ACCA P4 Class Notes June 2011 Version 3 FINAL 4th Feb 2011

ACCA Paper P4

Advanced Financial Management

Class Notes

June 2011

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2 www.studyinteract ive.org

Typeset by Debbie Crossman

Ken Preece January 2011

All rights reserved. No part of this publication may be reproduced, stored in a

retrieval system, or transmitted, in any form or by any means, electronic,

mechanical, photocopying, recording or otherwise, without the prior written

permission of Ken Preece.


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Contents PAGE

INTRODUCTION TO THE PAPER 5

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 7

CHAPTER 1: ISSUES IN CORPORATE GOVERNANCE 13

CHAPTER 2: ADVANCED INVESTMENT APPRAISAL SECTION 1 39

CHAPTER 3: ADVANCED INVESTMENT APPRAISAL SECTION 2 63

CHAPTER 4: COST OF CAPITAL 97

CHAPTER 5: EFFICIENT MARKET HYPOTHESIS 121

CHAPTER 6: THEORIES OF GEARING 129

CHAPTER 7: PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL 147

CHAPTER 8: ADJUSTED PRESENT VALUE 191

CHAPTER 9: VALUATIONS, ACQUISITIONS AND MERGERS SECTION 1 205



CHAPTER 12: CORPORATE RECONSTRUCTION AND REORGANISATION 281

CHAPTER 13: CORPORATE DIVIDEND POLICY 291

CHAPTER 14: MANAGEMENT OF INTERNATIONAL TRADE AND FINANCE 301

CHAPTER 15: HEDGING FOREIGN EXCHANGE RISK 317

CHAPTER 16: FUTURES AND OPTIONS 345

CHAPTER 17: HEDGING INTEREST RATE RISK 375

CHAPTER 18: SWAPS 407

CHAPTER 19: INTERNATIONAL INVESTMENT APPRAISAL 423


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Introduction to the

paper


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INTRODUCTION TO THE PAPER


Aim of the Paper

The aim of the paper is to apply relevant knowledge, skills and exercise

professional judgement as expected of a senior financial executive or advisor, in

taking or recommending decisions relating to the financial management of an

organisation.

Outline of the syllabus

A. Role and responsibility towards stakeholders

B. Economic environment for multinationals

C. Advanced investment appraisal

D. Acquisitions and mergers

E. Corporate reconstruction and re-organisation

F. Treasury and advanced risk management techniques

G. Emerging issues in finance and financial management

Format of the Exam Paper

The examination will be a three-hour paper (with the additional 15 minutes reading

and planning time) of 100 marks in total, divided into two sections:

Section A

Section A will contain two compulsory questions, comprising between 50

and 70 marks in total.

Section A will normally cover significant issues relevant to the senior financial

manager or advisor and will be set in the form of a short case study or scenario.

The requirements of the section A questions are such that candidates will be

expected to show a comprehensive understanding of issues from across the

syllabus. Each question will contain a mix of computational and discursive

elements. Each question in section A will comprise of between 25 and 40

marks. Candidates will be expected to provide answers in a specified form such as

a short report or board memorandum commensurate with the professional level of

the paper.

Section B

In section B candidates will be asked to answer two from three questions,

comprising of between 15 and 25 marks each.

Section B questions are designed to provide a more focused test of the syllabus

with, normally, one question being wholly discursive.

Candidates will be provided (within the examination paper) with a

formulae sheet as well as present value, annuity and standard normal

distribution tables.


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Formulae & tables

provided in the examination paper


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FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER


Formulae

Modigliani and Miller Proposition 2 (with tax)

ke = kie + (1 T)(k

ie kd)

e

d

V

V

Two asset portfolio

sp = baabba2

b2

b2

a2

a s s r w w 2 + s w + s w

The Capital Asset Pricing Model

E(rj) = Rf + j (E(rm) Rf)

The asset beta formula

a =

+

ede

e

))T-1(VV(

V +

+

dde

d

))T-1(VV(

)T-1(V

The Growth Model

P0 = g) - (r

g) + (1 D

e

0

Gordons growth approximation

g = bre

The weighted average cost of capital

WACC =

+ de

e

VV

V ke +

+ de

d

VV

V kd(1T)

The Fisher formula

(1 + i) = (1 + r) (1 + h)

Purchasing power parity and interest rate parity

S1 = S0 )h(1

)h(1

b

c

+

+ Fo = So

)i(1

)i(1

b

c

+

+


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Modified Internal Rate of Return

MIRR = n

1

I

R

PV

PV

(1 + re) 1

The Black Scholes Option

Pricing Model

c = Pa N(d1) Pe N(d 2) e-rt

Where:

d1 = ts

)t0.5s +(r + )/Pln(P 2ea

and

d2 = d1 ts

The Put Call Parity relationship

p = c Pa + Pe e -rt


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Present value table

Present value of 1 i.e. (1 + r)-n

Where 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 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15 ________________________________________________________________________________

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% ________________________________________________________________________________

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5

6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10

11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15


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Annuity table

Present value of an annuity of 1 i.e. r

r) + (1 - 1 -n

Where r = discount rate

n = number of periods

Discount rate (r)

Periods

(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% ________________________________________________________________________________

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10

11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11 12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12 13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13 14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14 15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15 ________________________________________________________________________________

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% ________________________________________________________________________________

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15


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Standard normal distribution table

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.0 0.1 0.2 0.3 0.4

0.5 0.6 0.7 0.8 0.9

1.0 1.1 1.2 1.3 1.4

1.5 1.6 1.7 1.8 1.9

2.0 2.1 2.2 2.3 2.4

2.5 2.6 2.7 2.8 2.9

3.0

0.0000 0.0398 0.0793 0.1179 0.1554

0.1915 0.2257 0.2580 0.2881 0.3159

0.3413 0.3643 0.3849 0.4032 0.4192

0.4332 0.4452 0.4554 0.4641 0.4713

0.4772 0.4821 0.4861 0.4893 0.4918

0.4938 0.4953 0.4965 0.4974 0.4981

0.4987

0.0040 0.0438 0.0832 0.1217 0.1591

0.1950 0.2291 0.2611 0.2910 0.3186

0.3438 0.3665 0.3869 0.4049 0.4207

0.4345 0.4463 0.4564 0.4649 0.4719

0.4778 0.4826 0.4864 0.4896 0.4920

0.4940 0.4955 0.4966 0.4975 0.4982

0.4987

0.0080 0.0478 0.0871 0.1255 0.1628

0.1985 0.2324 0.2642 0.2939 0.3212

0.3461 0.3686 0.3888 0.4066 0.4222

0.4357 0.4474 0.4573 0.4656 0.4726

0.4783 0.4830 0.4868 0.4898 0.4922

0.4941 0.4956 0.4967 0.4976 0.4982

0.4987

0.0120 0.0517 0.0910 0.1293 0.1664

0.2019 0.2357 0.2673 0.2967 0.3238

0.3485 0.3708 0.3907 0.4082 0.4236

0.4370 0.4484 0.4582 0.4664 0.4732

0.4788 0.4834 0.4871 0.4901 0.4925

0.4943 0.4957 0.4968 0.4977 0.4983

0.4988

0.0160 0.0557 0.0948 0.1331 0.1700

0.2054 0.2389 0.2703 0.2995 0.3264

0.3508 0.3729 0.3925 0.4099 0.4251

0.4382 0.4495 0.4591 0.4671 0.4738

0.4793 0.4838 0.4875 0.4904 0.4927

0.4945 0.4959 0.4969 0.4977 0.4984

0.4988

0.0199 0.0596 0.0987 0.1368 0.1736

0.2088 0.2422 0.2734 0.3023 0.3289

0.3531 0.3749 0.3944 0.4115 0.4265

0.4394 0.4505 0.4599 0.4678 0.4744

0.4798 0.4842 0.4878 0.4906 0.4929

0.4946 0.4960 0.4970 0.4978 0.4984

0.4989

0.0239 0.0636 0.1026 0.1406 0.1772

0.2123 0.2454 0.2764 0.3051 0.3315

0.3554 0.3770 0.3962 0.4131 0.4279

0.4406 0.4515 0.4608 0.4686 0.4750

0.4803 0.4846 0.4881 0.4909 0.4931

0.4948 0.4961 0.4971 0.4979 0.4985

0.4989

0.0279 0.0675 0.1064 0.1443 0.1808

0.2157 0.2486 0.2794 0.3078 0.3340

0.3577 0.3790 0.3980 0.4147 0.4292

0.4418 0.4525 0.4616 0.4693 0.4756

0.4808 0.4850 0.4884 0.4911 0.4932

0.4949 0.4962 0.4972 0.4979 0.4985

0.4989

0.0319 0.0714 0.1103 0.1480 0.1844

0.2190 0.2517 0.2823 0.3106 0.3365

0.3599 0.3810 0.3997 0.4162 0.4306

0.4429 0.4535 0.4625 0.4699 0.4761

0.4812 0.4854 0.4887 0.4913 0.4934

0.4951 0.4963 0.4973 0.4980 0.4986

0.4990

0.0359 0.0753 0.1141 0.1517 0.1879

0.2224 0.2549 0.2852 0.3133 0.3389

0.3621 0.3830 0.4015 0.4177 0.4319

0.4441 0.4545 0.4633 0.4706 0.4767

0.4817 0.4857 0.4890 0.4916 0.4936

0.4952 0.4964 0.4974 0.4981 0.4986

0.4990

This table can be used to calculate N(di), the cumulative normal distribution

functions needed for the Black-Scholes model of option pricing.

If di > 0, add 0.5 to the relevant number above.

If di < 0, subtract the relevant number above from 0.5


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Chapter 1

Issues in corporate governance


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CHAPTER 1 ISSUES IN CORPORATE GOVERNANCE


CHAPTER CONTENTS

FINANCIAL OBJECTIVES ------------------------------------------------ 15

THE UK CORPORATE GOVERNANCE CODE ----------------------------- 17

CODE OF BEST PRACTICE 17

INTERNATIONAL COMPARISONS OF CORPORATE GOVERNANCE -- 36

UNITED STATES OF AMERICA 36

GERMANY 36

JAPAN 37


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FINANCIAL OBJECTIVES

Advanced Financial Management is concerned with the following key decisions:

- What to invest in (INVESTMENT DECISIONS)

- How to finance the investment (FINANCING DECISIONS)

- The level of dividend distributions (DIVIDEND DECISIONS).

Objectives

Primary objective: to maximise the wealth of shareholders. A positive NPV equates

(in theory) to an increase in shareholder wealth.

Secondary objectives may be e.g. meeting financial targets (say satisfactory

ROCE), meeting productivity targets, establishing brands and quality standards and

effective communication with customers, suppliers, employees.

As an alternative to maximising the wealth of shareholders a company must in

reality consider satisficing objectives for each of the major stakeholders.

Stakeholders (user groups) and their goals

These include:

Shareholders

Ownership is separate from control. Institutional investors may have different

requirements from private shareholders. Information is provided to

shareholders via published financial statements, forecasts by directors

responding to takeover bids, investment analysts and the financial press.

Directors

The key decisions are made by directors, who are the stakeholders with the

most to lose their jobs, their investments and their reputation. Does this

influence their decisions? Hence the extensive work on corporate governance

matters.

Management and employees

Obviously they require long-term security and appropriate rewards

(pay/benefits). Should performance related incentives be offered e.g. share

options, long-term incentive plans (LTIPs)?

Loan creditors

Covenants in loan agreements may restrict gearing and dividend levels and

the sale of assets. Loan creditors would have remedies if the company

defaults.

Customers

No doubt these should be the most important interest group of all.

Suppliers

Must be reliable if not, consider internal production (vertical integration)

The government

Environmental pressure groups

The general public

Many of these groups may have conflicting objectives, which need to be reconciled.


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Corporate governance

Clearly the executive directors of a listed company are both decision-makers and

major stakeholders. They are therefore open to the accusation of making key

decisions for their own benefit. Following a number of notable financial scandals in

the UK during the late 20th century (e.g the Maxwell affair and the collapse of the

BCCI) the Cadbury Committee was set up to investigate procedures for appropriate

corporate governance.

The Cadbury Code (1992) defined corporate governance as the system by which

companies are directed and controlled. This initial document has been subject to

subsequent amendments by the Greenbury, Hampel and Higgs Reports. The

Financial Services Authority requires listed companies to confirm that they have

complied with the Code provisions or in the event of non-compliance to provide

an explanation of their reasons for departure.


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THE UK CORPORATE GOVERNANCE CODE

Code of best practice

Section A: Leadership

A.1 The Role of the Board

Main Principle: Every company should be headed by an effective board

which is collectively responsible for the long-term success of the company.

Supporting Principles

The boards role is to provide entrepreneurial leadership of the company

within a framework of prudent and effective controls which enables risk to be

assessed and managed. The board should set the companys strategic aims,

ensure that the necessary financial and human resources are in place for the

company to meet its objectives and review management performance. The

board should set the companys values and standards and ensure that its

obligations to its shareholders and others are understood and met.

All directors must act in what they consider to be the best interests of the

company, consistent with their statutory duties (as set out in the Companies

Act 2006).

Code Provisions

1.1 The board should meet sufficiently regularly to discharge its duties effectively.

There should be a formal schedule of matters specifically reserved for its

decision. The annual report should include a statement of how the board

operates, including a high level statement of which types of decisions are to

be taken by the board and which are to be delegated to management.

1.2 The annual report should identify the chairman, the deputy chairman (where

there is one), the chief executive, the senior independent director and the

chairmen and members of the board committees. It should also set out the

number of meetings of the board and its committees and individual

attendance by directors.

1.3 The company should arrange appropriate insurance cover in respect of legal

action against its directors.

A.2 Division of Responsibilities

Main Principle: There should be a clear division of responsibilities at the

head of the company between the running of the board and the executive

responsibility for the running of the companys business. No one individual

should have unfettered powers of decision.

Code Provision

2.1 The roles of chairman and chief executive should not be exercised by the

same individual. The division of responsibilities between the chairman and

chief executive should be clearly established, set out in writing and agreed by

the board.


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A.3 The Chairman

Main Principle: The chairman is responsible for leadership of the board and

ensuring its effectiveness on all aspects of its role.

Supporting Principle

The chairman is responsible for setting the boards agenda and ensuring that

adequate time is available for discussion of all agenda items, in particular

strategic issues. The chairman should also promote a culture of openness and

debate by facilitating the effective contribution of non-executive directors in

particular and ensuring constructive relations between executive and non-

executive directors.

The chairman is responsible for ensuring that the directors receive accurate,

timely and clear information. The chairman should ensure effective

communication with shareholders.

Code Provision

3.1 The chairman should on appointment meet the independence criteria set out

in B.1.1 below. A chief executive should not go on to be chairman of the

same company. If, exceptionally, a board decides that a chief executive

should become chairman, the board should consult major shareholders in

advance and should set out its reasons to shareholders at the time of the

appointment and in the next annual report. (Compliance or otherwise with

this provision need only be reported for the year in which the appointment is

made).

A.4 Non-executive Directors

Main Principle: As part of their role as members of a unitary board, non-

executive directors should constructively challenge and help develop

proposals on strategy.


Non-executive directors should scrutinise the performance of management in

meeting agreed goals and objectives and monitor the reporting of

performance. They should satisfy themselves on the integrity of financial

information and that financial controls and systems of risk management are

robust and defensible. They are responsible for determining appropriate

levels of remuneration of executive directors and have a prime role in

appointing and, where necessary, removing executive directors, and in

succession planning.

Code Provisions

4.1 The board should appoint one of the independent non-executive directors to

be the senior independent director to provide a sounding board for the

chairman and to serve as an intermediary for the other directors when

necessary. The senior independent director should be available to

shareholders if they have concerns which contact through the normal

channels of chairman, chief executive or other executive directors has failed

to resolve or for which such contact is inappropriate.

4.2 The chairman should hold meetings with the non-executive directors without

the executives present. Led by the senior independent director, the non-


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executive directors should meet without the chairman present at least

annually to appraise the chairmans performance and on such other occasions

as are deemed appropriate.

4.3 Where directors have concerns which cannot be resolved about the running of

the company or a proposed action, they should ensure that their concerns are

recorded in the board minutes. On resignation, a non- executive director

should provide a written statement to the chairman, for circulation to the

board, if they have any such concerns.

Section B: Effectiveness

B.1 The Composition of the Board

Main Principle: The board and its committees should have the appropriate

balance of skills, experience, independence and knowledge of the company

to enable them to discharge their respective duties and responsibilities

effectively.


The board should be of sufficient size that the requirements of the business

can be met and that changes to the boards composition and that of its

committees can be managed without undue disruption, and should not be so

large as to be unwieldy.

The board should include an appropriate combination of executive and non-

executive directors (and, in particular, independent non-executive directors)

such that no individual or small group of individuals can dominate the boards

decision taking.

The value of ensuring that committee membership is refreshed and that

undue reliance is not placed on particular individuals should be taken into

account in deciding chairmanship and membership of committees.

No one other than the committee chairman and members is entitled to be

present at a meeting of the nomination, audit or remuneration committee, but

others may attend at the invitation of the committee.

Code Provisions

1.1 The board should identify in the annual report each non-executive director it

considers to be independent. The board should determine whether the

director is independent in character and judgement and whether there are

relationships or circumstances which are likely to affect, or could appear to

affect, the directors judgement. The board should state its reasons if it

determines that a director is independent notwithstanding the existence of

relationships or circumstances which may appear relevant to its

determination, including if the director:

has been an employee of the company or group within the last five

years;

has, or has had within the last three years, a material business

relationship with the company either directly, or as a partner,

shareholder, director or senior employee of a body that has such a

relationship with the company;


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has received or receives additional remuneration from the company

apart from a directors fee, participates in the companys share option or

a performance-related pay scheme, or is a member of the companys

pension scheme;

has close family ties with any of the companys advisers, directors or

senior employees;

holds cross-directorships or has significant links with other directors

through involvement in other companies or bodies;

represents a significant shareholder; or

has served on the board for more than nine years from the date of their

first election.

1.2 Except for smaller companies (i.e. those below the FTSE 350 throughout the

year immediately prior to the reporting year), at least half the board,

excluding the chairman, should comprise non-executive directors determined

by the board to be independent. A smaller company should have at least two

independent non-executive directors.

B.2 Appointments to the Board

Main Principle: There should be a formal, rigorous and transparent

procedure for the appointment of new directors to the board.


The search for board candidates should be conducted, and appointments

made, on merit, against objective criteria and with due regard for the benefits

of diversity on the board, including gender.

The board should satisfy itself that plans are in place for orderly succession

for appointments to the board and to senior management, so as to maintain

an appropriate balance of skills and experience within the company and on

the board and to ensure progressive refreshing of the board.

Code Provisions

2.1 There should be a nomination committee which should lead the process for

board appointments and make recommendations to the board. A majority of

members of the nomination committee should be independent non-executive

directors. The chairman or an independent non-executive director should

chair the committee, but the chairman should not chair the nomination

committee when it is dealing with the appointment of a successor to the

chairmanship. The nomination committee should make available its terms of

reference, explaining its role and the authority delegated to it by the board.

(This requirement would be met by including the information on the company

website).

2.2 The nomination committee should evaluate the balance of skills, experience,

independence and knowledge on the board and, in the light of this evaluation,

prepare a description of the role and capabilities required for a particular

appointment.

2.3 Non-executive directors should be appointed for specified terms subject to re-

election and to statutory provisions relating to the removal of a director. Any

term beyond six years for a non-executive director should be subject to


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particularly rigorous review, and should take into account the need for

progressive refreshing of the board.

2.4 A separate section of the annual report should describe the work of the

nomination committee, including the process it has used in relation to board

appointments. An explanation should be given if neither an external search

consultancy nor open advertising has been used in the appointment of a

chairman or a non-executive director.

B.3 Commitment

Main Principle: All directors should be able to allocate sufficient time to the

company to discharge their responsibilities effectively.

Code Provisions

3.1 For the appointment of a chairman, the nomination committee should prepare

a job specification, including an assessment of the time commitment

expected, recognising the need for availability in the event of crises. A

chairmans other significant commitments should be disclosed to the board

before appointment and included in the annual report. Changes to such

commitments should be reported to the board as they arise, and their impact

explained in the next annual report.

3.2 The terms and conditions of appointment of non-executive directors should be

made available for inspection (at the companys registered office and at the

AGM). The letter of appointment should set out the expected time

commitment. Non-executive directors should undertake that they will have

sufficient time to meet what is expected of them. Their other significant

commitments should be disclosed to the board before appointment, with a

broad indication of the time involved and the board should be informed of

subsequent changes.

3.3 The board should not agree to a full time executive director taking on more

than one non-executive directorship in a FTSE 100 company nor the

chairmanship of such a company.

B.4 Development

Main Principle: All directors should receive induction on joining the board

and should regularly update and refresh their skills and knowledge.


The chairman should ensure that the directors continually update their skills

and the knowledge and familiarity with the company required to fulfil their

role both on the board and on board committees. The company should

provide the necessary resources for developing and updating its directors

knowledge and capabilities.

To function effectively, all directors need appropriate knowledge of the

company and access to its operations and staff.


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Code Provisions

4.1 The chairman should ensure that new directors receive a full, formal and

tailored induction on joining the board. As part of this, directors should avail

themselves of opportunities to meet major shareholders.

4.2 The chairman should regularly review and agree with each director their

training and development needs.

B.5 Information and Support

Main Principle: The board should be supplied in a timely manner with

information in a form and of a quality appropriate to enable it to discharge

its duties.


The chairman is responsible for ensuring that the directors receive accurate,

timely and clear information. Management has an obligation to provide such

information but directors should seek clarification or amplification where

necessary.

Under the direction of the chairman, the company secretarys responsibilities

include ensuring good information flows within the board and its committees

and between senior management and non-executive directors, as well as

facilitating induction and assisting with professional development as required.

The company secretary should be responsible for advising the board through

the chairman on all governance matters.

Code Provisions

5.1 The board should ensure that directors, especially non-executive directors,

have access to independent professional advice at the companys expense

where they judge it necessary to discharge their responsibilities as directors.

Committees should be provided with sufficient resources to undertake their

duties.

5.2 All directors should have access to the advice and services of the company

secretary, who is responsible to the board for ensuring that board procedures

are complied with. Both the appointment and removal of the company

secretary should be a matter for the board as a whole.

B.6 Evaluation

Main Principle: The board should undertake a formal and rigorous annual

evaluation of its own performance and that of its committees and

individual directors.


The chairman should act on the results of the performance evaluation by

recognising the strengths and addressing the weaknesses of the board and,

where appropriate, proposing new members be appointed to the board or

seeking the resignation of directors.

Individual evaluation should aim to show whether each director continues to

contribute effectively and to demonstrate commitment to the role (including

commitment of time for board and committee meetings and any other duties).


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Code Provisions

6.1 The board should state in the annual report how performance evaluation of

the board, its committees and its individual directors has been conducted.

6.2 Evaluation of the board of FTSE 350 companies should be externally facilitated

at least every three years. A statement should be made available of whether

an external facilitator has any other connection with the company. (This

requirement would be met by including the information on the company

website).

6.3 The non-executive directors, led by the senior independent director, should be

responsible for performance evaluation of the chairman, taking into account

the views of executive directors.

B.7 Re-election

Main Principle: All directors should be submitted for re-election at regular

intervals, subject to continued satisfactory performance.

Code Provisions

7.1 All directors of FTSE 350 companies should be subject to annual election by

shareholders. All other directors should be subject to election by shareholders

at the first annual general meeting (AGM) after their appointment, and to re-

election thereafter at intervals of no more than three years. Non-executive

directors who have served longer than nine years should be subject to annual

re-election. The names of directors submitted for election or re-election

should be accompanied by sufficient biographical details and any other

relevant information to enable shareholders to take an informed decision on

their election.

7.2 The board should set out to shareholders in the papers accompanying a

resolution to elect a non-executive director why they believe an individual

should be elected. The chairman should confirm to shareholders when

proposing re-election that, following formal performance evaluation, the

individuals performance continues to be effective and to demonstrate

commitment to the role.

Section C: Accountability

C.1 Financial and Business Reporting

Main Principle: The board should present a balanced and understandable

assessment of the companys position and prospects.


The boards responsibility to present a balanced and understandable

assessment extends to interim and other price-sensitive public reports and

reports to regulators as well as to information required to be presented by

statutory requirements.

Code Provisions

1.1 The directors should explain in the annual report their responsibility for

preparing the annual report and accounts, and there should be a statement by

the auditor about their reporting responsibilities.


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1.2 The directors should include in the annual report an explanation of the basis

on which the company generates or preserves value over the longer term (the

business model) and the strategy for delivering the objectives of the company

(This explanation would ideally be located within the Business Review required

by CA 2006).

1.3 The directors should report in annual and half-yearly financial statements that

the business is a going concern, with supporting assumptions or qualifications

as necessary.

C.2 Risk Management and Internal Control

(The Turnbull Guidance, last updated in October 2005, suggests means of

applying this part of the Code)

Main Principle: The board is responsible for determining the nature and

extent of the significant risks it is willing to take in achieving its strategic

objectives. The board should maintain sound risk management and

internal control systems.

Code provision

2.1 The board should, at least annually, conduct a review of the effectiveness of

the companys risk management and internal control systems and should

report to shareholders that they have done so. The review should cover all

material controls, including financial, operational and compliance controls.

C.3 Audit Committee and Auditors

(The FRC Guidance on Audit Committees - formerly referred to as the Smith

Guidance - suggests means of applying this part of the Code)

Main Principle: The board should establish formal and transparent

arrangements for considering how they should apply the corporate

reporting and risk management and internal control principles and for

maintaining an appropriate relationship with the companys auditor.

Code provisions

3.1 The board should establish an audit committee of at least three, or in the case

of smaller companies (i.e. those below the FTSE 350 throughout the year

immediately prior to the reporting year) two, independent non-executive

directors. In smaller companies the company chairman may be a member of,

but not chair, the committee in addition to the independent non-executive

directors, provided he or she was considered independent on appointment as

chairman. The board should satisfy itself that at least one member of the

audit committee has recent and relevant financial experience.

3.2 The main role and responsibilities of the audit committee should be set out in

written terms of reference and should include:

to monitor the integrity of the financial statements of the company and

any formal announcements relating to the companys financial

performance, reviewing significant financial reporting judgements

contained in them;

to review the companys internal financial controls and, unless expressly

addressed by a separate board risk committee composed of independent


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directors, or by the board itself, to review the companys internal control

and risk management systems;

to monitor and review the effectiveness of the companys internal audit

function;

to make recommendations to the board, for it to put to the shareholders

for their approval in general meeting, in relation to the appointment, re-

appointment and removal of the external auditor and to approve the

remuneration and terms of engagement of the external auditor;

to review and monitor the external auditors independence and

objectivity and the effectiveness of the audit process, taking into

consideration relevant UK professional and regulatory requirements;

to develop and implement policy on the engagement of the external

auditor to supply non-audit services, taking into account relevant ethical

guidance regarding the provision of non-audit services by the external

audit firm, and to report to the board, identifying any matters in respect

of which it considers that action or improvement is needed and making

recommendations as to the steps to be taken.

3.3 The terms of reference of the audit committee, including its role and the

authority delegated to it by the board, should be made available (e.g. by

including the information on the company website). A separate section of the

annual report should describe the work of the committee in discharging those

responsibilities.

3.4 The audit committee should review arrangements by which staff of the

company may, in confidence, raise concerns about possible improprieties in

matters of financial reporting or other matters. The audit committees

objective should be to ensure that arrangements are in place for the

proportionate and independent investigation of such matters and for

appropriate follow-up action.

3.5 The audit committee should monitor and review the effectiveness of the

internal audit activities. Where there is no internal audit function, the audit

committee should consider annually whether there is a need for an internal

audit function and make a recommendation to the board, and the reasons for

the absence of such a function should be explained in the relevant section of

the annual report.

3.6 The audit committee should have primary responsibility for making a

recommendation on the appointment, re-appointment and removal of the

external auditor. If the board does not accept the audit committees

recommendation, it should include in the annual report, and in any papers

recommending appointment or re-appointment, a statement from the audit

committee explaining the recommendation and should set out reasons why

the board has taken a different position.

3.7 The annual report should explain to shareholders how, if the auditor provides

non-audit services, auditor objectivity and independence is safeguarded.


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Section D: Remuneration

D.1 The Level and Components of Remuneration

Main Principle: Levels of remuneration should be sufficient to attract,

retain and motivate directors of the quality required to run the company

successfully, but a company should avoid paying more than is necessary

for this purpose. A significant proportion of executive directors

remuneration should be structured so as to link rewards to corporate and

individual performance.


The performance-related elements of executive directors remuneration should

be stretching and designed to promote the long-term success of the company.

The remuneration committee should judge where to position their company

relative to other companies. But they should use such comparisons with

caution, in view of the risk of an upward ratchet of remuneration levels with

no corresponding improvement in performance.

They should also be sensitive to pay and employment conditions elsewhere in

the group, especially when determining annual salary increases.

Code Provisions

1.1 In designing schemes of performance-related remuneration for executive

directors, the remuneration committee should follow the provisions in

Schedule A to this Code.

1.2 Where a company releases an executive director to serve as a non-executive

director elsewhere, the remuneration report (required by UK legislation)

should include a statement as to whether or not the director will retain such

earnings and, if so, what the remuneration is.

1.3 Levels of remuneration for non-executive directors should reflect the time

commitment and responsibilities of the role. Remuneration for non-executive

directors should not include share options or other performance- related

elements. If, exceptionally, options are granted, shareholder approval should

be sought in advance and any shares acquired by exercise of the options

should be held until at least one year after the non-executive director leaves

the board. Holding of share options could be relevant to the determination of

a non-executive directors independence (as set out in provision B.1.1).

1.4 The remuneration committee should carefully consider what compensation

commitments (including pension contributions and all other elements) their

directors terms of appointment would entail in the event of early termination.

The aim should be to avoid rewarding poor performance. They should take a

robust line on reducing compensation to reflect departing directors

obligations to mitigate loss.

1.5 Notice or contract periods should be set at one year or less. If it is necessary

to offer longer notice or contract periods to new directors recruited from

outside, such periods should reduce to one year or less after the initial period.


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D.2 Procedure

Main Principle: There should be a formal and transparent procedure for

developing policy on executive remuneration and for fixing the

remuneration packages of individual directors. No director should be

involved in deciding his or her own remuneration.


The remuneration committee should consult the chairman and/or chief

executive about their proposals relating to the remuneration of other

executive directors. The remuneration committee should also be responsible

for appointing any consultants in respect of executive director remuneration.

Where executive directors or senior management are involved in advising or

supporting the remuneration committee, care should be taken to recognise

and avoid conflicts of interest.

The chairman of the board should ensure that the company maintains contact

as required with its principal shareholders about remuneration.

Code Provisions

2.1 The board should establish a remuneration committee of at least three, or in

the case of smaller companies two, independent non-executive directors. In

addition the company chairman may also be a member of, but not chair, the

committee if he or she was considered independent on appointment as

chairman. The remuneration committee should make available its terms of

reference, explaining its role and the authority delegated to it by the board.

Where remuneration consultants are appointed, a statement should be made

available of whether they have any other connection with the company (This

requirement would be met by including the information on the company

website).

2.2 The remuneration committee should have delegated responsibility for setting

remuneration for all executive directors and the chairman, including pension

rights and any compensation payments. The committee should also

recommend and monitor the level and structure of remuneration for senior

management. The definition of senior management for this purpose should

be determined by the board but should normally include the first layer of

management below board level.

2.3 The board itself or, where required by the Articles of Association, the

shareholders should determine the remuneration of the non-executive

directors within the limits set in the Articles of Association. Where permitted

by the Articles, the board may however delegate this responsibility to a

committee, which might include the chief executive.

2.4 Shareholders should be invited specifically to approve all new long-term

incentive schemes (as defined in the Listing Rules) and significant changes to

existing schemes, save in the circumstances permitted by the Listing Rules.


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Section E: Relations with shareholders

E.1 Dialogue with Shareholders

Main Principle: There should be a dialogue with shareholders based on the

mutual understanding of objectives. The board as a whole has

responsibility for ensuring that a satisfactory dialogue with shareholders

takes place.


Whilst recognising that most shareholder contact is with the chief executive

and finance director, the chairman should ensure that all directors are made

aware of their major shareholders issues and concerns.

The board should keep in touch with shareholder opinion in whatever ways

are most practical and efficient.

Code Provisions

1.1 The chairman should ensure that the views of shareholders are communicated

to the board as a whole. The chairman should discuss governance and

strategy with major shareholders. Non-executive directors should be offered

the opportunity to attend scheduled meetings with major shareholders and

should expect to attend meetings if requested by major shareholders. The

senior independent director should attend sufficient meetings with a range of

major shareholders to listen to their views in order to help develop a balanced

understanding of the issues and concerns of major shareholders.

1.2 The board should state in the annual report the steps they have taken to

ensure that the members of the board, and, in particular, the non-executive

directors, develop an understanding of the views of major shareholders about

the company, for example through direct face-to-face contact, analysts or

brokers briefings and surveys of shareholder opinion.

E.2 Constructive Use of the AGM

Main Principle: The board should use the AGM to communicate with

investors and to encourage their participation.

Code Provisions

2.1 At any general meeting, the company should propose a separate resolution on

each substantially separate issue, and should, in particular, propose a

resolution at the AGM relating to the report and accounts. For each

resolution, proxy appointment forms should provide shareholders with the

option to direct their proxy to vote either for or against the resolution or to

withhold their vote. The proxy form and any announcement of the results of

a vote should make it clear that a vote withheld is not a vote in law and will

not be counted in the calculation of the proportion of the votes for and against

the resolution.

2.2 The company should ensure that all valid proxy appointments received for

general meetings are properly recorded and counted. For each resolution,

where a vote has been taken on a show of hands, the company should ensure

that the following information is given at the meeting and made available as


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soon as reasonably practicable on a website which is maintained by or on

behalf of the company:

the number of shares in respect of which proxy appointments have been

validly made;

the number of votes for the resolution;

the number of votes against the resolution; and

the number of shares in respect of which the vote was directed to be

withheld.

2.3 The chairman should arrange for the chairmen of the audit, remuneration and

nomination committees to be available to answer questions at the AGM and

for all directors to attend.

2.4 The company should arrange for the Notice of the AGM and related papers to

be sent to shareholders at least 20 working days before the meeting.

Schedule A: The design of performance-related

remuneration for executive directors

The remuneration committee should consider whether the directors should be

eligible for annual bonuses. If so, performance conditions should be relevant,

stretching and designed to promote the long-term success of the company. Upper

limits should be set and disclosed. There may be a case for part payment in shares

to be held for a significant period.

The remuneration committee should consider whether the directors should be

eligible for benefits under long-term incentive schemes. Traditional share option

schemes should be weighed against other kinds of long-term incentive scheme.

Executive share options should not be offered at a discount save as permitted by

the relevant provisions of the Listing Rules.

In normal circumstances, shares granted or other forms of deferred remuneration

should not vest, and options should not be exercisable, in less than three years.

Directors should be encouraged to hold their shares for a further period after

vesting or exercise, subject to the need to finance any costs of acquisition and

associated tax liabilities.

Any new long-term incentive schemes which are proposed should be approved by

shareholders and should preferably replace any existing schemes or, at least, form

part of a well considered overall plan incorporating existing schemes. The total

potentially available rewards should not be excessive.

Payouts or grants under all incentive schemes, including new grants under existing

share option schemes, should be subject to challenging performance criteria

reflecting the companys objectives, including non-financial performance metrics

where appropriate. Remuneration incentives should be compatible with risk policies

and systems.

Grants under executive share option and other long-term incentive schemes should

normally be phased rather than awarded in one large block.

Consideration should be given to the use of provisions that permit the company to

reclaim variable components in exceptional circumstances of misstatement or

misconduct.

In general, only basic salary should be pensionable. The remuneration committee

should consider the pension consequences and associated costs to the company of


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basic salary increases and any other changes in pensionable remuneration,

especially for directors close to retirement.

Schedule B: Disclosure of corporate governance

arrangements

Corporate governance disclosure requirements are set out in three places:

FSA Disclosure and Transparency Rules, which set out certain mandatory

disclosures;

FSA Listing Rules, which include the comply or explain requirement; and

The UK Corporate Governance Code (in addition to providing an explanation

where they choose not to comply with a provision, companies must disclose

specified information in order to comply with certain provisions).

These requirements are summarised below. There is some overlap between the

mandatory disclosures required under the Disclosure and Transparency Rules and

those expected under the UK Corporate Governance Code. Areas of overlap are

summarised in the Appendix to this Schedule. In respect of disclosures relating to

the audit committee and the composition and operation of the board and its

committees, compliance with the relevant provisions of the Code will result in

compliance with the relevant Rules.

Disclosure and Transparency Rules

The Disclosure and Transparency Rules (DTR) concern audit committees or bodies

carrying out equivalent functions.

DTR set out requirements relating to the composition and functions of the

committee or equivalent body:

An issuer must have a body which is responsible for performing the functions

set out below, and at least one member of that body must be independent

and at least one member must have competence in accounting and/or

auditing.

The requirements for independence and competence in accounting and/or

auditing may be satisfied by the same member or by different members of the

relevant body.

An issuer must ensure that, as a minimum, the relevant body must:

(1) monitor the financial reporting process;

(2) monitor the effectiveness of the issuers internal control, internal audit

where applicable, and risk management systems;

(3) monitor the statutory audit of the annual and consolidated accounts;

(4) review and monitor the independence of the statutory auditor, and in

particular the provision of additional services to the issuer.

The following disclosures are required:

The issuer must make a statement available to the public disclosing

which body carries out the above functions and how it is composed.

This can be included in the corporate governance statement as described

below.


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Compliance with the relevant provisions of the UK Corporate Governance

Code (as set out in the Appendix to this Schedule) will result in

compliance with much of the DTR.

Issuers are required to produce a corporate governance statement that

must be either included in the directors report; or in a separate report

published together with the annual report; or on the issuers website, in

which case there must be a cross-reference in the directors report.

DTR requires that the corporate governance statements must contain a

reference to the corporate governance code to which the company is

subject (for companies with a Premium listing this is the UK Corporate

Governance Code). DTR requires that, to the extent that it departs from

that code, the company must explain which parts of the code it departs

from and the reasons for doing so. Compliance with the comply or

explain rule will also satisfy these requirements.

DTR sets out certain information that must be disclosed in the corporate

governance statement i.e. the statement must contain:

o A description of the main features of the companys internal control

and risk management systems in relation to the financial reporting

process. DTR states that an issuer which is required to prepare a

group directors report must include in that report a description of

the main features of the groups internal control and risk

management systems in relation to the process for preparing

consolidated accounts.

o The information required by SI 2008 No. 410 [The Large and

Medium-sized Companies and Groups (Accounts and Reports)

Regulations 2008], where the issuer is subject to its requirements.

o A description of the composition and operation of the issuers

administrative, management and supervisory bodies and their

committees. Compliance with the provisions of the UK Corporate

Governance Code (as set out in the Appendix to this Schedule) will

satisfy the requirements of DTR.

Listing Rules

The Listing Rules state that in the case of a company that has a Premium listing of

equity shares, the following items must be included in its annual report and

accounts:

a statement of how the listed company has applied the Main Principles set out

in the UK Corporate Governance Code, in a manner that would enable

shareholders to evaluate how the principles have been applied;

a statement as to whether the listed company has:

o complied throughout the accounting period with all relevant provisions

set out in the UK Corporate Governance Code; or

o not complied throughout the accounting period with all relevant

provisions set out in the UK Corporate Governance Code, and if so,

setting out:

(i) those provisions, if any, it has not complied with;


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(ii) in the case of provisions whose requirements are of a continuing

nature, the period within which, if any, it did not comply with some

or all of those provisions; and

(iii) the companys reasons for non-compliance.

The UK Corporate Governance Code

In addition to the comply or explain requirement in the Listing Rules, the Code

includes specific requirements for disclosure which must be provided in order to

comply.

The annual report should include:

a statement of how the board operates, including a high level statement of

which types of decisions are to be taken by the board and which are to be

delegated to management;

the names of the chairman, the deputy chairman (where there is one), the

chief executive, the senior independent director and the chairmen and

members of the board committees;

the number of meetings of the board and those committees and individual

attendance by directors;

where a chief executive is appointed chairman, the reasons for their

appointment (this only needs to be done in the annual report following the

appointment);

the names of the non-executive directors whom the board determines to be

independent, with reasons where necessary;

a separate section describing the work of the nomination committee, including

the process it has used in relation to board appointments and an explanation

if neither external search consultancy nor open advertising has been used in

the appointment of a chairman or a non-executive director;

any changes to the other significant commitments of the chairman during the

year;

a statement of how performance evaluation of the board, its committees and

its directors has been conducted;

an explanation from the directors of their responsibility for preparing the

accounts and a statement by the auditors about their reporting

responsibilities;

an explanation from the directors of the basis on which the company

generates or preserves value over the longer term (the business model) and

the strategy for delivering the objectives of the company;

a statement from the directors that the business is a going concern, with

supporting assumptions or qualifications as necessary;

a report that the board has conducted a review of the effectiveness of the

companys risk management and internal control systems;

a separate section describing the work of the audit committee in discharging

its responsibilities;

where there is no internal audit function, the reasons for the absence of such

a function;


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where the board does not accept the audit committees recommendation on

the appointment, re-appointment or removal of an external auditor, a

statement from the audit committee explaining the recommendation and the

reasons why the board has taken a different position;

an explanation of how, if the auditor provides non-audit services, auditor

objectively and independence is safeguarded;

a description of the work of the remuneration committee as required under

the Large and Medium-Sized Companies and Groups (Accounts and Reports)

Regulations 2008 including, where an executive director serves as a non-

executive director elsewhere, whether or not the director will retain such

earnings and, if so, what the remuneration is;

the steps the board has taken to ensure that members of the board, in

particular the non-executive directors, develop an understanding of the views

of major shareholders about their company.

The following information should be made available (which may be met by placing

the information on a website that is maintained by or on behalf of the company):

the terms of reference of the nomination, audit and remuneration committees,

explaining their role and the authority delegated to them by the board;

the terms and conditions of appointment of non-executive directors;

where performance evaluation has been externally facilitated, a statement of

whether the facilitator has any other connection with the company; and

where remuneration consultants are appointed, a statement of whether they

have any other connection with the company.

The board should set out to shareholders in the papers accompanying a resolution

to elect or re-elect directors:

sufficient biographical details to enable shareholders to take an informed

decision on their election or re-election;

why they believe an individual should be elected to a non-executive role; and

on re-election of a non-executive director, confirmation from the chairman

that, following formal performance evaluation, the individuals performance

continues to be effective and to demonstrate commitment to the role.

The board should set out to shareholders in the papers recommending appointment

or reappointment of an external auditor:

if the board does not accept the audit committees recommendation, a

statement from the audit committee explaining the recommendation and from

the board setting out reasons why they have taken a different position.

Additional guidance

The Turnbull Guidance and FRC Guidance on Audit Committees contain further

suggestions as to information that might usefully be disclosed in the internal control

statement and the report of the audit committee respectively.


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Appendix: Overlap between the disclosure and transparency rules and the UK Corporate Governance Code

DISCLOSURE AND TRANSPARENCY

RULES

UK CORPORATE GOVERNANCE CODE

Sets out minimum requirements on

composition of the audit committee or

equivalent body.

Provision C.3.1

Sets out recommended composition of

the audit committee.

Sets out minimum functions of the audit

committee or equivalent body.

Provision C.3.2

Sets out the recommended minimum

terms of reference for the audit

committee.

The composition and function of the

audit committee or equivalent body must

be disclosed in the annual report.

Provision A.1.2

The annual report should identify

members of the board committees.

Provision C.3.3

The annual report should describe the

work of the audit committee. Further

recommendations on the content of the

audit committee report are set out in

the FRC Guidance on Audit Committees.

The corporate governance statement

must include a description of the main

features of the companys internal

control and risk management systems in

relation to the financial reporting

process.

Provision C.2.1

The Board must report that a review of

the effectiveness of the risk

management and internal control

systems has been carried out. Further

recommendations on the content of the

internal control statement are set out in

the Turnbull Guidance.

The corporate governance statement

must include a description of the

composition and operation of the

administrative, management and

supervisory bodies and their

committees.

This requirement overlaps with a

number of different provisions of the

Code:

A.1.1: the annual report should include

a statement of how the board operates.

A.1.2: the annual report should identify

members of the board and board

committees.


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B.2.4: the annual report should

describe the work of the nomination

committee.

C.3.3: the annual report should

describe the work of the audit

committee.

D.2.1: a description of the work of the

remuneration committee should be

made available. [Note: in order to

comply with DTR this information will

need to be included in the corporate

governance statement].

Schedule C: Engagement principles for institutional

shareholders

This schedule has been superseded by the Stewardship Code for institutional

investors.

Principle 1: Dialogue with companies

Main Principle: Institutional shareholders should enter into a dialogue

with companies based on the mutual understanding of objectives.

Principle 2: Evaluation of Governance Disclosures

Main Principle: When evaluating companies governance arrangements,

particularly those relating to board structure and composition, institutional

shareholders should give due weight to all relevant factors drawn to their

attention.

Principle 3: Shareholder Voting

Main Principle: Institutional shareholders have a responsibility to make

considered use of their votes.


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INTERNATIONAL COMPARISONS OF CORPORATE

GOVERNANCE

The broad principles of corporate governance are similar in the UK, the USA and

Germany, but there are significant differences in how they are applied. Whereas

the UK and Germany have voluntary corporate governance codes, the US system is

based upon legislation within the Sarbanes-Oxley Act.

United States of America

Whereas the UK has historically relied upon a system of self-regulation and

voluntary codes of best practice, the USA corporate governance structure is more

formalised, with legally enforceable controls.

In the US, statutory requirements for publicly-traded companies are set out in the

Sarbanes-Oxley Act. These requirements include the certification of published

financial statements by the CEO and the chief financial officer (CFO), faster public

disclosures by companies, legal protection for whistleblowers, a requirement for an

annual report on internal controls, and requirements relating to the audit

committee, auditor conduct and avoiding improper 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 the

disclosure of critical accounting policies, the composition of the Board and the

number of independent directors. The Act has also established an independent

body to oversee the accounting profession, which is known as the Public Company

Accounting Oversight Board. Managers must be careful to comply with regulations

to avoid possible legal action against the company or themselves individually.

Germany

As both the UK and Germany are members of the EU, they must both follow EU

directives on company law. 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), whereas German companies have a two-tier board of

directors. The Supervisory Board of non-executives (Aufsichtsrat) has

responsibility for corporate policy and strategy and the Management Board of

executive directors (Vorstand) has responsibility primarily for the day-to-day

operations of the company.

The Supervisory Board typically includes representatives from major banks that

have historically been large providers of long-term finance to German companies

(and are often major shareholders). 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.


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Japan

Although there are signs of change in Japanese corporate governance, much of the

system is based upon negotiation or consensual management rather than upon a

legal or even a self-regulatory framework. Banks as well as representatives of

other companies (in their capacity as shareholders) also sit on the Boards of

Directors of Japanese companies.

It is not uncommon for Japanese companies to have cross holdings of shares with

their suppliers, customers and banks etc., all being represented on each others

Board of Directors. There are often three boards of directors: Policy Boards,

responsible for strategy and comprised of directors with no functional responsibility;

Functional Boards, responsible for day to day operations; and largely symbolic

Monocratic Boards. The interests of the company as a whole should dictate the

actions of these boards. This is in contrast to the UK or USA systems where, at

least in theory, the board should act primarily in the best interests of the

shareholders, being the owners of the company.


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Chapter 2

Advanced investment

appraisal section 1


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CHAPTER 2 ADVANCED INVESTMENT APPRAISAL: SECTION 1


CHAPTER CONTENTS

INVESTMENT APPRAISAL TECHNIQUES ------------------------------- 41

1. ACCOUNTING RATE OF RETURN 41

2. PAYBACK PERIOD 42

3. DISCOUNTED CASH FLOW 42

CONGO LTD --------------------------------------------------------------- 44

INFLATION AND DISCOUNTED CASH FLOW -------------------------- 48

MONEY CASH FLOWS 48

REAL CASH FLOWS 48

RELATIONSHIP BETWEEN MONEY INTEREST RATES AND REAL INTEREST RATES 48

TAXATION AND INVESTMENT APPRAISAL ---------------------------- 50

CAPITAL RATIONING ---------------------------------------------------- 52

WHAT ARE THE 2 TYPES OF CAPITAL RATIONING? 52

CAPITAL RATIONING AND TIME 52

SINGLE PERIOD CAPITAL RATIONING 53

MULTI-PERIOD CAPITAL RATIONING 56


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INVESTMENT APPRAISAL TECHNIQUES

Assumed objective is

Selection of those projects which will maximise the wealth of the owners (or

shareholders) of the enterprise. Involves a consideration of FUTURE events, not

PAST performance.

Accepted techniques are

1. Accounting Rate of Return (alternatively called Return on Investment)

2. Payback Period

3. Discounted Cash Flow, of which there are two major variants:

(a) Net Present Value

(b) Internal Rate of Return (alternatively called Yield)

1. Accounting rate of return

The ARR (or ROI) is a measure of relative project profitability, which expresses:

1. The expected average annual profit (after allowing for depreciation, but before

taxation) emerging from a project,

AS A PERCENTAGE OF

2. The investment involved. Normally the average investment over the life of the

project is used, but initial investment is sometimes employed.

Advantages

It is relatively easy to understand

The required figures are readily available from accounting data.

The ROI technique is frequently used as an assessment of managements

actual (hindsight) performance.

It gives an indication as to whether available projects are meeting target

returns on capital employed.

Disadvantages

Based on accounting profits not cash flows - the success of an enterprise

depends on its ability to generate cash. The ability to invest depends on

availability of cash.

Ignores the time value of money

It is relative rate of return, thus ignores the size of the project

No set rules (theoretical or practical) for determining the cut-off rate of

return.


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2. Payback period

The Payback Period demonstrates how long an enterprise must expect to wait

before the after-tax cash flows generated by the project allow it to recoup the initial

amount invested. Thus it gives an investor an idea of how long their money will

be at risk; a short payback period is taken to reveal low risk, and a long payback -

high risk.

Advantages

The most tried and tested of all methods

Easy to calculate and understand

An enterprise with limited cash resources is obviously concerned with speed of

return.

Some companies combine DCF techniques with the payback method.

Disadvantages

Does not measure profitability nor increases in shareholders wealth, since it

ignores cash flows expected to arise beyond the payback period.

Ignores the time value of money (but discounted payback sometimes used).

No set rules (theoretical or practical) for determining the minimum acceptable

payback period.

May be difficult to measure the initial amount invested when e.g. net outlays

arise in both the initial and final years of a project.

3. Discounted cash flow

DCF is a method of capital investment appraisal which takes account of:

1. The overall cash flows arising from projects, and

2. The timing of those cash flows.

Only relevant cash flows are considered (i.e. those future cash flows which arise as

a result of those projects) and the timing effect is incorporated by means of the

discounting technique.

Both the Accounting Rate of Return and the Payback approaches are surpassed by

the DCF methods. The basic arguments are:

it is better to consider cash rather than profits because cash is how investors

will eventually see their rewards (i.e. dividends, interest, or the proceeds from

the s

Documents

ACCA P4 Class Notes June 2011 Version 3 FINAL 4th Feb 2011