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Corporate Finance

Corporate Finance is a key subject in the field of Accounting and Finance. In this category, we discuss various topical issues under Corporate Finance, some of which include the following:

Investment Appraisal, Business Reorganisation, Business Reconstruction, Working Capital Management, Risk Management, Cost of Capital theory and Calculation and many others.

These topics are very important to the management of organisations as investment across the globe are interested in how business take decisions concerning risk management, dividend policy, growth strategies, among others.

Also, governments across the globe are putting in place a lot of measures, policies, and strategies to help busineses to achieve their objective. When businesses are able to make the right decisions with the aid of the Chief Finance Officer, then the organisation will not only be atisfying the objective of the shareholders which is to maximise their wealth, but will also be satisfying the desires of other stakeholders.

Advanced Audit and AssuranceAudit and AssuranceBusiness Management and Information SystemsCorporate FinanceCorporate ReportingManagement AccountingPublic Sector Accounting and FinanceStrategic ManagementTaxation and Fiscal Policy

PREMIUM ICAG MAY 2018 MOCK EXAMINATION

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Thank you for visiting our website today. Our team of Expert Professional Educators has put together the following  mock examination questions with suggested solutions for the May 2018 examination.

Check them out and share with other colleagues to increase their chances of passing as well.

To JOIN our class next semester, fill our Online Admission Form  or send us an Email .

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FR – 2018 QUESTIONS

FR – 2018 SOLUTION

MA – 2018 MOCK

MA – MOCK 2018 SOLUTION

PSAF – 2018 MOCK QUESTION

PSAF – 2018 MOCK ANSWERS

CSEG – MOCK QUESTIONS – 2018

CSEG – MOCK ANSWERS – 2018

FM- MOCK 2018

FM – MOCK SOLUTION

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Advanced Audit and AssuranceAudit and AssuranceBusiness Management and Information SystemsCorporate FinanceCorporate ReportingFinancial ManagementFinancial ReportingManagement AccountingPublic Sector Accounting and FinanceStrategic ManagementTaxation and Fiscal Policy

JOIN OUR REVISION SESSION

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Join our revision session for ICAG May 2018 Examination.

Thank you for visiting our website today. Our team of Expert Professional Educators has put together the following documents, analysis and revision time table for the May 2018 examination.

Our revision session comes in three segment; Revision classes, Mock examination and Mock discussion.

Check them out and share with other colleagues to increase their chances of passing as well.

To sign up for the Revision Session, fill our Online Admission Form  or send us an Email .

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MODULE 1 – Conceptual Framework

MAY 2018 REVISION TIME TABLE

HIRE PURCHASE ACCOUNTS

FINANCIAL STATEMENTS IN THE PUBLIC SECTOR

BUDGETING AND BUDGETARY CONTROL

1522229395606_PEH-Level-three-MAY-2018

PSAF – Solution

PSAF – Questions

PEH-Level-two-MAY-2018

PEH – Level one (MAY 2018)

MODULE 7 – Public fund

MODULE 4 – Envirnmental Analysis

MODULE 3 – Regulatory Framework

POSSIBLE EXAMINABLE AREAS – Public Sector

We wish you the very best as you write your Examination.

 

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Corporate FinanceFinancial Management

A COMPREHENSIVE GUIDE TO BUSINESS RE-ORGANISATION

spoke_Biz

Business re-organisation refers to the changes in business structure and or operations to help improve its performance.

Methods for Business Re-organisation

A company seeking to improve its performance by business re-organisation can employ any of these methods:

  • Divestment
  • Sell- offs
  • Liquidation
  • Spin- offs
  • Demergers
  • Carve – outs
  • Management buy – outs / buy – ins.

Let’s look in details at each of these

Divestment /Divestiture

This refers to the complete sale of the assets of a business. It can also be defined as the reduction of some kind of asset for financial, ethical or political objectives or sale of an existing business by a firm.

Reasons for Divestments

  • It will enable the company to focus on core activities
  • It enables the company to sale -off the investments which lacks strategic fit
  • To improve the liquidity of the company
  • It enables the company to sale – off loss making investments
  • When there is lack of management skills
  • It is a decision to protect the firm against a takeover. The firm can sale off profitable investments to make the company non-attractive to

Sell – offs

This refers to the sale of part of an entity to a third party, usually another company in exchange for cash. It can also be defined as a sale of an unwanted business at a low price to encourage someone to buy it.

Reasons for Sell – offs

  • It enable the company to raise capital
  • It helps to curtail losses
  • It helps in efficiency gains
  • It’s also a strategy to prevent take over.

Spin – offs

This is where a new company is established and the shares in the new company are owned by the shareholders of the original company (existing shareholders).

Key issues:

  • There is no cash transacted
  • There is no change in ownership
  • The shares in the new company are owned completely by the existing shareholders on the basis of the number of shares each shareholder already has.
  • There is no dilution in Earnings Per Share

Demerger

It involves splitting a company into two separate parts of roughly comparable size which are large enough to carry on independently after the split.

Reasons for Demerger

  • “Unlocking shareholders’ value”
  • It enable the company to capture ‘revers synergy’ resulting from an existing ‘conglomerate discount’
  • It helps companies to remove ‘co-insurance benefits’ from debt-holders
  • Companies can also demerger or sell – off to meet regulatory requirements

Example of demerger: British Gas was separated in two different independent companies as:

  • Centrica : which is involve in the supplier of biogas and energy resources, while
  • BG Group: This is involved in the exploration of energy and oil.

Disadvantages of Demerger:

  • There is loss of economies of scale due to the slit out
  • There is lower profit due to higher overheads
  • It could be difficult to raise debt finance independently.

Carve – Outs:

This is where a company removes part of its business and set it up as a new company, with the shares in the new company offered to the general public.

Reasons for Carve – Outs

  • It is not a “full” spin- off
  • It is normally a minority stake that is offered to the general public

Benefits of Carve – Outs

  • It increase access to regional market therefore there is strong growth
  • It gives the company autonomy (board of directors).

Example of Carve – outs: Royal bank of Scotland (RBS) and World Pay. RBS carved out World Pay and offered 19.99% of the shares to the public. So World Pay operates on its own as an independent corporate entity.

Exams Focus:

In the question, you have to suggest which method is applicable to the case under discussion and also state the reasons why the others are not applicable.

  1. Management Buy – Outs (MBOs): This refers to the purchase of a business from existing owners by a team of managers of the company.
  2. Management Buy – INS (MBIs): This refers to the purchase of a business from existing shareholders by a team of external managers.

Reasons for a buyout

(a) From the buyout teams’ point of view:

i. to obtain ownership of the business rather than remain as employee

ii. To avoid redundancy when the business is threatened with closure

(b) From the seller’s point of view

i. to dispose of part of the company that does not fit in with the overall strategy of the company

ii. To dispose of a loss-making segment of the business which the directors do not have time or inclination to turn around

iii. In order to raise cash

iv. It is often easier to arrange a management buyout than to try and sell off parts of a business

In the open market

v. it may well avoid redundancy costs, strike action, etc. if closure if the only alternative

Reasons MBOs

  • There is a better future links: This is because managers have the experience, they can better manage the company knowing that it now longs to them personally.
  • It is a better alternative to management redundancy: Instead of the company being bought by an external party and management becoming redundant and establishing a similar company which will compete with the existing company, a MBO will be a better alternative.
  • There is a reduction in Agency Cost since managers are all responding in “one –direction”.
  • It helps the management to realise the value of the company
  • There is a tax savings due to the tax saving on interest.

Sources of Finance for MBOs

  • The buyout team (Personal finance)
  • Venture CAPITAL (Equity finance and representative on the board
  • Debt Finance
  • Mezzanine finance (using both debt and equity)
  • Government agencies
  • Pension funds
  • Merchant banks

Considerations of Finance Providers

The finance providers will take into consideration among other things the following factors:

  • The financial performance of the company (Future profits and past performance)
  • The market for the products
  • The financial commitment of the team of managers
  • Quality of management
  • The risk associated with the company. The Business risk, finance risk and others.
  • The exit route: What can be done if the company is not performing after the investment?

Capital reconstruction schemes

Restructuring a company is corporate surgery to enable a company to continue in business or to go into liquidation.

Legal framework

(a) The company must receive the court’s permission to launch a scheme

(b) Compromises must be agreed by all parties – classes of creditors should meet separately so that substantial minorities are not voted down. Every class must vote in favour for the scheme to succeed.

(c) Under the Insolvency Act a reconstruction can be achieved by transferring assets of the company to a new company in exchange for shares, these new shared being distributed to the existing shareholders. Creditors do not lose their rights in this arrangement.

Going private

All the listed shares of a company are bought by a small group of investors, and the company is de-listed.

(a) Both direct and indirect listing costs are saved

(b) A hostile takeover bid is impossible

(c) A small number of shareholders reduces the agency problem

 

 

 

 

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Corporate FinanceFinancial ManagementStrategic Management

STEP – BY – STEP GUIDE ON BUSINESS VALUATION APPROACHES [UPDATED]

Valuation 3d Word Collage Multiples Revenues Assets Company Busi

Many people ask various questions concerning business valuation. Some of which include; “how is a company valued when selling?”, “what are the methods or approaches use in business valuation?”, and “what are the factors taken into consideration when valuing a business either for acquisition or stock exchange listing?” These and many others are on the mind of various individual when the topic of business valuation is raised.

In this guide, we will discuss the step – by- step approaches / methods for valuing businesses and also consider the various factors that has to be taken into consideration when choosing a method and the significance of each approach.

Why do we need to value a business?

The reasons why businesses are valued can vary from several perspectives. Among the reasons are the following:

To use the assets of the business:

An acquiring company will value a target company to buy and use the assets of the company. In such cases, the target company may be having valuable assets such as land and building or plant facility which can be used to gain competitive advantage.

To earn dividend:

Investors would want to buy shares in companies and invest their money in such companies to earn dividends on their investment and hence would want to value the business whether it is worth its price.

To manage and control the business:

This is a real acquisition where the acquiring company wishes to buy the target company to become owners and manage the business to earn capital gain and dividend to shareholders thereby maximising the shareholders’ value.

INFORMATION REQUIREMENTS FOR VALUATION

There is a wide range of information that will be needed in order to value a business:

  • Financial statements: Statements of financial position, income statements, statements of changes in financial position and statements of shareholders equity for the past five year
  • Summary of non-current assets list and depreciation schedule
  • Aged accounts receivable summary
  • Aged accounts payable summary
  • List of marketable securities
  • Inventory summary
  • Details of any existing contracts e.g. leases, supplier agreements
  • List of shareholders with number of shares owned by each
  • Budgets or projections, for a minimum of five years
  • Information about the company’s industry and economic environment
  • List of major customers by sales
  • Organisational chart and management roles and responsibilities

Note: In an exam question as well as in practice, it is unlikely that one method would be used in isolation.

Several valuations might be made, each using a different technique or different assumptions. The valuations could then be compared, and a final price reached as a compromise between the different values. Remember that some methods may be more appropriate for valuing a small parcel of shares, others for valuing a whole company.

BUSINESS VALUATION METHODS / APPROACHES

Investors can use any of the following methods depending on their investment objectives to value a business.

ASSET BASE VALUATION:

This method can be used when

The Going Concern of the company is not certain

The target / seller company has fixed a certain minimum price below which they are not willing to sell the company.

Formula and format:

Using this method of valuation, the value of an equity share is equal to the net tangible assets divided by the number of shares.

Net tangible assets are the value in the statement of financial position of the tangible non-current assets (net of depreciation) plus current assets, minus liabilities.

Intangible assets (including goodwill) should be excluded, unless they have a market value (for example patents and copyrights, which could be sold)

Under this method of valuation, there are further three classifications/techniques that can be used. Any of which can be applicable depending on the objectives of the acquiring company.

Book Value (From the Financial Accounting perspective): With this approach, the figures in the financial statements (Balance sheet) are subject to adjustment based on historical and subjective basis.

Net Realisable Value (NRV): It is used when the assets of the business is to be disposed of. And for this reason, the company would wish to determine the wealth of the company should all the assets be sold.

Replacement Cost: This method of valuation is used when the company is a going concern and also the acquiring company intends to continue the business. The key question this technique tries to answer is this; “How much will it cost if we are to set up or establish this company (the target) today?”

DIVIDEND VALUATION MODEL (DVM)

With this method, the acquiring company is estimating the value of the company from the perspective of the existing shareholders. As such, this method is applicable when the acquiring company has a minimum or minority stake in the target company. Remember also that, this is the reverse of the cost of equity of the firm.

Assumptions of dividend models

The dividend models are underpinned by a number of assumptions that you should bear in mind:

(a) Investors act rationally and homogenously. The model fails to take into account the different expectations of shareholders, nor how much they are motivated by dividends vs future capital appreciation on their shares.

(b) The D0 figure used does not vary significantly from the trend of dividends. If D0 does appear to be a rogue figure, it may be better to use an adjusted trend figure, calculated on the basis of the past few years’ dividends.

(c) The estimates of future dividends and prices used, and also the cost of capital are reasonable. As with other methods, it may be difficult to make a confident estimate of the cost of capital. Dividend estimates may be made from historical trends that may not be a good guide for a future, or derived from uncertain forecasts about future earnings.

(d) Investors’ attitudes to receiving different cash flows at different times can be modelled using discounted cash flow arithmetic.

(e) Directors use dividends to signal the strength of the company’s position (however companies that pay zero dividends do not have zero share values).

(f) Dividends either show no growth or constant growth. If the growth rate is calculated using g=bR, then the model assumes that b and R are constant.

(g) Other influences on share prices are ignored.

(h) The company’s earnings will increase sufficiently to maintain dividend growth levels.

(i) The discount rate used exceeds the dividend growth rate.

The formulae to be used under this method of valuation can be either:

Market Value = Dividend/Cost of Equity

OR

Merit

It incorporates the time value of money.

Demerit

A small change in any of the variables will change the Market Value of the company.

QUESTION 1:

Alpha plc has in issue $1 shares and has just paid a dividend of 20c per share. Dividends are expected to remain constant. Shareholders required rate of return is 10% p.a.

What will be the current market value per share?

ANSWER:

Market value = 20p/ 10% = 200p ($2.00)

QUESTION 2:

Beta plc has in issue $0.50 shares and has just paid a dividend of 15c per share. Dividends are expected to remain constant. Shareholders required rate of return is 12%.

What will be the current market value per share?

ANSWER:

Market value = 15p/12% = 125p ($1.25)

Cum div / ex div values

In the above examples, the company had just paid a dividend, and therefore anyone buying the share would have to wait for a year until they were to receive their first dividend (in the examination we ignore the possibility of interim dividends).

We call this situation an ‘ex div’ valuation.

Suppose, however, that the company was about to pay a dividend. This would mean that someone buying the share would receive a dividend virtually immediately (in addition to all the future dividends). Therefore the price that they will be prepared to pay will be higher by the amount of the dividend about to be paid.

We call this situation a ‘cum div’ valuation.

Market value cum div = market value ex div + dividend about to be paid

QUESTION 3:

Beta plc has in issue $0.50 shares and is about to pay a dividend of 15c per share. Dividends are expected to remain constant. Shareholders required rate of return is 12%.

What will be the current market value per share?

ANSWER:

Market value (ex div) = 15p/12% = 125p ($1.25)

Market value (cum div) = 125 + 15 =140p ($1.40)

Note: The market value of a share is the present value of future expected dividends, discounted at the shareholders required rate of return

QUESTION 4

The information below was extracted from the books of Porhyira Limited. Use the information to determine the value of the business.

Share capital 2m
Current dividend 4c
Dividend two years ago 3.3c
Current equity Beta ( 1.6
Equity risk premium 10%
Risk free rate 5%

ANSWER:

From the question, we have been current dividend is 4c but we don’t know the growth rate and the Equity shareholders’ required rate of return. So we must find them before answering the question.

Cost of Equity (CAPM) = Risk free rate + Beta (Return on market – Risk free rate

= 5% +1.6(10%) = 21%

Calculating growth gives 10% using the formula

Market Value = 4(1+0.1)/0.21 – 0.1 = 4 or 400c per share

Value of the business = £4 per share by 2m shares = 8m

This is the value the existing shareholders are expecting.

Note: There is nothing like a perfect answer under valuation. However, it is coming out with our best guess of the value of the company.

Limitations of the Dividend Valuation Model

Although expected future dividends and the shareholders required rate of return certainly do impact upon the market value of shares, it would be unrealistic to expect the theory to work perfectly in practice

Main Reasons For This Include:

• The stock exchange is not perfectly efficient, and therefore the market value of a share may be distorted from day-to-day by factors such as rumours about a takeover bid.

• In practice, market values do not change instantly on changes in expectations – the speed at which the market value change depends on the volume of business in the share.

• The model only deals with constant growth in dividends. In practice this may not be the case.

However, do appreciate that the growth used in the model is the future growth that shareholders are expecting – this is perhaps more likely to be at a constant rate. The big problem is determining the rate of growth that shareholders expect! It is clearly impossible to ask them and to any estimate that we make for our calculations is only an estimate and course be completely different from the rate of growth that shareholders are in fact expecting.

EARNING BASIS VALUATION:

This is the measure of the profit and the P/E ratio of the company. This method of valuation is usually applicable when the acquiring company has a majority stake in the target company.

The suggestion is that, this year’s profit is a representative of what will be earned in the future and if that’s the case what will the company be worth today?

To answer that question, the value of the company is determined using the formula below:

The P/E ratio gives a view of the relationship between current earnings and future earnings. It means we place a value on the company based on its PAT and also what will happen to the profit in the future. If the company has a high P/E ratio, it means the future earnings are higher than current earnings.

The value of the PAT comes from the target company but the P/E ratio will come from the acquiring company or a proxy company.

If the target company and the acquiring company are in the same industry, then the P/E ratio of the acquiring company can be used because it is bringing that business to manage it. On the other hand, if they are not in the same industry, and the target is not quoted, the adjusted industrial average of quoted companies in that industry (target’) or a proxy company’s P/E ratio can be used.

Note: Both the PAT and P/E ratio must be adjusted.

PAT: Adjust for the cost savings after tax because of the dismissal of some senior managers.

P/E ratio: Adjust for risk or protected earnings. E.g. Unquoted Company.

QUESTION:

The information below was extracted from the books of both the acquiring and target companies:

BUYER TARGET
PAT £20m £12m
Share price £3 £4
EPS 20c 50c

Required: Value the target company assuming that both companies are in the same industry.

ANSWER:

PAT must come from the target company hence £12m

P/E ratio must come from the buyer/acquiring company

P/E ratio

Value of Business = £12m by 15 = £180m

THEORETICAL CONSIDERATION:

This method tries to combine two of the above methods by finding the Present Value of the Free Cash Flows to the firm.

Free Cash Flows to firms refers to the amount of cash distributable to finance providers within a given period of time.

With this method the value of the target company is calculated using the following formulae

NOTE: The second method is usually used !!!!

To determine the PV of free cash flows, we take into consideration the following:

  • Operating cash flows (excluding depreciation; it means we add back depreciation and amortisation to PBIT)
  • Tax payable
  • Capital Expenditure (CAPEX)
  • Tax relief
  • Saving (synergy; 1 + 1 )
  • Time Horizon: 5 years or 10 years or perpetuity. It means the company will generate revenue into the future.
  • Discount rate: It is usually going to be WACC which must be calculated.

Read also ACCAGLOBAL , THE BALANCE.COM, THIS BLOG

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Business Management and Information SystemsCorporate FinanceStrategic Management

BEST GUIDE TO STAKEHOLDER VALUE CREATION [2018]

valuecreation

Introduction

Stakeholder Value creation is an integral lesson of understanding how value is added to the investment of owners or shareholders who have contributed to the capital of the business.

One often reads in the literature that firms must be “managed” not only “for shareholders” but, more generally, “for stakeholders” (Freeman 2008; 2007; Harrison et al., 2010); or that they must “create value for all stakeholders” (Post, Preston, and Sachs, 2002); or even that they must “create the greatest possible value for all stakeholders” (or for some category of stakeholders, such as employees or consumers). What does this mean? What “value” are we talking about?

Economic Value Creation

In neoclassical theory, economic value is created when the price that consumers pay for goods and services is greater than the cost of producing them. The cost of producing goods and services is the opportunity cost of the resources (i.e., the gain that could be obtained from the best alternative use of the resources), and it is assumed that it is neither necessary nor possible to pay any more or less for the resources, given the competition in the goods and factor markets. The only resource that does not receive a market price is capital, i.e., ownership of the firm, which instead receives the residual value or profit.

In the neoclassical model, the economic value generated is the sum of the consumer surplus and the producer surplus. The consumer surplus is defined as the difference between the highest price that consumers would be willing to pay for a good or service and the price they actually pay, while the producer surplus is the difference between the price at which sellers actually sell and the cost of the resources employed. The question of value maximization boils down to that of the consumer surplus and the producer surplus or residual value, attributed to the owner.

This is not to say that other stakeholders do not also receive a surplus, merely that the task of determining the amount of the surplus and distributing it is transferred to the resource markets (labour, finance, commodities, etc.).

If a product is able to satisfy consumers’ present needs better without losing any of its capacity to satisfy future needs, then more value will be created because buyers will be willing to pay a higher price for the product.

And if a producer uses better technology, combines resources more efficiently or pays lower prices for them, again more economic value will be created. In the neoclassical model, therefore, the problem of value creation is separate from that of value distribution. If the stated conditions are met, consumers receive their surplus, the providers of resources receive their opportunity cost, and the company’s owners appropriate the producer surplus or profit, which is an incentive for them to make decisions that maximize profit and, also therefore, present and future efficiency.

As a consequence of all the above, an economic optimum – in terms of the maximization of “social value” (Jensen, 2001) for the economy as a whole – is attained. If consumers maximize their utility and companies maximize profit for their owners (i.e., the expected present value of the shares, assuming a long-term, stochastic view) (Mossin, 1977), the social (economic) value created will be maximal (Williamson, 1984).

For that to happen, however, certain conditions must be met: perfect competition (or sufficient competition, cf. Stigler, 1957) in all markets; markets for all goods and services, present and future (i.e., there can be no goods without a price); free entry to and exit from all markets; availability, to all concerned, of sufficient information on the prices, characteristics and availability of the goods and services for all to be able to make optimal decisions; non-existence of public goods; absence of positive or negative externalities (i.e., nobody bears the costs, risks or benefits of actions performed by other agents with which he does not have a market relationship), and so on.

In a stakeholder model, therefore, the theory of value creation implies that:

  1. all those who create or capture value, or who in their relationship with the firm assume risks, either inside the firm (owners, managers, employees) or outside the firm (consumers, suppliers), or who suffer the impact of the firm’s externalities or misinformation (local community, environment, future generations, society at large), must be considered stakeholders – at least for the purpose of value distribution, which is what concerns us here;
  2. maximizing value for consumers and resource providers is not enough to guarantee a social optimum, as there are other relevant stakeholders to be considered, and 3) in relations between stakeholders and the company, there are other variables to be taken into account besides the exchange of goods or services for a price, such as whether there are alternatives (alternatives that limit market power), whether information is provided (including the means to process it and use it rationally), whether protection is available against negative externalities (whether those affected have the means to defend themselves against externalities), and so on.
What is “Value” for a Stakeholder?

What do we mean when we say that a company creates, or should create, “value” for its stakeholders? So far we have been referring to economic value, but there are other ways of understanding what that “value” actually consists of.

What can a stakeholder be seeking when he starts an occasional transaction or a lasting relationship with a company?

Let’s take the example of an employee.

  1. An employee may be seeking an “extrinsic” result, which the company will provide as a consequence of the relationship and which may be an economic good or service, or something non-economic. He may be seeking remuneration, or he may be seeking intangible results, such as career promotion (which will also have economic consequences), recognition (Frey and Neckermann, 2009), and so on.
  2. An employee may be seeking “intrinsic” results, which are not provided by the company but which arise within the employee himself, and which may be psychological (satisfaction with the job or with the results achieved) or operational (operational learning, i.e., acquisition of knowledge, capabilities, etc.).
  3. An employee may be seeking results in other people (satisfaction of customers and suppliers, success of other employees and managers, etc.), which will give rise to “evaluative” learning in the employee himself, i.e., learning about how to take the interests of others (and his own interests) into account.
Based on this classification of the results of an action, we can identify six types of “value”:

1. Economic extrinsic value (economic value). This is created through collaboration among employees and may be appropriated by either side, as we explained earlier.

2.Intangible extrinsic value, which is provided by the company, e.g., recognition, some kinds of training, etc. This is not part of the economic value created by a company, although it may be a form of participation in intangible value (e.g., the personal status that comes from working for a highly regarded company).

3. Psychological intrinsic value, such as satisfaction with the work done. This is generated in the agent himself. It is not part of the economic rent creation process and cannot be appropriated by the company or other stakeholders, although they may help to create or destroy it. In an employee, it may be a (partial) substitute for extrinsic value (besides the satisfaction of working for the company, employees will need a minimum of remuneration).

4.Intrinsic value that takes the form of operational learning (acquisition of knowledge and capabilities). This is created in the agent, not in the company, but probably with the cooperation of other stakeholders. It is not part of the economic value created by the company, although it may contribute to the creation of economic value in the future. It may also be a (partial) substitute for economic value.

5.Transcendent value, which consists of evaluative learning (acquisition of virtues or vices). This is generated in the agent himself as a consequence of his own decisions. It alters the agent’s ability to assess the consequences of those decisions for himself and for other agents

6. Value that consists of positive or negative externalities, i.e., value that is felt by agents other than those with whom the relationship or transaction is conducted.

“Maximizing value for all stakeholders,” which was an impossible task so long as we limited ourselves to economic value, is now possible. And “appropriating value” now also means something different, as some types of value cannot be appropriated. All the different types of value are generated cooperatively, at least insofar as producing goods and services is a social activity.

Finally, “managing the firm so as to serve all stakeholders” is now possible because the challenge is not to share a scarce resource but to generate non-exclusive value which everybody needs. And that is a challenge which, though entrusted to managers, must be addressed by all.

Introducing value creation for all stakeholders broadens the framework of management, bringing it closer to a more realistic economic optimum, generating new cooperative value creation capabilities, and overcoming some conflicts. So long as the focus remains on economic value, however, any solutions adopted will be insufficient, because the processes of capturing that value will always be liable to conflicts of all kinds.

Credit: Antonio Argandoña –

RGB GLOBAL, emerandinsight, university of Virginia, this blog

Shareholder Value creation is very important for the Business Leader

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Business Management and Information SystemsCorporate FinanceStrategic Management

TODAY’S GUIDE TO STAKEHOLDER MAPPING [UPDATED]

stakeholder

Stakeholder mapping is a collaborative process of research, debate, and discussion that draws from multiple perspectives to determine a key list of stakeholders across the entire stakeholder spectrum.

Mapping can be broken down into four phases:

1. Identifying: listing relevant groups, organizations, and people

2. Analyzing: understanding stakeholder perspectives and interests

3. Mapping: visualizing relationships to objectives and other stakeholders

4. Prioritizing: ranking stakeholder relevance and identifying issues.

The process of stakeholder mapping is as important as the result, and the quality of the process depends heavily on the knowledge of the people participating.

Action: Gather a cross -functional group of internal participants to engage in this process.

Identify sources external to the company who may have important knowledge about or perspective on the issues, and reach out to these sources for input and participation.

Finally, identify a resource who can facilitate the work through the following activities.

Capture all the work in writing to help with future steps

IDENTIFYING

The first step in the mapping process is to understand that there is no magic list of stakeholders.

The final list will depend on the business, its impacts, and the current engagement objectives—as a result it should not remain static. This list will change as the environment around the business evolves and as stakeholders themselves make decisions or change their opinions.

Action: Brainstorm a list of stakeholders without screening, including everyone who has an interest in your objectives today and who may have one tomorrow.

Where possible, identify individuals. Use the following list to help you brainstorm:

  • Owners (e.g. investors, shareholders, agents, analysts, and ratings agencies)
  • Customers (e.g. direct customers, indirect customers, and advocates)
  • Employees (e.g. current employees, potential employees, retirees, representatives, and dependents)
  • Industry (e.g. suppliers, competitors, industry associations, industry opinion leaders, and media)
  • Community (e.g. residents near company facilities, chambers of commerce, resident associations, schools, community organizations, and special interest groups)
  • Environment (e.g. nature, nonhuman species, future generations, scientists, ecologists, spiritual communities, advocates, and NGOs)
  • Government (e.g. public authorities, and local policymakers; regulators; and opinion leaders)
  • Civil society organizations (e.g. NGOs, faith -based organizations, and labour unions)

ANALYZING

Once the organisation has identified a list of stakeholders, it is useful to do further analysis to better understand their relevance and the perspective they offer, to understand their relationship to the issue(s) and each other, and to prioritize based on their relative usefulness for this engagement.

BSR (Business for Social Responsibility) has developed a list of criteria to help an organisation analyse each identified stakeholder:

•Contribution (value): Does the stakeholder have information, counsel, or expertise on the issue that could be helpful to the company?

•Legitimacy: How legitimate is the stakeholder’s claim for engagement?

•Willingness to engage: How willing is the stakeholder to engage?

•Influence: How much influence does the stakeholder have? (You will need to clarify “who” they influence, e.g., other companies, NGOs, consumers, investors, etc.)

•Necessity of involvement: Is this someone who could derail or delegitimize the process if they were not included in the engagement?

Action:

The company can use these five criteria to create and populate a chart with short descriptions of how stakeholders fulfil them. Assign values (low, medium, or high) to these stakeholders. This first data set will help you decide which stakeholders to engage.

MAPPING

Mapping stakeholders is a visual exercise and analysis tool that the company can use to further determine which stakeholders are most useful to engage with. Mapping allows management to see where stakeholders stand when evaluated by the same key criteria and compared to each other and helps you visualize the often complex interplay of issues and relationships.

Action: Draw a mapping as follows to identify key stakeholders.

1. Draw a quadrant using two axes labelled “Low” to “High.”

2. Add “Expertise,” “Willingness,” and “Value”

3. Assign “Expertise” to the Y-axis and “Willingness” to the X-axis

4. Discuss and debate where each stakeholder falls

5. Plot the stakeholders on the grid.

6. Use small, medium, and large circle sizes to denote their “Value.”

7. To illustrate relationships, use arrows to depict “Influence.”

Consider quadrants, circle size, and influence arrows when prioritizing.

PRIORITIZING STAKEHOLDERS AND IDENTIFYING ISSUES

It is not practical and usually not necessary to engage with all stakeholder groups with the same level of intensity all of the time.

Being strategic and clear about whom the company is engaging with and why, before jumping in, can help save both time and money.

Action:

The company should look closely at stakeholder issues and decide whether they are material to the company’s engagement objectives, asking yourself the following questions:

What are the issues for these priority stakeholders?

  • Which issues do all stakeholders most frequently express?
  • Are the real issues apparent and relevant to our engagement objectives?

Credit: Business for Social Responsibility

Other reads, mindtools, this blog

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Corporate FinanceFinancial Management

THE BEST GUIDE TO SOURCES OF BUSINESS FINANCE – 2018

financial-management-33-728

Sources of Business Finance: Financing a business whether start-ups, Small and Medium Scale Enterprise (SMEs) or multinational companies is significant to enabling the organization gaining competitive advantage in their respective industries. For this reason, organisations are very keen when it comes to finding alternative cheap sources of finance.

The sources of capital or finance for businesses can range from various sources including equity finance, debt finance, Islamic finance, short term loans, among others.

In this post, we will discuss all these sources of financing options for businesses, for this purpose, we have divided the topic into long term, short term and other sources of finance.

LONG TERM

In order to finance long-term investments and the overall working capital, the company needs to raise long-term capital. It is part of the role of the Financial Manager to decide how best to raise this capital. Overall the choice is between equity finance (from shareholders) and debt finance (from lenders)

Equity

New shares – quoted companies

If a company is already quoted on a stock exchange then the following methods are available for the issue of new shares:

Public issue (offer for subscription)

A sale direct to the general public. Shares are advertised at a fixed offer price and the public are invited to buy them.

Public offer for sale by tender

A sale direct to the general public. However a price for the shares is not fixed and the public are invited to bid for shares.

Placing

With a placing, a sponsor (usually a merchant bank) arranges for its clients to buy shares. However, at least 25% of the shares placed must be made available to the general public.

Rights issue

An offer to existing shareholders to buy new shares in proportion to their existing shareholdings.

New shares – unquoted companies

If a company is unquoted, then they essentially have two choices:

Remain unquoted

In this case new shares can only be issued by way of a rights issue or a private placing

Become quoted

If they choose (and are able) to become quoted on a stock exchange, then the methods listed above become available to them.

It is difficult for a small company to become quoted on a stock exchange and have access to more finance because it is necessary that the company is already of a certain size before it will be accepted on to a stock exchange.

Rights issues

A rights issue is an issue of shares to existing shareholders.

The number of shares that each shareholder is offered is in proportion to their existing shareholding.

The shares are offered at a relatively low price and the effect of the issue is to reduce the market value of all the shares in issue.

Example 1:

Current share price is $5 per share.

The company makes a rights issue of 1 for 4 at $3.

(a) What is the theoretical ex-rights value per share?

(b) What is the value of a right?

Solution

Shares $
Current shares 4 Current value 20
New share 1 Price period 3
5 23

New market share = 23/5 = $4.60 per share

New market value:    $4.60

Rights price                ($3.00)

Value of a right           $1.60

Bonus issues

Bonus issues (or scrip issues) are the turning of reserves into share capital and issuing free shares to existing shareholders. The new shares are issued in proportion to shareholders’ existing shareholdings.

They are issued free and are therefore not a source of finance.

They have the effect of reducing the market value per share of all the shares in issue, and can thus make the shares more marketable.

Stock splits

Stock splits occur when shares are split in value. For instance each existing $1 share might be split into two 50c shares.

The total share capital of the company is unchanged, but there will be more shares in issue.

No cash is raised and therefore this is not a source of finance. It will have the effect of reducing the market value per share of all the shares in issue, and can thus make the shares more marketable.

Scrip dividends

This is the offering to shareholders of new shares instead of a cash dividend.

Shareholders are given the choice of whether to take the dividend in the form of cash or new shares. The incentive for shareholders is that it is a cheaper way of acquiring new shares then buying them on the stock exchange, and also there can be tax advantages.

For the company, this is a source of new finance in that new shares are issued (effectively) for cash.

It is a cheap way of raising finance and does not risk upsetting the shareholders in the same way that a reduction in dividend may do.

NOTE: Retained earnings are the best source of finance in that they avoid issue costs and the cash is immediately available.

Dividend

Dividend policy in practice

Although in recent years it has become common for companies to have high retention of earnings and pay low dividends (or even to pay no dividends – e.g. Microsoft), it is risky for a company to change its dividend policy without considering the consequences.

In particular they need to consider the following:

The Clientele effect

A constant dividend policy (e.g. always distributing 20% of earnings, or always increasing dividend by 5% p.a.) will attract a group of shareholders to whom the policy is suited (in terms of, for example, their tax position, or their need for income). Changing the dividend policy will upset these shareholders.

The Signalling effect

A reduction in dividend might be seen by the financial markets as a sign of company weakness

DEBT

Types of long-term debt

Preference shares

These are shares with a fixed rate of dividend having a prior claim on profits available for distribution (unlike ordinary shares where the dividend can fluctuate).

Although legally equity, these are often treated as debt because they carry a fixed rate of dividend.

(a) Advantages:

  1. they do not carry voting rights and there is therefore no loss of control
  2. unlike debt, dividends do not have to be paid if not enough profits and the shares are not secured on the company’s assets

(b) Disadvantages:

Dividends are not tax allowable, unlike debt interest- to attract investors there will be a need to pay a higher rate of interest because of the extra risk for shareholders.

Debentures (Loan Stock or Bonds)

A debenture is a written acknowledgement of a debt containing provisions for the payment of interest and repayment of the principal.

The debentures may be secured or unsecured.

  • Secured means that if the company goes into liquidation then the debenture holders have first charge on the assets that are used as security.
  • Unsecured debentures do not have this benefit and therefore usually need a higher rate of interest to compensate lenders.

Debentures can be traded on a stock exchange, normally in units of $100 nominal. They carry a fixed rate of interest and the interest is expressed as a % of nominal value.

Irredeemable debentures are never repaid (and do not exist in practice!).

Redeemable debentures are repayable at a fixed date (or during a fixed period) in the future. They are usually repaid at their nominal value (at par) but may be issued as repayable at a premium on nominal value.

Advantages

  • The interest paid by the company is usually less than the dividend the company would have to pay to shareholders. This is because investors find them less risky than shares and therefore require a lower return.
  • The interest paid is tax allowable to the company and therefore the net cost to the company is reduced.

Disadvantage

– The higher the amount of debt finance, the more fixed interest has to be paid out of profits that would otherwise be available to shareholders. This makes the dividends more risky as far as the shareholders are concerned.

Deep discount bonds (or debentures)

These are debentures which are issued at a large discount on nominal value, but are repayable at par on maturity.

Investors will receive a large ‘bonus’ on maturity and will therefore be prepared to accept a lower rate of interest from year to year.

Zero coupon bonds

These are bonds or debentures which are issued at an extremely large discount on their nominal value, but are redeemable at par on maturity.

Just as before, the investors will receive a large ‘bonus’ on maturity, but because the discount is so large they are prepared to receive no interest at all during the life of the bond.

Returns on Debt

Interest yield:

Interest yield= Annual interest payment / Market value of debt100%

This measures the return to investors each year ignoring any ‘profit’ or ‘loss’ on redemption.

Redemption yield:

This is the overall return earned by investors taking into account both the annual interest and the gain or loss on redemption.

(Note that you will not be required to calculate the redemption yield in Paper 2.4 – you are only expected to understand what it represents)

CONVERTIBLES AND WARRANTS

Convertibles

Convertibles are debentures that give the investor the choice on redemption of either taking cash or taking a pre-determined number of shares in the company.

Example

A company has in issue 8% debentures 2010.

On maturity the debentures may be redeemed at par or converted to 20 ordinary shares in company for every $100 nominal.

The share price is currently $4.50 per share.

(a) What will debenture holders choose to do on maturity if the share price of the company in 2010 is

(i) $4 per share

(ii) $6 per share

(b) Investors required return on debentures is 10%

If “now” is end of 2007 and the share price is expected to grow at 7% p.a.

(i) calculate the current market value.

(ii) calculate the conversion premium

Answer:

(a) (i) Take cash of $100 or 20 shares worth $80

Take cash

(ii) Take cash of $100 or 20 shares worth $120

Take shares.

(b) (i) Expected share price is 3 years’ time = $4.50 × = $5.51

Debenture holders will therefore be expected to convert and receive $110.20 (20 × $5.51) in 3 years’ time.

ii. Market value (per $100 nominal)

d.f. @ 10% P.V.
1 – 3 Interest 8 p.a. 2.577 20.62
3 Redemption 110.20 0.794 87.50
$ 107.12

 

(ii) Market value 107.12

Parity value (i.e. value of converting at current share price) 20 × $4.50 90.00

Conversion premium $17.12

(CLUE: to calculate the current market value, calculate the NPV of each $100 nominal debt and the value on redemption. Also, to determine the conversion premium, it is the difference between the Market Value –thus the NPV and the Parity Value- thus the value of converting at current share price. )

The advantage of convertibles to investors is that they allow the shareholders to gain if the company does well (and the share price increases), but they do not lose if the company does badly (provided that the company does not collapse completely!).

The advantage to the company is that they will pay a lower rate of interest (because investors find them attractive). Also, provided the company does well and investors do convert, the company will avoid any cash flow problem associated with repaying the debentures.

Warrants

A warrant is a right given to investors to subscribe for new shares at a future date at a fixed price.

They are sometimes issued with debentures in order to make them more attractive to investors (and therefore allow the company to pay lower interest).

The warrants may be bought or sold separately from the debentures during the exercise period.

SHORT – TERM SOURCES OF FINANCE

Bank overdraft

Bank Loans

Advantages of an overdraft over a loan

(a) The customer only pays interest when he is overdrawn.

(b) The bank has the flexibility to review the customer’s overdraft facility periodically, and perhaps agree to additional facilities, or insist on a reduction in the facility.

Advantages of a loan for longer term lending

(a) Both the customer and the bank know exactly what the repayments of the loan will be and how much interest is payable, and when. This makes planning (budgeting) simpler.

(b) The customer does not have to worry about the bank deciding to reduce or withdraw an overdraft facility before he is in a position to repay what is owed. There is an element of ‘security’ or ‘peace of mind’ in being able to arrange a loan for an agreed term.

(c) Loans normally carry a facility letter setting out the precise terms of the agreement.

Calculation of repayments on a loan

We can use the annuity table to calculate the repayments on a loan.

For example, a $30,000 loan is taken out by a business at a rate of 12% over 5 years. What will be the annual payment?

The annuity factor for 12% over 5 years is 3.605. Therefore $30,000 = 3.605 annual payment.

Annual payment = 30,000/3.606 = $8,321.

Other sources of finance that have been explained:

Leasing

Sale and lease back

Trade credit

SOURCES OF Business FINANCE – ISLAMIC FINANCE

Under the principles of Islamic law, wealth must be generated from legitimate trade and asset-based investment. Also, investments must have a social and ethical benefit. Speculative investments are not allowed, and investments in such areas as alcohol and gambling are forbidden.

Islamic financial instruments

(a) Murabaha

This is effectively a form of credit sale, where the customer receives the goods but pays for them later on a fixed date.

However, instead of charging interest, a fixed price is agreed before delivery – the mark-up effectively including the time value of money.

(b) Ijara

This is effectively a lease, where the lessee pays rent to the lessor to use the asset.

Depending on the agreement, at the end of the rental period the lessor might take back the asset (effectively an operating lease) or might sell it to the lessee (effectively a finance lease – Ijara-wa-Iqtina).

Whatever the agreement, the lessor remains the owner of the asset and is responsible for maintenance and insurance, thus incurring the risk of ownership.

(c) Muduraba

This is similar to equity finance, or a special kind of partnership. The investor provides capital and the business partner runs the business. Profits are shared between both parties, but all losses are attributable to the investor (limited to the capital provided).

(d) Musharaka

This again is similar to a partnership, but here both parties provide both capital and expertise.

Profits are shared between the parties according to whatever ratio is agreed in the contract, but losses are shared in proportion to the capital contributions.

It is regarded as being similar to venture capital.

(e) Sukuk

This is the equivalent of debt finance (Islamic bonds).

Sukuk must have an underlying tangible asset, and the holders of the Sukuk certificates have ownership of a proportional share of the asset, sharing revenues from the asset but also sharing the ownership risk.

Further reads: bbc, mantra, this blog

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Corporate FinanceFinancial Management

A COMPREHENSIVE GUIDE TO BUSINESS REORGANIZATION

bus. recon

Business reorganization refers to the changes in business structure and or operations to help improve its performance.

Methods for Business Reorganization

A company seeking to improve its performance by business re-organisation can employ any of these methods:

  • Divestments
  • Sell- offs
  • Liquidation
  • Spin- offs
  • Demergers
  • Carve – outs
  • Management buy – outs / buy – ins.

Let’s look in details at each of these

Divestment /Divestiture

This refers to the complete sale of the assets of a business. It can also be defined as the reduction of some kind of asset for financial, ethical or political objectives or sale of an existing business by a firm.

Reasons for Divestments

  • It will enable the company to focus on core activities
  • It enables the company to sale -off the investments which lacks strategic fit
  • To improve the liquidity of the company
  • It enables the company to sale – off loss making investments
  • When there is lack of management skills
  • It is a decision to protect the firm against a takeover. The firm can sale off profitable investments to make the company non-attractive to

Sell – offs

This refers to the sale of part of an entity to a third party, usually another company in exchange for cash. It can also be defined as a sale of an unwanted business at a low price to encourage someone to buy it.

Reasons for Sell – offs

  • It enable the company to raise capital
  • It helps to curtail losses
  • It helps in efficiency gains
  • It’s also a strategy to prevent take over.

Spin – offs

This is where a new company is established and the shares in the new company are owned by the shareholders of the original company (existing shareholders).

Key issues:

  • There is no cash transacted
  • There is no change in ownership
  • The shares in the new company are owned completely by the existing shareholders on the basis of the number of shares each shareholder already has.
  • There is no dilution in Earnings Per Share

Demerger

It involves splitting a company into two separate parts of roughly comparable size which are large enough to carry on independently after the split.

Reasons for Demerger

  • “Unlocking shareholders’ value”
  • It enable the company to capture ‘revers synergy’ resulting from an existing ‘conglomerate discount’
  • It helps companies to remove ‘co-insurance benefits’ from debt-holders
  • Companies can also demerger or sell – off to meet regulatory requirements

Example of demerger: British Gas was separated in two different independent companies as:

  • Centrica : which is involve in the supplier of biogas and energy resources, while
  • BG Group: This is involved in the exploration of energy and oil.

Disadvantages of Demerger:

  • There is loss of economies of scale due to the slit out
  • There is lower profit due to higher overheads
  • It could be difficult to raise debt finance independently.

Carve – Outs:

This is where a company removes part of its business and set it up as a new company, with the shares in the new company offered to the general public.

Reasons for Carve – Outs

  • It is not a “full” spin- off
  • It is normally a minority stake that is offered to the general public

Benefits of Carve – Outs

  • It increase access to regional market therefore there is strong growth
  • It gives the company autonomy (board of directors).

Example of Carve – outs: Royal bank of Scotland (RBS) and World Pay. RBS carved out World Pay and offered 19.99% of the shares to the public. So World Pay operates on its own as an independent corporate entity.

Exams Focus:

In the question, you have to suggest which method is applicable to the case under discussion and also state the reasons why the others are not applicable.

  1. Management Buy – Outs (MBOs): This refers to the purchase of a business from existing owners by a team of managers of the company.
  2. Management Buy – INS (MBIs): This refers to the purchase of a business from existing shareholders by a team of external managers.

Reasons for a buyout

(a) From the buyout teams’ point of view:

i. to obtain ownership of the business rather than remain as employee

ii. To avoid redundancy when the business is threatened with closure

(b) From the seller’s point of view

i. to dispose of part of the company that does not fit in with the overall strategy of the company

ii. To dispose of a loss-making segment of the business which the directors do not have time or inclination to turn around

iii. In order to raise cash

iv. It is often easier to arrange a management buyout than to try and sell off parts of a business

In the open market

v. it may well avoid redundancy costs, strike action, etc. if closure if the only alternative

Reasons MBOs

  • There is a better future links: This is because managers have the experience, they can better manage the company knowing that it now longs to them personally.
  • It is a better alternative to management redundancy: Instead of the company being bought by an external party and management becoming redundant and establishing a similar company which will compete with the existing company, a MBO will be a better alternative.
  • There is a reduction in Agency Cost since managers are all responding in “one –direction”.
  • It helps the management to realize the value of the company
  • There is a tax savings due to the tax saving on interest.

Sources of Finance for MBOs during Business reconstruction

  • The buyout team (Personal finance)
  • Venture CAPITAL (Equity finance and representative on the board
  • Debt Finance
  • Mezzanine finance (using both debt and equity)
  • Government agencies
  • Pension funds
  • Merchant banks

Considerations of Finance Providers

The finance providers will take into consideration among other things the following factors:

  • The financial performance of the company (Future profits and past performance)
  • The market for the products
  • The financial commitment of the team of managers
  • Quality of management
  • The risk associated with the company. The Business risk, finance risk and others.
  • The exit route: What can be done if the company is not performing after the investment?

Capital reconstruction schemes

Restructuring a company is corporate surgery to enable a company to continue in business or to go into liquidation.

Legal framework

(a) The company must receive the court’s permission to launch a scheme

(b) Compromises must be agreed by all parties – classes of creditors should meet separately so that substantial minorities are not voted down. Every class must vote in favour for the scheme to succeed.

(c) Under the Insolvency Act a reconstruction can be achieved by transferring assets of the company to a new company in exchange for shares, these new shared being distributed to the existing shareholders. Creditors do not lose their rights in this arrangement.

Going private

All the listed shares of a company are bought by a small group of investors, and the company is de-listed.

(a) Both direct and indirect listing costs are saved

(b) A hostile takeover bid is impossible

(c) A small number of shareholders reduces the agency problem

Further reads: Smithhancock, accaglobal, this blog

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Corporate FinanceFinancial Management

BEST GUIDE TO INTERNAL AUDIT FUNCTION

internal audit

Internal Audit Function: The role of the internal audit department of an organisation is critical to the success of the organisation. As such, their functions cannot be under estimate when discussing about the Going concern of the company.

This is certainly true because, the internal audit function helps the external auditors to effectively perform their duties in gathering sufficient and appropriate audit evidence.

In this regard, I will be explaining in details the Internal Audit Functions and its contribution to the organisation.

Are you ready? Let’s get into today’s lesson.

INTERNAL AUDIT

What is Internal Audit?

1.1. Considering the work of internal auditors

Internal auditing is an independent appraisal function established within an organisation to examine and evaluate its activities as a service to the organisation. It is a control which functions by examining and evaluating the adequacy and effectiveness of other controls.

The establishment of an internal audit function is seen as good corporate governance.

1.2. Types of internal audit

The internal audit department could be involved in the following types of audit:

Compliance auditing:

This would be concerned with the compliance of procedures with internal controls as laid down by management, as well as compliance with laws and regulations. The objective of the auditor to find out whether management and the company are following processes and procedures.

Efficiency auditing:

This would be concerned with determining whether resources are being used efficiently. For example, the auditor would be interested in determining whether costs are being minimised.

Value for money auditing:

This would be concerned with determining whether resources are being used to proper effect. This could be in the context of whether the company is obtaining value for money from its assets or its suppliers, as well as whether the company is providing value for money to its customers. For example, the auditor might consider whether it would be better for the entity to lease vans rather than purchase them outright.

Operational auditing:

This encompasses both efficiency and effectiveness. The idea is that the auditor is concerned with the whole organisation and not just with finance and accounting.

Fraud Investigation:

Fraud can range from theft of asset to fraudulent financial reporting. Internal audit may be asked to investigate specific instances of suspected fraud or, more generally, to review and test controls to prevent or detect fraud.

 

IT systems reviews:

Internal auditors may be asked to look specifically at controls over the accounting systems or instead over other computer systems that supply data to the accounting system.

1.3. Relationship with external auditors

The external auditor:

The objective of the external auditor is to form an opinion on the truth and fairness of the financial statements. Reliance may be placed on the internal controls but this is seen as a short cut to examining all the transactions for the period.

The internal auditor:

The prime objective of the internal auditor is to advise the management on whether its major operations have sound systems of internal controls. Therefore, they will test transactions to confirm the evaluation and determine the implications of any systems weaknesses. These systems are designed to ensure the future welfare of the entity rather than accounting for its activities.

Similarities

  • Both the external and the internal auditor carry out controls testing and both are concerned that the entity complies with its control procedures. However, the external auditor is more focused on financial systems and the financial statements.
  • Both operate as professionals and both produce formal reports on their activities.

Differences

  • The external auditor is not an employee of the entity. Internal auditors work for and on behalf of the entity.
  • Internal audit is not a legal requirement. It is a voluntary function which covers all the entity’s operations, not just the financial ones.
  • Internal auditors report to the board of directors or the audit committee. The external auditors report to the shareholders.

1.4. Duties or Functions of Internal Auditors

  • Review Authorisation of transactions
  • Review internal policies
  • Review or monitor recommend systems improvement
  • Risk assessments
  • Compliance with laws and regulation
  • Special investigation; such as fraud.
  • Evaluation of financial and operational information
  • Value for money audit.

AUDIT COMMITTEE AND INTERNAL AUDIT

Best practice is that the audit committee should:

• Ensure that the internal auditor has direct access to the board chairman and to the audit committee and is accountable to the audit committee.

• Review and assess the annual internal audit work plan.

• Receive periodic reports on the results of internal audit work.

• Review and monitor management’s responsiveness to the internal auditor’s findings and recommendations.

• Meet with the head of internal audit at least once a year without the presence of management.

• Monitor and assess the effectiveness of internal audit in the overall context of the company’s risk management system.

Example 1

Example; Explain the reasons why internal auditors should, or should not, report their findings on internal control to the following selection of entity officials:

(a) the finance director

(b) the board of directors

(c) the audit committee

Solution: Example 1

  1. Finance Director: It would be inappropriate for internal audit to report to the finance director, who is largely responsible for internal controls. It may be feasible for him to receive the report as well as the board. Otherwise, the internal audit function cannot be effectively independent as the finance director could suppress unfavourable reports, or could ignore the recommendations of such reports.

(ii) Board of Directors: A high level of independence is achieved by the internal auditors if they report directly to the board. However, there may be problems with this approach.

(1) the members of the board may not understand all the implications of the internal audit reports when accounting or technical information is involved.

(2) The board may not have enough time to spend considering the reports in sufficient depth. Important recommendations might therefore remain unimplemented. A way around these problems would be to have the audit committee deal with internal audit reports.

INTERNAL AUDIT AND RISK MANAGEMENT

Internal audit has two key roles to play in relation to risk management:

  1. Ensuring the company’s risk management system operate effectively
  2. Ensuring that strategies implemented in respect of business risks operate effectively.

Business risk

All companies face risks of many kinds.

• The risk that products may become technologically obsolete

• The risk of losing key staff.

• The risk of a catastrophic failure of IT systems.

• The risk of changes in government policy.

• The risk of fire or natural disaster.

Companies therefore need to:

• identify potential risks and

• decide on appropriate ways to minimize those risks.

Ways of reducing risk include:

• Identify the risks a company faces and maintain a risk register.

• Risks can be of many types – e.g. operational, financial, and legal.

• The company should then assess the relative importance of each risk by scoring it on a combination of its likelihood and potential impact.

This could take the form of a ‘risk map’.

• insurance

• implementing better procedures, e.g. health and safety provisions outsourcing

• discontinuing especially risky activities

• improving staff training.

Sometimes the company may be forced to accept the risk as an inevitable part of its operations.

INTERNAL CONTROLS AND RISK MANAGEMENT

One way of minimizing risk is to incorporate internal controls into a company’s systems and procedures.

Examples might be as follows:

• One person checking another person’s work.

• Locking important documents in a safe.

• Restricting access to places with security systems.

• Restricting access to information and systems held on computers through passwords etc.

• An internal audit department which checks that procedures and systems are operating as they should.

But they may be able to:

• reduce the risk that financial statements contain material errors

• reduce the risk of theft of the company’s assets

• reduce the risk that your business secrets might be handed over to a competitor.

LIMITATIONS OF THE INTERNAL AUDIT FUNCTION

The main limitations of internal audit are:

Independence (or lack of) – can internal audit be truly independent of the organisation of which it is a part? Since internal auditors are employed by the organisation, this can impair their independence and objectivity and ability to report fraud/error to senior management because of perceived threats to their continued employment within the company.

Variation of standards – not uniform across the profession. Compare this with external auditors who, on a global basis, have ISAs against which their performance can be measured.

  • Relatively new profession – still evolving.
  • Expectations gap – problem of what the internal auditor’s role is perceived to be.
  • Understanding of internal audit – negative view by some – perhaps seen as ‘checking up’ on other employees on behalf of ‘the bosses’.
  • Dual reporting relationship: To ensure transparency, best practice indicates that the internal audit function should have a dual reporting relationship. This means, reporting both to management and those charged with governance (Audit committee).

OUTSOURCED INTERNAL AUDIT SERVICES

  • Internal audit is not mandatory, so many entities have decided to outsource or contract out the function. This may result in the external audit firm providing both the external and the internal audit function.
  • The advantages of outsourcing internal audit include the following:
  • Some organisations are not large enough to warrant a separate internal audit department.

Outsourcing is therefore the only means by which they can benefit from the function:

  • The independence of the function is enhanced.
  • The investigation of sensitive areas such as management fraud is easier if outsourcing is used.
  • External providers may have easier access to specialist knowledge.

However, there may be disadvantages as well:

  • Outsourcing internal audit appears to go against the spirit of corporate governance which regards regular monitoring of key controls by internal audit as an integral part of the entity’s system of controls.
  • Using external providers may be more expensive because they are paid fees which include a profit element.
  • External staff may change frequently and the new staff will have to become acquainted with the system. Internal staff usually knows the system better and can therefore identify problems more easily. They are also closer to the daily activities of the entity and may get earlier indications of developments or problems.

AUDIT COMMITTEE

An audit committee reviews financial information and liaises between the auditors and company. It normally consists of the non-executive directors of the company.

Functions

  1. To monitor the integrity of the financial statements of the company, reviewing significant financial reporting issues and judgements contained in them.
  2. To review the company’s Internal financial control system and unless expressly addressed by a separate risk committee or by the board itself, risk management systems
  3. To monitor and review the effectiveness of the company’s Internal audit function
  4. To make recommendations to the board in relation to the appointment of the external auditor and to approve the remuneration and terms of engagement of the external auditors
  5. To monitor and review the external auditor’s independence, objectivity and effectiveness, taking into consideration relevant professional and regulatory requirements
  6. To develop and implement policy on the engagement of the external auditor to supply non-audit services, taking into account relevant ethical guidance regarding the provisions of non-audit services by the external audit firm.

In addition to these responsibilities, any responsible audit committee is likely to want:

(1) To ensure that the review procedures for interim statements, rights documents and similar information are adequate

(2) To review both the management accounts used internally and the statutory financial statements issued to shareholders for reasonableness

(3) To make appropriate recommendations for improvements in management control

There are a number of advantages and disadvantages.

THE INTERNATIONAL PROFESSIONAL PRACTICES FRAMEWORK

The international Professional Practices Framework (IPPF) organises the guidance issued by the Institute of Internal Auditors.

Guidance issued consists of mandatory guidance (Definition of Internal Auditing, the Code of Ethics and professional standards) and strongly recommended guidance (Practice Advisories and Practice Guides) which assists in the application of the mandatory guidance.

The International Professional Practices Framework (IPPF) is the conceptual framework that organizes guidance issued by the Institute of Internal Auditors (IIA). Authoritative guidance is made up of mandatory and non-mandatory guidance. Mandatory guidance is developed following due process, which includes public exposure. Compliance with the mandatory guidance is compulsory and is essential for the professional practice of internal auditing.

The mandatory guidance consists of:

  • Definition of Internal Auditing
  • Code of Ethics
  • Standards

Strongly recommended (but not mandatory) guidance is endorsed by the IIA through a formal review and approval process. Although compliance is not compulsory, it is strongly recommended that it is complied with.

This guidance is designed to assist internal auditors in implementing the Code of Ethics and Standards and acts as a guide to best practice.

It consists of:

  • Position Papers
  • Practice Advisories
  • Practice Guides

INTERNATIONAL STANDARDS FOR THE PROFESSIONAL PRACTICE OF INTERNAL AUDITING (STANDARDS)

The International Standards for the Professional Practice of Internal Auditing (the Standards) forms part of the mandatory guidance with which all internal auditors must comply.

Standards are developed by the Internal Auditing Standards Board (IASB) on behalf of the IIA. They consist of attribute standards, performance standards and implementation standards.

The Professional standards for internal auditing are developed by the Internal Audit Standards Board (IASB) on behalf of the IIA. The primary responsibility of the IASB is to provide guidance to practitioners.

Individuals and entities providing internal auditing services must comply with the Standards. Internal audit is carried out all over the world, influenced by different laws, customs and cultures and is carried out in extremely diverse organizations and environments. The Standards are therefore presented as broad principles so that they can be applied in very different circumstances.

The purpose of the Standards is set out in the ‘Introduction to the Standards’ as to:

(1) Delineate basic principles that represent the practice of internal auditing

(2) Provide a framework for performing and promoting a broad range of value-added internal auditing

(3) Establish the basis for the evaluation of internal auditing performance

(4) Foster improved organizational processes and operations.

The Standards consist of Attribute Standards, Performance Standards and Implementation Standards.

Attribute Standards describe the characteristics of entitles arid parties that provide internal auditing services.

Performance Standards provide criteria for guiding and evaluating all internal audit activities.

Attribute and Performance Standards apply regardless of the service provided. They provide guidance for assurance, consulting and other internal auditing services.

Attribute standards relate to the attributes of the internal auditor (or internal auditing organization) such as independence and objectivity, or proficiency and due professional care. Performance standards apply to the actual performance of internal audit work. They address issues such as assessing risk, control and governance processes, engagement planning and evaluating evidence.

Implementation Standards apply the Attribute and Performance standards in a more specific context.

Each group of Implementation Standards apply only to a major category of engagements. To date, they have been issued for assurance services and consulting services.

Implementation Standards are integrated within Assurance Standards and are designated by A (assurance) or C (consulting).

Assurance services: An objective examination of evidence for the purpose of providing an independent assessment on risk management, control or governance processes for the organization. Examples may include financial, performance, compliance, system security, and due diligence engagements.

Consulting services: Advisory and related client service activities, the nature and scope of which are agreed with the client and which are intended to add value and improve an organization’s governance, risk management, and control processes without the internal auditor assuming management responsibility. Examples include counsel, advice, facilitation and training.

Attribute Standards

1000 Purpose, Authority and Responsibility

1100 Independence and Objectivity

1200 Proficiency and Due Professional Care

1300 Quality Assurance and Improvement Program

Performance Standards

2000 Managing the Internal Audit Activity

2100 Nature of Work 2200 Engagement Planning

2300 Performing the Engagement

2400 Communicating Results 2500 Monitoring Progress

  1. solution of Managements Acceptance of Risks

ASSURANCE AND CONSULTANCY ENGAGEMENTS

Internal auditors conduct two key types of engagement: assurance engagements and consultancy engagement.

Internal audit can be involved in many different assignments as directed by management. These range from value for money projects to operational assignments looking at specific parts of business.

Value for money audits:

Values for money (VFM) audits examine the economy, efficiency and effectiveness of activities and processes. These are known as the three Es of VFM audits.

The three Es which form the basis of the VFM audit are very important for assessing the performance of not-for-profit organisations, because their performance cannot be properly assessed using conventional accounting ratios. As a result most not-for-profit organisations rely on measures that estimate the performance of the organisation in relation to the three Es. In Ghana the Auditor General is responsible for report on whether there has been economic, efficient and elective use of public resources.

The three Es can be defined as follows:

(a) Economy: attaining the appropriate quantity and quality of physical, human and financial resources (inputs) at lowest cost. An activity would not be economic, if, for example, there was over-staffing or failure to purchase materials of requisite quality at the lowest available price.

(b) Efficiency: this is the relationship between goods or services produced (outputs) and the resources used to produce them. An efficient operation produces the maximum output for any given set of resource inputs, or it has minimum inputs for any given quantity and quality of product or service provided.

(c) Effectiveness: this is concerned with how well an activity is achieving its policy objectives or other intended effects.

The internal auditors will evaluate these three factors for any given business system or operation in the company. Value for money can often only be judged by comparison. In searching for value for money, present methods of operation and uses of resources must be compared with alternatives.

The following list identifies areas of an organisation, process or activity where there might be scope for significant value for money improvements. Each of these should be reviewed within individual organisations.

• Service delivery (the, actual provision of a public service)

• Management process

• Environment

An alternative approach is to look at areas of spending. A value for money assessment of economy, efficiency and effectiveness would look at whether:

• Too much money is being spent on certain items or activities, to achieve the targets or objectives of the overall operation

• Money is being spent to no purpose, because the spending is not helping to achieve objectives

• Changes could be made to improve performance

An illustrative list is shown below of the sort of spending areas that might be looked at, and the aspects of spending where value for money might be improved.

• Employee expenses

• Premises expenses

• Suppliers and services

• Establishment expenses

• Capital expenditure

RISK BASED INTERNAL AUDITING

Risk Based Internal Audit (RBIA) seeks to link internal auditing to an organisation’s risk management framework.

Recent developments in corporate governance focus the importance of an organisation’s ability to identity and manage risk. It is management’s responsibility to identify and respond to risk, but as part of the organisation’s internal control, internal audit can help provide assurance that risks have been managed properly. A balance needs to be struck between a wish to increase the level of responsibility given to the internal audit activity (in order to benefit from their skills), and the danger that Involvement which amounts to management involvement would compromise the Independence of the internal auditors.

Risk Based Internal Auditing (RBIA) is an internal audit methodology. It seeks to link internal audit to the organisation’s own framework for identifying and managing risks by involving internal audit in evaluating whether the risk management framework operates effectively.

The range of processes that risk management may use is very wide. In a small organisation with a straightforward business, risk management may be carried out through informal and subjective processes. In a more complex organisation where exposure to financial risks, such as exchange rate risk is being managed through the use of derivative financial instruments, the techniques used will be quantitative and the processes are much more likely to be formalised.

Internal audit’s work will be influenced by the organisation’s appetite for bearing risks, but internal audit will assess:

  • The adequacy of the risk management and response processes for identifying, assessing, managing and reporting on risk
  • The risk management and control culture
  • The appropriateness of internal controls in operation to limit risks
  • The operation and effectiveness of the risk management processes, including the internal controls

It is possible that the risk management framework in an organisation will be poor or non-existent. In this case, RBIA is not appropriate for that organisation. In an organisation like this, internal auditors will seek to promote good risk management practices as part of their efforts to improve internal control.

RBIA is generally seen as harder to manage than traditional internal audit methodologies.

  1. Elements of RBIA

RBIA is a dynamic process. Whereas traditional internal audit proceeds in a straight line from start to finish, RBIA involves three interconnected stages or processes: assessing risk maturity; audit planning; audit assignments.

  1. Assessing risk maturity

Risk maturity here means how far the management of the organisation has gotten in its ability to identify and manage risks. The internal auditor assesses this because it gives a starting point for understanding how reliable management’s risk register might be.

  1. Audit planning

During the course of each period — usually a year — the assurance and consulting assignments that the organisation needs must be identified.

  1. Individual audit assignments

The internal auditor carries out the individual engagements planned for the period.

COSO framework:

In 1992, the Committee of Sponsoring Organisations of the Treadway Commission developed a model for evaluating internal controls.

COSO enterprise risk management framework provides a coherent framework for -organisations to deal with risk, based on the following components:

Internal control environment ; this includes Integrity and Ethical Values, Commitment to Competence, Board of Directors and Audit Committee, Management’s Philosophy and Operating Style, Organisational structure, Assignment of Authority and Responsibility, Human Resource Policies and Procedures

Objective setting

Event identification

Risk assessment; this includes Company – wide Objectives, Process- level Objectives, Risk Identification and Analysis, Managing Change

Risk response

Control activities; this includes Policies and Procedure, Security, Application Change Management, Business Continuity / Backups, Outsourcing

Information and Communication; this includes Quality of Information and Effectiveness of Communication

Monitoring; this includes On – going monitoring, Separate Evaluation and Reporting Deficiencies

Enterprise risk management is a process, affected by an entity’s board of directors, management and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity and manage risks to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives.

COSO states that enterprise risk management has the following characteristics,

(a) It is a process, a means to an end that should ideally be intertwined with existing operations and exist for fundamental business reasons.

(b) It is operated by people at every level of the organisation and is not just paperwork. It provides a mechanism helping people to understand risk, their responsibilities and levels of authority.

(c) It is applied in strategy setting, with management considering the risks in alternative strategies.

(d) It is applied across the enterprise. This means it takes into account activities at all levels of the organisation from enterprise-level activities such as strategic planning and resource allocation, to business unit activities and business processes. It includes taking an entity level portfolio view of risk. Each unit manager assesses the risk for his unit. Senior management ultimately consider these unit risks and also interrelated risks. Ultimately they will assess whether the overall risk portfolio is consistent with the organisation’s risk appetite.

(e) It is designed to identify events potentially affecting the entity and manage risk within its risk appetite, the amount of risk it is prepared to accept in pursuit of value. The risk appetite should be aligned with the desired return from a strategy.

(f) It provides reasonable assurance to an entity’s management and board. Assurance can at best be reasonable since risk relates to the uncertain future.

(g) It is geared to the achievement of objectives in a number of categories, including supporting the organisation’s mission, making effective and efficient use of the organisation’s resources, ensuring reporting is reliable, and complying with applicable laws and regulations.

Because these characteristics are broadly defined, they can be applied across different types of organisations, industries and sectors. Whatever the organisation, the framework focuses on achievement of objectives. An approach based on objectives contrasts with a procedural approach based on rules, codes or procedures. A procedural approach aims to eliminate or control risk by requiring conformity with the rules. However a procedural approach cannot eliminate the possibility of risks arising because of poor management decisions, human error, and fraud or unforeseen circumstances arising.

INTERNAL AUDIT ENGAGEMENT

During the internal audit process, internal auditors need to collect data which will form the basis of the internal auditor’s conclusion and recommendations. It is therefore important that the internal auditor obtain the appropriate evidence.

If the recommendations are not based on sound data, the internal auditor will struggle to get senior management’s agreement as his findings may be meaningless.

Audit evidence should be collected on all matters that relate to the engagement objectives and scope of work, Audit evidence can be gathered in many ways, including inquiry, Inspection, observation, monitoring and re-performance.

The most common technique used is inquiry. Auditors should choose the most appropriate method for the specific situation.

  1. Analytical procedures are used by internal auditors to identify and examine information. They involve comparing information and identifying any relationships or trends it may contain. This helps the auditor to identify anomalies which can then be further looked into. Such anomalies could identify errors, unusual transactions, inefficiencies, changes, or fraud.
  2. Supervision should take place at all stages of an audit, from the initial planning stages right through to follow-up. It will involve many different aspects, including ensuring the auditors are competent, that the working papers support the findings, and that the overall objectives of the engagement are met. Supervising an audit includes reviewing the working papers. This review should be evidenced to prove when, and by whom, the review was carried out. As well as ensuring the quality of the working papers and checking that the appropriate evidence has been collated and suitable conclusions drawn, review is also beneficial from a learning and development point of view. The review notes help the internal auditor learn where they do not collect sufficient evidence, or identify possible issues, for example. The review allows the supervisor to identify areas where training could be provided to the internal auditor to help him develop.

Problems identified should not wait until the end of the internal audit. They should be discussed with management in interim progress reports to make sure the client is fully aware of any potential problems, can begin to think about (or even implement) measures to remedy the problems and can clear up any misunderstandings with the internal auditor. Fraud should be immediately communicated to senior management and the board as soon as its existence becomes apparent to the internal audit activity.

Concluding and reporting

After the auditor has finished collecting data and evidence and recording the findings in the working papers, the auditor will need to review the evidence and the working papers in order to draw conclusions. The conclusions will form the basis of the report, which is the method by which the internal auditors communicate the results of the audit. The conclusions are based on the findings; they are the internal auditors professional opinion of the activity based on the facts gathered during the audit process.

As well as conclusions, internal audit reports also include an opinion. An opinion could be an overall assessment of the controls of the area that has been reviewed, or again, it could relate specifically to certain controls or aspects of the engagement. Audit findings and opinions can be positive as well as negative, presuming that there is sufficient reason to compliment the entity.

Conclusions can be positive, negative or mixed. Look at the following examples for a review of a Payroll system.

Positive conclusion

‘Based on the results of our audit, we believe that an adequate system of control has been established over the Payroll system and the objectives of the system are met effectively and efficiently.’

Mixed conclusion

‘In our opinion, the Payroll system is adequately controlled and, with the exception of the timely payment of casual workers, the system is operating efficiently arid effectively.’

Negative conclusion

‘In our opinion, the Payroll system is inadequately controlled due to the lack of segregation of duties and responsibilities within the system:

Developing recommendations

Recommendations suggest ways that operations can be improved, or existing conditions can be corrected. They are based upon the internal auditor’s observations and conclusions. It should be remembered that recommendations are only suggestions, not obligations.

It is important that auditors do not take on the responsibilities of management as doing this may threaten their objectivity, particularly in consulting engagements where the auditor may be required to give specific advice on a problem, such as whether or not a new computerised system should be installed.

If the auditor is responsible for actions based on recommendations, then their future objectivity is in doubt. This is because they could essentially end up auditing their own work.

Any impairment to objectivity should be disclosed to management immediately. Also, when making recommendations, the auditor should ensure any other conflicts of interest are disclosed.

Another way of preventing disagreements arising is through keeping the manager regularly informed of progress, alerting him to any developments or potential findings early on and keeping the channels of communication open throughout the audit to ensure any misunderstandings or disagreements are resolved early on.

Any disagreements should be fully documented along with the reasons for those disagreements and the views of both the management and the auditor. If appropriate, the comments of management can be included in the final report either as an appendix or in the covering letter.

Recommendations not obligations

It is important to remember that recommendations are just that: recommendations! They are not obligatory requirements that management must follow, rather they are a suggested course of action for remedying a problem. It is one option only, and auditors should remember that management may choose to follow a different course of action other than the one given in the report, this is because:

  • Managers have a wider understanding of the likely outcomes of acting upon a recommendation
  • Recommendations should be discussed with the manager before the end of the audit to ensure the best course of action is identified
  • Working with the manager to jointly identify a solution will improve their working relationship
  • The manager’s involvement in developing the recommendations will improve the perception of the manager by his superiors. Both the cost and benefit to the organisation of following a recommendation should be considered to ensure a balance between cost and risk, Sometimes however cost will be irrelevant, for example laws and regulation must be complied with regardless of the cost.

Reporting results to management and implementation of recommendations

At the end of the audit engagement, the results have to be communicated to relevant staff. The results will be made up of a number of findings and recommendations, and their aim is to get management to implement measures to solve the problems identified.

QUALITY ASSESSMENT OF THE INTERNAL AUDIT FUNCTION

The quality at an internal function depends on several factors, including its independence and the quality of its staff.

Independence of internal audit

Auditors should be independent of the activities audited. Although an internal audit department is part of an organisation, it should be independent of the line management whose sphere of authority it may audit.

Audit process

A lack of independence can mean that audits cannot be carried out to the extent and effectiveness desired. Internal auditors may not be able to examine all the areas they would like to, or determine how the areas selected will be audited. They may feel inhibited from carrying out certain procedures for fear of upsetting powerful or vocal managers or staff. In addition internal audit will be trusted more by managers and staff, and hence are more likely to have sensitive information disclosed to them, if they are felt to be independent.

Value of recommendations

Internal audits recommendations will only be valuable if they are influenced solely by what they find, and not biased by other factors. Factors that can distort the judgements internal audit make include a willingness to take sides, motives of personal advantage or a desire to use the audit to confirm their own previous judgements (for example dislikes of certain individuals).

Increased costs of internal audit

Clearly if internal audit produce recommendations that are flawed because they reflect the auditors’ lack of independence, the costs of their salaries will be wasted. In addition, costs will ratchet up if management uses internal audit’s recommendations as the basis for decisions about risk management. Risks unnecessarily highlighted by internal audit may be over-managed, incurring excessive costs. Risks which are not highlighted by internal audit when they should have been may materialise, causing significant losses to the organisation.

Confidence in recommendations

Line managers will be less willing to implement internal audit recommendations if they believe that internal audit is biased against them.

RECRUITING INTERNAL AUDITORS

 

The decision about where to recruit internal auditors from will partly depend on the skills available internally and externally. Clearly an internal recruit has familiarity with the organisation that an external recruit would lack. However there are a number of arguments in favour of recruiting externally.

  1. Other experience

An external recruit can bring in fresh perspectives gained from working elsewhere. He can use his experience of other organisations’ problems to identify likely risk areas and recommend practical solutions and best practice from elsewhere.

b. Independence of operational departments: An internal recruit is likely to have built up relationships and loyalties with people whom he has already worked, perhaps owing people favours. Equally he could have grievances or have come into conflict with other staff. As noted above, these could compromise his independence when he comes to audit their departments.

c. Prejudices and biases An internal recruit is likely to have absorbed the perspectives and biases of the organisation, and thus be more inclined to treat certain individuals or departments strictly, whilst giving others the benefit of the doubt when maybe that is not warranted.

BEST VALUE AUDITS

‘Best value’ is a performance framework introduced into local authorities by the UK government. They are required to publish annual best value performance plans and review all of their functions over a five-year period.

As part of best value authorities are required to strive for continuous improvement by implementing the ‘4 Cs’:

  • Challenge. How and why is a service provided?
  • Compare. Make comparisons with other local authorities and the private sector.
  • Consult. Talk to local taxpayers and services users and the wider business community in setting performance targets.
  • Compete. Embrace fair competition as a means of securing efficient and effective services.

One of internal audits standard roles in a company is to provide assurance that internal control system are adequate to promote the effective use of resources and that risks are being managed and systems are operating properly.

This role can be extended to ensure that the local authority has arrangements in place to achieve best value, that the risks and impacts of best value are incorporated into normal audit testing and that the authority keeps abreast of best value developments. As best value depends on assessing current services and setting strategies for development, internal audit can take part in the ‘position audit’, as they should have a good understanding of how services are currently organised and relate to each other. As assurance providers, internal audit will play a key part in giving management assurance that its objectives and strategies in relation to best value are being met.

Financial

The financial audit is internal audit’s traditional role. It involves reviewing all the available evidence to substantiate information in management and financial reporting. The substantive procedures and tests of controls employed by external audit are also used by internal audit. The importance of controls in preventing financial reporting errors mean that it is necessary to review certain areas regularly to ensure the relevant controls continue to be in place. Many internal audit functions with therefore adopt a cycle approach to financial internal audit engagements to ensure each area is reviewed on a regular basis.

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Corporate FinanceFinancial Management

BEST GUIDE TO COST OF CAPITAL

cost of capita front

The cost of capital is the rate of return that the enterprise must pay to satisfy the providers of funds, and it reflects the riskiness of providing funds.

Aspects of the cost of capital

The cost of capital has two aspects to it.

(a) The cost of funds that a company raises and uses, and the return that investors expect to be paid for putting funds into the company.

(b) It is therefore the minimum return that a company should make on its own investments, to earn the cash flows out of which investors can be paid their return.

The cost of capital can therefore be measured by studying the returns required by investors, and then used to derive a discount rate for DCF analysis and investment appraisal.

The cost of capital as an opportunity cost of finance

The cost of capital is an opportunity cost of finance, because it is the minimum return that investors require. If they do not get this return, they will transfer some or all of their investment somewhere else.

Here are two examples.

(a) If a bank offers to lend money to a company, the interest rate it charges is the yield that the bank wants to receive from investing in the company, because it can get just as good a return from lending the money to someone else. In other words, the interest rate is the opportunity cost of lending for the bank.

(b) When shareholders invest in a company, the returns that they can expect must be sufficient to persuade them not to sell some or all of their shares and invest the money somewhere else. The yield on the shares is therefore the opportunity cost to the shareholders of not investing somewhere else.

The cost of capital and risk

The cost of capital has three elements.

Risk free rate of return +

Premium for business risk +

Premium for financial risk = COST OF CAPITAL

(a) Risk-free rate of return

This is the return which would be required from an investment if it were completely free from risk.

Typically, a risk-free yield would be the yield on government securities.

(b) Premium for business risk

This is an increase in the required rate of return due to the existence of uncertainty about the future and about a firm’s business prospects. The actual returns from an investment may not be as high as they are expected to be. Business risk will be higher for some firms than for others, and some types of project undertaken by a firm may be more risky than other types of project that it undertakes.

(c)Premium for financial risk

This relates to the danger of high debt levels (high gearing). The higher the gearing of a company’s capital structure, the greater will be the financial risk to ordinary shareholders, and this should be reflected in a higher risk premium and therefore a higher cost of capital.

The relative costs of sources of finance

The cost of debt is likely to be lower than the cost of equity, because debt is less risky from the debt-holders’ viewpoint. In the event of liquidation, the creditor hierarchy dictates the priority of claims and debt finance is paid off before equity. This makes debt a safer investment than equity and hence debt investors demand a lower rate of return than equity investors. Debt interest is also corporation tax deductible (unlike equity dividends) making it even cheaper to a tax paying company. Arrangement costs are usually lower on debt finance than equity finance and once again, unlike equity arrangement costs, they are also tax deductible.

The creditor hierarchy (Increasing risk)

1 Creditors with a fixed charge

2 Creditors with a floating charge

3 Unsecured creditors

4 Preference shareholders

5 Ordinary shareholders

This means that the cheapest type of finance is debt (especially if secured) and the most expensive type of finance is equity (ordinary shares).

Let’s now discuss in details the various concepts of Cost of Capital:

Cost of equity

The cost of equity (existing shares)

The dividend growth model

The dividend growth model can be used to estimate a cost of equity, on the assumption that the market value of share is directly related to the expected future dividends from the shares.

New funds from equity shareholders are obtained either from new issues of shares or from retained earnings. Both of these sources of funds have a cost.

(a) Shareholders will not be prepared to provide funds for a new issue of shares unless the return on their investment is sufficiently attractive.

(b) Retained earnings also have a cost. This is an opportunity cost, the dividend forgone by shareholders.

If the future dividend per share is expected to be constant in amount, then the ex-dividend share price will be calculated by the formula:

Where:

= Equity investor’s required rate of return

= annual dividend per share just paid

= the ex-dividend share price (the price of a share where the share’s new owner is not entitled to the dividend that is soon to be paid).

Question:

Naylor plc is expected to pay a constant annual dividend of 30p per ordinary share. The current market price per share is £ 2.30 (cum – div) and the dividend is about to be paid.

Required: What is the cost of equity?

Solution:

=

Question:

S plc has in issue $1 shares with a market value of $2.40 per share. A constant dividend of 30c per share has just been paid.

What is the shareholders required return (), (and therefore the cost of equity to the company)?

Solution

Question:

Cygnus has a dividend cover ratio of 4.0 times and expects zero growth in dividends. The company has one million $1 ordinary shares in issue and the market capitalisation (value) of the company is $50 million. After-tax profits for next year are expected to be $20 million.

What is the cost of equity capital?

Solution:

Total dividends = 20 million/4 = $5 million.

= 5/50 = 10%.

Cost of equity (growth)

Shareholders will normally expect dividends to increase year by year and not to remain constant in perpetuity. The fundamental theory of share values states that the market price of a share is the present value of the discounted future cash flows of revenues from the share, so the market value given an expected constant annual growth in dividends would be:

Where:

= the shareholders required rate of return (= cost of equity)

= the current dividend

P0= the current market value per share (ex div)

g = the rate of dividend growth p.a.

Question:

T plc has in issue 50c shares with a market value of $4.20 per share. A dividend of 40c per share has just been paid.

Dividends are growing at 6% p.a.

What is the cost of equity?

Solution:

=

Question:

A share has a current market value of 96c, and the last dividend was 12c. If the expected annual growth rate of dividends is 4%, calculate the cost of equity capital.

Solution:

=

Estimating the rate of growth in dividends

When using the formula for the cost of equity, we need to know the rate of dividend growth that shareholders expect in the future. If this figure is given us in the examination then there is obviously no problem.

However, you may be expected to estimate the dividend growth rate using one of two approaches:

• using the rate of growth in the past

• using the ‘rb’ model – Gordon Approximation

Past dividend growth

With this approach, we can use the formula:

– 1

Where g is the growth rate (%) and n is the number of years for the growth.

Question:

It is now the year 2001, and X plc has paid out the following total dividends in past years:

1996 $28,000

1997 $29,000

1998 $32,000

1999 $31,000

2000 $33,000

Estimate the average rate of growth of dividends p.a.

Solution:

– 1 =

Therefore, the average rate of growth of dividends p. a. is 4.2%

Gordon’s growth approximation (‘rb’ growth)

The growth can be estimate using the following formula:

g = r b

Where: b = the proportion of earnings retained in the company

r = the rate of return that the company can earn on re-investment

Question:

Y plc retains 40% of earnings each year and is able to reinvest so as to earn a return of 20% p.a.

What is the expected growth rate in dividends?

Solution:

g = r b

Question:

Z plc has in issue $1 shares with a market value of $2.80 per share. A dividend of 20c per share has just been paid (earnings per share were 32c).

The company is able to invest so as to earn a return of 18% p.a.

(a) Estimate the rate of growth in dividends

(b) Estimate the cost of equity

(c) Estimate the market value per share in 2 years’ time

Solution:

r= 18%

b = =

Market Value in 2 years’ time =

Weaknesses of the dividend growth model

(a) The model does not incorporate risk.

(b) Dividend does not grow smoothly in reality so g is only an approximation.

(c) The model fails to take capital gains into account; however it is argued that a change of share ownership does not affect the present value of the dividend stream.

(d) No allowance is made for the effects of taxation although the model can be modified to incorporate tax.

(e) It assumes there are no issue costs for new shares.

Cost of equity (new equity)

When the company issues new shares, the calculation of the cost of capital is done using the formula below:

Where f is the issue costs.

Question:

Goodman plc wishes to finance a new project by the issue of 40000 ordinary shares of £2.50 each, out of which share issue costs of 8% of the issue price has to be paid. New shareholders expect constant annual dividend of 32.2p per share.

Required: Estimate the cost of capital.

Solution:

The cost of debt

The cost of debt is the return an enterprise must pay to its lenders.

For irredeemable debt, this is the (post-tax) interest as a percentage of the ex-interest market value of the bonds (or preferred shares).

For redeemable debt, the cost is given by the internal rate of return of the cash flows involved.

The cost of debt capital

The cost of debt capital represents:

(a) The cost of continuing to use the finance rather than redeem the securities at their current market price.

(b) The cost of raising additional fixed interest capital if we assume that the cost of the additional capital would be equal to the cost of that already issued. If a company has not already issued any fixed interest capital, it may estimate the cost of doing so by making a similar calculation for another company which is judged to be similar as regards risk.

Irredeemable debt capital

Cost of irredeemable debt capital, paying interest i in perpetuity, and having a current ex-interest price Po

Irredeemable debt is debt that is never repaid. It does not exist in practice, but in the examination you assume debt to be irredeemable unless told otherwise.

We will use the formulae below to estimate the cost of irredeemable debt:

Where i is interest, Po is the market value of debt and T is tax rate.

Question:

F plc has in issue 8% irredeemable debentures quoted at 90 p.c. ex int.

(a) What is the return to investors (kd)?

(b) What is the cost to the company, if the rate of corporation tax is 30%?

Solution:

When dealing with debt, you have to understand that interest is always payable on a £100/$100/GHS 100 nominal value.

=

Question:

Lepus has issued bonds of $100 nominal value with annual interest of 9% per year, based on the nominal value. The current market price of the bonds is $90. What is the cost of the bonds?

Solution

kd = 9/90 =10%

Redeemable debt

If the debt is redeemable then in the year of redemption the interest payment will be received by the holder as well as the amount payable on redemption. If this is so, then it means the above formula or concept doesn’t hold for redeemable debt.

To determine the cost of debt of a redeemable debt, we have to calculate the Internal Rate of Return (IRR). This gives us the cost of debt. However, we employ a trial and error approach here.

The best trial and error figure to start with in calculating the cost of redeemable debt is to take the cost of debt capital as if it were irredeemable and then add the annualised capital profit that will be made from the present time to the time of redemption.

Question:

G plc has in issue 6% debentures quoted at 85 ex int.

The debentures are redeemable in 5 years’ time at a premium of 10%

(a) What is the return to investors ()?

(b) What is the cost to the company if the rate of corporation tax is 30%?

Solution:

The return to investors is the same as the IRR, hence let’s calculate the IRR starting with a discount rate of 10%

    [email protected]% [email protected]% [email protected]% [email protected]%
0 (85) 1 (85) 1 (85)
1 – 5 6 p.a. 3.971 22.75 3.352 20.11
5 110 0.621 68.31 0.497 54.67
      NPV = +6.06   NPV = (10.22)

Comments: You will realize that starting with a discount rate of 10% gave us a positive NPV hence we have to increase the discount rate to 15% in order to arise at a negative NPV.

This is the same thing you are going to be doing at the exams hall, so be mindful of it.

Taking into consideration the tax rate means that the interest will be reduced by 30%

    [email protected]% [email protected]%
0 (85) 1 (85)
1-5 4.20 p.a. (70% of 6) 3.971 15.92
5 110 0.621 68.31
      0.77 (= nearly 0!)

Cost of debt = 10%

Comment: Since the NPV is nearly 0, we take the cost of debt as 10%.

Question:

Owen Allot has in issue 10% bonds of a nominal value of $100. The market price is $90 ex interest.

Calculate the cost of this capital if the bond is:

(a) Irredeemable

(b) Redeemable at par after 10 years

Ignore taxation.

Solution:

(a) The cost of irredeemable debt capital is

The cost of redeemable debt capital. The capital profit that will be made from now to the date of redemption is $10 ($100 – $90). This profit will be made over a period of ten years which gives an annualised profit of $1 which is about 1% of current market value. The best trial and error figure to try first is therefore 12%.

Year   Cash flow

$

Discount

factor

12%

PV

$

Discount

factor

11%

PV

$

0 Market value (90.0) 1.00 (90.0) 1.00 (90.0)
1–10 Interest 10 5.650 56.50 5.889 58.89
10 Capital repayment 100 0.322 32.20 0.352 35.20
             
        (1.30)   +4.09

The approximate cost of redeemable debt capital is, therefore:

Comments: You will realize in this example that, the discount rate was reduced from 12% to 11%. This is because the NPV was negative.

Also, you will realize the changes in the IRR formula. Make sure you understand the concept behind it.

THE WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The weighted average cost of capital is calculated by weighting the costs of the individual sources of finance according to their relative importance as sources of finance.

In the previous sections we have seen how to calculate the cost of both equity and debt.

However, most companies are financed using a mixture of both equity and debt.

It is useful for our later work to be able to calculate the average cost of capital to the company. We do this by calculating the cost of each source of finance separately (as in the previous sections) and then calculating a weighted average cost, using the ex div/int market values of the equity and debt.

WACC =

Where

Ke is the cost of equity

kd is the cost of debt

Ve is the market value of equity in the firm

Vd is the market value of debt in the firm

T is the rate of company tax

Question:

J plc is financed as follows:

Equity – 5 million $1 shares quoted at $2.50 cum div, on which a constant dividend of 32c per share is about to be paid.

Debt – $4M 8% debentures quoted at 92 ex int.

Corporation tax is 30%

(a) Calculate the returns to investors on equity and on debt

(b) Calculate the WACC of the company

Answer:

ke=

kd=

Cost of equity = ke = 14.68%

Cost of debt (after tax) = 8.70 × 0.7 = 6.09%

Value of equity = 218c per share

Value of debt = $92 per $100 nominal debt

WACC =

Question:

K plc is financed as follows:

Equity – 10 million $1 shares quoted at $3.20 ex div, on which a dividend of 20c per share has just been paid.

Dividends are growing at 8% p.a.

Debt – $6M 10% debentures quoted at 105 ex int. The debentures are redeemable in 6 years’ time at a premium of 10%

Corporation tax is 30%

Calculate the weighted average cost of capital

Answer:

To calculate the cost of debt we have to calculate the internal rate of return because, this is a redeemable debt.

df @ 10% PV @ 10% df @ 5% PV @ 5%

0 (105) 1 (105) 1 (105)

1 – 6 7 p.a. 4.355 30.49 5.076 35.53

6 110 0.564 62.04 0.746 82.06

(12.47) 12.59

Cost of debt=IRR= 5%+

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