Financial Management : WACC calculation formula & dividend policy

Three key decisions made by a Financial Manager :-
A. Dividend decision
B. Investment decision
C. Financial decision

2 key considerations are :-
i) Can we afford to pay dividend? This could be influenced by (which must be considered by company) legal position, levels of performance and free cash flow, expectations of shareholder, optimal gearing position, inflation, control, tax, liquidity and other sources of finance.

ii) How much can we afford to pay? Key determinant are dividend capacity and free cash flow to equity. Dividend can be paid either by cash (for cash rich company) or by shares (right issue or bonus issue)

In practice, there are a number of commonly adopted dividend policy:-
a ) Stable dividend policy - dividend paid are constant, but take into account the inflation rate, to satisfy investor.
b) Constant payout % - constant % of dividend on Profit After Tax, every year.
c) Residual approach - Should there be a positive NPV project available, the cash to fund the project are the first priority before dividend payout.
d) Zero payout - No dividend, usually for start-up company that need sufficient fund to grow.

Finance could be sourced either by debt or equity. However, the main concern of the company is that of the Cost of Finance, which is WACC (Weighted Average Cost of Capital). Company usually opt for lowest WACC.
Use of WACC --> Discount factor for appraising capital project (lower WACC, give a higher NPV, in order to maximise shareholders' wealth)
Used for business valuation.(The lower WACC, the higher the company's value).

Sources of Finance :-
i) Equity (Ke)
ii) Preference shares (Kp)
iii) Debt (Kd)

All of the formula below are very important in P4 ACCA examination, because most of the formulas are not provided in book, and in exam sheet. For calculation of one items, there are multiple formulas that could be used to calculate it. To use which formula, it depends on what information that provided in the scenario in the exam, which will be explained briefly below :-

There are 2 types of formulas used to calculate WACC. (WACC = Ko)
i. Traditional (formula will be given in exam sheet) - use this formula only when all elements needed to calculate WACC are provided in exam question scenario.

Ko = (Ke x e/Mc) + (Kd x d/Mc)x(1-T)

e = Market value of equity
d = Market value of debt
Mc = Market Capitalisation (e + d)
T = Tax rate

ii) Modigliani and Miller (This formula will NOT be given in the exam sheet, so have to memorise, this formula will be used when there is a missing element in the information given in the exam scenario question)

Ko =  Keu (1-DT/(D + E))

Keu = Cost of equity in an equivalent ungeared firm
D = Market value of debt
E = Market value of equity
T = Rate of tax

a) Calculation of Cost of Equity (Ke)
Please take note that The Cost Of Equity to the business is the same as the required Return to The Equity Investors.

There are 3 ways to calculate Ke - namely :-
i) DVM (if given level of dividend & rate of growth)
ii) CAPM (If given the rate of risk & return)
iii) Modigliani and Miller(there are missing element & Level of Gearing are given)

i) DVM method 
Ke = (D(1+g)/Po) + g 

D(1+g) = future dividend
Po = Current share price (ex-div)
D = use current dividend
g = rate of growth

Growth - exist when there is money retained to be reinvested, indicating growth. There are 2 ways to calculate growth (g)
a. Averaging (Historic)
g = (n √Di / Dn) - 1
Di = current dividend
Dn = dividend in the past
n = No. of years changing

b. Gordon's (Earning Retention Model) - given in exam

g = rb
r = Rate of return on reinvested funds (ARR or ROCE)
b = proportion of funds retained (minus % of funds distributed as dividends After Tax), which is PAT-div

ii) CAPM

Ke = rf + (rm - rf)ß
rf = risk free rate (return on government security)
rm = expected return on market
(rm - rf) = Equity risk premium (maybe given as a whole in exam)
ß = beta factor (level of systematic risk faced by an investor)

iii) Modigliani and Miller
Keg = Keu + (Keu - Kd) (D(1-T)/E)
Kd = Pre-tax cost of debt (Cost of debt x (1-T))

b) Calculation of Cost of Preference Shares (Kp)
-The cost of preference shares is the same as the return to the preference shares to investors.

Kp = D / Po

D = Dividend
Po = ex-div market price of company's preference shares

c) Calculation of cost of debt (Kd)
The cost of debt to the company is not the same as the return to the debt investors. This is because the company receives a tax reluef on the interest payment, where at the investors of debt receives their interest growth (pre-tax).

Debt can be categorised into TRADEABLE and NON-TRADEABLE

I) For TRADEABLE debt such as debentures, it could be categorised into REDEEMABLE & NON-REDEEMABLE

i) Irredeemable - unlimited life
Kd  = $I (1-T)/Po
$I = Interest paid, in monetary value (coupon rate x nominal value of debenture)
T = rate of tax
Po = ex-interest of the market value of debt

ii) Redeemable - Limited life, will be redeemable or paid back at certain fixed date in the future
Kd = IRR (1-T)
IRR = Internal Rate of Return
T = Rate of tax

II) Non-tradeable debt, such as bank-loan

Kd = %I (1-T)

%I = Interest paid in percentage
T = Rate of tax

Porter's Diamond - Nation Competitive Advantage of an Industry

Certain nation or country has a competitive advantage for certain industry. Michael E. Porter argued that a nation can create new advanced factor endowments such as skilled labor, a strong technology and knowledge base, government support, and culture. 

The role of government in Porter's Diamond Model is "acting as a catalyst and challenger, it is to encourage or even push companies to raise their aspirations and move to higher levels of competitive performance". They must encourage companies to raise their performance, stimulate early demand for advanced products, focus on specialized factor creation and to stimulate local rivalry by limiting direct cooperation and enforcing anti-trust regulations.

Porter suggested that there are four interlinked main factors which determine national competitive advantage and expressed them in the form of a diamond. These can be influenced in a pro-active way by government.

The 4 factors are :-
a) Factor conditions - physical resources such as land, minerals and water, capital, human resources, knowledge that can be used effectively and infrastructure. The basic factors are essential for an industry to exist, which advance factors can give competitive advantage to the industry to grow. Each country has its own particular set of factor conditions, such as low-cost labor or fertile soil (for agriculture industry).

b) Demand - there must be a strong home market demand for the product or services in order for the industry to be sustainable. This determines how industries perceive and respond to buyer needs and creates the pressure to innovate. According to Porter, home demand is determined by three major characteristics: their mixture (the mix of customers needs and wants), their scope and growth rate, and the mechanisms that transmit domestic preferences to foreign markets. Government can encouraging local demand by restricting import such as impose of tariff and non-tariff barriers.

c) Related and Supporting Industries - The success of an industry can be due to its suppliers and related industries. For example, a success of an industry in a certain nation is supported by the network of its related industries such as packaging and distribution. One internationally successful industry may lead to advantages in other related or supporting industries. 

d) Strategy, Structure and Rivalry - The conditions in a country that determine how companies are established, are organized and are managed, and that determine the characteristics of domestic competition. Here, cultural aspects play an important role. In different nations, factors like management structures, working morale, or interactions between companies are shaped differently. This will provide advantages and disadvantages for particular industries. Typical corporate objectives in relation to patterns of commitment among workforce are of special importance. They are heavily influenced by structures of ownership and control. Family-business based industries that are dominated by owner-managers will behave differently than publicly quoted companies. This will be also be determined by number and size of competitor. No. of competitor can be reduced by government by introducing government grant.

IFRS 3 & IAS 27 revised 2008 - Consolidation of financial statements

Revision of IFRS 3 in year 2008 has mean significant changes to :-

a. new restrictions on what expenses can form part of the acquisition cost
b. revisions of the treatment of contingent consideration, now it is recognised in the purchase consideration on the fair value & expected value basis. Previously, it will only be recognised if the amount to be paid is probable to happen.
c. measurement of the NCI (previously known as Minority Interest) , and the knock-on effect it has on the consolidated goodwill. (Step 3)
d. considerable guidance on recognising and measuring the identifiable assets and liabilities of the acquired subsidiary
e. accounting for step acquisitions

Steps taken in consolidating statement of comprehensive income statement & financial position:-

Step 1 : Determine the group structure, to determine whether you are dealing with subsidiary or associates.

Direct + indirect interests in an acquiree > 50% = subsidiary
20% > 50% = associates

An investment is considered as a subsidiary when there is more than 50% of direct and indirect interest, and the parent has the voting right in the meeting to make decision.

An investment is considered as an associate when there is a significant influence and between 20% to 50% (not more than 50%) of interests in the entity invested.

Step 2 : Calculate the Net current assets of subsidiary as at acquisition date and reporting date.

Share capital x
(+) Share premium x
(+) Reserves x
(+) Fair value adjustments (Note 1) x

Note 1 : All assets and liabilities of subsidiary are valued on the basis of fair value, that is market value.

Step 3 : Goodwill calculation
Subsequent to the revision of IFRS 3 on 2008, there are some changes to the calculation. The goodwill will be treated similar to the other asset and liabilities, that is 100% basis. Previously, goodwill are calculated by proportionate ("net") basis, which is called as the "old method". Revision of IFRS 3 on 2008 introduced the "new method" which is known as the "full goodwill" method.

"Old method" - NCI% x fair value of the net assets of the subsidiary at the acquisition date
"New method" - Fair value of NCI at date of acquisition (It could be Market value of share x no. of shares hold by NCI)

First we need to determined the purchase consideration, that is cost of investment. Under previous IFRS 3, purchase consideration including other cost of acquisition such as legal cost or cost of share issued. However, subsequent to the revision of IFRS 3 on 2008, cost of acquisition are NOT allowed to be included in the purchase consideration. It should be expensed in the period.

Purchase consideration (AT FAIR VALUE)
Cash x
(+) Shares (at market value) x
(+) Deferred consideration (discounted at present value) x
(+) Contingent consideration (at expected value) x

Calculation of goodwill :-
Fair value of parent's holding % (purchase consideration) x
(+) Fair value of NCI % (market value of shares x no. of shares) x
(-) Fair value of subsidiary's net assets @ acquisition date ( x )

Step 4 : NCI (previously known as Minority Interest)
In consistent with the "new method" that is calculation of goodwill on a full basis, there is a new method to calculate NCI.

NCI calculation
Fair value of NCI (goodwill and net assets) @ acquisition date x
(+) NCI % of post acquisition retained earnings x
(-) NCI% of unrealised profits (inventory or non-current assets)-Note 2 ( x )

Note 2 : It will be substracted by proportion of NCI % only and if ONLY the inventory are sold by subsidiary to parents, as the unrealised profits are included in Subsidiary's retained earnings. If parent sell to subsidiary, there is no need to make adjustment in NCI.

Step 5 : Group retained earnings
Parent company retained earnings (100%) x
(+) For each subsidiary : Parent % x post acquisition profit x
(-) Adjustment for unrealised profits (Note 3) ( x )
(-) Goodwill impairment ( x )

Note 3 : In conjunction with Note 2, unrealised profits could only happened when one entity in the group sell inventory or non-current assets to another entity in the group at a marked up profit, with portion of goods still left in the inventory. As it is treated as a group, there are deemed no profit gained, as the inventory still remained, and the profits that marked up are unrealised. Therefore, adjustment need to be made in order to reflect the real profit in the group.

The adjustment needs to be made to adjust the unrealised profit is as follows:-

If parent sell to subsidiary :-
Dr. Group retained earnings (100%) x
Cr. Inventory x

If subsidiary sell to parent :-
Dr. Group retained earnings (Parent %) x
Dr. NCI (NCI's %) x
Cr. Inventory x

The group reserves include the group's share of the post acquisition profits of each subsidiary. Pre-acquisition profits cannot be included in group reserves as they have been dealt with in the net assets working which leads to the calculation of goodwill.

Basically, this is the summary of consolidation of financial statements (IFRS 3)

First day class : 13.07.2010

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Strategic planning & freewheeling opportunism

Oh well, I suppose to study at the moment. But something that taught at class 2 days ago, when I attend Business Analysis class, it just caught my mind now. Actually it was something the tutor said, but it is relevant to the syllabus.

So, there are two types of personality, let's say to apply this in reality life (actually in my study, should be applied to business analysis). 1st is strategic planning (rational model) and secondly is freewheeling opportunism.

1. For strategic planning, it is a personality of a person who set goal in life, where he or she wants to be in next few years, or what he or she wants to achieve. This type of personality will follow the plan and route.

2. About freewheeling opportunism, this type of personality just grab whatever chances or opportunities that arise. There are no goal set in advance.

The 2nd personality could be sound like me, where I will grab chances or opportunities that arise. But still I have some goal in my life. Hence, it is lingering in my mind which personality could I be...

Student Oyster Card :)

Oh yea, I got mine student Oyster card finally !! I have posted the link before on how to purchase this card online, which entitle student above 18 years old 30% of discount for transport ^.^

Music - JJ Lin Jun Jie ( From How Many 100 days Album)

Transport in London, United Kingdom

It took me a while to learn about the transport system in London. Actually it is quite complicated for a newbie. There are Underground Tube, Overground, DLR and etc... etc..

However, for people who are planning to visit London, here are the link for the transport system, bus, tram or train, you could see the map & station in the link below :-

And don't forget to plan your budget, so you can opt for Oyster card. Just ordered a Student Oyster Card yesterday.

And you can plan your journey using this link too :-

Welcome to my blog ! ^.^

Hi there, Pek Sun here.. this is a personal blog, and generally will be consist of what I've encounter in London currently, and other general stuff as well.. Tune in !

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