ACCA paper f9 financial management FInal mock examination f9 study book

Objectives of the syllabus • Discuss the role and purpose of the financial management function.. Syllabus learning objective and Chapter reference: A FINANCIAL MANAGEMENT FUNCTION 1 The

How to Use the Materials

These Kaplan Publishing learning materials have been carefully designed to make your learning experience as easy as possible and to give you the best chances of success in your examinations.The product range contains a number of features to help you in the study process They include:(1) Detailed study guide and syllabus objectives

(2) Description of the examination

(3) Study skills and revision guidance

(4) Complete text or essential text

(5) Question practice

The sections on the study guide, the syllabus objectives, the examination and study skills should all be read before you commence your studies They are designed to familiarise you with the nature and content of the examination and give you tips on how to best to approach your learning

The complete text or essential text comprises the main learning materials and gives guidance

as to the importance of topics and where other related resources can be found Each chapter includes:

• The learning objectives contained in each chapter, which have been carefully mapped to the

examining body's own syllabus learning objectives or outcomes You should use these to check you have a clear understanding of all the topics on which you might be assessed in the examination

• The chapter diagram provides a visual reference for the content in the chapter, giving an

overview of the topics and how they link together

• The content for each topic area commences with a brief explanation or definition to put the

topic into context before covering the topic in detail You should follow your studying of the content with a review of the illustration/s These are worked examples which will help you to understand better how to apply the content for the topic

• Test your understanding sections provide an opportunity to assess your understanding of

the key topics by applying what you have learned to short questions Answers can be found at the back of each chapter

• Summary diagrams complete each chapter to show the important links between topics and

the overall content of the paper These diagrams should be used to check that you have covered and understood the core topics before moving on

• Question practice is provided at the back of each text.

additional content on-line (read it where you need further guidance or skip over when you are happy with the topic)

Illustration - Worked examples help you understand the core content

better

Test Your Understanding - Exercises for you to complete to ensure that you have understood the

topics just learned

Tricky topic - When reviewing these areas care should be taken and all illustrations and test your

understanding exercises should be completed to ensure that the topic is understood

On-line subscribers

Our on-line resources are designed to increase the flexibility of your learning materials and provideyou with immediate feedback on how your studies are progressing Ask your local customer

services staff if you are not already a subscriber and wish to join

If you are subscribed to our on-line resources you will find:

(1) On-line referenceware: reproduces your Complete or Essential Text on-line, giving you

anytime, anywhere access

(2) On-line testing: provides you with additional on-line objective testing so you can practice what you have learned further

(3) On-line performance management: immediate access to youron-line testing results Review your performance by key topics and chart your achievement through the course relative to your peer group

Paper background

The aim of ACCA Paper F9, Financial management, is to develop the knowledge and skills

expected of a financial manager, relating to issues affecting investment, financing, and dividend policy decisions

Objectives of the syllabus

• Discuss the role and purpose of the financial management function

• Assess and discuss the impact of the economic environment on financial management

• Discuss and apply working capital management techniques

• Carry out effective investment appraisal

• Identify and evaluate alternative sources of business finance

• Explain and calculate cost of capital and the factors which affect it

• Discuss and apply principles of business and asset valuations

• Explain and apply risk management techniques in business

Core areas of the syllabus

• Financial management function

• Financial management environment

• Working capital management

to the objectives at the beginning of each chapter

Syllabus learning objective and Chapter reference:

A FINANCIAL MANAGEMENT FUNCTION

1 The nature and purpose of financial management

(a) Explain the nature and purpose of financial management.[1] Ch 1

(b) Explain the relationship between financial management and financial and management

accounting.[1] Ch 1

The financial management function

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the nature of financial management

• explain all the purposes of financial management (raising finance, allocation of financial resources, maintaining control over resources)

• define financial management, financial accounting and management accounting

• distinguish between financial management and financial and management accounting and explain the relationship between them

• define and distinguish between corporate strategy and corporate objectives

• define and distinguish between financial strategy and financial objectives

• describe the relationship between corporate strategy, corporate objectives and financial objectives

• explain the features of the financial objective of shareholder wealth maximisation

• distinguish between shareholder wealth maximisation and satisficing in a scenario

• explain the features of the financial objective of profit maximisation

• explain the features of the financial objective of earnings per share (EPS) growth

1 The nature and purpose of financial management

Key decisions for financial managers

Financial management is concerned with the efficient acquisition and deployment of both short- and long-term financial resources, to ensure the objectives of the enterprise are achieved.Key areas of focus:

• identifying and setting appropriate corporate financial objectives

• achieving financial objectives, by taking decisions in three key areas:

– investment – should proposed investments (including potential acquisitions) be

undertaken?

– finance – from what sources should funds be raised?

– dividends – how should cash funds be allocated to shareholders?

An understanding of these three key areas is fundamental for the examination.

In all of the above areas the financial manager will need to take account of:

• the broader economic environment in which the business operates

• the potential risks associated with the decision and methods of managing that risk.The F9 syllabus covers all these key aspects of financial management

The balance sheet (statement of financial position) and financial management

Expandable text

• Investment appraisal considers the long-term plans of the business and identifies the right projects to adopt to ensure financial objectives are met The projects undertaken will nearly always involve the purchase of non-current assets at the start of the

balances are invested appropriately and payables are paid on a timely basis

• All businesses need finance A key financial management decision is the identification

of the most appropriate sources, taking into account the requirements of the company,the likely demands of the investors and the amounts likely to be made available

Financial management in context

Financial management should be distinguished from other important financial roles:

• management accounting – concerned with providing information for the more day to day functions of control and decision making

• financial accounting – concerned with providing information about the historical results of past plans and decisions

Expandable text

Test your understanding 1

Management accounting

Financial management

Financial accounting

Financial management

Financial accounting

Review of overtime spending √

Depreciation of non-current

assets

√

Evaluating proposed expansion

• The diagram above is key to understanding how financial management fits into overall

business strategy

• The distinction between 'commercial' and 'financial' objectives is to emphasise that not all objectives can be expressed in financial terms and that some objectives derive from

commercial marketplace considerations

Objectives/targets define what the organisation is trying to achieve Strategy considers how to go

about it

• Business strategy – how to compete successfully in particular markets.

• Operational strategy – how the component parts of an organisation deliver the

corporate and business level strategies effectively

Expandable text

• Corporate strategy concerns the decisions made by senior management about

matters such as the particular business the company is in, whether new markets should be entered or whether to withdraw from current markets Such decisions can often have important financial implications If, for example, a decision is taken to enter

a new market, an existing company in that market could be bought, or a new company

be started from scratch

• Business strategy concerns the decisions to be made by the separate strategic

business units within the group Each unit will try to maximise its competitive position within its chosen market This may involve for example choosing whether to compete

on quality or cost

• Operational strategy concerns how the different functional areas within a strategic business unit plan their operations to satisfy the corporate and business strategies being followed We are, of course, most interested in the decisions facing the finance function These day-to-day decisions include all aspects of working capital

management

Expandable text

• Implement a Just-In-Time (JIT) inventory system.

• Increase EPS by 5% on prior year

• Acquire a rival in a share-for-share purchase

• Buy four new cutting machines for $250,000 each

• Achieve returns of 15% on new manufacturing investment

• Improve liquidity ratio from 1.7 to 1.85

• Reduce unsold inventory items by 12%

• Update manufacturing capacity to incorporate new technology

• Improve brand awareness within the UK

Commercial objectives / targets

Financial objectives / targets

Financial objectives / targets

Acquire rival chain in

a share-for-share purchase

Business

level

Update manufacturing capacity to incorporate new technology

Achieve returns of 15%

on new manufacturing investment

Buy four new cuttingmachines for

3 Financial objectives

If strategy is developed in response to the need to achieve objectives, it is obviously important to

be clear about what those objectives are

Most companies are owned by shareholders and originally set up to make money for those

shareholders The primary objective of most companies is thus to maximise shareholder wealth (This could involve increasing the share price and/or dividend payout.)

Shareholder wealth maximisation is a fundamental principle of financial management You should seek to understand the different aspects of the syllabus (e.g finance, dividend policy, investment appraisal) within this unifying theme

Many other objectives are also suggested for companies including: profit maximisation

growthmarket sharesocial responsibilities

• profit maximisation

• growth

• market share

• social responsibilities

Note: The objectives of other stakeholders are considered in more detail in chapter 2.

Maximising and satisficing

The objective of management has been deemed to be primarily one of maximising shareholder wealth However in practice a distinction must be made between maximising and satisficing:

• maximising – seeking the best possible outcome

• satisficing – finding a merely adequate outcome

Expandable text

• not cash based.

The likelihood of this objective being adopted by management is greater where managerial

performance targets (and financial rewards) are linked to profit measures such as ROCE

Expandable text

• Long-run versus short-run issues: In any business it is possible to boost short-term

profits at the expense of long-term profits For example discretionary spending on

training, advertising, repairs and research and development (R&D) may be cut This

will improve reported profits in the short-term but damage the long-term prospects of

the business The stock exchange will normally see through such a tactic and share

prices will fall

• Quality (risk) of earnings: A business may increase its reported profits by taking a high

level of risk However the risk may endanger the returns available to shareholders

The stock exchange will then generally regard these earnings as being of a poor

quality and the more risk-averse shareholders may sell Once again the share price

could fall

• Cash: Accounting profits are just a paper figure Dividends are paid with cash

Investors will therefore consider cash flow as well as profit

Management and the achievement of

stakeholder objectives

Chapter learning objectives

Upon completion of this chapter you will be able to:

• list all the significant stakeholders in a company and identify the likely objectives of each

• identify and describe the main possible conflicts between the objectives of the significant stakeholders in

a company

• identify the potential conflicts between stakeholder objectives in a scenario

• describe the role played by management in ensuring stakeholder objectives are met

• explain the risk of management not behaving in a goal congruent manner when pursuing stakeholder objectives

• describe the principle of agency theory

• describe the range of managerial remuneration packages designed to encourage managers to achieve stakeholder objectives

• select appropriate remuneration packages to encourage managers in a scenario to achieve stakeholder objectives

• explain the guidance within the corporate codes of governance that relates to encouraging managerial goal congruence

• explain the terms in the stock exchange listing regulations that encourage managerial goal congruence

Corporate stakeholders

A stakeholder group is one with a vested interest in the company

In the previous chapter we stated that the primary objective of a company is to maximise the wealth of shareholders However many argue that a business must adopt the stakeholder view, which involves balancing the competing claims of a wide range of stakeholders, and taking account of broader economic and social responsibilities.

Typical stakeholders for an organisation would include:

• the community at large

or regulated organisations, such as organic foods, safe trains and cleaner petrol For organisations there are problems of measurement – what are returns to the

community at large? The goals of the community will be broad but will include such aspects as legal and social responsibilities, pollution control and employee welfare Recently, environmental pressure groups have achieved considerable prominence and it is very clear that organisations cannot separate themselves from the societies and environments in which they operate

• Company employees – obviously, many trade unionists would like to see their

members as the residual beneficiaries of any surplus the company creates Certainly, there is no measurement problem: returns = wages or salaries However, maximising the returns to employees does assume that risk finance can be raised purely on the basis of satisficing, i.e providing no more than an adequate return to shareholders

• Company managers/directors – such senior employees are in an ideal position to follow their own aims at the expense of other stakeholders Their goals will be both long-term (defending against takeovers, sales maximisation) and short-term (profit margins leading to increased bonuses)

• Equity investors (ordinary shareholders) – within any economic system, the equity investors provide the risk finance In the UK, it is usually ordinary shareholders, or sometimes the government There is a very strong argument for maximising the wealth of equity investors In order to attract funds, the company has to compete with risk-free investment opportunities, e.g government securities The attraction is the accrual of any surplus to the equity investors In effect, this is the risk premium which

is essential for the allocation of resources to relatively risky investments in companies

• Customers – satisfaction of customer needs will be achieved through the provision of value-for-money products and services There remains, of course, the requirement fororganisations to accurately identify precisely what those needs are

• Suppliers – suppliers to the organisation will have short-term goals such as prompt payment terms alongside long-term requirements including contracts and regular business The importance of the needs of suppliers will depend upon both their

relative size and the number of suppliers

• Finance providers – providers of finance (banks, loan creditors) will primarily be interested in the ability of the organisation to repay the finance including interest As a result it will be the organisation’s ability to generate cash both long- and short-term that will be the basis of interest to these providers

• The government – the government will have political and financial interests in the organisation Politically they will wish to increase exports and decrease imports whilst monitoring companies via the Competition Commission Financially they require long-term profits to maximise taxation income Equally importantly the government via its own agencies or via the legal system will seek to ensure that organisations observe health and safety, planning and minimum wage legislation Also, on behalf of the community at large, government must consider modifying the behaviour of both individuals and organisations for environmental/health reasons, e.g banning smoking

in certain public places and restricting the advertising of tobacco companies

Potential conflicts of objectives

With so many different groups having a vested interest in a company it is inevitable that at times those interests will conflict

Conflict between and within groups of stakeholders and the need for management to balance the various interests is a key issue

Test your understanding 1

Suggest the potential conflicts in objectives which could arise between the following

groups of stakeholders in a company

Employees  Shareholders

Customers  Community at large

Shareholders  Finance providers

Customers  Shareholders/ managers

Government  Shareholders

Shareholders  Managers

Test your understanding 1

Show Answer

Employees  Shareholders Employees may resist the introduction of automated

processes which would improve efficiency but cost jobs Shareholders may resist wage rises demanded by employees as uneconomical

Customers  Community at

large

Customers may demand lower prices and greater choice, but in order to provide them a company may need to squeeze vulnerable suppliers or import products

at great environmental cost

Shareholders  Finance

providers

Shareholders may encourage management to pursue risky strategies in order to maximise potential returns, whereas finance providers prefer stable lower-risk policies that ensure liquidity for the payment of debt interest

Customers  Shareholders/

managers

Customers may require higher service levels (such as

24 rather than 48 hour delivery) which are resisted by shareholders as too expensive or by management due

to increased workload

Government  Shareholders Government will often insist upon levels of welfare (such

as the minimum wage and health and safety practices) which would otherwise be avoided as an unnecessary expense

Shareholders  Managers Shareholders are concerned with the maximisation of

their wealth Managers may instead pursue strategies focused on growth as these may bring the greatest personal rewards

Expandable text

2 The role of management and agency theory

Agency theory

Agency theory is often used to describe the relationships between the various interested parties in

a firm and can help to explain the various duties and conflicts that occur:

Agency relationships occur when one party, the principal, employs another party, the agent, to

perform a task on their behalf In particular, directors (agents) act on behalf of shareholders

(principals)

Expandable text

Test your understanding 2

Fill in the gaps in the following table of agency relationships in a company.

Principal: Shareholders Loan creditors

Agent: Employees

Agent’s responsibility:

Show Answer

Principal: Shareholders Management Loan creditors

Agent’s

responsibility:

To run the company in thebest interests of the shareholders

To work hard as instructed by management

To manage the funds lent without taking excessive risks

The divorce of ownership and control

By far the most important conflict of those mentioned above is that between the interests of

shareholders who own the company and the directors/managers who run it

• Finding ways to reduce the problems of the agency relationship and ensure that managers take decisions which are consistent with the objectives of shareholders is a key issue

• Shareholders are reliant upon the management of the company to understand and pursue the objectives set for them

• Although shareholders can intervene via resolutions at general meeting, the managers are usually left alone on a day-to-day basis

• Management are uniquely placed to make decisions to maximise their own wealth or

happiness rather than the wealth of the shareholders

In the past 15 or so years, the following accusations of non-goal-congruent behaviour have been made against management:

• excessive remuneration levels

Expandable text

• be clearly defined, impossible to manipulate and easy to monitor

• link rewards to changes in shareholder wealth

• match managers’ time horizons to shareholders’ time horizons

• encourage managers to adopt the same attitudes to risk as shareholders

Common types of reward schemes include:

• remuneration linked to:

– minimum profit levels

– economic value added (EVA)

• If the share price falls when options have been awarded, and the options go

‘underwater’ and have no value, they cannot act as an incentive

• If a company issues large quantities of share options, there could be some risk of excessive dilution of the equity interests of the existing shareholders As a result, it has been suggested that companies should recognise the cost of share options to their shareholders, by making some form of charge for options in the income

Reward scheme Benefits Potential problems

Earnings linked to minimum

profit levels

Earnings linked to EVA

Earnings linked to turnover

• ‘relax’ once minimum profits are achieved

• use creative accounting to manipulate profitability figures

ESOP Directly aligns manager

and shareholder interests

• Only works until options exercised

• Does not work if shares fall in value

• Can dilute existing shareholders’ holdings

• May incentivise creative accounting

compromise the firm’s future survival

• Managers may gain bonuses simply because of the products concerned rather than their own efforts A target growth in EPS would be better

• Long-term shareholder value and EPS are not well correlated

• There is only one measure that focuses on final effects rather than operational

causes

Expandable text

– must give obligation to spend sufficient time with the company

– should be independent

• Executive directors

– separation of chairman and chief executive officer (CEO)

– submit for re-election

– clear disclosure of emoluments

– outnumbered by the NEDs

• Remuneration committees

• Nomination committees

• Annual general meeting (AGM)

• At least half of the members of the board, excluding the chairman, should be

independent NEDs These are directors who do not take part in the running of the business They attend board meetings, provide advice, listen to what is said and are generally meant to act as a control on the actions of the executive directors

Independence means they are free of any business or other relationship, which could materially interfere with the exercise of their independent judgement Boards should disclose in the annual report which of the NEDs are considered to be independent

• NEDs should get extra fees for chairing company committees but should not hold share options in their company There was concern that allowing NEDs to hold share options in a company could encourage corporate excess or wrongdoing

• One of the independent NEDs should be appointed a senior independent NED who would act as a champion for the interests of shareholders

• Prospective NEDs should conduct due diligence before accepting the role They should satisfy themselves that they have the knowledge, skills, experience and time tomake a positive contribution to the company board

• On appointment, the NEDs would also undertake that they have the time to meet theirobligations Company nomination committees would examine their performance, and make an assessment of whether they were devoting enough time to their duties

• The chairman and the CEO roles should be separate, and a CEO should not become chairman of the same company

• The chairman should be independent at the time of his appointment Note that the effect of this, combined with the point about independent NEDs making up at least half of the board, will be to place independent NEDs in a majority on the board

• All directors should submit themselves for re-election at least every three years

• There should be clear disclosure of directors’ total emoluments and those of the chairman and highest-paid UK director

• Boards should set as their objective the reduction of directors’ contract periods to one year or less

• Executive directors’ pay should be subject to the recommendations of a remuneration

Chapter summary

Measuring achievement of corporate

objectives

Chapter learning objectives

Upon completion of this chapter you will be able to:

• calculate return on capital employed (ROCE) with data provided

• explain the meaning and usefulness of a calculated ROCE figure

• calculate earnings per share (EPS) and price earnings (PE) ratio with data provided

• explain the meaning and usefulness of an EPS figure and a PE ratio

• calculate return on equity (ROE) with data provided

• explain the meaning and usefulness of a calculated ROE figure

• calculate dividend per share (DPS) with data provided

• explain the meaning and usefulness of a DPS figure

• calculate dividend yield with data provided

• explain the meaning and usefulness of a dividend yield figure

• calculate total shareholder return (TSR) (dividend yield plus capital growth) with data provided

• explain the meaning and usefulness of a TSR (dividend yield plus capital growth) figure

• select appropriate ratios to measure changes in shareholder wealth within a scenario and discuss the relevance of the findings

1 Measuring achievement of corporate objectives

For a company, the primary objective has been identified as the maximisation of shareholder wealth However in the short-term the management may set profitability targets (either as interim goals or because they better represent the concerns of the managers) This section looks at the calculation of a range of measures designed to assess both profitability and increase in wealth Some of the ratios have been met before in F5 but are covered here in full for completeness

Taken in isolation, the calculations are relatively meaningless when assessing performance Comparatives such as prior-year information, targets, industry averages and other forms of benchmarking are required if the measures are to be interpreted and the underlying causes investigated

Balance sheets(Statements of finanacial position) as at 31 May

–––––– ––––––

Equity and Liabilities

–––––– ––––––

PBIT = Operating profit

CE = Non-current assets + Current assets - Current liabilities

= Share capital + Reserves + Long-term loans

Disadvantage of ROCE:

• uses profit which is not directly linked to the objective of maximising shareholder wealth

Illustration 1 – ROCE

Profit after interest, after tax and after preference dividends

EPS = ––––––––––––––––––––––––––––––––––––––––––––––

Number of ordinary shares in issue

EPS can be analysed by studying the growth rate over time – trend analysis

Disadvantage of EPS

• EPS does not represent actual income of the shareholder and it uses earnings which are not directly linked to the objective of maximising shareholder wealth

Illustration 2 – EPS

The EPS is an improvement on the prior year It has grown by:

A high PE ratio indicates that investors perceive the firm’s earnings to be of high quality – usually amixture of high growth and/or lower risk expectations.

Investors are willing to buy shares in the company at 16.4 times last year’s earnings

compared with the previous year’s position when they were willing to pay 18 times the

earnings

This fall may be because the company is not expected to grow as much as in the previous

year The industry average PE increased year-on-year from 20 to 22, which may suggest

that this company is expected to generate slower growth or carries more risk than the

industry average

5 ROE

It is useful for comparing the profitability of a company with other firms in the same industry.

It is calculated as

Profit after tax and preference dividends

Ordinary share capital + reserves

Where there are no preference shares this is simplified to give:

PAT

Shareholders' funds

ROE is similar to ROCE except:

• PAT is used instead of operating profit

• Shareholders’ funds are used instead of CE (debt + equity)

Disadvantages of ROE:

• it uses profits which are an unreliable measure and not directly linked to shareholder wealth

• it is sensitive to gearing levels – ROE will increase as gearing ratio increases

Illustration 5 – DPS

20X6 20X5

Dividend per share

Dividends for the period 90 50

Expandable text

7 Dividend yield

This provides a direct measure of the wealth received by the (ordinary) shareholder It is the annual dividend per share expressed as an annual rate of return on the share price

Dividend yield = ––––––––––––––––––

Market price per share

It can be used to compare the return with that from a fixed-rate investment

Disadvantage of dividend yield:

• it fails to take account of any anticipated capital growth so does not represent the total return

to the investor

Illustration 6 – Dividend yield