Advanced Financial Management

Unit 1 – Introduction of Value and Risk

Introduction to value and risk – corporate goals and corporate governance; separation of
ownership and management; present value and net present value; a review of the basics; risk
and uncertainty; risk Vs. return; measurement and management of portfolio risk

Corporations face two broad financial questions: what investments should the firm make? And
how should it pay for those investments? The first question involves spending money; the
second one involves raising it.

The secret of success in financial management is to increase value. That is a simple statement
but not very helpful. It is like advising an investor in the stock market to “Buy low and sell high”,
the problem is how to do it?

They may be a few activities in which one can read a text book and then do it. But financial
management is not one of them. That is why finance is worth studying.

Finance is about money and markets, but it is also about people. The success of a corporation
depends on how well it harnesses everyone to work to a common end. The financial manager
must appreciate the conflicting objectives that are often encountered in financial management.
Resolving conflicts is particularly difficult when people have different information.

What is a corporation – not all businesses are corporations. Small ventures can be owned
and managed by a single individual. These are called sole-proprietor ships. In other cases
several people may join to own and manage a partnership.

Almost all large and medium sized businesses are organized as corporations. For example
British Petroleum, Unilever, Nestle, Volkswagen, and Sony are corporations. In each case the
firm is owned by stock holders who hold shares in the business.

When a corporation is first established, its shares may be held by a small group of investors,
perhaps the managers of the company and few promoters. In this case the shares are not
publicly traded and the company is closely held company. Eventually when the firm grows and
new share are issued to raise additional capital, its shares will be widely traded. Such
corporations are known as public companies. Yet some times it is common for large
companies to remain in private hands.

By organizing as a corporation, a business can attract a wide variety of investors. Although the
stock holders own the corporation, they do not manage it. Instead they vote to elect a board of
directors. The board of directors represents the shareholders. It appoints the top management
and is supposed to ensure that managers act in the best interests of the shareholders.

Although a corporation is owned by the share holders it is legally different from them. It is
based on the memorandum of association and the articles of association that set out the
purpose of the business. For many legal purposes the corporation is considered as a resident
of the state. As a legal person, it can borrow or lend money, can sue and be sued. It pays its
own taxes (may be the only limitation is that it cannot vote and act as a real person) because
 Advanced Financial Management
Unit 1 – Introduction of Value and Risk
the corporation is different from its shareholders, it can do things that partnerships and sole
proprietorships cannot do.

The role of a corporate financial manager – To carry out the business of a corporation, a
huge variety of real assets are required. Many of these assets are tangible, such as
machinery, factories and offices; others are intangible such as technical expertise, trade marks
and patents. All these need to be paid for. To obtain the necessary money the corporation sells
the claims on real assets and on the cash those assets will generate. These claims are called
financial assets or securities.

For example if the company borrows money from the bank, the bank gets a written promise
that the money will be repaid with interest. Thus the bank trades cash for a financial asset.
Financial assets include not only bank loans but also shares of stocks, bonds, and a variety of
specialized securities.

The financial manager stands in between the firms operations and the financial (or capital)
markets, where the investors hold the financial assets issued by the firm. The finance manager
is faced with two basic questions – what real assets should the firm invest in? And how should
the cash for the investment be raised? The answer to the first question is the firm’s investment
or capital budgeting decision and the answer to the second question is the financing decision.

Financial manager is anyone responsible for a significant investment or financing decision.

Usually the only in a small firm we find that a single person is responsible for all the finance
related decisions. In corporates usually the responsibility is dispersed. In corporations the
finance function is delivered by the Chief Financial Officer along with the support of the
treasurer and the controller.

Their roles are summarized as follows –

Senior Financial Managers in Large Corporations

Chief Financial Officer (CFO) responsible

for: Financial Policy and Corporate
Planning
Treasurer responsible
for: Cash Management,
Raising Capital,
Controller responsible
Banking Relationships
for: Preparation of
etc
Financial Statements,
Accounting, Taxation
etc.

-+
 Advanced Financial Management
Unit 1 – Introduction of Value and Risk
Separation of Ownership and Management –

In large business houses separation of ownership and management is a practical necessity.

Major corporations have hundreds of thousands of shareholders. There is no way for all of
them to be actively involved in the management. Therefore authority has to be delegated to
managers.

The separation of ownership and management has clear advantages. It allows share
ownership to change with out interfering with the operations of the business. It allows the firm
to hire professional mangers. But it also brings problems if the managers and owners
objectives differ. Example rather than attending to the wishes of share holders, managers may
seek a more leisurely or luxurious working lifestyle; they may shun unpopular decisions or may
attempt to build an empire with the shareholders money.

Such conflicts between the shareholders and managers objectives create Principal – agent
problems. The share holders are the principles; the managers are their agents. Shareholders
want management to increase the value of the firm, but managers may have their own nests to
feather. Thus agency costs are incurred.

Agency costs are incurred when-

(i) Managers do not attempt to maximize the firm value and
(ii) Shareholders incur costs to monitor the managers and influence their actions.

Of course there are no costs when the share holders are the managers, but this is practically
impossible in huge businesses.

Conflicts between shareholders and managers are not only principal – agent problems that the
financial manager is likely to encounter. For example just as shareholders need to encourage
managers to work for the shareholders interests, so senior management needs to think about
how to motivate everyone else in the company. In this case the senior management are the
principals and the junior management and other employees are their agents.

Agency costs can also arise in financing. In normal times the banks and the bondholders who
lend the company money are united with the shareholders in wanting the company to prosper.
But when the firm gets into trouble, this unity of purpose can break down. At such times
decisive action may be necessary to rescue the firm, but the lenders are concerned to get their
money back and are reluctant to see the firm making risky changes that could imperil the
safety of their loans. Squabbles may even break out between different lenders as they see the
company heading for possible bankruptcy and jostle for a better place in the queue of
creditors.

The companies overall value is divided among a number of claimants. These include the
management and the shareholders, as well as the company’s workforce and the bank and
investors who have bought the company’s debt. The government is a claimant too, since it
gets to tax the corporate profits.
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Unit 1 – Introduction of Value and Risk
All these claimants are bound together in a complex web of contracts and understandings.
Principal agent problems could be easier to resolve if everyone had the same information. This
rarely happens incase of finance. Managers, shareholder and lenders may all have different
information about the value of a real or financial asset and it may be many years before all the
information is revealed. Financial managers need to realize these information asymmetries
and find ways to assure the investors that there are no nasty surprises on the way.

Corporate Goals and Corporate Governance -

Goals set by an organization are specific, quantifiable targets that it commits to attain in order
to achieve its corporate mission and objectives.

Essentially, when an organization sets its specific goals it is saying; "We need to achieve these
specific targets in order to successfully achieve the mission and objectives of this
organization". In fact, goals are the translation of the mission and objectives of the organization
into specific quantifiable terms against which results can be measured.

Some examples of typical corporate goals follow:

"To produce and distribute to dealers at least 10,000 vehicles by year-end".

"To organize and host an international conference on the subject of the role of human factors
in aviation occurrences".

"To develop and implement a new methodology for carbon emission trading in the international
aviation industry".

"To draft a proposed new international standard for the estimation of risk and to present that
proposal to the Annual Conference of Statisticians in Paris, France in November".

"To manage our financial portfolios so that they earn a minimum of 7% annual return for our
investor clients."

The above statements are true goal statements in the sense that they can be quantified
in advance and their achievement (or non-achievement) can be specifically measured at
the end of the period in question.

The targets set for each goal are what management believes is the minimum
achievement necessary to accomplish the mission and objectives of the organization for
the period under consideration (typically one year).

Corporate governance is the set of processes, customs, policies, laws,

and institutions affecting the way a corporation (or company) is directed, administered
or controlled. Corporate governance also includes the relationships among the
many stakeholders involved and the goals for which the corporation is governed. The
principal stakeholders are the shareholders, management, and the board of directors.
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Unit 1 – Introduction of Value and Risk
Other stakeholders include employees, customers, creditors, suppliers, regulators, and
the community at large.

Corporate governance is a multi-faceted subject. An important theme of corporate

governance is to ensure the accountability of certain individuals in an organization
through mechanisms that try to reduce or eliminate the principal-agent problem

In A Board Culture of Corporate Governance, business author Gabrielle O'Donovan

defines corporate governance as 'an internal system encompassing policies, processes
and people, which serves the needs of shareholders and other stakeholders, by
directing and controlling management activities with good business savvy, objectivity,
accountability and integrity. Sound corporate governance is reliant on external
marketplace commitment and legislation, plus a healthy board culture which safeguards
policies and processes'.

Report of SEBI committee (India) on Corporate Governance defines corporate

governance as the acceptance by management of the inalienable rights of shareholders
as the true owners of the corporation and of their own role as trustees on behalf of the
shareholders. It is about commitment to values, about ethical business conduct and
about making a distinction between personal & corporate funds in the management of a
company.” The definition is drawn from the Gandhian principle of trusteeship and the
Directive Principles of the Indian Constitution. Corporate Governance is viewed
as business ethics and a moral duty.

Parties to Corporate Governance –

Parties involved in corporate governance include the regulatory body (e.g. the Chief
Executive Officer, the board of directors, management, shareholders and Auditors).
Other stakeholders who take part include suppliers, employees, creditors, customers
and the community at large.

In corporations, the shareholder delegates decision rights to the manager to act in the
principal's best interests. This separation of ownership from control implies a loss of
effective control by shareholders over managerial decisions. Partly as a result of this
separation between the two parties, a system of corporate governance controls is
implemented to assist in aligning the incentives of managers with those of shareholders.
With the significant increase in equity holdings of investors, there has been an
opportunity for a reversal of the separation of ownership and control problems because
ownership is not so diffuse.

A board of directors often plays a key role in corporate governance. It is their

responsibility to endorse the organization’s strategy, develop directional policy, appoint,
supervise and remunerate senior executives and to ensure accountability of the
organization to its owners and authorities.
 Advanced Financial Management
Unit 1 – Introduction of Value and Risk
The Company Secretary, known as a Corporate Secretary in the US and often referred
to as a Chartered Secretary if qualified by the Institute of Chartered Secretaries and
Administrators (ICSA), is a high ranking professional who is trained to uphold the
highest standards of corporate governance, effective operations, compliance and
administration.

All parties to corporate governance have an interest, whether direct or indirect, in the
effective performance of the organization. Directors, workers and management receive
salaries, benefits and reputation, while shareholders receive capital return. Customers
receive goods and services; suppliers receive compensation for their goods or services.
In return these individuals provide value in the form of natural, human, social and other
forms of capital.

A key factor is an individual's decision to participate in an organization e.g. through

providing financial capital and trust that they will receive a fair share of the
organizational returns. If some parties are receiving more than their fair return then
participants may choose to not continue participating leading to organizational collapse.

Principles of Corporate Governance –

Key elements of good corporate governance principles include honesty, trust and
integrity, openness, performance orientation, responsibility and accountability, mutual
respect, and commitment to the organization.

Of importance is how directors and management develop a model of governance that

aligns the values of the corporate participants and then evaluate this model periodically
for its effectiveness. In particular, senior executives should conduct themselves honestly
and ethically, especially concerning actual or apparent conflicts of interest, and
disclosure in financial reports.

Commonly accepted principles of corporate governance include:

 Rights and equitable treatment of shareholders: Organizations should respect

the rights of shareholders and help shareholders to exercise those rights. They can help
shareholders exercise their rights by effectively communicating information that is
understandable and accessible and encouraging shareholders to participate in general
meetings.
 Interests of other stakeholders: Organizations should recognize that they have
legal and other obligations to all legitimate stakeholders.

 Role and responsibilities of the board: The board needs a range of skills and
understanding to be able to deal with various business issues and have the ability to
review and challenge management performance. It needs to be of sufficient size and
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Unit 1 – Introduction of Value and Risk
have an appropriate level of commitment to fulfill its responsibilities and duties. There
are issues about the appropriate mix of executive and non-executive directors.
 Integrity and ethical behavior: Ethical and responsible decision making is not
only important for public relations, but it is also a necessary element in risk
management and avoiding lawsuits. Organizations should develop a code of conduct for
their directors and executives that promotes ethical and responsible decision making. It
is important to understand, though, that reliance by a company on the integrity and
ethics of individuals is bound to eventual failure. Because of this, many organizations
establish Compliance and Ethics Programs to minimize the risk that the firm steps
outside of ethical and legal boundaries.
 Disclosure and transparency: Organizations should clarify and make publicly
known the roles and responsibilities of board and management to provide shareholders
with a level of accountability. They should also implement procedures to independently
verify and safeguard the integrity of the company's financial reporting. Disclosure of
material matters concerning the organization should be timely and balanced to ensure
that all investors have access to clear, factual information.

Systematic Problems of Corporate Governance -

 Demand for information: In order to influence the directors, the shareholders

must combine with others to form a significant voting group which can pose a real threat
of carrying resolutions or appointing directors at a general meeting.
 Monitoring costs: A barrier to shareholders using good information is the cost of
processing it, especially to a small shareholder. The traditional answer to this problem is
the efficient market hypothesis (in finance, the efficient market hypothesis (EMH)
asserts that financial markets are efficient), which suggests that the small shareholder
will free ride on the judgments of larger professional investors.
 Supply of accounting information: Financial accounts form a crucial link in
enabling providers of finance to monitor directors. Imperfections in the financial
reporting process will cause imperfections in the effectiveness of corporate governance.
This should, ideally, be corrected by the working of the external auditing process.

Corporate Governance and Firm Performance –

In its 'Global Investor Opinion Survey' of over 200 institutional investors first undertaken
in 2000 and updated in 2002, McKinsey found that 80% of the respondents would pay a
premium for well-governed companies. They defined a well-governed company as one
that had mostly out-side directors, who had no management ties, undertook formal
evaluation of its directors, and was responsive to investors' requests for information on
governance issues. The size of the premium varied by market, from 11% for Canadian
companies to around 40% for companies where the regulatory backdrop was least
certain (those in Morocco, Egypt and Russia).
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Unit 1 – Introduction of Value and Risk
Other studies have linked broad perceptions of the quality of companies to superior
share price performance. In a study of five year cumulative returns of Fortune
Magazine's survey of 'most admired firms', Antunovich et al. found that those "most
admired" had an average return of 125%, whilst the 'least admired' firms returned 80%.
In a separate study Business Week enlisted institutional investors and 'experts' to assist
in differentiating between boards with good and bad governance and found that
companies with the highest rankings had the highest financial returns.

On the other hand, research into the relationship between specific corporate
governance controls and some definitions of firm performance has been mixed and
often weak.