The Functions of The Finance Manager 2. The Objectives of The Firm 3. Agency Conflicts

September 2, 2020
Introduction
1. The functions of the finance manager
2. The objectives of the firm
3. Agency conflicts
Ritesh Pandey
September 2, 2020
Ritesh Pandey Introduction 1 / 32

September 2, 2020 Chief financial officer, Treasurer and financial controller
Table of Contents
1 Chief financial officer, Treasurer and financial controller
2 Functions of the finance manager
3 Objectives of the firm
The traditional objective
Why maximizing stock price may be a good objective
Relationships impacting the firm’s objective
Solutions
Stock price maximization objective is internally self-correcting
Modified objective
4 Agency relationships
The concept
Agency conflicts between managers and shareholders
Agency conflicts between shareholders and bondholders
Agency conflicts between all three
The CFO, treasurer and financial controller
1 In small companies, these roles may be combined in the same

person.
2 The CFO is a board member and makes strategic decisions.
3 The other two are not board members.

The Controller performs the following functions

1 Accounting,
2 Reporting,
3 Budgeting,
4 Analysis,
5 Designing and maintaining management control systems,
6 Tax management, and
7 Handling compliances required by government and regulators.

The Treasurer performs the following functions

1 Raising capital (both long term and short term),
2 Investing excess capital,
3 Risk management,
4 Dealing with investors and lenders,
5 Collection activities, and
6 Insurance.

The CFO performs the following functions

1 Overseeing the controller and the treasurer,
2 Deciding about capital structure and dividends,
3 Helping develop business strategy, and
4 Managing financial intelligence.

September 2, 2020 Functions of the finance manager
Table of Contents
Solutions
Modified objective
The concept
The finance manager, in general, performs the following functions

1 Raising funds at lowest costs,
2 Managing capital structure,
3 Taking dividend decisions,
4 Investing surplus funds to get maximum returns,
5 Managing working capital,
6 Preparing financial, cost and management accounts,

7 Managing reporting requirements,

8 Managing other compliance requirements,
9 Budgeting,
10 Managing insurance,
11 Managing risk,
12 Handling tax,
13 Managing relations with investors and lenders,
14 Helping in developing and execution of business strategy, and
15 Collecting and analysing financial intelligence.

September 2, 2020 Objectives of the firm
Table of Contents
Solutions
Modified objective
The concept
1 Traditional corporate finance says managers should maximize

value of the firm.
2 A narrower objective: maximize shareholder value.
3 If shares are traded and markets are efficient: maximize share
price.


The firm’s balance sheet:
Assets
1 Firm value can be measured by the Assets side of the balance
sheet.
2 This side has value due to existing assets as well as an expected
value due to assets that will come in after future investments.
Liabilities
1 The Liabilities side has two components: Debt and Equity.
2 Debt has
1 Fixed claim,
2 Fixed maturity,
3 Tax deductibility, and
4 Little or no role in management.
3 Equity has
1 Residual claim,
2 Perpetual life, and
3 Major role in management.
Why maximizing stock price may be a good

objective
The stock price of a firm is a good target to maximize for the

following reasons.
1 It is asily observable,
2 It is constantly updated, and
3 If investors are rational, stock price may reflect the wisdom in
decisions taken.

Managers deal with

1 Stockholders
2 Bondholders
3 Financial markets
4 Society


Stockholders:
1 They have control over managers via Annual Meetings and the Board of Directors.
2 But real life is different.
3 Small stockholders have little say in meetings
4 Large stockholders don’t resist much; at max, they may leave/abstain.
5 Institutional investors play along
6 Meetings are largely scripted
7 Most directors are chosen via CEO recommendations and not by an outside search
agency.
8 Directors may have only nominal shareholdings in the company.
9 Most directors may be CEOs of other firms.
10 CEOs may sit on each other’s boards.
11 CEOs may also be the chairmen and control the agenda of meetings.
12 People crave consensus.
13 People appreciate loyalty.

Stockholders: Impact of all the above:

1 Managers overlook stockholders’ interests in favour of their own.
2 Hefty compensation packages
3 Costly anti-takeover defences
4 Golden Parachutes

Bondholders:
1 Bondholders are concerned about getting repaid.
2 But stockholders are more interested in upside potential.
3 Large dividends.
4 Increasing risk profile of projects above what lenders expected at
the time of lending.
5 Borrowing more on the same assets.

Financial Markets:
1 Managers may withhold negative information.
2 Managers may delay negative information.
3 Managers may give misleading information.
4 Investors may be irrational.
5 Investors may overreact.
6 Investors may be myopic.
7 Markets may be manipulated by insiders thus weakening any
relationship between share prices and firm value.

Society:
1 Firm’s actions may create benefits for as well as impose costs on
the society.
2 These may be difficult to quantify or to trace back to the firm.

All these realities may cause traditional corporate finance theory to

break down.

Solutions
1 Make people other than stockholders responsible for corporate
governance, say banks (as in Germany) or Keiretsus (as in
Japan).
2 Turn managers and employees into shareholders.
3 Protect bondholders.
4 Implement appropriate information systems.
5 Minimize social costs.
6 Have other objective functions:
1 Maximize revenues
2 Maximize profits
3 Maximize firm size
4 Maximize market share
5 Criterion is that the objective chosen should align with
long-term health and value of the company.
Stock price maximization objective is internally

self-correcting
Some forces inducing self-correction:

1 Market for corporate control.
2 Bondholder being more alert while lending.
3 More restrictive covenants
4 Convertible bonds
5 Puttable bonds
6 Ratings-sensitive interest rates
7 Markets becoming sceptical and punitive.
8 Social backlash and regulations.

Modified objective
Some forces inducing self-correction:

1 Publicly traded firm + efficient markets + protected
bondholders : maximize share price.
2 If markets inefficient in above mix : maximize shareholder value.
3 If, further, bondholders unprotected: maximize firm value. (this
is the best that can be done)
4 Private firm + protected bondholders: maximize shareholder
wealth.
5 Else: maximize firm value.

September 2, 2020 Agency relationships
Table of Contents
Solutions
Modified objective
The concept
Modified objective
1 Principals
1 hire agents to perform some service and
2 delegate decision making authority to them.
2 Both principals and agents may be individuals or firms.

Agency conflicts between managers and

shareholders
1 If managers own only a small percentage of stock, agency
conflicts may arise between shareholders and managers.
2 Examples:
1 Focus on increasing firm size
2 Maintaining job security
3 Benefiting friends
4 Increasing their power, status and salaries
5 Increasing their perquisites
6 Luxurious offices
7 Executive assistants
8 Expense accounts
9 Limousines
10 Corporate Jets
11 Glamorous retirement plans

shareholders
1 Shareholders cannot observe all managerial actions, and

managers may take actions against shareholders interests:
Moral Hazard.
2 To reduce agency conflicts and moral hazard problem,
shareholders have to incur Agency Costs:
1 Costs of monitoring and auditing
2 Costs of organizational structuring by bring in outside directors
3 Opportunity costs when managerial actions are restricted by
requirements like shareholders’ assent


shareholders
1 Clearly, agency costs have to be optimized.

2 Fully monitoring managers actions : very high agency costs
3 Compensating managers only on basis of share price: very low
agency costs but then talented managers will not join as share
price is also affected by factors beyond managerial control.


shareholders
Some mechanisms to control managers’ behaviour:

1 Compensation design
2 Performance shares
3 Employee stock options
4 Independent boards of directors
5 Threat of firing
6 Threat of hostile takeovers


shareholders
1 Stockholders may rip-off bondholders: They may, for instance:

1 Sell safe assets and invest in riskier ones:
1 Rate of return required on debt capital rises and so value of
existing debt falls.
2 Borrow more to repurchase stock to boost up stock price
2 While managers are agents of shareholders, they must play fairly
with bondholders.

Agency conflicts between all the three
1 During bankruptcy, managers get to make the first move and

they may try to reorganize the firm in order to preserve their
jobs.
2 The lenders usually want to liquidate the firm’s assets.
3 Each party can only get less than the face value of their due
claims, a process called haircut.
4 They may offer creditors more than what is their fair due, in
order to get creditor approval before the courts for the
reorganization process.

Thank you.

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September 2, 2020

Ritesh Pandey Introduction 1 / 32

The CFO, treasurer and financial controller

1 In small companies, these roles may be combined in the same

Ritesh Pandey Introduction 3 / 32

The CFO, treasurer and financial controller

The Controller performs the following functions

Ritesh Pandey Introduction 4 / 32

The CFO, treasurer and financial controller

The Treasurer performs the following functions

Ritesh Pandey Introduction 5 / 32

The CFO, treasurer and financial controller

The CFO performs the following functions

Ritesh Pandey Introduction 6 / 32

The CFO, treasurer and financial controller

The finance manager, in general, performs the following functions

Ritesh Pandey Introduction 8 / 32

The CFO, treasurer and financial controller

7 Managing reporting requirements,

Ritesh Pandey Introduction 9 / 32

The traditional objective

1 Traditional corporate finance says managers should maximize

Ritesh Pandey Introduction 11 / 32

The traditional objective

Why maximizing stock price may be a good

The stock price of a firm is a good target to maximize for the

Ritesh Pandey Introduction 13 / 32

Relationships impacting the firm’s objective

Managers deal with

Ritesh Pandey Introduction 14 / 32

Relationships impacting the firm’s objective

Ritesh Pandey Introduction 15 / 32

Relationships impacting the firm’s objective

Stockholders: Impact of all the above:

Ritesh Pandey Introduction 16 / 32

Relationships impacting the firm’s objective

Ritesh Pandey Introduction 17 / 32

Relationships impacting the firm’s objective

Ritesh Pandey Introduction 18 / 32

Relationships impacting the firm’s objective

Ritesh Pandey Introduction 19 / 32

Relationships impacting the firm’s objective

All these realities may cause traditional corporate finance theory to

Ritesh Pandey Introduction 20 / 32

Stock price maximization objective is internally

Some forces inducing self-correction:

Ritesh Pandey Introduction 22 / 32

Some forces inducing self-correction:

Ritesh Pandey Introduction 23 / 32

Ritesh Pandey Introduction 25 / 32

Agency conflicts between managers and

Agency conflicts between managers and

1 Shareholders cannot observe all managerial actions, and

Ritesh Pandey Introduction 27 / 32

Agency conflicts between managers and

1 Clearly, agency costs have to be optimized.

Ritesh Pandey Introduction 28 / 32

Agency conflicts between managers and

Some mechanisms to control managers’ behaviour:

Ritesh Pandey Introduction 29 / 32

Agency conflicts between managers and

1 Stockholders may rip-off bondholders: They may, for instance: