BAC 203 Topic One: Meaning and Scope of Business Finance PDF

TOPIC ONE: INTRODUCTION Scope and Nature of Business Finance Definition of Business Finance Business Finance is a discipline concerned with the generation and allocation of scarce resources (usually funds/money) to the most efficient user within the firm/business (the competing investment...

TOPIC ONE: INTRODUCTION Scope and Nature of Business Finance Definition of Business Finance Business Finance is a discipline concerned with the generation and allocation of scarce resources (usually funds/money) to the most efficient user within the firm/business (the competing investment projects) through a market pricing system (the required rate of return). A firm requires resources in form of funds raised from investors. The funds must be allocated within the organization to projects which will yield the highest return. 1 Cont’d… It is the duty of finance manager to raise funds for the enterprise. Various sources include: 1. Owners money-(owners equity)- for small businesses this is personal savings or for limited companies. For the latter, this comprises of ordinary share capital and reserves. Also a company retains some finance over time which is also part of owners’ money. Any company/enterprise should tap a large part of its financial resources from this source (retained earnings) as this is the base on which other finances can be raised. 2 Cont’d… 2. Other parties’ money- this includes:- - preference share capital - creditors’ finance- eg loans, debentures, hire purchase, lease financé, mortgages, factoring, sale and lease back, bills of exchange etc 3 Scope of Finance Function SCOPE OF FINANCE FUNCTIONS The functions of finance manager can broadly be divided into two: The Managerial Functions and Routine functions. Managerial Finance Functions Require skilful 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. 4 Cont’d… (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 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 decision-dividend policy The finance manager must decide whether the firm should distribute all profits to the shareholder, 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 divided 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. 5 Cont’d… 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 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 6 Cont’d… 2 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: (a) Supervision of cash receipts and payments (b) Safeguarding of cash balance (c) Custody and safeguarding of important documents (d) 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. 7 Goals of a business entity Any business firm would have certain objectives which it aims at achieving. The major goals of a firm are: Profit maximization Shareholders' wealth maximization Social responsibility Business Ethics Growth 8 Profit maximization  Any business entity invests its resources so as to gain maximum profit.  Traditionally, this was considered to be the major goal of the firm. 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 business must make profits; - To give returns to its owners (shareholders). The return must be satisfactory i.e. higher than the bank rate on savings account. The owner may pull out of the company if it is making losses. 9 Cont’d… - The company must give reasonable reward to employees-good salaries and benefits - The company must make profits some of which should contribute to social issues (corporate social responsibility-CSR) 10 Cont’d… 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.  The profit maximization goal has been criticized because of the following: (a) It ignores time value of money leading to uncertainty of returns. It also ignores risk. Two firms which use the same technology and same factors of production may eventually earn different returns. (b) It is vague in terms of returns achieved by a firm in different time period (c) It ignores other participants in the firm other than the shareholders. Exploitation of workers, compromising the quality of products produced leading to customer dissatisfaction 11 Shareholders’ wealth maximization Shareholder wealth maximization is the idea that the main goal of a business's managers should be to increase its share price as much as possible. This can be achieved through retention of earnings and subsequent reinvestment of those earnings in the business or other viable investment projects. Note that only those investment projects that have been ascertained to be viable should be undertaken 12 Cont’d… However, shareholder wealth maximization can be a negative if it encourages questionable behavior and decisions at the expense of society, the environment, and the company's own long-term sustainability. Shareholders' wealth maximization refers to maximization 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. 13 Cont’d… Shareholder wealth maximization helps to solve the problems with profit maximization. This is because, the goal: i. considers time value of money by discounting the expected future cash flows to the present. ii. it recognizes risk by using a discount rate (which is a measure of risk) to discount the cash flows to the present. 14 Illustration PT ltd is considering to undertake a project with the following net cash flow patterns Yr 1 2 3 4 5 NCF(sh‘000) (6000) (6000) 600 8500 10,400 The cost of capital is 11.5% The company’s current market price per share is sh.150 before the decision to undertake the project is made. The company has 1,500,000 ordinary shares in issue. Required: Assuming an efficient capital market, find the company’s market value per share immediately the decision to undertake the project is made. 15 Cont’d… (c) Business Ethics/Other goals The firm must decide whether to operate strictly in their shareholders' best interests or be responsible to their employers, 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. 16 Cont’d… 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: i. Product safety and quality ii. Fair employment practices iii. Fair marketing and selling practices iv. The use of confidential information for personal gain v. Illegal political involvement vi. Bribery or illegal payments to obtain business 17 Cont’d… i. Welfare of the employees: A contented body of employees will boost the company’s production sales and profits. The company must provide its employees with reasonable salaries commensurate with the employees’ qualification, competence, experience and nature of the job. Others include transport facilities, medical facilities, assurance of terminal benefits and recreation facilities. ii. Interest of customers: Any business must be mindful of its customers and must seek to retain them by ensuring consistent provision of quality products, fair prices and honest dealings with them. iii. Welfare of the society:- any business owes a social responsibility to the society in terms of: - maintaining sound industrial relations with the society around it - avoiding harmful production processes - contributing to the social cause- eg building schools, clinics 18 Cont’d… iv. Fair dealing with suppliers of goods/services v. Fair dealing with creditors vi. Duty to the government 19 Cont’d… Growth This is a major objective of small companies which may even invest in projects with negative NPV so as to increase their size and enjoy economies of scale in the future. 20  Agency Theory in Financial Management Agency theory proposed by Jensen and Meckling (1976) is a theory which suggests that the separation between owners and managers of a company can cause agency problems. The agency problem in question, among others, is the occurrence of asymmetric information (not the same) between those owned by the owner and manager. Hence, an agency relationship may be defined as a contract under which one or more people (principals) hire another person (the agent) to perform some services on their behalf and delegate some decision making authority to that agent. Types of Agency Relationships in Finance: Shareholders (principals) and the management (agent) Shareholders (agent) and debt holders (lenders) (principal) Shareholders and the government Shareholders and the auditors Shareholders and the head quarter’s office and the branch 21 Shareholders and Management Agency relationship A limited liability company is owned by the shareholders but in most cases is managed by a board of directors appointed by the shareholders. This is because: There are very many shareholders who cannot effectively manage the firm all at the same time Shareholders may lack the skills required to manage the firm. Shareholders may lack the required time. 22 Cont’d… Conflicts of interest usually occur between managers and shareholders in the following ways: Incentive problem: Managers have fixed salaries and hence have no incentive to work hard to maximize shareholders wealth if they perceive that they will not share in the benefit of their labour. Consumption of perquisite/perks: Managers may award themselves huge salaries and other benefits more than what a shareholder would consider reasonable. This is because they reduce the dividends paid to the ordinary shareholders. Managers may also maximize leisure time at the expense of working hard. 23  Cont’d… Different evaluation horizon: Managers might undertake projects which are profitable in the short run while shareholders prefer projects which are long term consistent with the going concern concept of the firm hence resulting into conflict Managers may undertake projects that improve their image at the expense of profitability. 24 Cont’d… Management Buy Out (MBO). The board of directors may attempt to acquire the business of the principal by forming nominee companies which buy shares of the company they are managing. Once a controlling interest has been acquired, they become owners of the firm, something shareholders may not like. Creative Accounting- This is the use of accounting policies to report high profits such as stock valuation methods, depreciation methods which may recognise profits immediately but in the long term, contribution contracts. 25 Cont’d… Solutions to this Conflict In general, to ensure that managers act to the best interest of shareholders, the firm (shareholders) will: a. Incur Agency Costs in the form of: Monitoring expenses such as audit fee; Expenditures to structure the organization so that the possibility of undesirable management behaviour would be limited. (This is the cost of internal control) Opportunity cost associated with loss of profitable opportunities resulting from structure not permit manager to take action on a timely basis as would be the case if manager were also owners. This is the cost of delaying decision. Incur bonding expenditures: Firms may seek protection against acts of dishonest managers by obtaining a fidelity bond from a third party bonding company which agrees to compensate the firm up to a certain amount if a certain manager’s dishonest acts entail losses to the firm. 26 Cont’d… b. The Shareholder may offer the management profit-based remuneration. This remuneration includes: An offer of shares so that managers become owners. Share options: (Option to buy shares at a fixed price at a future date). Profit-based salaries e.g. bonus 27 Cont’d… c. Threat of firing: Shareholders have the power to appoint and dismiss managers which is exercised at every Annual General Meeting (AGM). The threat of firing therefore motivates managers to make good decisions. d. Threat of Acquisition or Takeover: If managers do not make good decisions then the value of the company would decrease making it easier to be acquired especially if the predator (acquiring) company beliefs that the firm can be turned round. 28 Shareholders and Debtholders Agency Relationship An agency problem or conflict of interest between the bondholder (creditors) and shareholders may arise when the shareholders take actions which will reduce the market value of the debt (the bond). These actions include: Disposal of assets used as collateral for the debt: the bondholder is exposed to more risk because he may not recover the loan given in case of liquidation of the firm. Asset or investment substitution: The shareholders and the bond holder will agree on a specific low risk projects. However, it may be substituted with high risk project where cash flows have a very high standard deviation. 29 Cont’d… Payment of high dividends: Dividend may be paid from the current net profit and the existing retained earnings which is an internal source of finance. The payment of high dividends will lead to low level of capital formation. This reduces the market value of the firm and consequently the value of the bond. Under investments: if a firm may fail to undertake a particular project or fail to invest money in the entire project if there is an expectation that most of the return from the payment will benefit the lenders Borrowing more debt capital: The firm may borrow more capital using the same assets as collateral for the new debt. This is likely to reduce the value of the old debts if the new debts take priority on the collateral in case the firm is liquidated. 30 Cont’d… Solutions to these agency problems that the bondholders might take to secure themselves from the actions of the shareholders include: a. Restrictive debt covenants: Lenders can impose strict covenant on the borrowers in terms of; No more disposal of assets without the lenders permission No payment of dividends especially from the retained earnings Maintenance of a given level of liquidity indicated by the amount of current assets and current liabilities Restrictions of mergers and acquisition Restrictions of borrowing debts before the current debt is fully paid The lenders may recommend the type of project to undertake in relation to the riskiness of the project. 31 Cont’d… b. Representation: The lender or the bondholder may demand to have representation in the board of directors of the borrower, who will have to oversee the utilization of the debt capital borrowed. This ensures that the interests of the lender are safeguarded. c. Refuse to lend: If the borrowing company is involved in unethical practices associated with the debt capital borrowed, the lender may withhold the debt capital so that the borrowing firm may not be able to meet its investment needs. 32 Cont’d… d. Convertibility provision: On the breach of contract, the lender may have the right to convert the bonds into ordinary shares e. Transfer of assets: The bondholder may demand the transfer of assets to him/her on giving the date to the company. However, the company can retain the possession of the assets and the right to utilization. 33 Agency relationship between the shareholders and the Auditors Shareholders appoint the auditors as per the provision of the Companies Act. The auditors are supposed to monitor the performance of the management on behalf of the shareholders. The auditors are the agents and the shareholders are the principals. The auditors may however prejudice the position of the shareholders in ways such as: Colluding with the management in the performance of their duties where their independence is compromised. 34 Cont’d… Demanding very high audit fees even with insignificant audit work Issuing unqualified report which might be misleading hence leading to losses if investors rely on it to make critical investment decisions. Failure to apply professional care and due diligence in the performance of their work. 35 Solutions to these problems and conflict include: Firing the auditors from the office by the shareholders at the annual general meeting. Legal action: Shareholders can institute legal proceedings against the auditors who issue misleading reports leading to investment loss Disciplinary actions: Where professional bodies such as ICPAK have disciplinary procedures and measures against their members who are involved in unethical practices. Such actions include: i. Suspension of the auditors ii. Withdrawal of practicing certificate iii. Fines and penalties The use of Audit Committee and Audit Reviews 36 Agency relationship between the shareholders and the Government Shareholders operate within the environment provided by the government. The government expects the company to operate the business in a manner that is beneficial to the entire economy and society. The government is the principal and the company is the agent. The company must collect tax and pay to the government. Companies conduct businesses on behalf of the government since government may not have adequate resources to do business. Government provides conducive environment for the company and shares in the profits of the company in form of tax. The company may take some actions which are in conflict with the government position. 37 These actions may include: Tax evasion: This involves failure to give the accurate picture of the earnings of the firm so as to minimize tax liability Involvement in illegal businesses by the firm. Lukewarm response to social responsibility called by the government Lack of adequate measures to ensure the safety of the employees Avoiding certain types and areas of investment 38 Solutions that the government can take to protect itself include: Incurring monetary costs associated with statutory audit, investigations of the company under Companies Act, VAT refund, etc. Lobbying for directorship and representation in certain companies that are deemed to be strategic in nature and importance to the entire economy and society. Offering investment incentives: where investments in given areas and location is encouraged. This allowance may be in the form of capital allowance, tax holidays etc. 39 Cont’d… Legislation: The government provides legal framework to govern the operations of a company and provides protection to certain people in the society. These may include environmental protection, regulation associated with disclosure of information. The government can introduce support, a sense and spirit of social responsibility on the activities of the firm. Providing of guidelines on the minimum disclosures in the financial statements. 40 Revision question Executive compensation plans hinder value creation in a company. Citing reasons, justify the above statement. Shortcomings of executive compensation plans  Linkages between size and pay since big companies evidently have a higher pay, most executive strive for ‘bigness’ irrespective of whether it leads to value creation or not.  Emphasis on short term performance. Usually short term performance such as increase in sales and growth in earnings is given considerable weight which leads to myopic orientation and distract executives from value creation  Reliance on accounting measures/creative accounting. Accounting measures such as earnings and return on investments on which performance of executive is usually gauged are often poor proxies for value creation 41 Cont’d…  Required current recognition of income. Although the income tax liability on the growth realized in the cash value is deferred, the executive is required to recognize current income equal to business premium payment each year.  Loss of control over the life insurance policy and its value since the executive is the policy and its value. Since the executive is the policy owner, the employer’s control is limited to payment.  Inability to provide for employment loss recovery. Employer cost recovery is not a feature of executive bonus plans 42