S T U D Y PAPER F9 FINANCIAL MANAGEMENT BPP Learning Media is the sole ACCA Platinum Approved Learning Partner – content for the ACCA qualification In this, the only Paper F9 study text to be reviewed by the examiner: x We discuss the best strategies for studying for ACCA exams x We highlight the most important elements in the syllabus and the key skills you will need x We signpost how each chapter links to the syllabus and the study guide x We provide lots of exam focus points demonstrating what the examiner will want you to x We emphasise key points in regular fast forward summaries x We test your knowledge of what you've studied in quick quizzes x We examine your understanding in our exam question bank x We reference all the important topics in our full index BPP's i-Pass product also supports this paper FOR EXAMS IN 2012 T E X T First edition 2007 Fifth edition October 2011 ISBN 9781 4453 7766 (Previous ISBN 9780 7517 8926 3) e-ISBN 9781 4453 7589 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd BPP House, Aldine Place London W12 8AA www.bpp.com/learningmedia Printed in the United Kingdom Your learning materials, published by BPP Learning Media Ltd, are printed on paper sourced from sustainable, managed forests ii All our rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media Ltd We are grateful to the Association of Chartered Certified Accountants for permission to reproduce past examination questions The suggested solutions in the exam answer bank have been prepared by BPP Learning Media Ltd, unless otherwise stated © BPP Learning Media Ltd 2011 Contents Page Introduction Helping you to pass – the ONLY F9 Study Text reviewed by the examiner! Studying F9 The exam paper and exam formulae v vii viii Part A Financial management function Financial management and financial objectives Part B Financial management environment The economic environment for business Financial markets and institutions 35 55 Part C Working capital management Working capital Managing working capital Working capital finance 67 81 107 Part D Investment appraisal 10 11 Investment decisions Investment appraisal using DCF methods Allowing for inflation and taxation Project appraisal and risk Specific investment decisions 131 147 165 179 193 Part E Business finance 12 13 14 Sources of finance Dividend policy Gearing and capital structure 213 245 255 Part F Cost of capital 15 16 The cost of capital Capital structure 277 301 Part G Business valuations 17 18 Business valuations Market efficiency 319 341 Part H Risk management 19 20 Foreign currency risk Interest rate risk 353 377 Mathematical tables 391 Exam question bank Exam answer bank Index 395 417 475 Review form Contents iii A note about copyright Dear Customer What does the little © mean and why does it matter? Your market-leading BPP books, course materials and elearning materials not write and update themselves People write them: on their own behalf or as employees of an organisation that invests in this activity Copyright law protects their livelihoods It does so by creating rights over the use of the content Breach of copyright is a form of theft – as well being a criminal offence in some jurisdictions, it is potentially a serious breach of professional ethics With current technology, things might seem a bit hazy but, basically, without the express permission of BPP Learning Media: x Photocopying our materials is a breach of copyright x Scanning, ripcasting or conversion of our digital materials into different file formats, uploading them to facebook or emailing them to your friends is a breach of copyright You can, of course, sell your books, in the form in which you have bought them – once you have finished with them (Is this fair to your fellow students? We update for a reason.) But the e-products are sold on a single user licence basis: we not supply ‘unlock’ codes to people who have bought them second hand And what about outside the UK? BPP Learning Media strives to make our materials available at prices students can afford by local printing arrangements, pricing policies and partnerships which are clearly listed on our website A tiny minority ignore this and indulge in criminal activity by illegally photocopying our material or supporting organisations that If they act illegally and unethically in one area, can you really trust them? iv Helping you to pass – the ONLY F9 Study Text reviewed by the examiner! BPP Learning Media – the sole Platinum Approved Learning Partner - content As ACCA’s sole Platinum Approved Learning Partner – content, BPP Learning Media gives you the unique opportunity to use examiner-reviewed study materials for the 2012 exams By incorporating the examiner’s comments and suggestions regarding the depth and breadth of syllabus coverage, the BPP Learning Media Study Text provides excellent, ACCA-approved support for your studies The PER alert Before you can qualify as an ACCA member, you not only have to pass all your exams but also fulfil a three year practical experience requirement (PER) To help you to recognise areas of the syllabus that you might be able to apply in the workplace to achieve different performance objectives, we have introduced the ‘PER alert’ feature You will find this feature throughout the Study Text to remind you that what you are learning to pass your ACCA exams is equally useful to the fulfilment of the PER requirement Tackling studying Studying can be a daunting prospect, particularly when you have lots of other commitments The different features of the text, the purposes of which are explained fully on the Chapter features page, will help you whilst studying and improve your chances of exam success Developing exam awareness Our Texts are completely focused on helping you pass your exam Our advice on Studying F9 outlines the content of the paper, the necessary skills the examiner expects you to demonstrate and any brought forward knowledge you are expected to have Exam focus points are included within the chapters to highlight when and how specific topics were examined, or how they might be examined in the future Using the Syllabus and Study Guide You can find the syllabus and Study Guide on page ix of this Study Text Testing what you can Testing yourself helps you develop the skills you need to pass the exam and also confirms that you can recall what you have learnt We include Questions – lots of them - both within chapters and in the Exam Question Bank, as well as Quick Quizzes at the end of each chapter to test your knowledge of the chapter content Introduction v Chapter features Each chapter contains a number of helpful features to guide you through each topic Topic list Topic list Syllabus reference What you will be studying in this chapter and the relevant section numbers, together the ACCA syllabus references Introduction Puts the chapter content in the context of the syllabus as a whole Study Guide Links the chapter content with ACCA guidance Exam Guide Highlights how examinable the chapter content is likely to be and the ways in which it could be examined Knowledge brought forward from earlier studies What you are assumed to know from previous studies/exams FAST FORWARD Summarises the content of main chapter headings, allowing you to preview and review each section easily Examples Demonstrate how to apply key knowledge and techniques Key terms Definitions of important concepts that can often earn you easy marks in exams Exam focus points When and how specific topics were examined, or how they may be examined in the future Formula to learn Formulae that are not given in the exam but which have to be learnt Gives you a useful indication of syllabus areas that closely relate to performance objectives in your Practical Experience Requirement (PER) vi Introduction Question Gives you essential practice of techniques covered in the chapter Case Study Real world examples of theories and techniques Chapter Roundup A full list of the Fast Forwards included in the chapter, providing an easy source of review Quick Quiz A quick test of your knowledge of the main topics in the chapter Exam Question Bank Found at the back of the Study Text with more comprehensive chapter questions Cross referenced for easy navigation Studying F9 This paper examines a wide range of financial management topics, many of which will be completely new to you You will need to be competent at a range of quite tricky calculations as well as able to explain and discuss financial management techniques and issues The F9 examiner The examiner is Tony Head who was the examiner for Paper 2.4 under the old syllabus He expects you to be able to perform and comment on calculations, exercise critical abilities, clearly demonstrate understanding of the syllabus and use question information Syllabus update The F9 syllabus has been updated for the June 2012 sitting onwards The only change is the clarification of an area that was implicitly included in the syllabus previously, namely discounted payback Summary of changes to F9 ACCA periodically reviews its qualification syllabuses so that they fully meet the needs of stakeholders such as employers, students, regulatory and advisory bodies and learning providers There are no changes to the syllabus One area however has been clarified in the syllabus (it was implicitly included previously) and is shown in Table below:1 What F9 is about Table – Amendments to F9 Section and subject area Syllabus content D3f) Discounted cash flow (DCF) techniques Calculate discounted payback and discuss its usefulness as an investment appraisal method.[2] The aim of this syllabus is to develop the knowledge and skills expected of a finance manager, in relation to investment, financing and dividend policy decisions F9 is a middle level paper in the ACCA qualification structure There are some links to material you have covered in F2, particularly short-term decision making techniques The paper with a direct link following F9 is P4 which thinks strategically and considers wider environmental factors F9 requires you to be able to apply techniques and think about their impact on the organisation Introduction vii What skills are required? x You are expected to have a core of financial management knowledge x You will be required to carry out calculations, with clear workings and a logical structure x You will be required to explain financial management techniques and discuss whether they are appropriate for a particular organisation x You must be able to apply your skills in a practical context How to improve your chances of passing x There is no choice in this paper, all questions have to be answered x You must therefore study the entire syllabus, there are no short-cuts x Practising questions under timed conditions is essential BPP’s Practice and Revision Kit contains 25 mark questions on all areas of the syllabus x Questions will be based on simple scenarios and answers must be focused and specific to the organisation x Answer all parts of the question Even if you cannot all of the calculation elements, you will still be able to gain marks in the discussion parts x Make sure you write full answers to discussion sections, not one or two word lists, the examiner is looking for understanding to be demonstrated x Plan your written answers and write legibly x Include all your workings and label them clearly x Read Student Accountant (the ACCA’s student magazine) regularly – it often contains technical articles written either by or on the recommendation of the examiner which can be invaluable for future exams Brought forward knowledge You will need to have a good working knowledge of certain management accounting techniques from F2 In particular, short-term decision making techniques such as cost-volume-profit analysis and the calculation of relevant costs This Study Text revises these topics and brought forward knowledge is identified If you struggle with the examples and questions used, you must go back and revisit your previous work The examiner will assume you know this material and it may form part of an exam question The exam paper Format of the paper The exam consists of four compulsory 25 mark questions Time allowed is hours with 15 minutes’ reading time viii Introduction Syllabus and Study Guide The F9 syllabus and study guide can be found below Introduction ix 474 Note Key Terms and their page references are given in bold A ccounting rate of return method, 140 Accounts payable payment period, 73 Accounts receivable payment period, 72 Acid test ratio, 72 Agency problem, 24 Agency relationship, 16 Aggregate demand, 39 Aggressive approach to financing working capital, 125 Allocative efficiency, 47, 342 Alternative Investment Market (AIM), 58 Annuity tables, 152 Arbitrage, 304, 358 ARR and the comparison of mutually exclusive projects, 141 Assessing creditworthiness, 90 Asset beta formula, 309 Asset replacement decisions, 200 Asset turnover, 19 Asset valuation bases, 322 Average inventory, 85 Average production period, 72 Bad debt risk, 95 Balance sheet valuation, Balanced portfolio, 283 Bank of England, 381 Basic earnings per share, 263 Basis risk, 379 Baumol model, 118 Behavioural finance, 348 Benefits intangible, 138 Beta factor, 284 Bonds, 220 Break-up basis, Buffer safety inventory, 85 Bulk discounts, 86 Business angel financing, 269 Business risk, 307, 312 C ap, 385 Capital allowances, 171 Capital asset pricing model (CAPM), 283, 308 Capital budgeting process, 134 Capital budgets, 133 Capital employed, 18 Capital expenditure, 132 Capital rationing, 202 Capital structure, 269 Capital structure theories, 302 Cash budgets, 114 Cash cycle, 70 Cash flow, 70 Cash flow based valuation models, 328 Cash flow forecast, 109, 116 Cash flow problems, 109 Cash management models, 118 Cash operating cycle, 70 Centralised treasury department, 117 Certainty equivalent approach, 184 Certificates of deposit (CDs), 122 Chartists, 345 Collar, 385 Collecting amounts owing, 93 Competition Commission, 45 Competition policy, 45 Compounding, 148 Conservative approach to financing working capital, 125 Contract price, 370 Contract size, 370 Conversion premium, 221 Conversion value, 221 Convertible bonds, 221, 336 Convertible debt, 336 Corporate bonds, 58 Corporate governance, 25 Corporate governance regulation, 51 Corporate objectives, Cost of bank debt, 292 Cost of capital, 150, 263, 278, 293 Cost of convertible debt, 292 Cost of debt, 288, 312 Cost of floating rate debt, 292 Cost of preference shares, 293 Countertrade, 100 Coupon, 220 Credit control, 89 Credit insurance, 96 Credit ratings, 91 Credit utilisation report, 91 Creditor hierarchy, 279 Creditors, 15, 101 Creditworthiness, 90 Cum div, 21 Currency future, 370 Currency of invoice, 362 Current ratio, 71 D ay-of-the-week effects, 287, 347 Debentures, 220 Index 475 Debt collection policy, 93 Debt finance, 218 Debt ratios, 20, 260 Deep discount bonds, 220 Deferred payment sale, 237 Deregulation, 47 Discount rate, 293 Discount tables, 152 Discounted cash flow, 148 Discounted cash flow basis of valuation, 330 Discounted payback, 188 Discounts, 86 Dividend cover, 264 Dividend decision, Dividend growth model, 281, 328 Dividend policy, 247 Dividend valuation model, 280, 328 Dividend yield, 21, 265 Dividends, 121 Du Pont system of ratio analysis, 18 Early settlement discounts, 94 Earnings per share, 11, 21, 263 Earnings yield valuation method, 327 Economic exposure, 358 Economic order quantity (EOQ), 83 Economic policy, 17, 36 Economy, 28 Effectiveness, 28 Efficiency, 28 Efficient market hypothesis, 342 Employees, 15 Enterprise Initiative, 49 Environmental ('green') policies, 49 Equity finance, 226, 268 Equity gap, 268 Equivalent annual benefit, 201 Equivalent annual cost method, 200 Ethical investment funds, 51 Eurobond, 60 Eurocurrency, 59 Euro-equity, 60 European Union, 47 Ex div, 21 Exchange rate, 42, 354 Exchange rate policy, 38 Exchange-traded options, 372 Executive share options plans (ESOPs), 24 Expectations theory, 380 Expected cash flows, 116, 184 Export credit insurance, 100 External trade policy, 38 Externalities, 49 Finance house deposits, 122 Finance lease, 195, 239 Financial accounts, Financial analysis of long-term decisions, 135 Financial control, Financial gearing, 257 Financial intermediary, 56 Financial management, Financial objectives, Financial performance, 17 Financial planning, Financial risk, 256, 307, 312 Financial strategy, Financial targets, 12 Financing decision, Fiscal policy, 39 Fisher effect, 361 Fisher formula, 166 Fixed charge, 223 Fixed exchange rates, 43 Floating charge, 223 Floating exchange rates, 43 Floating rate debt capital, 307 Floor, 385 Fluctuating current assets, 124 Foreign currency derivatives, 370 Foreign currency risk management, 362 Foreign exchange (FX) markets, 356 Foreign exchange risk management, 117 Forward exchange contract, 364, 365 Forward interest rate agreements (FRAs), 381, 382 Forward rate, 354 Four-way equivalence, 362 Fundamental theory of share values, 281 Futures market, 370 Gap analysis of interest rate risk, 379 Gap exposure, 379 Geared betas, 309 Gearing, 12, 248, 251, 256, 309, 326 Gearing ratios, 20 Go/no go decision, 136 Goal congruence, 24 Gordon's growth approximation, 282 Government, 15, 17 Government aid, 269 Government assistance for business, 49 Government incentives, 49 Grants, 49 Green policies, 49 Growth in dividends, 282 Hard capital rationing, 134, 202 Factoring, 96, 97 476 Index Hedging, 117 Hour-of-the-day effects, 347 Ijara, 238, 239 Impact of cost of capital on investments, 307 Income based valuation bases, 324 Inflation, 166 Information processing efficiency, 343 Initial public offer (IPO), 227 Institutional investors, 59 Interest cover, 260 Interest rate derivatives, 383 Interest rate futures, 383 Interest rate option, 384 Interest rate parity, 358, 359 Interest rate risk management, 381 Interest rate swap, 385 Interest rates, 40, 60, 378 interest yield, 336 Internal rate of return (IRR) method, 154 Internal sources of finance, 246 International capital markets, 59 International Fisher effect, 361 International money markets, 59 Inventory approach to cash management, 118 Inventory management, 82 Inventory turnover, 72 Inventory turnover period, 72 Investing surplus cash, 120 Investment, 132 Investment appraisal, 135 Investment by not-for-profit organisations, 133 Investment decision-making process, 134 Investment decisions, Invoice currency, 362 Invoice discounting, 93, 98 Irredeemable debentures, 335 Irredeemable debt capital, 289 Issue price for a rights issue, 229 Just-in-time procurement, 87 Leading and lagging, 363 Lease or buy decisions, 196 Leasing, 194, 218 Leasing transactions, 238 Legislation, 17 Lessee, 194 Lessor, 194 LIBOR, 61, 379 Liquidity, 248 Liquidity preference theory, 380 Liquidity ratios, 20 Listing, 226 Loan Guarantee Scheme, 270 Local authority deposits, 122 Long range planning, 12 Macroeconomics, 36 Management accounts, Management buyout, 24 Management of cash, 108 Managerial reward schemes, 24 Managing accounts payable, 100 Managing accounts receivable, 88 Managing foreign accounts payable, 102 Marginal cost of capital, 294, 295 Market capitalisation, 321, 347 Market failure, 45 Market imperfections, 305 Market imperfections and pricing anomalies, 347 Market risk, 283 Market risk premium, 285 Market segmentation theory, 380 Market segmentation theory of interest rates, 380 Market values, Marketability and liquidity of shares, 346 Matching, 381 Matching assets and liabilities, 363 Matching receipts and payments, 363 Maturity gap, 268 Maturity matching, 125 Maximum inventory level, 85 Merger, 45, 324 Microeconomics, 36 Miller-Orr model, 119 Modigliani and Miller, 248, 302, 309 Monetary policy, 38, 40 Monetary Policy Committee, 381 Money market hedge, 366 Monopoly, 45 Month-of-the-year effects, 347 Mudaraba, 236 Mudarib, 236 Murabaha, 237 Musharaka, 237 Musharik, 237 N ature of working capital, 68 Net assets method of share valuation, 322 Net operating income, 303 Net present value, 150 Net working capital, 68 Netting, 363 Nominal rates of interest, 166 Non-divisible projects, 206 Non-financial objectives, 14 Non-systematic risk, 283 Index 477 Not-for-profit organisation, 27, 133 NPV, 150 Objectives of working capital, 69 Operating cycle, 70 Operating lease, 195, 239 Operational efficiency, 342 Operational gearing, 260 Option, 372 Ordinary shares, 226 Origination of proposals, 134 Over the counter (OTC) options, 372 Over-capitalisation, 74 Overdraft, 108, 215 Overseas factor, 99 Overtrading, 75 P /E ratio (earnings) method of valuation, 324 Payback, 139 Pecking order theory, 306 Performance-related pay, 24 Permanent current assets, 124 Perpetuity, 153 Pollution, 49 Precautionary motive, 108 Present value, 149 Price earnings (P/E) ratio, 22, 264 Prior charge capital, 257 Private equity, 236 Privatisation, 48 Probability analysis, 184 Probability distribution, 184 Profit margin, 19 Profit maximisation, 10, 11 Profitability, 12, 18 Profitability index, 203 Project-specific cost of capital, 308 Purchasing power parity, 360 Q ualitative issues in long-term decisions, 135 Quantity discounts, 86 Quick ratio, 72 R ab al mal, 236 Random walk theory, 346 Ratio analysis, 17 Raw materials inventory holding period, 72 Real interest rate, 166 Redeemable debt capital, 289 Redemption, 223 Regulation of markets, 45 Regulatory requirements, 25 478 Index Relationship between company value and cost of capital, 307 Relative costs of sources of finance, 279 Relevant cash flows, 136 Re-order level, 84 Replacement decisions, 200 Repurchase of shares, 251 Residual theory of dividend policy, 248 Restrictive practices, 47 Return on capital employed (ROCE), 12, 18, 140 Return on equity, 19 Return on investment (ROI) method), 140 Revenue expenditure, 132 Reverse yield gap, 62 Riba, 235 Rights issues, 229 Risk and uncertainty, 180 Risk management, 362 Risk-adjusted discount rates, 189 Risk-free rate of return, 279 Risk-free securities, 283 Risk-return trade-off, 62 Role of working capital management, 69 Safety inventory, 85 Sale and leaseback, 196, 218 Sales revenue/net working capital ratio, 73 Savings, 137 Scrip dividend, 250 Scrip issue, 234 Secondary ratios, 19 Semi-strong form efficiency, 343 Sensitivity analysis, 181 Settlement date, 370 Settlement discount, 94 Share option scheme, 24 Share ownership, 17 Share repurchase, 251 Share valuation, 320 Shareholder wealth maximisation, 8, 154 Shareholders, 15, 247 Shareholders and management, 16 Short-term debt instruments, 122 Short-term deposits, 121 Short-term interest rate futures, 384 Short-term investments, 121 Short-term loans, 216 Signalling, 248 Simulation model, 187 Single period capital rationing, 203 Small and medium-sized entities, 267 Smoothing, 382 Soft capital rationing, 134, 202 Sources of finance for SMEs, 268 Special dividend payment, 121 Speculation, 42 Speculative motive, 109 Spot rate, 354 Stakeholders, 14 Stock Exchange, 58 Stock Exchange introduction, 228 Stock Exchange listing regulations, 26 Stock market ratios, 21 Stock markets, 58 Stock split, 234 Strategy, Strong form efficiency, 344 Structure of interest rates, 379 Subjective judgement, 28 Sukuk, 239 Surplus cash, 120 Swap, 373 Systematic risk, 283, 309 Takeover, 321 Taxation, 170, 290 Theoretical ex rights price (TERP), 230 Tick size, 370 Time value of money, 160 Timing of cash flows, 151 Total shareholder return, 9, 247 Trade accounts payable, 101 Trade credit, 101, 218 Trade payables, 15 Trading cycle, 70 Traditional view of dividend policy, 248 Transaction exposure, 356 Transactions motive, 108 Translation exposure, 356 Treasury bills, 122 Treasury management, 117 Underwriters, 228 Ungeared betas, 309 Unit cost measurements, 28 Unsystematic risk, 283 Valuation of debt, 334 Value for money, 27, 28 Value of rights, 231 Venture capital, 224 Weak form efficiency, 343 Weighted average cost of capital, 294, 302 Working capital, 174 Working capital cycle, 70 Working capital financing, 124 Working capital funding strategies, 122 Working capital investment, 133 Working capital requirement, 122 Yield curve, 380 Zero cost collar, 385 Zero coupon bonds, 220 Index 479 480 Index Notes Notes Notes Notes Notes Notes Notes Notes ... ONLY F9 Study Text reviewed by the examiner! Studying F9 The exam paper and exam formulae v vii viii Part A Financial management function Financial management and financial objectives Part B Financial. .. with shareholders 1: Financial management and financial objectives ~ Part A Financial management function The nature and purpose of financial management FAST FORWARD Financial management decisions... investment, financing and dividend decisions of financial management throughout this Study Text Part A Financial management function ~ 1: Financial management and financial objectives Examples of different