Chapter 1 Financial Management Function

8/13/2019 Chapter 1 Financial Management Function

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Paper F9

Financial Management (FM)

Lecturer Stere Mihai


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Core areas of the syllabus

1. Financial management function

2. Financial management environment

3. Working capital management

4. Investment appraisal

5. Business finance

6. Cost of capital

7. Business valuations

8. Risk management


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CHAPTER 1

THE FINANCIAL MANAGEMENT

FUNCTION


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1. The nature and purpose of financial management

Financial management is concerned with theefficient acquisition and deployment of

short- and long- term financial resources, to

ensure thatfinancialobjectives of the

enterprise are achieved.

Three key decisions:

- financing decisions;

- investment decisions;

- dividends decisions.


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The financing decision

- Sources of finance (e.g. debt/equity?)

- Any optimal capital structure?

- Cost of capital

The investment decision- Investment appraisal;

- Working capital management;

- Risk

The dividend decision- Dividend policyWhen and how much cash funds should be

returned to shareholders?

- Is the value of the business affected by dividend decision?

(Business valuation)


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Distinguish financial managementfrom:

- financial accounting- management accounting

Financial managementis about making financial decisions.

Management/Financial accountingare about providing

informationto support decision making.

Financial accounting

information about historical results of past decisions;

Management accounting

information about day to day operations of control and

decision making.


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2. Relationship between corporate strategy and corporate

financial objectives

Financial objectivesmust be

alignedwith- strategyand

- commercial objectives

cascadedto lower organizational levels

- corporate

- business

- operational


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2. Relationship between corporate strategy and corporate

financial objectives

Detailed objectives

Commercial Financial Strategy

Expand into new

markets

ROCE? EPS?

Share price?

Project returns?

Cash levels?

Receivables days

Acquire and equip

new premises

Maintain liquidity

levels

Organic or

acquisition

Lease and buy?

Credit or cash on

delivery?

CORPORATE

BUSINESS

OPERATIONAL


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3. Financial objectivesShareholder wealth maximization

Financial objectives

1. SHAREHOLDER APPROACH

2. STAKEHOLDER APPROACH


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3. Financial objectivesShareholder wealth maximization

Overall objectiveMaximize shareholder wealth

- Maximize (increase) share-price

- and/or dividend payout

Alternative objectives suggested for companies:

- Profit maximization

- Growth

But these are problematic and not always in line with the

maximization of shareholder wealth:

- e.g. short-term profit maximization strategies may be

detrimental to long-term maximization of wealth.


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4. Stakeholder objective and conflicts

A stakeholdergroup is one with a vested interest in the company.

Internal- Company employees

- Company managers

Connected

- Equity investors (ordinary shareholders);- Customers;

- Suppliers;

- Finance providers;

- Competitors

External

- The government

-The community at large;

- Pressure groups,

- Regulators


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Should managers balancethe stakeholders objectives?

Not easy, since these objectives are often in conflict.

E.g. Shareholders objectives vs. Creditors objective

Shareholders as well as Creditors wealth is affected

asymmetrically if the company takes on risky/profitable projects

Shareholders get a variable dividend(if any)

Creditors get afixed interest.


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Stakeholder approach

- admits reality of conflictsbetween objectives of

several stakeholders;

- butfails to provide operational meansto:- reconcile or solve conflicting objectivesor

- rank conflicting objectives

Shareholder approach

- limited theoretically

- but operational


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5. Role of management and goal congruence

Shareholders vs. Managers

OVERALL FINANCIAL OBJECTIVE: Maximize shareholders wealth

ACTIONS:taken by the managers

However,

-interestsof managers and shareholders are not always aligned

-and managers may have superior information


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Agency theory

Agency relationshipone party (the principal) employs another party

(the agent) to perform a task on their behalf.

Agent

Principal

Third party

Employs

Performs tasks and activities with


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Agency theoryAgency problems

Contract

1 2 3

1. Adverse selection problemasymmetric information about the skills of the agent

2. Moral hazard problemasymmetric information about the acts of the agent

3. Costly state verificationasymmetric information about the outcome of the

contract


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Shareholders vs. Managers

Directors(agents) act on behalf of shareholders(principals).

Imperfections of the agency relationship:

- Asymmetric information

- Conflict of interest (goal incongruence):

-Excessive remuneration and bonuses;

-Empire building;

-Creative accounting;

-Off balance sheet finance

-Avoiding takeover bids

-Unethical activities

(All of the above are forms of the moral hazard problem)


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Establishing goal congruence between managers and shareholders

1. Managerial reward schemes;

2. Corporate governance codes;


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Establishing goal congruence between managers and shareholders

1. Managerial reward schemes;

Should be:

- clearly defined, impossible to manipulate, easy to monitor;- link reward to changes in shareholder wealth;

- match managers and shareholders time horizons;

- encourage managers to adopt the same attitudes to risk as

shareholders

Common types:

- remuneration linked to:

- minimum profit levels/turnover growth

- executive share-option plan (ESOP)


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2. Corporate governance codes

- Non-executive directors (NEDs)

- important presence of the board

- obligation to spend sufficient time with the company

- independence

- Executive directors (Eds)

- separation of chairman and CEO

- submit for re-election

- clear disclosure of financial rewards

- outnumbered by the NEDs


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2. Corporate governance codes

- Remuneration committees;

- Made up wholly of NEDs

- Objectively determine and make recommendations about

the EDs pay- Should advice the board on the remuneration of EDs

- Nomination committees;

- Made up of NEDs

- Establish a framework for selection of both EDs and NEDs

- Annual General Meeting (AGM)

- Shareholders ability to vote on separate issues

- Bundling un-related proposals in a single resolution should

cease


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6. Measuring achievement of corporate objectives

- Setting objectivesShareholders wealth max.- Measure results

- Compare against objectives

Ratio analysis (Chapter 19)

- Profitability and return;

- Debt and gearing;

- Liquidity;

- Investor.


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7. Objective setting in not-for-profit organizations (NFPs or NPOs)

Key features of NFPs

1. Objectives:

- not to make money;

- but to benefit a certain group.

2. A mixture of financial and non-financial objectives

- reliance placed on non-financial objectives

3. Difficulties with setting objectives:

- many are difficult to quantify financially;

- multiple and conflicting objectives are


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7. Objective setting in not-for-profit organizations (NFPs or NPOs)

Broad financial objectives for NFPs

-Raise as large a sum as possible;

-Spend funds as effectively as possible.

Specific financial objectives for NFPs

- Total to be raised in grants and voluntary income;

- Maximum percentage of fund raising expenses;

- Amounts to be spent on specified projects or in a particular area;

- Maximum permitted administration costs;

- Meeting budgets;

- Breaking-even in the long run.


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7. Objective setting in not for profit organizations (NFPs or NPOs)

Value for money (VFM) and the three Es.

VFM refers toachieving the desired level and quality of service at

he most economical cost.

VFM = Economy, Efficiency, Effectiveness (the three Es)

Effectivenessmeasures the degree of meeting the targets

Efficiencya measure of outputs over inputs

- input driven

- output driven

Economybeing effective and efficient at the lowest possible cost.


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7. Objective setting in not for profit organizations (NFPs or NPOs)

System analysis and performance measurement

Inputs:

Materials

Staff

Cash

Processes:

People,Structure,

Information,

Task requirements

Outputs:

Goods

Services

Outcomes:

Meetingobjective

Costs and cost

control

ECONOMY

Achieving

targetsEFFECTIVENESS

Systems and

methods

ECONOMY

Chapter 1 Financial Management Function

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