Chapter 15 - Investment implementation and review Flashcards
What is the primary strategic objective of a commercial company in the long-term?
Maximisation of the wealth of the shareholders
Who are stakeholders?
Those persons and entities that have an interest in the strategy of an entity. Stakeholders normally include shareholders, customers, staff and local community.
Define equity investors
Within any economic system, the equity investors provide the risk finance. There is a very strong argument for maximising the wealth of equity investors. In order to attract funds, the company has to compete with other risk-free investment opportunities, e.g. government securities. The shareholders require returns from the company in terms of dividends and increase in share prices.
Explain community at large as stakeholders
The goals of the community will be broad but will include such aspects as legal and social responsibilities, pollution control and employee welfare.
Explain company employees as stakeholders
Returns = wages or salaries. However, maximising the returns to employees does assume that risk finance can be raised purely on the basis of satisfying the returns to finance providers. The employees’ other interests also include job security and good conditions of employment.
Explain company managers/directors as stakeholders
Such senior employees are in an ideal position to follow their own aims at the expense of other stakeholders. Their goal will be both long-term (defending against takeovers, sales maximisation) and short-term (profit margin leading to increased bonuses).
Customers as stakeholders?
Satisfaction of customer needs will be achieved through the provision of value for money products and services.
Suppliers as stakeholders
Suppliers to the organisation will have short-term goals such as prompt payment terms alongside long-term requirements including contracts and regular business. The importance of the needs of suppliers will depend upon both their relative size and the number of suppliers
Finance providers as stakeholders
Providers of loan finance (banks, loan creditors) will primarily be interested in the ability of the firm to repay the finance including interest. As a result it will be the firm’s ability to generate cash both long and short term that will be the basis of the goals of these providers
The government as stakeholders
The government will have political and financial interests in the firm. Politically it will wish to increase exports and decrease imports whilst monitoring companies via the Competition Commission. Financially it requires long-term profits to maximise taxation income.
Managing stakeholder interests
Part of managing any company involves dealing with any groups interested in the company. Dealing with customers and suppliers might be dealt with by lower level management, whereas dealing with shareholders and the bank are more likely to be dealt with by the Board. Customers and suppliers will need to be dealt with on a daily basis and there will be probably specialist departments within the company to do this, such as accounts receivable and accounts payable. Any marketing or public relations departments may also be involved with customers.
Interest rate increase affects spending (falls). Explain
Expenditure by consumers, both individual and business, will be reduced. This occurs because the higher interest rates raise the cost of credit and deter spending. If we take incomes as fairly stable in the short term, higher interest payments on credit cards/mortgages, etc., leave less income for spending on consumer goods and services. This fall in spending means less aggregate demand in the economy and thus unemployment results.
Interest rate increase affects asset value (falls). Explain
The market value of financial assets will drop, because of the inverse relationship (between bonds and the rate of interest). This in term, will reduce many people’s wealth. It is likely that they will react to maintain the value of their total wealth and so may save, thereby further reducing expenditure in the economy. This phenomenon seems to fit the UK recession of the early 1990s when the house-price slump deepened the economic gloom. For many consumers today a house, rather than bonds, is their main asset.
Increase in interest rates affects The exchange rates (rise), inflation (falls). Explain
Exchange rates rise - the inflow of foreign funds raises demand for the domestic currency and so pushes up the exchange rate. This has the benefit of lowering import prices and thereby bearing down on domestic inflation. However, it makes exports more expensive and possibly harder to sell. The longer-term effect on the balance of payments could be beneficial or harmful depending on the elasticity of demand and supply for traded goods.
Inflation falls - higher interest rates affect the rate of inflation in three ways. First, less demand in the economy may encourage producers to lower prices in order to sell. This could be achieved by squeezing profit margins and/or wage levels. Second, new borrowing is deferred by high interest rates and so demand will fall. Third, the higher exchange rate will raise export prices and thereby threaten sales which in turn pressurises producers to cut costs, particularly wages. If workers are laid off then again total demand is reduced and inflation is likely to fall.
What are the effects of high inflation rates?
Distorts consumer behaviour - people may bring forward purchases because they fear higher prices later. This can cause hoarding and so destabilise markets, creating unnecessary shortages.
Redistributes income - people on fixed incomes or those lacking bargaining power will become relatively worse off, as their purchasing power falls. This is unfair.
Affects wage bargainers - trades unionists on behalf of labour may submit higher claims at times of high inflation, particularly if previously they had underestimated the future rise in prices. If employers accept such claims this may precipitate a wage - price spiral which exacerbates the inflation problem.
Undermines business confidence.wide fluctuations in the inflation rate make it difficult for entrepreneurs to predict the economic future and accurately calculate prices and investment returns. This uncertainty handicaps planning and production.
Weakens the county’s competitive position - if inflation in a country exceeds that in a competitor country, then it makes exports less attractive and imports more competitive. This could mean fewer sales of that country’s goods at home and abroad and thus a bigger trade deficit. For example, the decline of Britain’s manufacturing industry can be partly attributed to the growth of cheap imports when they were experiencing high inflation in the period 1978-1983.
Redistributes wealth - if the rate of interest is below the rate of inflation, then borrowers are gaining at the expense of lenders. The real value of savings is being eroded. This wealth is being redistributed from savers to borrowers and from payables to receivables. As the government is the largest borrower, via the national debt, it gains most during inflationary times.
What are the internal constraints on setting up the financial strategy?
Key internal constraints on strategy include:
- a shortage of key skills;
- limited production capacity
What are the external constraints on setting up the financial strategy?
Major external constraints are:
- The need to maintain good investor relations and provide a satisfactory return on investment
- Limited access to sources of finance either due to weak creditworthiness or lack of liquidity in the banking sector and capital markets.
- Gearing level - The main argument in favour of gearing is that introducing borrowings into the capital structure attracts tax relief on interest payments. The argument against borrowing is that it introduces financial risk into the entity. Financial managers have to formulate a policy that balances the effects of these opposing features.
- Debt covenants - these are clauses written into debt agreements which protect the lender’s interests by requiring the borrower to satisfy certain criteria (e.g. a minimum level of interest cover)
- Government influence
- Regulatory influence
- Major economic influences such as interest rates, growth in GDP, inflation rates and exchange rates.
- Accounting concepts
What is agency theory?
Agency theory: hypothesis that attempts to explain elements of organisational behaviour through an understanding of the relationship between principals (such as shareholders) and agents (such as company managers and accountants). A conflict may exist between the actions undertaken by agents in furtherance of their own self-interest, and those required to promote the interests of the principals.
In which cases the view of shareholders and managers may not be similar?
- Shareholders can spread their risk by investing in a number of entities. Managers have personal and financial capital invested in the entity and so may be averse to investing in a risky investment.
- Shareholder wealth will be maximised by investing in projects with positive net present values. Managers may be more interested in short-term payback than NPV as the investment criterion, in order to help further their own promotion prospects.
- Managers of entities that are subject to takeover bid often put up a defence to repel the predator. While arguing this action is in the shareholders’ best interests, shareholders of acquired entities often receive large gains in the value of their shares. The managers of the acquired entity often lose their jobs or status.
- Managers may be motivated to award themselves and staff better terms and conditions of service. This will incur costs and reduce profits. If equity investors are losing too much as a consequence, they may sell their shares and the market value of the entity will fall.
What is goal congruence?
In a control system, the state which leads the individuals or groups to take actions which are in their self-interest and also in best interest of the entity.
What are the progress and performance indicators?
In order to achieve the overall objective companies should set specific targets, financial and non-financial, in order to both communicate direction and measure performance. For example:
- Financial:
- Profitability
- Cash generation - Non-financial
- Market share
- Customer satisfaction
Discuss some of the financial performance indicators.
Financial:
-Return to investors - the return from ownership of shares in a profit-making entity can be measured by formula:
Annual return to investors=((P1 - P0) + dividend)/P0
This is the capital appreciation on shares (the difference between p1 and p0 - the share price at the end and the start of the year respectively), plus dividends received through the year.
- Cash generation - Poor liquidity is a greater threat to the
survival of an entity than is poor profitability. Unless the entity is prepared to fund growth with high levels of borrowings, cash generation is vital to ensure investment in future profitable ventures. In the private sector the alternative to cash via retained earnings is borrowing. In the public sector this choice has not been available in the past, and all growth has been funded by government. However, in the face of government-imposed cash limits, local authorities and other public-sector entities are beginning to raise debt on the capital markets, and are therefore beginning to be faced with the same choices as profit-making entities. - Value added - this is primarily a measure of performance. It is usually defined as revenues less the cost of purchased materials and services. It represents the value added to an entity’s products by its own efforts. A problem here is comparability with other industries - or even with other entities in the same industry. It is less common in public sector, although the situation is changing and many public sector entities - for example those in the health service - are now publishing information in their own value added.
- Profitability - may be defined as the rate at which profits are generated. It is often expressed as profit per unit of input (e.g. investment). However, profitability limits an entity’s focus to one output measure - profit. It overlooks quality, and this limitation must be kept in mind when using profitability as a measure of success.
- Return on Assets (RoA). This is an accounting measure, calculated by dividing annual profits by the average net book value of assets. It is therefore subject to the distortions inevitable when profit, rather than cash flows, is used to determine performance. Distorting factors for interpretation and comparison purposes include depreciation policy, inventory revaluations, write-off of intangibles such as goodwill, etc. A further defect is that RoA ignores the time value of money, although this may be of minor concern when inflation is very low.
What are the criticisms of profitability as a performance indicator?
- it fails to provide a systematic explanation as to why one business sector has more favourable prospects than another;
- it does not provide enough insight into the dynamics and balance of an entity’s individual business units, and the balance between them;
- it is remote from the actions that create value and cannot therefore be managed directly in any but the smallest entities;
- the input to the measure may vary substantially between entities.
What are the points which may affect interpretation of RoA in the public sector?
- difficulty in determining value
- there may be no resale value
- are for use by community at large
- charge for depreciation may have the effect of double taxation on the taxpayer
