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        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 KAPLAN PUBLISHING   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 KAPLAN PUBLISHING chapter Introduction       Paper Introduction     v Introduction       How to Use the Materials These Kaplan Publishing learning materials have been  carefully designed to make your learning experience as easy  as possible and to give you the best chances of success in  your examinations. 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KAPLAN PUBLISHING   • Test your understanding sections provide an  opportunity to assess your understanding of the key  topics by applying what you have learned to short  questions. Answers can be found at the back of each  chapter. • Summary diagrams complete each chapter to show  the important links between topics and the overall  content of the paper. These diagrams should be used to  check that you have covered and understood the core  topics before moving on. • Question practice is provided at the back of each text. Icon Explanations Definition ­ Key definitions that you will need to learn from  the core content. Key Point ­ Identifies topics that are key to success and are  often examined. Expandable Text ­ Expandable text provides you with  additional information about a topic area and may help you  gain a better understanding of the core content. Essential  text users can access this additional content on­line (read it  where you need further guidance or skip over when you are  happy with the topic) Illustration ­ Worked examples help you understand the  core content better. Test Your Understanding ­ Exercises for you to complete  to ensure that you have understood the topics just learned. Tricky topic ­ When reviewing these areas care should be  taken and all illustrations and test your understanding  exercises should be completed to ensure that the topic is  understood.   For more details about the syllabus and the format of your  exam please see your Complete Text or go online. On­line subscribers   Paper background  Syllabus objectives   Paper­based examination tips  KAPLAN PUBLISHING vii Introduction   Study skills and revision guidance Preparing to study Effective studying Further reading  You can find further reading and technical articles under the  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.       Expandable text   KAPLAN PUBLISHING 3 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.            Expandable text     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.      Expandable text        Test your understanding 1   Give examples of agency losses that can erode shareholder value.    4 KAPLAN PUBLISHING 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. KAPLAN PUBLISHING 5 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.      Expandable text     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).      Expandable text     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.      Expandable Text   6 KAPLAN PUBLISHING
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