Management Accounting - Financial Strategy

PUBLISHING CIMA'S Official Leorning System Strategic Level Management Accounting - Financial Strategy John Ogilvie ELSEVIER AMSTERDAM BOSTON HEIDELBERG LONDON NEW YORK OXFORD PARIS SAN DIEGO SAN FRANCISCO SINGAPORE SYDNEY TOKYO

Contents The CIMA Learning System xi Acknowledgements How to use your CIMA Learning System Guide to the Icons used within this Text Study technique Management Accounting - Financial Strategy Syllabus Formulae 1 Formulation of Financial Strategy 1 Learning Outcomes 3 1.1 Introduction 3 1.2 Objectives of profit-making entities 4 1.2.1 Financial objectives 4 1.2.2 Stakeholders 5 1.2.3 Non-financial.objectives 6 1.2.4 Agency theory 6 1.2.5 Shareholder value analysis 7 1.3 Objectives of not-for-profit entities 8 1.3.1 Value for money 10 1.4 Public and private - similarities and differences 11 1.5 Assessing attainment offinancialobjectives 11 1.5.1 Financial performance indicators 12 1.5.2 Non-financial performance indicators 13 1.6 The three key decisions offinancialmanagement 14 1.6.1 Investment decisions 14 1.6.2 Financing decisions 14 1.6.3 Dividend decisions 15 1.7 Policies for distribution of earnings 15 1.7.1 Practical dividend policies 16 1.7.2 Theory of dividend irrelevance 18 1.7.3 Scrip dividends 20 1.7.4 Share repurchases 20 1.8 The impact of internal and external constraints on financial strategy 21 1.8.1 Internal constraints 21 1.8.2 External constraints 21 1.9 Government influence 22 1.9.1 Market failure 22 1.10 Developing financial strategy in the context of regulatory requirements 23 1.10.1 Corporate governance 23 1.10.2 Regulatory bodies 24 1.10.3 The impact of regulation on business combinations 26 xi xi xii xiii xv xxi in

iv MANAGEMENT ACCOUNTING - FINANCIAL STRATEGY P9 1.11 Major economic influences 28 1.11.1 Interest rates 28 O 1.11.2 Term structure of interest rates 29 u 1.11.3 Inflation 32 1.11.4 Exchange rates 32 1.12 Modelling and forecasting cashflowsandfinancialstatements 33 1.12.1 Forecasting cash flows 33 1.12.2 Forecasting financial statements 34 1.12.3 Sensitivity analysis 40 1.13 Current and emerging issues in financial.reporting 40 1.13.1 IFRS 1firsttime adoption of IFRS 41 1.13.2 IFRS 2 share-based payment 41 1.13.3 Reporting environmental issues 43 1.13.4 Reporting of social issues 44 1.13.5 Inclusion of forecasts in the annual report 46 1.13.6 Reporting of human capital 47 1.14 Summary 47 Readings 49 Revision Questions 53 Solutions to Revision Questions 55 2 Financial Management 6i Learning Outcomes 63 2.1 Introduction 63 2.2 Thefinancefunction 63 2.2.1 Financial control 64 2.2.2 Evaluating key success factors in the management of the finance function 64 2.2.3 Relationships with stakeholders 65 2.2.4 Outsourcing and shared service centres 65 2.3 The treasury function 66 2.3.1 The role of the treasury function 66 2.3.2 Cost centre or profit centre 67 2.3.3 Advantages of a specialised central treasury function 68 2.4 Financial markets 68 2.4.1 Money market 68 2.4.2 Capital or securities market 69 2.4.3 The foreign exchange market 69 2.4.4 Derivatives markets 69 2.5 Share price volatility 70 2.5.1 Technical analysis or chartism 70 2.5.2 Fundamental analysis 70 2.5.3 Random Walk theory 70 2.6 The efficient market hypothesis 71 2.6.1 Weak form 71 2.6.2 Semi-strong form 71

MANAGEMENT ACCOUNTING - FINANCIAL STRATEGY v 2.6.3 Strong form 72 Q 2.6.4 Implications of EMH forfinancialmanagers 72 Z 2.7 Investor ratios 73 Z 2.7.1 Market price per share 73 2.7.2 Earnings per share 73 2.7.3 The price/earnings ratio 74 2.7.4 Earnings yield 74 2.7.5 Dividend-payout rate 74 2.7.6 Dividend yield 75 2.7.7 Dividend cover 75 2.7.8 Book value per share 76 2.8 Working capital management strategies 11 2.8.1 The investment decision 77 2.8.2 Thefinancingdecision 78 2.8.3 Liquidity ratios 79 2.8.4 The operating cycle 80 2.9 Overtrading 82 2.9.1 Symptoms of overtrading 83 2.9.2 Preventing overtrading 83 2.10 Multinational working capital management 84 2.11 Summary 84 Revision Questions 85 Solutions to Revision Questions 87 3 Sources of Long-term Finance 93 Learning Outcome 95 3.1 Introduction 95 3.2 Shareholders' funds 95 3.2.1 Ordinary shares 95 3.2.2 Preference shares 96 3.2.3 Reserves 97 3.3 Raising share capital 97 3.3.1 Stock market listing 97 3.3.2 Methods of obtaining a flotation 98 3.3.3 Rights issues 99 3.3.4 Bonus issues 105 3.3.5 Share splits 105 3.4 Debt finance 105 3.4.1 Bonds 105 3.4.2 Debt yields 106 3.4.3 Convertible bonds 108 3.4.4 Warrants 110 3.5 Medium-term financing 110 3.5.1 Term loans 110 3.5.2 Mezzanine finance 111 3.5.3 The lender's assessment of creditworthiness 111

vi MANAGEMENT ACCOUNTING - FINANCIAL STRATEGY P9 3.5.4 Leasing 112 \±± 3.5.5 Lease-or-buy decisions 113 3.5.6 Factoring 120 u 3.6 Financing of small profit-making entities 122 3.6.1 Venture capital 123 3.6.2 Business 'angels' 124 3.6.3 Government assistance 124 3.7 Summary 125 Readings 127 Revision Questions 131 Solutions to Revision Questions 137 4 Capital Structure and Cost of Capital 147 Learning Outcomes 149 4.1 Introduction 149 4.2 Gearing 150 4.2.1 Measuring gearing 150 4.2.2 Classification of debt and equity 152 4.2.3 Interest cover 154 4.2.4 Leverage 155 4.3 Cost of capital 155 4.3.1 Cost of equity 156 4.3.2 Cost of debt 160 4.3.3 Cost of preference shares 162 4.4 Weighted average cost of capital 163 4.4.1 Assumptions in the use of WACC 164 4.5 Marginal cost of capital 165 4.6 The traditional theory of gearing 166 4.7 Modigliani and Miller's theories of gearing 168 4.7.1 Limitations of MM theory 172 4.8 Cost of capital and adjusted cost of capital 173 4.8.1 Adj usted present value 173 4.8.2 Adjusted cost of capital-modigliani and Miller 175 4.9 Risk and reward 175 4.10 Portfolio theory 177 4.10.1 Systematic risk and unsystematic risk 180 4.11 The capital asset pricing model 181 4.11.1 Measuring beta values 182 4.11.2 The security market line 184 4.12 Using the CAPM as an investment tool 185 4.13 MM, CAPM and geared betas 187 4.13.1 Ungearing Beta 187 4.13.2 Geared equity beta 189 4.14 Use of CAPM in investment appraisal 190 4.14.1 Limitations of CAPM 191 4.15 Arbitrage pricing model 191 4.16 Summary 192 Revision Questions 195 Solutions to Revision Questions 201

MANAGEMENT ACCOUNTING - FINANCIAL STRATEGY vii Business Valuations 213 8 Learning Outcomes 215 ppj 5.1 Introduction 215? 5.2 Asset-based valuations 215 5.2.1 Choice of valuation base 216 5.2.2 The strengths and weaknesses of asset-based valuations 217 5.3 Earnings-based valuations 217 5.3.1 P/E ratio valuation 217 5.3.2 Earnings yield valuation 218 5.3.3 The strengths and weaknesses of earnings-based valuations 219 5.4 Dividend-based valuations 219 5.4.1 Dividend yield 219 5.4.2 Dividend growth model 220 5.4.3 Uneven growth rates 220 5.4.4 The strengths and weaknesses of dividend-based valuations 221 5.4.5 Capital asset pricing model 221 5.5 Cash-based valuations 222 5.5.1 Discounted cash flow 222 5.5.2 Free cash flow 223 5.5.3 Shareholder value analysis 223 5.5.4 Economic Value Added (EVA) 225 5.5.5 The strengths and weaknesses of cash-based valuations 225 5.5.6 Valuation of new economy entities 225 5.6 Business valuations and efficient markets 226 5.7 Intellectual capital, 227 5.7.1 Forms of intellectual capital 227 5.7.2 The components of intellectual capital 228 5.7.3 Valuing intellectual capital 231 5.7.4 Comparative indicators 232 5.8 Example - estimating flotation value 235 5.9 The impact of changing capital structure 238 5.10 Recognition of the interests of different stakeholder groups in company valuations 238 5.10.1 Liquidation 238 5.10.2 Re-financing 238 5.10.3 Mergers and acquisitions 239 5.11 Summary 239 Reference 239 Revision Questions 241 Solutions to Revision Questions 245 Mergers, Acquisitions and Buyouts 253 Learning Outcomes 255 6.1 Introduction 255 6.2 Terminology and types of merger 255 6.2.1 Terminology 255 6.2.2 Types of merger 256

viii MANAGEMENT ACCOUNTING - FINANCIAL STRATEGY P9 I O 6.3 The reasons for merger or acquisition 6.4 Defences against takeover 6.4.1 Before the bid 6.4.2 After the bid 6.5 Methods of payment for an acquisition 6.5.1 Cash 6.5.2 Share exchange 6.5.3 Other types of finance 6.5.4 Earn-out arrangements 6.6 The post-merger or post-acquisition integration process 6.6.1 Druker's Golden Rules 6.6.2 Post-acquisition value enhancement strategies 6.6.3 Impact on ratios or performance measures 6.6.4 Acquirer's post-acquisition share price 6.6.5 Example: Impact on stakeholders 6.6.6 Reasons why mergers and acquisitions fail 6.7 Exit strategies 6.7.1 Sell-off 6.7.2 Spin-off 6.8 Management buyouts 6.8.1 Financing MBOs 6.8.2 Evaluation by investors and financiers 6.9 Reconstruction 6.9.1 Effect on the share price of a listed entity 6.10 Summary, Readings Revision Questions Solutions to Revision Questions Investment Appraisal Techniques Learning Outcomes 7.1 Introduction 7.2 Accounting rate of return 7.3 Payback 7.3.1 Discounted payback 7.4 Discounting techniques 7.4.1 Net present value 7.4.2 Internal rate of return 7.4.3 Modified internal rate of return 7.4.4 Discussion of techniques 7.5 Capital rationing 7.5.1 Single-period capital rationing 7.5.2 Single-period rationing with mutually exclusive projects 7.5.3 Single-period rationing with indivisible projects 7.6 Annual equivalent cost 7.6.1 Asset replacement cycles 7.7 Summary 256 257 257 258 258 258 259 260 260 261 261 261 262 263 264 270 271 271. 271 272 272 273 274 275 275 277 281 289 299 301 301 302 304 305 305 305 306 309 310 311 312 313 314 314 316 317

MANAGEMENT ACCOUNTING - FINANCIAL STRATEGY ix Revision Questions 319 Q Solutions to Revision Questions 321 5 z 8 Advanced Investment Appraisal Techniques 325 Learning Outcomes 327 8.1 Introduction 327 8.2 Identification of a project's relevant costs and benefits 327 8.3 Taxation 328 8.3.1 Depreciation and tax depreciation allowances 329 8.4 Inflation 329 8.5 Working capital 332 8.6 Linking investments with customer requirements and product/ service design 335 8.6.1 Reasons for developing new products or services 335 8.7 Linking investment in IS/IT with strategic, operational and control needs 335 8.7.1 Benefits of a formal strategy 336 8.7.2 IS, IT and IM strategy 336 8.7.3 Content of information systems strategy 336 8.7.4 Cost-benefit analysis 337 8.7.5 Evaluating system performance 339 8.8 Adjusting for risk 340 8.8.1 Sensitivity analysis 340 8.8.2 Decision trees 343 8.8.3 Certainty equivalents 344 8.8.4 Non-constant discount rate 345 8.8.5 Risk-adjusted discount rate 345 8.8.6 Capital asset pricing model 346 8.9 Evaluating and reporting investment opportunities 347 8.10 Adjusted present value 349 8.10.1 Side-effects of financing 350 8.10.2 Advantages and disadvantages of APV 352 8.11 Assessing investments as options on future cash flows 352 8.11.1 The abandonment option 353 8.11.2 Timing options 356 8.11.3 Strategic investment options 356 8.11.4 Valuing options 357 8.12 Project implementation and control 357 8.12.1 The investment cycle 357 8.12.2 Post-completion auditing 358 8.12.3 Benefits of post-completion auditing 359 8.12.4 Limitations of post-completion auditing 360 8.12.5 Organisation of PCA 360 8.12.6 Role of post-appraisal in project abandonment 360 8.13 Summary 361 Revision Questions 363 Solutions to Revision Questions 371

MANAGEMENT ACCOUNTING - FINANCIAL STRATEGY P9 9 Financing and Appraisal of International Investments 383 Learning Outcomes 385 9.1 Introduction 385 9.2 Finance for international investments 385 9.2.1 Subsidiary 386 9.2.2 Joint venture 387 9.2.3 Risk 387 9.3 The effect of restrictions on remittances 388 9.4 The Euromarkets 388 9.4.1 Eurocurrency markets 389 9.4.2 Eurobonds 389 9.5 The effect of taxation 389 9.5.1 Double taxation relief 390 9.6 Evaluating international investments 390 9.6.1 Interest rate parity (IRP) 394 9.7 APV method 395 9.8 Summary 396 Revision Questions 397 Solutions to Revision Questions 401 Preparing for the Examination 409 Revision technique 411 Planning 411 Getting down to work 412 Tips for the final revision phase 412 Format of the examination 412 Structure of the paper 412 Types of question 413 Allocation of time 413 Weighting of subjects 414 Case-study Questions 417 Solutions to Case-study Questions 453 Scenario Questions 525 Solutions to Scenario Questions 577 November 2007 Examinations 699 Index 737