ADVANCED FINANCIAL MANAGEMENT EMERGING ISSUES AND TRENDS QUESTIONS AND ANSWERS

ANSWER 1
Ways in which corporate social responsibility (CSR) activities might enhance the
value of a firm:


CSR will help a company to build a positive reputation of its product and labour.
This will give a firm a competitive advantage.
Employees generally prefer to work for firms with a good reputation, thereby
reducing a firm’s costs of hiring new workers.
CSR leads to greater employee engagement.
An increase in perceived CSR may improve a firm’s reputation and thus permit it to
swap costly explicit claims for less costly implicit charges.

QUESTION 2
In the context of financial management, explain what is meant by “stakeholder
theory”.

The primary objective of a firm is to maximize the wealth of shareholders. This is a
simplistic argument since an organisation runs on the wheels of many interested
parties (stakeholders) whose objectives need to be met. The act of balancing
competing claims of a wider range of stakeholders is what is termed as stakeholder’s
views or theory.


Stakeholder theory addresses moral and ethical values in management of business
organizations.
This theory looks at the whole range of groups to which an organisation is
responsible. It contests the assertion that the main responsibility of management is
to the owners (shareholders) of a business

.
It argues, rather, that the company should not be managed only in the interest of its
shareholders but for all those stakeholders who have a legitimate interest in it.
Further, the theory argues that an organisation can enhance the interests of
shareholders (and owners) without damaging the interests of its wider stakeholders.
The “broadly managed” view suggests that the key attribute of stakeholder
management (which comprises attitudes, structures and practices) is simultaneous
attention to the legitimate interests of all appropriate stakeholders in establishing
organisation structure and general policies and in decision making.

QUESTION 3
‘Financial managers need only concentrate on meeting the needs of shareholders by
maximizing earnings per share – no other group matters.’ Discuss.

Profit maximization
One of the principles of the market economy is that if the owners of businesses attempt
to achieve maximum profitability and earnings this will help to increase the wealth of
society. As a result, it is usually assumed that a proper objective for private sector
organizations is profit maximization. This view is substantially correct. In general, the
market economy has outperformed planned economies in most places in the world. Two
key objectives of financial managers must therefore be the effective management of
shareholders’ funds and the provision of financial information which will help to
increase shareholder wealth.


Problems with profit maximization
However, profit-seeking organizations can also cause problems for society. For example,
monopolists are able to earn large returns which are disproportionate to the benefits
they bring to society. The costs of pollution fall on society rather than on the company
which is causing it. A company may increase profitability by making some of its
workforce redundant but the costs of unemployed people fall on society through the
social security system.
The question that then follows is ‘Should individual companies be concerned with these
market imperfections?’


Government’s role
There are two opposing viewpoints. On one hand, it can be argued that companies
should only be concerned with maximization of shareholders’ wealth. It is the role of
government to pick up the problems of market imperfections (e.g. by breaking up
monopolies, by fining polluters and by paying social security benefits).


Stakeholder interests
An alternative viewpoint is that a company is a coalition of different stakeholder groups:
shareholders, lenders, managers, employees, customers, suppliers, government and
society as a whole. The objectives of all these groups, which are often in conflict, need
to be considered by company managers when making decisions. From this viewpoint,
financial managers cannot be content with meeting the needs of shareholders only.


Consideration of stakeholders
The truth is somewhere in between. The overriding objective of companies is to create
long-term wealth for shareholders. However, this can only be done if we consider the
likely behaviour of other stakeholders.
For example, if we create extra short-term profits by cutting employee benefits or
delaying payments to creditors, there are likely to be repercussions which reduce longer

term shareholder wealth. Or if we fail to motivate managers and employees adequately,
the costs of the resulting inefficiencies will ultimately be borne by shareholders.
Conclusion
The financial manager is concerned with managing the company’s funds on behalf of
shareholders, and producing information which shows the likely effect of management
decisions on shareholder wealth. However, management decisions will be made after
also considering other stakeholder groups and a good financial manager will be aware
that financial information is only one input to the final decision.


QUESTION 4
Many decisions in financial management are taken in a framework of conflicting
stakeholder viewpoints.
Identify the stakeholders and some of the financial management issues involved in the
following situations.


(a) A private company converting into a public company
(b) A highly geared company attempting to restructure its capital finance
(c) A large conglomerate ‘spinning off’ its numerous divisions by selling them, or setting
them up as separate companies.

(a) A private company converting into a public company
When a private company converts into a public company, some of the existing
shareholder/managers will sell their shares to outside investors. In addition, new shares
may be issued. The dilution of ownership might cause loss of control by the existing
management.


The stakeholders involved in potential conflicts are as follows.
Existing shareholder/managers
They will want to sell some of their shareholding at as high a price as possible. This
may motivate them to overstate their company’s prospects. Those
shareholder/managers who wish to retire from the business may be in conflict with
those who wish to stay in control – the latter may oppose the conversion into a public
company.


New outside shareholders
Most of these will hold minority stakes in the company and will receive their rewards
as dividends only. This may put them in conflict with the existing
shareholder/managers who receive rewards as salaries as well as dividends. On
conversion to a public company there should be clear policies on dividends and
directors’ remuneration.
Employees, including managers who are not shareholders
Part of the reason for the success of the company will be the efforts made by
employees. They may feel that they should benefit when the company goes public.

One way of organizing this is to create employee share options or other bonus
schemes.


(b) A highly geared company attempting to restructure its capital finance
The major conflict here is between shareholders and lenders. If a company is very highly
geared, the shareholders may be tempted to take very high risks. If the gamble fails,
they have limited liability and can only lose the value of their shares. If they are lucky,
they may make returns many times the value of their shares. The problem is that the
shareholders are effectively gambling with money provided by lenders, but those lenders
will get no extra return to compensate for the risk.


Removal of risk
In restructuring the company, something must be done either to shift risk away from
the lenders or to reward the lenders for taking a risk.
Risk can be shifted away from lenders by taking security on previously unsecured loans
or by writing restrictive covenants into loan agreements (e.g. the company agrees to set
a ceiling to dividend pay-outs until gearing is reduced and to confine its business to
agreed activities).
Lenders can be compensated for taking risks by either negotiating increased interest
rates or by the issue of ‘sweeteners’ with the loans, such as share warrants or the issue
of convertible loan stock.


Other stakeholders
Other stakeholders who will be interested in the arrangements include trade creditors
(who will be interested that loan creditors do not improve their position at the expense
of themselves) and managers, who are likely to be more risk averse than shareholders
if their livelihood depends on the company’s continuing existence
.
(c) A large conglomerate spinning off its divisions
Large conglomerates may sometimes have a market capitalization which is less than the
total realisable value of the subsidiaries. It arises because more synergy could be found
by the combination of the group’s businesses with competitors than by running a
diversified group where there is no obvious benefit from remaining together.
The stakeholders involved in potential conflicts are;-


– Shareholders
They will see the chance of immediate gains in share price if subsidiaries are sold.
– Subsidiary company directors and employees
They may either gain opportunities (e.g. if their company becomes independent) or suffer
the threat of job loss (e.g. if their company is sold to a competitor).

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