Chapter 1 Financial Management and Financial Objectives

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Objectives
Explain the nature of financial management. Explain the purposes of financial management (raising finance, allocation of financial resources, maintaining control over resources). Distinguish between financial management and financial and management accounting and explain the relationship between them. Define and distinguish between financial strateg! and financial ob"ectives. describe the relationship between corporate strateg!, corporate ob"ectives and financial ob"ectives. Explain the features of the financial ob"ective of shareholder wealth maximi%ation. Distinguish between shareholder wealth maximisation and satisficing in a scenario. Explain the financial management in not(for(profit organi%ation. Explain the agenc! problems and describe the methods of how to reduce such problems.

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The Nature and Purpose of Financial Management

e! concepts (a) Financial management 4 can be defined as the management of the finances of an organi%ation in order to achieve the financial objectives of the organi%ation. 5he usual assumption in financial management for the private sector is that the ob"ective of the compan! is to ma"imi#e shareholders$ %ealth. Financial management decisions cover investment decisions, financing decisions, and dividend decisions and ris& management. Financial control 4 the control function of the financial manager becomes relevant for funding which has been raised. .re the various activities of the organi%ation meeting its ob"ectives6 .re assets being used efficientl!6 5o answer these 7uestions, the financial manager ma! compare data on actual performance with forecast performance.

(b) (c)

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'nvestment decisions( financing decisions and dividend decisions (a)

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(b)

'nvestment decisions (i) 5he investment decision considers the benefits of investing cash, either in projects or in %or&ing capital , or even in high !ield deposit accounts. (ii) 5his is important to shareholders, as it will determine the cash flows which are generated b! the compan! and will ultimatel! affect the dividends paid and the share price. (iii) -ssessing projects can be difficult as large investments are often re7uired which promise the possibilit! of returns over man! !ears, ma8ing the cash flows hard to estimate. (iv) /hareholders will also be concerned to compare the ris8 as well as the return between profits, as a higher ris& investment should carr! a higher return to compensate. Financing decisions (i) 5he financing decision considers the source of the finance re7uired for the business operations. 5his will be a mi"ture of e.uit! and long/ term debt finance. (ii) 9ompanies need to balance the benefits to their shareholders 4 debt is a cheaper form of finance as the returns re7uired are lower (due to
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(c)

lower ris8) and the debt interest is tax allowable, but e"cessive gearing can increase the ris& to the compan!, and hence the shareholders, dramaticall!. 0ividend decisions (i) 5he dividend decision loo8s at ho% much of the surplus cash generated should be paid out to the shareholders, and ho% much retained for future investments. (ii) 1hareholders generall! prefer a predictable( steadil! rising, dividend rather than one, which follows the fluctuations of the profits.

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Examples of different t!pes of investment decision: Decisions internal to the business enterprise Decision involving external parties Disinvestment decisions 0hether to underta8e new pro"ects 0hether to invest in new plant and machiner! 3esearch and development decisions ;nvestment in a mar8eting or advertising campaign 0hether to carr! out a ta8eover or a merger involving another business 0hether to engage in a "oint venture with another enterprise 0hether to sell off unprofitable segments of the business 0hether to sell old or surplus plant and machiner! 5he sale of subsidiar! companies

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5he statement of financial position and financial management:

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Financial Management( Management -ccounting and Financial -ccounting

-anagement accounting Financial management is mainl! concerned with ma8ing decisions for the long/term future of the compan!. ;t involves ma&ing forecasts for the future and needs much external information (e.g. 8nowledge of competitors). 5he purpose is to ma8e decisions which end up achieving the ob"ectives of the compan!. 1nce the long term decisions have been made, the! need to be implemented and controlled. 5his is management accounting. (a) Management accounting involves ma&ing short/term decisions as to how to implement the long(term strateg! and involves the setting up of a control s!stem in order to measure how well ob"ectives are being achieved in order that corrections ma! be made if necessar!. (b) ;t tends to be short(term, and involves both past information and forecasts for the future.

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,inancial accounting (a) ,inancial accounting is the reporting to sta&eholders 4 primaril! shareholders 4 of how the compan! has performed and therefore effectivel! how well the financial manager and management accountant are doing their "obs. (b) 5he financial accountant is fulfilling a legal re.uirement to report the profits, and it is not their role to loo8 for wa!s of performing better 4 that is the "ob of the financial manager. (c) 5he financial accountant is onl! loo&ing at past information and information internal to the compan!.

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Financial Objectives and Organi#ational 1trateg!

5he financial manager needs to decide on strategies for the raising of finance, for the investment of capital, and for the management of wor8ing capital. <owever, before he can decide on these strategies he needs to identif! what the ob"ectives of the compan! are. 5he following diagram is the 8e! to understanding how financial management fits into overall business strateg!. 5he distinction between =commercial= and =financial= ob"ectives is to emphasise that not
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all ob"ectives can be expressed in financial terms and that some ob"ectives derive from commercial mar8etplace considerations.

Test !our understanding 1 5he following list contains some commercial ob"ectives>targets, some financial ob"ectives>targets and some strategies, all at different levels of the business. ;dentif! which is which. 1. ;mplement a ?ust(;n(5ime (?;5) inventor! s!stem. 2. ;ncrease earnings per share (E+/) b! #@ on prior !ear. 3. .c7uire a rival in a share(for(share purchase. . Au! four new cutting machines for B2#C,CCC each. #. .chieve returns of 1#@ on new manufacturing investment. $. ;mprove the ratio of current assets to current liabilities from 1.& to 1.'#. &. 3educe unsold inventor! items b! 12@. '. Dpdate manufacturing capacit! to incorporate new technolog!. ). ;mprove brand awareness within the DE. Commercial objectives Corporate level 4usiness level Operational level Financial objectives 1trategies

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Financial Objectives
1hareholder 6ealth Ma"imi#ation (a)

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(b)

(c)

-ost companies are owned b! shareholders and originall! set up to ma8e mone! for those shareholders. 5he primar! objective of most companies is thus to maximise shareholder wealth. (5his could involve increasing the share price and7or dividend pa!out.) /hareholder wealth maximisation is a fundamental principle of financial management. Fou should see8 to understand the different aspects of the s!llabus (e.g. finance, dividend polic!, investment appraisal) within this unif!ing theme. -an! other ob"ectives are also suggested for companies including: (i) profit maximi%ation (ii) growth (iii) mar8et share

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social responsibilities

Ma"imising and satisficing 1ne problem for the financial manager is to satisf! the ob"ectives of several sta8eholders at the same time. ,or example, reducing wages might increase profits and might satisf! shareholders, but would be unli8el! to satisf! emplo!ees. 5herefore, in practice a distinction must be made between maximising and satisficing. (a) -aximising 4 see8ing the best possible outcome (b) /atisficing 4 finding a merel! ade.uate outcome.

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Objectives in Not/for/profit Organi#ations

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*ot(for(profit organi%ations include organi%ations such as charities, state health service and police force, where the! are not run to ma&e profits, but to provide a benefit. .lthough good financial management of these organi%ations is important, it is not possible to have financial ob"ectives of the same form as for companies. 5he focis therefore for these organi%ations is on value for mone!, i.e. attempting to get the ma"imum benefits for the least cost. 9alue for mone! can be defined as getting the best possible combination of services from the least resources, which means maximising the benefits for the lowest possible cost. 5his is usuall! accepted as re7uiring the application of econom!( effectiveness and efficienc!. :conom! is attaining the appropriate .uantit! and .ualit! of inputs at lo%est cost to achieve a certain level of outputs. ,or example, the econom! with which a school purchases e7uipment can be measured b! comparing actual costs with budgets, with costs in previous !ears, with government> local authorit! guidelines or with amounts spent b! other schools. :ffectiveness is the e"tent to which declared objectives7goals are met. ,or example, the effectiveness of a school=s ob"ective to produce 7ualit! teaching could be measured b! the proportion of students going on to higher or further education. :fficienc! is the relationship bet%een inputs and outputs.

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,or example, the efficienc! with which a school=s ;5 laborator! is used might be measured in terms of the proportion of the school wee8 for which it is used.

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1ta&eholders
.lthough the theoretical ob"ective of a private sector compan! might be to maximi%e the wealth of its owners, other individuals and groups have an interest in what a compan! does and the! might be able to influence its corporate ob"ectives. -n!one %ith an interest in the activities or performance of a compan! are <sta&eholders$ because the! have a sta8e or interest in what happens. ;t is usual to group sta8eholders into categories, with each categor! having its own interests and concerns. 5he main categories of sta8eholder group in a compan! are usuall! the following. 'nternal= (a) Directors (b) Emplo!ees Connected= (c) /hareholders (d) Genders (e) 9ustomers (f) /uppliers (g) Gabour union :"ternal= (h) Hovernment (i) /ociet! as a whole 5he influence of the various sta8eholders results in man! firms adopting non(financial ob"ectives in addition to financial ones. ,or example, (a) -aintaining a contented wor8force (b) /howing respect for the environment (c) +roviding a top 7ualit! service to customers

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-genc! Problem
)0ec +>( *un 12, Nature of agenc! problem (a) 5he agenc! problem arises because= (i) the objectives of managers differ from those of shareholdersI (ii) there is a divorce or separation of o%nership from control in modern
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(b)

companiesI and (iii) there is an as!mmetr! of information between shareholders and managers which prevents shareholders being aware of most managerial decisions. 5he primar! financial management objective of a compan! is usuall! ta8en to be the ma"imisation of shareholder %ealth. ;n practice, the managers of a compan! acting as agents for the principals (the shareholders) ma! act in wa!s which do not lead to shareholder wealth maximisation. 5he failure of managers to ma"imise shareholder %ealth is referred to as the agenc! problem.

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-genc! conflicts are differences in the interest of a compan!Js owners and managers. 5he! arise in several wa!s. (a) Moral ha#ard 4 . manager has an interest in receiving benefits from his or her position as a manager. 5hese include all the benefits that come from status, such as a compan! car, use of a compan! airplane, lunches, and so on. (b) :ffort level 4 -anagers ma! %or& less hard than the! would if the! were the owners of the compan!. 5he problem will exist in a large compan! at middle levels of management as well as senior management level. (c) :arnings retention 4 5he remuneration of directors and senior managers is often related to the si%e of the compan!, rather than its profits. -anagement are more li8el! to want to re/invest profits in order to ma&e the compan! bigger, rather than pa!out the profits as dividends. (d) ?is& aversion 4 Executive directors and senior managers usuall! earn most of their income from the compan! the! wor8 for. 5he! are therefore interested in the stabilit! of the compan!, because this will protect their job and their future income. 5his means that management might be ris8(averse, and reluctant to invest in higher(ris8 pro"ects. (e) Time hori#on 4 1hareholders concern about the long/term financial prospects of their compan!, because the value of their shares depends on expectations for the long(term future. ;n contrast, managers might onl! be interested in the short/term. 5his is partl! because the! might receive annual bonuses based on short(term performance, and partl! because the! might not expect to be with the compan! for more than a few !ears. ?educing the agenc! problem 4 /everal methods of reducing the agenc! problem have been suggested. 5hese include: (a) 0evising a remuneration pac&age for executive directors and senior
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managers that gives them an incentive to act in the best interests of the shareholders. ,or example, one wa! to encourage managers to act in wa!s that increase shareholder wealth is to offer them share options. /hare options will encourage managers to ma8e decisions that are li8el! to lead to share price increases (such as investing in pro"ects with positive net present values), since this will increase the rewards the! receive from share options. (b) <aving enough independent non/e"ecutive directors inside the board. 5he! have no executive role in the compan! and are not full(time emplo!ees. 5he! are able to act in the best interests of the shareholders. (c) ;ndependent non(executive directors should also ta8e the decisions where there is (or could be) a conflict of interest between executive directors and the best interests of the compan!. ,or example, non(executive directors should be responsible for the remuneration pac8ages for executive directors and other senior managers. 'ncentive schemes )management re%ard schemes, 5he structure of a remuneration pac8age for executive directors or senior managers can var!, but it is usual for a remuneration pac8age to have at least three elements. (a) . basic salar! 4 it needs to be high enough to attract and retain individuals with the re7uired s8ills and talent. (b) -nnual performance incentives 4 5he performance target might be stated as profit or earnings growth, E+/ growth, achieving a profit target, etc. /ome managers might also have a non(financial performance target. (c) @ong/term performance incentives 4 0hich are lin8ed in some wa! to share price growth. Gong term incentives are usuall! provided in the form of share a%ards or share options of the compan!. 0h! small and medium(si%ed entities (/-Es) might experience less conflict bet%een the objectives of shareholders and directors than large listed companies. (a) ;n man! cases shareholders are not different from directors , for example in a famil!(owned compan!. 0here that is the case, there is no separation bet%een o%nership and control, there is no difference bet%een the objectives of shareholders and directors, and there is no as!mmetr! of information. 9onflict between the ob"ectives of shareholders and directors will therefore not arise. (b) 5he shares of 1M:s are often o%ned b! a small number of shareholders , who ma! be in regular contact %ith the compan! and its directors . ;n these circumstances, the possibilit! of conflict is ver! much reduced.

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:"amination 1t!le Auestions

Auestion 1 .t a recent board meeting of Dartig 9o, a non(executive director suggested that the compan!Js remuneration committee should consider scrapping the compan!Js current share option scheme, since executive directors could be rewarded b! the scheme even when the! did not perform well. . second non(executive director disagreed, sa!ing the problem was that even when directors acted in wa!s which decreased the agenc! problem, the! might not be rewarded b! the share option scheme if the stoc8 mar8et were in decline. ?e.uired= Explain the nature of the agenc! problem and discuss the use of share option schemes as a wa! of reducing the agenc! problem in a stoc8(mar8et listed compan! such as Dartig 9o. (' mar8s) (.99. ,) ,inancial -anagement December 2CC' K1(e)) Auestion 2 Discuss the relationship between investment decisions, dividend decisions and financing decisions in the context of financial management, illustrating !our discussion with examples where appropriate. (' mar8s) (.99. ,) ,inancial -anagement ?une 2C1C K (c)) Auestion 2 Discuss the reasons wh! small and medium(si%ed entities (/-Es) might experience less conflict between the ob"ectives of shareholders and directors than large listed companies. ( mar8s) (.99. ,) ,inancial -anagement ?une 2C12 K3(a))

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