FINANCE THEORY

(Suitable for CFM / FAM & CF Candidates) CORPORATE FINANCE Corporate finance covers a wide range of topics and functions within an organisation, but the three main areas we will look at relate to answers to the following questions: 1. Which investments should the firm undertake? 2. How, where, when and how much finance should be raised? 3. How should the firms profits be used or distributed? These questions are more commonly referred to as: the investment decision; the financing decision; the dividend decision.

When making such decisions the firm must ensure that it achieves its objectives. Maximisation of shareholder wealth The underlying assumption of the theory of finance is that the main objective of the firm is the maximisation of shareholder wealth in the long term. To achieve this objective, and since the shareholders own the company, the main objective of a company should be to maximise the combined value of the company, together with any returns paid out to shareholders in the form of dividends or returns of capital. This should be done allowing for the time value of money; i.e. other things being equal, that shareholders prefer returns earlier rather than later. The amount returned in the form of dividends is the subject of dividend policy. Dividend policy may be constrained by various factors, including the need to maintain adequate liquidity, the fact that many shareholders prefer dividend payments to be steady rather than erratic, and that the amount of a dividend may be read as a signal from the management about how well the company is doing. Subject to considerations of this kind, a company should aim to get a return on investment that is at least equal to the return required by shareholders, which is the cost of equity capital. If investments can be found that offer such a return, it is appropriate to invest shareholders funds there. Investments that do not offer such a return are not an attractive use of shareholders funds and the company should return money to the shareholders, to whom it belongs, as they can be expected to find a better use for it.

This means that the amount paid out as dividends will depend on the nature of the company and the sector in which it operates. Companies in growth sectors, or which have prospects of profitable growth in other sectors, are likely to reinvest more of their profits than companies that do not have good growth prospects. Subject to considerations of the kind outlined above, and discussed in greater detail below, the objective of a company should be to maximise its market value. Depending on the nature of the company and its management, and the preferences of shareholders, this objective may be pursued over a longer or shorter time period. RISK MINIMISATION OBJECTIVE Risk may be interpreted and measured as variability in outcomes (typically variation in the return on investments). As part of their strategic financial planning, companies determine what level of risk they are prepared to take in pursuit of profit. This determination may be explicit or implicit. Companies operating in developing countries are exposed to more risk, arising from a wider range of causes, than companies operating in one country. Multinational companies are aware that they are taking such risks. Companies in some industries, where growth is slower, markets are more stable and the scope for innovation and change is limited, are often subject to less business risk arising from the nature of the markets, and their methods of operation, than others. Companies that use a large proportion of loan capital in relation to equity have a higher financial risk.

OTHER OBJECTIVES All of the objectives we have considered so far are financial. In addition, a company will have important non-financial objectives. These include: differentiating products and services so as to make them more attractive to customers than those of their competitors; providing products and services of high quality; innovation; raising the skills of the workforce; operating in compliance with the law.

Net present value maximisation

The market value of a company, which a company may be aiming to maximise in order to maximise shareholders wealth, depends on the value that the market puts on the companys shares. This is subject to many influences, including economic and political factors that are outside the companys control. The company cannot control market sentiment, even though it may influence investors perceptions of, and beliefs about, the company. Managers may well try to maximise a companys market valuation, particularly when they are rewarded by share options whose value is directly linked to the share price. And the time-scale over which managers try to maximise market value may be driven by considerations such as the dates at which options can be exercised, as well as the markets expectations and preferences about when returns will be achieved. In order to have a steadier target to aim for, one not influenced by day-to-day by market variations but nevertheless is related to market expectations, companies can use another measure of value: the present value of the companys future cash flows. The present value of a cash flow means the value of the future cash flow discounted to allow for the cost of capital. The cost of capital reflects the degree of risk of the companys business, and will be discussed in chapter 6.The present value of a future cash flow is the amount of money at todays date that would give the future amount if it were invested to earn the return expected by shareholders. So, in terms of value, shareholders should be indifferent between a cash flow received in the future and a smaller sum (its present value) received today. The further ahead a cash flow is projected, the more it will be discounted; in other words, the smaller the sum today that will be equivalent to the future sum. The total of the present values of all the companys future cash flows is the net present value (NPV) of the company. Other things being equal, managers should aim to maximise the NPV of the company. They can do this by investing funds in investment projects that themselves have positive NPVs. Another way of putting this, since the rate at which future cash flows are discounted to find a NPV is the return required by shareholders, then the NPV of the company is maximised if managers invest in projects that increase shareholders wealth, by giving discounted returns greater than the original investment, and in no others.

Shareholders and investors Shareholders are an important stakeholder group, being the owners of the business. To meet the needs of shareholders, management must: Maximise shareholder wealth (shown by the growth in share price and the payment of dividends). Achieve a specific level of earnings, earnings per share and dividends per share. Note that some shareholders prefer high dividends and some prefer capital gains but the needs of the majority should be met as far as possible.

Stick to a pre-set target for operating profitability represented by either a set return on capital employed or a profit/sales ratio. Expand the business when feasible to be a worthwhile investment, growth, level of risk, return on investment and profitability in relation to competitor businesses and other investment opportunities will be expected to be at an appropriate level. Maintain the security (as far as is consistent with profit-making) of the shareholders investment. (The risk/return trade-off.) This includes considering the fact that shareholders have different risk preferences and thus prefer different levels of gearing. Satisfy the investor that the company has sufficient cash flow to accommodate its plans and avoid future, potentially fatal, liquidity problems. Give details of political, charitable or social donations to allow shareholders to decide if the convictions of the management are in line with their own views.

Stakeholder theory We have seen how the interests of management and shareholders do not necessarily coincide, though they both have a general interest in the success and profitability of the company. In some cases the divergence of interest may be starker. Employees may have very different short-term interests from management and shareholders (e.g. during wage bargaining). In the longer term, all three groups could have a common interest in the longterm growth of a company to which a well-rewarded, skilled and motivated workforce makes a major contribution. The interests of external stakeholder groups such as customers or suppliers may also be compatible with those of management and shareholders: customers have an interest in a company that is a reliable supplier; suppliers have an interest in a company that offers the prospects of continuing healthy demand for the products and services they supply. Stakeholder theory provides a framework for analysing decisions of this kind. There are three main models, which set out different ways in which management the most powerful stakeholder group can resolve conflicts between the interests of other stakeholder groups. The strong form The strong form states that management is answerable to all stakeholder groups and should take account of and try to satisfy the needs of all stakeholders. This involves balancing the demands and possibly also the relative bargaining power of different groups. The minimalist version This statement of stakeholder theory asserts that management is answerable only to the shareholders as owners. This clarifies things, though it may mean that other stakeholders get little of what they want. The argument for this approach is not just a legal one. According to its proponents, if decisions are to be made about the competing claims of

different stakeholder groups, they are made by management. If management is the arbiter between conflicting claims, it can play one group off against another. By being answerable to all stakeholders, it is in effect answerable to none. So problems will be resolved in ways acceptable to and favoured by management. The argument is tempting in a situation where a commercial firm has non-commercial objectives, as it provides a justification for disregarding non-commercial claims or the claims of more diffuse stakeholder groups such as the community at large. The pragmatic view According to this view, management is not formally answerable to all stakeholder groups, but should take account of them for reasons of commercial practicality. Even a single stakeholder group may have potentially conflicting objectives: Shareholders who want dividend income also want future growth, which needs investment that may limit the scope for dividends in the short term. So the task of satisfying stakeholder expectations is never simple. Practical managers recognise the need to understand and cope with complexity. They know that taking pains to satisfy stakeholders is not idealistic but realistic and can offer commercial advantage. Employees who feel that their interests are being disregarded will lose motivation and may leave. So investing in staff development, training and communication is an investment in the future. Customers who do not get the service they expect may be lost. So investment in customer service is also an investment in the future. A good corporate citizen is not simply indulging the whims of altruistic managers; it is investing in its corporate reputation and enhancing the value of its assets.

Agency theory: the principal-agent problem An agency relationship exists where one person (an agent) acts on the behalf of another (the principal). The management-shareholder relationship is an example of an agency relationship. Goal congruence occurs when the objectives of the agents match those of the principals. The agency problem is the conflict that arises from the separation of management and ownership in many companies, leading to a lack of goal congruence. The financial and other rewards of managers (agents) may not be linked to the shareholders (principals) financial return. In theory, management should not be able to act contrary to the wishes of shareholders because shareholders can dismiss the managers or sell their shares. Unfortunately, this is often not the case. Small shareholders frequently have little knowledge about the running of the business and little power to alter its execution. The large institutional shareholders have often been passive and uninvolved. However, this is changing. Institutional shareholders are becoming more professional and better informed about the management of the companies in which they invest. They are increasingly willing

to make their views known to companies managers. An example is given below in connection with stock option schemes. A number of incentive schemes have been introduced in an attempt to encourage goal congruence between management and shareholders. The most popular is the stock option scheme. This gives senior managers the right to buy a certain number of the companys shares at a fixed price at a specified future date.The managers, therefore, have a financial incentive to act in ways to maximise the share price, which benefits all shareholders. However, such schemes have drawbacks: managers to whom options have been allotted are not obliged to buy shares if the price falls below the exercise price. The schemes can lead to volatility in the share price which is conflicts with the principle of a stable share price something many shareholders desire. In recent years, with less buoyant share prices, there have been moves by some company managers to rebase options (that is, to set a new, lower exercise price, which is more likely to be exceeded). Such moves are increasingly being challenged by large institutional shareholders. Another popular scheme involves profit-related incentives in which bonuses are based on the annual growth in earnings per share (EPS), measured against a pre-set target, such as the average performance of companies in the sector. However, it is possible to manipulate accounting figures and, as with any performance measure, EPS figures can also be affected by external factors such as the economic or business cycle or tax regimes. Such measures may therefore give a misleading picture of management performance. One way in which a lack of goal congruence may manifest itself is in satisficing. Since managers have objectives that are not identical with those of shareholders, they may be tempted to do only enough to provide a return that shareholders consider adequate, rather than maximising shareholder returns. The schemes described above offer one way of overcoming this, but there may be more general forces at work to discourage satisficing by managers. One is that markets for capital are competitive. If managers fail to maximise shareholder returns, their failure is reflected in a lower share price and a higher cost of equity capital. So companies that fail to exploit profit maximising opportunities will be penalised. Another is that the market for management jobs and the rewards they offer is also competitive. If managers perceive that success in job preferment is related to the achievement of corporate objectives, including increasing shareholder wealth, they will not believe that they can pass opportunities by. Internal audit and internal controls Many companies, particularly large ones, have an internal audit function. Internal auditors are employees of the company, unlike the external auditors, and work in the company throughout the year, not just during the annual audit. External and internal auditors cooperate, and information provided by the internal audit department helps the external auditors in doing their job expeditiously and economically.

Even with an external audit and an internal audit function, mistakes can occur. Lapses in internal controls allowed large losses by traders working for Deutsche Bank and Socit Gnrale. One of the problems for internal control systems, particularly in banks, is that some of the financial derivatives in which banks traders deal are only imperfectly understood by the managers who are responsible for the traders. In addition, in the competitive pursuit of profit, managers may be willing to allow traders working under their control to take large risks. Sometimes risky transactions turn out badly.