Tutor

Notes

CIMA Strategic Paper F3

Financial Strategy

For exams in November 2011 and May 2012

To be used with the BPP Study Text for exams in November 2011 and
May 2012

i
 First edition 2009
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ii
 So what are the benefits of our Tutor Notes?
page iv
How do I use the Tutor Notes?
page v
Teaching session planners
page ix
CONTENTS

chapter 1 chapter 10
OBJECTIVES OF ORGANISATIONS TREASURY FUNCTION
page 1 page 103

chapter 2 chapter 11
CONSTRAINTS ON FINANCIAL STRATEGY INVESTMENT APPRAISAL TECHNIQUES
page 13 page 113

chapter 3 chapter 12
FORECASTING AND ANALYSIS INTERNATIONAL INVESTMENT
page 25 APPRAISAL
page 131

chapter 4
SHORT-TERM FINANCIAL STRATEGY chapter 13
page 33 SPECIFIC INVESTMENT APPRAISAL
SCENARIOS
page 141
chapter 5
EQUITY FINANCE
page 45 chapter 14
CONTROL OF INVESTMENT PROJECTS
page 151
chapter 6
DEBT FINANCE
page 57 chapter 15
BUSINESS VALUATIONS
page 159
chapter 7
LEASING
page 73 chapter 16
AMALGAMATIONS AND RESTRUCTURING
page 175
chapter 8
COST OF CAPITAL
page 79 Answer bank
Page 191

chapter 9
CAPITAL STRUCTURE DECISION
page 91

Introduction iii
 INTRODUCING
BPP LEARNING MEDIA’S
TUTOR NOTES
BPP Learning Media’s Tutor Notes for the CIMA qualification have been developed under the
guidance of experienced tutors from BPP’s classroom courses division and have been written by
tutors and subject experts with many years’ experience of producing study material for the CIMA
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The Notes have been specially configured to add value in all the different teaching environments in
which BPP Learning Media materials are used throughout the world. We pilot tested the concept in
front of BPP students using a variety of technologies reflecting the range available in adopting
colleges and we refined them. Whether you are using a chalkboard or a smartboard, we are
confident these notes will enhance any course, help students pass their CIMA exams and that you
will find students recommending your courses to their friends.

So what are the benefits of our Tutor

notes?
Benefit 1: High standard of professional course
presentation
Students remember how their tutors performed in the classroom and they keep the course notes
their college gives them and show them to friends. Our Tutor Notes will enhance the impression you
make on your students and their friends’ impression of your college.
 With notes, graphics and carefully written Learning Examples pre-prepared, you can devote
your preparation time to deciding how to enhance your delivery, motivate interest and help
individual learners.
 Because our Tutor Notes are produced by the market-leading CIMA publisher they have a
consistent, professional appearance.
(The Passcards graphics used in the notes are available on request as PDFs, so you can incorporate
multimedia in your classrooms. This format means they can be enlarged and printed for attachment
to chalkboards, made into acetates, projected from beamersor displayed on smartboards.)

Benefit 2: Flexibility, so you can add value as you

see fit
Unlike other course notes, our Tutor Notes do not impose someone else’s script on you. Instead
they use Passcards graphics to highlight the essential knowledge elements of each topic and useful
Learning Examples to convey and reinforce the learning. Experienced tutors will add value in their
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to deliver the topic and the key points to make.

iv
 Benefit 3: The right format
The Tutor Notes are designed to be used as part of the tried-and-tested approach of paper media,
text books and good tutors in classrooms. You don’t need to register your students with us and we
don’t expect them to rely on the Internet to read their books. If you adopt our study materials, the
Tutor Notes can be hosted on your network. On request, we can facilitate this and provide
multimedia support right up to full hosted virtual learning environments. We know you will choose
the formats that are right for you - and we are ready to help.

Benefit 4: Unique integration

Tutor Notes follow the same sequence as our Study Text for the subject. Each topic is covered in
the same consistent way and the Notes provide signposts to you and your students on where to
look in the Study Text for more information and question practice.

Benefit 5: Continuity
Where courses are team-taught, or where tutors change mid-programme, the Tutor Notes provide
continuity because tutors can see how far their colleagues have progressed through the course. And
for students who miss classes, the notes provide a ready record of what they have missed.

How do I use the Tutor Notes?

Your students must bring their BPP Study Texts to each session as we recommend you incorporate
material and features from the Study Text into your teaching.

One set of notes for you, one for your students

You will actually be provided with two sets of notes for each subject.
 Student Notes are arranged in double-page spreads, with the Passcards diagram for each
topic on the left-hand side (LHS) and some introductory context and Learning Examples
(essentially classroom questions) on the right-hand side (RHS).
 Tutor Notes are page-for-page the same as the Student Notes. They reproduce the content
of the Student Notes but the tutor version also has annotations to the Passcards diagram
and, on the RHS, additional content such as teaching and topic tips and the solutions to the
Learning Examples.
Here’s what we recommend you do.
 Print out and duplicate the Student Notes and provide one copy to each student as part of
their course material along with the BPP Learning Media Study Text and other adopted
media. The files are arranged so that they print out double-sided (duplex) to save paper.
However they can be printed single-sided without any changes to the PDFs we provide.
 Print out one copy of the Tutor Notes for yourself, for your teaching file.
 Decide whether to hand out Student Notes as one complete bank at the beginning of the
course, or session by session. Some colleges prefer to hand out Notes in instalments to
ensure that students attend all sessions.
 The final chapter of the Student Notes is a bank of solutions to the Learning Examples used
in the teaching sessions. You may prefer to hold these in reserve so that students attempt
the Learning Examples rather than look for answers in the back of the Notes.

Introduction v
 Session planning
The Notes are arranged as chapters in the same order as the BPP Learning Media Study Text and
other resources for the subject. Chapters are topic based, and because topics vary in complexity
the chapters are of varying length. A teaching session may cover several short chapters or it may
not be long enough to cover a long chapter on a complex topic. Recommended session plans for
condensed (three-day) and full-length (six-day) courses, showing how chapters may be covered,
are shown on page ix onwards. These session plans can be adapted to fit the length of course your
college offers.

Teaching the topic

The Notes were designed, and developed further following pilot sessions, to support tutors’
preference for the following approach to teaching.

Step 1 Display the Passcards graphic from the LHS on a screen (more below).

Step 2 Introduce the topic by speaking around the Context note (which is also in the
Student Notes), linking it to the previous topic or explaining why it matters to the
accounting profession, the business environment or particular organisations.

Step 3 Speak about each element of the Passcards using the callouts on the Tutor Notes
version as guidance. (These annotations can be added by hand to the graphic on
screen for the students to copy into their notes (more below).)

Step 4 Return to the RHS of the Tutor Notes and speak around the Key Learning Points to
add emphasis and reassure students on what is important. Students can be
encouraged to take their own notes.

Step 5 Topic Tips can be used in various ways. Stating how and when the topic was
examined focuses the student and provides reassurance that the tutor knows the
exam.

Step 6 The Learning Examples are written especially for the Notes, they do not appear in
any other BPP Learning Media product. They provide illustrations or reinforcement of
the topic. Set them for the class to attempt and then debrief them before moving on
(more below).

Displaying the Passcard graphics

It is not essential that your college has the technology to display the Passcards graphics from the
LHS of the Tutor Notes. The Student Notes do include these and, in pilot testing, tutors were able to
provide perfectly intelligible lectures by referring students to them. The ability to display the
graphics to the class, and - probably more importantly - to annotate them, does improve the quality
of presentation, however.
Tutors in our pilot studies who were not able to display the Passcards graphic used several devices
to help students to understand which part of the graphic was being referred to.
 Referring to the Passcards using a clockface metaphor, such as ‘The points about x at 12
o’clock’ to refer to something at top-centre of the graphic
 Reading out the wording from the graphic slowly before talking about it
 Holding up the LHS of their Tutor Notes (or those of a student in the front row to avoid the
class seeing the tutor’s crib notes on the Tutor Notes version)
Other technologies that can be used to display the Notes include:
Tablet PC connected to a beamer. We have found this to be the best technology. Converting the
Student Notes into Journal documents means that you can annotate the graphics and fill in Learning
Example solutions using the tablet, and students can copy your annotations and solutions into their
Notes. To do this open the PDF, select Print, choose ‘Journal Note Writer’ and then once it has
converted you can save it to the PC. This approach also allows you to save the Journal file from the
lesson with the annotations and solutions. Students might ask for these to be emailed to them but
this raises two problems:

vi
 The files are very large and will crash many email accounts.
 The student will need to have Journal reader on their PC to read them. Journal reader is
available as a free download from the Microsoft site but obtaining it can present difficulties,
particularly on work machines if the employers’ IT security policy forbids downloads.
Hosting the Journal files on a college’s virtual learning environment may overcome the problem of
download size. For convenience the Student Notes are provided as a single PDF. This means that
you cannot post individual chapters but will have to re-use the same Journal file at each meeting of
the class and re-post to the VLE.
Conventional PC connected to a beamer. Displaying the PDF of the Student Notes helps
students navigate through their own notes and enables you, the tutor, to point at the Passcards
with a light-pointer or your hands. Without additional software and a tablet to write on it is not
possible to annotate the notes, however.
Printed on to acetate and used on an OHP. This is more effective than using a PC if you are
unable to annotate the projected image from the PC. Putting the acetate under a screen roll or
clean acetate on the OHP means that you can annotate without having to clean or reprint the
acetate with the Passcards graphic on it. You can use colour to emphasise points and you could well
find that your handwriting is better compared to when using PC tablets.
Printed out as an enlarged diagram and attached to chalkboard. The Notes are A4 format.
These can be enlarged to A3 on most photocopiers but even at double-size these are not legible
from a distance. So why not trim round the Passcards graphic, fix it to the middle of the chalkboard
and then write the call-outs at a legible size on the chalkboard outside the paper graphic. Students
can look at their notes, see where you are indicating and add in the call-out.

Using the Learning Examples in the Student Notes

The Learning Examples have been specially written to reinforce the Key Learning Points for each
Passcards graphic. Whilst not necessarily reflecting the types of question that your students could
face in the exam, they are an excellent means within a classroom environment of testing key points
that will form part of the larger questions that appear in exam papers. They also provide you with
an opportunity to encourage discussion and explore issues, and enable you to circulate amongst the
students to check their understanding of topics - for example by looking over their shoulder at what
they are writing or by listening to conversations about discussion Learning Examples.
The icons beside the Learning Examples denote our recommendations on how each may be used.

Pen icon
This denotes a Learning Example where students should produce a written response. This will
probably involve calculations, the completion of pro-formas or the evaluation or discussion of a
problem.
Some Learning Examples require brief written answers that can be fitted into the space provided on
the RHS of the Student Notes. Others will have longer solutions and so you should advise students
to write solutions on file paper and to insert this behind the relevant page of their Notes.
A successful strategy is to set the Learning Example and to provide the students with time to
complete it. Circulate amongst the students and you’ll be able to determine how the class is coping
with it.
 It might be generally understood and you won’t need to intervene.
 It may be causing general problems for the class. In this case you may decide to call a halt
and to give guidance on how to interpret the question and/or how to develop the solution.
 Difficulties might be experienced by a few students. In this case you can help each
individually or, if it is the same difficulty, gather together the students and provide help to
them as a group.
Debriefing written Learning Examples can be done by open discussion, working through on the
board/screen, or by directing students to turn to the solution at the back of the Student Notes. In
each case a vital part of the learning process will be to encourage students to ask questions about
things they are unsure of. In some subjects there will be no single correct solution and so
discussion of alternative answers should be encouraged (providing their interpretation of the
question is right and the points being made are valid).

Introduction vii
 Discussion icon
Discussion Learning Examples are principally for reinforcing knowledge and will be more valuable in
some subjects than others. If students query the value of these Examples, you can emphasise that:
 Discussion helps them through the process of analysing the problem and formulating a
solution, which is what they will need to do in the exam, but they should remember that
discussing it is much quicker than writing it down.
 Discussion can raise far more points than can a single written solution and many students
fail their CIMA exams because they cannot think of sufficient points.
 Explaining their thinking to other students helps them to develop effective
communication.
 Hearing about topics in the context of the different work experiences of other students shows
them ways to apply knowledge to unfamiliar contexts in the exam.
Facilitating discussion Learning Examples can be done in several ways and changing the approach
provides variety for students.
Open class discussion. Set the Learning Example and then throw it open to the class for
discussion. It helps if you note down salient contributions on the board/screen. A key tutor skill
here is the ability to listen to what the student says and to develop, articulate or clarify what they
mean without appearing to suggest their contribution is inadequate. Praising them and saying ‘so to
capture that in a quick note….’ and writing it down in a clearer way is effective. The problem with
this approach is that some students won’t contribute because you, the tutor, already know the
answer or because they are too shy to do so. Generally speaking, open class discussions are most
effective with small class sizes.
Small group discussion. Break the class into groups of four or five and set the Learning Example
to each to discuss. Discussion will be better if a time limit is set for the exercise and they are told
that they have to appoint someone to read out what they decide - the person appointed to speak
will ensure the discussion progresses. You should circulate around the groups after a few minutes
and discreetly listen to what is being said. Stir the pot with comments to a group, or to the room at
large, such as ‘one group had an interesting idea…’ or ‘some of you are taking a very interesting
approach to this..’ before contributing something to help them (whether or not any group had
actually come up with it themselves). Asking students to prepare and give elaborate presentations
on their findings tends to alienate students; they see it as a waste of time because CIMA does not
assess students using presentations.

Web icon
These denote Learning Examples that require students to research from the Internet. They are used
very sparingly because it may be difficult for colleges to assure Internet access for classes of
students, but they can sometimes be set for homework.

viii
Teaching session planners
Our planners are based on 90-minute sessions – this really is as long as you can expect your
students to concentrate without a break – over two types of course.
 A condensed three day course (so 12 sessions)
 A full-length six-day course (so 24 sessions)
Obviously your course might be structured differently but you should be able to adapt the planners
we have provided as necessary.

Condensed course

Session Chapters Learning examples

1 1 and 2 1.1 to 2.3

2 3 3.1 to 3.3

3 4 4.1 to 4.5

4 5 5.1 to 5.4

5 6 and 7 6.1 to 7.2

6 8 8.1 to 8.6

7 9 and 10 9.1 to 10.3

8 11 11.1 to 11.8

9 12 12.1 to 12.4

10 13 and 14 13.1 to 14.3

11 15 15.1 to 15.7

12 16 16.1 to 16.7

Introduction ix
 Standard course

Session Chapters Learning examples

1 1 1.1 to 1.5

2 2 2.1 to 2.3

3 3 3.1

4 3 3.2 and 3.3

5 4 4.1 to 4.3

6 4 4.4 and 4.5

7 5 5.1 and 5.2

8 5 5.3 and 5.4

9 6 6.1 to 6.4

10 7 7.1 and 7.2

11 8 8.1 to 8.3

12 8 8.4 to 8.6

13 9 9.1 to 9.4

14 10 10.1 to 10.3

15 11 11.1 to 11.4

16 11 11.5 to 11.8

17 12 12.1 to 12.4

18 13 13.1 and 13.2

19 13 13.3 and 13.4

20 14 14.1 to 14.3

21 15 15.1 to 15.4

22 15 15.1 to 15.7

23 16 16.1 to 16.4

24 16 16.5 to 16.7

x
chapter 1

OBJECTIVES 

STAKEHOLDERS 

AGENCY AND GOAL CONGRUENCE 

NOT-FOR-PROFIT ORGANISATIONS 

FINANCIAL MANAGEMENT DECISIONS 

This chapter looks at what an entity is trying to

achieve. The aim is to enable an understanding of what
the most important objectives are and how to recognise
whether thay have been achieved.

OBJECTIVES OF
ORGANISATIONS

1
OBJECTIVES

This underlies much of the

theories and techniques
we will be looking at.

Objectives Stakeholders Agency and Not-for-profit Financial

goal congruence organisations management decisions

Maximisation of shareholder wealth

is assumed to be the main objective of a profit-making entity. Share price goes up.

Measured using EPS, ROCE, DPS Other financial targets Non financial objectives

 Level of gearing  Quality measures

 Profit retentions  Customer-based measures
 Operating profitability  Employee welfare
 Cash generation  Society welfare
Conflicts  Value added  Innovation measures

 Short-term v long-term
 Multiple targets Balanced scorecard approach

These ratios will be These are much harder

revised in Chapter 3. to measure.

2
Context
For a profit-maximising company, the main financial objective is assumed to be maximisation of
shareholder wealth.

Key learning points

 Students need to be able to identify the financial and non-financial objectives of
different organisations
 They need to be able to identify whether objectives have been achieved and discuss
any conflicts there may be.

Topic tip
An exam question could give details of a company’s objectives and ask for a forecast to be prepared
to see if these objectives will be met.

Learning example 1.1

Discuss the objectives of an organisation with which you are familiar. Are there any conflicts
between different objectives?

1: Objectives of organisations 3
STAKEHOLDERS

Objectives Stakeholders Agency and Not-for-profit Financial

goal congruence organisations management decisions

Stakeholders Share price

are those persons and organisations that have an measures shareholder attitude to:
interest in the strategy of the organisation  The future – influenced by investment decisions
 Risk – influenced by financing decisions
 Managers
Internal  Cash – influenced by dividend decisions
 Employees
 Shareholders
 Bankers
Connected
 Customers
 Suppliers
 Government
External  Pressure groups
 Local communities

Investment, financing and

dividend decisions provide
the framework for
What objectives
maximising shareholder
would each of these
wealth.
stakeholders have?

4
Context
There is a variety of different groups or individuals whose interests are directly affected by the
activities of an organisation.

Key learning points

 Students need to be able to identify the range of stakeholders and their objectives.
 They also need to discuss the possible conflict between stakeholder objectives.
 Investment decisions eg in projects, takeovers or working capital, need to be analysed to
ensure they benefit the investor.
 Financing decisions look, for example, at how much debt an organisation is planning to
use and are aimed at minimising the cost of capital.
 Dividend decisions depend on how much profit the organisation chooses to retain for
investment.

Learning example 1.2

Discuss what conflict could arise between the objectives of shareholders and the objectives of
employees.

Solution 1.2
Shareholders want profits to be maximised which means keeping costs as low as possible.
Employees may want pay rises and improved working conditions. Both of these are likely to
increase costs and reduce profits, unless productivity improves in return.

1: Objectives of organisations 5
AGENCY AND GOAL CONGRUENCE

Managers may have

different objectives to
shareholders.

Objectives Stakeholders Agency and Not-for-profit Financial

goal congruence organisations management decisions

Agency problem Goal congruence

Managers acting as agents for is the state which leads individuals to take actions which are
shareholders may not act in best in their self-interest and also in the best interest of the entity.
interests of shareholders.
achieved by

Corporate governance Incentive schemes

Actions
The system by which
organisations are directed  Performance related
 Maximise short-term profits to and controlled pay
trigger bonuses  Share options
 Boost their own pay and perks  Rewarding managers
 Avoid debt finance to avoid careful with shares
cash management

The separation of These measures can

ownership and encourage the
control can cause achievement of
problems. shareholder objectives.

6
Context
Managers and shareholders sometimes have objectives other than shareholder wealth
maximisation. This can be dealt with by monitoring the actions of management or using
incentive schemes.

Key learning point

 Students need to be able to explain ways to encourage the achievement of stakeholder
objectives.

Learning example 1.3

Discuss objectives that managers, who are not owners of a business, may have.

Solution 1.3
 Maximise short-term profits to trigger bonus payments
 Minimise dividends to free up funds to use within the business
 Reduce risk by diversifying into new areas/products but shareholders can do this
themselves
 Boost their own pay and benefits
 Avoid debt finance to avoid the need for careful cash management

Learning example 1.4

A listed company is growing rapidly, having developed an exciting and successful new product.
However, the company is starting to have cash flow problems. Managers are given bonuses if there
has been growth in earnings per share (EPS) reported to shareholders.
Discuss the suitability of the current performance related pay scheme.

Solution 1.4
Advantages
 Managers will attempt to achieve growth in EPS which will please shareholders (goal
congruence)
 Reported EPS is audited so it will be difficult for managers to manipulate the figures
Disadvantages
 The company is growing rapidly but there is no incentive to monitor and control cash
flow and working capital. A company can be profitable but without adequate cash, it will
not survive.
 The exciting new product may have a short life cycle and there may be no incentive for
managers to develop a replacement (short-termism)

1: Objectives of organisations 7
NOT-FOR-PROFIT ORGANISATIONS

Objectives Stakeholders Agency and Not-for-profit Financial

goal congruence organisations management decisions

Not-for-profit organisations (NFPOs)

have a primary objective to provide a quality service within a value for money framework.

Value for money Objective setting for NFPOs

 Economy – purchase of inputs of appropriate  Who are the main stakeholders?

quality at minimum cost
 Which are the most important objectives?
 Efficiency – use of these inputs to maximise  How will achievement of objectives be
output measured?
 Effectiveness – use of these inputs to achieve
goals

More appropriate
objectives for NFPOs Can be difficult to
than profit determine if there is
maximisation. value for money.

8
Context
Not-for-profit organisations may obviously not have profit maximisation as a key objective but the
task of setting objectives and developing strategies and controls can help to improve performance.

Key learning points

 Students need to be able to discuss the impact of not-for-profit status on financial and
other objectives.
 Value for money and ways of measuring the achievement of objectives in not-for profit
organisations may also need to be discussed.

Learning example 1.5

(a) Suggest suitable performance measures for a hospital.
(b) Discuss the problems involved in monitoring the performance of a hospital using league
tables.
(c) What value for money performance measures could be used for a public sector further
education college?

Solution 1.5
(a) Incidents of MRSA; waiting times; number of compensations/complaints; under/over spends
against budget; overtime costs; re-admissions; costs per bed/night; number of bed blockers;
length of stay
(b) Concentration on single factors to detriment of others
How can it be made directly comparable (poor areas of country v affluent areas)
Creative accounting/fraud
Self fulfilling prophecy (downward spiral)
(c) Effectiveness
 Achieving target pass rates of grades
 Proportion of graduates employed within a year
Efficiency
 Cost of books per student
 Staff hours per student
 Teaching cost per student
 Total cost of producing a graduate
Economy
 Value for money in sourcing lecture staff of appropriate quality
 Competitive tendering for computers, security, cleaning

1: Objectives of organisations 9
FINANCIAL MANAGEMENT DECISIONS

Main focus is on how

much debt to use to
finance investments.

Objectives Stakeholders Agency and Not-for-profit Financial

goal congruence organisations management decisions

Maximisation of shareholder wealth

Investment decision Financing decision Dividend decision

 Identify investment  Long-term capital structure  Affects views of company’s

opportunities  Short-term working capital long-term prospects and
 Evaluate them management market value of shares
 Decide on optimal  Profitability v liquidity  Payment of dividend
allocation of scarce funds reduces amount of retained
 Source? Cost? Risk? earnings for investment
 New project? Takeover?
Merger? Sell-off?  How much? When?

The three decisions are integrated

Companies with high

Must be analysed to growth prospects and
ensure they are lots of investment
beneficial to opportunities may choose
investors. not to pay dividends.

10
Context
This syllabus concerns financial strategy and the three key decisions relating to investment,
financing and dividends.

Key learning points

 Students need to understand the three key decisions in financial strategy and also the links
between the three decisions.
 They also need to be able to recommend suitable strategies for a particular organisation.

Learning example 1.6

Why do you think that Microsoft did not pay a dividend for so many years and why did it suddenly
start paying dividends to shareholders?

Solution 1.6
Ever since its flotation on the Stock Exchange in 1986 until 2003, Microsoft did not pay dividends.
Investment opportunities, including research and development into new products, were too plentiful
to warrant paying dividends to shareholders. The decision to pay dividends represented Microsoft’s
transition from an archetypal ‘growth’ company that invests all its earnings to one that returns at
least some of its cash to shareholders. The declaration of paying a dividend was interpreted as
reflecting Microsoft’s confidence in its long term growth opportunities and financial strength.

1: Objectives of organisations 11
 Reinforcement
Study Text Chapter 1

 Expand notes on all of Chapter 1

 Attempt Quick Quiz
 Attempt Question 1 in the Exam Question Bank

12
chapter 2

CONSTRAINTS 

REGULATORY BODIES 

INFLATION AND EXCHANGE RATES 

INTEREST RATES 

Various external factors can affect an organisation’s

ability to implement its financial strategy.
Businesses must operate in an economy in which
government is trying to achieve its objectives. The
economic environment will impact on a business’s
activities and future plans.

CONSTRAINTS
ON FINANCIAL
STRATEGY

13
CONSTRAINTS

Small and medium sized Remember the links between

entities may find it financing, investment and
particularly hard to raise dividend decisions.
finance.

Constraints Regulatory Inflation and Interest

bodies exchange rates rates

Lack of funding
Need to keep
Business strategy investors happy
Constraints

Regulatory bodies Economic factors

Foreign exchange risk
Political risk
Entities which trade internationally
Geographical separation
have extra constraints
Litigation

Think about the risk

material covered in
Paper P3.

14
Context
Factors inside and outside an organisation can hold it back from implementing its financial
strategies. Multi-national companies will have different constraints to small and medium - sized
domestic organisations.

Key learning points

 Students need to be able to identify and analyse the impact of internal and external
constraints on financial strategy.
 Funding constraints will be covered in more detail later in the course when we look at debt
and equity financing.
 Students need to use their knowledge from the other two strategic papers when answering
discussion questions on this part of the syllabus. Commonsense business knowledge will be
very useful and should be developed if necessary.

Web
Business awareness can be developed by regularly reading business sections of newspapers.
www.bbc.co.uk/business
www.timesonline.co.uk/business
www.ft.com

2: Constraints on financial strategy 15

REGULATORY BODIES

Acting in accordance with

legislation may involve
extra costs of compliance
or penalties for failure to
comply.

Constraints Regulatory Inflation and Interest

bodies exchange rates rates

Legislation
Eg Companies Acts, Health and Safety, employment law

Regulatory bodies

Competition regulation Corporate governance

Industry regulators impose price and profit The system by which companies
controls where market is not competitive. are directed and controlled.
Competition authorities protect competion
and regulate takeovers.

For example, where there

is a natural monopoly such Covered in detail in
as water, gas or electricity. Paper P3.

16
Context
Powerful external constraints on the ability of a company to create wealth for its shareholders are
local or overseas governments or government regulators.

Key learning points

 Students need to be aware of the regulations which may impact on the financial strategy of
an organisation.
 Takeover legislation will be covered in more detail in Chapter 16.
 Corporate governance is covered in detail in Paper P3 and students should use their P3
knowledge as necessary in this exam.

2: Constraints on financial strategy 17

INFLATION AND EXCHANGE RATES

A country with a relatively

high inflation rate will see
its currency weaken Exporters will be usually
against those with a lower happy when the exchange
inflation rate. rate falls.

Constraints Regulatory Inflation and Interest

bodies exchange rates rates

Effects of inflation Effects of exchange rate increases

 ↑ costs of production  ↑ costs of exports
 ↓ costs of imports
 ↑ selling prices
 ↑ interest rates to dampen demand
 ↓ foreign exchange rates (through purchasing
power parity)
 ↓ demand (through higher prices/uncertainty)

Business and exchange rates

Businesses want certainty, but also an exchange rate that means that they are competitive. Exchange rate
uncertainty can lead to businesses financing investments abroad by borrowing in the same currency.

Exchange rate risk

can be managed in
other ways (use
knowledge from
Paper P3).

18
Context
A business will be affected by the economic environment in which it operates and the policies used
by the government to achieve its objectives.

Key learning point

 No detailed knowledge of economics is needed, just an awareness of how economic factors
can impact on a business.

Learning example 2.1

Discuss the impact on a business of the policy changes outlined.
Policy Why? Impact on business?
Fiscal policy
Increasing government
spending
Decreasing government
spending
Cutting taxes
Increasing taxes
Monetary policy
Increasing interest rates
Decreasing interest rates
Exchange rate policy
Raising exchange rates
Lowering exchange rates

Solution 2.1
The solution to this Learning Example is in the Answer Bank.

2: Constraints on financial strategy 19

INTEREST RATES

Investors prefer cash now

so a higher rate is
required for longer term Interest rates are the ‘price’
deposits. of lending and borrowing.

Constraints Regulatory Inflation and Interest

bodies exchange rates rates

Reasons why interest rates differ Effects of interest rate increase

 Risk
 Need to make profit on re-lending
 Duration of lending
 Size of loan
 Different types of financial asset
Nominal and real rates of interest
1 + nominal rate of interest – 1
Real rate of interest = ______________________
1 + rate of inflation
 Market value of interest-bearing securities falls
 Return expected from shares rises
 Price of shares falls
 Companies reduce total debt finance
 Companies raise new debt finance by short-
term borrowing/debt at variable interest rate
 Companies with surplus cash switch into
interest-bearing securities
 Required return on capital investments rises

Nominal rates of interest are the actual

rates of interest paid.
Real rates have been adjusted for inflation.

20
Context
Interest rates are an important element in the economic environment and are of particular
relevance in financial strategy.

Key learning points

 Students need to understand that interest rates impact on a company’s borrowing, the
exchange rates of the currencies it deals in and demand for its products.
 They also need to be aware of the implications of the risk-return trade-off, the higher the
risk, the higher the return required.
 The calculation of real and nominal rate of interest needs to be understood and learnt.

Learning example 2.2

If the nominal rate of interest is 6% and the rate of inflation is 4%, what is the real rate of interest?

Solution 2.2
Real rate of interest = [(1 + nominal rate of interest) / (1 + rate of inflation)] – 1
= (1.06/1.04) - 1
= 1.0192 – 1
= 1.9%

2: Constraints on financial strategy 21

INTEREST RATES

Normally, the longer the

term of an asset to
maturity, the higher the
interest rate paid on that
asset.

Constraints Regulatory Inflation and Interest

bodies exchange rates rates

Upward sloping yield curve

 Compensate investor for tying up
money
 Greater risk in lending long-term

Downward sloping yield curve

 Interest rates expected to fall
 Government influence
 Investors confined to one segment

Short-term rates are

higher than long-
term rates.

22
Context
Interest rates depend on the term to maturity of the asset. We usually expect long-term financial
assets to offer a higher yield than short-term assets.

Key learning points

 Students need to be able to describe and discuss the causes of interest rate
fluctuations and the impact on the financial strategy of an organisation.

Learning example 2.3

Discuss the factors that affect the general level of interest rates.

Solution 2.3
Inflation
Nominal rates of interest should be sufficient to cover expected rates of inflation over the term
of the investment and to provide a real return.
Uncertainty about future rates of inflation
When investors are uncertain about inflation and therefore about what future nominal and real
interest rates will be, they are likely to require higher interest yields to persuade them to take
the risk of investing, especially in the longer term.
Higher interest rates have to be offered to persuade savers to invest their surplus money. When
the demand to borrow increases, interest rates will rise.
Balance of payments
When a country has a continuing deficit on the current account of its balance of payments, and the
authorities are unwilling to allow the exchange rate to depreciate by more than a certain amount,
interest rates may have to be raised to attract capital into the country. The country can then
finance the deficit by borrowing from abroad.
Monetary policy
From mid-1997, decisions over UK interest rate policy have been made by the Monetary Policy
Committee of the Bank of England. The Bank of England influences very short-term money market
rates by means of open market operations. Usually longer term money market rates, and then
banks' base rates, will respond to the authorities' wish for interest rate changes.
Interest rates abroad
The rate of interest in one country will be influenced by external factors, such as interest rates in
other countries and expectations about the exchange rate. When interest rates in overseas
countries are high, interest rates on domestic currency investments must also be comparably high,
to avoid capital transfers abroad and a fall in the exchange rate of the domestic currency.

2: Constraints on financial strategy 23

 Reinforcement
Study Text Chapter 2

 Expand notes on any areas where more knowledge is needed

 Attempt Quick Quiz
 Attempt Question 2 in the Exam Question Bank

24
chapter 3

PERFORMANCE ANALYSIS 

FORECAST FINANCIAL STATEMENTS 

FINANCING REQUIREMENTS 

For this paper, you must be able to choose the

appropriate measures and indicators of an
organisation’s situation, and discuss whether these
indicate that the organisation has met its objectives.
You may also be asked to prepare forecast financial
statements as well as forecast cash flow statements,
and consider how different policies affect forecasts.

FORECASTING
AND ANALYSIS

25
PERFORMANCE ANALYSIS
Aiming to maximise These ratios are all revised
profits to maximise in the Study Text if needed.
shareholder wealth.

Performance Forecast financial Financing

analysis statements requirements

Remember!
 Only calculate relevant ratios  Profitability
 Understand the needs of the user  Liquidity
 Debt
 Shareholders’ investment
 Make meaningful comments applied to the scenario

 Is comparable information available?

 Understand the limitations  Is information up-to-date?
 Could information have been manipulated?
 What other information should be looked at?

Dividends Dividend yield

Returns to shareholders EPS
Capital gains from increases in market value P/E ratio
Profitability
ROCE = Profit margin × Asset turnover
PBIT Revenue
= ×
Revenue Capital employed
Liquidity
Receivables Inventory Accounts payable
Current ratio Quick ratio Cash cycle
collection period turnover period

You must know these by now!

Gearing
Debt ratios
Interest cover

Debt/equity is the
easiest one to
remember, preferably
using market values.

26
Context
Ratio analysis can be used to assess the performance of a company and determine whether
financial objectives are being met.

Key learning points

 Students need to be able to calculate these ratios competently and quickly. Revision and
practice will probably be needed.
 Students need be able to use ratio analysis to evaluate current performance and discuss
whether an organisation has met its objectives.

Learning example 3.1

Summary financial information for Shepherdson Inc is given below, covering the last two years.
Previous year Current year
$'000s $'000s
Revenue 109,500 120,000
Cost of sales 41,500 45,500
Salaries and wages 31,500 32,250
Other costs 14,750 18,500
Profit before interest and tax 21,750 23,750
Interest 3,000 2,500
Tax 6,000 7,000
Profit after interest and tax 12,750 14,250
Dividends payable 5,000 5,500
Shareholders’ funds 56,500 64,250
Long term debt 28,500 22,500
Number of shares in issue (‘000) 25,000 25,000
P/E ratio (average for year)
Shepherdson Inc 17.0 18.0
Industry 18.0 18.2

Discuss Shepherdson’s performance using profitability and shareholder investor ratios.

Solution 3.1
The solution to this Learning Example is in the Answer Bank.

3: Forecasting and analysis 27

FORECAST FINANCIAL STATEMENTS

Will the organisation need to

raise additional finance and
when?

Performance Forecast financial Financing

analysis statements requirements

Purpose of forecasting

Analysis of financing
Setting shareholder expectations Performance evaluation
requirements

1 Statement of comprehensive income

↓ retained earnings affect statement of financial position
2 Statement of financial position
↓ movement in assets and liabilities determines cash flow
3 Cash flow forecast

Any clear format can be used for a cash flow forecast but you need to be quick.

This exam is likely

to be very time
pressured so speed
is of the essence.

28
Context
Forecast financial statements are based on expected values for economic variables such as interest
rates and business variables such as volume and margins. They are an essential planning tool.

Key learning points

 Students should not worry about using a specific format as speed and clarity are the most
important aspects.
 It is very important to work through the full example in Section 3 of the Study Text and then
practise, practise, practise.

Learning example 3.2

Extracts from the financial statements for a business for the past three years are as follows:
20X4 20X5 20X6
$m $m $m
Profit before tax 21.6 24.4 26.7
Tax expense 7.7 2.6 4.3
Net cash generated after deducting interest, tax and 19.2 (7.1) 18.8
net capital expenditure, but excluding ordinary
dividends
Additional information
1 The opening cash balance in 20X4 for cash and cash equivalents was $6 million
2 The opening book value of equity in 20X4 was $60 million
3 Long-term borrowings remained at $50 million throughout the three years and the annual
gross interest cost on the borrowings was $1 million
4 There were a number of disposals of non-current assets in 20X4 and an exceptionally high
level of capital expenditure in 20X5
5 Dividends were 40 cents per share in 20X3 and grew by 5% per annum between 20X3 and
20X6. This pattern is expected to continue beyond 20X6. Dividends are paid in the year in
which they are declared
6 There are 20 million $1 ordinary shares in issue.
Calculate the following financial information for each of the years 20X4 to 20X6:
(i) Closing cash balance
(ii) Closing book value of equity

Solution 3.2
The solution to this Learning Example is in the Answer Bank.

3: Forecasting and analysis 29

FINANCING REQUIREMENTS

The obvious solution is to A company with lots of

borrow money but this surplus cash could be a
may not be possible. target for a takeover.

Performance Forecast financial Financing

analysis statements requirements

Easing cash flow problems Investing surplus cash

considerations

 Postponing capital expenditure

 Accelerating cash inflows  Liquidity
 Selling non-essential assets  Profitability
 Longer credit  Safety
 Rescheduling loan repayments
 Reducing dividend payments

Ratio analysis can be used to analyse the impact of different types of financing on the
potential achievement of objectives. Eg target EPS.

This is a classic way

for this topic to be
examined.

30
Context
Once the forecast has been prepared, decisions can then be made as to how to deal with a cash
shortage or surplus.

Key learning points

 Students need to be able to prepare forecasts and then discuss alternative financial
strategies for the particular circumstances of the organisation.

Learning example 3.3

Discuss four examples of suitable investments for a short-term cash surplus.

Solution 3.3
Treasury bills Short-term government IOUs, can be sold when needed.
Term deposits Fixed period deposits.
Certificates of deposit Issued by banks, entitle the holder to interest + principal, can be
sold when needed.
Commercial paper Short-term IOUs issued by companies, unsecured.

3: Forecasting and analysis 31

 Reinforcement
Study Text Chapter 3

 Expand notes on all of this important chapter and work through all of the
examples
 Attempt Quick Quiz
 Attempt Questions 3 and 4 in the Exam Question Bank

32
chapter 4

WORKING CAPITAL MANAGEMENT 

DIVIDEND POLICY 

FINANCIAL REPORTING ISSUES 

This chapter looks at alternative financial strategies for

an organisation, beginning with working capital
management.
With dividends, you may be asked to consider the
effect on earnings of different dividend policies, or how
different kinds of shareholders are affected by dividend
policy.
For financial reporting issues, concentrate on the
effects on financial strategy.

SHORT-TERM
FINANCIAL
STRATEGY

33
WORKING CAPITAL MANAGEMENT
This is referring to the
level of investment in
working capital.

Working capital Dividend Financial

management policy reporting issues

Conservative approach
 High levels of working capital
 High financing cost
 Reduced risk of system breakdown
 Possible inventory obsolesence and lack of flexibility to customer
demand

Level of working capital Moderate approach

Aggressive approach
 Low levels of working capital
 Aim to increase profitability by reducing financing cost
 Increased risk of system breakdown and loss of goodwill
 Easier with modern manufacturing techniques

Working capital financing

Short-term finance is usually cheaper than long-term finance.

In A (conservative) all
permanent and some
Assets
fluctuating current assets
($) A
Fluctuating financed out of long-term
current assets sources; may be surplus cash
for investment.
C
B In B (aggressive) all fluctuating
Permanent and some permanent current
current assets assets financed out of short-
term sources, possible liquidity
problems.
Non-current assets
In C long-term funds finance
permanent assets, short-term
0 Time
funds non-permanent assets.

Eg inventory and Vary according to

average level of normal business activity
accounts receivable eg due to seasonal
variations

34
Context
Maintaining adequate working capital is important to ensure the survival of a business but too high
a level of working capital will harm profitability.

Key learning points

 Students need to be able to discuss the conflict between liquidity and profitability.
 Students need to understand that the level of working capital is an investment decision
and the financing of working capital is a financing decision.
 Students should be prepared to calculate the level of fluctuating current assets and
permanent current assets. Being able to draw the diagram will aid a discussion on working
capital financing.

Learning example 4.1

Discuss how investment in higher levels of inventory and receivables affects profitability and
liquidity.

Solution 4.1
Profitability
Higher inventory may lead to higher sales as customers’ choices are more likely to be available.
Higher receivables may encourage more sales as credit terms will be more favourable for
customers.
Liquidity
Higher inventory and receivables mean more cash is tied up. This could lead to cash flow problems.
There is also a higher risk that inventory may become obsolete/damaged and receivables may
default.

Learning example 4.2

Figures for last year for a company were as follows:
Revenue $15 million
Gross profit margin 30% of revenue
Accounts receivable days minimum 15, maximum 35 days
Accounts payable days minimum 30, maximum 40 days
Inventories minimum 40, maximum 70 days
Non-current assets $18 million
It is assumed that the peak period for accounts receivable coincides with the peak period for
inventories and the lowest level of accounts payable.
Calculate the minimum and maximum working capital levels (in $m to 2 decimal places)

Solution 4.2
The solution to this Learning Example is in the Answer Bank.

4: Short-term financial strategy 35

WORKING CAPITAL MANAGEMENT

The business fails to

adequately plan how to
supply its forecast level of
cash flow needs.

Working capital Dividend Financial

management policy reporting issues

Overtrading
happens when a business tries to do too much too quickly with too little long-term capital.

Multinational working capital management

Symptoms of overtrading issues

 Rapid increase in turnover

 Longer distances involved
 Rapid increase in volume of current assets
 More parties involved
 Only a small increase in proprieters’ capital
 Political risk
 Increase in short-term credit finance eg overdraft
 Exchange rate fluctuations
 Dramatic change in liquidity ratios
 Managing inventory is more complex

36
Context
Businesses which are growing rapidly and multinational entities will have specific working capital
issues.

Key learning points

 Overtrading happens when a business tries to do too much too quickly with too little long-
term capital. Students need to be able to recognise, using ratio analysis, a business which
has this problem.
 Students need to recognise the specific working capital issues which apply to
multinational entities and be able to discuss these issues.
 Students need to be able to recommend working capital strategies that are suitable for
the specific entity in a scenario.

Learning example 4.3

Great Ambition Co has appointed a new managing director who has great plans to expand the
company. He wants to increase turnover by 100% within two years, and to do this he employs
extra sales staff. He recognises that customers do not want to have to wait for deliveries, and so he
decides that the company must build up its inventory levels. There is a substantial increase in the
company's inventories. These are held in additional warehouse space which is now rented. The
company also buys new cars for its extra sales representatives.
The managing director's policies are immediately successful in boosting sales, which double in just
over one year. Inventory levels are now much higher, but the company takes longer credit from its
suppliers, even though some suppliers have expressed their annoyance at the length of time they
must wait for payment. Credit terms for accounts receivable are unchanged, and so the volume of
accounts receivable, like the volume of sales, rises by 100%.
In spite of taking longer credit, the company still needs to increase its overdraft facilities with the
bank, which are raised from a limit of $40,000 to one of $80,000. The company is profitable, and
retains some profits in the business, but profit margins have fallen. Gross profit margins are lower
because some prices have been reduced to obtain extra sales. Net profit margins are lower because
overhead costs are higher. These include sales representatives' wages, car expenses and
depreciation on cars, warehouse rent and additional losses from having to write off out-of-date and
slow-moving inventory items.
Discuss the working capital issues Great Ambition Co is facing and suggest solutions.

Solution 4.3
The company is overtrading. If it had to pay its next trade account, or salaries and wages, before it
received any income, it may not be able to do so without the bank’s permission to exceed its
overdraft limit. The company is profitable, although profit margins have fallen, and it ought to
expect a prosperous future. But if it does not sort out its cash flow and liquidity, it will not survive
to enjoy future profits.
Suitable solutions to the problem would be measures to reduce the degree of overtrading.
(a) New capital from the shareholders could be injected.
(b) Better control could be applied to inventories and accounts receivable. The company could
abandon ambitious plans for increased sales and more non-current asset purchases until the
business has had time to consolidate its position, and build up its capital base with retained
profits.

4: Short-term financial strategy 37

DIVIDEND POLICY

Legal constraints on how What is the liquidity

much dividend can be situation?
paid.
What do shareholders
expect?

Working capital Dividend Financial

management policy reporting issues

Sufficient funds available   Investors want dividend/capital gains

Law on distributable profits   Preferred gearing level
Loan agreements 
Dividend policy  Other sources of finance
Funds for asset replacement   Consistency
How much earnings to retain   Avoid large falls/rises

Retain earnings Pay dividends

 No payment to finance providers  Signal of good prospects

 Enables directors to invest without asking for
 Ensures share price stability
approval by finance providers
 Avoids new share issue and change of control  Shareholders want regular income
and issue costs

Remember that it is the The signalling effect of dividends is

cash generated from very important. A large rise or fall
retention of earnings in dividends can significantly affect
which can be used. the share price.

38
Context
A company can choose to either retain earnings or pay dividends. This decision interacts with the
investment and financing decisions.

Key learning points

 Students need to understand and be able to discuss the relationship between the dividend
decision and the financing decision.
 The amount of surplus cash paid out as dividends will have a direct impact on finance
available for investment.

Topic tip
Dividend policy may be examined as a minor issue to comment on.

4: Short-term financial strategy 39

DIVIDEND POLICY
Companies at different The value of a company is
stages in the lifecycle determined solely by the
will have different earning power of its assets,
dividend policies. not the level of its dividends.

Working capital Dividend Financial

management policy reporting issues

Constant payout ratio Can create volatile dividend movements

Stable growth Set at a level that signals the company’s growth prospects
Residual policy Only pay a dividend after all attractive projects have been funded

Mature companies Young companies

Modigliani and Miller theory of dividend irrelevance

argues that if a company cuts dividends to invest in projects, shareholders can manufacture their own
dividends through selling shares.

Assumes
 No tax
 No transaction costs In reality shareholders do seem to care about dividend policy.
 All relevant information available

Share re-purchase (share buyback)

Share re-purchase can be from distributable profits or new issue proceeds. A private company can purchase its
own shares out of capital.
Benefits Disadvantages
 Use for surplus cash  Determination of purchase price
 Increase in earnings per share  No better use of funds
 Increase in gearing  Tax disadvantage for shareholders
 Prevention of takeover

Scrip dividend Scrip issue

is a dividend in the form of new shares. is the issue of new shares in proportion to existing
 Preserves cash position holdings, reducing equity reserves. It is also known
 May enhance borrowing capacity as a bonus issue.

This is not a dividend

and does not involve
cash.

40