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Financial management L. Fung AC3059 2015 Undergraduate study in Economics, Management, Finance and the Social Sciences This is an extract from a subject guide for an undergraduate course offered as part of the University of London International Programmes in Economics, Management, Finance and the Social Sciences. Materials for these programmes are developed by academics at the London School of Economics and Political Science (LSE). For more information, see: www.londoninternational.ac.ukThe 2015 edition of this guide was prepared for the University of London International Programmes by: L. Fung, Lecturer in Accounting and Finance, Birkbeck, School of Business, Economics and Informatics. It is a revised edition of previous editions of the guide prepared by J. Dahya and R.E.V. Groves, and draws on the work of those authors. This is one of a series of subject guides published by the University. We regret that due to pressure of work the author is unable to enter into any correspondence relating to, or arising from, the guide. If you have any comments on this subject guide, favourable or unfavourable, please use the form at the back of this guide. University of London International Programmes Publications Office Stewart House 32 Russell Square London WC1B 5DN United Kingdom www.londoninternational.ac.uk Published by: University of London © University of London 2015 The University of London asserts copyright over all material in this subject guide except where otherwise indicated. All rights reserved. No part of this work may be reproduced in any form, or by any means, without permission in writing from the publisher. We make every effort to respect copyright. If you think we have inadvertently used your copyright material, please let us know. Contents Contents Introduction ............................................................................................................ 1 Aims and objectives ....................................................................................................... 1 Syllabus ......................................................................................................................... 2 How to use the subject guide ......................................................................................... 5 Online study resources ................................................................................................... 5 Making use of the Online Library ................................................................................... 6 Examination advice........................................................................................................ 7 Summary ....................................................................................................................... 7 Abbreviations ................................................................................................................ 8 Chapter 1: Financial management function and environment ............................... 9 Essential reading ........................................................................................................... 9 Further reading .............................................................................................................. 9 Works cited ................................................................................................................... 9 Aims ............................................................................................................................. 9 Learning outcomes ........................................................................................................ 9 Two key concepts in financial management .................................................................... 9 The nature and purpose of financial management ........................................................ 11 Corporate objectives .................................................................................................... 14 The agency problem .................................................................................................... 15 Financial markets ......................................................................................................... 16 A reminder of your learning outcomes .......................................................................... 16 Practice questions ........................................................................................................ 16 Sample examination questions ..................................................................................... 17 Chapter 2: Investment appraisals 1 ...................................................................... 19 Essential reading ......................................................................................................... 19 Further reading ............................................................................................................ 19 Aims ........................................................................................................................... 19 Learning outcomes ...................................................................................................... 19 Overview ..................................................................................................................... 19 Basic investment appraisal techniques ......................................................................... 19 Pros and cons of investment appraisal techniques ........................................................ 23 Non-conventional cash flows ....................................................................................... 24 How to value perpetuity and annuity ............................................................................ 26 A reminder of your learning outcomes .......................................................................... 26 Practice questions ........................................................................................................ 26 Sample examination questions ..................................................................................... 26 Chapter 3: Investment appraisals 2 ...................................................................... 29 Essential reading ......................................................................................................... 29 Further reading ............................................................................................................ 29 Aims ........................................................................................................................... 29 Learning outcomes ...................................................................................................... 29 Advanced investment appraisals .................................................................................. 29 A reminder of your learning outcomes .......................................................................... 35 Practice questions ........................................................................................................ 35 Sample examination questions ..................................................................................... 35 iAC3059 Financial management Chapter 4: Investment appraisals 3 ...................................................................... 37 Essential reading ......................................................................................................... 37 Further reading ............................................................................................................ 37 Works cited ................................................................................................................. 37 Aims ........................................................................................................................... 37 Learning outcomes ...................................................................................................... 37 Replacement decision .................................................................................................. 37 Delaying projects ......................................................................................................... 39 Sensitivity analysis ....................................................................................................... 41 Practical consideration ................................................................................................. 42 A reminder of your learning outcomes .......................................................................... 42 Practice questions ........................................................................................................ 42 Sample examination questions ..................................................................................... 43 Chapter 5: Risk and return ................................................................................... 45 Essential reading ......................................................................................................... 45 Further reading ............................................................................................................ 45 Works cited ................................................................................................................. 45 Aims ........................................................................................................................... 45 Learning outcomes ...................................................................................................... 45 Overview ..................................................................................................................... 45 Introduction of risk measurement ................................................................................. 45 Diversification of risk and Portfolio Theory .................................................................... 48 A reminder of your learning outcomes .......................................................................... 50 Practice questions ........................................................................................................ 50 Sample examination questions ..................................................................................... 51 Chapter 6: Portfolio Theory and Capital Asset Pricing Model .............................. 53 Essential reading ......................................................................................................... 53 Further reading ............................................................................................................ 53 Aims ........................................................................................................................... 53 Learning outcomes ...................................................................................................... 53 Overview ..................................................................................................................... 53 Applications of the Capital Market Line (CML) .............................................................. 55 Derivation of Capital Asset Pricing Model (CAPM) ........................................................ 57 A reminder of your learning outcomes .......................................................................... 58 Practice questions ........................................................................................................ 58 Sample examination questions ..................................................................................... 58 Chapter 7: Practical consideration of Capital Asset Pricing Model and Alternative Asset Pricing Models .................................................................. 61 Essential reading ......................................................................................................... 61 Further reading ............................................................................................................ 61 Works cited ................................................................................................................. 61 Aims ........................................................................................................................... 61 Learning outcomes ...................................................................................................... 61 Overview ..................................................................................................................... 62 Alternative Asset Pricing Models .................................................................................. 65 Practical consideration of CAPM .................................................................................. 66 A reminder of your learning outcomes .......................................................................... 66 Practice question ......................................................................................................... 66 Sample examination questions ..................................................................................... 67 iiContents Chapter 8: Capital market efficiency .................................................................... 69 Essential reading ......................................................................................................... 69 Further reading ............................................................................................................ 69 Aims ........................................................................................................................... 69 Learning outcomes ...................................................................................................... 69 Capital markets ........................................................................................................... 69 Types of efficiency ....................................................................................................... 70 Efficient Market Hypothesis (EMH) ............................................................................... 70 A reminder of your learning outcomes .......................................................................... 74 Practice questions ........................................................................................................ 74 Sample examination questions ..................................................................................... 75 Chapter 9: Sources of finance – Equity ................................................................ 77 Essential reading ......................................................................................................... 77 Further reading ............................................................................................................ 77 Work cited................................................................................................................... 77 Aims ........................................................................................................................... 77 Learning outcomes ...................................................................................................... 77 Introduction ................................................................................................................ 77 Internal funds .............................................................................................................. 77 External funds ............................................................................................................. 78 Floatation .................................................................................................................... 78 Share issues ................................................................................................................ 79 Rights issues ............................................................................................................... 81 Private issues ............................................................................................................... 81 The role of stock markets ............................................................................................. 82 A reminder of your learning outcomes .......................................................................... 82 Practice questions ........................................................................................................ 82 Sample examination questions ..................................................................................... 83 Chapter 10: Sources of finance – Debt ................................................................. 85 Essential reading ......................................................................................................... 85 Further reading ............................................................................................................ 85 Aims ........................................................................................................................... 85 Learning objectives ...................................................................................................... 85 Introduction ................................................................................................................ 85 Corporate bonds.......................................................................................................... 85 ................................................................................................................ 87 Debt finance The issue of loan capital .............................................................................................. 88 A reminder of your learning outcomes .......................................................................... 89 Practice questions ........................................................................................................ 90 Sample examination questions ..................................................................................... 90 Chapter 11: Capital structure 1 ............................................................................ 91 Essential reading ......................................................................................................... 91 Further reading ............................................................................................................ 91 Works cited ................................................................................................................. 91 Aims ........................................................................................................................... 91 Learning outcomes ...................................................................................................... 91 Introduction ................................................................................................................ 91 Modigliani and Miller’s theory ...................................................................................... 92 Modigliani and Miller’s argument with corporate taxes ................................................. 94 Personal taxes ............................................................................................................. 95 iiiAC3059 Financial management Other tax shield substitutes .......................................................................................... 96 Financial distress ......................................................................................................... 96 Trade-off Theory ........................................................................................................... 97 A reminder of your learning outcomes .......................................................................... 98 Practice questions ........................................................................................................ 98 Sample examination questions ..................................................................................... 98 Chapter 12: Capital structure 2 ............................................................................ 99 Essential reading ......................................................................................................... 99 Further reading ............................................................................................................ 99 Works cited ................................................................................................................. 99 Aims ........................................................................................................................... 99 Learning outcomes ...................................................................................................... 99 Signalling effect ........................................................................................................... 99 Agency costs on debt and equity ................................................................................ 101 Pecking Order Theory ................................................................................................. 103 Conclusion ................................................................................................................ 103 A reminder of your learning outcomes ........................................................................ 104 Practice questions ...................................................................................................... 104 Sample examination questions ................................................................................... 104 Chapter 13: Dividend policy ............................................................................... 105 Essential reading ....................................................................................................... 105 Further reading .......................................................................................................... 105 Works cited ............................................................................................................... 105 Aims ......................................................................................................................... 105 Learning outcomes .................................................................................................... 105 Introduction .............................................................................................................. 106 Types of dividend ....................................................................................................... 106 Dividend controversy ................................................................................................. 107 Modigliani and Miller’s argument ............................................................................... 107 Clientele effect .......................................................................................................... 108 Information content of dividend and signalling effect ................................................. 109 Agency costs and dividend ......................................................................................... 110 Empirical evidence ..................................................................................................... 111 Conclusion ................................................................................................................ 112 A reminder of your learning outcomes ........................................................................ 112 Practice questions ...................................................................................................... 112 Sample examination questions ................................................................................... 112 Chapter 14: Cost of capital and capital investments ......................................... 115 Essential reading ....................................................................................................... 115 Further reading .......................................................................................................... 115 Aims ......................................................................................................................... 115 Learning outcomes .................................................................................................... 115 Introduction .............................................................................................................. 115 Cost of capital and equity finance .............................................................................. 115 Cost of capital and capital structure ........................................................................... 116 A reminder of your learning outcomes ........................................................................ 119 Practice questions ...................................................................................................... 120 Sample examination question .................................................................................... 120 ivContents Chapter 15: Valuation of business ...................................................................... 121 Essential reading ....................................................................................................... 121 Further reading .......................................................................................................... 121 Works cited ............................................................................................................... 121 Aims ......................................................................................................................... 121 Learning outcomes .................................................................................................... 121 Introduction .............................................................................................................. 121 Approaches to business valuation .............................................................................. 121 Valuation of debt/bonds ............................................................................................ 124 Valuation of equity .................................................................................................... 125 Conclusion ................................................................................................................ 128 A reminder of your learning outcomes ........................................................................ 128 Practice questions ...................................................................................................... 128 Sample examination question .................................................................................... 128 Chapter 16: Mergers ........................................................................................... 131 Essential reading ....................................................................................................... 131 Further reading .......................................................................................................... 131 Aims ......................................................................................................................... 131 Learning outcomes .................................................................................................... 131 Introduction .............................................................................................................. 131 Motives for mergers ................................................................................................... 132 Conclusion ................................................................................................................ 140 A reminder of your learning outcomes ........................................................................ 140 Practice questions ...................................................................................................... 140 Sample examination question .................................................................................... 140 Chapter 17: Financial planning and analysis ...................................................... 143 Essential reading ....................................................................................................... 143 Aims ......................................................................................................................... 143 Learning outcomes .................................................................................................... 143 Introduction .............................................................................................................. 143 Financial analysis ....................................................................................................... 143 Cash based ratios ...................................................................................................... 145 Financial planning ..................................................................................................... 150 Short-term versus long-term financing ....................................................................... 153 A reminder of your learning outcomes ........................................................................ 154 Practice questions ...................................................................................................... 154 Sample examination questions ................................................................................... 154 Chapter 18: Working capital management ......................................................... 155 Essential reading ....................................................................................................... 155 Aims ......................................................................................................................... 155 Learning outcomes .................................................................................................... 155 Introduction .............................................................................................................. 155 Working capital management .................................................................................... 155 Trade receivables management .................................................................................. 156 Working capital and the problem of overtrading ......................................................... 159 A reminder of your learning outcomes ........................................................................ 161 Practice questions ...................................................................................................... 161 Sample examination questions ................................................................................... 161 vAC3059 Financial management Chapter 19: Risk management – Concepts and instruments for risk hedging ... 163 Essential reading ....................................................................................................... 163 Further reading .......................................................................................................... 163 Works cited ............................................................................................................... 163 Aims ......................................................................................................................... 163 Learning outcomes .................................................................................................... 163 Introduction .............................................................................................................. 163 Reasons for managing risk ......................................................................................... 164 Instruments for hedging risk ...................................................................................... 165 Put-call parity ............................................................................................................ 166 Option pricing ........................................................................................................... 167 Futures and forward contracts .................................................................................... 168 Conclusion ................................................................................................................ 169 A reminder of your learning outcomes ........................................................................ 169 Practice questions ...................................................................................................... 169 Sample examination question .................................................................................... 169 Chapter 20: Risk management – Applications.................................................... 171 Essential reading ....................................................................................................... 171 Further reading .......................................................................................................... 171 Aims ......................................................................................................................... 171 Learning outcomes .................................................................................................... 171 Introduction .............................................................................................................. 171 Risk management ...................................................................................................... 171 Some simple uses of options ...................................................................................... 173 Corporate uses of options .......................................................................................... 174 Conclusion ................................................................................................................ 174 A reminder of your learning outcomes ........................................................................ 175 Practice questions ...................................................................................................... 175 Sample examination questions ................................................................................... 175 Appendix 1: Sample examination paper ............................................................ 177 viIntroduction Introduction AC3059 Financial management is a 300 course offered on the degrees and diplomas in Economics, Management, Finance and the Social Sciences (EMFSS) suite of programmes awarded by the University of London International Programmes. Financial management is part of the decision-making, planning and control subsystems of an enterprise. It incorporates the: • treasury function, which includes the management of working capital and the implications arising from exchange rate mechanisms due to international competition • evaluation, selection, management and control of new capital investment opportunities • raising and management of the long-term financing of an entity • need to understand the scope and effects of the capital markets for a company • need to understand the strategic planning processes necessary to manage the long and short-term financial activities of a firm. The management of risk in the different aspects of the financial activities undertaken is also addressed. Studying this course should provide you with an overview of the problems facing a financial manager in the commercial world. It will introduce you to the concepts and theories of corporate finance that underlie the techniques that are offered as aids for the understanding, evaluation and resolution of financial managers’ problems. This subject guide is written to supplement the Essential and Further reading listed for this course, not to replace them. The aim of the course is to provide an understanding and awareness of both the underlying concepts and practical application of the basics of financial management. The subject guide and the readings should also help to build in your mind the ability to make critical judgments of the strengths and weaknesses of the theories, just as it should be helping to build a critical appreciation of the uses and limitations of the same theories and their possible applications. Aims and objectives This course aims to cover the basic building blocks of financial management that are of primary concern to corporate managers, and all the considerations needed to make financial decisions both inside and outside firms. This course also builds on the concept of net present value and addresses capital budgeting aspects of investment decisions. Time value of money is then applied to value financial assets, before extensively considering the relationship between risk and return. This course also introduces the theory and practice of financing and dividend decisions, cash and working capital management and risk management. Business valuation and mergers and acquisitions will also be discussed. 1AC3059 Financial management By the end of this course and having completed the Essential reading and activities, you should be able to: Subject-specific objectives • describe how different financial markets function • estimate the value of different financial instruments (including stocks and bonds) • make capital budgeting decisions under both certainty and uncertainty • apply the Capital Assets Pricing Model in practical scenarios • discuss the Capital Structure Theory and dividend policy of a firm • estimate the value of derivatives and advise management how to use derivatives in risk management and capital budgeting • describe and assess how companies manage working capital and short- term financing • discuss the main motives and implications of mergers and acquisitions. Intellectual objectives • integrate subject matter studied on related modules and to demonstrate the multi-disciplinary aspect of practical financial management problems • use academic theory and research to question established financial theories. Practical objectives • be more proficient in researching materials on the internet and Online Library • be able to use Excel for statistical analysis. Syllabus The subject guide examines the key theoretical and practical issues relating to financial management. The topics to be covered in this subject guide are organised into the following 20 chapters: Chapter 1: Financial management function and environment This chapter outlines the fundamental concepts in financial management and deals with the problems of shareholders’ wealth maximisation and agency conflicts. Chapter 2: Investment appraisals 1 In this chapter we begin with a revision of investment appraisal techniques. The main focus of this chapter is to examine the advantages of using the discounted cash flow technique and its application in basic investment scenarios. Chapter 3: Investment appraisals 2 This chapter follows on from Chapter 2 to explore the application of the discounted cash flow technique in more complex scenarios: capital rationing, price changes and inflation, and tax effect. Chapter 4: Investment appraisals 3 This chapter illustrates the application of the discounted cash flow technique in further complex scenarios: replacement decision, project deferment and sensitivity analysis. 2Introduction Chapter 5: Risk and return We formally examine the concept and measurement of risk and return in this chapter. We also look at the necessary conditions for risk diversification, Portfolio Theory and the Two Fund Separation Theorem. Asset Pricing Models are discussed and practical considerations in estimating beta will be covered. Empirical evidence for and against the Asset Pricing Models will also be illustrated. Chapter 6: Portfolio Theory and Capital Assets Pricing Model This chapter introduces more formally the Portfolio Theory and discusses the derivation of the Capital Assets Pricing Model. Chapter 7: Practical consideration of the Capital Assets Pricing Model and Alternative Asset Pricing Model Following on from Chapter 6 we examine the techniques for estimating betas and their conceptual and practical considerations. We also introduce an Alternative Pricing Model based on the Arbitrage Pricing Model. Chapter 8: Capital market efficiency This chapter discusses the concepts and implications of market efficiency and the mechanism of equity and debt issuance. Chapter 9: Sources of finance – Equity In this chapter we focus on how companies raise funds from the stock and bond markets, and discuss the advantages and disadvantages of this financing method. Chapter 10: Sources of finance – Debt In this chapter we focus on how companies raise funds from the bond markets, and discuss the advantages and disadvantages of this financing method. Chapter 11: Capital structure 1 This chapter introduces the arguments of Modigliani and Miller on capital structure, and discuss the implication of the Trade-off Theory. Chapter 12: Capital structure 2 This chapter critically reviews the existing leading theories of capital structure. Specifically, signalling effect, agency cost of equity and debt, and the Pecking Order Theory will be examined. We will also evaluate the practical considerations of capital structure decisions made by corporate managers. Chapter 13: Dividend policy This chapter aims to explore how the amount of dividend paid by corporations would affect their market values. The tax, signalling and agency effects of dividend will be discussed. Chapter 14: Cost of capital and capital investments In this chapter we discuss how the cost of capital can be adjusted when firms are financed with a mixture of debt and equity. Chapter 15: Valuation of business We introduce the valuation of equity, debt, convertibles and warrants in this chapter. Chapter 16: Mergers This chapter focuses on the theory and motives of mergers and acquisitions. The determination of merger value and the defensive tactics 3AC3059 Financial management against merger threats will also be covered. The empirical evidence of using financial ratios to predict mergers and acquisitions will be discussed. Chapter 17: Financial planning This chapter focuses on the importance of careful financial planning and examines and evaluates the approaches to and methods of financial planning. Chapter 18: Working capital management The importance of managing working capital will be discussed in this chapter. Chapter 19: Risk management – concepts and instruments for risk hedging This chapter provides an introduction to risk management, including: the concepts of risk management and the use of derivatives in hedging. Chapter 20: Risk management – applications This chapter discusses the techniques commonly used in risk hedging. Reading Essential reading Brealey, R.A., S.C. Myers and F. Allen Principles of corporate finance. (New York: McGraw-Hill, 2010) tenth edition ISBN 9780071314268. Hereafter referred to as BMA, this textbook deals with most of the topics covered in this subject guide. Detailed reading references in this subject guide refer to the edition of the set textbook listed above. New editions of this textbook may have been published by the time you study this course. You can use a more recent edition of this book or of any of the books listed below; use the detailed chapter and section headings and the index to identify relevant readings. Also check the VLE regularly for updated guidance on readings. Further reading Please note that as long as you read the Essential reading you are then free to read around the subject area in any text, paper or online resource. You will need to support your learning by reading as widely as possible and by thinking about how these principles apply in the real world. To help you read extensively, you have free access to the virtual learning environment (VLE) and the University of London Online Library (see below). Other useful texts for this course include: Arnold, G. Corporate financial management. (Harlow: Financial Times/Prentice Hall, 2008) fourth edition ISBN 9780273719069. Hereafter referred to as ARN, this textbook also covers most of the topics in this subject guide. It is less technical than BMA. Copeland, T.E., J.F. Weston and K.S. Shastri Financial theory and corporate policy. (Harlow: Pearson-Addison Wesley, 2004) fourth edition ISBN 9780321127211. This is a classic finance textbook pitched at an advanced level. You may use this textbook for reference as it contains some useful updates of empirical studies in the field of corporate finance. Watson, D. and A. Head Corporate finance passnotes. (Harlow: Pearson Education, 2010) first edition ISBN 9780273725268.This concise version of a passnote neatly summarises the key concepts in financial management. You might find it useful as a revision tool. Apart from the above textbooks, this subject guide also refers to some of the original articles from which the financial management theories are 4Introduction developing. You should refer to the works cited in each chapter for the full reference of these articles. How to use the subject guide This subject guide is meant to supplement but not to replace the main textbook. You should use it as a guide to devise a plan for your own study of this subject. Suggested here is one approach to using this subject guide. Approach financial management in the same order as the chapters in this subject guide. It is specifically designed to help you build up your understanding of the subject. 1. For each chapter (apart from this Introduction) you should familiarise yourself with the aim and outcomes before reading the materials. 2. Read the introductory section of each chapter to identify the areas you need to focus on. 3. Carefully read the suggested chapters in BMA, with the aim of gaining an initial understanding of the topics. 4. Read the remainder of the chapter in the subject guide. You may then approach the Further reading suggested in the subject guide and BMA. 5. The subject guide is designed to set the scope of your studies of this topic as well as to attempt to reinforce the basic messages set out in BMA. Therefore you should pay careful attention to the examples in both the texts and the subject guide to ensure you achieve that basic understanding. By taking notes from BMA, and then from other books you should have obtained the necessary material for your understanding, application and later revision. 6. Pay particular attention to the practice questions and the examples given in the subject guide. The material covered in the examples and in the Activities complements the textbook and is important in your preparation for the examination. 7. Ensure you have achieved the listed learning outcomes. 8. Attempt the Sample examination questions at the end of each chapter and the quizzes on the virtual learning environment (VLE). 9. Check you have mastered each topic before moving on to the next. 10. At the end of your preparations, attempt the questions in the Sample examination paper at the end of the subject guide. Then compare your answers with the suggested solutions, but do remember that they may well include more information than the Examiner would expect in an examination paper, since the guide is trying to cover all possible angles in the answer, a luxury you do not usually have time for in an examination. Online study resources In addition to the subject guide and the Essential reading, it is crucial that you take advantage of the study resources that are available online for this course, including the VLE and the Online Library. You can access the VLE, the Online Library and your University of London email account via the Student Portal at: http://my.londoninternational. ac.uk You should have received your login details for the Student Portal with your official offer, which was emailed to the address that you gave on 5AC3059 Financial management your application form. You have probably already logged in to the Student Portal in order to register. As soon as you registered, you will automatically have been granted access to the VLE, Online Library and your fully functional University of London email account. If you have forgotten these login details, please click on the ‘Forgotten your password’ link on the login page. The VLE The VLE, which complements this subject guide, has been designed to enhance your learning experience, providing additional support and a sense of community. It forms an important part of your study experience with the University of London and you should access it regularly. The VLE provides a range of resources for EMFSS courses: • Self-testing activities: Doing these allows you to test your own understanding of subject material. • Electronic study materials: The printed materials that you receive from the University of London are available to download, including updated reading lists and references. • Past examination papers and Examiners’ commentaries: These provide advice on how each examination question might best be answered. • A student discussion forum: This is an open space for you to discuss interests and experiences, seek support from your peers, work collaboratively to solve problems and discuss subject material. • Videos: There are recorded academic introductions to the subject, interviews and debates and, for some courses, audio-visual tutorials and conclusions. • Recorded lectures: For some courses, where appropriate, the sessions from previous years’ Study Weekends have been recorded and made available. • Study skills: Expert advice on preparing for examinations and developing your digital literacy skills. • Feedback forms. Some of these resources are available for certain courses only, but we are expanding our provision all the time and you should check the VLE regularly for updates. Making use of the Online Library The Online Library contains a huge array of journal articles and other resources to help you read widely and extensively. To access the majority of resources via the Online Library you will either need to use your University of London Student Portal login details, or you will be required to register and use an Athens login: http://tinyurl.com/ollathens The easiest way to locate relevant content and journal articles in the Online Library is to use the Summon search engine. If you are having trouble finding an article listed in a reading list, try removing any punctuation from the title, such as single quotation marks, question marks and colons. For further advice, please see the online help pages: www.external.shl.lon.ac.uk/summon/about.php 6Introduction Unless otherwise stated, all websites in this subject guide were accessed in June 2012. We cannot guarantee, however, that they will stay connected and you may need to perform an internet search to find the relevant pages. Examination advice Important: the information and advice given here are based on the examination structure used at the time this guide was written. Please note that subject guides may be used for several years. Because of this we strongly advise you to always check both the current Regulations for relevant information about the examination, and the VLE where you should be advised of any forthcoming changes. You should also carefully check the rubric/instructions on the paper you actually sit and follow those instructions. The examination paper consists of eight questions of which you must answer four questions. Each question carries equal marks and is divided into several parts. The style of question varies but each question aims to test the mixture of concepts, numerical techniques and application of each topic. Since topics in financial management are often interlinked, it is inevitable that some questions might examine overlapping topics. Remember when sitting the examination to maximise the time spent on each question and although, throughout, the subject guide will give you advice on tackling your examinations, remember that the numerical type questions on this paper take some time to read through and digest. Therefore try to remember and practise the following approach. Always read the requirement(s) of a question first before reading the body of the question. This is appropriate whether you are making your selection of questions to answer, or when you are reading the question in preparation for your answer. In the question selection process at the start of the examination, by reading only the requirements, which are always placed at the end of a question, you only read material relevant to your choice, you do not waste time reading material you are not going to answer. Secondly, by reading the requirements first, your mind is focused on the sort of information you should be looking for in order to answer the question, therefore speeding up the analysis and saving time. Remember, it is important to check the VLE for: • up-to-date information on examination and assessment arrangements for this course • where available, past examination papers and Examiners’ commentaries for the course which give advice on how each question might best be answered. Summary Remember this introduction is only a complementary study tool to help you use this subject guide. Its aim is to give you a clear understanding of what is in the subject guide and how to study successfully. Systematically study the next 20 chapters along with the listed texts for your desired success. Good luck and enjoy the subject 7AC3059 Financial management Abbreviations AEV Annual equivalent value AIM Alternative investment market APM Arbitrage Pricing Model ARN Arnold, 2008 ARR Accounting rate of return BMA Brealey, Myers and Allen CAPM Capital Asset Pricing Model CFs Cash flows CME Capital market efficiency CML Capital market line CPI Consumer price index DFs Discount factors DPP Discounted payback period DPS Dividend per share EMH Efficient Market Hypothesis EPS Earnings per share EVA Economic value added IPO Initial public offer IRR Internal rate of return LSE London Stock Exchange MM Modigliani and Miller MVA Market value added NCF Net cash flow NPV Net present value NYSE New York Stock Exchange PE Price earnings ratio PI Profitability index PP Payback period ROA Return on assets ROC Return on capital ROE Return on equity S&P Standard and Poor’s Std dev Standard deviation VLE Virtual learning environment WACC Weighted average cost of capital 8Chapter 1: Financial management function and environment Chapter 1: Financial management function and environment Essential reading BMA, Chapters 1 and 2, pp.49 to 53. Further reading ARN, Chapter 1. Works cited Fisher, I. The theory of interest. (New York: MacMillan, 1930). Aims This chapter paves the foundation for you to understand what financial management is about. In particular, we will examine the roles of financial management, the environment in which businesses are operated, and Agency Theory. More importantly we explain the two key concepts which underpin much of the theory and practice of financial management. Learning outcomes By the end of this chapter, and having completed the Essential reading and activities, you should be able to: • outline the nature and purpose of financial management • describe the general environment in which businesses operate • explain the relationship between financial objectives and corporate 1 Risk is often measured strategies as a dispersion of the possible return outcomes • assess the impact of stakeholders on corporate strategies from the expected mean. • discuss the time value for money concept and the risk and return In Chapter 3 of this subject guide, we will relationship. more formally define the concept of risk in financial management Two key concepts in financial management and discuss the different Before we look at what financial management is about, it is essential for us methods to quantify risk. to understand two key concepts which lay the foundation of this subject. 2 Return refers to the The two key concepts are: financial reward gained as a result of making i. Risk and return. an investment. It is ii. Time value of money. often defined as the percentage of value gain Risk and return plus period cash flow 1 received to the initial Financial markets seem to reward investors of riskier investments with a investment value. 2 3 higher return. The following graph indicates this relationship. 3 The graph has been rescaled in log to fit the page. You should note the vast differences of the cash returns from each investment type. 9AC3059 Financial management Index (Approximate values) Small Cap. (5500) S&P (1800) 1000 Corp. Bonds (55) Long Bonds (39) T Bill (14) 10 1 Year 0.1 end 1925 1997 Figure 1.1: The cash return from five different investments. Source: BMA. Suppose we invested 1 in 1925 in each of the following five portfolios: i. the largest quoted companies in the US, Standard & Poor’s (S&P) ii. the smallest quoted companies measured by market capitalisation in the US iii. corporate bonds iv. long-term US government bonds, Long Bonds v. short-term US government bonds, T Bill. These portfolios have different levels of perceived risk. Arguably, smaller companies have higher varying returns than larger companies. Bonds, on the other hand, are a safer investment to investors. Over time, these portfolios generate cash returns which seem to follow the same order as their respective perceived risk. This leads us to one of the axioms in financial management: The higher the risk, the higher the expected return. Companies and investors should therefore only consider undertaking a riskier investment provided that they are suitably and sufficiently compensated by a higher return. Activity 1.1 What are the main reasons for smaller companies having higher perceived risk? What are the specific risks we are referring to? See the VLE for discussion. 4 4 BMA, Chapter 2 deals Time value of money with the concept of time Money (i.e. cash) has different values over time. Holders of money can value for money and either spend a sum of money now or delay their consumption by investing covers in detail how to the money in different investment opportunities until it is required. calculate present and future values. Suppose an investor can deposit a sum of money in a bank and earn an annual interest of 5%. The value of money to this investor would then be 5% per annum. If the same investor can invest the same sum of money in a financial asset which gives a return of 10% annually, then the value of 10Chapter 1: Financial management function and environment money to this investor would be 10% per annum. The future return from the money invested now is based on the duration of time, the risk of the investment and inflation. For example, 100 invested today will earn 10% per annum of return (i.e. 110 in one year’s time and 121 in two years’ time). An investor who assumes a 10% return will be indifferent between receiving 100 today and 110 in one year’s time as the two cash flows have identical value to the investor. In the time value of money terminology, the present value of 110 received in one year’s time is exactly 100. Similarly, the present value of 121 received in two years’ time is exactly 100, too. This concept can be applied to convert future cash flows into their present values. Denote the present value of a cash flow as PV and future (t-period) value of a cash flow as FV . The general relationship between the present t and future value is: t FV = PV(1+r) where r is the time value of money measured as a t percentage Re-arranging the above equation, we have: FV 1 t PV = =FV × t t t () 1+r () 1+r 1 is the t-period discount factor where t () 1+r The nature and purpose of financial management Having discussed the two key concepts in financial management, we can now turn our attention to the function of financial management. In general, there are three main tasks that financial managers need to undertake: i. Investing decisions – this is how financial managers select the ‘right’ investments. This can be examined in two stages. First we look at how financial managers invest in and manage short-term working capital (this is covered in Chapter 18 of this subject guide) and then we examine how financial managers may appraise long-term investment projects. ii. Financing decisions – this involves the choice of particular sources of funds which provide cash for investments. The key issues that financial managers should address are how: these sources of funds can be raised (covered in Chapters 9 and 10) the value of the business may be affected through the combination of different sources of funds (covered in Chapters 11 and 12) the sources of funds may affect the relationship between different stakeholders (covered in Chapters 11 and 12). iii. Dividend policy – this concerns the return to shareholders (covered in Chapter 13). So in theory and in practice, how are these decisions being considered by financial managers? Link between investing, financing and dividend decisions In a perfect and complete capital market where there are no transaction costs and information is widely available to everyone, it is argued that a firm’s investing, financing and dividend decisions are not interlinked. This is known as Fisher’s Separation Theorem (Fisher, 1930). This is illustrated in the following diagram. 11AC3059 Financial management C 1 a C 1, a Individual 1 Y 1 X C 1 Individual 2 CF 1 b C 1, b I 1 C 0 Y C C W C 0 0, b 0 0 0, a Figure 1.2: Fisher’s Separation Theorem. Suppose a firm is operating in a two-period environment (period 0 – now and period 1 – in one year’s time) with an initial cash flow of Y . It has 0 the opportunity to invest in two types of investments. The first type of project relates to investments which require an initial investment outlay (I ) and deliver CF in the next period for each investment (i). For example, i investing I in period 0 will produce CF in period 1. Hereafter these types i i of projects are referred to as production investment projects. The second type of investment is essentially financial, which allows the firm to borrow and lend an unlimited amount at an interest rate of r. In this case, if a firm borrows (or lends) W in period 0, it will pay back with interest (or receive 0 with interest) W = W (1+r). 1 0 Investing decision What should the firm do in terms of its investments? A firm will logically rank and invest in investment projects in descending order of their profitability (R for each i). A production opportunity frontier can be i obtained (such as the curve Y Y ). A firm will invest up to the point where 0 1 the marginal investment i yields a return that equals the return from the capital market (i.e. interest rate r). The total investment outlays – the amount represented by C Y – is the sum I for all i(i = 1 to i). Once the 0 0 i investment plan is fixed, the firm will have C in period 0 remaining and 0 a cash return of C in period 1. 1 12

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