AFM_Study_Text_2022-23_ISDC.pdf

Valid for September 2022, ACCA (AFM)...

Valid for September 2022, ACCA (AFM) December 2022, March 2023 and June 2023 Exam-focused ACCA Kaplan’s vast classroom experience helps many students pass first time. The books are designed to cover the whole syllabus and they reflect how topics are taught in the classroom, focusing on what will be required of you in the exam. Advanced Management Advanced Financial Student-friendly Using accessible language and engaging Financial formats to help you understand more complex areas, Kaplan simplifies the learning process Management (AFM) to make it easier for you to succeed. December 2022, March 2023 and June 2023 Valid for September 2022, Written by our expert tutors All Kaplan study materials are written by our subject specialists, experienced tutors who teach the paper so they know what works for students and how best to deliver it. Innovative solutions More than just books, our study materials are supported by a wealth of free online resources, including testing and course assessments. All accessible from our online learning environment MyKaplan. All the resources have been designed to keep you on your study plan and help you pass first time. Kaplan Publishing UK Study Text ISBN 978-1-83996-126-7 Study Text 9 781839 961267  ACCA Strategic Professional – Options Advanced Financial Management (AFM) Study Text  KAPLAN PUBLISHING’S STATEMENT OF PRINCIPLES LINGUISTIC DIVERSITY, EQUALITY AND INCLUSION We are committed to diversity, equality and inclusion and strive to deliver content that all users can relate to. We are here to make a difference to the success of every learner. Clarity, accessibility and ease of use for our learners are key to our approach. We will use contemporary examples that are rich, engaging and representative of a diverse workplace. We will include a representative mix of race and gender at the various levels of seniority within the businesses in our examples to support all our learners in aspiring to achieve their potential within their chosen careers. Roles played by characters in our examples will demonstrate richness and diversity by the use of different names, backgrounds, ethnicity and gender, with a mix of sexuality, relationships and beliefs where these are relevant to the syllabus. It must always be obvious who is being referred to in each stage of any example so that we do not detract from clarity and ease of use for each of our learners. We will actively seek feedback from our learners on our approach and keep our policy under continuous review. If you would like to provide any feedback on our linguistic approach, please use this form (you will need to enter the link below into your browser). https://docs.google.com/forms/d/1Vc4mltBPrfViy8AhfyKcJMHQKBmLaLPoa_WPqFNf4MI/edit We will seek to devise simple measures that can be used by independent assessors to randomly check our success in the implementation of our Linguistic Equality, Diversity and Inclusion Policy. P.2 KAPLAN PUBLISHING  British library cataloguing-in-publication 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 978-1-83996-126-7 © Kaplan Financial Limited, 2022 The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials. Printed and bound in Great Britain. Acknowledgements These materials are reviewed by the ACCA examining team. The objective of the review is to ensure that the material properly covers the syllabus and study guide outcomes, used by the examining team in setting the exams, in the appropriate breadth and depth. The review does not ensure that every eventuality, combination or application of examinable topics is addressed by the ACCA Approved Content. 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KAPLAN PUBLISHING P.3 P.4 KAPLAN PUBLISHING  Contents Page Chapter 1 The role and responsibility of the financial manager 1 Chapter 2 Investment appraisal 41 Chapter 3 International operations and international investment appraisal 73 Chapter 4 The financing decision 121 Chapter 5 The dividend decision 163 Chapter 6 The weighted average cost of capital (WACC) 195 Chapter 7 Risk adjusted WACC and adjusted present value 225 Chapter 8 Option pricing 249 Chapter 9 An introduction to risk management 283 Chapter 10 Hedging foreign exchange risk 323 Chapter 11 Hedging interest rate risk 363 Chapter 12 Strategic aspects of acquisitions 401 Chapter 13 Business valuation 443 Chapter 14 Corporate failure and reconstruction 485 Chapter 15 Professional skills 535 Chapter 16 Employability and technology skills 545 Chapter 17 Questions and Answers 555 Index I.1 KAPLAN PUBLISHING P.5 P.6 KAPLAN PUBLISHING  Introduction KAPLAN PUBLISHING P.7  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. The product range contains a number of features to help you in the study process. They include: 1 Detailed study guide and syllabus objectives 2 Description of the examination 3 Study skills and revision guidance 4 Study text 5 Question practice The sections on the study guide, the syllabus objectives, the examination and study skills should all be read before you commence your studies. They are designed to familiarise you with the nature and content of the examination and give you tips on how to best to approach your learning. The study text comprises the main learning materials and gives guidance as to the importance of topics and where other related resources can be found. Each chapter includes:  The learning objectives contained in each chapter, which have been carefully mapped to the examining body's own syllabus learning objectives or outcomes. You should use these to check you have a clear understanding of all the topics on which you might be assessed in the examination.  The chapter diagram provides a visual reference for the content in the chapter, giving an overview of the topics and how they link together.  The content for each topic area commences with a brief explanation or definition to put the topic into context before covering the topic in detail. You should follow your studying of the content with a review of the illustration/s. These are worked examples which will help you to understand better how to apply the content for the topic.  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. P.8 KAPLAN PUBLISHING   Summary diagrams complete each chapter to show the important links between topics and the overall content of the syllabus. 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. Quality and accuracy are of the utmost importance to us so if you spot an error in any of our products, please send an email to [email protected] with full details, or follow the link to the feedback form in MyKaplan. Our Quality Coordinator will work with our technical team to verify the error and take action to ensure it is corrected in future editions. 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. New – Identifies topics that are brand new. Test your understanding – Exercises for you to complete to ensure that you have understood the topics just learned. Illustration – Worked examples help you understand the core content better. 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. Supplementary reading – These sections will help to provide a deeper understanding of core areas. The supplementary reading is NOT optional reading. It is vital to provide you with the breadth of knowledge you will need to address the wide range of topics within your syllabus that could feature in an exam question. Reference to this text is vital when self studying. On-line subscribers Our on-line resources are designed to increase the flexibility of your learning materials and provide you with immediate feedback on how your studies are progressing. Ask your local customer services staff if you are not already a subscriber and wish to join. KAPLAN PUBLISHING P.9  If you are subscribed to our on-line resources, you will find: 1 On-line reference ware: reproduces your Study Text on-line, giving you anytime, anywhere access. 2 On-line testing: provides you with additional on-line objective testing so you can practice what you have learned further. 3 On-line performance management: immediate access to your on-line testing results. Review your performance by key topics and chart your achievement through the course relative to your peer group. Syllabus Examination background The aim of Advanced Financial Management (AFM) is to apply relevant knowledge, skills and exercise professional judgement as expected of a senior financial executive or advisor, in taking or recommending decisions relating to the financial management of an organisation in private and public sectors. Objectives of the syllabus Main capabilities On successful completion of this exam, candidates should be able to: A Explain and evaluate the role and responsibility of the senior financial executive or advisor in meeting conflicting needs of stakeholders and recognise the role of international financial institutions in the financial management of multinationals B Evaluate potential investment decisions and assessing their financial and strategic consequences, both domestically and internationally C Assess and plan acquisitions and mergers as an alternative growth strategy D Evaluate and advise on alternative corporate re-organisation strategies E Apply and evaluate alternative advanced treasury and risk management techniques F Apply a range of professional skills in addressing requirements within the Advanced Financial Management exam, and in preparation for, or to support, current work experience G Apply employability and technology skills P.10 KAPLAN PUBLISHING  ACCA Performance Objectives In order to become a member of the ACCA, as a trainee accountant you will need to demonstrate that you have achieved nine performance objectives. Performance objectives are indicators of effective performance and set the minimum standard of work that trainees are expected to achieve and demonstrate in the workplace. They are divided into key areas of knowledge which are closely linked to the exam syllabus. There are five Essential performance objectives and a choice of fifteen Technical performance objectives which are divided into five areas. The performance objectives which link to this exam are: PO2 Stakeholder relationship management (Essential) PO3 Strategy and innovation (Essential) PO5 Leadership and management (Essential) PO9 Evaluate investment and financing decisions (Technical) PO10 Manage and control working capital (Technical) PO11 Identify and manage financial risk (Technical) The following link provides an in depth insight into all of the performance objectives: https://www.accaglobal.com/content/dam/ACCA_Global/Students/per/PER- Performance-objectives-achieve.pdf KAPLAN PUBLISHING P.11  Progression There are two elements of progression that we can measure: first how quickly students move through individual topics within a subject; and second how quickly they move from one course to the next. We know that there is an optimum for both, but it can vary from subject to subject and from student to student. However, using data and our experience of student performance over many years, we can make some generalisations. A fixed period of study set out at the start of a course with key milestones is important. This can be within a subject, for example ‘I will finish this topic by 30 June’, or for overall achievement, such as ‘I want to be qualified by the end of next year’. Your qualification is cumulative, as earlier papers provide a foundation for your subsequent studies, so do not allow there to be too big a gap between one subject and another. We know that exams encourage techniques that lead to some degree of short term retention, the result being that you will simply forget much of what you have already learned unless it is refreshed (look up Ebbinghaus Forgetting Curve for more details on this). This makes it more difficult as you move from one subject to another: not only will you have to learn the new subject, you will also have to relearn all the underpinning knowledge as well. This is very inefficient and slows down your overall progression which makes it more likely you may not succeed at all. In addition, delaying your studies slows your path to qualification which can have negative impacts on your career, postponing the opportunity to apply for higher level positions and therefore higher pay. You can use the following diagram showing the whole structure of your qualification to help you keep track of your progress. P.12 KAPLAN PUBLISHING  Syllabus objectives We have reproduced the ACCA’s syllabus below, showing where the objectives are explored within this book. Within the chapters, we have broken down the extensive information found in the syllabus into easily digestible and relevant sections, called Content Objectives. These correspond to the objectives at the beginning of each chapter. Syllabus learning objective Chapter reference A ROLE OF SENIOR FINANCIAL ADVISER IN THE MULTINATIONAL ORGANISATION 1 The role and responsibility of senior financial executive/ advisor (a) Develop strategies for the achievement of the 1 organisational goals in line with its agreed policy framework. (b) Recommend strategies for the management of the 1 financial resources of the organisation such that they are utilised in an efficient, effective and transparent way. (c) Advise the board of directors or management of the 1 organisation in setting the financial goals of the business and in its financial policy development with particular reference to: (i) investment selection and capital resource allocation (ii) minimising the cost of capital (iii) distribution and retention policy (iv) communicating financial policy and corporate goals to internal and external stakeholders (v) financial planning and control (vi) the management of risk. 2 Financial strategy formulation (a) Assess organisational performance using methods such 14 as ratios and trends. (b) Recommend the optimum capital mix and structure 4 within a specified business context and capital asset structure. (c) Recommend appropriate distribution and retention 5 policy. KAPLAN PUBLISHING P.13  Syllabus learning objective Chapter reference (d) Explain the theoretical and practical rationale for the 9 management of risk. (e) Assess the organisation's exposure to business and 9 financial risk including operational, reputational, political, economic, regulatory and fiscal risk. (f) Develop a framework for risk management comparing 9 and contrasting risk mitigation, hedging and diversification strategies. (g) Establish capital investment monitoring and risk 9 management systems. (h) Advise on the impact of behavioural finance on financial 1 strategies/securities prices and why they may not follow the conventional financial theories. 3 Ethical and governance issues (a) Assess the ethical dimension within business issues 1 and decisions and advise on best practice in the financial management of the organisation. (b) Demonstrate an understanding of the 1 interconnectedness of the ethics of good business practice between all of the functional areas of the organisation. (c) Recommend, within specified problem domains, 1 appropriate strategies for the resolution of stakeholder conflict and advise on alternative approaches that may be adopted. (d) Recommend an ethical framework for the development 1 of an organisation’s financial policies and a system for the assessment of its ethical impact upon the financial management of the organisation. (e) Explore the areas within the ethical framework of the 1 organisation which may be undermined by agency effects and/or stakeholder conflicts and establish strategies for dealing with them. (f) Establish an ethical financial policy for the financial 1 management of the organisation which is grounded in good governance, the highest standards of probity and is fully aligned with the ethical principles of the Association. (g) Assess the impact on sustainability and environmental 1 issues arising from alternative organisational business and financial decisions. P.14 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference (h) Assess and advise on the impact of investment and 1 financing strategies and decisions on the organisation's stakeholders, from a governance perspective. 4 Management of international trade and finance (a) Advise on the theory and practice of free trade and the 3 management of barriers to trade. (b) Demonstrate an up-to-date understanding of the major 3 trade agreements and common markets and, on the basis of contemporary circumstances, advise on their policy and strategic implications for a given business. (c) Discuss how the actions of the World Trade 3 Organisation, the International Monetary Fund, The World Bank and Central Banks can affect a multinational organisation. (d) Discuss the role of international financial institutions 3 within the context of a globalised economy, with particular attention to the principal Central Banks (the Fed, Bank of England, European Central Bank and the Bank of Japan). (e) Discuss the role of the international financial markets 3 with respect to the management of global debt, the financial development of the emerging economies and the maintenance of global financial stability. (f) Discuss the significance to the organisation of the latest 3 developments in the world financial markets such as the causes and impact of the recent financial crisis, growth and impact of dark pool trading systems, the removal of barriers to the free movement of capital and the international regulations on money laundering. (g) Demonstrate an awareness of new developments in the 3 macroeconomic environment, assessing their impact upon the organisation, and advising on the appropriate response to those developments both internally and externally. KAPLAN PUBLISHING P.15  Syllabus learning objective Chapter reference 5 Strategic business and financial planning for multinationals (a) Advise on the development of a financial planning 3 framework for a multinational organisation taking into account: (i) compliance with national regulatory requirements (for example, the London Stock Exchange admission requirements) (ii) the mobility of capital across borders and national limitations on remittances and transfer pricing (iii) the pattern of economic and other risk exposures in the different national markets (iv) agency issues in the central coordination of overseas operations and the balancing of local financial autonomy with effective central control. 6 Dividend policy in multinationals and transfer pricing (a) Determine a corporation’s dividend capacity and its 5 policy given: (i) the corporation’s short- and long-term reinvestment strategy (ii) the impact of capital reconstruction programmes such as share repurchase agreements and new capital issues on free cash flow to equity (iii) the availability and timing of central remittances (iv) the corporate tax regime within the host jurisdiction (v) the organisational policy on the transfer pricing of goods and services across international borders. (b) Advise, in the context of a specified capital investment 5 programme, on an organisation’s current and projected dividend capacity. P.16 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference B ADVANCED INVESTMENT APPRAISAL 1 Discounted cash flow techniques (a) Evaluate the potential value added to an organisation 2 arising from a specified capital investment project or portfolio using the net present value model. Project modelling should include explicit treatment and discussion of: (i) inflation and specific price variation (ii) taxation including tax allowable depreciation and tax exhaustion (iii) capital rationing. Multi-period capital rationing to be limited to discussion only (iv) probability analysis and sensitivity analysis when adjusting for risk and uncertainty in investment appraisal (v) risk adjusted discount rates (vi) project duration as a measure of risk. (b) Outline the application of Monte Carlo simulation to 9 investment appraisal. Candidates will not be expected to undertake simulations in an exam context but will be expected to demonstrate an understanding of: (i) the significance of the simulation output and the assessment of the likelihood of project success (ii) the measurement and interpretation of project value at risk. (c) Establish the potential economic return (using internal 2 rate of return and modified internal rate of return) and advise on a project’s return margin. Discuss the relative merits of NPV and IRR. KAPLAN PUBLISHING P.17  Syllabus learning objective Chapter reference 2 Application of option pricing theory in investment decisions (a) Apply the Black-Scholes Option Pricing (BSOP) model 8 to financial product valuation and to asset valuation: (i) determine and discuss, using published data, the five principal drivers of option value (value of the underlying, exercise price, time to expiry, volatility and the risk-free rate) (ii) discuss the underlying assumptions, structure, application and limitations of the BSOP model. (b) Evaluate embedded real options within a project, 8 classifying them into one of the real option archetypes. (c) Assess, calculate and advise on the value of options to 8 delay, expand, redeploy and withdraw using the Black Scholes model. 3 Impact of financing on investment decisions and adjusted present values (a) Identify and assess the appropriateness of the range of 4 sources of finance available to an organisation including equity, debt, hybrids, lease finance, venture capital, business angel finance, private equity, asset securitisation and sale, Islamic finance and security token offerings. Including assessment on the financial position, financial risk and the value of an organisation. (b) Discuss the role of, and developments in, Islamic 4 financing as a growing source of finance for organisations; explaining the rationale for its use, and identifying its benefits and deficiencies. (c) Calculate the cost of capital of an organisation, 6 including the cost of equity and the cost of debt, based on the range of equity and debt sources of finance. Discuss the appropriateness of using the cost of capital to establish project and organisational value, and discuss its relationship to such value. (d) Calculate and evaluate project specific cost of equity 7 and cost of capital, including their impact on the overall cost of capital of an organisation. Demonstrate a detailed knowledge of business and financial risk, the capital asset pricing model and the relationship between equity and asset betas. P.18 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference (e) Assess an organisation's debt exposure to interest rate 6 changes using the simple Macaulay duration and modified duration methods. (f) Discuss the benefits and limitations of duration, 6 including the impact of convexity. (g) Assess the organisation’s exposure to credit risk, 6 including: (i) explain the role of, and the risk assessment models used by, the principal rating agencies (ii) estimate the likely credit spread over risk free (iii) estimate the organisation’s current cost of debt capital using the appropriate term structure of interest rates and the credit spread. (h) Assess the impact of financing and capital structure 4 upon the organisation with respect to: (i) Modigliani and Miller propositions, before and after tax (ii) pecking order propositions (iii) static trade-off theory (iv) agency effects. (i) Apply the adjusted present value technique to the 7 appraisal of investment decisions that entail significant alterations in the financial structure of the organisation, including their fiscal and transactions cost implications. (j) Assess the impact of a significant capital investment 7 project upon the reported financial position and performance of the organisation taking into account alternative financing strategies. 4 Valuation and the use of free cash flows (a) Apply asset based, income based and cash flow based 13 models to value equity. Apply appropriate models, including term structure of interest rates, the yield curve and credit spreads, to value corporate debt. (b) Forecast an organisation’s free cash flow and its free 13 cash flow to equity (pre- and post-capital reinvestment). KAPLAN PUBLISHING P.19  Syllabus learning objective Chapter reference (c) Advise on the value of an organisation using its free 13 cash flow and free cash flow to equity under alternative horizon and growth assumptions. (d) Explain the role of option pricing models, such as the 8 BSOP model, in the assessment of the value of equity, the value of debt, and default risk. 5 International investment and financing decisions (a) Assess the impact upon the value of a project of 3 alternative exchange rate assumptions. (b) Forecast project or organisation free cash flows in any 3 specified currency and determine the project’s net present value or organisation value under differing exchange rate, fiscal and transaction cost assumptions. (c) Evaluate the significance of exchange controls for a 3 given investment decision and strategies for dealing with restricted remittance. (d) Assess the impact of a project upon an organisation’s 3 exposure to translation, transaction and economic risk. (e) Assess and advise upon the costs and benefits of 4 alternative sources of finance available within the international equity and bond financial markets. C ACQUISITIONS AND MERGERS 1 Acquisitions and mergers versus other growth strategies (a) Discuss the arguments for and against the use of 12 acquisitions and mergers as a method of corporate expansion. (b) Evaluate the corporate and competitive nature of a 12 given acquisition proposal. (c) Advise upon the criteria for choosing an appropriate 12 target for acquisition. (d) Compare the various explanations for the high failure 12 rate of acquisitions in enhancing shareholder value. (e) Evaluate, from a given context, the potential for synergy 12 separately classified as: (i) revenue synergy (ii) cost synergy (iii) financial synergy. P.20 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference (f) Evaluate the use of the reverse takeover as a method of 12 acquisition and as a way of obtaining a stock market listing. 2 Valuation for acquisitions and mergers (a) Discuss the problem of overvaluation. 13 (b) Estimate the potential near-term and continuing growth 13 levels of a corporation’s earnings using both internal and external measures. (c) Discuss, assess and advise on the value created from 13 an acquisition or merger of both quoted and unquoted entities using models such as: (i) ’Book value-plus’ models (ii) Market based models (ii) Cash flow models, including free cash flows. Taking into account the changes in the risk profile and risk exposure of the acquirer and the target entities. (d) Apply appropriate methods, such as: risk-adjusted cost 13 of capital, adjusted net present values and changing price-earnings multipliers resulting from the acquisition or merger, to the valuation process where appropriate. (e) Demonstrate an understanding of the procedure for 13 valuing high growth start-ups. 3 Regulatory framework and processes (a) Demonstrate an understanding of the principal factors 12 influencing the development of the regulatory framework for mergers and acquisitions globally and, in particular, be able to compare and contrast the shareholder versus the stakeholder models of regulation. (b) Identify the main regulatory issues which are likely to 12 arise in the context of a given offer, and: (i) assess whether the offer is likely to be in the shareholders’ best interests (ii) advise the directors of a target entity on the most appropriate defence if a specific offer is to be treated as hostile. KAPLAN PUBLISHING P.21  Syllabus learning objective Chapter reference 4 Financing acquisitions and mergers (a) Compare the various sources of financing available for 12 a proposed cash-based acquisition. (b) Evaluate the advantages and disadvantages of a 12 financial offer for a given acquisition proposal using pure or mixed mode financing and recommend the most appropriate offer to be made. (c) Assess the impact of a given financial offer on the 12 reported financial position and performance of the acquirer. D CORPORATE RECONSTRUCTION AND REORGANISATION 1 Financial reconstruction (a) Assess an organisational situation and determine 14 whether a financial reconstruction is the appropriate strategy for a given business situation. (b) Assess the likely response of the capital market and/or 14 individual suppliers of capital to any reconstruction scheme and the impact their response is likely to have upon the value of the organisation. 2 Business reorganisation (a) Recommend, with reasons, strategies for unbundling 14 parts of a quoted company. (b) Evaluate the likely financial and other benefits of 14 unbundling. (c) Advise on the financial issues relating to a management 14 buy-out and buy-in. E TREASURY AND ADVANCED RISK MANAGEMENT TECHNIQUES 1 The role of the treasury function in multinationals (a) Discuss the role of the treasury management function 1 within: (i) the short term management of the organisation’s financial resources (ii) the longer term maximisation of corporate value (iii) the management of risk exposure. P.22 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference (b) Discuss the operations of the derivatives market 8, 9, 10, including: 11 (i) The relative advantages and disadvantages of exchange traded versus OTC agreements. (ii) Key features such as standard contracts, tick sizes, margin requirements and margin trading. (iii) The source of basis risk and how it can be minimised. (iv) Risks such as delta, gamma and theta, and how these can be managed. 2 The use of financial derivatives to hedge against forex risk (a) Assess the impact on an organisation to exposure in 10 translation, transaction and economic risks and how these can be managed. (b) Evaluate, for a given hedging requirement, which of the 10 following is the most appropriate strategy, given the nature of the underlying position and the risk exposure: (i) the use of the forward exchange market and the creation of a money market hedge (ii) synthetic foreign exchange agreements (SAFEs) (iii) exchange-traded currency futures contracts (iv) currency swaps (v) FOREX swaps (vi) currency options. (c) Advise on the use of bilateral and multilateral netting 10 and matching as tools for minimising FOREX transactions costs and the management of market barriers to the free movement of capital and other remittances. KAPLAN PUBLISHING P.23  Syllabus learning objective Chapter reference 3 The use of financial derivatives to hedge against interest rate risk (a) Evaluate, for a given hedging requirement, which of the 11 following is the most appropriate given the nature of the underlying position and the risk exposure: (i) forward rate agreements (ii) interest rate futures (iii) interest rate swaps (iv) interest rate options (including collars). F PROFESSIONAL SKILLS 1 Communication (a) Inform concisely, objectively and unambiguously, 15 adopting a suitable style and format, using appropriate technology. (b) Persuade using compelling and logical arguments, 15 demonstrating the ability to counter argue where appropriate. (c) Clarify and simplify complex issues to convey relevant 15 information in a way that adopts an appropriate tone and is easily understood by and reflects the requirements of the intended audience. 2 Analysis and evaluation (a) Investigate relevant information from a range of 15 sources, using appropriate analytical techniques to estimate outcomes, assist in decision-making and to identify opportunities or solutions. (b) Consider information, evidence and findings carefully, 15 reflecting on their implications and how they can be used in the interests of the wider organisational goals. (c) Assess and apply appropriate judgement when 15 considering organisational issues, problems or when making financial management decisions; taking into account the implications of such decisions on the organisation and those affected. (d) Appraise information objectively with a view to 15 balancing the costs, risks, benefits and opportunities, before recommending appropriate solutions or decisions. P.24 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference 3 Scepticism (a) Explore the underlying reasons for a given situation, 15 applying the attitude of an enquiring mind, beyond what is immediately apparent. (b) Question opinions, assertions and assumptions, by 15 seeking justifications and obtaining sufficient evidence for either their support and acceptance or rejection. (c) Challenge and critically assess the information 15 presented or decisions made, where this is clearly justified, in the wider professional, ethical, organisational, or public interest. 4 Commercial acumen (a) Demonstrate awareness of organisational and external 15 factors, which will affect the financial management decisions of an organisation. (b) Recognise key issues in a given scenario and use 15 judgement in proposing and recommending commercially viable solutions. (c) Show insight and perception in understanding financial 15 issues and wider organisational matters, demonstrating acumen in arriving at appropriate recommendations. G EMPLOYABILITY AND TECHNOLOGY SKILLS 1 Use computer technology to efficiently access and manipulate relevant information 2 Work on relevant response options, using available functions 16 and technology, as would be required in the workplace 3 Navigate windows and computer screens to create and 16 amend responses to exam requirements, using the appropriate tools 4 Present data and information effectively, using the 16 appropriate tools The superscript numbers in square brackets indicate the intellectual depth at which the subject area could be assessed within the examination. Level 1 (knowledge and comprehension) broadly equates with the Knowledge module, Level 2 (application and analysis) with the Skills module and Level 3 (synthesis and evaluation) to the Professional level. However, lower level skills can continue to be assessed as you progress through each module and level. KAPLAN PUBLISHING P.25  The examination Approach to examining the syllabus The Advanced Financial Management (AFM) exam builds upon the skills and knowledge examined in the Financial Management (FM) exam. At this stage candidates will be expected to demonstrate an integrated knowledge of the subject and an ability to relate their technical understanding of the subject to issues of strategic importance to the organisation. The study guide specifies the wide range of contextual understanding that is required to achieve a satisfactory standard at this level. The examination will also focus on the following professional skills and behaviours:  Communication  Analysis and Evaluation  Scepticism  Commercial Acumen Examination structure The syllabus is assessed by a three-hour 15 minutes examination. Section A Section A will always be a single 50 mark case study. The 50 marks will comprise of 40 technical marks and 10 professional skills marks. All of the professional skills will be examined in Section A. Candidates should understand that they will be expected to undertake calculations, draw comparison against relevant information where appropriate, analyse the results and offer recommendations or conclusions as required. Financial managers are required to look across a range of issues which affect an organisation and its finances, so candidates should expect to see the case study focus on a range of issues from at least two syllabus sections from A - E. These will vary depending on the business context of the case study. Section A questions will ask candidates to produce a response in a specific format, for example a report to the Board of Directors. Section B Section B will consist of two compulsory 25 mark questions. All section B questions will be scenario based and contain a combination of calculation and narrative marks. There will not be any wholly narrative questions. The 25 marks will comprise of 20 technical marks and 5 professional skills marks. Section B questions will contain a combination of professional skills appropriate to the question. Each question will contain a minimum of two professional skills from Analysis and Evaluation, Scepticism and Commercial Acumen. All topics and syllabus sections will be examinable in either section A or section B of the exam, but every exam will have question(s) which have a focus on syllabus sections B and E. Total 100 marks P.26 KAPLAN PUBLISHING  Examination tips – Computer Based Exam (CBE) In addition to reading the tips contained here, we recommend that you review the resources available on the ACCA Global Website before sitting the CBE. Here you will find guidance documents, videos and a link to the CBE question practice platform. Before the exam starts – You will be given 10 minutes to read the introductory page and the four pages of instructions. These will be the same for each AFM exam and therefore it is important that you familiarise yourself with these (using the ACCA practice exams) during your revision. The exam time (3 hours and 15 minutes) will start automatically at the end of the 10 minutes or earlier if requested by you. Plan your strategy before you go in; allocating 90 minutes to Section A, 45 minutes to each question in Section B (1.8 minutes per mark) and 15 minutes to skim through the questions at the start and as a buffer to review your answers at the end. Planning your answers – When the exam starts spend a few minutes skimming through the whole exam to get a feel for what is included. Once you have done this carry out an initial review of Section A. This will include a number of exhibits breaking down the scenario into relevant sections and including the detailed requirement. It will also include a list of the summarised requirements and an option to complete your answer in a word processing document and/or a spreadsheet document. You can move around and resize the windows that you open to lay the screen out in a format that suits you. Now copy and paste the specifics of the requirement into your answer document, perhaps highlighting in bold the different parts of the requirement and the verb used. Once complete review the exhibits in detail, highlighting and making notes as you do so and copy and pasting any relevant information to your answer document. These steps will help with your planning and structure but will also enable you to minimise the number of windows you have open. The procedure will be similar for Section B. Completing your answers – Start by revisiting the relevant exhibits for each requirement. Decide on the use of a word processing format, a spreadsheet format or both. For calculations, use a logical and well laid out structure. Calculations should be labelled and referenced in to any relevant discussion. For discursive answers use bold headings and sub-headings and professional language. Ensure all aspects of the requirement are covered in a sensible and balanced way. It is vital that you relate your answer to the specific circumstances given. In Section A you will usually be required to produce a report. Head up your answer as a report and use the requirements as a basis for your introduction. If you get completely stuck with a question return to it later. If you do not understand what a question is asking, state your assumptions. Even if you do not answer in precisely the way the examiner hoped, you should be given some credit, if your assumptions are reasonable. KAPLAN PUBLISHING P.27  Finally, use your buffer time to read through the answers, ensuring they are clear and organised, and to make any necessary changes. Strategic Professional Computer Based Examination (CBE) From March 2020, ACCA introduced Strategic Professional computer based examinations (CBE) in selected locations. Strategic Professional CBE will be extended to other locations over time, across subsequent examination sessions. Once CBE are offered in a location, the paper-based exam will no longer be available. For more information regarding when Strategic Professional CBE will be introduced in your market, please refer to the ACCA Global website. This Study Text is appropriate for both CBE and paper-based exams. It is essential that students who will be sitting the CBE become familiar with the CBE environment as part of their exam preparation. For additional support please refer to the ACCA Global website. Study skills and revision guidance This section aims to give guidance on how to study for your ACCA exams and to give ideas on how to improve your existing study techniques. Preparing to study Set your objectives Before starting to study decide what you want to achieve – the type of pass you wish to obtain. This will decide the level of commitment and time you need to dedicate to your studies. Devise a study plan Determine which times of the week you will study. Split these times into sessions of at least one hour for study of new material. Any shorter periods could be used for revision or practice. Put the times you plan to study onto a study plan for the weeks from now until the exam and set yourself targets for each period of study – in your sessions make sure you cover the course, course assignments and revision. If you are studying for more than one exam at a time, try to vary your subjects as this can help you to keep interested and see subjects as part of wider knowledge. When working through your course, compare your progress with your plan and, if necessary, re-plan your work (perhaps including extra sessions) or, if you are ahead, do some extra revision/practice questions. P.28 KAPLAN PUBLISHING  Effective studying Active reading You are not expected to learn the text by rote, rather, you must understand what you are reading and be able to use it to pass the exam and develop good practice. A good technique to use is SQ3Rs – Survey, Question, Read, Recall, Review: 1 Survey the chapter – look at the headings and read the introduction, summary and objectives, so as to get an overview of what the chapter deals with. 2 Question – whilst undertaking the survey, ask yourself the questions that you hope the chapter will answer for you. 3 Read through the chapter thoroughly, answering the questions and making sure you can meet the objectives. Attempt the exercises and activities in the text, and work through all the examples. 4 Recall – at the end of each section and at the end of the chapter, try to recall the main ideas of the section/chapter without referring to the text. This is best done after a short break of a couple of minutes after the reading stage. 5 Review – check that your recall notes are correct. You may also find it helpful to re-read the chapter to try to see the topic(s) it deals with as a whole. Note-taking Taking notes is a useful way of learning, but do not simply copy out the text. The notes must:  be in your own words  be concise  cover the key points  be well-organised  be modified as you study further chapters in this text or in related ones. Trying to summarise a chapter without referring to the text can be a useful way of determining which areas you know and which you don't. Three ways of taking notes: Summarise the key points of a chapter. Make linear notes – a list of headings, divided up with subheadings listing the key points. If you use linear notes, you can use different colours to highlight key points and keep topic areas together. Use plenty of space to make your notes easy to use. KAPLAN PUBLISHING P.29  Try a diagrammatic form – the most common of which is a mind-map. To make a mind-map, put the main heading in the centre of the paper and put a circle around it. Then draw short lines radiating from this to the main sub- headings, which again have circles around them. Then continue the process from the sub-headings to sub-sub-headings, advantages, disadvantages, etc. Highlighting and underlining You may find it useful to underline or highlight key points in your study text – but do be selective. You may also wish to make notes in the margins. Revision The best approach to revision is to revise the course as you work through it. Also try to leave four to six weeks before the exam for final revision. Make sure you cover the whole syllabus and pay special attention to those areas where your knowledge is weak. Here are some recommendations: Read through the text and your notes again and condense your notes into key phrases. It may help to put key revision points onto index cards to look at when you have a few minutes to spare. Review any assignments you have completed and look at where you lost marks – put more work into those areas where you were weak. Practise exam standard questions under timed conditions. If you are short of time, list the points that you would cover in your answer and then read the model answer, but do try to complete at least a few questions under exam conditions. Also practise producing answer plans and comparing them to the model answer. If you are stuck on a topic find somebody (a tutor) to explain it to you. Read good newspapers, websites and professional journals, especially ACCA's Student Accountant – this can give you an advantage in the exam. Ensure you know the structure of the exam – how many questions and of what type you will be expected to answer. During your revision attempt all the different styles of questions you may be asked. Further reading  A Student's Guide to Corporate Finance and Financial Management by David Evans – Kaplan Publishing  A Student's Guide to Writing Business Reports by Zoe Robinson and Stuart Pedley-Smith You can find further reading and technical articles under the student section of ACCA's website. P.30 KAPLAN PUBLISHING  FORMULAE AND TABLES Modigliani and Miller Proposition 2 (with tax) Vd ke = kie + (1 − T)(kie − kd) Ve The Capital Asset Pricing Model E(ri) = Rf + i(E(rm) − Rf) The asset beta formula  Ve   Vd (1 – T)  a =  βe  +  βd   (Ve + Vd (1 – T))   (Ve + Vd (1 – T))  The Growth Model Do (1  g) Po  (re – g) Gordon’s growth approximation g = bre The weighted average cost of capital  Ve   Vd  WACC =   ke +   k d (1 – T )  Ve + Vd   Ve + Vd  The Fisher formula (1 + i) = (1 + r) (1 + h) Purchasing power parity and interest rate parity (1+ hc ) (1+ ic ) S1 = S o x F0 = S o x (1+ hb ) (1+ ib ) Modified Internal Rate of Return 1  PV  n MIRR =  R  (1  re) – 1  PVI  The Black-Scholes option pricing model c = PaN(d1) – PeN(d2)e−rt Where: In(Pa /Pe ) + (r + 0.5s2 )t d1 = s t d2  d1 – s t The Put Call Parity relationship p = c − Pa + Pee−rt KAPLAN PUBLISHING P.31  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% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 Discount rate (r) Periods (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 P.32 KAPLAN PUBLISHING  Annuity table 1 – (1  r) – n Present value of an annuity of 1, i.e. r Where r = discount rate n = number of periods Discount rate (r) Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 8.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 Discount rate (r) Periods (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.968 4.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 KAPLAN PUBLISHING P.33  Standard normal distribution table 0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.0.0000.0040.0080.0120.0160.0199.0239.0279.0319.0359 0.1.0398.0438.0478.0517.0557.0596.0636.0675.0714.0753 0.2.0793.0832.0871.0910.0948.0987.1026.1064.1103.1141 0.3.1179.1217.1255.1293.1331.1368.1406.1443.1480.1517 0.4.1554.1591.1628.1664.1700.1736.1772.1808.1844.1879 0.5.1915.1950.1985.2019.2054.2088.2123.2157.2190.2224 0.6.2257.2291.2324.2357.2389.2422.2454.2486.2517.2549 0.7.2580.2611.2642.2673.2703.2734.2764.2794.2823.2852 0.8.2881.2910.2939.2967.2995.3023.3051.3078.3106.3133 0.9.3159.3186.3212.3238.3264.3289.3315.3340.3365.3389 1.0.3413.3438.3461.3485.3508.3531.3554.3577.3599.3621 1.1.3643.3665.3686.3708.3729.3749.3770.3790.3810.3830 1.2.3849.3869.3888.3907.3925.3944.3962.3980.3997.4015 1.3.4032.4049.4066.4082 4099.4115.4131.4147.4162.4177 1.4.4192.4207.4222.4236.4251.4265.4279.4292.4306.4319 1.5.4332.4345.4357.4370.4382.4394.4406.4418.4430.4441 1.6.4452.4463.4474.4484.4495.4505.4515.4525.4535.4545 1.7.4554.4564.4573.4582.4591.4599.4608.4616.4625.4633 1.8.4641.4649.4656.4664.4671.4678.4686.4693.4699.4706 1.9.4713.4719.4726.4732.4738.4744.4750.4756.4761.4767 2.0.4772.4778.4783.4788.4793.4798.4803.4808.4812.4817 2.1.4821.4826.4830.4834.4838.4842.4846.4850.4854.4857 2.2.4861.4864.4868.4871.4875.4878.4881.4884.4887.4890 2.3.4893.4896.4898.4901.4904.4906.4909.4911.4913.4916 2.4.4918.4920.4922.4925.4927.4929.4931.4932.4934.4936 2.5.4938.4940.4941.4943.4945.4946.4948.4949.4951.4952 2.6.4953.4955.4956.4957.4959.4960.4961.4962 4963.4964 2.7.4965.4966.4967.4968.4969.4970.4971.4972.4973.4974 2.8.4974.4975.4976.4977.4977.4978.4979.4980.4980.4981 2.9.4981.4982.4982.4983.4984.4984.4985.4985.4986.4986 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 Black-Scholes model of option pricing. If di > 0, add 0.5 to the relevant number above. If di < 0, subtract the relevant number above from 0.5. P.34 KAPLAN PUBLISHING Chapter 1 The role and responsibility of the financial manager Chapter learning objectives Study guide section Study guide outcome A1: The role and (a) Develop strategies for the responsibility of senior achievement of the organisational financial executive/ goals in line with its agreed policy advisor framework. (b) Recommend strategies for the management of the financial resources of the organisation such that they are utilised in an efficient, effective and transparent way. (c) Advise the board of directors or management of the organisation in setting the financial goals of the business and in its financial policy development with particular reference to: (i) Investment selection and capital resource allocation (ii) Minimising the cost of capital (iii) Distribution and retention policy (iv) Communicating financial policy and corporate goals to internal and external stakeholders (v) Financial planning and control (vi) The management of risk. KAPLAN PUBLISHING 1 The role and responsibility of the financial manager A2: Financial strategy (h) Advise on the impact of formulation behavioural finance on financial strategies/securities prices and why they may not follow the conventional financial theories. A3: Ethical issues in (a) Assess the ethical dimension financial management within business issues and decisions and advise on best practice in the financial management of the organisation. (b) Demonstrate an understanding of the interconnectedness of the ethics of good business practice between all of the functional areas of the organisation. (c) Recommend, within specified problem domains, appropriate strategies for the resolution of stakeholder conflict and advise on alternative approaches that may be adopted. (d) Recommend an ethical framework for the development of an organisation’s financial policies and a system for the assessment of its ethical impact upon the financial management of the organisation. (e) Explore the areas within the ethical framework of the organisation which may be undermined by agency effects and/or stakeholder conflicts and establish strategies for dealing with them. (f) Establish an ethical financial policy for the financial management of the organisation which is grounded in good governance, the highest standards of probity and is fully aligned with the ethical principles of the Association. 2 KAPLAN PUBLISHING  Chapter 1 (g) Assess the impact on sustainability and environmental issues arising from alternative organisational business and financial decisions. (h) Assess and advise on the impact of investment and financing strategies and decisions on the organisation's stakeholders, from a governance perspective. E1: The role of the (a) Discuss the role of the treasury treasury function in management function within: (i) multinationals The short term management of the organisations financial resources (ii) The longer term maximisation of corporate value (iii) The management of risk exposure. Four of the five ACCA PER Essentials performance objectives apply to the AFM paper (PO1, PO2, PO3 and PO5).Working through this chapter will give you an introduction to these objectives. KAPLAN PUBLISHING 3 The role and responsibility of the financial manager 1 Key roles and responsibilities of the financial manager The financial manager is responsible for making decisions which will increase the wealth of the company's shareholders. The specific areas of responsibility are listed below. However, it is also important that the financial manager considers the impact of his or her role on the other stakeholders of the firm. You may be asked in the exam to assess the  strategic impact  financial impact  regulatory impact  ethical impact  environmental impact of a financial manager's decisions. Link between strategy and financial manager's role You will remember from your earlier studies that the process of strategy selection starts with the development of a mission statement. A mission statement:  is the overriding purpose of the firm  guides and directs all decisions taken. The mission is then broken down into broad-based goals, and then further, into detailed objectives. Strategies can then be developed to bridge the gap between current forecast performance and the targets set. Policy framework The mission will also provide the basis for the development of a policy framework. The purpose of this framework is:  to govern the way in which decisions are taken, and  specify the criteria to be considered in the evaluation of any potential strategy. 4 KAPLAN PUBLISHING  Chapter 1 At a broad level, this framework will incorporate guidance on issues such as: Ethics and social responsibility A consideration of the role of business in society. It covers responsibilities towards society as a whole, the extent to which the company should fulfil or exceed its legal obligations towards stakeholders and the behaviour expected of individuals within the firm itself. Stakeholder protection The extent to which the needs and wishes of individual stakeholders are incorporated into decisions and the development of a framework to ensure their needs are met and their rights upheld. Corporate governance The system by which companies are directed and controlled, including issues of risk management. Sustainable development Ensuring that projects and developments that meet the needs of the present, do not compromise the ability of future generations to meet their own needs. This guidance is often formulated as a general principle: e.g. all suppliers used must demonstrate commitment to employee welfare, but may also form the basis for the generation of specific targets: e.g. increase by 10% the amount of raw materials sourced locally in the next 12 months. Financial policy Policies will also be developed to govern decisions within each operational area of the business. These policies specify generally applicable processes or procedures to be followed when decisions are being made, or state one overarching principle which the sets the boundaries for all decisions taken. KAPLAN PUBLISHING 5 The role and responsibility of the financial manager For example, within the finance function, policies will be developed over areas such as:  investment selection  overall cost of finance  distribution and retentions  communication with stakeholders  financial planning and control  risk management  efficient and effective use of resources. Key areas of responsibility for the financial manager The main roles and responsibilities of the financial manager can be summarised by the following headings:  investment selection and capital resource allocation  raising finance and minimising the cost of capital  distribution and retentions (dividend policy)  communication with stakeholders  financial planning and control  risk management  efficient and effective use of resources. The Advanced Financial Management syllabus (and the rest of this Text) covers these areas in detail. This chapter gives a brief introduction to each of them. Investment selection and capital resource allocation The primary goal of a company should be the maximisation of shareholder wealth, but any number of stakeholders may have views on the objectives a company should pursue. Therefore, key policy decisions need to be made:  How to incorporate ethical issues, such as minimising potential pollution or refusal to trade with unacceptable regimes, into the investment appraisal process?  What method of investment appraisal should be used? – NPV? – IRR? 6 KAPLAN PUBLISHING  Chapter 1  In times of capital rationing, how are competing projects to be evaluated? – use of theoretical methods – incorporation of non-financial factors such as: 1 closeness of match to objectives 2 degree to which all goals will be achieved.  As markets are not truly efficient, and investors treat earnings and dividend announcements as new information, to what extent should the impact on, for example: – ROCE – EPS – DPS be considered when evaluating a project? More on investment selection Incorporation of corporate policy issues If for example, a decision has been taken to pay a ‘fair’ wage to all employees regardless of the legal minimum requirement in the country where the business is operating, this rule must be applied to the wages figure used in any project evaluation. The financial executive must be aware of the policy requirement and ensure that sufficient research is carried out in advance that the correct figure is used. Methods of investment appraisal Assuming that the discounted cash flow techniques are preferred over Payback and ARR (which do not assure the maximisation of shareholder wealth), it is still necessary to designate which of the DCF methods is to be applied. Although NPV is theoretically superior, it is not as well liked by non-financial managers. IRR as a percentage is deemed clearer and simpler (although the point could be argued!). It is for the senior financial executive to decide on a method and ensure it is applied correctly. Capital rationing The rule for an NPV evaluation states that all projects with a positive NPV should be accepted. However, this presupposes no limits on the available funds. Where restrictions exist, theoretical models can be applied:  Shortages in one period only – use limiting factor analysis (covered in the Financial Management exam).  Shortages in multiple periods – see Chapter 2: Investment appraisal. KAPLAN PUBLISHING 7 The role and responsibility of the financial manager However, these methods do not build in evaluation of non-financial factors such as how well each strategy will meet the objectives set and practical difficulties that might be encountered along the way. Forms of evaluation such as Cost Benefit Analysis and Weighted Benefit Scoring can be used where these factors are significant. These methods, pioneered by the public sector where such problems are commonplace, include techniques to assign money values to non-financial factors and to weight subjective factors against each other. Detailed knowledge of such methods is outside the syllabus. Earnings and dividend measures Even where improving shareholder wealth is the primary concern of the financial executive, the impact of the investment decisions on the reported position and perceived performance of the firm cannot be ignored. In an imperfect market, the earnings of a company and the dividends paid, are treated as relevant information for evaluating a company’s worth and may impact the share price. Yet it is the share price that the executive is trying to improve. Behavioural finance Introduction Conventional financial management is based on the assumption that markets are efficient, and that investors behave in ways that are logical and rational. The efficient market hypothesis (EMH) The EMH states that security prices fully and fairly reflect all relevant information. This means that it is not possible to consistently outperform the market by using any information that the market already knows, except through luck. The idea is that new information is quickly and efficiently incorporated into asset prices at any point in time, so that old information cannot be used to predict future price movements. Behavioural finance Despite the evidence in support of the efficient markets theory, some events seem to contradict it, such as significant share price volatility and boom/crash patterns e.g. the stock market crash of October 1987 where most stock exchanges crashed at the same time. It is virtually impossible