CIMAPaperF3FinancialStrategyStudyNotes

HWiseF3

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ii

Contents

Page

Chapter 1 CIMAVerbHierarchystrategiclevelexams 1

Chapter 2 AnIntroductiontoFinancialStrategy 9

Chapter 3 PerformanceMeasurementinFinancialStrategy 31

Chapter 4 LongTermFinance 77

Chapter 5 ShortTermFinanceWorkingCapitalManagement

115

Chapter 6 CostofCapital 139

Chapter 7 CapitalStructure 177

Chapter 8 TheRoleofTreasury 219

Chapter 9 InvestmentAppraisalbasictechniques 231

Chapter 10 InvestmentAppraisalfurthertechniques 263

Chapter 11 InternationalInvestmentAppraisal 293

Chapter 12 BusinessValuation 315

Chapter 13 FinancialandStrategicImplicationsofMergersandAcquisitions

351

Chapter 14 ImplementationandControlProcedures 391

Chapter 15 Howtopreparefortheexam 401

Chapter 16 QuestionsandAnswers 433

iii

iv

PaperIntroduction

v

chapterIntro

How to Use the Materials TheseOfficialCIMAlearningmaterialsbroughttoyoubyElsevier/CIMAPublishingandKaplanPublishinghavebeencarefullydesignedtomakeyourlearningexperienceaseasyaspossibleandtogiveyouthebestchancesofsuccessinyour'FinancialStrategy'exam.

Theproductrangecontainsanumberoffeaturestohelpyouinthestudyprocess.Theyinclude:

ThisStudyTexthasbeendesignedwiththeneedsofhomestudyanddistancelearningcandidatesinmind.Suchstudentsrequireveryfullcoverageofthesyllabustopics,andalsothefacilitytoundertakeextensivequestionpractice.However,theStudyTextisalsoidealforfullytaughtcourses.

Thismainbodyofthetextisdividedintoanumberofchapters,eachofwhichisorganisedonthefollowingpattern:

adetailedexplanationofallsyllabusareas extensive'practical'materials generousquestionpractice,togetherwithfullsolutions anexampreparationsection,includingasuggested

approachonhowtotackethepreseeninformation,bothbeforeandduringtheexam.

Detailedlearningoutcomesexpectedafteryourstudiesofthechapterarecomplete.Youshouldassimilatethesebeforebeginningdetailedworkonthechapter,sothatyoucanappreciatewhereyourstudiesareleading.

Stepbysteptopiccoverage.Thisistheheartofeachchapter,containingdetailedexplanatorytextsupportedwhereappropriatebyworkedexamplesandexercises.Youshouldworkcarefullythroughthissection,ensuringthatyouunderstandthematerialbeingexplainedandcantackletheexamplesandexercisessuccessfully.Rememberthatinmanycasesknowledgeiscumulative:ifyoufailtodigestearliermaterialthoroughly,youmaystruggletounderstandlaterchapters.

vivi

Havingworkedthroughthechaptersyouarereadytobeginyourfinalpreparationsfortheexamination.ThefinaltwochaptersofthisStudyTextprovideyouwiththeguidanceyouneed.Theyincludethefollowingfeatures:

Youshouldplantoattemptthesamplepaperjustbeforethedateoftherealexam.Bythisstageyourrevisionshouldbecompleteandyoushouldbeabletoattemptthesamplepaperwithinthetimeconstraintsoftherealexam.

IfyouworkconscientiouslythroughtheofficialCIMAStudyTextaccordingtotheguidelinesaboveyouwillbegivingyourselfanexcellentchanceofexamsuccess.Goodluckwithyourstudies!

Activities.Somechaptersareillustratedbymorepracticalelements,suchascommentsandquestionsdesignedtostimulatediscussion.

Questionpractice.Thetestofhowwellyouhavelearnedthematerialisyourabilitytotackleexamstylequestions.Makeaseriousattemptatproducingyourownanswers,butatthisstagedonotbetooconcernedaboutattemptingthequestionsinexamconditions.Inparticular,itismoreimportanttoabsorbthematerialthoroughlybycompletingafullsolutionthantoobservethetimelimitsthatwouldapplyintheactualexam.

Solutions.Avoidthetemptationmerelyto'audit'thesolutionsprovided.Itisanillusiontothinkthatthisprovidesthesamebenefitsasyouwouldgainfromaseriousattemptofyourown.However,ifyouarestrugglingtogetstartedonaquestionyoushouldreadtheintroductoryguidanceprovidedatthebeginningofthesolution,whereprovided,andthenmakeyourownattemptbeforereferringbacktothefullsolution.

Howtousethepreseeninformationandpreparefortheexam.

Guidanceonhowtotackletheexamitself. Anexamstandardsetofpreseeninformation,with

detailedanalysisandexamplerequirementsandanswers.

Revisionquestions.Theseareexamstandardandshouldbetackedinexamconditions,especiallyasregardsthetimeallocation.

Solutionstotherevisionquestions. Asamplepaperthatyoucanattemptunderexam

conditions,alongwiththerelevantanswers.

vii

Icon Explanations

Definition thesesectionsexplainimportantareasofknowledgewhichmustbeunderstoodandreproducedinanexamenvironment.

Key Pointidentifiestopicswhicharekeytosuccessandareoftenexamined.

Supplementary readingidentifiesamoredetailedexplanationofkeyterms,thesesectionswillhelptoprovideadeeperunderstandingofcoreareas.Referencetothistextisvitalwhenselfstudying.

Test Your Understandingfollowingkeypointsanddefinitionsareexerciseswhichgivetheopportunitytoassesstheunderstandingofthesecoreareas.

Illustrationtohelpdevelopanunderstandingofparticulartopics.TheillustrativeexercisesareusefulinpreparingfortheTestyourunderstandingexercises.

Exclamation Markthissymbolsignifiesatopicwhichcanbemoredifficulttounderstand,whenreviewingtheseareascareshouldbetaken.

Study technique

Passingexamsispartlyamatterofintellectualability,buthoweveraccomplishedyouareinthatrespectyoucanimproveyourchancessignificantlybytheuseofappropriatestudyandrevisiontechniques.Inthissectionwebrieflyoutlinesometipsforeffectivestudyduringtheearlierstagesofyourapproachtotheexam.Laterinthetextwementionsometechniquesthatyouwillfindusefulattherevisionstage.

viii

Planning

Tobeginwith,formalplanningisessentialtogetthebestreturnfromthetimeyouspendstudying.Estimatehowmuchtimeintotalyouaregoingtoneedforeachsubjectyouarestudying.

Rememberthatyouneedtoallowtimeforrevisionaswellasforinitialstudyofthematerial.Youmayfindithelpfultoread"PassFirstTime!"secondeditionbyDavidR.HarrisISBN9781856177986.Thisbookwillprovideyouwithprovenstudytechniques.Chapterbychapteritcoversthebuildingblocksofsuccessfullearningandexaminationtechniques.ThisistheultimateguidetopassingyourCIMAexams,writtenby apastCIMAexaminerandshowsyouhowtoearnallthemarksyoudeserve,andexplainshowtoavoidthemostcommonpitfalls.Youmayalsofind"TheEWord:Kaplan'sGuidetoPassingExams"byStuartPedleySmithISBN:9780857322050helpful. StuartPedleySmithisaseniorlectureratKaplanFinancialandaqualifiedaccountantspecialisinginfinancialmanagement. Hisnaturalcuriosityandwiderinterestshaveledhimtolookbeyondthetechnicalcontentoffinancialmanagementtotheprocessesandjourneythatwecalleducation. Hehasbecomefascinatedbythewholeprocessoflearningandtheexamskillsandtechniquesthatcontributetowardssuccessintheclassroom. Thisbookisforanyonewhohastositanexamandwantstogivethemselvesabetterchanceofpassing. Itiseasytoread,writteninacommonsensestyleandfullofanecdotes,facts,andpracticaltips. Italsocontainssynopsesofinterviewswithpeopleinvolvedinthelearningandexaminingprocess.

Withyourstudymaterialbeforeyou,decidewhichchaptersyouaregoingtostudyineachweek,andwhichweeksyouwilldevotetorevisionandfinalquestionpractice.

Prepareawrittenschedulesummarisingtheaboveandsticktoit!

Itisessentialtoknowyoursyllabus.Asyourstudiesprogressyouwillbecomemorefamiliarwithhowlongittakestocovertopicsinsufficientdepth.Yourtimetablemayneedtobeadaptedtoallocateenoughtimeforthewholesyllabus.

StudentsareadvisedtorefertothenoticeofexaminablelegislationpublishedregularlyinCIMAsmagazine(FinancialManagement),thestudentsenewsletter(Velocity)andontheCIMAwebsite,toensuretheyareuptodate.

ix

Tips for effective studying

(1) Aimtofindaquietandundisturbedlocationforyourstudy,andplanasfaraspossibletousethesameperiodoftimeeachday.Gettingintoaroutinehelpstoavoidwastingtime.Makesurethatyouhaveallthematerialsyouneedbeforeyoubeginsoastominimiseinterruptions.

(2) Storeallyourmaterialsinoneplace,sothatyoudonotwastetimesearchingforitemsaroundyouraccommodation.Ifyouhavetopackeverythingawayaftereachstudyperiod,keeptheminabox,orevenasuitcase,whichwillnotbedisturbeduntilthenexttime.

(3) Limitdistractions.Tomakethemosteffectiveuseofyourstudyperiodsyoushouldbeabletoapplytotalconcentration,soturnoffallentertainmentequipment,setyourphonestomessagemode,andputupyour'donotdisturb'sign.

(4) Yourtimetablewilltellyouwhichtopictostudy.However,beforedivinginandbecomingengrossedinthefinerpoints,makesureyouhaveanoverallpictureofalltheareasthatneedtobecoveredbytheendofthatsession.Afteranhour,allowyourselfashortbreakandmoveawayfromyourStudyText.Withexperience,youwilllearntoassessthepaceyouneedtoworkat.

(5) Workcarefullythroughachapter,makingnotesasyougo.Whenyouhavecoveredasuitableamountofmaterial,varythepatternbyattemptingapracticequestion.Whenyouhavefinishedyourattempt,makenotesofanymistakesyoumade,oranyareasthatyoufailedtocoverorcoveredmorebriefly.

(6) Makenotesasyoustudy,anddiscoverthetechniquesthatworkbestforyou.Yournotesmaybeintheformoflists,bulletpoints,diagrams,summaries,'mindmaps',orthewrittenword,butrememberthatyouwillneedtoreferbacktothematalaterdate,sotheymustbeintelligible.Ifyouareonataughtcourse,makesureyouhighlightanyissuesyouwouldliketofollowupwithyourlecturer.

(7) Organiseyournotes.Makesurethatallyournotes,calculationsetccanbeeffectivelyfiledandeasilyretrievedlater.

x

Structure of subjects and learning outcomes

Eachsubjectwithinthesyllabusisdividedintoanumberofbroadsyllabustopics. Thetopicscontainoneormoreleadlearningoutcomes,relatedcomponentlearningoutcomesandindicativeknowledgecontent.

Alearningoutcomehastwomainpurposes:

Thelearningoutcomesarepartofahierarchyoflearningobjectives. Theverbsusedatthebeginningofeachlearningoutcomerelatetoaspecificlearningobjectivee.g.

"EvaluatetheproposedstrategytoexpandintotheNorthAmericanmarket."

Theverb'evaluate'indicatesalevelfivelearningobjective.

Theseverbsareoutlinedinthefirstchapterofthetext.

(a) Todefinetheskillorabilitythatawellpreparedcandidateshouldbeabletoexhibitintheexamination

(b) Todemonstratetheapproachlikelytobetakeninexaminationquestions

xi

xii

MATHS TABLES AND FORMULAE Present value table Present value of 1.00 unit of currency, that is (1 + r)-n where r = interest rate; n = number of periods until payment or receipt. Periods

(n) Interest rates (r)

1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Periods

(n) Interest rates (r)

11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.079 0.065 16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

Cumulative present value of 1.00 unit of currency per annum Receivable or Payable at the end of each year for n years

+

rr n)(11

Periods (n)

Interest rates (r) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514

Periods (n)

Interest rates (r) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

FORMULAE Valuation models

(i) Irredeemable preference shares, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value:

P0 = prefk

d

(ii) Ordinary (equity) shares, paying a constant annual dividend, d, in perpetuity, where P0 is the ex-div value:

P0 = ek

d

(iii) Ordinary (equity) shares, paying an annual dividend, d, growing in perpetuity at a constant rate, g, where P0 is the ex-div value:

P0 = gk

d

e

1 or P0 = gk

gd

+

e

0 ][1

(iv) Irredeemable bonds, paying annual after-tax interest, i [1 t], in perpetuity, where P0 is the ex-interest value:

P0 = netd

][1

k

ti

or, without tax: P0 = dk

i

(v) Total value of the geared entity, Vg (based on MM):

Vg = Vu + TB

(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 100 payable or receivable in n years, discounted at r% per annum:

PV = nr ][1

1

+

(viii) Present value of an annuity of 100 per annum, receivable or payable for n years, commencing in one year, discounted at r% per annum:

PV =

+

nrr ][1

11

1

(ix) Present value of 100 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per annum:

PV = r

1

(x) Present value of 100 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:

PV = gr

1

Cost of capital (i) Cost of irredeemable preference shares, paying an annual dividend, d, in perpetuity, and having a current

ex-div price P0:

kpref = 0P

d

(ii) Cost of irredeemable bonds, paying annual net interest, i [1 t], and having a current ex-interest price P0:

kd net = 0P

ti ][1

(iii) Cost of ordinary (equity) shares, paying an annual dividend, d, in perpetuity, and having a current ex-div price P0:

ke = 0P

d

(iv) Cost of ordinary (equity) shares, 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:

ke = gP

d+

0

1 or ke = g

P

gd+

+

0

0 ]1[

(v) Cost of ordinary (equity) shares, using the CAPM:

ke = Rf + [Rm Rf]

(vi) Cost of ordinary (equity) share capital in a geared entity :

keg = keu + [keu kd] E

DV

tV ][1

(vii) Weighted average cost of capital, k0 or WACC

WACC = ke

+

++

DE

D

DE

E

VV

Vt

VV

Vdk ][1

(viii) Adjusted cost of capital (MM formula):

Kadj = keu [1 tL] or r* = r[1 T*L]

(ix) Ungear :

u = g

+ ][1 tVV

V

DE

E + d

+ ][1

][1

tVV

tV

DE

D

(x) Regear :

g = u + [u d] E

DV

tV ][1

(xi) Adjusted discount rate to use in international capital budgeting (International Fisher effect)

A$/B$ rate Spot

time months' 12 in A$/B$ rate spot Future

A$ rate discount annual1

B$ rate discount annual1=

+

+

where A$/B$ is the number of B$ to each A$

Other formulae

(i) Expectations theory:

Future spot rate A$/B$ = Spot rate A$/B$ x rateinterestnominal1

rateinterestnominal1

countryA

countryB

+

+

where: A$/B$ is the number of B$ to each A$, and A$ is the currency of country A and B$ is the currency of country B

(ii) Purchasing power parity (law of one price):

Future spot rate A$B$ = Spot rate A$/B$ x rateinflation1

rateinflation1

countryA

countryB

+

+

(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 = factorannuityyear

yearsovercostsof

n

nPV

(v) Theoretical ex-rights price:

TERP = 1

1

+N [(N x cum rights price) + issue price]

(vi) Value of a right:

N

priceissuepricerightsex lTheoretica

where N = number of rights required to buy one share.

CIMAVerbHierarchystrategiclevelexamsChapter learning objectives

CIMA VERB HIERARCHY

CIMAplacegreatimportanceonthechoiceofverbsinexamquestionrequirements.Itisthuscriticalthatyouanswerthequestionaccordingtothedefinitionoftheverbused.

1

chapter

1

1CIMA verb hierarchy strategic level

Instrategiclevelexamsyouwillmainlymeetverbsfromlevels3,4and5.Examinershavecommentedonmanyoccasionsthattheyaskalevel5verbandgetalevel2response.Itisvitalthatthehigherlevelverbsareunderstoodandrespondedto.Veryoccasionallyyouwillalsoseelevel1and2verbsbuttheseshouldnotaccountformorethan510%ofthemarksintotal.

Level 3 APPLICATION

Howyouareexpectedtoapplyyourknowledge

VERBS USED

DEFINITION

Apply

Calculate

Demonstrate

Prepare

Reconcile

Solve

Tabulate

Puttopracticaluse.

Ascertainorreckonmathematically.

Provewithcertaintyorexhibitbypracticalmeans.

Makeorgetreadyforuse.

Makeorproveconsistent/compatible.

Findananswerto.

Arrangeinatable.

CIMA Verb Hierarchy strategic level exams

22

Level 4 ANALYSIS

Howyouareexpectedtoanalysethedetailofwhatyouhavelearned.

Level 5 EVALUATION

Howyouareexpectedtouseyourlearningtoevaluate,makedecisionsorrecommendations.

VERBS USED

DEFINITION

Analyse

Categorise

Compareandcontrast

Construct

Discuss

Interpret

Prioritise

Produce

Examineindetailthestructureof.

Placeintoadefinedclassordivision.

Showthesimilaritiesand/ordifferencesbetween.

Builduporcompile.

Examineindetailbyargument.

Translateintointelligibleorfamiliarterms.

Placeinorderofpriorityorsequenceforaction.

Createorbringintoexistence.

VERBS USED

DEFINITION

Advise

Evaluate

Recommend

Counsel,informornotify.

Appraiseorassessthevalueof.

Proposeacourseofaction.

chapter 1

3

2Further guidance on strategic level verbs that cause confusion

Verbsthatcausestudentsmostconfusionatthislevelareasfollows:

Level 3 verbs

Giventhatalllevel3verbsinvolveapplication, theverb"apply"israreintherealexam.Oneoftheothermorespecificverbsisusedinstead.

Thisisanumericalrequirementandusuallyinvolvesstartingwithoneofthefigures,adjustingitandendingupwiththeother.

Forexample,inabankreconciliationyoustartwiththerecordedcashatbankfigure,adjustitforunpresentedcheques,etc,and(hopefully!)endupwiththestatedbalanceinthecash"Taccount".

Theverb"todemonstrate"canbeusedintwomainways.

Firstlyitcouldmeantoprovethatagivenstatementistrueorconsistentwithcircumstancesgiven.Forexample,theFinanceDirectormayhavestatedinthequestionthatthecompanywillnotexceeditsoverdraftlimitinthenextsixmonths.TherequirementthenasksyoutodemonstratethattheDirectoriswrong.Youcoulddothisbypreparingacashflowforecastforthenextsixmonths.

Secondlyyoucouldbeaskedtodemonstratehowastatedmodel,framework,techniqueortheorycould be usedintheparticularscenariotoachieveaspecificresultforexample,howaprobabilitymatrixcouldbeusedtomakeaproductiondecision.Ensureinsuchquestionsthatyoudonotmerelydescribethemodelbutuseittogeneratethedesiredoutcome.

Level 4 verbs

Toanalysesomethingistoexamineitindetailinordertodiscoveritsmeaningoressentialfeatures.Thiswillusuallyinvolvebreakingthescenariodownandlookingatthefinedetail,possiblywithadditionalcalculations,andthensteppingbacktoseethebiggerpicturetoidentifyanythemestosupportconclusions.

The verb "to apply"

The verb "to reconcile"

The verb "to demonstrate"

The verb "to analyse"

CIMA Verb Hierarchy strategic level exams

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Forexample,ifaskedtoanalyseasetoffinancialstatements,thentheendresultwillbeasetofstatementsabouttheperformanceofthebusinesswithsupportingevidence.Thiscouldinvolvethefollowing:

Themainerrorstudentsmakeisthattheyfailtodrawoutanythemesandconclusionsandsimplypresentthemarkerwithacollectionofuninterpreted,unexplainedfactsandfigures.

Todiscusssomethingisverysimilartoanalysingit,exceptthatdiscussionusuallyinvolvestwoormoredifferentviewpointsorargumentsasthecontext,ratherthanasetoffigures,say.Todiscussviewpointswillinvolvelookingattheirunderlyingarguments,examiningthemcritically,tryingtoassesswhetheroneargumentismorepersuasivethantheotherandthenseekingtoreachaconclusion.

Forexample,ifaskedtodiscusswhetheraparticulartechniquecouldbeusedbyacompany,youwouldexaminetheargumentsforandagainst,makingreferencetothespecificcircumstancesinthequestion,andseektoconclude.

Toprioritiseistoplaceobjectsinanorder.Thekeyissuehereistodecideuponthecriteriatousetoperformtheordering.Forexample,prioritisingtheexternalthreatsfacingafirmcouldbedonebyconsideringthescaleoffinancialconsequences,immediacy,implicationsfortheunderlyingbusinessmodelandsoon.

Themainmistakestudentsmakeisthattheyfailtojustifytheirprioritisationwhyisthisthemostimportantissue?

(1) Youcouldbreakdownyouranalysisintoareasofprofitability,liquidity,gearingandsoon.

(2) Undereachheadinglookatkeyfiguresinthefinancialstatements,identifyingtrends(e.g.salesgrowth)andcalculatingsupportingratios(e.g.margins).

(3) Trytoexplainwhatthefiguresmeanandwhytheyhaveoccurred(e.g.whyhastheoperatingmarginfallen?)

(4) Startconsideringthebiggerpicturearetheratiospresentingaconsistentmessageordotheycontradicteachother?Canyouidentifycommoncauses?

(5) Finallyyouwouldthenseektopullallthisinformationtogetherandinterpretittomakesomehigherlevelcommentsaboutoverallperformance.

The verb "to discuss"

The verb "to prioritise"

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Level 5 verbs

Toevaluatesomethingistoassessitwithaviewtoplacingavalueonit. Inmanyrespects"evaluate"shouldbeseenasahigherlevelversionof"analyse"and"discuss"andcouldincludequalitativeandquantitativefactorswithinyourcriteria.Yourresultingargumentswillneedtobeprioritisedandweighedagainsteachothertoformaconclusion.

Forexample,supposeyouareaskedtoevaluateaproposedstrategyinpaperE3.Atitssimplestyouranswercouldcontainaseriesofargumentsforandagainstthestrategy.Eachargumentshouldbediscussedtoassessitsimportance.Theargumentscanthenbeweighedupagainsteachothertoformaconclusion.Youarethusevaluatingthefactorswithineachargumentandthenevaluatingtheargumentsagainsteachother.

Withsuchquestionsmanystudentsstruggletogenerateenoughpointsorarguments.Partofthesolutionistoproducementalchecklistswhenstudyingthepaperconcerned.Thesegivecriteriatouseforvaluingthematterathand.Withtheaboveexampleonstrategyevaluation,criteriacouldincludeanyofthefollowing:

Useofsuchachecklistwillensureyouhaveenoughpointstopass.

Insomequestionsyoumayhavetodomorepreliminaryworkbeforeyoucanevaluate.Forexample,ifaskedtoevaluateafirm'sapproachtochangemanagementyouwouldstartbyidentifyingwhattypeofapproachtheyaretaking(referencingtodifferentmodelsofchangemanagement)beforeyoucanevaluateit.

The verb "to evaluate"

Arethereanyusefulcalculationse.g.NPV,impactonprofit? Doesthestrategyresolveanymajorthreatsfacedbythefirm? Doesthestrategycapitaliseonthefirm'sstrengthsordo

weaknessesneedresolvingfirst? Doesthestrategyenhancethefirm'scompetitivestrategy? Doesthestrategyleadtoabetter"fit"withtheenvironment? Whataretherisksandaretheyacceptable? Whataretheimplicationsfordifferentstakeholdersandwoulditbe

acceptabletothem? Whataretheresourceimplicationshowfeasibleisthestrategy?

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Allthreelevel5verbsinvolveamixtureofidentifyingrelevantissues,analysingthem,evaluatingthemandthenfinishingwithsomeformofconclusion.Somewritersseethisasathreestepapproach:

Thedifferencebetweenthelevel5verbsliesinwherethemainemphasisisinthesethreesteps.With"advise"and"recommend"theexaminerwillbelookingformoredetailinstep3.Recommendationsinparticularcouldinvolveformulatingaplanofactionthatincludesbothshortandlongertermaspects.

The differences between the verbs "to evaluate", "to advise" and "to recommend"

(1) What?Identifyrelevantissues.

(2) So what?Whyaretheissuesrelevant?Howsignificantarethey?

(3) What now?Whatresponseisrequiredbythefirmbeingconsidered?

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CIMA Verb Hierarchy strategic level exams

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AnIntroductiontoFinancialStrategyChapter learning objectives

Lead Component

A1:Discusspotentialstrategicfinancialobjectives,andtherelationshipsamongandconstraintsontheelementsoffinancialstrategy.

(a) discussthepotentialstrategicobjectivesofanorganisation.

(b) discusstheinterrelationshipsbetweendecisionsconcerninginvestment,financinganddividends.

(c) discusstheimpactofinternalandexternalconstraintsonfinancialstrategy,includingtheimpactofregulationonbusinesscombinations.

9

chapter

2

Indicative syllabus content

Thefinancialandnonfinancialobjectivesofdifferentorganisations(e.g.valueformoney,maximisingshareholderwealth,providingasurplus).

Thethreekeydecisionsoffinancialmanagement(investment,financinganddividend)andtheirlinks.

Benefitsofmatchingcharacteristicsofinvestmentandfinancinginthelongerterm,(e.g.incrossborderinvestment)andinshorttermhedgingstrategies.

Considerationsintheformulationofdividendpolicyanddividenddecisions,includingmeetingthecashneedsofthebusiness.

Externalconstraintsonfinancialstrategy(e.g.funding,regulatorybodies,investorrelations,strategy,andeconomicfactors).

Developingfinancialstrategyinthecontextofregulatoryrequirements(e.g.priceandservicecontrolsexercisedbyindustryregulators)andinternationaloperations.

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1Overview of Chapter

2The Importance of Financial Strategy to the Organisation

Anorganisation'sfinancialmanagersmustplantheircoursesofactiontoachievetheorganisation'sfinancialobjectives.Decisionsthattheymusttakeinclude:

ThisChapterfirstdefinessomeofthekeytermswhichwillbeusedthroughoutthesyllabus,andthenlooksatthemaindecisions(financingdecision,investmentdecisionanddividenddecision)indetail.

Fromwhichsourcesshouldfundsberaised? Shouldproposedinvestmentsbeundertaken? Howlargeadividendshouldbepaid? Howshouldworkingcapitalbecontrolled,e.g.shoulddiscountsbe

offeredtodebtorsforpromptpayment?

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Definitions of key terms

3Financial Strategy and Overall Corporate Strategy

Eachlevelofabusinesscanhaveitsownstrategy.Threelevelsarecommonlyidentified:

Corporate strategy Thisconcernsthedecisionstobemadebyseniormanagementsuchastheparticularbusinessthatthecompanyisin,andwhethernewmarketsshouldbeenteredorcurrentmarketswithdrawnfrom.

Business strategyThisconcernsthedecisionstobemadebytheseparatestrategicbusinessunitswithinthegroup.Eachunitwilltrytomaximiseitscompetitivepositionswithinitschosenmarket.

Operational strategyThisconcernshowthedifferentfunctionalareaswithinastrategicbusinessunitplantheiroperationstosatisfythecorporateandbusinessstrategiesbeingfollowed.Weareofcoursemostinterestedinthedecisionsfacingthefinancefunctions.

Financialstrategywillbeimportantateachlevelinthishierarchy.Forexample,investmentdecisionsandfinancingdecisionsmaybeimportantatallthelevels(althoughalargenumberofcompaniesmanagefinancingcentrally).Dividenddecisionswillbemadeatthecorporatelevelonly.

4Objectives Financial objectives of profit seeking organisations

Decisionstobemadedependontheultimateobjectivesofanorganisation.

Academicstudieshaveshownthatorganisationsoftenhavemany,sometimesconflicting,objectives.

Itisgenerallyacceptedthattheprimarystrategicobjectiveofacommercialcompanyisthelongtermgoalofthemaximisation of the wealth of the shareholders.

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However,anorganisationhasmanyotherstakeholderswithbothlongandshorttermgoals,suchas:

Equityinvestors(ordinaryshareholders) Thecommunityatlarge Companyemployees Companymanagers/directors Customers Suppliers Financeproviders Thegovernment

Objectives and economic forces

Whensettingthecompany'sfinancialstrategythefinancialmanagerisoftenconstrainedbybothinternalandexternalfactors.

Forexample,significantexpansionandanincreaseindividendsmaynotbefeasibleiftheentityhasalackofskilledstaff,andmaybecomeuneconomicifinterestratesaresettorise(thusincreasingtheamountpayabletobanksandotherdebtfinanceproviders).

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Internal and external constraints on financial strategy

Examples of stakeholder objectives

The effect of interest rate and inflation changes

Definition of stakeholders

Stakeholder conflicts

Facedwithabroadrangeofstakeholders,managersarelikelytofindtheycannotsimultaneouslymaximisethewealthoftheirshareholdersandkeepalltheotherstakeholderscontent.

Inpractice,themainstrategicobjectivemaybeinterpretedasachievingthemaximumprofitpossible,consistentwithbalancingtheneedsofthevariousstakeholdersintheentity.

Suchapolicymayimplyachievingasatisfactoryreturnforshareholders,whilst(forexample)establishingcompetitivetermsandconditionsofservicefortheemployees,andavoidingpollutingtheenvironment.

Performance and progress indicators (PIs)

Inordertoachievetheoverallobjectivecompaniesshouldsetspecifictargets,financialandnonfinancial,inordertobothcommunicatedirectionandmeasureperformance,forexample:

Financial

Profitabilitye.g.annual10%improvementinearnings,orearningspershare.

Cashgeneratione.g.annual10%improvementinoperatingcashflow.

Nonfinancial

Marketsharee.g.fourproductsoutofsixaredominantinthemarket.

Customersatisfactione.g.complaintstoreducefrom5%to2%.

Thesetargetscanbeusedtodirectmanagers'attentiontowardskeystakeholderrequirements,toensurethattheorganisationbalancestheneedsofitsdifferentstakeholdersandminimisestheconflictbetweenthedifferentstakeholdergroups.

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More on financial and non financial objectives

Conflicts of objectives between managers and shareholders

Objectives of notforprofit organisations

Organisationssuchascharitiesandtradeunionsarenotruntomakeprofitsbuttobenefitprescribedgroupsofpeople.Forexample,theprimaryobjectiveofacharityistopursuewhatevercharitableobjectivesitwassetupfor.

Sincetheservicesprovidedarelimitedprimarilybythefundsavailable,secondaryobjectivesaretoraisethemaximumpossiblefundseachyear(netoffundraisingexpenses),andtousethefundsefficientlytomaximisethebenefitgenerated.

Performance and progress indicators Public sector

Publicsectorentitiesareoftenappraisedaccordingtothe"valueformoney"(VFM)thattheygenerate.

Valueformoneymaybedefinedas"performanceofanactivityinsuchawayastosimultaneouslyachieveeconomy,efficiencyandeffectiveness."(CIMAOfficialTerminology2005)

Thismeansmaximisingbenefitsforthelowestcostandhasthreeconstituentelements:

Economyisameasureofinputstoachieveacertainserviceorlevelofservice.

Effectivenessisameasureofoutputs,i.e.services/facilities.

Efficiencyistheoptimumofeconomyandeffectiveness,i.e.themeasureofoutputsoverinputs.

5The Key Decisions of Financial Management

Threekeydecisionsoffinancialmanagementthatcanbeidentifiedare:

Thesethreeareasareverycloselyinterlinked.

Investmentwhatprojectsshouldbeundertakenbytheorganisation? Financehowshouldthenecessaryfundsberaised? Dividendshowmuchcashshouldbeallocatedeachyeartobepaid

asareturntoshareholders?

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More detail on VFM

Financial objectives in the public sector

Investment decision

Financialmanagershaveresponsibilityfortheallocationoffinancialresourcestoachievetheorganisation'sobjectives.Animportantpartoftheirjobistounderstandtheshort,mediumandlongtermcapitalrequirementsforinvestmentinfixedassetsandworkingcapitalthatfitswiththeoverallstrategy.

Whilstfinancialmanagersareunlikelytobesolelyresponsibleforthefinalchoiceofcapitalinvestmentprojectstobeundertaken,theywillbeactivelyinvolvedintheevaluationofpossibleinvestmentopportunities.

Finance decision

Forbothfixedassetandworkingcapitalinvestment,thefinancialmanagermustdecideonthemostappropriatetypeandsourceoffunding.

Thiswillincludesuchconsiderationsas:

theextenttowhichrequirementscanbefundedinternally,fromtheorganisation'soperations.Thiswillinvolveconsiderationsofdividendpolicyandtaximplications

ifnew,externallyprovided,financeisrequired,whetheritshouldbeintheformofequityordebtfinance.Thismayaffectthelevelofgearing(theratioofdebttoequityfinance)whichcanhaveimplicationsforreturnsrequiredbytheprovidersofcapital

theextenttowhichworkingcapitalshouldbefinancedbylongtermfinanceorshorttermcredit.

Dividend decision

Whendecidingonthetypeofinvestmentandleveloffinanceneeded,thefinancialmanagermusthaveregardforthepotentialeffectsontheriskandlevelofdividendspayabletoshareholders.Iftheshareholdersarenothappywiththeirreturn,theywillbereluctanttoinvestfurther,whichinturnwillaffectthefundingavailableforfutureinvestment.

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More detail on the financing decision

More detail on the investment decision

Thedividenddecisionthushastwoelements:

Thelevelandregulargrowthofdividendsrepresentasignificantfactorindeterminingaprofitmakingentitysmarketvalue,thatis,thevalueplacedonitssharesbythestockmarket.

theamounttobepaidout,and theamounttoberetainedtosupportthegrowthoftheentity(notethat

thisisalsoafinancingdecision).

Links between the three key decisions

Itisclearfromthediscussionsabovethatthethreeareasarecloselyinterrelated.

Investmentdecisionscannotbetakenwithoutconsiderationofwhereandhowthefundsaretoberaisedtofinancethem.Thetypeoffinanceavailablewill,inturn,dependtosomeextentonthenatureoftheprojectitssize,duration,risk,capitalassetbacking,etc.

Dividendsrepresentthepaymentofreturnsontheinvestmentbacktotheshareholders,thelevelandriskofwhichwilldependupontheprojectitself,andhowitwasfinanced.

Debtfinance,forexample,canbecheap(particularlywhereinterestistaxdeductible)butrequiresaninterestpaymenttobemadeoutofprojectearnings,whichcanincreasetheriskoftheshareholders'dividends.

6Dividend Policy

Onelongstandingquestionincorporatefinanceis:Isshareholders'wealthaffectedbyacompany'sdividendpolicy?

Noticethatthequestionisnotaskingwhetherdividendsmatterofcoursetheydo(asweknowfromthedividendvaluationmodel)whatthequestionasksiswhetherthechosenpolicymatters.Examplesofsuchpoliciesmayinclude:

(i) payingaconstantannualdividend(ii) payingoutaconstantproportionofannualearnings(iii) increasingdividendsinlinewiththeannualrateofinflation,etc(iv) payingoutwhat'sleftafterfinancingallfutureinvestmenttheresidual

policy.

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Fouraspectstoconsiderinrelationtothepaymentofdividendsare:

Dividend irrelevancy

M&M'sdividendirrelevancytheorysaysthatthepatternofdividendpayoutshouldbeirrelevant.AslongascompaniescontinuetoinvestinpositiveNPVprojects,thewealthoftheshareholdersshouldincreasewhetherornotthecompanymakesadividendpaymentthisyear.

(1) ModiglianiandMiller's(M&M)dividendirrelevancyargument.(2) Theclienteleeffect.(3) Thebirdinthehandargument.(4) Thesignallingeffectorinformationcontentofdividends.

Clientele effect

Thisanalysisarguesthat,intherealworld,therearedifferentialtaxtreatmentsofdividendsandcapitalgains,andtherearetransactioncostsonsharedealings.

Asaresult,shareholdersareconcernedastohowtheirreturnisdeliveredtothembythecompany.Thuscompaniesshouldfollowaconsistentdividendpolicysoastoensurethattheygathertothemaclienteleofshareholderswholikethatparticularpolicy.

Thustheargumenthereisthattheactualdividendpolicythatacompanyfollowsisunimportantbut,havingdecidedonaparticularpolicy,itshouldthenkeeptoit.

The birdinthehand argument

Thisanalysisputsforwardaverysimpleargument.Someinvestorsmayfindcapitalgainsmoretaxefficientthandividends,andsomeinvestorswillavoidtransactioncostsiftheirreturnsaredeliveredintheformofcapitalgainsratherthandividendsdespiteallthis,investorsgenerallyhaveastrongpreferencefordividends.

Thereasongivenisthatadividendiscertainandinvestorspreferacertaindividendnow,tothepromiseofuncertainfuturedividends(arisingoutofretainingandreinvestingearnings).

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M & M's Dividend Irrelevancy Theory

The signalling effect

Thistheoryholdsthatinvestorsread'signals'intothecompany'sdividenddecisionandthatthesesignalssayasmuchaboutthecompany'sfuturefinancialperformanceastheysayaboutitspastfinancialperformance.

Thusmanagementwillnotnecessarilyreducethedividendpersharejustbecauselastyear'sperformancewaspoor,iftheybelievethatnextyear'sperformancewillbegood.

Ifthistheoryiscorrect,andinvestorsdoindeedreadsignalsintothedividenddecision,thenthedividenddecisionbecomesimportant:itbecomesimportantforthecompanynottogivethewrongsignal.

How to reconcile these differing views of dividend policy in the real world

Giventhesecontrastingviews,howaremanagerstodecideonthedividendpolicythattheyshouldpursue?

Theansweristhat,intherealworld,likesomuchelseincorporatefinance,managershavetomakeajudgementaftertakingmanyvaryingfactorsintoaccount.

Inthisprocesstheywillconsider:

Howevertheywillalsotakeintoaccountarangeofotherfactors,suchas:

(1) Whatdividendsareourshareholdersexpecting(i.e.theclienteleeffect)?

(2) Whatdividenddidwepaylasttime(i.e.wemustnotpaylessthanthatbecauseofthesignalthatitmightgive)?

(3) Isitlegaltopayoutadividend?(4) Isthecashavailabletopayoutadividend?(5) Dowehaveaminimumgearingratioimposedonthecompanyasa

financialcovenantinadebtagreement?(6) Whatisthetaximpactforshareholdersofpayingdividends?(7) Whatinvestmentopportunitiesdoesthecompanyface?

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More details on signalling

(8) Howdifficult/expensiveisittoraiseexternalfinance?(9) Whathasbeentherateofinflation(andsowhatdividendincreaseis

neededtomaintainthepurchasingpoweroflastyear'sdividends)?(10)Whathasbeenthecapitalgain/lossinthesharepriceoverthelast

year?

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Scrip / bonus dividends and share repurchase

7Exam style questions

Quotation1

'Thedirectorsofallbusinessesmustconsiderthewishesofallpotentialstakeholdersforwhosesupporttheyarecompetingnotjustownersbutemployees,suppliers,customers,lenders,regulatorsandthecommunityinwhichtheirbusinessoperates.'

Quotation2

'Stakeholdertheoryisincompatiblewithbusinessanditsobjectivesandshouldbefirmlyresisted.'

Required:

Discuss the opposing arguments in the two quotations given above, and explain how these views might be reconciled.

Publicsectororganisationsdonothavetherequirementtoproduce'profit'inthesamesenseastheprivatesector.However,theyareexpectedtoworkwithinbudgetsandrecogniseaspectsoffinancialmanagementfamiliartotheprivatesector.

Thefollowingarefourexamplesofdifferencesbetweenthepublicandprivatesector:

(1) Acompanythatoperatesachainofprivatehospitalsusesadiscountrateof16%toevaluateitsinvestmentdecisionsandgenerallyexpectsanaccountingrateofreturnof25%.Agovernmentfundedhospitaltrustisrequiredtoachieveareturnofonly6%onassets.

(2) Privatesectorcompaniesaremovingtowardsamoreflexibleapproachtobudgeting.Organisationsinthepublicsectoraremovingintheoppositedirectioni.e.towardsamorerigidapproachtobudgeting,enforcedbytheTreasury(uptothreeyears).

(3) Publicsectorpayissubjecttogovernmentcontrolsandhasformanyyearsfailedtokeeppacewithinflation.Marketforcesdeterminewagesandsalariesintheprivatesector.

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Test your understanding 1 Stakeholders

Test your understanding 2 Public v private sector objectives

Required:

Discuss the causes and consequences of the three scenarios outlined above, using examples to illustrate your answer where appropriate.

Note:Overseascandidatesmayuseexamplesoforganisationsintheirowncountry.

DIVSplcisalargeinternationalcompanywithwidespreadinterestsinadvertising,mediaandvariousconsultancyactivitiesassociatedwithsalespromotionandmarketing.Inrecentyearsthecompany'searningsanddividendpayments,inrealterms,havegrownonaverageby15%and12%peryearrespectively.Thecompanyislikelytohavesubstantialcashsurplusesinthecomingyear,butanumberofinvestmentopportunitiesarebeingconsideredforthesubsequenttwoyears.Theseniormanagersofthecompanyarereviewingtheirlikelyfundingrequirementsforthenexttwotothreeyearsandthepossibleconsequencesfordividendpolicy.

Atpresentthecompanyhasadebt:equityratioof1:5,measuredinmarketvalueterms.Itdoesnotwanttoincreasethisratioatthepresenttimebutmightneedtoborrowtopayamaintaineddividendinthefuture.

Theseniormanagersofthecompanyarediscussingarangeofissuesconcerningfinancialstrategyingeneralanddividendpolicyinparticular.

Required:

Assume you are an independent financial advisor to the board of DIVS plc. Write a report to the board which discusses the following issues:

(i) The repurchase of some of the company's shares in the coming year using the forecast surplus cash, the aim being to reduce the amount of cash needed to pay dividends in subsequent years. Other implications of share repurchase for the company's financial strategy should also be considered.

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Test your understanding 3 Dividend policy and financing

(25 marks)

(ii) The advisability of borrowing money to pay dividends in years 2 and 3.

(iii) The likely effect on the company's cost of equity if the company decides on share repurchase and / or further borrowing.

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Test your understanding answers

Asensiblestartingpointistolistthevariousstakeholdersandshowhowtheirinterestsmayconflict,beforereconcilingthetwostatements.

Afirmisacollectionofcontributors,allofwhomhaveastakeinitsongoingsuccessandsurvival.Inanarrowsense,theirrespectiveinterestsareboundtoconflictifpushedtothelimit.

Ifpushedtothelimit,mostoftheseaimsarelikelytobankruptthebusiness.Ifshareholders'aimsarepursuedneglectingallelse,itrequiresscrewingdownwagesandconditionstominimallevels,rackinguppricestotakemaximumadvantageofshorttermopportunities,neverpayingsuppliersuntilthreatenedwithlegalaction,andsoon.

Suchbehaviourisnotjustantisocial,itisantisurvival.Itwillattractcriticalattentionfromthegovernmentandotherbodies,resultinginpenalties,finesandongoingscrutinywhichwilldamagethefirm'sreputationandmarketpositionirretrievably.

TheSWMaimisnotashorttermprofitmaximisingaim.Itaimstocreatesustainableandpermanentvalueforowners.Itisthoroughlyconsistentwithtreatingcustomersandemployeeswellandbuildingupanimageasarespectedcontributortosociety.

Itisthuseasytoreconcilethetwostatementsfirmsthattreattheirstakeholdersbadlyareunlikelytosurviveintothelongterm.To'considerthewishesofallpotentialstakeholders'doesnotrequiremaximisingeveryone'sparticularinterestsbutstrikingabalancebetweenthemtotheultimateandongoingbenefitofall.Thisissimplygoodbusiness.

Ownerswantmaximumdividendsandshareprice. Lenderswantmaximumsecurityfortheirinvestment. Managerswantmaximumpayandotherformsofremuneration. Otheremployeeswantmaximumpayforminimumeffortplus

optimalhealthandsafetystandards. Customerswantmaximumqualityatminimumpriceplus

maximumcredit. Supplierswantminimumsettlementdelay. Governmentwantsmaximumtaxtake. Societywantsmaximumenvironmentalsafeguards,contributions

tocharityandlocalcommunityprojects.

An Introduction to Financial Strategy

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Test your understanding 1 Stakeholders

(1) Rates of return

Theprivatesectorcompanyhasahigherrequiredrateofreturn,andusesmoremeasuresoffinancialsuccessthanthepublicsectorentity.

Causes

Theprivatesectorentityhasaprimaryobjectivetoincreaseshareholderwealth,soithastomeasurefinancialperformancecarefully.

Itsrequiredrateofreturnishigherbecausetheinvestorsintheprivateentityperceiverisktobehigh.Publicsectorentitiesfacelowerrisksincetheyaresupportedbygovernments.

Thecostoffinanceforthepublicsectorentity(providedbythegovernment)willbelower,sincethegovernmentcanusuallyborrowmoneyverycheaply.Thismeansthattherequiredreturncanbelower.

Consequences

Thepublicsectorentitywillbemoreinclinedtoundertakerelativelylowreturnprojectswhichtheprivatesectorentitywillreject.Therefore,"unprofitable"treatmentswillstillbeundertakeninthepublicsector.

Theprivatesectorentitywillperformanarrowrangeoftreatmentsveryefficiently.Thepublicsectorentitywillofferamuchbroaderrangeoftreatments.

Thelowerrequiredreturninthepublicsectorwillgivelessincentivetoreducecosts,sothepublicsectorentitymaybelessefficientthantheprivatesector.

Privatesectorentitieshavemoreflexiblebudgetingproceduresthanpublicsectorentities.

Causes

Publicsectorentitiestendtobelarger,andhavemorebureaucraticstructures.Hence,publicsectorbudgetingcanbeamuchmorecomplexprocess.

(2) Budgets

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Test your understanding 2 Public v private sector objectives

Thepublicsectorisexpectedtolookfurtherintothefuture(3years)whereasaprivatesectorbudgetmayonlylastfor1year.

Privatesectorentitieshaveaflexibleapproachtofinancing(effectivelyanyprojectcanbeundertakenifthefinancecanbefound).Publicsectorentitiesareallocatedfinancebygovernmentandthereforehaveanobjectivetoworkwithinthisimposedconstraint.Flexibilityisthereforelessimportantinapublicsectorentity.

Thegovernmentlikestobeabletocompareperformanceofdifferentpublicsectorentities,sooftenastandard,rigidmethodofbudgetingisproposedtoenablecomparisonstobemadeeasily.

Consequences

Privatesectorentitiesfinditeasiertoadaptquicklytorealworldfactorswhichimpactthem.

Privatesectorentitiestendtohaveamoreflexible,"cando"culture.

Publicsectorbudgetstendtocontainmorebudgetaryslack,becausethebudgethasoftenbeensetwellinadvanceandthennotamendedtoreflectnewfactorswhichcometolight.

Publicsectorpaylagsbehindthatintheprivatesector.

Causes

Publicsectorjobsecuritytendstobebetter,sopayisnottheonlyattractionofholdingapublicsectorjob.

Also,publicsectorpensionstendtobegovernmentfunded,finalsalaryschemes.Intheprivatesector,finalsalaryschemesarebecominglessprevalentasfirmsstruggletoaffordthem.

Thegovernmentoftentriestocontrolinflationbykeepingpublicsectorpayrisesundercontrol.Alowpayriseforpublicsectorworkerscanbeusedasasignaloffinancialprudence.

Publicsectorstaffarepaidrelativelylittleasabonusorincentivepayment.Mostofthepaytendstobeabasicsalarydeterminedbyaverydetailedpayscale.

(3) Pay

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26

Consequences

Publicsectormoraleandmotivationisoftenlowerthanintheprivatesector.

Goodqualitystaffareoftenattractedtoprivatesectorroleswherethestaffarebetterrewarded.

Thelackofbonusesinthepublicsectorsometimesstiflescreativityanddiscouragestheuseofinitiative.

Report

To:BoardofDirectors,DIVSplc

From:Independentfinancialadvisor

Date:XX/XX/XX

Re:Dividendpolicyandotherfinancingissues

Youarecurrentlyconsideringthecurrentandfuturepositionofthecompanyasregardsdividendpaymentsandfinancingoverthenexttwotothreeyears,inthelightofyourcurrentcashsurplusandtheinvestmentopportunitiesavailabletoyoufromnextyear.

Thisreportaddressesthefollowingissues:

Youarelikelytohavesubstantialcashsurplusesinthecomingyear.Yourfirstdecisionistodecidehowmuchtodistribute,bearinginmindbothyourinvestmentfinancingrequirementsinthefutureandthepossiblereactionsofshareholdersandothermarketplayers.Inthecurrentclimate,itisexpectedthat'spare'cash,inexcessofthatrequiredforspecificprofitableinvestmentopportunities,shouldbereturnedtotheshareholderstodowithastheywish.

theimplicationsofsharerepurchasetoreducefuturedividendpayments

borrowingfundstofinancedividends thepossibleeffectsoncostofequityifeitherorbothoftheabove

actionsaretaken.(i) Sharerepurchase

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Test your understanding 3 Dividend policy and financing

Youhavesomeinvestmentopportunitiesopentoyouinthenearfuture.Whetherornotyouhavetoretainsomeofthecurrentsurpluscashtofundthesewilldependupontheextenttowhichyouexpecttheretobesparefundsgeneratedinthenexttwoorthreeyears.

Oncetheamounttobedistributed(ifany)hasbeendecidedupon,youthenneedtodecidewhethertoreturnittoalltheshareholdersasadividend,ortosomeofthemintheformofasharerepurchase.Thelatteroptionwillresultinonlyasmallnumberofshareholderslikelytobethelargeinstitutionalinvestorsreceivingcash,althoughtheirproportionateholding,andthereforeentitlementtofuturedividends,willbereduced.Othershareholderswillhavetosellshares,incurringtransactioncosts,to'manufacture'dividendsshouldtheyneedthem.

Itshouldbenotedthatasharerepurchaseisadministrativelymorecomplexinthatitrequirespriorapprovalfromageneralmeetingofshareholders(assumingtheArticlesofAssociationprovidethatitcanhappenatall).ItisalsonolongerpossibleforinstitutionstoreclaimtaxonthedistributionintheUK.

Thetwotypesofdistributionwillalsoaffectsharepricesdifferently.Whenadividendisdeclared,thevalueofthesharesfallsfromcumdivtoexdiv,theshareholdershavinghadsomeoftheircapitalinvestmentrealisedascash.

Intheory,ifthesharerepurchaseismadeatcurrentmarketprice,asharerepurchaseshouldleavetheindividualsharepriceunchangedtherehasbeenareductionintotalmarketvalueinproportiontothetotalnumberofsharesinissue.

ItshouldalsobenotedthatasharerepurchasewouldresultinahigherfutureEPSfigurethanifanormaldividendhadbeenpaid.Howeverthisshouldnotaffectthemarket'sperceptionofthehealthofthecompany,asitispurelyaresultofthesameearningsbeingspreadoverasmallernumberofshares.

Overall,itwouldappearthatthereisnoparticularlystrongargumentforasharerepurchaseinpreferencetoadividendpaymenttoallshareholders.Whilstyoumayseethisasameansofreducingfuturedividendpayments,itislikelythattheremainingshareholders,whowouldbeholdingagreaterproportionofsharesthanpreviously,wouldexpectahigherdividendpershare.Ifthisexpectationisnotmet,sharepricesmaybeaffectedadversely.

An Introduction to Financial Strategy

28

Ifitisdecidedtodistributeanamountinthecurrentyearthatcannotbemaintained(withplannedgrowth)infutureyearsoutofoperationalcashflows,thenadditionalfundswillneedtobeborrowed.

Thiswillraisethecompany'sgearinglevelabovethecurrent1:5debt:equityratio,withtwoconsequences.First,thecompanywillbefundedbyagreaterproportionofcheapfinance,particularlyasdebtinterestistaxdeductible.Second,shareholdersmayperceiveagreaterriskasbeingattachedtotheirdividends,asmoreoftheearningsareattributedtofixedinterestpayments.Itisaquestionoffindingtheoptimumbalancebetweenthesetwoeffects.

Theprobableeffectofincreasingthegearinglevelwillbe,asdiscussedin(ii)above,toincreasetherequiredreturnby(costof)equity.Borrowingwilldirectlyaffectthegearinglevel,byincreasingthedebtelement.

Thepaymentofadividendorasharerepurchasewillalsoincreasethegearinglevel,byloweringthevalueoftheequity(asdiscussedin(i)above,adividendresultsinalowersharepricewiththenumberofsharesbeingmaintainedasharerepurchaseresultsinamaintainedsharepricewithalowernumberofshares).

Thusbothactionsmayresultinahighercostofequity.

Overallrecommendations

ItisadvisedthatanysurpluscashoverandabovetheneedsofallpositiveNPVinvestmentsshouldbepaidoutintheformofadividend.This'residual'dividendpolicymayleadtofluctuatingdividends,however,andinstitutionalinvestorsgenerallypreferasteadydividendpatternyouwillneedtokeepacarefuleyeonyoursharepricetoensureitisnotbeingadverselyaffectedinthelongterm.

Shouldyouneedtoborrowinthefuture,youshouldfindthistoyouradvantage,asyourcurrentgearinglevelisquitelow,andthebenefitsofcheaperdebtshouldoutweighanyincreaseincostofequity.

(ii) Borrowingtopaydividends

(iii) Effectoncostofequity

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An Introduction to Financial Strategy

30

PerformanceMeasurementinFinancialStrategyChapter learning objectives

Lead Component

A2:Evaluatethestrategicfinancialstrategiesandobjectivesofanorganisationandtheextentoftheirattainment.

(a) identifyanorganisation'sobjectivesinfinancialterms.

(b) evaluatetheattainmentofanorganisation'sfinancialobjectives.

(c) evaluatecurrentandforecastperformancetakingaccountofpotentialvariationsineconomicandbusinessfactors.

(d) evaluatealternativefinancialstrategiesforanorganisation,takingaccountofassessmentoftheorganisationbyfinanciersandotherstakeholders,includinglikelychangestosuchassessmentinthelightofdevelopmentsinreporting.

31

chapter

3

Indicative syllabus content

Thefinancialobjectivesofanorganisationandeconomicforcesaffectingitsfinancialplans(e.g.interest,inflationandexchangerates).

Assessingattainmentoffinancialobjectives. Useoffinancialanalysisintheexternalassessmentofa

company(e.g.inassessingcreditworthinessandcompliancewithfinancingcovenants).

Modellingandforecastingcashflowsandfinancialstatementsbasedonexpectedvaluesforeconomicvariables(e.g.interestrates)andbusinessvariables(e.g.volumeandmargins)overanumberofyears.

Analysisofsensitivitytochangesinexpectedvaluesintheabovemodelsandforecasts.

Assessingtheimplicationsforshareholdervalueofalternativefinancialstrategies,includingdividendpolicy.(Note:ModiglianiandMillerstheoryofdividendirrelevancywillbetestedinbroadterms.Themathematicalproofofthemodelwillnotberequired,butsomeunderstandingofthegraphicalmethodisexpected).

Thelendersassessmentofcreditworthiness. Currentandemergingissuesinfinancialreporting(e.g.

proposalstoamendorintroducenewaccountingstandards)andinotherformsofexternalreporting(e.g.environmentalaccounting).

Performance Measurement in Financial Strategy

3232

1Overview of Chapter

Performance evaluation

Investors(bothshareholdersandlenders)willoftenappraisetheperformanceofanorganisation,toassesswhethertheorganisationrepresentsagoodinvestment.Ifitisshownthattheorganisation'sperformanceisdeclining,theshareholdersmaydecidetoselltheirshares,andthelendersmightchangetheirassessmentoftheorganisation'screditworthiness.

Inanexamquestion,youmightalsobeaskedtouseratioanalysistoassesswhetheranentityhasmetitsobjectives.

Toappraiseperformance,itisnecessarytofirstcalculateratiosunderthefollowingheadings:

profitabilityratios, liquidityratios(essentiallytheworkingcapitalratioscoveredinthelater

Chapter'ShortTermFinanceWorkingCapitalManagement'), gearingratios, stockmarketratios.

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33

WiththeexceptionoftheliquidityratioscoveredinthelaterChapter'ShortTermFinanceWorkingCapitalManagement',thecalculationoftheseratiosiscoveredinthisChapter.

However,aswellasperformingthecalculations,itwillalsobeimportanttocommentontheratios,anytrends,andanylikelyfuturedevelopments,soyouwillfinddetailedexplanationsofhowtointerprettheratiosthroughoutthisChapter.

2Limitations of ratio analysis

Anyanalysisofratioscalculatedfrominformationinthefinancialstatementsofanentitycanhelpustobetterunderstandtheperformanceofthatentity.However,itisimportanttounderstandthefollowinglimitationsoftheanalysis:

ratiosarealwaysbasedonhistoricinformation,theyarenotforwardlooking

inisolation,aratiofigureisuseless.Inordertointerpretthefigure,somesortofcomparison(withprioryears,budgetsorsimilarbusinesses)isnecessary

theyshowthepositionatasinglepointintime.Someanalysisovertimeisuseful,orperhapsaverage,ratherthanyearend,figuresshouldbeused

the'ideal'levelforaparticularratiowillvarywiththetypeofindustry.Forexample,inthefurnitureretailingindustry,profitmarginstendtobemuchhigherthaninthefoodretailingindustry

differentaccountingpoliciesmightdistortsomeratios,makingitdifficulttocomparedifferentbusinesses

thebasicratiofiguresneedtobeinterpretedcarefully.Forexample,anentitywithhighlevelsofreceivableswillappeartohavegoodliquidityratios,wheninfactitmaybestrugglingtocollectoverduedebts.

3Profitability Ratios

Severalprofitfigures(grossprofit,operatingprofit,netprofit)canbeidentifiedinatypicalincomestatement.

Eachmaybeusedtoevaluatetheprofitabilityofthebusiness.

Performance Measurement in Financial Strategy

34

Definitions of different profit figures

Rationale for analysing profitability

Therearetwomeasurescriticaltoanyanalysisofprofitability:

Return on capital employed (ROCE)

Returnoncapitalemployed(ROCE)isameasurementthatisfrequentlyusedintheanalysisoffinancialstatements.

Itshowstheoverallperformanceoftheentity,expressedasapercentagereturnonthetotalinvestment.Itmeasuresmanagementsefficiencyingeneratingprofitsfromtheresourcesavailable.

ROCEisexpressedasapercentage,andiscalculatedasfollows:

whereCapitalemployed=Thetotalfundsinvestedinthebusiness,i.e.shareholders'funds+longtermdebt,ortotalassetslesscurrentliabilities.

Return on equity (ROE)

ROEgivesanindicationastohowwellthecompanyhasperformedinrelationtoitsshareholders,themostimportantstakeholder.

ROEisexpressedasapercentage,andiscalculatedasfollows:

whereEquity=Thebookvalueofshareholders'funds

ItisusefultocomparetheROEtotheROCEtomeasuretheamountofthereturnunderlyingthebusinessthatpertainstotheshareholder.Note,however,thattheyarenotdirectlycomparable,ROEbeingbasedonnetprofitandROCEbasedonoperatingprofit.

(1) Return on Capital Employed (ROCE)

(2) Return on Equity (ROE)

OperatingprofitROCE = 100

Capitalemployed

NetprofitROE= 100

Equity

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Activity ratios

Profit margin calculations

Return on capital employed further analysis

WhentryingtoanalyseROCE,itcanbeusefultobreakitdownasfollowsintotwocomponentratios:

ROCE = Operating profit margin Asset turnover

Therelationshipbecomesclearwhenweputtheratiocalculationsintotheformula:

AnalysingthecomponentratiosmaythrowsomelightonthecauseofachangeinROCE.

Forexample,afallinROCEcouldbecausedby:

Operatingprofit Operatingprofit Revenue 100= 100

Capitalemployed Revenue Capitalemployed

generatinglowersalesfromthecompany'scapital(lowerassetturnover),and/or

generatingalowerprofitmarginonthesaleswhichhavebeenachieved(loweroperatingprofitmargin).

Acompanyisconsideringtwofundingoptionsforanewproject.ThenewprojectmaybefundedbyGBP10mofequityordebt.Belowaretheforecastfinancialstatementsreflectingbothmethodsoffunding.

Balance sheet extract

Equity DebtGBPm GBPm

Longtermliabilities(10%debentures) 0.0 10.0

CapitalSharecapital(50pence) 11.0 3.5Sharepremium 4.0 1.5Reserves 5.0 5.0

20.0 10.0

Performance Measurement in Financial Strategy

36

Example 1

Income Statement extract

Corporationtaxischargedat30%.

Required:

GBPmRevenue 100.0Grossprofit 20.0Lessexpenses(excludingfinancecharges)

(15.0)

Operatingprofit 5.0

(a) Calculate the operating profit margin and the asset turnover.

(b) Calculate Return on Capital Employed and Return on Equity, and compare the financial performance of the company under the two funding methods.

(c) What is the impact on the company's performance of financing by debt rather than equity?

Interpretation of profitability ratios

Ingeneralterms,highlevelsofprofitabilityaredesirable.

AnentitywithhighprofitmarginsandahighROCEisusuallyperceivedtobeperformingwell.Similarly,iftheratiosgrowovertime,thisisusuallyperceivedtobepositive.

Theidealvaluefortheprofitabilityratioswillvaryfromindustrytoindustry,sobesuretocomparethefigurestopreviousyearsandtoothersimilarbusinessesifpossible.

4Financial Gearing

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Rationale for analysing gearing

Definition of gearing

Gearingisthemixofdebttoequitywithinafirm'spermanentcapital.Therearetwoparticularlyusefulmeasures:

Capital gearing a measure of capital structure

Therearetwokeymeasuresofcapitalgearing:

Thecalculationofcapitalgearingcanbedoneinanumberofdifferentways.Inanexam,makesurethatyoushowyourworkings,andusethesameformulaconsistently.

What do debt and equity contain?

Debt

Allpermanentcapitalchargingafixedcharge(interest)maybeconsideredtobedebt.Thisincludesdebenturesandloansnaturally.Itmayincludebankoverdraftifsignificantandconsideredpartofthepermanentfinancing.Similarly,cashandcashequivalentsshouldbedeductedwhencalculatingdebtingearingcalculationsifthecashisregardedasa'permanent'cashbuffer.

Equity

Allordinarysharecapitalandsharepremiumtogetherwithreserves(theyrelatetotheordinaryshareholders).

A note on preference shares:

Preferencesharesshouldbetreatedinthefollowingwayiftheyareirredeemable,treatasequityand,ifredeemable,treatasdebt.

(1) Capitalgearingastatementoffinancialposition(balancesheet)measure.

(2) Interestcoveranincomestatementmeasure.

DebtCapitalgearing= 100

Equity

Debt 100Debt+Equity

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38

Market value and book value of equity and debt

Interest cover

Theinterestcoverratioindicatesthenumberoftimesprofitswillcovertheinterestchargethehighertheratio,thebetter.

Theinterestcoverratioisusedbylenderstodeterminethevulnerabilityofinterestpaymentstoadropinprofit.

Asanalternativetotheformulashownhere,investorsoftenuseEBITDAratherthanprofitbeforeinterestandtaxintheformula,becauseEBITDAisabetterapproximationtothecashgeneratedbythebusiness(andavailabletopayinterestwith).

Interestcover=

Profitbeforeinterestandtax

Interestpayable

Balance sheet (statement of financial position) for X Co

USDmNoncurrentassets(total) 23.0Currentassets(total) 15.0TOTAL ASSETS 38.0EquityandLiabilitiesOrdinarysharecapital 10.0Ordinarysharepremium 4.0Preferencesharecapital(irredeemable) 1.5Reserves 1.5NoncurrentliabilitiesDebenture10% 8.0CurrentliabilitiesTradecreditors 8.0Bankoverdraft 5.0TOTAL EQUITY & LIABILITIES 38.0

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Example 2

The debt ratio

X Co Income Statement Extract

Required:

USDmOperatingprofit(PBIT) 4.0FinanceCharges (1.0)

Profitbeforetax(PBT) 3.0Tax@30% (0.9)

Netprofit 2.1

(a) Calculate the interest cover and the capital gearing ratio for X Co.

(b) Comment on the results of your calculations in part (a).

Interpretation of gearing ratios

Statement of financial position

Ahighproportionofdebtfinanceintheentity'scapitalstructureisseenasbeingriskybytheentity'sshareholders(whichcausesthemtodemandhigherreturnsontheirequitysee'CapitalStructure'Chapterformoredetails).

However,itisdifficulttogiveanypracticalguidanceastowhata'safe'levelofgearingmightbe.Comparethegearingratiotoprioryearsandbudgets,andtothegearingratioofsimilarentities,toassesswhetheritlookstoohigh.

Also,considerinparticularthelevelofnoncurrentassetsonthebalancesheetwhichcouldbeusedforsecurity.Ahighlevelofnoncurrentassets(muchhigherthanthecurrentvalueofdebtfinance)indicatesthatpotentiallytheentityshouldbeabletoraisemoredebtfinancequiteeasily.

Performance Measurement in Financial Strategy

40

Operating and financial leverage

Income statement

Aninterestcoverratiolessthan1indicatesthattheentityishavingtroubleservicingitsdebtfinance.Thehighertheratioisabove1,theeasieritshouldbefortheentitytocontinuepayingitsinterest,sothelessriskytheentityappearstobe.

However,notethatalackofcash,ratherthanalackofprofit,isusuallythereasonwhyacompanyfailstomeetitsinterestobligations.ThisiswhyanalystsoftensubstituteEBITDA(orevencashflow)intotheformulainsteadofprofit,togiveamoreusefulmeasureofcover.

5Stock Market Ratios

Investorswillwishtoassesstheperformanceofthesharestheyhaveinvestedin(againstcompetingentitiesinthesamesector,againstthemarketasawhole,andovertime).

Thereareanumberofratioswhichwillbeofspecificinteresttoinvestors(bothdebtinvestorsandequityinvestors).

Earnings per share (EPS)

Beforewecancalculateanyratiosweneedtocalculateakeymeasureofreturn,theEarningspershare(EPS).

whereEarnings=Profitdistributabletoordinaryshareholders,i.e.afterinterest,taxandanypreferencedividend.

EarningsEPS=

Numberofordinarysharesinissue

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More details on EPS

Market price per share

P/E ratio

TheP/Eratioisameasureofgrowthitcomparesthemarketvalue(ameasureoffutureearnings)tothecurrentearnings.

or,alternatively,Totalmarketcapitalisation/Totalearnings.

ThehighertheP/Eratio,thegreaterthemarketexpectationoffutureearningsgrowth.Thismayalsobedescribedasmarketpotential.

Earnings yield

TheP/Eratioisthereciprocal(inmaths,anumberorquantitydividedinto1)oftheearningsyield.

or,alternatively,Totalearnings/Totalmarketcapitalisation.

Themarketpricewillincorporateexpectationsofallbuyersandsellersoftheentitysshares,andsothisisanindicationofthefutureearningpoweroftheentity.

Dividendpayout rate

Thecasheffectofpaymentofdividendsismeasuredbythedividendpayoutrate.

or,alternatively,Totaldividend/Totalearnings.

TherelationshipbetweentheaboveinvestorsratiosisusuallythatanentitywithahighP/Eratiohasalowdividendpayoutratioasthehighgrowthentityneedstoretainmoreresourcesintheentity.AmorestableentitywouldhavearelativelylowP/Eratioandhigherdividendpayoutratio.

Whenanalysingfinancialstatementsfromaninvestorspointofviewitisimportanttoidentifytheobjectivesoftheinvestor.Doestheinvestorrequirehighcapitalgrowthandhighrisk,oralowerrisk,fixeddividendpaymentandlowcapitalgrowth?

Currentshareprice P/Eratio=

EPS

EPS Earningsyield=

Currentshareprice

Dividendpershare Payoutrate=

EPS

Performance Measurement in Financial Strategy

42

Dividend yield

Thisistherelationshipofthedividendpaidtothecurrentmarketvalueofashare.

or,alternatively,Totaldividend/Totalmarketcapitalisation.

However,thedividendrepresentsonlypartoftheoverallreturnfromashare.

Theotherpartofthereturnisthecapitalgainfromanincreaseinthevalueoftheshare.Thecapitalgainfromasharemaywellbefarmoresignificantthanthedividend.

Dividendpershare Dividendyield=

Currentshareprice

Dividend cover

Dividendcovermeasurestheabilityoftheentitytomaintaintheexistinglevelofdividendandisusedinconjunctionwiththedividendyield.

or,alternatively,Totalearnings/Totaldividend.

Thehigherthedividendcoverthemorelikelyitisthatthedividendyieldcanbemaintained.

Dividendcoveralsogivesanindicationofthelevelofprofitsbeingretainedbytheentityforreinvestmentbyconsideringhowmanytimesthisyearsdividendiscoveredbythisyearsearnings.

EarningspershareDividendcover =

Dividendpershare

LilydaleCohas5mordinarysharesinissue.Itsresultsfortheyearare:

USD000Profitbeforetax 750Tax (150)

Profitaftertax(PAT) 600Ordinarydividendproposed (150)

Retainedprofit 450

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Example 3

Themarketpricepershareiscurrently83centscumdividend.

Required:

Calculate the following ratios:

(a) Price/earnings ratio

(b) Dividend payout rate

(c) Dividend yield, and

(d) Dividend cover.

6The use of published accounts for ratio analysis

Whenexternalstakeholders,suchaspotentialinvestorsandlenders,trytoassesstheperformanceofanentity,themostreadilyavailablesourceofinformationisthepublishedaccountsoftheentity.

Intryingtointerprettheratioscalculatedfromthepublishedaccountsfigures,itisimportanttounderstandthelimitationsofthepublishedfigures.

Limitations of published accounts figures for ratio analysis

Publishedaccountsarehistoricrecords,notforwardlooking.However,theOperatingandFinancialReview(OFR),whichcompaniesareencouragedtopresentaspartoftheirpublishedaccounts,willcontainthedirectors'viewofthecompany'sprospects.

Theincomestatementispreparedusingtheaccrualsconcept,soitisdifficulttorelatethefigurestotheentity'scashposition.Howevertheinclusionofthecashflowstatementinthepublishedaccountshelpstogiveanimpressionofthecashposition.

Thepublishedaccountshavehistoricallycontainedonlyfinancialinformation.Inrecentyearsentitieshavebeenencouragedtoreportonwiderissues(suchasenvironmentalandsocialissues),sousersoftheaccountsareabletoseeafullerviewoftheentity'sperformance.

Performance Measurement in Financial Strategy

44

The lender's assessment of creditworthiness

More on recent developments in financial reporting

7Forecasting Profits, Cash Flows and the Balance Sheet Planning

Allbusinessesneedtoplan.Theyneedtoidentifyexactlywhattheirbusinesswilllooklikefinanciallyshouldtheychoosetogoaheadwithaparticularstrategy.

Objective of planningtoallowanorganisationtoinfluenceitsownfuturebythinkingandactinginadvance.

Averypopularexamrequirementistocalculateaforecastincomestatement,balancesheetand/orcashflow.

Forecasting income statement and balance sheet values

Thisisaverysimpleprocess.Forexample,ifsalesarecurrentlyUSD10mandgrowthisforecasttobe5%,futuresalescanbeforecastas:

Tax adjustments

Thisisthemainsourceofdifficultyinmanyquestions.Thetaxshouldnotbechargeddirectlyontheaccountingprofits.Instead,thefirm'sdepreciationshouldbeaddedbackandthenthecapitalallowancesdeductedtogivetaxableprofit,towhichthetaxratecanbeapplied.

Year1:USD10mx1.05Year2:USD10mx(1.05)2

USD10.5mUSD11.025m

FallowCo'sdepreciationonitsplantandmachinerynextyearwillbeEUR2monastraightlinebasis.Fortaxpurposes,taxdepreciationallowancescanbeclaimedatarateof25%p.a.(reducingbalancebasis).Thecurrentbookvalue,andtaxwrittendownvalue,oftheplantisEUR10m.TheexpectedaccountingprofitforthecomingyearisEUR8m.Corporationtaxis30%.

Required:

Calculate the expected tax charge for next year.

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Example 4 Tax adjustments

Guidance for forecasting financial statements

GSDLtdisaprivateUKcompanyownedbythetwofamiliesthatstartedthebusinessin20X0.ThecompanyproducesorganicfoodproductsfordistributioninthedomesticUKmarketusingfoodproductsfromUKfarms.Thecompanyisexperiencingaperiodofrapidgrowth,withrevenueexpectedtoriseby15%ineachofthefollowingfiveyears.

Thecompanyishopingtoretainaprofitmargin(profitbeforeinterestandtaxesdividedbyrevenue)of30%throughoutthenextfiveyears.Theratioofworkingcapitaltorevenueisexpectedtoremainconstant,whereworkingcapitalisinventoriesplustradereceivableslesstradepayables.

Interestispaidontheoverdraftandbankloanat6%perannum.Interestonthebankloanandoverdraftiscalculatedonthebalanceoutstandingatthebeginningoftheyear.Corporationtaxispaidoneyearinarrearsatarateof30%,witha100%taxallowanceforcapitalexpenditureintheyearinwhichitisincurred.Inarrivingatoperatingprofit,depreciationischargedat25%onareducingbalancebasisbasedonyearendbalances.

ExtractsfromthemanagementaccountsofGSDLtdon31December20X4areasfollows:(N.B.thecurrencyofGSDistheBritishPoundGBP,or)

Balance sheet as at 31 December 20X4

mProperty,plantandequipment 15Workingcapital 9

24

Sharecapital(50pordinary) 10Retainedearnings 4Longtermborrowings(bankloan) 8Shorttermborrowings(overdraft) 1Currenttaxpayable 1

24

Performance Measurement in Financial Strategy

46

Illustration 1 Exam style forecasting question

Income statement for the year ended 31 December 20X4

Capitalexpenditureplansareforexpenditureonproperty,plantandequipmentof10min20X5,10min20X6and7mineachofyears20X7to20X9.Nodisposalsofproperty,plantandequipmentareexpectedinthisperiod.

Shareholdersexpectayearonyearincreaseindividendsof5%.Anyfundsdeficitintheyearwillbefundedbyoverdraftandanysurplusfundsusedtoreducetheoverdraft.However,withtheincreaseddemandsonthefundsofthebusinesstofinancegrowth,thedirectorsareconcernedthattheymayexceedtheoverdraftlimitof1.5m.Theymay,therefore,needtonegotiateanincreaseinthebankloan,althoughthebankhasindicatedthatitwouldnotacceptgearinghigherthan70%basedonbookvalueswheregearingisdefinedaslongandshorttermborrowings(includingoverdraft)dividedbyequity.Theshareholdershaveindicatedthattheydonotwishtoinjectanyadditionalcapitalintothebusiness.

Required:

Construct the balance sheet, income statement and a cash flow analysis of the company for each of the years 20X5 and 20X6 and advise the company on the extent of any additional funding requirement in that period. In your answer, round figures to the nearest 1,000.

RevenueProfitbeforeinterestandtaxesDividendpaidin20X4

45.0m13.5m

50pashare

Solution: 20X4 20X5 20X6

Income statements k k kRevenue(15%increasepa) 45,000

51,750

59,513

Profitbeforeinterestandtax(30%ofrevenue) 13,500 15,525 17,854Interestonbankloan(6%8m) (480) (480)Interestonoverdraft(6%openingbalance,seebelow)

(60)

(157)

Profitbeforetax 14,985 17,217Tax(W1) (3,371)

(4,322)

Profitaftertax 11,614

12,895

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20X5 20X6Cash flow analysis k kProfitbeforeinterestandtax 15,525 17,854Addbackdepreciation(W2) 6,250 7,188Deductincreaseinworkingcapital(W3) (1,350)

(1,553)

Cashflowfromoperations 20,425 23,489Interestpaidonbankloan(6%8m) (480) (480)Interestpaidonoverdraft(6%openingbalance)

(60) (157)

Dividendspaid(5%increasepa) (10,500)(11,025)Taxpaid(W1) (1,000) (3,371)Capitalexpenditure (10,000)

(10,000)

Netcashflowfortheyear (1,615) (1,544)Cashb/f (1,000)

(2,615)

Cashc/f (2,615)

(4,159)

20X5 20X6

Balance sheets k kProperty,plantandequipment(W2) 18,750 21,562Workingcapital(20%revenue) 10,350

11,903

29,100

33,465

Sharecapital 10,000 10,000Retainedearnings(W4) 5,114

6,984

15,114 16,984Longtermborrowings(bankloan) 8,000 8,000Shorttermborrowings(overdraft,fromcashflowanalysis)

2,615 4,159

Currenttaxpayable 3,371

4,322

29,100

33,465

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48

Workings20X5 20X6

(W1)Taxexpense k kProfitbeforeinterestandtax 15,525 17,854Addbackdepreciation(W2) 6,250 7,188Deductcapitalallowances (10,000)(10,000)Interestonbankloan (480) (480)Interestonoverdraft(6%openingbalance) (60)

(157)

Taxableprofit 11,235

14,405

Taxexpenseat30% 3,371 4,322

20X5 20X6(W2)Property,plantandequipment k k

Balanceb/f 15,000 18,750Capitalexpenditure 10,000

10,000

Nettotal 25,000 28,750Depreciationat25% (6,250)

(7,188)

Balancec/f 18,750

21,562

20X5 20X6

(W3)Movementsinworkingcapital k k kWorkingcapitalb/f 9,000Workingcapitalc/f(9/4551,750) 10,350

Increaseinyear 1,350Workingcapitalb/f 10,350Workingcapitalc/f( 9/45 59,513) 11,903

Increaseinyear 1,553

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Advicetothecompany

Theoverdraftlimitis1.5m,whereastheaboveforecastsshowaforecastoverdraftofapproximately2.6mattheendof20X5and4.2mattheendof20X6,ifthelongtermbankloaniskeptconstant.Thisisnotacceptable,sothecompanymustapproachthebankandseektoincreasethebankloanbytheexcess4.2m1.5m=2.7m.Forecasttotalborrowingsat31December20X6are12.2m.

Forecastequityat31December20X6is17.0m.

whichisabovethebankslimit.Someamendmentstothecompanysplansarenecessary,asdiscussedinthenextExample.

20X5 20X6(W4)Retainedearnings k k

Balanceb/f 4,000 5,114Profitfortheyear 11,614 12,895Dividends (10,500)

(11,025)

Balancec/f 5,114

6,984

Theforecastgearingratioat31December20X6is

12.2100%=72%,17.0

FollowingonfromtheforecastingIllustrationabove(regardingGSDLtd).

Required:

Discuss the interrelationships between financing, investment and dividend strategies with reference to the liquidity requirements of GSD Ltd. Include in your discussion how each could be adapted to meet the companys liquidity requirements in the years 20X5 and 20X6 and provide a recommendation.

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Example 5 Exam style forecasting question continued

8Exam style questions

ThedirectorsofABC,aconglomeratelistedonastockexchange,areappraisingoneoftheirwhollyownedsubsidiaries,XYZ,withaviewtodisinvestment.Thesubsidiaryisprimarilyinvolvedinthemanufactureanddistributionofcarcareproducts.

FinancialdataforXYZareshowninthetablebelow.

Required:

(10 marks)

(15 marks)

(Total: 25 marks)

(a) Calculate five ratios for each of the two years 20X1 and 20X2 which you consider to be appropriate for the evaluation of the subsidiary's gearing, profitability and liquidity over the twoyear period. Your selection of ratios should ensure measurement of the company's performance in all three areas.

(b) Prepare a report for the management of ABC. This report should discuss the following:(i) the performance of the subsidiary during the past two

years, using the ratios calculated in part (a) to guide your comments

(ii) the limitations of the type of historical analysis you have just provided

(iii) suggestions for the parent company's future course of action in respect of the subsidiary, including comment on an appropriate procedure for valuing the company

(iv) other, nonfinancial information which would be useful to the directors of ABC before they make any decision.

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Test your understanding 1 Ratio analysis

Summary accounts for XYZ

Balance sheet (statement of financial position) at 31 December

Extracts from the income statements for the years ended 31 December

20X2 20X1$000 $000

Noncurrentassets(plant&equip) 2,650 2,255Otherlongtermassets(Note1) 750 675

Cashandmarketablesecurities 195 162Receivables 765 476Inventoryandworkinprogress 1,250 893Othercurrentassets 150 91

Totalassets 5,760 4,552

Shareholders'funds 2,520 1,726

Longtermdebt 2,250 1,976Otherlongtermliabilities(Note2) 275 206

Currentliabilities 715 644

Totalequity&liabilities 5,760 4,552

20X2 20X1$000 $000

Turnover 6,575 5,918Costofgoodssold 5,918 5,444Otherexpenses 658 592Otherincome 23 20

Earningsbeforefinancechargesandtax 22 (98)FinanceCharges 395 339Taxonordinaryactivities(Note3) (120) (149)

Netloss (253) (288)

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Notes:

Other financial information

(1) Otherlongtermassetsaremotorvehiclesandofficeequipment.(2) Otherlongtermliabilitiesarefinanceleases.(3) Thetaxshowninthe20X1profitandlossextractwillberecovered

in20X2.

$000Depreciation20X2 175Netrealisablevalueofinventory 1,091Netrealisablevalueofplantandequipment 3,907Inventoryandworkinprogressat1January20X1 850Receivablesat1January20X1 435

STRisawellestablishedmarketingconsultancyinacountrywithalowinterestrate.STRisasuccessfulbusinesswhichhasexperiencedrapidgrowthinrecentyears.Thereare20million$1ordinarysharesinissue.Theseordinarysharesarequotedonarecognisedstockexchangeand40%areownedbythefoundersofthebusiness.Dividendswere40centspersharein20X3andgrewby5%perannumbetween20X3and20X6.Thispatternisexpectedtocontinuebeyond20X6.Dividendsarepaidintheyearinwhichtheyaredeclared.

Extractsfromthefinancialstatementsforthepastthreeyearsareasfollows:

Additional information:

20X4 20X5 20X6$million$million$million

Profitbeforetax 21.6 24.4 26.7Taxexpense 7.7 2.6 4.3Netcashgeneratedafterdeductinginterest,taxandnetcapitalexpenditure,butexcludingordinarydividends

19.2 (7.1) 18.8

Theopeningcashbalancein20X4forcashandcashequivalentswas$6million

Theopeningbookvalueofequityin20X4was$60million

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Test your understanding 2 Forecasting and ratio analysis

Thedirectorshavenoticedthebuildupofcashandcashequivalents.Theyareconcernedthatthismightnotbeinthebestinterestoftheshareholdersandcouldhaveanadverseeffectontheshareprice.Variousproposalshavebeenmadetoreducethelevelofcashandcashequivalents.

Required:

(3 marks)

(10 marks)

(7 marks)

(5 marks)

(Total for part (c) = 12 marks)

(Total: 25 marks)

Longtermborrowingsremainedat$50millionthroughoutthethreeyearsandtheannualgrossinterestcostontheborrowingswas$1million

Therewereanumberofdisposalsofnoncurrentassetsin20X4andanexceptionallyhighlevelofcapitalexpenditurein20X5.

(a) Calculate the following financial information for STR for each of the years 20X4 to 20X6:

Closing cash balance

Closing book value of equity.

(b) Analyse and discuss the financial performance of the entity from the viewpoint of both the lenders and shareholders, referring to the information calculated in part (a) above and making appropriate additional calculations. Up to 6 marks are available for calculations.

(c) (i) Discuss the comparative advantages and disadvantages

of a share repurchase versus a oneoff dividend payment.

(ii) Advise the directors of STR on alternative financial strategies that they could consider that would reduce the level of surplus cash.

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(a) YouareanewlyappointedFinanceManagerofanEducationalInstitutionthatismainlygovernmentfunded,havingmovedfromasimilarpostinaserviceentityintheprivatesector.Theobjective,ormissionstatement,ofthisInstitutionisshowninitspublicitymaterialas:

Toachieverecognizedstandardsofexcellenceintheprovisionofteachingandresearch.

TheonlyfinancialperformancemeasureevaluatedbythegovernmentisthattheInstitutionhastoremainwithincashlimits.ThecashallocationeachyearisdeterminedbyarangeofnonfinancialmeasuressuchasthenumberofresearchpublicationstheInstitutionsstaffhaveachievedandofficialratingsforteachingquality.

However,almost20%oftotalcashgeneratedbytheInstitutionisnowfromtheprovisionofcoursesandseminarstoprivatesectorentities,usingeitheritsownoritscustomersfacilities.Thesecustomersarelargelyunconcernedaboutresearchratingsandteachingqualityastheyrelatemoretoacademicawardssuchasdegrees.

TheHeadoftheInstitutionaimstoincreasethepercentageofincomecomingfromtheprivatesectorto50%overthenext5years.Shehasaskedyoutoadviseonhowthemanagementteamcanevaluateprogresstowardsachievingthisaimaswellasmeetingtheobjectivesetbythegovernmentfortheactivitiesitfunds.

Required:

Discuss the main issues that an institution such as this has to consider when setting objectives. Advise onwhether a financial objective, or objectives, could or should be determined and whether such objective(s) should be made public.

(9 marks)

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Test your understanding 3 Objectives / performance appraisal

Required:

Choose two of each type of measure, explain their purpose and advise on how they could be used by the Educational Institution over the next 5 years to assess how it is meeting the Head of the Institutions aims.

(16 marks)

Note: A report format is not required in answering this question.

(Total 25 marks)

(b) Thefollowingisalistoffinancialandnonfinancialperformancemeasuresthatwereinuseinyourpreviousprofitmakingentity:

Financial NonfinancialValue