Finance

Question 1

Finance Financial awareness

Answer 1

Chapter 11 of the ICAEW Workbook covers financial awareness because the
examiner wants learners to understand the issues that have occurred in recent years,
so that socially responsible decisions can be made about finance.
The key features of this chapter include:
 Financial strategy is defined as managing an organisation’s financial resources
so as to achieve its business objectives and maximise its value.
 The finance function should be involved in the decision making of a company
and labelling the finance function as a business partner is one way of doing this.
 Investors have a responsibility to incorporate ESG (environmental, social,
governance) factors into their investment portfolio. This should influence the
decisions of the companies they invest in.
In addition to this chapter, it is important to understand current issues and new
developments in finance.
A recap of markets and finance products can be found in Appendix 2 – Recap of
Financial Management.

Question 2

Finance Choosing an appropriate financing option

Answer 2

The choice of which financing option to use in a particular case will depend upon the
specific circumstances of the project, the business making the decision, and the
general business environment.
The main considerations are:
 Cost (as a general rule debt is cheaper than equity for both issue costs and
finance costs)
 Current level of gearing – not only the mix of debt to equity a company currently
has, but also the mix of short to long term debt
 The signalling effect (issuing equity may be seen as a last resort)
 Availability (size of the company)
 Security is often needed for debt finance
 Duration – match the term of finance to the term of the proposed project
 Control – equity issues may change the balance of control
 Cash flow – equity is more flexible if cash flows are uncertain
 Covenants in existing debt agreements
 Currency
 Green finance (finance available for environmentally beneficial companies)

Question 3

Finance Bonds

Answer 3

If a company wants to issue a bond, it needs to know what return (yield) is required
by the lenders so that it can set the appropriate issue price/coupon rate/redemption
premium. Market / issue prices are covered in more detail in Chapter 4 – Business
and securities valuation.

Question 4

Finance Bonds 3.1 Yield on a bond

Answer 4

Three key things that affect the yield required on a bond:
1 Base rates e.g. if base rates are low then the required yield will be low too
2 The credit worthiness of the company. For major listed companies, ratings
agencies will issue a credit rating – see detail below
3 The liquidity and marketability of the bonds. The smaller the number of bonds
that are issued the less liquid they are, and therefore riskier requiring a higher
yield

Question 5

Finance Bonds 3.2 Calculation of yield

Answer 5

There are two ways of calculating the yield on a bond:

1 Flat yield
This is simply the coupon rate divided by current market value. Consequently, it
ignores the impact of any redemption payment, so the flat yield is of little use in
practice.

2 Gross redemption yield (yield to maturity)
This is the more commonly used definition of yield. It is calculated by finding the
IRR of:
 the current market value
 the gross interest payments
 the redemption amount
It can be calculated using the spreadsheet function:
=IRR(cell range) or;
=RATE(number of periods, interest payment, current market value, redemption)

Question 6

Finance Bonds 3.3 The yield curve for a bond

Answer 6

The yield curve plots gross redemption yields of bonds of equal credit risk and
different maturities. It can help to measure bond investors’ feelings about risk.

The upward slope shows that the yield on a bond is greater the longer there is to
maturity.

For example, this means that 5% Treasury bills with 3 years to maturity will have a
lower yield than 5% Treasury bills with 5 years to maturity.
The main reason for the shape of the yield curve is the Liquidity Preference Theory.
This states that investors will demand a higher return the longer they have to wait for
redemption. If the bond is long dated, then the yield will rise compared to a short
dated bond.

Question 7

Finance Bonds 3.4 Credit ratings – credit risk and credit spread

Answer 7

The yield on a bond will be influenced by the likelihood of the company issuing the
bond to default (‘credit risk’).
Typical criteria to analyse for assessing credit risk
 Loan suitability – length of loan/term structure etc.
 Affordability
 Security availability
 Financial stability
 Capital structure
 Management
Credit rating companies (such as Standard and Poor’s, Moody’s and Fitch) assess
this risk, and bond yields are determined accordingly.

Yield on a corporate bond = risk free rate + credit spread

The ‘credit spread’ is determined by the assessed credit risk of the company.

Question 8

Finance Bonds 3.5 Volatility of a bond’s value

Answer 8

There is an inverse relationship between interest rates and bond prices.

So if interest rates rise bond prices fall (and vice versa).
However, the prices of some bonds are more sensitive to changes in interest rates
than others (their prices are more volatile).
The price of a bond is more volatile if the bond has a:
 Longer time until maturity
 Lower coupon
 Lower yield

In order to be able to compare the volatility of two different bonds we can use the
Macauley Duration.
This calculation gives a measure of the sensitivity of a bond’s price to changes in
interest rates (more sensitive/volatile bonds have longer durations).
It is the weighted average length of time to the receipt of a bond’s benefits.
The calculation itself is not examinable, but an awareness of the model can be useful
when assessing two different bond options.

Question 9

Finance Overseas finance

Answer 9

If a company is investing overseas then it might be more suitable to take out a
foreign currency loan, rather than a UK loan. It can often provide a natural hedge
against foreign currency risk.

Question 10

Finance Overseas finance 4.1 Factors affecting the financing decision Yield calculation

Answer 10

When calculating the yield on overseas finance, it is important to take account of the
exchange rate movement.
Step 1 – translate all currency cash flows into sterling at the predicted exchange
rates
Step 2 – apply the IRR / RATE function to the sterling cash flows

Question 11

Finance Overseas finance 4.1 Factors affecting the financing decision Tax:

Answer 11

 If interest isn’t tax deductible in the O/S country, then debt finance becomes
notably less attractive
 High local taxes increase the benefit of tax deductibility
 High withholding taxes or other remittance restrictions makes equity less
attractive

Question 12

Finance Overseas finance 4.1 Factors affecting the financing decision Exchange rate risk:

Answer 12

 Financing an O/S investment with a loan in another currency is risky, especially
if the exchange rate is volatile
 Financing a foreign investment with a local currency loan would remove this risk
(but borrowing in local currency may be more expensive for a foreign company)

Question 13

Finance Overseas finance 4.1 Factors affecting the financing decision Business risk:

Answer 13

 International diversification may reduce the volatility of the firm’s operating
profits, enabling the firm to take on more borrowing

Question 14

Finance Overseas finance 4.1 Factors affecting the financing decision Guarantees:

Answer 14

 A parent company may guarantee the debts of a subsidiary enabling it to have a
more highly geared capital structure than normal

Question 15

Finance Leasing

Answer 15

As an alternative to buying an asset outright with a loan, the company can lease the
asset. This will spread the cost over several years rather than a significant lump sum
up front.
We assume the asset and the project will remain the same regardless of the finance
option, therefore when comparing a loan to a lease agreement it becomes purely a
financing decision.
In order to compare the costs of finance, we calculate an NPV of the relevant cash
flows discounted at the post-tax cost of finance.

Question 16

Finance Leasing Relevant cash flows for leasing:

Answer 16

 The lease payments (often paid at the start of the year)
 The tax relief on lease payments (watch out for timing – if the lease payment is
at the start of the year (Year 0) the tax saving will be at the end of the year
(Year 1)).

Question 17

Finance Leasing Relevant cash flows for buying:

Answer 17

 The purchase payment and scrap value of the asset
 The tax savings from tax-allowable depreciation

Question 18

Finance Leasing Discount rate to be used:

Answer 18

For both sets of calculations use the post-tax cost of borrowing:
 Cost of borrowing  (1 – tax rate)

Question 19

Finance Dividend policy

Answer 19

Retained earnings are an important source of finance for a company, but a process
of reinvesting money back into the company can have an impact on the money being
paid out as dividends.
If investors are used to having a stable dividend policy, which is then changed, it can
impact on the value of the firm.

This impact can be assessed through a valuation model, such as the formula:

g = b (ROA + D (ROA – i(1 – t))) E

Where:
g is the growth rate
ROA is the return on the net assets of the company
b is the retention rate
D is the book value of debt
E is the book value of equity
i is the cost of debt
t is the corporate tax rate

Question 20

Financial reconstruction

Answer 20

Financial reconstruction schemes are undertaken when companies have got into
difficulties or as part of a strategy to enhance the value of the firm for its owners.

Question 21

Financial reconstruction Designing a reconstruction

Answer 21

Step 1: Estimate the position of each party if liquidation is to go ahead. This will
be the minimum acceptable.
1 Fixed charge holder
2 Liquidator’s fee
3 Preferential creditors (such as wages and salaries)
4 Floating charge holder
5 Unsecured creditors
 Step 2: Assess additional sources of finance.
 Step 3: Design the reconstruction according to the details of the question.
 Step 4: Calculate and assess the new position and also how each group has
fared, compare to step 1.
 Step 5: Check that the company is financially viable after the reconstruction.

Question 22

Financial reconstruction Methods of reconstruction

Answer 22

Leveraged capitalisation – a firm replaces the majority of its equity with a
package of debt.
 Debt-equity swap – A portion of the debt is exchanged for a predetermined
amount of equity, possibly done to reduce the gearing level.
 Equity-debt swap – shareholders are given the right to exchange their shares
for a predetermined amount of debt.
 Refinancing – a firm may replace current debt with a package of cheaper or
more flexible debt, but the benefits may be outweighed by penalty clauses or
transaction fees from paying off the original debt early.
 Securitisation – is the process of using non-liquid assets, such as future season
ticket sales for football clubs, or trade receivables as collateral for a loan.

Question 23

Financial distress Legal consequences of financial distress

Answer 23

 Fraudulent trading – occurs where a company has traded with intent to defraud
creditors.
 Wrongful trading – occurs when directors have continued to trade when the
company is no longer financially viable and should be in liquidation.

Question 24

Financial distress Management of companies in financial distress

Answer 24

 Administration – the powers of management are subjugated to the authority of
the administrator, who has the same powers as those of the directors and may
do anything necessary to try and save the company if possible.
 Company voluntary arrangement – the directors retain control and manage the
company and they must put together a proposal to put to creditors as an
acceptable alternative to liquidation.
Directors need to act responsibly when a company is in financial
distress. Poor decisions, such as wrongful trading can result in
imprisonment (Rule of Law).

Question 25

Financing options for small and
medium sized companies

Answer 25

Small and medium sized enterprises (SMEs) often find it difficult to raise finance to
fund their business plans, because they are usually unquoted and they have
relatively few assets which can be offered as security for loans.
However, there are numerous sources of finance available, such as:
 owner financing
 business angels
 venture capital
 leasing
 debt factoring
 bank loans
 government grants and loans
 green finance
 a medium sized company can issue their share on the Alternative Investment
Market (AIM). This market has no minimum market value and has fewer rules to
comply with than the stock exchange.