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F9
FINANCIAL MANAGEMENT
Study System
Sample Session
ATC
INTERNATIONAL
ACCA
PAPER F9
FINANCIAL MANAGEMENT
STUDY SYSTEM
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SESSION 00 CONTENTS
CONTENTS
Page
1
0101
0201
Investment Decisions
0301
0401
0501
Applications of DCF
0601
0701
Equity Finance
0801
Debt Finance
0901
1001
1101
1201
1301
14 Inventory Management
1401
15 Cash Management
1501
1601
17 Risk Management
1701
1801
19 Glossary
1901
Index
2001
(iii)
SESSION 00 CONTENTS
(iv)
SESSION 00 SYLLABUS
INTRODUCTION
This Study System has been specifically written for the Association of Chartered Certified
Accountants fundamentals level examination, Paper F9 Financial Management
It provides comprehensive coverage of the core syllabus areas and is designed to be used
both as a reference text and interactively with the ATC Learning System to provide you with
the knowledge, skill and confidence to succeed in your ACCA studies
SYLLABUS
AFM (P4)
FM (F9)
MA (F2)
Financial Management
Management Accounting
Aim
To develop the knowledge and skills expected of a finance manager, in relation to
investment, financing, and dividend policy decisions.
Main capabilities
On successful completion of this paper, candidates should be able to:
A
Assess and discuss the impact of the economic environment on financial management
Explain and calculate the cost of capital and the factors which affect it
(v)
SESSION 00 SYLLABUS
Financial
management function
(A)
Working capital
management (C)
Investment appraisal
(D)
Business finance
(E)
Cost of capital
(F)
Business valuations
(G)
Risk management
(H)
RATIONALE
The syllabus for Paper F9, Financial Management, is designed to equip candidates with the
skills that would be expected from a finance manager responsible for the finance function of
a business. The paper, therefore, starts by introducing the role and purpose of the financial
management function within a business. Before looking at the three key financial
management decisions of investing, financing, and dividend policy, the syllabus explores
the economic environment in which such decisions are made.
The next section of the syllabus is the introduction of investing decisions. This is done in two
stages - investment in (and the management of) working capital and the appraisal of longterm investments.
The next area introduced is financing decisions. This section of the syllabus starts by
examining the various sources of business finance, including dividend policy and how much
finance can be raised from within the business. Cost of capital and other factors that
influence the choice of the type of capital a business will raise then follows. The principles
underlying the valuation of business and financial assets, including the impact of cost of
capital on the value of the business is covered next.
The syllabus finishes with an introduction to, and examination of, risk and the main
techniques employed in the management of such risk.
(vi)
SESSION 00 SYLLABUS
DETAILED SYLLABUS
A
1.
2.
3.
4.
1.
2.
1.
2.
3.
Investment appraisal
1.
2.
3.
4.
5.
6.
(vii)
SESSION 00 SYLLABUS
Business finance
1.
2.
3.
4.
5.
Cost of capital
1.
2.
3.
4.
5.
6.
Business valuations
1.
2.
3.
4.
Risk management
1.
2.
3.
4.
(viii)
SESSION 00 SYLLABUS
(ix)
Formula sheet
Economic order quantity =
2C o D
Ch
3
3
4 transaction cost variance of cash flows
Spread = 3
interest rate
Vd (1 T )
Ve
a =
e +
d
(Ve + Vd (1 T ))
(Ve + Vd (1 T ))
D O (1 + g )
(re g )
(x)
(1 + h c )
(1 + h b )
f0 = s0 x
(1 + i c )
(1 + i b )
r = discount rate
n = number of periods until payment
Discount rate (r)
Periods
(n)
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1
2
3
4
5
0.990
0.980
0.971
0.961
0.951
0.980
0.961
0.942
0.924
0.906
0.971
0.943
0.915
0.888
0.863
0.962
0.925
0.889
0.855
0.822
0.952
0.907
0.864
0.823
0.784
0.943
0.890
0.840
0.792
0.747
0.935
0.873
0.816
0.763
0.713
0.926
0.857
0.794
0.735
0.681
0.917
0.842
0.772
0.708
0.650
0.909
0.826
0.751
0.683
0.621
1
2
3
4
5
6
7
8
9
10
0.942
0.933
0.923
0.914
0.905
0.888
0.871
0.853
0.837
0.820
0.837
0.813
0.789
0.766
0.744
0.790
0.760
0.731
0.703
0.676
0.746
0.711
0.667
0.645
0.614
0.705
0.665
0.627
0.592
0.558
0.666
0.623
0.582
0.544
0.508
0.630
0.583
0.540
0.500
0.463
0.596
0.547
0.502
0.460
0.422
0.564
0.513
0.467
0.424
0.386
6
7
8
9
10
11
12
13
14
15
0.896
0.887
0.879
0.870
0.861
0.804
0.788
0.773
0.758
0.743
0.722
0.701
0.681
0.661
0.642
0.650
0.625
0.601
0.577
0.555
0.585
0.557
0.530
0.505
0.481
0.527
0.497
0.469
0.442
0.417
0.475
0.444
0.415
0.388
0.362
0.429
0.397
0.368
0.340
0.315
0.388
0.356
0.326
0.299
0.275
0.350
0.319
0.290
0.263
0.239
11
12
13
14
15
(n)
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1
2
3
4
5
0.901
0.812
0.731
0.659
0.593
0.893
0.797
0.712
0.636
0.567
0.885
0.783
0.693
0.613
0.543
0.877
0.769
0.675
0.592
0.519
0.870
0.756
0.658
0.572
0.497
0.862
0.743
0.641
0.552
0.476
0.855
0.731
0.624
0.534
0.456
0.847
0.718
0.609
0.516
0.437
0.840
0.706
0.593
0.499
0.419
0.833
0.694
0.579
0.482
0.402
1
2
3
4
5
6
7
8
9
10
0.535
0.482
0.434
0.391
0.352
0.507
0.452
0.404
0.361
0.322
0.480
0.425
0.376
0.333
0.295
0.456
0.400
0.351
0.308
0.270
0.432
0.376
0.327
0.284
0.247
0.410
0.354
0.305
0.263
0.227
0.390
0.333
0.285
0.243
0.208
0.370
0.314
0.266
0.225
0.191
0.352
0.296
0.249
0.209
0.176
0.335
0.279
0.233
0.194
0.162
6
7
8
9
10
11
12
13
14
15
0.317
0.286
0.258
0.232
0.209
0.287
0.257
0.229
0.205
0.183
0.261
0.231
0.204
0.181
0.160
0.237
0.208
0.182
0.160
0.140
0.215
0.187
0.163
0.141
0.123
0.195
0.168
0.145
0.125
0.108
0.178
0.152
0.130
0.111
0.095
0.162
0.137
0.116
0.099
0.084
0.148
0.124
0.104
0.088
0.074
0.135
0.112
0.093
0.078
0.065
11
12
13
14
15
(xi)
Annuity table
Present value of an annuity of 1 i.e.
where
1 (1 + r ) n
r
r = discount rate
n = number of periods
Discount rate (r)
Periods
(n)
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
1
2
3
4
5
0.990
1.970
2.941
3.902
4.853
0.980
1.942
2.884
3.808
4.713
0.971
1.913
2.829
3.717
4.580
0.962
1.886
2.775
3.630
4.452
0.952
1.859
2.723
3.546
4.329
0.943
1.833
2.673
3.465
4.212
0.935
1.808
2.624
3.387
4.100
0.926
1.783
2.577
3.312
3.993
0.917
1.759
2.531
3.240
3.890
0.909
1.736
2.487
3.170
3.791
1
2
3
4
5
6
7
8
9
10
5.795
6.728
7.652
8.566
9.471
5.601
6.472
7.325
8.162
8.983
5.417
6.230
7.020
7.786
8.530
5.242
6.002
6.733
7.435
8.111
5.076
5.786
6.463
7.108
7.722
4.917
5.582
6.210
6.802
7.360
4.767
5.389
5.971
6.515
7.024
4.623
5.206
5.747
6.247
6.710
4.486
5.033
5.535
5.995
6.418
4.355
4.868
5.335
5.759
6.145
6
7
8
9
10
11
12
13
14
15
10.37
11.26
12.13
13.00
13.87
9.787
10.58
11.35
12.11
12.85
9.253
9.954
10.63
11.30
11.94
8.760
9.385
9.986
10.56
11.12
8.306
8.863
9.394
9.899
10.38
7.887
8.384
8.853
9.295
9.712
7.499
7.943
8.358
8.745
9.108
7.139
7.536
7.904
8.244
8.559
6.805
7.161
7.487
7.786
8.061
6.495
6.814
7.103
7.367
7.606
11
12
13
14
15
(n)
11%
12%
13%
14%
15%
16%
17%
18%
19%
20%
1
2
3
4
5
0.901
1.713
2.444
3.102
3.696
0.893
1.690
2.402
3.037
3.605
0.885
1.668
2.361
2.974
3.517
0.877
1.647
2.322
2.914
3.433
0.870
1.626
2.283
2.855
3.352
0.862
1.605
2.246
2.798
3.274
0.855
1.585
2.210
2.743
3.199
0.847
1.566
2.174
2.690
3.127
0.840
1.547
2.140
2.639
3.058
0.833
1.528
2.106
2.589
2.991
1
2
3
4
5
6
7
8
9
10
4.231
4.712
5.146
5.537
5.889
4.111
4.564
4.968
5.328
5.650
3.998
4.423
4.799
5.132
5.426
3.889
4.288
4.639
4.946
5.216
3.784
4.160
4.487
4.772
5.019
3.685
4.039
4.344
4.607
4.833
3.589
3.922
4.207
4.451
4.659
3.498
3.812
4.078
4.303
4.494
3.410
3.706
3.954
4.163
4.339
3.326
3.605
3.837
4.031
4.192
6
7
8
9
10
11
12
13
14
15
6.207
6.492
6.750
6.982
7.191
5.938
6.194
6.424
6.628
6.811
5.687
5.918
6.122
6.302
6.462
5.453
5.660
5.842
6.002
6.142
5.234
5.421
5.583
5.724
5.847
5.029
5.197
5.342
5.468
5.575
4.836
4.988
5.118
5.229
5.324
4.656
4.793
4.910
5.008
5.092
4.586
4.611
4.715
4.802
4.876
4.327
4.439
4.533
4.611
4.675
11
12
13
14
15
(xii)
EXAM TECHNIQUE
Time allocation
To allocate your time multiply the marks for each question by 1.8 minutes.
i.e. each 25 mark question should take you 25 1.8 = 45 minutes.
You should also apportion your time carefully between the parts of each question.
Do not be tempted to go over the time allocation on each question - remember the law of
diminishing returns the longer you spend the lower your efficiency in gaining marks. It is
more effective to move onto the next question.
Numerical elements
Before starting a computation, picture your route. Do this by noting down the steps
you are going to take and imagining the layout of your answer.
Use a columnar layout if appropriate. This helps to avoid mistakes and is easier for the
marker to follow.
Include all your workings and cross-reference them to the face of your answer.
A clear approach and workings will help earn marks even if you make an arithmetic
mistake.
If you later notice a mistake in your answer, it is not worthwhile spending time
amending the consequent effects of it. The marker of your script will not punish you for
errors caused by an earlier mistake.
Dont ignore marks for written recommendations or comments based upon your
computation. These are easy marks to gain.
If you write good comments based upon calculations which contain errors, you can still
receive all the marks for the comments.
If you could not complete the calculations required for comment then assume an answer
to the calculations. As long as your comments are consistent with your assumed answer
you can still pick up all the marks for the comments.
(xiii)
Written elements
Planning
Read the requirements carefully at least twice to identify exactly how many points you
are being asked to address.
Give your plan a structure which you will follow when you write up the answer.
Presentation
Use headings and sub-headings to give your answer structure and to make it easier to
read for the marker.
Use short paragraphs for each point that you are making.
Use bullet points where this seems appropriate e.g. for a list of advantages/disadvantages
Style
Concise, easily understood language scores good marks and requires less writing.
Lots of points briefly explained tend to score higher marks than one or two points
elaborately explained.
(xiv)
OVERVIEW
Objective
To use this model to estimate the cost of equity and the cost of debt.
SECURITY
VALUATION AND THE
COST OF CAPITAL
EQUITY
ANALYSIS
DEBT
ANALYSIS
Irredeemable debentures
Redeemable debentures
Semi-annual interest
Convertible debentures
1001
1.1
1.2
Constant Dividend
Ex-div market value is the market value assuming that a dividend has just been
paid.
Let:
Po
Dn
ke
=
=
=
D1
+
(1 + ke)
D2
(1 + ke)
D3
(1 + ke)
.....
Dn
n
(1 + ke)
D
ke
This version of the model can be used to determine the theoretical value of a share
which pays a constant dividend e.g. a preference share or an ordinary share in a zero
growth company.
1002
1.3
D0(1 + g)
ke g
D1
ke g
D O (1 + g )
(re g )
1.4
rational investors
all investors have the same expectations and therefore the same required rate of return
no transactions costs
large number of buyers and sellers of shares
no individual can affect the share price
all investors have all available information
dividends are paid just once a year and one year apart
1.5
The model can be used to estimate the theoretical fair value of shares in unlisted
companies where a quoted market price is not known. .
However if the company is listed, and the share price is therefore known, the model can
be used to estimate the required return of shareholders i.e. the companys cost of equity
finance.
1003
Illustration 1
Suppose that a share has a current ex-div market value of 80 cents and
investors expect a dividend of 10 cents per share to be paid each year as has
been the case for the past few years.
Using the dividend valuation model the required return of the investors for
this share can be determined:
Po
D
ke
80c
10c
ke
ke
10c
80c
ke
12.5%
Investors will all require this return from the share as the model assumes they
all have the same information about the risk of this share and they are all
rational.
If investors think that the dividend is due to increase to 15 cents each year then
at a price of 80 cents the share is giving a higher return than 12.5%. Investors
will therefore buy the share and the price will increase until, according to the
model, the value will be:
Po
15c
0.125
120 cents
Alternatively suppose that the investors' perception is that the dividend will
remain at 10 cents per share but that the risk of the share has increased thereby
requiring a return of 15%. If the share only gives a return of 12.5% (on an 80
cents share price) then investors will sell and the price will fall. The fair value
of the share according to the model will be:
Po
1004
10c
0.15
66.7 cents
1.6
The dividend valuation model gives a theoretical value, under the assumptions of the
model, for any security.
In practice there will be many factors other than the present value of cash flows from a
security that play a part in its valuation. These are likely to include:
interest rates
market sentiment
expectation of future events
inflation
press comment
speculation and rumour
currency movements
takeover and merger activity
political issues.
Share prices change, often dramatically, on a daily basis. The dividend valuation model
will not predict this, but will give an estimate of the underlying fair value of the shares.
COST OF EQUITY
2.1
D
ke
D
Po
If ke is the return required by the shareholders in order for the share value to remain
constant then ke is also the return that the company must pay to its shareholders.
Therefore ke also equates to the cost of equity of the company.
Therefore the cost of equity for a company with a constant annual dividend can be
estimated as the dividend divided into the ex-div share price i.e. the dividend yield.
The ex-div market value is the market value of the share assuming that the current
dividend has just been paid. A cum-div market value is one which includes the value of
the dividend just about to be paid. If a cum-div market value is given then this must be
adjusted to an ex div market value by taking out the current dividend.
1005
Example 1
A companys shares have a market value of $2.20 each. The company is just
about to pay a dividend of 20c per share as it has every year for the last ten
years.
What is the companys cost of equity?
Solution
2.2
The model can also deal with a dividend that is growing at a constant annual rate of g.
D 0 (1 + g)
ke g
Po
where
D1
ke g
D0(1 + g)
+g
Po
1006
Illustration 2
Do = 12c, Po (ex div) = $1.75, g = 5%.
What is the value of ke?
ke
0.12 (1.05)
+ 0.05
1.75
= 12.2%
The growth rate of dividends can be estimated using either of two methods.
Two methods
Extrapolation of
past dividends
2.3
If dividends have grown at 5% in each of the last 20 years, predicted future growth
= 5%.
New company with very high growth rates take care! It is unlikely to produce
such high growth in perpetuity.
No pattern do not use this method (i.e. dividends up one year, down the next).
1007
Example 2
A company has paid the following dividends over the last five years.
Cents per share
100
110
125
136
145
19X0
19X1
19X2
19X3
19X4
Estimate the growth rate and the cost of equity if the current (19X4) ex div
market value is $10.50 per share.
Solution
2.4
re
return on equity
Take an average of r and b over the preceding years to estimate future growth.
re
Retained profit
Profit after tax
These figures can be obtained from the statement of financial position and income
statement.
1008
Example 3
A company has 300,000 ordinary shares in issue with an ex-div market value of
$2.70 per share. A dividend of $40,000 has just been paid out of post-tax profits
of $100,000.
Net assets at the year end were valued at $1.06m.
Estimate the cost of equity.
Solution
1009
2.5
Illustration 3
A plc is all equity financed and has 1m shares quoted at $2 each ex div. It pays
constant annual dividends of 30c per share.
It is considering adopting a project which will cost $500,000 and which is of the
same risk as its existing activities. The cost will be met by a rights issue. The
project will produce inflows of $90,000 pa in perpetuity. All inflows will be
distributed as dividends.
What is the new value of the equity in A plc and what is the gain to the
shareholders? Ignore tax.
0.30
= 15%
2.00
ke =
New dividend
$
300,000
90,000
390,000
390 ,000
0.15
= $2,600,000
Shareholders gain
Project NPV
= ($500,000) +
90 ,000
0.15
= $100,000
Therefore the NPV of a project serves to increase the value of the companys shares i.e.
the NPV of a project shows the increase in shareholders wealth.
This proves that NPV is the correct method of project appraisal it is the only method
consistent with the assumed objective of maximising shareholders wealth.
1010
2.6
Ke
Preference dividends are normally quoted as a percentage, e.g. 10% preference shares.
This means that the annual dividend will be 10% of the nominal value, not the market
value.
D
Po
Example 4
A company has 100,000 12% preference shares in issue (nominal value $1).
The current ex-div market value is $1.15 per share.
What is the cost of the preference shares?
Solution
COST OF DEBT
3.1
Terminology of debentures
The coupon rate is the interest rate printed on the debenture certificate.
Annual interest = coupon rate nominal value
Nominal value is also known as par or face value. In the exam the nominal value of one
debenture is usually $100.
Market value (MV) is normally quoted as the MV of a block of $100 nominal value.
e.g. 10% debentures quoted at $95 means that a $100 block is selling for $95 and annual
interest is $10 per $100 block.
Market value (cum-int) includes the value of accrued interest which is just about to be
paid.
1011
3.2
Irredeemable debentures
Irredeemable debentures are a type of debt finance where the company will never repay
the principal but will pay interest each year until infinity. They are also referred to as
undated debentures.
The market value of undated debt can be calculated using the same logic as the
Dividend Valuation Model:
MV (ex interest) = present value of future interest payments discounted at the debentureholders required rate of return
MV (ex int) =
where
I
r
I = annual interest
r = return required by debenture holder
I
MV (ex int)
r =
The company gets tax relief on the debenture interest it pays, which reduces the cost of
debentures to the company known as the tax shield on debt.
Interest yield
Illustration 4
Consider two companies with the same earnings before interest and tax (EBIT).
The first company uses some debt finance, the second uses no debt.
$
100
(10)
___
$
100
90
100
Tax @ 33%
29.70
EBIT
Debt interest
___
33
$3.30 difference
Therefore
Effective cost of debt
Debt interest
Less Tax shield
$
10.00
(3.30)
_____
6.70
_____
1012
Because of tax relief, the cost to the company is not equal to the required return of the
debenture holders.
Unless told otherwise, we assume that tax relief is instant (in practice, there will be a
minimum time lag of nine months under the UK tax system).
Kd can be used to denote the cost of debt but care is needed as to whether it is stated
pre-tax or post-tax.
Example 5
12% undated debentures with a nominal value of $100 are quoted at $92 cum
interest. The rate of corporation tax is 33%.
Find
(a) the return required by the debenture-holders
(b) the cost to the company.
Solution
1013
3.3
The cost of any source of funds is the IRR of the cash flows associated with that source.
If we are looking at the return from an investors point of view, interest payments are
included gross.
If we are looking at the cost to the company, we take the interest payments net of
corporation tax. Assume instant tax relief.
Assume that the final redemption payment does not have any tax effects.
To find the cost of debt for a company find the IRR of the following cash flows:
Time
0
1n
n
$
x
(x)
(x)
Example 6
A company has in issue $200,000 7% debentures redeemable at a premium of
5% on 31 December 19X6. Interest is paid annually on the debentures on 31
December. It is currently 1 January 19X3 and the debentures are trading at $98
ex interest. Corporation tax is 33%.
What is the cost of debt for this company?
Solution
1014
Care should be taken not to confuse the required return of the debenture holders with
the cost of debt of the company.
Required return of the
redeemable debenture
holder
= Gross redemption
yield
The cost of debt of the company is then determined by finding the IRR of the market
value, net of tax interest payments and redemption value.
MV (ex interest) = present value of future interest payments and redemption value
discounted at the debenture-holders required rate of return
Example 7
A company has 8% debentures redeemable at a 5% premium in ten years.
Debenture-holders require a return of 10%.
What is the cost to the company? Corporation tax is 33%.
Solution
1015
3.4
In practice debenture interest is usually paid every six months rather than annually.
This practical aspect can be built into our calculations for the cost of debt.
If interest payments are being made every 6 months then when the IRR of the debenture
cash flows is calculated it should be done on the basis of each time period being 6
months.
The IRR, or cost of debt, will then be a 6 monthly cost of debt and must be adjusted to
determine the annual cost of debt.
Example 8
A company has in issue 6% debentures the interest on which is paid on 30 June
and 31 December each year. The debentures are redeemable at par on 31
December 19X9. It is now 1 January 19X7 and the debentures are quoted at
96% ex interest.
What is the effective annual cost of debt for the company? Ignore corporation
tax.
Solution
1016
3.5
Convertible debentures
Convertible debentures allow the investor to choose between redeeming the debentures
at some future date or converting them into a pre-determined number of ordinary
shares in the company.
To estimate the market value it is first necessary to predict whether the investor will
choose redemption or conversion. The redemption value will be known with certainty
but the future share price can only be estimated.
MV (ex interest) = present value of future interest payments and the higher of (i)
redemption value (ii) forecast conversion value, discounted at the debenture-holders
required rate of return
Example 9
A company has in issue 8% coupon bonds which are redeemable at their par value of $100 in
four years time. Alternatively, each bond may be converted on that date into 40 ordinary
shares. The current ordinary share price is $2.10 and this is expected to grow at a rate of 7%
per year for the foreseeable future. Bondholders required return is 9% per year.
Required:
Calculate the following values for each $100 convertible bond:
(i) market value;
(ii) floor value;
(iii) conversion premium
Solution
1017
To find the post-tax cost of convertible debt for a company find the IRR of the following
cash flows:
Time
0
1n
n
$
x
(x)
(x)
Example 10
A company has in issue some 8% convertible loan stock currently quoted at $85
ex interest. The loan stock is redeemable at a 5% premium in five years time, or
can be converted into 40 ordinary shares at that date. The current ex-div
market value of the shares is $2 per share and dividend growth is expected at
7% per annum. Corporation tax is 33%.
What is the cost to the company of the convertible loan stock?
Solution
1018
Key points
zero NPV transaction i.e. market price = present value of future cash flows
discounted at investors required return.
If the market price of a security is already known then the model can be rearranged to find the required return of investors i.e. the companys cost of
equity/debt finance.
Care must be taken with the cost of debt as interest, unlike dividends, is a
tax allowable expense form the side of the company.
FOCUS
You should now be able to:
1019