MODULE NO.

1 FIN1 BUSINESS FINANCE

In this chapter we shall deal with the following:

➢ role of business finance
➢ importance of the consideration of risk in financial decision making
➢ relationship between business finance and other disciplines, particularly accounting
➢ nature of the limited company
➢ what is meant by limited liability
➢ the formation of limited companies
➢ requirement for businesses trading as limited companies to signal the fact to the world
through the company name
➢ directors and their relationship with shareholders
➢ the duty of directors to account for their actions
➢ the way in which companies are managed
➢ corporate governance
➢ typical means of financing companies and the rights of suppliers of corporate finance
➢ liquidation of companies
➢ the nature of derivatives
➢ private equity funds

The Rolle of Business Finance

Businesses typically invest in real assets such as land, buildings, plant and
inventories (or stock), though they may also invest in financial assets, including making
loans to, and buying shares in, other businesses. People are employed to manage the
investments, that is, to do all those things necessary to create and sell the goods and
services in the provision of which the business is engaged. Surpluses remaining after
meeting the costs of operating the business – wages, raw material costs, and so forth –
accrue to the investors.
Of crucial importance to the business will be decisions about the types and
quantity of finance to raise, and the choice of investments to be made. Business finance is
the study of how these financing and investment decisions should be made in theory,
and how they are made in practice.’

Risk and business finance

All decision making involves the future. We can only make

decisions about the future; no matter how much we may regret it, we cannot alter the past.
Financial decision making is no exception to this general rule.

There is only one thing certain about the future, which is that we cannot be sure what is
going to happen. Sometimes we may be able to predict with confidence that what will occur
will be one of a limited range of possibilities. We may even feel able to ascribe statistical
probabilities to the likelihood of occurrence of each possible out- come; but we can never be
completely certain of the future. Risk is therefore an import- ant factor in all financial
decision making, and one that must be considered explicitly in all cases.

In business finance, as in other aspects of life, risk and return tend to be related. Intuitively
we expect returns to relate to risk in something like the way shown in Figure 1.1.

In investment, for example, people require a minimum rate to induce them to

invest at all, but they require an increased rate of return – the addition of a risk
premium – to compensate them for taking risks. In Chapter 7 we shall consider the
extent to which, when considering marketable shares and other securities, there does
actually appear to be the linear relationship that Figure 1.1 suggests between levels of risk
perceived and the returns that investors expect to receive. Much of business finance is
concerned with striking the appropriate balance between risk and return.
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Figure 1.1 Relationship between risk and

return

The relationship between business finance and

accounting

Business finance and accounting are not the same thing.

Accounting is concerned with financial record keeping, the production of periodic
reports, statements and analyses, and the dissemination of information to
managers and, to some extent, to investors and the world outside the business. It
is also much involved with the quality, relevance and timeliness of its information output.
Obviously, financial decision makers will rely heavily on accounting reports and the
accounting database generally. Knowledge of past events may well be a good pointer to
the future, so reliable information on the past is invaluable. However, the role of the
financial manager is not to provide financial information but to make decisions involving
finance.
In smaller businesses, with narrow portfolios of management skills,
the accountant and the financial manager may well be the same person. In a large
business, the roles are likely to be discharged by different people or groups of
people. Not surprisingly, many financial managers are accountants by training and
background, but some are not. With the increasing importance of business finance in the
curricula of business schools and in higher education generally, the tendency is probably
towards more specialist financial managers, with their own career structure.

What is a limited company?

A limited company is an artificially created legal person. It is an

entity that is legally separate from all other persons, including those who own and
manage it. It is quite possible for a limited company to take legal action, say for breach
of contract, against any other legal persons, including those who own and manage it.
Actions between limited companies and their owners or managers do occur from time to
time.
Obviously, an artificial person can only function through the intervention of human
beings. Those who ultimately control the company are the owners who each hold
one or more shares in the ownership or equity of it.
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Limited Liability

One of the results of the peculiar position of the company having its own separate
legal identity is that the financial liability of the owners (shareholders) is limited to the amount
that they have paid (or have pledged to pay) for their shares. If the company becomes
insolvent (financial obligations exceed value of assets), its liability is, like that of any human
legal person, limited only by the amount of its assets. It can be forced to pay over all of its
assets to try to meet its liabilities, but no more. Since the company and the owners are legally
separate, owners cannot be compelled to introduce further finance.

Transferability

As a separate legal entity, the company does not depend on the identity of its share-
holders for its existence. Transfer of shares by buying and selling or by gift is therefore
possible. Thus, a part, even all, of the company’s ownership or equity can change hands
without it necessarily having any effect on the business activity of the company.

Shareholders and directors

The shareholders (or members, as they are often known) are the owners of the
company. Company profits and gains accrue to the shareholders, and losses are borne by them
up to a maximum of the amount of their investment in the company. The shareholders, at any
particular time, need not be the original shareholders, that is, those who first owned the
shares. Transfers by sale or gift (including legacy on death) lead to shares changing
hands.
For a variety of sound practical reasons, the shareholders delegate the day-to-day
management of the company to the directors. The directors may or may not them- selves own
some shares in the company. Shareholders elect directors in much the same way as citizens
elect Members of Parliament in a parliamentary democracy. They also fail to re-elect them if the
directors’ performance is judged by shareholders to be unsatisfactory. Usually, one-third of the
directors retire from office each year, frequently offering themselves for re-election. Typically,
each shareholder has one vote for each share owned. Where a company has a large
number of shareholders, a particular individual holding a large number of shares, even
though not a majority of them, can wield tremendous power. The board of directors is the
company’s top level of management, therefore owning enough shares to control the board’s
composition is substantially to control the company.
In small companies, the shareholders may all be directors.

Corporate governance and the role of directors

In recent years, the issue of corporate governance has generated much debate. The
term is used to describe the ways in which companies are directed and controlled. The issue of
corporate governance is important because, with larger companies, those who own the
company (that is, the shareholders) are usually divorced from the day-to-day control of
the business. The shareholders employ the directors to manage the company for them.
Given this position, it may seem reasonable to assume that the best interests of shareholders
will guide the directors’ decisions. However, in practice this does not always occur. The
directors may be more concerned with pursuing their own interests, such as increasing their pay
and ‘perks’ (such as expensive motor cars, overseas visits and so on) and improving their job
security and status. As a result, a conflict can occur between the interests of shareholders and
the interests of directors.
Where directors pursue their own interests at the expense of the shareholders, there is
clearly a problem for the shareholders. However, it may also be a problem for society as a
whole. If shareholders feel that their funds are likely to be mismanaged, they will be reluctant to
invest. A shortage of funds will mean fewer investments can be made and the costs of funds will
increase as businesses compete for what funds are available. Thus, a lack of concern for
shareholders can have a profound effect on the performance of individual companies and, with
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this, the health of the economy. To avoid these problems, most competitive market economies
have a framework of rules to help monitor and control the behavior of directors.
These rules are usually based around three guiding principles:
-Disclosure. This lies at the heart of good corporate governance. An OECD report (see the
reference at the end of the book for details) summed up the benefits of dis- closure as follows:
Adequate and timely information about corporate performance enables investors to make
informed buy-and-sell decisions and thereby helps the market reflect the value of a corporation
under present management. If the market determines that present management is not
performing, a decrease in stock [share] price will sanction management’s failure and open the
way to management change. (OECD 1998)
-Accountability. This involves defining the roles and duties of the directors and establishing an
adequate monitoring process. In the UK, company law requires that the directors of a business
act in the best interests of the shareholders. This means, among other things, that they must not
try to use their position and knowledge to make gains at the expense of the shareholders. The
law also requires larger companies to have their annual financial statements independently
audited. The purpose of an independent audit is to lend credibility to the financial statements
prepared by the directors.
-Fairness. Directors should not be able to benefit from access to ‘inside’ information that is not
available to shareholders. As a result, both the law and the LSE place restrictions on the ability
of directors to buy and sell the shares of the business. One example of these restrictions is that
the directors cannot buy or sell shares immediately before the announcement of the annual
trading results of the business or before the announcement of a significant event such as a
planned merger or the loss of the chief executive.

Ordinary Shares

Ordinary shares are issued by the company to investors who are prepared
to expose themselves to risk in order also to expose themselves to the expectation of
high investment returns, which both intuition and the evidence, which we shall come across
later in the book, tell us is associated with risk. Ordinary shares are frequently referred to as
‘equities. It is normal for companies to pay part of their realized profits, after tax, Long-term
financing of companies to the shareholders in the form of a cash dividend. The amount that
each shareholder receives is linked directly to the number of shares he or she owns. The
amount of each year’s dividend is at the discretion of the directors.

Preference Shares

Preference shares represent part of the risk-bearing ownership of the company,

although they usually confer on their holders a right to receive the first slice of any
dividend that is paid. There is an upper limit on the preference share dividend per share,
which is usually defined as a percentage of the nominal value of the share. Preference share
dividends are usually paid in full. Preference shares give more sure returns than equities,
though they by no means provide certain returns. Preference shares do not usually confer
voting rights.

Liquidation

A limited company, because it has a separate existence from its shareholders,

does not die when they do. The only way in which the company’s death can be brought about
is by following the legally defined steps to liquidate (or wind up) the company. Liquidation
involves appointing a liquidator to realize the company’s assets, to pay the claimants and
formally to lay the company to rest.
The initiative to liquidate the company usually comes from either:
the shareholders, perhaps because the purpose for which the company was
formed has been served; or
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the company’s creditors (including lenders), where the company is failing to pay
its debts. In these circumstances the objective is to stop the company from trading and to
ensure that non-cash assets are sold, the proceeds being used to meet (perhaps only partially)
the claims of the creditors. This type of liquidation is sometimes referred to colloquially as
bankruptcy.

Order of paying claimants

Irrespective of which type of liquidation is involved, the liquidator, having realized all of
the non-cash assets, must take great care as to the order in which the claimants are paid.
Broadly speaking, the order is:
1. Secured creditor. These would tend to be loan creditors (those that have lent money
to the company). Where the security is on a specified asset or group of assets, the proceeds of
disposal of the asset are to be applied to meeting the specific claim. If the proceeds are
insufficient, the secured creditors must stand with the unsecured creditors for the shortfall. If the
proceeds exceed the amount of the claim, the excess goes into the fund available to unsecured
creditors.
2. Unsecured creditors. This group would usually include most trade payables (those
that have supplied goods and services to the business on credit). It would also include any
unsecured loan creditors.

Derivatives

A striking development of business finance, and of other areas of commercial

management, since around 1980 is the use of derivatives. Derivatives are assets or
obligations whose value is dependent on some asset from which they are derived. In
principle, any asset could be the subject of a derivative. In practice, assets such as commodities
(for example, coffee, grain, copper) and financial instruments (for example, shares in
companies, loans, foreign currency) are the ones that we tend to encounter as the basis of a
derivative.

Private Equity Funds

Another remarkable development, particularly since around the turn of the century, is the
rise of private equity funds and their ownership of a large portion of the world’s private sector
businesses. A private equity fund pools finance from various investors (very rich private
individuals and the institutions. The fund then uses the finance to buy private sector
businesses, often ones that were stock market listed. These businesses are then managed by
the fund. The types of business that tend to be the targets for private equity funds are those that
are seen to be underperforming under their previous senior management.