ADVANCED FINANCIAL

MANAGEMENT (AFM)

Optional Module

Chapter 1-The Role and Responsibility of Senior

Financial Executive/Advisor
Chapter 1: The Role and Responsibility of Senior Financial Executive/Advisor

Part A- Role of senior financial adviser in the multinational organisation

Learning Outcome:
a) Develop strategies for the achievement of the organisational goals in line with its agreed
policy framework.[3]

b) Recommend strategies for the management of the financial resources of the organisation
such that they are utilised in an efficient, effective and transparent way.[3]

c) Advise the board of directors or management of the organisation in setting the financial goals
of the business and in its financial policy development with particular reference to:[3]
i) Investment selection and capital resource allocation
ii) Minimising the cost of capital
iii) Distribution and retention policy
iv) Communicating financial policy and corporate goals to internal and external stakeholders
v) Financial planning and control
vi) The management of risk.
d) Recommend the optimum capital mix and structure within a specified business context and
capital asset structure.[3]
e) Recommend appropriate distribution and retention policy.[3]

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1 Financial goals and objectives
What is the role of senior financial adviser in the multinational
organization?

1.1 The principal role of the senior financial executive when setting financial
goals is the maximisation of shareholders' wealth.

1.2 Why profit maximisation is not a sufficient objective for investors?

The reasons are:

(i) Risk and uncertainty. This objective fails to recognise the risk and
uncertainty associated with certain projects. Shareholders tend to be very
interested in the level of risk and maximising profits may be achieved by
raising risk to unacceptable levels.

(ii) Dividend policy. Shareholders are interested in how much they will
receive as dividends. Retained profits can be increased by reducing the
dividend pay out ratio or by not paying a dividend at all. This is not

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 necessarily in the best interests of the shareholders, who might prefer a
certain monetary return on their investment.

(iii) Future profits. Shareholders may not want current profits to be

maximised at the expense of future profits.

(iv) Manipulation of profits. Unlike cash, profits can be easily manipulated

– for example, by changing depreciation policy or provision for doubtful
debts percentage. It is therefore not difficult to appear to be maximising
profits when in reality the company is no better off.

1.3 How to measure shareholders' wealth?

In order to measure shareholders' wealth, we must be able to measure the value of

the company and its shares. How to do this?

Type 1 -Statement of financial position valuation

Assets will be valued on a going concern basis. If retained profits increase year on
year then the company is a profitable one. Statement of financial position values are
not a measure of market value, although retained profits may give some indication
of the level of dividends that could be paid to shareholders.

Type 2- Break-up basis

This basis will only be used when the business is being wound up, there is a threat
of liquidation or management has decided to sell off individual assets to raise cash.

Type 3-Market value

Market value of the shares is the price at which buyers and sellers will trade shares
in a company. This value is the one that is most relevant to a company's financial
objectives. When shares are in a private company, and are not traded on any stock
exchange, there is no easy way to measure their market value. However, the principal
objective of such companies should still be the maximisation of ordinary
shareholders' wealth.

Shareholders' wealth comes from two sources (i) dividends received and (ii)
market value of shares.

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Shareholders' return on investment or Total Shareholder Return = Dividend yield
+ Capital gain on shares

1.4 How is the value of a business increased?

If a company's shares are traded on a stock market, the wealth of shareholders is
increased when the share price goes up. The price of a company's shares may
increase for a number of reasons, including the following.

• Potential takeover bid

• News of winning a major contract
• Announcement of attractive strategic initiatives
• Better than expected profit forecasts and published results
• Change in senior staff, such as a new CEO
• Announcement of an increase in the cash being returned to shareholders eg
via a share buyback by the company (which reduces supply of shares which
should increase the price)

2. Earnings per share (EPS) growth

2.1 Why might you be wary of using EPS to assess the performance of a
company?

Earnings per share (EPS) = Net profit (loss) attributable to ordinary shareholders
Weighted average number of ordinary shares

EPS is based on past data whereas investors should be more concerned with future
earnings. In addition, the measure is very easy to manipulate by changes in
accounting policies and by mergers and acquisitions. In reality, the attention given
to EPS as a performance measure is probably disproportionate to its true worth

2.2. The following are the financial targets set by the management
1 Earning per share
2 Dividend per share
3 Restriction on gearing
4 Profit retentions
5 Profit from operations
6 Cash generation
7 Value added

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3. Non-financial objectives

3.1 Non-financial objectives may limit the achievement of financial objectives.

Their existence suggests the assumption that the main purpose of a company is to
maximise shareholders' wealth is too simplistic.

3.2 Many companies have non-financial objectives that may limit their ability to
achieve their financial objectives. They do not negate the financial objectives but
emphasise the need for companies to have other targets than the maximisation of
shareholders' wealth.

3.3 Examples of non financial objectives:

• Maximise pass rates of examination;
• Provide up to date technology in the classroom
• Reduce queuing time.
• Develop new drugs to fight diseases

4. Investment decision

4.1 The three fundamental decisions that support the objective of maximising
shareholders' wealth are:
• Investment decisions
• Financing decisions
• Dividend decisions

Maximisation of shareholder wealth

Investment Decision Financing Decision Dividend Decision

Risk Management

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Investment decision: The financial manager will need to identify investment
opportunities, evaluate them and decide on the optimum allocation of scarce
funds available between investments.

Investment decisions may be on the undertaking of new projects within the

existing business, the takeover of, or the merger with, another company or the
selling off of a part of the business. Managers have to take decisions in the light of
strategic considerations, such as whether the business wants to grow internally
(through investment in existing operations) or externally (through expansion).

Financing decision
Organic growth.
A company which is planning to grow must decide on whether to pursue a policy of
'organic' internal growth or a policy of taking over other established businesses, or a
mix of the two.

Organic growth requires funding in cash, whereas acquisitions can be made by

means of share exchange transactions. A company pursuing a policy of organic
growth would need to take account of the following.

(a) The company must make the finance available, possibly out of retained profits.
However, the company should then know how much it can afford and, with careful
management, should not overextend itself by trying to achieve too much growth too
quickly.

(b) The company can use its existing staff and systems to create the growth
projects, and this will open up career opportunities for the staff.

(c) Overall expansion can be planned more efficiently. For example, if a company
wishes to open a new factory or depot, it can site the new development in a place
that helps operational efficiency

Growth by acquisition
The aim of a merger or acquisition, however, should be to make profits in the long
term as well as the short term. Acquisitions provide a means of entering a market,
or building up a market share, more quickly and/or at a lower cost than would be
incurred if the company tries to develop its own resources

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.
5. Capital resource allocation – capital rationing

5.1 Capital rationing is a restriction on an organisation's ability to invest capital

funds, caused by an internal budget ceiling being imposed on such expenditure by
management (soft capital rationing), or by external limitations being applied to
the company, as when additional borrowed funds cannot be obtained (hard capital
rationing).

5.2 Capital rationing may be necessary in a business due to internal factors (soft
capital rationing) or external factors (hard capital rationing).

Soft capital rationing may arise for Hard capital rationing may arise for
one of the following reasons. one of the following reasons.

(a) Management may be reluctant to (a) Raising money through the stock
issue additional share capital because market may not be possible if share
of concern that this may lead to prices are depressed.
outsiders gaining control of the
business. (b) There may be restrictions on bank
lending due to government control.
(b) Management may be unwilling to
issue additional share capital if it will (c) Lending institutions may consider
lead to a dilution of earnings per share. an organisation to be too risky to be
granted further loan facilities.
(c) Management may not want to
raise additional debt capital because (d) The costs associated with making
they do not wish to be committed to small issues of capital may be too great
large fixed interest payments.

(d) There may be a desire within the

organisation to limit investment to a
level that can be financed solely from
retained earnings.

(e) Capital expenditure budgets may

restrict spending

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 Practical methods of dealing with capital rationing

A company may be able to limit the effects of capital rationing and exploit new
opportunities.
(a) It might seek joint venture partners with which to share projects.

(b) As an alternative to direct investment in a project, the company may be able to

consider a licensing
or franchising agreement with another enterprise, under which the
licensor/franchisor company would receive royalties.

(c) It may be possible to contract out parts of a project to reduce the initial capital
outlay required.

(d) The company may seek new alternative sources of capital (subject to any
restrictions which apply to it), for example:
• Venture capital
• Debt finance secured on projects' assets
• More effective capital management
• Sale and leaseback of property or equipment
• Delay a project to a later period
• Grant aid

6. Financing decision

6.1. Sources of fund

Short-term sources Long-term sources

(a) Overdrafts Debt

Overdrafts arise when payments from a
current account exceed income to the
current account –
the deficit is financed by an overdraft.
Overdrafts are the most important source
of short-term
finance available to businesses (and
individuals!). They can be arranged
The choice of debt finance depends
on:
• The size of the business (a public
issue of bonds is only available to
large companies)
• The duration of the loan
• Whether a fixed or floating interest
rate is preferred

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relatively quickly and offer a degree of
flexibility. Interest is only charged when
the current account is overdrawn.
(b) Short-term loans
This is a loan of a fixed amount for a
specified period of time. The capital is
received immediately and is repaid either
at a specified time or in instalments.
Interest rates and capital repayment
structure are often predetermined.
(c) Trade credit
This is one of the main sources of short-
term finance for businesses, as they can
take advantage of credit periods granted
by suppliers. It is particularly useful during
periods of high inflation.
However, companies must consider the
loss of discounts that suppliers may offer
for early payment. Any unacceptable
delays in payment will have an adverse
effect on credit ratings.
(d) Leasing
Leasing is a popular source of finance and
is a useful alternative to purchasing an
asset. The two main types of lease are
operational lease and finance lease. The
difference between the two types of
lease lies with the extent of responsibility
the lessee has for the leased asset
(maintenance etc).
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• The security that can be offered
Bonds
Bonds are long-term debt capital
raised by a company for which
interest is paid, usually half-yearly
and at a fixed rate. Bonds can be
redeemable or irredeemable and
come in various forms, including
floating rate, zero coupon and
convertible
Equity
Equity finance is raised through the
sale of ordinary shares to investors
via a new issue or a rights issue.
Holders of equity shares bear the
ultimate risk, as they are at the
bottom of the creditor hierarchy in
the event of liquidation. As a result
of this high risk, equity shareholders
expect the highest return of long
term finance providers. The cost of
equity is always higher than the cost
of debt.
 6.2 How much debt a company should use? (Level of gearing)
The appropriate level of gearing depends on the following issues:

Issue 1-Stage in the company's life cycle

If a company is just starting up, or is in its early growth phase, a high level of
gearing is discouraged. The company will find it difficult to forecast future cash
flows with any degree of certainty and any debt that is obtained is likely to have
high interest rates attached.

Issue 2-Stability of earnings

This can be linked to the company's life cycle above. New companies tend to have
fluctuating earnings, as do companies in volatile businesses. As interest still has to
be paid regardless of earnings levels, unstable earnings are not conducive to high
gearing ratios.

Issue 3-Operational gearing (contribution/profit before interest and tax)

High levels of fixed costs mean that contribution (sales revenue – variable costs)
will be high relative to profits after fixed costs – that is, operational gearing will be
high. This cost structure means volatile cash flows, therefore high levels of gearing
are not recommended.

Issue 4-Security/collateral for the debt

If a company is unable to offer sufficient levels of security or collateral then debt

will be difficult to obtain. Any debt that is granted will reflect the risk of
insufficient collateral in high interest rates.

6.3 What are the factors to consider when using short term and long term
borrowing (ie. optimal financing mix)?
Under one view (the traditional view) there is an optimal capital mix at which the
average cost of capital, weighted according to the different forms of capital
employed, is minimised.
• Borrowing risk and costs
• Interest rate
• Taxes effect
• Risk attitude of company
• Loss of control
• Commitment
• Present source of finance
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7.Dividend Decision

7.1 Dividends and the company's life cycle

A company's dividend policy will vary depending on the stage of the company's
life cycle.

A young, growing company More mature companies may have built

with numerous profitable
investment opportunities is
unlikely to pay dividends, as
its earnings will be used for
investment purposes.
Shareholders should therefore
have low or no expectations of
receiving a dividend
.
up a sufficient surplus of cash to allow
them to pay dividends
while still being able to fund dividend
payments. Shareholders in such
companies may also benefit from
share buybacks whereby their shares
are repurchased by the company – an
alternative way of returning
surplus cash to shareholders

7.2 The amount of surplus cash paid out as dividends will have a direct impact on
finance available for investment. Finance managers have to decide:

• How much do they pay out to shareholders each year to keep them happy,

• What level of funds do they retain in the business to invest in projects that
will yield long-term income?

• When funds available from retained profits may be needed if debt finance is
likely to be unavailable?

• If taking on more debt would it expose the company to undesirable risks?

• What is on a suitable pay out policy that reflects the expectations and
preferences of investors

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7.3 Dividend Capacity. How to calculate?
Profits after interest, tax & preference dividends X
Less: Debts repayment (X)
Less: Share Repurchases (X)
Less: Investment in Assets (ie. Capital expenditure) (X)
Add: Depreciation X
Add: Any capital raised from new share issues or debt X
Total x

Practice
The following is the extract of the financial data of AVI Company

$m
Operating profit 400
Depreciation 60
Finance charges paid 30
Preference dividends paid 15
Tax paid 75
Ordinary dividends paid 60
The book value of AVI’s non current assets last year were $200 million. This is
projected to rise by $40 million.
AVI Co is planning to repay $100 million of debt during the next year.

Required: Estimate and comment on the dividend capacity of AVI Co.

Solution
$m
Profit after interest and tax (400-30-75) 295
Less: Preference dividends (15)
Less: Capital Expenditure (100)
(Closing NCA higher by 40+ Depreciation 60 = Capital
Expenditure)
Less: Debt repaid (100)
Add: Depreciation 60
Dividends Capability 140
Conclusion: The ordinary divided paid of $60 is below the $140 and AVI is
capable of paying.

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 8. Share repurchase schemes (Exam Focus)

Benefits of a share repurchase scheme

• Finding a use for surplus cash, which may be a 'dead asset'

• Increase in earnings per share through a reduction in the number of shares

in issue. This should lead to a higher share price than would otherwise be the
case, and the company should be able to increase dividend payments on the
remaining shares in issue

• Increase in gearing. Repurchase of a company's own shares allows debt to

be substituted for equity, so raising gearing. This will be of interest to a
company wanting to increase its gearing without increasing its total long-
term funding

• Readjustment of the company's equity base to more appropriate levels,

for a company whose business is in decline

• Possibly preventing a takeover or enabling a quoted company to withdraw

from the stock market

Drawbacks of a share repurchase scheme

• It can be hard to arrive at a price that will be fair both to the vendors and
to any shareholders who are not selling shares to the company.

• A repurchase of shares could be seen as an admission that the company

cannot make better use of the funds than the shareholders.

• Some shareholders may suffer from being taxed on a capital gain following
the purchase of their shares rather than receiving dividend income.

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9. Strategic cash flow planning

9.1 In order to survive, any business must have an adequate net inflow of cash.
Businesses should try to plan for positive net cash flows but at the same time it is
unwise to hold too much cash.

When a company is cash-rich it may choose to do one (or more) of the following.

• Plan to use the cash, for example for a project investment or a takeover bid
for another company

• Pay out the cash to shareholders as dividends, and let the shareholders
decide how best to use the cash for themselves

• Repurchase its own shares (share buyback)

9.2 Strategic fund management is an extension of cash flow planning, which

takes into consideration the ability of a business to overcome unforeseen problems
with cash flows. Where cash flow has become a problem, a company may choose
to sell off some of its assets. However, it is important to recognise the difference
between assets that a company can survive without and those that are essential for
the company's continued operation

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10- Risk management

10.1 The relationship between risk and return is demonstrated in the diagram
below

10.2 Risk can be managed in several different ways.

• Hedging. Hedging involves taking actions to make an outcome more
certain.

• Diversifying. This was mentioned earlier in this chapter and is effectively

the prevention of 'putting all your eggs in one basket'. A portfolio of
different investments, with varying degrees of risk, should help to reduce the
overall risk of the business. One way of achieving diversification is via
acquisition or merger.

• Risk mitigation. This involves putting control procedures in place to avoid

investments in projects whose risk is above the shareholders' required level

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11.Strategies for achieving financial goals

11.1 Characteristics of strategic decisions

Johnson, Scholes and Whittington (2008) have summarised the characteristics of
strategic decisions for an organisation as follows.

• Strategic decisions will be concerned with the scope of the organisation's

activities.

• Strategy involves the matching of an organisation's activities to the

environment in which it operates.

• Strategy also involves the matching of an organisation's activities to its

resource capability.

• Strategic decisions therefore involve major decisions about the allocation or

reallocation of resources.

• Strategic decisions will affect operational decisions, because they will set
off a chain of 'lesser' decisions and operational activities, involving the use of
resources.

• Strategic decisions will be affected by: (i) Environmental considerations

(ii) Resources availability, (iii) The values and expectations of the people in
power within the organisation

• Strategic decisions are likely to affect the long-term direction that the
organisation takes.

• Strategic decisions have implications for change throughout the organisation,

and so are likely to be complex in nature

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