Lecture 1

The Finance Function

Learning Objectives

• Identify the key decision areas concerning a Financial Manager.

• Why Shareholders Wealth (SW) Maximisation is the primary financial objective.

• Why in practice Shareholders Wealth is achieved by maximising the company’s share price.

• Constraints to maximising SW.

Introduction

• Corporate finance is concerned with the efficient and effective management of the finances of an organisation.

• This involves :– Planning and controlling the provision of

resources– Allocation of resources– Control of resources

Key Financial Decisions

• Investment –what projects should be undertaken by the organisation?

• Financing – how should the necessary funds be raised?

• Dividends – how much cash should be allocated each year to be paid as a return to shareholders?

• Risk – how is risk identified and managed

Key Financial Decisions

• The key financial decisions cannot be taken in isolation because they are interrelated.– No dividend payment (shares are likely to be

sold and share prices will fall).– High dividends (less money to push through

investment programmes).

• Decision in one area can have effect on the other areas.

Role of Financial Manager

Possible corporate objectives

• Shareholder wealth maximisation (SHWM)

• Maximisation of profit

• Maximisation of sales

• Survival

• Social responsibility

Which one should a company follow?

Shareholder wealth maximisation

• Total shareholders’ wealth is derived through the cash they received from dividend payment and the capital gained derived from owning shares in a company.

• Current and future dividends depend on future cash flows:– their magnitude or size– their timing– their associated risk.

NPV B

NPV C

NPV A

NPV D

CorporateNet

PresentValue

Share Price

SHWM

1

2

3

1: NPV is additive2: This link relies on market efficiency3: Share price taken as surrogate of SHW

Linking NPVto SHWM

The agency problem

Why does it arise?

• Divergence of ownership and control

• Managers’ goals differ from shareholders’

• Asymmetry of information as between shareholders and managers.

• The agency problem is considered as an internal constraint.

What are the consequences?

• Shareholder wealth is no longer maximised.

Consequences of an agency problem

• Managers will follow their own objectivesi.e. increasing their…– power

– job security

– pay and rewards

• Shareholders need to ensure that their own wealth is maximised (Personal Aspiration).

Signs of an agency problem

• Managers finance a company mainly with equity finance.

• Managers accept low risk, short payback investment projects.

• Managers diversify business operations.

• Managers follow ‘pet projects’.

• Managers are rewarded for performance that is ‘below average’.

Dealing with Agency Problem

• Best solution to the agency problem is to design managerial contracts that minimise the sum of the following costs:– financial contracting costs

– monitoring costs

– divergent behaviour costs.

Option 1: do nothing

Leaving managers to their own devices is problematic:

• Given human nature, managers will engage in suboptimal behaviour.

• Shareholders are satisficed rather than satisfied.

• No action is not really an option.

Option 2: monitoring

Problems associated with monitoring:

• Costly in terms of both time and money.

• Who will pay? Large shareholders? What about ‘free-riding’ smaller investors?

• Some managerial actions are hard to follow.

• May drive ‘bad managers’ underground.

Option 3: reward good behaviour

• What do we link managerial rewards to?

• Most commonly linked to: – profits

– share price (e.g. via share options).

• Rewarding is more common than monitoring.

• But…tying rewards to profits may encourage short-termism and creative accounting.

Option 3: reward good behaviour (Continued)

• There are also problems using share options:– how many options should managers be awarded?– at what share price should managers be able to

exercise their options?– managers can get rewarded for poor performance

if there is a ‘bull’ stock market.

Dealing with Agency Problem

• Incentives (encourage goal congruence) – Executive share option schemes– Performance related pay

• Corporate governance– Monitor the activities of management– Internal controls (financial reporting and

accountability)– The role of non-executive directors

Stakeholders Theory

• Stakeholders power and influence as a external constraint to maximising SW.

• External constraints from:– Banks– Trade suppliers– Customers– Government– Society / community

Corporate Governance

• Corporate governance is about promoting corporate fairness, transparency and accountability.

• It can be seen as an attempt to solve agency problem using externally imposed regulation.

• In the UK, good corporate governance is encouraged through a self-regulatory code of best practice.

Cadbury Committee (1992)

Recommended:

• A voluntary code of practice– 3 non-executive directors at board level

– maximum 3-year duration contracts

– posts of Chairman and C.E.O. should be separate

• Improved information flow to shareholders

• Increasing independence of auditors.

Greenbury Report (1995)

Recommended:

• One-year rolling contracts

• More sensitivity by remuneration committees

• PRP and share options to be phased out and replaced by ‘challenging’ long-term incentive plans (LTIPs)

• PIRC report (1996) indicated widespread abuse of the above.

Hampel Report (1998) and the Combined Code

• Stressed importance of a ‘balanced board’, non-executive directors and the role of institutional shareholders

Combined Code overseen by the London Stock Exchange

• Integrates Hampel, Cadbury and Greenbury recommendations

• Compliance is an LSE listing requirement.

Turnbull, Higgs and Smith

• Turnbull (1999): detailed how boards could maintain sound systems of internal control (significant risk/systems required)

• Higgs (2003): report designed to enhance the independence, and hence effectiveness, of non-executive directors

• Smith (2003): gave authoritative guidance on how audit committees should operate and be structured.

Is there an agency or corporate governance problem in UK

today?• Agency still remains a problem in the UK:

– legislation is only voluntary– human nature has not changed

• Directors still receive ‘excessive’ rewards

• The future: – US style shareholders coalitions? – statutory legislation?

Revision Notes

• Shareholders Wealth

• Key financial decisions

• Agency theory

• Stakeholders Theory

• Corporate Governance

Exercise for Seminar

• WH – Ch1 - Questions for Discussion 1, 2 and 3