CB1 CMP 2019 Business Finance PDF

Business Finance Combined Materials Pack for exams in 2019 The Actuarial Education Company on behalf of the Institute and Faculty of Actuaries All study material produced by ActEd is copyright and is sold for the exclusive use of the purchaser. The copyright is owned b...

Business Finance Combined Materials Pack for exams in 2019 The Actuarial Education Company on behalf of the Institute and Faculty of Actuaries All study material produced by ActEd is copyright and is sold for the exclusive use of the purchaser. The copyright is owned by Institute and Faculty Education Limited, a subsidiary of the Institute and Faculty of Actuaries. Unless prior authority is granted by ActEd, you may not hire out, lend, give out, sell, store or transmit electronically or photocopy any part of the study material. You must take care of your study material to ensure that it is not used or copied by anybody else. Legal action will be taken if these terms are infringed. In addition, we may seek to take disciplinary action through the profession or through your employer. These conditions remain in force after you have finished using the course. © IFE: 2019 Examinations The Actuarial Education Company CB1: Study Guide Page 1 Subject CB1 2019 Study Guide Introduction This Study Guide has been created to help guide you through Subject CB1. It contains all the information that you will need before starting to study Subject CB1 for the 2019 exams and you may also find it useful to refer to throughout your Subject CB1journey. The guide is split into two parts:  Part 1 contains general information about the Core Principles subjects  Part 2 contains specific information about Subject CB1. Please read this Study Guide carefully before reading the Course Notes, even if you have studied for some actuarial exams before. Contents Part 1 Section 1 Before you start Page 2 Section 2 Core study material Page 3 Section 3 ActEd study support Page 5 Section 4 Study skills Page 11 Section 5 The examination Page 16 Section 6 Queries and feedback Page 17 Part 2 Section 1 Subject CB1 – background Page 18 Section 2 Subject CB1 – Syllabus and Core Reading Page 19 Section 3 Subject CB1 – the course structure Page 27 Section 4 Subject CB1 – summary of ActEd products Page 28 Section 4 Subject CB1 – skills and assessment Page 29 Section 5 Subject CB1 – frequently asked questions Page 30 The Actuarial Education Company © IFE: 2019 Examinations  Page 2 CB1: Study Guide 1.1 Before you start When studying for the UK actuarial exams, you will need:  a copy of the Formulae and Tables for Examinations of the Faculty of Actuaries and the Institute of Actuaries, 2nd Edition (2002) – these are often referred to as simply the Yellow Tables or the Tables  a ‘permitted’ scientific calculator – you will find the list of permitted calculators on the profession’s website. Please check the list carefully, since it is reviewed each year. These are both available from the Institute and Faculty of Actuaries’ eShop. Please visit www.actuaries.org.uk. © IFE: 2019 Examinations The Actuarial Education Company  CB1: Study Guide Page 3 1.2 Core study material This section explains the role of the Syllabus, Core Reading and supplementary ActEd text. It also gives guidance on how to use these materials most effectively in order to pass the exam. Some of the information below is also contained in the introduction to the Core Reading produced by the Institute and Faculty of Actuaries. Syllabus The Syllabus for Subject CB1 has been produced by the Institute and Faculty of Actuaries. The relevant individual Syllabus Objectives are included at the start of each course chapter and a complete copy of the Syllabus is included in Section 2.2 of this Study Guide. We recommend that you use the Syllabus as an important part of your study. Core Reading The Core Reading has been produced by the Institute and Faculty of Actuaries. The purpose of the Core Reading is to assist in ensuring that tutors, students and examiners have clear shared appreciation of the requirements of the syllabus for the qualification examinations for Fellowship of the Institute and Faculty of Actuaries. The Core Reading supports coverage of the syllabus in helping to ensure that both depth and breadth are re-enforced. It is therefore important that students have a good understanding of the concepts covered by the Core Reading. The examinations require students to demonstrate their understanding of the concepts given in the syllabus and described in the Core Reading; this will be based on the legislation, professional guidance etc that are in force when the Core Reading is published, ie on 31 May in the year preceding the examinations. Therefore the exams in April and September 2019 will be based on the Syllabus and Core Reading as at 31 May 2018. We recommend that you always use the up-to-date Core Reading to prepare for the exams. Examiners will have this Core Reading when setting the papers. In preparing for examinations, students are advised to work through past examination questions and will find additional tuition helpful. The Core Reading will be updated each year to reflect changes in the syllabus, to reflect current practice, and in the interest of clarity. Accreditation The Institute and Faculty of Actuaries would like to thank the numerous people who have helped in the development of the material contained in this Core Reading. The Actuarial Education Company © IFE: 2019 Examinations Page 4 CB1: Study Guide ActEd text Core Reading deals with each syllabus objective and covers what is needed to pass the exam. However, the tuition material that has been written by ActEd enhances it by giving examples and further explanation of key points. Here is an excerpt from some ActEd Course Notes to show you how to identify Core Reading and the ActEd material. Core Reading is shown in this bold font. Note that in the example given above, the index will fall if the actual share price goes below the theoretical ex-rights share price. Again, this is consistent with what would happen to an underlying portfolio. This is After allowing for chain-linking, the formula for the investment index then becomes: ActEd text  Ni ,t Pi ,t I (t )  i This is Core B(t ) Reading where Ni ,t is the number of shares issued for the ith constituent at time t; B (t ) is the base value, or divisor, at time t. Copyright All study material produced by ActEd is copyright and is sold for the exclusive use of the purchaser. The copyright is owned by Institute and Faculty Education Limited, a subsidiary of the Institute and Faculty of Actuaries. Unless prior authority is granted by ActEd, you may not hire out, lend, give out, sell, store or transmit electronically or photocopy any part of the study material. You must take care of your study material to ensure that it is not used or copied by anybody else. Legal action will be taken if these terms are infringed. In addition, we may seek to take disciplinary action through the Institute and Faculty of Actuaries or through your employer. These conditions remain in force after you have finished using the course. © IFE: 2019 Examinations The Actuarial Education Company  CB1: Study Guide Page 5 1.3 ActEd study support This section gives a description of the products offered by ActEd. Successful students tend to undertake three main study activities: 1. Learning – initial study and understanding of subject material 2. Revision – learning subject material and preparing to tackle exam-style questions 3. Rehearsal – answering exam-style questions, culminating in answering questions at exam speed without notes. Different approaches suit different people. For example, you may like to learn material gradually over the months running up to the exams or you may do your revision in a shorter period just before the exams. Also, these three activities will almost certainly overlap. We offer a flexible range of products to suit you and let you control your own learning and exam preparation. The following table shows the products that we produce. Note that not all products are available for all subjects. LEARNING LEARNING & REVISION REVISION & REHEARSAL REVISION REHEARSAL Course Notes X Assignments Flashcards Revision Notes Mock Exam Combined ASET Mock Marking Materials Pack (CMP) X Assignment Marking Tutorials Online Classroom The products and services are described in more detail below. The Actuarial Education Company © IFE: 2019 Examinations Page 6 CB1: Study Guide ‘Learning’ products Course Notes The Course Notes will help you develop the basic knowledge and understanding of principles needed to pass the exam. They incorporate the complete Core Reading and include full explanation of all the syllabus objectives, with worked examples and questions (including some past exam questions) to test your understanding. Each chapter includes:  the relevant syllabus objectives  a chapter summary  a page of important formulae or definitions (where appropriate)  practice questions with full solutions. ‘Learning & revision’ products X Assignments The Series X Assignments are written assessments that cover the material in each part of the course in turn. They can be used to both develop and test your understanding of the material. Combined Materials Pack (CMP) The Combined Materials Pack (CMP) comprises the Course Notes and the Series X Assignments. The CMP is available in eBook format for viewing on a range of electronic devices. eBooks can be ordered separately or as an addition to paper products. Visit www.ActEd.co.uk for full details about the eBooks that are available, compatibility with different devices, software requirements and printing restrictions. X Assignment Marking We are happy to mark your attempts at the X assignments. Marking is not included with the Assignments or the CMP and you need to order it separately. You should submit your script as a PDF attached to an email. Your script will be marked electronically and you will be able to download your marked script via a secure link on the internet. Don’t underestimate the benefits of doing and submitting assignments:  Question practice during this phase of your study gives an early focus on the end goal of answering exam-style questions.  You’re incentivised to keep up with your study plan and get a regular, realistic assessment of your progress.  Objective, personalised feedback from a high quality marker will highlight areas on which to work and help with exam technique. © IFE: 2019 Examinations The Actuarial Education Company CB1: Study Guide Page 7 In a recent study, we found that students who attempt more than half the assignments have significantly higher pass rates. There are two different types of marking product: Series Marking and Marking Vouchers. Series Marking Series Marking applies to a specified subject, session and student. If you purchase Series Marking, you will not be able to defer the marking to a future exam sitting or transfer it to a different subject or student. We typically send out full solutions with the Series X Assignments. However, if you order Series Marking at the same time as you order the Series X Assignments, you can choose whether or not to receive a copy of the solutions in advance. If you choose not to receive them with the study material, you will be able to download the solutions via a secure link on the internet when your marked script is returned (or following the final deadline date if you do not submit a script). If you are having your attempts at the assignments marked by ActEd, you should submit your scripts regularly throughout the session, in accordance with the schedule of recommended dates set out in information provided with the assignments. This will help you to pace your study throughout the session and leave an adequate amount of time for revision and question practice. The recommended submission dates are realistic targets for the majority of students. Your scripts will be returned more quickly if you submit them well before the final deadline dates. Any script submitted after the relevant final deadline date will not be marked. It is your responsibility to ensure that we receive scripts in good time. Marking Vouchers Marking Vouchers give the holder the right to submit a script for marking at any time, irrespective of the individual assignment deadlines, study session, subject or person. Marking Vouchers can be used for any assignment. They are valid for four years from the date of purchase and can be refunded at any time up to the expiry date. Although you may submit your script with a Marking Voucher at any time, you will need to adhere to the explicit Marking Voucher deadline dates to ensure that your script is returned before the date of the exam. The deadline dates are provided with the assignments. Tutorials Our tutorials are specifically designed to develop the knowledge that you will acquire from the course material into the higher-level understanding that is needed to pass the exam. We run a range of different tutorials including face-to-face tutorials at various locations, and Live Online tutorials. Full details are set out in our Tuition Bulletin, which is available on our website at www.ActEd.co.uk. The Actuarial Education Company © IFE: 2019 Examinations Page 8 CB1: Study Guide Regular and Block Tutorials In preparation for these tutorials, we expect you to have read the relevant part(s) of the Course Notes before attending the tutorial so that the group can spend time on exam questions and discussion to develop understanding rather than basic bookwork. You can choose one of the following types of tutorial:  Regular Tutorials spread over the session.  A Block Tutorial held two to eight weeks before the exam. Online Classroom The Online Classroom acts as either a valuable add-on or a great alternative to a face-to-face or Live Online tutorial. At the heart of the Online Classroom in each subject is a comprehensive, easily-searched collection of tutorial units. These are a mix of:  teaching units, helping you to really get to grips with the course material, and  guided questions, enabling you to learn the most efficient ways to answer questions and avoid common exam pitfalls. The best way to discover the Online Classroom is to see it in action. You can watch a sample of the Online Classroom tutorial units on our website at www.ActEd.co.uk. ‘Revision’ products For most subjects, there is a lot of material to revise. Finding a way to fit revision into your routine as painlessly as possible has got to be a good strategy. Flashcards are an inexpensive option that can provide a massive boost. They can also provide a variation in activities during a study day, and so help you to maintain concentration and effectiveness. Flashcards Flashcards are a set of A6-sized cards that cover the key points of the subject that most students want to commit to memory. Each flashcard has questions on one side and the answers on the reverse. We recommend that you use the cards actively and test yourself as you go. Flashcards are available in eBook format for viewing on a range of electronic devices. eBooks can be ordered separately or as an addition to paper products. Visit www.ActEd.co.uk for full details about the eBooks that are available, compatibility with different devices, software requirements and printing restrictions. The following questions and comments might help you to decide if flashcards are suitable for you: Flashcards  Do you have a regular train or bus journey? Flashcards are ideal for regular bursts of revision on the move. © IFE: 2019 Examinations The Actuarial Education Company CB1: Study Guide Page 9  Do you want to fit more study into your routine? Flashcards are a good option for ‘dead time’, eg using flashcards on your phone or sticking them on the wall in your study.  Do you find yourself cramming for exams (even if that’s not your original plan)? Flashcards are an extremely efficient way to do your pre-exam memorising. If you are retaking a subject, then you might consider using flashcards if you didn’t use them on a previous attempt. ‘Revision & rehearsal’ products Revision Notes Our Revision Notes have been designed with input from students to help you revise efficiently. They are suitable for first-time sitters who have worked through the ActEd Course Notes or for retakers (who should find them much more useful and challenging than simply reading through the course again). The Revision Notes are a set of A5 booklets – perfect for revising on the train or tube to work. Each booklet covers one main theme or a set of related topics from the course and includes:  Core Reading with a set of integrated short questions to develop your bookwork knowledge  relevant past exam questions with concise solutions from the last ten years  other useful revision aids. ActEd Solutions with Exam Technique (ASET) The ActEd Solutions with Exam Technique (ASET) contains our solutions to eight past exam papers, plus comment and explanation. In particular, it highlights how questions might have been analysed and interpreted so as to produce a good solution with a wide range of relevant points. This will be valuable in approaching questions in subsequent examinations. ‘Rehearsal’ products Mock Exam The Mock Exam is a 100-mark mock exam paper that provides a realistic test of your exam preparation. Mock Marking We are happy to mark your attempts at the mock exams. The same general principles apply as for the X Assignment Marking. In particular:  Mock Exam Marking is available for the Mock Exam and it applies to a specified subject, session and student  Marking Vouchers can be used for the Mock Exam. The Actuarial Education Company © IFE: 2019 Examinations Page 10 CB1: Study Guide Recall that:  marking is not included with the products themselves and you need to order it separately  you should submit your script as a PDF attached to an email  your script will be marked electronically and you will be able to download your marked script via a secure link on the internet. © IFE: 2019 Examinations The Actuarial Education Company  CB1: Study Guide Page 11 1.4 Skills Technical skills The Core Reading and exam papers for these subjects tend to be very technical. The exams themselves have many calculation and manipulation questions. The emphasis in the exam will therefore be on understanding the mathematical techniques and applying them to various, frequently unfamiliar, situations. It is important to have a feel for what the numerical answer should be by having a deep understanding of the material and by doing reasonableness checks. As a high level of pure mathematics and statistics is generally required for the Core Principles subjects, it is important that your mathematical skills are extremely good. If you are a little rusty you may wish to consider purchasing additional material to help you get up to speed. The course ‘Pure Maths and Statistics for Actuarial Studies’ is available from ActEd and it covers the mathematical techniques that are required for the Core Principles subjects, some of which are beyond A-Level (or Higher) standard. You do not need to work through the whole course in order – you can just refer to it when you need help on a particular topic. An initial assessment to test your mathematical skills and further details regarding the course can be found on our website at www.ActEd.co.uk. Study skills Overall study plan We suggest that you develop a realistic study plan, building in time for relaxation and allowing some time for contingencies. Be aware of busy times at work, when you may not be able to take as much study leave as you would like. Once you have set your plan, be determined to stick to it. You don’t have to be too prescriptive at this stage about what precisely you do on each study day. The main thing is to be clear that you will cover all the important activities in an appropriate manner and leave plenty of time for revision and question practice. Aim to manage your study so as to allow plenty of time for the concepts you meet in these courses to ‘bed down’ in your mind. Most successful students will probably aim to complete the courses at least a month before the exam, thereby leaving a sufficient amount of time for revision. By finishing the courses as quickly as possible, you will have a much clearer view of the big picture. It will also allow you to structure your revision so that you can concentrate on the important and difficult areas. You can also try looking at our discussion forum on the internet, which can be accessed at www.ActEd.co.uk/forums (or use the link from our home page at www.ActEd.co.uk). There are some good suggestions from students on how to study. Study sessions Only do activities that will increase your chance of passing. Try to avoid including activities for the sake of it and don’t spend time reviewing material that you already understand. You will only improve your chances of passing the exam by getting on top of the material that you currently find difficult. The Actuarial Education Company © IFE: 2019 Examinations Page 12 CB1: Study Guide Ideally, each study session should have a specific purpose and be based on a specific task, eg ’Finish reading Chapter 3 and attempt Practice Questions 1.4, 1.7 and 1.12 ’, as opposed to a specific amount of time, eg ‘Three hours studying the material in Chapter 3’. Try to study somewhere quiet and free from distractions (eg a library or a desk at home dedicated to study). Find out when you operate at your peak, and endeavour to study at those times of the day. This might be between 8am and 10am or could be in the evening. Take short breaks during your study to remain focused – it’s definitely time for a short break if you find that your brain is tired and that your concentration has started to drift from the information in front of you. Order of study We suggest that you work through each of the chapters in turn. To get the maximum benefit from each chapter you should proceed in the following order: 1. Read the Syllabus Objectives. These are set out in the box at the start of each chapter. 2. Read the Chapter Summary at the end of each chapter. This will give you a useful overview of the material that you are about to study and help you to appreciate the context of the ideas that you meet. 3. Study the Course Notes in detail, annotating them and possibly making your own notes. Try the self-assessment questions as you come to them. As you study, pay particular attention to the listing of the Syllabus Objectives and to the Core Reading. 4. Read the Chapter Summary again carefully. If there are any ideas that you can’t remember covering in the Course Notes, read the relevant section of the notes again to refresh your memory. 5. Attempt (at least some of) the Practice Questions that appear at the end of the chapter. It’s a fact that people are more likely to remember something if they review it several times. So, do look over the chapters you have studied so far from time to time. It is useful to re-read the Chapter Summaries or to try the Practice Questions again a few days after reading the chapter itself. It’s a good idea to annotate the questions with details of when you attempted each one. This makes it easier to ensure that you try all of the questions as part of your revision without repeating any that you got right first time. Once you’ve read the relevant part of the notes and tried a selection of questions from the Practice Questions (and attended a tutorial, if appropriate) you should attempt the corresponding assignment. If you submit your assignment for marking, spend some time looking through it carefully when it is returned. It can seem a bit depressing to analyse the errors you made, but you will increase your chances of passing the exam by learning from your mistakes. The markers will try their best to provide practical comments to help you to improve. To be really prepared for the exam, you should not only know and understand the Core Reading but also be aware of what the examiners will expect. Your revision programme should include plenty of question practice so that you are aware of the typical style, content and marking structure of exam questions. You should attempt as many past exam questions as you can. © IFE: 2019 Examinations The Actuarial Education Company CB1: Study Guide Page 13 Active study Here are some techniques that may help you to study actively. 1. Don’t believe everything you read. Good students tend to question everything that they read. They will ask ‘why, how, what for, when?’ when confronted with a new concept, and they will apply their own judgement. This contrasts with those who unquestioningly believe what they are told, learn it thoroughly, and reproduce it (unquestioningly?) in response to exam questions. 2. Another useful technique as you read the Course Notes is to think of possible questions that the examiners could ask. This will help you to understand the examiners’ point of view and should mean that there are fewer nasty surprises in the exam room. Use the Syllabus to help you make up questions. 3. Annotate your notes with your own ideas and questions. This will make you study more actively and will help when you come to review and revise the material. Do not simply copy out the notes without thinking about the issues. 4. Attempt the questions in the notes as you work through the course. Write down your answer before you refer to the solution. 5. Attempt other questions and assignments on a similar basis, ie write down your answer before looking at the solution provided. Attempting the assignments under exam conditions has some particular benefits:  It forces you to think and act in a way that is similar to how you will behave in the exam.  When you have your assignments marked it is much more useful if the marker’s comments can show you how to improve your performance under exam conditions than your performance when you have access to the notes and are under no time pressure.  The knowledge that you are going to do an assignment under exam conditions and then submit it (however good or bad) for marking can act as a powerful incentive to make you study each part as well as possible.  It is also quicker than trying to write perfect answers. 6. Sit a mock exam four to six weeks before the real exam to identify your weaknesses and work to improve them. You could use a mock exam written by ActEd or a past exam paper. You can find further information on how to study in the profession’s Student Handbook, which you can download from their website at: www.actuaries.org.uk/studying The Actuarial Education Company © IFE: 2019 Examinations Page 14 CB1: Study Guide Revision and exam skills Revision skills You will have sat many exams before and will have mastered the exam and revision techniques that suit you. However it is important to note that due to the high volume of work involved in the Core Principles subjects it is not possible to leave all your revision to the last minute. Students who prepare well in advance have a better chance of passing their exams on the first sitting. Unprepared students find that they are under time pressure in the exam. Therefore it is important to find ways of maximising your score in the shortest possible time. Part of your preparation should be to practise a large number of exam-style questions under timed exam conditions as soon as possible. This will:  help you to develop the necessary understanding of the techniques required  highlight the key topics, which crop up regularly in many different contexts and questions  help you to practise the specific skills that you will need to pass the exam. There are many sources of exam-style questions. You can use past exam papers, the Practice Questions at the end of each chapter (which include many past exam questions), assignments, mock exams, the Revision Notes and ASET. Exam question skill levels Exam questions are not designed to be of similar difficulty. The Institute and Faculty of Actuaries specifies different skill levels that questions may be set with reference to. Questions may be set at any skill level:  Knowledge – demonstration of a detailed knowledge and understanding of the topic  Application – demonstration of an ability to apply the principles underlying the topic within a given context  Higher Order – demonstration of an ability to perform deeper analysis and assessment of situations, including forming judgements, taking into account different points of view, comparing and contrasting situations, suggesting possible solutions and actions, and making recommendations. Command verbs The Institute and Faculty of Actuaries use command verbs (such as ‘Define’, ‘Discuss’ and ‘Explain’) to help students to identify what the question requires. The profession has produced a document, ‘Command verbs used in the Associate and Fellowship written examinations’, to help students to understand what each command verb is asking them to do. © IFE: 2019 Examinations The Actuarial Education Company CB1: Study Guide Page 15 It also gives the following advice:  The use of a specific command verb within a syllabus objective does not indicate that this is the only form of question which can be asked on the topic covered by that objective.  The Examiners may ask a question on any syllabus topic using any of the agreed command verbs, as are defined in the document. You can find the relevant document on the profession’s website at: https://www.actuaries.org.uk/studying/prepare-your-exams The Actuarial Education Company © IFE: 2019 Examinations  Page 16 CB1: Study Guide 1.5 The examination What to take to the exam IMPORTANT NOTE: The following information was correct at the time of printing, however it is important to keep up-to-date with any changes. See the profession’s website for the latest guidance. For the written exams the examination room will be equipped with:  the question paper  an answer booklet  rough paper  a copy of the Yellow Tables. Remember to take with you:  black pens  a permitted scientific calculator – please refer to www.actuaries.org.uk for the latest advice. Past exam papers You can download some past exam papers and Examiners’ Reports from the profession’s website at www.actuaries.org.uk. However, please be aware that these exam papers are for the pre-2019 syllabus and not all questions will be relevant. © IFE: 2019 Examinations The Actuarial Education Company  CB1: Study Guide Page 17 1.6 Queries and feedback Questions and queries From time to time you may come across something in the study material that is unclear to you. The easiest way to solve such problems is often through discussion with friends, colleagues and peers – they will probably have had similar experiences whilst studying. If there’s no-one at work to talk to then use our discussion forum at www.ActEd.co.uk/forums (or use the link from our home page at www.ActEd.co.uk). Our online forum is dedicated to actuarial students so that you can get help from fellow students on any aspect of your studies from technical issues to study advice. You could also use it to get ideas for revision or for further reading around the subject that you are studying. ActEd tutors will visit the site from time to time to ensure that you are not being led astray and we also post other frequently asked questions from students on the forum as they arise. If you are still stuck, then you can send queries by email to the relevant subject email address (see Section 2.6), but we recommend that you try the forum first. We will endeavour to contact you as soon as possible after receiving your query but you should be aware that it may take some time to reply to queries, particularly when tutors are away from the office running tutorials. At the busiest teaching times of year, it may take us more than a week to get back to you. If you have many queries on the course material, you should raise them at a tutorial or book a personal tuition session with an ActEd tutor. Information about personal tuition is set out in our current brochure. Please email [email protected] for more details. Feedback If you find an error in the course, please check the corrections page of our website (www.ActEd.co.uk/paper_corrections.html) to see if the correction has already been dealt with. Otherwise please send details via email to the relevant subject email address (see Section 2.6). Each year our tutors work hard to improve the quality of the study material and to ensure that the courses are as clear as possible and free from errors. We are always happy to receive feedback from students, particularly details concerning any errors, contradictions or unclear statements in the courses. If you have any comments on this course please email them to the relevant subject email address (see Section 2.6). Our tutors also work with the profession to suggest developments and improvements to the Syllabus and Core Reading. If you have any comments or concerns about the Syllabus or Core Reading, these can be passed on via ActEd. Alternatively, you can send them directly to the Institute and Faculty of Actuaries’ Examination Team by email to [email protected]. The Actuarial Education Company © IFE: 2019 Examinations  Page 18 CB1: Study Guide 2.1 Subject CB1 – background History The Business subjects (Subjects CB1, CB2 and CB3) are new subjects in the Institute and Faculty of Actuaries 2019 Curriculum. ActEd is not involved in the delivery of Subject CB3. Subject CB1 is Business Finance. Predecessors The topics covered in the Business subjects (Subjects CB1 and CB2) cover content previously in Subjects CT2 and CT7:  Subject CB1 replaces Subject CT2.  Subject CB2 replaces Subject CT7. Exemptions You will need to have passed or been granted an exemption from Subject CT2 to be eligible for a pass in Subject CB1 during the transfer process. Links to other subjects  Subjects CB2 and CB3 – Business Economics and Business Management are the other subjects in the Business module.  Subject CM1 – Actuarial Mathematics 1  Subject CP1 – Actuarial Practice  Subject SP5 – Investment and Finance Principles.  Subject P0 – Generic UK Practice Module. © IFE: 2019 Examinations The Actuarial Education Company  CB1: Study Guide Page 19 2.2 Subject CB1 – Syllabus and Core Reading Syllabus The Syllabus for Subject CB1 is given here. To the right of each objective are the chapter numbers in which the objective is covered in the ActEd course. Aim The aim of the Business Finance subject is to:  provide a basic understanding of corporate finance including a knowledge of the instruments used by companies to raise finance and manage financial risk  provide the ability to interpret the accounts and financial statements of companies and financial institutions. Competences On successful completion of this subject, a student will be able to: 1. understand how companies are governed and structured 2. suggest appropriate ways to finance a company 3. analyse published accounts 4. produce management information. Syllabus topics 1. Corporate governance and organisation (10%) 2. How corporates are financed (20%) 3. Evaluating projects (20%) 4. Constructing and interpreting company accounts (40%) 5. Constructing management information and evaluating working capital (10%) The weightings are indicative of the approximate balance of the assessment of this subject between the main syllabus topics, averaged over a number of examination sessions. The weightings also have a correspondence with the amount of learning material underlying each syllabus topic. However, this will also reflect aspects such as:  the relative complexity of each topic, and hence the amount of explanation and support required for it  the need to provide thorough foundation understanding on which to build the other objectives  the extent of prior knowledge which is expected  the degree to which each topic area is more knowledge or application based. The Actuarial Education Company © IFE: 2019 Examinations Page 20 CB1: Study Guide Detailed syllabus objectives 1 Corporate governance and organisation (10%) 1.1 Explain the purpose and process of regulating the financial reporting information of incorporated entities. Chapter 1 1.2 Describe the key principles of corporate governance and the regulation of companies. Chapter 1 1.3 Demonstrate an awareness of the key principles of finance. Chapter 1 1.3.1 Outline the relationship between finance and the real resources and objectives of an organisation. 1.3.2 Outline the relationship between the stakeholders in an organisation (including lenders and investors). 1.3.3 Outline the role and effects of the capital markets. 1.3.4 Outline the maximisation of shareholder wealth as the main goal of financial management in a company. 1.3.5 Outline problems relating to the maximisation of shareholder wealth in practice: social responsibility concerns, agency problems and divergent objectives. 1.3.6 Outline the strategies employed by managers to maximise shareholder wealth. 1.3.7 Outline the determinants of value and the actions managers can take to influence value. 2 How corporates are financed (20%) 2.1 Describe the structure of a company and the different methods by which it may be financed. 2.1.1 Outline the distinctive characteristics of sole traders, partnerships and limited companies as business entities. (Chapter 2) 2.1.2. Describe the different types of loan and share capital. (Chapter 4) 2.1.3 Contrast authorised and issued share capital. (Chapter 4) 2.1.4 Discuss the economic advantages and disadvantages of a limited company as a business entity. (Chapter 2) 2.1.5 Outline the main differences between a private and public company. (Chapter 2) © IFE: 2019 Examinations The Actuarial Education Company CB1: Study Guide Page 21 2.1.6 Outline the different types of medium term company finance: (Chapter 6)  hire purchase  credit sale  leasing  bank loans. 2.1.7 Describe the following different types of short term company finance: (Chapter 6)  bank overdrafts  trade credit  factoring  bills of exchange  commercial paper. 2.1.8 Describe alternative methods of raising finance outside the regular banking system including ‘shadow banking’, direct project financing, crowd-funding and micro-finance. (Chapter 7) 2.2 Describe the basic principles of personal and corporate taxation. (Chapter 3) 2.2.1 Describe the basic principles of personal taxation of income and capital gains. 2.2.2 Describe the basic principles of company taxation. 2.2.3 Explain the different systems of company taxation from the points of view of an individual shareholder and the company. 2.2.4 Outline the basic principles of double taxation relief. 2.3 Demonstrate a knowledge and understanding of the characteristics of the principal forms of financial instrument issued or used by companies and the ways in which they may be issued. 2.3.1 Outline the reasons a company might have for seeking a quotation on the stock exchange. (Chapter 5) The Actuarial Education Company © IFE: 2019 Examinations Page 22 CB1: Study Guide 2.3.2 Describe the characteristics of: (Chapter 4)  debenture stocks  unsecured loan stocks  Eurobonds  preference shares  ordinary shares  convertible unsecured loan stocks  convertible preference shares  warrants  floating rate notes  subordinated debt  options issued by companies. 2.3.3 Describe the characteristics and possible uses by a non-financial company of: (Chapter 8)  financial futures  options  interest rate and currency swaps. 2.3.4 Outline the following methods of obtaining a quotation for securities: (Chapter 5)  offer for sale  offer for sale by tender  offer for subscription  placing  introduction. 2.3.5 Describe the following types of new issues to existing shareholders: (Chapter 5)  scrip issue  rights issue. 2.3.6 Describe the role of underwriting in the issue of securities. (Chapter 5) 2.4 Discuss the factors to be considered by a company when deciding on its capital structure and dividend policy. (Chapter 20) 2.4.1 Describe the effect that the capital structure used by a company will have on the market valuation of the company. 2.4.2 Describe the effect of taxation on the capital structure used by a company. 2.4.3 Discuss the principal factors that a company should consider in setting dividend policy. 2.4.4 Discuss alternative ways of distributing profits, such as buybacks. © IFE: 2019 Examinations The Actuarial Education Company CB1: Study Guide Page 23 2.4.5 Discuss the effect that the dividend policy will have on the market valuation of a company. 2.5 Discuss how companies grow and the different ways of company restructuring. (Chapter 18) 2.5.1 Describe why businesses want to grow larger, how companies achieve internal growth and explain the relationship between growth and profitability. 2.5.2 Describe the constraints on a firm’s growth. 2.6 Outline the motives for mergers and acquisitions. (Chapter 18) 2.6.1 Describe the characteristics of a merger. 2.6.2 Discuss methods of evaluating a target company. 2.6.3 Discuss the steps that a buyer will usually take in a leveraged buyout. 3 Evaluating projects (20%) 3.1 Discuss how a company’s cost of capital interacts with the nature of the investment projects it undertakes. (Chapters 19, 21 and 22) 3.1.1 Define what is meant by a company’s cost of capital. 3.1.2 Describe how to calculate a company’s weighted average cost of capital. 3.1.3 Discuss the principal methods that may be used to determine the viability of a capital project. 3.1.4 Carry out cashflow projections and techniques to estimate cashflows. 3.1.5 Describe methods commonly used to evaluate risky investments including simulation and certainty equivalents. 3.1.6 Discuss the issues in establishing the required rate of return for a capital project. 3.1.7 Discuss the factors underlying the choice of discount rate within project assessment, including:  the assumptions and limitations in the use of the weighted average cost of capital.  the allowance for leverage.  the allowance for risk. 3.1.8 Discuss the methods that may be used for identifying the risks that may be present for different types of project. 3.1.9 Discuss suitable techniques for ascertaining the probability of occurrence of different risks over varying timescales and the financial impact of occurrence. The Actuarial Education Company © IFE: 2019 Examinations Page 24 CB1: Study Guide 3.1.10 Discuss suitable techniques for ascertaining the distribution of the possible financial outcomes of a capital project. 4 Constructing and interpreting company accounts (40%) 4.1 Describe the basic construction of accounts of different types and the role and principal features of the accounts of a company. (Chapters 9 to 13 and 15) 4.1.1 Explain why companies are required to produce annual reports and accounts. 4.1.2 Explain the value of financial reporting on environmental, social and economic sustainability. 4.1.3 Describe alternatives to traditional financial reporting. 4.1.4 Explain the fundamental accounting concepts which should be adopted in the drawing up of company accounts. 4.1.5 Explain the purpose of a:  statement of financial position.  statement of comprehensive income.  cashflow statement.  and of the notes to the accounts. 4.1.6 Construct simple statements of financial position and statements of profit or loss. 4.1.7 Explain cashflow statements. 4.1.8 Describe the structure and content of insurance company accounts. 4.1.9 Explain what is meant by the terms subsidiary company and associated company. 4.1.10 Explain the purpose of consolidated accounts. 4.1.11 Explain how goodwill might arise on the consolidation of group accounts. 4.1.12 Explain how depreciation is treated in company accounts. 4.1.13 Explain the function of the following accounts – share capital, other reserves and retained earnings. 4.2 Assess the accounts of a company or a group of companies, including the limitations of such assessment. (Chapters 14 and 15) 4.2.1 Calculate and explain priority percentages and gearing. 4.2.2 Calculate and explain interest cover and asset cover for loan capital. 4.2.3 Describe the possible effects of interest rate movements on a highly geared company. © IFE: 2019 Examinations The Actuarial Education Company CB1: Study Guide Page 25 4.2.4 Calculate and explain price earnings ratio, dividend yield, dividend cover and EBITDA. 4.2.5 Explain net earnings per share. 4.2.6 Calculate and explain accounting ratios which indicate:  profitability  liquidity  efficiency. 4.2.7 Discuss the shortcomings of historical cost accounting. 4.2.8 Discuss the limitations in the interpretation of company accounts. 4.2.9 Discuss the ways that reported figures can be manipulated to create a false impression of a company's financial position. 5 Constructing management information and evaluating working capital (10%) 5.1 Determine the working capital position of a company. (Chapter 16) 5.1.1 Analyse accounts receivables, accounts payables and inventory ratios 5.1.2 Evaluate policies for working capital management, including its individual elements. 5.1.3 Discuss methods for financing working capital. 5.1.4 Analyse the short term cash position of a company. 5.1.5 Discuss measures to manage the short term cash position of a company. 5.1.6 Discuss dividend sustainability. 5.2 Describe the function of forecasts and budgets as sources of management information. (Chapter 17) 5.2.1 Explain the purpose of forecasts and budgets. 5.2.2 Prepare basic examples of forecasts and budgets. The Actuarial Education Company © IFE: 2019 Examinations Page 26 CB1: Study Guide Core Reading The Subject CB1 Course Notes include the Core Reading in full, integrated throughout the course. Accreditation Material from the Audit and Assurance Council (formerly Auditing Practices Board) in this Core Reading is reproduced by kind permission of the Audit and Assurance Council. For further information please visit www.frc.org.uk. Further reading The exam will be based on the relevant Syllabus and Core Reading and the ActEd course material will be the main source of tuition for students. Background references These background references, provided at the end of the Core Reading, are for further reading, if desired, and are not examinable:  Brealey, SC and Myers, RA, 2000, Principles of Corporate Finance, 6th ed, Irwin/McGraw-Hill  Atrill, P and McLaney, E, 2015, Management Accounting for decision makers, 8th ed, Pearson  Berry, A and Jarvis, R, 2011, Accounting in a business context, 5th ed, Cengage  Leiwy, D and Perks, R, 2013, Accounting Understanding and Practice, 4th ed, McGraw-Hill  Sloman, J, Garratt, D, Guest, J and Jones, E, 2016, Economics for Business, 7th ed, Pearson  FRC: The UK Corporate Governance Code, April 2016  Crowd funding regulation. Available at: https://www.fca.org.uk  www.thetakeoverpanel.org.uk/download-links/the-takeover-code  Global Reporting Initiative (GRI), GRI Sustainability Reporting Standards. Available at: https://www.globalreporting.org  The Association of Chartered Certified Accountants, London, 2010, ‘Sustainability reporting matters. What are national governments doing about it?’. Available at: http://www.accaglobal.com/content/dam/acca/global/PDF-technical/sustainability- reporting/tech-tp-srm.pdf  Companies Act, 2006, Contents of the strategic report. Available at: http://www.legislation.gov.uk/ukpga/2006/46/contents  The International Integrated Reporting Council, How to prepare an integrated report. Available at: http://integratedreporting.org/. © IFE: 2019 Examinations The Actuarial Education Company  CB1: Study Guide Page 27 2.3 Subject CB1 – the course structure There are three parts to the Subject CB1 course. The parts cover related topics. The parts are broken down into chapters. The following table shows how the parts, the chapters and the syllabus items relate to each other. The end columns show how the chapters relate to the days of the regular tutorials. We have also given you a broad indication of the length of each chapter. This table should help you plan your progress across the study session. No of Syllabus 3 full Part Chapter Title pages objectives days 1 Key principles of finance and corporate 29 1 governance 2 Business ownership 20 2.1 3 Taxation 20 2.2 1 4 Long-term finance 38 2.1, 2.3 5 Issue of shares 34 2.3 1 6 Short- and medium-term finance 21 2.1 7 Alternative sources of finance 17 2.1 8 Use of derivatives 21 2.3 9 Introduction to accounts 32 4.1 10 The main accounts 36 4.1 11 Depreciation and reserves 20 4.1 12 Constructing accounts 32 4.1 2 13 Group accounts and insurance company 23 4.1 2 accounts 14 Interpretation of accounts 53 4.2 15 Limitations of accounts and alternative 21 4.1, 4.2 reporting 16 Evaluation of working capital 29 5.1 17 Constructing management information 21 5.2 18 Growth and restructuring of companies 22 2.5, 2.6 3 19 Weighted average cost of capital 36 3.1 3 20 Capital structure and dividend policy 36 2.4 21 Capital project appraisal (1) 31 3.1 22 Capital project appraisal (2) 39 3.1 The Actuarial Education Company © IFE: 2019 Examinations  Page 28 CB1: Study Guide 2.4 Subject CB1 – summary of ActEd products The following products are available for Subject CB1:  Course Notes  X Assignments – three assignments: – X1-X3: 100-mark tests (you are allowed 3¼ hours to complete these) and X Assignment marking (Series Marking and Marking Vouchers)  Online Classroom – around 60 tutorial units  Flashcards  Revision Notes – A5 booklets  ASET – four years’ exam papers, ie eight papers, covering the period April 2014 to September 2017  Mock Exam and marking (Series Marking and Marking Vouchers). We will endeavour to release as much material as possible but unfortunately some revision products may not be available until the September 2019 or even April 2020 exam sessions. Please check the ActEd website or email [email protected] for more information. The following tutorials are typically available for Subject CB1:  regular tutorials (three days)  block tutorials (three days). Full details are set out in our Tuition Bulletin, which is available on our website at www.ActEd.co.uk. © IFE: 2019 Examinations The Actuarial Education Company  CB1: Study Guide Page 29 2.5 Subject CB1 – skills and assessment Technical skills The Business subjects (Subjects CB1 and CB2) are more ‘wordy’ (and less mathematical) than the other Core Principles subjects. Subject CB1 is assessed using objective test (multiple choice) questions and ‘free form’ answer questions. Don’t panic if you haven’t written an essay in a while – it is more important to come up with a set of clear, concise points for the ‘free form’ answers than to answer with flowing prose. Exam skills Exam question skill levels In the CB subjects, the approximate split of assessment across the three skill types is:  Knowledge – 25%  Application – 55%  Higher Order skills – 20%. Assessment Assessment consists of a 3¼-hour paper-based examination involving objective test questions and ‘free form’ answer questions. The Actuarial Education Company © IFE: 2019 Examinations  Page 30 CB1: Study Guide 2.6 Subject CB1 – frequently asked questions Q: What knowledge of earlier subjects should I have? A: No knowledge of earlier subjects is required. Q: What are the key question answering skills? A: Part 2 of the course cover the construction and interpretation of accounts. This work can be quite complex and it helps to have a quick numerical brain. A lot of question practice in this area will help. More generally, questions often ask you to recommend action for a particular firm or individual in a particular situation. You need to know and understand the course content and then be able to think practically to apply the principles to the given situation. Q: What should I do if I discover an error in the course? A: If you find an error in the course, please check our website at: www.ActEd.co.uk/paper_corrections.html to see if the correction has already been dealt with. Otherwise please send details via email to [email protected]. Q: Who should I send feedback to? A: We are always happy to receive feedback from students, particularly details concerning any errors, contradictions or unclear statements in the courses. If you have any comments on this course in general, please email to [email protected]. If you have any comments or concerns about the Syllabus or Core Reading, these can be passed on to the profession via ActEd. Alternatively, you can send them directly to the Institute and Faculty of Actuaries’ Examination Team by email to [email protected]. © IFE: 2019 Examinations The Actuarial Education Company CB1-01: Key principles of finance and corporate governance Page 1 Key principles of finance and corporate governance Syllabus objectives 1.1 Explain the purpose and process of regulating the financial reporting information of incorporated entities. 1.2 Describe the key principles of corporate governance and regulation of companies. 1.3 Demonstrate an awareness of the key principles of finance. 1. Outline the relationship between finance and the real resources and objectives of an organisation. 2. Outline the relationship between the stakeholders in an organisation (including lenders and investors). 3. Outline the role and effects of the capital markets. 4. Outline the maximisation of shareholder wealth as the main goal of financial management in a company. 5. Outline problems relating to the maximisation of shareholder wealth in practice: social responsibility concerns, agency problems and divergent objectives. 6. Outline the strategies employed by managers to maximise shareholder wealth. 7. Outline the determinants of value and the actions managers can take to influence value. The Actuarial Education Company © IFE: 2019 Examinations  Page 2 CB1-01: Key principles of finance and corporate governance 0 Introduction This chapter introduces some fundamental ideas relating to the theory of corporate finance and corporate governance. It provides an overview and the rest of the course explores many of these ideas further. You might find this chapter quite difficult on first reading, but it does give a very useful introduction to the course. Much of the remainder of the course builds on this and considers the material in more detail. Therefore, don’t worry too much about the technical details on your first read of the chapter, as more detailed explanations are often going to be given in later chapters. You might want to re-read this chapter when you have finished the course and are more familiar with some of the details. The aim at this initial stage is to provide an overview and to start setting some of the ideas in their real-world context. 0.1 Overview of the course In the other chapters of Part 1 of the course we study the ways in which businesses are set up and raise finance. In Part 2 of the course we look at financial reporting, ie company accounts. Financial reporting provides information on how well a company is doing and this information helps in making decisions. In Part 3 of the course we study in more detail various decisions that companies have to make, in particular the capital budgeting decision (what to invest in) and the financing decision (how to finance that investment) that are introduced in this chapter. 0.2 Overview of this chapter Section 1 discusses the two key decisions relating to the financing of a company’s operations, namely the capital budgeting decision and the financing decision. Subsequent sections consider business stakeholders and objectives. A company is a complex organisation with many interested parties or stakeholders, eg shareholders, managers, employees. Each group has its own set of objectives and these objectives might conflict with those of other groups. We look at the objective of the maximisation of shareholder wealth in the face of divergent objectives and how financial markets play their role in achieving in this objective. The final section of the chapter looks at the key principles of corporate governance, ie the systems by which companies are directed and controlled. © IFE: 2019 Examinations The Actuarial Education Company  CB1-01: Key principles of finance and corporate governance Page 3 1 Finance and real resources 1.1 Finance and the real resources of an organisation Any business needs a variety of real assets, ie assets that are used in the normal line of business to generate profits. We use the term real assets to distinguish them from financial assets, such as shares or bonds. To carry on business, companies need to employ real assets, both tangible and intangible. A company is an important type of business entity. We’ll study different types of business in the next chapter, eg companies, partnerships. Tangible assets are assets that physically exist (eg machinery and buildings) whereas intangible assets are assets that do not (eg goodwill, trademarks and brand names). Question Describe the possible real assets of an oak furniture manufacturing business. Solution The business would have tangible assets. Some of these would be fixed assets such as premises, machinery, tools, computers etc, which might last for many years. Some would be used up in the production of furniture, eg stocks of wood, nails, varnish etc. (These are known as current assets.) The business might also have intangible assets, eg valuable brand names. To acquire such assets, a company must raise finance. For example, when businesses start, the founders might contribute some of their own savings to the business; they might ask the bank (or other finance providers) for loans. If the business is set up as a company, issuing shares raises finance. Businesses might ask suppliers to give them credit. Some of these sources of finance are financial assets, eg shares are a financial asset. They are assets of the capital providers (eg shares are an asset of the investors who buy them) rather than the company raising the finance. A company’s financial managers are responsible for the major investment and financing decisions. The financial manager stands between:  the firm’s operations and  the financial markets (where investors hold the financial assets issued by the firm to obtain money). The Actuarial Education Company © IFE: 2019 Examinations  Page 4 CB1-01: Key principles of finance and corporate governance The role of the financial manager as the link between the firm’s operations and the financial markets is summarised by the following diagram. Financial markets (investors holding financial assets) cash raised by cash returned to selling financial investors assets Financial manager (makes cash investment and financing reinvested decisions) cash used to cash generated purchase real by operations assets Firm's operations (portfolio of real assets) 1.2 Finance and the organisation’s objectives Most companies aim to increase the value of their shares by investing in profitable projects and raising the finance in a cost-effective way. Finance involves two basic issues: 1. What real assets should the firm invest in? (the investment or capital budgeting decision) 2. How should the cash for the investment be raised? (the financing decision). Firms use real assets to undertake projects – a firm can essentially be thought of simply as a collection of projects. These projects generate revenues and incur costs. The aim of the firm should be to undertake those projects for which the revenues exceed the costs in order to generate profits on behalf of the owners of the firm – typically the shareholders. The capital budgeting decision considers the choice of projects, and hence real assets, in which the firms should invest. In practice, the capital budgeting decision is often complicated by the fact that:  there may be more than one apparently profitable project between which to choose  it is very difficult to estimate the future profitability of a project. The typical project requires a significant expenditure prior to the receipt of the first revenues. A net investment will therefore be required to get the project off the ground. The financing decision considers how best to raise the required finance. © IFE: 2019 Examinations The Actuarial Education Company  CB1-01: Key principles of finance and corporate governance Page 5 1.3 Responsibilities for financial decisions The first question is normally the remit of a controller or, in many instances, the Chief Financial Officer (CFO). However, capital budgeting decisions will be tied into plans for product development, production and marketing and so will involve managers from these areas (as well as any staff specialising in corporate planning). The second question is the responsibility of the treasurer who:  looks after the company’s cash  raises new capital and  maintains relationships with banks, shareholders and other investors. Typically, the CFO will report directly to the Chief Executive Officer (CEO) whilst the treasurer will report to the CFO. In practice, the controller/CFO and the treasurer are sometimes the same individual. Responsibility for financial issues will, ultimately, rest (by law or custom) with the board of directors. In practice, boards usually delegate decisions for small or medium-sized matters. 1.4 The importance of capital budgeting The importance of capital budgeting is due to the complexity of the analysis involved and the cost of poor decisions. It is difficult to project the prospective cashflows arising from a particular project with any great confidence. Further complications arise when allowing for different possible scenarios, incorporating options into the analysis and discounting the cashflows. Investment in working capital (liquidity) is largely routine and involves few complications or risks. Investment in fixed capital, however, often involves complex choices between:  alternative capital assets  dates of commencement  methods of financing. These choices are both complex and critical, given the scope for (and very high cost of) making the wrong decisions. Moreover, fixed capital outlays often have a serious bearing on the direction and pace of a firm’s growth. As such, they determine the opportunities open to a firm and the directions in which it can move. This is because fixed capital choices can involve the commitment of large sums of money for long periods of time. 1.5 Financial analysis Progress in management depends on applying logic to experiences, to known or assumed facts in order to enhance understanding. Investment decisions are no exception. The Actuarial Education Company © IFE: 2019 Examinations Page 6 CB1-01: Key principles of finance and corporate governance Even where it is impossible for financial analysis to improve the actual fortunes of a project, it may nevertheless be able to:  identify the risks involved in the project  highlight the salient factors  possibly suggest methods by which these risks might be reduced. More generally, it may provide greater insight on which to base informed and sensible investment decisions. Financial analysis in capital budgeting involves bringing together estimates and ideas from a variety of disciplines – marketing, technology, accounting, tax, law – so as to reveal their financial implications. As its name suggests, financial analysis in this context simply means analysing the financial implications of different possible courses of action. An in-depth financial analysis of a project may require the input of experts from each of several different disciplines such as those listed above. Ultimately, the problems of capital budgeting in any enterprise are both financial and political. Leaving the investment appraisal of a project to be conducted by the very people who are most concerned to see the project accepted – the department primarily interested in the project – is to expect impossible objectivity. In other words, all decisions are ultimately made by human beings who are not always impartial and objective. The use of a specialist finance function is an attempt to enforce impartiality and realism. However, the possible downside of this is that the finance function may lack specialist knowledge of the particular project under consideration. Question Explain the role of financial management in an organisation, including both why it is it important and why it is difficult. Solution Financial management involves making careful choices in the raising of finance (the financing decision) and in the investment of this finance in real assets (the capital budgeting decision). There are many factors to consider and it is important that the financial team gathers all the available information and examines the options objectively and realistically. It is very important because a wrong decision could have very serious consequences for the business. It is also very difficult because there are often many options to choose from and the outcomes from any of the options are subject to great uncertainty. © IFE: 2019 Examinations The Actuarial Education Company  CB1-01: Key principles of finance and corporate governance Page 7 2 Stakeholders We assume that companies aim to increase the value of their shares. We assume this because most businesses are owned by shareholders, who are interested in maximising the value of their investments in shares. We explore this theory of companies aiming to maximise shareholder wealth further in Section 3. The extent to which this is truly a company’s aim in reality depends on:  the extent to which the shareholders control the business  the extent to which other stakeholders are considered. 2.1 The stakeholders There are many groups involved in running a company, eg shareholders, managers, employees, lenders, suppliers, customers, the government. We must consider their interests and their role. Shareholders Consider a typical company structure: shareholders (owners) board of directors lenders general public managers suppliers employees government customers The shareholders own the company and elect the board of directors to run the company on their behalf. Sometimes the directors run the company themselves, but quite often they hire general managers, who are not shareholders but who are experts in their fields, to run the company. Ultimate responsibility for financial decisions within a company will usually lie with the directors. The directors are acting on behalf of the ultimate shareholders (who elected them). In practice, they will often delegate operational decision making to the executives, while retaining control of strategic issues. This is sometimes known as ‘the divorce of ownership from control’. Such separation of ownership and management has advantages – freedom for ownership to change without affecting operational activities, freedom to hire professional managers – but also disadvantages if the interests of the owners and managers diverge. The Actuarial Education Company © IFE: 2019 Examinations Page 8 CB1-01: Key principles of finance and corporate governance Question List possible objectives of a company’s shareholders. Solution The objectives of the shareholders might be:  to obtain an income from their investment, ie to obtain a regular dividend  to make a capital gain, ie to sell the shares for more than they cost  to maximise the overall return on their investment. Other stakeholders Question Give examples of possible objectives of: (i) managers (ii) employees (iii) banks and other lenders (iv) customers (v) government. © IFE: 2019 Examinations The Actuarial Education Company CB1-01: Key principles of finance and corporate governance Page 9 Solution (i) Managers may aim for:  job security  good pay  good benefits, eg perks such as company cars, long holidays  prestige and power. They may therefore wish the company to aim for:  growth (salary and prestige are often related to the size of the firm)  stability (and not to take unnecessary risks)  a satisfactory level of profit (rather than a maximum level of profit). (ii) Employees may wish the company to:  pay at least a market rate of pay for the work  stay in business  provide safe working conditions  provide training  provide a variety of benefits such as pensions, holidays etc. (iii) Banks and other lenders may wish the company to:  remain in business  to pay a market rate of return on the borrowed funds  to meet the payment deadlines. (iv) Customers may wish the company to:  remain in business (for after-sales service etc)  provide goods at reasonable prices  provide goods of good quality  produce and market goods ethically. (v) The government may wish the company to:  perform well so that it pays more corporation tax  perform well so that it provides jobs to as many citizens as possible  act legally and morally, eg in line with consumer law and ethics. The Actuarial Education Company © IFE: 2019 Examinations  Page 10 CB1-01: Key principles of finance and corporate governance 2.2 Conflicting objectives Shareholders and managers The scope for conflict between owners and managers is evident – managers may be motivated by objectives which are at variance with the desires (and interests) of the shareholders. For example, the main objective of shareholders will normally be to receive a high return on their investment in the company. In contrast, some managers might instead wish to pursue projects of interest over more profitable projects; to take over other companies and so gain control of as large a business empire as possible; to have a more leisurely or luxurious working lifestyle; or to aim for a satisfactory return (and secure job prospects) rather than a maximum return (and a higher risk of the company running into trouble). Providers of finance Of particular interest is the potential for conflict between providers of finance, notably lenders (such as banks and bondholders) and the providers of equity capital (the shareholders). For example, a company’s shareholders may be keener to see the company invest in a potentially high risk and high return project than are its lenders. This is because it is the shareholders who stand to benefit should the project prove successful, whereas the lenders have no particular interest in upside profits – they simply wish to ensure that they receive the promised interest and capital payments. Fundamentally, this can be characterised as the difference between the lenders’ short-term desire for security and the shareholders’ long-term interest in the development of the company. This may particularly be the case if the company is in financial difficulty. The shareholders may then be very keen to undertake a risky project as a last-ditch attempt to turn the company around, whereas lenders may not wish to see their capital placed in even more jeopardy. Thus, it is difficult for the management to simultaneously satisfy the preferences of both sets of investors. At times, however, the interests of different sub-groups of financiers may diverge. Question Give examples of other conflicts that may arise. © IFE: 2019 Examinations The Actuarial Education Company  CB1-01: Key principles of finance and corporate governance Page 11 Solution Other examples of conflicts include:  The shareholders and managers may wish to invest in labour-saving technology, but workers fear the loss of jobs and consumers fear a reduction in quality.  Shareholders, management and employees wish to expand production on a particular site, but the local community and local government may fear greater visual and air pollution and more congestion. 2.3 Contractual theory Contractual theory views a firm as a network of contracts, actual and implicit, which specify the roles of the various participants in the organisation (workers, managers, owners, lenders, etc) and define their rights, obligations and pay-offs under various conditions. For example, workers will expect an employment contract; banks will expect a loan agreement setting out details of the rate of interest and repayments dates. Most participants bargain for limited risk and fixed pay-offs, whereas the firm's owners are liable for any residual risk (and thus hold a residual claim on any assets and earnings of the firm that remain after covering costs). There are, however, potential conflicts. One such is between a firm's owners and its creditors. If managers substantially alter the riskiness of a firm's product-market investment activities, this will benefit shareholders greatly (if the investments are successful). However, risky investments that fail will reduce the security of debt holders and reduce debt values. If a firm does not give strong assurances to debt holders that investment policies will not be changed to their disadvantage, it must pay interest rates high enough to compensate debt holders against the possibility of such adverse policy changes. A main source of conflict and the costs it may entail is explained by the agency theory described in Section 3.2. In other words, the contracts drawn up must take into account, as far as possible, the various conditions that could face the firm and the reaction of the firm to those conditions. In this way, the stakeholders will be aware, as far as possible, of the risks they are taking. The Actuarial Education Company © IFE: 2019 Examinations  Page 12 CB1-01: Key principles of finance and corporate governance 3 Capital markets and the maximisation of shareholder wealth The capital markets are the markets in long-term finance for companies, such as the shares (or stock) market and the bond market. These markets provide a great deal of important information. This information will be used firstly, to monitor the performance of the financial manager and secondly, to assist the financial manager when making decisions. For large, publicly quoted companies, the stock market serves as a performance monitor. While share prices may react to the general economy or industry-wide factors, the basic component of the share price is the market's perception of the particular firm's current and expected future performance. If managers are not performing effectively, relative to the potential of the assets under their control, it will not be long before this is reflected in a lower share price. This may make the firm a bargain for a corporate acquirer and a take-over bid will be made. If the shareholders feel that the company is underperforming, they can elect a new board of directors, which, in turn, will probably appoint a new management team. Alternatively, shareholders might express their disapproval by selling their shares. If sufficient shareholders do this, then the share price falls. If the company is underperforming and the share price falls, the company is vulnerable to a take-over bid. The management team is likely to be replaced by one that will do what is necessary to maximise shareholder value. Business organisations are, therefore, directly and measurably subject to the disciplines of the financial markets. These markets are continuously determining the valuations of business firms' securities, thereby providing measures of the firms' performance. The presence of the capital markets' continuous assessment therefore stimulates efficiency and provides incentives to business managers to improve their performance. In this way the financial markets should serve to align the interests of managers and shareholders. The financial markets also provide useful information for the financial manager when making decisions on sources of finance and investment projects. Key effects of the capital markets on a firm's decisions include:  Sound investment decisions require accurate measurement of the cost of capital.  Limitations in the supply of capital focus attention on methods of raising finance.  Mergers and take-overs create threats and opportunities to be exploited.  ‘Externalities’ require managers to determine the appropriate role of organisations. An ‘externality’ is a cost or benefit that is incurred by a party who did not choose to incur it, for example pollution. Question Explain how the capital market provides information to help the financial manager make decisions. © IFE: 2019 Examinations The Actuarial Education Company  CB1-01: Key principles of finance and corporate governance Page 13 Solution The financial manager will be able to monitor the market’s reaction to various policies (either of its own company or others). For example, if shareholders think a company’s proposed investment is likely to increase shareholder wealth, the share price will tend to rise. Managers can also monitor the policies and performance of other companies. For example, if a company is buying other companies involved in a particular industry, then other such companies will consider themselves possible targets. A company that has been performing less well than the sector average and/or has lots of cash will be more vulnerable to a take-over because the predator will feel that it could make better use of the company’s resources. 3.1 The theory of the maximisation of shareholder wealth In market-based financial systems, such as the UK and the US, there are large equity and bond markets, shareholders are owners of the company and the company’s objective is to maximise shareholder wealth within external constraints. In these countries, company managers are accountable to the shareholders. Managers are duty-bound to act in shareholders’ interests, to protect the investors and to enable the financial markets to operate efficiently. 3.2 Practical problems with the maximisation of shareholder wealth There are however limitations on how well the discipline of the capital markets on a company’s managers works in practice. We have already described how different stakeholders are likely to have different objectives. Even different members of the same stakeholder group might have divergent objectives, eg one shareholder might prefer a company to pay a high dividend to provide them with income but another shareholder may prefer the company to focus instead on future growth. Agency theory One theory that tries to explain the complex relationships and conflicting objectives within an organisation is agency theory. Agency theory, which considers the relationship between a principal and an agent of that principal, includes issues such as the nature of the agency costs, conflicts of interest (and how to avoid them) and how agents may be motivated and incentivised. Consider the relationship between the shareholders and the management. The shareholders are the principals who employ the management as the agents to run the company on their behalf. Divergence of interests leads to the possibility of conflicts of interest. Such conflicts are referred to as principal-agent problems, and give rise to agency costs. These incl