APC308 financial management

Financial Management


The University of Sunderland
© 2012 The University of Sunderland
First published in 2007. Revised in 2012 by Dr Michael
Bromberg.
All rights reserved. No part of this publication may be
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Index prepared by Indexing Specialists (UK) Ltd, Hove, UK.


Contents
Introduction

vii

Unit 1

vii

Unit 2

Unit 3

Copyright © 2012 University of Sunderland

The nature of financial management
Introduction

1

1.1

The main areas of financial management

2

1.2

Corporate objectives

5

1.3

Agency theory: ownership and control

10

1.4

Addressing the agency problem

14

Case Study

18

Self-assessment questions

19

Feedback on self-assessment questions

20

Summary

21

Working capital mangement

22

Introduction

22

2.1

Working capital ratios

23

2.2

Managing accounts receivable and payable

34

2.3

Predicting corporate failure

38

Case Study

40

Self-assessment questions

41

Feedback on self-assessment questions

42

Summary

43

Budgeting

44

Introduction

44

3.1

The purpose of budgets and the importance of budgeting

47

3.2

The behavioural aspects of budgeting

50

3.3

The main types of budgetary control systems

55

3.4

The need for a budget

58

3.5

Conventional budgets and ‘beyond budgeting’ techniques 60

Case Study

60

Self-assessment questions

62

Feedback on self-assessment questions

63

Summary

65
iii

Unit 4

Unit 5

Unit 6

iv

Marketing efficiency

66

Introduction

66

4.1

The role of the capital markets

67

4.2

The efficient market hypothesis

69

4.3

Forms of market efficiency

73

4.4

Implications for managers and investors

83

Case Study

86

Self-assessment questions

86

Feedback on self-assessment questions

87

Summary

88

Investment appraisal

89

Introduction

89

5.1

The main techniques of investment appraisal

90

5.2

Deciding between investments if capital is rationed

116

5.3

Finding the real rate of return on an investment

119

5.4

The effect of taxation on investments

120

5.5

Why the NPV method of appraisal is preferable

124

Case Study

124

Self-assessment questions

125

Feedback on self-assessment questions

126

Summary

129

Appendix

131

Financial risk

135

Introduction

135

6.1

The financial concept of risk

136

6.2

Measuring risk

141

6.3

Portfolio theory

145

6.4

The capital asset pricing model and the beta value

163

6.5

Using the capital asset pricing model

167

Case Study

169

Self-assessment questions

170

Feedback on self-assessment questions

172

Summary

175

Copyright © 2012 University of Sunderland


Unit 7

Sources of capital

176

Introduction

Unit 8

Unit 9

Copyright © 2012 University of Sunderland

7.1

Factors that influence the financing decision

177

7.2

The distinction between equity and debt finance

180

7.3

Raising new equity and debt finance

182

7.4

Rights issues

183

7.5

Comparing different kinds of finance

191

Case Study

198

Self-assessment questions

198

Feedback on self-assessment questions

200

Summary

203

Appendix

203

Cost of capital

209

Introduction

209

8.1

The cost of capital

210

8.2

Calculating the costs of sources of finance

212

8.3

The weighted average cost of capital

219

8.4

WACC and CAPM compared

224

Case Study

226

Self-assessment questions

227

Feedback on self-assessment questions

227

Summary

230

Gearing ratios and shareholders

231

Introduction

231

9.1

Capital gearing

232

9.2

The problems with high gearing

237

9.3

The capital structure debate

238

9.4

Can a company influence the cost of capital?

247

9.5

The effects of gearing

247

Case Study

260

Self-assessment questions

261

Feedback on self-assessment questions

262

Summary

264

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Unit 10 The dividend decision

vi

266

Introduction

266

10.1 Practical aspects of the dividend decision

267

10.2 The traditional view: dividends are relevant

269

10.3 MM’s theory: dividends are irrelevant

274

10.4 Other theories of dividend policy

279

10.5 Alternatives to cash dividends

282

Case Study

284

Self-assessment questions

285

Feedback on self-assessment questions

286

Summary

287

References

289

Index

293

Copyright © 2012 University of Sunderland


Introduction
Welcome to the Financial Management learning pack! It has been designed to
assist you in studying for the core module of the BA (Hons) in Accounting and
Financial Management degree and covers all topics in the official module
descriptor.
However good the business model, in a world where the average survival time
for small company is less than four years ( />16872553/), the key to long run success is to get the finance right. Two financial
questions are critical for corporate success: ‘does our product generate sufficient
profit?’ and ‘are we producing sufficient returns to satisfy those who provide
our finance?’. The first of these questions is the province of management
accounting; this learning pack addresses the second.
The learning pack explains where companies acquire finance: from debt, equity
or their own internal resources; it also explains the calculations necessary to
assign a level of risk – and therefore a cost – to each of these sources. External
financing requires a market; the learning pack explains the basic operation of
financial markets. Spending the money raised is also important: one unit
delineates the basics of strategic planning and budgeting, another the optimal
way of choosing between different investment options.
The whole pack relies on a series of basic financial models that were developed
throughout the twentieth century. These models rely critically on a series of
assumptions about the financial world. It is evident from recent financial crises

that finance theory is a work in progress, not the finished product. After
studying the learning pack you should begin to understand the difference
between the perfect world of financial theory and the real world in which all
businesses operate.
By the end of the pack you will be in possession of all the tools necessary to
understand how business finance operates – but the theory is only a start.
Combining this theory with practical experience and your own ability will
determine how successful you will be in your future career whether it be in the
private, public or not-for-profit sector.

How to use this pack
The learning pack will take you step by step in a series of carefully planned
units and provides you with learning activities and self-assessment questions
to help you master the subject matter. The pack should help you organise and
carry out your studies in a methodical, logical and effective way, but if you
have your own study preferences you will find it a flexible resource too.
Before you begin using this learning pack, make sure you are familiar with any
advice provided by the University of Sunderland on such things as study skills,
revision techniques or support and how to handle formal assessments.
If you are on a taught course, it will be up to your tutor to explain how to use
the pack in conjunction with a programme of face-to-face workshops and
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vii


seminars – when to read the units, when to tackle the activities and questions,
and so on.
If you are on a self-study course, or studying independently with remote tutor
support, you can use the learning pack in the following way:

■

Scan the whole pack to get a feel for the nature and content of the subject
matter.

■

Plan your overall study schedule so that you allow enough time to complete
all units well before your examinations – in other words, leaving plenty of
time for revision.

■

For each unit, set aside enough time for reading the text, tackling all the
learning activities and self-assessment questions and for the suggested
further reading. Your tutor will advise on how they will plan activities
around these materials and opportunities to network with other students.

Now let’s take a look at the structure and content of the individual units.

Overview of the units
The learning pack breaks the content down into ten units, which vary from
approximately eight to ten hours’ duration each. However, we are not advising
you to study for this sort of time without a break! The units are simply a
convenient way of breaking the syllabus into manageable chunks. Most people
would try to study one unit a week, taking several breaks within each unit. You
will quickly find out what suits you best.
You will see that each unit is divided into sections. It is assumed, for the most
part, that you will study the units in the order presented. What is more
important is that you try to study each section of each unit in the order

presented. Each unit is written on the strict assumption that you will understand
the material in each section before moving to the next.
Each unit begins with a brief introduction which sets out the areas of the
syllabus being covered and explains, if necessary, how the unit fits in with the
topics that come before and after.
After the introduction there is a statement of the unit learning objectives. The
objectives are designed to help you understand exactly what you should be able
to do after you’ve studied the unit. You might find it helpful to tick them off as
you progress through the unit. You will also find them useful during revision.
There is one unit learning objective for each numbered section of the unit.
Following this, there are prior knowledge and resources sections. These will let
you know if there are any topics you need to be familiar with before tackling
each particular unit, or any special resources you might need, such as calculator,
graph paper or specific books.
Then the main part of the unit begins, with the first of the numbered main
sections. At regular intervals in each unit, we have provided you with learning
activities, which are designed to get you actively involved in the learning
process. You should always try to complete the activities before reading on.

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You will learn much more effectively if you are actively involved in doing
something as you study, rather than just passively reading the text in front of
you. The feedback or answers to the activities are provided immediately
following the activity. Do not be tempted to skip the activity.
Throughout the unit key terms are highlighted in bold with the definition
appearing in the margin.

Each unit contains recommended reading which also appears in the margin and
which refers you to relevant chapters of supporting textbooks including the
core textbook. It is essential that you do this reading, since it is not possible to
put everything you need to know in a single learning pack. At level 3 of a degree
wider reading is key to developing deeper subject learning through a
contemporary, contextual and critical perspective. This is important to consider
when approaching the related assessment of the module.
We provide a number of self-assessment questions at the end of each unit. These
are to help you to decide for yourself whether or not you have achieved the
learning objectives set out at the beginning of the unit. As with the activities,
you should always tackle them. The feedback or answers follow immediately
after at the end of the unit. If you still do not understand a topic having
attempted the self-assessment question, always try to re-read the relevant
passages in the textbook readings or unit, or follow the advice on further
reading given. Your allocated tutor will be available to deal with questions
arising from the material and will assist your study through the unit.
At the end of the unit is the summary. Use it to remind yourself or check off
what you have just studied, or later on during revision.
Finally, where possible, we have made reference to material on the internet since
this is easy to access. You may find that addresses change. This is annoying; but
with a bit of effort you will be able to track the material down (nothing
disappears completely from the web). And by searching you will learn even
more! Good luck and enjoy it.

Core textbooks
The essential text is:
Corporate Finance: Principles and Practice (5th edition, 2010) by Denzil
Watson and Antony Head, published by FT Prentice Hall.
This book is well structured and both readable and informative: it covers the
main topics of the course with a good level of detail. The mathematical

underpinning is sufficient for the course but not so technical as to frighten even
the student most fearful of numbers and equations. The book contains lots of
case studies and extra information supporting the text contained in these units
and – if studied carefully – will certainly lead to success in the module.
The book is strong in most areas covered by the module and provides lots of
extra references that can be consulted by the student who wants to go further
than the base material. It does not contain a chapter on budgeting so extra
references are suggested in the text for students looking for support in this area.

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Acknowledgements
We are grateful to Telegraph Media Group Limited for permission to reproduce
copyright material for the case study in Unit 2.
In some instances we have been unable to trace the owners of what might be
copyright material and we would appreciate any information that would enable
us to do so.

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Copyright © 2012 University of Sunderland


1

Unit

The nature of financial
management

‘The business schools reward difficult
complex behaviour more than simple
behaviour, but simple behaviour is more
effective.’
Warren Buffett, US investment guru

Introduction
Welcome to the first unit of the third-level module, entitled ‘Financial
management’. The module explores, within the context of the limited
company, three key areas of finance:

statement of financial position

■

investment

■

the sources of funds to enable investment

■

the rewards to the providers of those funds.

First we need to examine the nature of finance: finance is not ‘accountancy’.
A set of accounts will give you some information but not the information

needed to enable decision making in the three key areas of strategic
financial management. For the only time in this module, therefore, we want
you to read a statement of financial position (hereafter position
statement) to discover what it doesn’t tell you, rather than what it does!
Unit learning objectives
On completing this unit, you should be able to:
1.1 Identify the main areas of financial management.
1.2 Explain why, in terms of financial management, maximisation of
shareholder wealth is the most appropriate corporate objective.
1.3 Explain agency theory.
1.4 Suggest ways of addressing the agency problem.
Prior knowledge
This unit requires some basic knowledge of financial accounting.
Resources
The sections in this unit are supported by the chapter ‘The finance function’ in
your core textbook (Watson and Head, 2010).

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Financial Management

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1.1 The main areas of financial
management
Read through the simplified position statement in Figure 1.1, then answer
the questions that follow.
Bright Ltd statement of financial position
At 30 June 2012
(All figures in thousands)
Assets
£ Cost
Non-current assets
Land and buildings
Computers and equipment
Motor vehicles
Current assets
Inventories
Accounts receivable
Cash

£ Dep’n

£ Net book
value

70
17
17

6
8

70
11
9

104

14

90

15
16
5
36

Total assets

126

Equity and liabilities
Equity
Share capital
(Ordinary shares of £1 each)
Retained earnings

50

30
80

Non-current liabilities
Long-term borrowings (debenture)
Current liabilities
Accounts payable
Corporation tax
Dividends

15

11
15
5
31

Total liabilities

46

Total equity and liabilities

126

Figure 1.1: A simplified position statement
1. What has this company invested in?
2. What are the sources of the funds for those investments?
3. How does the company reward the providers of those funds?

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Unit 1

1a

The nature of financial mangement

1. Although you were given only a simplified position statement, you
should have been able to see, without any formal analysis, that the
company has invested in land, buildings, computers, equipment and
motor vehicles. It has no subsidiaries, investments in other companies or
intangible assets such as patent rights. It also has net current assets of
£5,000.
2. The funds have been provided by:
■

ordinary shareholders

■

company profits retained in the business

■

a debenture holder.

The first two sources are equity funding; the last is debt funding.
3. The shareholders are paid dividends – ordinary shareholders will be paid
an amount determined by the company out of residual profits. On the
other hand, the ordinary shareholders may not be paid a dividend at all
if it is decided that the funds would be better retained in the company
for future investment. Debenture holders are paid interest, which is
charged to the company’s statement of comprehensive income
(hereafter income statement).

profit

debenture

You can obtain a lot of information about what the company has done by
looking at the position statement. However, you cannot deduce from this
information:
■

Why the company decided to invest in those particular fixed assets.

■

Why it obtained funding from the debenture holder.

■

How much dividend it has decided to pay to shareholders (the amount
shown in the position statement is the amount owed, not the amount to be
paid) and on what that decision was based.

■

When the dividends are to be paid.

dividend

statement of comprehensive
income

The position statement is based on the historical cost of assets. It does not value
assets, as an investor might, on the basis of what the company might use the
assets for.
The following points cover the three main areas of decision making for the
corporate financial manager:
■

Investment: The choice of projects or assets in which to invest company
funds. Competing alternatives have to be assessed using a number of
techniques. This type of decision will also be of concern to the private
individual when making choices about which shares to buy.

■

Finance: How these investments should be financed. It is necessary to

evaluate the possible sources, external and internal, and the effect they will
have on the capital structure of the company.

■

Dividend: Whether corporate earnings should be retained or paid out in the
form of dividends and, if the latter, when the dividends should be paid.

capital structure

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Financial Management

1b

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These areas are not independent of each other. For example, the decision to
invest in a particular project may require a further decision about finance to be
raised.

1b

1. How might any investment also affect the dividend payment decision?
2. If the financial manager decides to pay a higher dividend to ordinary
shareholders, how might this affect the investment and finance
decisions?

1. The decision to invest in a particular project might mean a lower
dividend if the finance had to be raised internally.
2. If it was decided to pay a higher dividend than usual, this could mean
that there were insufficient retained funds for investment. If an
investment was subsequently thought to be necessary, finance would
have to be raised externally.

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Financial management also involves the management of risk. Risk attaches to
individual investments, the economy in general, to borrowing and to trading or
investment abroad.

Give an example of a risk that a company might incur from:
(a) Investment in a particular firm.
(b) The economy generally.
(c) Foreign exchange rates.

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(d) Borrowing funds to finance its activities.

1c

Some examples are:
(a) The firm may perform badly, causing the investment’s value to fall.
(b) There may be a sharp rise in rates of inflation or interest, or a general
economic recession.
(c) If a foreign country has high rates of inflation, the value of its currency
may fluctuate.
(d) The company may not be able to meet the interest payments on the
borrowed funds.
You may have thought of other examples.

In this learning pack, we will cover the topic of risk management as well as the
management of a company’s current assets and liabilities in its working capital
cycle. Assets must be managed effectively so they generate income and profits
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Unit 1

The nature of financial mangement

and so funds are available to pay accounts payable and take up opportunities
for investment.
In summary, we can say that financial management involves the following
areas, which this module will cover:
■

Investment decisions.

■

Funding decisions, including the company’s capital structure.

■

Dividend decisions.

■

Risk management.

1.2 Corporate objectives

1d

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Recommended reading for this
section is the corporate objectives
section of the chapter ‘The
finance function’ in Watson and
Head (2010).

1d

You may have noticed above that we referred to the ‘company’ and ‘corporate’.
In this module we deal with strategic financial management in the context,

principally, of the publicly quoted limited company, though the principles
involved apply equally to all kinds of firm. We begin with the question: ‘Why
do companies exist?’. This question is not concerned with why the company
exists as a limited company, but why it exists at all, or in whose interest(s) it
exists.

Why are companies created? Try to think of at least three possible objectives
that a company could have for being in existence.

This might seem to be a strange question and your first reaction was
probably something like, ‘It’s obvious!’ or ‘To carry on business’. You might
have come up with some of the following objectives:
■

To make profits from trading.

■

To survive in a competitive environment.

■

To provide work for people.

■

To sell its goods and services.

■

To grow, perhaps so that it can fulfil the previous objectives.

Earlier, we asked the question: ‘In whose interests does the company exist?’.
This can be rephrased as: ‘Who are the interested parties, or stakeholders?’.
The objectives that we suggested as answers to learning activity 1d imply
stakeholders in the ways shown in Table 1.1.
Possible objective

Stakeholders concerned

To make profits

Shareholders, managers and creditors, including lenders

To survive in a competitive environment

Employees, shareholders and managers

To provide work for people

Employees and society generally

To sell goods and services

Customers

To grow

Shareholders and managers
Table 1.1: How corporate objectives imply stakeholders

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Financial Management

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1e

1. Alongside the list of stakeholders shown in the table, write down what it
is that they provide to the company and what reward they receive. The
first one has been completed for you as an example.

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There is a political element to this question. The capitalist viewpoint would be
more concerned to emphasise profit making in a competitive marketplace. A
socialist view would emphasise the provision of work, the reduction of
unemployment figures and the provision of goods and services to society. The
environmentalist would emphasise that the existence of the company should
not be at the expense of depleting the world’s natural resources. The political
philosophy behind the question is not within the scope of this module.
However, the question of in whose interests a company is run is central to the

decision making involved in financial management, since any of the suggested
stakeholders will want sensible decisions taken, if only for the company’s
survival.

Stakeholder

Provision

Reward

Employees

Time and skills

Salary

Suppliers
Customers
Banks
Shareholders

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2. Which, if any, of the stakeholders run a risk of not being rewarded,

assuming that the company is trading?

1e

Stakeholder

Provision

Reward

Employees

Time and skills

Salary

Suppliers

Raw materials, goods and
services

Payment

Customers

Payment for goods and
services

Goods and services

Banks

Account services, loans

Charges and interest

Shareholders

Share capital

Dividends and enhanced
value of shares

2. As long as the company trades successfully, the employees will receive
salaries, suppliers will be paid, customers will buy goods and the banks
will receive interest on their debt. The regularity of the various payments
may vary but they will be made. The shareholders differ from the other
stakeholders in that there is no guarantee that they will receive their

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Unit 1

The nature of financial mangement

reward in the form of dividend payments, though if the company is
successful, the value of its shares should rise, enabling the shareholders
to create personal dividends by selling a few of their shares. Payment of
a dividend to ordinary shareholders is at the discretion of the company
and the value of its shares will only rise if it is trading successfully.
Therefore, it can be argued that the shareholders are taking a greater
risk than other stakeholders, in that their investment in the company
may reap no reward at all. If there is no reward, the shareholders will sell
their shares, invest elsewhere and the value of the company’s shares,
and thus of the company as a whole, will fall, making it difficult for it to
attract new investment. In time it will fail.

1e
continued

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This seems to suggest that rewarding the shareholder is a vital objective for the

company. Consider some of the alternative objectives that have been suggested:
■

Survival could only be a serious objective in the short term if something
threatened the company. In the long term it appears a rather inadequate, if
not static, objective. Shareholders will want to invest in a company where
there are gains to be made, not where things are just ticking over.

■

Expansion of an empire may not be an overt objective but, if managers’
salaries are linked to growth, this could be an implicit objective. We will
return to this point when we come to ownership and control.

■

Selling goods and services is, of course, the function of the company, and a
company with a market orientation may have as a strategic objective to
increase its market share. This may well aid its profit-making capabilities
but care must be taken not to over trade, that is increase sales without
regard to the availability of working capital, which can lead to failure and
liquidation. Maximisation of sales can, like survival, be a valid short-term
objective.

■

Providing work for those who would emphasise social responsibility will be
the principal objective of a company.

1. What other aspects of company activity might be termed socially

responsible?

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2. Do you think the prime objective of the company is to be socially
responsible? Give your reasons.

1f

1. You might include under this heading good working conditions and
practices, fair and equal salaries and opportunities, not polluting the
environment and creating products that do not offend society.

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Financial Management

1f
continued

2. Your answer here is dependent upon your personal views. You may have
considered that, if a company is to make profits and pay its shareholders
dividends at the expense of the workforce or of society, it may quickly
lose its workers and offend society and it will not survive. The provision
of work and the other aspects of social responsibility are certainly
important.

If the company is viewed as existing in the interests of all the stakeholders
referred to earlier, its primary objective could be seen as keeping all of them
satisfied (satisficing). This module is written with the view that this objective
is not the company’s prime objective but is supportive of it. There is one more
possible objective to address and that is making profits.

satisficing

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The making or maximising of profits may appear attractive as the prime reason
for the company’s existence. After all, if profits are not made, the company

cannot survive for long. Maximisation of profits was the prime objective for
free-market economists, such as Friedman (1970).

Consider this extract from Friedman (1970). Does it convince you that
maximisation of profit is the prime corporate objective? What do you
think Friedman means by ‘as long as it stays within the rules of the
game…’?

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‘…there is one and only one social responsibility of business – to use its
resources and to engage in activities designed to increase its profits as long
as it stays within the rules of the game.’

1g

You may find that the profit maximisation objective is a powerful concept,
especially as Friedman refers to the social responsibility of the business in its
use of resources. Arnold (2005) refers to the belief of pro-capitalist
economists like Friedman that making the interest of shareholders the
company’s prime objective benefits both the company and society. This is
not, as Arnold points out, as extreme as it sounds because pursuit of this
objective to the point of pollution, criminal activity and exploitation would
not benefit society. This is what Friedman means by the ‘rules of the
game’.

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However, there are problems with the objective of profit maximisation
described by Friedman.

1. Think about what profit is and write down a definition. (Don’t spend too
long on this!)
2. Profits can be increased relatively easily by cutting costs but why is this a
potential problem in the long term?

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Unit 1

1h

The nature of financial mangement

1. You probably found this difficult and that is why we asked you not to
spend too long on it. ‘Profit’ is not easy to define or measure. In an
income statement you can encounter gross and operating profit, profit
after interest, profit after interest and tax, and retained profit. Profits are
not the same as cash; profit may be available to pay a dividend but there
must also be sufficient cash as well. Profitability may be an objective,
and an indicator of the success or otherwise of the company, but it does
not guarantee that the primary risk takers, the ordinary shareholders,
receive their reward.
2. In the short term the company could cut costs, such as labour costs,
maintenance costs or perhaps research and development costs. In the
longer term this might put the company at risk by affecting its
performance and ability to be competitive. The economist Hayek’s
(1960) comment that ‘…the only specific purpose which corporations
ought to serve is to secure the highest long-term return on their
capital…’ illustrates this difficulty: that profits may vary in the short term
and give a distorted view of a company’s potential for growth in the
long term.

Variability of profits, in either the short or long term, also indicates a level of
risk in the company that investors may not find attractive. Not only will the
capital markets put a higher value on a company with greater long-term
potential but also shareholders are more likely to prefer to invest in a company
with steady growth and stability. It presents a less risky alternative.

Recommended reading for this
section is the maximisation of
shareholder wealth section of the
chapter ‘The finance function’ in
Watson and Head (2010).

Maximisation of shareholder wealth
Maximisation of profit may be achievable in the short term but, because of the
problems this might cause and because it still does not necessarily reward those
who take the risks, the primary objective of the company is generally regarded
as the maximisation of shareholder wealth.
The distinction between maximisation of profit and maximisation of
shareholder wealth is developed below. If financial management decisions are
all made with a single objective in mind the process will not be confused by
potentially conflicting objectives, such as increasing production and sales via
new technology, while maintaining the social responsibility to provide work.

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The next question is: ‘What is shareholder wealth?’. It needs to be defined
before we can discuss its maximisation.

It is clear that profit maximisation is not the prime objective of the company.
Equally, profits are not the yardstick by which shareholder wealth is
measured. Suggest a reason for this.

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We said above that profits do not equal cash and, while they may indicate
company success, they do not indicate that cash is available to pay
dividends. It is perfectly possible for a company to make profits over a
number of years yet be unable to pay any dividends because it has no
available cash.

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Profits also indicate only past success, since the accounts that show them are
historical. Past profits are no guide to what may happen in the future. This
implies that dividend payments, and gains made when selling a shareholding,
are better indicators of shareholder wealth than profits.
However, if dividend payments are not consistent over a period of time,

confidence in the company’s shares will not increase and their market price will
reflect the variability of dividend payments. When shareholders sell their
investment, they may lose money. The prime objective of the company therefore
needs to be adjusted slightly to the maximisation of long-term shareholder
wealth, which will be indicated by a combination of the maximisation of
dividends over time and the increased market value of ordinary shares.
If the share price reflects shareholder wealth, we can say that any financial
decision taken to increase the value of shares will be a decision that maximises
shareholder wealth and will be in keeping with the prime objective of the
company.
As you will see in the module, such decisions can involve:
■

Using appraisal techniques to assess investment projects.

■

Sourcing funding to provide for the company the most appropriate capital
structure that can be serviced from available funds.

■

Paying dividends that the company can afford, while leaving sufficient
retained earnings for investment.

■

Managing the risks associated with these decisions.

You may be left with the impression that the managers of a company will carry

out its day-to-day functions efficiently and effectively on behalf of the owners,
always asking themselves, ‘Does the result of this decision maximise
shareholder wealth?’. This is not a realistic view because of the tension between
ownership (the shareholders) and control (the management) of companies. It
forms the next area of concern and leads us to agency theory and the agency
problem.

agency theory

1.3 Agency theory: ownership and control
Recommended reading for this
section is the agency theory
section of the chapter ‘The
finance function’ in Watson and
Head (2010).

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The famous legal case of Salamon v Salamon & Co in 1897 established that a
limited company has to be incorporated under the law and has a separate legal
existence from its owners; shareholders are the owners of the business but are
legally separate from it. Their ‘ownership’ has different implications from that
of the partner or sole trader. Prior to the Salamon case, a firm was regarded as
an extension of the owner, whose rights dominated those of employees,
creditors and others. The Salamon case established that the limited company is
not an extension of its owners.

Copyright © 2012 University of Sunderland

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Unit 1

The nature of financial mangement

In the traditional view of a limited company, four groups can be identified:
directors, managers, employees and owners.
1. How would you rank these groups in terms of their distance from dayto-day company activity?
2. What relationship does that ranking bear to the level of risk they take in
contributing to the company?

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3. With which group do you think control of a large company really lies?

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1. The owners are furthest removed from the company’s activities. In most
cases, shareholders will not be fully aware of the range of the company’s
activities. Directors, in the form of a board, act on behalf of the
shareholders and are legally responsible for managing the company; so
their involvement is a little closer. Closer still are the managers, who act
on behalf of the directors and make decisions concerning the
implementation of the board’s policy, including the financial
management we are concerned with in this module. The employees are
closest to the day-to-day activity of the company, following the
instructions of management. This hierarchy can be less clear than the
explanation suggests: compressed in a small company, where the
owners may also be the directors and managers and have more than just
an ownership interest; extended in a more traditional company, with
many shareholders, some of whom are likely to be large financial
institutions such as pension funds. Here, control is in the hands of a
board of directors and the distance between ownership and control may
be great.
2. In theory, the level of risk is in inverse proportion to this ranking, in the
sense that employees put none of their own funds into the company,
receiving wages from it in return for their labour, while shareholders
bear all the risk by putting in capital and only having rights to residual
profits. However, employees risk losing their jobs if the company fails
and shareholders can always sell their shares and thus rid themselves of
the risk.
3. The control in large companies lies with the board of directors, who
formulate the company’s policies that management and employees
execute.

The hierarchy of owner/director/manager/employee thus becomes problematic.
Managers in a large company may be concerned to maximise their own wealth,

not that of the shareholders, from whom they are distanced. Their objectives
may well be growth, maximisation of market share, or provision of
employment for themselves.

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Shareholder power in a large company is limited to voting rights at the

annual general meeting (AGM). If you were a shareholder in a large
company, what could you do if you felt that the board was not acting in
your interests?

It seems from what has been said that the only recourse to shareholders is
to vote onto the board only those directors who will carry out the objective
of maximising shareholder wealth and remove those who will not. This is
difficult in a large, fragmented company; shareholders have only as many
votes as they have shares and it would need the cooperation of a large
number of small shareholders to carry such motions at the AGM.

Another alternative is to sell the shares and invest in a company where you feel
that the objective of shareholder wealth maximisation is paramount. The
majority of quoted shares in the UK are owned by institutions not by private
individuals and, if they sell their large holdings, the result will be to lower the
share price.
An alternative, often-adopted solution is to link management and shareholder
rewards by granting managers and directors options to purchase shares in the
company at a discount. In this way, if managers operate a policy of maximising
shareholder wealth the price of shares will rise and they will be able to take up
the option to buy, then sell at a profit, and thus maximise their own potential
wealth. However, there are problems with this solution, as we shall see later.

Agency theory
The relationship between shareholders and management is an example of the
principal–agent relationship, and has given rise to agency theory.

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You have already encountered the concept of agency in the level 1 Business
Law module, where an agent was defined as ‘a person used to effect a contract
between their principal and a third party’.

Apply the definition of an agent to the relationships between directors,
managers, employees and owners.
(a) Who is/are the principal(s)?
(b) Who is/are the agent(s)?

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(c) Who is/are the third party (ies)?

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In the traditional structure:
(a) The owners or shareholders are the principals.
(b) The directors and senior managers are their agents.

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The nature of financial mangement

(c) The third parties are those with whom the company deals: customers,
suppliers, lenders and others, though sometimes a principal–agent
relationship may also exist between directors/managers and lenders.

continued

Modern UK company law tends to impose upon the directors of a company the
position of principal when they make contracts with the outside world; the
company’s managers are their agents, carrying out their duties under a contract
of employment with the company.

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Agency theory has been developed and applied to companies using the
following assumptions:

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■

The parties in the agency relationship are rational, that is consistent in their
actions, and will wish to maximise their personal utility. This phrase refers
to the value placed by someone on an economic good received, or the
satisfaction that they receive from a level of economic well-being.

■

The parties form a contract when the utility achieved by the principal in
providing services, decisions or information is equal to the utility of the

agent in receiving salary and benefits.

■

The company is the link between these contracts, and its activities must be
understood in terms of the contract details.

Jensen and Meckling (1976) developed a view of the company as a series of
agency relationships. Who would you suggest was in an agency relationship
with the management of the company, apart from shareholders?

Management are the agents of the shareholders but they could also be
regarded as being in an agency relationship with other employees, where
they are the principals and the employees act as their agents.
This theory leads to an important problem: what happens when the agentdirectors have a different view or different agenda from that of the
principal-owners?
If the goals of the two parties are different, or they have a different view of
the risks involved in a course of action, then the contract whereby they are
trying to equate personal utility will not be the optimum one. In other
words, if the goals of the shareholders and the managers are different,
maximisation of shareholder wealth may not be achieved.

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1.4 Addressing the agency problem
It has already been suggested that one of the problems of the separation of
ownership and control might be that managers do not always act to
maximise shareholder wealth.
1. Give an example of how this might occur in the context of investment
risk.

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2. How might the agency problem manifest itself in the relationship
between shareholders and debt providers?

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1. We will be looking at the concept of risk in more detail later in the
module but it is clear that any investment decision will carry a level of
risk. Managers and shareholders may have different attitudes to risk; the

latter might prefer that the company invested in projects with a different
level of risk than that preferred by management. If managers are
rewarded on the basis of returns from projects, they may be tempted to
invest in those projects that are more risky but show a quick return.
2. Again there will be a problem if there is a different attitude to risk. Debt
providers are unlikely to want the company to invest in anything that is
such a risk that it damages their chances of repayment. Their return in
the form of interest payment is fixed, whereas that of the shareholders is
theoretically unlimited and their downside risk is limited to the price they
paid for their shares, so they may prefer to take more risk. Debt
providers can protect their interests by holding security for the debt.

Recommended reading for this
section is the corporate
governance section of the chapter
‘The finance function’ in Watson
and Head (2010).
monitoring cost

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bonding cost

The agency problem exists when managers or directors do not act in the best
interests of the shareholders to maximise the latter’s wealth. Management goals
could include increasing their own power base, creating job security for
themselves, or increasing their rewards. It was suggested in an earlier activity
that two ways to ensure that management act in shareholders’ interests are to
vote unacceptable directors off the board, or to offer share options. Jensen and
Meckling also suggested that shareholders could monitor the actions of
managers using independently audited accounts, backed up by additional
reporting requirements, and external analysts. These activities involve extra
costs known as monitoring and bonding costs.

What do you think might be the problems associated with:
(a) Offering share options and other incentives?
(b) Monitoring management actions over and above that required by
company law?

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(a) The two most common methods of ensuring appropriate management
actions are the share option schemes referred to earlier and
performance-related pay. These are not ideal, since the value of shares
will be affected by factors over and above the actions of the company’s
management. Performance-related pay carries the added burden of
working out how to measure performance accurately. After all, it is the
managers themselves who design such measurement and they have the
ability to change accounting profits by changing accounting policies –
such as depreciation rates and stock valuation methods – in order to
make the performance of the company appear more attractive.
(b) The costs of such actions would have to be borne by the shareholders
and might outweigh the benefits. It may be that not all shareholders
agreed to contribute to the costs, so some would benefit without
bearing costs.

Corporate governance
The agency problem was highlighted in the early years of this century when
several large corporations were found to have deceived their investors as to
their true financial position. The list of companies included energy giant Enron,
and others such as Worldcom, Tyco in the USA and Parmalat in Europe.
This has led to an increase in voluntary codes designed to produce a greater
degree of responsibility from the executive directors. One of these is produced
by the institutional fund manager Hermes ().
Hermes’ 12 principles are reproduced in Figure 1.2; a fuller explanation of the
principles is available on the company’s website.

Hermes’ overriding expectation is that companies be run in the long-term
interest of shareholders.
To sustainably create value, companies need to develop strategies that
exploit or provide them with a competitive advantage over competitors
and apply appropriate operational and financial disciplines. In order to
succeed in the long run, companies will need to manage effectively
relationships with key stakeholders and have regard for the environment
and society as a whole. Companies adhering to our overriding principle
will not only create sustainable value for their shareholders, but also
benefit stakeholders and the wider economy and society in which they
participate.

Transparency and communication
Principle 1
Companies should disclose adequate, accurate and timely information
concerning their business and key personnel, so as to allow investors to
make informed decisions about the acquisition, ownership obligations
and rights, and sale of shares. In particular they should clearly

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