seminar5materials / P4AFM-RQB_PDF_d08 / P4AFM-RQB-As_d08

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(c)

A developing country that had recently joined the WTO would be expected to gradually reduce any barriers to trade of its goods and services. However, because it is a developing country it would be permitted a much longer time to undertake such measures. The effect on multinational companies could vary. If the multinational currently takes advantage of protectionist barriers that exist in the country, such barriers would be gradually removed exposing the multinational to more competition.

However, freer trade might facilitate the expansion of the multinational’s exports into more markets and stimulate demand for its products. In either case the multinational company would normally have a considerable period of time in which to modify its operations in response to the reduction in barriers to trade.

Answer 65 GOVERNANCE

Corporate governance is the system by which companies are directed and controlled. In the UK the board of directors of a company is responsible for the company’s governance. Shareholders have the responsibility to appoint a board of directors and the auditors of a company, and to be satisfied that an appropriate governance structure exists. The board of directors is responsible for the development and implementation of strategic plans, supervising management and reporting to shareholders on the progress of the company. External auditors provide the shareholders with an objective check on the accuracy and basis of the financial statements that are produced by the directors.

The directors formally act on behalf of shareholders, but have a duty to take into account the interests of other groups such as the company’s employees. Although directors are subject to laws, and to company regulations as defined by the articles of association, there is less emphasis in the UK on control by legislation than in the US. The Cadbury Report in the UK suggested that corporate governance be improved by a voluntary code of best practice. Voluntary codes are also contained with the UK Financial Services Act. In the US, although the Board of Directors and auditors have similar functions to the UK, and are appointed in a similar manner, the amount of legislation affecting directors is much greater than in the UK. Additionally reporting requirements set by the Securities and Exchange Commission (SEC) are more detailed than those existing in the UK. It is also more common in the US for major liabilities and the chief executive officers of other companies to be represented on boards of directors.

Governance in Japan reflects the different corporate culture that exists in that country. There is no detailed framework of regulation relating to corporate governance. The system works more on consensus, via a process of negotiation, compromise and agreement. All stakeholders in Japanese companies are expected to work together in the best interests of the company, in contrast to directors working in the primary interest of the shareholders in the UK and US. Japan is often said to have a more flexible and responsive system of governance.

Three different types of boards of directors often exist:

Policy boards, responsible for long-term strategy

Functional boards, formed from senior executives with the main functional responsibilities

Monocratic boards, which are more symbolic boards with few significant responsibilities.

A very close relationship exists between banks and the corporate sector, with banks commonly represented on boards of directors where they take an active role in the decision-making process.

1131

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Answer 66 GOAL CONGRUENCE

Goal congruence refers to the situation where the goals of different groups coincide. In many companies there are potential conflicts of objectives between the owners of the company, the shareholders, and their agents, the managers of the company. Other interest groups such as liabilities, the government, employees, and the local community might also have conflicting objectives to the company’s shareholders.

One way by which managers, and sometimes employees in general, might be motivated to take decisions/engage in actions which are consistent with the goals of the shareholders is through ESOPs. ESOPs will not, however, assist in encouraging goal congruence between other interest groups and the shareholders and managers.

ESOPs allow managers to purchase a company’s shares at a fixed price during a specified period of time in the future, usually a period of years. They are aimed at encouraging managers to take decisions which will result in high NPV projects, which will lead to an increase in share price and shareholder wealth. The managers are believed to seek high NPV investments as they, as shareholders, will participate in the benefits as share prices increase.

There is, however, little evidence of a positive correlation between share option schemes and the creation of extra share value. There is no guarantee that ESOPs will achieve goal congruence. Share options will only be part of the total remuneration package and may not be the major influence on managerial decisions. If share prices fall managers do not have to purchase the shares, and the value of the option to buy shares becomes worthless or very small. This means that managers face less risk than shareholders as they have an option which may be exercised if things go well, but may be ignored if things go badly. Shareholders have to face both circumstances. Managers may be rewarded when share prices increase due to factors that have nothing to do with their managerial skills. Additionally ESOP schemes often base reward in part upon earnings per share, an accounting ratio which, at least in the short term, is subject to manipulation by managers to their advantage. Although ESOPs may assist in the achievement of goal congruence, they are by no means a perfect solution.

Answer 67 UK PLC

(a)

This suggested answer focuses upon the UK Combined Code. Answers which include comments on how points (i) – (vi) might comply with other corporate governance systems are equally acceptable.

Many aspects of the extracts would not comply with corporate governance systems such as the UK Combined Code guidelines. Specifically:

(i)It is correct to say that all audit fees, and fees for other services provided by auditors should be fully disclosed. However, it is recommended that the partner(s) responsible for the audit should be regularly changed so that the audit is perceived to be more objective, and there is less chance of missing important anomalies in the audit process.

(ii)No executive directors should be members of this committee. The remuneration committee should be comprised entirely of non-executive directors, who should objectively determine executive remuneration and individual packages for each executive director.

1132

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

(iii)A balance of power and authority should exist within companies; the same person should not normally hold the Chairman and Chief Executive positions. If the same person does hold both positions there should be a strong independent element in the Board of Directors limiting the power of such a person.

(iv)The disclosure of whether principles of good corporate governance have been applied is not normally enough; companies should also fully explain how such principles have been applied.

(v)There is a requirement for directors to meet regularly and to retain full and effective control over the company. It is doubtful if anyone holding so many Directorships, whether executive or non-executive, could devote sufficient time to each company to effectively fulfil their responsibilities.

(vi)This is likely to comply with the Combined Code. Regular reporting on the effectiveness of the company’s system of internal control would normally be a requirement of any system of corporate governance.

(b)Report on Corporate Governance in the US, Germany and Japan.

The broad principles of corporate governance are similar in the UK, the US and Germany, but there are significant differences in how they are applied and institutionalised.

US

There are many similarities between corporate governance in the UK and US. However, whereas the UK has historically relied upon a system of self-regulation and voluntary codes of best practice, the US corporate governance structure is more formalised, often with legally enforceable controls. Examples include the rules laid down by the Securities and Exchange Commission and FASB (the Financial Accounting Standards Board). Managers must be careful to comply with regulations to avoid possible legal action against the company.

Germany

As both the UK and Germany are members of the EU, they must both follow EU directives on company law. The main difference that exists is that the UK has a unitary board, whereas most German companies have a two-tier board of directors.

The Supervisory Board (Aufsichtsrat) has responsibly for corporate policy and strategy, and the Management Board (Vorstand) responsibility primarily for the day to day operations of the company. The composition of the supervisory board typically includes representatives from major banks that have historically been large providers of long-term finance to German companies. The Aufsichtsrat does not have full access to financial information, is meant to take an unbiased overview of the company, and is the main body responsible for safeguarding the external stakeholders’ interests. The presence on the supervisory board of representatives from banks and often trade unions may introduce perspectives that are not present in some UK boards.

Japan

Although there are signs of change in Japanese corporate governance, much of the system is based upon negotiation or consensual management rather than a legal or even a selfregulatory framework. As in Germany, banks have a significant influence, as have representatives of other external companies as shareholders. It is not uncommon for Japanese companies to have cross holdings of shares with their suppliers, customers, banks etc. all being represented on each others boards.

1133

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

There are often three boards of directors: Policy Boards, responsible for strategy and comprised of directors with no functional responsibility, Functional Boards, responsible for day to day operations, and largely symbolic Monocratic Boards. The interests of the company as a whole should dictate the actions of the boards. This is in contrast to the UK or US systems where, at least in theory, the board should act primarily in the best interests of the shareholders, the owners of the company.

The consensual management style should be respected even though at times decision-making might seem slow.

Answer 68 CONFLICTS

(a)

Bondholders are concerned that payments of interest and repayments of principal are made on time and without problems. The willingness of bondholders to provide funds to companies depends upon the risks and returns that they face, including the companies’ expected cash flows, assets (including available security on assets), and credit ratings. Shareholders, in theory, seek to maximise the value of their shares. This is not necessarily consistent with the interests of bondholders, or the incentive to maximise the total value of the company (the value of equity plus debt). Shareholders seeking to maximise their wealth might take actions that are detrimental to bondholders. For example, shareholders, normally through their agents, managers, might use the finance provide by bondholders to invest in very risky projects, which change the character of the risk that the bondholders face. If the risky projects are successful, then the rewards flow primarily to the shareholders. If the projects fail then much of the cost of failure will fall on the bondholders. If there are no constraints on shareholders, the shareholders might have a natural incentive to take such risks. Management, acting on behalf of shareholders, might also reduce the wealth, and/or increase the risk of bondholders by:

(i)Selling off assets of the company;

(ii)Paying large dividends;

(iii)Borrowing additional funds that rank above existing bonds in terms of prior payment upon liquidation.

The incentive for shareholders to take on risks at bondholders’ expense is especially strong when the company is in financial difficulties and in danger of failing. In such circumstances the shareholders may believe that they have little to lose by undertaking risky projects. In the case of corporate failure significant “bankruptcy costs” normally exist. Direct costs of bankruptcy include receivers and lawyers’ fees, whilst indirect costs might include loss of cash flow prior to failure through loss of sales, worse credit terms etc. When corporate failure occurs most of the firm’s value will be transferred to its debt holders who ultimately bear most of the bankruptcy costs.

(b)Bond covenants might include:

An asset covenant. This would govern the company’s acquisition, use and disposal of assets. This could be for specified types of assets, or assets in general.

Financing covenant. This covenant often defines the type and amount of additional debt that the company can issue, and its ranking and potential claim on assets in case of future default.

1134

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Dividend covenant. A dividend covenant restricts the amount of dividend that the company is able to pay. Such covenants might also be extended to share repurchases.

Financial ratio covenants, fixing the limit of key ratios such as the gearing level, interest cover, net working capital, or a minimum ratio of tangible assets to total debt.

Merger covenant, restricting future merger activity of the company.

Investment covenant, concerned with the company’s future investment policy.

Sinking fund covenant whereby the company makes payments, typically to the bond trustees, who might gradually repurchase bonds in the open market, or build up a fund to redeem bonds.

There will often also be a “bonding covenant” that describes the mechanisms by which the above covenants are to be monitored and enforced. This often includes an independent audit and the appointment of a trustee representing the interests of the bondholders

From the company’s perspective the major disadvantage of covenants is that they restrict the freedom of action of the managers, and could prevent viable investments, or mergers from occurring. They also necessitate monitoring and other costs. However, covenants are also of value to companies. Without covenants the company might not be able to raise as much funds in the form of debt, as lenders would not be prepared to take the risk. Even if lenders were to take the risk they would require a higher default premium (higher interest rates) in order to compensate for the risk. The existence of covenants therefore reduces the cost of borrowing for a company.

Answer 69 ETHICS

Non-financial issues, ethical and environmental issues in many cases overlap, and have become of increasing significance to the achievement of primary financial objectives such as the maximisation of shareholder wealth. Most companies have a series of secondary objectives that encompass many of these issues.

Traditional non-financial issues affecting companies include:

Measures that increase the welfare of employees such as the provision of housing, good and safe working conditions, social and recreational facilities.

These might also relate to managers and encompass generous perquisites.

Welfare of the local community and society as a whole. This has become of increasing significance, with companies accepting that they have some responsibility beyond their normal stakeholders in that their actions may impact on the environment and the quality of life of third parties.

Provision of, or fulfilment of, a service. Many organisations, both in the public sector and private sector provide a service, for example to remote communities, which would not be provided on purely economic grounds.

Growth of an organisation, which might bring more power, prestige, and a larger market share, but might adversely affect shareholder wealth.

1135

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Quality. Many engineering companies have been accused of focusing upon quality rather than cost effective solutions.

Survival. Although to some extent linked to financial objectives, managers might place corporate survival (and hence retaining their jobs) ahead of wealth maximisation. An obvious effect might be to avoid undertaking risky investments.

Ethical issues of companies have been brought increasingly into focus by the actions of Enron and others. There is a trade-off between applying a high standard of ethics and increasing cash flow or maximisation of shareholder wealth. A company might face ethical dilemmas with respect to the amount and accuracy of information it provides to its stakeholders. An ethical issue attracting much attention is the possible payment of excessive remuneration to senior directors, including very large bonuses and “golden parachutes”.

Should bribes be paid in order to facilitate the company’s long-term aims? Are wages being paid in some countries below subsistence levels? Should they be? Are working conditions of an acceptable standard? Do the company’s activities involve experiments on animals, genetic modifications etc? Should the company deal with or operate in countries that have a poor record of human rights? What is the impact of the company’s actions on pollution or other aspects of the local environment?

Environmental issues might have very direct effects on companies. If natural resources become depleted the company may not be able to sustain its activities, weather and climatic factors can influence the achievement of corporate objectives through their impact on crops, the availability of water etc. Extreme environmental disasters such as typhoons, floods, earthquakes, and volcanic eruptions will also impact on companies’ cash flow, as will obvious environmental considerations such as the location of mountains, deserts, or communications facilities. Should companies develop new technologies that will improve the environment, such as cleaner petrol or alternative fuels? Such developments might not be the cheapest alternative.

Environmental legislation is a major influence in many countries. This includes limitations on where operations may be located and in what form, and regulations regarding waste products, noise and physical pollutants.

All of these issues have received considerable publicity and attention in recent years. Environmental pressure groups are prominent in many countries; companies are now producing social and environmental accounting reports, and/or corporate social responsibility reports. Companies increasingly have multiple objectives that address some or all of these three issues. In the short term non-financial, ethical and environmental issues might result in a reduction in shareholder wealth; in the longer term it is argued that only companies that address these issues will succeed.

Answer 70 REMUNERATION

(a)

The suggestion by the managing director is intuitively attractive in that most companies believe they need to attract the best managers, and high remuneration is necessary to achieve this. Whilst this may be the case the link between a high salary and managerial performance is not proven. Paying more than the current “going rate” also has the effect of leading to continuing increases in senior management salaries, which might be unpopular with shareholders, employees and other stakeholders. There is also no suggestion of remuneration linked to performance.

1136

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

Suggestion (ii), linking salary to turnover, is probably the least credible. Although sales growth and market share might be important, this should not be at the expense of cash flow and wealth creation. An extreme example would be that turnover, and hence the managing director’s remuneration, could be increased by halving the price of the company’s products. This is not, however, very likely to create wealth.

Suggestion (iii) relates to share options, which have been commonly used by companies for many years. They are intended to motivate senior managers to take decisions that will result in share price increases and wealth creation, and goal congruence between shareholders and managers. To some extent they may achieve this, but potential problems are:

(i)Share price increases may be caused by factors outside of the control of managers, yet they will still be rewarded for such increases

(ii)The appropriate size of the option package is difficult to determine.

Many large companies have recently been criticised for offering share options deals that are too generous.

Suggestion (iv) relates to EVA®. Economic value added measures the annual wealth creation after taking into account a charge for the amount of capital employed. Remuneration schemes linked to EVA® are intended to reward the creation of value to the organisation. This is a valid objective, but EVA® is not suitable for all types of organisation (e.g. financial services companies), and may be creatively increased by relatively low levels of investment – at least in the short term. If an EVA® based incentive scheme is to be used it might be better to base it on a percentage of the incremental EVA® achieved by the new managing director rather than a percentage of the total EVA®.

(b)

The value of a call option on a share may be estimated using the put-call parity theorem, PP = PC – PS + Xe–rT

The option exercise price is 120 pence × 75% or 90 pence, and the put option price is given at 35 pence.

Therefore 35 = PC – 120 + 90e–(0·04)(1)

Solving, PC = 68·53 pence

Call options on 3,000,000 shares would have an approximate value of £2,055,900, which appears to be quite generous to an unproven manager. It would be better to fix the call option exercise price above the current market price rather than below it. The managing director would then be more likely to be rewarded for his own performance if the share price increases, although, as previously mentioned, share price movements are not always the result of good management. The period of the option at only one year is also very short; an option over a three or five-year period would give more time for the policies of the new managing director to be reflected in the share price.

EVA® estimates require a number of adjustments to profit. In order to estimate NOPAT (net operating profit after tax) advertising is normally removed from the income statement and added to capital employed. Three years will be added, but this is subjective. It is necessary to add back interest paid, as this will be included in the capital charge, the weighted average cost of capital. Additionally taxation will need to be increased by the benefit taken in the income statement from tax relief on interest payments (such tax relief is included in WACC), and the tax relief on the advertising expense.

1137

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

Capital employed should be based upon capital at the start of the year. Adjusting for three years advertising, the capital employed is £450 million.

EVA® is NOPAT – (Capital employed × cost of capital)

EVA® is 87·2 – (450 × 0·095) = £44·45 million.

If the managing director were to receive 1·5% of EVA this would be £666,750, much less than the share option. However, as previously mentioned, it might be better to link a remuneration scheme to incremental EVA® after the manager is in post.

Answer 71 SERVEALOT PLC

There are several aspects of the statement that might not be valid.

“The company aims to serve its shareholders by paying a high level of dividends.”

Not all shareholders would favour a high level of dividends. Where dividends are taxed at a higher rate than capital gains there might be a preference for low or no dividends to be paid in which case the payment of high dividends might be unpopular with shareholders and have a detrimental effect on share price.

“Adopting strategies that will increase the company’s share price.”

This is problematic for at least two reasons. Firstly, according to financial theory a company should attempt to maximise the returns (wealth) to shareholders. Increasing the share price is not the same as maximising the returns. Secondly, the objectives of most companies are much broader than a single objective of shareholder wealth maximisation. Companies have many stakeholders, including their customers, suppliers, employees, lenders of funds to the company, and normally the government and the local community. The objectives of companies will normally be influenced by such stakeholders. Additionally environmental issues and other aspects of corporate social responsibility are increasingly influencing the objectives and strategies of companies in many countries, and there are strong ethical grounds for companies to be sensitive to such issues.

“Satisfying our shareholders will ensure our success.”

As mentioned above there are many other stakeholders that the company might need to satisfy. Satisfying shareholders is not likely to ensure success as actions that satisfy shareholders might be at the expense of other stakeholders.

“The company will reduce costs by manufacturing overseas wherever possible.”

This strategy is contentious, as it normally means a loss of employment, wealth generation, and possibly taxation, in the home country. It is true that costs can often be reduced by manufacturing overseas, but there is an ethical question of how loyal a company should be to its local employees and the local community.

1138

REVISION QUESTION BANK – ADVANCED FINANCIAL MANAGEMENT (P4)

“Adopt a strategy of attempting to minimise the company’s global tax bill through the judicious use of tax haven facilities”

As long as the tax reduction is by means of legal tax avoidance then this strategy should lead to an increase in cash flow and share price. Many governments try to restrict the use companies make of overseas tax havens but they are not illegal. Government restrictions mean that it will not always be possible for companies to make use of tax havens.

1139

ADVANCED FINANCIAL MANAGEMENT (P4) – REVISION QUESTION BANK

ACCA Pilot Paper P4 – Answers

1 FliHi

(a)

The cost of equity capital is derived from the Capital Asset Pricing Model but given this is an unquoted company a proxy must be taken for the company’s beta and regeared to reflect the different financial risk exposure of FliHi.

Ideally, regearing beta requires an estimate of the market gearing for both companies. In the absence of that the book gearing can be used. However, the presence of corporation tax means that we need the values for both the debt and equity in Rover Airways.

BV(equity) = $13.25bn = $2.4bn

Gearing = BV(equity)BV(debt)

BV(debt) = BV(equity) × gearing

BV(debt) = $2.4bn × 1.5 = $3.6bn

Using the formula for the asset beta where debt carries zero market risk:

βA = βex(1–Wd)

where

Wd = 0.5122

βA = 2.0 × (1–0.5122)

βA = 0.9756

This is the asset beta for Rover Airways. We can now regear the beta to that for FliHi as follows:

Calculate the tax adjusted gearing ratio for FliHi.

1140