Notes. CIMA Paper F3. Financial Strategy. theexpgroup.com

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1 CIMA Paper F3 Financial Strategy Notes

2 Contents About ExPress Notes 3 1. Formulating Financial Strategy 7 2. Evaluating Financial Strategy Evaluating Financing Decisions Cost of Capital in Financing Decisions Evaluating Investment Decisions Valuations Mergers & Acquisitions 46 Page 2

3 START About ExPress Notes We are very pleased that you have downloaded a copy of our ExPress notes for this paper. We expect that you are keen to get on with the job in hand, so we will keep the introduction brief. First, we would like to draw your attention to the terms and conditions of usage. It s a condition of printing these notes that you agree to the terms and conditions of usage. These are available to view at Essentially, we want to help people get through their exams. If you are a student for the CIMA exams and you are using these notes for yourself only, you will have no problems complying with our fair use policy. You will however need to get our written permission in advance if you want to use these notes as part of a training programme that you are delivering. WARNING! These notes are not designed to cover everything in the syllabus! They are designed to help you assimilate and understand the most important areas for the exam as quickly as possible. If you study from these notes only, you will not have covered everything that is in the CIMA syllabus and study guide for this paper. Components of an effective study system On ExP classroom courses, we provide people with the following learning materials: The ExPress notes for that paper The ExP recommended course notes / essential text or the ExPedite classroom course notes where we have published our own course notes for that paper The ExP recommended exam kit for that paper. In addition, we will recommend a study text / complete text from one of the CIMA official publishers, but we do not necessarily give this as part of a classroom course, as we think that it can sometimes slow people down and reduce the time that they are able to spend practising past questions. ExP classroom course students will also have access to various online support materials, including: The unique ExP & Me e-portal, which amongst other things allows view again of the classroom course that was actually attended. ExPand, our online learning tool and questions and answers database Everybody in the World has free access to CIMA s own database of past exam questions, answers, syllabus, study guide and examiner s commentaries on past sittings. This can be Page 3

4 an invaluable resource. You can find links to the most useful pages of the CIMA database that are relevant to your study on ExPand at How to get the most from these ExPress notes For people on a classroom course, this is how we recommend that you use the suite of learning materials that we provide. This depends where you are in terms of your exam preparation for each paper. Your stage in study for each paper These ExPress notes ExP recommended course notes, or ExPedite notes ExP recommended exam kit CIMA online past exams Prior to study, e.g. deciding which optional papers to take Skim through the ExPress notes to get a feel for what s in the syllabus, the size of the paper and how much it appeals to you. Don t use yet Don t use yet Have a quick look at the two most recent real CIMA exam papers to get a feel for examiner s style. At the start of the learning phase Work through each chapter of the ExPress notes in detail before you then work through your course notes. Don t try to feel that you have to understand everything just get an idea for what you are about to study. Don t make any annotations on the ExPress notes at this stage. Work through in detail. Review each chapter after class at least once. Make sure that you understand each area reasonably well, but also make sure that you can recall key definitions, concepts, approaches to exam questions, mnemonics, etc. Nobody passes an exam by what they have studied we pass exams by being efficient in being able to prove what we know. In other words, you need to have effectively input the knowledge and be effective in the output of what you know. Exam practice is key to this. Try to do at least one past exam question on the learning phase for each major chapter. Don t use at this stage. Page 4

5 Your stage in study for each paper These ExPress notes ExP recommended course notes, or ExPedite notes ExP recommended exam kit CIMA online past exams Practice phase Work through the ExPress notes again, this time annotating to explain bits that you think are easy and be brave enough to cross out the bits that you are confident you ll remember without reviewing them. Avoid reading through your notes again. Try to focus on doing past exam questions first and then go back to your course notes/ ExPress notes if there s something in an answer that you don t understand. This is your most important tool at this stage. You should aim to have worked through and understood at least two or three questions on each major area of the syllabus. You pass real exams by passing mock exams. Don t be tempted to fall into passive revision at this stage (e.g. reading notes or listening to CDs). Passive revision tends to be a waste of time. Download the two most recent real exam questions and answers. Read through the technical articles written by the examiner. Read through the two most recent examiner s reports in detail. Read through some other older ones. Try to see if there are any recurring criticism he/ she makes. You must avoid these! The night before the real exam Read through the ExPress notes in full. Highlight the bits that you think are important but you think you are most likely to forget. Unless there are specific bits that you feel you must revise, avoid looking at your course notes. Give up on any areas that you still don t understand. It s too late now. Don t touch it! Do a final review of the two most recent examiner s reports for the paper you will be taking tomorrow. At the door of the exam room before you go in. Read quickly through the full set of ExPress notes, focusing on areas you ve highlighted, key workings, approaches to exam questions, etc. Avoid looking at them in detail, especially if the notes are very big. It will scare you. Leave at home. Leave at home. Page 5

6 Our ExPress notes fit into our portfolio of materials as follows: Notes Notes Notes Provide a base understanding of the most important areas of the syllabus only. Provide a comprehensive coverage of the syllabus and accompany our face to face professional exam courses Provide detailed coverage of particular technical areas and are used on our Professional Development and Executive Programmes. To maximise your chances of success in the exam we recommend you visit www. where you will be able to access additional free resources to help you in your studies. START About The ExP Group Born with a desire to be the leading supplier of business training services, the ExP Group delivers courses through either one of its permanent centres or onsite at a variety of locations around the world. Our clients range from multinational household corporate names, through local companies to individuals furthering themselves through studying for one of the various professional exams or professional development courses. As well as courses for CIMA and other professional qualifications, our portfolio of expertise covers all areas of financial training ranging from introductory financial awareness courses for non financial staff to high level corporate finance and banking courses for senior executives. Our expert team has worked with many different audiences around the world ranging from graduate recruits through to senior board level positions. Full details about us can be found at www. and for any specific enquiries please contact us at info@. Page 6

7 Chapter 1 Formulating Financial Strategy START The Big Picture Financial strategy is designed in the context of a corporation s overall strategic objectives and in keeping with its mission statement and core values. Managers are expected to have a clear understanding of where their company is headed if they are to be able to define and communicate objectives clearly throughout the organisations. Financial vs. non-financial objectives Different organisations have different financial and non-financial objectives: Profit-seeking companies: Maximising shareholder wealth is an over-arching objective; Page 7

8 Other (non-financial) objectives: supporting environmental good practices; promoting progressive labor policies/practices; pursuing steps to enhance its image/reputation; enforcing high standards of professional integrity/conduct Non-profit organisations: Though making a profit is not an objective of such organisations, cost controls (and maximizing funding sources) are; this is best summarized in the concept of Value for Money, consisting of: Economy: Getting the best deal on inputs; Efficiency: Converting inputs into the maximum number of outputs; Effectiveness: Ensuring that organizational objectives are being met Public-sector entities: Government-related organisations providing services to the public (non-financial objectives) and covering costs, providing a surplus, or at least minimize deficits (financial objectives). Financial objectives The financial objective of a firm is generally considered to be the maximisation of shareholder wealth. To achieve this, financial management consists of making decisions in three key areas: 1. Investing: What spending needs to be done to carried out to obtain the maximum financial impact (e.g. equipment, R&D, acquisitions, training, distribution network, technology, inventory) 2. Financing: Where to source the funding so as to minimize the cost of capital to the firm (equity, debt, suppliers) 3. Dividends: How much cash to allocate to the shareholders to maintain their commitment to the company while retaining appropriate resources for reinvestment Page 8

9 Matching principle Matching investments and financing Funding strategies are guided by the following considerations: Temporary cash shortages can be funded short-term, while Permanent shortages should be funded long-term The matching principle can be applied to the assets being financed: Fixed assets are generally funded long-term, along with the permanent portion of current assets (e.g. buffer stocks); Current assets of a fluctuating nature can rely on short-term finance (e.g. seasonal upswings in inventories / receivables) Cash surpluses, on the other hand, can be dealt with based on whether they are: Short-term: in this case they may be invested in short-term, low-risk, liquid investments (e.g. Treasury bills or marketable securities); Long-term: Make acquisitions; Reduce debt; Pay extraordinary dividend, etc. Dividends Dividend policies The relationship between dividend policy and shareholder wealth is addressed in different ways: The traditional theory of dividend policy maintains that there is an optimal payout ratio for dividends that suits shareholders and that will maximize the share price. Cash dividends can be seen as a payment to shareholders of residual or excess cash not required in the business for operational reasons. Page 9

10 External constraints Financial strategy must be formulated in the context of external constraints: Funding: Will the financial markets be willing to provide the funding needed? Regulatory bodies: The Chief Financial Officer must be aware of regulatory constraints on the choices made, both in the domestic market and where foreign operations are concerned. Examples: Price controls; Listing requirements (stock exchanges); Anti-monopoly rules; Industry-level regulations (incl. self-regulation); Corporate strategy: Is the strategy consistent with the company s risk acceptance and ethical policies; Economic factors: Where is the economy headed and how will trends affect financial strategy? Page 10

11 Chapter 2 Evaluating Financial Strategy START The Big Picture Identifying the risks to a chosen strategy and the techniques necessary to evaluate them are key parts of the skill set of any manager. Financial risks In formulating financial strategy, a company must plan for and make assumptions regarding: Interest rate risks Another area of financial risk is the sensitivity of a company s assets and liabilities to a change (up or down) in interest rates. A company should know what the net impact of such movements will be on its financial condition. Page 11

12 Inflation Price increases reduce the purchasing power of money. Foreign Exchange Risks Foreign exchange risk occurs when a company is potentially affected by changes in foreign exchange rates. Companies with assets, liabilities, revenues or expenses denominated in currencies different fro its home currency is exposed to foreign exchange risk. Assessing creditworthiness When assessing the creditworthiness of (potential) clients, companies can use the approach typically employed by banks, referred to (originally) as the 3 C s of credit, later expanded to the 5 C s. They are: Character: Focuses on the reputation of the principals/decision makers at a company; credit checking agencies and bank references assist to this end; Capacity: Examines the company s cash flow generation in the context of management s ability to perform competently and reliably in meeting their obligations, based on an examination of their track record (either directly or via the experiences of others). Financial statement analysis is a major part of the exercise here (and in the next point); Capital: Identifies and assesses the financial staying power and resources of the business; how much of a capital cushion do they have to withstand losses and how much do they have committed at risk in a proposed transaction that incentivizes them to succeed (one can refer to this as the pain factor ); Collateral: Assesses what (if any) security the company is willing to provide in support of the intended transaction. Banks refer to this as providing additional exits ( ways out ) from a transaction. Conditions: This is a general review of the economic environment to appreciate to what extent a customer may be affected by a decline in general business conditions (business cycle influences). Page 12

13 Financial forecasting Financial modelling involves the determination of cash flows and financial statements based on forecasts and assumptions. Variables include: Interest rates; Volume of sales; Profit margins; Foreign exchange rates Forecasts are made over a number of years. Sensitivity analysis This asks the following question: How are budgetary outcomes affected if certain key variables are altered? The technique is one-dimensional in that it isolates and alters each (key) variable in turn in order to measure the impact. Monte Carlo simulation This is a simulation model that uses probability distribution analysis to analyze the possible outcomes affecting a business (or a project). It is built on the simultaneous changes of many variables, the relationships between these variables being defined in advance, e.g. if price is reduced, how much demand may go up. Each variable itself has a probability distribution and the combinations of variables are modeled by running the model repeatedly, resulting in a distribution of simulation results. Modigliani and Miller Modigliani and Miller (MM) developed a theory which suggested that financial gearing does not matter. WACC stays the same as (cheaper) cost of debt is offset by rising cost of equity. Their theory at this stage ignored taxes. Page 13

14 They further concluded (in MM Proposition 1) that the enterprise value of a company remains the same, regardless of its capital structure. Furthermore (MM Proposition 2) the addition of debt introduces financial risk, which causes the cost of equity to rise. WACC remains unchanged. The drawback of MM theory is that it ignores the tax deductibility of interest payments. When this possibility is introduced (tax relief on debt), MM observed that the WACC will decline in linear fashion. MM concluded that on this basis, a company should (theoretically) borrow as much as possible! Another conclusion of MM is that the value of a leveraged company will exceed the value of the same company unleveraged by the value of its tax shields. Trends in financial reporting Convergence of reporting standards Financial reporting is on a global trend of convergence, e.g. plans to harmonise IFRS with US GAAP. Environmental concerns Issues of environmental concern and sustainability have become established and recognized agenda points for corporations. Many stakeholders are coming to expect explicit acknowledgment of such matters. The triple bottom line approach expands the scope of a company s concerns, beyond the merely economic, to social and ecological as well. Carbon trading programmes are schemes by which a company which outperforms its environmental targets is rewarded by being able to sell its credits to companies that pollute beyond permitted limits. To operate properly, this arrangement requires supervision by a central authority (government) in what is known as a cap and trade regime. Page 14