0 Syllabus
Review the aim of the paper and the main capabilities on page (v). This is a large syllabus - significant home study will be essential to ensure a pass.
The overview diagram (vi) shows how the main topics are related to each other.
Move to (vii - viii) for more detail on the syllabus. Page (ix) shows the format of the exam – 4
compulsory 25 mark questions.
Note that many formulae will be provided in the exam as per page (x). Discount factor and annuity factor tables are also provided - required for what is arguably the most important topic in the
syllabus, Net Present Value (NPV) calculations. 1 The Financial Management Function
This first session puts the syllabus into context and asks the question”what is the objective of financial management”? The answer lies in stakeholder analysis i.e. identifying the groups of people who have some involvement in the organisation and then suggesting what objectives such groups may have.
In the private/corporate sector there is clearly a key stakeholder – shareholders, which leads to the assumed objective behind much of the theory in the syllabus – maximisation of shareholder wealth. Indeed this supports the view that NPV is the most important technique in financial
management - as NPV shows the change in shareholder wealth due to a business decision.
2 The Financial Management Environment
This session contains two main areas – the economic environment and the financial environment. Do not become too lost in details – you are more likely to be asked about the impact of economics and
government policy on business than to discuss pure economic theory.
The key theories of importance in the financial environment are the Efficient Markets Hypothesis (EMH) and the Term Structure of Interest Rates.
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3 Investment Decisions
Read through section 2 on Payback period and section 3 on the Accounting Rate of Return (ARR). Attempt Example 1
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4 Discounted Cash Flow (DCF) Techniques
Read through sections 3–5
Attempt Example 4 on the basics of Net Present Value (NPV) calculations.
Try Example 5 on calculating the present value of an equal annual cash flow (an annuity). Be aware that the published annuity factor tables are calculated on the assumption that the cash flow starts after one year. However in this example the cash flow starts after three years which requires a careful
adjustment.
Read section 6 on the Internal Rate of Return (IRR) – the discount rate that results in NPV of zero.
Try Example 9 which tests “interpolation” – the most common method of estimating IRR.
5 Relevant Cash Flows for DCF
Exam questions may present you with large amounts of data – some of which will be relevant for discounting and some not. Read section 1.1 on the characteristics of relevant revenues and costs for NPV/IRR calculations i.e.
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future¾
incremental¾
operating¾
cash flows.If you are now comfortable with the basics of DCF (which you may already know from university days) then you can move on to section 2 on the impact of the UK tax system (which is definitely a new area).
Do not panic – exam questions will tell you the tax rates/policies to use. All you really need to know is that depreciation expense is NOT a tax allowable deduction in the UK – companies are allowed to deduct something similar called a Writing Down Allowance (WDA), also called a Capital Allowance (CA)
Try Examples 2 and 3
Section 3 on discounting with inflation – the key to success here is consistency e.g. if inflation is
included in the cash flow forecast (known as nominal cash flows) then be sure to discount at a rate which also includes inflation (the nominal discount rate). Try example 4.
Section 4 on working capital – if an exam question gives you data produced in an accruals accounting style you must convert to a cash flow basis prior to
6 Applications of DCF
There are 3 specialist areas which can be examined:
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capital rationing; where there is not enoughfinance available to undertake all positive NPV projects. Make sure you know the definitions of hard and soft capital rationing and how to deal with divisible projects (use of “profitability index”) and non-divisible projects (trial and error)
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asset replacement decisions; they key here is the use of Annual Equivalent Cost to compare the cost of cycles of different lengths.¾
lease vs. buy; tax effects are crucial here – if an asset is bought the owner can claimWDA’s/CA’s, if it is leased then no WDA’s can be claimed but the lease payments are tax deducible.
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7 Project Appraisal under Risk
Expected values are simply the mathematical average of several possible outcomes with attached probabilities.
Sensitivity analysis is arguably the most important part of this session – in real life it is extremely important to know how sensitive project NPV is to changes in key factors and therefore it is likely that the examiner will build this into his questions.
8 Equity Finance
Make sure you have knowledge of the methods of share issue for both listed and unlisted companies. Note that the examiner is particularly interested in SME finance, for the following good reasons:
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SME’s often have problems raising finance dueto “asymmetry of information”
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SME’s are a major part of many economies e.g. in the UK the small/medium-sized business sector accounts for almost half of GDP.¾
SME’s are key to the future of every economy as they bring both diversification and higher long-term sustainable growth rates.In terms of calculations the key technique in this session is TERPS - Theoretical Ex-Rights Price of a Share. Learn the formula, it will not be provided in the exam.
Finally do not forget the existence, and importance, of internal equity finance i.e. reinvestment of
operating cash flows back into the business. This has advantages in that there are no issue costs and no problems with asymmetry of information. For these reasons many company managers prefer to use internal finance over external finance, known as “Pecking Order Theory”.
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9 Debt Finance
Many firms use some level of financial gearing/leverage as debt is relatively cheap compared to equity finance (debt investors take lower risk and require lower returns) and interest is tax allowable (unlike dividends) – the “tax shield”.
10 Security Valuation and Cost of Capital
The key to this whole session is the statement that “in perfect capital markets the sale/purchase of any security is a zero NPV transaction” i.e. the market price of a security is the present value of its future cash flows discounted at the investor’s required return.
If we apply this to share valuation we arrive at the Dividend Valuation Model i.e. the theoretical share price is the present value of future dividends discounted at the shareholder’s required return. The model can then be reversed i.e. if we know the share price (for a listed company) then we can imply the required return of investors and hence the firm’s cost of equity finance.
A similar approach can be taken to the analysis of bonds i.e. bond value = present value of future interest and principal discounted at the bond holder’s required return. However the required return of bond holders is not the firm’s cost of debt finance because interest payments are allowable deductions in the corporate tax system – the tax shield on debt.
Post-tax cost of cost = IRR of bond cash flows from the side of the firm i.e. market price, post-tax interest payments, redemption price.
11 Weighted Average Cost of Capital and Gearing
WACC is simply a mix of the cost of equity and post-tax cost of debt – weighting should be done using market values in preference to book values. WACC therefore measures the firm’s average cost of long-term finance and is a potential discount rate for new projects. However it is important to recognise that the existing WACC reflects the existing profile of the firm i.e. its level of business risk and level of financial gearing. The existing WACC should therefore only be used to evaluate a project which would not disturb this profile.
The second part of this session looks at theories of how financial gearing affects the WACC. There is no universally agreed answer to this question - you need an awareness of the main theories i.e.
traditional trade-off view, Modigliani and Miller’s model without tax and their model with corporate tax. Each theory has its own strength and weakness – you need an appreciation of the useful elements of each.
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12 Capital Asset Pricing Model
As noted in the previous session a firm’s existing WACC should only be used to evaluate a project which will not change the firm’s level of business risk. This raises the issue of what to do if business risk will change?
The answer is given by CAPM and the use of beta factors - published indexes of the level of risk of different industries. We look for the beta factor of companies engaged in the area of business of our potential project. Care must then be taken to ensure
13 Working Capital Management
Read through the whole chapter as it gives a good introduction to this major topic.
Try Example 1 on the cash operating cycle – again note the importance of ratios in this exam.
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14 Inventory Management
The Economic Order Quantity (EOQ) should be revision of previous studies. In this exam you will not be asked to derive/prove the model, just to apply it. The formula is published.
Do not confuse EOQ with the re-order level i.e. the level to which inventory should fall before an order is placed.
You should also have an appreciation of the
Japanese system of Just-In-Time (JIT) – also known as “Kanban” or “demand-driven production”. JIT itself can be considered in two areas – JIT
purchasing and JIT production.
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15 Cash Management
Cash flow forecasting is a key area of real-life financial management and therefore may be
required in the exam. Ensure you use a clear format, cross-referenced to separate workings.
Ensure you have knowledge of suitable investments for short-term cash surpluses e.g. treasury bills and possible sources of short-term finance e.g. overdraft (although expensive and risky finance as repayable on demand).
Technical models in this part of the syllabus are the Baumol model (EOQ applied to cash) and the more complex Miller-Orr model which attempts to manage cash balances between an upper and lower limit. Formulae for the Miller-Orr model are
published in the exam – bring a scientific calculator!
16 Management of Accounts Receivable and Payable
Exam questions often test calculations on whether settlement discounts should be offered to credit customers (or taken from suppliers) or whether debt factoring should be used.
The key to many of these calculations of use of working capital ratios “in reverse” e.g. if you are given the level of sales and the accounts receivable days then you should be able to calculate the level of receivables in the balance sheet. By analysing the change in the level of receivables caused by using discounts or factoring, you can then calculate the fall in the cost of financing working capital, to compare to the cost of offering the discount or using a factor.
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17 Risk Management
Paper F9 introduces this topic which is taken to higher levels in P4 Advanced Financial Management. You may be required to use the most common models for forecasting future exchange rates i.e. Purchasing Power Parity (PPP) and Interest Rate Parity (IRP).
Be aware that here are three types of currency risk – translation, economic and transaction. The last of these can be effectively hedged using forward contracts, money markets, options, futures and swaps. Calculations should only be required on forwards and money market hedges.
The classic scenario for interest rate risk is a firm which is worried about rising interest rates. You need to have an appreciation of how the firm can
18 Business Valuation and Ratio Analysis
Business valuation is an attempt to value the firm’s entire equity. The balance sheet equation tells us that equity = assets- liabilities. However balance sheets are often based upon book values rather than market values and many key assets may not be recorded by financial accounting e.g. internally generated goodwill. Hence balance sheet valuations may be of limited use.
More relevant valuations are based upon
predictions of future flows produced by the firm, either profit flows or dividend flows. This leads to valuations using P/E ratios and the Dividend Valuation Model
Ratio analysis is a topic which appears in many areas of the syllabus e.g. choice of business finance, working capital management. It is now vital to consolidate your knowledge of all key ratios – the examiner has stated on several occasions that he is often disappointed with candidates’ ability in this area.
