Ch 1 - Key principles of finance & corporate governance

Question 1

Finance involves 2 basic decisions

Answer 1

1) capital budgeting decision - What real** assets should the firm invest in?

2)financing decision - How should the cash for the investment be raised?

**assets used in the normal line of business to generate profits (these can be either tangible/intangible)

[financial assets -> shares]

Question 2

Financial managers is responsible for

Answer 2

-firms’ operations
-financial markets (where investors hold the financial assets issued by the firm to obtain money)

Question 3

How can a company increase the value of their shares?

Answer 3

1) investing in profitable projects
2) raising finance in a cost-effective way

[projects generate revenue & incur costs - aim should be s.t revenue>costs]

(capital budgeting is complicated by:
a) may be more than 1 apparent profitable project to choose from

b) very difficult to estimate the future profitability of a project)

Question 4

Name the 4 main parties involved in making financial decisions

Answer 4

1) Treasurer
2) Controller
3) CFO
4) B.O.D

Question 5

What is the responsibility of the treasurer?

Answer 5

-looks after company’s cash
-raises new capital
-maintains relationship with banks, shareholders & other investors

Question 6

Why is capital budgeting important?

Answer 6

Because the cost of mistakes are high and lots of complexity of analysis is involved. And it’s very difficult since there are many options to assess and future cashflows are uncertain

Question 7

Investment in fixed capital often involves complex choices between:

Answer 7

MAD

Method of financing
Alternative Capital Assets
Dates of commencement

Question 8

What can financial analysis do?

Answer 8

HIP

-Highlight the salient FACTORS
-Identify the RISKS involved in the project
-Possibly suggest METHODS by which these risks might be reduced

Question 9

Explain financial analysis

Answer 9

involves bring together estimates & ideas from a variety of different disciplines - marketing, technology, accounting, tax, law - to reveal their financial implication (may require expert input > enforces impartiality & realism)

Question 10

Explain ‘the divorce of ownership from control’

Answer 10

SH’s own the company & elect B.O.D to run the company on their behalf. Sometimes directors run the co. themselves but often they hire G.M who are not SH but experts in their fields.

Ultimate responsibility for financial decisions lie with the directors. Directors acting on behalf of the SH often delegate operational decision making to the execs, while retaining control.

Question 11

Give 2 advantages & 1 disadvantage of the separation of ownership and management

Answer 11

Adv:
-freedom for ownership to change w/o affecting operational activities
-freedom to hire professional managers

Disadv:
-interests of owners & managers diverge

Question 12

List 3 objectives of a company’s shareholders

Answer 12

RIC

1) maximise overall ROI
2) obtain INCOME from investment
3) make CAPTAIN GAIN (CG)

Question 13

Explain conflicting objectives that may arise between a) SH’s & managers as well as with b) providers of finance

Answer 13

a) SH (receive high ROI or dividend) vs. managers (pursue projects of interest over more profitable projects, gain business control, more leisurely or luxurious working lifestyle, satisfactory return vs maximum return - lower risk)

b) lenders (banks & bondholders-> short-term desire for security) vs providers of equity capital (SH’s-development of company) ; this point could also arise when SH undertake a risky project but lender may see their capital being placed in jeopardy

Question 14

Contractual theory

Answer 14

views a firm as a network of contracts, actual & implicit, which specify the roles of the various participants in the organisation and define their rights, obligations and pay-offs under various conditions

*most participants bargain for limited risk & fixed pay-offs, whereas the firm’s owners are liable for any residual risk (& thus hold a residual claim on any assets and earnings of the firm that remain after covering costs)

*contracts drawn must take into consideration as much C.O.I as possible, the various conditions that the firm could face & reaction of the firm to such conditions

Question 15

Capital markets

Answer 15

Markets in long-term capital, such as the share (or stock) markets and the bond market.

The capital market provides info to assess the performance of financial managers [through share price] and also to assist the financial managers when making decisions [continuous assessment stimulates efficiency & provides incentives to business managers to improve their performance].

Question 16

What are the key effects of capital markets on a firm’s decisions?

Answer 16

SLiME

> Sound investment decisions require accurate measurement of cost of capital (CoC)
Limitations in the supply of capital focus attention on methods of raising finance
Mergers & takeovers create threats & opportunities to be exploited
‘Externalities’ require managers to determine the appropriate role of organisations

Question 17

Theory of the maximisation of shareholder wealth

Answer 17

SH are owners of the company & the company’s objective is to maximise SH wealth within external constraints. In the UK & US, company managers are accountable to the SH’s & are duty-bound to act in the SH’s interests, to protect the investors & to enable the financial markets to operate efficiently.

Question 18

List 3 practical problems with the maximisation of shareholder wealth

Answer 18

1) Agency theory
2) Role of info
3) Role of agreements

Question 19

Agency theory

Answer 19

Considers the relationship between a principal & an agent of that principal, includes issues such as the nature of agency costs, C.O.I & how agents may be motivated and incentivised.

*conflicts may be referred to as principal-agent problems & give rise to agency costs (associated with monitoring the actions of others & seeking to influence their actions)

Question 20

Agency costs include those incurred in:

Answer 20

a) monitoring managers
b) seeking to influence the actions of managers
c) because managers don’t act in the owner’s best interests

Question 21

Role of Info

Answer 21

A lot of the problems may be easier to resolve if all parties share the same insights into the fortunes of the company. However info asymmetries will exist between different classes of the stakeholders.

(It’s normally difficult to keep everyone informed & might also be restricted for competitive/commercial reasons)

Question 22

Role of agreements

Answer 22

Written agreements between various classes of stakeholders may specify key aspects of the relationship between them but cannot realistically cover all possible future eventualities, which need to be supplemented by less formal understandings & arrangements

Question 23

How can the value of a company be determined?

Answer 23

Either by discounting CF’s at an appropriate discount rate (e.g an investors required rate of return) or using the market value (MV) to calculate the assets.

As the needs & objectives of individual SH’s may vary, their valuations of a company will vary.

Question 24

Needs (& objectives) of shareholders vary according to factors such as:

Answer 24

a) attitude towards risk (ATR)
b) time preference & consumption needs
c) balance between need for income & for capital growth
d) tax position

Question 25

Explain how the opportunity cost of capital as discount rates

Answer 25

It can be used as the rate which future CF’s are discounted.
-all opportunities that display a positive NPV will add to the current value of SH’s wealth
-all opportunities that display a negative NPV will be regarded as ‘value destroying’ and should be avoided

Question 26

Explain the cost of capital

Answer 26

rate foregone by investing in the project rather than investing in securities (these can be identified in the market as the rate of return offered by equivalent investment alternatives in the capital market)

One needs to assess opportunities from the POV of SH (& check what uses their capital can be put to instead of just going with the project whose return is greater than the cost of borrowing the funds needed to finance it). Additionally, consider what risks apply.

Question 27

Economic Value Added

Answer 27

Measure which evaluates the ability of managers to add value to the firm. (Focuses on economic profit)

EVA evaluates management performance by comparing net operating profit adjusted for taxes during the year to the firm’s total cost of capital including the cost of equity.

Question 28

Responsibilities of principals & agents

Answer 28

Agents act of behalf of their principals & so agents should act in line with their principals’ priorities & ethics

(Occasionally, their might be individuals who hold strong moral views about a particular issue of who is unhappy with their behaviours of a company for which he/she is working or advising should resign their position &/ report those behaviours to senior management of make them public. Code of conduct of professional bodies often give advice on such ‘whistleblowing’)

Question 29

Friedman’s shareholder theory

Answer 29

Managers have a duty to maximise SH returns (i.e SH’s are the primary stakeholders in a company)

Question 30

Friedman’s 4 qualifies

Answer 30

1) Referring to managers working on behalf of companies & arguing that it was their MORAL & CONTRACTUAL OBLIGATION to meet the objectives of SH’s.

2) Managers might lead them not to want to work in the ROLE they occupied- but that didn’t change their responsibilities to SH’s if they did choose to work for the company.

3) Companies might have a range of SOCIAL OBJECTIVES beyond making profits, but these should be determined by their owners (not their managers).

4) Companies should comply with the RULES OF SOCIETY including those embodied in ethical customs.

Question 31

Environmental & Social Governance goals (ESG) criteria on how a company:

Answer 31

-performs as a steward of the environment
-manages relationships with employees, supply chain, customers, & the communities in which it operates
-deals with issues such as executive pay & SH rights

(Dilemma for investors to invest in a company which doesn’t have the same stance on ESG which may affect their reputation or should they disinvest and lose the ability to influence policy on a day2day basis)

Question 32

Regulated financial reporting

Answer 32

Aim of financial reports is to help all parties associated with an organisation make decisions. The reports provide info about the financial position & performance of an entity.

Regulated bodies such as the IASB (International Accounting Standards Board) & FRC (Financial Reporting Council) set standards for companies to ensure they are reliable & useful.

-> IASB sets IFRSs (a set of high-quality global standards with an objective of harmonising standards for international accounting)

->FRC ensure high standards of reporting & audit to promote investor confidence, enable capital markets to operate efficiently & therefore help drive economic growth.

Question 33

Corporate Governance

Answer 33

System by which companies are directed and controlled

(According to the FRC, the purpose of corp gov is to facilitate effective, entrepreneurial & prudent management that can deliver the long-term success of the company)

Question 34

UK Corporate Governance (Underlying principles of good practice)

Answer 34

FAT P

• focus on the LT success of the company
  -accountability
  -transparency
  -probity (ethical behaviour)

Question 35

Main principles of the Code

Answer 35

BDCAR (Bad Drivers Cannot Always Race)

-Board leadership & company purpose
-Division of responsibilities
-Composition, succession & evaluation
-Audit, risk & internal control
-Remuneration

Question 36

Board leadership & company purpose

Answer 36

‘a successful co. is led by an effective and entrepreneurial board, whose role is to promote the LT sustainable success of the company, generating value for SH’s and contributing to wider society’

other principles include:
-set company’s purpose, values & strategy, satisfying itself that these and its culture are aligned
-assess & manage risk, with a framework of prudent & effective controls
-ensure effective engagement with SH’s & stakeholders
-ensure workforce policies & practices adhere to the company’s value & supports its LT sustainable success

Question 37

Division of responsibilities

Answer 37

includes the independence of their role

-effective contribution of all non-exec directors
-provision of accurate, timely & clear info to the directors
-no domination in the board’s decision making
-non-exec directors having sufficient time to carry out their duties

Question 38

Composition, succession & evaluation

Answer 38

-rigorous procedure of board appointments, based on merit & objective criteria
-effective succession plan for board & snr management
-promotion of diversity of gender, social & ethnic backgrounds
-formal & rigorous annual evaluation of board’s effectiveness

Question 39

Audit, risk & internal control

Answer 39

board ‘should present a fair, balanced & understandable assessment of the company’s position and prospects’

Board needs to put into place formal & transparent policies & procedures to ensure independence & effectiveness of internal & external audit functions and satisfy itself on the integrity of financial and narrative statements. Also required to assess the risks involved in achieving its LT strategic objectives & maintain sound risk management systems.

Question 40

Remuneration

Answer 40

‘Remuneration policies & practices should be designed to support strategy & promote LT sustainable success’

Board required to put into place a formal & transparent procedure to determine policy on exec, directors & snr management remuneration. (Also requires that individual directors are not involved in deciding their own remuneration)