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Controlling Conflicts Between Stakeholders

As we discussed in the an earlier section, the various stakeholder groups can and will
fight. These conflicts play a critical role in the financial landscape.

Controlling the Shareholder-manager conflicts has received much attention.


There are many ways this conflict can be lessened, but before this can be done it is worth
examining what shapes the conflicts may take.

Shareholders and management can disagree over many things:

Managers may wish to hold more cash, they may wish to lower the firm's risk and
subsequently increase job security, they may not want to work hard, they may want to
pay employees more than they deserve, they may want other perks such as a fancy office
or a jet plane. These are but a few of the nearly infinite number of things that managers
and shareholders can disagree over.

Since well before the time of Adam Smith, these "agency costs" have been well
documented and studied. The arise due to the fact that managers are people and will act
in what they believe to be their own best interests. (See Theories of Human Behavior).
The fact that managers and shareholders have differing incentives is well established.
Thus to lower agency costs these incentives must somehow aligned.

One way to align incentives is to constantly watch over managers and if the effort is not
what shareholders expect, to remove managers. This can be classified as the managerial
labor market which can act as a constraint on management forcing them to act in
shareholders' best interests. However, this constant shareholder monitoring is expensive
and only partially successful (often the managers have better information and are more
knowledgeable).

The Board of Directors (BOD) is the group that is designated to look out for shareholders'
interests and monitor management. The Board is elected by shareholders with the
fiduciary obligation to look out for the best interests of shareholders. For many reasons,
this is only partially successful. (for example management is generally also on the BOD).

It is often easier to align incentives with a compensation contract that makes the manager
better off if the shareholders are "happy" than to constantly monitor management. This
can be done indirectly with giving raises to managers who make shareholders "happy", or
by giving bonuses if certain measures (usually accounting-based) are met. However these
methods do have problems--for example any accounting based measure leads to short
term thinking and may be counterproductive since managers often influence and control
accounting practices.

Using market-based compensation is often a more efficient method. This can be done
either through stock options, Stock Appreciation Rights (SARs), pay based on MVA, or
pure stock ownership. Over the past 15-20 years there has been an explosion in the use of
executive stock options. These options (long-term calls) rely on the high leverage aspects
of options to align managerial interests with Stockholder interests. Although the use of
stock options has come under some attacks by those who feel they have led to too high a
level of pay, it is widely acknowledged that managers are more focused on stock returns
than in past decades.

Controlling Bondholder-Shareholder problems

Bondholders and Shareholders can also have disagreements. These disagreements can be
over many things. For example, Myers (1977) (and others) suggested that firms with
much debt would be more likely to pass up positive growth opportunities since the
benefits might accrue to bondholders and not shareholders.

The firm's bondholders and stock holders can likewise disagree about the amount of risk
the firm has. For example, if we view the equity of a levered firm as equivalent to a call
option we can easily see how shareholders have an incentive to increase the riskiness of
the firm. (That is the payoff to shareholders is unbounded so there is some positive
probability of a large payoff, whereas debt holders' payoff is limited.) To prevent this
type of opportunistic behavior, bondholders would

o Not lend money to the firm


o Presume that shareholders will increase the riskiness of the firm and thus
bondholders would charge a higher interest rate as a means of "price-
protecting" themselves.
o Require a "neutral third party" to help monitor firm.
o Write restrictive contracts that limit what shareholders can do with the
money.
o Rely on shareholder reputation to limit their opportunistic behavior (that is
the shareholders will likely need more money in the future and if they take
advantage of shareholders now, they will not be able to borrow money in
the future).
o Agree to lend money but only if they could convert the debt into equity
(convertible debt) or if the firm's shareholders agree to buy back the debt
if something "bad" happens (puttable debt).

In reality, all of these are used to varying degrees at different times.

risks from one security (or other investment) by buying or selling others. A common
example is the use of options and futures to reduce the risks of holding a portfolio of
investments.
A hedge may be static or dynamic. A hedge may also be reversed to replicate the cash
flows of a security, thus, by the law of one price, allowing one to value the hedged
security in terms of the securities used to hedge it. If there are discrepancies, the hedge
can he used to exploit an arbitrage opportunity.

Foreign exchange futures are also very commonly used by importers and exporters who
would otherwise be faced with a very high level of short term risk from exchange rate
fluctuations.

More complex hedges are used and can involve the use of complex financial instruments
and large numbers of transactions to provide effective hedges at the lowest cost. Some
securities may only be hedged with a dynamic hedge, or by the use of a large number of
other securities.

Once the debt is outstanding, shareholders have the incentive to take actions that
benefit themselves at the expense of the bondholders. So if there is debt
outstanding, the objectives of maximizing the value of the firm and the value of
the equity are not identical. Some examples of bondholder--shareholder conflicts
are: claim dilution, dividend payout and asset substitution. Let's examine in more
detail some of these conflicts.

Consider claim dilution. With debt outstanding, stockholders have incentives to


issue claims of equal or senior priority. The proceeds from the "new" debt issue
will be greater the higher the priority of the new debt. The claim dilution
increases the risk of the "old" debt and its market value falls. The combined value
of the new and old debt is fixed. By making new debt equal or higher priority, the
value of the old debt falls and the proceeds from the new debt issue rises. Claim
dilution benefits the stockholders at the expense of the "old" bondholders.

But the bondholders are not stupid. The price of the bonds equals the present
value of the expected cash flows. The bondholders include the affects of conflicts
of interest in estimating cash flows and pricing the debt. Bondholders only pay for
what they expect to get.

Since the conflicts of interest between stockholders and bondholders reduce the
price of the debt, the stockholders bear all of the costs of the conflict. Even
though the shareholders bear the costs of the conflict, there is still an incentive to
extract value or expropriate from the bondholders -- after the debt is outstanding.

Since the stockholders bear the costs that arise from the conflicts of interest, they
have an incentive to minimize the agency costs. Bond covenants are detailed
enforceable contracts that reduce agency costs by restricting the stockholders'
actions after the debt is issued. The covenants may restrict the production and
investment policy (i.e. mergers, sale of certain assets and lines of business). The
covenants may restrict the financial policy of the firm (i.e. dividend payouts,
priority and total debt). Furthermore, there is usually a provision for auditing. The
bond covenants will reduce but will not eliminate these agency costs. Note that
there are also costs involved in monitoring the firm's actions.

TITLE 1

INTRODUCTION TO FINANCIAL MANAGEMENT

OBJECTIVES

At the end of the session, you will be able to:

1. Define financial management;

2. Describe corporate and management objectives;

3. Discuss the role of corporation towards society;

4. Describe the role of a financial manager;

5. Discuss the concept of risk-return trade off; and

6. Explain the financial functions.

CONTENTS

1.1 What is financial management?

1.2 The corporate objectives.

1.3 Profit maximization versus maximizing shareholder wealth.


1.4 Owners' and management objectives.

1.5 Social responsibility and shareholder wealth.

1.6 The role of a financial manager.

1.7 The risk-return relationship in financial decisions.

1.8 Financial functions in a company.

1.9 Questions.

1.1 WHAT IS FINANCIAL MANAGEMENT?

Financial management is that management activity which is primarily concerned with


the raising of capital, planning of cash and credit requirements, appraising capital
investments, and effective controlling of a company's financial resources.

From this definition, we can understand the following primary activities involved in financial
management:

a. raising capital funds from outside the business;

b. forecasting the future needs of capital funds for increased level of business operations;

c. controlling cash flows in accordance with corporate objectives and plans, and with
changing economic circumstances;

d. converting forecasts into budgets;

e. investing surplus funds effectively; and

f. planning the appropriate capital structure.


1.2 THE CORPORATE OBJECTIVES

Financial Objectives

In any business enterprise, effective management of funds implies the existence of some objective
or goal. Surely, corporate financial decisions are not made in a vacuum, rather with some objective
in mind.á In financial management we assume that the primary goal of companies is to Maximize
The Wealth Of Its Shareholders. Put simply, this means maximizing the price of the ordinary
shares in the stock market.

Non-Financial Objectives

A company may have important non-financial objectives, which will limit the
achievement of financial objectives. Looking into the employees' welfare, providing
community services and helping to improve the economy are some examples of non-
financial objectives.

Nevertheless, a financial manager has the primary goal of enriching the shareholders
through the stock market process.

1.3 PROFIT MAXIMIZATION VS. MAXIMIZING SHAREHOLDER WEALTH

It is important to note that maximizing the value of the existing ordinary share is not
simply a matter of profit maximization. Management could simply issue additional
equity shares, for example, and invest the proceeds in long-term government
securities. The profits of the company would increase, but there would now be more
shareholders with whom these new profits would have to be shared.á If the rate of
return on the government securities were lower than the company's normal rate of
return on investment, as is most likely, earnings per share would be diluted and the
ordinary share would decline in value. Hence, management must be concerned with
the impact of its decisions on earnings per share rather than focus only on total
profits.

Furthermore, profit maximization is not as inclusive a goal as maximizing shareholder wealth as it:
(i) does not take into consideration the timing and duration of returns from investment.

(ii) ignores risk of prospective earnings.

Modern financial management theory operates on the assumption that the primary objective of a
business enterprise is to maximize the value of the company's shares. The market price of a
company's shares on the other hand, reflects the markets' judgment as to the value of the company.
This implies that for value creation, companies should, therefore, be seeking to concentrate on
their cash flow generation, and the factors which affect this. The theory of finance confirms this view
of valuing the companies, and attributes it to three components:

(i) The quantum of future cash flows to be received,

(ii) The timing of these cash flows, and

(iii) The risk involved.

The evaluation takes into account the present and prospective earnings per share,
the timing, duration and riskiness of their earnings, the dividend policy of the
company, and other factors that affect the market price of the share. The higher the
price of the share, the better management's performance.á Thus the market price
serves as a performance index of the company's progressive growth or
deterioration.á

1.4 OWNERS' AND MANAGEMENT OBJECTIVES

While the goal of the company is the maximization of shareholder wealth, a number of people argue
that in reality, managers may substitute this with their own objectives. This difference in objectives
between shareholders and managers, often referred to as the Agency Problem. It arises as a
result of a separation of management and ownership of the company and the delegation of decision
making authority to managers who have little or no ownership of the company. Managers it is
argued are more interested in the growth in size of the company to ensure themselves bigger
salaries, and other perks.á They may thus make decisions not in line with the goal of maximization
of shareholder wealth. Three major areas of potential conflict between shareholders and managers
have been identified:

(i) Managers may use corporate resources to provide themselves with `perks' or embark on
expansions that are not in the shareholders' best interests.

(ii) Managers may have shorter time horizon than shareholders. For example, managers may
prefer short term projects with early returns at the expense of those that mature too late to
influence their promotion.

(iii) Managers and owners may differ in their evaluation of risk.

Managing The Agency Problem

It is also argued that shareholders can control managers to make optimal decisions by:

(i) monitoring management through systematic reviews, auditing systems and explicitly
limiting management decisions. Shareholders do have the ultimate power to replace
management and this, it is felt, is enough to keep managers oriented to the best interests of
the owners of the company.

(ii) providing them with incentives such as bonuses, share options, etc., where management
performance is in line with shareholder goals.

Therefore, other things held constant, if management of a company is interested in


the well-being of its shareholders, it should follow the contemporary financial
management theory of maximizing wealth rather than on total corporate earnings.

1.5 SOCIAL RESPONSIBILITY AND SHAREHOLDER WEALTH


Is the shareholder wealth maximization objective consistent with concern for social responsibility
(i.e., undertaking employee welfare programs, creating employment opportunities for the
disadvantaged, promoting the concept of a caring society and becoming involved in protecting the
environment)?

Wealth maximization was considered to be objective of business. Direct dealings with social
problems were considered outside the business. Governments were responsible for social systems.
In view of the growing importance of industrialization in Malaysia under Vision 2020 and control
over resources, now the theme is that conduct of business be a concern for society.á

One question remains to be answered. Where corporations get funds to finance their social
responsibility? This is only from generation of internal resources which are mainly from profits. If a
corporation takes more responsibility, there may be an indirect pressure for more profits to finance
various schemes. More profits may lead to higher prices. In a competitive business environment,
the voluntary socially responsible corporation will not be able to compete for a fair share of business
profits.á The corporation may experience lower sales and will be forced to abandon its social
responsibility commitments.

On the other hand, if the corporation decides to keep the price of its products unchanged then the
corporation will operate with lower earnings. This probably results in a lower share price. Most
investors are likely to shun the socially oriented corporation, thus putting it at a disadvantage in the
capital market.

It is very difficult to determine the exact balance between the maximization of the
shareholder wealth and the goal of social responsibility. However, one can argue that
shareholder wealth, over the long term, rests on companies building long-term
relationships with suppliers, customers and employees, and promoting a reputation
for honesty, financial integrity and corporate social responsibility. Since a company
acquires its income from the consumers of goods and services, it is appropriate that
some of the income be returned to the people through community projects and
services.

1.6 THE ROLE OF A FINANCIAL MANAGER


In order to understand the broadening role of a modern financial manager, it is
appropriate to relate it to the following mix of financial activities in a business
organization.

1. Financial analysis, forecasting, and planning:

(a) monitoring the company's financial conditions.

(b) determining the amount of capital funds to operate the business.

(c) interacting with other line managers so that they all will look ahead in a joint effort to
develop corporate plans, which will shape the future position of the company.

2. Investment decision-making:

(a) allocating adequate funds to specific assets that will produce good returns.

(b) preparing long-range capital budgets.

(c) evaluating investment and capital projects.

3. Management of financial resources:

(a) managing and monitoring working capital.

(b) maintaining optimal level of investments in each of the current assets.

4. Financing and capital structure decision:

(a) appraising and determining the mix of financing from equity-debt for both short-term and
long term.

(b) borrowing funds at the lowest cost, and on the most favorable terms
possible.

5. Having an overall understanding of the corporate planning and control processes


of the various functional activities of a company.
1.7 THE RISK-RETURN RELATIONSHIP IN FINANCIAL DECISIONS

All financial decisions influence both the size of the earnings stream or profitability
and the riskiness of the company. These factors, profits and risk determine the value
of the company or shareholder wealth.á Most financial decisions will involve some
sort of risk-return tradeoff. As such, the financial manager will be continuously
involved in evaluating the risk-return tradeoff of financial policy decisions.

Financial policy decisions relating to the line of business, size of the company, type of equipment to
be used, the extent to which debt is to be employed, the company's liquidity position, etc., affect
both risk and profitability. The more risk the company is willing to take, the higher the expected
return from a given course of action. For example, an increase in cash position reduces risk.
However as cash is not an income-earning asset, converting other assets into cash will reduce
profits. Similarly in the area of working capital management, the less inventory held on hand the
higher the expected return (since fewer of the company's assets are involved in non-income
generating functions) but there is also the greater risk of running out of inventory.á In the area of
financial structure, the decision to use additional debt will raise the rate of return or profitability on
the shareholders' net worth, but more debt also means more risk.

The financial manager therefore tries to strike that particular balances between risk and return that
will maximize the wealth of the company's shareholders. This decision is referred to as the risk-
return tradeoff.

1.8 FINANCIAL FUNCTIONS IN A COMPANY

One way of depicting the management of a company is to divide its activities into
three types: (i) operations; (ii) strategy; and (iii) risk management.á

The finance function of a company is involved in all three areas.

1. in strategy via the setting of financial criteria for capital investment decisions;

2. in risk management concerning the risks arising from the choice of finance and any risk
arising from the foreign currency operations of the company;
3. in operations by ensuring that sufficient funds are available to meet net cash deficits.

Using this framework, we can identify the three main finance functions of the
company and their components (apart from the accounting and financial control
functions) as follows:

Capital budgeting. Capital investment criteria. Financial valuation of capital projects. Cash flow
budgeting.

Decisions about capital investment, together with projections of cash flows arising from operations,
determine the net amount of finance required over a planning period to meet planned cash deficits
and to ensure a margin of flexibility.

Choice of capital structure. Debt: equity ratio. Choice of debt types. Dividend policy.

The decision on capital investment gives rise to a need for decisions concerning the form of
financing should take, and to decisions about the dividend level.á

Liquidity management. Liquid asset/liability management. Cash flow monitoring.

Given its investment and financing policy, the job of liquidity management is to
invest surplus cash balances to earn a satisfactory rate of return, subject to envisage
cash flow requirements, and to negotiate any short-term borrowing required.
Liquidity management also embraces policy decisions concerning the possible
hedging of risks arising from unexpected movements in exchange rates, interest
rates or commodity prices.

1.9 QUESTIONS

1.
(a) Describe the role of the Finance Manager, and how he/she can ensure that the overall
Corporate Objectives of the organization be met.á (Briefly state the corporate objectives
of an organization in financial management.)

(b) Briefly describe the likely consequences of the following errors in financial management:

(i) bad timing for capital raising;

(ii) inefficient capital raising;

(iii) inefficient use of funds.

(DIMP June 1995)

2. Why is the focal point of financial management on the funds flow of the company?

3. What are the pros and cons for managers to own a sizable amount of shares in the company?

4. If you were the financial manager of a large public corporation, would you make decisions to
maximize your shareholders' welfare or your own personal interest?

5. What do you understand by the terms Profit Maximization and Maximizing Shareholder
Wealth? The trend today for some financial managers and entrepreneurs is to move towards
maximizing shareholder wealth rather than profit maximization. Why do you think this is
happening?
Using your own words, explain what are the tasks of a financial manager?

(DIMP November 1994)

6. For the purpose of the exposition of financial management techniques, the assumed single
objective of commercial entities is often taken to be the maximization of shareholders' wealth.
Comment on the extent to which this assumed single objective is realistic and
explains why corporate management needs to be concerned with company valuation.
How can financial management techniques assist in meeting actual corporate
objectives?

(DIMP November 1995)

7. "Financial Management is concerned with the investment, financing and management of


assets with some overall goal in mind..." (Van Horne).

(a) Discuss the "investment", "financing" and "management" functions of financial


management.

(b) Discuss what "...some overall goal..." means.á Give examples to illustrate.

(DIMP November 1996)

8. Explain the term `agency relationships' and discuss the conflicts that might exist in the
relationships between shareholders and managers.á What steps might be taken to overcome
these conflicts?