ACCA P4 Advanced Financial Management December 2011 Exams

1. ACCA P4 Advanced Financial Management December 2011 Exams

2. Capital asset pricing model • CAPM basics • Arbitrage

3. CAPM basics 1 The CAPM formula • E (ri) = Rf + βi (E (rm) – Rf) Where E (ri) is expected return from security / project • Rf is risk-free rate of return • E(rm) is expected return from market • βi is beta factor of security / project • (E (rm) – Rf) is market premium for risk This formula is given in the exam.

4. CAPM basics 2 Capital asset pricing model • Based on a comparison of the systematic risk of individual investments with the risks of all shares in the market CAPM assumes: • Investors / companies require return in excess of risk-free rate • Unsystematic risk can be diversified away and no premium is required for it • Investors / companies require a higher return from investments where systematic risk is greater

5. CAPM Basics 3 Beta factor of portfolios • Portfolio consisting of all (non risk-free) securities on stock market will have beta factor of 1 • Portfolio consisting entirely of risk-free securities will have beta factor of 0 • Beta factor of investor’s portfolio is weighted average of beta factors of securities in portfolio • Investors should decide on desired β levels, invest in low β shares when returns falling, high β shares when returns rising

6. CAPM Basics 4 • Investors should consider international diversification through investment in different countries or multinationals • Market segmentation may complicate situation

7. CAPM Basics 5 Problems with CAPM Assumptions unrealistic? • Zero insolvency costs • Investment market efficient • Investors hold well-diversified portfolios • Perfect capital market

8. CAPM Basics 6 Problems with CAPM continued Required estimates difficult to make: • Excess return • Risk-free rate (govt. securities’ rates vary with lending terms) • β factors difficult to calculate • Hard to determine risk-free rate, systematic risk and expected return on market portfolio

9. CAPM Basics 7 CAPM and returns • CAPM can be used to calculate the required return on projects • Particularly projects with significantly different business risk characteristics to a company’s current operations • CAPM produces a discount rate based on systematicrisk and can be used to compare projects of different risk classes • CAPM assumes company’s investors wish investments to be evaluated as if they are capital market securities

10. CAPM Basics 8 Limitations of CAPM in investment decisions • Hard to estimate returns under different economic environments • CAPM is single period, but investments are evaluated over time • Difficult to model complications in decision-making

11. CAPM Basics 9 Geared betas • May be used to obtain an appropriate required return when an investment has differing business and finance risks from the existing business

12. CAPM Basics 10 Where: • βa = asset (or ungeared) beta • βe = equity (or geared) beta • βd = beta factor of debt in the geared company • Vd = market value of debt in the geared company • Ve = market value of equity capital in the geared company • T = rate of corporate tax

13. CAPM Basics 11 Weaknesses in the formula • Difficult to identify firms with identical operating characteristics • Estimate of beta factors not wholly accurate • Assumes that cost of debt is risk-free • Does not include growth opportunities • Differences in cost structures and size will affect beta values between firms

14. Arbitrage 1 Arbitrage pricing theory • The theory assumes that the return on each security is based on a number of independent factors

15. Arbitrage 2 • Where E (rj) is expected return on security • B1 is sensitivity to changes in Factor 1 • F1 is difference between Factor 1 actual and expected values • B2 is sensitivity to changes in Factor 2 • F2 is difference between Factor 2 actual…e is a random term • Main problem – identifying macroeconomic factors and risk

16. Arbitrage 3 Factor analysis • Analysis used to determine factors to which security returns are sensitive Four key factors indicated by research are: • Unanticipated inflation • Changes in industrial production levels • Changes in risk premiums on bonds • Unanticipated changes in interest rate term structure

17. Arbitrage 4 Arbitrage trading • Trading will occur if certain combinations of securities are expected to produce higher returns than indicated by risk sensitivities

18. Chapter 1 The role and responsibility of senior financial executive • Financial management • Financial planning

19. Financial management 1 Financial objectives • The prime financial objective is to maximise the market value of the company’s shares • Primary targets are profits and dividend growth • Other targets may be the level of gearing, profit retentions, operating profitability and shareholder value indicators

20. Financial management 2 Why profit maximisation is not a sufficient objective • Risk and uncertainty • Profit manipulation • Sacrifice of future profits? • Dividend policy

21. Financial management 3 Non-financial objectives • Non-financial objectives do not negate financial objectives • However they do mean that the primary financial objectives may be modified • They take account of ethical considerations

22. Financial management 4 Examples - non-financial objectives • Employee welfare • Management welfare • Society’s welfare • Service provision • Responsibilities towards customers / suppliers

23. Financial management 5 Investment decisions Investment decisions include: • New projects • Takeovers • Mergers • Sell-off / Divestment

24. Financial management 6 The financial manager must: • Identify decisions • Evaluate them • Decide optimal fund allocation

25. Financial management 7 Financing decisions Financing decisions include: • Long-term capital structure • Need to determine source, cost and risk of long-term finance • Short-term working capital management • Balance between profitability and liquidity is crucial

26. Financial management 8 Dividend decisions • Dividend decisions may affect views of the company’s long-term prospects, and thus the shares’ market values • Payment of dividends limits the amount of retained earnings available for re-investment

27. Financial planning 1 Strategic planning • The formulation, evaluation and selection of strategies to prepare a long-term plan of action to attain objectives • Strategic decisions should be suitable, feasible and acceptable • Long-term direction • Matching activities to environment / resources

28. Financial planning 2 Key elements of financial planning • Planning involves a long horizon, uncertainties and contingency plans • Consideration of which assets are essential and how easily assets can be sold • Long-term investment and short-term cash flow • Surplus cash • How finance raised • Profitable

29. Financial planning 6 • Strategic analysis means analysing the organisation - its resources, competences, mission and objectives • Strategic choice involves generating and evaluating strategic options and selecting strategy

30. Financial planning 7 Strategic cash flow management • Planning involves a long horizon, uncertainties and contingency plans Strategic fund management • Consideration of which assets are essential and how easily assets can be sold

31. Financial planning 8 Strategic planning • Selection of products / markets • Target profits • Purchase of major non-current assets • Debt / equity mix • Growth v dividend payout

32. Financial planning 9 Tactical planning • Other non-current asset purchases • Efficient / effective resource usage • Pricing • Lease v buy • Scrip v cash dividends

33. Financial planning 10 Tactical planning and control • Conflict may arise between strategic planning (need to invest in more expensive machinery, R&D) and tactical planning (cost control)

34. Financial planning 11 • Johnson and Scholes separate power groups into 'internal coalitions' and 'external stakeholder groups'

35. Financial planning 12 Stakeholder goals • Shareholders – Providers of risk capital, aim to maximise wealth • Suppliers – To be paid full amount by date agreed, and continue relationship (so may accept later payment) • Long-term lenders – To receive payments of interest and capital by due date

36. Financial planning 13 Stakeholder goals continued • Employees – To maximise salaries and benefits; also prefer continuity in employment • Government – Political objectives such as sustained economic growth and high employment • Management – Maximising their own rewards

37. Chapter 2 Financial strategy formulation • Assessing corporate performance • Financial strategy • Risk and risk management

38. Assessing corporate performance 1 Probability and return • Return on capital employed • Profit margin • Asset turnover Debt and gearing • Debt ratio (Total debts: Assets) • Gearing (Proportion of debt in long-term capital) • Interest cover • Cash flow ratio (Cash inflow: Total debts)

39. Assessing corporate performance 2 Liquidity ratios • Current ratio • Acid test ratio • Inventory turnover • Receivables’ days • Payables’ days

40. Assessing corporate performance 3 Stock market ratios • Dividend yield • Interest yield • Earnings per share • Dividend cover • Price / earnings ratio

41. Assessing corporate performance 4 Comparisons with previous years • % growth in profit • % growth in turnover • Changes in gearing ratio • Changes in current / quick ratios • Changes in inventory / receivables’ turnover • Changes in EPS, market price, dividend

42. Assessing corporate performance 5 Remember however • Inflation – can make figures misleading • Results in rest of industry / environment, or economic changes Comparisons with companies in same industry • These can put improvements on previous years into perspective if other companies are doing better • Also can provide further evidence of effect of general trends • Eg growth rates, retained profits, non-current asset levels

43. Assessing corporate performance 6 Comparisons with companies in different industries • Investors aiming for diversified portfolios need to know differences between industrial sectors • Sales growth • Profit growth • ROCE • P/E ratios • Dividend yields

44. Assessing corporate performance 7 Economic Value Added (EVATM) • EVATM = NOPAT - (cost of capital x capital employed) Adjustments to NOPAT • Add: – Interest on debt – Goodwill written off – Accounting depreciation – Increases in provisions – Net capitalised intangibles

45. Assessing corporate performance 8 Adjustments to capital employed • Add: – Cumulative goodwill written off – Cumulative depreciation written off – NBV of intangibles – Provisions

46. Assessing corporate performance 9 Types of sources of funds Shares • Ownership stake • Equity (full voting rights) • Preference (prior right to dividends) • All companies can use rights issues • Listed companies can use offer for sale / placing

47. Assessing corporate performance 10 Debt / Bonds • Fixed or floating rate • Zero coupon (no interest) • Convertible loan stock • Bank loans • Security over property may be required

48. Assessing corporate performance 11 Comparison of finance sources When comparing different sources of finance, the following factors will generally be important: • Cost • Flexibility / time period available • Commitments • Uses • Speed / availability • Certainty of raising amounts

49. Assessing corporate performance 12 Estimating cost of equity • Theoretical valuation models, eg Capital Asset Pricing Model (CAPM) or Arbitrage Pricing Theory (APT) • Bond-yield-plus-premium approach: adds a judgmental risk premium to the interest rate on the firm’s own long-term debt • Market-implied estimatesusing discounted cash flow (DCF) approach (based on an assumption on earnings growth rate of earning of the company)

50. Assessing corporate performance 13 Practicalities in issuing new shares • Costs • Income to investors • Tax effect • Effect on control