ATD NOTES – FUNDAMENTALS OF FINANCE NOTES

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PAPER NO. 11. FUNDAMENTALS OF FINANCE

 UNIT DESCRIPTION

This unit covers the competencies required to manage finances in an organisation. Competencies include: Applying finance concepts in evaluating financial implications of relevant business decisions, applying time value of money principles in evaluating financing and investment decisions, evaluating appropriate source of business finance, applying appropriate capital budgeting techniques, maintaining liquidity through appropriate working capital management, applying risk and return concepts in making optimal investment decisions, identifying concepts that inform the dividend decision making process and identifying finance and investment opportunities using Islamic finance concepts

 

LEARNING OUTCOMES

  • Apply finance concepts to manage finance in an organisation
  • Apply time value of money principles to evaluate financing and investment decisions
  • Determine the optimal cost of capital of an organisation
  • Make capital budgeting decision using appropriate techniques
  • Make working capital management decisions using appropriate methods
  • Apply risk and return concepts to make optimal investment decisions
  • Identify concepts that inform the dividend decision making process
  • Apply valuation models to determine the value of securities

 

CONTENT:

  1. Apply finance concepts to manage finance in an organisation
    • Nature and scope of finance
      • Investment decisions
      • Dividend decisions
      • Financing decisions
      • Liquidity decisions
    • Relationship between accounting and finance
      • Similarities and differences
      • Cost accounting
      • Financial accounting
      • Management accounting
    • Finance Functions
      • Routine
      • Non-Routine (Managerial)
    • Goals/Objectives of a Firm
      • Financial
      • Non-financial goals
      • Overlaps and conflicts among the objectives
    • Agency Theory
      • Key definitions
        • Principal
        • Agent
      • The nature of agency relationships
        • Ordinary shareholders and management
        • Shareholders and debenture holders
        • Shareholders and external auditors
        • Shareholders and Government
      • Causes of conflict in each relationship and suggested remedial measures

 

2.            Evaluate appropriate source of business finance

  • Factors to consider when choosing a source of finance
  • Sources of finance
    • Short term
    • Medium term and
    • Long-term
  • Types of finance
    • Internally generated funds
    • Externally generated funds
  • The nature of each source of funds
  • Characteristics for sources based on
    • Short term sources
    • Medium term sources

2.2.3   Long-term sources

  • Merits and demerit for:
    • Short term sources
    • Medium term sources
    • Long-term sources
  • Sources of finance for small and medium sized enterprises (SMEs)
    • The SME owner, family and friends
    • The business angel
    • Trade credit
    • Leasing
    • Factoring and invoice discounting
    • The venture capitalist
      • Listing
      • Supply chain financing
    • Challenges encountered by SMEs in raising capital and remedial measures
      • SMEs’ difficulties in accessing finance
      • Lack of information infrastructure for SMEs
      • Low level of business R&D in SMEs sector
      • Insufficient use of information technology in SMEs
    • Remedies for the above challenges
      • Diversifying Channels of Financing
      • Development of SME Database and Credit Risk Analysis of SMEs
      • R&D Tax Incentives
    • Utilising Information for SMEs

 

3.            Apply time value of money principles to evaluate financing and investment decisions

  • The Time value of money
    • Time value versus time preference for money
    • The relevance of time value of money
  • Estimating cash flows
    • Compounding techniques
    • Discounting techniques
  • Preparation of the loan amortization schedule
    • Principal amount
    • Repayment period
    • Rate of interest

 

4.            Apply valuation models to determine the value of securities

  • Nature and scope of valuation models
  • Relevance of valuation of securities
    • Debentures
    • Preference shares
    • Ordinary shares
  • Concept of value
    • Going concern value
    • Liquidation value
    • Fair value
    • Investment value
    • Intrinsic value
  • Valuation of:
    • Debentures
    • Preference shares
    • Ordinary shares

 

5.            Determine cost of capital for a business entity

  • The Cost of capital
    • Relevance of cost of capital to firms
    • Usage
    • Factors influencing a firm’s cost of capital
  • Components of cost of capital
    • Debt
    • Ordinary shares
    • Preference shares
  • The firm’s overall cost of capital:
    • Weighted average cost of capital
    • Weighted Marginal cost of capital
  • Limitations of the weighted average cost of capital

 

6.            Apply appropriate project appraisal technique to make capital budgeting decisions

  • Nature and importance of capital investment decisions
  • Characteristics of capital investment decisions
    • Large investments
    • Irreversible decision
    • High risk
    • Long-term effect on profitability
    • Impacts cost’s structure
  • Types of capital investment decisions
    • On the basis of expansion
    • On the basis of dependency
  • Capital investment cash flows:
    • Total initial cash outlay
    • The total terminal cash flows and
    • Annual net operating cash flows
  • The features of an ideal capital budgeting technique:
    • Based on size
    • Based on duration
    • Based on risk
    • Based on impact to cost structure
    • Based on difficulty
  • Capital Budgeting techniques
    • Non discounted techniques
      • Accounting Rate of Return (ARR)
      • Payback period
    • Discounted techniques
      • Internal Rate of Return
      • Net Present Value
      • Profitability index and
      • Discounted payback period approach
    • Merits and demerits of each capital budgeting technique
    • Conflict between NPV and IRR in Ranking Projects
    • Practical challenges of capital budgeting in the real world
      • Small businesses
      • Large businesses
      • Public institutions
      • Private institutions

 

7.            Maintain liquidity through appropriate working capital management

  • Nature and importance of working capital management
  • Factors influencing working capital needs of a firm based on the:
    • Nature of business
    • Size of business
    • Production policy
    • Manufacturing process/length of production cycle
    • working capital cycle
    • Based on credit policy
    • business cycle
  • Working capital operating cycle
    • The relevance
    • Components of the cycle
    • Computation of the cycle
  • Working capital financing policies
    • Management of Cash
    • Management of Debtors
    • Management of creditors
    • Management of inventory

 

8.            Apply risk and return concepts to make optimal investment decisions

  • The nature of risk and return
  • Distinction between risk-free and risky assets
  • Sources of risk
    • Competitive risk
    • Financial risk
    • Market and opportunity
    • Political and economic risk
    • Technology risk
    • Operational risk
    • Environmental risk
  • Expected Return
    • For single asset
    • For two assets

 

  • Risk
    • Standard deviation and variance:
      • For a single asset
      • For two assets
    • Coefficient of variation
  • Relationship between risk and return on investment/Risk return trade off

 

9.            Identify concepts that inform the dividend decision making process

  • Factors influencing the dividend decision of a firm
  • Forms of dividend payment
    • Stock
    • Cash
    • Property
    • Script
    • Liquidating
  • The firm’s dividend policy
    • Stable predictable policy
    • Constant pay-out Ratio policy
    • Regular plus extra policy and
    • Residual Dividend
  • Dividend payment process
    • Declaration date
    • Ex-Dividend date
    • Record date
    • Payment date
  • Dividend theories
    • The MM dividend irrelevance theory
    • The residual dividend theory
    • The bird-in-the-hand theory
    • The tax preference theory

 

10.         Identify finance and investment opportunities using Islamic finance concepts

  • History of Islamic finance
  • The nature of Islamic finance:
    • Islamic banks
    • Islamic insurance (Takaful) and Islamic financial instrument
  • Principles of Islamic finance
    • Equity based contracts
    • Sale based contracts
    • Debt based contracts
    • Charitable based contracts
  • Differences between Islamic and conventional finance
  • The concept of interest (riba) and how returns are made by Islamic financial securities
    • Sources of Islamic finance
  • Islamic finance drivers
    • Changing nature of regulation
    • Technological advancements
    • Cross border transactions
    • Growing Muslim populations
    • Emerging economic growth

 

  • Regulation of Islamic finance institutions
  • Emerging issues and trends
    • Cryptocurrency
    • Block chain technology
    • Crowdfunding

 

 

SAMPLE WORK

Complete copy of ATD FUNDAMENTALS OF FINANCE STUDY NTES is available in SOFT copy (Reading using our MASOMO MSINGI PUBLISHERS APP) 

Phone: 0728 776 317

Email: info@masomomsingi.co.ke

CHAPTER ONE

 APPLY FINANCE CONCEPTS TO MANAGE FINAANCE IN AN ORGANIZATION

 

INTRODUCTION

Finance is called “The science of money”. It studies the principles and the methods of obtaining control of money from those who have saved it, and of administering it by those into whose control it passes.

 

Involves the task of raising funds required by the firm at the most favorable terms.

It’s the study of how best to raise funds needed by the business and allocation of the utilized and the distribution of returns generated.

 

The above definition will therefore cover the four financial management functions namely;

  1. Financing function
  2. Investing function
  3. Dividend function
  4. Liquidity function

 

Financing function

The finance management is responsible for making projections of the firms’ future financial needs. He has to determine the companies fixed capital needs in the short, medium and long-term as well as the working capital needs.

He has to  ensure  that the finance  is provided in the most  appropriate form and for  the  purpose for  which it  is required at the  lowest possible  cost to the  company.

He needs to be well equipped with the requirement of financial markets.

 

Investing function

The finance manager has to ensure that the funds raised are allocated to the most efficient and most productive uses so as to fulfill the company’s objective of maximizing shareholders wealth.

 

Liquidity function

The finance manager has additional responsibility of advising on the quantity and timing of funds since cash receipts and distribution don’t always consider.

He should ensure that the firms’ financial resources are well managed by;

  1. Ensure that there is proper management of working capital.
  2. Maintain optimal level of investments in each of the working capital items investments (stocks), debtors, opportunity costs in order to efficiently with deal cash shortage or surplus.

 

Dividend function

Involves allocation of profits available for distribution

Appropriate of earnings attributable to shareholders i.e. profit after interest and tax and preference dividend is paid out as cash dividend and the other proportion is to be retained for re-investment.

  

GOALS OF A FIRM

 This can be divided into 2:

  1. Financial goals
  2. Non-financial goals

 

FINANCIAL GOALS

 Profit maximization goals

The main aim of economic activity is earning profits

A business concern also function mainly for the purpose of earning profit

Profit maximization however, is a traditional and narrow approach which aims at maximizing the profits of the business concern.

 

Favorable arguments for profit maximization (advantages)

 The following points are important in the profit objective of the entity.

  1. Main aim is to make profit
  2. Profit is the economic measure of efficient business operation
  3. Profit is the main source of finance
  4. Profit reduces risk of business concern
  5. Profitability meets the social needs.

 

Unfavorable arguments for profit maximization (disadvantages) 

  1. Leads to exploitation of workers and consumers
  2. Creates immoral practices such as corrupt practice and unfair trade
  3. Leads to inequality among shareholders
  4. Profit maximization is vague in the sense that it doesn’t specify the profit at the expense of his profitability.

 

Wealth Maximization:

Wealth Maximization is considered as the appropriate objective of an enterprise. When the firms maximizes the stock holder’s wealth, the individual stockholder can use this wealth to maximize his individual utility. Wealth maximization is the single substitute for a stock holder’s utility.

  

A Stock holder’s wealth is shown by:

 Stock holder’s wealth = No. of shares owned x Current stock price per share.

The higher the stock price per share, the greater will be the stock holder’s wealth.

 

Arguments in favour of Wealth Maximization: 

  1. Due to wealth maximization, the short term money lenders get their payments in time.
  2. The long time lenders too get a fixed rate of interest on their investments.
  3. The employees share in the wealth gets increased.
  4. The various resources are put to economical and efficient use.

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Argument against Wealth Maximization: 

  1. It is socially undesirable.
  2. It is not a descriptive idea.
  3. Only stock holders wealth maximization does not lead to firm’s wealth maximization.
  4. The objective of wealth maximization is endangered when ownership and management are separated.

In spite of the arguments against wealth maximization, it is the most appropriative objective of a firm.

 

NON- FINANCIAL GOALS

Are also known as corporate social responsibility (CSR) goals

 

CSR goals can be defined as making a positive effort to help the society i.e. is the managerial responsibility to take actions that protect and promotes the welfare of the various stakeholders of the firm and not just shareholders.

 

Is organization’s responsibility to improve the overall welfare of society by avoiding harmful practices. This has a long term advantage to the firm and therefore in the long run the stakeholders’ wealth will be maximized.

 

Area of social responsibility 

 Social responsibility may extend from the stakeholders towards;

Employees

  1. Paying fair salaries and wage
  2. Providing conducive working environment
  3. Offer opportunities for growth and development  g. training
  4. Involve them in decision making

 

Customers

  1. Charging fair prices
  2. Providing relevant information pertaining commodity
  3. Offer good quality products and services
  4. Offer opportunities for growth and development e.g. training
  5. Be honest with weight measurements
  6. Regular supply of goods and services

 

Suppliers/creditors

  1. Prompt payment
  2. Give accurate financial statements
  3. Negotiations should be done

 

Government

  1. Pay taxes promptly
  2. Refrain from engaging in unlawful practices
  3. Provide accurate  information when applying for permits

 

Community

  1. Taking care of  the  environment
  2. Employing people within the  community
  3. Giving bursaries to needy students
  4. Contributing to construction of schools and hospitals for less privileged

 

 

AGENCY THEORY CONCEPT, CONFLICT AND RESOLUTION IN A FIRM

 Agency is a relationship that occurs between a principal and an agent. It arises when the principal hires an agent to perform some tasks on behalf of him.

In financial theory, the agency concept arises due to separation between the ownership of the business and management of business.

The ownership is rested in the hands of shareholders while the management of the business is left in the hands of the managers.

Shareholders, as owners can’t manage the business because of;

  1. Geographical distances hence lack of time
  2. Lack of relevant technical skills to manage the firm
  3. May be too many to manage a simple firm

 

An agency conflict arises due to the divergence of interest of principal (shareholders) and agent (manager).

 

Types of agency relationship

 Shareholder (principal) versus management (agents)

In modern time, there is a significant separation between ownership and management of the firm. The owners provide funds and other resources and expect the management to put this to the best use. The management undertakes the day to day operations of the firm since they have the technical skills and expertise.

An agency problem presents itself whenever there is divergence of interest between the shareholder and management.

The following are some of the decisions by management which would result in conflict with shareholders;

 

Sources of conflict between management and shareholders 

  1. Managements may use corporate resources for personal use
  2. Managements may take holidays and spend huge sum of company money.
  3. Creative accounting – involves manipulation of finances
  4. Empire building – managers may organize for mergers beneficial to themselves and not shareholders.
  5. Failure to declare dividend for no good reason.

 

 Resolution of conflicts 

  1. Performance based remuneration

This involves remunerating managements for actions they take that maximizes shareholders wealth. Managements could be given bonuses, commission for superior performance in certain periods.

  1. Incurring agency cost

Agency costs are those incurred by shareholders in trying to cut management behaviour and action and therefore minimize agency conflicts.

 

Types of agency costs 

  1. Monitoring cost- arise as a result of mechanism put in place to ensure interest of shareholders are met. These include; cost of hiring auditors.
  2. Boding assurance – insurance taken for managers who engage in harmful practice.
  3. Opportunity cost- costs incurred either because of the benefit foregone for not investing in a riskier but more profitable investment or due to the delay when procedures have to be followed.
  4. Restructuring cost– Are costs incurred in changing an organization structure so as to prevent undesirable management activities.

 

  1. Direct intervention by shareholders

These may be done in the following ways;

  1. Making recommendations to the management on how the firm should be run
  2. Threat of firing

 

Use of corporate governance principles which specify the manner in which organizations are acted and managed. The duties and rights of all stakeholders are outlined.

 

Threat of hostile takeover (sell the business)

This may be arranged by shareholders to lock out managements who aren’t responsible

 

Creditors/suppliers/lenders (principals) versus shareholders/management (agents)

 In this relationship the shareholders (agents) are expected to manage the credit funds provided by the creditors. The shareholders manage these funds through management

The following actions by shareholders through management could lead to conflict between them and creditors.

  1. Shareholders could invest in very risky projects
  2. Dividend payment to shareholders could be very high
  3. Default on interest payment
  4. Shareholders could organize mergers which aren’t beneficial to creditors
  5. Shareholders could acquire additional debt that increases the financial risk of the firm.
  6. Manipulation of financial statements so as to mislead creditors
  7. Shareholders could dispose of assets which are security for credit given

 

Reduction of above conflicts 

  1. Restrictive covenants: these are covenants/agreements entered into between the firm and creditors to protect the creditor’s interest.

 

Types of restrictive covenants 

  1. Asset based covenants: states that the minimum asset base to be maintained by the firm.
  2. Liability based covenants: this limits the firm’s ability to incur  more debts
  3. Cash flow based covenants: this states the minimum working capital to be held by the firm
  4. It may also restrict amount of dividends to be paid in future.
  5. Control based covenants: these limits management ability to make various decisions e.g. providers of debt capital may require to be represented in the board meetings.
  6. Callability provision – This provision will provide that the borrower will have to pay the debt before the expiry of the maturity period if there is breach of terms and conditions of the bond covenant.
  7. The lenders may sue the company
  8. Incurring agency costs such as hiring external auditors
  9. Use of corporate governance principles so as to minimize the conflict

Shareholders (principals) versus external auditors (agents)

Auditors are appointed by shareholders to monitor the performance of management

They are expected to give an opinion as to the true and fair view of the company’s financial position and performance as reflected in the finances that managers prepare.

 

Causes of conflict/problem

  1. When auditors collude with management in the performance of duty whereby the independence is compromised.
  2. Demanding very high audit fees which reduces the firms profit even when the company has a strong internal control system existing.
  3. Issuing unqualified reports which might be misleading to shareholders thus exposing them to investment loss.
  4. Failure to apply to professional care and due diligence in performance of audit work.

SAMPLE WORK

Complete copy of ATD FUNDAMENTALS OF FINANCE STUDY NTES is available in SOFT copy (Reading using our MASOMO MSINGI PUBLISHERS APP) 

Phone: 0728 776 317

Email: info@masomomsingi.co.ke

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