Finance and the Firm - Lecture Notes

Finance and the Firm

Introduction

  • This chapter introduces fundamental ideas relating to corporate finance and corporate governance.

Finance and Real Resources

  • Businesses need real assets to generate profits.
  • Real assets are distinguished from financial assets (shares, bonds, etc.).
  • To acquire real assets, a company must raise finance.
  • Real Assets:
    • Tangible assets: Physically exist (e.g., machinery, buildings).
    • Intangible assets: Do not physically exist (e.g., patents, trademarks).

Financial Manager

  • The financial manager stands between the firm's operations and the financial markets.
  • Financial markets are where investors hold the financial assets issued by the firm.
  • Cash flow:
    • Cash raised by selling financial assets.
    • Cash used to purchase real assets.
    • Cash generated by operations.
    • Cash returned to investors (dividends, loan repayments).

Two Basic Issues in Finance

  • What real assets should the firm invest in? (the investment/capital budgeting decision) - handled by the Chief Financial Officer (CFO).
  • How should the cash for the investment be raised? (the financing decision) - handled by the Treasurer.

Treasurer Responsibilities

  • Looks after the company’s cash.
  • Raises new capital.
  • Maintains relationships with banks, shareholders, and other investors.

Capital Budgeting

  • The process a business uses to decide which big projects or investments are worth spending money on.
  • Why capital budgeting is important:
    • Complexity of the analysis involved.
    • Cost of poor decisions.
  • Investment in working capital (liquidity) is largely routine and involves few complications or risks.
  • Investment in fixed capital involves complex choices between alternative capital assets, dates of commencement, and methods of financing.
  • Fixed capital outlays often have a serious bearing on the direction and pace of a firm’s growth.

Financial Analysis

  • Progress in management depends on applying logic to experiences, to known or assumed facts in order to enhance understanding.
  • Financial analysis must be able to:
    • Identify the risks involved in the project.
    • Highlight the salient factors.
    • Possibly suggest methods by which these risks might be reduced.
  • Financial analysis in capital budgeting involves bringing together estimates and ideas from a variety of disciplines (marketing, technology, accounting, tax, etc.) to reveal their financial implications.
  • The problems of capital budgeting in any enterprise are both financial and political.
  • The use of a specialist finance function is an attempt to enforce impartiality and realism.

Stakeholders

  • There are many groups of stakeholders in an organization, each with its own objectives.
  • Stakeholders include: directors, managers, employees, shareholders (owners), customers, government, general public, lenders, and suppliers.
  • Directors:
    • Ultimately responsible for financial decisions within a company.
    • Acting on behalf of the ultimate shareholders.
    • Delegate operational decision-making to the executives, while retaining control of strategic issues.
  • Separation of ownership and management:
    • Advantage: freedom for ownership to change without affecting operational activities, freedom to hire professional managers.
    • Disadvantage: if the interests of the owners and managers diverge.

Stakeholders - Objectives Examples

  • Managers: want to grow the company, receive performance bonuses, gain promotions and job security.
  • Employees: want fair salary and benefits, safe and comfortable working conditions, job stability and career growth.
  • Banks and other lenders: want the company to pay back loans on time, ensure the business stays profitable (so it can repay debt), want low risk of default.
  • Customers: want good quality products or services, fair prices, good customer service.
  • Government: want the business to pay taxes, follow laws and regulations, create jobs and support the economy.

Stakeholders – Conflicting Objectives

  • Shareholders vs. Managers:
    • Shareholders: to receive a high return on their investment.
    • Managers: wish to pursue projects of interest over more profitable projects; to have a more leisurely working lifestyle etc.
  • Lenders vs. Shareholders:
    • Lenders: short-term desire for security.
    • Shareholders: long-term interest in the development of the company.

Stakeholders - Contractual Theory

  • Contractual theory views a firm as a network of contracts, actual and implicit, which specify the roles of the various participants in the organizations (workers, managers, owners, lenders, etc.) and define their rights, obligations and pay-offs under various conditions.
  • Most participants bargain for limited risk and fix pay offs, where is the firm's owners are liable for any residual risk (and thus hold a residual claim on any assets and earnings of the firm that remain of after covering costs).
  • They are, however, potential conflicts. One such is between a firm’s owners and its creditors.
  • If managers substantially alter the riskiness of a firm's product-market investment activities, this will benefit shareholders greatly (If the investments are successful).
  • However, risky investments that fail will reduce the security of debt holders and reduce debt values. If a firm does not give strong assurances to debt holders the investment policies will not be changed to their disadvantage, it must pay interest rates high enough to compensate debt holders against the possibility of such adverse policy changes.

Capital Market and the Maximization of Shareholder Wealth

  • For large, publicly quoted companies, the stock market serves as a performance monitor. While share prices may react to the general economy or industry-wide factors, the basic component of the share price is the market's perception of the particular firm’s current and expected future performance.
  • If managers are not performing effectively, relative to the potential of the assets under their control, it will not be long before this is reflected in a lower share price. This may make the firm a bargain for a corporate acquirer and a takeover bid will be made.
  • Business organizations are, therefore, directly and measurably subject to the disciplines of the financial markets. These markets are continuously determining the valuations of business firms’ securities, thereby providing measures of the firm's performances. The presence of the capital markets continuous assessment therefore stimulates efficiency and provides incentives to business managers to improve their performance.

Key Effects of the Capital Markets on a Firm’s Decisions

  • Sound investment decisions require accurate measurement of the cost of capital.
  • Limitations in the supply of capital focus attention on methods of raising finance.
  • Mergers and take-overs create threats and opportunities to be exploited.
  • ‘Externalities’ require managers to determine the appropriate role of organizations.
  • In market-based financial systems, there are large equity and bond markets, shareholders are owners of the company and the company's objective is to maximize shareholder wealth within external constraints.
  • Managers are duty-bound to act in shareholders’ interests, to protect the investors and to enable the financial markets to operate efficiently.

Practical Problems with the Maximization of Shareholder Wealth

1. Agency Theory

  • Agency Theory considers the relationship between a principal and an agent of that principal, including issues such as the nature of agency costs, conflicts of interest (and how to avoid them), and how agents may be motivated and incentivized.
  • Such conflicts are referred to as principal-agent problems and give rise to agency costs. This includes the cost associated with monitoring the actions of others and seeking to influence their actions.
  • Conflicts of interest may equally arise between other stakeholders - junior management, other employees, customers, suppliers, pensioners, etc.

2. The Role of Information

  • Such problems may be easier to resolve if all parties share the same insights into the fortunes of the company. However, information asymmetries will often exist between the various classes of stakeholder.

3. The Role of Agreements

  • Written agreements between the various classes of stakeholder may specify key aspects of the relationship between them, but cannot realistically cover all possible future eventualities.
  • Such agreements therefore need to be supplemented by less formal understandings and arrangements.

4. Social Responsibility

  • Efficient, well-managed operations (relative to consumer demand patterns) lead to new products, new technologies, and greater employment.
  • But firms must take into account the effects of their policies and actions on society as a whole.
  • The expectations of workers, consumers, and various interest groups create other dimensions of the external environment that firms must respond to.
  • ‘Externalities’ (such as pollution, product safety, and job security) must be considered when formulating policy.
  • In summary, industry and government should co-operate in establishing rules for corporate behavior so that firms strive to maximize shareholder wealth within external constraints.

The Value of a Company

  • Generally, the value of an asset is the present value of its expected return. To convert the stream of returns over the life of the security to a value for the security, this must be discounted at the required rate of return for the security.
  • The valuation requires:
    • The stream of expected returns.
    • The required rate of return on the investment (the discount rate).
  • To determine the (intrinsic) value of a company, a variety of discounted cashflow (DCF) (also known as present value cashflow (PVCF)) techniques can be used.
  • These techniques use different cashflows and assume different growth rates for cashflows but all use a discount rate very close to the required rate of return; a rate of return that compensates the shareholder for investing in the risky stock.
  • For example, in the dividend discount model (DDM), the present value of future dividends determines share value, and since dividends go directly to the shareholder, the cost of equity is used as the discount rate.
  • In other models, stable cash flows to the firm, adjusted appropriately and discounted at the weighted average cost of capital, are used to determine the share value.

The Value of a Company – Financial Manager

  • Most large organizations will have many thousands, if not millions, of individual shareholders.
  • Needs/Objectives of Shareholders:
    • Attitude toward risk.
    • Time preference and consumption needs.
    • Balance between the need for income and for capital growth.
    • Tax position.
  • How can managers and directors, acting as agents for the ultimate owners, satisfy the different desires of these owners? Indeed, how can they even know what these desires are?
  • Provided that a free, competitive, capital market exists, shareholders can choose their investment to meet their needs for cash flow, risk, and so on.
  • If we assume that all shareholders seek to be rich as possible, the goal of the financial manager is simply stated: to increase the market value of its shareholder’s stake in the firm.

The Value of the Company - The Opportunity Cost of Capital

  • This goal can be further refined to provide an operational tool for financial management. Any operational decision will be reflected in a pattern of future cashflows.
  • EXAMPLE: A project costs RM 1.5 million and is expected to bring in a net cash flow of RM 500,000 each year for the next 4 years. Assuming a discount rate of 10%, determine whether this project is worth doing.
  • By discounting the cash flows at an appropriate rate of interest convert we can establish the net present value of any opportunity.
  • If we use the opportunity cost of capital as to rate at which future cashflows are discounted:
    • positive net present value will add to the current value of shareholders wealth.
    • negative present value are ‘value destroying’ an should be avoided.
  • The market enables us to identify the appropriate cost of capital to use in decision making - the rate of return.

The Value of the Company - The Opportunity Cost of Capital - EVA

  • Economic Value Added (EVA) is used to evaluate the ability of managers to add value to the firm.
  • These measures focus on economic profit, which is similar to NPV used in evaluating investment opportunities.
  • Evaluates management performance by comparing net operating profit adjusted for taxes during the year to the firm's total cost of capital, including the cost of equity.
  • net
    profits > cost
    of capital (+ve EVA) indicates Management of the firm has added value for its shareholders.
  • net
    profits < cost
    of capital (-ve EVA) indicates the firm has not earned enough to cover its total cost of capital, and the firm's value has declined.

Regulating Financial Reporting

  • The aim of financial reports is to help all parties associated with an organization make decisions. The reports provide information about the financial position and the performance of an entity.
  • Regulatory bodies set the standards or financial reporting so that companies financial reports are reliable and useful.
  • Examples:
    • The International Accounting Standards Board (IASB).
    • The Financial Reporting Council (FRC).

Corporate Governance and Organization

  • Corporate governance is the system by which companies are directed and controlled.
  • The FRC is responsible for setting the UK Corporate Governance and Stewardship Codes and UK standards for accounting over auditing an actual work.
  • Purpose of corporate governance is to facilitate effective, entrepreneurial and prudent management that can deliver the long-term success of the company.
  • Boards of directors are responsible for the governance of their companies.
  • The shareholders’ role in governance is to appoint directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.
  • The responsibilities of the board include setting the company strategy aims, providing the leadership to put them into effect, supervising the management of the business and reporting to shareholders on their stewardship.
  • The board's actions are subjects to laws, regulations and the shareholders in general meeting.

The UK Corporate Governance Code Main Principles

  • Board leadership and company purpose.
  • Division of responsibilities.
  • Composition, succession and evaluation.
  • Audit, risk and internal control.
  • Remuneration.