CIMA P9 Text - Management Accounting-Financial Strategy

CIMAS Ofcial Study System

Strategic Level

ManagementAccounting Financial Strategy

John OgilvieChristine Parkinson

AMSTERDAM BOSTON HEIDELBERG LONDON NEW YORK OXFORDPARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYO

CIMA PublishingAn imprint of ElsevierLinacre House, Jordan Hill, Oxford OX2 8DP30 Corporate Drive, Burlington, MA 01803

First published 2005

Copyright 2005, Elsevier Ltd. All rights reserved

No part of this publication may be reproduced in any material form (including photocopying or storing in any medium by electronic means and whether or not transiently or incidentally to some other use of this publication) without the written permission of the copyright holder except in accordance with the provisions of the Copyright, Designs and Patents Act 1988 or under the terms of a licence issued by the Copyright Licensing Agency Ltd, 90 Tottenham Court Road,London, England W1T 4LP. Applications for the copyright holders written permission to reproduce any part of this publication should be addressed to the publisher

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British Library Cataloguing in Publication DataA catalogue record for this book is available from the British Library

ISBN 0 7506 6715 X

Typeset by Newgen Imaging Systems (P) Ltd, Chennai, IndiaPrinted in Great Britain

For information on all CIMA publicationsvisit our website at www.cimapublishing.com

Important Note

A new edition of the CIMA Ofcial Terminology is due to be published inSeptember 2005. As this is past the publication date of this Study System thepage reference numbers for Management Accounting Ofcial Terminologycontained in this Study System are for the 2000 edition. You should ensure thatyou are familiar with the 2005 CIMA Ofcial Terminology (ISBN 0 7506 6827 X)once published, available from www.cimapublishing.com

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The CIMA Study System xiAcknowledgements xiHow to use your CIMA Study System xiStudy technique xiiiManagement Accounting Financial Strategy Syllabus xivTransitional arrangements xix

1 Formulation of Financial Strategy 11.1 Introduction 11.2 Objectives of prot-making entities 1

1.2.1 Financial objectives 21.2.2 Non-nancial objectives 31.2.3 Agency theory 31.2.4 Shareholder value analysis 4

1.3 Objectives of not-for-prot organisations 51.3.1 The three Es 7

1.4 Public and private similarities and differences 81.5 Assessing attainment of nancial objectives 10

1.5.1 Financial performance indicators 101.5.2 Non-nancial performance indicators 11

1.6 The three key decisions of nancial management 121.6.1 Investment decisions 121.6.2 Financing decisions 121.6.3 Dividend decisions 13

1.7 Policies for distribution of earnings 131.7.1 Practical dividend policies 141.7.2 Theory of dividend irrelevance 161.7.3 Scrip dividends 181.7.4 Share repurchases 18

1.8 The impact of internal and external constraints on nancial strategy 191.8.1 Internal constraints 191.8.2 External constraints 20

1.9 Developing nancial strategy in the context of regulatory requirements 201.9.1 Corporate Governance and the Cadbury Report 201.9.2 The Greenbury Report 211.9.3 The Hampel Report 221.9.4 Regulatory bodies 221.9.5 The regulation of takeovers and the competition commission 24

Contents

1.10 Major economic inuences 261.10.1 Interest rates 261.10.2 Term structure of interest rates 271.10.3 Ination 301.10.4 Exchange rates 30

1.11 Modelling and forecasting cash ows and nancial statements 311.11.1 Forecasting cash ows 311.11.2 Forecasting nancial statements 321.11.3 Sensitivity analysis 35

1.12 Current and emerging issues in nancial reporting 361.12.1 IFRS 1 rst time adoption of IFRS 361.12.2 IFRS 2 Share-based payment 361.12.3 Reporting environmental issues 381.12.4 Reporting of social issues 401.12.5 Inclusion of forecasts in the annual report 421.12.6 Reporting of human capital 42

1.13 Summary 43

Readings 45

Revision Questions 51

Solutions to Revision Questions 53

2 Financial Management 592.1 Introduction 592.2 The nance function 59

2.2.1 Evaluating key success factors in the management ofthe nance function 60

2.3 The treasury function 602.3.1 The role of the treasury function 612.3.2 Cost centre or prot centre 61

2.4 Financial markets 622.4.1 Money market 622.4.2 Capital or securities market 632.4.3 The foreign exchange market 642.4.4 Derivatives markets 64

2.5 Share price volatility 642.5.1 Technical analysis or chartism 652.5.2 Fundamental analysis 652.5.3 Random Walk Theory 65

2.6 The efcient market hypothesis 652.6.1 Weak form 662.6.2 Semi-strong form 662.6.3 Strong form 662.6.4 Implications of EMH for nancial managers 67

2.7 Investor ratios 672.7.1 Market price per share 672.7.2 Earnings per share 68

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2.7.3 The price/earnings ratio 682.7.4 Earnings yield 692.7.5 Dividend-payout rate 692.7.6 Dividend yield 692.7.7 Dividend cover 702.7.8 Book value per share 71

2.8 Working capital management strategies 712.8.1 The investment decision 722.8.2 The nancing decision 722.8.3 Multinational working capital management 74

2.9 Summary 74

Readings 75



3 Sources of Long-term Finance 853.1 Introduction 853.2 Shareholders funds 85

3.2.1 Ordinary shares 853.2.2 Preferred and deferred ordinary shares 863.2.3 Preference shares 873.2.4 Reserves 87

3.3 Raising share capital the stock market 873.3.1 New issues 883.3.2 Rights issues 893.3.3 Share splits and bonus issues 94

3.4 Debt nance 953.4.1 Debentures 953.4.2 Debt yields 963.4.3 Convertibles 983.4.4 Warrants 99

3.5 Medium-term nancing 1003.5.1 Term loans 1003.5.2 Mezzanine nance 1003.5.3 The lenders assessment of creditworthiness 1013.5.4 Leasing 1013.5.5 Lease-or-buy decisions 104

3.6 Financing of small businesses 1083.6.1 Venture capital 1093.6.2 Business angels 1103.6.3 Government assistance 110

3.7 Summary 111

Readings 113



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4 Capital Structure and Cost of Capital 1334.1 Introduction 1334.2 Measuring gearing 134

4.2.1 Capital gearing 1344.2.2 Interest cover 1364.2.3 Leverage 136

4.3 Cost of capital 1374.3.1 Cost of equity 1384.3.2 Cost of debt 1424.3.3 Cost of preference shares 144

4.4 Weighted average cost of capital 1444.4.1 Assumptions in the use of WACC 146

4.5 Marginal cost of capital 1464.6 The traditional theory of gearing 1484.7 Modigliani and Millers theories of gearing 149

4.7.1 Limitations of MM theory 1544.8 Cost of capital and adjusted cost of capital 154

4.8.1 Adjusted present value 1544.8.2 Adjusted cost of capital Modigliani and Miller 156

4.9 Risk and reward 1574.10 Portfolio theory 158

4.10.1 Systematic risk and unsystematic risk 1614.11 The capital asset pricing model 162

4.11.1 Measuring beta values 1644.11.2 The security market line 165

4.12 Using the CAPM as an investment tool 1674.13 MM, CAPM and geared betas 168

4.13.1 Ungearing beta 1684.13.2 Geared equity beta 170

4.14 Use of CAPM in investment appraisal 1714.14.1 Limitations of CAP-M 172

4.15 Arbitrage pricing model 1724.16 Summary 173

Readings 175



5 Business Valuations 1975.1 Introduction 1975.2. Asset-based valuations 198

5.2.1 Choice of valuation base 1985.2.2 Merits of asset-based valuations 198

5.3 Earnings-based valuations 1985.3.1 P/E ratio valuation 1985.3.2 Earnings yield valuation 199

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5.4 Dividend-based valuations 1995.4.1 Dividend yield 2005.4.2 Dividend growth model 2005.4.3. Problems of dividend-based valuations 2005.4.4 Capital asset pricing model 201

5.5 Cash-based valuations 2015.5.1 Discounted cash ow 2015.5.2 Shareholder value analysis 202

5.6 Business valuations and efcient markets 2025.7 Intellectual capital 203

5.7.1 Forms of intellectual capital 2035.7.2 The components of intellectual capital 2055.7.3 Valuing intellectual capital 2085.7.4 Comparative indicators 211

5.8 The impact of changing capital structure 2135.9 Recognition of the interests of different stakeholder groups in

company valuations 2135.9.1 Liquidation 2135.9.2 Re-nancing 2145.9.3 Mergers and acquisitions 214

5.10 Summary 214References 214

Readings 215



6 Mergers, Acquisitions and Buyouts 2356.1 Introduction 2356.2 Terminology and types of merger 235

6.2.1 Terminology 2356.2.2 Types of merger 236

6.3 The reasons for merger or acquisition 2366.4 Defences against takeover 237

6.4.1 Before the bid 2376.4.2 After the bid 238

6.5 Methods of payment for an acquisition 2386.5.1 Cash 2386.5.2 Share exchange 2396.5.3 Other types of nance 2406.5.4 Earn-out arrangements 240

6.6 The post-merger or post-acquisition integration process 2406.6.1 Impact on ratios or performance measures 2406.6.2 Acquirers post-acquisition share price 2426.6.3 Example of share valuation,

its effects and reasons for acquisition 2426.7 Reasons why mergers and acquisitions fail 248

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6.8 Management buyouts 2496.8.1 Financing MBOs 2496.8.2 Evaluation by investors and nanciers 250

6.9 Reconstruction 2516.9.1 Effect on the share price of a listed company 252

6.10 Summary 252

Readings 253



7 Investment Appraisal Techniques 2757.1 Introduction 2757.2 Accounting rate of return 2767.3 Payback 278

7.3.1 Discounted payback 2797.4 Discounting techniques 279

7.4.1 Net present value 2797.4.2 Internal rate of return 2807.4.3 Modied internal rate of return 2837.4.4 Discussion of techniques 284

7.5 Capital rationing 2857.5.1 Single-period capital rationing 2867.5.2 Single-period rationing with

mutually exclusive projects 2877.5.3 Single-period rationing with indivisible projects 288

7.6 Annual equivalent cost 2887.6.1 Asset replacement cycles 290

7.7 Summary 291



8 Advanced Investment Appraisal Techniques 3058.1 Introduction 3058.2 Taxation 305

8.2.1 Depreciation and capital allowances 3068.3 Ination 3078.4 Working capital 3098.5 Identication of a projects relevant costs and benets 3108.6 Linking investment in IS/IT with strategic, operational and

control needs 3118.6.1 Benets of a formal strategy 3128.6.2 IS, IT and IM strategy 3128.6.3 Content of information systems strategy 3128.6.4 Costbenet analysis 3138.6.5 Evaluating system performance 315

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8.7 Adjusting for risk 3168.7.1 Sensitivity analysis 3168.7.2 Decision trees 3198.7.3 Certainty equivalents 3208.7.4 The discount rate 3208.7.5 Adjusted discount rate 3218.7.6 Capital asset pricing model 321

8.8 Evaluating and reporting investment opportunities 3228.9 Adjusted present value 3248.10 Assessing investments as options on future cash ows 326

8.10.1 The abandonment option 3268.10.2 Timing options 3298.10.3 Strategic investment options 3308.10.4 Valuing options 330

8.11 Project implementation and control 3308.11.1 The investment cycle 3308.11.2 Post-completion auditing 3328.11.3 Benets of post-completion auditing 3328.11.4 Organisation of PCA 3338.11.5 Role of post-appraisal in project abandonment 334

8.12 Summary 334

Readings 337



9 Financing and Appraisal of Overseas Operations 3599.1 Introduction 3599.2 Financing overseas operations a global strategy 3599.3 The effect of restrictions on remittances 3619.4 The Euromarkets 361

9.4.1 Eurocurrency markets 3629.4.2 Eurobonds 362

9.5 The effect of taxation 3629.5.1 Double taxation relief 362

9.6 International capital budgeting 3639.7 APV method 3669.8 Summary 368



Preparing for the Examination 381Revision technique 381

Planning 381Getting down to work 382Tips for the nal revision phase 382

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Format of the examination 382Structure of the paper 382Types of question 383Allocation of time 383Weighting of subjects 384

Case-study Questions 387Solutions to Case-study Questions 419

Scenario Questions 479

Solutions to Scenario Questions 519

Index 611

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AcknowledgementsEvery effort has been made to contact the holders of copyright material, but if any herehave been inadvertently overlooked the publishers will be pleased to make the necessaryarrangements at the rst opportunity.

How to use your CIMA Study SystemThis Management Accounting Financial Strategy Study System has been devised as a resource forstudents attempting to pass their CIMA exams, and provides:

A detailed explanation of all syllabus areas; extensive practical materials, including readings from relevant journals; generous question practice, together with full solutions an exam preparation section, complete with exam standard questions and solutions

This Study System has been designed with the needs of home-study and distance-learning candidates in mind. Such students require very full coverage of the syllabus topics,and also the facility to undertake extensive question practice. However, the Study Systemis also ideal for fully taught courses.

The main body of the text is divided into a number of chapters, each of which is organ-ised on the following pattern:

Detailed learning outcomes. expected after your studies of the chapter are complete. Youshould assimilate these before beginning detailed work on the chapter, so that you canappreciate where your studies are leading.

Step-by-step topic coverage. This is the heart of each chapter, containing detailed explanatory textsupported where appropriate by worked examples and exercises. You should work carefullythrough this section, ensuring that you understand the material being explained and cantackle the examples and exercises successfully. Remember that in many cases knowledge iscumulative: if you fail to digest earlier material thoroughly, you may struggle to understandlater chapters.

Readings and activities. Some chapters are illustrated by more practical elements, such asrelevant journal articles or other readings, together with comments and questionsdesigned to stimulate discussion.

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The CIMA Study System

Question practice. The test of how well you have learned the material is your ability to tackleexam-standard questions. Make a serious attempt at producing your own answers, but atthis stage do not be too concerned about attempting the questions in exam conditions.In particular, it is more important to absorb the material thoroughly by completing a fullsolution than to observe the time limits that would apply in the actual exam.

Solutions. Avoid the temptation merely to audit the solutions provided. It is an illusion tothink that this provides the same benets as you would gain from a serious attempt ofyour own. However, if you are struggling to get started on a question you should read theintroductory guidance provided at the beginning of the solution, and then make yourown attempt before referring back to the full solution.

Having worked through the chapters you are ready to begin your nal preparations forthe examination. The nal section of this CIMA Study System provides you with the guid-ance you need. It includes the following features:

A brief guide to revision technique. A note on the format of the examination. You should know what to expect when you

tackle the real exam, and in particular the number of questions to attempt, which ques-tions are compulsory and which optional, and so on.

Guidance on how to tackle the examination itself. A table mapping revision questions to the syllabus learning outcomes allowing you to

quickly identify questions by subject area. Revision questions. These are of exam standard and should be tackled in exam condi-

tions, especially as regards the time allocation. Solutions to the revision questions. As before, these indicate the length and the quality of

solution that would be expected of a well-prepared candidate.

If you work conscientiously through this CIMA Study System according to the guide-lines above you will be giving yourself an excellent chance of exam success. Good luck withyour studies!

Guide to the Icons used within this TextKey term or denition

Equation to learn

Exam tip to topic likely to appear in the exam

Exercise

Question

Solution

Comment or Note

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Study techniquePassing exams is partly a matter of intellectual ability, but however accomplished you are inthat respect you can improve your chances signicantly by the use of appropriate study andrevision techniques. In this section, we briey outline some tips for effective study duringthe earlier stages of your approach to the exam. Later in the text we mention some tech-niques that you will nd useful at the revision stage.

PlanningTo begin with, formal planning is essential to get the best return from the time you spendstudying. Estimate how much time in total you are going to need for each subject that youface. Remember that you need to allow time for revision as well as for initial study of thematerial. The amount of notional study time for any subject is the minimum estimated timethat students will need to achieve the specied learning outcomes set out earlier in thischapter. This time includes all appropriate learning activities, for example, face-to-facetuition, private study, directed home study, learning in the workplace, revision time, etc. Youmay nd it helpful to read Better exam results by Sam Malone, CIMA Publishing, ISBN:075066357X. This book will provide you with proven study techniques. Chapter by chapterit covers the building blocks of successful learning and examination techniques.

The notional study time for Strategic level Financial Strategy is 200 hours. Notethat the standard amount of notional learning hours attributed to one full-time academicyear of approximately 30 weeks is 1,200 hours.

By way of example, the notional study time might be made up as follows:

Note that all study and learning-time recommendations should be used only as aguideline and are intended as minimum amounts. The amount of time recommended forface-to-face tuition, personal study and/or additional learning will vary according to thetype of course undertaken, prior learning of the student, and the pace at which differentstudents learn.

Now split your total time requirement over the weeks between now and the assessment.This will give you an idea of how much time you need to devote to study each week.Remember to allow for holidays or other periods during which you will not be able to study(e.g. because of seasonal workloads).

With your study material before you, decide which chapters you are going to study ineach week, and which weeks you will devote to revision and nal question practice.

Prepare a written schedule summarising the above and stick to it!The amount of space allocated to a topic in the study material is not a very good guide as

to how long it will take you. For example, Summarising and Analysing Data has a weight of25 per cent in the syllabus and this is the best guide as to how long you should spend on it. Itoccupies 45 per cent of the main body of the text because it includes many tables and charts.

Hours

Face-to-face study: up to 60Personal study: up to 100Other study e.g. learning in the workplace, revision, etc.: up to 1140

200

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It is essential to know your syllabus. As your course progresses you will become morefamiliar with how long it takes to cover topics in sufcient depth. Your timetable may needto be adapted to allocate enough time for the whole syllabus.

Tips for effective studying1. Aim to nd a quiet and undisturbed location for your study, and plan as far as possible

to use the same period of time each day. Getting into a routine helps to avoid wastingtime. Make sure that you have all the materials you need before you begin so as to min-imise interruptions.

2. Store all your materials in one place, so that you do not waste time searching for itemsaround the house. If you have to pack everything away after each study period, keepthem in a box, or even a suitcase, which will not be disturbed until the next time.

3. Limit distractions. To make the most effective use of your study periods you should beable to apply total concentration, so turn off the TV, set your phones to message mode,and put up your do not disturb sign.

4. Your timetable will tell you which topic to study. However, before diving in and becom-ing engrossed in the ner points, make sure you have an overall picture of all the areasthat need to be covered by the end of that session. After an hour, allow yourself a shortbreak and move away from your books. With experience, you will learn to assess the paceyou need to work at. You should also allow enough time to read relevant articles fromnewspapers and journals, which will supplement your knowledge and demonstrate awider perspective.

5. Work carefully through a chapter, making notes as you go. When you have covered asuitable amount of material, vary the pattern by attempting a practice question.Preparing an answer plan is a good habit to get into, while you are both studying andrevising, and also in the examination room. It helps to impose a structure on your solu-tions, and avoids rambling. When you have nished your attempt, make notes of anymistakes you made, or any areas that you failed to cover or covered only skimpily.

6. Make notes as you study, and discover the techniques that work best for you. Your notesmay be in the form of lists, bullet points, diagrams, summaries, mind maps, or the writ-ten word, but remember that you will need to refer back to them at a later date, so theymust be intelligible. If you are on a taught course, make sure you highlight any issues youwould like to follow up with your lecturer.

7. Organise your paperwork. There are now numerous paper storage systems available toensure that all your notes, calculations and articles can be effectively led and easilyretrieved later.

Management Accounting Financial StrategySyllabusTo be rst examined in May 2005

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Syllabus outlineThe syllabus comprises:

Learning aimsStudents should be able to:

understand and apply contemporary thinking on strategic nancial management, understand and utilise appropriate tools for strategic nancial management, evaluate strategic nancial management options in light of the needs of management and

the policy of the enterprise, characterise and describe the enterprises nancial strategy and use that characterisation

to develop optimal nancial strategy for all stages of the life-cycle, and assess and evaluate proposed strategies.

Assessment strategyThere will be a written examination paper of three hours, with the following sections.Section A 50 marks

A maximum of four compulsory questions, totalling 50 marks, all relating to a singlescenario.Section B 50 marks

Two questions, from a choice of four, each worth 25 marks. Short scenarios will be given,to which some or all questions relate.

Learning outcomes and syllabus contentA Formulation of nancial strategy 20%Learning outcomesOn completion of their studies students should be able to:

(i) identify an organisations objectives in nancial terms and evaluate their attainment;(ii) discuss the interrelationships between decisions concerning investment, nancing and

dividends;(iii) identify and analyse the impact of internal and external constraints on nancial strat-

egy (e.g. funding, regulatory bodies, investor relations, strategy, and economic factors);(iv) evaluate current performance, taking account of potential variations in economic and

business factors;(v) recommend alternative nancial strategies for an organisation.

Syllabus content The nancial and non-nancial objectives of different organisations (e.g. value for

money, maximising shareholder wealth, providing a surplus).

Topic Study WeightingA Formulation of Financial Strategy 20%B Financial Management 30%C Business Valuations and Acquisitions 25%D Investment Decisions and Project Control 25%

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The three key decisions of nancial management (by which we mean investment, nanc-ing, dividend) and their links.

Benets of matching characteristics of investment and nancing, for example, in cross-border investment.

Identifying the nancial objectives of an organisation and the economic forces affectingits nancial plans, for example, interest, ination and exchange rates.

Assessing attainment of nancial objectives. Developing nancial strategy in the context of regulatory requirements (e.g. price and

service controls exercised by industry regulators) and international operations. Modelling and forecasting cash ows and nancial statements based on expected values

for economic variables (e.g. interest rates) and business variables (e.g. volume and mar-gins) over a number of years.

Analysis of sensitivity to changes in expected values in the above models and forecasts. Identifying nancing requirements ( both in respect of domestic and international oper-

ations) and the impacts of different types of nance on the above models and forecasts. Assessing the implications for shareholder value of alternative nancial strategies, includ-

ing dividend policy. Note: Modigliani and Millers theory of dividend irrelevancy will betested in broad terms. The mathematical proof of the model will not be required, butsome understanding of the graphical method is expected.

Current and emerging issues in nancial reporting (e.g. proposals to amend or introducenew accounting standards) and in other forms of external reporting (e.g. environmentalaccounting).

B Financial management 30%Learning outcomesOn completion of their studies students should be able to:

(i) identify and describe optimal strategies for the management of working capital and sat-isfaction of longer term nancing requirements;

(ii) identify and evaluate key success factors in the management of the nance functionand its relationship with other parts of the organisation and, where necessary, withexternal parties;

(iii) discuss the role and management of the treasury function.

Syllabus content Working capital management strategies. (Note: No detailed testing of cash and stock

management models will be set since these are covered at the Managerial level.) Types and features of domestic and international long-term nance: share capital (ordi-

nary and preference shares, warrants), long-term debt (bank borrowing and forms ofsecuritised debt, e.g. convertibles) and nance leases, and methods of issuing securities.

The lenders assessment of creditworthiness. The lease or buy decision (with both operating and nance leases). The operation of stock exchanges (e.g. how share prices are determined, what causes

share prices to rise or fall, and the efcient market hypothesis). (Note: No detailed knowl-edge of any specic countrys stock exchange will be tested.)

The capital asset pricing model (CAPM): calculation of the cost of equity using the div-idend growth model (knowledge of methods of calculating and estimating dividend

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growth will be expected), the ability to gear and ungear betas and comparison to the arbi-trage pricing model.

The ideas of diversiable risk (unsystematic risk) and systematic risk. (Note: use of thetwo-asset portfolio formula will not be tested.)

The cost of redeemable and irredeemable debt, including the tax shield on debt (numer-ical questions on the cost of convertible debt will not be tested).

The weighted average cost of capital (WACC): calculation, interpretation and uses. Criteria for selecting sources of nance, including nance for international investments. The effect of nancing decisions on balance sheet structure and on ratios of interest to

investors and other nanciers (gearing, earnings per share, priceearnings ratio, dividendyield, dividend cover gearing, interest cover).

Management of the nance function and relationships with professional advisors(accounting, tax and legal), auditors and nancial stakeholders (investors and nanciers).

The role of the treasury function in terms of setting corporate objectives, liquiditymanagement, funding management, currency management.

The advantages and disadvantages of establishing treasury departments as prot centresor cost centres, and their control.

C Business valuations and acquisitions 25%Learning outcomesOn completion of their studies students should be able to:

(i) calculate values of organisations of different types, for example, service, capitalintensive;

(ii) identify and calculate the value of intangible assets (including intellectual property);(iii) identify and evaluate the nancial and strategic implications of proposals for mergers,

acquisitions, demergers and divestments;(iv) compare and recommend alternative forms of consideration for, and terms of,

acquisitions;(v) calculate post-merger or post-acquisition value of companies;(vi) identify and evaluate post-merger or post-acquisition value enhancement strategies;(vii) discuss and illustrate the impact of regulation on business combinations;(viii) evaluate exit strategies.

Syllabus content Valuation bases for assets (e.g. historic cost, replacement cost and realisable value), earn-

ings (e.g. price/earnings multiples and earnings yield) and cash ows (e.g. discounted cashow, dividend yield and the dividend growth model).

The strengths and weaknesses of each valuation method and when each is most suitable. Recognition of the interests of different stakeholder groups in mergers, acquisitions and

company valuations. Application of the efcient market hypothesis to business valuations. Selection of an appropriate cost of capital for use in valuations. The impact of changing capital structure on the market value of a company. (Note: An

understanding of Modigliani and Millers theory of gearing, with and without taxes, willbe expected, but proof of their theory will not be examined.)

Forms of intellectual property and methods of valuation.

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The reasons for merger or acquisitions (e.g. synergistic benets). Forms of consideration and terms for acquisitions (e.g. cash, shares, convertibles and

earn-out arrangements), and their nancial effects. The post-merger or post-acquisition integration process (e.g. management transfer and

merger of systems). The implications of regulation for business combinations. (Note: Detailed knowledge of

the City Code and EU competition rules will not be tested.) The function/role of management buy-outs, venture capitalists. Types of exit strategy and their implications.

D Investment decisions and project control 25%Learning outcomesOn completion of their studies students should be able to:

(i) analyse relevant costs, benets and risks of an investment project;(ii) evaluate investment projects (domestic and international) taking account of potential

variations in business and economic factors;(iii) recommend methods of funding investments, taking account of basic tax considerations;(iv) evaluate procedures for the implementation and control of investment projects;(v) recommend investment decisions when capital is rationed.

Syllabus content Identication of a projects relevant costs (e.g. infrastructure, marketing and human

resource development needs), benets (including incremental effects on other activitiesas well as direct cash ows) and risks (i.e. nancial and non-nancial).

Linking investments with customer requirements and product/service design. Linking investment in IS/IT with strategic, operational and control needs (particularly

where risks and benets are difcult to quantify). Calculation of a projects net present value and internal rate of return, including tech-

niques for dealing with cash ows denominated in a foreign currency and use of theweighted average cost of capital.

The modied internal rate of return based on a projects terminal value (reecting anassumed reinvestment rate).

The effects of taxation (including foreign direct and withholding taxes), potential changesin economic factors (ination, interest and exchange rates) and potential restrictions onremittances on these calculations.

Recognising risk using the certainty equivalent method (when given a risk free rate andcertainty equivalent values).

Adjusted present value. (Note: The two-step method may be tested for debt introducedpermanently and debt in place for the duration of the project.)

Capital investment real options (i.e. to make follow-on investment, abandon or wait). Project implementation and control in the conceptual stage, the development stage, the

construction stage and initial manufacturing/operating stage. Post completion audit of investment projects. Single period for capital rationing for divisible and non-divisible projects. (Note: Multi-

period rationing will not be tested)

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Transitional arrangementsStudents who have passed the Financial Strategy paper under the Beyond 2000 syllabus willbe given a credit for the Financial Strategy paper under the new 2005 syllabus. For furtherdetails of transitional arrangements, please contact CIMA directly or visit their website atwww.cimaglobal.com.

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Formulae

Valuation models(i) Irredeemable preference share, paying a constant annual dividend, d, in perpetuity,

where P0 is the ex-div value:

(ii) Ordinary (Equity) share, paying a constant annual dividend, d, in perpetuity, where P0is the ex-div value:

(iii) Ordinary (Equity) share, paying an annual dividend, d, growing in perpetuity at a con-stant rate, g, where P0 is the ex-div value:

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

or, without tax:

(v) Total value of the geared rm, Vg with taxes (based on MM):

Vg Vu TB

where TB is the value of tax shield.(vi) Future value of S, of a sum X, invested for n periods, compounded at r % interest:

S X[1 r ]n

(vii) Present value of 1 payable or receivable in n years, discounted at r % per annum:

(viii) Present value of an annuity of 1 per annum, receivable or payable for n years, com-mencing in one year, discounted at r % per annum:

(ix) Present value of 1 per annum, payable or receivable in perpetuity, commencing inone year, discounted at r % per annum:

PV 1r

PV 1r1 1[1 r ]n

PV 1[1 r ]n

P0 i

kd

P0 i[1 t]

kd net

P0 d1

ke g or P0

d0[1 g]ke g

P0 dke

P0 d

kprefTH

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(x) Present value of 1 per annum, receivable or payable, commencing in one year, grow-ing in perpetuity at a constant rate of g% per annum, discounted at r % per annum:

Cost of capital(i) Cost of irredeemable preference capital, paying an annual dividend d in perpetuity,

and having a current ex-div price P0:

(ii) Cost of irredeemable debt capital, paying annual net interest i(1 t ), and having acurrent ex-interest price P0:

(iii) Cost of ordinary (Equity) share capital, paying an annual dividend d in perpetuity, andhaving a current ex div price P0:

(iv) Cost of ordinary ( Equity) share capital, having a current ex div price, P0, having justpaid a dividend, d0, with the dividend growing in perpetuity by a constant g % per annum:

(v) Cost of ordinary (Equity) share capital, using the CAPM:

ke Rf [Rm Rf ]

(vi) Cost of ordinary (Equity) share capital in a geared rm, (No tax):

(vii) Cost ordinary (Equity) share capital in a geared rm, (With tax)

(viii) Weighted average cost of capital, k0:

(ix) Adjusted cost of capital (MM formula)

kadj keu[1 tL] or r* r[1 T *L]

In the following formulae to calculate Beta, u is used for an ungeared , and g isused for a geared :

(x) u from g, taking d as zero, (No tax):

u g VEVE VD

k0 keg VEVE VD kd VDVE VD

keg keu [keu kd]VD[1 t]

VE

keg k0 [k0 kd]VDVE

ke d1P0

g or ke d0[1 g]

P0 g

ke dP0

Kd net i[1 t]

P0

kpref dP0

PV 1r g

(xi) u from g, taking d as zero, (With tax):

Other formulae(i) Interest Rate Parity ( International Fisher Effect) For indirect quotes

(ii) Purchasing Power Parity (Law of one price)

(iii) Link between nominal (money) and real interest rates

[1 nominal (money) rate] [1 real interest rate][1 ination rate]

(iv) Equivalent annual cost

(v) Theoretical ex-rights price

(vi) Value of a right

where N number of rights required to buy one share.

orTheoretical ex rights price Issue price

N

Value of a right Rights on price Issue price

N 1

TERP 1N 1[(N rights on price) Issue price]

Equivalent annual cost PV of costs over n years

n year annuity factor

Forward rate US$ Spot US$ 1 US inflation rate1 UK inflation rate

Forward rate US$ Spot US$ 1 nominal US interest rate1 nominal UK interest rate

u g VEVE VD[1 t]

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Formulation ofFinancial Strategy

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1LEARNING OUTCOMESAfter completing this chapter you should be able to:

identify an organisations objectives in nancial terms and evaluate their attainment;

discuss the interrelationships between decisions concerning investment, nancing anddividends;

identify and analyse the impact of internal and external constraints on nancial strategy;

evaluate current performance, taking account of potential variations in economic andbusiness factors;

recommend alternative nancial strategies for an organisation;

discuss and illustrate the impact of regulation on business combinations.

1.1 IntroductionIn this chapter we identify the nancial and non-nancial objectives of different organisa-tions; the three key decisions of nancial management and their links; economic forcesaffecting nancial plans; regulatory requirements; modelling and forecasting of cash owsand nancial statements; dividend policy, and current and emergency issues in nancialreporting.

1.2 Objectives of prot-making entities

Strategy: A course of action, including the specication of resources required, toachieve a specic objective. (Management Accounting: Ofcial Terminology, 2000)

Financial strategy is the aspect of strategy which falls within the scope of nancial man-agement, which will include decisions on investment, nancing and dividends.

Strategic nancial management: The identication of the possible strategies capable ofmaximising an organisations net present value, the allocation of scarce capital

resources among the competing opportunities and the implementation and monitoring ofthe chosen strategy so as to achieve stated objectives. (Ofcial Terminology, 2000)

The denitions above both indicate that strategy depends on objectives. For a prot-making entity the main strategic objective is to optimise the wealth of the proprietors, whichmeans achieving the maximum prot possible consistent with balancing the needs of thevarious stakeholders in the entity, including shareholders, fund lenders, customers, suppliers,employees and government (in terms of taxation and legal constraints on operations). Thehealth of the entity also depends on a proper balance being achieved between long-termprojects and short-term opportunities, a major constraint against the latter being that theymust not be taken where there is a signicant risk that they will damage long-term viability.

If all these factors can be effectively balanced the result should be the achievement ofthe overriding strategic nancial management objective of maximising shareholder value.

1.2.1 Financial objectivesFor a prot-making entity the main strategic objective is to optimise the wealth of the pro-prietors. In other words, the objective is assumed to be to maximise shareholder wealth. In prac-tice, this may be interpreted as achieving the maximum prot possible consistent withbalancing the needs of the various stakeholders in the entity.

StakeholdersStakeholders: Groups or individuals having a legitimate interest in the activities of anorganisation, generally comprising customers, employees, the community, share-

holders, suppliers and lenders.

The various stakeholder groups may have different interests in the activities of anorganisation:

Shareholders maximisation of wealth from their investment. Fund lenders receipt of interest and capital repayments by the due date. Customers a continuous trading relationship with suppliers. Suppliers to ensure that they are paid in full by the due date. Employees to maximise rewards paid to them in salaries and benets, and continuity of

employment. Government may have the broad objectives of sustained economic growth and main-

taining levels of employment.

Economists, and many accountants, believe that cash ow is the main criterion to judgea companys performance. Cash is a fact, whereas prot can be manipulated by accountingpolicies. Companies have in fact gone out of business because of a back of funds, eventhough they were protable. In reality, shareholder wealth is based on the present value offuture cash ows.

Managers in practice may have broader objectives perhaps undertaking any nancing,investment, or dividend decision that will achieve satisfactory returns rather than those that

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may optimise returns. Alternatively, objectives may be more related to achievement of a levelof: sales, earnings per share, dividend per share, or survival.

Shareholder wealth may be measured by the return that shareholders receive from theirinvestment, represented partly by the dividend received each year and partly by the capitalgain from the increase in the value of the shares over that period.

1.2.2 Non-nancial objectivesA company may also have a number of important non-nancial objectives, which may berelated to:

customer satisfaction; welfare of employees; welfare of management; the environment.

For example, in its annual report for 2004, J. Sainsbury plc, stated the following objec-tives which recognised in some detail the interests of other stakeholders.

Our objective is to meet our customers needs effectively and thereby provide shareholders with good, sus-tainable nancial returns. We aim to ensure all colleagues have opportunities to develop their abilities and arewell rewarded for their contribution to the success of their business. Our policy is to work with all of our sup-plies fairly, recognising the mutual benet of satisfying customers needs. We also aim to full our responsi-bilities to the communities and environments in which we operate.

Contrast this with the all-embracing objective of International Power plc in its annual report for 2002:

Our objective is to enhance shareholder values through the viable growth of our business in a socially respon-sible manner.

The general thrust of this objective features in various sections of the companys annualreport but it is not quantied and it might be useful to consider how its achievement mightbe measured.

In both the examples given above, the lack of quantication of the objectives wouldmake it difcult for shareholders to challenge their achievement in an Annual GeneralMeeting.

1.2.3 Agency theoryA possible conict can arise when ownership is separated from the day-to-day managementof an organisation. In larger companies, the ordinary shares are likely to be diversely held,and so the actions of shareholders are likely to be restricted in practical terms. The respon-sibility of running the company will be with the board of directors, who may only own asmall percentage of the shares in issue.

The managers of an organisation are essentially agents for the shareholders, being taskedwith running the organisation in the shareholders best interests. The shareholders, how-ever, have little opportunity to assess whether the managers are acting in the shareholdersbest interests.

Agency theory: Hypothesis that attempts to explain elements of organisationalbehaviour through an understanding of the relationships between principals (such as

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shareholders) and agents (such as company managers and accountants). A conict may existbetween the actions undertaken by agents in furtherance of their own self-interest, andthose required to promote the interests of the principals. (Ofcial Terminology, 2000)

Investor relationsWhere ownership is separated from the day-to-day management of an organisation,managers may be motivated to behave in ways that are not optimal to the shareholders ofthe organisation:

Shareholders can spread their risk by unresting in a number of companies. Managers havepersonal and nancial capital invested in the company and so may be averase to investingin a risky investment.

Shareholders wealth will be maximised by investing in projects with positive net presentvalues. Managers may be more interested in short-term payback than net present value asthe investment criterion, in order to help further their own promotion prospects.

Managers of companies that are subject to a takeover bid often put up a defence to repelthe predator. While arguing this action is in the shareholders best interests, Shareholdersof acquired companies often receive large gains in the value of their shares. The managersof the acquired company often lose their jobs or status.

Goal congruenceThe general term covering the possible conicts of interest within a company, and the vari-ous methods by which attempts are made to overcome such obstacles to goal congruence,is called agency theory. In its broadest sense the term relates to economic models which pro-vide comparisons of information systems.

Goal congruence: In a control system, the state which leads individuals or groups totake actions which are in their self-interest and also in the best interest of the entity.

(Ofcial Terminology, 2000)

It is evident that an important element within companies is the extent to which all mem-bers of the management team and their staff work together to achieve the strategic objec-tives of that company. An aspect of agency theory aims to demonstrate that while variouskinds of contract exist, formal and informal (such as job descriptions, departmental respon-sibilities and ofce and factory rules), these can only be effective in helping to make a com-pany successful if there is general acceptance of them in practice, and a concerted effort byall concerned to strive in the same direction, that is, to achieve genuine goal congruence.

1.2.4 Shareholder value analysisTraditionally, managers of limited liability companies have used nancial measures such asprot margin and return on assets to assess progress, and have used discounted cash-owmeasures to assess the viability of projects or investments. Shareholder value analysis (SVA)is used to bring these three measurement systems into line, and starts from the view thatthe main objective of the directors of a company is to maximise the wealth of the share-holders. Coca-Cola, Monsanto, Unilever and Tate and Lyle have all used SVA to measurenancial performance.


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An assumption of SVA is that the value of a business is the net present value of futurecash ows, discounted at an appropriate cost of capital. Financing and investment decisionsshould be evaluated on their ability to maximise value for the shareholders. The inferenceis that the decision made will be reected in the share price. Seven key value drivers havebeen identied that have the greatest impact on share price:

sales growth rate (per cent); prot margin (per cent); cash tax rate (per cent); working capital/sales (per cent); capital expenditure/sales (per cent); cost of capital (per cent); value growth duration period (years).

The value growth duration period represents the future period for which the companyhas a foreseeable competitive advantage.

SVA is used to indicate the amount of economic value created in a period. It does so bymeasuring and managing cash ows of the business that take account of risk and the true valueof money. The cash ows used in SVA are the net prots after tax, plus non-cash items, lessany investments in working capital and xed assets. These are known as the free cash ows.

Free cash ow: Cash ow from operations after deducting interest, tax, dividends andongoing capital expenditure, but excluding capital expenditure associated with strate-

gic acquisitions and/or disposals. (Ofcial Terminology, 2000)

A major difculty is calculating those future cash ows. This problem can be partlyresolved by breaking the value of the business into two constituent parts, such that thevalue of the business equals the present value of free cash ows during the normal plan-ning horizon, plus a residual value. The residual value represents the present value of freecash ows after the normal planning horizon. Nevertheless, it is still difcult to establish areliable estimate for the residual value.

You will nd a comprehensive article on shareholder value analysis in the Readings sec-tion of this chapter.

1.3 Objectives of not-for-prot organisationsAs a general rule, books on nancial management, and modern corporate nance theories, arewritten in the context of the prot-seeking segment of the private sector. Note that the verysurvival of such enterprises depends on their being able to identify and satisfy needs and tooffer the prospect of an adequate nancial return. Those which can hold out such a prospectare able to attract the funds necessary to grow their businesses, while those which cannot mustinevitably shrink. Financial management involves not only heeding that discipline but alsotranslating it into a criterion for the allocation of resources within the enterprise.

In this context, the expression an adequate return describes a situation in which thevalue of outputs (to customers or, in more upmarket situations, clients) exceeds the valueof inputs of all kinds: not just bought-in goods and services and labour, but also capital.

It would be easy to overlook the fact that these prot-seeking enterprises (even if weinclude privately owned businesses as well as publicly quoted ones) represent only a minorityof economic activity. The majority comprises a wide variety of enterprises which are usually


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referred to as not for prot. In the private sector, you might think of:

trades unions, trade associations, employers organisations and federations thereof (suchas the Confederation of British Industry);

professional bodies, such as the Chartered Institute of Management Accountants; housing associations (currently accounting for over 4 per cent of UK housing stock, and

building 50,000 units a year), friendly societies, clubs and cooperatives; charities; religious organisations, such as the Church of England.

It is enlightening to ask which of the business imperatives do not apply to such organi-sations. Can they operate without identifying and satisfying needs? To operate, can they dowithout adequate investment in resources, and hence the need to attract funds? Is it con-ceivable that they could do so if the value of their outputs is perceived as being less thanthe value of inputs? The answers to all these questions must be in the negative. In a way, theexpression not-for-prot is somewhat misleading: if prot is the legitimate reward for thecommitment of funds, why should any organisation which requires long-term funding notseek a prot (albeit under a different name, for example, surplus of income over expendi-ture, and with an intention that it be ploughed back)?

So it is with the public sector, of which central government (currently responsible forover 40 per cent of UK gross domestic product) is the most prominent example. Activitiesin this sector should not be insulated from the application of nancial disciplines. Would itmake sense, for example, for:

the Civil Service College to use a different criterion from CIMA Mastercourses? a National Health trust hospital to use a different criterion from a private hospital?

If the rate of return sought by enterprises in the public sector were to be lower than thatsought in the private sector, then the result would inevitably be that the public sector wouldgrow (nanced by taxation or borrowing) while the private sector would shrink. In short,the criterion used in resource allocation should be the same across all sectors: the value ofoutputs should exceed the value of inputs.

At this point, however, the distinguishing feature of the not-for-prot organisationsbegins to emerge. It is that their customers are not synonymous with their clients.Accountancy institutes use funds supplied by their members to develop their specialism forthe benet of employers and the public. Charities and religious organisations use the cashfrom donors to alleviate suffering or promote a belief. The government takes money fromthose in employment to give it to those out of work, or from the healthy to give to the sick.All of these redistributions are noble in themselves, but they lack the direct link betweenconsumption and price. It is a well-known economic law that as the price of a service atthe point of delivery tends towards zero, so demand for it tends towards innity.Consequently, organisations whose income comes from a source other than payingcustomers are frequently plagued by an excess of demand over supply.

There are variations on the customer/client theme, as follows:

Some organisations have elaborate transfer pricing arrangements, which could allowinternal customers to relate cost to value, by reference to: benchmarks derived from prices prevailing in the market economy, for example, the

Civil Service Colleges charges can be compared with those of a private institution; the prices quoted by quasi-competitive units within the organisation, as with the National

Health Service.


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In some cases, the clients (e.g. the passengers travelling on some railway routes in Britain) willcontribute towards the cost but the taxpayer meets the balance in the form of a subsidy.

In other cases, the primary function is a regulatory one, and fees are charged to thosebeing regulated, for example, Companies House.

To various degrees, however, managers in such organisations see their role in terms ofrationing their limited resources. Specically, many are uncomfortable with the concept ofvalue, and retreat into choosing between costs. Resources are assumed to be nite, and thetask is seen as trading-off within one time-frame, for example the current scal year. Ona small scale, for example, a church councils decisions could include choosing between atoilet for the disabled or paying for a missionary to go to a far-off land.

On a large scale, the UK government makes a political assessment of what it can raise intaxation and borrowings, and this becomes the total that it can afford to spend. Choiceshave to be made and confrontation (in this case between spending ministries:Health/Education/Defence, etc.) is inevitable. Lower down the scale, departments use theterm virement (signicantly, a term which is unknown in the private sector) to refer to theneed to get permission to offset an overspend on one account against an underspend inanother.

Managers in the public sector are well aware of the trends, but see considerable obstaclesto going with the tide. The stance of national government is to seek stability through rigidplanning. The problems with plans is that, in a rapidly changing environment, they are soquickly overtaken by events: exibility and adaptability are required today. The UKTreasurys cash limit approach to nancial management, for example, is tactical and short-termist, and in the absence of any countervailing strategic control inhibits adaptation.

1.3.1 The three EsThe public sector is usually credited with having drawn attention to the distinctions between:

economy, which is generally thought of in terms of doing things as cheaply as possible, andis therefore associated with the operational level of control;

efciency, which is generally thought of in terms of productivity (the ratio of output toinput) and is therefore associated with the tactical level of control;

effectiveness, which is generally thought of in terms of doing the right things, and is there-fore associated with the strategic level of control.

The rst two are much in evidence in public-sector management-control systems. Anagency such as the Civil Service College will measure the number of students, the numberof courses, the ratio of lecturers to students, and so on. It will also seek its customersassessments of the standard of, for example, its lecturing and catering, and compare themwith preset targets. In the language of strategic nancial management, these are answers tothe question How well did we do what we chose to do?. You should also be aware, by now,of the dangers of concentrating on what can be measured. Note, for example, that it is pos-sible to measure crime detection, but it is not possible to measure crime prevention; it ispossible to measure the extent to which the sick are cured, but not the extent to which sick-ness is prevented. People can be rewarded on the basis of measurables, but it should come asno surprise if they then skimp on the immeasurables: you get what you measure. Measuringperformance is but a part of monitoring progress: assessing potential and changes thereinare at least as important.


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Disturbingly, the third (and, arguably, the most important) E effectiveness is the leastin evidence. Where the word strategy is used, it usually means a 3-year budget. Zero vari-ances (and hence zero feedback) are expected. Health-service purchasers tend to talk, forexample, of delivering a strategy as though it were a result a destination rather than theroute thereto. This stems, perhaps, from the top-down style which we have seen is still thenorm: top management decides what is to be done, middle management has some choiceas to how it is done, the vast majority are seen as responsible for doing it.

In other words, the emphasis is on tactics, in the form of leadership from behind: Carryon doing what you have been doing but do it cheaper/faster/more accurately, etc. Partly,this is cultural, reecting an antipathy towards uncertainty, risk and surprises. When public-sector investments go awry (e.g. investments in information technology not producing theexpected benets) they tend to be reported in terms of wasting public money. The sameoutcome in the private sector might be seen as the risk inevitably associated with pushingout the boundaries.

1.4 Public and private similarities anddifferences

The public sector is as affected by managerial trends as the private sector. Authority hasbeen delegated, but there is a consequent need for strategic accountability. As in a group ofcompanies, strategy is not just something which exists within one single business, but is alsoconcerned with the relationship between the businesses and the centre. The language ofstrategy in general, and nancial management in particular, is therefore necessary and isdeveloping.

Consequently, the decision-support techniques used in the private sector are largely alsoapplicable in the public sector. Take the UK Civil Service College, for example. Given thetrend towards generalism, and the reputation of the service for generalism, it might see anopportunity to mount a course for private-sector delegates. But what outlays would beinvolved, and would they be matched by income? The college is known to research anddevelop relevant management techniques: again, costs and benets need to be matched. Itsreport stresses that its greatest assets are ones the knowledge and commitment of its staff not shown on its balance sheet. It is important that such assets are recognised, cost-effectivelyenhanced, employed to deliver good value for taxpayers money, and suitably monitored. Incorporate strategy terms, it is possible to quantify the cash ows from the rest of the publicsector to the college, obtain its net present value, and then compare with the cost of the next-best alternative, for example, using a private-sector provider (or, possibly, to compare with theprice which could be obtained on disposal).

So, subject only to a willingness by those in authority to quantify their judgements, nan-cial management is, on the whole, equally applicable to the not-for-prot sector generallyand the public sector in particular. It is worth stressing perhaps, that in common with theprivate sector it is never possible to say whether or not value has been maximised. We donot know what we do not know: specically, we do not know what opportunities have beenmissed. This is not a problem for those familiar with devolved authority, as it is the onlyapproach compatible with empowerment: you cannot tell an explorer what to nd, or iden-tify what he/she has not found! Some bridge is usually required, from the known to theunknown, for example, to relate the value of a unit to the costs of its tangible assets, and


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to consider what intangibles explain the difference. This will often act as a very goodattention-directing tool, but recognise it as holding up a mirror: in reality, value is not afunction of cost.

The health sector provides other examples. Investments in medical equipment representdecisions to trade in purchasing power now in the expectation of benets later. These ben-ets may take the form of increased throughput (and hence reduced waiting lists) or themeeting of needs which would otherwise go unsatised. These benets are not measurable,because it is not possible to measure something which has not yet happened; they are judg-mental. But this does not mean that they are not quantiable and hence capable of evalua-tion. The main obstacle is usually an unwillingness on the part of those in authority (e.g.politicians) to express value judgements, perhaps because they fear such judgements beingtaken down and used in evidence against them.

For the avoidance of doubt, it is worth stressing that values are equally subjective in theprivate sector. No one pretends that they can measure the effectiveness of a proposedinvestment in advertising: they forecast the improvement after assessing the likely reactionsof competitors, direct customers and ultimate consumers. The management accountant ful-ls a vital role in being able to synthesise these judgements together with others (e.g. thevolumecost relationship and the cost of capital) to identify the optimum level of invest-ment they imply. The forecast outcome is logged, so as to provide a benchmark by whichto monitor progress.

Of course, there are differing degrees of difculty discomfort, even in making valuejudgements in the public sector. Currently and foreseeably, the health sector is providingmany examples. Thanks to results of research in pharmaceuticals, for example, previouslyincurable illnesses are being dealt with, and people are living longer. Demand for drugs, etc.,is correlated with age, so demand continues to increase. With a progressively smaller pro-portion of the population in employment, the nancial pressures are substantial. How doesone make an informed choice as to the transfer of funds between the well and the unwell?What value does one put on curing an illness, or saving a life? These are societal matters,the discomfort being one of the reasons they are placed rmly in the public sector, ratherthan being left to the survival of the ttest philosophy associated with the competitivestruggle for existence that we call the market economy.

In the UK, this is being addressed by reforms characterised by the creation of the inter-nal market. The main feature is the separation of purchasers (representing a particular geo-graphical area) from the providers (hospitals and other healthcare facilities). The providersare competing among themselves for the purchasers funds, the idea being that those offer-ing the best value for money will gain an increasing share of the available funds.

In the early days, at least, various rules of the game have been laid down, most notably(from a strategic nancial management point of view) in the area of pricing. Given thatthe health service is still one large (but hybrid) business, formula-based transfer pricing isto be expected. The rules are very simple: price must equal cost, and cost must equal totalcost, including a target return on capital employed. Those who framed the rules seem tohave been thinking in terms of there being one objectively veriable cost of an activity(which is valid only when looking backwards) but prices have to be established inadvance. The demand for sophisticated yet pragmatic costing systems will, consequently,be high for some considerable time to come, as providers seek costs which signal goodvalue for money for the business they seek to attract, and poor value for those they wishto repel.


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1.5 Assessing attainment of nancial objectives

Traditionally, managers have focused on nancial measures of performance and progress.Increasingly, organisations in both the private and public sectors are using non-nancialindicators to assess success across a range of criteria, which need to be chosen to help anorganisation meet its objectives.

We discuss a number of common nancial and non-nancial indicators below.

1.5.1 Financial performance indicators Cash generation. Poor liquidity is a greater threat to the survival of an enterprise than is

poor protability. Unless the organisation is prepared to fund growth with high levels ofdebt, cash generation is vital to ensure investment in future protable ventures. In the pri-vate sector the alternative to cash via retained earnings is debt. In the public sector thischoice has not been available in the past, and all growth has been funded by government.However, in the face of government-imposed cash limits, local authorities and otherpublic-sector institutions are beginning to raise debt on the capital markets, and are there-fore beginning to be faced with the same choices as private companies.

Value added. This is primarily a measure of performance. It is usually dened as salesvalue less the cost of purchased materials and services. It represents the value added toa companys products by its own efforts. A problem here is comparability with otherindustries or even with other companies in the same industry. It is less common in thepublic sector, although the situation is changing and many public-sector organisations for example, those in the health service are now publishing information on their ownvalue added.

Protability. Protability may be dened as the rate at which prots are generated. It isoften expressed as prot per unit of input (e.g. investment). However, protability limitsan organisations focus to one output measure prot. It overlooks quality, and this limi-tation must be kept in mind when using protability as a measure of success. Protabilityas a measure of decision-making has been criticised because: it fails to provide a systematic explanation as to why one business sector has more

favourable prospects than another; it does not provide enough insight into the dynamics and balance of an enterprises

individual business units, and the balance between them; it is remote from the actions that create value, and cannot therefore be managed

directly in any but the smallest organisations; the input to the measure may vary substantially between organisations.

Nevertheless, it is a well-known and accepted measure which, once the input has beendened, is readily understood. Provided the input is consistent across organisations andtime periods, it also provides a useful comparative measure. Although the concept ofprot in its true sense is absent from most of the public sector, protability may be usedto relate inputs to outputs if a different measure of output is used for example: surplusafter all costs, to capital investment.

Return on assets (RoA). This is an accounting measure, calculated by dividing annual prof-its by the average net book value of assets. It is therefore subject to the distortionsinevitable when prot, rather than cash ows, is used to determine performance.Distorting factors for interpretation and comparison purposes include depreciation


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policy, stock revaluations, write-off of intangibles such as goodwill, etc. A further defectis that RoA ignores the time value of money, although this may be of minor concernwhen ination is very low.

RoA may not adequately reect how efciently assets were utilised: in a commercialcontext, taking account of prots but not the assets used in their making, for whateverreason, would overstate a companys performance. In the public sector, the concept ofprot is absent, but it is still not unrealistic to expect organisations to use donated assetswith maximum efciency. If depreciation on such assets were to be charged againstincome, this would depress the amount of surplus income over expenditure. Otherpoints which may affect interpretation of RoA in the public sector are: difculty in determining value; there may be no resale value; are for use by community at large; charge for depreciation may have the effect of double taxation on the taxpayer.

1.5.2 Non-nancial performance indicators Market share. A performance indicator that could conceivably be included in the list of

nancial measures, market share is often seen as an objective for a company in its ownright. However, it must be judged in the context of other measures such as protabilityand shareholder value. Market share, unlike many other measures, can take quality intoaccount it must be assumed that if customers do not get the quality they want or expectthen the company will lose market share.

Gaining market share must be seen as a long-term goal of companies to ensure out-lets for their products and services, and to minimise competition. However, market sharecan be acquired only within limits if a monopoly situation is to be avoided.

It is a measure that is becoming increasingly relevant to the public sector for exam-ple universities and the health service. Health providers must now sell their services totrusts established to buy from them. Those providers which are seen to fail their cus-tomers will lose market share as the trusts will buy from elsewhere (within certain limits).

Customer satisfaction. This can be linked to market share. If customers are not satised theywill take their business elsewhere and the company will lose market share and go into liqui-dation. Measuring customer satisfaction is difcult to do formally, as the inputs andoutputs are not readily dened or measurable. Surveys and questionnaires may be usedbut these methods have known aws, mainly as a result of respondent bias. It can ofcourse be measured indirectly by the level of sales and increase in market share.

The UK Citizens Charter was designed to help customers of public services gain satis-faction, and provided for redress if they do not for example, ticket refunds for the laterunning of trains.

Competitive position. The performance of a business must be compared with that of its com-petitors to establish a strategic perspective. A number of models and frameworks havebeen suggested by organisational theorists as to how competitive position may be deter-mined and improved. A manager needing to make decisions must know by whom, by howmuch, and why he is gaining ground or being beaten by competitors. Conventional meas-ures, such as accounting data, are useful but no one measure is sufcient. Instead, an arrayof measures is needed to establish competitive position. The most difcult problem toovercome in using competitive position as a success factor is in collecting and acquiringdata from competitors.


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The public sector is increasingly in competition with other providers of a similar serviceboth in the private and public sectors. For example, hospitals now have to compete forthe funds of health trusts. Their advantage is that it is easier to gain access to data fromsuch competitors than it is in the private sector.

Risk exposure. Risk can be measured according to nance theory. Some risks for example,exchange-rate risk and interest-rate risk can be managed by the use of hedging mecha-nisms. Shareholders and companies can therefore choose how much risk they wish to beexposed to for a given level of return. However, risk can take many forms, and the theorydoes not deal with risk exposure to matters such as recruitment of senior personnel orcompetitor activity.

Public-sector organisations tend to be risk-averse because of the political repercus-sions of failure and the fact that taxpayers, unlike shareholders, do not have the option toinvest their money in less (or more) risky ventures.

1.6 The three key decisions of nancialmanagement

The practical applications of nancial management can be grouped into three main areasof decisions investment decisions, nancing decisions and dividend decisions whichreect the responibilities of acquiring nancial resources and managing those resources.

1.6.1 Investment decisionsInvestment decisions are those which determine how scarce resources in terms of fundsavailable are committed to projects, which can range from acquisition of plant to the acqui-sition of another entity. Investing in xed assets usually carries the need for supportinginvestment in working capital, for example, stocks and debtors, less creditors, an aspectoften not properly taken into account by management. Investment to enhance internalgrowth is often called internal investment as compared with acquisitions, which representexternal investment.

The other side of the investment coin is disinvestment, which means the preparedness towithdraw from unsuccessful projects, and the disposal of parts of an entity which no longerfit with the parent entitys strategy. Such decisions usually involve one very special element the right timing for the action to be taken.

Disinvestment decisions can also be involved in reconstructions, where an entity has toalter its capital structure, possibly to survive as a result of heavy losses.

1.6.2 Financing decisionsFinancing decisions relate to acquiring the optimum nance to meet nancial objectives andseeing that xed and working capital are effectively managed. The nancial manager mustpossess a good knowledge of the sources of available funds and their respective costs, andshould ensure that the entity has a sound capital structure, that is, a proper balance betweenequity capital and debt. Such managers also need to have a very clear understanding of thedifference between prot and cash ow, bearing in mind that prot is of little avail unlessthe entity is adequately supported by cash to pay for assets and sustain the working capitalcycle. Financing decisions also call for a good knowledge of evaluation of risk: excessive


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debt carries high risk for an entitys equity because of the priority rights of the lenders.A major area for risk-related decisions is in overseas trading, where an entity is vulnerableto currency uctuations, and the manager must be well aware of the various protectiveprocedures such as hedging which are available.

The opportunity cost of nanceIn making nancial decisions, the manager must always be aware of the opportunity cost aspectinvolved. Thus, if a company wishes to raise money by means of an issue of ordinary shares,the terms must be made attractive enough to make it worth while for the investor to forgothe opportunity cost of investing in the next-best investment project. Also if a companywishes to maintain or improve its share price, it must pay satisfactory dividends and showgood long-term growth prospects, otherwise it will lose out because its investors will nd itmore satisfactory to sell out and not forgo the opportunity cost of alternative equities.

In setting a price for anything whether it be for a companys product or services, orthe rate of interest to be paid for borrowings or to receive on loans, or the cost of equitycapital it is important to be fully aware of what the market requires and what the market will bear.

1.6.3 Dividend decisionsDividend decisions relate to the determination of how much and how frequently cash canbe paid out of the prots of an entity as income for its proprietors. The owner of anyprot-making organisation looks for reward for his or her investment in two ways: thegrowth of the capital invested and the cash paid out as income. For a sole trader this incomewould be termed drawings and for a limited liability company the term is dividends.

The dividend decision thus has two elements: the amount to be paid out and the amountto be retained to support the growth of the entity, the latter being also a nancing decision;the level and regular growth of dividends represent a signicant factor in determining a prot-making companys market value, that is, the value placed on its shares by the stock market.

The three types of decision are interrelated, the rst two pertaining to any kind of entity,while the third relates only to prot-making organisations. Thus it can be seen that nan-cial management is of vital importance at every level of business activity, from the soletrader to the largest multinational corporation. It is instructive to think this point throughby taking the case of the sole trader. He (she) has to invest capital in a shop, ttings andequipment and in the purchase of stock and sustaining debtors (working capital); he has tohave sources of capital to nance his investment such as his own capital and bank borrow-ings; and he has to make dividend decisions to determine how much can be reasonably with-drawn from the business to ensure that it will remain sufciently liquid and, if desired,capable of growth.

1.7 Policies for distribution of earningsDividend policy is one of a companys nancing decisions. How should a company divideits earnings between payments to shareholders and retention for future investments if theaim is to increase the market value of the rm?

Using internally generated funds is often thought to be a free form of nance. This isof course not the case, and it is important to remember that these funds do have a cost, thatis, an opportunity cost, normally taken as the weighted average cost of capital.


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In deciding a companys dividend policy the following factors should be considered:

Liquidity. In order to pay dividends, a company will require access to cash. Even veryprotable companies might sometimes have difculty paying dividends if resources aretied up in other forms of asset, especially if bank overdraft facilities are not available.

Repayment of debt. Dividend payout may be made difcult if debt is scheduled for repay-ment and this is not nanced by a further issue of funds.

Restrictive covenants. The Articles of Association may contain agreed restrictions on divi-dends. In addition, some forms of debt may have restrictive covenants limiting theamount of dividend payments or the rate of growth which applies to them.

Rate of expansion. The funds may be needed to avoid overtrading. Stability of prots. Other things being equal, a company with stable prots is more likely to

be able to pay out a higher percentage of earnings than a company with uctuating prots. Control. The use of retained earnings to nance new projects preserves the companys

ownership and control. This can be advantageous in rms where the present dispositionof shareholdings is of importance.

Policy of competitors. Dividend policies of competitors may inuence corporate dividendpolicy. It may be difcult, for example, to reduce a dividend for the sake of further invest-ment, when competitors follow a policy of higher distributions.

Signalling effect. This is the information content of dividends. Dividends are seen as signalsfrom the company to the nancial markets and shareholders. Investors perceive dividendannouncements as signals of future prospects for the company. This aspect of dividendpolicy is assuming increasing importance, and there have been numerous instancesreported in the press where companies have paid an increased dividend when nancialprudence suggests that they should be paying no dividend at all.

Having taken into account the above factors, companies will formulate standard dividendpolicies, three of which are discussed below.

1.7.1 Practical dividend policiesConstant payout ratioThere are important links between dividends and prots. In company law, for instance, theprohibition of paying dividends other than out of prots is seen as an important protec-tion for creditors (including lenders, who may well specify a maximum proportion of protswhich can be declared as dividends while their loans remain in force). This is reinforced bythe accounting concept which denes prot as what you could afford to distribute, and stillbe as well off as you were. Such links encourage a backward-looking approach to dividendpolicy, with some boards of directors publishing an objective to maintain a certain dividendcover, that is, to declare dividends which represent a constant percentage of prots after tax.

In a stable state, one would expect some symmetry in the gures, for example, a com-pany whose prots after tax represented a 10 per cent per annum return might choose toplough half back into the business, and look forward to a 5 per cent per annum growth inits prots (and earnings per share) and hence dividends. This forms the basis of the ideathat the value of a company is a multiple of its past prots. The reality, however, is not oneof a stable state.

One very specic shock to the system has been the instability of the unit of measure(money). Should dividends be related to the prots calculated under the historical cost con-vention, or after making an adjustment to exclude the inationary element? Ought they to be


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inuenced by translation gains and losses (usually taken direct to the reserves gure on thebalance sheet)? Bear in mind that well-offness is measured by reference to the cost ofunconsumed tangible assets. No allowance is made for the intangible assets (such as quality,reputation and pace of innovation) which are so crucial to survival in a rapidly changing envi-ronment. Intriguingly, what the accountant calls an asset, for example, an old-fashioned pieceof plant, can actually be a strategic liability.

Stable policy signallingSome boards of directors think not in terms of maintaining dividend cover, but in terms ofmaintaining a trend in the absolute level of payout. Their starting point for deciding thisyears dividend is what was paid last year, what rate of increase it represented on the previ-ous year, and whether they feel that this rate can be repeated, taking into account considera-tions of liquidity. Rightly or wrongly, the dividend decision is seen as a powerful signal to themarket of the directors condence in the future of the enterprise, and this does appear tobe supported by evidence that unexpected dividend cuts have been followed by a reductionin share prices. The danger, of course, is that this can become a game, in which directors seekto give the signal they think will have the most favourable effect on the share price. Someeven argue that the aim must not be to surprise the market, which leads to the suggestionthat the dividend should be what the analysts are predicting.

In pure economic terms, companies should pay zero div

Documents

CIMA P9 Text - Management Accounting-Financial Strategy