ch01

Slide 1.
Chapter 1
The finance function
Watson and Head, Corporate Finance: Principles and Practice PowerPoints on the Web, 6th Edition Pearson Education Limited 2014
Slide 1.2
Two key concepts

Relationship between risk and return
Time value of money.
Slide 1.3
Risk and return

Risk refers to the possibility that actual
outcome may differ from expected outcome.
Risk can be measured by standard deviation.
Investors require increasing compensation
(return) for taking on increasing risk.
Return on an investment can be measured
over a standard period such as 1 year.
Slide 1.4
Risk and return (Continued)

Shareholder return is annual dividend (D 1)
plus share price increase (P1 P0).
Relative return in percentage terms is
100 [(P1 P0) + D1]/P0.
This is called total shareholder return.
Slide 1.5
Future values: compounding

Invest 100 now at 5% interest per year
After 1 year: 105.00 (100 1.05)
After 2 years: 110.25 (105 1.05).
These are future values of 100 after 1 and
2 years.
Future values are found by compounding
interest forward through time.
Slide 1.6
Present values: discounting

What sum of money invested now at 5% will
give 120 in 2-years time?
This will be 120/1.052 = 108.84.
This is the present value of 120 received in
2 years, if your required rate of return is 5%.
Dividing by 1.052 to find a present value is
called discounting.
Slide 1.7
Present values: discounting

(Continued)
A rational investor will prefer 108.84 to 100

at the current time.
Discounting allows us to compare 120 in
2-years time with 100 now.
Note that 1/1.052 = 0.907.
0.907 is the present value factor or discount
factor of 5% over 2 years (see tables).
Hence 120 0.907 = 108.84.
Slide 1.8
Decision-making areas
A financial managers tasks can be divided
into 3 areas:
Financing decisions
Dividend decisions
Investment decisions
Key point: understand the interrelationship
of these 3 decision areas.
Slide 1.9
The financial manager

Who is the financial manager in reality?
Finance Director
(strategic decision making)
Corporate Treasurer
(day-to-day cash management).
Slide 1.10
Possible corporate objectives
Shareholder wealth maximisation (SHWM)

Maximisation of profit
Maximisation of sales
Survival
Social responsibility
Which one should a company follow?
Slide 1.11
Shareholder wealth maximisation

Shareholders want both dividends and
capital gains.
Capital gains reflect future dividends.
Current and future dividends depend on
future cash flows:
their magnitude or size
their timing
their associated risk.
Slide 1.12
NPV A
Linking
NPV
to SHWM
NPV B
NPV C
1
Corporate
Net
Present
Value
2
NPV D
1: NPV is additive
2: This link relies on
market efficiency
3: Share price taken as
surrogate of SHW
Share Price
3
SHWM
Slide 1.13
The agency problem

Why does it arise?
Divergence of ownership and control
Managers goals differ from shareholders
Asymmetry of information.
What are the consequences?
Shareholder wealth is no longer maximised.
Slide 1.14
Consequences of an agency
problem
Managers will follow their own objectives
i.e. increasing their
power
job security
pay and rewards
Shareholders need to ensure that their own

wealth is maximised.
Slide 1.15
Signs of an agency problem

Managers finance a company mainly with
equity finance.
Managers accept low risk, short payback
investment projects.
Managers diversify business operations.
Managers follow pet projects.
Managers are rewarded for performance that
is below average.
Slide 1.16
Optimal contracts and agency

Best solution to the agency problem is to
design managerial contracts that minimise
the sum of the following costs:
financial contracting costs
monitoring costs
divergent behaviour costs.
Slide 1.17
Option 1: do nothing
Leaving managers to their own devices is
problematic:
Given human nature, managers will engage
in suboptimal behaviour.
Shareholders are satisficed rather than
satisfied.
No action is not really an option.
Slide 1.18
Option 2: monitoring
Problems associated with monitoring:
Costly in terms of both time and money.
Who will pay? Large shareholders? What
about free-riding smaller investors?
Some managerial actions are hard to follow.
May drive bad managers underground.
Slide 1.19
Option 3: reward good behaviour

What do we link managerial rewards to?
Most commonly linked to:
profits
share price (e.g. via share options).
Rewarding is more common than monitoring.

Buttying rewards to profits may encourage
short-termism and creative accounting.
Slide 1.20
Option 3: reward good behaviour

(Continued)
There are also problems using share options:

how many options should managers be awarded?
at what share price should managers be able to
exercise their options?
managers can get rewarded for poor performance
if there is a bull stock market.
Slide 1.21
Other areas of agency

Companies are made up of a series of agency
relationships:
Shareholders
Managers
Employees
Creditors
i.e.banks,
suppliers and
bondholders
The
Company
Customers
N.B. Arrows goes from principal to agent and show capital flows.
Slide 1.22
Other areas of agency

(Continued)
Debt holders (principals) and shareholders
(agents)
Solutions: security, restrictive covenants
Managers (principles) and employees
(agents)
Solutions: executive share option plans
(ESOPs), monitoring, performance-related
pay (PRP).
Slide 1.23
Corporate governance
Corporate governance is about promoting
corporate fairness, transparency and
accountability.
It can be seen as an attempt to solve agency
problem using externally imposed regulation.
In the UK, good corporate governance is
encouraged through a self-regulatory code of
best practice.
Slide 1.24
Cadbury Committee (1992)

Recommended:
A voluntary code of practice
3 non-executive directors at board level
maximum 3-year duration contracts
posts of Chairman and C.E.O. should be separate
Improved information flow to shareholders

Increasing independence of auditors.
Slide 1.25
Greenbury Report (1995)

Recommended:
One-year rolling contracts
More sensitivity by remuneration committees
PRP and share options to be phased out
and replaced by challenging long-term
incentive plans (LTIPs)
PIRC report (1996) indicated widespread
abuse of the above.
Slide 1.26
Hampel Report (1998) and the

Combined Code
Stressed importance of a balanced board,
non-executive directors and the role of
institutional shareholders
Combined Code overseen by the London
Stock Exchange
Integrates Hampel, Cadbury and Greenbury
recommendations
Compliance is an LSE listing requirement.
Slide 1.27
Turnbull, Higgs and Smith

Turnbull (1999): detailed how boards could
maintain sound systems of internal control
(significant risk/systems required)
Higgs (2003): report designed to enhance
the independence, and hence effectiveness,
of non-executive directors
Smith (2003): gave authoritative guidance on
how audit committees should operate and be
structured.
Slide 1.28
Is there an agency or corporate

governance problem in UK today?
Agency still remains a problem in the UK:
legislation is only voluntary
human nature has not changed
Directors still receive excessive rewards

The future:
US style shareholders coalitions? e.g. CalPers
statutory legislation?

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Slide 1.

Two key concepts

Risk and return

Risk and return (Continued)

Future values: compounding

Present values: discounting

Present values: discounting

A rational investor will prefer 108.84 to 100

The financial manager

Possible corporate objectives

Shareholder wealth maximisation (SHWM)

Shareholder wealth maximisation

The agency problem

Shareholders need to ensure that their own

Signs of an agency problem

Optimal contracts and agency

Option 3: reward good behaviour

share price (e.g. via share options).

Rewarding is more common than monitoring.

Option 3: reward good behaviour

There are also problems using share options:

Other areas of agency

Other areas of agency

Cadbury Committee (1992)

Improved information flow to shareholders

Greenbury Report (1995)

Hampel Report (1998) and the

Turnbull, Higgs and Smith

Is there an agency or corporate

Directors still receive excessive rewards

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