ACC741: CORPORATE FINANCIAL MANAGEMENT I TOPIC ONE: INTRODUCTION TO FINANCIAL MANAGEMENT OUTLINE 1.1 What is finance? 1.2 General areas of finance. 1.3 The importance of finance in non-finance areas. 1.4 Increasing importance of managerial finance. 1.5 What goals should businesses pursue? Learning Objectives The purpose of Topic 1 is to provide an overview of managerial finance. On successful completion of this topic you should be able to answer the following questions: What is finance, and why it is important to understand basic financial concepts? What goal(s) should firms pursue? Do firms always pursue appropriate goals? What is the role of ethics in successful businesses? 1.1 What is Finance? In simple terms, finance is concerned with decisions about money, or more appropriately, cash flows. Finance decisions deal with how money is raised and used by businesses, governments and individuals. Thus, finance is the art and science of managing money, that is, the process, institutions, markets and instruments involved in the transfer of money between individuals, businesses and government. 1.2 General Areas of Finance The study of finance consists of four interrelated areas: 1. Financial Markets and Institutions Financial institutions, which include banks, insurance companies, savings and loans, and credit unions, are an integral part of the general financial services marketplace. The success of these organisations requires an understanding of factors that cause interest rates to rise and fall, regulations to which financial institutions are subject, and the various types of financial instruments, such as mortgage, loans and certificates of deposits, that financial institution offer. 2. Investments This area of finance focusses on the decisions made by businesses and individuals as they choose securities for their investment portfolios. The major functions in the investments area are (1) determining the values, risks and returns associated with such financial assets as stocks and bonds and (2) determining the optimal mix of securities that should be held in a portfolio of investments. 1 3. Financial Services Financial services refer to functions provided by organisations that operate in the finance industry. In general, financial services organisations deal with the management of money. People who work in these organisations, which include banks, insurance companies, brokerage firms, and other similar companies, provide services that help individuals (and companies) determine how to invest money to achieve such goals as home purchase, retirement, financial stability and sustainability, budgeting, and related activities. The financial services industry is one of the largest in the world. 4. Managerial (Business) Finance Managerial finance deals with decisions that all firms make concerning their cash flows. As a consequence, managerial finance is important in all types of businesses, whether they are public or private, deal with financial services, or manufacture products. The types of duties encountered in managerial finance range from making decisions about plant expansions to choosing what types of securities to issue to finance such expansions. Financial managers also have the responsibility for deciding the credit terms under which customers can buy, how much inventory the firm should carry, how much cash to keep on hand, whether to acquire other firms (merger analysis), and how much of the firm’s earnings to reinvest in the business and how much to pay out as dividends. 1.3 The Importance of Finance in Non-finance Areas Everyone is exposed to finance concepts almost every day. Thus, even if you do not intend to pursue a career in a finance-related position, it is important that you do have some basic understanding of finance concepts. Let’s consider how finance relates to some of the non- finance areas in a business. 1. Accounting In many firms (especially small ones), it is difficult to distinguish between the finance function and the accounting function. Often, accountants make financial decisions, and vice versa, because the two disciplines are closely related. Financial managers rely heavily on accounting information because making decisions about the future requires information about the past. As a result, accountants must understand how financial managers use accounting information in planning and decision making so that it can provide in an accurate and timely fashion. Similarly, accountants must understand how accounting data are viewed (used) by investors, creditors, and other outsiders who are interested in the firm’s operations. Emphasis on cash flows The accountant’s primary function is to develop and provide data for measuring the performance of the firm, assessing its financial position and paying taxes. Using certain standardized and generally accepted principles, the accountant prepares financial statements that recognize revenue at the point of sale and expenses when incurred. This approach is referred to as the accrual basis. 2 The financial manager, on the other hand, places primary emphasis on cash flow – the intake and outflow of cash. He/she maintain the firm’s solvency by analyzing and planning the cash flows necessary to satisfy its obligations and to acquire assets needed to achieve its goals. The financial manager uses this cash basis to recognize the revenues and expenses only with respect to actual inflows and outflows of cash. Regardless of its profit or loss, a firm must have a sufficient flow of cash to meet its obligations as they come due. Illustration: A small yacht dealer, in the calendar year just ended sold one yacht for $100,000, the yacht was purchased during the year at a total cost of $80,000. Although the firm paid in full for the yacht during the year, at the end of the year it has yet to collect the $100,000 from the customer to whom the sale was made. The accounting view and the financial view of the firm’s performance during the year are given by the following income (profit and loss) and cash flow statements, respectively. Accounting view Income Statement Sales revenue Less: Costs Net profit $100,000 Financial view Cash Flow Statement Cash flow $0 $80,000 $20,000 Less: Cash outflow Net cash flow $80,000 ($80,000) In an accounting sense the firm is profitable, but in terms of actual cash flow it is a financial failure. The firm’s lack of cash flow resulted from the uncollected account receivable of $100,000. Without adequate cash inflows to meet its obligations the firm will not survive, regardless of its level of profits. 2. Management When we think of management, we often think of personal decisions and employee relations, strategic planning, and the general operations of the firm. Strategic planning, which is one of the most important activities of management, cannot be accomplished without considering how such plans impact the overall financial wellbeing of the firm. Such personal decisions as setting salaries, hiring new staff, and paying bonuses must be coordinated with financial decisions to ensure that any needed funds are available. For these reasons, managers must have at least a general understanding of financial management concepts to make informed decisions in their areas. 3. Marketing If you have taken basic marketing course, probably one of the first things you learned was the four Ps of marketing – product, price, place and promotion – determine the success of products that are manufactured and sold by companies. Clearly, the price that should be charged for a product and the amount of advertising a firm can afford for the product must be determined in consultation with financial managers because the firm will lose money if the price of the product 3 is too low or too much is spent on advertising. Coordination of the finance function and the marketing function is critical to the success of a company, especially for a small, newly formed firm, because it is necessary to ensure that sufficient cash is generated to survive. For these reasons, people in marketing must understand how marketing decisions affect and are affected by such issues as funds availability, inventory levels, and excess plant capacity. 4. Information Systems Businesses thrive by effectively collecting and using information, which must be reliable and available when needed for making decisions. The process by which the delivery of such information is planned, developed and implemented is costly, so are the problems caused by a lack of good information. Without appropriate information, decisions relating to finance, management, marketing and accounting could prove disastrous. 5. Economics The field of finance is related to economics. Since every business firm operates within the economy, the financial manager must understand the economic framework and be alert to the consequences of varying levels of economic activity and changes in economic policy. The finance manager must also be able to use economic theories as guidelines for efficient business operation. Examples include supply and demand analysis, profit maximizing strategies and price theory. The primary economic principle used in managerial finance is marginal cost-benefit analysis, the principle that financial decisions should be made and actions taken only when the added benefits exceed the added costs. Thus, nearly all financial decisions ultimately come down to an assessment of their marginal benefits and marginal costs. Illustration: If for illustration purpose, Joan the financial manager for Bulk Shop – a chain of department stores operating in Solomon Islands, is currently trying to decide whether to replace one of the firm’s online computers with a new, more sophisticated one that would both speed process time and handle a larger volume of transactions. The new computer would require a cash outlay of $80,000, and the old computer could be sold to net $28,000. The total benefits from the new computer (measured in today’s dollars) would be $100,000, and the benefits over a smaller time period from the old computer (measured in today’s dollars) would be $35,000. Applying the marginal cost-benefit analysis to the data, is as follows: Benefits with new computer Less: benefits with old computer Marginal (added) benefits $100,000 $35,000 $65,000 Cost of new computer Less: proceeds from sale of old computer Marginal (added) costs Net benefits $80,000 $28,000 $52,000 $13,000 4 Since the marginal (added) benefits of $65,000 exceed the marginal (added) costs of $52,000, the purchase of the new computer to replace the old one is recommended. The company will experience a net gain of $13,000 as a result of this action. 6. Finance in the Organizational Structure of the Firm The importance of the managerial finance function depend on the size of the company. In small businesses, the finance function is generally performed by the accounting department. As the firm grows, the importance of the finance function typically results in the evolution of a separate department linked directly to the CEO through a finance director, sometimes called the chief financial officer (CFO) 1.4 Increasing Importance of Managerial Finance The historical trends have greatly increased the importance of managerial finance. In earlier times the marketing manager would project sales, the engineering and production staffs would determine the assets necessary to meet those demands, and the financial manager’s job was simply to raise the money needed to purchase the required plant, equipment and inventories. The situation no longer exists, decisions now are made in a much more coordinated manner, and the financial manager generally has direct responsibility for the control process. It is also becoming increasingly important for people in marketing, accounting, production, personnel, and other areas to understand finance in order to do a good job in their own fields. People in marketing for instance, must understand how marketing decisions affect and are affected by funds availability, by inventory levels, by excess plant capacity, and so on. Similarly, accountants must understand how accounting data are used in corporate planning and are viewed by investors. As well, financial managers must have an understanding of marketing, accounting, and so forth to make more informed decisions about replacement or expansion of plant and equipment and how to best finance their firms. Thus, there are financial implications in virtually all business decisions, and nonfinancial executives simply must know enough finance to work these implications into their own specialised analysis. 1.5 What Goals Should Businesses Pursue? As noted earlier, the owners of a corporation are normally distinct from its managers. Actions of the financial manager relating to financial analysis and planning, and investment and financing decisions, should be guided by the objectives of the firm’s owners: its shareholders. In most cases, if the financial managers are successful in this endeavour, they will also achieve their own financial and professional objectives. Thus financial managers need to know what the objectives of the firm’s owners are. 1. Managerial Actions to Maximise Shareholder Wealth 5 The general assumption is that owner’s objective is always to maximise profits. To achieve the goal of profit maximisation, the financial manager takes only those actions that are expected to make a major contribution to the firm’s overall profits. For each alternative being considered, the financial manager would choose the one expected to result in the highest monetary return. Firms commonly measure profits in terms of earning per share (EPS), which represent the amount earned during the period – typically a quarter or a year – on each issue share. EPS are calculated by dividing the period’s total earnings available for the firm’s ordinary shareholders – the firm’s owners – by the number of shares issued. But is profit maximisation a reasonable goal? No. It fails for a number of reasons. It ignores the following: Timing of returns Since the firm can earn a return on the funds it receives, the receipt of funds sooner as opposed to later is preferred. Illustration: John, the financial manager of a particular manufacturing firm is attempting to choose between two investments: Investment A or Investment B. Each is expected to have the following effects over its three-year life. Investment A B Earnings per share Year 1 Year 2 Year 3 $1.40 $0.60 $1.00 $1.00 $0.40 $1.40 Total for years 1, 2 and 3 $2.80 $3.00 Based on the profit-maximisation goal, investment B would be preferred over Investment A since it results in higher EPS over the three-year period. However, Investment A provides greater EPS in the first year and this earlier returns could be re-invested to provide greater future earnings. Cash flows available to shareholders Profits do not represent cash flows available to the shareholders. Owners receive returns earlier through cash dividends paid or by selling their shares for a higher price than initially paid. A greater EPS does not necessary mean that a firm’s board of directors will vote to increase dividend payments. Further, a higher EPS does not necessary translate into higher share price. Firms sometimes experience earnings increases without any corresponding favourable change in share price. Only when earnings increases are accompanied by increased future cash flows would a higher share price be expected. 6 Illustration: A firm in a highly competitive technology-driven business could increase its earnings by significantly reducing its research and development expenditures. As a result, the firm’s expenses would be reduced, thereby increasing its profits. But, because of its lessened competitive position, the firm’s share price would drop, as many well-informed investors sell shares in recognition of lower future cash flows. In this case, the earnings increase was accompanied by lower future cash flows and therefore a lower share price. Risk Profit maximisation also disregard risk – the chance that actual outcomes may differ from those expected. A basic premise in managerial finance is that a trade-off exists between return (cash flow) and risk. Return and risk are in fact the key determinants of share price, which represents the wealth of the owners in the firm. Cash flow and risk affect share price differently: higher cash flow is generally associated with a higher share price. Higher risk tends to result in a lower share price, because the shareholder must be compensated for the greater risk. For example, if a legal action claiming significant damages is filed against a company, its share price will typically immediately drop. This occurs not because of any near-term cash flow reduction, but rather in response to the firm’s increased risk – there is a chance that the firm will have to pay out a large amount of cash sometime in the future to eliminate or fully satisfy the claim (i.e., increased risk reduces firm’s share price). Shareholders generally are risk-averse – they want to avoid risk. When risk is involved, shareholders expect to earn higher rates of return on investments of higher risk and lower rates of return on lower-risk investments. Differences in risk can significantly affect the value of an investment. Profit maximisation does not achieve the objectives of the firm’s owners, thus it should not be the goal of the financial manager. It is the shareholders who own the firm and elect the management team. Management in turn, is supposed to operate in the best interests of the shareholders. As noted above, the wealth of the owners is measured by the share price, which in turn is based on the timing of returns (cash flows), their magnitude and their risk. Share price represents the owner’s wealth in the firm, therefore share price maximisation is consistent with owner wealth maximisation. 2. Corporate Governance The system used to direct and control a corporation is referred to as corporate governance. It defines the rights and responsibilities of key corporate participants such as shareholders, board of directors, officers, managers and other stakeholders, and the rules and procedures for making corporate decisions. Typically, it also 7 specifies the structure through which the company sets objectives, develops plans for achieving them and establishing procedures for monitoring performance. Companies listed on the Australian Securities Exchange (ASX) now have guidance on good governance practices. The ASX has issued corporate governance principles which companies can address when framing their standards of corporate governance. The core eight principles to guide a sound governance policy and practice are listed below. Further details are on the ASX website. Principle 1: Lay solid foundations for management and oversight Principle 2: Structure the board to add value Principle 3: Promote ethical and responsibility decision-making Principle 4: Safeguard integrity in financial reporting Principle 5: Make timely and balanced disclosure Principle 6: Respect the rights of shareholders Principle 7: Recognise and manage risk Principle 8: Renumerate fairly and responsibly Individual versus institutional investors It is also worth noting that there are two classes of owners – individuals and institutions. Individual investors are investors who buy relatively small quantities of shares so as to earn a return on idle funds, build a source of retirement income or provide financial security. Institutional investors are investment professionals that are paid to manage other people’s money. They hold and trade large quantities of securities for individuals, businesses and governments. Examples include banks, insurance companies and pension funds. Because they hold and trade large blocks of shares, institutional investors tend to have a much greater influence on corporate governance than do individual investors. Corporate misdeeds Numerous corporate misdeeds are uncovered by journalists and by various regulatory bodies. The misdeeds derive from two main types of issues: (1) false disclosure in financial reporting and other information releases, and (2) undisclosed conflicts of interest between corporations and their analysts, auditors and lawyers. 3. Business Ethics Business ethics are the standards of conduct or moral judgement that apply to persons engaged in commerce. Violation of these standards in finance involves a variety of actions: creative accounting, earnings management, misleading financial forecasts, insider trading, fraud, excessive executive compensation, and bribery and so on. Examples include directors and other statutory officers of major corporations whose actions were deemed unethical and, in some cases, criminal. Today, society in general and the financial community in particular are developing and enforcing ethical standards. The goal of these standards is to motivate business and market participants to adhere to both, and laws and regulations concerned with 8 all aspects of business practice. Most business leaders believe businesses actually strengthen their competitive position by manipulating high ethical standards. And all companies operating on the ASX are expected to promote ethical and responsible decision-making. Ethics and share price An ethical program is believed to enhance corporate value. It can produce a number of positive benefits: reduce potential litigation and judgement costs, maintain a positive corporate image, build shareholder confidence and gain the loyalty, commitment and respect of all the firm’s constituents. Such actions are expected to impact positively on the firm’s share price. Ethical behaviour is therefore view as necessary for the achievement of the firm’s goal of owner maximisation. 4. Manager’s Roles as Agents of Stockholder We have seen that the goal of the financial manager should be to maximise the wealth of the owners of the firm. Thus, managers can be viewed as agents of the owners who have hired them and given them decision-making authority to manage the firm for the owner’s benefit. In theory, most financial managers would agree with the goal of owner wealth maximisation. In practice, however, managers are also concerned with their personal wealth, job security, lifestyle and perquisites (benefits such as golf club memberships, company vehicles and impressive offices, all provided at company expense). Such concerns may make managers reluctant or unwilling to take more than moderate risk if they perceive that too much risk might result in the loss of their job and damage to their personal wealth. The result of such a ‘satisfying’ approach (a compromise between satisfaction and maximisation) is a less-thanmaximum return and a potential loss of wealth for the owners. The conflict between owner and managers is called the agency problem – the likelihood that managers may place personal goals ahead of corporate goals. Two factors act to prevent or minimize agency problems: i. Market forces - One market force is major shareholders, particularly large institutional investors. These holders of large blocks of a firm’s shares exert pressure on management to perform. When necessary, they exercise their voting rights as shareholders to replace underperforming management. - Another market force is the threat of takeover by another firm that believe it can enhance the firm’s value by restructuring its management, operations and financing. The constant threat of a takeover tends to motivate management to act in the best interest of the firm’s owners. ii. Agency costs To minimize agency problems and contribute to the maximisation of owners’ wealth, shareholders incur agency costs. These are costs of monitoring management behaviour, ensuring against dishonest acts of management, and 9 giving managers the financial incentive to maximise share price. An example is to structure management compensation to correspond with share price maximisation through incentive plans – tie management compensation to share price, e.g. granting share options to management, and performance plans – tie management compensation to measures such as EPS, growth in EPS and other ratios of return, e.g. performance shares and cash bonuses. 10 TUTORIAL QUESTIONS 1. Would the role of the financial manager be likely to increase or increase in importance relative to other executives if the rate of inflation increased? Explain. 2. Should stockholder wealth maximisation be thought of as a long-term or short-term goal? For instance, if one action would probably increase the firm’s stock price from a current level of $20 to $25 in six months and then to $30 in five years, but another action would probably keep the stock at $20 for several years but then increase it to $40 in five years, which action would be better? Can you think of some specific corporate actions that might have these general tendencies? 3. Drawing on your background in accounting, can you think of any accounting procedure differences that might make it difficult to compare the relative performance of different firms? 4. Would the management of a firm in an oligopolistic or in a competitive industry be more likely to engage in what might be called ‘socially conscious’ practices? Explain your reasoning. 5. If you were the president of a large, publicly owned corporation, would you make decisions to maximise stockholders’ welfare or your own personal interests? What are some actions stockholders could take to ensure that management’s interests and those of stockholders coincided? What are some other factors that might influence management’s actions? 11