Financial Management Topic 1

 

QUESTION 1

  •  Explain how the objective of wealth maximisation differs from that of profit maximisation for a company listed at the securities exchange.
    • Difference between goals of profit maximisation and wealth maximisation.

    Profit maximisation is the traditional approach which ensures short term survival by increasing revenues or cutting costs. It enables the firm to pay rent, employees’ salaries etc. To achieve this, the firm must make prudent decisions in relation to investing, financing and liquidity.

    Wealth maximisation, on the other hand, focuses on the market price of capital invested by shareholders. To achieve this, the company must make prudent decisions in relation to dividends in addition to investing, financing and liquidity. It must also manage the information relayed to and relations with investors in order to enhance the market value.

QUESTION 2

Explain the term “agency theory” as applied in financial management.

QUESTION 2

 Agency theory 

This is a theory which explains the agency relationship which arises whenever one party called the principal contracts gives or appoints another party called an agent and delegates to him decision making authority to perform some services on his behalf.

Hence the agency problem arises whenever there is a divergence of interest between the  principal and the agent.

 

 

QUESTION 3
  1.  Executive compensation plans hinder value creation in a company. Citing three reasons, justify the above statement.QUESTION 3
    1.  Shortcomings of executive compensation plans.
    • Linkages between size and pay since big companies evidently have a higher pay, most executive strive for “bigness” irrespective of whether it leaders to value creation or not.
    • Emphasis on short term performance. Usually short term performance such as increase in sales or growth in earnings is given considerable weight which leads to myopic orientation and distract executives from value creation.
    • Reliance on accounting measures/ creative accounting
    • Accounting measures such as earnings and return on investments on which performance of executive is usually gauged are often poor proxies for value creation.
    • Required current recognition of income
    • Although the income tax liability on the growth realized in the cash value is deferred, the executive is required to recognize current income equal to the bonuses premium payment each year.
    • Loss of control over the life insurance policy and its values since the executive is the policy and its values. Since the executive is the policy owner, the employer’s control is limited to the payment
    • Inability to provide for employment loss recovery.
    • Employer cost recovery is not a feature of executive bonus plans.

 

QUESTION 4
  1.  Explain three causes of conflict of interest between shareholders and debt holders.
    1. Causes of conflict between shareholders and debt holders.
    • Managers tend to take very risky decisions using debt holders money to finance company projects with a belief that the benefits of their decisions will accrue to shareholders the projects fails, and the company fails, debt holders may suffer a great loss than equity
    • Managers may pay considerable sums of money as dividends hence jeopardizing the company’s future ability to maintain its liquidity. The amount advanced by the debt holders may be at risk.
    • Shareholders and managers may wish to prolong the company’s life as long as possible whereas the debt holders may wish to safeguard the amount loaned and realize their security as soon as the company appears to be getting into financial difficulties.
    • Managers may try to undermine the position of debt holders by seeking further loan capital committing the company to an increased interest burden and hence greater financial risk of insolvency.

 

QUESTION 5
  1. Describe four ways that could be used to mitigate agency conflict between managers and shareholders.
    1.  Ways to mitigate agency conflict between managers and shareholders
    • Incur monitoring expenditures

    Firms incur expenditure on audit and control procedures aimed at assessing and limiting managerial behaviour to those actions that sub serve the interest of shareholders.

    • Incur bonding expenditures

    Firms may seek protection against dishonest acts of managers by obtaining a fidelity bond from a third party bonding company which agrees to compensate the firm up to a certain amount  if a certain manager’s dishonest acts entail financial losses to the firm.

    • Structuring expenditures  

    To promote greater congruence between the goals of the managers and shareholders, managers are offered monetary and stock incentives such as stock options and performance shares.

    • Incurring opportunity costs

    The structures of a company are arranged in a manner that decision making is slower and therefore firms may not be able to seize profitable opportunities because of bureaucratic procedures and control mechanisms that stifle managerial initiatives.

 

QUESTION 6
  •  Citing relevant examples in each case, distinguish between “agency costs” and “financial distress costs”.
    • a Agency costs are costs incurred by the owners of the company as a result of not being directly involved in the management of the company. The shareholders appoint the directors to run the company on their behalf. Examples of agency costs are:- Costs of the incentives given to the management
    •       Costs of external audit

    . Costs of installing systems of internal control  iv. Restructuring costs

    Financial distress costs are costs associated with Bankruptcy of the company. Examples of financial distress costs are:-

    • Selling of valuable assets at bargaining prices to raise cash ii.     Lawyers’ fees, court costs and huge administrative expenses
    • Rust of machinery, vandalization of buildings, obsolescence of inventories all due to delay in the liquidation of assets as bankruptcy cases take long to settle
    • High borrowing costs

 

QUESTION 7

In relation to the financial objectives of a business entity, distinguish between the terms “maximizing” and “satisficing”.

In relation to financial objectives of a business entity, distinguish between the terms ‘maximizing’ and ‘satisficing’

Maximizing entails reporting the highest profit in the course of the year. Shareholders will want the managers to engage in policies that will result in the maximum profits.

 

Satisficing is a decision-making strategy that attempts to meet an acceptability threshold. This is contrasted with optimal decision-making, an approach that specifically attempts to find the best option available. A satisficing strategy may often be (near) optimal if the costs of the decisionmaking process itself, such as the cost of obtaining complete information, are considered in the outcome calculus.

 

 

 

    Brief notes on:

  •  Role of finance manager
  •  Goals of a firm
  • Nature of agency conflict
  •  Managerial compensation

Managerial incentives NOTES 

SCOPE OF FINANCE FUNCTIONS

The functions of Financial Manager can broadly be divided into two:  The Routine functions and the Managerial Functions.

 

Managerial Finance Functions

Require skillful planning, control and execution of financial activities.  There are four important managerial finance functions.  These are:

 

  • Investment of Long-term asset-mix decisions

These decisions (also referred to as capital budgeting decisions) relates to the allocation of funds among investment projects.  They refer to the firm’s decision to commit current funds to the purchase of fixed assets in expectation of future cash inflows from these projects.  Investment proposals are evaluated in terms of both risk and expected return.

 

Investment decisions also relates to recommitting funds when an old asset becomes less productive.  This is referred to as replacement decision.

 

  • Financing decisions

Financing decision refers to the decision on the sources of funds to finance investment projects.  The finance manager must decide the proportion of equity and debt.  The mix of debt and equity affects the firm’s cost of financing as well as the financial risk.  This will further be discussed under the risk return trade-off.

 

  • Division of earnings decision

The finance manager must decide whether the firm should distribute all profits to the shareholder, retain them, or distribute a portion and retain a portion.  The earnings must also be distributed to other providers of funds such as preference shareholder, and debt providers of funds such as preference shareholders and debt providers.  The firm’s divided policy may influence the determination of the value of the firm and therefore the finance manager must decide the optimum dividend – payout ratio so as to maximize the value of the firm.

 

  • Liquidity decision

The firm’s liquidity refers to its ability to meet its current obligations as and when they fall due.  It can also be referred as current assets management.  Investment in current assets affects the firm’s liquidity, profitability and risk.  The more current assets a firm has, the more liquid it is.  This implies that the firm has a lower risk of becoming insolvent but since current assets are non-earning assets the profitability of the firm will be low.  The converse will hold true.

The finance manager should develop sound techniques of managing current assets to ensure that neither insufficient nor unnecessary funds are invested in current assets.

 

Routine functions

For the effective execution of the managerial finance functions, routine functions have to be performed.  These decisions concern procedures and systems and involve a lot of paper work and time.  In most cases these decisions are delegated to junior staff in the organization.  Some of the important routine functions are:

 

  • Supervision of cash receipts and payments
  • Safeguarding of cash balance
  • Custody and safeguarding of important documents
  • Record keeping and reporting

 

The finance manager will be involved with the managerial functions while the routine functions will be carried out by junior staff in the firm.  He must however, supervise the activities of these junior staff.

 

OBJECTIVES OF A BUSINESS ENTITY

Any business firm would have certain objectives which it aims at achieving.  The major goals of a firm are:

 

  • Profit maximization
  • Shareholders’ wealth maximization
  • Social responsibility
  • Business Ethics
  • Growth

 

  • Profit maximization

 

Traditionally, this was considered to be the major goal of the firm.  Profit maximization refers to achieving the highest possible profits during the year.  This could be achieved by either increasing sales revenue or by reducing expenses.   Note that:

 

Profit                    =       Revenue – Expenses

The sales revenue can be increased by either increasing the sales volume or the selling price.  It should be noted however, that maximizing sales revenue may at the same time result to increasing the firm’s expenses.

The pricing mechanism will however, help the firm to determine which goods and services to provide so as to maximize profits of the firm.

 

The profit maximization goal has been criticized because of the following:

  • It ignores time value of money
  • It ignores risk and uncertainties
  • it is vague
  • it ignores other participants in the firm rather than the shareholders

 

  • Shareholders’ wealth maximization

Shareholders’ wealth maximization refers to maximization of the net present value of every decision made in the firm.  Net present value is equal to the difference between the present value of benefits received from a decision and the present value of the cost of the decision.  (Note this will be discussed further in Lesson 2).

 

A financial action with a positive net present value will maximize the wealth of the shareholders,while a decision with a negative net present value will reduce the wealth of the shareholders.  Under this goal, a firm will only take those decisions that result in a positive net present value.

 

Shareholder wealth maximization helps to solve the problems with profit maximization.  This is because, the goal:

  • Considers time value of money by discounting the expected future cashflows to the present.
  • It recognises risk by using a discount rate (which is a measure of risk) to discount the cashflows to the present.

 

 Social responsibility

The firm must decide whether to operate strictly in their shareholders’ best interests or be responsible to their employers, their customers, and the community in which they operate.  The firm may be involved in activities which do not directly benefit the shareholders, but which will improve the business environment.  This has a long term advantage to the firm and therefore in the long term the shareholders wealth may be maximized.

 Business Ethics

Related to the issue of social responsibility is the question of business ethics.  Ethics are defined as the “standards of conduct or moral behaviour”.  It can be thought of as the company’s attitude toward its stakeholders, that is, its employees, customers, suppliers, community in general, creditors, and shareholders.  High standards of ethical behaviour demand that a firm treat each of these constituents in a fair and honest manner.  A firm’s commitment to business ethics can be measured by the tendency of the firm and its employees to adhere to laws and regulations relating to:

  • Product safety and quality ii) Fair employment practices
  •       Fair marketing and selling practices
  •  The use of confidential information for personal gain
  • Illegal political involvement
  •  bribery or illegal payments to obtain business

 

  Growth

This is a major objective of small companies which may even invest in projects with negative NPV so as to increase their size and enjoy economies of scale in the future.

 

AGENCY THEORY

An agency relationship may be defined as a contract under which one or more people (the principals) hire another person (the agent) to perform some services on their behalf, and delegate some decision making authority to that agent.  Within the financial management framework, agency relationship exist between:

 

  • Shareholders and Managers
  • Debt holders and Shareholders

 

Shareholders versus Managers

A Limited Liability company is owned by the shareholders but in most cases is managed by a board of directors appointed by the shareholders.  This is because:

 

  • There are very many shareholders who cannot effectively manage the firm all at the same time.
  • Shareholders may lack the skills required to manage the firm. iii) Shareholders may lack the required time.

 

 

Conflict of interest usually occurs between managers and shareholders in the following ways:

 

  • Managers may not work hard to maximize shareholders wealth if they perceive that they will not share in the benefit of their labour.
  • Managers may award themselves huge salaries and other benefits more than what a shareholder would consider reasonable
  • Managers may maximize leisure time at the expense of working hard. iv) Manager may undertake projects with different risks than what shareholders would consider reasonable.
  • Manager may undertake projects that improve their image at the expense of profitability.
  • Where management buyout is threatened. ‘Management buyout’ occurs where management of companies buy the shares not owned by them and therefore make the company a private one.

 

Solutions to this Conflict

In general, to ensure that managers act to the best interest of shareholders, the firm will:

 

Incur Agency Costs in the form of:

  1. Monitoring expenses such as audit fee;
  2. Expenditures to structure the organization so that the possibility of undesirable management behaviour would be limited. (This is the cost of internal control)
  • Opportunity cost associated with loss of profitable opportunities resulting from structure not permit manager to take action on a timely basis as would be the case if manager were also owners. This is the cost of delaying decision.

 

The Shareholder may offer the management profit-based remuneration. This remuneration includes:

  1. An offer of shares so that managers become owners.
  2. Share options: (Option to buy shares at a fixed price at a future date). iii) Profit-based salaries e.g. bonus

 

  • Threat of firing: Shareholders have the power to appoint and dismiss managers which is exercised at every Annual General Meeting (AGM). The threat of firing therefore motivates managers to make good decisions.
  • Threat of Acquisition or Takeover: If managers do not make good decisions then the value of the company would decrease making it easier to be acquired especially if the predator (acquiring) company beliefs that the firm can be turned round.

 

Debt holders versus Shareholders

A second agency problem arises because of potential conflict between stockholders and creditors.  Creditors lend funds to the firm at rates that are based on:

 

  • Riskiness of the firm’s existing assets
  • Expectations concerning the riskiness of future assets additions iii) The firm’s existing capital structure iv) Expectations concerning future capital structure changes.

 

These are the factors that determine the riskiness of the firm’s cashflows and hence the safety of its debt issue.  Shareholders (acting through management) may make decisions which will cause the firm’s risk to change.  This will affect the value of debt.  The firm may increase the level of debt to boost profits.

This will reduce the value of old debt because it increases the risk of the firm. Creditors will protect themselves against the above problems through:

 

  • Insisting on restrictive covenants to be incorporated in the debt contract. These covenants may restrict:

 

  • The company’s asset base
  • The company’s ability to acquire additional debts
  • The company’s ability to pay future dividend and management remuneration. Ø The management ability to make future decision (control related covenants)

 

  • if creditors perceive that shareholders are trying to take advantage of them in unethical ways, they will either refuse to deal further with the firm or else will require a much higher than normal rate of interest to compensate for the risks of such possible exploitations.

 

It therefore follows that shareholders wealth maximization require fair play with creditors.  This is because shareholders wealth depends on continued access to capital markets which depends on fair play by shareholders as far as creditor’s interests are concerned.

 

 

The meaning of earthly existence  lies, not as we have grown used  

to thinking, in prospering, but

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