Introduction To Business Finance PDF

LESSON ONE INTRODUCTION TO BUSINESS FINANCE Content Introduction to Business Finance  Scope of Business Finance.  Functions of Business Finance  Financial Goals or Objectives  Role of Finance Managers  The relationship between financial management an...

LESSON ONE INTRODUCTION TO BUSINESS FINANCE Content Introduction to Business Finance  Scope of Business Finance.  Functions of Business Finance  Financial Goals or Objectives  Role of Finance Managers  The relationship between financial management and other management disciplines  Agency theory. Meaning and Definition “Business is every human activity directed towards producing or acquiring wealth through buying and selling of goods and services” L Haney. “Business is an enterprise which makes, distribute or provides any article, goods or services which are required by members of the society and are able and willing to pay for” Urwick and Hunt Business may be considered as an economic activity which generates some article, goods and services which are offered to the society with an aim to make profit and providing a product that will meet market needs Finance may be defined as the art and science of managing money and includes financial services and financial instruments. The finance function is the procurement of funds and their effective utilization in business concerns. The concept of finance includes capital, funds, money, and amount. The term finance should be understood in two perspectives - finance as a resource and finance as a discipline. Finance, as a resource, refers to monetary means of financing assets of an entity. Finance as a discipline or subject of study, describes how individuals, governments and corporate organizations manage the flows of money through an organization. “Business finance is concerned aided with the sources of funds available to enterprises of all sizes and the proper use of money or credit obtained from such sources.” Professor Gloss and Baker “Business finance is to planning, controlling, coordinating and implementing financial activities of the business institution.” E.W Walker According to Guthumann and Dougall, “Business finance can broadly be defined as the activity concerned with planning, raising, controlling, administering of the funds used in the business”. In the words of Parhter and Wert, “Business finance deals primarily with raising, administering and disbursing funds by privately owned business units operating in non-financial fields of industry”. Business finance is the process by which a financial manager provides finance for business use as and when it is needed. Business Finance refers to that area of finance which deals with money and credit used in the business and how the money is raised. It is all about estimation, arrangement, and application of funds so that the business has sufficient cash to carry out operations effectively and efficiently, without any interruption. The Scope of Business Finance Business finance studies, analyses and examines wide aspects related to the acquisition of funds for business and allocates those funds. There are various fields covered by business finance and some of them are: 1. Financial planning and control: A business firm must manage and make their financial analysis and planning. To make these plans and management, the financial manager should have knowledge about the financial situation of the firm. On this basis of the information, he/she regulates the plans and managing  strategies for the future financial situation of the firm within a different economic scenario. The financial budget serves as the basis of control over financial plans. 2. Financial Statement Analysis: One of the scopes of business finance is to analyze financial statements. It also analyses the financial situations and problems that arise in the promotion of the business firm. This statement consists of the financial aspect related to the promotion of new business, administrative difficulties in the way of expansion, and necessary adjustments for the rehabilitation of the firm in difficulties. 3. Working capital Budget: The financial decision-making that relates to current assets or short-term assets is known as working capital management. Short-term survival is a requirement for long-term success and this is an important factor in a business. Therefore, the current assets should be efficiently managed so that the business won’t suffer any inadequate or unnecessary funds locked up in the future. This aspect implies that the individual current assets such as cash, receivables, and inventory should be very efficiently managed. 4. Capital Structure Management: The capital structure management seeks to safeguard the ongoing business operations, to ensure flexible access to capital markets and secure adequate funding at a competitive rate. Capital structure management might comprises both equity and interest-bearing debt. 5. Raising Capital: Raising capital is when an investor or a lender gives business funds to assist with starting, growing, and managing day-to-day operations. A business owner might look at different fundraising methods to service different capital needs. Typically, there are two forms of fundraising: equity and debt financing 6. Investing Capital: Invested capital is the total amount of money raised by a company by issuing securities to equity shareholders and debt to bondholders, where the total debt and capital lease obligations are added to the amount of equity issued to investors. Invested capital is not a line item in the company's financial statement because debt, capital leases, and stockholder’s equity are each listed separately in the balance sheet. 7. Managing the finance risk: Financial risk management is the practice of protecting economic value in a firm by using financial instruments to manage exposure to risk: operational risk, credit risk and market risk, foreign exchange risk, shape risk, volatility risk, liquidity risk, inflation risk, business risk, legal risk, reputational risk, sector risk, etc. Similar to general risk management, financial risk management requires identifying its sources, measuring them, and plans to address them Objectives of Business Finance 1. Profit maximization This is a traditional and a cardinal objective of a business.. Profit maximization refers to achieving the highest possible profits during the year. This could be achieved by either increasing sales revenue or by reducing expenses. Note that: Profit = Revenue – Expenses The sales revenue can be increased by either increasing the sales volume or the selling price. It should be noted however, that maximizing sales revenue may at the same time result to increasing the firm’s expenses. The pricing mechanism will however, help the firm to determine which goods and services to provide so as to maximize profits of the firm. This is so for the following reasons: To earn acceptable returns to its owners. (i.e. Must not be less than bank rates + inflation + risk) So as to survive (through plough backs) 1  To meet its day to day obligations. Favourable Arguments for Profit Maximization The following important points are in support of the profit maximization objectives of the business concern: (i) Main aim is earning profit. (ii) Profit is the parameter of the business operation. (iii) Profit reduces risk of the business concern. (iv) Profit is the main source of finance. (v) Profitability meets the social needs also. Unfavourable Arguments for Profit Maximization The following important points are against the objectives of profit maximization: (i) Profit maximization leads to exploiting workers and consumers. (ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc. (iii) Profit maximization objectives leads to inequalities among the stakeholders such as customers, suppliers, public shareholders, etc. Drawbacks of Profit Maximization Profit maximization objective consists of certain drawback also: i. It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion regarding earning habits of the business concern. ii. It ignores the time value of money: Profit maximization does not consider the time value of money or the net present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow during a particular period. iii. It ignores risk and uncertainty: Profit maximization does not consider risk of the business concern. Risks may be internal or external which will affect the overall operation of the business concern. iv. it ignores other participants in the firm rather than shareholders 2. Shareholders’ wealth maximisation Shareholders’ wealth maximisation refers to maximisation of the net present value of every decision made in the firm. Net present value is equal to the difference between the present value of benefits received from a decision and the present value of the cost of the decision. A financial action with a positive net present value will maximize the wealth of the shareholders, while a decision with a negative net present value will reduce the wealth of the shareholders. Under this goal, a firm will only take those decisions that result in a positive net present value. Shareholder wealth maximisation is important because: It influences company’s share prices. It facilitates growth (plough backs). It boosts the company’s credit rating. This is what owners claim from the company. Favourable Arguments for Wealth Maximization i. Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders. ii. Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern. iii. Wealth maximization considers both time and risk of the business concern. 2 iv. Wealth maximization provides efficient allocation of resources. v. It ensures the economic interest of the society. Unfavourable Arguments for Wealth Maximization i. Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities. ii. Wealth maximization is nothing, it is also profit maximization and it is the indirect name of the profit maximization. iii. Wealth maximization creates ownership-management controversy as Management alone enjoy certain benefits. iv. The ultimate aim of the wealth maximization objectives is to maximize the profit. v. Wealth maximization can be activated only with the help of the profitable position of the business concern. 3. Social responsibility The firm must decide whether to operate strictly in their shareholders’ best interests or be responsible to their employees, their customers, and the community in which they operate. The firm may be involved in activities which do not directly benefit the shareholders, but which will improve the business environment. This has a long term advantage to the firm and therefore in the long term the shareholders wealth may be maximized. 4. Business Ethics Related to the issue of social responsibility is the question of business ethics. Ethics are defined as the “standards of conduct or moral behaviour”. It can be thought of as the company’s attitude toward its stakeholders, that is, its employees, customers, suppliers, community in general creditors, and shareholders. High standards of ethical behaviour demand that a firm treat each of these constituents in a fair and honest manner. A firm’s commitment to business ethics can be measured by the tendency of the firm and its employees to adhere to laws and regulations relating to: Product safety and quality Fair employment practices Fair marketing and selling practices The use of confidential information for personal gain Illegal political involvement Bribery or illegal payments to obtain business. Functions of Business Finance The functions of Financial Manager can broadly be divided into two: The Routine functions and the Managerial Functions. I. Managerial Finance Functions Require skillful planning, control and execution of financial activities. There are four important managerial finance functions. These are: a) Investment of Long-term asset-mix decisions; - These decisions (also referred to as capital budgeting decisions) relates to the allocation of funds among investment projects. They refer to the firm’s decision to commit current funds to the purchase of fixed assets in expectation of future cash inflows from these projects. Investment proposals are evaluated in terms of both risk and expected return. Investment decisions also relates to recommitting funds when an old asset becomes less productive. This is referred to as replacement decision. b) Financing decisions; - Financing decision refers to the decision on the sources of funds to finance investment projects. The finance manager must decide the proportion of equity and debt. The mix of debt 3  and equity affects the firm’s cost of financing as well as the financial risk. This will further be discussed under the risk return trade-off. c) Division of earnings (Dividend) decision; - The finance manager must decide whether the firm should distribute all profits to the shareholders, retain them, or distribute a portion and retain a portion. The earnings must also be distributed to other providers of funds such as preference shareholder, and debt providers of funds such as preference shareholders and debt providers. The firm’s dividend policy may influence the determination of the value of the firm and therefore the finance manager must decide the optimum dividend – payout ratio so as to maximize the value of the firm. d) Liquidity decision; - The firm’s liquidity refers to its ability to meet its current obligations as and when they fall due. It can also be referred to as current assets management. Investment in current assets affects the firm’s liquidity, profitability and risk. The more current assets a firm has, the more liquid it is. This implies that the firm has a lower risk of becoming insolvent but since current assets are non-earning assets the profitability of the firm will be low. The converse will hold true. The finance manager should develop sound techniques of managing current assets to ensure that neither insufficient nor unnecessary funds are invested in current assets. II. Routine functions For the effective execution of the managerial finance functions, routine functions have to be performed. These decisions concern procedures and systems and involve a lot of paper work and time. In most cases these decisions are delegated to junior staff in the organization. Some of the important routine functions are:  Supervision of cash receipts and payments  Safeguarding of cash balance  Custody and safeguarding of important documents  Record keeping and reporting The finance manager will be involved with the managerial functions while the routine functions will be carried out by junior staff in the firm. He must however, supervise the activities of these junior staff. Role of a Finance Manager Finance manager is one of the important role players in the field of finance function. He must have entire knowledge in the area of accounting, finance, economics and management. His position is highly critical and analytical to solve various problems related to finance. He is one of the top management team and its roles are: 1. Raising funds – he makes sure that the firm has enough cash to meet its obligation and for mergers, consolidation, re-organization and recapitalization. 2. Allocation of funds- to ensure that funds are invested in viable projects by combining a number of function: - Increasing pace with industrialization - Technological innovation and inventions - Intense competition - Increased interventions by the government - Population growth or demographic aspects He must do optimum allocations all summed up to wise use of money. 3. Profit planning – it involves deciding on pricing, cost, volume, selection of product or service lines. 4. Understanding the capital market – The financial manager has to deal with capital markets where the firms securities are traded he should fully understand the operations of capital markets and the way in which securities are valued. He should also know how risk is measured in capital markets and how to cope with investment or financing decisions, which often involve considerable risk. 4 The task and responsibilities of finance managers vary from organisation to organisation depending upon the nature and size of the business, but Inspite of these variations the main tasks and responsibilities of finance manager can be classified as follows: a) Compliance with policy and procedures laid by the Board of Directors. b) Compliance with various rules and procedures as laid by law. c) Information generation for various stakeholders. d) Effective and efficient utilisation of funds. The main tasks and responsibilities of a financial manager are discussed below: a. Financial Planning and Forecasting: Financial manager is also concerned with planning and forecasting of production, sales and level of inventory In addition to this, he has also to plan and forecast the requirement of funds and the sources from which the funds are to be raised. b. Financial Management: Fund management is the primary responsibility of the finance manager. Fund management includes effective and efficient acquisition, allocation and utilisation of funds. The fund management includes the following:  Acquisition of funds: The finance manager has to ensure that adequate funds are available from the right sources at the right cost at the right time. The finance manager will have to decide the mode of raising fund, whether it is to be through the issue of securities or lending from the bank.  Allocation of funds: Once funds are acquired the funds have to be allocated to various projects and services as per the priority fixed by the Board of Directors.  Utilisation of funds: The objective of business finance is to earn profiles, which on a very large extent depend upon how effectively and efficiently allocated funds are utilised. c. Disposal of Profits: Finance manager has to decide the quantum of dividend which the company wants to declare. The amount of dividend will depend upon mainly the future requirement of funds for expansion and the prevailing tax policy. d. Maximization of Shareholder’s Wealth: The objective of any business is to maximize and create wealth for the investors, which is measured by the price of the share of the company. The price of the share of any company is a function of its present and expected future earnings. The finance managers should pursue policies which maximizes earnings. e. Interpretation and Reporting: Interpretation of financial data requires skills. The finance manager should analyze financial data and find out the reasons for variance from standards and report the same to the management. He should also assess the likely financial impact of these variances. f. Legal Obligations: All the companies are governed by specific laws of the land. These laws relate to payment of taxes, salaries, pension, corporate governance, preparation of accounts etc. The finance manager should ensure that a true and correct picture of the state of affairs should be reflected in the statement of accounts. Relationship between Business Finance and Other Disciplines 1. Business Finance and Economics Economic concepts like micro and macroeconomics are directly applied with the business financial management approaches. Investment decisions, micro and macro environmental factors are closely associated with the functions of a financial manager. Financial economics is one of the emerging areas, which provides immense opportunities to finance, and economical areas. 5 2. Business Finance and Accounting Accounting records include the financial information of the business concern and this plays an important part in decision making, business finance uses accounting information to analyse and interprate business decision as well as to take decisions. 3. Business Finance and Production Management Production management is the operational part of the business concern, which helps to multiple the money into profit. Production performance needs finance because the production department requires raw material, machinery, wages, operating expenses, etc. These expenditures are decided and estimated by the financial department and the finance manager allocates the appropriate finance to the production department. The financial manager must be aware of the operational process and finance required for each process of production activities. 4. Business Finance and Marketing Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The financial manager or finance department is responsible to allocate adequate finance to the marketing department. Hence, marketing and business finance management are interrelated and depend on each other. 5. Business Finance and Human Resource Business finance management is also related to the human resource department, which provides manpower to all the functional areas of the management. The financial manager should carefully evaluate the requirement of manpower to each department and allocate the finance to the human resource department as wages, salary, remuneration, commission, bonus, pension and other monetary benefits to the human resource department. Significance of Business Finance The significance or Importance of business finance is inescapable part of any company and efficient financial decisions are essential for success and growth since it involves the management of financial activities and financial resources of the company. The following may be considered;  Determination of Business Success: Sound financial management leads to optimum utilization of resources which is the key factor for successful enterprises. If we analyse the factors which lead to an enterprise turning sick one of the main factors would be mismanagement of financial resources. Financial Management helps in preparation of plans for growth, development, diversification and expansion and their successful execution.  Optimum Utilisation of Resources: One of the basic objectives of financial management is to measure the input and output in monetary terms. Since finance managers are responsible for the allocation of resources, they are also responsible to ensure that resources are used in an optimum manner. In fact, the failure of business enterprise is not due to inadequacy of financial resources, but is the result of defective management of financial resources.  Acquisition of Funds: Financial management involves the acquisition of required finance to the business concern. Acquiring needed funds play a major part of the financial management, which involve possible source of finance at minimum cost.  Financial Planning: Financial management helps to determine the financial requirement of the business concern and leads to take financial planning of the concern. Financial planning is an important part of the business concern, which helps to promotion of an enterprise. 6  Focal Point of Decision Making: Financial management is the focal point of decision-making as it provides various tools and techniques for scientific financial analysis. Some of the techniques of financial management are comparative financial statement, budgets, ratio analysis, variance analysis, cost- volume, profit analysis, etc. These tools help in evaluating the profitability of the project.  Measurement of Performance: The performance of the firm is measured by its financial results. The value of the firm is determined by the quantum of earnings and the associated risk with these earnings. Financial decisions which increases earnings and reduces risk will enhance the value of the firm.  Financial Decision: Financial management helps to take sound financial decision in the business concern. Financial decision will affect the entire business operation of the concern. Because there is a direct relationship with various department functions such as marketing, production personnel, etc.  Information Generator for Various Stakeholders: In this modern era where business managers are trustees of public money, it is expected that the firm provides information to the various stakeholders about the functioning of the firm. One of the major objectives of financial management is to provide timely information to various stakeholders.  Asset Creation: In the long-term, finance is required for buying assets like machinery, land, equipment, etc. to expand the production scale. Scaling up production will create assets, help the business grow and penetrate areas that are current. The business must have capital that is enough doing so and cannot be determined by short-term finances because of this. Either they must have savings or should know the importance of business finance and able to raise and infuse capital investment through equity or debt financing.  Business Cycles: Business cycles of growth, boom, recession, depression and renewal caused by changes in the economy and other factors that are outside a real possibility. And regardless of how well it is doing, the continuing company is bound to bear such consequences and should be ready to face these cycles. That’s why businesses which are smart economic plans for downturns  Improve Profitability: Profitability of the concern purely depends on the effectiveness and proper utilization of funds by the business concern. Financial management helps to improve the profitability position of the concern with the help of strong financial control devices such as budgetary control, ratio analysis and cost volume profit analysis.  Increase the Value of the Firm: Financial management is very important in the field of increasing the wealth of the investors and the business concern. Ultimate aim of any business concern will achieve the maximum profit and higher profitability leads to maximize the wealth of the investors as well as the nation.  Promoting Savings: Savings are possible only when the business concern earns higher profitability and maximizing wealth. Effective financial management helps to promoting and mobilizing individual and corporate savings. Nowadays financial management is also popularly known as business finance or corporate finances. The business concern or corporate sectors cannot function without the importance of the financial management.  Advisory Role: The finance manager plays an important role in the success of any organisations. 7 The Agency Theory An agency relationship arises where one or more parties called the principal contracts/hires another called an agent to perform on his behalf some services and then delegates decision making authority to that hired party (Agent) in the field of finance shareholders are the owners of the firm. However, they cannot manage the firm because, they may be too many to run a single firm, may not have technical skills and expertise to run the firm or are geographically dispersed and may not have time. In the light of the above shareholders are the principal while the management are the agents. Agency problem arises due to the divergence of interest between the principal and the agent. The conflict of interest between management and shareholders is called agency problem in finance. There are various types of agency relationship as follows: a. Shareholders and Management b. Shareholders and Creditors/Bond/Debenture Holders c. Shareholders and the Government d. Shareholders and Auditors e. Head Office and Subsidiary/Branch A. Shareholders and Management There is near separation of ownership and management of the firm. Owners employ professionals (managers) who have technical skills. Managers might take actions, which are not in the best interest of shareholders which might be in conflict with the interest of the owners. Causes of Conflict of Interest The actions of the managers are in conflict with the interest of shareholders will be caused by:- 1. Incentive Problem: Managers may have fixed salary and they may have no incentive to work hard and maximize shareholders wealth. This is because irrespective of the profits they make, their reward is fixed. They will therefore maximize leisure and work less which is against the interest of the shareholders. 2. Consumption of Perquisites: Prerequisites refer to the high salaries and generous fringe benefits which the directors might award themselves. This will constitute directors remuneration which will reduce the dividends paid to the ordinary shareholders. Therefore the consumption of perquisites is against the interest of shareholders since it reduces their wealth. 3. Different Risk-profile: Shareholders will usually prefer high-risk-high return investments since they are diversified i.e. they have many investments and the collapse of one firm may have insignificant effects on their overall wealth. Managers on the other hand, will prefer low risk low return investment since they have a personal fear of losing their jobs if the projects collapse. This difference in risk profile is a source of conflict of interest since shareholders will forego some profits when low-return projects are undertaken. 4. Different Evaluation Horizons: Managers might undertake projects which are profitable in short-run. Shareholders on the other hand evaluate investments in long-run horizon which is consistent with the going concern aspect of the firm. The conflict will therefore occur where management pursue short-term profitability while shareholders prefer long term profitability. 5. Management Buy Out: The board of directors may attempt to acquire the business of the principal. This is equivalent to the agent buying the firm which belongs to the shareholders. This is inconsistent with the agency relationship and contract between the shareholders and the managers. 6. Pursuing power and self-esteem goals: This is called “empire building” to enlarge the firm through mergers and acquisitions hence increase in the rewards of managers. 7. Creative Accounting: This involves the use of accounting policies to report high profits e.g. stock valuation methods, depreciation methods recognizing profits immediately in long term construction contracts etc. Solutions to Conflict of Interest Conflicts between shareholders and management may be resolved as follows: 8 1. Pegging/attaching managerial compensation to performance: This will involve restructuring the remuneration scheme of the firm in order to enhance the alignments/harmonization of the interest of the shareholders with those of the management e.g. managers may be given commissions, bonus etc. for superior performance of the firm. 2. Threat of firing: This is where there is a possibility of firing the entire management team by the shareholders due to poor performance. Management of companies have been fired by the shareholders who have the right to hire and fire the top executive officers e.g. the entire management team of Unga Group, IBM, G.M. have been fired by shareholders. 3. The Threat of Hostile Takeover: If the shares of the firm are undervalued due to poor performance and mismanagement. Shareholders can threatened to sell their shares to competitors. In this case the management team is fired and those who stay on can lose their control and influence in the new firm. This threat is adequate to give incentive to management to avoid conflict of interest. 4. Direct Intervention by the Shareholders: Shareholders may intervene as follows: Insist on a more independent board of directors. By sponsoring a proposal to be voted at the annual general meeting Making recommendations to the management on how the firm should be run. 5. Executive Share Options Plans: selected employees can be given a number of share options, each of which gives the holder the right after a certain date to subscribe for shares in the company at a fixed price. The value of an option will increase if the company is successful and its share price goes up. The theory is that this will encourage managers to pursue high net present value strategies and investments, since them as shareholders will benefit personally from the increase in the share price that results from such investments. The choice of an appropriate remuneration policy by a company will depend, among other things, on: Cost: the extent to which the package provides value for money Motivation: the extent to which the package motivates employees both to stay with the company and to work to their full potential. Fiscal effects: government tax incentives may promote different types of pay. At times of wage control and high taxation this can act as an incentive to make the ‘perks’ a more significant part of the package. Goal congruence: the extent to which the package encourages employees to work in such a way as to achieve the objectives of the firm – perhaps to maximize rather than to satisfy. 6. Incurring Agency Costs: Agency costs are incurred by the shareholders in order to monitor the activities of their agent. The agency costs are broadly classified as. a) The contracting cost- These are costs incurred in devising the contract between the managers and shareholders. The contract is drawn to ensure management act in the best interest of shareholders and the shareholders on the other hand undertake to compensate the management for their effort. Examples of the costs are: Negotiation fees, legal costs of drawing the contracts fees and the costs of setting the performance standard, b) Monitoring Costs - This is incurred to prevent undesirable managerial actions. They are meant to ensure that both parties live to the spirit of agency contract. They ensure that management utilize the financial resources of the shareholders without undue transfer to themselves. Examples are: External audit fees, Legal compliance expenses e.g. Preparation of Financial statement according to international accounting standards, company law, capital market authority requirement, stock exchange regulations etc. Financial reporting and disclosure expenses, Investigation fees especially where the investigation is instituted by the shareholders. Cost of instituting a tight internal control system. c) Opportunity Cost/Residual Loss- This is the cost due to the failure of both parties to act optimally e.g. Lost opportunities due to inability to make fast decision due to tight internal control system; Failure to undertake high risk high return projects by the manager leads to lost profits when they undertake low risk, low return projects. 9  d) Restructuring Costs – e.g. new internal control system, business process reengineering etc. B. Shareholders and Creditors/Bond/Debenture Holders Bondholders are providers or lenders of long term debt capital. They will usually give debt capital to the firm on the strength of the following factors: The existing asset structure of the firm, the expected asset structure of the firm, the existing capital structure or gearing level of the firm and the expected capital structure of gearing after borrowing the new debt. Causes of Conflict of Interest An agency problem or conflict of interest between the bondholders (principal) and the shareholders (agents) will arise when shareholders take action which will reduce the market value of the bond and by extension, the wealth of the bondholders. These actions include: a) Disposal of assets used as collateral for the debt: In this case the bondholder is exposed to more risk because he may not recover the loan extended in case of liquidation of the firm. b) Assets/investment substitution: In this case, the shareholders and bond holders will agree on a specific low risk project. However, this project may be substituted with a high risk project whose cash flows have high standard deviation. This exposes the bondholders because should the project collapse, they may not recover all the amount of money advanced. c) Payment of High Dividends: Dividends may be paid from current net profit and the existing retained earnings. Retained earnings are an internal source of finance. The payment of high dividends will lead to low level of capital and investment thus reduction in the market value of the shares and the bonds. A firm may also borrow debt capital to finance the payment of dividends from which no returns are expected. This will reduce the value of the firm and bond. d) Under investment: This is where the firm fails to undertake a particular project or fails to invest money/capital in the entire project if there is expectation that most of the returns from the project will benefit the bondholders. This will lead to reduction in the value of the firm and subsequently the value of the bonds. e) Borrowing more debt capital: A firm may borrow more debt using the same asset as a collateral for the new debt. The value of the old bond or debt will be reduced if the new debt takes a priority on the collateral in case the firm is liquidated. This exposes the first bondholders/lenders to more risk. Solutions to Agency Problem The bondholders might take the following actions to protect themselves from the actions of the shareholders which might dilute the value of the bond. These actions include: 1. Restrictive Bond/Debt Covenant: In this case the debenture holders will impose strict terms and conditions on the borrower. These restrictions may involve: a) No disposal of assets without the permission of the lender. b) No payment of dividends from retained earnings c) Maintenance of a given level of liquidity indicated by the amount of current assets in relation to current liabilities. d) Restrictions on mergers and organisations e) No borrowing of additional debt, before the current debt is fully serviced/paid. 2. Callability Provisions: These provisions will provide that the borrower will have to pay the debt before the expiry of the maturity period if there is breach of terms and conditions of the bond covenant. 3. Transfer of Asset: The bondholder or lender may demand the transfer of asset to him on giving debt or loan to the company. However the borrowing company will retain the possession of the asset and the right of utilization. On completion of the repayment of the loan, the asset used as a collateral will be transferred back to the borrower. 10 4. Representation: The lender or bondholder may demand to have a representative in the board of directors of the borrower who will oversee the utilization of the debt capital borrowed and safeguard the interests of the lender or bondholder. 5. Refuse to lend: If the borrowing company has been involved in un-ethical practices associated with the debt capital borrowed, the lender may withhold the debt capital hence the borrowing firm may not meet its investments needs without adequate capital. The alternative to this is to charge high interest on the borrower as a deterrent mechanism. 6. Convertibility: On breach of bond covenants, the lender may have the right to convert the bonds into ordinary shares. C. Shareholders and the Government Shareholders and by extension, the company they own operate within the environment using the charter or licence granted by the government. The government will expect the company and by extension its shareholders to operate the business in a manner which is beneficial to the entire economy and the society. The government in this agency relationship is the principal while the company is the agent. It becomes an agent when it has to collect tax on behalf of the government especially withholding tax and PAYE. The company also carries on business on behalf of the government because the government does not have adequate capital resources. It provides a conducive investment environment for the company and share in the profits of the company in form of taxes. Conflict of Interest The company and its shareholders as agents may take some actions that might prejudice the position or interest of the government as the principal. These actions include: Tax evasion: This involves the failure to give the accurate picture of the earnings or profits of the firm to minimize tax liability. Involvement in illegal business activities by the firm. Lukewarm response to social responsibility calls by the government. Lack of adequate interest in the safety of the employees and the products and services of the company including lack of environmental awareness concerns by the firm. Avoiding certain types and areas of investment coveted by the government. Solutions to the agency problem The government can take the following actions to protect itself and its interests. 1. Incur monitoring costs; E.g. the government incurs costs associated with: Statutory audit Investigations of companies under Company Act Back duty investigation costs to recover tax evaded in the past VAT refund audits 2. Lobbying for directorship (representation): The government can lobby for directorship in companies which are deemed to be of strategic nature and importance to the entire economy or society e.g. directorship in KPLC, Kenya Airways, and KCB etc. 3. Offering investment incentives: To encourage investment in given areas and locations, the government offers investment incentives in form of capital allowances as laid down in the Second schedule of Cap 470. 4. Legislations: The government has provided legal framework to govern the operations of the company and provide protection to certain people in the society e.g. regulation associated with disclosure of information, minimum wages and salaries, environment protection etc. 5. The government can in calculate the sense and spirit of social responsibility on the activities of the firm, which will eventually benefit the firm in future. 11 D. Shareholders and Auditors Shareholders appoint auditors as per the provisions of Section 159(1)-(6) of the Companies Act. The auditors are supposed to monitor the performance of the management on behalf of the shareholders. They act as watchdogs to ensure that the financial statements prepared by the management reflect the true and fair view of the financial performance and position of the firm. Causes of Conflict of Interest Since auditors act on behalf of shareholders they become agents while shareholders are the principal. The auditors may prejudice the interest of the shareholders thus causing agency problems in the following ways: a) Colluding with the management in performance of their duties whereby their independence is compromised. b) Demanding a very high audit fee (which reduces the profits of the firm) although there is insignificant audit work due to the strong internal control system existing in the firm. c) Issuing unqualified reports which might be misleading the shareholders and the public and which may lead to investment losses if investors rely on such misleading report to make investment and commercial decisions. d) Failure to apply professional care and due diligence in performance of their audit work. Solutions to the conflict 1. Firing: The auditors may be removed from office by the shareholders at the AGM. 2. Legal action: Shareholders can institute legal proceedings against the auditors who issue misleading reports leading to investment losses. 3. Disciplinary Action – Professional bodies have disciplinary procedures and measures against their members who are involved in un-ethical practices. Such disciplinary actions may involve: Suspension of the auditor Withdrawal of practicing certificate Fines and penalties Reprimand 4. Use of audit committees and audit reviews. E. Head Office and Subsidiary/Branch MNC has diverse operations set up in different geographical locations. The HQ acts as the principal and the subsidiary as an agent thus creating an agency relationship. The subsidiary management may pursue its own goals at the expense of overall corporate goals. This will lead to sub-optimization and conflict of interest with headquarter. This conflict can be resolved in the following ways: a) Frequent transfer of managers b) Adopt global strategic planning to ensure commonality of vision c) Having a voluntary code of ethical practices to guide the branch managers An elaborate performance reporting system providing a 2 way feedback mechanism. Performance contracts with managers with commensurate compensation package for the same. 12 Revision Exercise Q 1. a. Define agency relationship from the context of public limited company and briefly explain how this arise b. Highlight the various measures that would minimize agency problems between the owners and the management. Q 2. In a company, an agency problem may exist between management and shareholders on one hand and the debt holders (creditors and lenders) on the other because management and shareholders, who own and control the company, have the incentive to enter into transactions that may transfer wealth from debt holders to shareholders. Hence the need for agreements by debt holders in lending contracts. a. State and explain any four actions or transactions by management and shareholders that could be harmful to the interests of debt holders (sources of conflict). b. Write short notes on any four restrictive covenants that debt holders may use to protect their wealth from management and shareholder raids. Q3 a. Explain the term “agency costs” and give any three examples of such costs. b. Identify and briefly explain the three main forms of agency relationship in a firm. c. Although profit maximization has long been considered as the main goal of a firm, shareholder wealth maximization is gaining acceptance amongst most companies as the key goal of a firm. Required: (i) Distinguish between the goals of profit maximization and shareholder wealth maximization. (ii) Explain three limitations of the goal of profit maximization. Q4 Two neighboring countries have chosen to organize their electricity supply industries in different ways. In country A, electricity supplies are provided by a nationalised industry. On the other hand in country B electricity supplies are provided by a number of private sector companies. Required a) Explain how the objectives of the nationalised industry in country A might differ from those of the private sector companies in country B. b) Briefly discuss whether investment planning and appraisal techniques are likely to differ in nationalised industry and private sector companies. Q5 Discuss the objectives of financial management and critically evaluate various approaches to the financial management. Q6 Within a business finance context, discuss the problems that might exist in the relationships (sometimes referred to as agency relationships) between: Shareholders and managers, and Shareholders and creditors. 13