APC308 financial management

1.2 Explain why, in terms of financial management, maximisation of shareholder wealth is the most appropriate corporate objective.. 1.2 Recommended reading for this section is the corpor

First published in 2007 Revised in 2012 by Dr Michael

Bromberg

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Index prepared by Indexing Specialists (UK) Ltd, Hove, UK

1.3 Agency theory: ownership and control 10

2.2 Managing accounts receivable and payable 34

3.5 Conventional budgets and ‘beyond budgeting’ techniques 60

Feedback on self-assessment questions 63

4.1 The role of the capital markets 67

4.4 Implications for managers and investors 83

7.1 Factors that influence the financing decision 1777.2 The distinction between equity and debt finance 1807.3 Raising new equity and debt finance 182

8.2 Calculating the costs of sources of finance 2128.3 The weighted average cost of capital 219

9.4 Can a company influence the cost of capital? 247

Feedback on self-assessment questions 262

10.1 Practical aspects of the dividend decision 26710.2 The traditional view: dividends are relevant 26910.3 MM’s theory: dividends are irrelevant 27410.4 Other theories of dividend policy 27910.5 Alternatives to cash dividends 282

Welcome to the Financial Management learning pack! It has been designed toassist you in studying for the core module of the BA (Hons) in Accounting andFinancial Management degree and covers all topics in the official moduledescriptor.

However good the business model, in a world where the average survival timefor small company is less than four years (http://www.msnbc.msn.com/id/16872553/), the key to long run success is to get the finance right Two financialquestions are critical for corporate success: ‘does our product generate sufficientprofit?’ and ‘are we producing sufficient returns to satisfy those who provideour finance?’ The first of these questions is the province of managementaccounting; this learning pack addresses the second

The learning pack explains where companies acquire finance: from debt, equity

or their own internal resources; it also explains the calculations necessary toassign a level of risk – and therefore a cost – to each of these sources Externalfinancing requires a market; the learning pack explains the basic operation offinancial markets Spending the money raised is also important: one unitdelineates the basics of strategic planning and budgeting, another the optimalway of choosing between different investment options

The whole pack relies on a series of basic financial models that were developedthroughout the twentieth century These models rely critically on a series ofassumptions about the financial world It is evident from recent financial crisesthat finance theory is a work in progress, not the finished product Afterstudying the learning pack you should begin to understand the differencebetween the perfect world of financial theory and the real world in which allbusinesses operate

By the end of the pack you will be in possession of all the tools necessary tounderstand how business finance operates – but the theory is only a start.Combining this theory with practical experience and your own ability willdetermine how successful you will be in your future career whether it be in theprivate, public or not-for-profit sector

How to use this pack

The learning pack will take you step by step in a series of carefully plannedunits and provides you with learning activities and self-assessment questions

to help you master the subject matter The pack should help you organise andcarry out your studies in a methodical, logical and effective way, but if youhave your own study preferences you will find it a flexible resource too.Before you begin using this learning pack, make sure you are familiar with anyadvice provided by the University of Sunderland on such things as study skills,revision techniques or support and how to handle formal assessments

If you are on a self-study course, or studying independently with remote tutorsupport, you can use the learning pack in the following way:

■ Scan the whole pack to get a feel for the nature and content of the subjectmatter

■ Plan your overall study schedule so that you allow enough time to completeall units well before your examinations – in other words, leaving plenty oftime for revision

■ For each unit, set aside enough time for reading the text, tackling all thelearning activities and self-assessment questions and for the suggestedfurther reading Your tutor will advise on how they will plan activitiesaround these materials and opportunities to network with other students.Now let’s take a look at the structure and content of the individual units

Overview of the units

The learning pack breaks the content down into ten units, which vary fromapproximately eight to ten hours’ duration each However, we are not advisingyou to study for this sort of time without a break! The units are simply aconvenient way of breaking the syllabus into manageable chunks Most peoplewould try to study one unit a week, taking several breaks within each unit Youwill quickly find out what suits you best

You will see that each unit is divided into sections It is assumed, for the mostpart, that you will study the units in the order presented What is moreimportant is that you try to study each section of each unit in the orderpresented Each unit is written on the strict assumption that you will understandthe material in each section before moving to the next

Each unit begins with a brief introduction which sets out the areas of the

syllabus being covered and explains, if necessary, how the unit fits in with thetopics that come before and after

After the introduction there is a statement of the unit learning objectives The

objectives are designed to help you understand exactly what you should be able

to do after you’ve studied the unit You might find it helpful to tick them off asyou progress through the unit You will also find them useful during revision.There is one unit learning objective for each numbered section of the unit

Following this, there are prior knowledge and resources sections These will let

you know if there are any topics you need to be familiar with before tacklingeach particular unit, or any special resources you might need, such as calculator,graph paper or specific books

Then the main part of the unit begins, with the first of the numbered main

sections At regular intervals in each unit, we have provided you with learning

activities, which are designed to get you actively involved in the learning

process You should always try to complete the activities before reading on

following the activity Do not be tempted to skip the activity.

Throughout the unit key terms are highlighted in bold with the definitionappearing in the margin

Each unit contains recommended reading which also appears in the margin andwhich refers you to relevant chapters of supporting textbooks including thecore textbook It is essential that you do this reading, since it is not possible toput everything you need to know in a single learning pack At level 3 of a degreewider reading is key to developing deeper subject learning through acontemporary, contextual and critical perspective This is important to considerwhen approaching the related assessment of the module

We provide a number of self-assessment questions at the end of each unit These

are to help you to decide for yourself whether or not you have achieved thelearning objectives set out at the beginning of the unit As with the activities,you should always tackle them The feedback or answers follow immediatelyafter at the end of the unit If you still do not understand a topic havingattempted the self-assessment question, always try to re-read the relevantpassages in the textbook readings or unit, or follow the advice on furtherreading given Your allocated tutor will be available to deal with questionsarising from the material and will assist your study through the unit

At the end of the unit is the summary Use it to remind yourself or check off

what you have just studied, or later on during revision

Finally, where possible, we have made reference to material on the internet sincethis is easy to access You may find that addresses change This is annoying; butwith a bit of effort you will be able to track the material down (nothingdisappears completely from the web) And by searching you will learn evenmore! Good luck and enjoy it

Core textbooks

The essential text is:

Corporate Finance: Principles and Practice (5th edition, 2010) by Denzil

Watson and Antony Head, published by FT Prentice Hall

This book is well structured and both readable and informative: it covers themain topics of the course with a good level of detail The mathematicalunderpinning is sufficient for the course but not so technical as to frighten eventhe student most fearful of numbers and equations The book contains lots ofcase studies and extra information supporting the text contained in these unitsand – if studied carefully – will certainly lead to success in the module.The book is strong in most areas covered by the module and provides lots ofextra references that can be consulted by the student who wants to go furtherthan the base material It does not contain a chapter on budgeting so extrareferences are suggested in the text for students looking for support in this area

In some instances we have been unable to trace the owners of what might becopyright material and we would appreciate any information that would enable

us to do so

‘The business schools reward difficult complex behaviour more than simple behaviour, but simple behaviour is more

effective.’

Warren Buffett, US investment guru

IntroductionWelcome to the first unit of the third-level module, entitled ‘Financial management’ The module explores, within the context of the limited company, three key areas of finance:

■ investment

■ the sources of funds to enable investment

■ the rewards to the providers of those funds.

First we need to examine the nature of finance: finance is not ‘accountancy’.

A set of accounts will give you some information but not the information needed to enable decision making in the three key areas of strategic financial management For the only time in this module, therefore, we want you to read a statement of financial position (hereafter position statement) to discover what it doesn’t tell you, rather than what it does! Unit learning objectives

On completing this unit, you should be able to:

1.1 Identify the main areas of financial management.

1.2 Explain why, in terms of financial management, maximisation of shareholder wealth is the most appropriate corporate objective 1.3 Explain agency theory.

1.4 Suggest ways of addressing the agency problem.

The main areas of financial management

Read through the simplified position statement in Figure 1.1, then answerthe questions that follow

Bright Ltd statement of financial position

At 30 June 2012 (All figures in thousands)

Assets

value Non-current assets

Figure 1.1:A simplified position statement

1 What has this company invested in?

2 What are the sources of the funds for those investments?

3 How does the company reward the providers of those funds?

1 Although you were given only a simplified position statement, youshould have been able to see, without any formal analysis, that thecompany has invested in land, buildings, computers, equipment andmotor vehicles It has no subsidiaries, investments in other companies orintangible assets such as patent rights It also has net current assets of

The first two sources are equity funding; the last is debt funding

3 The shareholders are paid dividends – ordinary shareholders will be paid

an amount determined by the company out of residual profits On theother hand, the ordinary shareholders may not be paid a dividend at all

if it is decided that the funds would be better retained in the companyfor future investment Debenture holders are paid interest, which is

charged to the company’s statement of comprehensive income

(hereafter income statement)

You can obtain a lot of information about what the company has done bylooking at the position statement However, you cannot deduce from thisinformation:

■ Why the company decided to invest in those particular fixed assets

■ Why it obtained funding from the debenture holder

■ How much dividend it has decided to pay to shareholders (the amountshown in the position statement is the amount owed, not the amount to bepaid) and on what that decision was based

■ When the dividends are to be paid

The position statement is based on the historical cost of assets It does not valueassets, as an investor might, on the basis of what the company might use theassets for

The following points cover the three main areas of decision making for thecorporate financial manager:

■ Investment: The choice of projects or assets in which to invest company

funds Competing alternatives have to be assessed using a number oftechniques This type of decision will also be of concern to the privateindividual when making choices about which shares to buy

■ Finance: How these investments should be financed It is necessary to

evaluate the possible sources, external and internal, and the effect they will

have on the capital structure of the company.

■ Dividend: Whether corporate earnings should be retained or paid out in the

form of dividends and, if the latter, when the dividends should be paid

These areas are not independent of each other For example, the decision toinvest in a particular project may require a further decision about finance to beraised.

1 How might any investment also affect the dividend payment decision?

2 If the financial manager decides to pay a higher dividend to ordinaryshareholders, how might this affect the investment and financedecisions?

1 The decision to invest in a particular project might mean a lowerdividend if the finance had to be raised internally

2 If it was decided to pay a higher dividend than usual, this could meanthat there were insufficient retained funds for investment If aninvestment was subsequently thought to be necessary, finance wouldhave to be raised externally

Financial management also involves the management of risk Risk attaches toindividual investments, the economy in general, to borrowing and to trading orinvestment abroad

Give an example of a risk that a company might incur from:

(a) Investment in a particular firm

(b) The economy generally

(c) Foreign exchange rates

(d) Borrowing funds to finance its activities

Some examples are:

(a) The firm may perform badly, causing the investment’s value to fall

(b) There may be a sharp rise in rates of inflation or interest, or a generaleconomic recession

(c) If a foreign country has high rates of inflation, the value of its currencymay fluctuate

(d) The company may not be able to meet the interest payments on theborrowed funds

You may have thought of other examples

In this learning pack, we will cover the topic of risk management as well as themanagement of a company’s current assets and liabilities in its working capitalcycle Assets must be managed effectively so they generate income and profits

and so funds are available to pay accounts payable and take up opportunitiesfor investment.

In summary, we can say that financial management involves the followingareas, which this module will cover:

You may have noticed above that we referred to the ‘company’ and ‘corporate’

In this module we deal with strategic financial management in the context,principally, of the publicly quoted limited company, though the principlesinvolved apply equally to all kinds of firm We begin with the question: ‘Why

do companies exist?’ This question is not concerned with why the companyexists as a limited company, but why it exists at all, or in whose interest(s) itexists

Why are companies created? Try to think of at least three possible objectivesthat a company could have for being in existence

This might seem to be a strange question and your first reaction wasprobably something like, ‘It’s obvious!’ or ‘To carry on business’ You mighthave come up with some of the following objectives:

■ To make profits from trading

■ To survive in a competitive environment

■ To provide work for people

■ To sell its goods and services

■ To grow, perhaps so that it can fulfil the previous objectives

Earlier, we asked the question: ‘In whose interests does the company exist?’.This can be rephrased as: ‘Who are the interested parties, or stakeholders?’.The objectives that we suggested as answers to learning activity 1d implystakeholders in the ways shown in Table 1.1

1.2

Recommended reading for this

section is the corporate objectives

section of the chapter ‘The

finance function’ in Watson and

To make profits Shareholders, managers and creditors, including lenders

To survive in a competitive environment Employees, shareholders and managers

To provide work for people Employees and society generally

To sell goods and services Customers

There is a political element to this question The capitalist viewpoint would bemore concerned to emphasise profit making in a competitive marketplace Asocialist view would emphasise the provision of work, the reduction ofunemployment figures and the provision of goods and services to society Theenvironmentalist would emphasise that the existence of the company shouldnot be at the expense of depleting the world’s natural resources The politicalphilosophy behind the question is not within the scope of this module.However, the question of in whose interests a company is run is central to thedecision making involved in financial management, since any of the suggestedstakeholders will want sensible decisions taken, if only for the company’ssurvival.

1 Alongside the list of stakeholders shown in the table, write down what it

is that they provide to the company and what reward they receive Thefirst one has been completed for you as an example

2 Which, if any, of the stakeholders run a risk of not being rewarded,assuming that the company is trading?

1

2 As long as the company trades successfully, the employees will receivesalaries, suppliers will be paid, customers will buy goods and the bankswill receive interest on their debt The regularity of the various paymentsmay vary but they will be made The shareholders differ from the otherstakeholders in that there is no guarantee that they will receive their

L ea

rn ing act i

vi t

1e

SuppliersCustomersBanksShareholders

1e

F eedback

Suppliers Raw materials, goods and Payment

servicesCustomers Payment for goods and Goods and services

servicesBanks Account services, loans Charges and interestShareholders Share capital Dividends and enhanced

value of shares

reward in the form of dividend payments, though if the company issuccessful, the value of its shares should rise, enabling the shareholders

to create personal dividends by selling a few of their shares Payment of

a dividend to ordinary shareholders is at the discretion of the companyand the value of its shares will only rise if it is trading successfully

Therefore, it can be argued that the shareholders are taking a greaterrisk than other stakeholders, in that their investment in the companymay reap no reward at all If there is no reward, the shareholders will selltheir shares, invest elsewhere and the value of the company’s shares,and thus of the company as a whole, will fall, making it difficult for it toattract new investment In time it will fail

This seems to suggest that rewarding the shareholder is a vital objective for thecompany Consider some of the alternative objectives that have been suggested:

■ Survival could only be a serious objective in the short term if something

threatened the company In the long term it appears a rather inadequate, ifnot static, objective Shareholders will want to invest in a company wherethere are gains to be made, not where things are just ticking over

■ Expansion of an empire may not be an overt objective but, if managers’

salaries are linked to growth, this could be an implicit objective We willreturn to this point when we come to ownership and control

■ Selling goods and services is, of course, the function of the company, and a

company with a market orientation may have as a strategic objective toincrease its market share This may well aid its profit-making capabilitiesbut care must be taken not to over trade, that is increase sales withoutregard to the availability of working capital, which can lead to failure andliquidation Maximisation of sales can, like survival, be a valid short-termobjective

■ Providing work for those who would emphasise social responsibility will be

the principal objective of a company

1 What other aspects of company activity might be termed sociallyresponsible?

2 Do you think the prime objective of the company is to be sociallyresponsible? Give your reasons

1 You might include under this heading good working conditions andpractices, fair and equal salaries and opportunities, not polluting theenvironment and creating products that do not offend society

2 Your answer here is dependent upon your personal views You may haveconsidered that, if a company is to make profits and pay its shareholdersdividends at the expense of the workforce or of society, it may quicklylose its workers and offend society and it will not survive The provision

of work and the other aspects of social responsibility are certainlyimportant

If the company is viewed as existing in the interests of all the stakeholdersreferred to earlier, its primary objective could be seen as keeping all of them

satisfied (satisficing) This module is written with the view that this objective

is not the company’s prime objective but is supportive of it There is one morepossible objective to address and that is making profits

The making or maximising of profits may appear attractive as the prime reasonfor the company’s existence After all, if profits are not made, the companycannot survive for long Maximisation of profits was the prime objective forfree-market economists, such as Friedman (1970)

Consider this extract from Friedman (1970) Does it convince you thatmaximisation of profit is the prime corporate objective? What do you think Friedman means by ‘as long as it stays within the rules of thegame…’?

‘…there is one and only one social responsibility of business – to use itsresources and to engage in activities designed to increase its profits as long

as it stays within the rules of the game.’

You may find that the profit maximisation objective is a powerful concept,especially as Friedman refers to the social responsibility of the business in itsuse of resources Arnold (2005) refers to the belief of pro-capitalist

economists like Friedman that making the interest of shareholders thecompany’s prime objective benefits both the company and society This isnot, as Arnold points out, as extreme as it sounds because pursuit of thisobjective to the point of pollution, criminal activity and exploitation wouldnot benefit society This is what Friedman means by the ‘rules of the game’

However, there are problems with the objective of profit maximisationdescribed by Friedman

1 Think about what profit is and write down a definition (Don’t spend toolong on this!)

2 Profits can be increased relatively easily by cutting costs but why is this apotential problem in the long term?

1 You probably found this difficult and that is why we asked you not tospend too long on it ‘Profit’ is not easy to define or measure In anincome statement you can encounter gross and operating profit, profitafter interest, profit after interest and tax, and retained profit Profits arenot the same as cash; profit may be available to pay a dividend but theremust also be sufficient cash as well Profitability may be an objective,and an indicator of the success or otherwise of the company, but it doesnot guarantee that the primary risk takers, the ordinary shareholders,receive their reward.

2 In the short term the company could cut costs, such as labour costs,maintenance costs or perhaps research and development costs In thelonger term this might put the company at risk by affecting itsperformance and ability to be competitive The economist Hayek’s(1960) comment that ‘…the only specific purpose which corporationsought to serve is to secure the highest long-term return on theircapital…’ illustrates this difficulty: that profits may vary in the short termand give a distorted view of a company’s potential for growth in thelong term

Variability of profits, in either the short or long term, also indicates a level ofrisk in the company that investors may not find attractive Not only will thecapital markets put a higher value on a company with greater long-termpotential but also shareholders are more likely to prefer to invest in a companywith steady growth and stability It presents a less risky alternative

Maximisation of shareholder wealth

Maximisation of profit may be achievable in the short term but, because of theproblems this might cause and because it still does not necessarily reward thosewho take the risks, the primary objective of the company is generally regarded

as the maximisation of shareholder wealth

The distinction between maximisation of profit and maximisation ofshareholder wealth is developed below If financial management decisions areall made with a single objective in mind the process will not be confused bypotentially conflicting objectives, such as increasing production and sales vianew technology, while maintaining the social responsibility to provide work.The next question is: ‘What is shareholder wealth?’ It needs to be definedbefore we can discuss its maximisation

It is clear that profit maximisation is not the prime objective of the company.Equally, profits are not the yardstick by which shareholder wealth is

measured Suggest a reason for this

1h

F eedback

Recommended reading for this

section is the maximisation of

shareholder wealth section of the

chapter ‘The finance function’ in

Watson and Head (2010).

We said above that profits do not equal cash and, while they may indicatecompany success, they do not indicate that cash is available to paydividends It is perfectly possible for a company to make profits over anumber of years yet be unable to pay any dividends because it has noavailable cash.

Profits also indicate only past success, since the accounts that show them arehistorical Past profits are no guide to what may happen in the future Thisimplies that dividend payments, and gains made when selling a shareholding,are better indicators of shareholder wealth than profits

However, if dividend payments are not consistent over a period of time,confidence in the company’s shares will not increase and their market price willreflect the variability of dividend payments When shareholders sell theirinvestment, they may lose money The prime objective of the company therefore

needs to be adjusted slightly to the maximisation of long-term shareholder

wealth, which will be indicated by a combination of the maximisation ofdividends over time and the increased market value of ordinary shares

If the share price reflects shareholder wealth, we can say that any financialdecision taken to increase the value of shares will be a decision that maximisesshareholder wealth and will be in keeping with the prime objective of thecompany

As you will see in the module, such decisions can involve:

■ Using appraisal techniques to assess investment projects

■ Sourcing funding to provide for the company the most appropriate capitalstructure that can be serviced from available funds

■ Paying dividends that the company can afford, while leaving sufficientretained earnings for investment

■ Managing the risks associated with these decisions

You may be left with the impression that the managers of a company will carryout its day-to-day functions efficiently and effectively on behalf of the owners,always asking themselves, ‘Does the result of this decision maximiseshareholder wealth?’ This is not a realistic view because of the tension betweenownership (the shareholders) and control (the management) of companies It

forms the next area of concern and leads us to agency theory and the agency

problem

Agency theory: ownership and control

The famous legal case of Salamon v Salamon & Co in 1897 established that a

limited company has to be incorporated under the law and has a separate legalexistence from its owners; shareholders are the owners of the business but arelegally separate from it Their ‘ownership’ has different implications from that

of the partner or sole trader Prior to the Salamon case, a firm was regarded as

an extension of the owner, whose rights dominated those of employees,creditors and others The Salamon case established that the limited company isnot an extension of its owners

1i

F eedback

1.3agency theory

Recommended reading for this

section is the agency theory

section of the chapter ‘The

finance function’ in Watson and

Head (2010).

In the traditional view of a limited company, four groups can be identified:directors, managers, employees and owners.

1 How would you rank these groups in terms of their distance from to-day company activity?

day-2 What relationship does that ranking bear to the level of risk they take incontributing to the company?

3 With which group do you think control of a large company really lies?

1 The owners are furthest removed from the company’s activities In mostcases, shareholders will not be fully aware of the range of the company’sactivities Directors, in the form of a board, act on behalf of the

shareholders and are legally responsible for managing the company; sotheir involvement is a little closer Closer still are the managers, who act

on behalf of the directors and make decisions concerning theimplementation of the board’s policy, including the financialmanagement we are concerned with in this module The employees areclosest to the day-to-day activity of the company, following the

instructions of management This hierarchy can be less clear than theexplanation suggests: compressed in a small company, where theowners may also be the directors and managers and have more than just

an ownership interest; extended in a more traditional company, withmany shareholders, some of whom are likely to be large financialinstitutions such as pension funds Here, control is in the hands of aboard of directors and the distance between ownership and control may

be great

2 In theory, the level of risk is in inverse proportion to this ranking, in thesense that employees put none of their own funds into the company,receiving wages from it in return for their labour, while shareholdersbear all the risk by putting in capital and only having rights to residualprofits However, employees risk losing their jobs if the company failsand shareholders can always sell their shares and thus rid themselves ofthe risk

3 The control in large companies lies with the board of directors, whoformulate the company’s policies that management and employeesexecute

The hierarchy of owner/director/manager/employee thus becomes problematic.Managers in a large company may be concerned to maximise their own wealth,not that of the shareholders, from whom they are distanced Their objectivesmay well be growth, maximisation of market share, or provision ofemployment for themselves

Shareholder power in a large company is limited to voting rights at theannual general meeting (AGM) If you were a shareholder in a largecompany, what could you do if you felt that the board was not acting inyour interests?

It seems from what has been said that the only recourse to shareholders is

to vote onto the board only those directors who will carry out the objective

of maximising shareholder wealth and remove those who will not This isdifficult in a large, fragmented company; shareholders have only as manyvotes as they have shares and it would need the cooperation of a largenumber of small shareholders to carry such motions at the AGM

Another alternative is to sell the shares and invest in a company where you feelthat the objective of shareholder wealth maximisation is paramount Themajority of quoted shares in the UK are owned by institutions not by privateindividuals and, if they sell their large holdings, the result will be to lower theshare price

An alternative, often-adopted solution is to link management and shareholderrewards by granting managers and directors options to purchase shares in thecompany at a discount In this way, if managers operate a policy of maximisingshareholder wealth the price of shares will rise and they will be able to take upthe option to buy, then sell at a profit, and thus maximise their own potentialwealth However, there are problems with this solution, as we shall see later

Apply the definition of an agent to the relationships between directors,managers, employees and owners

(a) Who is/are the principal(s)?

(b) Who is/are the agent(s)?

(c) Who is/are the third party (ies)?

In the traditional structure:

(a) The owners or shareholders are the principals

(b) The directors and senior managers are their agents

(c) The third parties are those with whom the company deals: customers,suppliers, lenders and others, though sometimes a principal–agentrelationship may also exist between directors/managers and lenders.

Modern UK company law tends to impose upon the directors of a company the

position of principal when they make contracts with the outside world; the

company’s managers are their agents, carrying out their duties under a contract

of employment with the company

Agency theory has been developed and applied to companies using thefollowing assumptions:

■ The parties in the agency relationship are rational, that is consistent in their

actions, and will wish to maximise their personal utility This phrase refers

to the value placed by someone on an economic good received, or thesatisfaction that they receive from a level of economic well-being

■ The parties form a contract when the utility achieved by the principal inproviding services, decisions or information is equal to the utility of theagent in receiving salary and benefits

■ The company is the link between these contracts, and its activities must beunderstood in terms of the contract details

Jensen and Meckling (1976) developed a view of the company as a series ofagency relationships Who would you suggest was in an agency relationshipwith the management of the company, apart from shareholders?

Management are the agents of the shareholders but they could also beregarded as being in an agency relationship with other employees, wherethey are the principals and the employees act as their agents

This theory leads to an important problem: what happens when the directors have a different view or different agenda from that of the

agent-principal-owners?

If the goals of the two parties are different, or they have a different view ofthe risks involved in a course of action, then the contract whereby they aretrying to equate personal utility will not be the optimum one In otherwords, if the goals of the shareholders and the managers are different,maximisation of shareholder wealth may not be achieved

Addressing the agency problem

It has already been suggested that one of the problems of the separation ofownership and control might be that managers do not always act tomaximise shareholder wealth

1 Give an example of how this might occur in the context of investmentrisk

2 How might the agency problem manifest itself in the relationshipbetween shareholders and debt providers?

1 We will be looking at the concept of risk in more detail later in themodule but it is clear that any investment decision will carry a level ofrisk Managers and shareholders may have different attitudes to risk; thelatter might prefer that the company invested in projects with a differentlevel of risk than that preferred by management If managers arerewarded on the basis of returns from projects, they may be tempted toinvest in those projects that are more risky but show a quick return

2 Again there will be a problem if there is a different attitude to risk Debtproviders are unlikely to want the company to invest in anything that issuch a risk that it damages their chances of repayment Their return inthe form of interest payment is fixed, whereas that of the shareholders istheoretically unlimited and their downside risk is limited to the price theypaid for their shares, so they may prefer to take more risk Debt

providers can protect their interests by holding security for the debt

The agency problem exists when managers or directors do not act in the bestinterests of the shareholders to maximise the latter’s wealth Management goalscould include increasing their own power base, creating job security forthemselves, or increasing their rewards It was suggested in an earlier activitythat two ways to ensure that management act in shareholders’ interests are tovote unacceptable directors off the board, or to offer share options Jensen andMeckling also suggested that shareholders could monitor the actions ofmanagers using independently audited accounts, backed up by additionalreporting requirements, and external analysts These activities involve extra

costs known as monitoring and bonding costs

What do you think might be the problems associated with:

(a) Offering share options and other incentives?

(b) Monitoring management actions over and above that required bycompany law?

Recommended reading for this

section is the corporate

governance section of the chapter

‘The finance function’ in Watson

and Head (2010).

(a) The two most common methods of ensuring appropriate managementactions are the share option schemes referred to earlier and

performance-related pay These are not ideal, since the value of shareswill be affected by factors over and above the actions of the company’smanagement Performance-related pay carries the added burden ofworking out how to measure performance accurately After all, it is themanagers themselves who design such measurement and they have theability to change accounting profits by changing accounting policies –such as depreciation rates and stock valuation methods – in order tomake the performance of the company appear more attractive

(b) The costs of such actions would have to be borne by the shareholdersand might outweigh the benefits It may be that not all shareholdersagreed to contribute to the costs, so some would benefit withoutbearing costs

Corporate governance

The agency problem was highlighted in the early years of this century whenseveral large corporations were found to have deceived their investors as totheir true financial position The list of companies included energy giant Enron,and others such as Worldcom, Tyco in the USA and Parmalat in Europe.This has led to an increase in voluntary codes designed to produce a greaterdegree of responsibility from the executive directors One of these is produced

by the institutional fund manager Hermes (http://www.hermes.co.uk)

Hermes’ 12 principles are reproduced in Figure 1.2; a fuller explanation of theprinciples is available on the company’s website

Transparency and communication

Principle 1

Companies should disclose adequate, accurate and timely informationconcerning their business and key personnel, so as to allow investors tomake informed decisions about the acquisition, ownership obligations

communicate on their objectives, strategy, competitive position andoperational and risk management They should be willing to have anopen, ongoing and high-level dialogue with shareholders on these issues.

Corporate culture

Principle 2

Companies should establish and maintain a strong internal culture whichfocuses its staff on sustainable value creation Such a culture will ensurethat employees act cohesively to promote the long-term success of thebusiness Boards should establish, maintain and oversee an appropriatecorporate culture and ensure that related objectives are reflected inarrangements such as job responsibilities, performance measurementand assessments and remuneration

Principle 3

Companies should have, and continue to develop, a coherent corporatestrategy and strategies for each of their business units These shouldideally be expressed in terms of their target markets and of thecompetitive advantage the business has in exploiting opportunities inthem in order to generate sustainable returns in excess of the cost ofcapital The company should understand the factors which drive therelevant market, and the particular strengths which underpin itscompetitive position Companies should also be able to explain why theyare the ‘best parent’ of each of the businesses they run

Principle 4

Companies as a priority should seek to maximise the sustainableoperating performance from their existing core business or businesses.Growth opportunities should be pursued in a measured way and be built

on the core capabilities of the companies They should not unduly divertresources from the existing core business Ideally, any acquisition should

be fully and properly integrated before further businesses are acquired

Principle 5

Companies should ensure that all investment plans have been criticallytested in terms of their ability to create long-term shareholder value If acompany is considering diversifying from or rapidly expanding its corebusiness, especially if by acquisition, it should apply significantly higherhurdles within such tests to reflect the greater risks inherent in such astrategy

Financial disciplines and structure and risk management

Principle 6

Companies should have appropriate measures and systems in place toensure that they know which activities and competencies contributemost to maximising long-term shareholder value It is equally importantthat companies analyse and measure risks and have robust systems andprocedures in place to do so in order effectively to manage the risksassociated with its activities Boards should have robust practices in place

to oversee risk management

Principle 7

Companies should have an efficient capital structure which will minimisethe long-term cost of capital Where the capital structure is inefficienttaking the particular circumstances of the company concerned intoaccount, the balance of debt and equity should be reconsidered

Stakeholders, environmental and social issues

Principle 8

Companies should manage effectively relationships with their employees,suppliers and customers and others who have a legitimate interest intheir activities with a view to maximising long-term shareholder value

Principle 9

Companies should manage effectively environmental and social factorsthat affect their business and society at large with a view to enhancingtheir long-term sustainability They should demonstrate how they identifyand explore related business opportunities and explain the structures andprocedures in place to manage related risks Where appropriate,

companies should support voluntary and statutory measures whichminimise the externalisation of costs to the detriment of society at large

Principle 10

Companies should allow shareholders to participate in an appropriateform in decisions concerning fundamental corporate changes, such asmajor acquisitions and disposals, and adopt governance structures andprocedures that give shareholders the powers effectively to hold theirboards and – at least indirectly – senior management to account

Principle 11

Companies should be guided by boards that are made up of memberswith an appropriate and diverse range of competencies, knowledge andexperience to enable them effectively to carry out their duties andresponsibilities These include selecting, guiding, monitoring, challengingand where necessary, replacing management and thus require an ability

to step back and act objectively and independently in the long-terminterests of the company and its shareholders The leadership structure ofboards should reflect these objectives Ideally, boards should be led by anindependent non-executive chair Where a different approach is

preferred, this should be explained and justified Boards should establishand maintain an appropriate corporate culture and assume responsibilityfor remuneration policies and oversee the risk management function

Principle 12

Companies should design and implement remuneration policies thatadequately incentivise their senior executives and align the interests ofmanagement with the interests of shareholders in the maximisation oflong-term value Companies should seek shareholder approval of theirremuneration policies and of any significant changes to those policies

Figure 1.2:The Hermes principles

Case Study

There have also been statutory attempts, notably in the USA, to improve the level

of corporate governance through the Sarbanes–Oxley Act placing more stringentcompliance requirements on companies operating on stock markets in the USA

If you have access to the internet you may wish to do a quick search on ‘Enron’.You will find plenty of material giving an insight into the key problems thecompany faced

Corporate objectives

Throughout this unit we have emphasised that increasing shareholderwealth is the major aim for firms in a competitive economy But how welldoes this accord with what firms say they do in practice? Below are somekey aims and objectives for three of the UK’s largest companies Clearly,they do not explicitly state the aim of creating value for shareholders,though this may well be the result of adhering to the specified aims Nexttime you switch on your computer to log in to Facebook or Twitter, spend

a few minutes looking at the websites of some firms you know How many

of them explicitly identify creating shareholder wealth as a goal?

Tesco website (www.tescoplc.com)

■ Offer the best solutions for our customers and clients

■ Operate profitably throughout the crisis, offering security for customers

as well as stability to the financial system as a whole

Case Study continued Executing our strategy

Our execution priorities are capital, returns, income growth and citizenship

Barclays website (http://group.barclays.com)

Self-assessment questions

1.1 The financial manager of a limited company decides to use a moreexpensive source of finance than usual How will this affect subsequentinvestment and dividend decisions, and the management of the workingcapital cycle?

1.2 Which of these is the most accurate definition of ‘satisficing’?

(a) Maximising the return to stakeholders

(b) Providing a satisfactory return to stakeholders

(c) Providing a satisfactory return to employees

(d) Maximising the return to employees

1.3 A company with an ordinary share capital of one million shares of £1each makes an annual profit of £200,000 The profits can be increased to

£220,000 from a new project by raising a further £200,000 worth ofordinary share capital If this project is accepted, which one of thefollowing statements is clearly correct?

(a) Sales are maximised

(b) Shareholder wealth is maximised

(c) The return on ordinary shares is maximised

(d) Profits are maximised

1.4 Explain briefly why neither of the following objectives maximises term shareholder wealth:

long-(a) Maximisation of profits

(b) Maximisation of sales

1.5 Which of the following best describes the agency problem?

(a) Employees may not act in the best interests of the management.(b) Shareholders may prefer to invest in more risky projects than would

be acceptable to the management

(c) The management may not act in the best interests of the share holders

-(d) Lenders may prefer the company to invest in less risky projects.1.6 What are the advantages and disadvantages of the following measuresused to reduce the agency problem:

(a) Share option schemes for managers

(b) Use of the shareholders’ voting powers

(c) Performance-related pay for managers

Feedback on self-assessment questions

1.1 If the finance is more expensive, there will be less cash available to thecompany for investment in fixed assets or projects and for the payment

of dividends to ordinary shareholders In managing the working capitalcycle, greater attention will need to be paid to the availability of cash topay the increased interest rates

1.2 Satisficing here refers to the social responsibility of a company and thecorrect definition is ‘providing a satisfactory return to stakeholders’.1.3 Acceptance of the project tells us nothing about the effect on the sales ofthe company so we cannot say that (a) is correct There is no indicationfrom the question of the market value of the shares, either before or afterthe project, so we cannot pass an opinion on (b) either The return onordinary shares before the project is 200,000/1,000,000 = 0.2 or 20%.After the project, it is 220,000/1,200,000 = 0.183 or 18.3% so (c) isincorrect The project will increase profits by £20,000, so the correctresponse is therefore: (d) profits are maximised

(a) Maximisation of profits does not maximise long-term shareholderwealth because that wealth is based on the market value of sharesand capital gains made by the company ‘Profit’ is a short-term,single-period measure Profit figures, being dependent on accountingpolicies, can be manipulated by management and profits are historicalfigures with no indication of future performance Dividends toshareholders are paid from available cash of the company and profits

do not indicate that cash is available to pay dividends, althoughdividends can be paid only out of profits Profitability does notguarantee that the primary risk takers, the shareholders, receive theirreward

(b) Maximisation of sales may mean that the company will increase itsmarket share and this is an acceptable initial goal for the companybut, if carried to extremes, can lead to overtrading and insolvency.Like profits, sales give no indication of the cash flows of the

Share option schemes

company and are an historical measure They may be maximised

by incorrect pricing or over-generous credit terms to customers This

is not an objective that will maximise shareholder wealth

1.5 The agency problem arises because of the tension between ownership byshareholders and control by directors and managers of a limited company.Response (a) therefore does not describe the problem since it is concernedwith employees (b) and (d) may well be true, and (b) is an example ofhow the problem manifests itself, but the best description is: (c) Themanagement may not act in the best interest of the shareholders.1.6

Summary

The key points in this unit are as follows:

■ The main areas of corporate financial management are the decisionsconcerning investment, funding, dividend payment, risk management andworking capital management

■ The most appropriate corporate objective in financial management terms isthe maximisation of long-term shareholder wealth This means maximisingthe market value of the ordinary shares

■ Agency theory is based on the separation of ownership and control thatdistinguishes the limited-liability company from the other two mostcommon business entities of sole trader and partnership

■ The agency problem is that managers may not always act in the best interest

Share option schemes

in their being able to sell shares at

a higher price

Shareholders can voteunacceptable directors off theboard

They can also vote for increasedmonitoring measures

This encourages concern forcompany performance and oughttherefore to ensure that managerswill act in shareholders’ bestinterests

The price of shares is influenced bysome factors outside the control ofmanagement, so the benefits mayaccrue despite managementactions Managers may also changeaccounting policies to improve theperformance of the company andinfluence the share price

deliberately for short-term gain

These decisions may be difficult toachieve in a large company withmany shareholders

Increased monitoring will be costlyand not all shareholders may wish

to contribute

It might be difficult to measureperformance accurately Themeasures would in any event bedesigned by management, andwould therefore not be impartial

‘The highest use of capital is not to make more money, but to make money

do more for the betterment of life.’

Henry Ford

Introduction

In the previous unit we saw that the basic function of a firm in the private sector is to maximise its shareholders’ wealth Achieving this in the longer term is the focus of much of this learning pack However, a firm will not survive for very long if it runs out of cash with which to pay its workers and for its supplies; put simply, cash is the lifeblood of a company This unit is concerned with the way organisations control their cash resources, which of necessity involves discussion of the control of the current assets and liabilities that constitute their working capital Unit learning objectives

On completing this unit, you should be able to:

2.1 Compute the following working capital ratios and assess the significance of the calculation:

■ Current and acid ratios for a company.

■ Number of days accounts receivable a company has outstanding.

■ Number of days accounts payable a company has outstanding.

■ Number of days of inventory (raw materials, work in progress, finished goods) a company has outstanding.

■ Length of a company’s working capital cycle.

2.2 Evaluate the benefits to a company of offering credit to its customers and taking credit from its suppliers and be able to critically evaluate different credit policies

2.3 Use the Altman model for predicting corporate failure.

management

1 2

Unit

Working capital ratios

What benefits do you think a business would gain by managing the level ofits investment in working capital?

You might have come up with several different answers but they should all

revolve around the idea of balancing profitability with liquidity By

minimising the cost of its investment in current assets, the firm has moremoney available to use for its normal, profit-generating activities However,

it needs sufficient cash for its immediate needs; bills have to be paid

Treasury management is beyond the scope of this module but investingfinancial resources so as to maximise interest income is another way thatfirms seek to increase their overall profits and thus returns for shareholders

When would you expect each of the following to generate cash?

(a) Sale of a chocolate bar

(b) Sale of materials to a manufacturing firm

(c) Construction of a mile of motorway

(a) This would almost certainly be a sale for cash; money would go into theretailer’s till immediately

(b) Most firms issue invoices on a monthly basis, and invoices are typicallypaid a month or more later The selling firm would not have the cashavailable to spend until a couple of months after the actual date of sale.(c) Although there may be an up-front payment, the bulk of the cash maynot be received for a considerable time Usually on major contracts

‘stage’ payments are made as various agreed milestones are reached

For most organisations, selling their goods and services does not immediatelygenerate cash A small shop turns goods into cash very quickly Most manu -facturing organisations send out invoices for their wares and receive payment,usually within a relatively short period Civil engineers and others working onlarge projects may receive payments at various stages of their work Often thelast payment is in the form of a retainer paid a year or more after the project’scompletion The retainer ensures that any repairs becoming necessary after theproject’s completion are paid for by the contractor Some service organisationsmay not receive payment until after they have delivered the service; for example,

2.1

Recommended reading for this

section is the objectives section of

the chapter ‘Short-term finance

and the management of working

capital’ in Watson and Head

The sales figure from the income statement records sales when a product orservice has been successfully delivered, or part delivered, to a customer Thesales turn into cash only when the customer pays for those goods or services.Similarly, the firm has a liability to pay for the goods and services it buys when

it gets them, even though it often does not pay for them until some time later.Some items on the income statement have no cash effect at all Depreciation is

a charge against profit but the cash effect of depreciation comes about when afixed asset is purchased Buying a large piece of equipment may result in a verysignificant outflow of cash but there is no immediate effect on profit

The result is a vital one for anyone in business to understand – profits can bemade without a comparable effect on cash flow Probably the single biggestcause of bankruptcy results from businesses that increase their profits quicklybut have no similar immediate increase in cash The business expands to meetincreased sales but has no cash available to purchase necessary supplies and sodies for want of capital Of course, it is usually possible for profitable firms toborrow short-term funds from a bank but this may not be possible underdifficult trading conditions

Apart from cash itself, the most important current assets and liabilities areinventories, accounts receivable and payable

(a) How difficult is it to turn each of these into cash?

(b) Which should be maximised and which minimised for best control of thebusiness?

(a) Inventories are most difficult of all to turn into cash You should knowfrom your accounting studies that inventories are normally valued at thelower of cost or net realisable value Inventories would normally beexpected to sell for more than their cost value but, if trading conditionsbecame difficult, a forced sale might reduce the price that could beasked for them In a highly technological age, what value has the stock

of iPad version 157 when the new iPad version 158 has already beenreleased? Worse, rising inventory values might indicate a companyalready finding difficulty in making sales Minimising inventory is best forcontrol of funds, though of course a minimum stock level is essential tokeep customers satisfied

(b) Both accounts payable and accounts receivable will normally turn intoactual cash relatively quickly Companies will try to collect cash as quickly

as possible from their customers whilst delaying payment of their owndebts We shall return to this issue shortly

How liquid are:

(a) Non-current assets?

(b) Investments in quoted companies?

(c) Investments in unquoted companies?

(a) Non-current assets are highly illiquid Selling a building may take months

or years Some non-current assets, for example cars or computers, mayhave little or no resale value

(b) Investments in quoted companies are relatively liquid The shares can besold through a broker on the stock market and the funds will arrivewithin a month at the most

(c) Investments in unquoted companies may almost be not liquid at all if asuitable buyer cannot be found Recall that such investments cannot beoffered to the public

Current and acid ratios

The degree of liquidity of a company’s current assets is captured by twoimportant accounting ratios The first of these, the current ratio, is simply theratio between current assets and liabilities Figure 2.1 is an extract from Sunco’sposition statement and shows its assets at 31 December 2011

Figure 2.1:Sunco’s position statement

Calculate Sunco’s current ratio

The current ratio is just the ratio between current assets and currentliabilities:

Recommended reading for this

section is the objectives section of

the chapter ‘Short-term finance

and the management of working

capital’ and the assessing financial

performance section of the

chapter ‘Capital markets, market

efficiency and ratio analysis’ in

Watson and Head (2010).

The current ratio tells us that the value of Sunco’s current assets is twice that

of its current liabilities – it should not have any problem in paying its accountspayable as they become due A current ratio of two to one is often quoted as atarget but this target originates from the USA in the early years of the twentiethcentury and the ratio should not necessarily be seen as ideal for other countriesand other time periods

There is a problem with the current ratio because of the difficulties in raisingfunds from sale of stock we discussed earlier To combat these, a second ratio,variously known as the quick, acid, or acid test ratio, is often employed Thisremoves the value of inventory from the calculation

Calculate Sunco’s quick ratio

The quick ratio is the ratio between current assets less inventories andcurrent liabilities:

(295 – 95):145 = 1.38:1 or just 1.38

In the same way – and with the same caveats – as the ideal current ratio is oftenquoted as two to one, it is often suggested the quick ratio should be one to one.There should be just enough cash and cash due from trade receivables to coverthe trade payables

Number of days accounts receivable

We now move on to look at ratios that assess the level of receivables, payablesand stock Sunco has annual sales of £1.5m If sales are made equally across theyear that equates to daily sales of:

Sales per day were:

1,250,000/365 = £3,425and its year-end receivables £150,000, so the number of days to collect thecash was:

150,000 × 365/1,250,000 = 43.8

Number of days accounts payable

An exactly comparable method is used to calculate how many days it takes acompany to pay its accounts payable This time the year-end accounts payablefigure will be used together with the company’s purchases The formula is:

Accounts payable × 365/PurchasesNote that purchases are not always revealed in published accounts, so the ratiocan only be calculated by those inside the company The exception would be for

a company which purchased goods for resale; in this case purchases wouldrepresent the cost of goods sold

In 2011, Sunco’s purchases were £650,000 and its year-end trade accountspayable, £145,000 How many days did it take it to pay for the goods it hadbought?

Using the formula:

Payable days = Accounts payable × 365/Purchases

Number of days accounts payable

A similar calculation can be made for inventories, though a little morecomplexity arises from the different types of inventory held by firms Figure2.2 illustrates the three different types of inventory held by a typicalmanufacturing firm

Figure 2.2:Three types of stock (inventory)

Goods (raw materials) coming from external suppliers are stored in the rawmaterials store As the materials are required for production, they are transferred

to the production line where they are worked on In costing terms both labourand overhead costs are added to the cost of materials Finally, the completedproduct is held in the store of finished goods from where it is delivered tocustomers The result is that three separate inventories exist: raw materials stock,held in the raw materials store; work in progress (WIP) stock on the productionline; and finished goods stock, held in the finished goods store The number ofdays each type of inventory is held can be computed in a similar way to thereceivables and payables days The three formulae concerned are:

Raw materials days = Value of raw materials stock × 365/PurchasesWork in progress (WIP) days = Value of WIP stock × 365/Cost of goods soldFinished goods stock = Value of finished goods stock × 365/Cost of goods soldNote that purchases form the denominator in the first formula because no othercosts have yet been added to the raw materials By the time the WIP stock is

Labour and overhead costs

Work in progress stock

Production line

valued, labour and overhead costs have been added Since the cost of goodssold is the total cost of materials, labour and overheads, we use that as thedenominator for the other two formulae.

In 2011, Sunco’s inventory, valued above at £95,000, was formed fromstock of:

Raw materials £20,000Work in progress £35,000Finished goods £40,000Its cost of goods sold was £750,000

Calculate the number of:

(a) Raw materials days

(b) Work in progress days

(c) Finished goods stock days

(a) Raw materials days = Value of raw materials stock × 365/Purchases20,000 × 365/650,000 = 11.2

(b) Work in progress (WIP) days = Value of WIP stock × 365/Cost of goodssold

35,000 × 365/750,000 = 17.0(c) Finished goods stock = Value of finished goods stock × 365/Cost ofgoods sold

40,000 × 365/750,000 = 19.5

The working capital cycle

The link between cash and profit is sometimes expressed in a cycle known as

the cash flow, operating, trading, or working capital cycle Our preference is for

the latter term; it is the one we will use here Figure 2.3 shows the workingcapital cycle in diagrammatic form

Cash is used to purchase materials, to pay labour and to make other paymentsfor overhead expenses In a manufacturing company these so-called factors ofproduction would be used to produce stock for sale; the stock produced is latersold, generating cash to go into the pool In a service industry the service isnormally composed of labour and overheads only, few materials are used Forexample, in a hairdresser’s the product is mainly labour, with just a few minormaterials added, and the cash generated more quickly

Figure 2.4 expands on the theme This time the top of the cycle shows apotential cash surplus after cash has been received from sales and before it has

Recommended reading for this

section is the working capital and

the cash conversion cycle section

of the chapter ‘Short-term finance

and the management of capital’

in Watson and Head (2010).

working capital cycle

potentially dangerous cash deficit Cash has been spent before it can be regained

by making sales This is the danger area for the small business; being in a cashdeficit situation may mean paying the interest cost of an overdraft without anycorresponding benefit In the post-2008 recession the situation has been evenworse for many businesses, which have found it impossible to borrow funds at

at any cost Small businesses are particularly susceptible; they are likely to havefewer assets to sustain them through a lean period than their larger counter -parts Moreover, as times get hard, larger firms may be able to delay payment

to their smaller suppliers, who cannot afford to give up the businessopportunities the larger firm offers

Figure 2.3: The working capital cycle

Figure 2.4:The extended working capital cycle

Receive cash for goods

Purchase materials pay labour

Sell goods

Pay for materials

Receive cash for goods

Purchase materials pay labour

Sell goods

Pay for materials

Cash surplus

Cash deficit

Receive cash

Receivables increased Payables

increased