INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS OF RWANDA CPA I1.1 MANAGERIAL FINANCE Study Manual 2nd edition February 2020, © ICPAR All copy right reserved All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of ICPAR. Acknowledgement We wish to officially recognize all parties who contributed to revising and updating this Manual, Our thanks are extended to all tutors and lecturers from various training institutions who actively provided their input toward completion of this exercise and especially the Ministry of Finance and Economic Planning (MINECOFIN) through its PFM Basket Fund which supported financially the execution of this assignment INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS OF RWANDA Intermediate Level I1.1 MANAGERIAL FINANCE 2nd Edition February 2020 This Manual has been fully revised and updated in accordance with the current syllabus/ curriculum. It has been developed in consultation with experienced tutors and lecturers. Table Of Contents Unit title page Introduction to the course 5 Managerial finance as an integral part of the syllabus 5 Learning outcomes 5 1. Objectives of financial management 6 Introduction 7 Scope of finance functions 7 Agency theory 10 Public sector/not-for-profit organisations 16 Corporate social responsibility 17 Impact of government on activities 19 Composition of shareholders 19 2. Source of finance 20 Long-term sources of finance 21 Equity finance 21 Loan capital 24 Warrants 26 Methods of share issue 27 Bank lending 28 Capital markets 29 Main functions 29 Operating and finance leases operating 31 Advantages of leasing 32 Venture capital 33 Stages of investment 33 Specialist areas 33 Business plan 34 Methods of withdrawal by venture capitalist 34 2 I1.1 MANAGERIAL FINANCE CPA EXAMINATION STUDY MANUAL 3. Cost of Funds 35 Introduction 36 Calculation of cost of capital 37 Weighted average cost of capital (wacc) 39 4. Capital structure 40 Capital structure 41 Capital structure theories 41 The net income approach (ni) 41 5. Capital budgeting 47 Nature and stages of investment appraisal 48 Investment appraisal techniques 49 Relevant cash flows 58 The effects of taxation on the investment decision 62 Corporation tax 62 Capital allowances 62 Timing of taxation effects 63 Real v nominal (money) discount rates 64 Handling different inflation rates 66 General considerations - inflation 66 Replacement of asset 66 Equiv alent annual cost 67 Capital rationing 68 Ranking of projects 68 Possible ways of solving capital rationing 69 Lease v buy decision 70 Lease v buy decision 72 6. Working capital management 75 Concept of working capital 76 Determinants of working capital needs 77 Importance of working capital management 77 The management of debtors 84 CPA EXAMINATION I1.1 MANAGERIAL FINANCE 3 STUDY MANUAL The management of creditors 91 The management of stocks 91 The discount is worthwhile 93 7. Portfolio theory 94 Introduction 95 Portfolio risk and return 95 Capital asset pricing model 98 Systematic and unsystematic risk 100 8. Corporate dividend policy and strategy; 105 Introduction 106 Alternative dividends policies 107 9. Company valuations 116 Introduction 117 V aluation bases 117 Defence tactics 119 Due dilligence 119 10. Emerging issues in financial management 121 11. Sundry definitions 122 Introduction 123 Sundry definitions 123 4 I1.1 MANAGERIAL FINANCE CPA EXAMINATION STUDY MANUAL INTRODUCTION TO THE COURSE Stage: Intermediate Level 1 Subject Title: I1.1 Managerial Finance AIM The aim of this subject is to ensure that students understand the nature and scope of financial management. They should be able to assess an entity‟s funding requirements, calculate the cost of the available sources of finance, and advise on the optimum financing structure for an entity. Students should be able to evaluate the role of, and apply, corporate planning and budgetary control techniques. They are also expected to demonstrate excellent written communication skills and the ability to integrate learning from the syllabi of this and other subjects. MANAGERIAL FINANCE AS AN INTEGRAL PART OF THE SYLLABUS Managerial Finance develops the knowledge of students with respect to the financial management of organisations and builds on the Foundation 2 level Management Accounting subject. This subject is an essential underpinning for Strategic Corporate Finance, Strategic Performance Management and Strategy, Leadership & Knowledge Management at Advanced level. LEARNING OUTCOMES On successful completion of this subject students should be able to: • Interpret, and critically appraise corporate objectives (including shareholder value, stakeholder value, value creation, investment policy and long and short- term financing); • Analyse and evaluate the main financial management decisions of a company (including capital budgeting, investment appraisal, working capital management, capital structure and dividend decisions). • Describe and discuss the relationship between risk and return and demonstrate its application to portfolio theory and the Capital Asset Pricing Model (CAPM). • Apply, evaluate and compare common business valuation models. • Evaluate the role of corporate planning and budgetary control as key elements in managerial finance including the preparation and utilisation of performance measurement statements. • Prepare and present quantitative and qualitative information for management decision-making integrating analysis, argument, and commentary in a form appropriate to the intended audience. CPA EXAMINATION I1.1 MANAGERIAL FINANCE 5 STUDY MANUAL Study Unit 1 Objectives of Financial Management Contents A. Introduction B. Agency Theory C. Public Sector/Not-For-Profit Organisations D. Corporate Social Responsibility (CSR) E. Impact of Government on Activities F. Composition of Shareholders 6 I1.1 MANAGERIAL FINANCE CPA EXAMINATION STUDY MANUAL A. INTRODUCTION Financial Management is a branch of economies concerned with the generation and allocation of scarce resources to the most efficient user within the economy (or the firm). The allocation of these resources is done through a market pricing system. A firm requires resources in form of funds raised from investors. The funds must be allocated within the organisation to projects that will yield the highest return. Financial Management is a discipline concerned with the generation and allocation of scarce resources (usually funds) to the most efficient user within the firm (the competing projects) through a market pricing system (the required rate of return). Managerial Finance is the science of managing financial resources in a firm so as to maximize the value of the firm while on the other side managing the financial risks. SCOPE OF FINANCE FUNCTIONS The functions of Financial Manager can broadly be divided into two: The Routine functions and the Managerial Functions. Managerial Finance Functions Require skilful planning, control and execution of financial activities. There are four important managerial finance functions. These are: a) Investment of Long-term asset-mix decisions These decisions (also referred to as capital budgeting decisions) relates to the allocation of funds among investment projects. They refer to the firm’s decision to commit current funds to the purchase of fixed assets in expectation of future cash inflows from these projects. Investment proposals are evaluated in terms of both risk and expected return. Investment decisions also relates to recommitting funds when an old asset becomes less productive. This is referred to as replacement decision. b) Financing decisions Financing decision refers to the decision on the sources of funds to finance investment projects. The finance manager must decide the proportion of equity and debt. The mix of debt and equity affects the firm’s cost of financing as well as the financial risk. This will further be discussed under the risk return trade-off. c) Division of earnings decision The finance manager must decide whether the firm should distribute all profits to the shareholders, retain them, or distribute a portion and retain a portion. The earnings must also be distributed to other providers of funds such as preference shareholder, and debt providers of funds such as preference shareholders and debt providers. The firm’s dividend policy may influence the determination of the value of the firm and therefore the finance manager must decide the optimum dividend – payout ratio so as to maximise the value of the firm. d) Liquidity decision The firm’s liquidity refers to its ability to meet its current obligations as and when they fall due. It can also be referred to as current assets management. Investment in current assets affects the firm’s liquidity, profitability and risk. The more current assets a firm has, the more liquid it is. This implies that the firm has a lower risk of becoming insolvent but since current assets are non-earning assets the profitability of the firm will be low. The converse will hold true. The finance manager should develop sound techniques of managing current assets to ensure that neither insufficient nor unnecessary funds are invested in current assets. CPA EXAMINATION I1.1 MANAGERIAL FINANCE 7 STUDY MANUAL Routine functions For the effective execution of the managerial finance functions, routine functions have to be performed. These decisions concern procedures and systems and involve a lot