Chapter 1: Financial management and financial objectives Syllabus Purpose of financial management and relationship to financial and management

accounting. Financial objectives and relationship with corporate strategy How examined -discussion question examining importance of shareholder wealth maximisation -discuss the relationship between investment/dividend/financing decisions. Use of ratio analysis to assess achievement of objectives Past Paper QSX June 2010 part c

NG Dec 2009 part b QSX June 2010 part a,b YNM June 2011 part a Bar Co Dec 2011 part b c GWW Co Dec 2012 part c Dartig Dec 2008 part e Zigto June 12 part a Bar Dec 2011 part d

Stakeholders objectives

an

impact

on

corporate

Financial and other objectives in NFP organisations

-Discussion of how to motivate managers to achieve objectives. -discussion of conflict between stakeholders Comparison of objectives of not for profit and profit seeking organisations.

QSX June 2010 Q4

(a) Year Dividend yield = dividend /share price at the start of the year Capital gain = opening closing share price(expressed as monetary amount or percentage) total shareholder return = capital gain% + dividend yield % or =(dividend paid+ monetary capital gain)/opening share price

2008 385/740 = 52% 835 740 = 95c or 128% (100 x 95/740) 100 x (95 + 385)/740 = 180% (52% + 128%)

2009 400/835 = 48% 648 835 = (187c) or (224%) (100 x 187/835) 100 x (187 + 40)/835 = 176% (48% 224%)

(i) The return on equity predicted by the CAPM The actual return for a shareholder of QSX Co, calculated as total shareholder return, is very different from the return on equity predicted by the CAPM. In 2008 the company provided a better return than predicted and in 2009 the company gave a negative return while the CAPM predicted a positive return. Year Total shareholder return ROE predicted by CAPM 2008 18% 12% 2009 -17.6% 8%

Ch13 CAPM capital asset pricing model to calculate a cost of equity and incorporate risk Because the risk-free rate of return is positive and the equity risk premium is either zero or positive, and because negative equity betas are very rare, the return on equity predicted by the CAPM is invariably positive. This reflects the reality that shareholders will always want a return to compensate for taking on risk. In practice, companies sometimes give negative returns, as is the case here. The return in 2008 was greater than the cost of equity, but the figure of 10% quoted here is the current cost of equity; the cost of equity may have been different in 2008. (ii) Other comments QSX Co had turnover growth of 3% in 2008, but did not generate any growth in turnover in 2009. EPS grew by 41% in 2008, but fell by 83% in 2009. Dividends per share also grew by 41% in 2008, but unlike earnings per share, dividend per share growth was maintained in 2009. It is common for dividends to be maintained when a company suffers a setback, often in an attempt to give reassurance to shareholders. There are other negative signs apart from stagnant turnover and falling EPS. The shareholder will be concerned about experiencing a capital loss in 2009. He will also be concerned that the decline in the price/earnings ratio in 2009 might be a sign that the market is losing confidence in the future of QSX Co. If the shareholder was aware of the proposal by the finance director to suspend dividends, he would be even more concerned. It might be argued that, in a semi-strong form-efficient market, the information would remain private. If QSX Co desires to conserve cash because the company is experiencing liquidity problems, however, these problems are likely to become public knowledge fairly quickly, for example through the investigations of capital market analysts. Year PE= Closing share price/EPS Dividend cover= EPS/dividend per share EPS growth Dividend per share growth Turnover growth 2009 $6.48/58.9c = 11 times 58.9c/40c = 1.5 times =(64.2-58.9)/64.2= -8.3% 3.9% nil 2008 $8.35/64.2c = 13 times 64.2c/38.5c = 1.7 times 4.1% 4.1% 3% 2007 61.7c/37c = 1.7 times

(b) Ch15 dividend growth model: can be used to estimate a cost of equity, on the assumption that the market value of share is directly related to the expected future dividends from the shares Historical dividend growth rate = (40/37)05 1 = 004 or 4% per year 0.04054054+0.038961038/2 = 4% Share price using dividend growth model = (40 x 104%)/(10% 4%) = 693c or $693 p.257

In three years time, the present value of the dividends received from the fourth year onwards can be calculated by treating the fourth-year dividend as D1 in the dividend growth model and assuming that the cost of equity remains unchanged at 10% per year. Applying the dividend growth model in this way gives the share price in three years time: Share price = 70/(01 003) = 1,000c or $1000. For comparison purposes this share price must be discounted back for three years: Share price = 0751 x 1000 = $751. The current share price of $648 is less than the share price of $693 calculated by the dividend growth model, indicating perhaps that the capital market believes that future dividend growth will be less than historic dividend growth. The share price resulting from the proposed three-year suspension of dividends is higher than the current share price and the share price predicted by the dividend growth model. However, this share price is based on information that is not public and it also relies on future dividends and dividend growth being as predicted. It is very unlikely that a prediction as tentative as this will prove to be accurate. (c) Investment decisions, dividend decisions and financing decisions have often been called the decision triangle of financial management. The study of financial management is often divided up in accordance with these three decision areas. However, they are not independent decisions, but closely connected. For example, a decision to increase dividends might lead to a reduction in retained earnings and hence a greater need for external finance in order to meet the requirements of proposed capital investment projects. Similarly, a decision to increase capital investment spending will increase the need for financing, which could be met in part by reducing dividends. The question of the relationship between the three decision areas was investigated by Miller and Modigliani. They showed that, if a perfect capital market was assumed, the market value of a company and its weighted average cost of capital (WACC) were independent of its capital structure. The market value therefore depended on the business risk of the company and not on its financial risk. The investment decision, which determined the operating income of a company, was therefore shown to be important in determining its market value, while the financing decision, given their assumptions, was shown to be not relevant in this context. In practice, it is recognised that capital structure can affect WACC and hence the market value of the company. Miller and Modigliani also investigated the relationship between dividend policy and the share price of a company, i.e. the market value of a company. They showed that, if a perfect capital market was assumed, the share price of a company did not depend on its dividend policy, i.e. the dividend decision was irrelevant to value of the share. The market value of the company and therefore the wealth of shareholders were shown to be maximised when the company implemented its optimum investment policy, which was to invest in all projects with a positive NPV. The investment decision was therefore shown to be theoretically important with respect to the market value of the company, while the dividend decision was not relevant. In practice, capital markets are not perfect and a number of other factors become important in discussing the relationship between the three decision areas. Pecking order theory, for example, suggests that managers do not in practice make financing decisions with the objective of obtaining an optimal capital structure, but on the basis of the convenience and relative cost of different sources of finance. Retained earnings are the preferred source of finance from this perspective, with a resulting pressure for annual dividends to be lower rather than higher. NG Dec 2009 part b NG Co has exported products to Europe for several years and has an established market presence there. It now plans to increase its market share through investing in a storage, packing & distribution network. The investment will cost 13 million and is to be financed by equal amounts of equity and debt. The return in euros before interest and taxation on the total amount invested is forecast to be 20% per year.

The debt finance will be provided by a 65 million bond issue on a large European stock market. The interest rate on the bond issue is 8% per year, with interest being payable in euros on a six-monthly basis. The equity finance will be raised in dollars by a rights issue in the home country of NG Co. Issue costs for the rights issue will be $312,000. The rights issue price will be at a 17% discount to the current share price. The current share price of NG Co is $400 per share and the market capitalisation of the company is $100 million. (Market value of outstanding shares) NG Co pays taxation in its home country at a rate of 30% per year. The currency of its home country is the dollar. The current price/earnings ratio of the company, which is not expected to change as a result of the proposed investment, is 10 times. The spot exchange rate is 13000 /$. All European customers pay on a credit basis in euros. (a) Calculate the theoretical ex rights price per share after the rights issue. (4 marks) Amount of equity finance to be invested (euros) = 13m/2 = 65 million Amount of equity to be invested (dollars) = 65m/13000 = $5 million The amount of equity finance to be raised (dollars) = 5m + 0312m RI = $5312m Rights issue price = 400 x 083(100%-17%) = $332 per share Number of new shares issued = 5312m/332 = 16 million shares Current ordinary shares = $100m/400 = 25 million shares After the rights issue = 25m + 16m = 266 million shares Theoretical ex rights price = ((25m x 4) + (16m x 332))/266 = 105312/266 = $396 per share (b) Evaluate the effect of the European investment on: (i) the earnings per share of NG Co; and (ii) the wealth of the shareholders of NG Co. Assume that the current spot rate and earnings from existing operations are both constant. (9 marks) (i) Effect on earnings per share Current EPS = 400/10 = 40 cents per share (Alternatively, current PAT = MV/PE=100m/10 = $10 million Current EPS = 10m/25m = 40 cents per share) EPS = Profit distributed to ordinary shareholders/weighted average number of ordinary shareholders PE = Market value per share/EPS Increase in profit before interest and tax = 13m x 02 = 2,600,000 Dollar increase in profit before interest and tax = 2,600,000/13000 = $2 million Increase in PBIT Increase in interest 6.5m*8% Increase in PBT Tax 2.08m*30% Increase in PAT Current PAT 100m/10 Revised PAT 000 2,600 520 2,080 624 1,456 /1.3 = $1,120 $10,000 $11,120

Revised EPS = 11.12m/26.6m(a)=41.8c/share (ii) Effect on shareholder wealth Share price = $418 per share This should be compared to the theoretical ex rights price per share in order to evaluate any change in shareholder wealth.

The investment produces a capital gain of 22 cents per share ($418 $396(a)) In the absence of any information about dividend payments, it appears that the investment will increase the wealth of shareholders.

YNM June 2011 part a

Interest cover = PBIT/interest total shareholder return = capital gain(share price growth)% + dividend yield%

or =(dividend paid+ monetary capital gain)/opening share price dividend yield = dividend per share/ share price

Bar Co Dec 2011 part b c

4 (a) Theoretical ex rights price Rights issue price = 750 x 08(20% discount) = $600 per share Number of shares issued = $90m/600 = 15 million shares Number of shares currently in issue = 60 million shares RI: 1 for 4 basis

Theoretical ex rights price = ((4 x 750) + (1 x 600))/5 = $720 per share

(b) Financial acceptability to shareholders of buying back bonds The financial acceptability to shareholders of the proposal to buy back bonds can be assessed by calculating whether shareholder wealth is increased or decreased as a result. The bonds are being bought back by Bar Co at their market value of $11250 per bond, rather than their nominal value of $100 per bond. The total nominal value of the bonds redeemed will therefore be less than the $90 million spent redeeming them.

Nominal value of bonds redeemed = 90m x (100/11250) = $80 million Interest saved by redeeming bonds = 80m x 008 = $64 million per year

EPS will be affected by the redemption of the bonds and the issue of new shares. Revised PBT = 49m (10m 64m interest) = $454 million Revised PAT (earnings) = 454m x 07 tax = $3178 million . Revised EPS = (3178m/75m) = 4237 cents per share
Current EPS = 100 x (27m/60m) = 45 cents per share Current PE ratio = 750/45 = 167 times The revised EPS can be used to calculate a revised share price if the PE ratio is assumed to be constant. PE=Share price/EPS Revised share price = PE constant x EPS revised =167 x 4237 = 708 cents or $708 per share This share price is less than the theoretical ex rights price per share ($720) and so the effect of using the rights issue funds to redeem the bonds is to decrease shareholder wealth. From a shareholder perspective, therefore, this use of the funds cannot be recommended. However, this conclusion depends heavily on the assumption that the PE ratio remains constant, as this ratio was used to calculate the revised share price from the revised earning per share. In reality, the share price after the redemption of bonds will be set by the capital market and it is this market-determined share price that will determine the PE ratio, rather than the PE ratio determining the share price. Since the financial risk of Bar Co has decreased following the redemption of bonds, the cost of equity is likely to fall and the share price is likely to rise, leading to a higher PE ratio. If the share price increases to above the theoretical ex rights price per share, corresponding to an increase in the PE ratio to more than 17 times (720/4237), shareholders will experience a capital gain and so using the cash raised by the rights issue to buy back bonds will become financially acceptable from their perspective. (c) Current interest coverage ratio = 49m/10m = 49 times Revised interest coverage ratio = 49m/(10m 64m) = 49m/36m = 136 times Current debt/equity ratio = 100 x (125m/140m) = 89% Revised book value of bonds = 125m 80m = $45 million Revised book value of equity = 140m + 90m 10m = $220 million A loss of $10 million is deducted here because $90 million has been spent to redeem bonds with a total nominal value (book value) of $80 million. Revised debt/equity ratio = 100 x (45m/220m) = 205% Redeeming bonds with a book value of $80m has reduced the financial risk of Bar Co, as shown by the significant reduction in gearing from 89% to 205%, and by the significant increase in the interest coverage ratio from 49 times to 136 times. Examiners note: full credit would be given to a revised gearing calculation (196%) that omits the loss due to buying back bonds at a premium to nominal value.

(d) A key financial objective for a stock exchange listed company is to maximise the wealth of shareholders. This objective is usually replaced by the objective of maximising the companys share price, since maximising the market value of the company represents the maximum capital gain over a given period. The need for dividends can be met by recognising that share prices can be seen as the sum of the present values of future dividends. Maximising the companys share price is the same as maximising the equity market value of the company, since equity market value (market capitalisation) is equal to number of issued shares multiplied by share price. Maximising equity market value can be achieved by maximising net corporate cash income and the expected growth in that income, while minimising the corporate cost of capital. Listed companies therefore have maximising net cash income as a key financial objective. Not-for-profit (NFP) organisations seek to provide services to the public and this requires cash income. Maximising net cash income is therefore a key financial objective for NFP organisations as well as listed companies. A large charity seeks to raise as much funds as possible in order to achieve its charitable objectives, which are non-financial in nature. Both listed companies and NFP organisations need to control the use of cash within a given financial period, and both types of organisations therefore use budgets. Another key financial objective for both organisations is therefore to keep spending within budget. The objective of value for money (VFM) is often identified in connection with NFP organisations. This objective refers to a focus on economy, efficiency and effectiveness. These three terms can be linked to input (economy refers to securing resources as economically as possible), process (resources need to be employed efficiently within the organisation) and output (the effective use of resources in achieving the organisations objectives). Described in these terms, it is clear that a listed company also seeks to achieve value for money in its business operations. There is a difference in emphasis, however, which merits careful consideration. A listed company has a profit motive, and so VFM for a listed company can be related to performance measures linked to output, e.g. maximising the equity market value of the company. An NFP organisation has service-related outputs that are difficult to measure in quantitative terms and so it focuses on performance measures linked to input, e.g. minimising the input cost for a given level of output. Both listed companies and NFP organisations can use a variety of accounting ratios in the context of financial objectives. For example, both types of organisation may use a target return on capital employed, or a target level of income per employee, or a target current ratio. Comparing and contrasting the financial objectives of a stock exchange listed company and a notfor-profit organisation, therefore, shows that while significant differences can be found, there is a considerable amount of common ground in terms of financial objectives.

GWW Co Dec 2012 part c

(c) (i) Calculation of market value of bond The market value of the bond is the present value of the future cash flows from the bond, discounted at the before-tax cost of debt. Market value of bond = (8 x 5582) + (100 x 0665) = 4466 + 6650 = $11116 (ii) Debt/equity ratio (book value basis) D/E = 100 x 250/672 = 372% (iii) Debt/equity ratio (market value basis) Market value of debt = 250 x 11116/100 = $278 million Market value of equity = 400 x 200/05 = $1600 million D/E = 100 x 278/1600 = 174% Debt/equity ratio and assessing financial risk Financial risk relates to the variability in shareholder returns (profit after tax or earnings) that is caused by the use of debt in a companys capital structure. The debt/equity ratio is therefore useful in assessing financial risk as it measures the relative proportion of debt to equity. Financial risk will increase as the debt/equity ratio increases, whether the ratio uses a book value basis or a market value basis. In assessing financial risk, however, the debt/equity ratio, like other accounting ratios, needs a basis for comparison. It is often said that a ratio in isolation has no meaning. In assessing financial risk, therefore, the trend over time in a companys debt/equity ratio can be considered, a rising trend indicating increasing financial risk. A comparison can also be made with the debt/equity ratios of similar companies, or with sector average debt/equity ratio, in order to assess relative financial risk. Since financial risk relates to the variability in shareholder returns in the income statement, another commonly used way of assessing financial risk is the interest coverage ratio, sometimes calculated as interest gearing. This can be a more sensitive measure of financial risk than the debt/equity ratio, in that it can indicate when a company is experiencing increasing difficulty in meeting its interest payments. It should be noted that difficulty in meeting interest payments can be a problem even when the debt/equity ratio is low.