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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 1 PRIVATE V PUBLIC SECTOR OBJECTIVES

(a)Financial objectives

(i)State owned enterprise

(1)The overall objective is commonly to fulfil a social need.

(2)Because of problems of measuring attainment of social needs the government usually sets specific targets in accounting terms.

(3)Examples include target returns on capital employed, requirement to be self financing, cash or budget limits.

(ii)Private sector

(1)The firm has more freedom to determine its own objectives.

(2)A stock market quotation will mean that return to shareholders becomes an important objective.

(3)Traditionally financial management sees firms as attempting to maximise shareholder wealth. Note that other objectives may exist, e.g. social responsibilities, and the concept of satisficing various parties are important.

(b)Strategic and operational decisions

The major change in emphasis will be that decisions will now have to be made on a largely commercial basis. Profit and share price considerations will become paramount. The following are examples of where significant changes might occur.

Financing decisions. The firm will have to compete for a wide range of sources of finance. Choices between various types of finance will now have to be made, e.g. debt versus equity.

Dividend decision. The firm will now have to consider its policy on dividend payout to shareholders.

Investment decision. Commercial rather than social considerations will become of major importance. Diversifications into other products and markets will now be possible. Expansion by merger and takeover can also be considered.

Threat of takeover. If the government completely relinquishes its ownership it is possible that the firm could be subject to takeover bids.

Other areas. Pricing, marketing, staffing etc will now be largely free of government constraints.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Answer 2 AGENCY RELATIONSHIPS

Agency relationships exist when one or more persons, the principal(s), hire another person, the agent, to perform some task on his (or their) behalf. The principal will delegate some decision-making authority to the agent. The problems of agency relationships occur when there is a conflict of interest between the principal(s) and the agent.

(a)Shareholders and managers

As the manager’s share of total equity decreases (the divorce of ownership and control) the cost to him of decisions that are not optimal for other shareholders also decreases. Examples of possible conflict include the following.

Managers might not work industriously to maximise shareholder wealth if they feel that they will not fairly share in the benefits of their labours.

There might be little incentive for managers to undertake significant creative activities, including looking for profitable new ventures or developing new technology.

Managers might award themselves high salaries or “perks”.

Managers might take a more short-term view of the firm’s performance than the shareholders would wish.

(b)Shareholders and creditors

Creditors (including the lenders of loan finance) provide funds for a company on the basis of the company’s assets, gearing levels and cash flow (both present and anticipated). If the managers take on more risky projects than expected by the creditors, the burden of the extra risk will fall largely upon the creditors. Conversely, if the risky investments were successful, the benefits would accrue to the shareholders.

If gearing is increased, the providers of “old debt” will face a greater risk of the company getting into financial distress or going into liquidation.

In order to try to ensure that managers act in the best interests of shareholders, the shareholders incur agency costs. Such costs include:

(1)cost of monitoring management actions, e.g. management audit

(2)cost of structuring corporate organisations to minimise undesirable management actions.

If the remuneration of management is partially a function of the success of the firm, then conflict of interest should be reduced. This might involve share option schemes, performance shares (e.g. based on earnings per share) and profit based salaries or bonuses.

The threat of firing (including the board being “deposed” by discontented shareholders) is suggested to be an incentive for efficient management, as is the possibility of job loss if a company’s share price through management action is low and a takeover occurs.

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

It has been suggested that the nature of the managerial labour market negates much of the agency problem. A manager’s wealth is made up of present wealth plus the present value of future income. The better the manager’s performance, the higher the company’s share price, and the greater the salary, both now and in the future, the manager can obtain. The manager’s desire for wealth maximisation will tend to cause him to act in the shareholders’ interests.

The main way in which creditors might protect themselves against conflicts of interest with shareholders is to insist on restrictive covenants being incorporated into loan agreements. Such covenants might restrict the level of additional debt finance that might be raised, or prevent management (here acting on the shareholders’ behalf) from disposing of major fixed assets without the agreement of the providers of debt, or restrict the level of dividends that can be paid. Additionally, if creditors perceive that they are being unfairly treated, they can either refuse to provide further credit, or only agree to provide future credit at higher than normal rates, both of which are likely to have adverse effects on shareholder wealth, and are deterrents to managers acting unfairly against the creditors’ interests.

Answer 3 STOCK MARKET EFFICIENCY

The efficient market hypothesis is often considered in terms of three levels of market efficiency.

Weak form efficiency

Semi-strong form efficiency

Strong form efficiency

The accuracy of the statement in the question depends in part upon which form of market efficiency is being considered. The first sentence states that all share prices are correct at all times. If “correct” means that prices reflect true values (the true value being an equilibrium price which incorporates all relevant information that exists at a particular point in time), then strong form efficiency does suggest that prices are always correct. Weak and semi-strong prices are not likely to be correct as they do not fully consider all information (e.g. semi-strong efficiency does not include inside information). It might be argued that even strong form efficiency does not lead to correct prices at all times as, although an efficient market will react quickly to new relevant information, the reaction is not instant and there will be a short period of time when prices are not correct.

The second sentence in the statement suggests that prices move randomly when new information is publicly announced. Share prices do not move randomly when new information is announced. Prices may follow a random walk in that successive price changes are independent of each other. However, prices will move to reflect accurately any new relevant information that is announced, moving up when favourable information is announced, and down with unfavourable information. If strong form efficiency exists, prices might not move at all when new information is publicly announced, as the market will already be aware of the information prior to public announcement and will have already reacted to the information.

Information from published accounts is only one possible determinant of share price movement. Other include the announcement of investment plans, dividend announcements, government changes in monetary and fiscal policies, inflation levels, exchange rates and many more.

Fundamental and technical analysts play an important role in producing market efficiency. An efficient market requires competition among a large number of analysts to achieve “correct” share prices, and the information disseminated by analysts (through their companies) helps to fulfil one of the requirements of market efficiency, i.e. that information is widely and cheaply available.

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

An efficient market implies that there is no way for investors or analysts to achieve consistently superior rates of return. This does not say that analysts cannot accurately predict future share prices. By pure chance some analysts will accurately predict share prices. However, the implication is that analysts will not be able to do so consistently. The same argument may be used for corporate financial managers. If, however, the market is only semi-strong efficient, then it is possible that financial managers, having inside information, would be able to produce a superior estimate of the future share price of their own companies and that if analysts have access to inside information they could earn superior returns.

Answer 4 COST OF CAPITAL

(a)Cost of debt (pre-corporation tax)

££1085 + 11.76%

We need to find the IRR of the following cash flows.

=23%

As redeemable at current market price, then

£10

£100

Irredeemable 65p5p + 7.7%

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

(d)Dividend valuation model

= £0.10 × 10,000 × 3.352 + £0.10×10,000×(1.05) × 0.497 (0.15−0.05)

= £8,570 Per share ≈ 0.86

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STUDY QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Answer 5 KELLY PLC

(a)Six-monthly gross redemption yield

This is found as the IRR of the following cash flows.

≈5.6%

(b)Redemption date and effective annual gross redemption yield

Kelly plc will presumably choose the option which minimises the effective cost (based on similar IRR calculations) of the loan stock to itself.

(i)Redeem 19X8

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ADVANCED FINANCIAL MANAGEMENT (P4) – STUDY QUESTION BANK

Therefore Kelly will redeem the loan stock in July 19X8. The effective annual gross redemption yield is (1.05)2 – 1 = 10.25%.

(c)Price of debentures on 1 July 19X5

The value at 1 October 19X5 is the present value, at 6%, of two cash flows.

(i)Interest - nine interest payments of £3 plus £3 due on 1 October 19X5.

(ii)Redemption - £100 in nine half years’ time.

=£80.23

(d)Factors influencing the market price of issued corporate debentures

The market price of a corporate debenture will be equal to the present value of the expected future interest payments plus the present value of the amount due on redemption. Since the coupon rate of the loan stock and the terms for redemption will be known with certainty, the price is largely a function of the discount rate applied to the future cash flows.

Generally it is agreed that the discount rate used to capitalise an anticipated cash flow stream is a function of the risk-free rate and a premium for risk. The risk-free rate is often taken to be the return on Government stock. Strictly speaking, Government stock is not risk-free; it is default-free. Whist there is no realistic possibility that the Government will not meet its obligations to pay interest and redemption of capital, there is a risk for the holders of Government stock, since their returns, in real terms, are influenced by the rate of inflation.

Therefore, the required return from a corporate debenture, and hence its market value, is a function of

the true “risk-free” rate

a premium for inflation

a premium for risk.

Each of these will now be considered in turn.

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