denzil watson and antony head, corporate finance: principles and practice, 4 th edition, © pearson...

Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007

Slide 1.1

Chapter 1

The Finance Function


Slide 1.2

Two key concepts

• Relationship between risk and return

• Time value of money


Slide 1.3

Risk and return

• Risk refers to the possibility that actual outcome may differ from expected outcome.

• Risk can be measured by standard deviation.

• Investors require increasing compensation (return) for taking on increasing risk.

• Return on an investment can be measured over a standard period, such as one year.


Slide 1.4

Risk and return

• Shareholder return is annual dividend (D1) plus share price increase (P1 – P0).

• Relative return in percentage terms is

100 x [(P1 – P0) + D1]/P0

• This is called total shareholder return.


Slide 1.5

Future values: compounding

• Invest £100 now at 5% interest per year.

After 1 year: £105.00 (100 x 1.05)

After 2 years: £110.25 (105 x 1.05)

• These are future values of £100 after 1 and 2 years.

• Future values are found by compounding interest forward through time.


Slide 1.6

Present values: discounting

• What sum of money invested now at 5% will give £120 in 2 years’ time?

• This will be £120/1.052 = £108.84.

• This is the present value of £120 receivedin two years if your required rate of returnis 5%.

• Dividing by 1.052 to find a present value is called discounting.


Slide 1.7

Present values: discounting

• A rational investor will prefer £108.84 to £100 at the current time.

• Discounting allows us to compare £120 in two years’ time with £100 now.

• Note that 1/1.052 = 0.907.

• 0.907 is the present value factor or discount factor of 5% over 2 years (see tables).

• Hence £120 x 0.907 = £108.84.


Slide 1.8

Decision-making areas

A financial manager’s tasks can be divided into 3 areas:

• Financing decisions

• Dividend decisions

• Investment decisions

Key point: appreciate the interrelationship of these 3 decision areas


Slide 1.9

The financial manager

Who is the financial manager in reality?

• Finance Director

(strategic decision making)

• Corporate Treasurer

(day-to-day cash management)


Slide 1.10

Possible corporate objectives

• Shareholder wealth maximisation (SHWM)

• Maximisation of profit

• Maximisation of sales

• Survival

• Social responsibility

Which one should we follow?


Slide 1.11

Shareholder wealth maximisation

• Shareholders want dividends and capital gains

• Capital gains reflect future dividends

• Current and future dividends depend on future cash flows:– their magnitude or size– their timing– their associated risk.


Slide 1.12

NPV B

NPV C

NPV A

NPV D

CORPORATENET

PRESENTVALUE

SHARE PRICE

SHWM

1

2

31: NPV is additive2: Link relies on market efficiency3: Share price taken as surrogate of SHW

Linking NPVto SHWM


Slide 1.13

The agency problem

Why does it arise?

• Divergence of ownership and control

• Managers’ goals differ from shareholders’

• Asymmetry of information

What are the consequences?

• Shareholder wealth is no longer maximised.


Slide 1.14

Consequences of agency problem

• Managers will follow their own objectives i.e. increasing their....

– power

– job security

– pay and rewards.

• Shareholders need to ensure that their own wealth is maximised.


Slide 1.15

Signs of an agency problem

• Managers finance company predominantly with equity finance.

• Managers accept low risk, short payback investment projects.

• Managers diversify operations.• Managers follow ‘pet projects’.• Management gets reward for ‘below

average’ performance.


Slide 1.16

Optimal contracts and agency

• Best solution to the agency problem is to design managerial contracts that minimise the sum of the following costs:

– financial contracting costs

– monitoring costs

– divergent behaviour costs.


Slide 1.17

Option 1: do nothing

Leaving managers to their own devices is problematic:

• Given human nature, managers will engage in sub-optimal behaviour.

• Shareholders are satisficed rather than satisfied.

• No action is not really an option.


Slide 1.18

Option 2: monitoring

Problems associated with monitoring:

• Costly in terms of both time and money

• Who will pay? Large shareholders? What about ‘free-riding’ smaller investors?

• Some managerial actions are hard to follow

• May drive ‘bad managers’ underground


Slide 1.19

Option 3: reward good behaviour

What do we link managerial rewards to? • Most commonly linked to:

– profits– share price (e.g. via share options).

• Rewarding is more common than monitoring.

• But...tying rewards to profits may encourage short-termism and creative accounting.


Slide 1.20

• There are also problems using share options:– How many options should managers be

awarded?– At what share price should managers be

able to exercise their options?– Managers can get rewarded for poor

performance if there is a ‘bull’ stock market.

Option 3: reward good behaviour


Slide 1.21

Other areas of agency Companies are made up of a series of

agency relationships:

The Company

Managers

Employees

Creditorsi.e.banks, suppliers, bond holders

Customers

Shareholders

N.B. Arrows go from ‘principal’ to ‘agent’ and show capital flowscapital flows


Slide 1.22

Other areas of agency

• Debt holders (principals) and shareholders (agents)

• Solutions: security, restrictive covenants

• Management (principles) and employees (agents)

• Solutions: executive share option plans (ESOPs), monitoring, performance-related pay (PRP)


Slide 1.23

Corporate governance

‘ Corporate governance is about promoting corporate fairness, transparency and accountability’ J. Wolfensohn, President (World Bank), Financial Times, June 21, 1999.

• Can be seen as attempt to solve agency problem using externally imposed regulation.

• In the UK it is administered through a series of self-regulatory codes.


Slide 1.24

Cadbury Committee (1992)

Recommended:

• A voluntary code of practice• 3 non-executive directors at board level• Maximum 3-year duration contracts• Posts of Chairman and C.E.O. should be

separate

• Improved information flow to shareholders

• Increasing independence of auditors


Slide 1.25

Greenbury Report (1995)

Recommended:

• One-year rolling contracts

• More sensitivity by remuneration committees

• PRP and share options to be phased out and replaced by ‘challenging’ long-term incentive plans (LTIPs)

A 1996 PIRC report indicated widespread abuse of above.


Slide 1.26

Hampel Report (1998) and the Combined Code:

• Stressed importance of a ‘balanced board’, non-executive directors and the role of institutional shareholders

Combined code overseen by the London Stock Exchange:

• Embodies Hampel, Cadbury and Greenbury recommendations

• Compliance is an LSE listing requirement


Slide 1.27

Turnbull, Higgs and Smith• Turnbull (1999): detailed how boards could

maintain sound systems of internal control (significant risk/systems required).

• Higgs (2003): report designed to enhance the independence, and hence effectiveness, of non-executive directors.

• Smith (2003): gave authoritative guidance on how audit committees should operate and be structured.


Slide 1.28

Is there an agency or corporate governance problem in UK today?

• Agency still remains a problem in the UK:– legislation is only voluntary– human nature has not changed.

• Managers still receive ‘excessive’ rewards

• The future: – US style shareholders coalitions? e.g. CalPers– statutory legislation?

denzil watson and antony head, corporate finance: principles and practice, 4 th edition, © pearson...

Documents