11. Module B_Essentials by Louis Li

Essentials

Module B Financial Management CopyrightÂŠ Kaplan Financial (HK) Limited 2009

All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from the publisher.

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ESSENTIALS

Contents

STRATEGY FORMATION PROCESS & SWOT (CLP SECTION 5)

WHAT IS STRATEGY?

Page I.

Strategy Formation & SWOT

II.

Short-term decision making

III.

Budgeting

IV.

Performance Indicators & measures

Transfer Pricing

VI.

Variance Analysis

VII.

Operational, and Strategic measures of performance

VIII.

Control elements of organisation systems

IX.

Cost measurement and analysis in service & manufacturing environments

Project Appraisal techniques & processes

XI.

Treasury & Financial environment

XII.

Risk management & the finance and treasury function

XIII.

Financial Strategy, Capital structure & Dividend policy

Strategy is the direction and scope of an organisation over the long term: which achieves advantage for the organisation through its configuration of resources within a changing environment, to meet the needs of markets and to fulfil stakeholder expectations. Johnson and Scholes

Corporate Strategy is the pattern of major objectives, purposes or goals and essential policies or plans for achieving those goals, stated in such a way as to define what business the company is in or it to be in and the kind of company it is or is to be. Kenneth Andrews

Strategy: A course of action, including the specification of resources required, to achieve a specific objective. Charted Institute of Management Accountants

Corporate strategy is concerned with an organisationâ&#x20AC;&#x2122;s basic direction for the future: its purpose, its ambitions, its resources and how it interacts with the world in which it operates. Richard Lynch

PROCESS OF DELIBERATE / RATIONAL / FORMAL / PLANNED STRATEGIC MANAGEMENT

XIV.

Long-term financing

XV.

Short-term financing & working capital management

Strategic management is concerned with ensuring that an effective strategy is devised and implemented. It can be described as having three elements:

XVI.

Other issues in treasury and finance

Strategic analysis -seeking to understand the strategic position of the organisation

XVII.

Business failure, insolvency & reconstruction

Strategic choice -about the formulation of possible courses of action, their evaluation and the choice between them

Strategy implementation -planning how the strategy can be put into effect.

The various stages are shown in the figure below Budgeting, monitoring & adjustment

Internal Business Analysis

Vision, Mission and Objectives

2. Strategic Generation, Evaluation and Choice

1. Strategic Analysis

3. Strategy Implementation

External Analysis

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ESSENTIALS

STRATEGIC ANALYSIS

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3.2

The aim of strategic analysis is to form a view of the main influences on the present and future well-being of the organisation. This will obviously affect the strategy choice. 2.1

BCG Matrix / Product- market portfolio The matrix is divided into four quadrants. As a generalisation, the cash characteristics of the products are defined by the quadrants into which they fall:

SWOT Analysis High

A SWOT analysis is used to identify the Strengths and Weaknesses of an organisation and the Opportunities and Threats facing it.

Rate of Growth of Market (%)

Strengths and Weaknesses are usually internal and cover things management can control. A Strength is something the firm is good at doing or a resource it can call upon to reach its goals. They are sometimes termed distinctive competences. A Weakness is generally a resource shortage which renders the firm vulnerable to competitors.

CASH COW

High

3.1

The product / industry life cycle

Critical success factors / Key performance indicators Critical success factors (CSF’s) are those elements of competitive behaviour that are crucial to future competitive success. These CSF’s must be identified early in the strategic process, to ensure that the agreed strategy is one that will deliver competitive advantage in areas that make a difference to customers.

The product / industry life-cycle concept suggests that all products have a similar life cycle, which is illustrated below: Growth Phase Sales and profits

Maturity or Saturation Phase

Introductory

Declining or Revitalisation stage

3.4

Sales

Porters Value Chain Porter’s value chain model, shown in the diagram below, can be used to analyse activities for the purpose of identifying where the firm is able to create value and competitive advantage either through low cost (cost leadership), or high quality (differentiation).

Development Phase

The value chain Firm infrastructure

Time Support

Human resource management

activities

Technology development

Profits

Procurement Inbound logistics

The length of the cycle will vary with the type of product and technology; e.g. long for aircraft, short for fashion garments.

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Low Relative Market Share (%)

3.3 INTERNAL ANALYSIS

DOG

Low

Opportunities and Threats are generally external (environmental) to the firm and are factors which cannot be controlled by management. Opportunities and Threats are strategic challenges to the firm. Because these are so often things like competitors, changing technology or imminent economic recession, most managers assume them to be solely external. However some things inside the firm can also be Threats or Opportunities, e.g. unrest among the labour force or the discovery of a new product innovation respectively (although these are often linked to external factors such as better job offers elsewhere or a market need which the innovation can satisfy, for instance).

QUESTION MARK

STAR

Operations

Outbound logistics

Marketing and sales

Service

Primary activities

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“Primary” activities

EXTERNAL ANALYSIS

Inbound logistics – receiving, storing and handling raw material inputs. For example, a just-in-time stock system could give a cost advantage.

4.1

PESTEL

Operations – transformation of the raw materials into finished goods and services. For example, using skilled craftsmen could give a quality advantage.

Outbound logistics – storing, distributing and delivering finished goods to customers. For example, outsourcing delivering could give a cost advantage.

Marketing and sales. For example, sponsorship of a sports celebrity could enhance the image of the product.

Service – all activities that occur after the point of sale, such as installation, training, repair, etc. For example, Marks & Spencer’s friendly approach to returns gives it a perceived quality advantage.

PESTEL analysis seeks to identify opportunities and threats by looking at the wider economic environment under the following headings. Political environment Need to be aware of possible changes in the business/economic environment resulting from political change – e.g. a change in government or government policy. Government Policy is important because its provides: Social infrastructure

to provide a reasonable standard of living for all

Market infrastructure

to provide an efficient and fair free market economy protect domestic jobs and industries balance imports and exports ensure fair take-overs and mergers

Physical infrastructure

to provide a safe and secure environment various policies, including transport policies, agriculture policies and environmental policies.

“Secondary” activities These activities include the following. x

Firm infrastructure – how the firm is organised. For example, centralised buying could result in cost savings due to bulk discounts.

Technology development – how the firm uses technology. For example, the latest computer-controlled machinery gives greater flexibility to tailor products to individual customer specifications.

Human resources development – how people contribute to competitive advantage. For example, employing expert buyers could enable a supermarket to purchase better wines than competitors.

Procurement – purchasing, but not just limited to materials. For example, buying a building out of town could give a cost advantage over high street competitors.

Economic environment The state of the economy affects all organisations, both commercial and non-commercial. Economic influences include: x x x x

Trade cycles - Booms and recessions The balance of trade and exchange rates The level of unemployment Interest rates and availability of credit – cost of capital

Social environment Social change involves changes in the nature, attitudes and habits of society. For a profit organisation it will be most concerned about customer behaviour, and may ask questions such as: What Who Why

Demanded? Consumer trends? Needed? Who will be our customer? How can the business help?

Technological influences This is an area in which change takes place very rapidly and the organisations need to be constantly aware of what is going on. Technological change can influence the following: x x x x

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Changes in production techniques. Changes in the types of products that are made and how they are sold. Changes how the business is managed. How we identify markets, and perform marketing research.

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POWER OF BUYERS

In 2005 Lei and Slocum classified 4 types of Industry Ecosystems, according to their relative rate of technological change and life cycle phase.

POWER GREATEST WHERE ¾ Concentration of buyers ¾ Alternative sources of supply exist ¾ Cost of purchase is high proportion of TC ¾ Threat of backward integration ¾ Low switching costs ¾ Buyers have low profits ¾ Buyers have full information

Industry Ecosystems

Can we find new markets for our products To what extent is there a danger Can it be minimised by differentiation or low cost

SUB STITUTES

RIVALRY AMONGST COMPETITORS

NEW ENTRANTS

POWER OF SUPPLIERS

¾ ¾

©Kaplan Financial 2009

POWER GREATEST WHERE ¾ Few suppliers ¾ Few substitutes ¾ Switching costs are high ¾ Possibility of integrating forward ¾ Customer not significant ¾ Supplier's product differentiated

Competitors are of similar size Slow growth in market High fixed costs - price wars to maintain turnover Lack of differentiation High exit barriers

This would include specific legislation that could effect the organisation, including: x Company Law. x Health and safety legislation x Employment law x Legislation on competitive behaviour

4.2 BARRIERS TO ENTRY ¾ Economies of scale ¾ Other cost advantages ¾ Capital requirements ¾ Access to distribution ¾ Patents, government policy ¾ Reactions of existing firms

Legal environment

Which barriers exist To what extent do they limit entry Are we trying to get in or keep others

Organisations are encouraged by politicians and by legislation to: x reduce their emissions x improve their re-cycling x cost of disposal of raw materials is also increasing

¾ ¾

Porter’s 5 forces analysis

Environmental issues continue to have an impact on organisations.

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4.3

Environmental influences ESSENTIALS

ESSENTIALS

PORTERS GENERIC STRATEGIES gain a competitive advantage, achieved through:

STRATEGIC CHOICE There are three parts to this element:

LOW COST (COST LEADERSHIP)

1. GENERATION of strategic options.

Set out to be the lowest cost producer in an industry with large economies of scale.

ANSOFF’S MATRIX (DIRECTIONS)

DIFFERENTIATION (HIGH QUALITY). Here the firm creates a product that is perceived to be unique in the market, through: PRODUCTS

M A R K E T S

E X I S T I N G

N E W

EXISTING 1. Market Penetration x Could look at cost reductions and improving efficiency but key area for growth is to gain market share. x This could involve cutting prices, spending more on advertising and / or minor product improvements.

3. Market Development x This involves finding new markets for existing products x These could be new segments in current markets (e.g. B2C, B2B) or overseas markets x Question is the market attractive? would the firm have a competitive advantage in the new market, can barriers to entry be overcome?

NEW 2. Product Development x Basic idea is to get more money from existing customers. x Can be particularly good if use existing resources, distribution channels, etc x New products could arise from RnD, joint ventures, buying in other peoples’ products or licensing.

Quality Differentiation This has to do with the features of the product that make it better - not fundamentally different but just better.

Design / Image Differentiation Differentiate on the basis of design and offer the customer something that is truly different as it breaks away from the dominant design if there is one.

FOCUS (‘NICHE’ / SPECIALISED SEGMENT) Position the business to uniquely serve one particular niche in the market. A focus strategy is based on fragmenting the market and focusing on particular market segments. The firm will not market its products industry wide but will concentrate on a particular type of buyer or geographical area.

4. Diversification x This could be related to what we do at the moment (e.g. vertical or horizontal integration – see below) or completely unrelated (conglomerate diversification)

2. EVALUATION of the options to assess their relative merits of feasibility, acceptability and suitability. 3. SELECTION OF THE STRATEGY or option that the organisation will pursue.

6. RELATED DIVERSIFICATION VERTICAL INTEGRATION - Downstream (forward) – nearer the end customer

HORIZONTAL INTEGRATION (sideways)

STRATEGY IMPLEMENTATION Strategy implementation is concerned with the translation of strategy into action. implementation process can also be thought of as having several parts.

The

Resource planning and the logistics of implementation. The process will address the problems of the tasks that need to be carried out and also the timing of them.

The organisational structure may need to be changed, eg from centralised to decentralised.

The systems employed to manage the organisation may be improved. These systems provide the information and operational procedures needed in the organisation. It may be that a new information management system is required to monitor the progress of the strategy. Staff may need to be retrained or new staff recruited.

Upstream (backwards) – towards supply

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ESSENTIALS

7.1

PURPOSES / ADVANTAGES OF STRATEGIC MANAGEMENT AND PLANNING x

Provide direction for the business

Respond to environmental change better

Helps to identify risks and prevent their effects.

Make best use of scarce resources

Aids the formulation of organisational goals and objectives.

Monitor progress through comparing actual results to expected results

Concentrates management's attention on long-term matters

Ensure consistent objectives.

ESSENTIALS

II.

Short Run Decision Making and Control (CLP Section 6)

CVP ANALYSIS Contribution â&#x20AC;&#x201C; The difference between sales revenue and the marginal cost of sales. It may be thought as short for â&#x20AC;&#x153;Contribution towards covering fixed costs and making a profitâ&#x20AC;? key relationship to remember

Sales revenue - Variable cost = Contribution = Fixed cost + Profit

PER UNIT

DISADVANTAGES x

Trying to accurately forecast for the long term due to the complexity and volatility of the environment.

Management is under pressure to achieve short-term results and strategy is concerned with the long term.

Planning becomes a straightjacket (the rigidity of the long-term plan may place the company in a position where it is unable to react to short-term unforeseen opportunities or crisis)

IN TOTAL

This is useful for break-even analysis and decision making purposes. 2.

BREAK-EVEN POINT The break-even point is the level of sales at which neither a profit or loss is made.

Break - even point (units)

The strategic planning process can be costly, taking up time and money.

Break - even point (sales revenue) 8.

Fixed Cost Contribution per unit

To find the sales volume required for a particular target profit, the formula becomes:

ETHICS AND STRATEGIC DECISION MAKING Fundamental Principles

Sales volume to achieve a target profit =

Integrity

Objectivity

Professional Competence and Due Care

Confidentiality

Professional Behaviour

Fixed Costs Contribution/Sales ratio

Fixed cost Required profit Contribution per unit

DECISION MAKING The choice between two or more alternatives, decision making normally considers only the short term consideration of maximising profitability at this point in time. It may also include use of discounted cash flows when considering investment appraisal. We base our decisions on relevant costs.

The American Accounting Association (AAA) Model can be used to overcome Ethical Dilemmaâ&#x20AC;&#x2122;s by taking a step approach:

Relevant cost: â&#x20AC;&#x153;Futureâ&#x20AC;? â&#x20AC;?cash flowâ&#x20AC;? â&#x20AC;&#x153;arising as a direct result of the decisionâ&#x20AC;?

Determine the facts

Define the Ethical Issues

Identify the Fundamental Principles, Rules and Values

Sunk costs - costs incurred (not future, not arising from decision).

Specify the Alternaives

Committed costs - future expenditure which will/can not be affected by the decision.

Compare Values and Alternatives â&#x20AC;&#x201C; See if thereâ&#x20AC;&#x2122;s a Clear Decision

Non cash flows - any cost which does not reflect cash flow eg depreciation.

Assess the consequences

Make your Decision

Overheads absorbed - does not necessarily reflect cash flow, only overheads incurred may be relevant.

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Non-relevant costs

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ESSENTIALS

Relevant costs include: x x x x 3.1

Scarce raw materials

Opportunity cost

Shortage of skilled labour

The benefit foregone by choosing one alternative in preference to the next best alternative. In many decisions there is more than a simple “do nothing” alternative. In such circumstances the benefit/cost of one course of action will be determined by other possible courses of action.

Limited machine capacity

Finance (see capital rationing in FM) Aim : Maximise the contribution per unit of scarce resource

Where resources are not

Given the limitation it is necessary to generate the most contribution in relation to this resource, this is done by following the steps below:

Avoidable costs Costs attached to a part or segment of a business which could be avoided if that part or segment ceased to exist. Variable costs are normally considered avoidable, fixed costs normally not. Fixed costs may be considered avoidable if they arise within the single part or segment of the business that is relevant. They are particularly applicable in shutdown decisions.

3.3

Calculate the contribution per unit of sale.

Divide through by scarce resource per unit of sale to identify the contribution per unit of scarce resource.

Rank this in order - highest first.

Use up the resource in order of the ranking.

KEEP OR DROP A DIVISION The decision whether to shut down a part or segment of a business. In normal reporting, it is likely that we would use absorption costing to link costs to products. Using this system it may appear that the product is making a loss and should be eliminated. What we must consider is whether the cost is avoidable.

Incremental costs Those additional costs (or revenues) which arise as a result of the decision. This classification is particularly useful for further processing decisions, but may be used as a basis for tackling any relevant cost analysis.

Variable costs Those costs which vary proportionately with the level of activity. As seen above the variable nature of the cost often makes it more likely to be relevant. We should already know that the variable cost is useful for break-even analysis or any other form of contribution analysis.

3.4

LIMITING FACTOR DECISION The factor which limits the level of activity at which the company may operate. In budgeting we would normally assume this to be sales demand. Here the limiting factor will be anything other than sales demand i.e. a factor of production. Examples include:

Opportunity cost Avoidable cost Variable cost Incremental cost

Opportunity costs only apply to the use of scarce resources. scarce, no sacrifice exists from using these resources. 3.2

ESSENTIALS

Normally, we would expect all variable costs to be avoidable and the majority of fixed costs to be general to the business as a whole and hence not avoidable. It is possible for fixed costs to be avoidable if they are specific to the part or segment of the business being considered. The simplest way to consider such a problem is to re-draft any information in the form of a marginal costing profit statement.

MAKE OR BUY DECISION The decision to make a component or product ‘in-house’ or alternatively to buy it from an outside supplier. The underlying assumption of this decision is that all fixed costs of manufacture are general to the organisation as a whole and hence only the marginal cost of making the component is relevant. Decision criteria :

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Compare marginal cost of making to the purchase price (the marginal cost of buying)

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Illustration (Production environment)

III.

Budgeting (CLP Section 7)

AIMS / USE / BENEFITS OF BUDGETING Sales

Selling and distribution budget

We can identify the aims of a budget in six ways: 1.

Planning

A budgeting process forces a business to look to the future. If a business does not look to the future it will fail in the short, medium or long term. It will fail because the organisation will become ‘out of kilter’ with its environment. 2.

Master Budget:

Finished goods stock

Control

Cash flow Profit and loss Balance Sheet

The budget acts as a comparator against which the actual results may be compared. 3.

Communication Production

The budget may form the basis of the reporting hierarchy. It is a formal communication channel that allows junior and senior mangers to converse. 4.

Co-ordination

The budget allows the business to co-ordinate all diverse actions towards a common corporate goal. 5.

Material Usage

Evaluation

Labour

Production Overheads

Administration

The budget may be used to evaluate the results of a part of the business such as a cost centre. It may further be used to evaluate the actions of a manager within the business. The costs and revenues appraised must be within the control that we are evaluating. 6.

Motivation

Fixed Assets

Material Stock

Research and Development

The budget may be used as a target for managers to aim for.

SEQUENCE OF OPERATIONAL BUDGET PREPARATION The sequence in which budgets are prepared differs from one organisation to another and is normally determined by the principal factor.

Purchases

In a production environment sales is normally the starting point and there is a defined order in which budgets can be prepared. Stock A typical operational budgeting exam question will ask you to prepare: (i) Sales Budget (ii) Production budget (iiI) Forecast financial statements such as Income St. (P/L) , Balance sheet and cash budget / forecast can also be asked for.

When considering stock we must simply remember that an increase in stock during the period means more input than output, and a decrease less input than output. Stock Formula Budgeted production = Forecast sales + closing stock – opening stock

Below is an Illustration of the inter-linking activities for a production company: Materials Formulae: Materials Usage = Usage per unit x units produced Materials purchases budget = forecast materials usage + closing stock – opening stock

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ESSENTIALS

CASH BUDGETS 4.

TRADITIONAL TYPES OF BUDGET

A cash budget is one of the most important budgets prepared in an organisation. It shows the expected cash receipts and expected cash payments during the budget period. Liquidity and cash flow management are key factors in the successful operation of any organisation.

When looking at differing types of budgeting we are concerned with the benefits or otherwise to the more traditional budget techniques. We would normally expect a budget to be:

What is in a cash budget?

Incremental –

Prepared from previous budgets, updated incrementally to reflect known changes.

Periodic –

Prepared for a separate time period.

A cash budget must contain every type of cash inflow or receipt and every type of cash outflow or payment. In addition to the amounts, the timings of receipts and payments must also be forecast.

Participatory – Involving all levels of management in its preparation.

It is important to realise that cash receipts and payments are not the same as sales and the costs of sales found in the firms Profit and Loss Account because: (i)

Not all cash receipts affect profit and loss account income. E.g. the issue of new shares results in a cash inflow but would not be shown on the profit and loss account.

(ii)

Not all cash payments affect the costs shown in the profit and loss account. E.g., the purchase of a fixed asset.

(iii) Some profit and loss items are derived from accounting conventions and are not cash flows. E.g., depreciation and the profit or loss on the sale of a fixed asset. (iv) The timing of cash receipts and payments does not coincide with the profit and loss accounting period. E.g. A sale is recognised in the profit and loss account when the invoice is raised yet the cash payment from the debtor may not be received until the following period or later.

In comparison to this we will look at three alternative budgeting types: - Zero based budgeting (ZBB) - Continuous (or rolling) budgets - Non-participatory budgets

ZERO BASED BUDGETING A simple idea of preparing a budget from a ‘zero base’ each time ie as though there is no expectation of current activities to continue from one period to the next. The principal behind this technique is to prepare for current future need, rather than reflect past actions. ZBB is normally found in service industries where costs are more likely to be discretionary. A form of ZBB is used in local government. There are four basic steps to follow:

Pro forma for a cash budget

• Identify all possible service departments (and levels of service) that may be provided and then cost each service or level of service, considering both in-house cost and outsource service cost.

Months 1 HK$

2 HK$

3 HK$

4 HK$

5 HK$

6 HK$

• Rank the services in order of importance, starting with the mandatory requirements of the organisation.

Inflows (Few lines) . sub-total

• Identify the level of funding that will be allocated to the services. • Use up the funds in order of the ranking until exhausted.

Outflows (Many lines) . .

Advantages (as opposed to incremental budgeting)

• • • • •

sub-total Net cashflow Op. bal.

Disadvantages

Cl. bal.

• • • • •

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Emphasis on future need not past actions. Eliminates past errors that may be perpetuated in an incremental analysis. A positive disincentive for management to introduce slack into their budget. A considered allocation of resources. Encourages cost reduction.

Can be costly and time consuming. May lead to increased stress for management. Only really applicable to a service environment. May ‘re-invent’ the wheel each year. May lead to lost continuity of action and short term planning.

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ESSENTIALS

CONTINUOUS BUDGETING (ALSO KNOWN AS ‘ROLLING BUDGETS’)

ESSENTIALS

In a periodic budgeting system the budget is normally prepared for one year, a totally separate budget will then be prepared for the following year. In continuous budgeting the budget from one period is ‘rolled on’ from one year to the next.

We wish to compare the budgeted results to the actual results. In order to be able to do this we need to have sufficient information about the budget. Fixed budget: A budget prepared at a single level of activity.

Advantages (as opposed to periodic budgeting) • The budgeting process should be more accurate. • Much better information upon which to appraise the performance of management. • The budget will be much more ‘relevant’ by the end of the budgeting period. • It forces management to take the budgeting process more seriously. Disadvantages • More costly and time consuming. • An increase in budgeting work may lead to less control of the actual results. 7.

NON-PARTICIPATORY BUDGETING Some organisations may not require junior management to participate in the budgetary process. This may be because of security or more likely due to centralised nature of the company. Advantages • Saves time and money. • Individual wishes of senior management will not be diluted by others’ plans. • Reduces the likelihood of information ‘leaking’ from the company. Disadvantages • Individuals are less likely to accept the targets and be committed to achieving them. • Could lead to less realistic targets. • Can encourage negative attitudes and result in demotivation and alienation.

TOP DOWN VS BOTTOM UP PLANNING Top down planning implies top management giving instructions which are filtered down through the management structure. Bottom up planning builds up information from lower levels, progressively consolidating the results until an overall summary is produced for top management. Problems of a purely bottom up approach • Overall control may be difficult • Conflicting objectives may be developed • Lack of direction for the firm as a whole

FIXED AND FLEXIBLE BUDGETS

Flexible budget: A budget prepared with the cost behaviour of all cost elements known and classified as either fixed or variable. The budget may be prepared at a number of activity levels and can be ‘flexed’ or changed to the actual level of activity for budgetary control purposes.

10.

INTERNAL REPORTING SYSTEMS Within an organisation there are many different levels of management. Some managers are responsible for the day-to-day activities whilst others are responsible for long-term planning and decision-making. Each of these managers requires information to assist them in carrying out their duties. It is the responsibilities of the manager which determine the type of information required. Those managers responsible for long-term planning and decisions require: ¾

summarised information

including performance reports comparing actual market / product achievements with budgets and forecasts.

Those managers responsible for medium- term targets require: ¾

Information about their departmental or functional responsibilities

although summarised, are quite detailed

comparison between actual and target performance, but may also be specific information on a particular aspect of the business e.g. the running cost and activity of a machine.

Managers responsible for day-to-day activities require ¾

information on a daily or even more frequent basis.

information they receive may not be measured in financial terms; for example

output units, number of labour hours worked

machine hours lost etc.

Problems of a purely top down approach • Slow to adapt in changing circumstances • Demotivation of key staff members Ultimately it is suggested companies implement a mix of both top down and bottom up, which should lead to better budgeting and motivation for all, but this process is slow and will take up a lot of staff time.

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ESSENTIALS

10.1

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INTERNAL REPORTING SYSTEMS – DESIGN AND OPERATION

IV.

Performance Indicators and Measures (CLP Section 8)

An internal reporting system compares the financial performance of a department with the budget. Action is then taken to improve the department's performance if possible. The elements of the control system are:

THE NATURE OF DIVISIONS / RESPONSIBILITY CENTRES

standard: the budget (e.g. standard costs)

sensor: the costing system, which records actual costs

feedback: the actual results for the period, collected by the costing system

comparator: the 'performance report' for the department, comparing actual with budget (e.g. variance analysis)

effector: the manager of the department, in consultation with others, takes action to minimise future adverse variances and to exploit opportunities resulting from favourable variances.

1 2 3 4

Effector Production control department

Standard Finished product Target quantity/time Target quality Standard cost

Adjust

1 2 3 4 5 6

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1.2

Process Operation of plant to convert inputs to outputs

Output - Finished goods - Information

Decisions over cost Decisions over costs and revenue Decisions over costs, revenue and capital Investments

The type of decision that can be delegated

The type of decisions which will remain centralised

1.3

Points for central management to consider x Monitoring results and performance evaluation x Central office cost apportionment x Effect of divisionalisation on management x Setting transfer prices

DIVISIONAL PERFORMANCE MEASURES

2.1

Required aspects of performance measures

Feedback Sensor Measure: Quantity, quality, cost of finished goods

Cost centre Profit centre Investment centre

Often those necessary to co-ordinate the “pieces” of the business x Financing decisions x Major capital expenditure x Transfer prices x Tax planning x Strategic planning

Output information - Failures - Action taken - Suggestions

Type of decision which may be taken

Depends on degree of decentralisation but typically for a profit centre x Product decisions x Plant replacement within limits x Stock carrying x Short-term financing

Influence standards

Comparator 1 Identify failures in meeting standards 2 Discover causes 3 Generate actions to improve

- Changes to inputs - Update methods

Inputs Materials Labour Equipment Services Processing methods Information

Feedback: Attempt to

1.1

Type of division

Measures designed to assess the performance of a division or its manager should x provide incentive to promote performance as a division with overall company objectives x

only incorporate factors for which the manager (division) can be held responsible (accountable)

distinguish between whether it is the manager or the division that is being assessed

recognise longer-term objectives as well as short-term

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ESSENTIALS

2.2

Potential problems with inappropriate measures

ESSENTIALS

Manipulation of information provided by managers

Demotivation and stress-related conflict between a manager, his subordinates and his superiors

Excessive concern for control of short-term costs, possibly at the expense of longer-term profitability

Assessment of a manager/division as an isolated unit rather than as an integral part of the organisation as a whole

Affect on profit of unsuitable transfer pricing policies or cost allocation systems

Transfer Pricing (CLP Section 8) A transfer price is the price at which goods or services are transferred from one division to another within the same organisation. The transfer price represents “revenue per unit” to the profit centre “selling” the good or service and “cost per unit” to the profit centre “buying” the good or service. Transfer pricing is purely an internal bookkeeping exercise, which does not affect the overall profitability of the organisation, but allows the performance of each division to be evaluated on the basis of profit.

OBJECTIVES OF A TRANSFER PRICING SYSTEM There are many ways in which transfer prices can be established, but ideally they should be set in a way which allows the following objectives to be met.

CENTRALISATION VERSUS DECENTRALISATION A large company may be distinguished in character from smaller ones by the use it makes of centralisation and decentralisation. Centralisation is the degree to which decision-making is undertaken at headquarters. Functional structures tend to be more centralised than divisional ones.

Goal congruence

The strengths and weaknesses of centralised decision-making are summarised below:

Performance appraisal

Advantages of decentralisation

The performance of each division should be capable of being assessed and a good transfer price would enable each centre to be evaluated on the basis of profit.

The decisions made by each profit centre manager should be consistent with the objectives of the organisation as a whole. The transfer price should not encourage sub-optimal behaviour.

Divisional autonomy

• Senior managers are freed from less important tasks • Higher motivation for local managers • Local managers may have greater expertise re local customers, market conditions, etc and may therefore make better decisions • Quicker responses to local developments • Smoother career progression possible.

Advantages of centralisation

• • • • •

The system used to set transfer prices should seek to maintain the autonomy of profit centre managers. If autonomy is maintained, managers tend to be more highly motivated but suboptimal decisions may be made. 2.

METHODS

2.1

Market Price Based Method - An external market price is used to set the transfer price.

Better co-ordination of different activities within the organisation Able to employ higher calibre staff No duplication of resources Better control, especially in a crisis Simpler structures

- Divisions can make independent decisions, and closure of a production division will not affect the other divisions profits. - However, there might be imperfections in the external market making it difficult to decide a precise market price.

It is important that an organisation chooses not only a suitable structure but also an appropriate degree of authority at each level.

- Also, if the supplying division has spare capacity and has covered all fixed costs, there’s an argument saying the division should transfer at less than the market price.

As businesses become more complex and industries change more rapidly, it is argued that most organisations will benefit from the flexibility brought about by decentralising authority. 4.

ROI – RETURN ON INVESTMENT & RI – RESIDUAL INCOME

ROI evaluation = RI evaluation =

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(NET PROFIT/TOTAL INVESTMENT) x 100% NET PROFIT IMPUTED INTEREST ON CAPITAL EMPLOYED

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ESSENTIALS

2.2

ESSENTIALS

Full Cost Based

VI.

Variance Analysis (CLP Section 8)

- Units are transferred at the sum of variable cost plus fixed cost per unit.

Material Variances

- Sometimes a notional unit profit is added by the supplying division.

We need to further sub-analyse into:

- Receiving manager sees this unit cost as an entirely variable cost.

Price – how much we pay per unit of input. Usage – how much we use in production.

- Therefore, receiving manager may set selling price high to maximise own profits, restricting demand.

Working sheet:

- Divisions may then work below capacity with sub-optimal profits for the firm as a whole.

Actual Quantity x Actual Price (AQAP)

- However both divisions make a profit: managers happy. Price variance 2.3

Variable cost Based

Actual Quantity x Standard Price (AQSP)

- In the absence of an external market, marginal cost is the optimal price for overall firm's profits. - The receiving manager receives meaningful cost information for decision-making.

Total variance

Usage Variance Standard Quantity x Standard Price (SQSP) (For actual production)

- If the variable cost equates to marginal cost, it is a satisfactory price for the receiving division and for the firm as a whole. - However, it is unsatisfactory and demotivating for the supplying division manager, who makes a loss.

2.4

Possible reasons Price Variance

Usage Variance

Wrong budgeting Lower/higher quality material Good/poor purchasing External factors (inflation, exchange rates etc)

Negotiated Transfer Price Based - Easier when there are comparable market prices.

Wrong budgeting Lower/higher quality of material Lower/higher quality of labour Theft

- However, evidence shows that divisional strength is influential. 2.

- Therefore, there is a possibility of sub-optimal TPs.

The variances required are: Rate variance – how much we pay per hour Efficiency variance – how many hours used

- Also, a possibility of lack of agreement between managers.

Labour Variances

EXAM METHOD (BEST METHOD) – ECONOMISTS APPROACH BASED

Working sheet: Actual Hours x Actual Rate (AHAR)

This method takes an opportunity cost approach. It can be calculated as:

Rate variance

TP = MC Supplying Division + Opportunity cost Actual Hours x Standard Rate (AHSR) Note : Adjust the supplying divisions MC for any internal costs which would not be incurred such as selling, shipping, packing and insurance costs.

Total variance

Efficiency Variance Standard Hours x Standard Rate (SHSR) (For actual production)

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ESSENTIALS

Fixed Overhead Variances

Possible reasons Rate Variance

Efficiency Variance

Wrong budgeting Wage inflation Lower/higher skilled employees Unplanned overtime or bonuses 3.

Note:

Wrong budgeting Lower/higher morale Lower/higher skilled employees Lower/higher quality of material

Due to their fixed nature the fixed overheads are treated differently to variable costs in variance analysis. The starting point will be the total cost, which is broken up between units. In particular we must be aware of the costing methodology in operation. As we know fixed costs are treated differently under absorption and marginal costing: NOTE Absorption costing links the fixed cost to the product. Marginal costing charges fixed costs directly to the profit and loss account.

Variable Overhead Variances

Remember, unless told otherwise, we assume a variable overhead absorption rate based on labour hours. This means that you should treat these exactly as you would labour variances.

Absorption Costing Principles

The variances required are:

The fixed overhead total variance can be sub-divided into two variances:

Expenditure (or rate or price) variance – the amount paid per labour hour

- The fixed overhead expenditure variance which looks at the difference between the budgeted expenditure and the actual fixed overhead expenditure; and

Efficiency variance – the hours input in relation to hours of output achieved.

- The fixed overhead volume variance which looks at the difference between the budgeted output and the actual output

Working sheet: Actual Hours x Actual Rate (AHAR)

Total variance Expenditure (rate) variance

Actual Hours x Standard Rate (AHSR)

Total variance

Expenditure variance

Volume variance

Working sheet: Efficiency Variance Standard Hours x Standard Rate (SHSR) (For actual production) Actual Cost

Expenditure variance Possible reasons Efficiency Variance

Budgeted Output x standard cost

Total Variance

As per labour efficiency Volume Variance Expenditure (rate) Variance Variable overheads are made up of many different cost elements; to identify reasons for the variance we would need to analyse all elements separately.

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Actual Output x standard cost

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ESSENTIALS

5.1

ESSENTIALS

More Sub-divisions

Sales Variances The variances are analysed into two elements:

The volume variance can be further sub-divided into an efficiency variance and a capacity variance. The volume variance means that production was greater than or less than budget. This can only happen in one of two ways, either the workers worked faster or slower than expected (an efficiency variance) or they worked more or less hours than expected (a capacity variance).

Volume - more or less units sold than budgeted. Price – setting a higher or lower price than budgeted.

Total variance 6.1

Expenditure variance

Volume Variance The difference between budgeted and actual sales volume valued at standard profit or contribution margin.

Volume variance

Calculate the volume variance assuming an ABSORPTION costing system. Capacity / Utilisation variance

Efficiency variance FORMULA

Standard Hours of output (Actual Sales – Budgeted Sales) x Standard Profit Margin To calculate the capacity and efficiency variances, the output MUST be measured in standard hours of output, and we MUST use an hourly overhead absorption rate. Working sheet:

Actual Cost 6.2

Price Variance

Expenditure variance The difference between standard and actual selling price of actual sales volume. Budgeted Hours at Standard Rate (Budgeted Hours x OAR)

FORMULA (Actual Price – Standard Price) x Actual Sales Capacity / Utilisation Variance Total Volume Variance Variance

Actual Hours at Standard Rate (Actual Hours x OAR)

Possible reasons: The price and volume variances are inversely related for most products. An increase in price will lead to a fall in volume and vice versa.

Efficiency Variance Standard Hours at Standard Rate (Standard Hours x OAR)

Note: The standard hours is the standard hours that should be taken for the ACTUAL OUTPUT. Marginal costing Principles There is only one fixed overhead variance - the expenditure variance. This is calculated as above (that is the difference between actual and budgeted overhead cost).

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ESSENTIALS

Operating Statement

ESSENTIALS

Reconciliation of budgeted or standard profit or cost to the actual profit or cost incurred.

Marginal Costing Approach

Actual profit will be different depending whether absorption or marginal costing is used. Why?????? Variances that remain the same:

Variances that change:

Variable cost variances (material, labour and variable overheads)

Fixed overhead volume variances (efficiency and capacity) disappear!

Budgeted Profit

Fixed overhead expenditure variance

Sales volume variance

Sales Volume Variance

Sales price variance

Operating Statement – Absorption Costing Principles HK$

HK$

Standard Profit on actual sales Sales price variance

8.1

Revised Sales volume variance

FORMULA Cost Variances

FAV

ADV (Actual Sales – Budgeted Sales) x Standard Contribution Margin

Materials Price Usage Labour Rate Efficiency Variable Overheads Expenditure (or Rate) Efficiency Fixed Overhead Expenditure Capacity Efficiency Sub total Actual Profit

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ESSENTIALS

Marginal Costing Principles

ESSENTIALS

10.

In certain industries it is possible that the materials (and other components) input to the product are interchangeable. In this situation it makes sense to identify variances related to the substitution of one material for another. Mix and yield variances are a sub-analysis of the usage variance.

Operating Statement – Marginal Costing Principles

HK$

Mix and Yield Variances

HK$

Budgeted Contribution Total Material Sales Volume Variance Standard Contribution Sales price variance Price Cost Variances

FAV

Usage

ADV

Materials Price Usage Mix

Yield

Labour Rate Efficiency Example – manufacture Variable Overheads Expenditure (or Rate) Efficiency Sub Total

MIX

Inputs

Actual Contribution

Material A 2 tonnes

Material B 8 tonnes

Less Budgeted fixed overhead Fixed overhead variance Actual Profit

PROCESS

Waste = 8 tonnes

Outputs

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Final Product = 2 tonnes

ESSENTIALS

10.1 What does this show?

Sales Mix and Quantity Variances Related to the mix and yield variances. They are based on the sales volume variance where there is more than one product being sold and the products are to some degree interchangeable. These variances tend to be much easier than mix and yield variances to prepare as there are no losses to deal with. Examples may include sales of soap powder under differing brands and similar industries.

Mix – The relationship of one material input to another. The standard mix shows the proportion of a material that we expect to use in a given mix. The mix variance identifies the amount by which the actual proportion differs to the standard mix. Yield – the relationship of inputs in total to the outputs. In most questions of this type there is a yield loss, this means that the input is expected to be greater than the output, there is an expected or ‘normal’ loss in the process. A yield variance identifies if the inputs (in total) are greater or less than expected for a given output.

Total Sales Sales Price

Sales Volume

Price variance Material:

Material A

Material B

Sales Mix

Total

Sales Quantity

Sales Price variance AQAP Product

Product A

Product B

Product C

Total

AQSP Actual Price Variance

Standard Price Difference u Actual Sales

Usage Variances

Variance Material: 1. AQAM (Actual Quantity at Actual mix)

Material A

Total Volume Variances Workings

Mix

Product:

2. AQSM (Actual Quantity at standard mix) 3. SQSM (Standard Quantity at standard mixfor actual output)

Material B

Usage

Product A

Product B

Product C

Total

Product A

Product B

Product C

Total

1. ASAM (Actual Sales at Actual mix)

Yield

Mix 2. ASSM (Actual Sales at standard mix)

4. Standard Price (HK$)

3. BSSM (Budgeted sales at standard mix)

Quantity

Standard Margin (HK$)

Variances (all at standard Price) Material:

Material A

Material B

Total

Mix Variances (all at standard margin)

Yield

Material: Usage Mix Quantity

Volume

QP Module B (Feb 09) - Essentials

ESSENTIALS

VII.

Performance Measures (CLP Section 9)

OPERATIONAL EFFICIENCY

OPERATING AND FINANCIAL RATIOS

2.1

Asset turnover Low turnover suggests that the business is capital intensive, involved in manufacturing and perhaps concentrating on specialised products. High turnover alternatively would suggest a retailer of standardised products.

PROFITABILITY 1.1

Operating profit margin

Turnover

PBIT u 100

Operating Profit Margin =

Asset Turnover = Capital Employed

Turnover 2.2 1.2

Operating cycle

Return on capital employed - ROCE Stock Days = Raw Material Days + Work-in-Progress Stock days + Finished Goods Stock Days

A measure of the underlying performance of the business before finance. It gives an Gearing has no impact on the return and hence this is the most important measure of profitability to calculate.

Raw Material Days =

Operating Profit (PBIT) ROCE = u 100 Capital Employed

Raw material Stock u 365 Purchases *

Work-in-Progress days = Note: Capital Employed represents the total funds invested in the business, it includes Equity and Long-term Debt. Finished Goods days = 1.3

Return on equity - ROE This is a measure of return relating solely to the shareholders. The impact of differing levels of gearing will have an impact on the return.

Debtor days =

Profit after tax ROE = u 100 Shareholders funds

Creditor days =

Work - in - progress u 365 Production cost *

Finished Goods stock u 365 cost of sales *

Debtor balance u 365 Credit sales *

Creditor balance u 365 Credit purchases *

* Or nearest approximation – depending on available data. Key Working

PBIT Interest Profit Before Tax Tax Profit After Tax

(Used for calculating ROCE)

(Used for calculating ROE)

$ X (X) X (X) X

LIQUIDITY RATIOS

3.1

Current Ratio

Current Assets Current Ratio = Current Liabilities A simple measure of how much of the total current assets are financed by current liabilities. If, for example the measure is 2:1 this means that only a limited amount of the assets are funded by the current liabilities.

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ESSENTIALS

3.2

ESSENTIALS

Quick Ratio

Debt All permanent capital charging a fixed interest may be considered debt.

Current Assets minus Stock Quick Ratio (or acid test)

This includes

Current Liabilities

â&#x20AC;˘ Debentures and loans. â&#x20AC;˘ Possibly bank overdraft if significant and considered part of the permanent financing.

A measure of how well current liabilities are covered by liquid assets. A measure of 1:1 means that we are able to meet our existing liabilites if they all fall due at once.

â&#x20AC;˘ Finally preference share capital and premium may also be included because of its fixed 4.

4.1

coupon. Note a company may be able to defer payment of preference share dividends and hence these are less risky to the company than straight debt.

GEARING Gearing is a measure of risk.

Equity

Operating Gearing

All ordinary share capital and share premium together with reserves (they pertain to the ordinary shareholders).

A measure of risk relating to the cost behaviour of the cost elements. High fixed costs mean the company is highly geared and is very risky. Operating gearing relates to some degree to business risk, i.e. inherent business risk will be exacerbated by high operating gearing and that high operating gearing may be a requirement of the type of business that the company is in. This is dealt with earlier in management accounting. 4.2

Financial Gearing

In addition to the definitions above, we will need to decide whether to use book value or market value to calculate the gearing. It is more usual to use book value and you should use this unless the examiner suggests otherwise.

4.5

A measure of risk pertaining to the manner in which the company is financed. Financial gearing directly considers the problem of financial risk. Impact

Interest Cover A profit and loss account measure that considers the ability of the business to cover the cost of debt as it falls due.

Interest Cover = 4.3

MEASURES OF FINANCIAL GEARING

PBIT Interest

There are two measures: Capital Gearing â&#x20AC;&#x201C; a balance sheet measure. 5.

Economic Value Added (EVA)

Interest Cover â&#x20AC;&#x201C; a profit and loss account measure. This method looks at the ability of a business to earn returns in excess of its cost of capital. EVA can be calculated as: 4.4

Capital Gearing Capital Gearing may be calculated in a number of different ways and it is likely that the examiner will specify the method required. The two main measures are as a ratio or as a proportion.

Ratio Measure Capital Gearing =

Less:

Net operating profit after tax (NOPAT) Invested capital x the companyâ&#x20AC;&#x2122;s WACC Economic value added

Proportion Measure

Debt u 100 Equity

Capital Gearing=

Debt u 100 Debt Equity

Invested capital = (according to CLP)

$ X (X) X

Total assets less current liabilities

Note: There are differences in approach to the calculation of Invested capital So, what do we mean by Debt and Equity????

QP Module B (Feb 09) - Essentials

ÂŠ Kaplan Financial 2009

QP Module B (Feb 09) - Essentials

ÂŠ Kaplan Financial 2009

ESSENTIALS

STRATEGIC MEASURES

6.1

Kaplan and Norton’s Balanced scorecard

ESSENTIALS

Lynch and Cross’s Performance Pyramid

Kaplan and Norton developed the balanced scorecard technique to integrate the various features of Performance. It deals with internal and external, current and future perspectives. The Vision Financial Perspective Return on Investment Operating Income Return on Equity Cash flow

Corporate level

SBU level

Customer Perspective Customer Satisfaction Surveys Customer Retention Market Share New Customer Acquisition

Organisation’s Vision and Strategy

Internal Business Perspective Production Flexibility % of Sales for New Products Product Quality After Sales Service

Operational

Market satisfaction

Customer satisfaction

Quality

Financial measures

Flexibility

Delivery

Process time

6.2

Aims The aim of the balanced scorecard is:

Cost

Operation

External effectiveness Learning and Growth Perspective Employee Training Employee Satisfaction Strategic Investment Decisions

Productivity

Internal efficiency

7.1

The Performance Pyramid In 1991 Richard Lynch and Kelvin Cross published their book, “Measure Up! Yardsticks for continuous improvement”. The diagram above shows a four-level pyramid of objectives and measures that ensures an effective link between strategy and operations by translating strategic objectives from the top down and measures from the bottom up.

BENCHMARKING Benchmarking is whereby the organisation makes comparison between its divisions and departments, operations and processes. It can compare them against its own, its competitors and Industry standards.

to move away from the short term emphasis of management accounts.

to encourage continued focus on key factors which are critical for financial success in the longer term, eg market share, sales growth, profits.

Any activity that can be measured can be benchmarked. However, it is impracticable to benchmark every process, and organisations should concentrate on areas that:

to encourage directors to concentrate on a relatively small number of critical measures out of the very large number available.

to encourage a balanced approach by ensuring that no one measure is attained to the detriment of the business as a whole, eg short term quantity against long term quality.

x x x

to develop and use exception reporting, ie even when using a relatively small number of measures you should be concerned mostly by those measures that are ‘out of line’.

QP Module B (Feb 09) - Essentials

tie up most cash; significantly improve the relationship with customers; and impact on the final results of the business.

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ESSENTIALS

THE APPLICATION ORGANISATIONS

MANAGEMENT

ACCOUNTING

NOT-FOR-PROFIT

ESSENTIALS

VIII.

The not-for-profit (NFP)sector incorporates a diverse range of operations including national government, local government, charities, executive agencies, trusts and so on. The critical thing about such operations is that they are not motivated by a desire to maximise profit.

Reasons for responses - development & changes in…

Instead a NFP organisation will try to provide value for money 9.1

Control Elements of Organisational Systems (CLP Section 10)

External

Traditional

Modern

x Environment

x Technology (e.g.

- labour intensive

- Computer & machine Intensive - Adv. Manufacturing Tech. (AMT) - E.g. CAD/CAM

Traditional Manf.

Modern Manf.

Value for money and the The ‘3 Es approach’ of the Audit Commission x

Economy – Sourcing reasonable resource input at the lowest cost (tend to be financial indicators)

Efficiency – Maximise the output of services for a given level of resource input (tend to be financial indicators)

CLP 10

Effectiveness – looks at the output and ultimate objectives of the organisation (tend to be non-financial indicators)

Manufacturing technology IT etc)

x Organisation

A management accountant will need to ensure the NFP organisation is achieving the 3 E’s and therefore providing value for money.

Supplier Driven Low Customer Expectation Low Competition Slow/ Little Changes

SVC

Not-for-profit organisations have a variety of different objectives, and the general problem of management in the not-for-profit sector is that objectives may be diverse and ill-defined; and may change regularly through the political process 9.2

Customer Driven High Customer Expectation High Competition Fast/ Drastic Changes

Tech / e-bus

A Product

Performance measurement for NFP organisations

- Long Product Life Cycle

- Short Product Life Cycle

Example - Hospital The costs of the service must be compared against budgets but other performance indicators may be used in total for the establishment and within each ward/department.

CLP 10

B Philosophy (Belief)

These measures include:

Push

Pull / Kanban

(Prod’n then Sell)

(Sell then Prod’n)

[Ignore…

Overall: • Numbers of patients treated • Amount of government funding received • Proportion of successful operations • Quality of care • Number of awards of achievement

Target customer Their expectation]

JIT & TQM Activities will be undertaken when needed.

Ward: • Cost per patient • Staff / Patient ratios • Patients per ward • Number of working hours per member of staff • Availability of facilities e.g. TV, Radio, Internet, etc.

It requires only a little imagination to develop a similar range of performance indicators for other NFP operations.

QP Module B (Feb 09) - Essentials

ESSENTIALS

APPROPRIATE RESPONSES - LEVELS OF CONTROL

ESSENTIALS

TOTAL QUALITY MANAGEMENT

Strategic, management and task controls

Quality costs (Quality report) can be classified into the following four groups:

One approach is to consider three tiers of planning and control systems:

Prevention costs :

the costs of any action taken to investigate, prevent or reduce defects and failures.

Appraisal costs :

the costs of assessing quality achieved.

Internal failure costs :

costs arising within the organisation of failure to achieve the quality specified.

External failure costs :

costs arising outside the manufacturing organistion of failure to achieve the specified quality.

Strategic Planning and Control Long term strategic planning, including: • Supplier analysis • Customer analyisis • Competitor analysis Management Control

TQM aims to invest in Prevention cost, which should reduce Appraisal, Internal and External failure costs, and therefore ensures production has:

Strategic planning is concerned with making decisions about the direction in which an organisation is going, whereas management control is concerned with translating the strategy into detailed operational plans.

Zero defects, and Gets it right first time

Task Control Ensuring that specific tasks are carried out effectively and efficiently, including: • TQM • JIT • Throughput • Computer integrated manufacturing

JUST-IN-TIME SYSTEMS This is a totally different approach to the manufacturing process.

2.1

The traditional approach: x x

The various information characteristics required for each level of management are illustrated below. Time Level Source Degree of Frequency horizon of detail certainty Long term

Aggregated Mainly summarised external

Uncertain

2.3

Tactical

QP Module B (Feb 09) - Essentials

Immediate Highly detailed

Internal

Certain

Frequent

Just-in-time approach : x x

Infrequent

Strategic

Operational

2.2

manufacturing was "production-driven" substantial stock-holding levels

manufacturing should be "demand-driven" minimal stock-holdings

Further points on JIT : x

production and purchasing are linked closely to sales demand on a week-to-week basis.

this enables a fairly continuous flow of raw materials stocks into work-in-progress, which becomes finished goods and goes straight to the customer.

raw materials will be purchased only when needed for the manufacture of a component.

components will only be manufactured when needed for a unit of the finished product

finished products will only be produced when there is a customer for the item

QP Module B (Feb 09) - Essentials

ESSENTIALS

THROUGHPUT ACCOUNTING

ESSENTIALS

IX.

This is probably the area which has gained the most popularity in recent years. 1.

Basic principle

The mathematical equation is very similar to the treatment of Limiting factors using a marginal costing basis. The major difference is Throughput only considers material to be variable, all other costs are treated as fixed.

Overhead COST Cost Item

(Computer assisted engineering)

This enables specifications to be designed, analysed and tested, according to different assumptions.

Cost driver: The ‘Root Cause’, the causal link between the activity and the cost unit. They describe exactly how the production of units incur costs within the activity. The overhead is linked to the cost unit using a cost driver rate. Further, the cost driver rate may be considered critical to control of overheads. By controlling (or reducing) the incidence of the cost driver, the amount of overhead can be controlled.

(Computer assisted design)

This allows for further analysis, design and testing to produce the final specification, ready to be manufactured. CAM

Cost driver rate

(Computer assisted manufacturing)

Computers control and direct the process.

Cost

Activity cost pool: An activity that incurs cost. Costs are linked to the activity accurately and from the activity to the cost unit. Knowledge of the activity is key to the application of ABC. The knowledge gained should enhance the decision making of the business because the manner in which costs are incurred is now better understood. Costs may also be better controlled because they may be controlled (and reduced) at source.

The first few on the list can be dealt with together as they are simply some of the techniques for which computers can be useful.

CAD

Cost Pool

Impact: More accurate product costs

COMPUTER INTEGRATED MANUFACTURING (CIM) TECHNIQUES

CAE

ACTIVITY BASED COSTING (ABC) An improved form of absorption costing.

Profit is a function of the speed with which the organisation can meet customer requirements. The first concept is that the majority of costs are predetermined in the short term and that, therefore, all costs except material costs can be treated as fixed costs.

Cost Measurement and Analysis in Service and Manufacturing Environments (CLP Section 11)

1.1

The aim is to :

improve response times reduce unit costs improve quality

Used particularly in :

materials handling (JIT systems) production and assembly (using robots -- guided vehicle systems)

Cost pool Level of cost drivers

Favourable Conditions For ABC The purpose of moving from a traditional costing system to an activity-based system should be based on the premise that the new information provided will lead to action that will increase the overall profitability of the business. This is most likely to occur when the analysis provided under the ABC system differs significantly from that which was provided under the traditional system, which is most likely to occur under the following conditions:

CUSTOMER PROFITABILITY ANALYSIS (CPA)

x when production overheads are high relative to direct costs, particularly direct labour.

CPA is about determining the costs and revenues associated with servicing particular customers or customer groups.

x where there is great diversity in the product range.

CPA exercises often disclose that a small numbers of customers generate a high proportion of the profits of a business – 20% of customers giving 80% of profit. Such a finding might induce appropriate management action. For example, less profitable customer accounts might be priced upwards, reallocated to another agent or even closed.

x when consumption of overhead resources is not driven primarily by volume.

QP Module B (Feb 09) - Essentials

x where there is considerable diversity of overhead resource input to products.

Information from an ABC analysis may indicate opportunities to increase profitability in a variety of ways, many of which are long-term. For example, an activity-based analysis may reveal that small-batch items are relatively expensive to produce, and are therefore unprofitable at current prices.

QP Module B (Feb 09) - Essentials

ESSENTIALS

ABSORPTION COSTING

PRICING

Overhead absorption is achieved by means of a predetermined Overhead Absorption Rate.

4.1

Practical factors affecting selling prices

Overhead Absorption Rate (OAR) =

When evaluating pricing, the three main factors to be discussed can be summariised as the “Three C’s’:

Budgeted Overheads Budgeted Level of Activity

Costs Customers Competitors

Budgeted level of activity may be direct labour hours or machine hours. Absorption principle 4.2

Practical pricing strategies

All costs (direct + indirect) are included in the value of the cost unit. NOTE : In general terms, a company will normally set its selling price so that it at least covers its costs. 3.

LIFE CYCLE COSTING BUT : There may be occasions when a different strategy is needed. Life-cycle costing is the accumulation of costs for activities that occur over the entire life cycle of a product, from inception to abandonment. Companies operating in an advanced manufacturing environment are finding that about 90% of a product’s life-cycle cost is determined by decisions made early in the cycle. In many industries a large fraction of the life-cycle costs consist of costs incurred on product design, prototyping, programming, process design and equipment acquisition. This has created a need to ensure that the tightest controls are at the design stage, because most costs are committed or “locked-in” at this point in time. Management accounting systems should therefore be developed that aid the planning and control of product life-cycle costs and monitor spending and commitments at the early stages of a product’s life-cycle. There are a number of factors that need to be managed in order to maximize a product’s return over its life cycle. These are: x

maximize the length of the life cycle itself

design costs out of the product

minimize the time to market

QP Module B (Feb 09) - Essentials

Product / Service Introduction x

Price skimming – (High initial price that with time reduces) - aim for the top end of the market. If the launch is successful, then invest

Penetration pricing – (Low initial price that eventually is increases) - break in to the market and establish market share by charging a low price

Long Term Pricing Strategies x

Loss leaders – sell the product at loss to enable to get known

Product line pricing – branding

Price discrimination – have one product sold in different markets at different prices

Target costing / pricing – set a price to achieve a desired target

Premium / differentiation pricing - High price for perceived high quality

Cost leadership – Lowest cost and price in the market

QP Module B (Feb 09) - Essentials

ESSENTIALS

Project Appraisal Techniques & Processes (CLP Section 12)

Disadvantages

PAYBACK

â&#x20AC;˘ It does not consider the time value of money. â&#x20AC;˘ It is based upon (subjective) accounting profit. â&#x20AC;˘ It is not an absolute measure of return.

The length of time it takes for cash inflows from trading to pay back the initial investment. Decision criteria Only select projects that pay back within the acceptable period (e.g. 3 years)

DISCOUNTED CASH FLOW

If there is more than one project you choose between (mutually exclusive) select the project with the shorter payback period.

The application of the idea that there is a TIME VALUE OF MONEY. What this means is that money received will have more worth than the same amount received at some point in the future.

Advantages

â&#x20AC;˘ â&#x20AC;˘ â&#x20AC;˘ â&#x20AC;˘ â&#x20AC;˘

Simple to understand and calculate. A simple measure of risk, the longer the payback, the higher the risk. May be important to companies with limited cash resources for budgeting purposes. Uses cash flows that are less open to manipulation than profits. Emphasises cash flow in the early years.

3.1

Discounting

Revising the formula

PV = FV x Disadvantages

1 = FV Â° (1+r)-n (1 r) n

Use tables to calculate the present values of the example on the previous page

â&#x20AC;˘ It does not consider the time value of money. â&#x20AC;˘ There is no measure of return â&#x20AC;˘ Only cashflows up to payback are considered.

3.2

Net present value (NPV)

The net benefit or loss of benefit in present value terms from an investment opportunity. 2.

ACCOUNTING RATE OF RETURN (ARR)

Decision criteria

This measure has a close relationship to the performance measure Return on investment (ROI) or ROCE. It is a measure of the impact of an investment on accounting profit. It may be calculated many ways and is based upon profit (which already allows scope for manipulation).

If the investment has a positive NPV then the project should be accepted. This means that the project will increase the wealth of the company by the amount of the NPV. Faced with a mutually exclusive decision, choose the investment with the greater NPV.

ARR =

Estimated Average Annual Profit Average or Initial Investment

u 100

Decision criteria The ARR for an investment is to be compared to a target (often related to a company ROCE). If the return is greater we will accept the investment.

Advantages

â&#x20AC;˘ â&#x20AC;˘ â&#x20AC;˘ â&#x20AC;˘ â&#x20AC;˘

It does consider the time value of money. It is an absolute measure of return. It is based on cash flows not profits. It considers the whole life the project. It should lead to the maximisation of shareholders wealth.

If two projects are mutually exclusive we select the project with the greater ARR. Disadvantages Advantages

â&#x20AC;˘ â&#x20AC;˘ â&#x20AC;˘ â&#x20AC;˘

Widely used. Simple to understand and calculate. Can be calculated from available accounting data. It considers the whole of the investment and is some measure of (accounting) return.

QP Module B (Feb 09) - Essentials

ÂŠ Kaplan Financial 2009

â&#x20AC;˘ Not easily explained to managers. â&#x20AC;˘ Requires that the rate of interest (or cost of capital) is known. â&#x20AC;˘ Relatively complex.

QP Module B (Feb 09) - Essentials

ÂŠ Kaplan Financial 2009

ESSENTIALS

INTERNAL RATE OF RETURN (IRR)

ESSENTIALS

CALCULATION OF COST OF CAPITAL

5.1

Calculation of WACC

The rate of return at which the NPV equals zero.

WACC

The formula for the IRR is:

IRR

Where

Â§ NL L Â¨Â¨ ÂŠ NL NH L= H= NL = NH =

Âˇ Â¸Â¸ u ( H L) Âš

E + Kd (1 - t) E+D

D E+D

Where:

Lower rate of interest Higher rate of interest NPV at lower rate of interest NPV at higher rate of interest

Cost of equity

Cost of Debt

Market value of equity

Market value of Debt

Corporate tax rate

Decision criteria If the IRR is greater than the cost of capital accept the project. If the projects are mutually exclusive choose the higher IRR (but be careful).

Advantages

â&#x20AC;˘ â&#x20AC;˘ â&#x20AC;˘ â&#x20AC;˘

It does consider the time value of money. A percentage is easily understood It considers the whole life of the project. It does not need the cost of capital to be known.

This can be calculated be either the DVM or CAPM, depending on the information given in the question.

6.1

Disadvantages

The Dividend Valuation Model

â&#x20AC;˘ It is not a measure of absolute profitability. â&#x20AC;˘ Interpolation only provides an estimate. â&#x20AC;˘ Non-conventional cashflows may give rise to multiple IRRs.

QP Module B (Feb 09) - Essentials

COST OF EQUITY

D1 P0

Cost of equity

Dividend expected in one yearâ&#x20AC;&#x2122;s time or DO x (1+g)

Constant annual growth rate in dividends (given; or calculated using the Gordon growth model)

Current ex-div share price

Where:

ÂŠ Kaplan Financial 2009

QP Module B (Feb 09) - Essentials

ÂŠ Kaplan Financial 2009

ESSENTIALS

6.2

The Capital Asset Pricing Model (CAPM)

ESSENTIALS

The Capital Asset Pricing Model (CAPM) sets out to describe just how the Cost of Equity (required return) of a share depends on its level of systematic risk.

For investment appraisal calculations, we can only use the existing WACC as a discount rate where there is no change in gearing as a result of a new project and the project has the same risk as the company.

We measure systematic risk using beta factors. The risk-free rate of return has a beta of zero and the market as a whole is given a beta of one.

If the project represents a diversification into a business with a risk profile different to that of the existing business, then we must adjust the cost of equity to take account of the project’s individual systematic risk and the appropriate level of gearing as follows:

Individual shares will have a beta factor of more or less than one depending upon whether they exhibit more or less systematic risk than the market average.

= Rf + (Rm - Rf) E

Where: Rf

Risk free rate (Government or Exchange fund Bills, notes, bonds, etc.)

Geared beta

Market return

Obtain beta for project by obtaining betas of companies in the relevant industry.

Adjust beta to allow for company’s gearing level (convert to ungeared beta asset and then reconvert to geared equity beta).

Use CAPM to estimate project specific cost of equity and project specific WACC.

THE COST OF DEBT

8.1

Bank Loans Kd is the bank loan Interest rate

The Ungeared Beta of a company measures that element of systematic risk which is due to the underlying nature of the business and excludes financial gearing effects.

Geared and Ungeared Beta’s

RISK-ADJUSTED WACC CALCULATIONS

8.2

Ej [1 + D/E(1-t)]

Irredeemable Bonds / Debentures Debentures of listed companies are normally traded on the stock market. If a debenture is irredeemable, the interest stream is a flat perpetuity.

Where:

Ungeared beta – unlevered Eu in CLP

Geared beta – published Ej in CLP

Market value of Equity

Market value of Debt

Kd =

8.3

The Ungeared beta is the beta for equity and are a measurement of business risk only. The risk from being a geared company has been excluded.

Annual Interest Market price of the Debenture

Redeemable Bonds / Debentures The cost of debt for a redeemable bond / debenture will be given in the question, since calculation of it is complex and beyond the syllabus.

The beta of a geared company will be higher than that of an ungeared company as shareholders will perceive greater risk. This is because in addition to business risk, they will now have financial risk (part of systematic risk) in a geared company. The beta of a geared company will be higher than that of an ungeared company as shareholders will perceive greater financial risk (part of systematic risk) in a geared company. The formula allows us to “gear” betas to take account of the way in which gearing amplifies the risk implicit in earnings.

QP Module B (Feb 09) - Essentials

ESSENTIALS

XI.

Treasury & Financial Environment (CLP Section 13)

THE TREASURY FUNCTION

RISK

A function devoted to all aspects of cash within an organisation, this includes:

Risk is the chance of loss because of the uncertainty of the future. The financial world operates in an environment of uncertainty which means that all decisions are risky to some extent.

• • • • • • 1.1

Investment Raising finance Banking and exchange Cash and currency management Risk Insurance

THE FINANCIAL ENVIRONMENT

In relation to return there is normally some trade-off with risk. We would assume that investors are rational and risk averse.

• A rational investor selects the investment with the higher return assuming similar risk. • A risk averse investor will select the investment with the lower risk given similar levels of

Role of the treasurer

return.

The definition as stated by the association of the corporate treasurers is: This means that there must be some trade-off between risk and return; investors will require to be compensated for additional risk with higher return. In other words, the higher the risk of a course of action, the higher the returns need to be for an investor to follow that course of action Risk may be split into two elements:

‘Treasury management is the corporate handling of all financial matters, the generation of external and internal funds for business. The management of currencies and cash flows, and complex strategies, policies and procedures of corporate finance.’ The role being summarised under 5 headings:

• • • • •

• Business risk • Financial risk

Corporate objectives Liquidity management Investment management Funding management Currency management

2.1

Business risk Business risk is that risk which is inherent to the business and relates to the environment in which the business operates. The key to business risk is that it arises as a result of being in business and is difficult to avoid. Examples of business risk may include:

Corporate objectives – the treasurer must link the treasury function into the overall objectives of the business. In particular to facilitate a stock market listing, raise funds as required or have an appropriate dividend policy.

Competition – The loss of market share to a competitor is a classic part of business risk, unless you operate a monopoly or cartel this cannot be avoided.

Liquidity management – manage the flow of cash to ensure sufficient liquidity at all times whilst minimising the cost of so doing. This requires ongoing maintenance of banking relationships and use of appropriate payment and receipt methods.

Market – The market for your goods may grow or shrink without any input from yourself. Legislation – The government may pass laws that either help or hinder the operation of your company.

Investment management – ensuring that the short-term fluctuations of cash available are invested appropriately.

Economic conditions – Underlying strength or weakness of the economy may have a direct impact on the profitability of the business.

Funding management – providing advice of the relative costs of funds to the financial manager and keeping abreast of the potential current and future sources of funds. 2.2 Currency management – the use of hedging strategies to minimise the risk associated with overseas trade. The role includes the maintenance of balances in all the currencies that are being traded.

Financial risk Risk associated with the manner in which the company is financed. If the company is financed using equity, it carries no financial risk. This is because it has no need to pay shareholders a return (dividend) in the event of a poor trading year. If the company finances itself using debt as well as equity then it must generate sufficient cash flow to pay interest payments as they fall due. The greater the level of debt, the greater the interest payments falling due and hence the higher the risk of default. This is financial risk.

QP Module B (Feb 09) - Essentials

ESSENTIALS

2.3

Types of currency risk

ESSENTIALS

3.1

PROFIT CENTRE vs. COST CENTRE

Transaction risk

Should the treasury department be run as a cost centre or a profit centre?

The risk that the currency exchange rate moves between the date of invoice and the date of payment.

Cost centre – A function to which costs are accumulated. Profit centre – A function to which both costs and revenues are accounted for.

Translation risk

The profit centre would charge each part or division of the business for use of a service provided by the department.

This is a balance sheet problem. It arises from the consolidation of overseas subsidiary assets and liabilities. It should not affect the value of the company and therefore tends to be ignored.

Advantages of using a profit centre

• The use of the treasury department is given a value which limits the use of the service by Economic risk

the divisions.

Potentially, the most important type of risk for a company. The long term adverse movements in exchange rates can affect the profitability of a company.

• The prices charged by the treasury department are a measure of the relative efficiency of that internal service and may be compared to external provision.

• The treasury department may decide to undertake part of the hedging risk of a trade

CENTRALISATION vs. DECENTRALISATION In a large organisation there is the opportunity to have a single head office treasury department or to individual treasury departments in each of the divisions. Modern practice would suggest the decentralised route where there is little or no head office intervention in the workings of an autonomous division. This runs contrary to treasury practice where large companies tend to have a centralised function.

thereby saving the company as a whole money. The profit motive is important to ensure that the department will be motivated to do so.

•

The department may gain outside business if there is surplus capacity within the department effectively subsidising the cost of the internal service.

• Speculative positions may be taken that net substantial returns to the business. Advantages of centralisation Disadvantages of using a profit centre

• No need to duplicate the skills of treasury across each division. A centralised team will enable the use of specialist employees in each of the roles of the department.

• Additional costs of monitoring a ‘different business activity’. The treasury function is likely to be very different to the rest of the business and hence require specialist oversight if run as a profit making venture.

• Borrowing can be made in bulk taking advantage of better terms in the form of keener interest rates and less onerous conditions or covenants.

• The treasury function is unlikely to be of sufficient size in most companies to make a profit function viable.

• Investments will similarly take advantage of higher rates of return than smaller amounts. • Pooling of cash resources will allow cash-rich parts of the organisation to fund other parts of the business in need of cash.

•

The company may be taking a substantial risk by speculation that it cannot readily quantify. In the event of a position going wrong the company may be dragged down as a result of a single transaction.

• Closer management of the foreign currency risk of the business, the total exposure of the company can be identified and hence a better appreciation of the overall risk can be gained and hence acted upon.

• Closer control of individual divisions can be maintained due to underlying knowledge of cash flows. Advantages of decentralisation

• Greater autonomy of action may be taken by individual treasury departments allowing them to reflect local requirements and problems.

• Closer attention to the importance of cash by divisions.

QP Module B (Feb 09) - Essentials

ESSENTIALS

STATUTORY AND OTHER CONSTRAINTS ON FUNDING METHODS

4.2

SOFT CAPITAL RATIONING CONSTRAINTS

4.1

HARD CAPITAL RATIONING CONSTRAINTS

Soft capital rationing is self-imposed, i.e. the company constraints itself over funding.

Hard capital rationing is where funds are constrained from externalities such as legal or political influences.

To be rational, a company should invest in all projects with a positive NPV, this would maximise shareholders wealth. To constrain funds to less than this position would put shareholders at a theoretically worse position.

There are two considerations: 1. Industry wide factors limiting funds 2. Company specific factors limiting funds

Reasons for soft capital rationing 1. 2. 3. 4.

Industry-wide factors In a well-developed economy such as HK it is unlikely that there will be legal and political constraints over funds available to invest in potentially profitable ventures for a successful plc.

Limited management skills available. Desire to maximise return of a limited range of investments. Limiting of exposure to external finance. Encourage acceptance of only substantially ‘profitable business.

In a third world or underdeveloped country legal and political constraints are often found.

In HK, only soft capital rationing constraints are likely to be suffered by a successful plc.

It is possible that temporary phenomena such as a sharp economic down-turn may reduce available funds dramatically in the short-term.

HK having a well developed financial sector most listed companies should have little trouble raising funds.

Company specific factors

For smaller companies this is not the case and hard capital rationing is very possible.

It is far more likely that a company is unlikely to get funding and suffer hard rationing due to its own specific difficulties. These may include: 1. 2. 3. 4.

Lack of track record Poor track record Non-payment of bills Poor management team

4.3

PROJECT SELECTION UNDER FUNDING CONSTRAINTS Capital rationing constraints may arise over a single period or over a number of periods (multiperiod). Multi-period capital constraints

To qualify for an equity listing (IPO), the company must satisfy numerous listing criteria, principally:

A situation where there is a shortage of funds in more than one period. This makes the analysis more complicated because we have multiple limitations and multiple outputs. This situation would be beyond the scope of this syllabus as it would require a computer spreadsheet to evaluate the outcomes.

1. It must provide fully audited accounts covering at least 3 years.

Single period capital constraints

2. It must be an independent business activity which has earned revenue for at least a 3 year period.

There is a shortage of funds in the present period which will not arise in following periods. Note that the constraint in this situation is very similar to the limiting factor decision that we know from short-term operating decision making.

Equity constraints

3. The senior management and key directors should not have changed significantly throughout the 3 year period, and should possess appropriate expertise and experience.

In this situation we try to maximise the $ return per $ of investment by calculating the profitability index:

4. At least 25% of the company’s ordinary shares must be in public hands. Profitability index (P.I.) Debt constraints For raising additional debt the constraints can be legal restrictive covenants (legal restrictions) not allowing a company to borrow further debt.

P.I.

Gross PV / Investment

Having a lack of suitable assets available for security can be another constraint.

QP Module B (Feb 09) - Essentials

ESSENTIALS

XII.

Risk Management & Finance Treasury Function (CLP Section 14)

OTC 1: Forward Contact

FOREIGN CURRENCY HEDGING

Now:

Spot Market Target (e.g.) Receipt £x

To hedge or not to hedge – factors to consider

• Exchange rate system • • • • •

Later: e.g. 3 months

Attitude to risk Materiality of transactions Matching of transactions Volatility of exchange rates Time period

* $/£

Hedging Techniques (HT)

Bank HK Futures Exchange (HKFE) + : Low Hedge Cost - : Lower Hedge Efficiency

OTC 2: Money Market Hedge ET 1: Currency Futures OTC 3: Currency Swap

Due to… Inflation Differential (HK vs UK) Interest Differential (HK vs UK)

Purchasing Power Parity (PPP) Interest Rate Parity (IRP)

OTC 2: Money Market Hedge Exchange Traded (Fin Der. Mkt) ET

OTC 1: Forward contract

Forward Rate

Etc

Step 2: External HT

+ : High Hedge Efficiency - : High Hedging Cost

Actual Receipt £x @HK$/£ HK$x

Expected Spot Rate

Step 1: Internal HT - Home currency billing - Matching - Leading & Lagging - Netting / Bilateral Netting / Multilateral Netting

Tailor to Need (OTC)

Forward Market (Bank) Enter a 3 months £ Forward Contract with 3 months Forward rate of HK$/£* for £x

ET 2: Currency Options

Aim: Expected Foreign currency Receipt/Payment Convert into… Home Currency Receipt/ Payment Via… Borrowing & Deposit

Foreign Payment

Foreign Receipt

Exchange and deposit foreign currency today that will grow into the foreign payment

Borrow foreign currency and exchange today the amount that will grow into the foreign receipt

Take a home currency loan out today from home country bank

Deposit home currency today in home country bank

OTC 4: OTC Currency options

‘Standardised contract’

Standardised contact size Std. maturity date

QP Module B (Feb 09) - Essentials

A hedge is created as exchanges are made today – i.e. today’s Spot Rate

QP Module B (Feb 09) - Essentials

ESSENTIALS

OTC 3: Currency Swap

ESSENTIALS

Exchange Traded 1: Currency Futures A HK Co… Foreign Payment

Principle Intermediaries

Company A

Counter Party

Bank

(1 May) Now: (Target Payment £X in 3 months)

Spot Market

HKFE (Currency Futures)

(£X)

In order to trade… Initial M/D is required Buy/Sell M, J, S, D £Futures @(HK$15.3/£) For XX Contracts

(1)

(Spot Rate) Equitable bases

(2)

Swap

(3) End of Swap Period X

Swap Back

£X £X/contract <Should the price of the Futures contract move adversely, variation margin is required> (31 July) Later: (3 months) Spot but, Futures

Spot Rate

Japan N

US A $

JKL

Desired: ¥ <Swap. R: $1:¥110> (1) Borrow: $100m @7%p.a Fixed

¥11000m @6% p.a. Fixed

(2) Swap: ¥11000m For 5 years interest

$100m 6% p.a. 7% p.a.

6% p.a. 7% p.a. (3) End of 5 years Swap back: $100m

OTC 4: ET 2:

£X @Spot Rate Loss (HK$X) Gain Net HK$X

Close out Sell / Buy S £Futures HK$15.3/£ For XX Contracts e.g. >HK$15.3/£ Gain/£ x £x/contract x # contract $ Gain

Currency options It is a contract that represent a Right to… - Buy (Call option) An underlying asset (e.g. currency) - Sell (Put options) At an exercise/strike price - On the expiry date: European Style option or - Any time until the expiry date: American Style option

¥11000m Available at… OTC (Bank) - Participant: Hedger

QP Module B (Feb 09) - Essentials

HKFE - Participant: Hedge & Speculator Buy Call / Put option

ESSENTIALS

INTEREST RATE HEDGING 2. HEDGING TECHNIQUES 1.

CASHFLOW TECHNIQUES FOR MEASURING INTEREST RATE RISK

Gapping

OTC (1)

Gapping provides information about the effect of interest rate movements on the companies assets and liabilities. However, it does not include the time value of money.

Forward Rate Agreement (FRA) Example 8 (pg. 14 – 48)

OTC (2)

Swap

Interest Rate Swap (example 6)

Fixed / Floating rate currency Swap Gapping allows the company to see how a movement up or down in interest rates would effect the company during certain periods.

For: Forex Risk management

Duration Duration calculates the weighted (by time) average of the present value of the future debt cash flows. Its useful for measuring and comparing the risk of various types of fixed rate loans.

& Interest Rate Risk management Refer to Example 6 (p. 14-36) Principle 1. Identify the types & Desired Interest Rate structure for each party Fixed Rate Floating Rate 2. Identify the potential benefits attributable to each party in the Swap 3. Design the Swap Summarize these arrangement by showing the settlement between the two parties.

The higher the duration the greater the risk Duration can be useful for comparing assets / investments of certain types for risk, and also is useful if the investor wants a certain cash low return over a certain period.

QP Module B (Feb 09) - Essentials

ESSENTIALS

OTC (3) ET (2)

ET (1) Interest Rate Futures 1. Calculate Value of a tick

Interest Rate Options

A call option gives the holder the right to buy the futures contract

0.01% = 1/100 of 1% = One tick = in decimal format (=0.0001) The value of a tick depends on the size of the future contracts: $ contracts = $5,000,000 (Standard size) One tick = $5,000,000 x .0001 x 3/12 = $125

A put option gives the holder the right to sell the futures contract You always buy the option – buy the right to buy or buy the right to sell Cash Market:

Note - Be aware examiner can change standard size!

2. What will the company INITIALLY do in the futures exchange

Futures Market:

Interest rate futures are effectively contracts to buy or sell the interest on a notional threemonth deposit. Deposits

Loans

Buy futures

Sell futures

Sell futures contracts

Buy Calls

Buy Puts

Collars – Combination of Caps and Floors

Future contracts are issued on a three-month cycle. The contracts mature (expire) at the end of March, June, September and December. It is normal to choose the first contract to expire after the loan is required or deposit is made.

4. Calculation of no. of contracts: Loan or deposit period in months 3 months – contract duration

Loan

Buy futures contacts

Options Market:

Borrower For Hedging … (premium paid)

3. Which futures – Mar, June, Sept or Dec?

Loan or deposit amount Contract size

Deposits

Alt… for hedging but aim to reduce the premium cost

Buy Cap Sell Floor

Buy

Cap

(Premium) Premium Low Net Premium Paid

Collar

Depositor Buy a Floor & (premium paid)

Buy Floor Sell Cap

(Premium) Premium Lower Net Premium Paid

Collar

5. Calculate the cash flow from the profit or loss on the futures. Method: Ticks per contract x tick value x numbers of contracts

Practical Question 2 (p. 14-57)

QP Module B (Feb 09) - Essentials

ESSENTIALS

XIII.

Financial Strategy, Capital Structure & Dividend Policy (CLP Section 15)

FINANCE

Dividends represent a return by a business to its shareholders. Factors that will influence the level of dividend will include:

The type of funding required and available to the business will depend on both the specific use of the funds and the size and type of the organisation. Considerations will include:

Profitability – the level of profitability will determine over the longer term the level of funds available for all cash uses.

The overall level of funds required by the business, or expected to be required in the future. This will be closely related to the growth rate of the business in addition to the cash generative nature of it. Constraints on funding are particularly felt by small and newer businesses who may be restricted to internally generated funds.

Growth – the retention of a high level of funds will be necessary if a company wishes to grow organically. Taxation – the level of funds paid out in the form of dividend may be affected by tax treatment if the dividend payment is treated differently to capital gain by the tax authorities.

The level of funding generated internally in relation to that funding required from an outside source. Some companies avoid taking on debt and restrict themselves to only internally generated funds. This tends to be less risky and has the added advantage of better confidentiality for the business. The balance of debt to equity (gearing) accepted by the business. This is further dependant on the acceptable level of risk to the company and the ability of the company to borrow funds or raise equity. The mix of long-term to short-term funds. Long-term funds may be considered safer for the company because they need replenishment less frequently. They are normally more costly because the debt holder will require compensation for the longer term. 2.

Legal restrictions – A company may only pay out dividends from distributable profits. Additionally the level of dividend may be restricted by covenants in operation from debt. Liquidity – sufficient funds must be available to pay the dividend. 4.

DIVIDEND POLICY Most organisations attempt to follow a consistent dividend policy to ensure that shareholders are able to have some confidence in the likelihood of a relatively constant payout. Policies may include:

CAPITAL STRUCTURE

Constant payout proportion – The company pays out a fixed dividend in proportion to the earnings available for distribution. The dividend will fluctuate in proportion with earnings.

The WACC is the Weighted Average Cost of Capital for a company. That is the weighted average cost of equity and debt.

Residual approach – Retained earnings are used to finance all investments that earn a return (positive net present value). Whatever remains (the residual) is paid out to the shareholder.

Since debt is generally cheaper than equity it would appear that a company could lower the WACC by adding 'cheap' debt to an equity base. The effect of this is highly significant. In the traditional view of gearing, shareholders are deemed unlikely to respond adversely to minor increases of gearing so long as the prospect of default looks remote. Substitution of lower cost debt for equity will lower the overall cost of capital.

Dividend Irrelevance theory - Miller and Modigliani put forward a theory that, in a perfect world, the value of a firm is unaffected by the distribution of dividends. Stable dividend (Dividend relevance) – A fixed dividend is paid out each year, an incremental change may be built in to indicate inflation or preferably improved results of the company year on year.

However, sooner or later providers of additional debt are likely to raise their requirements as they perceive the probability of default increasing. The WACC will eventually be forced to rise, as indicated in the diagram below:

Cost of Capital (%)

Level of gearing

100%

DIVIDENDS

QP Module B (Feb 09) B – Essentials

ESSENTIALS

XIV.

Long Term Financing (CLP Section 17)

Disadvantages

• High Cost: Cost of issuing shares is higher than raising the same level of finance by loans.

1.1

Ordinary Shares (Equity Finance)

Also the returns required to satisfy shareholders are higher than interest on loans (to compensate for the high risk).

Features:

•

• Owning a share confers part ownership of the business.

• Dividends are not tax-deductible, which makes equity relatively more expensive than loans.

•

Shareholders have full rights to participate in the business through voting in general meetings.

1.3

Issuing ordinary shares to new shareholders dilutes the degree of control of existing members.

Preference Shares (Non Equity)

• Shareholders are entitled to payment of dividends out of profit.

• Pays a fixed dividend, ranking before (in preference to) ordinary shareholders.

• Share capital is permanent financing which is not expected to be paid back.

• Hybrid form of finance

• Shareholders are entitled to repayment of capital in the event of liquidation, but only after all

• For gearing purposes, usually considered to be debt

other claims have been met.

• Usually (but not always) carry no voting rights

• Ordinary shareholders bear the greatest risk: If there is no profit then dividend does not have to be paid. Conversely, if the profits are high then high dividends can be paid.

• Ranks after debtholders but before ordinary shareholders for repayment in the event of liquidation

• Shares are not tax efficient as dividends are post-tax as an appropriation of profit.

• No obligation for company to pay dividend

• Shares are marketable if listed.

• May be cumulative (rights to dividend carried forward if insufficient profit in any year), or non cumulative.

Authorised, Issued, Par values and Reserves

• Dividends are paid out of post tax profit, which means they are more expensive than debt for the company

• Authorised Share Capital: maximum number of shares that may be issued, set in the articles of association and can only by altered with the agreement of the ordinary shareholders

• Issued Share Capital: Number of shares actually issued. Must, of course, be less than or equal to authorised

• Par Value (or nominal value) of a share: Value of a share stated on the balance sheet. Has no real significance and should be read in conjunction with the share premium account, which represents the difference between the price received by the company for the shares when they were issued and the par value of the shares.

• Reserves: These belong to the ordinary shareholder 1.2

DEBT Debt is something that has to be repaid. It is the loan of funds to a business without conferring ownership rights. The usual methods of repayment is a combination of a regular interest payment, with capital repayments either spread over a period or given as a lump sum at the end of the borrowing. Features

• Interest is paid out of pre-tax profits as an expense of the business.

Advantages and Disadvantages to the company of raising finance by issuing ordinary shares

• Cheaper for the company than equity because it is cheaper to arrange and interest payments

Advantages

• It carries a risk of default if interest and principal payments are not met, so the debtholder

• No fixed charges (e.g. interest payments). Dividends are paid if the company generates sufficient cash, the level being decided by the directors.

usually lower than dividends (because less risky to investor). can force the company into liquidation.

• No rights to share in the profits if the company is very successful.

• No repayment required. It is truly permanent capital. •

In the case of retained profits and rights issues, directors have greater control over the amount and timing, with minimal paperwork or issuing costs.

QP Module B (Feb 09) B – Essentials

ESSENTIALS

4.3 3.

COVENANTS

Mezzanine finance

• High risk finance issued when other sources are unavailable. A typical use is to fund a management buy out.

A further means of limiting the risk to the lender is to restrict the actions of the directors through the means of covenants. These are specific requirements or limitations laid down as a condition of taking on debt financing. They may include:

• Also can be issued if there is a covenant restricting further loan issue. Ranks between 'Senior' loans and equity for repayment.

Dividend restrictions - limitations on the level of dividends a company is permitted to pay. This is designed to prevent excessive dividend payments which may seriously weaken the company's future cash flows and thereby place the lender at greater risk.

• Very high interest rates because of the high risk. • Mezzanine finance is usually provided by a Venture Capitalist.

Financial ratios - specified levels below which certain ratios may not fall, e.g. debt to net assets ratio, current ratio. 4.4 Financial reports - regular accounts and financial reports to be provided to the lender to monitor progress.

The issue of debt in a currency other than that of the country. Issuing bonds in a foreign currency increases the amount of potential investors, and can in some cases reduce exchange rate risk if the company earns foreign revenue.

Issue of further debt - the amount and type of debt that can be issued may be restricted. Subordinated loan stock (i.e. stock ranking below the existing unsecured loan stock) can usually still be issued. 4.

TYPES OF DEBT

4.1

Bank finance

Eurobonds / USDollarbonds

This form of finance is only available to the largest international corporations. 4.5

Convertible Bonds / Debentures Normal bonds that also give the holder the right, but not the obligation, to exchange the bonds at some stage in the future into ordinary shares according to some prearranged formula.

For companies that are unlisted and for many listed companies the first port of call for borrowing money would be the banks. These could be the high street banks or more likely for larger companies the large number of merchant banks concentrating on ‘securitised lending’. The key advantage of borrowing from banks is the confidential nature of the arrangement.

Advantages of Convertible bonds

• The benefit to the investor is the potential to share in profits if the company does very well.

A term loan is a business loan with an original maturity of more than one year and a specified schedule of principal and interest payments. It may or may not be secured. Terms and conditions are negotiable dependant on term amount and the credit rating of the company wishing to make the borrowing.

• The benefit to the company is that the original bond can be issued at a lower rate of interest. • Another benefit to the company is that they are self liquidating – that means the company

4.2

does not have to find the funds to redeem the debt.

Bonds / Debentures / Loan Stock (traded investments) As an alternative to borrowing funds from a bank the company, if listed on the stock exchange, may issue debt to investors over the long-term. Typical features may include: The debt is denominated in units of HK$100, this is the value eventually redeemed on maturity. It is often the value on issue (the cost to the investor) but the debt may be issued at a discount (for less) or even at a premium.

4.6

Warrants Warrants are options, usually issued with debt, which at some later point in time give a right to buy additional shares (equity) in the company.

Interest is paid (normally at a fixed rather than floating rate) on the nominal value of the loan. EG a 9% bond will pay annual interest of HK$9. This interest is sometimes known as the 'coupon'. Market rates of bonds will fluctuate, depending on the prevailing interest rates. As with all debt, it is a less risky for investors than ordinary shares.

QP Module B (Feb 09) B – Essentials

ESSENTIALS

XV. 1.

ESSENTIALS

Short Term Financing and Working Capital Management (CLP Section 16) WORKING CAPITAL MANAGEMENT

Working Capital Balancing Act

Working Capital is the capital available for conducting the day-to-day operations of an organisation; normally the excess of current assets over current liabilities. Illustration

CURRENT ASSETS

MINUS

CURRENT LIABILITIES

Stock

Creditors

Debtors

Bank overdraft

Cash and Bank

Ensuring current assets are sufficiently liquid to minimise the risk of insolvency

Maximising the return on capital employed hence minimising investment in working capital

Balancing figure

Require funding

Provide funding

Leading to two fundamental questions…

Aim: Maximise current liabilities

Aim : Minimise current assets

What is the appropriate level of investment in working capital?

QP Module B (Feb 09) B – Essentials

How should the investment in working capital be funded?

ESSENTIALS

1.1 The Level Of working capital

2.2

The level of working capital required is affected by the following factors:

•

ESSENTIALS

The nature of the business, e.g. manufacturing companies need more stock than service companies;

• Uncertainty in supplier deliveries. Uncertainty would mean that extra stocks need to be carried in order to cover fluctuations;

OPERATING CYCLE Also known as the cash cycle or trading cycle. The operating cycle is the length of time between the company’s outlay on raw materials, wages and other expenditures and the inflow of cash from the sale of goods. In a manufacturing business this is the average time that raw materials remain in stock less the period of credit taken from suppliers plus the time taken for producing the goods plus the time the goods remain in finished inventory plus the time taken for customers to pay for the goods. Illustration

• The overall level of activity of the business. As output increases, debtors, stock, etc. all tend to increase.

• The company’s credit policy. The tighter the company’s policy the lower the level of debtors.

Purchases

Sales Stock days

• The length of the operating cycle. The longer it takes to convert material into finished goods into

Debtors Pay Debtor Days

cash the greater the investment in working capital.

Creditor days

Working Capital Measures

DAYS

There are two kinds of measures:

• Liquidity Ratios • Operating cycle 2.1

Operating Cycle

Pay Creditors

LIQUIDITY RATIOS

Calculation of Days

We looked in detail at these ratio’s earlier

Stock Days = Raw Material Days + Work-in-Progress Stock days + Finished Goods Stock Days

Current Ratio Raw Material Days =

Current Assets

Raw material Stock u 365 Purchases *

Current Ratio = Current Liabilities

Work-in-Progress days =

A simple measure of how much of the total current assets are financed by current liabilities. If, for example the measure is 2:1 this means that only a limited amount of the assets are funded by the current liabilities.

Finished Goods days =

Work - in - progress u 365 Production cost *

Finished Goods stock u 365 cost of sales *

Quick Ratio Debtor days =

Current Assets minus Stock Quick Ratio = (or acid test)

Current Liabilities Creditor days =

A measure of how well current liabilities are covered by liquid assets. A measure of 1:1 means that we are able to meet our existing liabilites if they all fall due at once.

QP Module B (Feb 09) B – Essentials

Debtor balance u 365 Credit sales * Creditor balance u 365 Credit purchases *

* Or nearest approximation – depending on available data.

QP Module B (Feb 09) B – Essentials

ESSENTIALS

2.3

Implications

WORKING CAPITAL MANAGEMENT

The operating cycle is a critical measure of the overall cash requirements for working capital. This can be summed up from two perspectives:

MANAGING DEBTORS

• Where level of activity (sales) is constant and the number of days of the operating cycle increase the amount of funds required for working capital will increase approximate proportion to the number of days.

• Where the cycle remains constant but activity (sales) increase the funds required for working capital will increase in approximate proportion to sales. By monitoring the operating cycle the manager gains a macro view of the relative efficiency of the working capital utilisation. Further it may be a key target to reduce to improve the efficiency of the business.

ESSENTIALS

Selling on credit means that cash from sales is delayed in reaching the company’s bank account, and so the company is effectively investing its money in its debtors. The expected returns from such an investment take the form of increased sales (because customers who want trade credit are attracted to buy the company’s goods) and hopefully increased profits. These returns have to outweigh the cost of reduced liquidity and collection and administration costs. Sales should increase as the amount of credit offered increases, but problems of slow payment and bad debts also increase. Discounts for prompt payment speed up the collection time of the debts, but reduce the amount from each sale which is collected.

Illustration

OVERTRADING

Debtor Balancing Act

Overtrading is trading by an organisation beyond the resources provided by its existing capital. Overtrading tends to lead to liquidity problems as too much stock is bought on credit and too much credit is extended to its customers, so that ultimately there is not sufficient cash available to pay the debts as they arise. Overtrading is caused by rapid growth. Indicators:

• • • • •

Rapid increase in turnover Increase in trade creditor balances Decrease in cash/increase in overdraft Increasing operating cycle No matching increase in permanent capital (overtrading is sometimes called undercapitalisation)

Collecting sales receipts as quickly as possible to reduce the cost of financing the debtor balance.

Extending the credit period to customers to encourage additional sales.

Remedies:

• Cut back trading • Raise further permanent capital • Improve working capital management

QP Module B (Feb 09) B – Essentials

ESSENTIALS

5.1

Credit Control

ESSENTIALS

Trade credit is the simplest and most important source of short-term finance for many companies. By delaying payment to creditors companies face possible problems:

Assessing Customer’s Credit Risk To minimise the risk of bad debts occurring, a company should investigate the creditworthiness of all new customers (credit risk), and should review that of existing customers from time to time, especially if they request that their credit limit should be raised

• • • •

Agreeing Terms Once it has been decided to offer credit to a customer, the company needs to set limits for both the amount of credit offered and the time taken to repay

6.1

An effective administration system for debtors must be established.

5.2

Suppler may refuse to supply in future Supplier may only supply on a cash basis Loss of reputation Supplier may increase price in future

Discounts Trade credit is normally seen as a 'free' source of finance. Whilst this is normally true, it may be that the supplier offers a discount for early payment. In this case delaying payment is no longer free, since the cost will be the lost discount.

Collecting Payment

• • • •

MANAGING CREDITORS

Be strict with the credit limit Send invoices promptly Systematically review debtors eg aged debtor analysis Chase slow payers

MANAGING STOCK Stock is a major investment for many companies. In particular, manufacturing companies can easily be carrying stock equivalent to between 50% and 100% of the turnover of the business.

FINANCIAL IMPLICATIONS When looking at differing strategies to control cost associated with debtors the key is to identify the interest cost. The outstanding debtor balance will need to be funded.

Stock Balancing Act

Cost of financing debtors Key working

Interest cost = Debtor balance u Interest (overdraft) rate

Reducing stock to the lowest possible level hence minimising the level of capital employed to be funded

Debtor days Debtor balance = Sales u 365

Ensuring that sufficient stock is held to ensure that stock outs do not arise

Possible ways of reducing the cost of debtors

• Offering discounts for prompt payment • Factoring • Invoice discounting

QP Module B (Feb 09) B – Essentials

ESSENTIALS

7.1

Material costs

Material costs are a major part of a company’s costs and need to be carefully controlled. There are 4 types of cost associated with stock:

• • • • 7.2

ESSENTIALS

ordering costs, holding costs, stockout costs and the purchase cost

CASH MANAGEMENT Like working capital management in general, financial managers have a balancing act to perform when trying to determine the optimum level of cash. The more cash that is on hand, the easier the company will find it to meet its bills and take advantage of discounts. By carrying a quantity of cash or possessing securities at short call, the company is buying peace of mind. Cash is an idle asset, however, and the more that the company has lying idle the less there is available to invest in the company in order to generate profits. Illustration

Economic Order Quantity

Cash

When the reorder quantity is chosen so that the total cost of holding and ordering is minimized, it is known as the economic order quantity or EOQ.

Balancing Act

As the size of the order increases, the average stock held increases and holding costs will also tend to increase. Similarly as the order size increases the number of orders needed decreases and so the ordering costs fall. The EOQ determines the optimum combination. Cost Total cost Cost £

C C o s t

Being able to pay debts as they fall due

Minimising the holding of cash – an idle asset

Holding Costs

Ordering Costs

EOQ

Reorder William Baumol first noted that cash balances are in many respects similar to inventories, and that the EOQ inventory model can be used to establish the target cash balance. Baumol’s model assumes that the firm uses cash at a steady predictable rate and that the firm’s cash inflows also occur at a steady predictable rate

Quantity Calculating EOQ

Q =

2DP C

Q =

P = Cost per order D = Annual demand C = Cost of holding one unit for one year

7.3

Where

JUST-IN-TIME STOCK MANAGEMENT An alternative view of stock management is the reduction or elimination of stock, since stock is seen as waste. The supplier holds the stock until it is needed and delivers just in time for production. This involves a close relationship with the supplier, who must be able to deliver materials of the correct quality at exactly the right time. Failure to do so could lead to breaks in production and be very expensive.

QP Module B (Feb 09) B – Essentials

2DP C

= The brokerage cost (per transaction) of making a securities trade or borrowing

= The total amount of net new cash needed for transactions over the entire period, or the excess cash available to in vest in short-term securities

= Opportunity cost of holding cash

QP Module B (Feb 09) B – Essentials

ESSENTIALS

SHORT-TERM FINANCE SOURCES

9.1

Trade Credit

ESSENTIALS

9.6

A means of payment whereby by a ‘promissory note’ is exchanged for goods. The bill of exchange is simply an agreement to pay a certain amount at a certain date in the future. No interest is payable on the note but is implicit in the terms of the bill.

The delayed payment to suppliers is effectively a source of finance. By paying on credit terms the company is able to ‘fund’ its stock of the material at the expense of its suppliers. To maximize this benefit the company should aim to pay as late as possible without damaging its trading relationship with its suppliers. 9.2

The bill of exchange is a source of finance because it can be sold on the money markets by the recipient allowing the supplying company to receive its payment early. The bill will be sold at a discount to its full value reflecting the time value of money.

Overdrafts A flexible source of short-term funding which is used by a high proportion of companies to fund fluctuating working capital requirements. Its great advantage is that you only pay for that part of the finance that you need.

9.3

Bank Loans

If held to the full term the bill is presented to the customer’s bank for payment. Bills of exchange are often used when trading with foreign companies.

9.7

Leases Some sources of finance are used to purchase individual assets using the asset as security against which the funds are borrowed.

Bank loans or term loans are loans over between one and three years which have become increasingly popular over the past ten to fifteen years as a bridge between overdraft financing and more permanent funding. 9.4

Bills of Exchange

Factoring 10. The outsourcing of the credit control department to a third party. The debts of the company are effectively sold to a Factor (normally owned by a bank). The factor takes on the responsibility to collect the debt for a fee. The factor offers three services: Debt collection and Administration – With this form of factoring the factor takes over the whole of the company’s sales ledger, issuing invoices and collecting debts. The company is relieved of all the administration associated with debt management and collection. Financing Provision – Using this arrangement the factor will agree to buy the debts from the company, and at the same time will advance up to 80% of their value to the company; the remainder (minus interest) being paid when the debts are collected.

THE FINANCING MIX – SHORT OR LONG TERM FINANCING Short-term sources of finance are generally cheaper than long-term ones. Trade creditors do not usually carry an interest cost. Short-term finance also tends to be more flexible.

Fluctuating

Total

Assets

current assets

Credit insurance – The factor may take the responsibility for bad debt, for this to be the case the factor would dictate to whom the company was able to offer credit to. This is called ‘without recourse’ factoring. 9.5

Short-term credit

Permanent current assets

Long-term finance

Advantages and Disadvantages of factoring

Fixed assets

Advantages

• Saving in administration costs. • Reduction in the need for management control. • Particularly useful for small and fast growing businesses where the credit control department

Time

may not be able to keep pace with volume growth. Disadvantages

• Likely to be more costly than an efficiently run internal credit control department. • Factoring has a bad reputation associated with failing companies; using a factor may suggest your company has money worries.

• Customers may not wish to deal with a factor. • Once you start factoring it is difficult to revert easily to an internal credit control.

QP Module B (Feb 09) B – Essentials

ESSENTIALS

XVI. 1.

ESSENTIALS

Other Issues in Treasury and Finance (CLP Section 18)

The value of an option decreases as the time to expiration decreases. The holder of a longerdated option, whether call or put, will have more time for the option to move “in-the-money”.

Treasury functions: The firms Treasury must monitor and report on:

• • • • • • • 1.1

Time to Expiration

Liquidity and funding Interest rate risk Foreign exchange risk Commodity and credit risks Financial structure Market conditions Legal and regulatory compliance

Interest Rate

The higher the interest rates, the higher (lower) the price of call (put) options will be. As the market price of the share is in today’s dollars and the exercise price is in future dollars, the present value of the exercise price is lower when the interest rate is higher, resulting in a more valuable call option. 5.

Price Volatility of the Underlying Asset

The higher the price volatility of a share, the higher the probability of upward and downward movements in the share price. As a result, the chance of either call or put options moving into the money increases.

Elements of an Option Price Other Factors

Call Option = Gives you the right, but not the obligation to BUY Put Option = Gives you the right, but not the obligation to SELL

Dividend Payments When a share goes ex-div, the price of the share falls by the amount of the dividend, all else being equal. Therefore, the value of the call option will fall and the value of the put option will rise. The greater the dividend, the greater the effect on option prices.

The price at which an option trades = INTRINSIC VALUE + TIME VALUE

European vs American Options Intrinsic Value

European options give the holder the right to exercise on the final day of the contract period, while American options give the holder the right to exercise the options at any time up to and including the final day of the contract period. The extra flexibility of American options makes them more expensive as you are buying more rights.

in-the-money amount; minimum value – 0 Share price – strike price (calls)

Time Value

Strike price – share price (puts)

Option Pricing

a function of the time to expiration

3.1

Put-call Parity Put-call parity is a relationship that enables us to value a put, once we have calculated the value of a call.

The Determinants of Option Prices

Value of Put

Option prices are determined by five major factors (assuming no dividends are paid):

• • • • • 1.

Underlying share price Exercise price Time to expiration Interest rate Price volatility of underlying asset

3.2

Value of + Call

PV of Exercise Price

Share Price

Call Options To Calculate a CALL Option you use the Black Scholes Model. Note that the use of Black Scholes model is beyond the QP Syllabus.

Underlying Share Price

The higher the underlying share price, the more (less) the call (put) option will be worth. 2.

Exercise Price

The lower the exercise price, the more (less) the call (put) option will be worth.

QP Module B (Feb 09) B – Essentials

ESSENTIALS

MERGERS VS ACQUISITIONS

ESSENTIALS

Mergers and acquisitions are a core topic in most modern financial strategy examinations. The techniques used to calculate the cost of capital are frequently used in this style of question and the subject area draws heavily on other disciplines.

VALUATION OF BUSINESS ENTITIES AND SHAREHOLDERS EQUITY When a takeover is contemplated, a valuation of the target’s shares will be carried out to gauge which price to offer. If the target is not a listed company, any takeover price must be negotiated by arrangement with the existing vendors.

4.1

Company growth Purpose of growth should be to increase shareholder wealth. achieved by one of two processes:

If the target is a listed company, a bid will be made and the takeover only completed if it is accepted by the target’s shareholders.

Company growth can be

The types of valuation method fall into two broad categories: asset based and income based.

• Internal or organic development • External development by merger or acquisition

5.1

Internal growth can be a slow process so often external growth is pursued, which can take several forms: Horizontal Vertical Conglomerate

= = =

competitor supplier or customer unrelated

Synergies: to increase shareholder wealth, the market value of the combination of the two companies should be greater than the sum of the market values of the individual companies.

4.2

Merger

Valuation methods 1. Asset based measures There is a number of asset based measures which can be used on the Balance Sheet. There simple and quick, but unfortunately never give a reliable valuation as they exclude future company value. Asset based measures Net book value Net realisable value Replacement cost

2. Current Share Price

The features of a true merger, which is in essence a pooling of interests, are as follows:

• The parties are approximately equal in size; • Management of the two entities is combined or unified after the combination; • The shareholders of the two combining businesses are still shareholders after the combination; and

If the company is listed on the HK stock exchange, and very quick, simple and effective way to value the company is from its current share price. The only problem with this method is the shares might be under or overvalued. Also, if the company is not listed, then obviously this method cannot be used!

• The combination is effected by setting up a new holding company which issues its shares in exchange for those of the combining parties. Income based measures 4.3

3. Present Value of Dividends (Direct valuation method)

Acquisition Acquisitions normally involve a larger company acquiring a smaller company. acquisitions are referred to as mergers so as to:

Many

This is normally applied when the takeover is an off-market purchase. The model used is the normal dividend valuation model. D1 Ke - g

• portray a better message to the customers of the target; • appease employees of the target company; and • integrate the employees of the new company more easily.

Where: However, its perfectly normal in financial management to call an acquisition or merger, since this sounds less threatening to the target staff.

QP Module B (Feb 09) B – Essentials

Share price we are trying to determine

Dividend paid in a year’s time

Cost of equity

Constant annual growth rate in dividends

QP Module B (Feb 09) B – Essentials

ESSENTIALS

XVII. Business Failure, Insolvency & Reconstruction (CLP Section 19)

4. P/E Multiple Ratio (Comparables method) This method is often employed in practice to value the shares in a non-listed company.

Business may find that they are operating in a declining industry

A price earnings ratio is the current share price divided by the most recent earnings per share. It is a common stock market indicator and reflects the market’s expectations of risk and growth in the company’s earnings.

Possible strategies are for dealing with a decline situation are:

• • • • •

The PE ratio is a measure of future earnings growth, it compares the market value to the current earnings.

Current Share Price P/E Ratio

Total MV

Corporate decline

Withdraw – if high exit barriers do not make this impossible Sell the business to a competitor who can make better use of it Purchase competitor firms that are less effective and combine capacity If decline due to substitute product either start making substitute or innovate Reduce capacity

= EPS

Profit after Tax

The higher the PE ratio, the greater the market expectation of future earnings growth. This may also be described as market potential.

1.1

Slatter outlined ten major symptoms of corporate decline:

By multiplying a P/E ratio for a comparable listed company by the most recent maintainable earnings, a suitable share price for a non-listed business can be estimated. Other possible multiples could be:

Corporate decline: symptoms and causes

• • • • • • • • • •

Price / Sales ratio Price / Earnings after tax ratio Price / Cash ratio Enterprise Value / EBIT(DA)

5. DCF / PV of future free cash flows to the firm (Indirect Valuation method)

falling profitability reduced dividends falling sales increasing debt decreasing liquidity delays in publishing financial results declining market share high turnover of managers top management fear of action lack of planning or strategic direction

It can be calculated as: The causes of decline were also identified by Slatter. They are: Free cash flows of the firm

EBIT(1-t) + Depreciation – Capital – Expenditure

Increase in net working capital

• • • • • • • •

The free cash flows should then be discounted at the appropriate weighted average cost of capital (WACC). Value of firm NPV of the free cash flows to the firm for infinity Free cash flow is a measure of the cash which is freely available, after the payment of interest and tax expenses, debt repayments and lease obligations, any changes in working capital and capital spending on assets needed to continue existing operations (ie. replacement capital expenditure), for distribution in the form of dividends and for reinvestment in the business. Value of equity = value of firm – net debt

QP Module B (Feb 09) B – Essentials

1.2

Going concern evaluation When reviewing going concern the following matters should be considered:

Poor strategic leadership Not doing anything Risk averse decision making Economies of production and administration Limited opportunities for innovation and diversification Acquisitions that fail to match expectations Poor financial or operating management Poor marketing

Symptoms indicating an inability to meet debts as they fall due Borrowings in excess of limits imposed by debenture trust deeds Default on loans or similar agreements Dividends in arrears Restrictions placed on usual trade terms Excessive or obsolete stock Long overdue debtors Non-compliance with statutory capital requirements

QP Module B (Feb 09) B – Essentials

ESSENTIALS

• • • •

ESSENTIALS

CAPITAL RECONSTRUCTION ANSWER PLAN:

Deterioration of relationship with bankers Necessity of seeking new sources or methods of obtaining finance Potential losses on long-term contracts Other factors not necessarily suggesting inability to meet debts

1. LIST THE RECONSTRUCTION PRINCIPLES A scheme is likely to be successful if it ensures that:

Internal matters

• • • • • •

loss of key management or staff significantly increasing stock levels work stoppages or other labour difficulties substantial dependence on the success of a particular project or particular asset excessive reliance on the success of a new product uneconomic long-term commitments

a) It raises adequate finance / financially viable b) No group is worst off under the scheme. c) It treats all parties fairly.

External matters

• • • • • • • 2.

2. STATE THE REASON WHY THE SCHEME IS REQUIRED

legal proceedings that may put a company out of business loss of a key franchise or patent loss of a principal supplier or customer the undue influence of a market dominant competitor political risks technical developments which render a key product obsolete frequent financial failures of enterprises in the same industry

As a result of the recent considerable losses there is inadequate funds available to finance the redemption of debentures.

3. DOES THE SCHEME RAISE ADEQUATE FINANCE?

FINANCIAL RECONSTRUCTIONS

Unprofitable businesses (debit balance on revenue reserves)

Cash in: Equity Debentures Sale of surplus assets (i.e. investments)

Profitable businesses (which run out of cash overtrading)

Total raised Total required Scheme surplus/(deficit) Current cash balance New cash balance Continue to be unprofitable

Liquidation

Take remedial action Promise of future profits

Agreement with creditors

Capital Reconstruction

Assets sold off and distributed in priority order

QP Module B (Feb 09) B – Essentials

No agreement

Cash out:(repayments) Debentures Creditors (unsecured) Working capital requirements Scheme funding Total required

X X X X (X) X/(X) X

(X) (X) (X) (X) (X)

You should state that an estimate of the incremental working capital requirements would be essential, if the question is silent on the matter.

Liquidation

Assets sold off and distributed in priority order

QP Module B (Feb 09) B – Essentials

ESSENTIALS

5. IS THE SCHEME ACCEPTABLE TO ALL PARTIES? 4. THE CAPITAL REPAYMENT POSITION – PRIORITY ORDER (a)

It is common to find in exam situations that there may not be enough funds to discharge the unsecured creditors. They end up only receiving say 60 cents per $.

(b)

The capital repayment position of the unsecured creditors will normally improve under a scheme, because the cash from the issue of new equity is used to purchase assets, on which they will have a prior claim to shareholders. General points:

X (X)

Preferential creditors – Taxes and Wages / Redundancy

Total unsecured creditors (bank o/d’s & directors loans)

(X)

Funds available to pay shareholders

Treat all the parties fairly. No party should be treated with disproportionate favour in comparison with another. This is a matter of subjective judgement. Whatever judgement you make remember to justify your answer.

(X) (X)

(X)

(X) (X)

Calculation of how much in the $ to unsecured creditors

(X) (X)

(X)

Funds available to pay unsecured creditors

The “What’s in it for me?” syndrome. Each party must be in at least as good a position after the scheme as they whether before the scheme or else they will not agree to the scheme. A secured creditor, who would receive full payment in liquidation, will have to get something extra for agreeing to the scheme e.g. a higher interest rate.

New Assets purchased (realisable value may be considerable less) Less: Secured creditors – debentures New debentures

(X) X

The likely situation in the exam is that the company will be liquidated if the scheme is not accepted. Therefore you should compare the position of each group: a) b)

Upon liquidation Under the scheme

In relation to shares and debentures it may be worthwhile to note their market value before the scheme i.e. their current exit value.

Preference shareholders (including unpaid dividends)

Approach:

(X)

6. CONCLUSION Balance of funds to ordinary shareholders

Exam focus: ‘Who gets what” The question will give you an indication of break-up asset values. Do not forget the structure of creditor priorities: 1 st:

Secured debt (including unpaid interest) : fixed charge

2 nd:

Secured debt (including unpaid interest) : floating charge

3 rd:

Taxes and unpaid wages

4 th:

Unsecured creditors (including any ‘directors loans’)

5 th:

Preference shareholders (including any unpaid dividends)

6 th:

Ordinary shareholders.

QP Module B (Feb 09) B – Essentials

Try and reach a sensible conclusion about the scheme, which is justified by your analysis. Don’t be afraid to say that you think the scheme in its current form, will not be acceptable. Suggest any possible improvements to the scheme, explaining their logic and appeal.

QP Module B (Feb 09) B – Essentials