ACCA AFM Chapter

1. FINANCIAL STRATEGY –FORMULATION - 1
1. FINANCIAL STRATEGY –FORMULATION
1. Financial Objectives
1.1 Maximizing profits is not sufficient financial objective:
Within organization it is normal to reward management on some measure of profit such as ROI or RI.
In simple terms we would expect a close relationship between profit and shareholders’ wealth.
There are, however, ways in which they may conflict such as:
 Short-termism [enhance profits at the expense of future profits]
 Cash vs accruals [wealth is created on cash basis but profit based on accrual basis]
 Risk [chances of accepting risky projects for short term profits]
1.2 Reasons why profit is not a sufficient objective
 Investors care about the future
 Investors care about the dividend
 Investors care about financing plans
 Investors care about risk management
1.3 Maximizing shareholders’ wealth:
 It’s the primary objectives of the company intended to maximize value of company.
 The valuation might be on the basis of balance sheet approach (going concern), Break-up basis
(possibility of liquidation) and market values (active market like stock exchange).
 The wealth comes through distribution of dividends and capital gains i.e. changes in price.
1.4 Satisficing:
Finding a merely adequate outcome, holding returns at a satisfactory level, avoiding risky ventures and
reducing workloads (employees).
2. Financial Management
The management of all matters associated with the future cash flow of the organisation both short and
long-term.
Financial Manager has key responsibility in following areas:
i. Investment Decision

2. FINANCIAL STRATEGY –FORMULATION - 2
ii. Financing Decision
iii. Dividend Decisions
iv. Risk Management Function
v. Financial planning and control
vi. Communication with stakeholders
vii. Efficient and effective use of resources
i. The Investment Decision (Investment selection and capital resource allocation)
A company may invest its funds in one of three basic areas:
 Capital assets: [Risk, Return, Cash Flow and Profit]
 Working capital: [Balance the risk of insolvency against the cost of funding]
 Financial assets: [Risk, Return, Liquidity]
Appraisal
 method of investment appraisal
 ethical issues
 financial ratios such as ROCE, EPS, DPS
ii. The Financing Decision [Raising finance and Minimizing Cost of capital]
When looking at the financing of a business there are 4 basic questions to consider:
 Total funding required #
 Internally generated vs externally sourced [retained earning vs. external issue or borrowings]
 Debt or equity [risk vs. cost]
 Long-term or short-term debt. [purpose, flexibility, cost]
 Life cycle of business, operating gearing, stability of revenue, security
 Financial planning and control
# The funding requirement will be determined by an assessment of the following:
Application of funds Source of funds
Existing asset base Existing funding
New assets Redemption of existing debt
Disposals Funds generated through trading
Change in Working Capital
iii. The Dividend Decision [Cash or Scrip]
• Profitability
• Influence of investment decision
• Cash flow (liquidity)
• Growth
• Legal Considerations
• Influence of lifecycle
-(Young Company – Zero or low dividend payout)
-(Mature Company – higher dividend payout)
• Shareholders expectation

3. FINANCIAL STRATEGY –FORMULATION - 3
Modigliani and Miller's theory
This view was developed by Modigliani and Miller and may now be regarded as the classic position:
 Their argument is that the source of equity finance is in itself irrelevant.
 Since ultimately it represents a sacrifice of consumption (or other investment opportunities) by
the investor at identical risk levels, it makes no difference whether dividends are paid to the
investor, or equity is raised as new issues, or profits are simply retained.
 The only differences would arise due to institutional frictional factors, such as issue costs, taxation
and so on.
 If both new equity and retained earnings have the same cost then it should be irrelevant, in terms
of shareholder wealth, where equity funds come from.
 Provided any cash retained is invested at the shareholders’ required return, a cut in dividend of
any size should not adversely affect the investor
 It theoretically makes no difference whether the new investment is funded by retention of
dividend or new equity raised.
 The key issue is thus the investment policy not the dividend policy.
Having considered these factors, companies will formulate and communicate their policy to ensure that
shareholders have realistic expectations regarding the dividends they are likely to receive.
FACTORS THAT INFLUENCE DIVIDEND POLICY
1. Company growth rate. A company that is rapidly growing, even if profitable, may have to restrict its
dividend payments in order to keep needed funds within the company for growth opportunities.
2. Restrictive covenants. Sometimes there is a restriction in a credit agreement that will limit the
amount of cash dividends that may be paid.
3. Profitability. Dividend distribution is keyed to the profitability of the company.
4. Earnings stability. A company with stable earnings is more likely to distribute a higher percentage of
its earnings than one with unstable earnings.
5. Maintenance of control. Management that is reluctant to issue additional common stock because it
does not wish to dilute its control of the firm will retain a greater percentage of its earnings. Internal
financing enables control to be kept within.
6. Degree of financial leverage. A company with a high debt-to-equity ratio is more likely to retain
earnings so that it will have the needed funds to meet interest payments and debts at maturity.
7. Ability to finance externally. A company that is capable of entering the capital markets easily can
afford to have a higher dividend payout ratio. When there is a limitation to external sources of
funds, more earnings will be retained for planned financial needs.
8. Uncertainty. Payment of dividends reduces the chance of uncertainty in stockholders’ minds about
the company’s financial health.
9. Age and size. The age and size of the company bear upon its ease of access to capital markets.
10. Taxation. The dividend tax and capital gain tax policy of the government, both will effect dividend
policy of the company.
11. Tax penalties. Possible tax penalties for excess accumulation of retained earnings may result in high
dividend payouts.
12. The signaling effect of dividends to shareholders and the financial markets in general

4. FINANCIAL STRATEGY –FORMULATION - 4
Dividend Policy
Types of Dividend Policies
a) Stable dividend policy
Paying a constant or constantly growing dividend each year:
 offers investors a predictable cash flow
 reduces management opportunities to divert funds to non-profitable activities
 works well for mature firms with stable cash flows.
However, there is a risk that reduced earnings would force a dividend cut.
b) Constant pay-out ratio
Paying out a constant proportion of equity earnings:
 maintains a link between earnings, reinvestment rate and dividend flow, but cash flow is
unpredictable for the investor
 gives no indication of management intention or expectation.
c) Residual dividend policy
A dividend is paid only if no further positive NPV projects available.
This may be popular for firms:
 in the growth phase
 without easy access to alternative sources of funds.
However:
 cash flow is unpredictable for the investor
 gives constantly changing signals regarding management expectations.
d) Zero dividend policy
All surplus earnings are invested back into the business. Such a policy:
 is common during the growth phase
 should be reflected in increased share price.
When growth opportunities are exhausted (no further positive NPV projects are available):
 cash will start to accumulate
 a new distribution policy will be required.

5. FINANCIAL STRATEGY –FORMULATION - 5
Types of Dividend Payments
a) Scrip dividends
 A scrip dividend is a dividend paid by the issue of additional company shares, rather than by cash.
 A stock dividend is the issuance of additional shares of stock to stockholders.
 A stock dividend may be declared when the cash position of the firm is inadequate and/or when the
firm wishes to prompt more trading of its stock by reducing its market price.
Advantages of scrip dividends
a. They can preserve a company's cash position.
b. Investors may be able to obtain tax advantages if dividends are in the form of shares.
c. Investors looking to expand their holding can do so without incurring the transaction costs of
buying more shares.
d. A small scrip dividend issue will not dilute the share price significantly. However, if cash is not
offered as an alternative, empirical evidence suggests that the share price will tend to fall.
e. A share issue will decrease the company's gearing, and may therefore enhance its borrowing
capacity.
Disadvantages of scrip dividends
a. Dilute the share price significantly.
b. Scrip dividends may be seen as a negative signal by the market i.e. the company is experiencing cash
flow issues.
b) Share repurchase
 Purchase by a company of its own shares can take place for various reasons and must be in
accordance with any requirements of legislation.
 In many countries companies have the right to buy back shares from shareholders who are willing
to sell them, subject to certain conditions.

6. FINANCIAL STRATEGY –FORMULATION - 6
 Treasury stock is the name given to previously issued stock that has been purchased by the
company. Buying treasury stock is an alternative to paying dividends.
 Since outstanding shares will be fewer after stock has been repurchased, earnings per share will rise
(assuming net income is held constant). The increase in earnings per share may result in a higher
market price per share.
For a smaller company with few shareholders, the reason for buying back the company's own shares
may be that there is no immediate willing purchaser at a time when a shareholder wishes to sell shares.
For a public company, share repurchase could provide a way of withdrawing from the share market and
'going private'.
When Share repurchase?
The share repurchases is done by the company as a form of dividend payments when:
 company is over-capitalized i.e. the existing capital has no better opportunities for investment
within a company, &
 company has abundance of liquidity
 has no positive NPV projects
 wants to increase the share price [cosmetic exercise]
 wants to reduce the cost of capital by increasing its gearing
 wants to give a positive signal to the market
Example: Travis Company earned $2.5 million in 20X1. Of this amount, it decided that 20 percent
would be used to purchase treasury stock. At present there are 400,000 shares outstanding. Market
price per share is $18. The company can use $500,000 (20%x2.5 million) to buy 25,000 shares through
a tender offer of $20 per share.
Current earnings per share is:
EPS = net income/outstanding shares = $2,500,000/400,000 = $6.25
The current P/E multiple is:
Market price per share/Earnings per share = $18/$6.25 =2.88 times
Earnings per share after treasury stock is acquired becomes:
$2,500,000/375,000 = $6.67
The expected market price, assuming the P/E ratio remains the same, is:
P/E multiple x new earnings per share = expected market price
2.88 x $6.67 = $19.21
c) Stock Split
 A stock issuing a substantial amount of additional shares and reducing the par value of the stock on
a proportional basis.
 A stock split is often prompted by a desire to reduce the market price per share, which will make it
easier for small investors to sell or purchase shares where split involves.
iv. The Risk Management (Business Risk and Financial Risk)
 Risk management decisions, in the AFM exam, mainly involve management of exchange rate and
interest rate risk and project management issues.

7. FINANCIAL STRATEGY –FORMULATION - 7
 Again, the volatility of an organization’s cash flows are a powerful influence on its approach to risk
management.
 The more volatile cash flows are, the more important risk management becomes.
 Risk management is covered later.
A number of policy decisions must be made:
 What is the firm’s appetite for risk?
 How should risk be monitored?
 How should risk be dealt with?
v. Financial planning and control
Financial planning and control is the main role of the management accountant within a company.
The senior financial executive will need to oversee the development of policies to govern the way in
which the process is carried out.
To govern the way in which the process is carried out, policies will be needed over areas such as:
 the planning process
 business plans
 budget setting
 monitoring and correcting activities
 evaluating performance
vi. Communication with Stakeholders
For financial strategy to be successful it needs to be communicated and supported by key stakeholder
groups:
Stakeholders are people, groups or organizations that can affect or be affected by the actions or policies
of an organization.
Stakeholders make direct claims (raise voice like shareholders, suppliers) or indirect claims (animals and
plants) upon the organization.
Classification of Stakeholders
Internal – employees, management, board
Connected – shareholders, customers, suppliers, lenders
External – government, public, pressure group, media, trade unions
Stakeholders may be viewed as Active or Passive stakeholders.
Active – who seek to participate in organization’s activities (managers, pressure groups, etc.)
Passive - who do not seek to participate in organization’s activities (local communities, governments,
etc.)
Incorporating the interests of other stakeholders
We usually assume that the primary objective of a business is to maximise shareholder wealth.

8. FINANCIAL STRATEGY –FORMULATION - 8
Satisficing
However, a company is unlikely to be successful unless it also aims to satisfy the needs of its other
stakeholders. The financial manager will have to identify potential conflicts between stakeholders'
objectives and aim to resolve these conflicts.
Conflicts of Interest between stakeholders
 Excessive Remuneration (linkage to performances)
 Empire building (developing large conglomerate for prestige and power losing control over
performance)
 Creative accounting (flatter their published accounts and perhaps artificially boost the share price
eg: capitalizing revenue expense)
 Off balance sheet finance (The collapse of Enron in the US in late 2001 put the spotlight on the
various forms of off-balance-sheet finance used, and further scrutiny and regulation is inevitable)
 Takeover bids (BOD may prevent takeover bids to protect their jobs when bid is in best interest of
company)
 Unethical activities (activities emitting pollution but not prohibited by law)
Agency Theory
Agency relationship is a contract
under which one or more
persons (the principals) engage
another person (the agent) to
perform some service on their
behalf that involves delegating
some decision-making authority
to agent.
For larger companies this has led
to separation of ownership of the
company from its management.
Thus, there is potential for conflicts of interest between management and shareholders i.e. agency
problem.
Goal Congruence
Goal congruence is defined as the state which leads individuals or groups to take actions which are in
their self-interest and also in the best interest of the entity.
For an organisation to function properly, it is essential to achieve goal congruence at all level. All the
components of the organisation should have the same overall objectives, and act cohesively in pursuit of
those objectives.
In order to achieve goal congruence, the organization should have following practices which will be
consistent with the objectives of the shareholders.
A. Ethical Practices
B. Good Governance
C. Environmental and Social Impact Assessment

9. FINANCIAL STRATEGY –FORMULATION - 9
Ethics can be rule based or principle based:
 Principle based: IFAC Code of ethics
 Rule based: Do’s and don’ts list
Typical features of ethical Code Trucker’s Five Questions
The fundamental ethical principles issued by ACCA that commensurate with IFAC
B. Corporate Governance
Corporate Governance: a set of relationship between a company’s directors, its shareholders and other
stakeholders. It also provides structure through which the objectives of the company are set, and the
means of obtaining these objectives and monitoring performance are determined. [OECD, 2004: P.4]
Corporate Governance is the system by which organizations are directed and controlled. [Cadbury,
1992: P.15]
The key areas of Corporate Governance can be:
 Role of NEDs: their presence in boards, independency
 ED (board’s leadership): chairman separate from CEO, disclosure of financial rewards,

10. FINANCIAL STRATEGY –FORMULATION - 10
 Board’ Responsibilities: composition, knowledge, skills, leadership, membership, etc.
 Responsibilities of committees: remuneration, audit, risk and presence of NEDs in such committees.
 Board Membership: qualification, appointment
 Knowledge, Skills & Appraisals: CPD
 Unitary and Multi-tier Board: Supervisory and Management Board
 Leaving the Board: Conditions for leaving the board
C. Environmental and Social Impact Assessment
Sustainability means:
- Meeting the needs of the present without compromising the needs of future generations.
- Long-term maintenance of systems according to environmental, economic and social considerations.
Sustainability means limiting the use of depleting resources to a level that can be replenished.
Environmental Perspectives:
Examples of unsustainable activities:
 Use of non-renewable resources such as oil,
gas
 Long-term damage to the environment from
CO2 and chlorofluorocarbons (CFCs)
Economic Perspectives:
Examples of unsustainable activities:
 Strategies for short term gain,
 Paying bribes or forming cartels,
 Suspect accounting treatments,
 Underpayment of taxes, etc.
Social Perspectives:
Examples of unsustainable activities:
 Urban rich and rural poor
 Rich manufacturing countries and poor
consuming countries
vii. Efficient and effective use of resources
It will be important to develop a
framework to ensure all
resources (inventory, labour and
non-current assets as well as
cash) are used to provide value
for money.
Spending must be:
 economic
 efficient
 effective
 transparent
Performance measures can be developed in each area to set targets and allow for regular monitoring.
Financial manager's decisions can have:
Strategic Impact
 Does the new investment project help to enhance the firm's competitive advantage?

11. FINANCIAL STRATEGY –FORMULATION - 11
 Fit with environment
 Use of resources (3Es)
 Stakeholder reactions
 Impact on risk (overall risk of company)
Financial Impact
 Likely impact on share price (NPV of the project)
 Likely impact on financial statements (like negative CF in earlier years may signal negativity)
 Impact on cost of capital
The environmental impact
 Carbon-trading and emissions
 Triple Bottom Line (TBL) reporting (People, Plant and Profit)
 energy conservation
 recycling
 sustainable development
The ethical impact
Society level: wishes of all stakeholders should be taken into account
Corporate level: the approach they take to corporate governance and stakeholder conflict.
Individual level: Individuals running the company apply to their own actions and behaviors.
Regulatory Impact
The extent to which the financial manager's actions are scrutinized by regulators is determined by:
 the type of industry – some industries (for example the privatised utility industries in the UK) are
subject to high levels of regulation
 whether the company is listed or not