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2012 DeVry/Becker Educational Development Corp. All rights reserved.

ACCA

PAPER F9

FINANCIAL MANAGEMENT

STUDY SYSTEM

JUNE 2012

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2012 DeVry/Becker Educational Development Corp. All rights reserved.

No responsibility for loss occasioned to any person acting or refraining from action as a result of anymaterial in this publication can be accepted by the author, editor or publisher.

This training material has been published and prepared by Accountancy Tuition Centre (InternationalHoldings) Limited:

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Copyright 2012 DeVry/Becker Educational Development Corp. All rights reserved.

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SESSION 00 CONTENTS

2012 DeVry/Becker Educational Development Corp. All rights reserved. (iii)

CONTENTS

Page

Introduction (v)

Syllabus (vi)

Study guide (xi)

Tables and formulae (xix)

Exam technique (xxii)

1 The Financial Management Function 0101

2 The Financial Management Environment 0201

3 Investment Decisions 0301

4 Discounted Cash Flow Techniques 0401

5 Relevant Cash Flows for Discounted Cash Flow Techniques 0501

6 Applications of Discounted Cash Flow Techniques 0601

7 Project Appraisal under Risk 0701

8 Equity Finance 0801

9 Debt Finance 0901

10 Security Valuation and Cost of Capital 1001

11 Weighted Average Cost of Capital and Gearing 1101

12 Capital Asset Pricing Model 1201

13 Working Capital Management 1301

14 Inventory Management 1401

15 Cash Management 1501

16 Management of Accounts Receivable and Payable 1601

17 Risk Management 1701

18 Business Valuation and Ratio Analysis 1801

19 Glossary 1901

Index 2001

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SESSION 00 CONTENTS

(iv) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

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SESSION 00 SYLLABUS

2012 DeVry/Becker Educational Development Corp. All rights reserved. (v)

INTRODUCTION

This Study System has been specifically written for the Association of Chartered CertifiedAccountants fundamentals level examination, Paper F9 Financial Management

It provides comprehensive coverage of the core syllabus areas and is designed to be usedboth as a reference text and as an integral part of your studies to provide you with theknowledge, skill and confidence to succeed in your ACCA examinations

About the author: Mike Ashworth is ATC Internationals lead tutor in financialmanagement and has more than 10 years experience in delivering ACCA exam-basedtraining.

How to use this Study System

You should first read through the syllabus, study guide and approach to examining the

syllabus provided in this session to familiarise you with the content of this paper. Thesessions which follow include:

An overview diagram at the beginning of each session.This provides a visual summary of the topics covered in each Sessionand how they are related

The body of knowledge which underpins the syllabus. Features of thetext include:

Definitions Terms are defined as they are introduced.

Illustrations These are to be read as part of the text. Any solutionsto numerical illustrations follow on immediately.

Examples These should be attempted using the proformasolution provided (where applicable).

Key points Attention is drawn to fundamental rules andunderlying concepts and principles.

Commentaries These provide additional information.

Focus These are the learning outcomes relevant to thesession, as published in ACCAs Study Guide.

Example solutions are presented at the end of each session.A bank of practice questions is contained in the Study Question Bank provided. These arelinked to the topics of each session and should be attempted after studying each session.

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SESSION 00 SYLLABUS

(vi) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

SYLLABUS

Advanced Financial Management

Financial Management

Management Accounting

Aim

To develop the knowledge and skills expected of a finance manager, in relation toinvestment, financing, and dividend policy decisions.

Main capabilities

On successful completion of this paper, candidates should be able to:

A Discuss the role and purpose of the financial management function

B Assess and discuss the impact of the economic environment on financial management

C Discuss and apply working capital management techniques

D Carry out effective investment appraisal

E Identify and evaluate alternative sources of business finance

F Explain and calculate the cost of capital and the factors which affect it

G Discuss and apply principles of business and asset valuations

H Explain and apply risk management techniques in business.

AFM (P4)

FM (F9)

MA (F2)

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SESSION 00 SYLLABUS

2012 DeVry/Becker Educational Development Corp. All rights reserved. (vii)

Financial management environment (B)

Working capitalmanagement (C)

Investment appraisal(D)

Business finance(E)

Cost of capital(F)

Risk management(H)

Business valuations(G)

Financialmanagement function

(A)

RATIONALE

The syllabus for Paper F9, Financial Management, is designed to equip candidates with theskills that would be expected from a finance manager responsible for the finance function ofa business. The paper, therefore, starts by introducing the role and purpose of the financialmanagement function within a business. Before looking at the three key financialmanagement decisions of investing, financing, and dividend policy, the syllabus exploresthe economic environment in which such decisions are made.

The next section of the syllabus is the introduction of investing decisions. This is done intwo stages - investment in (and the management of) working capital and the appraisal oflong-term investments.

The next area introduced is financing decisions. This section of the syllabus starts byexamining the various sources of business finance, including dividend policy and how muchfinance can be raised from within the business. Cost of capital and other factors thatinfluence the choice of the type of capital a business will raise then follows. The principlesunderlying the valuation of business and financial assets, including the impact of cost ofcapital on the value of the business is covered next.

The syllabus finishes with an introduction to, and examination of, risk and the maintechniques employed in the management of such risk.

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SESSION 00 SYLLABUS

(viii) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

DETAILED SYLLABUS

A Financial management function

1. The nature and purpose of financial management

2. Financial objectives and relationship with corporate strategy

3. Stakeholders and impact on corporate objectives

4. Financial and other objectives in not-for-profit organisations

B Financial management environment

1. The economic environment for business

2. The nature and role of financial markets and institutions

C Working capital management

1. The nature, elements and importance of working capital

2. Management of inventories, accounts receivable, accounts payable and cash

3. Determining working capital needs and funding strategies

D Investment appraisal

1. The nature of investment decisions and the appraisal process

2. Non-discounted cash flow techniques

3. Discounted cash flow (DCF) techniques

4. Allowing for inflation and taxation in DCF

5. Adjusting for risk and uncertainty in investment appraisal

6. Specific investment decisions (lease or buy, asset replacement, capital rationing)

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SESSION 00 SYLLABUS

2012 DeVry/Becker Educational Development Corp. All rights reserved. (ix)

E Business finance

1. Sources of, and raising short-term finance

2. Sources of, and raising long-term finance

3. Raising short and long term finance through Islamic financing

4. Internal sources of finance and dividend policy

5. Gearing and capital structure considerations

6. Finance for Small and Medium-size Entities (SMEs)

F Cost of capital

1. Sources of finance and their relative costs

2. Estimating the cost of equity

3. Estimating the cost of debt and other capital instruments

4. Estimating the overall cost of capital

5. Capital structure theories and practical considerations

6. Impact of cost of capital on investments

G Business valuations

1. Nature and purpose of the valuation of business and financial assets

2. Models for the valuation of shares

3. The valuation of debt and other financial assets

4. Efficient Markets Hypothesis (EMH) and practical considerations in the valuation ofshares

H Risk management

1. The nature and types of risk and approaches to risk management

2. Causes of exchange rate differences and interest rate fluctuations

3. Hedging techniques for foreign currency risk

4. Hedging techniques for interest rate risk

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SESSION 00 STUDY GUIDE

(xii) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

Explain the need for, and theinteraction with, planning anddecision-making in business of:

competition policy government assistance forbusiness

green policies corporate governance

regulation.

2. The nature and role of financialmarkets and institutions

Identify the nature and role ofmoney and capital markets, bothnationally and internationally.

Explain the role of financialintermediaries.

Explain the functions of a stockmarket and a corporate bondmarket.

Explain the nature and features ofdifferent securities in relation to therisk/return trade-off.

C WORKING CAPITAL

MANAGEMENT

1. The nature, elements andimportance of working capital

Describe the nature of workingcapital and identify its elements.

Identify the objectives of workingcapital management in terms ofliquidity and profitability, and

discuss the conflict between them.

Discuss the central role of workingcapital management in financialmanagement.

Ref:

2

9

13

2. Management of inventories,accounts receivable, accountspayable and cash

Explain the cash operating cycleand the role of accounts payableand accounts receivable.

Explain and apply relevantaccounting ratios, including:

current ratio and quick ratio inventory turnover ratio,

average collection period andaverage payable period

sales revenue/net workingcapital ratio

Discuss, apply and evaluate the useof relevant techniques in managinginventory, including the EconomicOrder Quantity model and Just-in-Time techniques.

Discuss, apply and evaluate the useof relevant techniques in managingaccounts receivable, including:

assessing creditworthiness managing accounts receivable collecting amounts owing offering early settlement

discounts

using factoring and invoicediscounting

managing foreign accountsreceivable.

Discuss and apply the use ofrelevant techniques in managingaccounts payable, including:

using trade credit effectively evaluating the benefits of

discounts for early settlementand bulk purchase

managing foreign accountspayable.

Ref:

13

13

14

16

16

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Explain the various reasons forholding cash, and discuss andapply the use of relevant techniquesin managing cash, including:

preparing cash flow forecaststo determine future cash flowsand cash balances

assessing the benefits ofcentralised treasurymanagement and cash control

cash management models, suchas the Baumol model and theMiller-Orr model

investing short-term.3. Determining working capital needs

and funding strategies

Calculate the level of workingcapital investment in current assetsand discuss the key factorsdetermining this level, including:

the length of the workingcapital cycle and terms of trade

an organisations policy on thelevel of investment in currentassets

the industry in which theorganisation operates

Describe and discuss the key factorsin determining working capitalfunding strategies, including:

the distinction betweenpermanent and fluctuatingcurrent assets

the relative cost and risk ofshort-term and long-termfinance

the matching principle the relative costs and benefits

of aggressive, conservative andmatching funding policies

management attitudes to risk,previous funding decisions and

organisation size.

Ref:

15

13

D INVESTMENT APPRAISAL

1. The nature of investment decisionsand the appraisal process

Distinguish between capital andrevenue expenditure, and betweennon-current assets and workingcapital investment.

Explain the role of investmentappraisal in the capital budgetingprocess.

Discuss the stages of the capitalbudgeting process in relation tocorporate strategy.

2. Non-discounted cash flow

techniques

Identify and calculate relevant cashflows for investment projects.

Calculate payback period anddiscuss the usefulness of payback asan investment appraisal method.

Calculate return on capitalemployed (accounting rate ofreturn) and discuss its usefulness as

an investment appraisal method.3. Discounted cash flow (DCF)

techniques

Explain and apply concepts relatingto interest and discounting,including:

the relationship betweeninterest rates and inflation, andbetween real and nominalinterest rates

the calculation of future valuesand the application of theannuity formula

the calculation of presentvalues, including the presentvalue of an annuity andperpetuity, and the use ofdiscount and annuity tables

the time value of money andthe role of cost of capital in

appraising investments.

Ref:

3

5

3

3

5

4

4

4

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(xiv) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

Calculate net present value anddiscuss its usefulness as aninvestment appraisal method.

Calculate internal rate of return anddiscuss its usefulness as aninvestment appraisal method.

Discuss the superiority of DCFmethods over non-DCF methods.

Discuss the relative merits of NPVand IRR.

Calculate discounted payback anddiscuss its usefulness as aninvestment appraisal method

4. Allowing for inflation and taxationin DCF

Apply and discuss the real-termsand nominal-terms approaches toinvestment appraisal.

Calculate the taxation effects ofrelevant cash flows, including thetax benefits of capital allowancesand the tax liabilities of taxableprofit.

Calculate and apply before- andafter-tax discount rates.5. Adjusting for risk and uncertainty in

investment appraisal

Describe and discuss the differencebetween risk and uncertainty inrelation to probabilities andincreasing project life.

Apply sensitivity analysis toinvestment projects and discuss the

usefulness of sensitivity analysis inassisting investment decisions.

Apply probability analysis toinvestment projects and discuss theusefulness of probability analysis inassisting investment decisions.

Apply and discuss other techniquesof adjusting for risk and uncertaintyin investment appraisal, including:

simulation adjusted payback risk-adjusted discount rates

Ref:4

4

4

4

7

5

5

10

7

6. Specific investment decisions (Leaseor buy; asset replacement; capitalrationing)

Evaluate leasing and borrowing tobuy using the before-and after-taxcosts of debt.

Evaluate asset replacementdecisions using equivalent annualcost.

Evaluate investment decisionsunder single-period capitalrationing, including:

the calculation of profitabilityindexes for divisible

investment projects the calculation of the NPV of

combinations of non-divisibleinvestment projects

a discussion of the reasons forcapital rationing

E BUSINESS FINANCE

1. Sources of and raising short-termfinance

Identify and discuss the range ofshort-term sources of financeavailable to businesses, including:

overdraft short-term loan trade credit lease finance

2. Sources of and raising, long-termfinance

Identify and discuss the range oflong-term sources of financeavailable to businesses, including:

equity finance debt finance lease finance venture capital

Ref:6

9

8,9

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2012 DeVry/Becker Educational Development Corp. All rights reserved. (xv)

Identify and discuss methods ofraising equity finance, including:

rights issue placing public offer stock exchange listing

3. Raising short and long term financethrough Islamic financing

Explain the major differencebetween Islamic finance and theother conventional finance.

Explain the concept of interest(riba) and how returns are made byIslamic financial securities.(calculations are not required).

Identify and briefly discuss a rangeof short and long term Islamicfinancial instruments available tobusinesses including:

trade credit (murabaha) lease finance (ijara) equity finance (mudaraba) debt finance (sukuk) venture capital (musharaka)

4. Internal sources of finance anddividend policy

Identify and discuss internalsources of finance, including:

retained earnings increasing working capital

management efficiency

Explain the relationship betweendividend policy and the financingdecision.

Discuss the theoretical approachesto, and the practical influences on,the dividend decision, including:

legal constraints liquidity shareholder expectations alternatives to cash dividends

Ref:

8

2

8

5. Gearing and capital structureconsiderations

Identify and discuss the problem ofhigh levels of gearing.

Assess the impact of sources offinance on financial position andfinancial risk using appropriatemeasures, including:

ratio analysis using statementof financial position gearing,operational and financialgearing, interest coverage ratioand other relevant ratios

cash flow forecasting

effect on shareholder wealth

6. Finance for small and medium sizedentities (SMEs)

Describe the financing needs ofsmall businesses.

Describe the nature of the financingproblem for small businesses interms of the funding gap, thematurity gap and inadequate

security. Explain measures that may be taken

to ease the financing problems ofSMEs, including the responses ofgovernment departments andfinancial institutions.

Identify appropriate sources offinance for SMEs and evaluate thefinancial impact of different sourcesof finance on SMEs.

F COST OF CAPITAL

1. Sources of finance and their relativecosts

Describe the relative risk-returnrelationship and the relative costs ofequity and debt.

Describe the creditor hierarchy andits connection with the relative costsof sources of finance.

Ref:

11

18

8,9

9

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(xvi) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

2. Estimating the cost of equity

Apply the dividend growth modeland discuss its weaknesses.

Apply the capital asset pricingmodel (CAPM) and describe andexplain the assumptions andcomponents of the CAPM.

Explain and discuss the advantagesand disadvantages of the CAPM.

3. Estimating the cost of debt andother capital instruments

Calculate the cost of capital of arange of capital instruments,including:

irredeemable debt redeemable debt convertible debt preference shares bank debt

4. Estimating the overall cost of capital

Distinguish between average andmarginal cost of capital.

Calculate the weighted average costof capital (WACC) using bookvalue and market value weightings.

5. Capital structure theories andpractical considerations

Describe the traditional view ofcapital structure and itsassumptions.

Describe the views of Miller andModigliani on capital structure,both without and with corporatetaxation, and their assumptions.

Identify a range of capital marketimperfections and describe theirimpact on the views of Miller andModigliani on capital structure.

Explain the relevance of peckingorder theory to the selection ofsources of finance.

Ref:

10

12

12

10

11

11

6. Impact of cost of capital oninvestments

Explain the relationship betweencompany value and cost of capital.

Discuss the circumstances underwhich WACC can be used ininvestment appraisal.

Discuss the advantages of theCAPM over WACC in determininga project-specific cost of capital.

Apply the CAPM in calculating aproject-specific discount rate.

G BUSINESS VALUATIONS

1. Nature and purpose of thevaluation of business and financialassets

Identify and discuss reasons forvaluing businesses and financialassets.

Identify information requirementsfor valuation and discuss thelimitations of different types ofinformation.

2. Models for the valuation of shares

Asset-based valuation models,including:

net book value (statement offinancial position basis).

net realisable value basis. net replacement cost basis.

Income-based valuation models,including:

price/earnings ratio method earnings yield method.

Cash flow-based valuation models,including:

dividend valuation model andthe dividend growth model.

discounted cash flow basis.

Ref:

10

11

12

12

18

18

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3. The valuation of debt and otherfinancial assets

Apply appropriate valuationmethods to:

irredeemable debt redeemable debt convertible debt preference shares

4. Efficient Market Hypothesis (EMH)and practical considerations in thevaluation of shares

Distinguish between and discussweak form efficiency, semi-strong

form efficiency and strong formefficiency.

Discuss practical considerations inthe valuation of shares andbusinesses, including:

marketability and liquidity ofshares

availability and sources ofinformation

market imperfections andpricing anomalies

market capitalisation Describe the significance of investor

speculation and the explanations ofinvestor decisions offered bybehavioural finance.

H RISK MANAGEMENT

1. The nature and types of risk andapproaches to risk management

Describe and discuss different typesof foreign currency risk:

translation risk transaction risk economic risk

Ref:

10

2

10

10

17

Describe and discuss different typesof interest rate risk:

gap exposure basis risk

2. Causes of exchange rate differencesand interest rate fluctuations

Describe the causes of exchangerate fluctuations, including:

balance of payments purchasing power parity

theory

interest rate parity theory four-way equivalence

Forecast exchange rates using: purchasing power parity interest rate parity

Describe the causes of interest ratefluctuations, including:

structure of interest rates andyield curves

expectations theory liquidity preference theory market segmentation

3. Hedging techniques for foreigncurrency risk

Discuss and apply traditional andbasic methods of foreign currencyrisk management, including:

currency of invoice netting and matching leading and lagging forward exchange contracts money market hedging asset and liability management

Compare and evaluate traditionalmethods of foreign currency riskmanagement.

Ref:17

17

17

2

17

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(xviii) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

Identify the main types of foreigncurrency derivatives used to hedgeforeign currency risk and explainhow they are used in hedging. (Nonumerical questions will be set onthis topic)

4. Hedging techniques for interest raterisk

Discuss and apply traditional andbasic methods of interest rate riskmanagement, including:

matching and smoothing asset and liability management forward rate agreements.

Identify the main types of interestrate derivatives used to hedgeinterest rate risk and explain howthey are used in hedging. (Nonumerical questions will be set onthis topic).

Ref:

17

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SESSION 00 TABLES AND FORMULAE

2012 DeVry/Becker Educational Development Corp. All rights reserved. (xix)

Formula Sheet

Economic order quantity

=h

o

C

DC2

Miller Orr Model

Return point = Lower limit + (1/3 spread)

Spread =

3

1

rateinterest

flowscashofvariancecostntransactio

3 4

3

The Capital Asset Pricing Model

E(ri) = Rf+i(E(rm)Rf)

The asset beta formula

a =( )( )

+e

de

e T1VV

V+

( )

( )( )

+

d

de

d T1VV

T1V

The Growth Model

PO=( )

( )gg

+

e

O

r

1D

Gordons growth approximation

g = bre

The weighted average cost of capital

WACC = ede

e KVV

V

++ ( )T1K

VV

Vd

de

d

+

The Fisher formula

(1+i) = (1+r) (1+h)

Purchasing power parity and interest rate parity

S1= S0x( )( )

b

c

h1

h1

+

+ F0= S0x

( )( )

b

c

i1

i1

+

+

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SESSION 00 TABLES AND FORMULAE

(xx) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

Present value table

Present value of 1 i.e. (1 + r)n

where r = discount rate

n = number of periods until payment

Discount rate (r)

Periods(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 12 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 23 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 34 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4

5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 67 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 78 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 89 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 910 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 1112 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 1213 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13

14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 1415 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 12 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 23 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 34 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 45 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5

6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 67 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 78 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 89 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 910 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10

11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 1112 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 1213 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 1314 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 1415 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15

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SESSION 00 EXAM TECHNIQUE

(xxii) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

EXAM TECHNIQUE

Reading and planning time

During the 15 minutes reading and planning time you may write on the question paper but

not in your answer booklet.

Try to rank the four questions in their level of difficulty plan to attempt the easiestquestion first and the most difficult last. This should help keep your confidence high duringthe exam.

Although you may use your calculator during the reading and planning time it would bemore effective to draft bullet points for the written elements of the questions.

Any calculations done in the reading and planning time should be restricted to the firstcalculation required in each question.

Time allocation

To allocate your time multiply the marks for each question by 1.8 minutes.

So each 25 mark question should take you 25 1.8 = 45 minutes.

You should also apportion your time carefully between the parts of each question.

Do not be tempted to go over the time allocation on each question - remember the law ofdiminishing returns the longer you spend the lower your efficiency in gaining marks. It ismore effective to move onto the next question.

Attempt all parts of each question. DO not attempt to pass the exam by only performingcalculations or by only attempting three questions.

Numerical elements

Before starting a computation, picture your route. Do this by noting down the stepsyou are going to take and imagining the layout of your answer.

Use a columnar layout if appropriate (e.g. when forecasting a projects cash flows). Thishelps to avoid mistakes and is easier for the marker to follow.

Use lots of space. Include all your workings and cross-reference them to the face of your answer. A clear approach and workings will help earn marks even if you make an arithmetic

mistake.

If you later notice a mistake in your answer, it is not worthwhile spending timeamending the consequent effects of it. The marker of your script will notpunish you forerrors caused by an earlier mistake.

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2012 DeVry/Becker Educational Development Corp. All rights reserved. (xxiii)

Dont ignore marks for written recommendations or comments based on yourcomputation. These are easy marks to gain.

If you write good comments based on calculations which contain errors, you can stillreceive all the marks for the comments.

If you could not complete the calculations required for comment then assumean answerto the calculations. As long as your comments are consistent with your assumedanswer you can still pick up all the marks for the comments.

Write your assumptions if you are not sure how to interpret something in the questionthen state your assumed interpretation.

Written elements

You should aim for good quality in discursive aspects.

Planning

Read the requirements carefully at least twice to identify exactly how many points youare being asked to address.

Note down relevantthoughts on your plan. Give your plan a structure which you will follow when you write up the answer.Presentation

Use headings and sub-headings to give your answer structure and to make it easier toread for the marker. The examiner does not want a long, continuous monologue. Use short paragraphs for each point that you are making. Use bullet points where this seems appropriate (e.g. for a list of advantages/disadvantages)

however each bullet point mustbe followed by a full sentence.

Separate paragraphs by leaving at least one line of space between each. Write legibly.Style

Long philosophical debate does not impress markers. Concise, easily understood language scores good marks and requires less writing. Many points briefly explained tend to score higher marks than one or two points

elaborately explained.

Give real life examples to support our comments. Make sure your handwriting is clear consider using block capitals.

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(xxiv) 2012 DeVry/Becker Educational Development Corp. All rights reserved.

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SESSION 01 THE FINANCIAL MANAGEMENT FUNCTION

2012 DeVry/Becker Educational Development Corp. All rights reserved. 0101

OVERVIEW

Objective

To understand the nature of financial management. To appreciate the various stakeholders in an organisation and their respective

objectives.

NATURE OFFINANCIAL

MANAGEMENT

ORGANISATIONALOBJECTIVES

CONFLICTS OFINTEREST

Corporate objectives Maximisation of shareholder

wealth

Public sector organisations Environmental impacts

Agency theory Stakeholders Directors and shareholders Goal congruence

Financial management decisions Relationships between financial

management, financial and

management accounting

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0102 2012 DeVry/Becker Educational Development Corp. All rights reserved.

1 NATURE OF FINANCIAL MANAGEMENT

Definition

The management of activities associated with the efficient acquisition and useof short and long-term financial resources.

1.1 Financial management decisions

Decisions that are within the scope of financial management include:

What types of funds should be raised equity capital or debt capital? How should the funds be raised? On which proposed investments should the funds be spent? How much dividend should be paid to the shareholders? How much working capital should the organisation have and how should it be

financed?

How should risk be managed?1.2 Relationships between financial management, financial and

management accounting

Financial accounting may influence financial management in various ways. For example:

Directors of quoted companies need to consider the impact of financing decisions on thepublished financial statements (e.g. operating leases are off balance sheet whereasfinance leases would increase reported financial gearing).

Directors of quoted companies need to consider the impact of investment decisions onkey ratios such as return on capital employed.

Management accounting information can often assist the financial manager. For example:

The budgeting process may identify potential cash deficits/surpluses which thefinancial manager must plan to finance/invest.

Analysis of costs into fixed and variable elements may assist financial managementdecisions.

Variance analysis may help to control the costs of new projects.

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2 ORGANISATIONAL OBJECTIVES

2.1 Corporate objectives

In practice companies are likely to have a variety of different objectives which may include a

number of the following:

profit targets; market share targets; share price growth; local and environmental concerns; contented workforce; meeting short-term targets; long-term plans.These objectives can be classified as follows:

Profit goals objectives which lead directly to increased profits (e.g. cost reductionmeasures);

Surrogate profit goals objectives which lead indirectly to increased profits (e.g.maintaining a contented workforce);

Constraints on profit objectives which actually restrict profit (e.g. ensuring that thecompanys operations do no harm to the environment);

Dysfunctional goals objectives which do not provide a benefit even in the long run(e.g. the pursuit of market leadership at all costs).

A company may aim at either maximising or satisficing these objectives:

Maximising involves seeking the best possible outcome; Satisficing involves finding an adequate outcome.2.2 Maximisation of shareholders wealth

In theoretical terms a single corporate objective is assumed and this is the maximisation ofshareholder wealth.

Shareholder wealth is the combination of dividend and share price growth togetherreferred to as Total Shareholder Returns (TSR).

The objective of maximising shareholder wealth can be justified in the following ways:

The company which provides the highest returns for its investors will find it easiest toraise new finance and grow in the future. If a company does not provide competitivereturns it will inevitably decline.

The directors of a company have a legal duty to run the company on behalf of theshareholders. It is generally considered a reasonable assumption that the shareholdersof listedcompanies (mainly institutional investors) seek to maximise wealth.

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Criticisms of the above include the following:

Maximizing TSR ignores the interests of other stakeholders such as employees,customers and arguably, society as a whole ;

In the case of unlisted companies even the shareholders may not require maximisedreturns (e.g. some closely held companies are run as lifestyle firms whose mainobjective is to create prestige for the owners).

2.3 Public sector organisations

2.3.1 Not-for-Profit Organisations

The objective of public sector organisations is to provide the service for which theorganisation was established. These organisations are frequently called Not for ProfitOrganisations (NPOs). Such organisations are not constrained by cost/profit objectives to

the same extent as companies. However they are often constrained by having multiplestakeholders with potentially conflicting objectives.

Consider a state funded university as an example:

Principals Students Government Employers

Universitymanagement

Agent

The university management is accountable to multiple stakeholders (i.e. students,government and potential employers).

However the requirements of the principals may conflict e.g.

Students may desire small class sizes, a large library and courses that meet theirpersonal interests,;

The government may wish to minimise costs per student; Potential employers may want graduates with relevant skills for industry (e.g.

engineering graduates as opposed to anthropology graduates).

Designing a performance measurement system where multiple and conflicting objectivesexist is obviously very difficult. Management must try to rank its principals/stakeholdersand prioritise objectives.

NPOs are sometimes said to have as their objective the maximisation of the differencebetween the benefits they generate and the costs of their operations. However it is often

very difficult to quantify the benefits that such organisations produce.

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2.3.2 Value for money

There is an increasing emphasis on Value For Money (VFM) and achieving EconomyEfficiency, and Effectiveness - the 3 Es:

Economy minimizing the input costs of the organisation;

Efficiency maximizing the output/input ratio; Effectiveness in meeting the organisations objectives.Illustration 1

University

Area Economy Efficiency Effectiveness

Possiblemeasure

Minimisingcosts per student

Maximisingstudent/staff ratio

Quality ofdegrees awarde

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Example 1

Lewisville is a town with a population of 100,000 people. The town council ofLewisville operates a bus service which links all parts of the town with thetown centre. The service is non-profit seeking and its mission statement is toprovide efficient, reliable and affordable public transport to all the citizens ofLewisville. Attempting to achieve this mission often involves operatingservices that would be considered uneconomic by private sector buscompanies, due either to the small number of passengers travelling on someroutes or the low fares charged.

However, one member of the council has recently criticised the performance ofthe Lewisville bus service as compared to those operated by private sector buscompanies in other towns. She has produced the following information for themost recent financial year:

Summarised Income and Expenditure Account

$000 $000Passenger fares 1,200Staff wages 600Fuel 300Depreciation 280

_____ 1,180

_____

Surplus 20

_____Summarised Statement of financial position

$000 $000AssetsNon-current assets (net) 2,000Current assetsInventories 240Cash 30

_____ 270

_____

Total assets 2,270_____

Equity and liabilitiesOrdinary share capital ($1 shares) 2,000Reserves 210

_____

2,210Current liabilities 60

_____

Total equity and liabilities 2,270_____

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2.4 Environmental impacts

An area of growing concern to all parties, companies included, is that of the environment orgreen issues.

It is important that managers understand the impact of the operations of the organisation onthe environment, in order to satisfy public concerns and, increasingly, to avoid any penaltiesor costs due to environmental regulations.

For these reasons environmental reporting is becoming more common as part of generalcompany financial reporting.

The triple bottom line approach - a method of true cost accounting which considers theimpact of production decisions in terms of ecological and social value, as well as economicvalue. Those firms that create environmental and social value alongside economic value areoften considered to have a sustainable triple bottom line.

3 CONFLICTS OF INTEREST

3.1 Agency theory

Agency theory examines the duties and conflicts that occur between the parties within acompany that have an agency relationship.

PRINCIPAL

AGENT

AGENTS RESPONSIBILITY

Shareholders

Directors

Directors

Employees

Loan creditors

Shareholders

Generate maximumreturn for

shareholders

Work tomaximumefficiency

Minimise riskfrom uses of

borrowed funds

A company can be viewed as a set of contracts between each of these various interestgroups. The company will not succeed unless all of the groups are working towards thesame objectives.

Whilst most research has focused on the potential conflicts between directors andshareholders there are other potential sources of tension within a firm.

For example when a firms assets are close to the level of its liabilities the debt investors willpressurize the directors to only undertake low risk projects. This is because the debtinvestors have nothing to gain from risky projects (they receive fixed returns) but everythingto lose (if assets fall below liabilities the firm may become unable to service its debts).

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Equity investors, on the other hand, may encourage the directors to take on risky projects.This is because equity investors participate in any excess returns but, due to the protectionprovided by their limited liability status, they cannot be forced to cover any losses.

3.2 Stakeholders

Companies are made up of a variety of different interest groups or stakeholders all ofwhom are likely to have different interests in and objectives for the company:

Equity shareholders

maximum wealth

Directors

remuneration power esteem

Employees

pay and conditions job security

COMPANY

Loan creditors

security cash flow

long term prospects

Trade creditors

short termcash flow

Community

environmentalissues

While shareholders are clearly the key stakeholder modern corporate governance suggeststhat directors should take into account the objectives of a wider range of interested parties.Directors are therefore expected to show responsibility to creditors (e.g. reasonable paymentterms), responsibility to employees (e.g. health and safety) and ultimately to society as awhole (e.g. minimising pollution, investing in social projects Corporate SocialResponsibility (CSR)).

Therefore the overall corporate objective may become satisficing (i.e. producingsatisfactory rather than maximum returns for shareholders). With the rise of the ethical

investor on world stock markets it appears that many shareholders are in fact willing toaccept slightly lower returns in exchange for their companies following a wide range of bothfinancial and non-financial objectives.

3.3 Directors and shareholders

In larger companies the shareholders entrust the management of the company to thedirectors referred to as the separation of ownership from control. The directors aremanaging the company on behalf of the shareholders and should therefore always act in thebest interests of the shareholders, while taking into account the objectives of otherstakeholder groups.

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This may not always be the case as the directors may have other personal objectives such as:

increasing personal remuneration levels; maximising bonus payments; empire building; job security.In addition to the personal aspects shown above a small number of directors have beenguilty of not fulfilling their fiduciary duties by:

creative accounting, by choosing creative accounting policies the directors can flatter theaccounts known as window dressing;

off balance sheet finance (e.g. via the use of special purpose vehicles); takeovers; in defending the company from takeovers some directors have been accused

of trying to protect their own jobs rather than acting in the interests of theirshareholders;

disregard for environmental issues; directors may allow processes which emit pollutionor test products on animals.

If directors follow personal objectives which conflict with those of their shareholders thisleads to agency costs (i.e. lost potential returns for shareholders). This can be referred toas the agency problem.

Good corporate governance procedures should be implemented to minimise the impact ofagency costs. Unfortunately the implementation of corporate governance brings its owncosts (particularly in the case of the Sarbanes-Oxley Act) and hence a cost-benefit approachshould be followed to determine an appropriate level of control over directors.

It can be argued that the actual return to shareholders = maximum potential return agencycosts cost of following Corporate Social Responsibility.

To some degree shareholders should be more active in monitoring the behaviour ofdirectors. Most shares in listed companies are held by institutional investors (e.g. pensionfunds). Fund managers have often been guilty of operating in a very passive way, forexample not even using the proxy voting rights given to them by the funds investors. Untilthere is a rise in shareholder activism it remains likely that some directors will continue to

work in their own best interest.

3.4 Goal congruence

Goal congruence is where each of the parties in an organisation seek to achieve personalobjectives which are also in the best interests of the company as a whole.

For example managers should be encouraged to aim for long-term growth and prosperityrather than short-term reported profitability.

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Methods of encouraging goal congruence between directors and shareholders:

Executive Share Option Plans (ESOPs) although the evidence is mixed regarding thesuccess of such schemes in motivating directors to improve performance (e.g. acompanys share price may rise due to a general rise in the stock market rather than the

quality of its management).

Long Term Incentive Plans (LTIPs) paying a bonus to directors if over several yearsthe companys performance is good when benchmarked against that of competitors.

Transparency in corporate reporting. Increased shareholder activism (e.g. using voting rights). Improved corporate governance (e.g. through the appointment of truly independent

non-executive directors).

4 CORPORATE GOVERNANCE

4.1 Definition

Corporate governance is defined as the system by which companies aredirected and controlled.

The objective of corporate governance may be considered as the reduction ofagency costs to a level acceptable to shareholders.

4.2 Principles of good governance

Various countries have developed their own codes on corporate governance. Althoughdetailed knowledge of specific codes is not required candidates should have an awareness ofthe main principles:

Every company should be headed by an effective board which should lead and controlthe company.

Chairman and CEO there should be a clear division of responsibilities at the head ofthe company between running the board (chairman) and running the business (CEO);no single individual should dominate.

The board should have a balance of executive and independentnon-executive directors. All directors should be required to submit themselves for re-election on a regular basis. Remuneration committees should comprise independent non-executive directors. Remuneration committees should provide the packages needed to attract, retain and

motivate executive directors and avoid paying more.

No director should be involved in setting his own remuneration.

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The board should maintain a solid system of internal control to safeguard shareholdersinvestment and the companys assets.

4.3 Government regulation

The UK Combined Code is included in the Listing Rules of the London Stock Exchange.Although compliance is not obligatory, any listed company which does not comply with theCombined Code must explain its reasons for non-compliance.

The US Sarbanes Oxley Act applies to all companies listed on a US stock market including their foreign subsidiaries. Compliance is mandatory.

Key points

The first step in developing the objectives of financial management is toidentify the relevant stakeholders in the organisation

In the corporate sector the key stakeholders are clearly the shareholders.Most traditional finance theory is therefore built on the assumption that acompany4 objective is to maximise the wealth of its shareholders.

However modern Corporate Social Responsibility (CSR) suggests thatdirectors should also take into account other stakeholders and thereforealso follow a range of non-financial objectives (e.g. employee satisfaction,reducing environmental impacts).

Such non-financial objectives may be in conflict with maximisingshareholder wealth. Therefore the overall objective may be to producesatisfactoryreturns for shareholders, whilst attempting to meet thedemands of other interest groups.

In practice managers may also have personal objectives which conflictwith their responsibilities as agents of the shareholders. Some managersmay try to maximise personal wealth (e.g. through manipulating bonusschemes or even theft of company assets).

This creates agency costs for the shareholders. Good corporategovernance systems should reduce these costs to an acceptable level.

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FOCUS

You should now be able to:

discuss the nature and scope of financial objectives for private sector companies; discuss the role of social and non-financial objectives in private sector companies and

identify their financial implications;

discuss the problems of multiple stakeholders in financial management and theconsequent multiple objectives and scope for conflict;

identify objectives (financial and otherwise) in not-for-profit organisations and identifythe extent to which they differ from private sector companies.

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EXAMPLE SOLUTIONS

Solution 1

(a) Performance of the Lewisville Bus Service compared with the private sector

When looking at profitability, the Lewisville Bus Service (LBS) has performed poorlycompared to the industry averages for the private sector. Return on capital employed is0.9% compared to 10% for private companies. Profit margins are also low 1.7% is thenet profit margin compared to 30% for private companies. This is probably due to thefact that being a public sector provider, LBS has to provide services on less profitableroutes. It also charges lower fares than private sector. However, given that LBS is not acommercial enterprise, and that its mission is to provide efficient, affordable transportto the residents of Lewisville, such profitability measures are not relevant.

Asset turnover is higher for LBS than for the private sector revenue is 0.54 times

capital employed, compared to 0.33 for the private sector. This suggests that the LBSbusses achieve higher utilisation than private sector busses. This may be because LBSfares are lower compared with the private sector. The busses are probably utilised to agreater extent, with more journeys per day than private sector busses. This is a goodsign as it shows that LBS is achieving greater utilisation of its capital than the privatesector busses in terms of revenue.

Cost per passenger mile, at 27.3 is only 73% of the industry average of 37.4. This is agood sign as it means that the company is managing to provide more journey distancefor a lower cost, which represents a better use of resources. The main reason may wellbe the higher number of passengers, or the bus routes may also be longer, particularly if

LBS is covering routes to outlying suburbs that are far from the city centre.

The fares per passenger mile charged by LBS are only 52% of the fares charged by theprivate sector bus companies. As already discussed, this reduces the profitability ofLBS. However, low fared are likely to be appreciated by the users of the bus. The lowerfares are part of the policy of providing affordable public transport.

Appendix calculation of ratios

Return on capital employed

EmployedCapitalprofitOperating 100 =

210,220 100 = 0.9%

Net margin

Sales

profitOperating 100 =

200,1

20 100 = 1.7%

Asset turnover

employedCapital

Sales 100 =

210,2

200,1 100 = 0.54 times

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Average cost per passenger mile

milesPassenger

costsOperating=

000,320,4

000,180,1= 27.3c

Fares charged by bus services

Lewisville fare per passenger mile = passenger fares passenger miles

= $1,200,000 4,320,000 = 278c

Private sector = Average cost (1 net margin)

= 374c (1 03) = 534c

(b) Validity of comparison

There are several reasons why comparing the performance of LBS with the averageratios for the private sector is not a valid exercise. Firstly, the objectives of LBS, asstated in its mission are to provide efficient, reliable and affordable public transport tothe citizens of Lewisville. Private sector companies are more likely to wish to maximisethe wealth of shareholders. This means that direct comparisons become less meaningfulfor the following reasons:

Calculation of return on capital and profit margin are not relevant for LBS, as theorganisation does not exist to make a profit.

Private sector bus companies may cherry pick the most profitable routes, andavoid providing services on less populated routes. A public sector company suchas LBS may provide services on less populated routes as part of its mission ofproviding services to all citizens.

The public sector bus company may aim to charge lower fares particularly tocertain groups such as pensioners and children. Private sector companies may notfeel obliged to do this, and will use a pricing policy that will maximise profits.

In spite of these limitations, some benefits can be obtained by comparing the two. Areasrelated to the costs of running the services, quality, and utilisation could lead to somebenefits whereby the public sector could use the private sector as a benchmark.

However, account would still need to be taken of the lower profit routes that are served.

(c) Economy, Effectiveness and Efficiency.

When measuring the performance of public sector organisations it is sometimessuggested that they should be assessed on the basis of the 3 Es; economy,effectiveness and efficiency.

Economyis an input measure and is normally based around the expenditure of theorganisation. In the case of the Lewisville bus service it could be measured by totalexpenditure as compared to budget.

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Effectivenessis an output measure and looks at what the organisation achieves in termsof its objectives. In the case of the Lewisville bus service it could be measured by thenumber of passengers carried, or the number of passenger miles travelled.

Efficiencyis a combination of the above two measures. It considers output in relation to

input. In the case of the Lewisville bus service it could be measured by cost perpassenger mile travelled.

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SESSION 02 THE FINANCIAL MANAGEMENT ENVIRONMENT


OVERVIEW

Objective

To understand the economic environment within which organisations operate. To understand the financial environment in which financial management is practised.

ECONOMICPOLICY

FINANCIALMARKETSTHEORY

THE ECONOMICENVIRONMENT

BANKINGSYSTEM

Macroeconomicpolicy

Monetary policy Fiscal policy Supply side

approach

IMPACT ONBUSINESS

Inflation Government

intervention

The Euro

Financialintermediaries

Commercial clearingbanks

Credit creation

The financial markets Stock exchange

operations

Financial marketefficiency

Money market interestrates

THE FINANCIALENVIRONMENT

THE FINANCIALMANAGEMENTENVIRONMENT

ISLAMICFINANCE

Background The prohibitions Islamic Instruments The Shariah board Developments

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1 MACROECONOMIC POLICY

1.1 Definition

The setting of economic objectives by the government (e.g. full employment,economic growth, the avoidance of inflation) and the use of controlinstruments to achieve those objectives (e.g. fiscal policy and monetary policy).

1.2 Objectives of macroeconomic policy

Macroeconomic policies are adopted in order achieve the following objectives:

full employment; economic growth and thereby improved living standards; an acceptable distribution of wealth; price stability and therefore limited inflation; a solid balance of payments a continual external deficit, where a country is importing

more goods and services than it is exporting, is unsustainable and is likely to lead to anexchange rate crisis.

The above objectives can often be in conflict (e.g. economic growth can lead to excessdemand for resources and lead to an increase in inflation).

1.3 Global economic events

Financial managers must understand not only national government economic policy but,due to the increasing interdependence of economies through both the movement of tradeand capital, world macroeconomic trends.

Recent world economic events include:

the dot.com bubble following over-optimism by both business and investors of thepotential returns from the high technology sector.

the launch of the European single currency the Euro in which UK is not currentlyparticipating.

the growing importance of emerging economies (e.g. the BRIC countries (Brazil, Russia,India and China)).

the 2007 US sub-prime meltdown which, coupled with financial contagion (i.e. highinterdependence between countries) led to frozen debt markets and the global recession.Some countries, such as Russia, initially believed they were sufficiently de-coupledfrom the US economy to escape the worst effects of the credit crunch. Regrettably thiswas not the case as many companies in Russia (and throughout Central and EasternEurope) had large amounts of foreign debt which could not be easily refinanced.

volatile commodity prices, interest rates, exchange rates and capital markets.

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2 MONETARY POLICY

2.1 Definition

Monetary policy can be defined as those actions taken by the government orthe central bank to achieve economic objectives using monetary instruments.These actions may either directly control the amount of money in circulation(the money supply) or attempt to reduce the demand for money through itsprice (interest rates). For instance, if the rate of interest on funds is increased,the cost of borrowing is increased and therefore the demand for goods isdecreased and the result of this tends to be a decrease in the rate of inflation.By exercising control in these ways governments can regulate the level ofdemand in the economy. Those who see the use of monetary policies as crucialin the control of macroeconomic activity are known as monetarists.

2.2 Direct control of the money supply

Governments or central banks can directly control the money supply in the following ways:

2.2.1 Open market operations

If the central bank sells government securities the money supply is contracted, as someof the funds available in the market are soaked up by the purchase of the governmentsecurities.

Equally, if the central bank were to buy back securities then funds would be releasedinto the market. The sale of government securities will lead to a reduction in bankdeposits due to the level of funds that have been soaked up.

This in turn can lead to a further reduction in the money supply, as the banks ability tolend is reduced. This is known as the multiplier effect.

2.2.2 Reserve asset requirements

The central bank can set a minimum level of liquid assets which banks must maintain.This limits their ability to lend and thereby reduces the money supply.

2.2.3 Special deposits

The central bank can have the power to call for special deposits. These deposits donot count as part of the banks reserve base against which it can lend. Hence they havethe effect of reducing the banks ability to lend and thereby reducing the money supply.

2.2.4 Direct control

The central bank may set specific limits on the amount which banks may lend. Credit controls are difficult to impose as, with fairly free international movement of

funds, they can easily be circumvented.

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2.3 Reducing the demand for money

Governments can reduce the demand for money, and therefore indirectly the money supply,by encouraging an increase in short-term interest rates.

2.4 Problems of monetary policy

Problems arise due to the following:

there is often a significant time lag between the implementation of a policy and itseffects;

the ineffectiveness of credit control in the modern global economy; the fact that the relationship between interest rates, level of investment and consumer

expenditure is not actually stable and predictable;

the undesirable side effects of increasing interest rates: less investment, leading to reduced industrial capacity, leading to increased

unemployment (as higher interest rates increases the cost of capital for a companyusing debt finance);

an overvalued currency which reduces demand for exports.2.5 How the money supply may be measured

If governments want to control the money supply it is necessary to be able to measure thesupply of money in the economy.

In the UK a number of alternative indicators have emerged including the following:

M0 Notes and coins in circulation and in banks tills.

M3 M0 plus deposits at banks.

M4 M3 plus deposits at building societies.

M5 M4 plus private sector holdings of certain types of government debt.

Whilst M5 may be the most suitable measure to use it is the hardest to control. Equally, whilst M0 is the easiest measure to control it is probably the least

representative of overall economic activity.

Commentary

In recent times UK governments have attempted to monitor both M0 and M4.

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However, problems can arise due to the following:

it is not possible to cut government spending dramatically in sectors such as healthcareor education;

increasing taxation discourages enterprise.Keynesians favour adjusting the level of government spending in preference to adjusting taxrates, as they believe it has a quicker and greater impact on the level of demand in theeconomy.

3.3 The relationship between fiscal and monetary policy

Fiscal and monetary policies are interdependent and governments will use both fiscal andmonetary policies to achieve their monetary and budgetary targets. Which policiesdominate depends on the economic theory preferred by the government of the day. In theUK there was a Keynesian approach to the management of the economy from the 1930s to

the 1970s. However, this was believed to have contributed to the boom-bust economiccycles that were experienced. Hence recent governments have followed a more monetaristapproach.

4 SUPPLY SIDE APPROACH

4.1 Definition

Supply side policies are policies which focus on creating the right conditions inwhich private enterprise can grow and therefore raise the capacity of theeconomy to provide the output demanded. The private sector, being driven bythe profit motive, is deemed to be more efficient at providing the outputrequired than the public sector.

4.2 Supply side policy examples

Supply side policies include:

low corporate tax rates to encourage private enterprise; the promotion of a stable, low inflation economy with minimal government

intervention; limited government spending; a balanced fiscal budget; deregulation of industries; a reduction in the power of their trade unions; an increase in the training and education of the workforce; an increase in the provision of the infrastructure required by business for example

business parks;

a reduction in planning legislation.

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4.3 Supply side policies and fiscal policy

Supporters of supply side policies believe that, if business is to flourish, the economy mustbe in a stable condition and therefore fiscal policy should be in equilibrium. In other words,government spending should not exceed government receipts from taxation. Additionally,

if the private sector is to be encouraged, tax rates should be kept to a minimum andgovernment expenditure also should be kept to a minimum.

4.4 Supply side policies and monetary policy

Monetary policy is used to control inflation to provide the stable economy, in whichbusiness can flourish.

4.5 Problems with the supply side approach

Problems with using supply side policies include the following:

there is a time delay before the policies have any impact; the private sector will not provide all the goods and services required by society for

example health care provision.

5 INFLATION

5.1 Definition

The rate of increase of the general level of prices in the economy.

5.2 Measurement

The normal way of measuring inflation is to use the Consumer Price Index (CPI) whichattempts to measure changes over time in the monetary cost of a representative basket ofgoods and services. The CPI relates to retail goods and services, and hence only gives abroad indication of how fast prices are rising across the economy.

The maintenance of a low level of inflation is a key economic objective.

Alternative measures of inflation also exist which, for instance, look at the increases in thecosts of manufacturing industry.

5.3 Causes of inflation

Keynesians consider the following to be the major causes of inflation:

5.3.1 Demand-pull inflation Inflation arises due to demand exceeding the maximum output of the economy with full

employment.

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5.3.2 Cost-push inflation

Increases in the cost of raw materials or the cost of labour lead to increases in the unitcosts of firms, and therefore inevitably leads to an increase in prices as these highercosts are passed on to the consumer. The increased costs suffered by industry may be as

a result of the increase in the cost of imported goods, in which case the term importedcost-push inflation is used.

Monetarists, on the other hand, believe that inflation arises as a result of too much moneychasing too few goods. Therefore, in the short term inflation should be controlled bycontrolling the money supply, whilst in the long term inflation should be controlled byenhancing the ability of the economy to produce goods and services.

Inflation is also thought to be brought about by peoples expectations, as anticipation offuture price increases is built into wage negotiations in order to protect future real incomes.In turn, expected increases in costs such as wage costs are built into output prices. This is

sometimes known as the wage-price spiral and it suggests that inflation is on-going andinevitable.

5.4 The general economic consequences of inflation

The general economic consequences of inflation include the following:

The redistribution of income from those in a weak bargaining position to those in astrong bargaining position who are therefore able to maintain the real value of theirincome;

A disincentive to save as the purchasing power of investments may be reduced; Where inflation reaches very high levels money is no longer able to carry out its key

functions of being a medium of exchange and a store of value;

A fall in the exchange rate; A need for higher nominal interest rates.5.5 Consequences of inflation for companies

Entrepreneurial activity is reduced as it is harder to estimate the likely returns from anew venture and higher interest rates make borrowing more expensive;

International competitiveness suffers where prices rise faster than those of foreigncompetitors;

Uncertainty is increased and hence new investment by existing businesses is reduced; Higher interest rates reduce the number of profitable investment opportunities and

therefore the level of investment;

In periods of rapid inflation the need to search for the best price currently available forthe purchases required and the need to be constantly updating selling prices addssignificant costs to industry.

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6.4 Grants and subsidies

Governments also intervene in the economy through the use of official aid schemes. Theseaid schemes include the use of cash grants, consultancy advice and tax incentives in order toencourage investment in high technology or investment in areas of particularly high

unemployment.

Grants may also be available from transnational institutions. For example, the EuropeanRegional Development Fund has assisted with many infrastructure projects in the remoterregions of the UK.

6.5 Green policies

Governments are increasingly taking active steps to improve the environmentalperformance of firms. Measures include:

Carbon credits where the government allocates each polluting firm a quota of thenumber of tonnes of greenhouse gasses that it can emit. If a firm then switches togreener production techniques it may find it has a surplus of carbon credits which canthen be sold to a firm that is exceeding its quota (i.e. carbon trading).

Government environment agencies the UK Environment Agencys stated purpose is,to protect or enhance the environment, taken as a whole so as to promote theobjective of achieving sustainable development.

6.6 Corporate governance

Detailed knowledge of specific corporate governance codes is not required for theexamination. The material below is provided to give an idea of the main principles.

The UK Combined Code is included in the Listing Rules of the London Stock Exchange.Although compliance is not obligatory, any listed company which does not comply with theCombined Code must explain its reasons for non-compliance.

It sets out the following Principles of Good Governance:

Every listed company should be headed by an effective board which should lead andcontrol the company.

Chairman and CEO there should be a clear division of responsibilities at the head ofthe company between running the board and running the business; no single individualshould dominate.

The board should have a balance of executive and independentnon-executive directors. All directors should be required to submit themselves for re-election at least every three

years.

Remuneration committees should be 100% independent non-executive directors. Remuneration committees should provide the packages needed to attract, retain andmotivate executive directors and avoid paying more.

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Executive service contracts should be for one year or less. No director should be involved in setting his own remuneration.The US Sar

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