Overview of Financial
Management
Readings: Chapter 1
At the end of this unit students should be able to:
-
Identify some of the forces that will affect financial management in the new millennium.
-
State the primary goal in a publicly traded firm, and explain where social responsibility and business ethics fit in.
-
Define an agency relationship, give some examples of potential agency problems, and identify possible solutions.
- Identify major factors that determine the price of a company’s stock, including those which managers have control over and those which they do not.
What
is Financial Management?
Financial Management issues of the new millennium
- Use of computers and electronic
transfers of information
- The globalization of business
(See Table 1 below)
Table 1:
A
Financial Manager is a generic term for the person who has the responsibility
to plan for, acquire and use the company's funds to purchase assets to carry on
production. He makes the link between the financial markets (we'll see what
this means later on) and the corporation. Financial Managers work closely with
other types of managers. For instance, they rely on accountants for raw
financial data and on marketing managers for information about products and
sales. Financial managers coordinate with technology experts to determine how
to communicate financial information to others in the firm. Financial managers also
provide advice and recommendations to top management. More common terminology
includes, Director of Finance & Chief Financial Officer
(CFO).
Goal of the Firm/Objective
of the company
What is it?
The major
deficiency is that profit maximization often ignores the element of risk and
just because an investment provides a larger return it is often given
preference irrespective of the risk element involved.
|
Important - Before proceeding let's establish some points about profit and revenues: (1) Profit is simply revenues minus expenses (2) Revenues can be comprised of cash as well as credit sales. |
E.g. Company
A had two options:
1. Spend $1,000,000 on promoting "Sting - the greatest one night reggae show on Earth" with an expected inflow of $10,000,000 if there is no bottle throwing i.e. a profit of $9,000,000.
2. Spend $1,000,000 on promoting "Heineken
Star Time" with an expected inflow of $8,000,000 if there is no
bottle throwing i.e.
a profit of $7,000
In profit
maximization, option 1 would have been chosen, but the risk element is ignored
(Will Sting be free of bottle throwing?....there have been numerous incidents in
the past which have caused the promoters additional expenses )
Another deficiency, (but to a lesser
extent) is that the timing of the returns is also not factored in.
- The first one incurs expenses
of $2,000, but the sales of $6,000 are on 3 months' credit. Therefore
while it makes a profit of $4,000 it doesn't receive the cash flow until 3
month's time.
- The second alternative incurs
expenses of $2,000 but the sales of $5,000 are all cash. Therefore, while
it earns profit of $3,000, it receives the inflow of cash immediately,
thus having excess funds to invest elsewhere.
In profit
maximization, option 1 would have been chosen, but in shareholders' wealth
maximization option 2 would have been chosen
Shareholders' wealth maximization.
Major
Factors
Affecting the Goal of the Firm (Stock Price)
A.
B.
Timing
C.
Uncertainty (Risk)
A.
Cash Flows
Ultimately
cash rules, the ability of a company to generate cash inflows and its
corresponding ability to reduce cash outflows will eventually lead to an
increase in its value. Additionally, the larger the inflows and the smaller the
outflows, the higher the firm's value will be.
B.
Timing of
Cash flows (was illustrated previously)
a) If you were to receive a total of
$10,020, would you prefer to receive $10,000 today and $20 next year or receive
$20 today and $10,000 next year?
b) You owe $3,000; would you prefer to pay
$500 now and $2,500 next year or pay $2,500 now and $500 next year?
The way we quantify the financial implications of timing will be
explained later in the course - TIME VALUE OF MONEY
The less certain owners and investors are about a firm's future cash
flows, then the lower they'll value the company. The more certain they are
about the future cash flows, then the higher they'll value the company.
The way we quantify this risk element will be explained later in the
course - RISK & RETURN CONCEPTS.
The above factors are ultimately dependent upon management's actions with respect to their Investments decisions, Financing decisions and Dividend policy.
Other factors affecting the firm's stock price which are outside the control of management include:
-
Legal constraints
-
Environmental regulations
-
International rules
-
Economic activity levels
-
Tax laws
-
Stock Market conditions
In the desire to achieve this goal of
shareholder's wealth maximization, a number of social and ethical challenges face managers. Three of the more
important challenges are:
1.
The Agency problem
2. The interests of stakeholders
3. The interests of the society in
general
Shareholders
vs. Managers
The more
common causes include:
·
Management providing
themselves with luxury benefits which adds no value to the firm (which is what the
owners are interested in)
·
The choice between
paying out dividends from profits earned or retaining the profits in the
business. See Figure
#1 below.
Figure #1
|
Shareholder blasts Grace over dividend |
Executive chairman of
Grace, Kennedy and Company, Douglas Orane on Monday fended off criticism
from a shareholder who complained at Grace, Kennedy’s annual general
meeting that the firm’s 10 percent dividend pay out was inadequate,
and fell short of what other profitable, publicly traded companies were
distributing.
“The company is making profits, profits are increasing and dividends are declining,” declared Charles Leiba “Why are directors of this company treating shareholders this way, it is a very shameful exercise”. Leiba’s charge was the second in
less than a week against a publicly listed firm. Last week Wednesday, several shareholders of Lascelles
pressed directors to increase the half-yearly one cent per share
dividend, arguing that the dividend policy was stifling the performance
of the stock. In defending Grace’s
policy of paying out a minimum of ten percent of its profit as dividend,
Orane told the shareholders that the firm needed to retain the profit to
re-invest in the business in order to survive in the highly competitive
global market. “We had a choice
either to invest in business or close down,” Orane said.
“We recognize we had to make more money and had to reinvest to
continue running. The
demands to reinvest in the business gets larger and larger every
year.” Though Leiba was the
sole complainant at the Grace AGM, his extensive deliberation on the
issue dominated the meeting. He
argued that the Grace dividend lagged in comparison to other listed
companies, primarily those with foreign ownership.
He said while Grace paid dividends at an average ten percent of
profit some companies, like Bank of Nova Scotia, Cable & Wireless
and Goodyear, disbursed up to 30 and 40 percent profit to shareholders. However, Orane pointed
out that dividend pay-out to Grace’s shareholders had actually doubled
over the past five years from $29 million in 1994 to $56 million in
1998. For the year ended
December 1998, Grace, Kennedy paid an interim dividend of 20 cents per
stock unit on May 21, translating into total payout of $36 million. Leiba said this compared with 25 cents for the 1997
year-end and 30 cents the 1996 year-end.
Furthermore, he said, the decline in dividend per stock came
during a period of increased profits and increased remuneration for
executive directors. “Why has directors’
remuneration gone up from $77 million in 1996 to $96 million in 1997 and
$106 million in 1998 and my dividend has gone down from 30 cents to 20
cents,” Leiba said. Over
the same period profits increased from $412 million in 1996 to 446 in
1997 and $505 million in 1998, he noted. Leiba pointed to
reserves of franked income totalling $196.7 million as at December 31,
1998, as what he said was money available for distribution to
stockholders, more dividends. Again Orane defended the
pay package of the directors. “Our
responsibility is to have well paid senior managers who will be able to
carry this company through to the future, “ he told the shareholders. The policy of
competitive remuneration was, according to Orane, one that had served
Grace, Kennedy well. In any
event, he said, there were 20 executive directors and the $100 million
in total executive expenses translated into $5 million per person. It’s a hundred million
dollars and its 20 executive directors, plus external directors who also
receive some compensation, so that’s $5 million on average per
director,” said Orane. Leiba also expressed
concern about the profitability of the company in relation to its
revenue. He noted that
Grace’s $14 billion revenue last year translated into $500 million net
profit while other companies had reported profit in excess of $100
million based on smaller turnover.
He suggested that the group divest some of it subsidiaries, some
of which he argued, were a strain on the company. But Orane said that
Grace Kennedy’s subsidiaries were operating in a highly competitive
global market, which was squeezing their margins.
The current structure and composition of the group, according to
Orane, had worked well for the shareholders.
|
| Source: Business Observer, page B13, Wednesday June
2, 1999 .
(Note - Interestingly, in the year 2000, Grace Kennedy disposed of its wholly-owned subsidiaries, Grace, Kennedy Travel Limited, Grace Tours Limited and its 84% holding in Caribbean Freight Forwarders & Customs Brokers Limited.) |
·
The desire to pursue
decisions which result in higher profits even though the element of risk is
high. This prevalent in cases where management may receive bonuses as a
percentage of profits, because of this package they may do everything to
inflate/maximize profits. However, the owners are primarily concerned about
their value, in which the risk element is a key ingredient, as mentioned
earlier.
As can bee
seen, managers are naturally inclined to act in their own best interests.
However, the following factors will affect this adverse managerial behaviour:
- Managerial compensation plans e.g. Tie bonuses to the
Company's stock price (as this reflects the value of the company)
Click
here
for a recent article.
- Direct intervention by
shareholders (Institutionalized Investors)
- The threat of firing
- The threat of takeover
i.e. another company wanting to take over
Shareholders
(through managers) vs. Creditors
The following
scenario explains a possible conflict:
Creditors have a claim on part of a company's earnings for payment of
interest and principal on the debt and they have a claim on the company's
assets in the event of bankruptcy. Shareholders (through managers) have control
of the decisions that affect the profitability and risk of the company.
However, when creditors lend money to companies, they charge a particular rate
based on a number of factors including the risk involved as well as the
profitability. Now if the shareholders (through management) cause the company
to take on a large new project that is far riskier than was anticipated, the
increased risk will cause the required rate of return on the company's debt to
increase, and that will cause the value of the outstanding debt to fall (Topic
# 6 will provide more details about the relationship). If the risky project
is successful, all the benefits go to the shareholders, because the creditors
returns are fixed at the old, low-risk rate. However if the project is
unsuccessful, the creditors may have to share in the losses (by receiving
the liquidated value of assets only).
If
creditors perceive that the company's managers are trying to take advantage of
them, they will either refuse to deal further with the company or charge a
higher-than-normal interest rate to compensate for the risk of possible
exploitation, both of which could be detrimental to the company. In view of
this, it is best that the company's managers try to treat their creditors as fairly
as possible as this will eventually be in the shareholders' best
interest.
2. The interests of stakeholders
There are other people who have a
stake in a company. These people are referred to as "Stakeholders";
they include
· Other non-executive employees
·
Suppliers
·
customers
The
interest of these people can significantly influence business decisions, which
in turn affect the firm's value. It is therefore on of management's aims to
ensure that these stakeholders' welfare have been properly attended to. (E.g.
customer appreciation day, staff retreats, timely settlement of debts
outstanding, etc.)
3. The interests of the society in general
The most common challenge is how to deal with the adverse side effects
of the goods and services a company provides. A typical example is the
pollution caused by the emissions from the bauxite plants in Jamaica.
Excessive pollution control costs namely lawsuits, medical bills, etc
may result in high outflows of cash, which in turn can reduce the value of the
companies in question.
On the other hand firms often embark upon numerous projects all aimed at
being socially responsible including donations to charities, community
programs, campaign programs e.g. "Don't use drugs"; "Use a
condom". To long term aim here is to provide "Goodwill" which in
turn generates increased sales, cash inflows and ultimately, additional wealth
for the owners.