Introduction to Financial Management

2BUS0197 – Financial Management Introduction to Financial Management Lecture 2

Learning outcomes By the end of this session students should: Understand the concept of time value of money and the relationship between risk and return Appreciate the three decision areas of financial managers Understand reasons behind shareholder wealth maximisation as a primary business objective Appreciate the agency problem and corporate governance developments aimed at addressing it

Financial management The fundamental aim of financial managers is the optimal allocation of the scarce financial resources available to them

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

Relationship between risk and return • Return: the financial rewards gained from an investment • The nature of return depends on the form of investment • Profit for a company investing in fixed assets • Dividend payment and capital gains for an investor buying ordinary shares • Interest payments for an investor buying corporate bonds

Relationship between risk and return Risk: refers to the possibility that the actual return may be different from the expected return A risky investment entails a significant probability of its actual return being different from the expected return The higher the risk, the higher the expected return that investors and companies will demand

Expected return Risk Relationship between risk and return • Investors require a minimum expected return to invest • Additional returns required to compensate increasing risk taking • Should balance risk and return

Time value of money Time value of money: refers to the fact that the value of money changes over time Question: Do you prefer £100 today or £100 in one year’s time?

Better £100 today than in a year’s time! Time: Can use the liquidity or invest to earn interest on £100 Inflation: The purchasing power of £100 is greater today than in a year’s time Risk: The promise of receiving £100 in a year’s time may be risky

Future values: compounding Compounding is the way to determine the future value of a sum of money invested now The future value depends on the rate of interest paid, the initial sum invested and the number of years the sum is invested for FV = C0(1+i)n Example: £20 deposited for 5 years at an annual interest rate of 6% will have a future value of: FV = £20*(1+0.06)5 = £26.76

Present values: discounting Discounting allows to determine the present value of a future sum of money Hence, discounting takes us backward from the future value of a cash flow to its present value PV = FV (1+i)n

Present values: discounting Example: £1000 now or £1200 in one year’s time? To compare the two options need to change the future value of £1200 into a present value, and compare this present value with the offer of £1000 now If the best investment the investor can make offers an annual interest rate of 10%, this will be the discount rate to apply. Hence: PV = 1200 = £1091 (1+0.1)1 Question: What do you conclude?

Class activity 1 • In groups of four calculate: • The future value of £100 deposited for 7 years at an annual interest rate of 8% • The present value of £300 in 2 years time. Assume that 15% is the annual interest rate offered on best investment opportunity available

Decision-making areas • Financial managers are responsible for three interdependent areas: • Investment decisions – advising on the allocation of funds in terms of amount, composition and risk profile • Financing decisions – choosing among the different sources of financing (i.e. cost, availability, maturity, risk) offered on financial markets • Dividend decisions – concerning the choice between the amount of earnings retained for internal financing and the amount paid out to shareholders as a dividend

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

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

Shareholder wealth maximisation (SHWM) • The aim is to maximise the value of the company for its owners’ wealth • Shareholders’ wealth is increased through the cash received in dividend payments (current dividends) and the capital gains arising from increasing share prices (future dividends) • Current and future dividends depend on three variables: • The magnitude, or size, of cash flows accumulating to the company • The timing of those cash flows • The risk associated with those cash flows

Indicator of shareholder wealth • The indicator of shareholder wealth usually taken is a company’s ordinary share price • Ordinary shares’ price will reflect: • expectations about future dividend payments • Investors’ views about the long-term prospects of the company and its expected cash flows • SHWM is pursued through maximisation of the current market price of the company’s ordinary shares, hence the market value of the company

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

A company’s value will be maximised if the financial manager makes ‘good’ investment, financing and dividend decisions The outcome of any decision will also be affected by the conditions prevailing in the financial markets How can the financial manager achieve SHWM?

Occurs when managers make decisions that are not consistent with the objective of SHWM Why does it arise? Divergence of ownership and control Managers’ (agents’) goals differ from shareholders’ (principals’) Asymmetry of information The agency problem

Managers will follow their own objectives, i.e. increasing their: Power Job security Pay and rewards Shareholders need to ensure that their own wealth is maximised Consequences of agency problem

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

Jensen and Meckling (1976) suggested two ways to deal with agency problems Monitoring – e.g. use of external auditors and analysts Can entail free riding by smaller shareholders Optimal contracts – formalising constraints, incentives and punishments Should minimise total agency costs (e.g. financial contracting costs, opportunity costs of contractual obligations, cost of managers’ incentives and bonuses, monitoring costs etc.) Dealing with the agency problem

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

Changes to UK legislation 1992, ‘Code of Best Practice on Corporate Governance’ concerned with accountability and financial reporting 1995, code of practice dealing with executive remuneration and conditions 1998, the above two codes were amalgamated in the ‘Combined Code’. All listed companies must comply to it Turnbull (1999), Higgs (2003) and Smith (2003) 2006, latest revision of the ‘Combined Code’ 26

Cadbury Committee (1992) Recommended: A voluntary code of practice 3 non-executive directors at board level Maximum 3-year duration contracts Posts of Chairman and C.E.O. should be separate Improved information flow to shareholders Increasing independence of auditors

Greenbury Report (1995) Recommended: • One-year rolling contracts • More sensitivity by remuneration committees • Performance-related-pay and share options to be phased out and replaced by ‘challenging’ long-term incentive plans However… • A 1996 report from Pension and Investment Research Consultants indicated widespread abuse of above

Hampel Report (1998) and the Combined Code • Stressed the importance of a ‘balanced board’, non-executive directors and the role of institutional shareholders • The combined code is overseen by the London Stock Exchange: • Embodies Hampel, Cadbury and Greenbury recommendations • Compliance is a LSE listing requirement

Turnbull, Higgs and Smith • Turnbull (1999): detailed how boards could maintain sound systems of internal control (significant risk/systems required) • Higgs (2003):report designed to enhance the independence, and hence effectiveness, of non-executive directors • Smith (2003):gave authoritative guidance on how audit committees should operate and be structured

Governance of public limited companies:The Combined Code (2006) Every listed company should have a board of directors There should be a clear division of responsibilities between the chairman and the chief executive officer There should be a balance between executive and non-executive directors The board should receive timely information Appointments to the board should be subject to rigorous, formal and transparent procedures Boards should use the annual general meeting to communicate with private investors The board should publish a balanced and understandable assessment of the company’s position and performance Internal controls should be in place to protect the shareholders’ wealth The board should set up an audit committee of non-executive directors to oversee the internal controls and financial reporting 31

Class activity 2 • The key purpose of corporate governance regulations is to: • Introduce rules that promote corporate fairness and transparency • Attempt to solve the agency problem, by promoting corporate fairness, transparency and accountability • Develop corporate social responsibility • Enable companies’ CEO to camouflage information to shareholders

Summary Today we looked at: • Time value of money, risk and return • Role of financial manager • Shareholder wealth maximisation • Agency problem • Corporate governance rules as a mean to deal with agency

Readings Textbook Watson D. and Head A., (2007), Corporate Finance Principles and Practice, 5th (4th) edition, FT Prentice Hall, Chapter 1 Research paper Jensen, M.C and Meckling, W.H., (1976), Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Journal of Financial Economics, Vol.3 (4), pp. 305-360

Introduction to Financial Management