1 Financial management and objectives

Topic list:
 The nature and purpose of financial management

 Financial objectives and the relationship with corporate objectives

 Stake holders

 Measuring the achievement of corporate objectives

 Encouraging the achievement of stakeholder objectives

1 The nature and purpose of financial management

Financial management decisions cover investment decisions, financing decisions, dividend
decisions and risk management.

Financing decisions
Businesses need funding to invest in capital (e.g. equipment, machinery, buildings, etc.), to pay
expenses and for working capital (e.g. salaries, inventories, utilities, etc.). Financing decisions relate
to the decisions about where this money comes from, and is primarily about balancing. This money
can generally come from:
• Equity - Investment from owners/shareholders
• Debt – Money from lenders such as banks or bonds
• Retained earnings – Unspent/accumulated profits from prior periods

Investment decisions
Once raised, the money needs to be invested, and investment decisions help the organisation decide
where to invest this money to repay debt (and interest payments) and achieve a good rate of return for
shareholders. Strategic options are generated as part of the business strategy-setting process. As part
of the evaluation of the strategic options, investment decisions can be made using techniques such as:
• Net present value (NPV) – This is the difference between the present value of cash inflows and the
present value of cash outflows for a project. The present value aspect is useful for projects that last
several years, since it takes into account elements such as inflation.
• Internal rate of return (IRR) – This looks at an investment in terms of the optimal rate of return for
the company, rather than the net value. Higher rates of return are generally preferable.
• Payback period – This is the length of the time taken for an investment to make a return on the
initial expenditure (e.g. a £50 investment with a £25 annual payback would have a two-year payback
period).
• Return on capital employed (ROCE) – This compares a company's capital with its earnings to
measure how efficiently capital has been used to make money.
Dividend decisions
Assuming investments were well made, funds can be returned to shareholders in the form of dividend
payments. The directors have to balance the payment of dividends with retention of cash in the
business to allow for future investment and growth.

Risk management

1.1 What is financial management?

Financial management can be defined as the management of the finances of an organization in order to achieve the
financial objectives of the organization. The usual assumption in financial management for the private sector is that the
objective of the company is to maximize shareholders' wealth.

1.2 Financial planning

The financial manager will need to plan to ensure that enough funding is available at the right time to meet the needs of the
organization for short, medium and long-term capital.
(a) In the short term, funds may be needed to pay for purchases of inventory, or to smooth out
changes in receivables, payables and cash: the financial manager is here ensuring that
working capital requirements are met.
(b) In the medium or long term, the organization may have planned purchases of fixed assets
such as plant and equipment, for which the financial manager must ensure that funding is
available.
The financial manager contributes to decisions on the uses of funds raised by analysing financial data to determine uses
which meet the organization’s financial objectives. Is project A to be preferred to Project B? Should a new asset be
bought or leased?
1.3 Financial control
The control function of the financial manager becomes relevant for funding which has been raised. Are the various
activities of the organization meeting its objectives? Are assets being used efficiently? To answer these questions, the
financial manager may compare data on actual performance with forecast performance. Forecast data will have been
prepared in the light of past performance (historical data) modified to reflect expected future changes. Future changes may
include the effects of economic development, for example an economic recovery leading to a forecast upturn in revenues.

1.4 Financial management decisions

The financial manager makes decisions relating to investment, financing and dividends. The management of
risk must also be considered.
Investments in assets must be financed somehow. Financial management is also concerned with the management of short-
term funds and with how funds can be raised over the long term

The retention of profits is a financing decision. The other side of this decision is that if profits are retained, there is
less to pay out to shareholders as dividends, which might deter investors. An appropriate balance needs to be struck in
addressing the dividend decision: how much of its profits should the company pay out as dividends and how much
should it retain for investment to provide for future growth and new investment opportunities?
2 Financial objectives and the relationship with corporate strategy
Strategy is a course of action to achieve an objective.

2.1 Strategy
Strategy may be defined as a course of action, including the specification of resources required, to
achieve a specific objective.

Strategy can be short-term or long-term, depending on the time horizon of the objective it is intended
to achieve.

This definition also indicates that since strategy depends on objectives or targets, the obvious starting
point for a study of corporate strategy and financial strategy is the identification and formulation of
objectives.

Strategic financial management can be defined as 'the identification of the possible strategies capable
of maximizing an organization’s net present value, the allocation of scarce capital resources among
the competing opportunities and the implementation and monitoring of the chosen strategy so as to
achieve stated objectives'.

Financial strategy depends on stated objectives or targets. Examples of objectives relevant to financial strategy are given
below.
2.2 Corporate Objectives
Corporate objectives are relevant for the organization as a whole, relating to key factors for business success.

Corporate objectives are those which are concerned with the firm as a whole. Objectives should be explicit,
quantifiable and capable of being achieved. The corporate objectives outline the expectations of the firm and the
strategic planning process is concerned with the means of achieving the objectives.
Objectives should relate to the key factors for business success, which are typically as follows.
• Profitability (return on investment)
• Market share
• Growth
• Cash flow
• Customer satisfaction
• The quality of the firm's products
• Industrial relations
• Added value
2.3 Financial Objectives
Financial targets may include targets for:
 earnings;
 earnings per share;
 dividend per share;
 gearing level;
 profit retention;
 operating profitability.
The usual assumption in financial management for the private sector is that the primary financial objective of the company
is to maximize shareholders' wealth.

2.3.1 Shareholder wealth maximization

The shareholder wealth maximization (SWM) principle states that the immediate operating goal and
the ultimate purpose of a public corporation is and should be to maximize return on equity capital.
The SWM specification of what is often termed the corporate objective makes operating goal and
ultimate purpose the same: Managers and investors should focus narrowly on SWM

If the financial objective of a company is to maximize the value of the company, and in particular the value of its
ordinary shares, we need to be able to put values on a company and its shares. How do we do it?
Three possible methods for the valuation of a company might occur to us.
(a) Balance sheet valuation
Here assets will be valued on a going concern basis. Certainly, investors will look at a company's
balance sheet. If retained profits rise every year, the company will be a profitable one. Balance sheet
values are not a measure of 'market value', although retained profits might give some indication of
what the company could pay as dividends to shareholders.
(b) Break-up basis
This method of valuing a business is only of interest when the business is threatened with
liquidation, or when its management is thinking about selling off individual assets to raise cash.
(c) Market values
The market value is the price at which buyers and sellers will trade stocks and shares in a company.
This is the method of valuation which is most relevant to the financial objectives of a company.
(i) When shares are traded on a recognized stock market, such as the Stock Exchange, the market
value of a company can be measured by the price at which shares are currently being traded.
(ii) When shares are in a private company, and are not traded on any stock market, there is no easy
way to measure their market value. Even so, the financial objective of these companies should be
to maximize the wealth of their ordinary shareholders.
The wealth of the shareholders in a company comes from:
• Dividends received
• Market value of the shares
A shareholder's return on investment is obtained in the form of:

• Dividends received
• Capital gains from increases in the market value of his or her shares
If a company's shares are traded on a stock market, the wealth of shareholders is increased when the share price goes
up. The price of a company's shares will go up when the company makes attractive profits, which it pays out as
dividends or re-invests in the business to achieve future profit growth and dividend growth. However, to increase the
share price the company should achieve its attractive profits without taking business risks and financial risks which
worry shareholders.
If there is an increase in earnings and dividends, management can hope for an increase in the share price too, so that
shareholders benefit from both higher revenue (dividends) and also capital gains (higher share prices). Management
should set targets for factors which they can influence directly, such as profits and dividend growth. A financial
objective might be expressed as the aim of increasing profits, earnings per share and dividend per share by, say, 10% a
year for each of the next five years.
2.3.2 Profit maximization
In traditional economic model of the firm it is assumed that a firm’s objective is to maximise short-
run profits, that is, profits in the current period which is generally taken to be a year. In various forms
of market structure such as perfect competition, monopoly, monopolistic competition the traditional
microeconomic theory explains the determination of price and output by assuming that firm’s aim is
to maximise current or short-run profits. This current short-run profit maximisation model of the firm
has provided decision makers with useful framework with regard to efficient management and
allocation of resources.

Profit is a difference between the total revenue and total cost. It may be noted that the concept of cost
used in economic theory and managerial economics is different from the concept of accounting cost
used by accountants. This difference in the concepts of costs makes the concept of profits used in
economic theory different from that used in its calculation by the accountant. It is to state here that
economic profits is the difference between total revenue and economic cost

Although profits do matter, they are not the best measure of a company's achievements.
Accounting profits are not the same as 'economic' profits. Accounting profits can be manipulated to some extent by
choices of accounting policies.
2.3.3 Earnings per share growth

Earnings per share is calculated by dividing the net profit or loss attributable to ordinary shareholders by the
weighted average number of ordinary shares.
Earnings per share (EPS) is widely used as a measure of a company's performance and is of particular importance in
comparing results over a period of several years. A company must be able to sustain its earnings in order to pay
dividends and re-invest in the business so as to achieve future growth. Investors also look for growth in the EPS from one
year to the next.

2.3.4 Other financial targets

In addition to targets for earnings, EPS, and dividend per share, a company might set other financial targets, such as:
(a) A restriction on the company's level of gearing, or debt. For example, a company's
management might decide:
(i) The ratio of long-term debt capital to equity capital should never exceed, say, 1:1.
(ii) The cost of interest payments should never be higher than, say, 25% of total profits
before interest and tax.
(b) A target for profit retentions. For example, management might set a target that dividend
cover (the ratio of distributable profits to dividends actually distributed) should not be less
than, say, 2.5 times.
 (c) A target for operating profitability. For example, management might set a target for the
profit/sales ratio (say, a minimum of 10%) or for a return on capital employed (say, a
minimum ROCE of 20%).
These financial targets are not primary financial objectives, but they can act as subsidiary targets or constraints
which should help a company to achieve its main financial objective without incurring excessive risks. They
are usually measured over a year rather than over the long term.
Remember however that short-term measures of return can encourage a company to pursue short-term objectives at
the expense of long-term ones, for example by deferring new capital investments, or spending only small amounts
on research and development and on training.
A major problem with setting a number of different financial targets, either primary targets or supporting
secondary targets, is that they might not all be consistent with each other. When this happens, some
compromises will have to be accepted.
2.4 Non-financial objectives
A company may have important non-financial objectives, which will limit the achievement of financial objectives.
Examples of non-financial objectives are as follows.
(a) The welfare of employees
A company might try to provide good wages and salaries, comfortable and safe working conditions, good
training and career development, and good pensions. If redundancies are necessary, many companies will
provide generous redundancy payments, or spend money trying to find alternative employment for redundant
staff.
(b) The welfare of management
Managers will often take decisions to improve their own circumstances, even though their decisions will incur
expenditure and so reduce profits. High salaries, company cars and other perks are all examples of managers
promoting their own interests.
(c) The provision of a service
The major objectives of some companies will include fulfilment of a responsibility to provide a service to
the public. Examples are the privatized British Telecom and British Gas. Providing a service is of course a key
responsibility of government departments and local authorities.
(d) The fulfilment of responsibilities towards customers
Responsibilities towards customers include providing in good time a product or service of a quality that
customers expect, and dealing honestly and fairly with customers. Reliable supply arrangements, also
after-sales service arrangements, are important.
(e) The fulfilment of responsibilities towards suppliers
Responsibilities towards suppliers are expressed mainly in terms of trading relationships. A company's size
could give it considerable power as a buyer. The company should not use its power unscrupulously. Suppliers
might rely on getting prompt payment, in accordance with the agreed terms of trade.
(f) The welfare of society as a whole
The management of some companies is aware of the role that their company has to play in exercising
corporate social responsibility. This includes compliance with applicable laws and regulations but is wider
than that. Companies may be aware of their responsibility to minimize pollution and other harmful
 'externalities' (such as excessive traffic) which their activities generate. In delivering 'green1 environmental
policies, a company may improve its corporate image as well as reducing harmful externality effects.
Companies also may consider their 'positive' responsibilities, for example to make a contribution to the
community by local sponsorship.
Other non-financial objectives are growth, diversification and leadership in research and development.
Non-financial objectives do not negate financial objectives, but they do suggest that the simple theory of
company finance, that the objective of a firm is to maximize the wealth of ordinary shareholders, is too
simplistic. Financial objectives may have to be compromised in order to satisfy non-financial objectives.

3 Stakeholders
Stakeholders are individuals or groups who are affected by the activities of the firm. They can be classified as internal
(employees and managers), connected (shareholders, customers and suppliers) and external (local communities, pressure
groups, government).

There is a variety of different groups or individuals whose interests are directly affected by the activities of a firm. These
groups or individuals are referred to as stakeholders in the firms

The various stakeholders’ groups in a firm can be classified as follows.

Internal Employees and pensioners

Managers
Connected Shareholders
Debt holders
Customers
Bankers
Suppliers
competitors
External Government
Pressure groups
Local and national communities
Professional and regulatory bodies

3.1Objectives of stakeholder groups

The various groups of stakeholders in a firm will have different goals which will depend in part on the particular situation of the
enterprise. Some of the more important aspects of these different goals are as follows.
(a) Ordinary (equity) shareholders
Ordinary (equity) shareholders are the providers of the risk capital of a company. Usually their goal will be to
maximize the wealth which they have as a result of the ownership of the shares in the company.

(b) Trade payables

Trade payables have supplied goods or services to the firm. Trade payables will generally be profit-maximizing
firms themselves and have the objective of being paid the full amount due by the date agreed. On the other
hand, they usually wish to ensure that they continue their trading relationship with the firm and may sometimes
be prepared to accept later payment to avoid jeopardizing that relationship.
 (c) Long-term payables (creditors)
Long-term payables, which will often be banks, have the objective of receiving payments of interest and capital
on the loan by the due date for the repayments. Where the loan is secured on assets of the company, the creditor
will be able to appoint a receiver to dispose of the company's assets if the company defaults on the repayments.
To avoid the possibility that this may result in a loss to the lender if the assets are not sufficient to cover the
loan, the lender will wish to minimize the risk of default and will not wish to lend more than is prudent.
(d) Employees
Employees will usually want to maximize their rewards paid to them in salaries and benefits,
according to the particular skills and the rewards available in alternative employment. Most
employees will also want continuity of employment.
(e) Government
Government has objectives which can be formulated in political terms. Government agencies impinge on
the firm's activities in different ways including through taxation of the firm's profits, the provision of
grants, health and safety legislation, training initiatives and so on. Government policies will often be related
to macroeconomic objectives such as sustained economic growth and high levels of employment.
(f) Management
Management has, like other employees (and managers who are not directors will normally be employees),
the objective of maximizing their own rewards. Directors and the managers to whom they delegate
responsibilities must manage the company for the benefit of shareholders. The objective of reward
maximization might conflict with the exercise of this duty.

3.2Stakeholder groups, strategy and objectives

The actions of stakeholder groups in pursuit of their various goals can exert influence on strategy and objectives. The
greater the power of the stakeholder, the greater his influence will be. Each stakeholder group will have different
expectations about what it wants, and the expectations of the various groups may conflict. Each group, however, will
influence strategic decision-making.
3.3Shareholders and management
Although ordinary shareholders (equity shareholders) are the owners of the company to whom the board of directors
are accountable, the actual powers of shareholders tend to be restricted, except in companies where the shareholders
are also the directors. The day-to-day running of a company is the responsibility of management. Although the
company's results are submitted for shareholders' approval at the annual general meeting (AGM), there is often
apathy and acquiescence in directors' recommendations.
Shareholders are often ignorant about their company's current situation and future prospects. They have no right to
inspect the books of account, and their forecasts of future prospects are gleaned from the annual report and
accounts, stockbrokers, investment journals and daily newspapers. The relationship between management and
shareholders is sometimes referred to as an agency relationship, in which manager’s act as agents for the
shareholders.
Agency relationship: a description of the relationship between management and shareholders expressing the idea that
managers act as agents for the shareholder, using delegated powers to run the company in the shareholders' best
interests.

However, if managers hold none or very few of the equity shares of the company they work for, what is to stop them
from working inefficiently? or not bothering to look for profitable new investment opportunities? or giving
themselves high salaries and perks?
One power that shareholders possess is the right to remove the directors from office. But shareholders have to take
the initiative to do this, and in many companies, the shareholders lack the energy and organization to take such a step.
Even so, directors will want the company's report and accounts, and the proposed final dividend, to meet with
shareholders' approval at the AGM.

Another reason why managers might do their best to improve the financial performance of their company is that
managers' pay is often related to the size or profitability of the company. Managers in very big companies, or in very
profitable companies, will normally expect to earn higher salaries than managers in smaller or less successful
companies. There is also an argument for giving managers some profit-related pay, or providing incentives which are
related to profits or share price.

What Is Agency Theory?

Agency theory is a principle that is used to explain and resolve issues in the relationship
between business principals and their agents. Most commonly, that relationship is the one
between shareholders, as principals, and company executives, as agents.

KEY TAKEAWAYS

 Agency theory attempts to explain and resolve disputes over the respective priorities
between principals and their agents.
 Principals rely on agents to execute certain transactions, which results in a difference
in agreement on priorities and methods.
 The difference in priorities and interests between agents and principals is known as
the principal-agent problem.
 Resolving the differences in expectations is called "reducing agency loss."
 Performance-based compensation is one way that is used to achieve a balance
between principal and agent.
 Common principal-agent relationships include shareholders and management,
financial planners and their clients, and lessees and lessors.

Understanding Agency Theory

An agency, in broad terms, is any relationship between two parties in which one, the agent,
represents the other, the principal, in day-to-day transactions. The principal or principals
have hired the agent to perform a service on their behalf.

Principals delegate decision-making authority to agents. Because many decisions that affect
the principal financially are made by the agent, differences of opinion, and even differences
in priorities and interests, can arise. Agency theory assumes that the interests of a principal
and an agent are not always in alignment. This is sometimes referred to as the principal-
agent problem.

By definition, an agent is using the resources of a principal. The principal has entrusted
money but has little or no day-to-day input. The agent is the decision-maker but is incurring
little or no risk because any losses will be borne by the principal.
Financial planners and portfolio managers are agents on behalf of their principals and are
given responsibility for the principals' assets. A lessee may be in charge of protecting and
safeguarding assets that do not belong to them. Even though the lessee is tasked with the job
of taking care of the assets, the lessee has less interest in protecting the goods than the actual
owners.

Areas of Dispute in Agency Theory

Agency theory addresses disputes that arise primarily in two key areas: A difference in goals
or a difference in risk aversion.

For example, company executives, with an eye toward short-term profitability and elevated
compensation, may desire to expand a business into new, high-risk markets. However, this
could pose an unjustified risk to shareholders, who are most concerned with the long-term
growth of earnings and share price appreciation.

Another central issue often addressed by agency theory involves incompatible levels
of risk tolerance between a principal and an agent. For example, shareholders in a bank may
object that management has set the bar too low on loan approvals, thus taking on too great a
risk of defaults.

Reducing Agency Loss

Various proponents of agency theory have proposed ways to resolve disputes between
agents and principals. This is termed "reducing agency loss." Agency loss is the amount that
the principal contends was lost due to the agent acting contrary to the principal's interests.

Chief among these strategies is the offering of incentives to corporate managers to maximize
the profits of their principals. The stock options awarded to company executives have their
origin in agency theory. These incentives seek a way to optimize the relationship between
principals and agents. Other practices include tying executive compensation in part to
shareholder returns. These are examples of how agency theory is used in corporate
governance.

These practices have led to concerns that management will endanger long-term company
growth in order to boost short-term profits and their own pay. This can often be seen
in budget planning, where management reduces estimates in annual budgets so that they are
guaranteed to meet performance goals. These concerns have led to yet another compensation
scheme in which executive pay is partially deferred and to be determined according to long-
term goals.

These solutions have their parallels in other agency relationships. Performance-based

compensation is one example. Another is requiring that a bond is posted to guarantee
delivery of the desired result. And then there is the last resort, which is simply firing the
agent.
What Disputes Does Agency Theory Address?
Agency theory addresses disputes that arise primarily in two key areas: A difference in goals
or a difference in risk aversion. Management may desire to expand a business into new
markets, focusing on the prospect of short-term profitability and elevated compensation.
However, this may not sit well with a more risk-averse group of shareholders, who are most
concerned with long-term growth of earnings and share price appreciation.

There could also be incompatible levels of risk tolerance between a principal and an agent.
For example, shareholders in a bank may object that management has set the bar too low on
loan approvals, thus taking on too great a risk of defaults.

4 Encouraging the achievement of stakeholder objectives

4.1Managerial reward schemes
It is argued that management with only make optimal decisions if they are monitored and appropriate incentives are given.

The agency relationship arising from the separation of ownership from management is sometimes characterized as the
'agency problem'. For example, if managers hold none or very little of the equity shares of the company they work for,
what is to stop them from working inefficiently, not bothering to look for profitable new investment opportunities, or
giving themselves high salaries and perks?
Goal congruence is accordance between the objectives of agents acting within an organization and the objectives of the
organization as a whole.

Goal congruence may be better achieved and the 'agency problem' better dealt with by offering organizational rewards
(more pay and promotion) for the achievement of certain levels of performance. The conventional theory of reward
structures is that if the organization establishes procedures for formal measurement of performance, and rewards
individuals for good performance, individuals will be more likely to direct their efforts towards achieving the
organization’s goals.
Examples of such remuneration incentives are:
(a) Performance-related pay

Pay or bonuses usually related to the size of profits, but other performance indicators may be used.
(b) Rewarding managers with shares

This might be done when a private company 'goes public' and managers are invited to subscribe for shares in the
company at an attractive offer price. In a management buy-out or buy-in (the latter involving purchase of the
business by new managers; the former by existing managers), managers become owner-managers.
(c) Executive share options plans (ESOPs)

In a share option scheme, selected employees are given a number of share options, each of which gives the holder
the right after a certain date to subscribe for shares in the company at a fixed price. The value of an option will
increase if the company is successful and its share price goes up.
4.2 Regulatory requirements
The achievement of stakeholder objectives can be enforced using regulatory requirements such as corporate
governance codes of best practice and stock exchange listing regulations.

4.2.1 Corporate governance

Good corporate governance involves risk management and internal control, accountability to stakeholders
and other shareholders and conducting business in an ethical and effective way.

Corporate governance is the system by which organizations are directed and controlled

There are a number of key elements in corporate governance:

(a) The management and reduction of risk is a fundamental issue in all definitions of good
governance; whether explicitly stated or merely implied.
(b) The notion that overall performance enhanced by good supervision and management
within set best practice guidelines underpins most definitions.
(c) Good governance provides a framework for an organization to pursue its strategy in an
ethical and effective way from the perspective of all stakeholder groups affected, and offers
safeguards against misuse of resources, physical or intellectual.
(d) Good governance is not just about externally established codes, it also requires a
willingness to apply the spirit as well as the letter of the law.
(e) Accountability is generally a major theme in all governance frameworks.

Corporate governance codes of good practice generally cover the following areas:

(a) The board should be responsible for taking major policy and strategic decisions.
(b) Directors should have a mix of skills and their performance should be assessed regularly.
(c) Appointments should be conducted by formal procedures administered by a nomination committee.
(d) Division of responsibilities at the head of an organization is most simply achieved by separating the roles of
chairman and chief executive.
(e) Independent non-executive directors have a key role in governance. Their number and status should mean that
their views carry significant weight.
(f) Directors' remuneration should be set by a remuneration committee consisting of independent non-executive
directors.
(g) Remuneration should be dependent upon organization and individual performance.
(h) Accounts should disclose remuneration policy and (in detail) the packages of individual directors.
(i) Boards should regularly review risk management and internal control, and carry out a wider review annually, the
results of which should be disclosed in the accounts.
(j) Audit committees of independent non-executive directors should liaise with external audit, supervise internal
audit, and review the annual accounts and internal controls.
 (k) The board should maintain a regular dialogue with shareholders, particularly institutional shareholders. The
annual general meeting is the most significant forum for communication.
(l) Annual reports must convey a fair and balanced view of the organization. They should state whether the
organization has complied with governance regulations and codes, and give specific disclosures about the board,
internal control reviews, going concern status and relations with others.

HALLENGE QUESTIONS1.Agency theory has been criticized for assuming that

managers, lefton their own, will behave in ways that reduce the wealth of outsideequity
holders when, in fact, most managers are highly responsibles t e w a r d s o f t h e a s s e t s
t h e y c o n t r o l . This alternative view of managers has been calledstewardship
theory. Do you agree withthis criticism of agency theory?Why or why not

uppose that the concept of stewardship theory is correct and thatmost managers, most of
the time, behave responsibly and maked e c i s i o n s t h a t m a x i m i z e t h e p r e s e n t
v a l u e o f t h e a s s e t s t h e y control.What implications, if any, would this supposition
have onorganizing to implement diversification strategies