CIMA BA 1 fundamentals of business economics study text

Contents Chapter 1 Microeconomic and Organisational Context I: The Goals and Decisions of Organisations 1 Chapter 2 Microeconomic and Organisational Context II: The Market System 29 Ch

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British Library Cataloguing in Publication Data

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ISBN: 978-1-78740-173-0

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Contents

Chapter 1 Microeconomic and Organisational Context I:

The Goals and Decisions of Organisations

1

Chapter 2 Microeconomic and Organisational Context II:

The Market System

29

Chapter 3 Financial Context of Business I 75

Chapter 4 Macroeconomic and Institutional Context I:

The Domestic Economy

113

Chapter 5 Macroeconomic and Institutional Context II:

The International Economy

175

Chapter 6 Financial Context of Business II:

International aspects

213

Chapter 7 Financial Context of Business III:

Discounting and Investment Appraisal 231

Chapter 8 Informational Context of Business I:

Summarising and Analysing Data 263

Chapter 9 Macroeconomic and Institutional Context III:

Index Numbers 283

Chapter 10 Informational Context of Business II:

Inter-relationships between variables 305

Chapter 11 Informational Context of Business III:

Forecasting

329

Chapter 12 Mock Assessment 351

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Microeconomic and Organisational Context I: The Goals and

Decisions of Organisations

Chapter learning objectives

Upon completion of this chapter you will be able to:

• distinguish between the goals of profit-seeking organisations, not-for-profit organisations (NFPs) and governmental

organisations

• explain shareholder wealth, the variables affecting shareholder wealth and its application in management decision making

• distinguish between the potential objectives of management, shareholders, and other stakeholders and the effects of these on the behaviour of the firm

Chapter

1

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Microeconomic and Organisational Context I: The Goals and Decisions of Organisations

1 The nature of organisations

1.1 What is an organisation?

‘Organisations are social arrangements for the controlled performance of

collective goals.’ (Buchanan and Huczynski)

The key aspects of this definition are as follows:

(a) ‘Collective goals’ – organisations are defined primarily by their goals

A school has the main goal of educating pupils and will be organised

differently from a company where the main objective is to make profits

(b) ‘Social arrangements’ – someone working on his own does not constitute

an organisation Organisations have structure to enable people to work

together towards the common goals Larger organisations tend to have

more formal structures in place but even small organisations will divide up

responsibilities between the people concerned

(c) ‘Controlled performance’ – organisations have systems and procedures to

ensure that goals are achieved These could vary from ad-hoc informal

reviews to complex weekly targets and performance reviews

Illustration 1 – Definition of organisations

For example, a football team can be described as an organisation

because:

• It has a number of players who have come together to play a game

• The team has an objective (to score more goals than its opponent)

• To do their job properly, the members have to maintain an internal

system of control to get the team to work together In training they work out tactics so that in play they can rely on the ball being passed to those who can score goals

• Each member of the team is part of the organisational structure and

is skilled in a different task: the goalkeeper has more experience in stopping goals being scored than those in the forward line of the team

• In addition, there must be team spirit, so that everyone works

together Players are encouraged to do their best, both on and off the field

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Chapter 1

Test your understanding 1

A queue of people standing at a bus stop is an example of an organisation if they all want to travel to the same place

True/False

Defining organisations

As yet there is no widely accepted definition of an organisation This is because the term can be used broadly in two ways:

• It can refer to a group or institution arranged for efficient work

• Organisation can also refer to a process, i.e structuring and arranging the activities of the enterprise or institution to achieve the stated objectives

There are many types of organisations, which are set up to serve a number of different purposes and to meet a variety of needs, including companies, clubs, schools, hospitals, charities, political parties,

governments and the armed forces

What they all have in common is summarised in the definition given

1.2 Why do we need organisations?

Organisations enable people to:

• share skills and knowledge

• specialise and

• pool resources

The resulting synergy allows organisations to achieve more than the individuals could on their own

As the organisation grows it will reach a size where goals, structures and

control procedures need to be formalised to ensure that objectives are

achieved

These issues are discussed in further detail below

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Illustration 2 – The nature of organisations

When families set up and run a chain of restaurants, they usually do not

have to consider formalising the organisation of their business until they

have five restaurants

After this stage responsibilities have to be clarified and greater delegation

is often required

1.3 Classifying organisations by profit orientation

Organisations can be classified in many different ways, including the

following:

Profit-seeking organisations

Some organisations, such as companies and partnerships, see their main

objective as maximising the wealth of their owners Such organisations

are often referred to as ‘profit-seeking’

The objective of wealth maximisation is usually expanded into three

primary objectives:

• to continue in existence (survival)

• to maintain growth and development

• to make a profit

Not-for-profit organisations

Other organisations do not see profitability as their main objective Such

not-for-profit organisations (‘NFPs’ or ‘NPOs’) are unlikely to have

financial objectives as their primary ones

Instead they are seeking to satisfy particular needs of their members or

the sectors of society that they have been set up to benefit

Illustration 3 – NFP organisations

NFPs include the following:

• government departments and agencies (e.g HM Revenue and

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Chapter 1

The objectives of NFPs can vary tremendously:

• Hospitals could be said to exist to treat patients

• Councils often state their ‘mission’ as caring for their communities

• A charity may have as its main objective ‘to provide relief to victims of

disasters and help people prevent, prepare for, and respond to emergencies’

• Government organisations usually exist to implement government policy

NFPs must stay within their budgets to survive But their stakeholders are

primarily interested in how the organisation contributes to its chosen field This

can frequently lead to tensions between financial constraints and the NFP's

objectives

Which of the following best completes the statement 'Financial considerations are a constraint in not-for-profit organisations because '

A they have no profits to reinvest

B they meet the needs of people who cannot afford to pay very much

C they do not have a flow of sales revenue

D their prime objectives are not financial but they still need money to enable them to reach them

Which one of the following is not a key stakeholder group for a charity?

A employees and volunteers

B shareholders

C donors

D beneficiaries

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Financial objectives in NFPs

Many NFPs view financial matters as constraints under which they have

to operate, rather than objectives For example

• Hospitals seek to offer the best possible care to as many patients as

possible, subject to budgetary restrictions imposed upon them

• Councils organise services such as refuse collection, while trying to

achieve value for money with residents’ council tax

• Charities may try to alleviate suffering subject to funds raised

One specific category of NFPs is a mutual organisation Mutual organisations

are voluntary not-for-profit associations formed for the purpose of raising funds

by subscriptions of members, out of which common services can be provided to

those members

Mutual organisations include:

• some building societies

• trade unions and

• some social clubs

Which one of the following would not be a stakeholder for a mutual

Some building societies have demutualised and become banks with

shareholders Comment on how this may have affected lenders and

borrowers

1.4 Classifying organisation by ownership/control

Public sector organisations

The public sector is that part of the economy that is concerned with

providing basic government services and is thus controlled by

government organisations

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Chapter 1

Illustration 4 – Public sector organisations

The composition of the public sector varies by country, but in most countries the public sector includes such services as:

• police

• military

• public roads

• public transit

• primary education and

• healthcare for the poor

Private sector organisations

The private sector, comprising non-government organisations, is that part

of a nation’s economy that is not controlled by the government

Illustration 5 – Private sector organisations

Within these will be profit-seeking and not-for-profit organisations

This sector thus includes:

enterprise

(The International Co-operative Alliance Statement on the Co-operative Identity, Manchester 1995)

Co-operatives are thus businesses with the following characteristics:

• They are owned and democratically controlled by their members – the people who buy their goods or use their services They are not owned by investors

• Co-operatives are organised solely to meet the needs of the member-owners, not to accumulate capital for investors

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For example, a retail co-operative could comprise a group of people who

join together to increase their buying power to qualify for discounts from

retailers when purchasing food

Co-operatives are similar to mutual organisations in the sense that the

organisations are also owned by the members/clients that they exist for

However, they tend to deal primarily in tangible goods and services such

as agricultural commodities or utilities rather than intangible products

such as financial services

Which of the following are usually seen as the primary objectives of

companies?

(i) To maximise the wealth of shareholders

(ii) To protect the environment

(iii) To make a profit

A (i), (ii) and (iii)

B (i) and (ii) only

C (ii) and (iii) only

D (i) and (iii) only

Many schools run fund-raising events such as fêtes, where the intention

is to make a profit This makes them ‘profit-seeking’

True or False?

2 Shareholder wealth

2.1 Maximising shareholder wealth

As stated above, companies have the primary objective of maximising

shareholder wealth This should ultimately be reflected in

• higher share prices

• higher dividend payments

The role of the managers within the business is to make decisions that will

affect the value of the company and therefore the value of shareholder wealth

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Chapter 1

Attempts to measure and increase shareholder value have focussed on

incorporating three key issues:

• Cash is preferable to profit

Cash flows have a higher correlation with shareholder wealth than profits

• Exceeding the cost of capital

The return, however measured, must be sufficient to cover not just the cost of debt (for example by exceeding interest payments) but also the cost of equity (the return required by shareholders)

• Managing both long- and short-term perspectives

Investors are increasingly looking at long-term value When valuing a company’s shares, the stock market places a value on the company’s future potential, not only its current profit levels

Profit and shareholder value

Just because a company has made a profit, it does not follow that shareholder wealth has been increased by a level that satisfies the shareholders Consider the following example

EVA plc has the following financial structure:

• $100 million debt with an interest rate (pre-tax) of 6%

• $200 million equity where it is estimated that shareholders want a return of 15%

The company has made a profit before interest and tax of $36 million and pays tax at 30%

Comment on whether directors have achieved their objective of increasing shareholder wealth

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2.2 Short-term measures of financial performance

It is quite possible that financial performance of a business in the short-term

could be different to its performance in the long-term Thus measures are

needed both of short-term and long-term financial performance

Two standard measures of short-term performance are:

1 return on capital employed

2 earnings per share

Return on capital employed (ROCE)

ROCE = profit before interest and tax

average capital employed × 100%

Comments:

• ROCE gives an indication as to how well a business uses its capital (or the

assets purchased with the capital) to generate profits

• Being a percentage makes it easy to compare the ROCE of different

companies

Another similar measure of the return to shareholders’ capital is:

Return on net assets (RONA) =

operating profit(before interest and tax)total assets minus current

liabilities

× 100%

The higher the figure for ROCE or the return on net assets is, the more

profitable the company is However, ROCE is a measure of the net income

generated by the business and not about where that income goes

Shareholders will be more interested in profits after the payment of interest and

tax

Earnings per share (EPS)

As its name suggests, EPS determines the profits available to ordinary

shareholders, expressed per share

EPS = profits after interest, tax and preference share dividends

number of ordinary shares issued

Of course this figure only gives the earnings per share that each owner of

ordinary shares might expect to receive It is up to the Directors to decide

whether/how much to pay out as a dividend

Furthermore, to calculate a rate of return for the shareholder, the price that the

potential shareholder has to pay to acquire a share must be taken into account

Note that the main weakness of both ROCE and EPS is that they do not

correlate directly to the goal of maximising shareholder wealth

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Chapter 1

The following is an extract from the accounts of EBG

RGP currently has an eps figure of 10c with 1 million shares in issue

A proposed new project will increase profit after tax by $25,000 per annum and will be financed by the issue of a further 400,000 shares

Calculate the new eps and indicate how shareholders will perceive the change

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2.3 Long-term measures of financial performance

In addition to measuring current financial performance, companies also need to

be able to measure longer-term performance, in particular, in relation to

investment In this case it is important that a business can be sure that returns

to shareholders are at least equal to the cost of acquiring the capital required to

produce a long-term flow of earnings

In making these sorts of assessment several problems arise:

• establishing the cost of capital to finance the investment project

• estimating the flow of income derived from the capital investment over the

whole life of the investment

• valuing that flow of income

To solve these problems we calculate the present value of future cash flows by

a process of discounting See later chapter on 'Discounting and Investment

Appraisal'

2.4 Share values

The concept of discounted cash flows can be used to explain how press

releases and market rumours can affect the share price

• Suppose the company announces a new project If the market believes

that the project will deliver a positive net present value, then the share

price should rise You will see in more detail in a later chapter that the net

present value (NPV) of a project is the sum of the discounted future cash

flows minus the capital cost of the project

• Any information that reaches the market that suggests that future cash

flows will be higher than previously forecast should result in a share price

rise

• If bad news reaches the market then as well as revising forecast cash

flows downwards, investors may reassess the investment as having higher

risk This will result in a higher cost of capital and thus future receipts will

be less valuable than previously estimated The end result is a fall in the

share price

Many variables will affect the value of shares These tend to fall into two groups:

1 factors external to the business which may affect a wide range of shares:

the onset of a recession would tend to depress share values in general as

would a rise in interest rates

2 factors internal to the business that might affect the future flow of profits

such as the failure of a new product, an expected decline in sales or a

significant rise in costs

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