OVERVIEW
Objective
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To understand the nature of financial management.¾
To appreciate the various stakeholders in an organisation and their respective objectives.NATURE OF FINANCIAL MANAGEMENT
ORGANISATIONAL OBJECTIVES
CONFLICTS OF INTEREST
¾ Corporate objectives
¾ Public and private companies ¾ Public sector organisations
¾ Interest groups
¾ Directors and shareholders ¾ Goal congruence
1
NATURE OF FINANCIAL MANAGEMENT
Definition
The management of activities associated with the efficient acquisition and use of short and long-term financial resources.
The types of decisions that are within the scope of financial management are:
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What types of funds should be raised – equity capital or debt capital?¾
How should the funds be raised?¾
On which proposed investments should the funds be spent?¾
How much dividend should be paid to the shareholders?¾
How much working capital should the organisation have and how should it be controlled?2
ORGANISATIONAL OBJECTIVES
2.1
Corporate objectives
In practice companies are likely to have a variety of different objectives which may include a number of the following:
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profit targets;¾
market share targets;¾
share price growth;¾
local and environmental concerns;¾
contented workforce;¾
short-term targets;¾
long-term plans.These objectives can be classified as follows:
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Profit goals – objectives which lead directly to increased profits (e.g. cost reduction programmes);¾
Surrogate profit goals – objectives which lead indirectly to increased profits (e.g. maintaining a contented workforce);¾
Constraints on profit – objectives which actually restrict profit (e.g. ensuring that the company’s operations do no harm to the environment);A company may aim at either maximising or satisficing these objectives.
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Maximising involves seeking the best possible outcome;¾
Satisficing involves finding an adequate outcome.2.1.1
Wealth maximisation
In theoretical terms a single corporate objective is assumed and this is “the maximisation of shareholder wealth”.
The objective of maximising shareholder wealth can be justified in the following ways:
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The company which provides the highest returns for its investors will find it easiest to raise new finance and grow in the future. If a company does not provide competitive returns it will inevitably decline.¾
The directors of a company have a legal duty to run the company on behalf of the shareholders. It is generally assumed that the purchaser of a share in a listed company buys that share in an attempt to maximise his/her wealth.Criticisms of the above include the following:
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It ignores the needs of society that will not necessarily be provided by the free market, such as health, education and defence;¾
It ignores the other interest groups in the company, such as the employees.In practice a company will often seek to maximise profit subject to satisficing a number of other objectives.
2.2
Public limited companies and private companies
The key objective of listed Plc’s is to maximise the wealth of their shareholders as measured by the Total Shareholder Returns (TSR) – share price growth and dividend income.
For a private company, however, there is no quoted share price to be measured. Smaller private companies may also have a close relationship between the owners and the managers, and therefore the directors may be aware of the real objectives of the owners.
2.3
Public sector organisations
The objective of public sector organisations is to provide the service for which the organisation was established. These organisations are frequently called “Not for Profit Organisations” (NPO’s). Such organisations are not constrained by cost/profit objectives to the same extent as companies. However they are often constrained by having multiple and possibly conflicting objectives or responsibilities. For instance a university has a
NPO’s are sometimes said to have as their objective the maximisation of the difference between the benefits they generate and the costs of their operations. However it is often very difficult to quantify the benefits that such organisations produce.
There is an increasing emphasis on Value For Money (VFM) and achieving Economy Efficiency, and Effectiveness - the “3 E’s”.
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Economy - minimizing the input costs of the organisation¾
Efficiency – maximizing the output/input ratio¾
Effectiveness - in meeting the organisation’s objectives.3
CONFLICTS OF INTEREST
3.1
Interest groups/stakeholders
Companies have a variety of different interest groups or “stakeholders” - all of whom are likely to have different interests in and objectives for a company.
Stakeholder
−
Objective
Equity shareholders − maximum wealth
Directors − remuneration
power esteem
Employees − pay and conditions
job security Loan creditors − security
cash flow
long-term prospects Trade creditors − short-term cash flow
Customers − continued existence
Government − profitability
environmental and social issues General public − environmental issues
social issues
3.2
Directors and shareholders
In larger companies the shareholders (as principals) delegate the management of the company to the directors (as agents) – known as “agency theory”. The directors are
managing the company on behalf of the shareholders and should therefore always act in the best interests of the shareholders.
This may not always be the case, as the directors may have other personal objectives such as:
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increasing personal remuneration;¾
maximising bonus payments;¾
empire building;¾
job security.If directors fail to act in the best interest of shareholders this leads to sub-optimal returns to shareholders. This lost potential wealth for shareholders is known as “agency costs”. Shareholder activism should put pressure on the company to follow good corporate governance practices. Implementing the UK Combined Code on corporate governance or the US Sarbanes-Oxley Act should limit agency costs to an acceptable level.
3.3
Goal congruence
Goal congruence is where each of the parties within an organisation are seeking to achieve personal objectives that are also within the best interests of the company as a whole. For example, managers should be encouraged to aim for long-term growth and prosperity, rather than shorter-term reported profitability.
Methods of encouraging goal congruence between managers/directors and shareholders include:
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Executive share option schemes (ESOPs) – although the evidence is mixed as to their success in promoting goal congruence.¾
Long-term incentive plans (LTIPs) e.g. paying managers a bonus if, over a period of several years, the company’s performance exceeds the industry average.¾
Transparency in corporate reporting¾
Improved corporate governance e.g. through the appointment of truly independent non-executive directors.3.4
Environmental concerns
An area of growing concern to all parties, companies included, is that of the environment or “green” issues.
It is important that managers understand the impact of the operations of the organisation on the environment, in order to satisfy public concerns and, increasingly, to avoid any penalties or costs due to environmental regulations.
For these reasons environmental reporting is becoming more common as part of general company financial reporting.
‘Environmental Management Accounting’ (EMA) attempts to measure the full
environmental impact of a company’s operations e.g. the cost of inefficient energy usage due to poor insulation of buildings.
Key points
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The first step in developing the objectives of financial management is to identify the relevant stakeholders in the organisation³
In the corporate sector the key stakeholders are clearly the shareholders. Most traditional finance theory is therefore built on the assumption that a company’s objective is to maximise the wealth of its shareholders³
However modern Corporate Social Responsibility (CSR) suggests that directors should also take into account other stakeholders and therefore also follow a range of non-financial objectives e.g. employee satisfaction, reducing environmental impacts³
Such non-financial objectives may be in conflict with maximising shareholder wealth. Therefore the overall objective may be to producesatisfactory returns for shareholders, whilst attempting to meet the demands of other interest groups
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In practice managers may also have personal objectives which conflict with their responsibilities as agents of the shareholders. Some managers may try to maximise personal wealth e.g. through manipulating bonus schemes or even theft of company assets.FOCUS
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