CORPORATE FINANCE & MGT - INTRODUCTION.pptx

The theory stems from the separation of ownership from control which is a feature of modern corporations.
The assumption in agency theory is that managers are risk averse utility maximizing economic agents whose interests in the firm may conflict with those of the shareholders

1. Corporate Finance/Financial Management -

2. Objectives of the Training To enable participants appreciate the centrality of finance in the organization, and the goal in financial decisions To enable non finance professionals to read, understand and analyse financial statements. To enable participants understand the major financial decisions and equip them to be able to make such decisions in an informed manner To enable participants understand the various classification of costs and the application of the CVP analysis (breakeven analysis) in profit planning and control To enable participants to understand the principle of time value of money and its application in financial decisions. To enable participants to understand and use the various techniques for evaluating projects To enable participants understand the need for working capital management, and to be able to manage different aspects of working capital such as cash, inventory, and debtors.

3. The Centrality of Finance in an Organization Organizations make use of different assets and resources for their operations – human and material resources At every point in the life of any organization, decisions have to be made as to which resources/assets should be acquired and when they should be acquired how to raise the necessary financial resources to acquire the required human and material resources. what to do with profits generated – to reinvest them or distribute them to the owners of the business.

4. Shareholder Wealth Maximization One of the dominant views concerning the goal of the firm and the goal managers should pursue seems to be shareholder wealth maximization. The argument is that the shareholders are the owners of the business and aim at earning a good return on their investment without undue risk exposure. The shareholders elect the directors who appoint the managers to run the business on a day to day basis. The managers as agents of the shareholders are supposed to be working on behalf of the shareholders (principals) and should therefore pursue policies that aim at enhancing the wealth of the shareholders.

5. Shareholder Wealth Maximization and Stock Price Shareholder wealth maximization have come to translate into maximizing the price of the firm’s common stock. The reason for the focus on stock price is that for publicly traded firms, stock prices are easily observable and constantly updated to reflect what the market thinks of the effects of current information about, and decisions of the firm on the firms value. The market price of a firm’s common stock represents the value that market participants place on the company and this is what will be available to the shareholders if they choose to realize any portion of their wealth tied in the company. They have the discretion to sell their shares whenever they want, but do not have the discretion to receive dividend whenever they want. Therefore, managers must strive to take those courses of action that maximize the stock price which in turn is a reflection of the firm’s financial decision.

6. Assumptions and Criticisms of the Shareholder Wealth Maximization theory It assumes that stockholders have absolute power over managers and can hire and fire them – theoretically, shareholders have power over the managers through the Board, and the Annual meetings. The interest of managers and shareholders are not always aligned, and the shareholders to not always have effective control over managers. It assumes that the interest of bondholders/lenders and other stakeholders are protected by managers such that they don’t get ripped off even if they do not protect themselves. Managers reveal information honestly and timely, and markets are efficient and accurately and timeously assess the impact of information and factor it into prices. There are no social costs – all costs can be traced and charged to firms These assumptions are utopian and form the bases of the criticisms against shareholder wealth maximization. The pursuit of this objective is a recipe for disaster in the real world.

7. Stakeholder Theory and the Objective of Financial Management The firm is a “nexus of contracts” in the sense that the firm has both implicit and explicit contracts with a variety of individuals and groups (stakeholders), and therefore owes them the obligation to protect their interests. A stakeholder of the organization is any person or group that affects or is affected by the activities of the organisation (Freeman, 1984) The interests of these stakeholders differ, and sometimes conflict, and it is difficult to satisfy all of them at the same time. The manager has the onerous task of reconciling these conflicts where possible, and deciding whose interest should be given priority at different times .

8. Which Stakeholder’s Interest should be Prioritized? These stakeholders provide various resources on which the firm depends. Some of these stakeholders’ interests are more critical than others at certain times because of the criticality of the resources they provide to the firm at that time. The combination of stakeholder theory and resource dependency theory suggests that while managers aim at satisfying all stakeholders as much as possible, the criticality of the resource provided by each of the stakeholders will determine the priority given to each stakeholder’s interests. However, in a dynamic environment, the criticality of resources changes, such that what is critical today may not be what will be critical tomorrow. In the light of this dynamism, we see that the prioritization of stakeholders is an ever changing process where the stakeholder that is favoured today may not be the one that will be favoured tomorrow .

9. Criticisms of the Stakeholder Theory of Objectives of Financial Management Jensen ( 2010) has criticizes the stakeholder view of the goal of the firm on the following grounds: It is confusing in the sense that it requires managers to pursue multiple goals which at the end of the day leaves every stakeholder worse off Provides coverage for managers to waste resources – if for instance they fail to make profit, they might argue that the focus was on other stakeholders. It is incomplete to the extent that it fails to specify the criteria for assessing any expenditure on any stakeholder. He therefore proposes what he calls the enlightened value maximization as what should be the goal of the firm.

10. The Enlightened Value Maximization Objective The enlightened value maximization view builds on the stakeholder view but goes beyond it to specify criteria for assessing any expenditure on any stakeholder. The criterion according to this view is that expenditure on any stakeholder should add something to the long term value of the firm. This emphasizes long term value which is different from the short term financial result focus of shareholders ( Pichet , 2011). It is also consistent with the stakeholder view, for as Jensen ( 2010) points out, long term value maximization is impossible if any of the important stakeholders are ignored or mistreated (p. 38).

11. Corporate Governance The modern corporation has many stakeholders with conflicting interest at times. Not all the stakeholders are involved in the day-to-day management of the corporation. As a result, there is asymmetric information. As a result of this asymmetric information, the relationships between stakeholders, and stakeholder positions may therefore be exploited to the advantage of some and the disadvantage of others. There is therefore the need to prevent this exploitation in the interest of the survival of the market system that has come to rely so much on this form of corporate ownership and control. Mostovicz et al. (2011) conceptualized corporate governance as “processes customs, policies, laws and institutions affecting the way corporations are directed, administered, or controlled, and its purpose is to influence directly or indirectly, the behavior of the organization towards its stakeholders” (p. 613).

12. Corporate Governance The recent high profile corporate failures and bankruptcies such as that of Enron, Arthur Andersen, Worldcom , Bear Stearns, Lehman Brothers, the near collapse of AIG, Citigroup, and the U.S auto industry e. t. c that have largely been attributed to failures in corporate governance have brought corporate governance issues to the center stage in recent times ( Fisch , 2010; Mostovicz et al., 2011 ). The objectives a firm pursues and the achievement of such objectives are influenced by its corporate governance structures, and these in turn affect the performance of the firm Three theoretical frameworks - the stewardship theory, the stakeholder theory and the agency theory - have informed the choice of corporate governance mechanisms around the world The agency theory has been the predominant framework that has influenced corporate governance practices all over the world.

13. Agency Theory and Corporate Governance The theory stems from the separation of ownership from control which is a feature of modern corporations. The assumption in agency theory is that managers are risk averse utility maximizing economic agents whose interests in the firm may conflict with those of the shareholders On the basis of this assumption, it is argued that managers have incentives to pursue their personal interests especially if their private benefits from such decisions exceed their private cost, even if such decisions may lead to loss of shareholder value It is also argued that they are more likely to do so if left uncontrolled It therefore becomes prudent on the shareholders to reduce their potential losses from the self-serving behaviour of managers by putting mechanisms in place to reduce such behaviours.

14. Agency Theory and Corporate Governance cont’d From the agency theory perspective of corporate governance, corporate decision making which is left to the chief executive officer (CEO) and other managers is separated from decision control which is a function that lies with the board and also separated from the investment and risk bearing function of shareholders who are widely dispersed. Agency theory prescriptions for corporate governance are aimed at: Aligning managerial interest with that of the shareholders for the purpose of increasing shareholder wealth Monitoring and controlling managers’ self-serving behaviour so as to protect the shareholders from possible losses arising from such behaviour.

15. Agency Theory Prescriptions for Corporate Governance Interest alignment mechanisms: Insider ownership Executive compensation schemes that tie compensation to firm performance – pay-for-performance. These mechanisms are aimed at increasing the manager’s private cost from his decisions, thus increasing his incentives to avoid value destroying decisions Managerial monitoring and control mechanisms Block/concentrated shareholding, Smaller sized boards, Independent boards Separation of CEO and chairman’s position. Increased leverage Active market for corporate control Shareholding voting and litigation Succession plans that encourage CEO monitoring and whistle blowing by subordinates