Acca p4 2012 Notes

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ACCA Paper P4
Advanced Financial Management

For exams in 2012
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Notes
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ExPress Notes

ACCA P4 Advanced Financial Management
Contents
About ExPress Notes
1. 2. 3. 4. 5. 6. 7. Role and Responsibility towards Stakeholders Economic Environment for Multinationals Advanced Investment Appraisal Acquisition & Mergers
Corporate Reconstruction & Re-Organisation
Treasury & Advanced Risk Management Techniques
Emerging Issues in Finance & Financial Management
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2012 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .
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We are very pleased that you have downloaded a copy of our ExPress notes for this paper. We expect that you are keen to get on with the job in hand, so we will keep the introduction brief. First, we would like to draw your attention to the terms and conditions of usage. Its a condition of printing these notes that you agree to the terms and conditions of usage. These are available to view at www.theexpgroup.com. Essentially, we want to help people get through their exams. If you are a student for the ACCA exams and you are using these notes for yourself only, you will have no problems complying with our fair use policy. You will however need to get our written permission in advance if you want to use these notes as part of a training programme that you are delivering. WARNING! These notes are not designed to cover everything in the syllabus!
They are designed to help you assimilate and understand the most important areas for the exam as quickly as possible. If you study from these notes only, you will not have covered everything that is in the ACCA syllabus and study guide for this paper. Components of an effective study system
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ACCA online past exams Skim through the ExPress notes to get a feel for whats in the syllabus, the size of the paper and how much it appeals to you. Have a quick look at the two most recent real ACCA exam papers to get a feel for examiners style. Dont use at this stage. Work through each chapter of the ExPress notes in detail before you then work through your course notes. Dont try to feel that you have to understand everything just get an idea for what you are about to study. Work through in detail. Review each chapter after class at least once. Dont make any annotations on the ExPress notes at this stage. Make sure that you understand each area reasonably well, but also make sure that you can recall key definitions, concepts, approaches to exam questions, mnemonics, etc. Nobody passes an exam by what they have studied we pass exams by being efficient in being able to prove what we know. In other words, you need to have effectively input the knowledge and be effective in the output of what you know. Exam practice is key to this. Try to do at least one past exam question on the learning phase for each major chapter.
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Your stage in study for each paper Practice phase These ExPress notes ExP recommended course notes, or ExPedite notes Avoid reading through your notes again. Try to focus on doing past exam questions first and then go back to your course notes/ ExPress notes if theres something in an answer that you dont understand. ExP recommended exam kit This is your most important tool at this stage. You should aim to have worked through and understood at least two or three questions on each major area of the syllabus. You pass real exams by passing mock exams. Dont be tempted to fall into passive revision at this stage (e.g. reading notes or listening to CDs). Passive revision tends to be a waste of time. Dont touch it! ACCA online past exams ACCA P4 Advanced Financial Management
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At the door of the exam room before you go in.
The night before the real exam
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Work through the ExPress notes again, this time annotating to explain bits that you think are easy and be brave enough to cross out the bits that you are confident youll remember without reviewing them. Read through the technical articles written by the examiner. Read through the two most recent examiners reports in detail. Read through some other older ones. Try to see if there are any recurring criticisms he or she makes. You must avoid these! Do a final review of the two most recent examiners reports for the paper you will be taking tomorrow. Read through the ExPress notes in full. Highlight the bits that you think are important but you think you are most likely to forget. Unless there are specific bits that you feel you must revise, avoid looking at your course notes. Give up on any areas that you still dont understand. Its too late now. Read quickly through the full set of ExPress notes, focusing on areas youve highlighted, key workings, approaches to exam questions, etc. Avoid looking at them in detail, especially if the notes are very big. It will scare you. Leave at home. Leave at home.
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Notes
Provide a base understanding of the most important areas of the syllabus only.
To maximise your chances of success in the exam we recommend you visit www.theexpgroup.com where you will be able to access additional free resources to help you in your studies.
START About The ExP Group
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Notes Notes
Provide a comprehensive coverage of the syllabus and accompany our face to face professional exam courses Provide detailed coverage of particular technical areas and are used on our Professional Development and Executive Programmes.
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ExPress Notes
Chapter 1
START The Big Picture
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The CFO Role
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Consistent with the principles of corporate governance outlined above, the role of the Chief Financial Officer (CFO) is to advise the board of directors of the firm in setting the financial goals of the business and its financial policies. A CFO will typically address the following areas: (a) The allocation of capital and investment choices;
Strategic choices and the Relationship with Corporate Goals In selecting appropriate strategies, the firm must ensure that those strategies are congruent i.e. consistent with its overall corporate goals.
KEY KNOWLEDGE The Role of Senior Financial Executive / Advisor
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Role and Responsibility towards Stakeholders
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(b) (c) (d) (e) (f) Minimising the cost of capital; Dividend policy; Communicating with key constituencies; Planning, control and risk management; Ethical standards
KEY KNOWLEDGE Business risks
This is a broad category with indistinct boundaries, but it generally covers risks to a companys ability to generate returns from its ordinary operations, including its strategy, business model, competitive position, political/legal environment (including regulatory/ compliance/ intellectual property), products, marketing, clients and reputation.
KEY KNOWLEDGE Risk management and diversification
Risks can be managed through mitigating, hedging or diversification strategies. Diversification can be demonstrated through the 2-asset portfolio:
The expected return of the portfolio is the weighted average return of the individual shares. The risk of the portfolio is represented by the standard deviation, denoted as (sigma):
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_________________________ p = xa2a2 + xb2 b2 +2xaxb (ab)
The terms are defined as follows: a , b = standard deviation of the returns of share a, resp. share b xa , xb = the proportions of shares a and b in the portfolio (a+b = 100%). = correlation coefficient between shares a and b
The correlation coefficient () varies between +1 and -1.
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ExPress Notes

KEY KNOWLEDGE Conflicting Stakeholder Interests

The formal separation between management and ownership in a corporation has important behavioral and organizational consequences. Maximize shareholder value: It is the duty of management (toward the owners of the business, the shareholders) to maximize shareholder value (or wealth). Shareholder value is measured by the dividends that shareholders receive and by the increase in the value of their shares (capital gain).
Agency theory: addresses the risk that management will not act in the best interest of the shareholders, but will make decisions that will serve its own interests.
Examples of self-serving management behavior could include: (a) artificially boosting corporate profits in the short-term in order to earn bonuses; (b) paying too much to acquire another company for reasons of prestige or in order to build empires; (c) rejecting opportunities, such as takeover bids, or restructuring initiatives, that might jeopardize their positions (an orientation to maintain the status quo).
Transaction cost economics refer to the evaluation of corporate alternatives in search of the most beneficial outcomes for the company. As seen in the foregoing paragraph, what is best for the company may not coincide with self-interest of the managers. Other stakeholder conflicts
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The agency problem between management and shareholders is only one of many potential conflicting interests that can exist between various stakeholder groups. A stakeholder is defined as anyone with an interest in the affairs of a company:
Management and employees are most intimately interested in the company, since they seek to preserve employment and to collect salaries/wages. Unions represent the employees collectively, seeking job security and good wages;
Customers, suppliers and creditors are also closely interested in a company based on financial and other benefits received; The public, via public interest groups and concerned citizens, may take an interest in a company for reasons of product safety and environmental concerns; The government has an interest in seeing that a company creates/maintains jobs and also generates corporate taxes;
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ExPress Notes
Even competitors may be regarded as stakeholders, though usually with a less than generous motives.
Mendelows matrix is one tool which can be used in order to examine stakeholder influence and to actively manage the relationship with relevant stakeholders.
KEY KNOWLEDGE Corporate Governance
Corporate governance structures have been developed setting forth guidelines and principles on which corporate management is expected to conduct its business. The need for good corporate governance has been spurred by such highly-publicized corporate scandals as the failure of Enron; however, corporate governance is not limited to the detection of fraud and crime. Good corporate governance includes:
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Corporate governance models
There are several models of corporate governance: Shareholder based models and (continental) European-based models. Shareholder-based models
The US and UK are typically cited as basing their principles of corporate governance on a shareholder-based system, where shareholdings are widely dispersed among many individuals and therefore require protection: Sarbanes-Oxley: Refers to legislation in the USA that imposes corporate governance principles on publicly-quoted US corporations. It seeks to safeguard the economic interests of shareholders;
Strengthening the role of non-executive directors on the board of directors; Holding management accountable for their actions; Ensuring that the interests of shareholders are protected; An ethical approach to behavior towards all stakeholders; Clear policy-making processes; Explicit risk management policy and monitoring systems; and Transparency and professionalism.
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Management must understand the power/influence and level of active interest of the various stakeholder groups in order to reconcile, or at least prioritize, and address their concerns.
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UK Corporate Governance Code: In the UK, these are a set of principles that are voluntarily adopted by public companies.
In contrast to the US/UK, there is the European model: Continental Europe has a greater prevalence of bank and industrial shareholdings, which concentrate corporate control; such interests tend to take a broader and more participatory approach to stakeholder interests.
In Germany, for example, there is a two-tier board structure: the supervisory board and the executive/ management board. The supervisory board, which monitors the activities of the management board, has among its membership representatives from the trade union.
KEY KNOWLEDGE The Impact of Environmental & Ethical Issues

Environmental concerns
Issues of environmental concern and sustainability have become established and recognized agenda points for corporations. Many stakeholders are coming to expect explicit acknowledgment of such matters. The triple bottom line approach expands the scope of a companys concerns, beyond the merely economic, to social and ecological as well.
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Ethical Issues
An ethical approach to doing business is not just a matter of personal virtue, but needs to be addressed by policy (and action) at the company level as well. Ethical frameworks are not merely nice to have, but are considered crucial to building long-term professionalism. Their absence can undermine motivation and the sense of purpose a company must have in order to succeed.
Carbon trading programmes are schemes by which a company which outperforms its environmental targets is rewarded by being able to sell its credits to companies that pollute beyond permitted limits. To operate properly, this arrangement requires supervision by a central authority (government) in what is known as a cap and trade regime.
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ExPress Notes
Chapter 2
KEY KNOWLEDGE Management of International Trade & Finance

International Trade and Finance -- Institutions
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Since World War II governments have sought to facilitate world trade by reducing barriers to trade (tariffs, quotas, etc.). The current international body coordinating this effort is the World Trade Organisation. Barriers to trade remain in place for reasons of national preference and economic protectionism. Agriculture in the western countries enjoys considerable protection in the form of government subsidies.
The international financial architecture is under-going significant reforms as a result of the financial crisis of 2008-09. The International Monetary Fund (IMF) was formed to assist governments in overcoming balance of payments deficits. The World Bank focused on financing developing and emerging economies to modernize and achieve growth through infrastructure projects. The Bank of International Settlements (BIS) was created as an institutional coordinating body between central banks and now hosts (and gives its name to) efforts to devise international capital adequacy standards in the banking sector.
An understanding of the global financial and trade systems is a basic requirement for anyone involved in business activities.
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Economic Environment for Multinationals
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ExPress Notes
The monetary policy setting powers at the national level are located within the central banks of those countries which maintain their own currencies (Federal Reserve in the US, Bank of England, Bank of Japan, and the Swiss National Bank) and at the supra-national level for the European currency (at the European Central Bank). Regular reading of international business publications is the best way to understand the above organizations in their contemporary context.
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ExPress Notes
Chapter 3
Advanced Investment Appraisal
START The Big Picture

Discounting Free Cash Flows
In order to value a project or company, it is necessary to forecast free cash flows and to discount these at an appropriate cost of capital. Note: Be sure to review your mathematical discounting methods from earlier papers.
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KEY KNOWLEDGE Free cash flow
This is the amount of net cash generated from period-to-period and available to capital providers (i.e. it is not re-invested in the project/company).
Free cash flow is relevant: non-cash, sunk, committed or allocated costs should be ignored when forecasting revenues, costs and investments.
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ExPress Notes
Free cash flow = Revenues Costs Investments (capital expenditures / working capital) Forecasting of cash flows must take the following into consideration:
It is conceptually most straightforward to use nominal values when forecasting cash flows, particularly if there are differential inflation rates applying to the future cash flows, i.e. if there is no uniform (single) price change for revenues and various cost categories (materials, labor, etc.). Fisher formula: used to convert nominal rates to real (and vice versa) (1 + i) = (1 + r)(1 + h)
i = nominal (or money) rate r = real rate h = inflation rate
If the nominal interest rate is 8% p.a. and inflation is running at 6%, then the real rate is 1.88%. (ii) Taxation
The impact of taxation is reflected in the cash flows showing explicitly: 1) Tax payable on operating cash flows; and 2) Tax relief derived from Written Down Allowances (WDA)
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When forecasting cash flows, there are two levels of Free Cash Flow one can choose from: 1) One can model operating cash flows (revenues, costs and investments, including taxation effects) and derive a bottom line entitled Free Cash Flow to Capital Providers, which represents the cash flow available to providers of debt and equity to the company.
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WACC =
Free Cash Flows to Equity vs. Free Cash Flows to Capital (providers)
This is the recommended method and follows the definition of Free Cash Flow presented earlier. Free Cash Flows to Capital Providers must be discounted at the companys Weighted Average Cost of Capital (WACC). Recall from Paper F9: E x ke + - D x kd (1-t) D+E D+E
Be sure to preserve this distinction when performing calculations.
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(i) The role of inflation
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ExPress Notes
Note: be sure to use market values of Debt (D) and Equity (E) wherever possible. The cost of equity (ke) is derived from the Capital Asset Pricing Model (CAPM). The cost of debt is after-tax (the cost to the company!). The pre-tax cost of debt (kd) must therefore be multiplied by (1-t) to obtain the after-tax cost. 2) The alternative method to modeling cash flows is to derive the Free Cash Flow to Equity (Holders). In order to arrive at this level of cash flow, one must perform the following steps: (Starting point:) Less: Less: Add: Free Cash Flow to Capital Providers (as in 1 above) Interest payments on debt (cash outflow) Repayments of debt (cash outflow) New debt raised (cash inflow)
Free Cash Flows to Equity must be discounted at the companys Cost of Equity (note the difference to 1 above)
Both approaches (1 & 2) are equivalent to each other, i.e. different paths to ultimately determining the share value of the same company. Method 1, however, is considered easier to apply (reduces errors). It is also conceptually more satisfying, as it isolates debt and equity from operating cash flows. Many industry practitioners recommend Method 1 for its conceptual clarity, as debt and equity are addressed directly when considering the companys capital structure.
Calculating the value of a company using the discounted cash flow method (DCF) is covered in a later section of these Notes.
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Time 0 1
KEY KNOWLEDGE IRR and MIRR
The internal rate of return (IRR) is defined as the discount rate (r) at which the net present value (NPV) of a stream of cash flows will be equal to zero. In other words, If, at a discount rate r, NPV = 0, then r = IRR
The IRR includes among its assumptions the following: any cash flows generated in the course of the project being evaluated are calculated as being reinvested at the IRR rate. This is illustrated thus: Cash flows (20,000) 5,000
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ExPress Notes
2 30,000 The IRR of the above cash flows (using interpolation or a calculator) is 35.61%.
Time 0 1 2
The IRR of the cash flows shown in Column (B) is 35.61% -- exactly the same as in Column (A). Note: Column (B) cash flows now resemble that of a zero-coupon bond, with investment at time 0 and no cash returns until the final year. This calculation confirms that interim cash flows are re-invested at the IRR rate. This assumption has been criticized for being unrealistic, since cash paid out of a project (returned to the investors, for example) is unlikely to obtain the same rate if invested elsewhere: they may be higher (i.e. interest rates may have risen in the meantime), or lower (placed in the bank to earn deposit interest). Modified IRR (MIRR)
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Time 0 1 2
In this case, the MIRR would be calculated as follows: Cash flows (A)
Thus, to take our example above, suppose the 5,000 in Year 1 would earn only 12% if invested (outside the project).
This method modifies the re-investment rate assumption by applying a different interest rate to the interim cash flows.
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The IRR modified this way (the MIRR) is 33.42%.
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Cash flows (A) Cash flows (B) (20,000) 5,000 30,000 (20,000) 0 36,780.5 (30,000 + 6,780.5*) * 5,000 x 1.3561 = 6,780.5 Cash flows (C) (20,000) 5,000 30,000 (20,000) 0 35,600 (30,000 + 5,600*) * 5,000 x 1.12 = 5,600
The above cash flows are equivalent to re-investing the 5,000 (in Year 1) at the IRR rate (35.61%) to maturity (Year 2).
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ExPress Notes

This is a simulation model that uses probability distribution analysis to analyze the possible outcomes of a project. It is built on the simultaneous changes of many variables, the relationships between these variables being defined in advance, e.g. if price is reduced, how much demand may go up. Each variable itself has a probability distribution and the combinations of variables are modeled by running the model repeatedly, resulting in a distribution of simulation results.
KEY KNOWLEDGE Value at Risk (VAR)
This is also a statistics-based model, using the distribution of outcomes to measure the probability of loss. It goes beyond the expected value of an asset, and looks at the range of probabilities of downside (or loss) situations. VAR can be applied to the following situation: If a portfolio of investments has an expected value of $50m, what is the probability that the value could drop to $40m?
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Plain-vanilla options are covered in earlier papers and it is essential to have a clear grasp of the practical effects of buying and selling these instruments.
One might look at this the other way around and ask: what level of value (expressed in USD) would correspond to a 5% chance of occurrence?
KEY KNOWLEDGE Options
KEY KNOWLEDGE Puts
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KEY KNOWLEDGE Monte Carlo Simulation
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ExPress Notes
An investor bought shares (in this case, the underlying asset) at $40 which have since increased to $52, a gain of 30%. To protect a budgeted return of 20% (corresponding to $48, or $40 x 1.20), she decides to buy a put option on the shares at a strike price of $50. Expiry of the option is year-end. The strike (or exercise price, $50) is the minimum that the investor will get for selling her shares: (a) If the market price is higher than the strike price (say, $52), then the investor can sell the shares at the market price; the option is out-of-the-money and expires unused;
(b) If the market price drops below strike, say to $47, then the investor can exercise the option and sell for $50. The option, being-in-the-money, has an intrinsic value of $3; In this case, the investor has achieved a hedge against her share investment dropping in value.
KEY KNOWLEDGE Calls
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The treasurer has hedged against an appreciating GBP; 1.15 is the maximum price that he will have to pay for the GBP.
The Black-Scholes option pricing formula is core to this part of the syllabus. The formula is based on 5 principal drivers of value, several of which have appeared in the preceding examples:
The treasurer of the Italian subsidiary of a UK group plans to pay a dividend of 500,000 to the parent company in December. Since the treasurer believes that GBP (in this case, the underlying asset) could become cheaper by the end of the year (GBP/EUR is currently 1.14), he does not buy it now; instead he buys a call option at the rate of GBP/EUR 1.15 (strike, or exercise, price) with a December expiry date.
KEY KNOWLEDGE Black-Scholes Options Pricing (BSOP) Model
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Vi si t

Advanced Financial Management

Corporate Reconstruction & Re-Organisation

Treasury & Advanced Risk Management Techniques

Emerging Issues in Finance & Financial Management

START About ExPress Notes

ACCA P4 Advanced Financial Management

At the start of the learning phase

At the door of the exam room before you go in.

The night before the real exam

START About The ExP Group

START The Big Picture

KEY KNOWLEDGE The Role of Senior Financial Executive / Advisor

Role and Responsibility towards Stakeholders

KEY KNOWLEDGE Business risks

KEY KNOWLEDGE Risk management and diversification

_________________________ p = xa2a2 + xb2 b2 +2xaxb (ab)

The correlation coefficient () varies between +1 and -1.

KEY KNOWLEDGE Conflicting Stakeholder Interests

KEY KNOWLEDGE Corporate Governance

Corporate governance models

KEY KNOWLEDGE The Impact of Environmental & Ethical Issues

KEY KNOWLEDGE Management of International Trade & Finance

Economic Environment for Multinationals

ACCA P4 Advanced Financial Management

Advanced Investment Appraisal

START The Big Picture

KEY KNOWLEDGE Free cash flow

ACCA P4 Advanced Financial Management

i = nominal (or money) rate r = real rate h = inflation rate

Be sure to preserve this distinction when performing calculations.

(i) The role of inflation

KEY KNOWLEDGE IRR and MIRR

The IRR modified this way (the MIRR) is 33.42%.

KEY KNOWLEDGE Value at Risk (VAR)

KEY KNOWLEDGE Options

KEY KNOWLEDGE Puts

KEY KNOWLEDGE Monte Carlo Simulation

KEY KNOWLEDGE Calls

KEY KNOWLEDGE Black-Scholes Options Pricing (BSOP) Model

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