The financial management function
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Learning Objectives
• To discuss the role of finance function within the business
• To appreciate the three decision areas of the financial manager
• To identify and discuss the primary financial objective of the
company
• To understand the time value of money and the relationship
between risk and return
• To understand agency problem and role of corporate governance
in addressing it
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Figure 1.1 The tasks of the finance function
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
The financial manager
Who is the financial manager in reality?
• Finance Director
(strategic decision-making)
• Corporate Treasurer
(day-to-day cash management)
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Figure 1.2 The role of managers
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Decision-making areas
A financial manager’s tasks can be divided
into key areas:
• Financing decisions
• Dividend decisions
• Investment decisions
•Working capital management decisions
Key point: understand the interrelationship
of these three decision areas
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Two key concepts
• Relationship between risk and return
• Time value of money
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Risk and return
• Risk refers to the possibility that actual return
may be different from expected return.
• Risk can be measured by standard deviation.
• Investors require increasing compensation
(return) for taking on increasing risk.
• Return on an investment can be measured
over a standard period such as 1 year.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Risk and return (continued)
• Shareholder return is annual dividend (D1)
plus share price increase (P1 – P0).
• Relative return in percentage terms is
100 × [(P1 – P0) + D1]/P0.
• This is called total shareholder return.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Relationship between risk and return
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Future values: compounding
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Present values: discounting
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Present values: discounting
(continued)
• A rational investor will prefer £108.84 to
£100 at the current time.
• Discounting allows us to compare £120 in
2-years’ time with £100 now.
• Note that 1/1.052 = 0.907.
• 0.907 is the present value factor or discount
factor of 5% over 2 years (see tables).
• Hence £120 × 0.907 = £108.84.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Possible corporate objectives
• Shareholder wealth maximisation (SHWM)
• Maximisation of profit
• Maximisation of sales
• Survival
• Social responsibility
Which one should a company follow?
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Shareholder wealth maximisation
• Shareholders want both dividends and
capital gains.
• Capital gains reflect future dividends.
• Current and future dividends depend on
future cash flows:
– Their magnitude or size
– Their timing
– Their associated risk
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Linking NPV to SHWM
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
The agency problem
Why does it arise?
• Divergence of ownership and control
• Managers’ goals differ from shareholders’
• Asymmetry of information
What are the consequences?
• Shareholder wealth is no longer maximised
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Agency problem consequences
• Managers will follow their own objectives,
i.e. increasing their:
– power;
– job security;
– pay and rewards.
• Shareholders need to ensure that their own
wealth is maximised.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Signs of an agency problem
• Managers mainly finance company 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’.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Optimal contracts and agency
• 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
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
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.
• Doing nothing is not really an option.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
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.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
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.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
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.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Other areas of agency
Companies are made up of a series of agency
relationships:
N.B. Arrows go from ‘principal’ to ‘agent’ and show capital flows.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Other areas of agency (continued)
• Debt holders (principals) and shareholders
(agents)
• Solutions: security, restrictive covenants
• Managers (principles) and employees
(agents)
• Solutions: executive share option plans
(ESOPs), monitoring, performance-related
pay (PRP)
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
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.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Cadbury Committee (1992)
Recommended:
• A voluntary code of practice:
– Three non-executive directors at board level
– Maximum 3-year duration contracts
– Posts of Chairman and CEO should be separate
• Improved information flow to shareholders
• Increasing independence of auditors
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
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
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
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
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
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.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
Corporate Governance in the USA
• The USA’s approach to corporate
governance focuses on legislation compared
to the UK’s ‘comply or explain’ philosophy.
• Sarbanes-Oxley Act (2002): this is the key
legislation that details the statue-backed
rules that companies must comply with.
• Critics argue that it brought significant
compliance costs while supporter said it
restored much needed confidence in the US.
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
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? e.g. CalPers
– statutory legislation?
Copyright © 2019, 2016, 2013 Pearson Education, Inc. All Rights Reserved
