FM Study text 2023-24 ISDC.pdf

Valid for September 2023, ACCA (FM)...

Valid for September 2023, ACCA (FM) December 2023, March 2024 and June 2024 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 Management Financial required of you in the exam. Financial Student-friendly Using accessible language and engaging Management formats to help you understand more complex areas, Kaplan simplifies the learning process (FM) to make it easier for you to succeed. December 2023, March 2024 and June 2024 Valid for September 2023, 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 978-1-83996-362-9 Study Text 9 781839 963629  ACCA Applied Skills Financial Management (FM) 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 978-1-83996-362-9 © Kaplan Financial Limited, 2023 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. Nor does the review comprise a detailed technical check of the content as the Approved Content Provider has its own quality assurance processes in place in this respect. We are grateful to the Association of Chartered Certified Accountants and the Chartered Institute of Management Accountants for permission to reproduce past examination questions. The answers have been prepared by Kaplan Publishing. KAPLAN PUBLISHING P.3 P.4 KAPLAN PUBLISHING  Contents Page Chapter 1 The financial management function 1 Chapter 2 Basic investment appraisal techniques 35 Chapter 3 Investment appraisal – Discounted cash flow techniques 55 Chapter 4 Investment appraisal – Further aspects of discounted cash flows 93 Chapter 5 Asset investment decisions and capital rationing 123 Chapter 6 Investment appraisal under uncertainty 147 Chapter 7 Working capital management 177 Chapter 8 Working capital management – Inventory control 215 Chapter 9 Working capital management – Accounts receivable and payable 239 Chapter 10 Working capital management – Cash and funding strategies 273 Chapter 11 The economic environment for business 313 Chapter 12 Financial markets and the treasury function 339 Chapter 13 Foreign exchange risk 375 Chapter 14 Interest rate risk 417 Chapter 15 Sources of finance 439 Chapter 16 Dividend policy 485 Chapter 17 The cost of capital 495 Chapter 18 Capital structure 547 Chapter 19 Financial ratios 579 Chapter 20 Business valuations and market efficiency 607 Chapter 21 Employability and technology skills 645 Chapter 22 Questions and Answers 653 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 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, 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.  Summary diagrams complete each chapter to show the important links between topics and the overall content of the examination. 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. P.8 KAPLAN PUBLISHING  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 give feedback 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. 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. KAPLAN PUBLISHING P.9  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. 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. Ask your local customer services staff if you are not already a subscriber and wish to join. Syllabus Introduction Syllabus background The aim of ACCA FM, Financial management, is to develop the knowledge and skills expected of a financial manager, in relation to investment, financing, and dividend policy decisions. Main capabilities  A – Discuss the role and purpose of the financial management function.  B – Assess and discuss the impact of the economic environment on financial management.  C – Discuss and apply working capital management techniques.  D – Carry out effective investment appraisal.  E – Identify and evaluate alternative sources of business finance.  F – Discuss and apply principles of business and asset valuations.  G – Explain and apply risk management techniques in business.  H – Apply employability and technology skills. P.10 KAPLAN PUBLISHING  Core areas of the syllabus  Financial management function (A).  Financial management environment (B).  Working capital management (C).  Investment appraisal (D).  Business finance (E).  Business valuations (F).  Risk management (G).  Employability and technology skills (H). ACCA performance objectives All ACCA students are required to complete their exams, take the Ethics and Professional Skills module and complete the PER (Practical Experience Requirement) before they can become an ACCA member. Performance objectives are benchmarks of effective performance that describe the types of work activities students and affiliates will be involved in as trainee accountants. Trainees are required to achieve nine performance objectives in total – all five Essentials performance objectives and any four Technical performance objectives. The financial management syllabus relates to four of the technical performance objectives: P09 – Evaluate investment and financing decisions P10 – Manage and control working capital P11 – Identify and manage financial risk P22 – Data analysis and decision support You can find more information on PER on the ACCA website: https://www.accaglobal.com/uk/en/student/practical-experience.html 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 study guide below, showing where the objectives are explored within this book. Within the chapters, we have broken down the extensive information found in the study guide 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 FINANCIAL MANAGEMENT FUNCTION 1 The nature and purpose of financial management (a) Explain the nature and purpose of financial management. 1 (b) Explain the relationship between financial management and financial and management accounting. 1 2 Financial objectives and the relationship with corporate strategy (a) Discuss the relationship between financial objectives, corporate objectives and corporate strategy. 1 (b) Identify and describe a variety of financial objectives, including: 1 (i) shareholder wealth maximisation (ii) profit maximisation (iii) earnings per share growth. 3 Stakeholders and impact on corporate objectives (a) Identify the range of stakeholders and their objectives. 1 (b) Discuss the possible conflict between stakeholder objectives. 1 (c) Discuss the role of management in meeting stakeholder objectives, including the application of agency theory. 1 (d) Describe and apply ways of measuring achievement of corporate objectives including: 19 (i) ratio analysis using appropriate ratios such as return on capital employed, return on equity, earnings per share and dividend per share (ii) changes in dividends and share prices as part of total shareholder return. KAPLAN PUBLISHING P.13  Syllabus learning objective Chapter reference (e) Explain ways to encourage the achievement of stakeholder objectives, including: (i) managerial reward schemes such as share options and performance-related pay 1 (ii) regulatory requirements such as corporate governance codes of best practice and stock exchange listing regulations 4 Financial and other objectives in not-for-profit organisations (a) Discuss the impact of not-for-profit status on financial and other objectives. 1 (b) Discuss the nature and importance of Value for Money as an objective in not-for-profit organisations. 1 (c) Discuss ways of measuring the achievement of objectives in not-for-profit organisations. 1 B FINANCIAL MANAGEMENT ENVIRONMENT 1 The economic environment for business (a) Identify and explain the main macroeconomic policy targets. 11 (b) Define and discuss the role of fiscal, monetary, interest rate and exchange rate policies in achieving macroeconomic policy targets. 11 (c) Explain how government economic policy interacts with planning and decision-making in business. 11 (d) Explain the need for, and the interaction with, planning and decision-making in business of: 11 (i) competition policy (ii) government assistance for business (iii) green policies and sustainability issues (iv) corporate governance regulation. P.14 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference 2 The nature and role of financial markets and institutions (a) Identify the nature and role of money and capital markets, both nationally and internationally. 12 (b) Explain the role of financial intermediaries. 12 (c) Explain the functions of a stock market and a corporate bond market. 12 (d) Explain the nature and features of different securities in relation to the risk/return trade-off. 15 (e) Explain the impact of Fintech in changing the nature and role of financial markets and institutions. 12 3 The nature and role of money markets (a) Describe the role of the money markets in: 12, 13, 14 (i) Providing short-term liquidity to the private sector and the public sector (ii) Providing short-term trade finance (iii) Allowing an organisation to manage its exposure to foreign currency risk and interest rate risk (b) Explain the role of banks and other financial institutions in the operation of the money markets. 12 (c) Explain and apply the characteristics and role of the principal money market instruments: 12 (i) Interest-bearing instruments (ii) Discount instruments (iii) Derivative products. C WORKING CAPITAL MANAGEMENT 1 The nature, elements and importance of working capital (a) Describe the nature of working capital and identify its elements. 7 (b) Identify the objectives of working capital management in terms of liquidity and profitability, and discuss the conflict between them. 7 (c) Discuss the central role of working capital management in financial management. 7 KAPLAN PUBLISHING P.15  Syllabus learning objective Chapter reference 2 Management of inventories, accounts receivable, accounts payable and cash (a) Explain the cash operating cycle and the role of accounts payable and accounts receivable. 7 (b) Explain and apply relevant accounting ratios, including: 7 (i) current ratio and quick ratio (ii) inventory turnover ratio, average collection period and average payable period (iii) sales revenue/net working capital ratio. (c) Discuss, apply and evaluate the use of relevant techniques in managing inventory, including the Economic Order Quantity model and Just-in-Time techniques. 8 (d) Discuss, apply and evaluate the use of relevant techniques in managing accounts receivable, including: 9 (i) assessing creditworthiness (ii) managing accounts receivable (iii) collecting amounts owing (iv) offering early settlement discounts (v) using factoring and invoice discounting (vi) managing foreign accounts receivable. (e) Discuss and apply the use of relevant techniques in managing accounts payable, including: 9 (i) using trade credit effectively (ii) evaluating the benefits of early settlement and bulk purchase discounts (iii) managing foreign accounts payable. (f) Explain the various reasons for holding cash, and discuss and apply the use of relevant techniques in managing cash, including: 10 (i) preparing cash flow forecasts to determine future cash flows and cash balances (ii) assessing the benefits of centralised treasury management and cash control (iii) cash management models, such as the Baumol model and the Miller-Orr model (iv) investing short-term P.16 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference 3 Determining working capital needs and funding strategies (a) Calculate the level of working capital investment in current assets and discuss the key factors determining this level, including: 7 (i) the length of the working capital cycle and terms of trade (ii) an organisation’s policy on the level of investment in current assets (iii) the industry in which the organisation operates. (b) Evaluate and discuss the key factors in determining working capital funding strategies, including: 10 (i) the distinction between permanent and fluctuating current assets. (ii) the relative cost and risk of short-term and long- term finance. (iii) the matching principle. (iv) the relative costs and benefits of aggressive, conservative and matching funding policies. (v) management attitudes to risk, previous funding decisions and organisation size: D INVESTMENT APPRAISAL 1 Investment appraisal techniques (a) Identify and calculate relevant cash flows for investment projects. 2 (b) Calculate payback period and discuss its usefulness as an investment appraisal method. 2 (c) Calculate discounted payback and discuss its usefulness as an investment appraisal method. 6 (d) Calculate return on capital employed (accounting rate of return) and discuss its usefulness as an investment appraisal method. 2 (e) Calculate net present value and discuss its usefulness as an investment appraisal method. 3 (f) Calculate internal rate of return and discuss its usefulness as an investment appraisal method. 3 (g) Discuss the superiority of discounted cash flow (DCF) methods over non-DCF methods. 3 (h) Discuss the relative merits of NPV and IRR. 3 KAPLAN PUBLISHING P.17  Syllabus learning objective Chapter reference 2 Allowing for inflation and taxation in DCF (a) Apply and discuss the real-terms and nominal-terms approaches to investment appraisal. 4 (b) Calculate the taxation effects of relevant cash flows, including the tax benefits of tax-allowable depreciation and the tax liabilities of taxable profit. 4 (c) Calculate and apply before- and after-tax discount rates. 17 3 Adjusting for risk and uncertainty in investment appraisal (a) Describe and discuss the difference between risk and uncertainty in relation to probabilities and increasing project life. 6 (b) Apply sensitivity analysis to investment projects and discuss the usefulness of sensitivity analysis in assisting investment decisions. 6 (c) Apply probability analysis to investment projects and discuss the usefulness of probability analysis in assisting investment decisions. 6 (d) Apply and discuss other techniques of adjusting for risk and uncertainty in investment appraisal, including 6 (i) simulation (ii) adjusted payback (iii) risk-adjusted discount rates. 4 Specific investment decisions (Lease or buy, asset replacement, capital rationing) (a) Evaluate leasing and borrowing to buy using the before- and after-tax costs of debt. 5 (b) Evaluate asset replacement decisions using equivalent annual cost and equivalent annual benefit. 5 (c) Evaluate investment decisions under single-period capital rationing, including: 5 (i) the calculation of profitability indexes for divisible investment projects (ii) the calculation of the NPV of combinations of non-divisible investment projects (iii) a discussion of the reasons for capital rationing. P.18 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference E BUSINESS FINANCE 1 Sources of, and raising, business finance (a) Identify and discuss the range of short-term sources of finance available to businesses, including: 15 (i) overdraft (ii) short-term loan (iii) trade credit (iv) lease finance. (b) Identify and discuss the range of long-term sources of finance available to businesses, including: 15 (i) equity finance (ii) debt finance (iii) lease finance (iv) venture capital. (c) Identify and discuss methods of raising equity finance, including: 15 (i) rights issue (ii) placing (iii) public offer (iv) stock exchange listing. (d) Identify and discuss methods of raising short- and long-term Islamic finance including: 15 (i) major difference between Islamic finance and other forms of business finance (ii) The concept of riba (interest) and how returns are made by Islamic financial securities (iii) Islamic financial instruments available to businesses including: (i) murabaha (trade credit) (ii) Ijara (lease finance) (iii) mudaraba (equity finance) (iv) sukuk (debt finance) (v) musharaka (venture capital) (note calculations are not required) KAPLAN PUBLISHING P.19  Syllabus learning objective Chapter reference (e) Identify and discuss internal sources of finance, including: 15 (i) retained earnings 15 (ii) increasing working capital management efficiency. 15 (iii) the relationship between dividend policy and the financing decision 16 (iv) the theoretical approaches to, and the practical influences on, the dividend decision, including legal constraints, liquidity, shareholder expectations and alternatives to cash dividends 16 2 Estimating the cost of capital (a) Estimate the cost of equity, including: 17 (i) Application of the dividend growth model, its assumptions, advantages and disadvantages (ii) Explanation and discussion of systematic and unsystematic risk (iii) Relationship between portfolio theory and the capital asset pricing model (CAPM) (iv) Application of the CAPM, its assumptions, advantages and disadvantages. (b) Estimating the cost of debt: 17 (i) irredeemable debt (ii) redeemable debt (iii) convertible debt (iv) preference shares (v) bank debt. (c) Estimating the overall cost of capital, including: 17 (i) Distinguishing between average and marginal cost of capital (ii) Calculating the weighted average cost of capital (WACC) using book value and market value weightings. P.20 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference 3 Sources of finance and their relative costs (a) Describe the relative risk-return relationship and the relative costs of equity and debt. 17 (b) Describe the creditor hierarchy and its connection with the relative costs of sources of finance. 17 (c) Identify and discuss the problem of high levels of gearing. 18 (d) Assess the impact of sources of finance on financial position, financial risk and shareholder wealth using appropriate measures, including: 19 (i) ratio analysis using statement of financial position gearing, operational and financial gearing, interest coverage ratio and other relevant ratios (ii) cash flow forecasting. (iii) leasing or borrowing to buy. (e) Impact of cost of capital on investments, including: 17 (i) the relationship between company value and cost of capital (ii) the circumstances under which WACC can be used in investment appraisal (iii) the advantages of the CAPM over WACC in determining a project-specific cost of capital (iv) the application of CAPM in calculating a project- specific discount rate. 4 Capital structure theories and practical considerations (a) Describe the traditional view of capital structure and its assumptions. 18 (b) Describe the views of Miller and Modigliani on capital structure, both without and with corporate taxation, and their assumptions. 18 (c) Identify a range of capital market imperfections and describe their impact on the views of Miller and Modigliani on capital structure. 18 (d) Explain the relevance of pecking order theory to the selection of sources of finance. KAPLAN PUBLISHING P.21  Syllabus learning objective Chapter reference 5 Finance for small and medium-sized entities (SMEs) (a) Describe the financing needs of small businesses. 15 (b) Describe the nature of the financing problem for small businesses in terms of the funding gap, the maturity gap and inadequate security. 15 (c) Explain measures that may be taken to ease the financing problems of SMEs, including the responses of government departments and financial institutions. 15 (d) Identify and evaluate the financial impact of sources of finance for SMEs, including sources already referred to in syllabus section E1 and also: 15 (i) Business angel financing (ii) Government assistance (iii) Supply chain financing (iv) Crowdfunding/peer-to-peer funding F BUSINESS VALUATIONS 1 Nature and purpose of the valuation of business and financial assets (a) Identify and discuss reasons for valuing businesses and financial assets. 20 (b) Identify information requirements for valuation and discuss the limitations of different types of information. 20 2 Models for the valuation of shares (a) Discuss and apply asset-based valuation models, including: 20 (i) net book value (statement of financial position) basis. (ii) net realisable value basis. (iii) net replacement cost basis. (b) Discuss and apply income-based valuation models, including: 20 (i) price/earnings ratio method (ii) earnings yield method (c) Discuss and apply cash flow-based valuation models, including: 20 (i) dividend valuation model and the dividend growth model (ii) discounted cash flow basis. P.22 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference 3 The valuation of debt and other financial assets 20 (a) Discuss and apply appropriate valuation methods to: (i) irredeemable debt (ii) redeemable debt (iii) convertible debt (iv) preference shares. 4 Efficient market hypothesis (EMH) and practical considerations in the valuation of shares (a) Distinguish between and discuss weak form efficiency, semi-strong form efficiency and strong form efficiency. 20 (b) Discuss practical considerations in the valuation of shares and businesses, including: 20 (i) marketability and liquidity of shares (ii) availability and sources of information (iii) market imperfections and pricing anomalies (iv) market capitalisation. (c) Describe the significance of investor speculation and the explanations of investor decisions offered by behavioural finance. 20 G RISK MANAGEMENT 1 The nature and types of risk and approaches to risk management (a) Describe and discuss different types of foreign currency risk: 13 (i) translation risk (ii) transaction risk (iii) economic risk. (b) Describe and discuss different types of interest rate risk: 14 (i) gap exposure (ii) basis risk KAPLAN PUBLISHING P.23  Syllabus learning objective Chapter reference 2 Causes of exchange rate differences and interest rate fluctuations (a) Describe the causes of exchange rate fluctuations, including: 13 (i) balance of payments (ii) purchasing power parity theory (iii) interest rate parity theory (iv) four-way equivalence (b) Forecast exchange rates using: 13 (i) purchasing power parity (ii) interest rate parity. (c) Describe the causes of interest rate fluctuations, including: 14 (i) structure of interest rates and yield curves (ii) expectations theory (iii) liquidity preference theory (iv) market segmentation. 3 Hedging techniques for foreign currency risk (a) Discuss and apply traditional and basic methods of foreign currency risk management, including: 13 (i) currency of invoice (ii) netting and matching (iii) leading and lagging (iv) forward exchange contracts (v) money market hedging (vi) asset and liability management. (b) Compare and evaluate traditional methods of foreign currency risk management. 13 (c) Identify the main types of foreign currency derivatives used to hedge foreign currency risk and explain how they are used in hedging. (No numerical questions will be set on this topic) 13 P.24 KAPLAN PUBLISHING  Syllabus learning objective Chapter reference 4 Hedging techniques for interest rate risk (a) Discuss and apply traditional and basic methods of interest rate risk management, including: 14 (i) matching and smoothing (ii) asset and liability management (iii) forward rate agreements (b) Identify the main types of interest rate derivatives used to hedge interest rate risk and explain how they are used in hedging. (No numerical questions will be set on this topic) 14 H EMPLOYABILITY AND TECHNOLOGY SKILLS 1 Use computer technology to efficiently access and manipulate relevant information 2 Work on relevant response options, using available functions and technology, as would be required in the workplace 3 Navigate windows and computer screens to create and amend responses to exam requirements, using the appropriate tools 4 Present data and information effectively, using the 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 Examination format The syllabus is assessed by a three-hour computer based examination. All questions are compulsory. The exam will contain both computational and discursive elements. Some questions will adopt a scenario/case study approach. Prior to the start of the exam candidates are given an extra 10 minutes to read the exam instructions. Candidates are provided with a formulae sheet and tables of discount and annuity factors. Examination tips Read the examination questions carefully.  Divide the time you spend on questions in proportion to the marks on offer.  One suggestion for this examination is to allocate 1.8 minutes to each mark available (180 minutes/100 marks), so a 20 mark question should be completed in approximately 36 minutes. FM is divided into three different sections, requiring the application of different skills to be successful. Section A This section comprises 15 objective testing (OT) questions worth 2 marks each. Stick to the timing principle of 1.8 minutes per mark. This means that the 15 OT questions in section A (30 marks) should take 54 minutes. Work steadily. Rushing leads to careless mistakes and the OT questions are designed to include answers which result from careless mistakes. If you don’t know the answer, eliminate those options you know are incorrect and see if the answer becomes more obvious. Remember that there is no negative marking for an incorrect answer. After you have eliminated the options that you know to be wrong, if you are still unsure, guess. Practice section A style questions can be found at the end of each chapter. OT questions in sections A of the CBEs will be of varying styles. These styles include multiple choice, number entry, pull down list, multiple response, hot area, and drag and drop. The questions in section A can cover any areas of the syllabus. P.26 KAPLAN PUBLISHING  Section B This section comprises 3 case study type questions. Each question will contain a scenario and 5 OT questions worth 2 marks each. You will need to read the scenario information for each case before attempting the questions related to it. Each OT question is worth two marks. Therefore, you have 18 minutes (1.8 minutes per mark) to answer the five OT questions relating to each case. It is likely that all of the cases will take the same length of time to answer, although some of the OT questions within a case may be quicker than other OT questions within that same case. Once you have read through the information, you should first answer any of the OT questions that do not require workings and can be quickly answered. You should then attempt the OT questions that require workings utilising the remaining time for that case. Practice section B style questions can be found in Chapter 21. All of the tips for section A are equally applicable to each section B question. OT questions in sections B of the CBEs will be of varying styles. These styles include multiple choice, number entry, pull down list, multiple response, hot area, and drag and drop. The questions in section B can cover any areas of the syllabus. Section C This section comprises 2 constructed response (CR) questions, each worth 20 marks in total and usually made up of a number of different parts. The CR questions in section C will require a written response made up of a combination of computational elements and discursive elements. Therefore, different techniques need to be used to score well. For computational style questions, you will be provided with a spreadsheet answer space. For discursive style questions, you will be provided with a word processing style answer space. Unless you know exactly how to answer the question, spend some time planning your answer. Stick to the question and tailor your answer to what you are asked. Pay particular attention to the verbs in the question e.g. 'Calculate', 'State', 'Explain'. If you get completely stuck with a question, flag the question and 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 examining team hoped, you should be given some credit, provided that your assumptions are reasonable. You should do everything you can to make things easy for the marker. The marker will find it easier to identify the points you have made if your answers are legible and labelled. KAPLAN PUBLISHING P.27  Computations: It is essential to include all your workings in your answers. Many computational questions require the use of a standard format. Be sure you know these formats thoroughly before the examination and use the layouts that you see in the answers given in this book and in model answers. Adopt a logical approach and cross reference workings to the main computation to keep your answers tidy. Practice section C style questions can be found in Chapter 21. The questions in section C will mainly come from the working capital management, investment appraisal and business finance areas of the syllabus (although other areas may be texted here for a few marks). All sections Don’t skip parts of the syllabus. The FM exam has 32 different questions so the examination can cover a very broad selection of the syllabus each sitting. Spend time learning the rules and definitions. There are many formulae that are not provided in the formulae sheets available during the exam. Ensure that you learn all necessary formulae. Practice plenty of questions to improve your ability to apply the techniques and perform the calculations. Spend the last five minutes reading through your answers and making any additions or corrections. Method of Examination Computer-based examinations (CBEs) are the method of examination for the ACCA Applied Skills Level examinations. If you would like further information on sitting a CBE FM examination, please contact either Kaplan, or the ACCA. Computer-based examination (CBE) – Tips Be sure you understand how to use the software before you start the exam. If in doubt, ask the assessment centre staff to explain it to you. Questions are displayed on the screen and answers are entered using keyboard and mouse. The CBE exam will not only examine multiple choice questions but could include questions that require data entry or a multiple response. Do not attempt a CBE until you have completed all study material relating to it. Do not skip any of the material in the syllabus. Read each question very carefully. Double-check your answer before committing yourself to it. Answer every question – if you do not know an answer, you don't lose anything by guessing. Think carefully before you guess. P.28 KAPLAN PUBLISHING  You will be able to flag questions that you would like to come back to later. This is a useful function for questions where you are unsure of the answer or that you feel will take a long time to answer. The CBE question types are as follows:  Multiple choice – where you are required to choose one answer from a list of options provided by clicking on the appropriate ‘radio button’  Multiple response – where you are required to select more than one response from the options provided by clicking on the appropriate tick boxes (typically choose two or three options from the available list)  Fill in the blank – where you are required to type an answer into a box (which may be numerical or text)  Drag and drop – where you are required to drag an answer and drop it into the correct place. There may be more than one answer to drag and potentially more answer choices than response areas  Drop down list – where you are required to select an answer from a drop down list, of which there may be more than one  Hot spot – where you are required to select a point on an image as your answer.  Hot area – where you are required to select one or more areas in an image. With an objective test question, it may be possible to eliminate first those answers that you know are wrong. Then choose the most appropriate answer(s) as required from those that are left. This could be a single answer (e.g. multiple choice) or more than one response (e.g. multiple response and multiple response – matching). After you have eliminated the ones that you know to be wrong, if you are still unsure, guess. But only do so after you have double-checked that you have only eliminated answers that are definitely wrong. Don't panic if you realise you've answered a question incorrectly. Try to remain calm, continue to apply examination technique and answer all questions required within the time available. ACCA support For additional support with your studies, please also 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. KAPLAN PUBLISHING P.29  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 examination 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. 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. P.30 KAPLAN PUBLISHING  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. 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. 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. In addition, 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. KAPLAN PUBLISHING P.31  Read good newspapers 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 You can find further reading and technical articles under the student section of ACCA’s website. The following publications may also support your studies for this, and other, ACCA examinations: A Student’s Guide to Corporate Finance and Financial Management by David Evans – Kaplan Publishing Technical update This text has been updated to reflect Examinable Documents September 2023 to June 2024 issued by ACCA. P.32 KAPLAN PUBLISHING  FORMULAE AND TABLES Economic Order Quantity 2CO D =ඨ CH Miller-Orr Model Return point = Lower limit + (13 × spread) 3 ଵ/ଷ 4 × transaction cost × variance of cash flows Spread = 3 ൥ ൩ interest rate The Capital Asset Pricing Model E(ri) = Rf + βi(E(rm) − Rf) The Asset Beta Formula Ve Vd (1–T) βa = ൬ βe ൰ + ቆ β ቇ (Ve + Vd (1–T)) (Ve + Vd (1–T)) d The Growth Model D0 (1 + g) D0 ሺ1 + gሻ P0 = re = +g ሺre – gሻ ሺP0 ሻ Note: D0(1+g) may be replaced by D1 Gordon’s Growth Approximation g = bre The Weighted Average Cost of Capital Ve Vd WACC = ൤ ൨ ke + ൤ ൨ k (1–T) Ve +Vd Ve +Vd d The Fisher Formula (1+i) = (1+r)(1+h) Purchasing Power Parity and Interest Rate Parity ሺ1 + hc ሻ ሺ1 + ic ሻ S1 = S0 × F0 = S0 × ሺ1 + hb ሻ ሺ1 + ib ሻ KAPLAN PUBLISHING P.33  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.34 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 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 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 6.495 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.35 P.36 KAPLAN PUBLISHING Chapter 1 The financial management function Chapter learning objectives Upon completion of this chapter, you will be able to:  explain the nature and purpose of financial management  distinguish between financial management and financial and management accounting  discuss the relationship between financial objectives, corporate objectives and corporate strategy  identify and describe a variety of financial objectives, including: – shareholder wealth maximisation – profit maximisation – earnings per share growth  identify stakeholders, their objectives and possible conflicts  discuss the possible conflict between stakeholder objectives  discuss the role of management in meeting stakeholder objectives, including the use of agency theory  explain ways to encourage the achievement of stakeholder objectives, including: – managerial reward schemes – regulatory requirements  discuss the impact of not-for-profit status on financial and other objectives  discuss the nature and importance of Value for Money as an objective in not-for-profit organisations  discuss ways of measuring the achievement of objectives in not-for-profit organisations. KAPLAN PUBLISHING 1 The financial management function 1 The nature and purpose of financial management Financial management is concerned with the efficient acquisition and deployment of both short- and long-term financial resources, to ensure the objectives of the enterprise are achieved. Decisions must be taken in three key areas:  investment – both long-term investment in non-current assets and short- term investment in working capital;  finance – from what sources should funds be raised?  dividends – how should cash funds be allocated to shareholders and how will the value of the business be affected by this? 2 KAPLAN PUBLISHING  Chapter 1 An understanding of these three key areas is fundamental for the examination. In taking these decisions, the financial manager will need to take account of:  the organisation's commercial and financial objectives  the broader economic environment in which the business operates  the potential risks associated with the decision and methods of managing that risk. The FM syllabus covers all these key aspects of financial management, which will also be relevant for those who choose to study for the advanced financial management exam. The investment decision To operate, all businesses will need finance and part of the financial manager's role is to ensure this finance is used efficiently and effectively to ensure the organisation's objectives are achieved. This can be further broken down into two elements:  Investment appraisal considers the long-term plans of the business and identifies the right projects to adopt to ensure financial objectives are met. The projects undertaken will nearly always involve the purchase of non-current assets at the start of the process. KAPLAN PUBLISHING 3 The financial management function  For a business to be successful, as well as identifying and implementing potentially successful projects, it must survive day to day. Working capital management is concerned with the management of liquidity – ensuring debts are collected, inventory levels are kept at the minimum level compatible with efficient production, cash balances are invested appropriately and payables are paid on a timely basis. The financing decision Before a business can invest in anything, it needs to have some finance. A key financial management decision is the identification of the most appropriate sources (be it long- or short-term), taking into account the requirements of the company, the likely demands of the investors and the amounts likely to be made available. The dividend decision Having invested wisely, a business will hopefully be profitable and generate cash. The final key decision for the financial manager is whether to return any of that cash to the owners of the business (in the form of dividends) and if so, how much should be distributed. The alternative is to retain some of the cash in the business where it can be invested again to earn further returns. This decision is therefore closely linked to the financing decision. The decision on the level of dividends to be paid can affect the value of the business as a whole as well the ability of the business to raise further finance in the future. Financial management should be distinguished from other important financial roles:  management accounting – concerned with providing information for the more day-to-day functions of control and decision making  financial accounting – concerned with providing information about the historical results of past plans and decisions. 4 KAPLAN PUBLISHING  Chapter 1 Financial roles Management accounting and financial management are both concerned with the use of resources to achieve a given target. Much of the information used and reported is common to both functions. The main difference is in the time scales. Financial management is concerned with the long-term raising of finance and the allocation and control of resources; it involves targets, or objectives, that are generally long-term by nature, whilst management accounting usually operates within a 12-month time horizon. Management accounting is concerned with providing information for the more day-to-day functions of control and decision-making. This will involve budgeting, cost accounting, variance analysis, and evaluation of alternative uses of short-term resources. Financial accounting is not directly involved in the day-to-day planning, control and decision making of an organisation. Rather, it is concerned with providing information about the historical results of past plans and decisions. Its purpose is to keep the owners (shareholders) and other interested parties informed of the overall financial position of the business, and it will not be concerned with the detailed information used internally by management accountants and financial managers. The following table illustrates the distinction between some of the tasks carried out by each of these financial roles: Management Financial Financial accounting management accounting Review of overtime  spending Depreciation of non-  current assets Establishing dividend  policy Evaluating proposed  expansion plans Apportioning overheads to cost  units Identifying accruals  and prepayments KAPLAN PUBLISHING 5 The financial management function 2 The relationship between corporate strategy and corporate and financial objectives Objectives/targets define what the organisation is trying to achieve. Strategy considers how to go about it. Objectives and strategy The diagram above is key to understanding how financial management fits into overall business strategy The business should recognise its overriding purpose or mission and develop broad-based goals for the business to pursue to ensure it fulfils that purpose. 6 KAPLAN PUBLISHING  Chapter 1 Each goal is then further broken down into detailed commercial and financial objectives, each of which should have appropriate identifiable, measurable targets so that progress towards them can be monitored. The distinction between 'commercial' and 'financial' objectives is to emphasise that not all objectives can be expressed in financial terms and that some objectives derive from commercial marketplace considerations. These are then cascaded down throughout the organisation through the setting of targets so that all parts of the business are working to achieve the same overall goal. For example, the accounts receivable collection period (cash collection) target of the credit control department should be linked to the cash needs of the investment projects, and the projects should be selected to achieve the overall corporate aim such as improving the share price. This in turn then satisfies the shareholders by increasing their wealth. Once objectives and targets are set, the enterprise must then work to achieve them by developing and implementing appropriate strategies. Strategies will be developed at all levels of the business.  Corporate strategy concerns the decisions made by senior management about matters such as the particular business the company is in, whether new markets should be entered or whether to withdraw from current markets. Such decisions can often have important financial implications. If, for example, a decision is taken to enter a new market, an existing company in that market could be bought, or a new company be started from scratch.  Business strategy concerns the decisions to be made by the separate strategic business units within the group. Each unit will try to maximise its competitive position within its chosen market. This may involve for example choosing whether to compete on quality or cost.  Operational strategy concerns how the different functional areas within a strategic business unit plan their operations to satisfy the corporate and business strategies being followed. We are, in this syllabus, most interested in the decisions facing the finance function. These day-to-day decisions include all aspects of working capital management. Almost all strategies developed by the business will have financial implications and the financial manager has a key role to play in helping business strategies succeed. KAPLAN PUBLISHING 7 The financial management function Additional question – Objectives and strategy The following list contains some commercial objectives/targets, some financial objectives/targets and some strategies, at each level of the business. Place one in each box of the table, as appropriate.  Implement a Just-In-Time (JIT) inventory system.  Increase earnings per share (EPS) by 5% on prior year.  Acquire a rival in a share-for-share purchase.  Buy four new cutting machines for $250,000 each.  Achieve returns of 15% on new manufacturing investment.  Improve the ratio of current assets to current liabilities from 1.7 to 1.85.  Reduce unsold inventory items by 12%.  Update manufacturing capacity to incorporate new technology.  Improve brand awareness within the UK. Commercial Financial Strategies objectives/targets objectives/targets Corporate level Business level Operational level The answer to this question can be found after the chapter summary diagram at the end of this chapter. 3 Financial objectives Shareholder wealth maximisation Shareholder wealth maximisation is a fundamental principle of financial management. You should seek to understand the different aspects of the syllabus (e.g. finance, dividend policy, investment appraisal) within this unifying theme. Many other objectives are also suggested for companies including:  profit maximisation  growth  market share  social responsibilities 8 KAPLAN PUBLISHING  Chapter 1 Financial objectives Shareholder wealth maximisation If strategy is developed in response to the need to achieve objectives, it is obviously important to be clear about what those objectives are. Most companies are owned by shareholders and originally set up to make money for those shareholders. The primary objective of most companies is thus to maximise shareholder wealth. (This could involve increasing the share price and/or dividend pay-out.) Profit maximisation In financial management, we assume that the objective of the business is to maximise shareholder wealth. This is not necessarily the same as maximising profit. Firms often find that share prices bear little relationship to reported profit figures (e.g. Tesla’s share price grew from an average of $4.67 in 2010 to $63.4 in 2018 without recording anything other than annual losses during this time). There are a number of potential problems with adopting an objective of profit maximisation:  Long-run versus short-run issues: In any business, it is possible to boost short-term profits at the expense of long-term profits. For example, discretionary spending on training, advertising, maintenance and research and development (R&D) may be cut. This will improve reported profits in the short-term but damage the long-term prospects of the business. The stock exchange will normally see through such a tactic and share prices will fall.  Quality (risk) of earnings: A business may increase its reported profits by taking a high level of risk. However, the risk may endanger the returns available to shareholders. The stock exchange will then generally regard these earnings as being of a poor quality and the more risk-averse shareholders may sell. Once again the share price could fall.  Cash: Accounting profits are just a paper figure. Dividends are paid with cash. Investors will therefore consider cash flow as well as profit KAPLAN PUBLISHING 9 The financial management function Earnings per share (EPS) growth A widely used measure of corporate success is EPS (calculated as profit after tax and preference share dividends divided by the number of shares in issue) as it provides a measure of the return to equity holders. EPS growth is therefore a commonly pursued objective. However, it is a measure of profitability, not wealth generation, and it is therefore open to the same criticisms as profit maximisation above. The disadvantage of EPS is that it does not represent income of the shareholder. Rather, it represents that investor’s share of the income generated by the company according to an accounting formula. Whilst there is obviously a correlation between earnings and the wealth received by individual shareholders, they are not the same. Maximising and satisficing A distinction must be made between maximising and satisficing:  maximising – seeking the maximum level of returns, even though this might involve exposure to risk and much higher management workload