QUESIONS AND ANSWERS
Question 1
a)The objective of financial management is to maximize the value of the firm.‟
You are required to discuss how the achievement of this objective might be compromised by
the conflicts which may arise between the various stakeholders in an organization. (10 marks)
(b) You are required to discuss the arguments for and against the introduction of statutory controls on
corporate governance
Describe the main types of foreign exchange rate system. Briefly discuss how such systems might affect the
ability of financial managers to forecast exchange rates
Answers
If it is agreed to maximize the value of the firm, it is necessary to ask two fundamental questions:
who is the firm?
What do we mean by value? In the United Kingdom the traditional view has been for the interests of a firm to equate with those of the current equity shareholders. But is it now recognized that this is much too narrow. The employees and lenders to a business certainly have a legitimate interest, probably also the government. Some companies would add a company‟s suppliers and customers as part of the stakeholders. Perhaps the general public also belongs to the list.Each of the members of the above list has different key objectives. For example employees might want their labour remuneration to be larger, while the shareholders want labour costs to be low so that higher profits can lead to higher dividends. Shareholders might be uninterested whether the company invests in „unethical‟areas of business such as armaments or cigarettes, as long as their investment is profitable, while certain sections of the public will discourage unethical products.
The value of an investment in terms of financial management theory is the present value of the cash returns available from the investment. However this varies from investor to investor depending on personal discount rate, tax position, period of investment, etc. For example the value of a share bought today and expected to be sold in five years time will be the present value of the five years dividends plus the present value of the expected net realizable value at the end of the holding period. So the value of the same share will be different to different shareholders, and the job of the managers to maximize the total value becomes impossible.
A further problem arises in the conflict between short-term results and long-term viability. Managers might be on annual service contracts and therefore are motivated to report the highest possible short-term profits. This might involve cutting down on revenue investment such as maintaining fixed assets, advertising, research costs, etc. Such a policy is in the best interests of management, since they will be paid a bonus for reporting good results, but is not in the long-term interests of the company.
Financial managers often deal with the above conflicts by adopting a satisfying approach rather than an optimizing approach. The hope to please everyone by following moderate policies which are not exclusively in the interests of one of the sectional stakeholders of the business.
(b)Arguments for the introduction of statutory controls on corporate governance include the following:(1)there already exist a raft of statutory controls on corporate governance, mainly in the Companies Act. For example companies must appoint auditors, directors can be removed according to standard procedures, and directors may not generally receive loans from their companies. What we are arguing here is whether the present statutory controls should be extended. It is fair to say that the existing controls have rather developed on a piecemeal basis, prohibiting specific acts when they have been observed in practice; thus the statute has lagged behind the reality. It would be more satisfactory if statutory controls could be developed at the same pace as developments in practice, though this ideal situation is impractical.
(2)the board of directors is supposed to act in the best interests of shareholders. However there may be situations where the interests of shareholders diverge from the managers‟ own interests; this conflict can be so strong that statutory controls are required to ensure that companies are run in the best interests of the shareholders. An example is directors‟ remuneration and service contracts might want large remuneration and contracts offering large compensation if they are sacked. The Companies Act requires total remuneration paid to directors to be disclosed.
(3)a further conflict arises where auditors are appointed by the directors, and the directors fix their remuneration, yet they report to the shareholders. There is a temptation for auditors to which to please the directors who have appointed them, rather than to act objectively in the shareholders‟ best interests. The independence of mind of auditors is guaranteed by their professionalism required by the Companies Act.
(4)the best way of ensuring good governance is likely to be the threat of further statutory controls. When directors see that a government is sincere in wishing to encourage good governance, the worst practices will be stopped for fear of attracting new legislation.
Arguments against the introduction of new statutory controls on corporate governance include the following:
(1)one cannot legislate against evil. If a bad man is determined to carry out a fraud, whether or not controls are enshrined in statute will be irrelevant.
(2)statutory controls may stifle individual entrepreneurship. Many companies have flourished in recent years because of the existence of one strong individual business person combining the roles of chairman and chief executive and pushing through their will, eg. Hanson in the UK. If the Cadbury recommendation to split the role of chairman and chief executive wherever possible had been enshrined in statute, such companies may not have enjoyed the success that they did.
(3)putting rules into statute encourages companies to obey the letter of the law rather than the spirit. The whole experience of the Securities and Investments Board in implementing the Financial Services Act regulations has proved that detailed rule books are an ineffective means of regulation. Statute should contain broad rules, backed up by self-regulatory practice notes and points of interpretation. It is this latter approach that has been adopted by the Accounting Standards Board in drawing up its new accounting standards, an approach that has proved successful to date. The Cadbury recommendations should follow this same successful course of action
