ACCA APPROVED CONTENT PROVIDER ACCA Passcards Paper P4 Advanced Financial Management Passcards for exams from September 2015 – 31 August 2016 ACP4PC15.indd 23/03/2015 11:29 (000)ACP4PC14_FP_Ricoh.qxp 3/30/2015 5:29 PM Page i Professional Paper P4 Advanced Financial Management (000)ACP4PC14_FP_Ricoh.qxp 3/30/2015 5:29 PM First edition 2007, Eighth edition Apr il 2015 ISBN 9781 4727 2708 e ISBN 9781 4727 2773 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library Published by BPP Learning Media Ltd BPP House, Aldine Place 142-144 Uxbridge Road London W12 8AA www.bpp.com/learningmedia Printed in the UK by RICOH UK Limited Unit Wells Place Merstham RH1 3LG Your learning materials, published by BPP Learning Media Ltd, are printed on paper obtained from traceable sustainable sources Page ii All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of BPP Learning Media © BPP Learning Media Ltd 2015 (000)ACP4PC14_FP_Ricoh.qxp 3/30/2015 5:29 PM Page iii Preface Contents Welcome to BPP Learning Media’s ACCA Passcards for Professional Paper P4 Advanced Financial Management They focus on your exam and save you time They incorporate diagrams to kickstart your memory They follow the overall structure of BPP Learning Media’s Study Texts, but BPP Learning Media’s ACCA Passcards are not just a condensed book Each card has been separately designed for clear presentation Topics are self contained and can be g rasped visually ACCA Passcards are still just the right size for pockets, briefcases and bags Run through the Passcards as often as you can during your final revision period The day before the exam, try to go through the Passcards again! You will then be well on your way to passing your exams Good luck! Page iii (000)ACP4PC14_FP_Ricoh.qxp 3/30/2015 5:29 PM Page iv Preface Page 3a 3b 3c 7a 7b The role and responsibility of senior financial executive Financial strategy formulation Conflicting stakeholder interests Ethical issues in financial management Environmental issues Trading and planning in a multinational environment DCF Application of option pricing theory in investment decisions Impact of financing and APV method Valuation and free cash flows International investment decisions 17 23 25 31 41 47 51 65 73 Contents Page Acquisitions and mergers vs growth 81 10 Valuation for acquisitions and mergers 87 11 Regulatory framework and processes 99 12 Financing mergers and acquisitions 105 13–14 Reconstruction and reorganisation 111 15 The treasury function in multinationals 119 16 Hedging forex risk 123 17 Hedging interest rate risk 135 18 Dividend policy in multinationals and transfer pricing 143 19 Recent developments 149 (001)ACP4PC14_CH01.qxp 3/30/2015 5:30 PM Page 1: The role and responsibility of senior financial executive Topic List Financial management Financial planning Senior financial executives are required to make crucial decisions, including those related to investment, distribution and retention (001)ACP4PC14_CH01.qxp 3/30/2015 5:30 PM Page Financial management Financial planning Financial objectives Non-financial objectives The prime financial objective is to maximise the market value of the company’s shares Primary targets are profits and dividend growth Other targets may be the level of gearing, profit retentions, operating profitability and shareholder value indicators Non-financial objectives not negate financial objectives, but they mean that the pr imary financial objectives may be modified They take account of ethical considerations Why profit maximisation is not a sufficient objecture Risk and incertainty Profit manipulation Sacrifice of future profits? Dividend policy Examples Employee welfare Management welfare Society’s welfare Service provision Responsibilities towards customers/suppliers (001)ACP4PC14_CH01.qxp 3/30/2015 Investment decisions Investment decisions include: New projects Takeovers Mergers Sell-off/Divestment The financial manager must: Identify decisions Evaluate them Decide optimal fund allocation Page 5:30 PM Page Financing decisions Dividend decisions Financial decisions include: Long-term capital structure Need to determine source, cost and risk of long-term finance Short-term working capital management Balance between profitability and liquidity is crucial Dividend decisions may affect views of the company’s long-term prospects, and thus the shares’ market values Payment of dividends limits the amount of retained earnings available for re-investment 1: The role and responsibility of senior financial e xecutive (001)ACP4PC14_CH01.qxp 3/30/2015 5:30 PM Page Financial management Strategic planning The formulation, evaluation and selection of strategies to prepare a long-term plan of action to attain objectives Strategic decisions should be suitable, feasible and acceptable Long-term direction Matching activities to environment/resources Strategic analysis means analysing the organisation in its environment, its resources, competences, mission and objectives Strategic choice involves generating and evaluating strategic options and selecting strategy Financial planning Key elements of financial planning Long-term investment and short-term cash flow Surplus cash How finance raised Profitable Strategic cash flow management Planning involves a long horizon, uncertainties and contingency plans Strategic fund management Consideration of which assets are essential and how easily assets can be sold (001)ACP4PC14_CH01.qxp Strategic Tactical 3/30/2015 5:30 PM Page Investment Financing Dividend Selection of products/markets Target profits Purchase of major non-current assets Other non-current asset purchases Efficient/effective resource usage Pricing Debt/equity mix Growth v dividend payout Lease v buy Scrip v cash dividends Tactical planning and control Conflict may arise between strategic planning (need to invest in more expensive machinery, research and development) and tactical planning (cost control) Page 1: The role and responsibility of senior financial e xecutive (019)ACP4PC14_CH17.qxp 3/30/2015 FRAs 5:40 PM IR futures Greeks Delta – change in call option pr ice/change in value of share Gamma – change in delta value/change in value of share Theta – change in option price over time Rho – change in option price as interest rates change Vega – change in option price as volatility changes Gamma Higher for share which is close to expiry and 'at the money' Page 142 IR swaps IR options The Greeks Delta hedging determines number of shares required to create the equivalent portfolio to an option, and hence hedge it Vega is the change in value of an option (call or put) resulting from a 1% point change in its v olatility +ve gamma means that a position benefits from movement -ve theta means the position loses money if the underlying asset price does not move (020)ACP4PC14_CH18.qxp 3/30/2015 5:40 PM Page 143 18: Dividend policy in multinationals and transfer pricing Topic List Dividend policy Transfer pricing Multinational businesses operate through subsidiaries, affiliates or joint ventures in more than one countr y, and produce and sell products globally Revenues are repatriated to the parent company in the form of dividends, royalties or licence payments Overseas operations’ ability to repatriate funds can have a major impact on the parent company’s ability to pay dividends to external shareholders and finance its investment plans (020)ACP4PC14_CH18.qxp 3/30/2015 5:40 PM Page 144 Dividend policy Dividend capacity The dividend capacity of a company depends on: after tax profits, investment plans, foreign dividends Transfer pricing Dividend policy Revenue after operating costs, interest and tax + Dividends from foreign affiliates and subsidiaries – Free Cash Flow to Equity (FCFE) FCFE = Dividends that could be paid to shareholders = Net profit after tax + Depreciation + F oreign Dividends – Total Net Investment + Net debt Issuance + Net Share Issuance Net investment in non-current assets – Net investment in working capital + Net debt issued + Net equity issued (020)ACP4PC14_CH18.qxp 3/30/2015 5:40 PM Dividend repatriation Factors affecting dividend repatriation policies Financing – how much needed for dividends / investment at home? Tax – often the primary reason for the firm’s repatriation policies Managerial control – regularised dividends restrict discretion of foreign managers (so reducing agency problems) Timing – to take advantage of possible currency movements (although these are difficult to forecast in practice) Page 145 Page 145 UK companies’ subsidiaries’ foreign profits are liable to UK corporate tax, whether repatriated or not, with a credit for tax already paid to the host country Similarly, the US government does not distinguish between income earned abroad and income earned at home and gives credit to MNCs headquartered in the US for tax paid to foreign governments Collecting early (lead) payments from currencies vulnerable to depreciation and late (lag) from currencies expected to appreciate will benefit from expected movements in exchange rates 18: Dividend policy in multinationals and transfer pricing (020)ACP4PC14_CH18.qxp 3/30/2015 5:40 PM Page 146 Dividend policy Transfer prices are prices at which goods or ser vices are transferred from one process or depar tment to another or from one member of a g roup to another Transfer price bases Standard cost Marginal cost: at marginal cost or with gross profit margin added Opportunity cost Full cost: at full cost, or at a full cost plus pr ice Market price Market price less a discount Negotiated price, which could be based on any of the other bases Transfer pricing Using market value transfer prices Giving profit centre managers freedom to negotiate prices with other profit centres results in marketbased transfer prices Transfer pricing motivations Evaluation of performance of divisions Management incentives Cost allocation between divisions Financing considerations – to boost or to disguise the profitability of a subsidiar y External factors, including taxes, tariffs, rule of origin tests and exchange controls (020)ACP4PC14_CH18.qxp 3/30/2015 5:40 PM Page 147 Transfer price regulation Tax authorities often use an arm's length standard: price intra-firm trade of multinationals as if it took place between unrelated parties acting in competitive markets Method 1: use price negotiated between unrelated parties C and D as proxy for intra-firm transfer A to B C Arm’s length transfer A A Intrafirm transfer B Arm’s length transfer B Intrafirm transfer Page 147 D Method 2: use price at which A sells to unrelated party C as proxy C 18: Dividend policy in multinationals and transfer pricing (020)ACP4PC14_CH18.qxp 3/30/2015 5:40 PM Page 148 Dividend policy Arm’s length pricing methods (tangible goods) Transaction-based Comparable uncontrolled price (CUP) Resale price (RP) Cost plus (C+) Profit based Comparable profit method (CPM) Profit split (PS) PS: Common when there are no suitable product comparables (CUP) or functional comparables (RP and C+) Profits on a transaction earned by two related parties are split between the parties, usually on basis of return on operating assets: operating profits to operating assets Transfer pricing CUP: Based on a product comparable transaction, possibly between different parties but in similar circumstances – a method preferred by tax authorities RP: Tax auditor looks for firms at similar trade levels that perform a similar distribution function (a functional comparable) – method best used when distributor adds relatively little value, making it easier to estimate Profit margin derived from that earned by comparable distributors, subtracted from known retail price to determine transfer price C+: Appropriate mark-up (estimated from similar manufacturers) added to costs of production, measured using recognised accounting principles CPM: Method is based on premise of similar financial ratios and performance of companies in similar industries (021)ACP4PC14_CH19.qxp 3/30/2015 5:40 PM Page 149 19: Recent developments Topic List Developments in world financial markets Developments in international trade Developments in Islamic finance It is important to keep up to date with recent developments in the business environment This chapter focuses on such developments in world financial markets and international trade (021)ACP4PC14_CH19.qxp 3/30/2015 5:40 PM Page 150 Developments in world financial markets The credit crunch The credit crunch first became a global issue in early 2007 How the global crisis happened Billions of dollars of ‘sub-prime’ mortages in the US Rise in interest rates caused defaults on such mortgages Collateralised debt obligations (CDOs) containing sub-prime mortgages sold onto hedge funds Value of CDOs fell due to defaults Huge losses by the banks Developments in international trade Developments in Islamic finance Financial reporting Common accounting standards are increasing transparency and comparability for investors – improving capital market efficiency and facilitating cross-border investment Monetary policy In advanced economies, monetary policy has encompassed the task of controlling inflation Interest rates are commonly set by central banks independent of Government – enhancing credibility and so lowering inflation expectations A low inflation environment is conducive to longterm business planning and investment (021)ACP4PC14_CH19.qxp 3/30/2015 5:40 PM Page 151 The credit crunch and IFRS Entities must value financial assets and liabilities at ‘fair value’ Page 151 19: Recent developments (021)ACP4PC14_CH19.qxp 3/30/2015 5:40 PM Page 152 Developments in world financial markets Developments in international trade Developments in Islamic finance Tranching Where claims on cash flows are split into several classes (such as Class A, Class B) Risks of tranching Very complex May not be divided properly Rebuilding Benefits of tranching A good way of dividing risk Potential to make a lot of money from ‘junior’ tranches (021)ACP4PC14_CH19.qxp 3/30/2015 5:40 PM Page 153 Credit default swaps (CDS) allow the transfer of third party credit risk from one party to another Similar to insurance policies Credit default swaps Uses of CDS Speculation Hedging ‘Spread’ is similar to an insurance premium CDS market is unregulated Page 153 19: Recent developments (021)ACP4PC14_CH19.qxp 3/30/2015 5:40 PM Page 154 Developments in world financial markets Trends in global financial markets Integration and globalisation – fostered by liberalisation of markets and technological change; creating more efficient allocation of capital and economic growth Growth of derivatives markets – advances in technology, financial engineering and risk management have enhanced demand for more complex derivatives products Securitisation – eg sale of loan books by banks Now a common form of financing, leading to increased bond issuance Convergence of financial institutions – abolition of barriers to entry in various segments of financial services industries has led to conglomerates with operations in banking, securities and insurance Developments in international trade Developments in Islamic finance Effects of financial sector convergence Economies of scale Economies of scope: a factor of production can be employed to produce multiple products Reduced earnings volatility Reduced search costs for consumers Money laundering A side effect of globalisation and the free movement of capital has been a growth in money laundering, and there has been increased legislation and regulation to combat it (021)ACP4PC14_CH19.qxp 3/30/2015 5:40 PM Page 155 Developments in world financial markets Trade financing has become easier for companies to obtain Financing for international trade transactions includes commercial bank loans within the host country and loans from international lending agencies Trade bills may be discounted through foreign banks, for short-term financing Eurodollar financing is another method for providing foreign financing Eurodollar loans are short-term working-capital loans, unsecured and usually in large amounts The Eurobond market is widely used for long-term funds for multinational US companies In many countries, development banks provide intermediate- and long-term loans to private enterprises Page 155 Developments in international trade Delevopments in Islamic finance Regulation Globalisation creates incentives for governments to intervene in favour of domestic MNCs in respect of ‘macroeconomic’ and ‘macrostructural’ policies Pressure groups Transnationally networked pressure groups can influence the public and put pressure on governments to take measures against multinational companies 19: Recent developments (021)ACP4PC14_CH19.qxp 3/30/2015 5:40 PM Page 156 Developments in world financial markets Developments in international trade Delevopments in Islamic finance Islamic finance operates under the principle that there should be a link betw een the economic activity that creates value and the financing of that activity Advantages of Islamic finance Islamic funds are available worldwide Gharar (uncertainty, risk, speculation) is not allowed Excessive profiteering is not allowed Banks cannot use excessive leverage All parties take a long-term view Emphasis on mutual interest and co-operation Drawbacks of Islamic finance No international consensus on Sharia’a interpretations No standard Sharia’a model, which leads to higher transaction costs Additional compliance work increases transaction costs Islamic banks cannot minimise risk through hedging Some Islamic products may not be compatible with financial regulations Limited trading in Sukuk products ... BPP Learning Media © BPP Learning Media Ltd 2015 (000)ACP4PC14_FP_Ricoh.qxp 3/30/2015 5:29 PM Page iii Preface Contents Welcome to BPP Learning Media’s ACCA Passcards for Professional Paper P4. .. diagrams to kickstart your memory They follow the overall structure of BPP Learning Media’s Study Texts, but BPP Learning Media’s ACCA Passcards are not just a condensed book Each card has been separately...(000)ACP4PC14_FP_Ricoh.qxp 3/30/2015 5:29 PM Page i Professional Paper P4 Advanced Financial Management (000)ACP4PC14_FP_Ricoh.qxp 3/30/2015 5:29 PM First