Paper F9 Financial Management (FM) Lecturer Stere Mihai

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

CHAPTER 1

THE FINANCIAL MANAGEMENT FUNCTION

1. The nature and purpose of financial management

Financial management is concerned with the efficient acquisition and deployment of short- and long- term financial resources, to ensure that financial objectives of the enterprise are achieved.
Three key decisions:

- financing decisions;
- investment decisions;

- dividends decisions.

1. The nature and purpose of financial management

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 policy When and how much cash funds should be returned to shareholders? - Is the value of the business affected by dividend decision? (Business valuation)

1. The nature and purpose of financial management Distinguish financial management from: - financial accounting - management accounting Financial management is about making financial decisions. Management/Financial accounting are about providing information to 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.

2. Relationship between corporate strategy and corporate financial objectives

Financial objectives must be

aligned with - strategy and - commercial objectives cascaded to lower organizational levels - corporate - business - operational

2. Relationship between corporate strategy and corporate financial objectives

Detailed objectives

Commercial

Financial

Strategy

CORPORATE

Expand into new markets

ROCE? EPS? Share price?

Organic or acquisition

BUSINESS

Acquire and equip new premises

Project returns?

Lease and buy?

OPERATIONAL

Maintain liquidity levels

Cash levels? Receivables days

Credit or cash on delivery?

3. Financial objectives Shareholder wealth maximization

Financial objectives

1. SHAREHOLDER APPROACH

2. STAKEHOLDER APPROACH

3. Financial objectives Shareholder wealth maximization

Overall objective Maximize 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.

4. Stakeholder objective and conflicts A stakeholder group 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

4. Stakeholder objective and conflicts

Should managers balance the 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 a fixed interest.

4. Stakeholder objective and conflicts

Stakeholder approach

- admits reality of conflicts between objectives of several stakeholders;

- but fails to provide operational means to: - reconcile or solve conflicting objectives or - rank conflicting objectives Shareholder approach - limited theoretically - but operational

5. Role of management and goal congruence

Shareholders vs. Managers

OVERALL FINANCIAL OBJECTIVE: Maximize shareholders wealth ACTIONS: taken by the managers However, -interests of managers and shareholders are not always aligned - and managers may have superior information

5. Role of management and goal congruence

Agency theory
Agency relationship one party (the principal) employs another party (the agent) to perform a task on their behalf.

Principal

Employs

Agent

Performs tasks and activities with Third party

5. Role of management and goal congruence

Agency theory Agency problems
1 2

Contract

1. Adverse selection problem asymmetric information about the skills of the agent 2. Moral hazard problem asymmetric information about the acts of the agent 3. Costly state verification asymmetric information about the outcome of the contract

5. Role of management and goal congruence

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)

5. Role of management and goal congruence

Establishing goal congruence between managers and shareholders

1. Managerial reward schemes; 2. Corporate governance codes;

5. Role of management and goal congruence

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)

5. Role of management and goal congruence

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

5. Role of management and goal congruence

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

6. Measuring achievement of corporate objectives

- Setting objectives Shareholders wealth max. - Measure results - Compare against objectives
Ratio analysis (Chapter 19)
- Profitability and return; - Debt and gearing; - Liquidity; - Investor.

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

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.

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

Value for money (VFM) and the three Es.

VFM refers to achieving the desired level and quality of service at he most economical cost.
VFM = Economy, Efficiency, Effectiveness (the three Es) Effectiveness measures the degree of meeting the targets Efficiency a measure of outputs over inputs - input driven - output driven Economy being effective and efficient at the lowest possible cost.

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

System analysis and performance measurement

Inputs: Materials

Processes: People, Structure, Information, Task requirements

Outputs: Goods

Outcomes: Meeting objective

Staff
Cash

Services

Costs and cost control ECONOMY

Systems and methods ECONOMY

Achieving targets EFFECTIVENESS