The Finance Function

The FinanceFunction

CIMA

Shahin A. Shayan2004 - 2005

Topics

Introduction Financial management decisions “Not-for-profit” organization The treasury function Financial markets Financial intermediaries Share price volatility The efficient market hypothesis

Introduction

Financial management defined as follows.

“The management of all of the processesAssociated with the efficient acquisition anddeployment of both short- and long-term financialresources”

Financial Management Decisions

Investment Decisions

Investment decisions are those which determine how scarceresources in terms of funds available are committed to.

The other side of the investment coin is disinvestment.

Financing Decisions

Financing decisions relate to acquiring the optimum financeto meet financial objectives and seeing that fixed and workingcapital are effectively managed.

In making financial decisions, the manager must always beaware of the opportunity cost aspect involved.


Dividend Decisions

Dividend decisions concern how much and how frequently cash can bepaid out of the profits of an entity as income for its proprietors. Theowner of any profit-making organization looks for reward for hisinvestment in two ways: the growth of the capital invested and the cashpaid out as income. For a sole trader this income would be termeddrawings and for a limited liability company the term is dividends.

The dividend decision thus has two elements: the amount to be paid outand the amount to be retained to support the growth of the entity, thelatter being also a financing decision; the level and regular growth ofdividends is a significant factor in determining a profit-making company’smarket value, i.e. the value placed on its shares by the stock market.


Financial Objectives

For a profit-making entity the main strategic objective is tooptimize the wealth of the proprietors. In other words theobjective is assumed to be to maximize shareholderwealth.

Shareholder wealth may be measured by the returnshareholders receive from their investment. The return ashareholder receives is represented partly by the dividendreceived each year, and partly by the capital gain from theincrease in the value of the shares over that period.

Financial Management Decisions Financial Objectives

However, in practice we try to achieve maximum profit through balancingvarious Stakeholders needs, who may include: Shareholders Fund providers Customers Suppliers Employees Government (taxation, legal and social constraints)

Non-financial objectives; customer satisfaction, employee welfare, managementwelfare and the environment

Economist believe that cash flow is the main criterion to judge a company’sperformance. Cash is a fact, whereas profit can be manipulated by accountingpolicies. Many companies have gone bankrupt because of lack of funds, eventhough they were profitable

Shareholder wealth is based on the present value of future cashflows


Agency Theory

A possible conflict can arise when ownership is separatedfrom the day to day management of an organization. In largercompanies, the ordinary shares are likely to be diversely held,and so the actions of shareholders are likely to be restricted inpractical terms. The responsibility of running the companywill be with the board of directors, who may only own a smallpercentage of the shares in issue.

The managers of an organization are essentially agents for theshareholders, being tasked with running the organization inthe shareholders’ best interests.


Agency Theory Examples

Cadbury Schweppes plc states in its annual report for 1998:

‘Our primary objective is to grow the value of the business for ourshareowners.’

This objective is quantified in terms of three financial targets:

1. to increase our earnings per share by at least 10% every year2. to generate £150 million of free cash flow every year3. to double the value of our shareowners’ investment within four years.


Agency Theory Examples

Contrast this with the objectives of J Sainsbury plc as stated in their annual report for1999:

‘To provide shareholders with good financial returns by focusing on customer needs, addingvalue through our expertise and innovation, and investing for future growth.

To provide unrivalled value to our customers in the quality of the goods we sell, in thecompetitiveness of our prices and in the range of choice we offer.

To achieve efficiency of operation, convenience and customer service in our stores, therebycreating as attractive and friendly a shopping environment as possible.

To provide a working environment where there is a concern for the welfare of each memberof staff, where all have opportunities to develop their abilities and where each is wellrewarded for their contribution to the success of the business.

To fulfil our responsibilities by acting with integrity, maintaining high environmentalstandards, and contributing to the quality of life of the community.’

Not-for-profit organizations

Modern corporate finance theories, are writtenin the context of the profit-seeking segment ofthe private sector

Organizations whose incomes comes from asource other than paying customers arefrequently plagued by excess of demand oversupply

Not-for-profit organizations Trade unions, trade associations, employers’

organizations and federations such as theConfederation of British Industry

Professional bodies, such as the Chartered Institute ofManagement Accountants and the InternationalFederation of Accountants

Housing associations (currently accounting for over 4per cent of UK housing stock, and building 50,000units a year), friendly societies, clubs and co-operatives

Charities Religious organizations, such as the Church of England.

Not-for-profit organizations The three Es

The public sector is usually credited with having drawn attention to thedistinctions between:

Economy, which is generally thought of in terms of doing things as cheaplyas possible, and is therefore associated with the operational level of control

Efficiency, which is generally thought of in terms of productivity (the ratio ofoutput to input) and is therefore associated with the tactical level of control

Effectiveness, which is generally thought of in terms of doing the right things,and is therefore associated with the strategic level of control

Formula-based transfer pricing; price = total costs (incl. roc) Public and private – similarities and differences

The treasury function

The treasury function exists in every business, thoughin small businesses it may form part of a departmentcovering other functions, such as accounting orcompany secretarial work. In a larger company, it islikely to be a separate department reporting to the chieffinancial officer, but communications with the rest ofthe organization need to be in good order if an effectiveservice is to be provided.

The treasury function represents one of the two mainaspects of financial management, the other beingfinancial control (and also planning)


In larger companies and groups, treasury will usually becentralized at head office, providing a service to all thevarious units of the entity and thereby achievingeconomies of scale, e.g. by obtaining better borrowingrates, whereas financial control is now frequentlydelegated to individual units, where it can more closelyimpact on customers and suppliers and relate morespecifically to the competition which those units haveto face. As a result, treasury and financial control mayoften tend to be separated by location as well as byresponsibilities


The main functions (requires special expertise andexperience) of the treasurer can be classified as follows: Banking Liquidity management Funding management Currency management

The treasurer’s key tasks can also be categorizedaccording to the three levels of management: Strategic; capital, dividend and funding strategies Tactical; cash, investment and hedging issues Operational; internal and external cash and banking relations

The treasury function The main advantages of operating treasury as a profit center

rather than as a cost center are as follows. Individual business units of the entity can be charged a market rate for the service

provided, thereby making their operating costs more realistic. The treasurer is motivated to provide services as effectively and economically as possible

to ensure that a profit is made at the market rate, e.g. in managing hedging activitiesfor a subsidiary, thereby benefiting the group as a whole.

The main disadvantages are as follows. The profit concept is a temptation to speculate, e.g. by swapping funds from currencies

expected to depreciate into ones expected to appreciate. Management time is unduly spent in arguments with business units over charges for

services, even though market rates may have been impartially checked (say by internalaudit department).

Additional administrative costs may be excessive.

The treasury function Example: Treasury management at J Sainsbury

The annual report of J Sainsbury for 1999 states:

‘Treasury policy and significant treasury transactions are reviewed andapproved by the Board and the Finance Management Sub-committeeof the Board is responsible for monitoring treasury activity andperformance.

The Group’s major treasury activities, with the exception of theoperations of Sainsbury’s Bank, are centralized in the Group Treasuryfunction.

Group Treasury operates as a cost center with Group wideresponsibilities for cash management, funding and interest rate andcurrency risk management. In this context Group policy permits theuse of derivative instruments but they may only be used to reduceexposures arising from underlying business activities and not forspeculative purposes.’

Financial Markets

Money Market

The money market is the market for trading inrelatively short-dated funds, usually for less than oneyear. These markets are dominated by the majorbanks and other financial institutions. Largecompanies will also borrow and lend on the moneymarket.

Financial Markets

Capital or Securities Market

Capital or securities markets trade in longer-dated securities(usually over twelve months) such as shares and loan stocks.Examples of capital markets would be the Stock Exchange,the bond market and the Eurobond market.

Capital markets have two main functions.

They provide a primary market for raising new capital for business, usually inthe form of equity (shares) to new shareholders or existing shareholders (viarights issues).

They also allow trading in existing securities – the secondary market. This isan important function as it provides investors with a means of selling theirinvestments should they wish to.

Financial Markets


In the UK, the London Stock Exchange is theprincipal trading market for long-dated securities. Itcontrols and regulates two markets:

the Official List or Main Market the Alternative Investment Market (AIM)

Financial Markets Capital or Securities Market

Flotation Flotation is the process of making shares available to investors by

obtaining a quotation on the Stock Exchange. There are a number of advantages and disadvantages of a flotation on

the Stock Exchange. Advantages of flotation:

Once listed, the market will provide a more accurate valuation of thecompany than had been previously possible.

Realization of paper profits. Raise profile of company which may have an impact on sales,

credibility with suppliers and long-term providers of finance. Raise capital for future investment. Makes employee share schemes more accessible.

Financial Markets


Disadvantages of flotation: Costly for a small company (flotation, underwriting costs,

etc.). Investors perceive small companies to be riskier and

therefore may require higher returns if they are to beattracted at all.

Making enough shares available to allow a market. Reporting requirements are more onerous. Stock Exchange rules for obtaining a quotation on the full

market are quite stringent.

Financial Markets

The Foreign Exchange Market

The foreign exchange market is a market for tradingin currencies. Deals here may be for immediatedelivery (spot deals) or for future delivery (forwarddeals).

Financial Markets

Derivatives Market

An example of a fourth type of market is the LondonInternational Financial Futures and Options Exchange(LIFFE) where derivatives are traded. Derivatives isa generic term for a range of traded financialinstruments which have developed from securities,commodity and currency trading. Examples ofderivatives are options and swaps. These can be usedas hedging devices, to reduce risks, or simply forspeculation.

Financial Intermediaries Financial markets provide a mechanism to match providers

of funds (lenders) with users of funds (borrowers). In this,financial intermediaries play an important role.

The main functions of financial intermediaries may besummarized as: Parcelling – collecting small savings and ‘parcelling’ them into larger

amounts which may be borrowed by businesses; Transformation – borrowing funds for relatively short periods of time and

lending them for longer periods; Spreading risk – small savers can diversify their risk by investing in, for

example, unit trusts; Reducing transaction costs – economies of scale mean that intermediaries can

transact business at lower costs than can individuals on their own behalf; Advice – providing financial advice and other services to lenders and

borrowers.

Financial Intermediaries Deposit-taking institutions

Retail banks. The clearing banks dominate the retail sector although theyare also active in wholesale and international banking. They areresponsible for most of the UK’s cash distribution and money transmissionfacilities.

Merchant and other wholesale banks. Merchant banks concentrate onproviding services to the corporate sector. They provide a wide range of services to their clients, such as:

providing advice on types of finance (shares, loans etc.) for new issues; developing new financial products & financial engineering (derivatives); providing advice on mergers and acquisitions (they can also play an active role in

finding takeover targets or merger partners); managing investment portfolios for institutional, and occasionally personal, investors

including charities; providing advice on other advisers, e.g. lawyers; arranging large-scale loan projects for corporate borrowers; arranging foreign exchange deals.

Finance houses. Finance houses offer credit facilities such as hire purchaseand leasing.

Building societies

Financial Intermediaries

Contractual savings institutions These are mainly insurance companies or

pension funds. Insurance companies operateboth long-term business (such as life assurance)and general business (such as house or motorinsurance).

Pension funds collect contributions on a regularbasis from employees and employers in order tomake provision for retirement pensions.


Investment funds

Unit trusts collect funds from investors and investthem primarily in equities.

Investment trusts are not trusts in the usual sense butare limited liability companies that can issue equityand debt.


Miscellaneous other institutions

3i is a venture capital company quoted on the stockexchange. Venture capitalists raise long-term moneyvia equity or loans and lend small amounts todeveloping companies (‘small’ is relative here and£1m would be considered small by a venturecapitalist).

Financial Intermediaries Exercise

Explain what is meant by venture capital. Solution:

Venture capital is available from organizations that specialize in providing this type of finance. It isusual for existing companies to be offered this funding if they are perceived as having a high growthpotential and also have a strong management team. It is also common to find that funding can beobtained from venture capitalists at the initial stages of a company’s development, especially if thepotential of the business is considered to be very good. Management buyouts (MBOs) are anotherarea where funding is often available through organizations that invest in projects requiring venturecapital.

It is often difficult for companies to obtain finance at the initial stages of their development andbefore they are established. This is the area in which venture capitalists specialize, as they areprepared to take more risks than other financial organizations. This means that they provide auseful service to companies that wish to grow.

The funds are often provided in “packages” of debt and equity which has implications for thecompany in terms of both its risk profile and the cost of capital. The venture capitalists will also beinterested in having an equity stake so that they can benefit from the success of the companies thatthey have assisted by providing the finance that has enabled them to prosper

Share price volatility

An example of the volatility of today’s businessenvironment, of particular interest to financialmanagers, is that displayed by the prices atwhich the shares of publicly quoted companieschange hands. The return from such aninvestment is the reward required by investorsand equates to the dividend plus the capital gain.

Share price volatility The required reward will reflect the level of risk

undertaken by the investor. Different types of shareprice analysis are: Extrapolation from past price data (known as ‘technical

analysis’). This is the approach taken by ‘chartists’, analystswho believe future prices can be charted and a patternidentified which can be used to predict future prices.

Estimated future prices based on the analysis of all known information(known as ‘fundamental analysis’). Analysts employed bybrokers, fund managers and journalists study a particularcompany in the context of its markets, and talk to itsdirectors, with a view to assessing its prospects. From thisthey conclude that the share is undervalued or overvaluedand recommend buying or selling accordingly.

Share price volatility The performance of the stock market is measured by an index.

In the UK, the broadest measure of performance is the FTSEAll-Share Index. This index is calculated by combining the pricemovements of the shares listed on the London Stock Exchangein proportion to the size of the companies they represent. Fromthis, the movement in a large company’s share price has aproportionately larger effect on the movement of the index thanthat of a smaller company.

On the available evidence, it is not surprising that theorists havedeveloped the idea that the progress of a particular share price isa ‘random walk’, rendering the achievement of consistentlysuperior returns an impossibility. In other words, tomorrow’sshare price is independent of today’s share price.

The Efficient Market Hypothesis The purpose of a stock market is to bring together those people who

have funds to invest with those who need funds to undertakeinvestments.

For this to happen, stock markets must price shares efficiently.Efficient pricing means incorporating into the share price allinformation that could possibly affect it. In an efficient marketinvestors can buy and sell shares at a fair price and companies can raisefunds at a cost which reflects the risk of the investments they areseeking to undertake.

A considerable body of finance theory has been built on the hypothesisthat, in an efficient market, prices fully and instantaneously reflect allavailable information. The efficient market hypothesis (EMH) istherefore concerned with information and pricing efficiency.

Three levels or forms of efficiency have been defined: these aredependent on the amount of information available to the participantsin the market

The Efficient Market Hypothesis

Weak form

The EMH in its weak form says that the current share pricereflects all the information which could be gleaned from a studyof past share prices. If this holds, then no investor canearn above-average returns by developing tradingrules based on historical price or return information.This form of the hypothesis can be related to theactivities of chartists using technical analysis. TheEMH in its weak form questions the value oftechnical analysis.


Semi-strong form

The semi-strong form of the EMH says that the current shareprice will not only reflect all historical information, but will alsoreflect all other published information. If this holds, then noinvestor can be expected to earn above-average returnsfrom trading rules based on any publicly availableinformation. This form of the hypothesis can be relatedto fundamental analysis. Fundamental analysis attemptsto identify over or undervalued companies throughstudying publicly available information. The EMH in thesemi-strong form suggests that any publicly availableinformation will already be captured in the current shareprice.


Strong form

The strong form of the EMH says that the current share priceincorporates all information, including non-publishedinformation. This would include insider informationand views held by the directors of the company. Ifthis holds, then no investor can earn above-averagereturns using any information whether publiclyavailable or not.

The Efficient Market Hypothesis The more efficient the market is, the less the opportunity to

make a speculative profit. If the market displays strong-form efficiency, it becomes impossible to consistentlyoutperform the market. Research has suggested that the UKcapital markets are efficient in the semi-strong form.Abnormal gains may be made from what is called insiderdealing, where an investor obtains internal informationabout the company and purchases or sells shares based onthat information. Insider dealing is an offence in the UK inorder to protect the stability of the capital markets.

In some countries (e.g. Japan), however, insider dealing isnot illegal and is considered to be a useful contributor to aninformationally efficient market.

Revision Questions

Discuss how achievement of financial objectivesmight be compromised by the conflicts that mayrise between the various stakeholders in anorganization

When a company seeks a listing for its shares on astock exchange, it usually recruits the assistance ofa merchant bank. Explain the role of a merchantbank in a listing operation and possible conflictsof interest that may rise in various financialservices it provides

Documents

The Finance Function