of cash: ● turnover growth rate; ● operating proﬁt margin; ● the percentage of incremental revenue spent on ﬁxed capital net of depreciation; ● the similar percentage for working capital; ● the percentage tax rate – paid rather than the accounted charge. These drivers need to be measured over the future period for which the company has perceived competitive advantage – what Rappaport calls ‘the value growth potential period’. 3. The traditional cost of capital reﬂected in the proﬁt and loss account – interest – is inadequate. When assessing the validity of a project or an investment a company will use a composite capital cost rate that contains not just the cost of loan interest but also some proxy for the cost of shareholders’ funds. The same concept of a composite rate is needed in the evaluation of the total enterprise. Normally a company will use the traditional weighted average cost of capital, which takes both the cost of debt and of equity and weights them according to the book, or projected book, gearing. 4. What needs to be measured is how well the company is performing to the beneﬁt of its owners, the shareholders. There is a view strongly held by many that companies are only there to generate value for their shareholders. The shareholder knows after the event how much he has made by measures such as total shareholder return (the increase in the value of his portfolio assuming reinvestment of all dividends). What is needed is a tool to help management deliver it. Although all consultancies follow these four basic logical steps they all have their own individual models, which can broadly be grouped under three main types. Cash-ﬂow return on investment (CFROI)

There are many variants of this approach, which is perhaps the most popular in the UK, but all follow the original Rappaport thinking. Future cash ﬂows are compared with the weighted average cost of capital either as an absolute sum of money surplus or future cash ﬂows are stated as an internal rate of return (IRR) which in turn is compared with the WACC. Each consultancy will have its own version of how the result is to be computed. Each will have its own way of handling inﬂation, of valuing assets and of portraying the ﬁnal result. It is general practice to make a distinction between replacement capital and growth capital, treating the former as negative cash ﬂow like normal expenses and only the latter as genuine investment. Some will want to evaluate past performance on the basis of actual data and some will want to forecast future CFROI on the basis of projected results. Essentially, it seeks to value company performance using similar techniques to those traditionally used in evaluating individual items of investment. Consistent with the use of CFROI is the use of the Q ratio, originally a macro-economic measure in which the market value of a company (plus debt) is compared with the inﬂationadjusted value of its assets. The Q ratio indicates whether a company’s managers have generated value for their shareholders with the assets they control. 2005.1

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Developed by consultants Stern Stewart, this methodology has received considerable publicity and has a growing acceptance among companies, particularly in the USA. The Stern Stewart method is to start with proﬁt rather than cash ﬂow. In recognition of the potential distortions caused by traditional accounting methodologies, however, they make changes to the reported proﬁt from a shopping list of some 160 different adjustments. The guiding principles of EVA adjustments are: ●

●

Investment decisions taken by the company should result in assets regardless of how they are treated in the accounts. Thus some training expense, perhaps some marketing expense, will be capitalised. Most notably, goodwill expense that has been written off will normally be reinstated as an asset. Assets once created cannot be eliminated by accounting action. For example, where a company has capitalised goodwill and subsequently, for perfectly prudent accounting reasons, decides to write down the value of the goodwill, the write-down (in the USA called asset impairment) is written back in the EVA calculation. It is therefore perfectly possible to report an after-tax loss and yet still report a positive EVA.

Despite the complexity of these adjustments, the basic concept of EVA is not difﬁcult to understand. Consider Figure 1. By all traditional measures company B is the better company: it is double the size, has a higher after-tax proﬁt margin and a higher return on capital employed. Yet when the cost of equity is deducted it has a negative Economic Value Added compared with the positive result in company A. Essentially (apart from the accounting adjustments), the only difference between the traditional P&L and the EVA result is the cost of equity. As such, it is not a difﬁcult concept to grasp and a growing number of companies are quoting an annual EVA value in their annual report. Stern Stewart supplements EVA with MVA (market value added) which reﬂects the spread between the capital invested in a company and the market value of a business.

Revenue Operating proﬁt Tax* Capital Debt/equity ratio Interest rate Cost of equity Operating proﬁt after tax Cost of interest: 10% 3 300 10% 3 100 Traditional proﬁt after tax Cost of equity: 15% 3 300 25% 3 900

Company A 400 200 100 600 50/50 10% 15% 100

Economic value added ROCE (70 600) (190 1000) PROFIT %

Company B 800 400 200 1000 10/90 10% 25% 200

30 70

10 190

45 225 25

35

12% 17.5%

19% 23.75%

* Includes tax effect of interest (EVA and Economic Value Added are registered trademarks of Stern Stewart & Co.)

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Economic value added (EVA)™

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Operating cash ﬂow OCFD Cash value added CVA Index

Year 1 180 273 (123) 0.66

Year 2 270 287 (17) 0.94

Year 3 350 301 19 1.16

Year 4 390 316 74 1.23

Year 5 430 332 98 1.34

Average discounted CVA Index 1.03

Figure 2

Cash value added (CVA)™

This concept, developed by Swedish consultants FWC AB, takes cash ﬂow as the starting point, making a similar distinction as with CFROI between strategic investments and book assets. To calculate CVA, ﬁrst calculate what FWC call the operating cash-ﬂow demand (OCFD). This represents the annual cash-ﬂow amounts, growing by the assumed rate of inﬂation that will yield an IRR equal to the WACC on the original investment. Thus in Figure 2, the OCFD line shows the annual amounts, growing at an assumed inﬂation rate of 5 per cent which give a NPV of zero over the ﬁve-year period with a discount rate (WACC) of 15 per cent and an original investment of 1,000. Annual cash ﬂows in some years are insufﬁcient to meet this requirement, the extent being measured by the CVA index. Over the full ﬁve years the average index (the PV of the operating cash ﬂow divided by the PV of the OCFD) being greater than 1, the business is generating value. So what?

Does this amount to more than merely the latest way in which consultancies can make money? Perhaps only time will tell, but there are a number of pointers that suggest that something radical has changed in the way companies will be managed: ●

●

●

An increasing number of stockbrokers and analysts are using the new methodologies to assist in forming the opinions they give their clients as to which shares to buy. To the extent that a company convinces the analysts that it will add value so the analyst will recommend it and so the share price will rise. A self-fulﬁlling prophecy. With wider share ownership and the sophistication of markets, shareholders are demanding a healthy return. No longer is it sufﬁcient for a company continually to deliver decent proﬁts. Now the shareholder understands measures like Total Shareholder Return and wants to invest in companies that deliver it. Management now understand that they are employed ultimately by the shareholders and to keep their jobs they must deliver shareholder value. These new models help them to manage their companies in ways that will do so. No longer is the management and manipulation of proﬁt, the opinion, sufﬁcient. Management must re-learn the skills of managing the fact, cash. Controlling the cash drivers that Rappaport deﬁned presents a new way of managing a business. What else could be more important?

Green signals ‘go’ Danka Starovic, Financial Management, October 2002. Reproduced with permission.

Sustainable development has crept up the corporate agenda in the past few years. An issue that was still a marginal concern when the Body Shop became a public company in 1985, it 2005.1

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now claims a place in boardrooms around the country. This surge of interest is less connected to mounting evidence of manmade environmental and social disasters than to intense pressure from protesters. The ﬁrms that were targeted in anti-capitalist riots and media campaigns in the past few years are often the ones putting corporate social responsibility (CSR) on the map – Shell after publicity about Nigeria and Brent Spar, Monsanto after GM crops, Nike after the NoLogo campaign and the Seattle riots. They are recognising that the activists cannot be ignored. Managing reputational risk has become a serious corporate governance concern. This is hardly surprising considering that brands can be a company’s most signiﬁcant intangible asset. In addition, the internet has made it much easier for people to disseminate information and voice their dissatisfaction. Many ﬁrms’ ﬁrst line of defence is to produce a CSR report. Voluntary reporting guidelines are emerging all the time, as are independent social and environmental auditing standards. This is a positive development. The more we know about what companies are doing, the more we can make informed investment choices. But, if such reporting fails to translate into a mechanism for improving performance, it cannot reduce a company’s environmental impact or promote social equity. Indeed, there is a danger that, in a rush to appear good, the purpose of reporting is being forgotten. In June, British American Tobacco issued its ﬁrst social report. Although it was designed to meet standard AA1000 and was audited by an independent veriﬁer, it failed to convince BAT’s key stakeholders (many of whom had refused to participate in its production). The company was accused of hypocrisy. BAT’s arguments that no industry is wholly good or bad, and that risky businesses are in particular need of this type of report, may be valid – up to a point. The problem is that no amount of stakeholder engagement will make cigarettes safe. An attempt to build trust by increased disclosure inevitably seems misplaced. Real sustainability involves structural changes, either to your value chains or to your entire business model. This may seem drastic, but we have to tackle the paradox that, while capitalism has created more wealth than any previous economic system, it has done so at a price. Environmental rating agency Trucost recently said that no UK company would be proﬁtable if the cost of its impact on the environment was reﬂected in its bottom line. It is debatable whether any of the most respected companies of the past 100 years have ever made an environmentally sustainable proﬁt. If BAT is at one end of the scale, the Co-operative Bank is at the other. Last year, it refused £2.5 million of business on ethical grounds. Around 98 percent of the bank’s electricity comes from renewable sources, its water consumption has been cut by 9.1 per cent and it saves £3.5 million a year primarily from reduced paper usage. It also reports that its ethical stance has contributed £20 million to its pre-tax proﬁts of £107.5 million. In the Co-operative Bank’s case, sustainability is about adjusting what it does, not simply making it transparent. Reporting should be the visible part of the structure. It should be supported by a robust internal architecture for measuring performance and a decision-making capability that reﬂects a wider range of concerns. Of course, more ﬁrms should still be encouraged to produce audited CSR reports. Companies such as the Co-operative Bank show the beneﬁts to be gained from stakeholder engagement. If nothing else, it helps ﬁrms to stay ahead of the regulators. Compliance may still be the biggest driver for sustainable development. Those who trust that industry interest will prevail over government intervention should remember not only the mandatory Operating and Financial Review (part of the Company

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Law Review), but a spate of EU legislation such as the end-of-life vehicle and end-of-life electronic and electric equipment directives. This autumn Linda Perham MP is reintroducing to the Commons the corporate responsibility bill, which seeks to put social reporting on a par with mandatory ﬁnancial reporting. It may not go through, but it has been signed by more than 200 MPs and reﬂects a change of mood on this issue. It is unrealistic to expect companies to drop proﬁt-making operations to save the planet We should focus instead on ﬁndings such as those of the Business in the Environment survey that FTSE-100 ﬁrms are gaining competitive advantage by being ahead of the law in this area. Change should be incremental, not accompanied by a big regulatory stick. Enforced regulation will at best produce grudging compliance. For markets to operate with sustainable development principles ﬁrmly embedded as a basis for decision-making, this is not enough. There has to be a programme of education that should engender a gradual shift in views. Firms whose reputations were damaged by protesters should be at the forefront. It is far better to be judged on controlled performance indicators, developed in consultation with stakeholders, than to be considered guilty because of rumours.

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Revision Questions

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Question 1 The objective of a health authority (a public-sector organisation) is stated in its most recent annual report as: To serve the people of the region by providing high-quality healthcare within expected waiting times.

The ‘mission statement’ of a large plc in a manufacturing industry is shown in its annual report as: ‘In everything the company does, it is committed to creating wealth, always with integrity, for its shareholders, employees, customers and suppliers and the community in which it operates.’

Requirements (a) Discuss the main differences between the public and private sectors which have to be addressed when determining corporate objectives, or missions. (8 marks) (b) (i) Describe three performance measures which could be used to assess whether or not the health authority is meeting its current objective. (6 marks) (ii) Explain the difﬁculties which public-sector organisations face in using such measures to inﬂuence decision-making. (6 marks) Note: Candidates may draw on their knowledge and experience of the public sector in their own country when answering this question. (Total marks 20)

Question 2 Assume that you are a ﬁnancial analyst attending a shareholders’ meeting at PDQ plc on behalf of your employers, a large pension fund. Your company is one of the few institutional investors in PDQ plc, which is a medium-sized listed company. The majority of the shareholders are small, private investors. At the shareholders’ meeting you overhear a group of shareholders discussing the company’s dividend policy. Some of the comments you hear are as follows: ●

●

‘I think the company should increase its dividend payout to the maximum it can afford without having to borrow. That way our returns are less risky.’ ‘I don’t agree. I think the company should reduce the dividend and retain even more of its earnings for future investment.’ 51

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●

‘I would prefer no cash dividend at all and receive annual bonus shares. The value of my shareholding would then immediately increase.’ ‘I read somewhere that dividend policy has no effect at all on the value of the company’s shares.’

Requirements (a) Discuss the validity or otherwise of the shareholders’ comments. (15 marks) (b) The expectations and requirements of institutional investors in respect of a company’s dividend policy may be different in a number of respects from those of private, individual shareholders. Explain these differences and comment on the problems PDQ plc might face in trying to reconcile the requirements of the two groups of shareholders. (10 marks) (Total marks 25)

Question 3 When determining the ﬁnancial objectives of a company, it is necessary to take three types of policy decision into account – investment policy, ﬁnancing policy and dividend policy. Requirements (a) Discuss the nature of these three types of policy decision, commenting on how they are interrelated and how they might affect the value of the ﬁrm (i.e. the present value of projected cash ﬂows.) (10 Marks) (b) Describe the different function of treasury and ﬁnancial control departments of an organisation and comment on the relative contributions of these two departments to policy determination and the achievement of ﬁnancial objectives. (10 marks) (Total marks 20)

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Solutions to Revision Questions

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Solution 1 (a) Among the differences between the public and private sectors of the economy, as far as objectives and missions are concerned, are the following: ● Those of the public-sector bodies are likely to have been spelled out in a statute or vesting document. As such, managers would have difﬁculty in adapting them as conditions change. On the other hand, the directors of a private-sector enterprise are able to determine its objectives and mission themselves, and to change them as conditions dictate. ● The value of the output of a private-sector organisation is determined by paying customers, and can be incorporated in its objectives, missions and decision criteria. One of the main arguments for retaining an endeavour in the public sector is that it cannot be left to the market to determine its income. Unfortunately, however, top managers in the public sector are generally reticent about quantifying the value of such endeavours. ● In the private sector, failure to meet the aspirations of the various stakeholders (e.g. as listed in the plc mission statement) brings penalties, and may trigger the demise of the enterprise. In the public sector, disbelief can be suspended for long periods, with the result that some stakeholders’ aspirations are ignored. Objectives often boil down simply to the aim to achieve the results spelled out in a plan imposed from above. ● The public sector is constrained by tactical controls in the shape of short-term cash limits. This often ushers in rationing, which amounts to a conﬂict between stakeholders. Private-sector companies can look far enough ahead to see how the interests can be harmonised – though not all avail themselves of this facility! ● Private-sector organisations are acutely aware of the need to earn a satisfactory return on investment (typically around 15 per cent per annum in terms of operational cash ﬂows in the UK). The public sector is only slowly moving away from the concept of capital being free at the point of delivery (a recipe for demand in excess of supply) and has not yet embraced the idea that it is a commodity which is freely available at a price. (b) (i) Unfortunately, ‘high-quality healthcare’ and ‘within expected waiting times’ are rather vague. It would be useful to quantify them in some way. Assuming that is done, among the measurements which might be useful are: ● waiting time for accident/emergency admissions, or arrival of ambulance, compared with expectation (or failing that, a regional or national average); 53

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length of waiting lists for important elective surgery, again compared with expectation (or failing that, a regional or national average); ● patients’ view as to quality of service, against declared aim. (ii) Some of the difﬁculties of the public sector are just beneath the surface of the question. Health authorities are responsible for the purchasing of healthcare from providers (typically NHS trusts). However, they are constrained by rigid budgets allocated by the NHS Executive. lf an authority fails to live up to objectives along the lines of those quoted, or to achieve expected results, it could simply be because it does not have the funds. Letting waiting lists lengthen is the easiest way to keep within an inadequate budget. That is not a reason for not measuring performance of course, but it does affect the interpretation of the measurements. Some performance measurements in the public sector can run counter to what constituents want and, in many cases, to common sense. Judging police forces on the basis of costs per crime recorded, for example, discourages crime prevention. If surgeons were inﬂuenced by the measurement of how quickly they discharge their patients, they would not meet the patients’ aspirations. The more important things in life cannot be measured, because they have not happened – e.g. crimes and illnesses which have been prevented, or opportunities created. The way forward is to be honest about constraints, e.g. to phrase the health authority’s objective in terms of obtaining the maximum value in healthcare terms for a given budget. ●

Solution 2 (a) The fact that different shareholders have different views as to what the company should do is hardly surprising, but some of the remarks could be based on misunderstandings. Dealing with each in turn: ● The idea that the company should increase its pay-out to the amount it can afford has considerable merit in corporate governance terms in the sense that, to the extent that it acquired funds for expansion, it would have to make the case to its shareholders’ general meeting. We do not know what the company’s borrowings are, so we do not know what impact there would be of establishing zero borrowings as the criterion. The shareholder should be dissuaded from thinking, however, that the net result such a policy would be to reduce the risk associated with the returns to shareholders. The uncertainty associated with returns achieved by the company depends on the projects in which it chooses to invest, and the individual shareholder is also subject to the risk that, when he comes to sell the shares, the price will be at a cyclical low. ● To the extent that funds are retained in the business, rather than paid as a dividend, the important question is whether the investments are viable, that is, enhance the net present value of the equity. From an individual shareholder’s point of view, there is a secondary question as to whether this enhancement will be reﬂected in the share price at the time he comes to sell his holding. ● Paying no dividend at all is an extreme case of the situation described in the previous paragraph. The viability of the investments the retentions would fund is what affects the value of the business (as an entity and therefore, indirectly, to its shareholders). There is no necessity to capitalise the retentions in the form of a bonus issue – indeed, the effect of doing so is to make them undistributable for ever more, thereby weakening shareholder power vis-à-vis the directors. ● The net cash ﬂow attributable to shareholders is a function of the investment and borrowing decisions made by the board of the company concerned. In other 2005.1

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How the company deals with these possible conﬂicts depends on a number of factors: ●

●

●

whether it is happy with the mix of individual and institutional shareholders it has at present, or whether it wished to attract more institutions; market image – if it is to satisfy institutions it may need to raise dividends even when it cannot afford to (as noted above) or when it does not wish to; its belief in the importance of dividend policy. 2005.1

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words, the difference between distributions (e.g. dividends) and financing (e.g. rights issues) is predetermined. Directors can ‘mix and match’ these two components as they see ﬁt, and there is a spectrum of possibilities, from paying high dividends and having frequent rights issues, to retaining a high proportion of proﬁts and occasionally buying back some of their shares. There may well be some tax beneﬁts – for some shareholders at least – in adopting a particular policy. This will be identiﬁed by a treasury function which has the aim of maximising the proportion of entity value which is attributable to the equity. Whether this value is reﬂected in the share price at any particular point in time is, of course, a different question again. If the speakers accept these comments, they might well ask what dividend policy does make economic sense. The answer is to see the dividend as being a return to shareholders of those funds which cannot be invested for a return in excess of the cost of capital. This would make dividends as volatile as the rest of the environment, but is consistent with a rational investment policy (i.e. projects are supported if they show positive net present value) and recognises that the share price is part of a zero-sum game: for every buyer there is a seller. Over and above those considerations, it should be recognised that there are a number of factors, given current regulations and practices, which prompt many people to see short-run share prices as important in themselves. If enough people believe that share prices are a function of current dividends then they will be, and this will inﬂuence directors’ decisions – especially if they have some share options about to mature. Setting out to maximise the short-term share price will rarely maximise the long-term ﬁnancial health of the entity. (b) One theory of dividend policy is that a company attracts particular types of shareholder because of its policies, including its dividend policy. This is known as the ‘clientele’ effect. This effect might inﬂuence the attitudes of the two types of shareholder mentioned in the question. Other considerations are as follows: ● Financial institutions are largely non-taxpaying because they can reclaim the advance corporation tax that they pay on dividends. This means that they will be mostly unconcerned about dividends or capital gains as far as taxation is concerned. However, there are two main considerations: cash ﬂow and transaction costs. ● It is likely that institutions would press for a higher payout, as they did in 1991–92, when companies were reporting lower proﬁts. ● Small private investors are less easy to categorise. If they are wealthy they may prefer capital gains because they are tax-efﬁcient (even when tax rates are the same there is an annual tax-free allowance, and capital gains tax is not paid until it is assessed. Dividends are taxed at source). If they are not particularly wealthy they may prefer a high, stable dividend which guarantees them a regular income. In fairness, these individuals are most likely to prefer investment in gilt-edged securities, high-quality corporate debt, or National Savings.

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Solution 3 Aim of question. This question dealt with the determination of ﬁnancial objectives and the role of treasurer and ﬁnancial controller. The question aimed to test candidates’ abilities to examine, evaluate and assess the policy decisions and organisation structure of an organisation. Tips/guidance/common errors ● Most candidates made a satisfactory to good effort at Part (a). ● Not many candidates managed to discuss the interrelationships of the three policies and how they affected the value of the ﬁrm. ● Many candidates spent far too long discussing dividend policy to the detriment of the answer as a whole. ● Answers to Part (b) of the question were varied. ● Most candidates recognised the major functions of the two departments but these were often provided as a list with no discussion of the relative contributions to the achievement of ﬁnancial objectives. This question examines the following syllabus area: (i) The ﬁnance function. ● ●

●

The three key decisions of ﬁnancial management: The role of the treasury function; The beneﬁts and shortcomings of establishing treasury departments as proﬁt centres and cost centres; The ﬁnancial objectives of different organisations.

(a) Investment decisions involve the analysis and appraisal of capital expenditure projects, acquisitions, mergers and disinvestments, together with the related committal of funds; also decisions relating to working capital and trade investments, with the aim of maintaining satisfactory returns for the organisation. Financial controllers will assess the likely cash ﬂows of the various alternatives and identify the one with the maximum net present value. Financing decisions relate to obtaining suitable and adequate funds with which to operate the business, and to the desired level of gearing represented by the most appropriate combination of short-, medium- and long-term debt, together with equity, including internally generated funds. If capital needs to be raised the company will seek that mix of sources that minimises the weighted average cost of capital. Dividend decisions are based in part on making payments to shareholders that will currently satisfy their desired long-term rate of return and thereby help to maintain the company’s share price. They are also based in part on retaining sufﬁcient proﬁts to sustain and advance the level of operations to secure shareholders’ aspirations for the future. The key decision is whether shareholders would be better off having money now or allowing it to be reinvested in the business to produce a higher level of cash ﬂow in future. The three kinds of decision are subsets of comprehensive ﬁnancial management and are linked by the twin foundations thereof: cash ﬂow and the cost of capital. Financial management is about heeding the discipline of the market economy (that only enterprises that can offer the prospect of an adequate return will be able to raise the money required to fund their growth) and translating it into a criterion for the deployment of funds (to business opportunities that offer the prospect of an adequate return, that is, 2005.1

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in excess of the cost of capital). On this (dynamic) basis, dividends reﬂect the amount of cash not required for investment or reducing borrowings. (b) In summary, a treasurer handles the acquisition and custody of funds, whereas the controller has responsibility for accounting, reporting and control. The CIMA Ofﬁcial Terminology describes treasury management as the function concerned with the provision and use of ﬁnance. The main functions of such a department include: – establishment of corporate ﬁnancial objectives; – managing the ﬁrm’s liquid assets – cash, marketable securities, etc.; – managing the company’s funding – determination of policies, identifying sources and types of funds; – corporate ﬁnance and related issues, such as taxation, pension fund investment, etc. (although these functions are sometimes performed by the controller); – (in a multinational) dealing with currency management – dealing in foreign currencies, hedging currency risks, etc. The ﬁnancial control function is concerned mainly with the recording and reporting of ﬁnancial information such as: – preparation of budgets and budgetary control; – preparation of periodic ﬁnancial statements such as monthly accounts and annual accounts; – management and administration of activities such as payroll and internal audit (which in some cases may be a separate department responsible directly to the ﬁnance director). From the above it appears that treasury has the main responsibility for setting corporate objectives and policy, and ﬁnancial control has the responsibility for implementing policy and ensuring the achievement of corporate objectives. This distinction is probably far too simplistic: in reality, both departments will make contributions to both determination and achievement of objectives. There is a circular relationship, in that treasurers quantify the cost of capital, which controllers use as the criterion for the deployment of funds; and controllers quantify projected cash ﬂows, which in turn trigger treasurers’ decisions to employ capital. In smaller ﬁrms the functions of treasury and ﬁnancial control may be combined, and even in larger ﬁrms the two roles often include related activities – for example, management of cash. Although the controller has the main reporting responsibilities, the treasurer will typically report on cash ﬂows and cash management. In some cases, ownership of responsibility for certain activities is not clear-cut. For example, credit control, taxation, insurance and pensions are sometimes handled by the treasury department, sometimes by the controller’s department.

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Financial Management

LEARNING OUTCOMES After completing this chapter you should be able to: 䉴

identify and evaluate optimal strategies for the management of working capital;

䉴

identify and evaluate key success factors in the management of the ﬁnance function;

䉴

discuss the role and management of the treasury function.

2.1 Introduction Financial management is deﬁned in CIMA’s (Management Accounting: Ofﬁcial Terminology) as follows: ‘The management of all the processes associated with the efﬁcient acquisition and deployment of both short- and long-term ﬁnancial resources’. We begin this chapter with a discussion of the ﬁnance function, which in larger organisations is likely to be split into ﬁnancial control and treasury. This is followed by a discussion of the efﬁciency of capital markets. We consider key success factors by which stock market analysts measure performance and conclude with an evaluation of the strategies for the management of working capital.

2.2 The ﬁnance function In a large company the ﬁnance function may be split between treasury and ﬁnancial control, with both functions reporting to the chief ﬁnancial ofﬁcer. The ﬁnancial control function will be concerned primarily with the allocation and effective use of resources, and will have responsibility for investment decisions. The treasury function is usually responsible for obtaining ﬁnance and managing relations with the ﬁnancial stakeholders of the organisation who will include shareholders, fund lenders, and taxation authorities. 59

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The relationship between ﬁnancial control and treasury is often blurred, but two examples of the relationship may be: 1. The treasurer is best able to assess the cost of capital and quantify the organisation’s aversion to risk, while the ﬁnancial controller relates these factors to group strategy. 2. The ﬁnancial controller identiﬁes the organisation’s currency risks, while the treasurer advises on the best means to hedge the risk.

2.2.1 Evaluating key success factors in the management of the ﬁnance function There are many methods of measuring the success of the ﬁnance function; two are identiﬁed here. Balanced Scorecard This is an approach that emphasises the need to provide information that addresses all relevant areas of performance in an objective and unbiased fashion. The information provided may include both ﬁnancial and non-ﬁnancial elements, and cover areas such as customer satisfaction, internal efﬁciency, and innovation. Benchmarking The relative performance of the ﬁnance function could be measured by benchmarking against ﬁnance functions is other organisations. Alternately, in a large organization, the ﬁnance functions in subsidiary companies could be benchmarked against each other.

2.3 The treasury function The establishment of a specialist treasury function within the ﬁnance department can be traced back to the late 1960s. Developments in technology, the breakdown of exchange controls, increasing volatility in interest rates and exchange rates, combined with the increasing globalisation of business have all contributed to greater opportunities and risks for businesses. To survive in today’s complex ﬁnancial environment, businesses need to be able to actively manage both their ability to undertake these opportunities, and their exposure to risks. A separate treasury function is more likely to develop the appropriate skills, and it should also be easier to achieve economies of scale; for instance, in achieving lower borrowing rates, or netting-off balances. In larger companies and groups, treasury will usually be centralised at head ofﬁce, providing a service to all the various units of the entity and thereby achieving economies of scale, for example, by obtaining better borrowing rates, whereas ﬁnancial control is now frequently delegated to individual units, where it can more closely impact on customers and suppliers and relate more speciﬁcally to the competition that those units have to face. As a result, treasury and ﬁnancial control may often tend to be separated by location as well as by responsibilities. 2005.1

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The key responsibilities of the treasury function are: ●

●

●

●

Banking. The treasurer will be responsible for managing relationships with the banks. In this book we view this function as an integral part of the three other functions identiﬁed below, and it is considered within the chapters covering those speciﬁc functions. Liquidity management. This will involve working capital and money management. The treasurer will need to ensure that the business has the liquid funds it needs, and invests surplus funds. Funding management. Funding management is concerned with identifying suitable sources of funds, which requires knowledge of the sources available, the cost of those sources, whether any security is required, and management of interest rate risks. Currency management. The treasurer would be responsible for providing the business with forecasts of exchange rate movements, which in turn will determine the procedures adopted to manage exchange rate risks. Dealing in the foreign exchange markets and dayto-day management of foreign exchange risks becomes a key function for the treasurer.

The treasurer’s responsibilities can also be categorised according to the three levels of management: ●

●

●

strategic, for example, matters concerning the capital structure of the business and distribution/retention policies, the actual raising of capital, including share issues, the assessment of the likely return from each source and the appropriate proportions of funds from each source, the decision as to the level of dividends, and consideration of alternative forms of ﬁnance; tactical, for example, the management of cash/investments and decisions as to the hedging of currency or interest rate risk; operational, for example, the transmission of cash, placing of ‘surplus’ cash and other dealings with banks.

Treasurers require specialist skills to be able to handle effectively an ever growing range of capital instruments, for example convertible preference shares issued in the name of an offshore subsidiary, and to determine the most suitable way to protect their company from foreign exchange risk, which demands a good knowledge of forward markets and an ability to select the most appropriate methods of hedging and foreign exchange cover. They also need a knowledge of taxation in all areas in which the group operates and, deriving from that, the ability to advise effectively on policies such as transfer pricing in permissible ways to minimise overall tax liability, and to be able to liaise competently with the group taxation department. The capacity to make large gains or losses is enormous: a treasurer can wipe out, in a few hours, all the proﬁt made from making and selling things over several months. It is important, therefore, that authority and responsibility associated with the treasury function are carefully deﬁned and monitored. This becomes even more important as the range of derivatives increases. Senior managers need to be aware of which risks are being carried, which laid off, and, where appropriate, taken on. There is also growing pressure for companies to disclose, in their annual reports, more information about their treasury policies, and their ‘positions’ as at the balance sheet date.

2.3.2 Cost centre or proﬁt centre An area for debate is whether the treasury activities should be accounted for simply as a cost centre, or as a business in its own right, seeking to make a proﬁt out of its activities – for 2005.1

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2.3.1 The role of the treasury function

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example, by charging other businesses in the enterprise for its services (and giving those businesses the choice of whether they use it or a bank). The main advantages of operating treasury as a proﬁt centre rather than as a cost centre are as follows: ●

●

Individual business units of the entity can be charged a market rate for the service provided, thereby making their operating costs more realistic. The treasurer is motivated to provide services as effectively and economically as possible to ensure that a proﬁt is made at the market rate, for example, in managing hedging activities for a subsidiary, thereby beneﬁting the group as a whole. The main disadvantages are as follows:

●

●

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The proﬁt concept is a temptation to speculate, for example, by swapping funds from currencies expected to depreciate into ones expected to appreciate. Management time is unduly spent in arguments with business units over charges for services, even though market rates may have been impartially checked (say by internal audit department). Additional administrative costs may be excessive.

The decision as to whether to operate treasury as a proﬁt centre may well depend on the particular ‘style’ of the company and the extent of centralisation or decentralisation of its activities. Example: Treasury management at J Sainsbury The annual report of J Sainsbury for 2004 states: Treasury policies are reviewed and approved by the Board. The Chief Executive and Finance Director have joint delegated authority from the Board to approve ﬁnance transactions up to £300m and responsibility for monitoring treasury activity and performance. The group’s central treasury function operates as a cost centre with responsibility for funding, interest rate and currency risk management and cash management. Group policy permits the use of derivative instruments but only for reducing exposures arising from underlying business activity and not for speculative purposes.

2.4 Financial markets Financial assets and claims on ﬁnancial assets are traded in ﬁnancial markets. Nowadays there may be no physical marketplace, transactions taking place by telecommunications. The major ﬁnancial centres throughout the world will, typically, have three (or possibly four) ﬁnancial markets. These are as follows.

2.4.1 Money market The money market is the market for trading in relatively short-dated funds, usually for less than one year. These markets are dominated by the major banks and other ﬁnancial institutions. Large companies will also borrow and lend on the money market. The term ‘money market’ encompasses the markets for trading in: ● ●

Short-term inter-bank loans. Terms may range from overnight to 12 months or more. Short-term inter-company loans. Large companies will be able to lend and borrow directly with banks on the inter-bank market.

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●

●

●

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Short-term local authority debt instruments. Local authorities have a requirement for short-term cash, with terms ranging from overnight to twelve months or more. Interest would be payable on these instruments. Bills of exchange. Bills of exchange enable suppliers to receive the beneﬁt of payment will before the customer actually pays. Certiﬁcates of deposit. Certiﬁcates of deposit (CDs) are issued by banks at a ﬁxed interest rate for a ﬁxed term, usually between 3 and 5 years. Commercial paper. Large companies may issue unsecured short-term loan notes, referred to as commercial paper. These loan notes will generally mature within nine months, typically between a week and three months. The notes can be sold on the discount market at any time before their maturity date. Eurocurrency. Banks lend and borrow in foreign currencies.

2.4.2 Capital or securities market Capital or securities markets trade in longer-dated securities (usually over twelve months) such as shares and loan stocks. Examples of capital markets would be the Stock Exchange, the bond market and the Eurobond market. Capital markets have two main functions: 1. They provide a primary market for raising new capital for business, usually in the form of equity (shares) to new shareholders or existing shareholders (via rights issues). 2. They also allow trading in existing securities – the secondary market. This is an important function as it provides investors with a means of selling their investments should they wish to. In the UK, the London Stock Exchange is the principal trading market for long-dated securities. It controls and regulates two markets: 1. the Ofﬁcial List or Main Market, which deals in the securities of larger, more established companies; 2. the Alternative Investment Market (AIM), which deals in the securities of smaller, less wellestablished companies. The compliance rules and costs of this market are less onerous than for the Ofﬁcial List. The London Stock Exchange is also the market for government securities (gilts). Flotation Flotation is the process of making shares available to investors by obtaining a quotation on the Stock Exchange.

Exercise 2.1 Before reading the solution see if you can list the main advantages and disadvantages of ﬂotation for a company.

Solution There are a number of advantages and disadvantages of a ﬂotation on the Stock Exchange. 2005.1

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Advantages of ﬂotation ●

● ●

● ●

Once listed, the market will provide a more accurate valuation of the company than had been previously possible. Realisation of paper proﬁts. Raise proﬁle of company, which may have an impact on sales, credibility with suppliers and long-term providers of ﬁnance. Raise capital for future investment. Makes employee share schemes more accessible.

Disadvantages of ﬂotation ● ●

● ● ●

Costly for a small company (ﬂotation, underwriting costs, etc.). Investors perceive small companies to be riskier and therefore may require higher returns if they are to be attracted at all. Making enough shares available to allow a market. Reporting requirements are more onerous. Stock Exchange rules for obtaining a quotation on the full market are quite stringent.

A private company seeking a stock market quotation may obtain a listing on the Alternative Investment Market initially, with the intention of progressing to the Ofﬁcial List at a later date.

2.4.3 The foreign exchange market The foreign exchange market is a market for trading in currencies. Deals here may be for immediate delivery (spot deals) or for future delivery (forward deals).

2.4.4 Derivatives markets An example of a fourth type of market is the London International Financial Futures and Options Exchange (LIFFE) where derivatives are traded. Derivatives is a generic term for a range of traded ﬁnancial instruments that have developed from securities, commodity and currency trading. Examples of derivatives are options and swaps. These can be used as hedging devices, to reduce risks, or simply for speculation.

2.5 Share price volatility An example of the volatility of today’s business environment, of particular interest to ﬁnancial managers, is that displayed by the prices at which the shares of publicly quoted companies change hands. The return from such an investment is the reward required by investors and equates to the dividend plus the capital gain. The required reward will reﬂect the level of risk undertaken by the investor. In terms of this return on investment, the dividend is dwarfed by the potential for capital gains (or losses). In recent years, for example, the dividend yield on UK shares has been around 4 per cent per annum, but it has not been unusual for the price of a share in a particular company to rise or fall by 50 per cent in a year. Anyone able to predict such movements would become very wealthy indeed! 2005.1

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2.5.1 Technical analysis or chartism Technical analysts or chartists believe future prices can be charted and a pattern identiﬁed that can be used to predict future prices. Technical analysis: The analysis of past movements in the prices of ﬁnancial instruments, currencies, commodities etc, with a view to, by applying analytical techniques, predicting future price movements. (Ofﬁcial Terminology, 2000).

2.5.2 Fundamental analysis The fundamental theory of share valuation states that the value of a share will be equal to the discounted present value of the future expected dividends from the share, discounted at the shareholders’ cost of capital. Fundamental analysis: Analysis of external and internal inﬂuences upon the operations of a company with a view to assisting in investment decisions. Information accessed might include ﬁscal/monetary policy, ﬁnancial statements, industry trends, competitor analysis etc. (Ofﬁcial Terminology, 2000) Fundamental analysts will assess whether a share is undervalued or overvalued and recommend buying or selling accordingly.

2.5.3 Random Walk Theory Despite the considerable efforts made in this area, however, it is signiﬁcant that the majority of funds underperform the index of the equity market as a whole. This has led many practitioners (e.g. pension fund trustees) to choose passive management, i.e. buying and holding a selection of shares representative of the market as a whole. There has also been a signiﬁcant increase in the number of ‘tracker’ funds in recent years. These are funds that provide a return in line with the stock market as a whole. They do this by investing in all the companies in the stock market, or investing in a representative sample of those companies. On the available evidence, it is not surprising that theorists have developed the idea that the progress of a particular share price is a ‘random walk’, rendering the achievement of consistently superior returns an impossibility. In other words, tomorrow’s share price is independent of today’s share price.

2.6 The efﬁcient market hypothesis The purpose of a stock market is to bring together those people who have funds to invest with those who need funds to undertake investments. Companies seeking to raise equity are asking investors for a permanent investment as equity shares have no redemption date. Investors may not be encouraged to invest on these terms unless they can be convinced that they will be able to realise their investment at a fair price at any time in the future. 2005.1

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There are people who claim to be able to do so, their techniques ranging from interpretation of zodiac horoscopes though to more sophisticated computer based techniques.

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For this to happen, stock markets must price shares efﬁciently. Efﬁcient pricing means incorporating into the share price all information that could possibly affect it. In an efﬁcient market investors can buy and sell shares at a fair price and companies can raise funds at a cost that reﬂects the risk of the investments they are seeking to undertake. A considerable body of ﬁnance theory has been built on the hypothesis that, in an efﬁcient market, prices fully and instantaneously reﬂect all available information. The efﬁcient market hypothesis (EMH) is therefore concerned with information and pricing efﬁciency. Three levels or forms of efﬁciency have been deﬁned: these are dependent on the amount of information available to the participants in the market.

2.6.1 Weak form The EMH in its weak form says that the current share price reﬂects all the information that could be gleaned from a study of past share prices. If this holds, then no investor can earn above-average returns by developing trading rules based on historical price or return information. This form of the hypothesis can be related to the activities of chartists using technical analysis. The EMH in its weak form questions the value of technical analysis, as share prices will move randomly if the market shows weak form efﬁciency. The weak form of the efﬁcient market hypothesis has been tested by subjecting series of share prices or indices to statistical tests to determine whether there is any correlation between past and present prices. Evidence suggests that it is not possible to predict future prices by looking at a series of past prices. Another series of tests has been to establish whether trading rules enable above-average returns to be earned. These tests attempt to determine if it is possible to earn above-average returns by following standardised trading rules.

2.6.2 Semi-strong form The semi-strong form of the EMH says that the current share price will not only reﬂect all historical information, but will also reﬂect all other published information. If this holds, then no investor can be expected to earn above-average returns from trading rules based on any publicly available information. This form of the hypothesis can be related to fundamental analysis. Fundamental analysis attempts to identify over- or undervalued companies through studying publicly available information. The EMH in the semi-strong form suggests that any publicly available information will already be captured in the current share price. Studies have shown that it is not possible to beneﬁt from always buying shares when good news is published. This is explained by the fact that the speed at which the market reacts to public information is so rapid that individual investors cannot adopt a policy that will consistently result in exceptional proﬁts from a quick reaction to good news.

2.6.3 Strong form The strong form of the EMH says that the current share price incorporates all information, including non-published information. This would include insider information and views held by the directors of the company. If this holds, then no investor can earn aboveaverage returns using any information whether publicly available or not. It is difﬁcult to test this proposition as with ‘insider information’ it should be possible to gain some advantage. A member of staff involved in a takeover bid could predict the likely 2005.1

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2.6.4 Implications of EMH for ﬁnancial managers If capital markets are efﬁcient, the main implications for ﬁnancial managers are: ●

● ●

the timing of issues of debt or equity is not critical, as the prices quoted in the market are ‘fair’; a company cannot mislead the markets by adopting ‘creative accounting’ techniques; the company’s share price will reﬂect the net present value of the company’s future cash ﬂows, so managers must only ensure that all investments are expected to exceed the company’s cost of capital. A summary of the hypothesis is as follows:

● ●

●

the weak form of efﬁciency is where share prices reﬂect all historical information; the semi-strong form of efﬁciency is where share prices reﬂect all publicly available information; the strong form of efﬁciency is where share prices reﬂect all information (public and internal) and is the perfect information environment.

The more efﬁcient the market is, the less the opportunity to make a speculative proﬁt. If the market displays strong-form efﬁciency, it becomes impossible to consistently outperform the market. Research has suggested that the UK capital markets are efﬁcient in the semi-strong form. Abnormal gains may be made from what is called insider dealing, where an investor obtains internal information about the company and purchases or sells shares based on that information. Insider dealing is an offence in the UK in order to protect the stability of the capital markets. In some countries (e.g. Japan), however, insider dealing is not illegal and is considered to be a useful contributor to an informationally efﬁcient market. Although there are some dissidents, the majority of observers would appear to be satisﬁed that the random pattern of share price movements is consistent with the semi-strong form, that is, that shares reﬂect all published information. Given that insider dealing is illegal, they say, that is good enough: the market can be presumed to be efﬁcient.

2.7 Investor ratios Investors will wish to assess the performance of the shares they have invested in: over time, against competing companies in the same sector, and against the market as a whole. There are a number of ratios which will be of speciﬁc interest to investors. The use of the market price of equity is an important component of this type of analysis.

2.7.1 Market price per share The market price (MPS) used throughout Management Accounting: Financial Strategy is the exdividend market price. Ex-dividend means that in buying a share today, the investor will not 2005.1

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movement in the share price of the companies concerned. It would then be possible to buy or sell shares in the companies before the details of the takeover bid were published. As ‘insider trading’ is illegal, it is difﬁcult to test this form of the EMH.

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participate in the forthcoming dividend payment. Sometimes in an examination, the market price may be quoted cum-dividend which means with dividend rights attached. Here the investor will participate in the forthcoming dividend if purchasing the share today. Arguably the investor will be willing to pay a higher price for the share, knowing that a dividend payment is forthcoming in the near future. The relationship between the cum-dividend price and the ex-dividend price is then: MPS (ex-dividend) MPS (cum-dividend) forthcoming dividend per share

2.7.2 Earnings per share Earnings per share (EPS) is a company’s net proﬁt attributable to ordinary shareholders divided by the number of ordinary shares in issue. A simple example of an EPS calculation is shown below. Example 2.A Earnings before interest and tax Interest on debt Earnings after debt interest Tax payable Earnings after tax available for distribution

£m 525 075 450 125 325

Number of shares in issue 175 million EPS

£325m 186 pence per share 175m

An important point to remember is that EPS is a historical ﬁgure and can be manipulated by changes in accounting policies, mergers or acquisitions, etc. The City and company executives occasionally appear obsessed about EPS as a performance measure, an obsession which many think is quite disproportionate to its true value. It is future earnings which should concern investors, a ﬁgure far more difﬁcult to estimate.

2.7.3 The price/earnings ratio A common benchmark when analysing different companies is the use of the price/ earnings (P/E) ratio, which expresses in a single ﬁgure the relationship between the market price of a company’s shares and the earnings per share. It is calculated as: Market price per share (MPS) Earnings per share (EPS) Using the ﬁgures from the EPS example above, and assuming that the company’s current share price is 2,250p, the P/E ratio would be 2,250/186, or approximately 12. The P/E ratio is often referred to as the market capitalisation rate. This simply means that the market value of the company’s equity can be calculated by multiplying last year’s earnings per share by the P/E ratio (to give the share price), then multiplying by the number of shares in issue. 2005.1

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The P/E ratio is the reciprocal (in maths, a number or quantity divided into 1) of the earnings yield. Again, using the EPS example above, the gross earnings yield is 8.3 per cent (186/2,250 100), or 0.083. The P/E is therefore the reciprocal of this, that is, 1/0.083, or approximately 12. The market price will incorporate expectations of all buyers and sellers of the company’s shares, and so this is an indication of the future earning power of the company. Earnings yield EPS MPS

2.7.5 Dividend-payout rate The cash effects of payment of dividends is measured by the dividend-payout rate. Payout rate

Dividend per share (DPS) Earnings per share (EPS)

Assuming the cash dividend is 20p per ordinary share out of EPS of 40p, then the dividend-payout rate is 20/40 0.5 or 50 per cent. The relationship between the above investors’ ratios is usually that a company with a high P/E ratio has a low dividend payout ratio as the high growth company needs to retain more resources in the business. A more stable business would have a relatively low P/E ratio and higher dividend-payout ratio. When analysing ﬁnancial statements from an investor’s point of view it is important to identify the objectives of the investor. Does the investor require high capital growth and high risk, or a lower-risk, ﬁxed dividend payment and low capital growth?

2.7.6 Dividend yield Dividend yield will indicate the return on capital investment, relative to market price. Dividend yield

Dividend per share (DPS) Market price per share (MPS)

Assuming a dividend of 25p per ordinary share and a market price of 250p per share, then dividend yield is 25/250 0.1 or 10 per cent. Buying the share today for 250p should give the investor a return of 10 per cent for the year, based on the dividend income. Remember that the dividend represents only part of the overall return from a share. The other part of the return is the capital gain from an increase in the value of the share. The capital gain from a share may well be far more signiﬁcant than the dividend. 2005.1

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2.7.4 Earnings yield

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2.7.7 Dividend cover Dividend cover measures the ability of the company to maintain the existing level of dividend and is used in conjunction with the dividend yield. Dividend cover

Earnings per share (EPS) Dividend per share (DPS)

Assuming EPS of 50p and net dividend of 20p, then dividend cover is 50/20 2.5 times. The higher the dividend cover the more likely it is that the dividend yield can be maintained. Dividend cover also gives an indication of the level of proﬁts being retained by the company for reinvestment by considering how many times this year’s dividend is covered by this year’s earnings. Example 2.B Lilydale plc has 5,000,000 ordinary shares in issue. Its results for the year end are as follows:

Proﬁt before taxation Taxation Proﬁt after taxation Ordinary dividend – proposed Retained proﬁt

£ 750,000 150,000 600,000 150,000 450,000

The market price per share is currently 83p cum-dividend. The tax credit on dividends is currently 10 per cent.

Requirements Calculate the following ratios: (i) (ii) (iii) (iv)

price/earnings; dividend payout; dividend yield; and dividend cover.

Solution Earnings per share

Dividend per share

600,000 Profit after tax 12p 5,000,000 Number of shares Ordinary dividend Number of shares

MPS (ex-div) MPS (cum-div) less DPS

83p 83p 80p

(i) Price earnings

MPS 80 6.7 EPS 12

(ii) Dividend payout

DPS 3 25% EPS 12

(iii) Dividend yield

DPS 3 3.75% EPS 80

(iv) Dividend cover

EPS 12 4. DPS 3

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From a capital point of view the balance sheet may be used in computing ratios for the investor. The book value per share indicates the asset backing of the investment Shareholders’ funds Number of equity shares in issue at the balance sheet date Assume shareholders’ funds of £2.5 million and number of equity shares in issue to be 5 million, then the asset book value per ordinary share is 2.5/5.0 £0.5, or 50p per share. Note that shareholders’ funds for this calculation must be those attributable to equity, that is, the ordinary shareholders. However, this must be interpreted with care: 1. The valuation of the balance sheet may be based on historical cost values. Other valuations of assets may be more informative. 2. The ratio may be irrelevant in service-based businesses where the major asset is the quality of staff and other intangibles which may not be included in the balance sheet. The book value per share may be compared to the market value per share to determine the market’s evaluation of the business.

2.8 Working capital management strategies In CIMA’s Ofﬁcial Terminology, working capital is deﬁned as: Working capital: The capital available for conducting the day-to-day operations of an organisation; normally, the excess of current assets over current liabilities. In accounting terms, this is a static balance sheet concept, referring to the excess – at a particular moment in time – of permanent capital plus long-term liabilities over the ﬁxed assets of the business. As such, it depends on accounting rules, such as what is capital and what is revenue, what constitutes a retained proﬁt, the cut-off between long term and short term (12 months from the balance sheet date for published accounts), and when revenue should be recognised. If working capital, thus deﬁned, exceeds net current operating assets (stocks plus debtors less creditors) the company has a cash surplus (usually represented by bank deposits and investments); otherwise it has a deﬁcit (usually represented by a bank loan and/or overdraft). On this basis, therefore, the control of working capital can be subdivided into areas dealing with stocks, debtors, creditors and cash. A business must be able to generate sufﬁcient cash to be able to meet its immediate obligations and therefore continue trading. Unproﬁtable businesses can survive for quite some time if they have access to sufﬁcient liquid resources, but even the most proﬁtable business will quickly go under if it does not have adequate liquid resources. Working capital is therefore essential to the company’s long-term success and development, and the greater the degree to which the current assets cover the current liabilities, the more solvent the company. The efﬁcient management of working capital is important from the points of view of both liquidity and proﬁtability. Poor management of working capital means that funds are 2005.1

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2.7.8 Book value per share

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unnecessarily tied up in idle assets, hence reducing liquidity, and also reducing the ability to invest in productive assets such as plant and machinery, so affecting proﬁtability. A company’s working capital policy is a function of two decisions: ●

●

the appropriate level of investment in, and mix of current assets to be decided upon, for a set level of activity – this is the investment decision; the methods of ﬁnancing this investment – the ﬁnancing decision.

2.8.1 The investment decision All businesses, to one degree or another, require working capital. The actual amount required will depend on many factors, such as the age of the company, the type of business activity, credit policy, and even the time of year. There is no standard ﬁxed requirement. It is essential that an appropriate amount of working capital is budgeted for to meet anticipated future needs. Failure to budget correctly could result in the business being unable to meet its liabilities as they fall due. If a business ﬁnds itself in such a situation, it is said to be technically insolvent. In conditions of uncertainty ﬁrms must hold some minimal level of cash and inventories based on expected sales, plus additional safety stocks. With an aggressive working capital policy, a ﬁrm would hold minimal safety stock. Such a policy would minimise costs, but it could lower sales because the ﬁrm may not be able to respond rapidly to increases in demand. Conversely, a conservative working capital policy would call for large safety stocks. Generally, the expected return is lower under a conservative policy than under an aggressive one, but the risks are greater under the aggressive policy. A moderate policy falls somewhere between the two extremes in terms of risk and returns.

2.8.2 The ﬁnancing decision Working capital ﬁnancing decisions involve the determination of the mix of long-term versus short-term debt. When the yield curve is upward-sloping, short-term debt costs less than long-term debt. With an aggressive ﬁnancing policy, the ﬁrm ﬁnances part of its permanent asset base with short-term debt. This policy generally provides the highest expected return (because short-term debt costs are typically less than long-term costs) but it is very risky. Under a conservative ﬁnancing policy, the ﬁrm would have permanent ﬁnancing (long-term debt plus equity) which exceeds its permanent base of assets. The conservative policy is the least risky but also results in the lowest expected return. The maturity matching policy falls between the two extremes. There is a basic difference between cash and inventories on the one hand, and receivables on the other. In the case of cash and inventories, higher levels mean safety stock, hence a more conservative position. There is no such thing as a ‘safety stock of receivables’, and a higher level of receivables in relation to sales would generally mean that the ﬁrm was extending credit on more liberal terms. If we characterise aggressive as being risky, then lowering inventories and cash would be aggressive but raising receivables would also be aggressive. The ﬁnancing of working capital depends upon how current- and ﬁxed-asset funding is divided between long-term and short-term sources of funding. Three possible policies exist, and these are shown in Figures 2.1–2.3. 2005.1

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73 FINANCIAL MANAGEMENT

Figure 2.1

Conservative ﬁnancing policy

Figure 2.2

Aggressive ﬁnancing policy

Figure 2.3

Moderate ﬁnancing policy

A conservative policy is where all of the permanent assets – both ﬁxed assets and the permanent part of the current assets (i.e. the core level of investment in stocks and debtors, etc.) – are ﬁnanced by long-term funding, as well as part of the ﬂuctuating current assets. Short-term ﬁnancing is used only for part of the ﬂuctuating current assets. 2005.1

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An aggressive policy for ﬁnancing working capital uses short-term ﬁnancing to fund all the ﬂuctuating current assets as well as some of the permanent part of the current assets. This policy carries the greatest risk of illiquidity, as well as the greatest returns. A moderate policy matches the short-term ﬁnance to the ﬂuctuating current assets, and the long-term ﬁnance to the permanent part of current assets plus ﬁxed assets.

2.8.3 Multinational working capital management The aims of a multinational enterprise in relation to cash management will be similar to those for a purely domestic enterprise, which will be to: ● ● ● ●

ensure fast collection of cash; take larger to pay out cash; optimise cash ﬂow within the enterprise; generate the best return on cash surpluses.

Achieving these aims will be more difﬁcult in a multinational enterprise due to the longer distances involved, the number of parties involved, and the risk of governments placing restrictions on the transfers of funds out of certain countries. Granting credit is often an essential condition to undertake international business. In addition to the normal risks of default ﬁrm granting credit, exchange rate ﬂuctuations between the time of sale and the time the debt is collected provide an additional risk. Management of stocks is also similar to but more complex than for a purely domestic enterprise. The balance between minimising stockholdings and being able to meet customer demands is more difﬁcult to judge. The movement is exchange rates will also inﬂuence the timing of purchases, and the level of stocks held in a particular currency. Political risk is a further consideration; multinationals will need to allow for the prospect of import or export quotas or tariffs being imposed. In certain countries, the risk of expropriation of stocks will lead to minimal stock holdings being maintained. Some countries have property taxes on assets, including stocks, where the tax payable is based on holdings on a particular date in the year, which again will inﬂuence the strategy adopted for stock management by a multinational.

2.9 Summary This chapter has described the two principal rules within the ﬁnancial management function, that is, treasury and ﬁnancial control, pointing out their relationships and respective duties. Financial markets and their efﬁciency have been examined. An efﬁcient capital market is one in which share prices move rationally, and reﬂect all information that could affect the price. Conservative and aggressive ﬁnancing and investment strategies for working capital have been evaluated.

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2

Readings

The article below discusses the volatility in the UK and US stock markets during the ﬁrst quarter of 2000. In doing so, it raises questions about the validity of fundamental analysis and the efﬁcient market hypothesis.

Volatility unvanquished Phillip Coggan, Financial Times, 8/9 April 2000. © Financial Times. Reproduced by permission.

Remember those 1960s and 1970s sci-ﬁ ﬁlms where giant computers - the kind that ﬁlled a whole room – plotted to take over the world? Maybe it is time for some sequels. This week investors suffered Turbulent Tuesday, when the tech stocks on the UK Nasdaq market brieﬂy fell nearly 14 per cent, before recovering. Then there was Washed-Out Wednesday when a computer problem at the London Stock Exchange meant that trading could not even start until the middle of the afternoon. Perhaps we have had a glimpse of the computers’ master plan. Cause so much stress among the human population that we all die out – and leave them to take control. It is certainly as plausible an explanation as any other. Tough to argue the case for an efﬁcient market made up of rational investors when the same stocks trade in a 14 per cent range within a matter of hours. Can earnings expectations have altered so much so quickly? It is also hard to believe in a ‘new era’ of highly productive technology when the stock exchange in one of the world’s leading ﬁnancial centres can crash for several hours. So what has really been going on? Our old friends fear and greed have certainly played their part. Investors have been buying stocks in some companies, not because they have rationally analysed the fundamentals, but because they have been going up. Some in the US have been buying on margin, i.e. borrowed money. The good news for investors is that this kind of buying can drive share prices up to unimagined heights. Fundamental analysis simply does not work. Investors do not care about the price they pay for shares because they expect someone else to pay a higher price in a month’s, or a week’s time. Witness the more than doubling in the Techmark 100 index in four short months. What had changed about the fundamentals of technology stocks in that period? Not much. The big change was in investors’ perceptions. The bad news, alas, is that when the spell fades, there can be nothing to support the shares. It can be rather like those Road Runner cartoons where Wile E Coyote runs happily over the edge of the cliff – until he suddenly looks down. 75

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Take poor old Lastminute.com. When everybody thought they were going to make their fortunes from the shares, the spread-betting ﬁrms were quoting prices of over 500p. Once the shares started trading, the magic dissipated; the price dipped below 200p this week. Nothing has changed about the business in the meantime. All this does not necessarily signal that the overall market is in for a bloodbath. There are plenty of investors who believe in ‘buying on the dips’. They have absorbed the age-old lesson that equities outperform over the long term. Thus, market dips are not a cause for panic but a buying opportunity. That has been a pretty good general rule but it is worth remembering that there have been occasions – Wall Street during 1929–32 or the UK in 1972–74, for example – when investors needed immense patience for it to come right. Investors who bought into the Tokyo stock market in 1989 are still waiting. For the moment, the old economy gets the beneﬁt whenever the new economy suffers and vice versa, leaving indices like the FTSE 100 stuck in a trading range. Credit Suisse First Boston points out that the nine, largely new economy, stocks that joined the Footsie on March 6 have underperformed the market by an average of 32 per cent, while the old economy groups that were dumped out of the index have outperformed by 23 per cent. Investors may also have been getting more selective, looking for the new economy stocks with established brands or strong niches, and discarding those that never looked like making a proﬁt. They have also started to realise there are plenty of old-economy businesses that will not suffer from the internet (and there are even some that will beneﬁt). This is a pretty healthy development but it seems unlikely that stock markets have seen the last of the kind of volatility that dominated events this week. Interest rates are still likely to rise in the US, Europe and the UK (although the Bank of England left them on hold on Thursday). New economy stocks (technology, media and telecoms) still, as a group, trade on very fancy price–earnings ratios, which suggests that there may be a lot of scope for disappointments at the individual company level. The UK market will also lose shortly the support from the ‘ISA effect’ – the end of tax year cash ﬂows into individual savings accounts that tend to keep the market buoyant in March and April. As if the ﬁrst quarter has not been exciting enough, investors could be in for a testing summer. Perhaps the computers are running amok after all.

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Revision Questions

2

Question 1 (a) Explain the weak form of the efﬁcient market hypothesis (EMH). (4 marks) (b) Outline and appraise the empirical research undertaken to test the validity of the weak form of EMH. (4 marks) (c) If the capital markets are efﬁcient, this has implications for corporate ﬁnance. Discuss the implications for the ﬁnancial manager of a large company that is trying to maximise the wealth of its shareholders. (12 marks) (Total marks 20)

Question 2 ABC plc is a UK-based service company with a number of wholly owned subsidiaries and interests in associated companies throughout the world. In response to the rapid growth of the company, the managing director has ordered a review of the company’s organisation structure, particularly the ﬁnance function. The managing director holds the opinion that a separate treasury department should be established. At present, treasury functions are the responsibility of the chief accountant. Requirements (a) Describe the main responsibilities of a treasury department in a company such as ABC plc and explain the beneﬁts that might accrue from the establishment of a separate treasury function. (12 marks) (b) Describe the advantages and disadvantages that might arise if the company established a separate treasury department as a proﬁt centre rather than as a cost centre. (8 marks) (Total marks 20)

Question 3 UR is a privately owned machine tool manufacturing company based in the Rupublic of Ireland. For the past ﬁve years, it has operated an aggressive policy in respect of the management of its working capital. The following information concerns the conpany’s forecast end-of-year ﬁnancial outcomes if it continues with this type of policy. 77

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78

Receivables Inventory Cash at bank Total current assets Non-current assets Trade creditors

€000 5,200 2,150 14,350 7,700 14,500 4,500

Revenue Operating costs Operating proﬁt

17,500 14,000 13,500

Earnings

2,625

There are 2.5 million shares in issue. The company has been experiencing a series of problems because of the type of working capital management policy it has been following and is considering an alternative approach to working capital management. The percentage ﬁgures shown below are changes to the above forecast. These changes are anticipated to occur if a more conservative policy is adopted. Receivables Inventory Cash (ﬁgures in €000) Non-current assets Curent liabilities Forecast revenue Operating proﬁt and earnings

40% 20% Increase to €1,000 No change 30% 5% 5%

Requirement Evaluate the two working capital management policies described above and recommend a proposed course of action. Include in your evaluation a discussion of the problems that might have arisen as a result of operating aggressive working capital management policies and thekey elements to consider and actions to take before making a decision to change. You should calculate appropriate and relevant ratios or performance measures to support your arguments. [The calculations will earn up to 8 marks.] (25 marks)

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Solutions to Revision Questions

2

Solution 1 This question examines the following syllabus area: ●

The efﬁcient market hypothesis (EMH).

(a) The weak form of EMH states that the current share price reﬂects all the information contained in the record of past prices. Studies have shown that share prices usually display the features of a random walk and this means that future prices do not follow past trends. This has implications for people who chart the prices of shares in fundamental analysis. Even the weak form of the EMH would make ‘charting’ a waste of time. (b) The weak form of the efﬁcient market hypothesis has been tested by subjecting a series of share prices or indices to statistical tests to determine whether there is any correlation between past and present prices. Evidence suggests that it is not possible to predict future prices by looking at a series of past prices. Another series of tests has been to establish whether following trading rules enables above-average returns to be earned. (c) It is generally acknowledged that the prime objective of a company is to maximise the wealth of shareholders. Can ﬁnancing decisions contribute to the increase in wealth of the shareholders? If the capital markets are perfect, then ﬁnancing decisions will not create value. If the capital markets are efﬁcient, on the other hand, it is possible that shareholders’ wealth could be increased by the ‘right’ decisions being made by ﬁnancial managers, though it is unlikely that the beneﬁts will be generated consistently. So managers can make investment decisions that generate positive NPVs and create value through the disequilibriums that often exist in the real markets. However, the nature of the capital markets, especially the evidence of efﬁciency, means that it is less likely to occur in the area of ﬁnance. If capital markets are efﬁcient, the main implications for corporate ﬁnance are as follows: ●

● ●

It is not possible to generate a surplus by timing an issue of new securities at the ‘best’ time. A company can sell as many securities as it wishes without affecting the price. A company cannot mislead the markets by adopting ‘creative accounting’ techniques.

Efﬁcient market theory has provided valuable insights into the functioning of the markets for ﬁnancial assets. It appears to be sensible for corporate ﬁnancial managers to assume that the ﬁnancial markets are highly efﬁcient and it is, therefore, important that this is taken into consideration when they develop strategic plans to create value for shareholders. 79

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Solution 2 This question examines the following syllabus areas: ● ●

●

The role of the treasury function; The beneﬁts and shortcomings of establishing treasury departments as proﬁt centres or cost centres; The control of treasury departments when established as cost centres or proﬁt centres.

Tips ●

●

A signiﬁcant minority of candidates were ignorant of the treasurer’s role and confused the job’s functions with those of the ﬁnancial manager/controller. Another weakness was to confuse separation with decentralisation. The question did not require a discussion of decentralisation, or devolvement to overseas subsidiaries, although candidates were given credit for making good points.

(a) CIMA Ofﬁcial Terminology describes the treasury function as the function concerned with the provision and use of ﬁnance. It includes provision of capital, short-term borrowing, foreign currency management, banking, collections and money-market investment. The main functions of such a department include: 1. Establishment of corporate ﬁnancial objectives. 2. Managing the ﬁrm’s liquid assets: cash, marketable securities, etc. 3. Management of the company’s funding: determination of policies (e.g. on transfer pricing), identifying sources and types of funds. 4. Corporate ﬁnance and related issues such as taxation, pension fund investment, etc. 5. In a multinational such as ABC, it will also deal with currency management: dealing in foreign currencies, hedging currency risks, etc. 6. Cash management in a multinational such as ABC can involve centralised cash management and multilateral netting of foreign currency transactions between subsidiaries and associated companies. Treasury is usually a centralised function in that the relationships mentioned above are usually concentrated in head ofﬁce, that is, the parent company of a group. Financial control, meanwhile, is increasingly being devolved to individual business units, so as to be close to the customer, alert to competition, etc. Where this is the situation, a separation of treasury from control is inevitable. The skills required are also different, for example, given the liberalisation of ﬁnancial markets and foreign exchanges, treasurers need to be aware of the expanding range of hybrid capital instruments (e.g. convertible preference shares issued in the name of a subsidiary registered in the Dutch Antilles) and ﬁnancial instruments (forward markets and the various ‘derivatives’) and to be able to select from these the ones that are appropriate to the company’s needs in the prevailing circumstances. A separate treasury function is more likely to develop the appropriate skills: it is impossible for anyone to be expert in these matters and have time to be proactively involved in the management of individual businesses. It will also be easier to achieve economies of scale (e.g. better borrowing rates and the netting-off of balances).

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Solution 3 Preliminary calculations Appropriate choice could include EPS, return on net assets and the current and/or quick ratio. Other calculations could include debtors/creditors days, stock days/turnover and the operating cycle.

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(b) As indicated in the answer to part (a), the case for a separation of treasury – not only from accounting but also from ﬁnancial control – is a strong one. The question remains, however, as to how its performance/progress should be measured/assessed. Some people would argue for a ‘proﬁt centre’ approach. This usually means that the treasury charges individual business units a market rate for the service it provides. If it writes currency options, for example, it charges the business unit a premium in line with that charged by the banks. It then has the task of managing that option (by buying and selling in the forward market, or by using derivatives) for a cost that leaves it with a proﬁt. The main argument for this is that the treasurer is then motivated to do what is best for the company as a whole, that is, to minimise the cost of the operation. Spot checks are obviously required (e.g. by internal audit) to ensure that charges are indeed at market rates, since there is an imbalance in the amount of information available to the two parties (weighted in favour of the treasurers). There are obviously some administrative costs involved, but the main drawback in practice has been that some treasurers have interpreted the proﬁt concept as encouraging them to speculate. If it can make a proﬁt writing options, why not write them for other companies? If it understands the foreign currency markets, why not speculate – for example, swap funds from currencies expected to depreciate into ones expected to appreciate? Often spectacular gains can be made, but the record shows that spectacular losses are at least as likely. A sound internal control system is a necessity in any treasury function, but especially so when speculation is encouraged. Consequently there are many who advocate a ‘cost centre’ approach. This usually means that the costs of running the department are collected (and, no doubt, compared with budget) but that the substance of the transactions that they manage is reﬂected in the business unit’s books: for example, the ‘proﬁt’ made on writing options is credited to the business for which it was written. Alternatively, the proﬁts/losses are allowed to lie where they fall: for example, the business unit carries the proﬁt or loss on an overseas sale (according to the spot rate when the cash is received) and the treasury carries the offsetting currency loss/gain respectively (the difference between the forward rate obtained and the eventual spot rate). This approach collects the total cost/beneﬁt of hedging. It discourages speculation but may, by the same token, discourage initiative. Confrontation can occur when the business unit bears a loss, caused – as it sees it – by the treasury. The debate as to which method is appropriate mirrors that in various other aspects of business enterprise. Perhaps the most important observation is that the accounting model – whether it focuses on costs or proﬁts - is insufﬁciently dynamic/long-termist to provide a platform for strategic control. What is required is a distinctive ﬁnancial management approach.

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Policy Receivables Inventory Cash Current assets Non-current assets Current liabilities Forecast revenue Forecast proﬁt Forecast earnings Current assets less current liabilities Net assets Earnings per share (€) Return on net assets (%) Current ratio Quick ratio Debtors days Creditors days Stock days Operating cycle Operating proﬁt margin ROCE

Aggressive €000 5,200 2,150 2,350

€000

Conservative €000 3,120 2,580 1,000

€000

7,700 14,500 (4,500) 17,500 3,500 2,625

6,700 14,500 (3,150) 16,625 3,675 2,756

3,200 17,700

3,550 18,050

1.05 19.8 1.71 1.23 108.5 117.3 56.1 47.3 20.0 13

1.10 20.40 2.13 1.31 68.5 88.8 72.7 52.4 22.11 15

Evaluation of the alternative policies Investment in working capital is, typically, in stocks, debtors and cash or marketable securities (highly liquid, short-term assets). In conditions of uncertainty ﬁrms must hold some minimal level of cash and stock based on expected sales, plus additional safety stocks. With an aggressive working capital policy, a ﬁrm would hold minimal safety stocks. Such a policy would minimise costs, but it could lower sales because the ﬁrm could not respond rapidly to increases in demand. Conversely, a more conservative working capital policy would call for large safety stocks. There is a basic difference between cash and stock, on the one hand, and receivables on the other. In the case of cash and stock, higher levels mean higher safety stock, hence a more conservative position. There is no such thing as a ‘safety stock of receivables’, and a higher level of receivables in relations to sales would generally mean that the ﬁrm was extending credit on more liberal terms. Possible explanations for UR’s problems/difﬁculties of changing policy The problems UR has been experiencing are likely to be one or more of the following: ● ● ● ●

increase in bad debts because of more liberal credit policies; increased overdraft charges because the company may have unexpected cash shortfalls; stock outs because of low stock levels and, possibly, inadequate, JIT-type systems; refusal of supplies or even legal action because of late payments to creditors.

The main difﬁculty likely to be experienced by a change in policy is the loss of custom. This issue is discussed further below. The key elements to consider/actions to take before making a decision The implications for change could be wide-ranging and the likely effect on customer relations and sales are key considerations. The main elements to review and evaluate before a 2005.1

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●

●

●

●

●

●

●

●

Industry-related characteristics, for example if competitors offer 90 days credit. It is difﬁcult to require a shorter payment period unless you offer a much superior product or service or other unque factor. UR’s debtors’ days are at present 108.5, which seems generous and was probably the result of a campaign to increase sales under the ‘aggressive’ policy regime. This ratio would fall to 68.5 days under the proposed policy. Industry ﬁgures are not given so it is not possible to make any valid comparisons. The current ratio, even under an aggressive policy, seems high for modern working capital management. This would rise to 2.13 under the proposed policy, which might imply under-utilised current assets. Cash lying idle in a bank account is not a good use of money and again the need is to investigate cash management systems before deciding it is simply the cash balances that are too low. A detailed cash ﬂow budget should be prepared. The use of cash management models should be considered if the company is likely to now be always in cash surplus. A review of stock control polices should be carried out to assess whether the problems are faulty systems rather than too low stock levels. The type of product or service sold. The operating cycle for UR is expected to be 47.3 days based on the information available and the existing policies are maintained. This ﬁgure would rise to 52.4 if the proposed policy were adopted. Again, industry ﬁgures are needed but transport and distribution does not have a long cycle and these ﬁgures may not be untypical. Volume of sales: organisations such as supermarkets have very high volume sales but, typically, low margin. The operating proﬁt margin for UR is currently only 20 per cent seems low for a company such as this. This would rise to 22.1 per cent under the proposed policy, but this is fairly marginal. Level of centralisation of working capital management: the more centralised the tighter the control (usually) that allows a more aggressive approach. UR is a relatively small company and it is likely their WCM will be centralised. This would favour an aggressive policy so before a decision is taken the real reason for the problems should be reviewed and evaluated. The efﬁciency of the credit control department in an organisation. If the company has a long period between invoice production and despatch, it needs to recognise this in the credit period allowed. This is unknown from the information in the question, but the 108.5 debtor’s days suggest this could be investigated.

Recommendation The ﬁgures calculated in support of the evaluation suggest that proﬁts, EPS and return on net assets will increase if UR adopts the proposed policy. The current ratio rises from 1.71 to 2.13 (quick ratio from 1.23 to 1.31). This is not a dramatic change and, given modern debt collection, ordering and banking practices and the installation of a new computer system, a ratio of 1.71 might be considered comfortable enough. However, before a decision is taken, UR should consider the effect on its customers, suppliers and staff. The company should review the various components of working capital and the procedures as well as policies for their management. The calculations so far do not provide an overwhelming case for a change in policy. The current ratio is already generous and the likely increases in proﬁts, earnings and return on net assets are relatively small. It is possible that the same beneﬁts could be obtained by better management of the existing policies rather than risking customer relations and loss of custom. 2005.1

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decision is taken are summarised below:

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Sources of Long-term Finance

3

LEARNING OUTCOME After completing this chapter you should be able to: 䉴

Identify and calculate optimal strategies for the satisfaction of longer-term ﬁnancing requirements.

3.1 Introduction The topics covered in this chapter are as follows: ● ● ● ● ● ●

Types of share capital. Equity issues; new and rights issues. Long-term debt ﬁnance. Methods of issuing securities. Operating and ﬁnance leases. The difference between the coupon on debt and the yield to maturity.

3.2 Shareholders’ funds 3.2.1 Ordinary shares An equity interest in a company can be said to represent a share of the company’s assets and a share of any proﬁts earned on those assets after other claims have been met. The equity shareholders are the owners of the business – they purchase shares (commonly called ordinary shares), the money is used by the company to buy assets, the assets are used to earn proﬁts, and the assets and proﬁts belong to the ordinary shareholders. Equity shares entail no agreement on the company’s part to return to the shareholders the amount of their investment. Ordinary shares are sometimes referred to as the risk capital of a business; it is the ordinary shareholders who take most of the risk in business. Nominal value Ordinary shares may be issued with a nominal value of, say, 10 pence each. These shares will continue to be referred to as 10 pence shares, even though the price at which they are 85

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STUDY MATERIAL P9

bought and sold on the stock market may differ substantially from this. Shares without a nominal value, or shares of no par value, are common in the USA and have for some years been advocated in the UK, but their issue would be illegal under current legislation. Dividends are usually paid in pence per share and are not based on nominal values, which is usually the case with ﬁxed-interest securities. There is no express relationship between the nominal value and the market value of a share. However, company law in the UK prevents shares from being issued below their nominal value. This means that a company whose share price has fallen below the nominal value would not be able to raise additional funds by way of a share issue. Book value Book values apply to both assets and liabilities. The book value of an asset is the net result of the accounting procedures and adjustments to which the balance has been subjected, for example, depreciation charges. However, it is not necessarily any guide to the market, or realisable-value of the asset. In Financial Strategy we are likely to be more concerned with the differences between book and market values of shareholders’ equity. The book value of equity is the sum of the ordinary share capital shown in the balance sheet plus the value of shareholders’ reserves (share premium account, revaluation reserve, retained earnings, etc.). This value may be quite different from the market value of equity. This is mainly because the book value: (a) reﬂects accounting procedures and adjustments; and (b) is a historical ﬁgure. Market values reﬂect investors’ expectations about future earnings. Market value This is the value of an asset based on the amount it is believed it would command if sold. Some assets, such as securities, are traded regularly on an organised market and their value is relatively simple to establish. However, the market value of, for example, specialised plant and machinery may be more difﬁcult to establish. The market value of shares is