1.3. Financial Managers Flashcards
Financial managers…
Choose the best investment projects and prepare a financial plan to fund them.
Rarely a single individual, the board of directors will commonly make financial decisions together.
Cash moves through financial managers:
- Cash is raised through the selling of shares to investors.
- Cash is invested in the firm’s operations.
- Cash is generated through the firm’s operations.
- Cash can be reinvested or paid out as dividends.
Investment trade-off…
Financial managers must work to maximise shareholder wealth.
By choosing projects that maximise the stock value. These are ‘value-added’.
Shareholders do not accept investment projects if it earns less than their opportunity cost of capital.
Investment decisions involve a trade-off as the firm can either choose to reinvest them or pay them as dividends. If they reinvest them, they must generate more than the equivalent dividend was going to be, otherwise the investors will not be happy.
Agency problem…
Refers to the conflict of interest that arises due to the separation of management and ownership.
As shareholders cannot control the business themselves, they delegate control to managers.
Managers are trusted to work for maximum wealth maximisation of shareholders.
The agency problem occurs as management don’t act in the best interest, for example, choosing to pay themselves massive bonuses rather than a dividend, or avoiding slightly risky projects because they are afraid to lose their jobs.
Costs of the agency problem…
Investment activity: managers may choose investment projects that benefit them rather than the shareholder (i.e. politician contract).
Monitoring costs: costs incurred to the shareholder to monitor management, such as fees paid to independent auditors who must monitor the company for fraud.
Setting-up costs: extra costs incurred by the company to set up a structure to reduce the agency problem.
Opportunity costs: extra time to get a consensus before letting managers take actions.
Reducing the problem…
Compensation structure: using a stock-based compensation structure ensures that managers work to the best interests of the shareholders because their bonuses will be an award of company stock. Employee stock ownership programmes (for example).
Corporate governance: increase supervisory effectiveness by employing independent directors. This may be a board member who serves on the company’s board but is neither a shareholder or employee.
Capital structure: greater financial leverage can help reduce the agency problem. For example, increasing a corporation’s debt and reducing capital levels forces a director to make good decisions to avoid going bankrupt.
