APC308 financial management

Financial Management The University of Sunderland © 2012 The University of Sunderland First published in 2007 Revised in 2012 by Dr Michael Bromberg All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without permission of the copyright owner While every effort has been made to ensure that references to websites are correct at time of going to press, the world wide web is a constantly changing environment and the University of Sunderland cannot accept any responsibility for any changes to addresses The University of Sunderland acknowledges product, service and company names referred to in this publication, many of which are trade names, service marks, trademarks or registered trademarks All materials internally quality assessed by the University of Sunderland and reviewed by academics external to the University Instructional design and publishing project management by Wordhouse Ltd, Reading, UK Index prepared by Indexing Specialists (UK) Ltd, Hove, UK Contents Introduction vii Unit vii Unit Unit Copyright © 2012 University of Sunderland The nature of financial management Introduction 1.1 The main areas of financial management 1.2 Corporate objectives 1.3 Agency theory: ownership and control 10 1.4 Addressing the agency problem 14 Case Study 18 Self-assessment questions 19 Feedback on self-assessment questions 20 Summary 21 Working capital mangement 22 Introduction 22 2.1 Working capital ratios 23 2.2 Managing accounts receivable and payable 34 2.3 Predicting corporate failure 38 Case Study 40 Self-assessment questions 41 Feedback on self-assessment questions 42 Summary 43 Budgeting 44 Introduction 44 3.1 The purpose of budgets and the importance of budgeting 47 3.2 The behavioural aspects of budgeting 50 3.3 The main types of budgetary control systems 55 3.4 The need for a budget 58 3.5 Conventional budgets and ‘beyond budgeting’ techniques 60 Case Study 60 Self-assessment questions 62 Feedback on self-assessment questions 63 Summary 65 iii Unit Unit Unit iv Marketing efficiency 66 Introduction 66 4.1 The role of the capital markets 67 4.2 The efficient market hypothesis 69 4.3 Forms of market efficiency 73 4.4 Implications for managers and investors 83 Case Study 86 Self-assessment questions 86 Feedback on self-assessment questions 87 Summary 88 Investment appraisal 89 Introduction 89 5.1 The main techniques of investment appraisal 90 5.2 Deciding between investments if capital is rationed 116 5.3 Finding the real rate of return on an investment 119 5.4 The effect of taxation on investments 120 5.5 Why the NPV method of appraisal is preferable 124 Case Study 124 Self-assessment questions 125 Feedback on self-assessment questions 126 Summary 129 Appendix 131 Financial risk 135 Introduction 135 6.1 The financial concept of risk 136 6.2 Measuring risk 141 6.3 Portfolio theory 145 6.4 The capital asset pricing model and the beta value 163 6.5 Using the capital asset pricing model 167 Case Study 169 Self-assessment questions 170 Feedback on self-assessment questions 172 Summary 175 Copyright © 2012 University of Sunderland Unit Sources of capital 176 Introduction Unit Unit Copyright © 2012 University of Sunderland 7.1 Factors that influence the financing decision 177 7.2 The distinction between equity and debt finance 180 7.3 Raising new equity and debt finance 182 7.4 Rights issues 183 7.5 Comparing different kinds of finance 191 Case Study 198 Self-assessment questions 198 Feedback on self-assessment questions 200 Summary 203 Appendix 203 Cost of capital 209 Introduction 209 8.1 The cost of capital 210 8.2 Calculating the costs of sources of finance 212 8.3 The weighted average cost of capital 219 8.4 WACC and CAPM compared 224 Case Study 226 Self-assessment questions 227 Feedback on self-assessment questions 227 Summary 230 Gearing ratios and shareholders 231 Introduction 231 9.1 Capital gearing 232 9.2 The problems with high gearing 237 9.3 The capital structure debate 238 9.4 Can a company influence the cost of capital? 247 9.5 The effects of gearing 247 Case Study 260 Self-assessment questions 261 Feedback on self-assessment questions 262 Summary 264 v Unit 10 The dividend decision vi 266 Introduction 266 10.1 Practical aspects of the dividend decision 267 10.2 The traditional view: dividends are relevant 269 10.3 MM’s theory: dividends are irrelevant 274 10.4 Other theories of dividend policy 279 10.5 Alternatives to cash dividends 282 Case Study 284 Self-assessment questions 285 Feedback on self-assessment questions 286 Summary 287 References 289 Index 293 Copyright © 2012 University of Sunderland Introduction Welcome to the Financial Management learning pack! It has been designed to assist you in studying for the core module of the BA (Hons) in Accounting and Financial Management degree and covers all topics in the official module descriptor However good the business model, in a world where the average survival time for small company is less than four years (http://www.msnbc.msn.com/id/ 16872553/), the key to long run success is to get the finance right Two financial questions are critical for corporate success: ‘does our product generate sufficient profit?’ and ‘are we producing sufficient returns to satisfy those who provide our finance?’ The first of these questions is the province of management accounting; this learning pack addresses the second The learning pack explains where companies acquire finance: from debt, equity or their own internal resources; it also explains the calculations necessary to assign a level of risk – and therefore a cost – to each of these sources External financing requires a market; the learning pack explains the basic operation of financial markets Spending the money raised is also important: one unit delineates the basics of strategic planning and budgeting, another the optimal way of choosing between different investment options The whole pack relies on a series of basic financial models that were developed throughout the twentieth century These models rely critically on a series of assumptions about the financial world It is evident from recent financial crises that finance theory is a work in progress, not the finished product After studying the learning pack you should begin to understand the difference between the perfect world of financial theory and the real world in which all businesses operate By the end of the pack you will be in possession of all the tools necessary to understand how business finance operates – but the theory is only a start Combining this theory with practical experience and your own ability will determine how successful you will be in your future career whether it be in the private, public or not-for-profit sector How to use this pack The learning pack will take you step by step in a series of carefully planned units and provides you with learning activities and self-assessment questions to help you master the subject matter The pack should help you organise and carry out your studies in a methodical, logical and effective way, but if you have your own study preferences you will find it a flexible resource too Before you begin using this learning pack, make sure you are familiar with any advice provided by the University of Sunderland on such things as study skills, revision techniques or support and how to handle formal assessments If you are on a taught course, it will be up to your tutor to explain how to use the pack in conjunction with a programme of face-to-face workshops and Copyright © 2012 University of Sunderland vii seminars – when to read the units, when to tackle the activities and questions, and so on If you are on a self-study course, or studying independently with remote tutor support, you can use the learning pack in the following way: ■ Scan the whole pack to get a feel for the nature and content of the subject matter ■ Plan your overall study schedule so that you allow enough time to complete all units well before your examinations – in other words, leaving plenty of time for revision ■ For each unit, set aside enough time for reading the text, tackling all the learning activities and self-assessment questions and for the suggested further reading Your tutor will advise on how they will plan activities around these materials and opportunities to network with other students Now let’s take a look at the structure and content of the individual units Overview of the units The learning pack breaks the content down into ten units, which vary from approximately eight to ten hours’ duration each However, we are not advising you to study for this sort of time without a break! The units are simply a convenient way of breaking the syllabus into manageable chunks Most people would try to study one unit a week, taking several breaks within each unit You will quickly find out what suits you best You will see that each unit is divided into sections It is assumed, for the most part, that you will study the units in the order presented What is more important is that you try to study each section of each unit in the order presented Each unit is written on the strict assumption that you will understand the material in each section before moving to the next Each unit begins with a brief introduction which sets out the areas of the syllabus being covered and explains, if necessary, how the unit fits in with the topics that come before and after After the introduction there is a statement of the unit learning objectives The objectives are designed to help you understand exactly what you should be able to after you’ve studied the unit You might find it helpful to tick them off as you progress through the unit You will also find them useful during revision There is one unit learning objective for each numbered section of the unit Following this, there are prior knowledge and resources sections These will let you know if there are any topics you need to be familiar with before tackling each particular unit, or any special resources you might need, such as calculator, graph paper or specific books Then the main part of the unit begins, with the first of the numbered main sections At regular intervals in each unit, we have provided you with learning activities, which are designed to get you actively involved in the learning process You should always try to complete the activities before reading on viii Copyright © 2012 University of Sunderland You will learn much more effectively if you are actively involved in doing something as you study, rather than just passively reading the text in front of you The feedback or answers to the activities are provided immediately following the activity Do not be tempted to skip the activity Throughout the unit key terms are highlighted in bold with the definition appearing in the margin Each unit contains recommended reading which also appears in the margin and which refers you to relevant chapters of supporting textbooks including the core textbook It is essential that you this reading, since it is not possible to put everything you need to know in a single learning pack At level of a degree wider reading is key to developing deeper subject learning through a contemporary, contextual and critical perspective This is important to consider when approaching the related assessment of the module We provide a number of self-assessment questions at the end of each unit These are to help you to decide for yourself whether or not you have achieved the learning objectives set out at the beginning of the unit As with the activities, you should always tackle them The feedback or answers follow immediately after at the end of the unit If you still not understand a topic having attempted the self-assessment question, always try to re-read the relevant passages in the textbook readings or unit, or follow the advice on further reading given Your allocated tutor will be available to deal with questions arising from the material and will assist your study through the unit At the end of the unit is the summary Use it to remind yourself or check off what you have just studied, or later on during revision Finally, where possible, we have made reference to material on the internet since this is easy to access You may find that addresses change This is annoying; but with a bit of effort you will be able to track the material down (nothing disappears completely from the web) And by searching you will learn even more! Good luck and enjoy it Core textbooks The essential text is: Corporate Finance: Principles and Practice (5th edition, 2010) by Denzil Watson and Antony Head, published by FT Prentice Hall This book is well structured and both readable and informative: it covers the main topics of the course with a good level of detail The mathematical underpinning is sufficient for the course but not so technical as to frighten even the student most fearful of numbers and equations The book contains lots of case studies and extra information supporting the text contained in these units and – if studied carefully – will certainly lead to success in the module The book is strong in most areas covered by the module and provides lots of extra references that can be consulted by the student who wants to go further than the base material It does not contain a chapter on budgeting so extra references are suggested in the text for students looking for support in this area Copyright © 2012 University of Sunderland ix Acknowledgements We are grateful to Telegraph Media Group Limited for permission to reproduce copyright material for the case study in Unit In some instances we have been unable to trace the owners of what might be copyright material and we would appreciate any information that would enable us to so x Copyright © 2012 University of Sunderland Financial Management The alternative view, represented by Modigliani and Miller, is that the pattern of dividend payments does not affect shareholder wealth The determinant of share value and shareholder wealth is the availability of investment projects with a positive net present value Shareholders can make their own dividends by selling shares or can reinvest unwanted dividends In a sense, shareholders determine dividend policy But this theory is weakened by the assumption of a perfect market with no taxation, issue costs or transaction costs Dividends may have implications other than for share value: they have an informational content, signalling management confidence in the company; they may attract a particular category of investor to the company (the clientele effect); and they connect with agency theory 288 Copyright © 2012 University of Sunderland References Primary reference Watson, D and A Head (2010) Corporate Finance: Principles and Practice, 5th edition Harlow: Pearson Education Secondary references Unit 3: Watson and Head (2010) doesn’t have a chapter on budgeting but you could try the chapter on budgeting in the latest edition (the 6th at the time of writing) of Atrill, P and E McLaney (2009) Management Accounting for Decision Makers Harlow: Pearson Education Unit 4: Stern, JM and D Chew Jr (2003) The Revolution in Corporate Finance Oxford: Blackwell Publishing; the first section of this book provides some interesting articles on efficient markets References from the text Altman, EI (1968) ‘Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy’, The Journal of Finance, 23, 4, 589–609 Altman, EI (2000) Predicting Financial Distress of Companies: Revisiting the Z-score and Zeta Models Stern School of Business, New York University Argyris, C (1953) ‘Human Problems with Budgets’, Harvard Business Review, 31, 1, 97–110 Ariely, D, U Gneezy and G Loewenstein (2009) ‘Large Stakes and Big Mistakes’, Review of Economic Studies, 76, 451–69 Arnold, G (2005) Corporate Financial Management, 3rd edition London: Financial Times Management Atrill, P (1997) Financial Management for Non Specialists Hemel Hempstead: Prentice Hall Baker, HK, DE Farrelly and RB Edelman (1985) ‘A Survey of Management Views on Dividend Policy’, Financial Management, 14, 3, 78–84 Ball, R and P Brown (1968) ‘An Empirical Evaluation of Accounting Income Numbers’, Journal of Accounting Research, autumn, 159–78 Beaver, W (1967) ‘Financial Ratios as Predictors of Failure, Empirical Research in Accounting: Selected Studies’, Supplement, Journal of Accounting Research, 5, 71–127 Black, F (1986) ‘Noise’, The Journal of Finance, 12, 3, 529–43 Brownell, P (1980) Participation in Budgeting, Locus of Control and Organizational Effectiveness: A Field Extension Cambridge, Mass.: Alfred P Sloan School of Management, Massachusetts Institute of Technology CIMA (2009) Management Accounting Tools for Today and Tomorrow London: CIMA Cyert, R and J March (1963) Behavioural Theory of the Firm Oxford: Blackwell Copyright © 2012 University of Sunderland 289 References Dann, L, D Mayers and R Raab (1977) ‘Trading Rules, Large Blocks and the Speed of Price Adjustment’, Journal of Financial Economics, 4, 1, 3–27 Dean, J (1954) ‘Measuring the Productivity of Capital’, Harvard Business Review, Jan–Feb Donaldson, G (1961) Corporate Debt Capacity Harvard University Press Fama, EF (1965) ‘The Behaviour of Stock Market Prices’, Journal of Business, January Fama, EF, L Fisher, M Jensen and R Roll (1969) ‘The Adjustment of Stock Prices to New Information’, International Economic Review, 10, 121 Fernandez, P and J del C Baonza (2010) Market Risk Premium Used in 2010 by Analysts and Companies: A survey with 2,400 answers Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1609563 Forrester, JW (1961) Industrial Dynamics Cambridge, Mass.: MIT Press Francke, L (2003) Interview with Lennart Francke: Managing without budgets at Svenska Handelsbanken Available at http://www.juergendaum.com/news/ 02_24_2003.htm Friedman, M (1970) ‘The Social Responsibility of Business is to Increase its Profits’, New York Magazine, 30 September Goetzmann, WN and RG Ibbotson (2005) History and the Equity Risk Premium Available at http://www.econ.ucsb.edu/conferences/equity05/papers/ Goetzmann.pdf Gordon, M (1959) ‘Dividends, Earnings and Stock Prices’, Review of Economics and Statistics, 41, 99–105 Hayek, F (1960) ‘The Corporation in a Democratic Society – In whose interest ought it and should it be run?’ in M Asher and C Bach (eds) Management and Corporations New York: McGraw Hill Hermes (2010) The Hermes Responsible Ownership Principles London: Hermes Hofstede, Geert H (1968) The Game of Budget Control How to Live with Budgetary Standards and Yet Be Motivated By Them Assen: Van Gorcum and Comp Hope, J and R Fraser (2003a) ‘Who Needs Budgets?’, Harvard Business Review, 81, 2, 108–115 Hope, J and R Fraser (2003b) Beyond Budgeting: How managers can break free from the annual performance trap Cambridge, Mass.: Harvard Business School Publishing Corporation Hopwood, AG (1972) ‘An Empirical Study of the Role of Accounting Data in Performance Evaluation’, Journal of Accounting Research, 10, 156–82 Hopwood, AG (1976) Accounting and Human Behaviour Eaglewood Cliffs, New Jersey: Prentice Hall Howells, P and K Bain (2008) Financial Markets and Institutions London: Pearson Education http://www-03.ibm.com/press/us/en/pressrelease/34366.wss 290 Copyright © 2012 University of Sunderland References http://group.barclays.com http://www.bbrt.org/beyond-budgeting/bb-principles.html http://www.bp.com http://www.hermes.co.uk http://www.ons.gov.uk/ons/dcp171778_235461.pdf http://www.tescoplc.com Hurley, J (2011) ‘Stick with the Small Guys to Savour Organic Growth’, The Telegraph, 20 September Ibbotson, RG and RA Sinquefield (1976) ‘Stocks, Bonds, Bills and Inflation: Simulations of the future 1976–2000’, Journal of Business, 49, 1, 11–47 Imoisili, OA (1989) ‘The Role of Budget Data in the Evaluation of Managerial Performance’, Accounting, Organizations and Society, 14, 4, 325–35 Jensen, MC and WH Meckling (1976) ‘Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure’, Journal of Financial Economics, 3, 4, 305–60 Kaplan, R and R Roll (1972) ‘Investor Evaluation of Accounting Information: Some empirical evidence’, Journal of Business, 43, 225–57 Kendall, R (1953) ‘The Analysis of Economic Time Series’, Journal of the Royal Statistical Society, 69, 1, 1129 Keown, A and J Pinkerton (1981) ‘Merger Announcements and Insider Trading Activity’, Journal of Finance, September, 855–70 Keynes, JM (1936) General Theory of Employment, Interest and Money Cambridge: Macmillan Cambridge University Press Lintner, J (1956) ‘Distribution of Incomes of Corporations Among Dividends, Retained Earnings and Taxes’, American Economic Review, 46, 97–113 Malkiel, Burton G (1973) A Random Walk Down Wall Street New York: WW Norton & Co Malkiel, Burton G (2005) ‘Reflections on the Efficient Market Hypothesis: 30 years later’, Financial Review, 40, 1–9 Markowitz, H (1952) ‘Portfolio Selection’, Journal of Finance, 7, 13–37 McGregor, D (1957) ‘The Human Side of Enterprise’, The Management Review, 46, 11, 22–8 McKinsey Global Institute (2010) Farewell to Cheap Capital? The implications of long-term shifts in global investment and saving Available at http://www.mckinsey.com/Insights/MGI/Research/Financial_Markets/Farewell_ cheap_capital Merchant, KA and J-F Manzoni (1989) ‘The Achievability of Budget Targets in Profit Centers: A field study’, The Accounting Review, 64, 3, 539–58 Miller, M and F Modigliani (1958) ‘The Cost of Capital, Corporation Finance and the Theory of Investment’, American Economic Review, 48, 261–96 Miller, M and F Modigliani (1961) ‘Dividend Policy, Growth and the Valuation of Shares’, Journal of Business, 34, 411–33 Copyright © 2012 University of Sunderland 291 References Miller, M and F Modigliani (1963) ‘Taxes and the Cost of Capital: A correction’, American Economic Review, 53, 433–43 Miller, M (1977) ‘Debt and Taxes’, Journal of Finance, 32, 261–75 Mishkin, FS (2007) Monetary Policy Strategy Cambridge, Mass: MIT Press Myers, Stewart C (1984) Capital Structure Puzzle NBER Working Paper Series, w1393 Available at http://ssrn.com/abstract=227147 Otley, DT (1987) Accounting Control and Organisational Behaviour London: Heinemann Porterfield, J (1965) Investment Decisions and Capital Costs New Jersey: Prentice Hall Roberts, H (1959) ‘Stock-Market “Patterns” and Financial Analysis’, The Journal of Finance, 14, 1, 1–10 Ryan, PA and GP Ryan (2002) ‘Capital Budgeting Practices of the Fortune 1000: How have things changed?’, Journal of Business and Management, 8, 4, winter Scarlett, R (1995) ‘Further Aspects of the Impact of Taxation on the Viability of Investment’, Management Accounting, May, 54 Simon, HA (1957) Models of Man: Social and Rational New York: Wiley Slater, J (1998) Beyond the Zulu Principle Orion Business Smith, T (1992) Accounting for Growth Century Business 292 Copyright © 2012 University of Sunderland Index Index 2007-08 financial crisis 30, 255 abnormal returns 71 Abramovich, Roman 135 accounting policies 80, 85 accounting rate of return (ARR) 94–97 accounts payable cash collection 24 days 27–29, 33 management of 34–38 accounts receivable cash collection 24 days 26–27, 33 management of 34–38 acid ratios 25–26 activity-based budgeting 56 administrative controls 49 age debt analysis 36–37 agency costs 259 agency problem 14–18 agency theory 10–13, 281 AIM (Alternative Investment Market) 284–285 allocational efficiency 70 Alternative Investment Market (AIM) 284–285 Altman model 38–39 analysts 79, 82 announcements of earnings 80 annuities 100 arbitrage 78 arbitrageurs 78 Argyris, Christopher 44 ARR (accounting rate of return) 94–97 asset replacement 113–115 asset values 232 Atlantic Power 198 bank finance 193–197, 208, 255 bank lending 255 bank overdrafts 194, 208 bankruptcy cause 24 gearing 253–254 prediction model 38–39 Barclays Bank plc 18–19 beating the market 71 behavioural issues, budgeting 50–55 Copyright © 2012 University of Sunderland beta risk 164, 165–167 beta value 255–257 ‘beyond budgeting’ techniques 60–62 board of directors 11 see also directors bonding cost 14 bonds 193, 205–206, 224 bonus issues 186–188 book values 232 booms and crashes 81–82 borrowing cost 226 see also capital costs bottom-up budgeting 46 bounded rationality 54 BP Group corporate objectives 18 ‘Z’-score calculation 39–40 bubble phenomenon 81–82 budget-constrained managers 52–53 budgeting/budgets 44–65 activity-based budgeting 56 behavioural aspects 50–55 ‘beyond budgeting’ techniques 60–62 bottom-up budgeting 46 budget period 53 case study 60–62 communication 47–48 control 48–49, 55–58 conventional budgets 60–62 coordination 49–50 definition 44 evaluation 50 expectations budgets 52 feedback loop 48–49 fixed budgets 55 flexed budgets 55 Handelsbanken case study 60–62 human relations problems 51 importance 47–50 incremental budgets 52 management issues 51 master budgets 46 motivation 51–53 need for 58–59 negotiated budgets 46 organisational slack 54–55 participation 53–54 period 53 293 Financial Management planning process 45 principal budget factor 46 purpose of 47–50 rolling budgets 57 slack 54–55 static budgets 55 top-down budgeting 46 types 46 zero-based budgets 58 Buffett, Warren buyouts 232 capital asset pricing model (CAPM) beta value 163–165 gearing 255–257 investment returns 167–169 and weighted average cost of capital 220, 221, 222, 224–225 capital costs 209–230 capital asset pricing model 220, 221, 222, 224–225 capital structure 247 case study 226 debt 216–218, 242–246 demand for capital 226 discount rate 210–211 equity finance 212–214 preference shares 214–216 retained profits 218 risk 224, 225 weighted average cost of capital 211, 219–225 capital gearing 232–237 capital investment projects 90–91 capital market line 163 capital markets 67–69 efficient market hypothesis 72 primary markets 68 secondary markets 68–69 capital, raising 31 capital sources 176–208 bank finance 193–197, 208 bonds 205–206 bonus issues 186–188 case study 198 convertible loan stock 206 debentures 205–206 debt finance 180–183, 189–190 decision-making 177–180, 191–198 equity finance 180–183, 204–205 Eurobonds 206 external funding 181, 203–208 294 finance choice 177–180, 191–198 grant finance 207 internal funding 180–181, 204, 208 leasing 193–197, 207 loans 205–206, 208 long-term finance 178–180, 191–193, 203–204 matching of funds 178–180 preference shares 205 retained profits 181, 208 rights issues 182, 183–190 scrip issues 186–188 share issues 191–193 short-term finance 178–180, 204 stock split 186–188 capital structure agency costs 259 capital costs 17, 247 case study 260 ‘clientele’ effect 257–258 definition information asymmetry 258 MM theory 247–255 ‘pecking order’ theory 257 signalling 258 taxation 252–254 traditional view 238–246, 254–255 CAPM see capital asset pricing model case studies Alternative Investment Market 284–285 Atlantic Power 198 borrowing costs 226 budgeting 60–62 capital costs 226 capital sources 198 capital structure 260 corporate objectives 18–19 dividend decision 284–285 dot.com companies 86 gearing 260 HaiKe Chemical Group Ltd 284–285 Handelsbanken 60–62 net present value 124 Premier Foods 260 risk and return 169–170 sources of capital 198 What on Earth 40–41 cash collection 24, 34–35, 36 cash flows 119–120, 247 see also working capital cycle chartist investors 75–77 Copyright © 2012 University of Sunderland Index ‘clientele’ effect capital structure 257–258 dividend policy 280–281 coefficient of correlation, risk 151–153 combination returns 154–158 communication budgets 47–48 corporate governance 15–16 companies capital costs 247 capital structure 17 cash collection 34–35, 36 communication 15–16 corporate culture 16 credit policies 35–36 factoring 34–35 hierarchy 10–11 limited companies 10–11 ownership and control 10–13 position statements 277–278 rational companies 211 risk management 16 transparency 15–16 contingency theory 53 conventional budgets 60–62 convertible loan stock 206 corporate culture 16 corporate failure prediction 38–40 see also bankruptcy corporate finance see capital sources corporate governance 15–18 corporate investment 90 corporate objectives 5–10, 18–19 correlation coefficient, risk 151–153 costs bankruptcy 253–254 incremental costs 111 labour 31 sunk costs 110 see also capital costs coupon interest rate 188 crashes 81–82 credit policies 35–36 crisis of 2007–08 30, 255 cum rights price 184 cumulative net present value, tables 133–134 current ratios 25–26 customer accounts, analysis of 36 de Polla, Rolf 40–41 dealers 68 Copyright © 2012 University of Sunderland debentures 3, 205–206 debt analysis 36–37 debt, cost of 216–218, 242–246 see also capital costs debt finance 180–183, 189–190 demand for capital 226 depreciation 24 directors 11, 13, 258, 281 discount rate 98, 210–211 discounted payback method 101–103 discounting 98–100 dividend decision 266–288 agency theory 281 alternatives to cash dividends 282–284 case study 284–285 cash alternatives 282–284 ‘clientele’ effect 280–281 informational content 279–280 investor behaviour 280–281 liquidity 282 managers’ views 280 MM theory 274–279 position statements 277–278 practical aspects 267–269 relevance of dividends 269–279 scrip dividends 282–283 share repurchase 283–284 takeovers 282 timing of payments 268–269 traditional view 269–274 dividends consistency 10 definition Gordon’s growth model 270–272 relevance/irrelevance of 269–279 risk anomaly 273–274 scrip dividends 80, 186–188, 279, 282–283 taxation 279, 280 timing of payments 268–269 variability 10 see also dividend decision Donaldson, G 257 dot.com companies 82, 86 Dutch tulip mania 81 dysfunctional behaviour 52 earnings announcements 80 earnings per share (EPS) 234–237, 283 efficiency, weak-form 73–74, 75–79 efficient area 159–160, 161 295 Financial Management efficient frontier 156–158, 162–163 efficient market hypothesis 69–72 see also market efficiency employees 11 environmental issues, corporate governance 17 EPS (earnings per share) 234–237, 283 equity finance cost of 212–214, 242–246 debt finance comparison 180–183 issuing of 183 ordinary shares 204–205 Eurobonds 206 ex rights price 184 expectations budgets 52 expected value 142 experts 83 external funding 181, 203–208 factoring 34–35 fair game model 72 feedback loops, budgetary control 48–49 filter rules 78 financial crisis of 2007–08 30, 255 financial management 1–21 agency problem 14–18 agency theory 10–13 corporate governance 15–18 corporate objectives 5–10, 18–19 investment 3–4 main areas 2–5 principal-agent relationship 12–13 profit maximisation 8–10 risk management financial risk 135–175 beta risk 164, 165–167 capital asset pricing model 163–165, 167–169 case study 169–170 coefficient of correlation 151–153 combination returns 154–158 concept of 136–141 correlation coefficient 151–153 definition 135 diversifying risk 160 efficient area 159–160, 161 efficient frontier 156–158, 162–163 example 142–145 expected value of return 142 financing risk 146 market portfolios 162 296 measurement 141–145 operational risks 146 portfolio theory 145–163 rational investors 137 risk aversion 138 security market line 164 specific risks 146, 147 systematic risks 146, 147 three-asset portfolios 158–159 total company risk 147 two-asset portfolios 150–158 utility theory 136–141 see also risk… financing leases 193 financing risk 146 finished goods stock 28 fixed budgets 55 flexed budgets 55 Ford, Henry 22 Friedman, Milton fundamental analysts 79 funding see capital sources gearing 231–265 bankruptcy costs 253–254 beta value 255–257 capital asset pricing model 255–257 capital costs 247 capital gearing 232–237 capital structure 238–255, 257–259 case study 260 definition 193 earnings per share 234–237 effects of 247–259 funding availability 259 high gearing problems 237–238 insolvency costs 253–254 MM theory 247–255 problems with high gearing 237–238 risk 251, 259 weighted average cost of capital 237, 238, 240–246, 247, 254–255 Gibson-Smith, Chris 209 global financial crisis of 2007-08 30, 255 goal congruence 50 goods and services, selling 7, 23–24 Gordon’s dividend growth model 270–272 governance, corporate 15–18 grants 207 Copyright © 2012 University of Sunderland Index HaiKe Chemical Group Ltd 284–285 Handelsbanken 60–62 Hermes' principles 15–17 hire purchase 193 Holland, tulip mania 81 hurdle rate 94 hybrid finance 206 IBM 284 income statements 47 incremental budgets 52 incremental costs 111 information asymmetry 258 information for investors 279–280 insiders 82–83 insolvency see bankruptcy internal funding 180–181, 204, 208 internal rate of return (IRR) 103–109 investment appraisal 124 using formula 105–109 using graph 104–105 internet companies 82, 86 inventories 24, 28–29 investment capital asset pricing model 167–169 definition 89, 90 see also investors investment appraisal 89–134 accounting rate of return 94–97 asset-replacement problem 113–115 capital investment projects 90–91 capital rationing 116–118 corporate investment 90 examples 109–115 internal rate of return 103–109, 124 net present value 97–101, 124 payback method 91–94 rationing of funds 116–118 real rate of return 119–120 taxation 120–123 techniques 90–115 investors chartists 75–77 choices 3–4 dividend policy 280–281 efficient markets 71 information for 279–280 market efficiency 85–86 naive investors 81 rational investors 137 invoice discounting 34 IRR see internal rate of return Copyright © 2012 University of Sunderland issuing houses 188 Jaffé, Jeremy 40–41 labour costs 31 leasing 193, 207 lending, banks 255 leveraging see gearing limited companies 10–11 liquidity 23, 24–25, 268, 282 loans 177, 191–193, 205–206, 208 see also capital costs London Stock Exchange (LSE) 68–69, 284 long-term finance 178–180, 191–193, 203–204 LSE (London Stock Exchange) 68–69, 284 Malkiel, Burton G 66 management accounting 48 management buyouts 232 managers agency relationship 13 directors 11 dividend policy 280 goals 14 market efficiency 83–85 monitoring of 14–15 responsibility centre managers 47 styles 52–53 Theory X and Theory Y managers 51 types 51 market analysts 82 market efficiency 66–88 accounting policies 80, 85 arbitrage 78 capital markets 67–69 earnings announcements 80 efficient market hypothesis 69–72 filter rules 78 forms of 73–83 investors 85–86 managers 83–85 reaction speed 81 scrip issues 80 semi-strong-form efficiency 74, 79–80 strong-form efficiency 74–75, 82–83 weak-form efficiency 73–74, 75–79 market portfolios 162 market values 188, 232 master budgets 46 297 Financial Management matching of funds 178–180 mezzanine finance 206 Miller, Merton 247 mission statements 44, 45 MM (Miller and Modigliani) theory capital structure 247–255 dividend irrelevancy 274–279 models Altman model 38–39 capital asset pricing model 163–165, 167–169, 220, 221, 222, 224–225 Gordon’s dividend growth model 270–272 insolvency prediction model 38–39 see also theories Modigliani, Franco 247 Monday effect 78–79 money cash flows 119 monitoring cost 14–15 motivation, budgets 51–53 mutually exclusive projects 107 naive investors 81 negotiated budgets 46 net present value (NPV) case study 124 definition 85 dividend policy 275 investment appraisal 97–101, 124 tables 131–134 Netherlands, tulip mania 81 noise trading 81 nominal value 188 non-accounting managers 52–53 NPV see net present value offer for sale, shares 188, 189 operating cycle see working capital cycle operational efficiency 70 operational leases 193 operational risks 146 ordinary shares see equity finance organisational slack 54–55 outsourcing, cash collection 34–35, 36 overdrafts 194, 208 overtrading 31 P/E (price/earnings) ratio 274 pay, performance-related 15 payback method 91–94, 101–103 ‘pecking order’ theory 257 perfect markets 69–70 298 performance-related pay 15 perpetuities 100 personal utility 13 placing, shares 188, 189 planning process, budgets 45 portfolio theory 145–163 extension of 158–163 three-asset portfolios 158–159 two-asset portfolios 150–158 position statements 1, 2–3, 31, 277–278 preference shares 192, 214–216 Premier Foods 260 present value 97 see also net present value price/earnings (P/E) ratio 274 pricing efficiency 70 primary markets 68 principal-agent relationship 12–13 principal budget factor 46 profit-conscious managers 52–53 profit, definition profit maximisation 8–10 profitability index 117 public issues 188, 189 rate of return accounting rate of return 94–97 internal rate of return 103–109, 124 investment appraisal 119–120 real rate of return 119–120 shareholder expectations 85 rational companies 211 rational investors 137 rationing of funds 116–118 raw materials days 28 reaction speed, market efficiency 81 real cash flows 119 real rate of return 119–120 references 289–292 responsibility centre managers 47 retained profits 181, 208, 218 return on capital employed (ROCE) 283 returns abnormal returns 71 accounting rate of return 94–97 case study 169–170 combination returns 154–158 expected value of 142 internal rate of return 103–109, 124 real rate of return 119–120 return on capital employed 283 risk and return 169–170 Copyright © 2012 University of Sunderland Index to shareholders 85, 234–239, 247–255, 258 rights issues 182, 183–190 risk attitudes to 14 aversion to 138 beta risk 164, 165–167 capital costs 224, 225 case study 169–170 coefficient of correlation 151–153 combination returns 154–158 definition 135 diversifying 160 efficient area 159–160, 161 efficient frontier 156–158, 162–163 financial concept of 136–141 financing risk 146 gearing 251, 259 measurement 141–145 operational risks 146 security market line 164 specific risks 146, 147 systematic risks 146, 147 total company risk 147 two-asset portfolios 151–158 see also financial risk risk anomaly, dividends 273–274 risk management 4, 16 ROCE (return on capital employed) 283 rolling budgets 57 Salamon v Salamon & Co (1897) 10 sale and leaseback 193 satisfaction see utility theory satisficing 8, 54 scrip issues 80, 186–188, 279, 282–283 seasonal effects, shares 78 secondary markets 68–69 securities 67, 71 security market line 164 self-control 49 semi-strong-form efficiency 74, 79–80 shareholders company management 11 dividend policy 6–7, 281 earnings per share 234–237 gearing ratios 231–265 monitoring of managers 14–15 rate of return 85 returns to 234–239, 247–255, 258 selling/buying shares 275 signalling 258 Copyright © 2012 University of Sunderland voting rights 12 wealth 9–10, 273, 275–277 shares bonus issues 186–188 discounted options 12 market efficiency 72–83 Monday effect 78–79 offer for sale 188, 189 option schemes 12, 15 ordinary shares 204–205 placing 188, 189 preference shares 192, 205 public issues 188, 189 reaction speed 81–82 repurchase 283–284 rights issues 183–190 risk and return 170 scrip issues 186–188, 279, 282–283 seasonal effects 78 share issues 84 shareholder wealth 10 unusual movements 81 short-term finance 178–180, 204 signalling 258 slack, organisational 54–55 social controls 49 social issues, corporate governance 17 Soros, George 83 sources of capital see capital sources South Sea Bubble 81 specific risks 146, 147 stakeholders corporate governance 17 corporate objectives rewards/provisions 6–7 statements of comprehensive income statements of financial position 1, 2–3, 31 static budgets 55 stock exchanges 68–69 stock markets 81–82 stock split 186–188 stockbrokers 68 strong-form efficiency 74–75, 82–83 sunk costs 110 systematic risks 146, 147 takeovers 84, 198, 258, 282 Tata, Ratan 266 taxation capital structure 252–254 dividends 279, 280 299 Financial Management investment appraisal 120–123 tax relief 196 Tesco plc 18 theories agency theory 10–13, 281 capital structure 247–255 contingency theory 53 dividend decision 274–279 management types 51 MM theory 247–255, 274–279 ‘pecking order’ theory 257 portfolio theory 145–163 utility theory 136–141 see also models Theory X and Theory Y managers 51 three-asset portfolios 158–159 time value of money 98 top-down budgeting 46 total company risk 147 trading cycle see working capital cycle transparency 15–16 tulip mania 81 two-asset portfolios 150–158 weak-form efficiency 73–74, 75–79 weighted average cost of capital (WACC) capital cost 219–225 definition 211 gearing 237, 238, 240–246, 247, 254–255 What on Earth case study 40–41 work in progress (WIP) stock 28–29 working capital cycle 29–34 working capital management 22–43 accounts payable/receivable management 34–38 bankruptcy prediction 38–40 factoring 34–35 working capital cycle 29–34 working capital ratios 23–34 accounts payable days 27–29, 33 accounts receivable days 26–27, 33 acid ratios 25–26 current ratios 25–26 liquidity 23, 24–25 working capital cycle 29–34 underwriting 189 utility theory 136–141 zero-based budgets (ZBB) 58 Zulu principle 83 voting rights, shareholders 12 300 Copyright © 2012 University of Sunderland Unit Copyright © 2012 University of Sunderland The nature of financial mangement 301 Financial Management 302 Copyright © 2012 University of Sunderland [...]... of strategic financial management For the only time in this module, therefore, we want you to read a statement of financial position (hereafter position statement) to discover what it doesn’t tell you, rather than what it does! Unit learning objectives On completing this unit, you should be able to: 1.1 Identify the main areas of financial management 1.2 Explain why, in terms of financial management, ... by management, and would therefore not be impartial Use of the shareholders’ voting powers Performance-related pay for managers Summary The key points in this unit are as follows: ■ The main areas of corporate financial management are the decisions concerning investment, funding, dividend payment, risk management and working capital management ■ The most appropriate corporate objective in financial management. .. problem Prior knowledge This unit requires some basic knowledge of financial accounting Resources The sections in this unit are supported by the chapter ‘The finance function’ in your core textbook (Watson and Head, 2010) Copyright © 2012 University of Sunderland 1 Financial Management ga nin ct 1a y ivit Lear 1.1 The main areas of financial management Read through the simplified position statement in Figure... risk management as well as the management of a company’s current assets and liabilities in its working capital cycle Assets must be managed effectively so they generate income and profits 4 Copyright © 2012 University of Sunderland Unit 1 The nature of financial mangement and so funds are available to pay accounts payable and take up opportunities for investment In summary, we can say that financial management. .. nature of financial management ‘The business schools reward difficult complex behaviour more than simple behaviour, but simple behaviour is more effective.’ Warren Buffett, US investment guru Introduction Welcome to the first unit of the third-level module, entitled Financial management The module explores, within the context of the limited company, three key areas of finance: statement of financial. .. structure Copyright © 2012 University of Sunderland 3 Financial Management 1b eedb ac k F ga nin ct y ivit Lear These areas are not independent of each other For example, the decision to invest in a particular project may require a further decision about finance to be raised 1b 1 How might any investment also affect the dividend payment decision? 2 If the financial manager decides to pay a higher dividend... structure ■ Dividend decisions ■ Risk management 1.2 Corporate objectives 1d eedb ac k F ga nin ct y ivit Lear Recommended reading for this section is the corporate objectives section of the chapter ‘The finance function’ in Watson and Head (2010) 1d You may have noticed above that we referred to the ‘company’ and ‘corporate’ In this module we deal with strategic financial management in the context, principally,... managers, who act on behalf of the directors and make decisions concerning the implementation of the board’s policy, including the financial management we are concerned with in this module The employees are closest to the day-to-day activity of the company, following the instructions of management This hierarchy can be less clear than the explanation suggests: compressed in a small company, where the owners... problems associated with: (a) Offering share options and other incentives? (b) Monitoring management actions over and above that required by company law? 14 Copyright © 2012 University of Sunderland eedb ac k F Unit 1 1o The nature of financial mangement (a) The two most common methods of ensuring appropriate management actions are the share option schemes referred to earlier and performance-related... acquisition, ownership obligations and rights, and sale of shares In particular they should clearly Copyright © 2012 University of Sunderland 15 Financial Management communicate on their objectives, strategy, competitive position and operational and risk management They should be willing to have an open, ongoing and high-level dialogue with shareholders on these issues Corporate culture Principle 2 ... corporate financial management are the decisions concerning investment, funding, dividend payment, risk management and working capital management ■ The most appropriate corporate objective in financial. .. Introduction Welcome to the Financial Management learning pack! It has been designed to assist you in studying for the core module of the BA (Hons) in Accounting and Financial Management degree and... this unit, you should be able to: 1.1 Identify the main areas of financial management 1.2 Explain why, in terms of financial management, maximisation of shareholder wealth is the most appropriate