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Chapter 1 The Finance Function

Chapter 1 The Finance Function. Two key concepts. Relationship between risk and return Time value of money. Risk and return. Risk refers to the possibility that actual outcome may differ from expected outcome. Risk can be measured by standard deviation.

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Chapter 1 The Finance Function

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  1. Chapter 1 The Finance Function

  2. Two key concepts • Relationship between risk and return • Time value of money

  3. Risk and return • Risk refers to the possibility that actual outcome may differ from expected outcome. • 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 one year.

  4. Risk and return • Shareholder return is annual dividend (D1) plus share price increase (P1 – P0). • Relative return in percentage terms is 100 x [(P1 – P0) + D1]/P0 • This is called total shareholder return.

  5. Future values: compounding • Invest £100 now at 5% interest per year. After 1 year: £105.00 (100 x 1.05) After 2 years: £110.25 (105 x 1.05) • These are future values of £100 after 1 and 2 years. • Future values are found by compounding interest forward through time.

  6. Present values: discounting • What sum of money invested now at 5% will give £120 in 2 years’ time? • This will be £120/1.052 = £108.84. • This is the present value of £120 receivedin two years if your required rate of returnis 5%. • Dividing by 1.052 to find a present value is called discounting.

  7. Present values: discounting • A rational investor will prefer £108.84 to £100 at the current time. • Discounting allows us to compare £120 in two 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 x 0.907 = £108.84.

  8. Decision-making areas A financial manager’s tasks can be divided into 3 areas: • Financing decisions • Dividend decisions • Investment decisions Key point: appreciate the interrelationship of these 3 decision areas

  9. The financial manager Who is the financial manager in reality? • Finance Director (strategic decision making) • Corporate Treasurer (day-to-day cash management)

  10. Possible corporate objectives • Shareholder wealth maximisation (SHWM) • Maximisation of profit • Maximisation of sales • Survival • Social responsibility Which one should we follow?

  11. Shareholder wealth maximisation • Shareholders want 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.

  12. NPV A 1 Linking NPV to SHWM CORPORATE NET PRESENT VALUE NPV B NPV C 2 NPV D SHARE PRICE 1: NPV is additive 2: Link relies on market efficiency 3: Share price taken as surrogate of SHW 3 SHWM

  13. 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.

  14. Consequences of agency problem • 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.

  15. Signs of an agency problem • Managers finance company predominantly with equity finance. • Managers accept low risk, short payback investment projects. • Managers diversify operations. • Managers follow ‘pet projects’. • Management gets reward for ‘below average’ performance.

  16. 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.

  17. Option 1: do nothing Leaving managers to their own devices is problematic: • Given human nature, managers will engage in sub-optimal behaviour. • Shareholders are satisficed rather than satisfied. • No action is not really an option.

  18. 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

  19. 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.

  20. Option 3: reward good behaviour • 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.

  21. Other areas of agency Companies are made up of a series of agency relationships: Shareholders Creditors i.e.banks, suppliers, bond holders Managers The Company Employees Customers N.B. Arrows go from ‘principal’ to ‘agent’ and show capital flows

  22. Other areas of agency • Debt holders (principals) and shareholders (agents) • Solutions: security, restrictive covenants • Management (principles) and employees (agents) • Solutions: executive share option plans (ESOPs), monitoring, performance-related pay (PRP)

  23. Corporate governance ‘ Corporate governance is about promoting corporate fairness, transparency and accountability’ J. Wolfensohn, President (World Bank), Financial Times, June 21, 1999. • Can be seen as attempt to solve agency problem using externally imposed regulation. • In the UK it is administered through a series of self-regulatory codes.

  24. 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

  25. 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) A 1996 PIRC report indicated widespread abuse of above.

  26. 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: • Embodies Hampel, Cadbury and Greenbury recommendations • Compliance is an LSE listing requirement

  27. 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.

  28. 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. • Managers still receive ‘excessive’ rewards • The future: • US style shareholders coalitions? e.g. CalPers • statutory legislation?

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