ACCA paper f9 financial management study materials F9FM session01 d08

2.1 Corporate objectives In practice companies are likely to have a variety of different objectives which may include a number of the following: Ü profit targets; Ü market share targets

OVERVIEW

Objective

Ü To understand the nature of financial management

Ü To appreciate the various stakeholders in an organisation and their respective

objectives

NATURE OF FINANCIAL MANAGEMENT

ORGANISATIONAL OBJECTIVES

CONFLICTS OF INTEREST

Ü Corporate objectives

Ü Public and private companies

Ü Public sector organisations

Ü Interest groups

Ü Directors and shareholders

Ü Goal congruence

Ü Environmental concerns

1 NATURE OF FINANCIAL MANAGEMENT

Definition

The management of activities associated with the efficient acquisition and use

of short and long-term financial resources

The types of decisions that are within the scope of financial management are:

Ü What types of funds should be raised – equity capital or debt capital?

Ü How should the funds be raised?

Ü On which proposed investments should the funds be spent?

Ü How much dividend should be paid to the shareholders?

Ü How much working capital should the organisation have and how should it be

controlled?

2.1 Corporate objectives

In practice companies are likely to have a variety of different objectives which may include a number of the following:

Ü profit targets;

Ü market share targets;

Ü share price growth;

Ü local and environmental concerns;

Ü contented workforce;

Ü short-term targets;

Ü long-term plans

These objectives can be classified as follows:

Ü Profit goals – objectives which lead directly to increased profits (e.g cost reduction programmes);

Ü Surrogate profit goals – objectives which lead indirectly to increased profits (e.g

maintaining a contented workforce);

Ü Constraints on profit – objectives which actually restrict profit (e.g ensuring that the company’s operations do no harm to the environment);

Ü Dysfunctional goals – objectives which do not provide a benefit even in the long run

A company may aim at either maximising or satisficing these objectives

Ü Maximising involves seeking the best possible outcome;

Ü Satisficing involves finding an adequate outcome

2.1.1 Wealth maximisation

In theoretical terms a single corporate objective is assumed and this is “the maximisation of shareholder wealth”

The objective of maximising shareholder wealth can be justified in the following ways:

Ü The company which provides the highest returns for its investors will find it easiest to raise new finance and grow in the future If a company does not provide competitive returns it will inevitably decline

Ü The directors of a company have a legal duty to run the company on behalf of the

shareholders It is generally assumed that the purchaser of a share in a listed company buys that share in an attempt to maximise his/her wealth

Criticisms of the above include the following:

Ü It ignores the needs of society that will not necessarily be provided by the free market, such as health, education and defence;

Ü It ignores the other interest groups in the company, such as the employees

In practice a company will often seek to maximise profit subject to satisficing a number of other objectives

2.2 Public limited companies and private companies

The key objective of listed Plc’s is to maximise the wealth of their shareholders as measured

by the Total Shareholder Returns (TSR) – share price growth and dividend income

For a private company, however, there is no quoted share price to be measured Smaller private companies may also have a close relationship between the owners and the managers, and therefore the directors may be aware of the real objectives of the owners

2.3 Public sector organisations

The objective of public sector organisations is to provide the service for which the

organisation was established These organisations are frequently called “Not for Profit Organisations” (NPO’s) Such organisations are not constrained by cost/profit objectives to the same extent as companies However they are often constrained by having multiple and possibly conflicting objectives or responsibilities For instance a university has a

responsibility to potential employers to produce graduates with relevant skills for business, but also a responsibility to students to provide courses on subjects which interest them academically

NPO’s are sometimes said to have as their objective the maximisation of the difference between the benefits they generate and the costs of their operations However it is often very difficult to quantify the benefits that such organisations produce

There is an increasing emphasis on Value For Money (VFM) and achieving Economy

Efficiency, and Effectiveness - the “3 E’s”

Ü Economy - minimizing the input costs of the organisation

Ü Efficiency – maximizing the output/input ratio

Ü Effectiveness - in meeting the organisation’s objectives

3.1 Interest groups/stakeholders

Companies have a variety of different interest groups or “stakeholders” - all of whom are likely to have different interests in and objectives for a company

Equity shareholders − maximum wealth

power esteem

job security Loan creditors − security

cash flow long-term prospects Trade creditors − short-term cash flow

environmental and social issues General public − environmental issues

social issues

Companies which attempt to take into account the objectives of a wide range of stakeholders may be described as following Corporate Social Responsibility (CSR)

3.2 Directors and shareholders

In larger companies the shareholders (as principals) delegate the management of the

company to the directors (as agents) – known as “agency theory” The directors are

managing the company on behalf of the shareholders and should therefore always act in the best interests of the shareholders

This may not always be the case, as the directors may have other personal objectives such as:

Ü increasing personal remuneration;

Ü maximising bonus payments;

Ü empire building;

Ü job security

If directors fail to act in the best interest of shareholders this leads to sub-optimal returns to shareholders This lost potential wealth for shareholders is known as “agency costs”

Shareholder activism should put pressure on the company to follow good corporate

governance practices Implementing the UK Combined Code on corporate governance or the US Sarbanes-Oxley Act should limit agency costs to an acceptable level

3.3 Goal congruence

Goal congruence is where each of the parties within an organisation are seeking to achieve personal objectives that are also within the best interests of the company as a whole

For example, managers should be encouraged to aim for long-term growth and prosperity, rather than shorter-term reported profitability

Methods of encouraging goal congruence between managers/directors and shareholders include:

Ü Executive share option schemes (ESOPs) – although the evidence is mixed as to their success in promoting goal congruence

Ü Long-term incentive plans (LTIPs) e.g paying managers a bonus if, over a period of several years, the company’s performance exceeds the industry average

Ü Transparency in corporate reporting

Ü Improved corporate governance e.g through the appointment of truly independent non-executive directors

Ü Increased shareholder activism e.g using voting rights

3.4 Environmental concerns

An area of growing concern to all parties, companies included, is that of the environment or

“green” issues

It is important that managers understand the impact of the operations of the organisation on the environment, in order to satisfy public concerns and, increasingly, to avoid any penalties

or costs due to environmental regulations

For these reasons environmental reporting is becoming more common as part of general company financial reporting

‘Environmental Management Accounting’ (EMA) attempts to measure the full

environmental impact of a company’s operations e.g the cost of inefficient energy usage due

to poor insulation of buildings

Key points

ÐThe first step in developing the objectives of financial management is to

identify the relevant stakeholders in the organisation

ÐIn the corporate sector the key stakeholders are clearly the shareholders

Most traditional finance theory is therefore built on the assumption that a

company’s objective is to maximise the wealth of its shareholders

ÐHowever modern Corporate Social Responsibility (CSR) suggests that

directors should also take into account other stakeholders and therefore

also follow a range of non-financial objectives e.g employee satisfaction,

reducing environmental impacts

ÐSuch non-financial objectives may be in conflict with maximising

shareholder wealth Therefore the overall objective may be to produce

satisfactory returns for shareholders, whilst attempting to meet the

demands of other interest groups

ÐIn practice managers may also have personal objectives which conflict

with their responsibilities as agents of the shareholders Some managers

may try to maximise personal wealth e.g through manipulating bonus

schemes or even theft of company assets

ÐThis creates agency costs for the shareholders Good corporate governance

systems should reduce these costs to an acceptable level

FOCUS

You should now be able to:

Ü discuss the nature and scope of financial objectives for private sector companies;

Ü discuss the role of social and non-financial objectives in private sector companies and identify their financial implications;

Ü discuss the problems of multiple stakeholders in financial management and the

consequent multiple objectives and scope for conflict;

Ü identify objectives (financial and otherwise) in not-for-profit organisations and identify the extent to which they differ from private sector companies