ACCA FM (F9)

COMPLETE SUBJECT NOTES

BY VERTEX LEARNING SOLUTIONS
VALID UNTIL SEPT 2023
 TABLE OF CONTENTS
CHAPTER TOPIC PAGE NO.
1.1 Introduction to Financial Management - Objectives - 4
Introduction Part 1
1.2 Introduction to Financial Management - Objectives - 11
Introduction part-2
1.3 Introduction to Financial Management - The Economic 13
Environment for Business
1.4 Introduction to Financial Management - Financial Markets 22
1.5 Introduction to Financial Management - Stock Market Listing 24
2.1 Working Capital - Introduction 27
2.2 Working Capital - Working Capital Requirement 32
2.3 Working Capital - Over Trading _ Over Capitalization 33
2.4 Working Capital - Inventories Part 1 35
2.5 Working Capital - Inventories Part 2 39

2.6 Working Capital - Factoring Payables 41

2.7 Working Capital - Managing Receivables 45
2.8 Working Capital - Cashflow Forecast 55
2.9 Working Capital - Miller Model 61
3.1 Capital Budgeting - Investment Decisions - Introduction 64
3.2 Capital Budgeting - Discounted Cash Flows 66
3.3 Capital Budgeting - Compounding and Discounting 70
3.4 Capital Budgeting - Net Present Value (NPV) 73
3.5 Capital Budgeting - Internal Rate of Return (IRR) 77
3.6 Capital Budgeting - IRR _ NPV 80
3.7 Capital Budgeting - Allowing for Taxation 82
3.8 Capital Budgeting - Allowing for Inflation 83

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3.9 Capital Budgeting - Annuity - Perpetuity 85
3.10 Capital Budgeting - Project Appraisal _ Risk 87
3.11 Capital Budgeting - Probability Analysis _ Discounted Payback 90
4.1 Specific Investment Decisions - Asset Replacement Decisions 93
4.2 Specific Investment Decisions - Lease or Buy 96
4.3 Capital Budgeting - Relevant Cashflows 99
4.4 Capital Budgeting - Capital Rationing 102
5.1 Sources of Finance – Introduction 106
5.2 Sources of Finance - Islamic Financing 109
5.3 Sources of Finance - Dividend Policy 111
6.1 Cost of Capital - Introduction 114
6.2 Cost of Capital - Bonds, Convertibles and Equity 116
6.3 Cost of Capital - CAPM Complete 121
6.4 Cost of Capital - CAPM and Beta Continued 126
6.5 Cost of Capital - Cost of Debt _ WACC 130
6.6 Capital Structure - Introduction 136
6.7 Capital Structure - Introduction and Capital Structure 140
Theories
7.1 Business Valuation - Introduction 143
7.2 Business Valuation - Asset Based Valuation 145
7.3 Business Valuation - Earning (Income) Based Approach 146
7.4 Business Valuation - Overview of Dividend Valuation Model 148
and Gordon Growth
7.5 Business Valuation - Effect of Debt on EPS 151
7.6 Business Valuation - Market Efficiency 152
8.1 Risk Management - Foreign Currency Risk Management - 155
Introduction
8.2 Risk Management - Types of Risks in Foreign Currency Risk 156
8.3 Risk Management - Futures, Currency options _ Swaps 158

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8.4 Risk Management - Money Market Hedging Strategies _ 162
Forward Contracts
8.5 Risk Management - Derivatives 167
8.6 Risk Management - Interest Rate Risk Management 170
8.7 Risk Management - Interest Rate Swaps 178

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1.1 Introduction to Financial Management - Objectives
- Introduction Part 1

Financial Management & Its Objectives

Profit maximisation is often assumed, incorrectly, to be the main objective of a

business.

Reasons Why Profit Is Not a Sufficient Objective:

• Investors care about the future

• Investors care about the dividend
• Investors care about financing plans
• Investors care about risk management
• For a profit-making company, a better objective is the maximisation of
shareholder wealth; this can be measured as total shareholder return (the
dividend per share plus capital gain divided by initial share price).

Key Decisions:

Investment

• (In projects or takeovers or working capital) need to be analyzed to ensure that

they are beneficial to the investor.
• Investments can help a firm maintain strong future cash flows by the
achievement of key corporate objectives
• e.g., market share, quality.

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Finance

Mainly focus on how much debt a firm is planning to use.

The level of gearing that is appropriate for a business depends on several practical
issues:

• Life cycle - A new, growing business will find it difficult to forecast cash flows
with any certainty so high levels of gearing are unwise.
• Operating gearing - If fixed costs are a high proportion of total costs, then cash
flows will be volatile; so high gearing is not sensible.
• Stability of revenue - If operating in a highly dynamic business environment then
high gearing is not sensible.
• Security - If unable to offer security, then debt will be difficult and expensive
to obtain.

Dividends

how returns should be given to shareholders

Risk Management

mainly involve management of exchange rate and interest rate risk and project
management issues.

3 Key Elements to The Process of Financial Management

Financial Planning

• Management needs to ensure that enough funding is available at the right time
to meet the needs of the business.
• In the short term, funding may be needed to invest in equipment and stocks, pay
employees and fund sales made on credit.
• In the medium and long term, funding may be required for significant additions
to the productive capacity of the business or to make acquisitions.

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Financial Control

• Financial control is a critically important activity to help the business ensure that
the business is meeting its objectives.
• Financial control addresses questions such as:
• Are assets being used efficiently?
• Are the businesses assets secure?
• Do management act in the best interest of shareholders and in accordance with
business rules?

Financial Decision-making

The key aspects of financial decision-making relate to investment, financing and

dividends:

• Investments must be financed in some way – however there are always financing
alternatives that can be considered.
• For example, it is possible to raise finance from selling new shares, borrowing
from banks or taking credit from suppliers
• A key financing decision is whether profits earned by the business should be
retained rather than distributed to shareholders via dividends.
• If dividends are too high, the business may be starved of funding to reinvest in
growing revenues and profits further.

Shareholder Wealth Maximization (Share Price)

Maximisation of shareholder wealth is measured by the share price (if the company is
listed of course). This is because the share price is simply the value of all future
dividends coming to the shareholders.

However, sometimes a business reports a profit increase, and the share price falls due
to the way they made the profit. This suggests that that profit is not sufficient as a
business objective

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Share price could also rise and fall due to potential investment decisions or the fact
that a new loan is being taken out or that dividends are to be increased or lowered.

Corporate Strategies

Clearly corporate strategies are wider than purely financial, they look at the business.
Once these are set appropriate financial objectives can then be set and measured

Examples include:

• Return on investment
• Market share
• Growth
• Customer satisfaction
• Quality

Financial Objectives

Profit Maximisation

• Focusing on profits could mean undue risk and short termism.

• Also, there is the problem that profits can be manipulated using financial
accounting, unlike cash.
• So maybe profit maximisation focuses on financial profit too much and not
enough on cash generation.

Earnings Per Share Growth

• This still uses earnings (profits) rather than cash unfortunately.

• EPS looks at the amount of profits made in the year for each individual share.
• Remember it is the ORDINARY shareholders who are interested in EPS. Therefore,
EPS is: (Profit after tax - preference dividends) / Weighted average Ordinary
shares

Illustration
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What is the EPS in each year?

Last Year Current Year

Profit before Interest and 22,300 23,726
Tax
Interest 3,000 3,000
Tax 5,790 6,218
Profit After Tax 13,510 14,508
Preference Dividends 200 200
No. of Ordinary Shares 100,000 100,000
Issued

Solution

Last year:

Earnings (13,510 - 200) = 13,310

EPS = Earnings 13,310 / Shares 100,000 = 13.31p

Current year

Earnings (14,508 - 200) = 14,308

EPS = Earnings 14,308 / Shares 100,000 = 14.31p

Stakeholders and Impact on Corporate Objectives

We have just seen that the primary objective of a company is the maximisation of
shareholder wealth.

However, there is an alternative known as the stakeholder view.

This means balancing shareholder wealth with the objectives of other stakeholders.

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Let’s have a look at some stakeholders and their objectives:

Stakeholder Objective
Staff High Salaries; Safe Job
Managers High Bonuses
Shareholders High Share Price; Dividend Growth
Banks Minimize company risk
Customer Quality service
Suppliers Good liquidity
Government Good accounting records; Training
initiatives

Clearly meeting all stakeholders, objectives entirely is impossible.

Often, they conflict with each other. Therefore, a degree of compromise is reached.

For example, Performance related pay for example is a means of satisfying both staff
and shareholders.

There is a fundamental problem highlighted here. The owners of the business are
generally not those who manage the business.

As both parties have different objectives this causes a problem.

The danger that managers may not act in the best interest of the owners is known as….

The Agency Problem

The managers are acting as agents for the owners.

So how can the owners ensure that the agents are working for the owner’s objectives
and not just their own?

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Fixed Wages

Not always the optimal way to organize relationships between principals and agents.

A fixed wage might create an incentive for the agent to shirk since his compensation
will be the same regardless of the quality of his work or his effort level.

Performance Related Pay

When agents have incentive to shirk, it is often more efficient to replace fixed wages
with compensation based on the profits of the firm, since it makes their compensation
dependent on their performance.

However, this can lead to individuals not working for the team by inflating budgets
required etc.

Output may also be encouraged rather than quality. It disregards job satisfaction also

Share Options

Seems like a great idea as if the share price goes up then both the managers and the
owner’s benefit.

However often shares go up and down in line with market movements regardless of how
well the managers have performed so many managers would not like to be measured
and paid solely this way.

Some elements of share options within their pay though would be a good thing and
acceptable by all

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1.2 Introduction to Financial Management - Objectives
- Introduction part-2

Stakeholders and Maximizing Shareholder Wealth

Regulatory Requirements

These can be imposed through corporate governance codes of best practice and stock
market listing regulations

• CG codes try to reduce risk and increase director’s accountability

• CG codes ensure directors must identify, assess and manage risks
• CG codes ensure a balanced perspective by requiring NEDs on the audit,
nominations and remuneration committees
• Stock exchange listings ensure financial reports are produced annually
• Stock exchange listings ensure that detailed information is given about director’s
pay
• Stock exchange listings ensure companies pay attention to their corporate social
responsibilities

Prospects Should Be Communicated to Stakeholders

• To show the company has enough working capital for its current needs and for
at least the next 12 months
• A general description of the future and prospects must be given
• Audited historical financial information covering latest three full years and any
published later interim period
• 50% of board to be NEDs

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Corporate Governance - Best Practice

• Although UK corporate governance rules do not apply to the non-UK companies,

investors would expect similar standard, and an explanation for any differences.
• UK companies are expected to:
• Splitting the roles of Chairman and CEO
• Have an independent audit committee, a remuneration committee and a
nomination committee
• Provide evidence of a high standard of financial controls and accounting system

Differences To a Listed Company

• Often Family owned

• Often no separation between management and owners
• Little differences between owner and director objectives
• Smaller number of shareholders - who are often in contact with the company -
so conflict less likely

In a listed Company it's different.

• Objectives of shareholders and directors may be different

• Asymmetry of information
• Shareholders get less info than directors, making monitoring harder
• A separation between ownership and control
• Shareholders and directors are different people

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1.3 Introduction to Financial Management - The
Economic Environment for Business

Economic Environment

The four major objectives are:

• Full employment
• Price stability
• A high, but sustainable, rate of economic growth
• Keeping the Balance of Payments in equilibrium.

Full Employment

• Full employment was considered very important after the Second World War.
• Unemployment in the 80s was seen as an inevitable consequence of the steps
taken to make industry more efficient.
• De-industrialization made higher unemployment feel inevitable, and so this
objective became much less important than it had been .

Growth & Low Inflation

• Growth and low inflation have always been important.

• Without growth peoples’ standard of living will not increase, and if inflation is
too high then the value of money falls negating any increase in living standards.
• Sustainable growth means growth without inflation.

Balance of Payments

The total of all the money coming into a country from abroad less all the money going
out of the country during the same period.

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Policies to Reduce a BOP Deficit:

• Higher Interest Rates

- will act to slowdown the growth of consumer demand and therefore lead to
cutbacks in the demand for imports.

• Fiscal Policy

(i.e., increases in direct taxes) might also be used to reduce aggregate demand.

The risk is that a sharp fall in consumer spending might lead to a steep economic
slowdown (slower growth of GDP) or a full-scale recession

Is a BOP Deficit a bad Thing?

Yes, because….

• A current account deficit is financed through borrowing or foreign investment

• Borrowing is unsustainable in the long term and countries will be burdened with
high interest payments.
• E.g., Russia was unable to pay its foreign debt back in 1998. Other developing
countries have experience similar repayment problems Brazil, African c (3rd
World debt)
• Foreigners have an increasing claim on home assets, which they could desire to
be returned at any time.
• E.g., a severe financial crisis in Japan may cause them to repatriate their
investments
• Export sector may be better at creating jobs
• A Balance of Payments deficit may cause a loss of confidence

No because….

• Current Account deficit could be used to finance investment

• E.g., US ran a Current account deficit for a long time as it borrowed to invest in
its economy.
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 • This enabled higher growth and so it was able to pay its debts back and countries
had confidence in lending the US money
• Japanese investment has been good for the UK economy not only did the
economy benefit from increased investment, but the Japanese firms also helped
bring new working practices in which increased labor productivity.
• With a floating exchange rate, a large current account deficit should cause a
devaluation which will help reduce the level of the deficit
• It depends on the size of the budget deficit as a % of GDP, for example the US
trade deficit has nearly reached 5% of GDP at this level it is concerning
economists
• It may well be offset by foreign investment.

Policies to Taxation & Spending

Decisions relating to taxation and government spending with the aim of full
employment, price stability, and economic growth

• By changing tax laws, the government can alter the amount of disposable income
available to its taxpayers. If taxes increased consumers would have less money
to spend.
• This difference in disposable income would go to the government instead of going
to consumers, who would pass the money onto companies.
• Or the government could increase its spending by purchasing goods from
companies. This would increase the flow of money through the economy and
would eventually increase the disposable income available to consumers.
• Unfortunately, this process takes time, as the money needs to wind its way
through the economy, creating a significant lag between the implementation of
fiscal policy and its effect on the economy.

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Governments Can Borrow:

• Short-term, e.g., Treasury bills

• Long-term, e.g., National Savings certificates.

This can have bad effects on the economy by ‘crowding out’ private investment by
pushing up interest rates.

The regulation of the money supply and interest rates by a central bank in order to
control inflation and stabilize currency

• The volume of money in circulation is called the money supply

• The price of money is called interest rates

Monetary Policy

Monetary policy is one of the ways the government can impact the economy.

By impacting the effective cost of money, the government can affect the amount of
money that is spent by consumers and businesses.

Effect on Growth

When interest rates are high, fewer people and businesses can afford to borrow, so this
usually slows the economy down.

Also, more people will save (if they can) because they receive more on their savings
rate.

When the central banks set interest rates it is the amount, they charge other banks to
borrow money.

This is a critical interest rate, in that it affects the entire supply of money, and hence
the health of the economy.

High interest rates can cause a recession.

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Effect on Exchange rates

High interest rates attract foreign investment ⇨ increase in exchange rates:

• exports dearer

• imports cheaper.

Effect on Inflation

High interest rates should restrict growth and inflation.

Exchange Rate Policy

• It may want to influence the exchange rate by using its gold and foreign currency
reserves held by its central bank to buy and sell its currency.
• A fall in the exchange rate will mean that the price of imports will rise while
exporters should become more internationally competitive. Import volumes
should fall whilst export volumes should rise.
• Output at home should rise, leading to higher economic growth and a fall in
unemployment.

There should be an improvement in the current account of the balance of payments

too as the gap between export values and import values improves.

However, higher import prices will feed through to a rise in inflation in the economy.

Target Fiscal Policy Monetary Policy Exchange Rates

Growth in Economy More Spending Lower Interest Lower
Rates
Low Inflation Lower Spending Higher Interest Higher
Rates
BOP Deficit Lower Spending Higher Interest Lower
Reduction Rates

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Competition Policy

The Competition Commission prevents takeovers that are against the public interest.

Competition policy aims to ensure:

• Wider consumer choice

• Technological innovation, and
• Effective price competition

Government assistance for business

Government grants available for certain investments and small business in areas such
as rural development, energy efficiency, education etc.

Green Policies

Air-fuel tax for example can threaten an airline business but create opportunities for
other forms of transport or makers of new greener aircraft.

Treasury Function

A company can be raising money by selling commercial paper into the MONEY market

It’s a relatively safe place to put money as everything is short term and highly liquid.

Money Market Securities

These are essentially IOUs issued by governments, financial institutions and large
corporations

Most trade in very high denominations

Let’s look at some in more detail.

Treasury Bills

• (T-bills) are the most marketable money market security.

• Short-term government securities that mature in one year or less
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 • Issued at a discount and then the government pays the full par value on maturity
• One of the few money market instruments that are affordable to individuals with
investors denominations as low as $1,000
• Considered safe as government backed, but this means a small return also
• Might not get back all your investment if you cash out before maturity

Certificates of Deposit

• Normally issued by commercial banks but they can be bought through brokerages
• Have a maturity date (from three months to five years), a specified interest rate,
and can be issued in any denomination
• Cannot be withdrawn on demand.

Commercial Papers

• No security is needed, and they are short term. Normally 1 - 2 months. This
makes them safe to invest in, though normally only good credit companies’ issue
these
• They’re normally used to finance working capital (trade finance) such as
receivables and inventories
• They are normally in denominations of $100,000 or more - Therefore, smaller
investors can only invest in commercial paper indirectly through money market
funds
• They are normally issued at a discount and paid back at par value (the difference
is obviously the interest)

Bankers’ Acceptance

• A BA is a short-term credit investment, and a bank guarantees payment.

• Companies use them for financing imports and exports, when the
creditworthiness of a foreign trade partner is unknown
• They don’t need to be held until maturity, and can be sold off in the secondary
markets where investors and institutions constantly trade BAs
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Money Market Derivatives

These derive their value from Treasury bills, Euro, dollars, certificates of deposits (CD)
and interest rates.

They are commonly traded as futures, forwards, options and swaps as well as caps and
floors.

Let's have a quick look at futures (there's further on in the course for the others)

• When a currency futures contract is bought or sold, the buyer or seller is required
to deposit a sum of money with the exchange, called initial margin.

If losses are incurred as exchange rates and hence the prices of currency futures
contracts change, the buyer or seller may be called on to deposit additional funds
(variation margin) with the exchange

• Equally, profits are credited to the margin account daily as the contract is
‘marked to market’.

Most currency futures contracts are closed out before their settlement dates by
undertaking the opposite transaction to the initial futures transaction, i.e., if buying
currency futures was the initial transaction, it is closed out by selling currency
futures.

A gain made on the futures transactions will offset a loss made on the currency
markets and vice versa.

Advantages

• Lower transaction costs than money market

• They are tradable and so do not need to always be closed out

Disadvantages

• Cannot be tailored as they are standard contracts

• Only available in a limited number of currencies

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 • Still cannot take advantage of favorable movements in actual exchange rates
(unlike in options)

A Money Market Fund

This provides investors with a safe place to invest easily accessible cash-equivalent
assets

However, the fund will provide only relatively low returns so it’s not a long-term
investment option

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