ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing
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Formulae and tables
© EWP Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides 15
Or
(
)
(
)
102
-rf
dNFdXN ep
−−
−=
Where:
()
Ts
2/TsX/Fn1
d
2
o
1
+
=
and
Tsdd
12
−
−=
The Put Call Parity relationship
rt
ea
ePPcp
−
+−=
Paper P4: Advanced Financial Management
16 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP
Present value table
Present value of 1 i.e.
n
)r1(
−
+
where r = discount rate
n = number of periods until payment
Periods Discount rate (r)
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1
2
3
4
5
0.990
0.980
0.971
0.961
0.951
0.980
0.961
0.942
0.924
0.906
0.971
0.943
0.915
0.888
0.863
0.962
0.925
0.889
0.855
0.822
0.952
0.907
0.864
0.823
0.784
0.943
0.890
0.840
0.792
0.747
0.935
0.873
0.816
0.763
0.713
0.926
0.857
0.794
0.735
0.681
0.917
0.842
0.772
0.708
0.650
0.909
0.826
0.751
0.683
0.621
1
2
3
4
5
6
7
8
9
10
0.942
0.933
0.923
0.914
0.905
0.888
0.871
0.853
0.837
0.820
0.837
0.813
0.789
0.766
0.744
0.790
0.760
0.731
0.703
0.676
0.746
0.711
0.677
0.645
0.614
0.705
0.665
0.627
0.592
0.558
0.666
0.623
0.582
0.544
0.508
0.630
0.583
0.540
0.500
0.463
0.596
0.547
0.502
0.460
0.422
0.564
0.513
0.467
0.424
0.386
6
7
8
9
10
11
12
13
14
15
0.896
0.887
0.879
0.870
0.861
0.804
0.788
0.773
0.758
0.743
0.722
0.701
0.681
0.661
0.642
0.650
0.625
0.601
0.577
0.555
0.585
0.557
0.530
0.505
0.481
0.527
0.497
0.469
0.442
0.417
0.475
0.444
0.415
0.388
0.362
0.429
0.397
0.368
0.340
0.315
0.388
0.356
0.326
0.299
0.275
0.350
0.319
0.290
0.263
0.239
11
12
13
14
15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1
2
3
4
5
0.901
0.812
0.731
0.659
0.593
0.893
0.797
0.712
0.636
0.567
0.885
0.783
0.693
0.613
0.543
0.877
0.769
0.675
0.592
0.519
0.870
0.756
0.658
0.572
0.497
0.862
0.743
0.641
0.552
0.476
0.855
0.731
0.624
0.534
0.456
0.847
0.718
0.609
0.516
0.437
0.840
0.706
0.593
0.499
0.419
0.833
0.694
0.579
0.482
0.402
1
2
3
4
5
6
7
8
9
10
0.535
0.482
0.434
0.391
0.352
0.507
0.452
0.404
0.361
0.322
0.480
0.425
0.376
0.333
0.295
0.456
0.400
0.351
0.308
0.270
0.432
0.376
0.327
0.284
0.247
0.410
0.354
0.305
0.263
0.227
0.390
0.333
0.285
0.243
0.208
0.370
0.314
0.266
0.225
0.191
0.352
0.296
0.249
0.209
0.176
0.335
0.279
0.233
0.194
0.162
6
7
8
9
10
11
12
13
14
15
0.317
0.286
0.258
0.232
0.209
0.287
0.257
0.229
0.205
0.183
0.261
0.231
0.204
0.181
0.160
0.237
0.208
0.182
0.160
0.140
0.215
0.187
0.163
0.141
0.123
0.195
0.168
0.145
0.125
0.108
0.178
0.152
0.130
0.111
0.095
0.162
0.137
0.116
0.099
0.084
0.148
0.124
0.104
0.088
0.074
0.135
0.112
0.093
0.078
0.065
11
12
13
14
15
Formulae and tables
© EWP Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides 17
Annuity table
Present value of an annuity of 1 i.e.
(
)
r
r11
n−
+−
where r = discount rate
n = number of periods
Periods
Discount rate (r)
(n)
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1
2
3
4
5
0.990
1.970
2.941
3.902
4.853
0.980
1.942
2.884
3.808
4.713
0.971
1.913
20829
3.717
4.580
0.962
1.886
2.775
3.630
4.452
0.952
1.859
2.723
3.546
4.329
0.943
1.833
2.673
3.465
4.212
0.935
1.808
2.624
3.387
4.100
0.926
1.783
2.577
3.312
3.993
0.917
1.759
2.531
3.240
3.890
0.909
1.736
2.487
3.170
3.791
1
2
3
4
5
6
7
8
9
10
5.795
6.728
7.652
8.566
9.471
5.601
6.472
7.325
8.162
8.983
5.417
6.230
7.020
7.786
8.530
5.242
6.002
6.733
7.435
8.111
5.076
5.786
6.463
7.108
7.722
4.917
5.582
6.210
6.802
7.360
4.767
5.389
5.971
6.515
7.024
4.623
5.206
5.747
6.247
6.710
4.486
5.033
5.535
5.995
6.418
4.355
4.868
5.335
5.759
6.145
6
7
8
9
10
11
12
13
14
15
10.37
11.26
12.13
13.00
13.87
9.787
10.58
11.35
12.11
12.85
9.253
9.954
10.63
11.30
11.94
8.760
9.385
9.986
10.56
11.12
8.306
8.863
9.394
9.899
10.38
7.887
8.384
8.853
9.295
9.712
7.499
7.943
8.358
8.745
9.108
7.139
7.536
7.904
8.244
8.559
6.805
7.161
7.487
7.786
8.061
6.495
6.814
7.103
7.367
7.606
11
12
13
14
15
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1
2
3
4
5
0.901
1.713
2.444
3.102
3.696
0.893
1.690
2.402
3.037
3.605
0.885
1.668
2.361
2.974
3.517
0.877
1.647
2.322
2.914
3.433
0.870
1.626
2.283
2.855
3.352
0.862
1.605
2.246
2.798
3.274
0.855
1.585
2.210
2.743
3.199
0.847
1.566
2.174
2.690
3.127
0.840
1.547
2.140
2.639
3.058
0.833
1.528
2.106
2.589
2.991
1
2
3
4
5
6
7
8
9
10
4.231
4.712
5.146
5.537
5.889
4.111
4.564
4.968
5.328
5.650
3.998
4.423
4.799
5.132
5.426
3.889
4.288
4.639
4.946
5.216
3.784
4.160
4.487
4.772
5.019
3.685
4.039
4.344
4.607
4.833
3.589
3.922
4.207
4.451
4.659
3.498
3.812
4.078
4.303
4.494
3.410
3.706
3.954
4.163
4.339
3.326
3.605
3.837
4.031
4.192
6
7
8
9
10
11
12
13
14
15
6.207
6.492
6.750
6.982
7.191
5.938
6.194
6.424
6.628
6.811
5.687
5.918
6.122
6.302
6.462
5.453
5.660
5.842
6.002
6.142
5.234
5.421
5.583
5.724
5.847
5.029
5.197
5.342
5.468
5.575
4.836
4.988
5.118
5.229
5.324
4.656
4.793
4.910
5.008
5.092
4.486
4.611
4.715
4.802
4.876
4.327
4.439
4.533
4.611
4.675
11
12
13
14
15
Paper P4: Advanced Financial Management
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Standard normal distribution table
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.0000 0.0040 0.0080 0.0120
0.0160
0.0199
0.0239
0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517
0.0557
0.0596
0.0636
0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.0910
0.0948
0.0987
0.1026
0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293
0.1331
0.1368
0.1406
0.1443 0.1480 0.1517
0.4 0·1554 0.1591 0.1628 0.1664
0.1700
0.1736
0.1772
0.1808 0.1844 0.1879
0.5 0.1915 0.1950 0.1985 0·2019
0·2054
0.2088
0.2123
0·2157 0·2190 0·2224
0.6 0.2257 0.2291 0.2324 0.2357
0.2389
0.2422
0.2454
0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673
0.2703
0.2734
0.2764
0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967
0.2995
0.3023
0.3051
0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238
0.3264
0.3289
0.3315
0.3340 0.3365 0.3389
1.0 0.3413 0.3438 0.3461 0.3485
0.3508
0.3531
0.3554
0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708
0.3729
0.3749
0.3770
0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907
0.3925
0.3944
0.3962
0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082
0.4099
0.4115
0.4131
0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236
0.4251
0.4265
0.4279
0.4292 0.4306 0.4319
1.5 0.4332 0.4345 0.4357 0.4370
0.4382
0.4394
0.4406
0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484
0.4495
0.4505
0.4515
0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582
0.4591
0.4599
0.4608
0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664
0.4671
0.4678
0.4686
0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732
0.4738
0.4744
0.4750
0.4756 0.4761 0.4767
2.0 0.4772 0.4778 0.4783 0.4788
0.4793
0.4798
0.4803
0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834
0.4838
0.4842
0.4846
0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871
0.4875
0.4878
0.4881
0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901
0.4904
0.4906
0.4909
0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925
0.4927
0.4929
0.4931
0.4932 0.4934 0.4936
2.5 0.4938 0.4940 0.4941 0.4943
0.4945
0.4946
0.4948
0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957
0.4959
0.4960
0.4961
0.4962 0.4963 0.4964
2.7 0.4965 0·4966 0.4967 0.4968
0.4969
0.4970
0.4971
0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977
0.4977
0.4978
0.4979
0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983
0.4984
0.4984
0.4985
0.4985 0.4986 0.4986
3.0 0.4987 0.4987 0.4987 0.4988
0.4988
0.4989
0.4989
0.4989 0.4990 0.4990
This table can be used to calculate N(d
i
), the cumulative normal distribution
functions needed for the Black-Scholes model of option pricing. If d
i
> 0, add 0·5 to
the relevant number above. If d
i
< 0, subtract the relevant number above from 0·5.
© EWP Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides 19
Paper P4
Advanced Financial Management
CHAPTER
1
The role and responsibilities
of financial managers
Contents
1 Conflicting stakeholder interests
2 Improving corporate governance
3 Role and responsibility of the senior financial
management executive
4 Dividend and retentions policy
Paper P4: Advanced Financial Management
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Conflicting stakeholder interests
The objectives of an organisation
Primary corporate objective
Theories supporting differing views of the primary corporate objective
Separation of ownership from control
Agency theory
Transaction cost theory
Stakeholder theory
Differing governance models
Resolving stakeholder conflict
1 Conflicting stakeholder interests
1.1 The objectives of an organisation
Every organisation exists for a purpose, which can be expressed in a mission
statement. For example, an organisation might exist to manufacture electronic
equipment, manufacture chemicals, provide a transport service or provide an
education to children.
Within this overall purpose, an organisation should have a primary objective.
For companies, the main objective might be to maximise the wealth of the
company’s owners, its equity shareholders
For state-owned organisations, the main objective might be stated in terms of
providing a certain standard of public service
For a charity, the main objective might be to provide maximum aid or support
for a particular group of people.
When the main objective of an organisation is not a financial objective, there is
always a financial constraint on its objective, such as providing the highest quality
of public service with the available finance.
1.2 The primary corporate objective
For companies, the main objective might be to maximise the wealth of its owners,
the equity shareholders. However, there is some debate about whether a company
should also have important objectives with regard to other ‘stakeholder groups’,
such as its employees, its major suppliers, lenders to the company, its customers, the
government and even the general public.
Chapter 1: The role and responsibilities of financial managers
© EWP Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides 21
Two differing views of the objectives of an organisation are therefore:
The only significant objective of a company is to maximise the wealth of the
equity shareholders. This is achieved by maximising the combined value of
dividends and share price growth
A company should have several objectives, which might be, for example, to
increase the wealth of shareholders, to treat employees fairly and well, to treat
customers and suppliers in a proper and ethical way, and to take into
consideration the needs of society and the need to preserve the environment.
Corporate social responsibility (CSR)
Corporate social responsibility is a term to describe the view that a company should
pursue objectives that are in the interests of stakeholder groups other than
shareholders, such as employees and society as a whole (the ‘public’).
1.3 Theories supporting differing views of the primary corporate objective
Several theories have been developed that support differing views about how a
company should be governed (corporate governance) and what the primary
objective of a company should be. Three such theories are:
Agency cost theory
Transaction cost economic theory
Stakeholder theory.
The differing views about the objectives of a company can give rise to conflicts of
interest, as different stakeholder groups argue that the company should be aiming
to do something different and achieve different goals.
Agency theory and transaction cost economics both recognise that problems with
pursuing the best interests of a company arise because of a separate of company
ownership from control.
1.4 Separation of ownership from control
Problems with agreeing the aims and objectives of a company exist because of the
separation of the ownership of a company from its control.
Shareholders are the owners of the company.
However, the company is a separate legal person, and decisions are made by the
company in its own name, not in the name of the shareholders.
The directors and senior managers of a company control the decisions that the
company makes.
The legal rights of shareholders to make decisions for the company are very limited
(by law, by stock market regulations and by the company’s constitution) in all
countries. The shareholders therefore rely on the directors and senior managers to
govern the company in the interests of the shareholders and other stakeholders, and
laws and codes of corporate governance are aimed at achieving this.
Paper P4: Advanced Financial Management
22 Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides © EWP
1.5 Agency theory
Agency theory, which was developed by Jensen and Meckling (1976), is based on
the separation of the ownership and control. Jensen and Meckling argued that when
directors and managers are appointed to run a company, an agency-principal
relationship is created. This agency relationship is a form of contract between a
company’s owners and its managers, where the owners (as principal) appoint an
agent (the managers) to manage the company on their behalf. Within this
arrangement, decision-making authority is delegated by the shareholders to the
management.
However, Jensen and Meckling argued that this agency relationship creates a
serious conflict of interest between the company’s owners and managers.
Most shareholders want to increase their income and wealth over the long-term.
The value of their shares depends on the long-term financial prospects for the
company. Shareholders are concerned about short-term profits and dividends,
but they are even more concerned about long-term profitability and wealth
creation.
The managers run the company on behalf of the shareholders. They have an
employment contract and earn a salary. If they do not own shares in the
company, they have no direct interest in future returns for shareholders, or in
the value of the shares. Unless their remuneration is linked to profits or share
values, their main interests are likely to be the size of their remuneration
package and their status as company managers.
In an ideal situation, the ‘agency contract’ between the owners and the managers of
a company should ensure that the managers always act in the best interests of the
owners. However, it is impossible to arrange the ‘perfect contract’, because
decisions by the managers affect their own personal welfare as well as the interests
of the owners.
Agency conflicts are differences in the interests of owners and managers. Some of
these conflicts that might have a direct impact on the financial management of a
company are as follows:
Earnings retention. The remuneration of directors and senior managers is often
related to the size of the company (for example, annual turnover) rather than its
profits. This gives managers an incentive to increase the size of the company,
rather than to increase the returns to the company’s shareholders. When this
happens, companies might invest in capital investment projects where the
expected return is quite small, or propose over-priced takeover bids for other
companies.
Time horizon. Shareholders are concerned about the long-term financial
prospects of their company because the share price depends on expectations for
the long-term future. In contrast, managers might only be interested in the short-
term. This is partly because they might receive annual bonuses based on short-
term performance, and partly because they might not expect to be with the
company for more than a few years.
Chapter 1: The role and responsibilities of financial managers
© EWP Go to www.emilewoolfpublishing.com for Q/As, Notes & Study Guides 23
Agency theory is based on the view that the system of corporate governance should
be designed to minimise the agency problem, and reduce agency costs. The theory
may be summarised as follows:
In large companies there is a separation of ownership from control. Professional
managers are appointed to act as agents for the owners of the company.
Individuals are driven by self-interest.
Conflicts of self-interest arise between shareholders and managers.
Managers, because they are driven by self-interest, cannot be relied on to act in
the best interests of the shareholders. This creates problems in the agency
relationship between shareholders and management.
These agency problems create costs for the shareholders.
The aim should be to minimise these costs, by improving the monitoring of
management and/or providing management with incentives to bring their
interests closer to those of the shareholders.
1.6 Transaction cost theory
Transaction cost theory provides a different explanation of the relationship between
the owners of a company and its management, but reaches a similar conclusion as
agency theory.
The theory of transaction cost economics (TCE) is closely associated with the work
of Oliver Williamson in the 1970s. He suggested that the operating activities of a
company can be performed either through market transactions (with external
suppliers) or by doing the work in-house. For example, a company could either
obtain its raw materials from an external supplier or it could make the materials
itself. Similarly, a company could outsource work, or it could hire full-time
employees to do the work ‘in-house’. In economic terms, the decision about whether
to arrange transactions in the open market or whether to do the work in-house
should depend on which is cheaper. If a company does the work in-house, it needs a
management structure and a hierarchy of authority with senior management at the
top. According to transaction cost theory, the structure of a firm and the relationship
between the owners of a firm and its management depends on the extent to which
transactions are performed in-house.
In transaction cost theory, total costs are defined as the sum of production costs and
transaction costs.
Production costs are the costs that would be incurred by the company in an
ideal economic market. In an ideal economic market, production costs are
minimised.
Transaction costs are additional costs incurred whenever the perfect economic
market is not achieved. For example, a company might buy goods from a
supplier who is not the cheapest available, because it is not aware that a cheaper
supplier exists. A company might sell goods on credit to a customer, not
knowing that the customer is a high bad debt risk, and that the debt might never
be collected.
Paper P4: Advanced Financial Management
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In this analysis, the only difference between in-house operations and buying the
materials or work externally is the difference in transaction costs between the two.
Total costs are minimised when transaction costs are minimised. This should
determine the optimal size of the firm (and the extent to which it is ‘vertically
integrated’) and the size of the management hierarchy in the firm. As a general rule,
it is in the interests of a company’s management to carry out transactions internally,
and not in the external market. Doing the work internally:
removes the risks and uncertainties about prices of products and product quality
removes all the risks and costs of dealing with external suppliers.
Transaction cost theory also considers the implications of human behaviour for the
way in which a company is managed and governed. Williamson made two
assumptions about behaviour:
bounded rationality
opportunism.
Bounded rationality
Human beings act rationally, but only within the limits of their understanding. This
means that a company manager will act rationally in trying to maximise the value of
the company for its shareholders, but the limits to his understanding and ability to
act rationally might make him act differently. In any business, there is a limit to the
amount of information that individuals can remember, understand and deal with.
No one is capable of assessing all the possible courses of action and no one can
anticipate what will happen in the future. In a competitive market, no one can
anticipate with certainty what competitors will do.
Opportunism
Williamson also argued that individuals will act in a self-interested way, and ‘with
guile’. They are always be honest and truthful about their intentions. Opportunism,
according to Williamson, is the effort to realise individual gains via a lack of
candour or truthfulness in transactions. An individual might try to take advantage
of an opportunity to gain a benefit at the expense of someone else. Managers are
opportunistic by nature. Given the opportunity, they will take advantage of
available ways of improving their own benefits and privileges
In terms of transaction cost economics, a problem with opportunism is that external
parties – such as contractors and suppliers of goods – cannot always be trusted to
act honestly. As a result, there may be a tendency for a company to carry out
transactions itself, rather than rely on external suppliers. However, there is also a
risk that by taking control of transactions internally, managers will have
opportunities to take decisions and actions that are in their own personal interests.
This self-interested behaviour needs to be controlled. In this respect, transaction cost
theory has similarities with agency theory.