ACCA
Paper P4
Advanced financial
management
Essential text
British library cataloguinginpublication data
A catalogue record for this book is available from the British Library.
Published by:
Kaplan Publishing UK
Unit 2 The Business Centre
Molly Millars Lane
Wokingham
Berkshire
RG41 2QZ
ISBN 9781847105516
© Kaplan Financial Limited, 2008
Printed and bound in Great Britain.
Acknowledgements
We are grateful to the Association of Chartered Certified Accountants and the Chartered Institute of
Management Accountants for permisssion to reproduce past examination questions. The answers
have been prepared by Kaplan Publishing.
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 the prior written permission of Kaplan Publishing.
ii
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Contents
Page
Chapter 1
Stakeholders
Chapter 2
Financial strategy development
25
Chapter 3
Dividend policy
39
Chapter 4
Capital structure and raising finance
51
Chapter 5
Risk management
65
Chapter 6
Investment appraisal I – DCF and the use of free 77
cash flows
Chapter 7
Investment appraisal II – the impact of financing 129
and adjusted present value
Chapter 8
Investment appraisal III – option pricing
Chapter 9
International investment and financing decisions 181
Chapter 10
Capital investment and financial reporting
213
Chapter 11
Acquisitions and mergers
225
Chapter 12
Valuations
261
Chapter 13
Corporate reconstruction and reorganisation
297
Chapter 14
The economic environment for multinationals
331
Chapter 15
International money markets and complex
financial instruments
351
Chapter 16
Hedging foreign exchange risk
373
Chapter 17
Hedging interest rate risk
409
Chapter 18
Managing other forms of risk
433
Chapter 19
Dividend policy and transfer pricing in
multinationals
451
Chapter 20
Emerging issues in business finance
479
Chapter 21
Questions & Answers
491
KAPLAN PUBLISHING
1
157
iii
iv
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vii
Introduction
Study skills and revision guidance
Preparing to study
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Further reading
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student section of ACCA's website.
viii
KAPLAN PUBLISHING
MATHEMATICAL TABLES
Formulae and tables
Modigliani and Miller Proposition 2 (with tax)
ke = kie + (1 − T)(kie − kd)
Vd
Ve
Two asset portfolio
sp =
w a2 s a2 + w 2b s 2b + 2w a w b rab s a s b
The Capital Asset Pricing Model
E(ri) = Rf + βi(E(rm) − Rf)
The asset beta formula
⎡
⎤ ⎡ Vd (1 − T )
⎤
Ve
βe ⎥ + ⎢
βd ⎥
⎣ (Ve + Vd (1 − T )) ⎦ ⎣ Ve + Vd (1 − T )) ⎦
βa = ⎢
The Growth Model
Po =
D o (1 + g )
(re − g )
Gordon’s growth approximation
g = bre
The weighted average cost of capital
⎡ Ve ⎤
⎡ Vd ⎤
WACC = ⎢
⎥k e + ⎢
⎥ k d (1 − T )
⎣ Ve + Vd ⎦
⎣ Ve + Vd ⎦
The Fisher formula
(1+i) = (1+r)(1+h)
Purchasing power parity and interest rate parity
s1 = S o x
KAPLAN PUBLISHING
(1 + h c )
(1 + h b )
f0 = so x
(1 + i c )
(1 + i b )
ix
The Black-Scholes option pricing model
The forex modified Black-Scholes
option pricing model
c = PaN(d1) – PeN(d2)e−rt
c = e−rt F0N(d1) − XN(d2)
Where:
Or
2
d1 =
In(Pa / Pe ) + (r + 0.5s ) t
d 2 = d1 − s t
s t
p = e–rt XN(−d2) − F0N(−d1)
Where:
2
d1 =
1n (F0 / X ) + s T / 2
s T
and
d 2 = d1 − s T
The Put Call Parity relationship
p = c − Pa + Pee−rt
x
KAPLAN PUBLISHING
Present value table
Present value of 1, i.e. (1 + r)−n
Where
r = discount rate
n = number of periods until payment
Discount rate (r)
Periods
(n)
1
2
3
4
5
1%
0.990
0.980
0.971
0.961
0.951
2%
0.980
0.961
0.942
0.924
0.906
3%
0.971
0.943
0.915
0.888
0.863
4%
0.962
0.925
0.889
0.855
0.822
5%
0.962
0.907
0.864
0.823
0.784
6%
0.943
0.890
0.840
0.792
0.747
7%
0.935
0.873
0.816
0.763
0.713
8%
0.926
0.857
0.794
0.735
0.681
9%
0.917
0.842
0.772
0.708
0.650
10%
0.909
0.826
0.751
0.683
0.621
6
7
8
9
10
0.942
0.933
0.923
0.914
0.905
0.888
0.871
0.853
0.837
0.820
0.837
0.813
0.789
0.766
0.744
0.790
0.760
0.731
0.703
0.676
0.746
0.711
0.677
0.645
0.614
0.705
0.665
0.627
0.592
0.558
0.666
0.623
0.582
0.544
0.508
0.630
0.583
0.540
0.500
0.463
0.596
0.547
0.502
0.460
0.422
0.564
0.513
0.467
0.424
0.386
11
12
13
14
15
0.896
0.887
0.879
0.870
0.861
0.804
0.788
0.773
0.758
0.743
0.722
0.701
0.681
0.661
0.642
0.650
0.625
0.601
0.577
0.555
0.585
0.557
0.530
0.505
0.481
0.527
0.497
0.469
0.442
0.417
0.475
0.444
0.415
0.388
0.362
0.429
0.397
0.368
0.340
0.315
0.388
0.356
0.326
0.299
0.275
0.350
0.319
0.290
0.263
0.239
Discount rate (r)
Periods
(n)
1
2
3
4
5
11%
0.901
0.812
0.731
0.659
0.593
12%
0.893
0.797
0.712
0.636
0.567
13%
0.885
0.783
0.693
0.613
0.543
14%
0.877
0.769
0.675
0.592
0.519
15%
0.870
0.756
0.658
0.572
0.497
16%
0.862
0.743
0.641
0.552
0.476
17%
0.855
0.731
0.624
0.534
0.456
18%
0.847
0.718
0.609
0.516
0.437
19%
0.840
0.706
0.593
0.499
0.419
20%
0.833
0.694
0.579
0.482
0.402
6
7
8
9
10
0.535
0.482
0.434
0.391
0.352
0.507
0.452
0.404
0.361
0.322
0.480
0.425
0.376
0.333
0.295
0.456
0.400
0.351
0.308
0.270
0.432
0.376
0.327
0.284
0.247
0.410
0.354
0.305
0.263
0.227
0.390
0.333
0.285
0.243
0.208
0.370
0.314
0.266
0.225
0.191
0.352
0.296
0.249
0.209
0.176
0.335
0.279
0.233
0.194
0.162
11
12
13
14
15
0.317
0.286
0.258
0.232
0.209
0.287
0.257
0.229
0.205
0.183
0.261
0.231
0.204
0.181
0.160
0.237
0.208
0.182
0.160
0.140
0.215
0.187
0.163
0.141
0.123
0.195
0.168
0.145
0.125
0.108
0.178
0.152
0.130
0.111
0.095
0.162
0.137
0.116
0.099
0.084
0.148
0.124
0.104
0.088
0.074
0.135
0.112
0.093
0.078
0.065
KAPLAN PUBLISHING
xi
Annuity Table
Present value of an annuity of 1, i.e.
Where
1 − (1 + r ) − n
r
r = discount rate
n = number of periods until payment
Discount rate (r)
Periods
(n)
1
2
3
4
5
1%
0.990
1.970
2.941
3.902
4.853
2%
0.980
1.942
2.884
3.808
4.713
3%
0.971
1.913
2.829
3.717
4.580
4%
0.962
1.886
2.775
3.630
4.452
5%
0.952
1.859
2.723
3.546
4.329
6%
0.943
1.833
2.673
3.465
4.212
7%
0.935
1.808
2.624
3.387
4.100
8%
0.926
1.783
2.577
3.312
3.993
9%
0.917
1.759
2.531
3.240
3.890
10%
0.909
1.736
2.487
3.170
3.791
6
7
8
9
10
5.795
6.728
7.652
8.566
9.471
5.601
6.472
7.325
8.162
8.983
5.417
6.230
7.020
7.786
8.530
5.242
6.002
6.733
7.435
8.111
5.076
5.786
6.463
7.108
7.722
4.917
5.582
6.210
6.802
7.360
4.767
5.389
5.971
6.515
7.024
4.623
5.206
5.747
6.247
6.710
4.486
5.033
5.535
5.995
6.418
4.355
4.868
5.335
5.759
6.145
11
12
13
14
15
10.368
11.255
12.134
13.004
13.865
9.787
10.575
11.348
12.106
12.849
9.253
9.954
10.635
11.296
11.938
8.760
9.385
9.986
10.563
11.118
8.306
8.863
9.394
9.899
10.380
7.887
8.384
8.853
9.295
9.712
7.499
7.943
8.358
8.745
9.108
7.139
7.536
7.904
8.244
8.559
6.805
7.161
7.487
7.786
8.061
8.495
6.814
7.103
7.367
7.606
Discount rate (r)
xii
Periods
(n)
1
2
3
4
5
11%
0.901
1.713
2.444
3.102
3.696
12%
0.893
1.690
2.402
3.037
3.605
13%
0.885
1.668
2.361
2.974
3.517
14%
0.877
1.647
2.322
2.914
3.433
15%
0.870
1.626
2.283
2.855
3.352
16%
0.862
1.605
2.246
2.798
3.274
17%
0.855
1.585
2.210
2.743
3.199
18%
0.847
1.566
2.174
2.690
3.127
19%
0.840
1.547
2.140
2.639
3.058
20%
0.833
1.528
2.106
2.589
2.991
6
7
8
9
10
4.231
4.712
5.146
5.537
5.889
4.111
4.564
4.968
5.328
5.650
3.998
4.423
4.799
5.132
5.426
3.889
4.288
4.639
4.946
5.216
3.784
4.160
4.487
4.772
5.019
3.685
4.039
4.344
4.607
4.833
3.589
3.922
4.207
4.451
4.659
3.498
3.812
4.078
4.303
4.494
3.410
3.706
3.954
4.163
4.339
3.326
3.605
3.837
4.031
4.192
11
12
13
14
15
6.207
6.492
6.750
6.982
7.191
5.938
6.194
6.424
6.628
6.811
5.687
5.918
6.122
6.302
6.462
5.453
5.660
5.842
6.002
6.142
5.234
5.421
5.583
5.724
5.847
5.029
5.197
5.342
5.468
5.575
4.836
4.968
5.118
5.229
5.324
4.656
4.793
4.910
5.008
5.092
4.486
4.611
4.715
4.802
4.876
4.327
4.439
4.533
4.611
4.675
KAPLAN PUBLISHING
Standard Normal Distribution Table
0.01
0.02
0.03
0.04
0.05
0.06
0.07
0.08
0.09
0.0
0.1
0.2
0.3
0.4
.0000
.0398
.0793
.1179
.1554
.0040
.0438
.0832
.1217
.1591
.0080
.0478
.0871
.1255
.1628
.0120
.0517
.0910
.1293
.1664
.0160
.0557
.0948
.1331
.1700
.0199
.0596
.0987
.1368
.1736
.0239
.0636
.1026
.1406
.1772
.0279
.0675
.1064
.1443
.1808
.0319
.0714
.1103
.1480
.1844
.0359
.0753
.1141
.1517
.1879
0.5
0.6
0.7
0.8
0.9
.1915
.2257
.2580
.2881
.3159
.1950
.2291
.2611
.2910
.3186
.1985
.2324
.2642
.2939
.3212
.2019
.2357
.2673
.2967
.3238
.2054
.2389
.2703
.2995
.3264
.2088
.2422
.2734
.3023
.3289
.2123
.2454
.2764
.3051
.3315
.2157
.2486
.2794
.3078
.3340
.2190
.2517
.2823
.3106
.3365
.2224
.2549
.2852
.3133
.3389
1.0
1.1
1.2
1.3
1.4
.3413
.3643
.3849
.4032
.4192
.3438
.3665
.3869
.4049
.4207
.3461
.3686
.3888
.4066
.4222
.3485
.3708
.3907
.4082
.4236
.3508
.3729
.3925
4099
.4251
.3531
.3749
.3944
.4115
.4265
.3554
.3770
.3962
.4131
.4279
.3577
.3790
.3980
.4147
.4292
.3599
.3810
.3997
.4162
.4306
.3621
.3830
.4015
.4177
.4319
1.5
1.6
1.7
1.8
1.9
.4332
.4452
.4554
.4641
.4713
.4345
.4463
.4564
.4649
.4719
.4357
.4474
.4573
.4656
.4726
.4370
.4484
.4582
.4664
.4732
.4382
.4495
.4591
.4671
.4738
.4394
.4505
.4599
.4678
.4744
.4406
.4515
.4608
.4686
.4750
.4418
.4525
.4616
.4693
.4756
.4430
.4535
.4625
.4699
.4761
.4441
.4545
.4633
.4706
.4767
2.0
2.1
2.2
2.3
2.4
.4772
.4821
.4861
.4893
.4918
.4778
.4826
.4864
.4896
.4920
.4783
.4830
.4868
.4898
.4922
.4788
.4834
.4871
.4901
.4925
.4793
.4838
.4875
.4904
.4927
.4798
.4842
.4878
.4906
.4929
.4803
.4846
.4881
.4909
.4931
.4808
.4850
.4884
.4911
.4932
.4812
.4854
.4887
.4913
.4934
.4817
.4857
.4890
.4916
.4936
2.5
2.6
2.7
2.8
2.9
.4938
.4953
.4965
.4974
.4981
.4940
.4955
.4966
.4975
.4982
.4941
.4956
.4967
.4976
.4982
.4943
.4957
.4968
.4977
.4983
.4945
.4959
.4969
.4977
.4984
.4946
.4960
.4970
.4978
.4984
.4948
.4961
.4971
.4979
.4985
.4949
.4962
.4972
.4980
.4985
.4951
4963
.4973
.4980
.4986
.4952
.4964
.4974
.4981
.4986
3.0
.4987
.4987
.4987
.4988
.4988
.4989
.4989
.4989
.4990
.4990
This table can be used to calculate N(di), the cumulative normal distribution functions needed for the BlackScholes model of option pricing. If d1 > 0, add 0.5 to the relevant number above. If d1 < 0, subtract the
relevant number above from 0.5.
KAPLAN PUBLISHING
xiii
xiv
KAPLAN PUBLISHING
chapter
1
Stakeholders
Chapter learning objectives
Upon completion of this chapter you will be able to:
•
explain the following concepts and their relevance for corporate
governance:
– the separation of ownership and control
–
transaction cost theory
–
agency theory
•
explain the ways in which the behaviour of those charged with
corporate governance may give rise to a conflict of interest with
stakeholders
•
identify the potential conflicts between stakeholders and those
charged with corporate governance in a specific scenario
•
identify, explain and recommend the alternative approaches that
may be adopted to resolve the conflicts of interests between
those charged with governance and stakeholders
•
describe, compare and contrast the emerging governance
structures and policies in the UK, the US and Europe, with
respect to corporate governance in general and the role of the
financial manager in particular
•
list and define the ethical principles governing members of the
association
•
explain the importance of establishing an ethical financial policy
for the financial management of the firm (incorporating the ethical
principles of the association and the principles of good corporate
governance) and describe the role and responsibility of senior
financial executives/advisors with regard to its development
•
describe the ways in which the ethical framework of a firm could
be undermined by agency effects and/or stakeholder conflicts
1
Stakeholders
•
identify and analyse the areas in a scenario where the ethical
framework of the firm may be undermined by agency effects
and/or stakeholder conflicts and recommend strategies for
dealing with them
•
identify and explain the ethical issues which may arise within
business issues and decisions of a firm in a scenario question
•
advise a firm, in a scenario question, on the best ethical practice
in its financial management
•
explain the interconnectedness of the ethics of good business
practice between all of the functional areas of the firm
•
recommend, in a scenario question, an ethical framework for the
development of a firm’s financial policies and a system for the
assessment of their ethical impact upon the financial
management of the firm
•
analyse the potential impact of the following on corporate
objectives and governance
– of sustainability and environmental risk issues
–
the carbontrading economy and emissions
–
environmental audits and the triple bottom line approach.
2
KAPLAN PUBLISHING
chapter 1
1 Stakeholder interests
We usually assume that the primary objective of a business is to maximise
shareholder wealth. However, the goals and intentions of those running the
company may be in conflict with shareholder interests. The following
sections consider the reason for the conflict.
The separation of ownership and control
In an ownermanaged firm, the owner manager:
•
•
makes all the management decisions and
has a claim to the profits of the firm.
However in a larger firm:
Shareholders
Profits Have a claim on all residual profits
Control Have little effective control over daily
activities
Managers
Have no claim on
profits
Control policy and
action
This split between the shareholders (who own the company) and the
management is known as the divorce of ownership and control.
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Stakeholders
Agency theory
The result of the separation of ownership and control discussed above, is
that an agency relationship is created between the company (and hence
the shareholders) and the managers/directors.
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The difficulty with an agency relationship, is that once the agent has been
appointed, he is able to act in his own selfish interests rather than pursuing
the objectives of the principal.
This resultant loss to the principal is known as agency loss.
In the case of shareholders and directors, this may mean:
•
•
the directors pursue their own interests at the expense of the company
shareholders do not earn optimum returns.
Principal agent theory underpins much of the corporate governance
developments discussed in section 4 below. However, some have criticized
this approach for adopting an excessively negative view of directors as
being "opportunistic shirkers". "Stewardship theory", in contrast, views
directors as wanting to be good stewards of the company's resources. The
issue is not executive motivation but whether or not the organisational
structure helps the executive to formulate and implement plans for high
corporate performance.
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Test your understanding 1
Give examples of agency losses that can erode shareholder
value.
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chapter 1
Test your understanding 2
For each of the following groups of stakeholders in a company,
suggest a potential conflict of interest and give an example of the
resulting costs such a conflict could give rise to.
Stakeholders
Potential
conflict
Costs resulting from
the conflict
Employees v Shareholders
Customers v Community at
large
Shareholders v Finance
providers
Government v
Shareholders
Transaction cost economics
Firms face many ‘makeorbuy’ decisions: whether it is better to provide
a product or service from within the organisation, with hierarchical co
ordination, or from outside the organisation, with market coordination.
Transaction costs are the expenses incurred by allowing some activity to be
undertaken outside the organisation and include the following:
•
Search and information costs are costs such as those incurred in
determining that the required good is available on the market, which
supplier has the lowest prices, etc.
•
Bargaining costs are the costs required to come to an acceptable
agreement with the other party to the transaction, drawing up an
appropriate contract, etc.
•
Policing and enforcement costs are the costs of making sure the other
party sticks to the terms of the contract, and taking appropriate action
(often through the legal system) if this turns out not to be the case.
Transaction cost economics suggests that where transaction costs are high,
firms should choose to bring the process (or assets) inhouse. However,
where transaction costs are low, outsourcing may be preferable. For
example,
•
If a product or service is a standard design, then specification will be
straightforward and the transaction costs will be low.
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Stakeholders
•
With more sophisticated products and services there needs to be a
great deal of negotiation between the organisation and its supplier.
The key application to the principalagent problem is that directors may
choose to expand the firm (e.g. as part of “empire building”) when
transaction cost economics would suggest outsourcing to be preferable.
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2 Specific strategies for managing conflict between stakeholders
Hierarchies of decision making
In order to prevent abuse of decisionmaking power by the executive, control
over decisions tends to be distributed between:
•
•
•
the full board
individual executive directors making operational decisions
nonexecutive directors
– audit committee
–
•
•
remuneration committee.
shareholders in general meeting
specific classes of shareholders where particular rights are concerned.
In addition, a company may elect to take some key decisions in consultation
with the employees (see section 4.6 below).
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Performance monitoring and evaluation systems
Managers are more likely to act in accordance with shareholders’ wishes
when their performance is regularly monitored and appraised against
proscribed targets. To be of real value, the targets must be congruent with
the maximisation of shareholder value.
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