P4 Course notesSyllabus A: Role of The Senior Financial Adviser... 2 1. The role and responsibilty of senic ial executive/advisor 2 A2. Financial strategy formulation 10 AS. Ethical and governance issues. 38 ‘A4, Management of international trade and finance 62 AS. SI business and financial planning for multinationals 73 AG. Dividend policy in multinationals and transfer pricing 82 Syllabus B: Advanced Investment Appraisal . B1. Discounted cash flow techniques 102 B2. Ag B3. ime B4. Valuation and the us BBS. Intem: ions 144 financing of free cash flows. ional invesiment and financing decisions. Syllabus C: Acquisitions And Mergers. C1. Acauisitions and mergers versus ather growth strategies 269 C2. Valuation for acquisitions and Mergers. cet: 281 C8. Regulatory framework and processes. 282 C4. Financing acquisitions and mergers. 301 Syllabus D: Corporate Reconstruction And Re-Organ... re-organisation 306 Syllabus E: Treasury And Advanced Risk Management.... 319 E1. The role of the treasury function in multinationals E2, The use of financial derivati rex risk s to hedge aga ES. The use of fins ial derivatives to hedge against interest rate risk DDowrlosdod by Phebioon Mukwenha (omukwena3@orlSyllabus A: Role of The Senior Financial Syllabus A1. The role and responsibility of senior financial executive/advisor. Financial management is getting and using financial resources well to meet objectives Financial objectives Profit maximisation is often assumed, incorrectly, to be the main objective of a business. Reasons why profit is not a sufficient objective: Investors care about the future Investors care about the dividend Investors care about financing plans oN Investors care about risk management For a profit-making company, a better objective is the maximisation of shareholder wealth. This can be measured as total shareholder return (dividend yield + capital gain or the dividend per share plus capital gain divided by initial share price) , © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloade y Phebioon Mukwenha (omukwena3@orslKey decisions: 1, Investment {in projects or takeovers or working capital) need to be analysed to ensure that they are beneficial to the investor. Investments can help a firm maintain strong future cash flows by the achievement of key corporate objectives e.g. market share, quality. 2. Finance mainly focus on how much debt a firm is planning to use. The level of gearing that is appropriate for a business depends on a number of practical issues: Life cycle - A new, growing business will find it difficult to forecast cash flows with any certainty so high levels of gearing are unwise Operating gearing - If fixed costs are a high proportion of total costs then cash flows will be volatile; so high gearing is not sensible. ‘Stability of revenue - If operating in a highly dynamic business environment then high gearing is not sensible. Security - if unable to offer security then debt will be difficult and expensive to obtain 3. Dividends how returns should be given to shareholders 4, Risk management mainly involve management of exchange rate and interest rate risk and project management issues. 3 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Key Objectives of Financial Management Taking a commercial business as the most common organisational structure, the key objectives of financial management would be to: + Create wealth for the business + Generate cash, and + Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested 3 key elements to the process of financial management 1. Financial Plan ing Management need to ensure that enough funding is available at the right time to meet the needs of the business. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit. Inthe medium and long term, funding may be required for significant additions to the productive capacity of the business or to make acquisitions. 2. Financial Control Financial control is a critically important activity to help the business ensure that the business is meeting its objectives Financial control addresses questions such as: + Are assets being used efficiently? + Are the businesses assets secure? + Do management act in the best interest of shareholders and in accordance with business rules? 4 © aCOWtancy “This documents avaiable foo of chaos on SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)3. Financial Decision-making The key aspects of financial decision-making relate to investment, financing and dividends: Investments must be financed in some way — however there are always financing alternatives that can be considered. For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers Akeey financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via dividends. If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further 5 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)ncial resources ant way. The main roles and responsibilities of the financial manager are varied: They can include: 1. investment selection and capital resource allocation 2. raising finance and minimising the cost of capital 3. distribution and retentions 4. communication with stakeholders 5. financial planning and control 6. risk management 7. efficient and effective use of resources. 5 e aCOWtancy “This documents avaiable foo of chaos on SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Let's look at these in a bit more detail, hot pants, below... 1) Investment selection and capital resource allocation Profit maximising may not be the only goal for a company, its stakeholders may want other things. ‘Therefore, other considerations are as follows: + Ethical considerations when deciding on what to invest in + What method of investment appraisal should be used? NPV? IRR? + What our stakeholders will think of the investments effects on: -ROCE —EPS 2) Raising finance and minimising the cost of capital All investments needs financing Where should we get this financing from? The following issues thus need to be considered: + Are the current gearing levels minimising the cost of capital for the company? + What gearing level is required? + What sources of finance are available? + Tax implications + The risk appetite of investors and management + Restrictions such as debt covenants + Implications for key ratios 7 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)3) Distribution and retention policy Retained earnings is a great source of finance... so should we give dividends away? It depends on. + Will our investments (funded by retained earings) increase the share price and thus shareholder wealth? + Will paying high dividends mean we need alternative finance for capital expenditure or working capital requirements? Will paying low dividends fail to give shareholders their required income levels. + What are the investor preferences for cash dividends now or capital gains in future from enhanced share value? 4) Communication with stakeholders We need to keep stakeholders informed... + Shareholders will need information about: — dividends — gearing levels — risk Suppliers and customers will need information about: — credit policies — pricing policies. + Internal stakeholders Mission statements and current goals and strategies is important for employees at all levels 5 © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)§) Financial planning and control The senior financial executive will need to develop policies on + Planning processes + Business plans + Budgets + Evaluating performance 6) The management of risk Risk management is key and so the following needs understanding + Risk appetite + How are risks identified, Analysed, Planned for and Monitored? 7) Use of resources It will be important to develop a framework to ensure all resources (inventory, labour and noncurrent assets as well as cash) are used to provide value for money, Spending must be: + economic + efficient + effective + transparent. 2 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Accounting Ratios In your exam, you may be required to calculate some ratios in order to support your strategic analysis of the case. This section shall only present a summary and list of ratios that could potential be used in your exam for such purpose. Ratios may be divided into the following categories: + PROFITABILITY RATIOS ‘These are measures of value added being generated by an organisation and include the following ROCE Capital Employed Capital Employed Capital Employed Gross margin Net Margin ROE RI 10 Operating Profit (PBIT)/Capital Employed Equity + LT liabilities Non current assets + net current assets Total assets - current liabilities Gross Profit/Sales Net Profit/Sales Profit After Tax - Preference dividends/Shareholders’ Funds (Ordinary shares + Reserves) Profit After Tax - (Operating Assets x Cost of Capital) © aCOWtaney ‘The dosmertisaatticte stesso SLUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)+ EFFICIENCY RATIOS These are measures of utilisation of Current & Non-current Assets of an organisation. Efficiency Ratios consist of the following: Asset Turnover Sales/Capital Employed ROCE Margin X Asset Turnover Receivables Days (Receivables Balance / Credit Sales) x 365 Payables Days (Payable Balance / Credit Purchases) x 365 Inventory Days (Inventory / Cost of Sales) x 365, + LIQUIDITY & GEARING RATIOS Liquidity Ratios measure the extent to which an organisation is capable of converting assets into cash and cash equivalents. On the other hand, Gearing Ratios measure the dependence of an organisation on external financing as against shareholder funds. Liquidity and Gearing Ratios are outlined below: Liquidity Current Ratio Current Assets / Current Liabilities Quick Ratio (Current Assets — Inventory) / Current Liabilities Gearing Financial Gearing Debt/Equity Financial Gearing Debt/Debt + Equity Operational gearing Contribution / PBIT n © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)+ INVESTOR'S RATIOS These ratios measures return on investment generated by stakeholders. Such ratios include: Dividend Cover _Profit After Tax / Total Dividend Dividend Yield Dividends per share / Share price Interest Cover PBIT / interest Interest yield (coupon rate / market price) x 100% Earnings Per Profit After Tax and preference dividends / Number of Share Shares PE Ratio Share Price / EPS + Inthe exam you have to act like a detective. You have to sift through evidence and extract meaningful messages for effective business decisions. The starting point is often the basic accounting documents that record the progress of any business, the Income statement & SFP These are closely related and so need reading together. The balance sheet is a snapshot of a business at one point in time. The income statement is dynamic and describes the flow of money through the business over a period of time. » © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)mance using methods such 4s Ratios aren't always comparable Factors affecting comaparability 1. Different accounting policies Eg One company may revalue its property; this will increase its capital employed and (probably) lower its ROCE Others may carry their property at historical cost 2. Different accounting dates Eg One company has a year ended 30 June, whereas another has 30 September If the sector is exposed to seasonal trading, this could have a significant impact on many ratios. 3. Different ratio definitions Eg This may be a particular problem with ratios like ROCE as there is no universally accepted definition B © aCOWtanecy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)4. Comparing to averages Sector averages are just that: averages Many of the companies included in the sector may not be a good match to the type of business being compared Some companies go for high mark-ups, but usually lower inventory turnover, Whereas others go for selling more with lower margins 5. Possible deliberate manipulation (creative accounting) 6. Different managerial policies e.g. different companies offer customers different payment terms Compare ratios with 1. Industry averages 2. Other businesses in the same business 3. With prior year information m © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)0 the optimum capital mix an High Gearing problems The higher a company’s gearing, the more the company is considered risky, ‘An acceptable level is determined by comparison to companies in the same industry. ‘A company with high gearing is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are. A greater proportion of equity provides a cushion and is seen as a measure of financial strength. The best known examples of gearing ratios include 1. debt-to-equity ratio (total debt / total equity), 2. interest cover (EBIT / total interest), 3. equity ratio (equity / assets), and 4, debt ratio (total debt / total assets) Dangers associated with high gearing: 1. Need to cover high fixed costs, may tempt companies to increase sales prices and so lose sales to competition 2. Risk of non payment of a fixed cost and litigation 3. Risk of unsettling shareholders by having no spare funds for dividends 4. Risk of lower credit rating 5. Risk of unsettling key creditors 45 e aCOWtancy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)How finance can affect financial position and risk Financial Position Gearing Gearing can be a financially sound part of a business's capital structure particularly if the business has strong, predictable cash flows. Operational gearing Operating gearing is a measure which seeks to investigate the relationship between the fixed operating costs and the total operating costs. + In cases where a business has high fixed costs as a proportion of its total costs, the business is deemed to have a high level of operational gearing Potentially this could cause the business problems in as it relies on continuing demand to stay afloat. + If there is a fall in demand, the proportion of fixed costs to revenue becomes even greater. It may turn profits into serious losses. Normally, businesses cannot themselves do a great deal about the operational gearing, as it may be typical and necessary in the industry, such as the airline business. 16 © aCOWtaney “This documents avaiable fee otchaveon SEUDOCU.COM DDowrloados by Phebioon Mukwenha (omukwanas@gmallcom)The normal equation used is: + Fixed operating costs / Total operating costs In this sense total operating costs include both fixed and variable operating costs. Interest cover Interest cover is a measure of the adequacy of a company's profits relative to interest payments on its debt. The lower the interest cover, the greater the risk that profit (before interest) will become insufficient to cover interest payments. Itis: Itis a better measure of the gearing effect of debt on profits than gearing itself. Avvalue of more than 2 is normally considered reasonably safe, but companies with very vol earnings may require an even jher level, whereas companies that. have very stable earnings, such as utiles, may well be very safe at a lower level. Similarly, cyclical companies at the bottom of their cycle may well have a low interest cover but investors who are confident of recovery may not be overly concerned by the apparent risk. v7 e aCOWtancy DDowrloados by Phebioon Mukwenha (omukwanas@gmallcom)Sources of Finance Operating Leases This is a useful source of finance for the following reasons: 1. Protection against obsolescence Since it can be cancelled at short notice without financial penalty. The lessor will replace the leased asset with a more up-to-date model in exchange for continuing leasing business. This flexibility is seen as vallable in the current era of rapid technological change, and can also extend to contract terms and servicing cover 2. Less commitment than a loan There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be avoided, existing assets need not be tied up as security and negative effects on return on capital employed can be avoided Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt 3. Cheaper than a loan By taking advantage of bulk buying, tax benefits ete the lessor can pass on some of these to the lessee in the form of lower lease rentals, making operating leasing a more attractive proposition that borrowing. 1s © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)4. Off balance sheet finance Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of the leased asset does not appear in the balance sheet. Debt v Equity These are the things you need to think about when asked about raising finance - so just put all these in your answer and link them to the scenario. Job done. + Gearing and financial risk Equity finance will decrease gearing and financial risk, while debt finance will increase them + Target capital structure The aim is to minimise weighted average cost of capital (WACC). In practical terms this can be achieved by having some debt in capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (WAC can be decreased further) or too much gearing (the company suffers from the costs of financial distress) + Availability of security Debt will usually need to be secured on assets by either a fixed charge (on specific assets) or a floating charge (on a specified class of assets). + Economic expectations If buoyant economic conditions and increasing profitability expected in the future, fixed interest debt commitments are more attractive than when difficult trading conditions lie ahead. + Control issues A tights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors. 19 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Rights Issues A\1 for 2 at $4 (MV $6) right issue means..... The current shareholders are being offered 1 share for $4, for every 2 they already own. (The market value of those they already own are currently $6) + Calculation of TERP (Theoretical ex- rights price) The current shareholders will, after the rights issue, hold: 1@$4=$4 2@$6 So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.33, + Effect on EPS Obviously this will fall as there are now more shares in issue than before, and the company has not received full MV for them To calculate the exact effect simply multiply the current EPS by the TERP / Market value before the rights issue Eg Using the above illustration EPS x 5.33/6 + Effect on shareholders wealth There is no effect on shareholders wealth after a rights issue. This is because, although the share price has fallen, they have proportionately more shares Equity issues such as a rights issue do not require security and involve no loss of control for the shareholders who take up the right The factors considered when reducing the amount of debt by issuing equity As the proportion of debt increases in a company’s financial structure, the level of financial distress increases and with it the associated costs. Companies with high levels of financial distress would find it more costly to contract with their stakeholders. 20 © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)For example, they may have to pay higher wages to attract the right calibre of employees, give customers longer credit periods or larger discounts, and may have to accept supplies on more onerous terms. Less financial distress may therefore reduce the costs of contracting with stakeholders. 2. Having greater equity would also increase the company's debt capacity. This may enable the company to raise additional finance 3. On the other hand, because interest is payable before tax, larger amounts of debt will give companies greater taxation benefits, known as the tax shield 4. Reducing the amount of debt would result in a higher credit rating for the company and reduce the scale of restrictive covenants. a © aCOWtanecy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Sylabus AZd) Explain th Risk and the risk management process 5 step process: 1. Identify Risk Make list of potential risks continually. Identify risks facing the company - through consultation with stakeholders 2. Decide on acceptable risk Decide on acceptable risk - and the loss of return/ extra costs associated with reduced risks 3. Analyse Risk Prioritise according to threat/likelihood, Assess the likelinood of the risk occurring - management attention obviously on the higher probability risks 4. Plan for Risk Look at how impact of these risks can be minimised - through consultation with affected parties. Avoid or make contingency plans (TARA) 5. Monitor Risk Assess risks continually. Understand the costs involved in the internal controls set up to manage these risks - and weighed against the benefits » © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Why do all this? To ensure best use is made of opportunities Risks are opportunities to be siezed Can help enhance shareholder value 23 Downloaded by Phebicon Mukwenha (omukwenss@gmaicom) © aCOWtancyIdentifying Risks Management must be aware of potential risks They change as the business changes So this stage is particularly important for those in turbulent environments Uncertainty can come from any of the political, economic, natural, socio- demographic or technological contexts in which the organisation operates. Categories of risk + Strategic risks Refers to the positioning of the company in its environment, Typically affect the whole of an organisation and so are managed at board level + Operational risks Refers to potential losses arising from the normal business operations. Are managed at risk management level and can be managed and mitigated by internal controls. os © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)+ Financial risks = are those arising from a range of financial measures. The most common financial risks are those arising from financial structure (gearing), interest rate risk, liquidity + Business risks The risk that the business won't meet its objectives. If the company operates in a rapidly changing industry, it probably faces significant business risk. Any kind of deterioration in the way in which the organisation is perceived When the disappointed stakeholder has contractual power over the organisation, the cost of the reputation risk may be material. + Market risk Those arising from any of the markets that a company operates in, such as where the business gets its inputs, where it sells its products and where it gets its finance/capital Market risk reflects interest rate risk, currency risk, and other price risks 25 © aCOWtanecy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)+ Entrepreneurial risk The risk associated with any new business venture In Ansoff terms, it is expressed the unknowns of the market reception It also refers to the skills of the entrepreneurs themselves. Entrepreneurial risk is necessary because it is from taking these risks that business opportunities arise. + Credit risk Credit risk is the possibility of losses due to non-payment by creditors. + Legal, of litigation risk arises from the possibilty of legal action being taken against an organization + Technology risk arises from the possibilty that technological change will occur + Environmental risk arises from changes to the environment over which an organisation has no direct control, e.g. global warming, or occurrences for which the organisation might be responsible, €.g. oil spillages and other pollution. 16 © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)+ Business probity risk related to the governance and ethics of the organisation + Derivatives risk due to the use of underperforming financial instruments + Fiscal risks risk that the new taxes and limits on expenses allowable for taxation purposes will change. + Health and safety risk Health and safety risks include loss of employees’ time because of injury and the risks of having to pay compensation or legal costs because of breaches. Health and safety risks can arise from: Lack of health and safety policy Lack of emergency procedures + Liquidity risk If a business suddenly finds that it is unable to cover or renew its short-term liabilities, there will be a danger of insolvency if it cannot pay its debts However current liabilities are often a cheap method of finance (trade payables do not usually carry an interest cost). Businesses may therefore consider that, in the interest of higher profits, it is worth accepting some risk of insolvency by increasing current liabilities, taking the maximum credit possible from suppliers. » © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Business Risk The risk that the business won't meet its objectives ‘The objective is normally profit maximisation So we are looking for problems which may impact on the business To look for Risks. You could use PESTEL Business risk identification is literally putting yourselfiin the shoes of the management. + Political risks e.g, The current government may be unstable and if there is a change of government, the new government may impose restrictions. The Company will need to assess the likelihood of such restrictions. + Economic risks + Social and taste changes + Technological changes + Environmental issues + Legal issues 28 © aCOWtaney “This documents avaiable foo of chaos on SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Financial Statement Risk Simply the risk that the FS are materially misstated (before any audit procedures) ‘The risk comes from potential errors or deliberate misstatements ess v Financial Risk + Business risks will affect the FS if not addressed by management + Business risks can lead to errors on specific areas of the FS (eg. Technological change leading to obsolete stock) + Business risk can have a more general effect on FS (eg. Poor controls leading to errors) + Business risks can lead to going concem problems. This too would be a FS risk (wrong basis of accounting) » © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)The risk framework All projects are risky. When a capital investment programme commences, a framework for dealing with this risk must be in place. This framework must cover: 1. risk awareness 2. risk assessment and monitoring 3. tisk management (i.e.strategies for dealing with risk and planned responses should unprotected risks materialise) 1) Risk awareness In appraising most investment projects, reliance will be placed on a large number of estimates For all material estimates, a formal risk assessment should be carried out to identity: + potential risks that could affect the forecast + the probability that such a risk would occur. 30 © aCOWtancy “This documents avaiable foo of chaos on SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Risks may be: strategic 2. tactical 3. operational Once the potential risks have been identified, a monitoring process will be needed to alert management if they arise. 2) Risk assessment and monitoring Auseful way to manage risk is to identify potential risks (usually done in either brainstorming meetings or by using external consultants) and then categorise them according to the likelihood of occurrence and the significance of their potential impact. Decisions about how to manage the risk are then based on the assessment made. ‘These assessments may be time consuming and the executive will need to decide: + how they should be carried out + what criteria to apply to the categorisation process and + how often the assessments should be updated. The essence of risk is that the retums are uncertain As time passes, so the various uncertain events on which the forecasts are based will occur. Management must monitor the events as they unfold, reforecast predicted results and take action as necessary. The degree and frequency of the monitoring process will depend on the significance of the risk to the project’s outcome. 3 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)3) Risk management Strategies for dealing with risk Risk can be either accepted or dealt with. Possible solutions for dealing with risk include: 1. mitigating the risk — reducing it by setting in place control procedures 2. hedging the risk = taking action to ensure a certain outcome 3. diversification — reducing the impact of one outcome by having a portfolio of different ongoing projects. Well-diversified portfolios Shareholders holding well-diversified portfolios will have diversified away unsystematic or company specific risk, and will only face systematic risk, ie risk that can not be diversified away. Therefore a company can not reduce risk further by undertaking diversification within the same system or market. However, further risk reduction may occur if the diversification is undertaken by the company, on behalf of the shareholders, into a system or market where they themselves do not invest. Some studies indicate that even shareholders holding well-diversified portfolios may benefit from risk diversification where companies invest in emerging markets. 2 © aCOWtaney This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Behavioural Finance Behavioural finance looks at why people make irrational decisions Much of conventional finance is based on rational and logical theories, such as the CAPM and EMH These theories assume that people, for the most part, behave rationally and predictably But the real world is a very messy place people behave very unpredictably. Contrary to convention we are not always "wealth maximisers” Buying a lottery tickets is financially irrational for example. Behavioral finance seeks to explain why we buy them 33 e aCOWtancy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)The "Anomalies" that behavioural finance seeks to explain: 1. January Effect Average monthly return for small firms is consistently higher in January than any other month of the year. Conversely, EMH suggests a "random walk" 2. The Winner's Curse The winning bid in an auction often exceeds the intrinsic value of the item purchased - maybe due to increased bid aggressiveness as more bidders enter the market 3. Equity Premium Puzzle CAPM says investors with riskier investments should get higher returns - but not so much! Shares historically return 10% and government (risk free) bonds 3% - yet shares are not over 3 times more risky - so why is the return premium so high? Behavioural finance shows people have a loss aversion tendency- so are more worried by losses in comparison to potential gains - so in fact a very short-term view on an investment. So shareholders overreact to the downside changes. Therefore, itis believed that equities must yield a high-enough premium to compensate for the investor's considerable aversion to loss. aa © aCOWtancy “This documents avaiable foo of chaos on SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Key concepts of Behavioural Finance 1. Anchoring We tend to "anchor" our thoughts to a reference point - especially in new situations Large Coffee - £5 Medium Coffee - £3.50 Small Coffee - £3 The large is the anchor - get you used to a price (with no logic behind it) thus now making the medium seem cheap. Especially as small (another anchor) is £3. A share falls in value from £80 to £30 - it now seems a bargain - but thats just not rational - you need to see the fundamentals of WHY the price fell not just look at the £80 anchor 2. Mental Accounting Individuals assign different functions to each of their assets, often irrationally So a fund set aside for a vacation or a new home, while still carrying substantial credit card debt is crazy (if the debt is costing more than the deposit account) ‘Some investors divide their investments between a safe and a speculative portfolio - all this work and money spent separating the portfolios, yet his net wealth will be no different than if he had held one larger porttolio. 3. Confirmation Bias We all have a preconceived opinion So we selectively filter and pay more attention to information that supports our opinions, while ignoring the rest An investor "sees" information that supports her original idea and not the contradictory info 35 e aCOWtancy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)4. Gambler's Fallacy You've flicked a coin 10 times - its always been heads amazingly. Whats the chances of it being Tails on the next throw? A gambler MAY incorrectly use the past info to try and predict the future. This is crazy. The chance is still 50% Some investors sell after a share has risen many times in the recent past - surely it can't continue going up? Of course it can - the past has no effect on the future in these situations 5. Herd Behaviour We mimic the actions (rational or irrational) of a larger group. Why else would anyone choose BPP or Kaplan over us?? :) Individually, however, most people would not necessarily make the same choice, The common rationale that i's unlikely that such a large group could be wrong. After all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might stil follow the herd, believing they know something that you don't. This is especially prevalent in situations in which an individual has very litle experience, Think about investors in many dot.com companies in the past - al following each other when fundamentally the businesses were not strong 6. Overconfidence 74% of professional fund managers believe they deliver above-average job performance! :) Overconfident investors generally conduct more trades than their less-confident counterparts. 36 © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)37 Overconfident investors/traders tend to believe they are better than others at choosing the best stocks and best times to enter/exit a position Unfortunately, traders that conduct the most trades tended, on average, to receive significantly lower yields than the market. Overreaction Bias (One consequence of having emotion in the stock market is the overreaction toward new information. According to EMH semi strong markets, new information should more or less be reflected instantly in a security's price. For example, good news should raise a business’ share price accordingly, and that gain in share price should not decline if no new information has been released since. Reality, however, tends to contradict this theory. Often, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security's price. Furthermore, it also appears that this price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time. © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Fundamental Principles The 5 fundamental principles of the ACCA Code of Ethics must be followed The 5 Fundamental principles and what they mean 1. Integrity Be straightforward and honest in all professional relationships 2. Objectivity No bias or conflict of interest influencing your business judgements 3. Professional Competence & Due Care Keep up your professional knowledge and skill so as to give a competent professional service, using current developments and techniques Act diligently and within appropriate standards when providing professional services 38 © aCOWtaney “This documents avaiable foo of chaos on SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)4. Confidentiality Don't disclose any confidential information to third parties without proper and specific authority You can, however, if there is a legal or professional right or duty to disclose Obviously never use it for personal advantage of yourself or third parties 5. Professional behaviour A professional accountant should act in a manner consistent with the good reputation of the profession Refrain from any conduct which might bring discredit to the profession In the exam question you may have to apply these to a case study - groovy baby. 39 e aCOWtancy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)a) Recommend an ethical fame a for the: Ethical issues in financial management The ACCA has developed a five-step framework to help you make ethical decisions. These are: Step 1 - establishing the issues Abu: ss needs to be aware of the ethical issues that ‘Step 2 - are there threats to compliance with fundamental principles? A company’s fundamental ethical principles need to be clearly understood. Step 3 - are the threats significant? if an employee is unsure about this, they should use the mirror test. If felt to be significant, it needs to be reported to the ethics department to deal with it. «0 © aCOWtaney “This documents avaiable foo of chaos on SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Step 4 - are there safeguards to reduce threats to an acceptable level? Safeguards in place in the work environment such as policies and procedures to monitor the quality of work, or to encourage communication of ethical concerns. Step 5 - can you face yourself in the mirror? Sometimes called the mirror test. Whether or not you choose to perform the action, it's useful to look in the mirror and ask yourself: Is it legal? What will others think? — How would you feel explaining what you did to a friend, a parent, a spouse, a child, a manager, or the media? Is it right? - What does your conscience or your instinct tell you? “ © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Agency Relationship Agency is defined in relation to a principal. What?! Well all this means is an owner (principal) lets somebody run her business (manager). The agent is doing this job on behalf of someone else. Footballers, film stars etc all have agents. They work on behalf of the star. The star hopes that the agent is working in their best interest and not just for their own commission. Principals and Agents principal appoints an agent to act on his or her behalt. In the case of corporate governance, the principal is a shareholder and the agents are the directors. The directors are accountable to the principals, Agency Costs + Acost to the shareholder through having to monitor the directors + Over and above normal analysis costs + Aresult of comprised trust in directors 2 © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)8 for ak Transaction cost theory General Transaction costs occur when dealing with another party. If items are made within the company itself, therefore, there are no transaction costs + Analysing these costs can be difficult because of: © Bounded rationality - our limited capacity to understand business situations © Opportunism - actions taken in an individual's best interests + Company will try to keep as many transaction as possible in-house in order to: © reduce uncertainties about dealing with suppliers avoid high purchase prices © manage quality a3 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Are the transaction costs (of dealing with others and not doing the thing yourself) worth it? ‘The 3 factors to take into account as to whether the transaction costs are worthwhile are: 1. Uncertainty Do we trust the other party enough? © The more certain we are, the lower the transaction / agency cost 2. Frequency how often will this be needed The less often, the lower the transaction/agency cost 3. Asset specificity How unique is the item © The more unique the item, the more worthwhile the transaction / agency cost is Applied to Agency theory This can be applied to directors who may take decisions in their own interests also: 1. Uncertainty - Will they get away with it? 2. Frequency - how often will they try it? 3. Asset specificity - How much is to gain? 44 e aCOWtancy ‘rissoamentisanististeeoteraneon SLUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)UK corporate governance In the UK there are 3 main reports recommending best practice in Corporate Governance 1. The Cadbury report 2. The Greenbury report 3. Hampel report The reports recommend: + Separate MD & chairman + Minimum 50% non executive directors, (NEDs) + Independent chairperson + Maximum one-year notice period + Independent NEDs (three-year contract, no share options) + Executive remuneration should be subject to the recommendations of a remuneration committee (entirely or mainly NEDs).. + An Audit committee, comprising of at least 3 NEDs. + Governance should be viewed as an opportunity to enhance long term shareholder value. + The Board is responsible for maintaining a sound system of internal control 45 e aCOWtancy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)US corporate goverance In the US, statutory requirements for publicly-traded companies are set out in the Sarbanes-Oxley Act These requirements include: 1. The certification of published financial statements by the CEO and the chief financial officer (CFO) 2. Faster public disclosures by companies 3. Legal protection for whistleblowers 4. A requirement for an annual report on internal controls 5. Requirements relating to the audit committee, auditor conduct and avoiding proper’ influence of auditors. The Act also requires the Securities and Exchange Commission (SEC) and the main stock exchanges to introduce further rules relating to matters such as 1, the disclosure of critical accounting policies, 2. the composition of the Board and 3. the number of independent directors. European corporate governance In Europe most large companies are not listed on a Stock Market, and are often dominated by a single shareholder with more than 25% of the shares (often a corporate investor or the founding family) ts © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Banks are powerful shareholders and generally have a seat on the boards of large ‘companies. A major difference that exists in the board structure for companies is that the UK has a unitary board (consisting of both executive and non-executive directors). Itis common in Europe to have a two-tier board structure consisting of a supervisory board (elected by sharcholders normally) and an executive board, Ih Germany, the supervisory board has to consist of 50% trade union representatives. ‘The Supervisory Board does not have full access to financial information, is meant to take an unbiased overview of the company, and is the main body responsible for safeguarding the external stakeholders’ interests. The presence on the Supervisory Board of representatives from banks and employees (trade unions) may introduce perspectives that are not present in some UK boards. In particular, many members of the Supervisory Board would not meet the criteria under UK Corporate Governance Code for their independence. ” © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Social and Environmental Issues Social and environmental issues in the conduct of business and of ethical behaviour + Economic activity is only sustainable where its impact on society and the environment is also sustainable. Sustainability can be measured empirically or subjectively Environmental Footprint Measures a company's resource consumption of inputs such as energy, feedstock, water, land use, ete. Measures any harm to the environment brought about by pollution emissions. Measures resource consumption and pollution emissions in either qualitative, quantitative or replacement terms. Together, these comprise the organisation's environmental footprint. Atarget may be set to reduce the footprint and a variance shown. Not all do this and so this makes voluntary adoption controversial Sustainable development ‘The development that meets the needs of the present without compromising the ability of future generations to meet their own needs s © aCOWtaney This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Energy, land use, natural resources and waste emissions etc should be consumed at the same rate they can be renewed. Sustainability affects every level of organisation, from the local neighborhood to the entire planet Itis the long term maintenance of systems according to environmental, economic and social considerations. Full cost accounting This means calculating the total cost of company activities, including environmental, economic and social costs TBL (Triple bottom line) accounting BL accounting means expanding the normal financial reporting framework of a ‘company to include environmental and social performance. The concept is also explained using the triple ‘P’ headings of ‘People, Planet and Profit” The principle of TBL reporting is that true performance should be measured in terms of a balance between economic (profits), environmental (planet) and social (people) factors; with no one factor growing at the expense of the others. The contention is that a corporation that accommodates the pressures of all the three factors in its strategic investment decisions will enhance shareholder value, as long as the benefits that accrue from producing such a report exceeds the costs of producing it. Learn more list Lauren Laverne on Ethical trade Nice article 49 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Purpose and content of an integrated report To explain to providers of financial capital how an organisation creates value over The ‘building blocks’ of an integrated report at + Guiding principles These underpin the integrated report They guide the content of the report and how it is presented + Content elements These are the key categories of information They are a series of questions rather than a prescriptive list Guiding Principles 1. Are you showing an insight into the future strategy..? 2. Are you showing a holistic picture of the the organisation's ability to create value over time? Look at the combination, inter-relatedness and dependencies between the factors that affect this Are you showing the quality of your stakeholder relationships? 4. Are you disclosing information about matters that materially affect your ability to create value over the short, medium and long term? 5. Are you being concise? Not being burdened by less relevant information 6. Are you showing Reliability, completeness, consistency and comparability when showing your own ability to create value. This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Content Elements 1. Organisational overview and external environment What does the organisation do and what are the circumstances under which it operates? 2. Governance How does an organisation’s governance structure support its ability to create value in the short, medium and long term? 3. Business model What is the organisation's business model? 4. Risks and opportunities What are the specific risk and opportunities that affect the organisation's ability to create value over the short, medium and long term, and how is the organisation dealing with them? 5. Strategy and resource allocation Where does the organisation want to go and how does it intend to get there? 6. Performance To what extent has the organisation achieved its strategic objectives for the period and what are its outcomes in terms of effects on the capitals? 7. Outlook What challenges and uncertainties is the organisation likely to encounter in pursuing its strategy, and what are the potential implications for its business model and future performance? 5 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Free trade and the management of barriers to trade Free trade Practical reasons for overseas trade 1. Choice The diversity of goods available in a domestic economy is increased through the import of goods that could be uneconomic or impossible to produce at home. 2. Competition International trade will increase competition in domestic markets, which is likely to lead to both a reduction in price, together with increasing pressure for new products and innovation. 3. Economies of scale By producing both for the home and international markets companies can produce at a larger scale and therefore take advantage of economies of scale. 4, Specialisation If country specialises in producing the goods and services at which it is most efficient, it can maximise its economic output. 2 © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Trade barriers There are a number of ways that a country can seek to restrict imports. Trade barriers include: * Quotas — imposition of a maximum number of units that can be imported e.g. quotas on the number of cars manufactured outside of Europe that can be imported into the EU. + Tariffs — imposition of an import tax on goods being imported into the country to make them uncompetitive on price. + Exchange controls — domestic companies wishing to buy foreign goods will have to pay in the currency of the exporter’s country. To do this they will need to buy the currency involved by selling sterling. If the government controls the sale of sterling it can control the level of imports purchased. + Administrative controls — a domestic government can subject imports to excessive levels of administration, paperwork and red tape to slow down and increase the cost of importing goods into the home economy. + Embargoes — the prohibition of commerce and trade with a certain country, Multinational companies have to find ways of overcoming these barriers, for example by investing directly and manufacturing within a country rather than importing into it. 33 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Trade agreements and common markets In many parts of the world, governments have created trade agreements and ‘common markets to encourage free trade. However, the World Trade Organisation (WTO) is opposed to these trading blocs and customs unions (e.g. the European Union) because they encourage trade between members but often have high trade barriers for nonmembers. Specific strategic issues for multinational organisations - national governance requirements, + A multinational company (MNC) is defined as one which generates at least 25% of its sales from activities in countries other than its own. This rules out returns from portfolio investment and eliminates unit and investment trusts. + Different countries have different governance requirements. These national governance requirements will impact on the behaviour of multinational organisations. sa © aCOWtaney This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)The World Trade Organisation (WTO) Aims are: 1. to reduce the barriers to international trade It does this by seeking to prevent protectionist measures such as tariffs, quotas and other import restrictions. 2. resolving trade disputes it acts as a forum for negotiation and offering settlement processes to resolve disputes between countries. The WTO wil pose fines, if members are in breach of their rules. Members of the WTO cannot offer selective free trade deals with another country without offering it to all other members of the WTO (the most favoured nation principle). The benefits of reducing protectionist measures are: 1. increased trade and economic growth 2. allow to specialise and gain competitive advantage in certain products and services, and compete more effectively globally 3. gain political capital and more influence worldwide 55 e aCOWtancy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)The drawbacks of reducing protectionist measures are: the need to protect certain industries. It may be that these industries are developing and in time would be competitive on a global scale. They may fail too quickly due to international competition, and would create large scale unemployment 2. dumping’ of goods at a very cheap price, which hurt local producers. 56 © aCOWtaney “This documents avaiable foo of chaos on SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)The management of international finance Central banks Central banks normally have control over interest rates and support the stability of the financial system. Collaboration between central banks is supported by the Bank of International Settlements (BICS). In the context of international trade, a key role of the central bank is to guarantee the convertibility of a currency (eg from £s to $s) The International Monetary Fund (IMF) The IMF's main purpose is to support the stability of the international monetary system by providing support to countries with balance of payments problems; most countries are members. Where a member is having difficulties overcoming balance of payments problems the IMF will: 1. offer advice on economic policy 2. lend money, at subsidised rates to finance short-term exchange rate intervention IMF loans are conditional on action being taken to reduce domestic demand, and are normally repayable over a five-year period 37 e aCOWtancy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)The IMF has been criticised as being controlled by those who don't need funds, for failing to control its own costs and for holding on to its substantial gold reserves. The World Bank ‘The World Bank, partially funded by the IMF, exists to fund reconstruction and redevelopment. Loans are normally made directly to governments, for periods of 10-20 years and tied to specific projects. The International Bank for Reconstruction and Development (IBRD) Popularly known as the World Bank, it was also created at Bretton Woods in 1944, with the aim of financing the reconstruction of Europe after the Second World War. ‘The World Bank is now an important source of long-term low interest funds for developing countries. ‘The Bank for International Settlements (BIS) Established in Basle, Switzerland in 1930, it acts as a supervisory body for central banks assisting them in the investment of monetary assets. Itacts as a trustee for the IMF in loans to developing countries and provides bridging finance for members pending their securing longer term finance for balance of payments deficits. se © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)The role of international financial institutions US Federal Reserve System (the FED) is the central banking system of the United States. Created in 1913, Its roles 1. condueting the US monetary policy 2. maintaining stability of the financial system 3. supervising and regulating banking institutions. Bank of England ‘The Bank of England is the central bank of the UK. Its roles and aims: + The maintenance of price stability and support of British economic policies + Stable prices and market confidence in sterling are the two main criteria for monetary stability + The Bank aims to meet inflation targets set by the Government by adjusting interest rates. + The Bank can also operate as a ‘lender of last resort’ - that is, it will extend credit when no other institution will 39 e aCOWtancy Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)European Central Bank (ECB) was established in 1998 and is based in Frankfurt, + tis responsible for administering the monetary policy of the EU Eurozone member states. + The main objective of the ECB is to maintain price stability within the Eurozone (keep inflation low). Bank of Japan is Japan's central bank and is based in Tokyo. In 1997, the Bank was given greater independence from the government The bank has ignored government requests to stimulate the Japanese economy. As a result the Japanese economy remains in a critical state. However in August 2011, the Bank of Japan announced a scheme to offer 3 trillion yen (approximately $35 billion) in low- interest loans in an attempt to stimulate the economy. 0 © aCOWtancy This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)The Euromarkets ‘The Euromarkets refer to transactions between banks and depositors/borrowers of Eurocurrency. Eurocurrency refers to a currency held on deposit outside the country of its origin eg Eurodollars are $US held in a bank account outside the USA. Eurobonds are bonds issued (for 3 to 20 years) simultaneously in more than one country. They usually involve a syndicate of international banks and are denominated in a curreney other than the national currency of the issuer. Interest is paid gross. Eurocurrency loans are bank loans made to a company, denominated in a currency of a country other than that in which they are based. ‘The term of these loans can vary from overnight to the medium term. 6 © aCOWtaney Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Euronotes are issued by companies on the Eurobond market. Companies issue short-term unsecured notes promising to pay the holder of the Euronote a fixed sum of money on a specified date or range of dates in the future. Euroequity market refers to the international equity market where shares in US or Japanese companies are placed on as overseas stock exchange (eg London or Paris). These have had only limited success, probably due to the absence of a effective secondary market reducing their liquidity. a © aCOWtancy “This documents avaiable foo of chaos on SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)Multinationals need to consider three main issues These are: 1. Minimisation of global taxes Parent company financing of its overseas subsidiaries in the form of debt brings the benefits of: (a) reducing the corporation tax bill overseas (b) avoiding withholding taxes on dividend payments 2. Financial market tortions Local governments may directly or indirectly offer subsidised finance: Direct - Low cost loans may be offered to encourage multinational investment - Other incentives may include exchange control guarantees, grants, tax holidays etc Indirect - Local governments may reduce the interest rates to stimulate the local economy 3. Managing risk Overseas debt finance is a useful means of managing risk: Downloaded by Phebicon Mukwenha (omukwenss@gmaicom)Risk Impact of overseas debt finance types Political Reduces exposure to overseas tax increases If assets are seized, allows the firm to default on the loan (if raised from the host government) or to use international development agencies (with influence over the local government) Economic The risk of a local devaluation offset by the benefit of lower repayments on a loan Obtaining a listing on one or more exchanges Where overseas equity is preferred a listing onan overseas exchange may be considered; this can have a number of advantages. It will be important to conform to local regulations. Taking when the London Stock Exchange is used as an overseas exchange, the relevant regulations are: 1. Atleast three years of audited published accounts 2. At least 25% of the company’s shares must be in public hands when trading begins 3. Minimum market capitalisation of £700,000 4, A prospectus must be published containing a forecast of expected performance 5. In addition the company will have to be introduced by a sponsoring firm and to comply with the local corporate governance requirements. 6s © aCOWtaney This documents avaiatie tee ot crargsen SEUDOCU.COM Downloaded by Phebicon Mukwenha (omukwenss@gmalcom)