Revision 1 Financial Management, Financial Objectives and Financial Environment

Topics List
1. Financial Management Exam Q estion Re!erence a. Financial management decisions investment, financing and Jun10 Q4c dividend decisions b. Three decisions relationship under M M vie! Jun 10 Q4c Financial Objectives a. "rimar# ob$ective ma%imi&e shareholders' !ealth b. Ma%imi&ing and satisficing c. Financial indicators for ma%imi&ing shareholders' !ealth d. (on)financial indicators e. *%ternal factors #. $ta%e&olders a. +ategories of sta,eholder group b. -ta,eholders' areas of interest Objectives in (ot)!or)pro!it Organi*ations a. .alue for mone# b. *conom#, effectiveness and efficienc# ,genc- problem a. Meaning b. 1o! to reduce the agenc# problem2 Macroeconomic Targets a. *conomic gro!th and high emplo#ment b. 3o! inflation c. 4alance of pa#ments stabilit# d. T#pes of polic#

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Financial 0nstit tions a. T#pes of financial institutions b. Functions of financial intermediaries

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Financial Mar%ets a. Mone# mar,ets b. +apital mar,ets c. *uromar,ets

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Financial Management
Financial management decisions cover investment decisions, !inancing decisions and dividend decisions. The# are interlin,ed. 23 ne "4145 6ecision 7nvestment decision Explanation 8hether to underta,e ne! pro$ects 8hether to invest in ne! plant and machiner# 8hether to carr# out a ta,eover or a merger, etc. +ash available !ithin the compan# 9ccess to ne! sources of finance +ost of finance :89++; "a# less dividend if profits need to be retained ne! for investment

Financing decision

/ividend decision

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The three decisions relationship under Miller and Modigliani :M M; investigation< :3 ne "4145 7n perfect capital mar,et, the mar%et val e of a compan# and its !eighted average cost of capital :7,88; !ere independent o! its capital str ct re. Therefore, the mar%et val e depended on t&e b siness ris% of the compan# and not on its !inancial ris%. 0nvestment decision determined the operating income of a compan#, so it !as important in determining t&e mar%et val e. Financing decision, under M M's assumptions, !as sho!n to be irrelevant in determining t&e mar%et val e. 6ividend polic- !as also irrelevant to val e o! t&e s&are under the assumption of a perfect capital mar,et. 9s a result, the investment decision 9as t&e most important !actor !or t&e mar%et val e of the compan# and also the primar- objective o! maximi*ation o! s&are&olders 9ealt&. 7n practice, capital mar%ets are not per!ect and a number of other factors affect the three decision areas. For e%ample, pec%ing order t&eor- suggests that managers do not in practice ma%e !inancing decisions 9it& t&e objective o! obtaining an optimal capital str ct re, but on t&e basis o! t&e convenience and relative cost o! di!!erent so rces o! !inance.

Q estion 1 Financial management decisions /iscuss the relationship bet!een investment decisions, dividend decisions and financing decisions in the conte%t of financial management, illustrating #our discussion !ith e%amples !here appropriate. :0 mar,s; :9++9 F5 Financial Management June 6010 Q4:c;;

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Financial Objectives
For profit ma,ing compan#, the primar- objective is to maximi*e s&are&older 9ealt&. This could involve increasing t&e s&are price and:or dividend pa-o t. >ne problem for the financial manager is to satisf# the ob$ectives of several sta,eholders at the same time. Therefore, in practice a distinction must be made bet!een ma%imi&ing and satisficing. Maximi*ing see,ing the best possible o tcome. $atis!icing finding a merel- ade; ate o tcome. Financial indicators pointing to!ards ma%imi&ing shareholder !ealth include< *" /" ?>+* "rofit after ta% ?evenue, etc. (on)financial indicators include< Mar,et share +ustomer satisfaction Qualit# measures *%ternal factors, for e%amples< 7nterest rate if falls -timulate demand and revenue 3o!er the cost of debt and improve profits 7nvestors s!itch to share mar,et for better returns 7nflation rate if rises +osts rise causing a drop in profits +ause interest rates to rise /evalues the home currenc# Foreign e%change rate if rises ?educe cash receipts for e%porters

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3o!ers the cost for importers /iscourage e%porting A/" if falls ?educe demand and revenue +ause interest rates to fall to stimulate demand

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$ta%e&olders
9n#one !ith an interest in the activities or performance of a compan# are sta,eholders because the# have a sta,e or interest in !hat happens. The main categories of sta,eholder group in a compan# are usuall# the follo!ing< $ta%e&olders 0nternal< :a; /irectors Examples o! areas o! interest ?e!ard structure "romotion -alar# "romotion 8ealth ma%imi&ation "rofit ma%imi&ation 7nterest pa#ment 3iBuidit# -olvenc# -atisfaction Qualit# /eliver# time "rompt pa#ment 3iBuidit# Ta% pa#ments *nvironmental protection Macroeconomic influence

:b; *mplo#ees 8onnected< -hareholders

3enders

+ustomers

-uppliers External< Aovernment -ociet# as a !hole

Q estion " $ta%e&olders= interest "rivate sector companies have multiple sta,eholders !ho are li,el# to have divergent interests. Re; ired< 7dentif# five sta,eholder groups and briefl# discuss their financial and other ob$ectives. :16 mar,s;

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Objectives in (ot)!or)pro!it Organi*ations

The# are not r n to ma%e pro!its b t to provide bene!its . Therefore, it is recogni&ed that these organi&ations should demonstrate the principles of val e !or mone-, i.e. attempting to get the ma%imum benefits for the least cost. This is usuall# accepted as reBuiring the application of econom-, e!!ectiveness and e!!icienc-. Econom- attain the appropriate ; antit- and ; alit- o! inp ts at lo9est cost to achieve a certain level of outputs. E!!ectiveness is the e%tent to !hich declared objectives: goals are met. E!!icienc- is the relations&ip bet9een inp ts and o tp ts.

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Q estion # (ot)!or)pro!it organi*ation /iscuss the nature of the financial ob$ectives that ma# be set in a not)for)profit organisation such as a charit# or a hospital. :0 mar,s;

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,genc- >roblem

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The agenc# problem occurs !hen there are di!!erences in t&e interest o! a compan-=s o9ners and managers. For e%ample< Moral &a*ard manager has an interest in receiving benefits from his or her position as a mangaer. E!!ort level !or, less hard than the# !ould if the# !ere the o!ners of the compan#. Earnings retention management ma# !ant to re)invest profits in order to ma,e the compan# bigger, rather than pa#out the profits as dividends.

Ris% aversion management might be ris,)averse and so reluctant to invest in higher)ris, pro$ects in order to protect their $ob. Time &ori*on management might onl# be interested in the short)term prospects, but shareholders concern about long)term gro!th.

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1o! to reduce the agenc# problem2 /evising a rem neration pac%age adeBuate incentive to act in the best interests of the shareholders, such as share options scheme !hich is li,el# to lead to share price increase. 1aving eno g& independent non)exec tive directors inside the board the# are able to act in the best interests of the shareholders because the# are not the emplo#ees of the compan#.

Q estion ' ,genc- problem 9t a recent board meeting of /artig +o, a non)e%ecutive director suggested that the compan#'s remuneration committee should consider scrapping the compan#'s current share option scheme, since e%ecutive directors could be re!arded b# the scheme even !hen the# did not perform !ell. 9 second non)e%ecutive director disagreed, sa#ing the problem !as that even !hen directors acted in !a#s !hich decreased the agenc# problem, the# might not be re!arded b# the share option scheme if the stoc, mar,et !ere in decline. Re; ired< *%plain the nature of the agenc# problem and discuss the use of share option schemes as a !a# of reducing the agenc# problem in a stoc,)mar,et listed compan# such as /artig +o. :0 mar,s; :9++9 F5 Financial Management /ecember 6000 Q1:e;;

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Macroeconomic Targets
Aovernment ob$ectives for the econom# are referred to as macroeconomic ob$ectives or targets. The three main targets are usuall#< :a; *conomic gro!th and high emplo#ment :b; 3o! inflation :c; 4alance of pa#ments stabilit#

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"olicies for achieving macroeconomic targets >olic- t-pe Fiscal polic# Monetar# polic# *%change rate polic# +ompetition polic# Areen polic# 6e!inition 1o! much the government decides to spend, and to raise as ta% revenue +ontrol over the mone# suppl# and of interest rates 7f the value of the local currenc# is forced do!n in value it ma,es imports more e%pensive and e%ports cheaper "olicies to ta,eovers encourage competition, e.g. bloc,ing

"olicies to encourage protection of the environment

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Financial 0nstit tions

T#pes of financial institutions T-pes Merchant ban,s "ension funds 7nsurance companies F nctions "rovide large corporate loans, often s#ndicated. Manager investment portfolios for corporate clients 7nvest to meet future pension liabilities. 7nvest to meet future liabilities. 26ecember "44?5

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Financial intermediaries provide the follo!ing functions< F nctions Maturit# transformation 6escriptions

9 ban, can ma,e a 10)#ear loan :long)term; !hile still allo!ing its depositors to ta,e mone# out !henever the# !antE so short)term deposits become long)term investments. 9 ban, can aggregate lots of small amounts of mone# into a large loan. Man# individuals ma# be scared of lending mone# directl# to one particular compan# because of that compan# going ban,rupt. 9 ban, !ill be lending mone# to man# companies and !ill therefore be reducing the ris, to themselves and therefore to the individuals !hose mone# the# are using.

9ggregation of funds /iversification of ris,

Q estion + Role o! !inancial intermediaries /iscuss the role of financial intermediaries in providing short)term finance for use b# business organisations. :4 mar,s; :9++9 F5 Financial Management /ecember 6005 Q4:a;;

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Financial Mar%ets
Mone- mar%ets if a compan# or a government needs to raise funds for short)term :normall# less than one #ear;, the# can access the mone# mar,ets. For e%amples< Treasur# bills +ertificates of deposit :+/; +ommercial paper :issued b# companies !ith high credit rating; 4ills of e%change 8apital mar%ets 7f a compan# needs to raise funds for the long)term, it can access the capital mar,ets :normall# more than one #ear;. For e%amples< 4onds 3isted shares E romar%ets in recent #ears a strong mar,et has built up !hich allo9s large companies 9it& excellent credit ratings to raise !inance in a !oreign c rrenc-. This mar,et is organised b# international commercial ban,s

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Ot&er Examination $t-le Q estions

Q estion . E!!icient mar%et &-pot&esis, e!!ect o! interest rate increase and comparison o! objectives o! not)!or)pro!it organi*ation and private compan-. Tagna is a medium)si&ed compan# that manufactures lu%ur# goods for several !ell),no!n chain stores. 7n real terms, the compan# has e%perienced onl# a small gro!th in turnover in recent #ears, but it has managed to maintain a constant, if lo!, level of reported profits b# careful control of costs. 7t has paid a constant nominal :mone# terms; dividend for several #ears and its managing director has publicl# stated that the primar# ob$ective of the compan# is to increase the !ealth of shareholders. Tagna is financed as follo!s< Fm 1.0 6.0 4.@ D.@ Tagna has the agreement of its e%isting shareholders to ma,e a ne! issue of shares on the stoc, mar,et but has been informed b# its ban, that current circumstances are unsuitable. The ban, has stated that if ne! shares !ere to be issued no! the# !ould be significantl# under) priced b# the stoc, mar,et, causing Tagna to issue man# more shares than necessar# in order to raise the amount of finance it reBuires. The ban, recommends that the compan# !aits for at least si% months before issuing ne! shares, b# !hich time it e%pects the stoc, mar,et to have become strong)form efficient. The financial press has reported that it e%pects the +entral 4an, to ma,e a substantial increase in interest rate in the near future in response to rapidl# increasing consumer demand and a sharp rise in inflation. The financial press has also reported that the rapid increase in consumer demand has been associated !ith an increase in consumer credit to record levels. Re; ired< :a; /iscuss the meaning and significance of the different forms of mar,et efficienc# :!ea,, semi)strong and strong; and comment on the recommendation of the ban, that Tagna !aits for si% months before issuing ne! shares on the stoc, mar,et. :5 mar,s; >n the assumption that the +entral 4an, ma,es a substantial interest rate increase, discuss the possible conseBuences for Tagna in the follo!ing areas<

>verdraft 10 #ear fi%ed interest ban, loan -hare capital and reserves

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:i; salesE :ii; operating costsE and, :iii; earnings :profit after ta%;. :c; :10 mar,s; *%plain and compare the public sector ob$ective of Gvalue for mone#H and the private sector ob$ective of Gma%imisation of shareholder !ealthH. :C mar,s; :6@ mar,s;

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