ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 1: The role and responsibilities of financial managers

 Respect for human rights: this might involve avoiding business dealings with

unethical suppliers or suppliers who use child labour or slave labour.

 Concern for the environment: the need to reduce or avoid pollution and the need

to develop a sustainable business.

 Recognition by large companies of the social responsibilities to the communities

in which they exist and operate.

Some companies have expressed their concern for ethical conduct in a formal

corporate code of ethics.

Corporate codes of ethics

A corporate code of ethics is a code of ethical behaviour, issued by the board of

directors of a company. The decisions and actions of all employees in the company

must be guided by the code. The effectiveness of a code of ethics depends on the

leadership of the company – its directors and senior managers. These individuals

must be seen to comply with the ethical code; otherwise other employees will see no

purpose in complying with the code themselves.

It has been suggested that there are three reasons why companies might develop a

code of ethics. These reasons are progressive, which means that companies might

begin by having a code of ethics for the first reason, but then progress to the second

and third reasons as they gain experience with implementing the code and

appreciating its potential benefits.

 Reason 1: Managing for compliance. The company wants to ensure that all its

employees comply with relevant laws and regulations, and conduct themselves

in a way that the public expects. For example, companies providing a service to

the general public need to ensure that their employees are polite and well-

behaved in their dealings with customers.

 Reason 2: Managing stakeholder relations. A code of ethics can help to improve

and develop the relations between the company and its shareholders, by

improving the trust that shareholders have in the company. The code might

therefore include the ethical stance of the company on disclosing information to

shareholders and the investing public (openness and transparency) and on

respecting the rights of shareholders.

 Reason 3: Creating a value-based organisation. A company might recognise the

long-term benefits of creating an ethical culture, and encouraging employees to

act and think in a way that is consistent with the values in its code of ethics. (It

could be argued that an ethical company, like a well-governed company, is a

more likely to be successful in business in the long-term. However, there is no

firm evidence to prove this point, and it is therefore a matter of opinion.)

Note on global organisations. Global companies might have difficulty in

developing and implementing a code of ethics for the entire organisation world-

wide, because of differences in ethical values in different cultures in different parts

of the world. A criticism of codes of ethics of global companies is that they often

focus on the company’s relationships with stakeholders in their ‘home country’ and

do not give enough thought to their operations in other countries.

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The content of a corporate code of ethics

There is no standard format or content for a code of ethics, but a typical code

contains:

 general statements about ethical conduct by employees

 specific reference to the company’s dealings with each stakeholder group, such

as employees, customers, shareholders and local communities.

A code of conduct should specify that compliance with local laws is essential. In

addition, employees should comply with the policies and procedures of the

company. There might be a statement that any employee who fails to comply with

the company’s code of conduct will face disciplinary action.

The code might also include an overview of business conduct, and the need to

protect the company’s reputation and ‘good name’. It might also contain statements

about the values of the company, such as:

 acting at all times with integrity

 protecting the environment

 the ‘pursuit of excellence’

 respect for the individual.

A code of conduct might address its main concerns about its dealings with

stakeholder groups and its ethical treatment of each group.

 Employees. A code of ethics might include statements about:

- human rights, including the right of all employees to join legally-authorised

organisations such as a trade union or political party

- equal opportunities for all employees, regardless of gender, race, ethnic

origin, religion, age, disability or sexual orientation

- refusal to tolerate harassment of employees by colleagues or managers

- concern for the health and safety of employees

- respect for the privacy of confidential information about each employee

- company policy on giving or receiving entertainment or bribes.

 Customers. A code of ethics might include statements about:

- fair dealing with customers

- product safety and/or product quality

- the truthfulness of advertisements

- respect for the privacy of confidential information about each customer.

 Competitors. A code of ethics might include statements about:

- fair dealing with competitors

- the use of techniques for obtaining information about competitors (industrial

spying)

Chapter 1: The role and responsibilities of financial managers

 Shareholders. A code of ethics might not include much about shareholders,

because the relationship between a company and its shareholders might be

contained in a code of corporate governance that the company follows. The key

issue with shareholders is to maintain and develop trust and confidence, which

might be achieved through disclosure of information (openness and

transparency).

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Dividend and retentions policy

 Retentions

 Dividend policy

 Monitoring dividend policy

4 Dividend and retentions policy

4.1 Retentions

Companies retain earnings to reinvest in the business, and many companies rely

extensively on retained profits as a source of new finance. There are several reasons

why companies might prefer retained earnings to other sources of new capital:

 There are no issue costs with retained earnings, whereas there is a cost of issuing

shares and some costs of arranging borrowing.

 No formalities are required to obtain the capital, and holding on to profits as

retained earnings is very convenient.

 Shareholders usually expect some proportion of earnings to be retained in the

business.

Retentions and dividend growth: Gordon’s growth model

Retained earnings should be invested for growth in future profits, earnings and

dividends. The Gordon growth model will be dealt with in more detail in a later

chapter. Briefly, however, the rate of annual growth in dividends can be expressed

as:

g = br

where

g is the annual rate of dividend growth

b is the proportion of earnings that is retained for reinvestment rather than paid as

dividend, and

r is the rate of return on investments by the company.

For example, if a company retains 40% of its earnings and the return on company

capital investment is 8%, annual growth in earnings and dividends should be 3.2%

(40% × 8%). If 60% of earnings are retained, only 40% of earnings are available for

dividends, but the expected rate of annual earnings and dividend growth should be

4.8%.

4.2 Dividend policy

Stock market companies do not usually announce a dividend policy, and inform

investors of the dividends they will expect to pay in future years. However,

companies often adopt a consistent dividend policy, and investors might base their

expectations of a company’s future dividends on what the company has done in the

past.

Chapter 1: The role and responsibilities of financial managers

According to academic theory (for example, the theory put forward by Modigliani

and Miller) the value of a company’s shares does not depend on the dividend policy

of the company. Shareholders ought to be indifferent about whether a company

pays out its after-tax profits as dividends, or re-invests them. If a company does not

pay out its profits to shareholders as dividends, it will reinvest the profits for

growth in profits, so that future dividends will be larger and the share price will

increase.

If a shareholder needs cash, he should not have to rely on dividend payments. He

can borrow the money instead, or even sell the shares.

In practice, however, the dividend policy of a company can affect its share price and

does matter to many shareholders.

 Some investors want cash returns from their investments, and expect companies

in which they hold shares to pay dividends. On the other hand, some investors

buy shares to invest in growth, and are not concerned in the short-term about

receiving dividends. Investors can buy shares in companies that have a dividend

policy consistent with their preferences. (For example, for many years Microsoft

did not pay any dividends at all and reinvested all its profits to grow the

business. Investors in Microsoft shares knew that they were investing in a high-

growth stock, and dividend payments were not important to them.)

 The tax position of investors might give them a preference for dividends or

capital growth, when the tax rate on dividend payments is different from the tax

rate on capital gains

 Paying a dividend might send a signal from the company to the market. If the

signal is that the board of directors are confident about the future of the

company, this might give investors more confidence in the company and boost

the share price

 When a company reduces its dividend below the amount of dividends paid in

previous years, this could be a signal that the company is in financial difficulty,

and the share price is likely to fall.

4.3 Monitoring dividend policy

A company’s dividend policy can be monitored with a few simple ratios.

 Dividend per share as a percentage of earnings per share. EPS is the maximum

amount that a company could pay as dividends out of the year’s profits. A low

dividend/EPS ratio indicates high earnings retention. A high dividend/EPS

ratio indicates low earnings retention – and this could restrict the ability of the

company to finance investments in new capital projects for future growth.

 Percentage growth or decline in annual dividends per share.

 Dividends as a proportion of free cash flow to equity. Free cash flow can be

defined in several ways, but for the purpose of analysing dividend policy, a

useful measure of free cash flow to equity is after deduction of capital spending

on investments in replacement non-current assets.

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Example

The following information is available about Company X and Company Y for the

past five years:

Company X

Earnings after

tax

Number of

Free cash flow

to equity (FCFE)

Dividends per

$ million million $ million cents

Year 1 34.5 100 28.0 20

Year 2 32.3 100 (25.0) 20

Year 3 31.5 120 12.0 21

Year 4 40.0 120 30.1 22

Year 5 48.0 120 32.7 24

Company Y

Earnings after

tax

Number of

Free cash flow

to equity (FCFE)

Dividends per

$ million million $ million cents

Year 1 27.0 40 9.6 13.5

Year 2 24.5 40 (5.0) 12.3

Year 3 26.8 40 (6.5) 13.4

Year 4 29.8 40 5.2 14.9

Year 5 31.6 40 17.3 15.8

Required

(a) Compare the dividend policy of Company X and Company Y.

(b) It has been reported that in the past two or three years, Company X has

chosen not to invest in some projects that had a good expected NPV. Suggest

how dividend policy might explain this state of affairs.

Answer

Company X

Dividends/Earnings

Dividend

growth

Dividends/FCFE

% % %

Year 1 58.0 - 71.4

Year 2 61.9 0.0 (80.0)

Year 3 80.0 5.0 210.0

Year 4 66.0 4.8 87.7

Year 5 60.0 9.1 88.1

Chapter 1: The role and responsibilities of financial managers

Company Y

Dividends/Earnings

Dividend

growth

Dividends/FCFE

% % %

Year 1 20.0 - 56.3

Year 2 20.0 (8.9) (98.4)

Year 3 20.0 8.9 (82.5)

Year 4 20.0 3.7 114.6

Year 5 20.0 6.0 36.5

The dividend policy of Company X appears to be to pay a consistent dividend per

share from one year to the next, but with some dividend growth. Dividends have

risen fairly consistently over the five year period from 20 cents in Year 1 to 24 cents

in Year 5. Investors might expect dividends to remain about the same next year – 24

cents if earnings do not rise and a bit more if earnings increase.

In contrast, the dividend policy of company Y is to pay dividends that are a

consistent ratio of earnings. Dividends were exactly 20% of earnings in each year.

This means that dividends per share rise and fall at the same rate as fluctuations in

earnings.

It is also noticeable that the dividend payout ratio (ratio of dividends to earnings) is

much higher in Company X than in Company Y. In Company Y, the payout ratio is

very low – the company is reinvesting 80% of its earnings, and it might therefore be

expected that earnings growth and dividend growth should be higher than it has

been.

The ratio of dividends to free cash flow fluctuates considerably for both companies.

Clearly, dividend policy is not related to their free cash flows.

(b)

It has been reported that in the past two or three years, Company X has chosen not

to invest in some projects that had a good expected NPV. This might be explained

by a combination of two factors:

(1) The fairly high dividend payout ratio in Company X, which indicates that the

company is not building up equity reserves by retaining profits

(2) The high ratio of dividend payout to FCFE in Years 4 and 5, following years in

which FCFE was negative (Years 2 and 3). Company X has not been

generating enough cash flows after dividend payments to finance new capital

projects from internal cash flows.

Paper P4: Advanced Financial Management

Paper P4

Advanced Financial Management

CHAPTER

Impact of environmental

issues on corporate

objectives and governance

Contents

1 Social and environmental footprints:

environmental risk

2 Sustainability reporting and environmental

audits

3 Carbon trading

Paper P4: Advanced Financial Management

Social and environmental footprints: environmental risk

 Environmental footprint (ecological footprint)

 Carbon neutrality

 Social footprint

 Sustainability and environmental risk

1 Social and environmental footprints: environmental

risk

The purpose of economic activity is to create economic wealth. It is now recognised,

much more than in the past, that economic activity also has an environmental

impact and a social effect. An organisation is said to create an ‘environmental

footprint’ and a ‘social footprint’ - a visible mark on the environment and on society.

The social footprint may be either beneficial or damaging. The environmental

footprint is almost inevitably damaging.

1.1 Environmental footprint (ecological footprint)

An environmental footprint, also called an ecological footprint, is a term that refers

to the impact that an entity has on the environment, in terms of:

 the amount of raw materials that it uses to make its products or services, where

the raw materials are subject to depletion (see note)

 non-renewable resources that it uses to make its products or services

 the quantity of wastes and emissions that it creates in the process.

Note: Raw materials subject to depletion are raw materials that can be renewed, but

where the current total rate of consumption exceeds the total current rate of

renewal. Fish stocks and hard wood timber are examples.

In the past, it was accepted that in order to grow, companies (and economic activity

as a whole) had to increase its environmental footprint. With the recognition today

that the world cannot go on increasing its environmental footprint, many leading

companies are looking for ways to reduce the size of their own particular footprint

and ‘tread more softly’.

Reducing an environmental footprint involves the development and

implementation of policies for:

 better (more efficient) resource management, and using different resources

 ‘green’ procurement policies

 waste minimisation and waste management (for example, policies on reducing

pollution and recycling waste).

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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