denzil watson and antony head, corporate finance: principles and practice, 4 th edition, © pearson...
TRANSCRIPT
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.1
Chapter 1
The Finance Function
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.2
Two key concepts
• Relationship between risk and return
• Time value of money
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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 one year.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.4
Risk and return
• Shareholder return is annual dividend (D1) plus share price increase (P1 – P0).
• Relative return in percentage terms is
100 x [(P1 – P0) + D1]/P0
• This is called total shareholder return.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.5
Future values: compounding
• Invest £100 now at 5% interest per year.
After 1 year: £105.00 (100 x 1.05)
After 2 years: £110.25 (105 x 1.05)
• These are future values of £100 after 1 and 2 years.
• Future values are found by compounding interest forward through time.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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 receivedin two years if your required rate of returnis 5%.
• Dividing by 1.052 to find a present value is called discounting.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.7
Present values: discounting
• A rational investor will prefer £108.84 to £100 at the current time.
• Discounting allows us to compare £120 in two 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 x 0.907 = £108.84.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.8
Decision-making areas
A financial manager’s tasks can be divided into 3 areas:
• Financing decisions
• Dividend decisions
• Investment decisions
Key point: appreciate the interrelationship of these 3 decision areas
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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)
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.10
Possible corporate objectives
• Shareholder wealth maximisation (SHWM)
• Maximisation of profit
• Maximisation of sales
• Survival
• Social responsibility
Which one should we follow?
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.11
Shareholder wealth maximisation
• Shareholders want 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.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.12
NPV B
NPV C
NPV A
NPV D
CORPORATENET
PRESENTVALUE
SHARE PRICE
SHWM
1
2
31: NPV is additive2: Link relies on market efficiency3: Share price taken as surrogate of SHW
Linking NPVto SHWM
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.14
Consequences of 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.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.15
Signs of an agency problem
• Managers finance company predominantly with equity finance.
• Managers accept low risk, short payback investment projects.
• Managers diversify operations.• Managers follow ‘pet projects’.• Management gets reward for ‘below
average’ performance.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.17
Option 1: do nothing
Leaving managers to their own devices is problematic:
• Given human nature, managers will engage in sub-optimal behaviour.
• Shareholders are satisficed rather than satisfied.
• No action is not really an option.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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.
• But...tying rewards to profits may encourage short-termism and creative accounting.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.20
• 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.
Option 3: reward good behaviour
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.21
Other areas of agency Companies are made up of a series of
agency relationships:
The Company
Managers
Employees
Creditorsi.e.banks, suppliers, bond holders
Customers
Shareholders
N.B. Arrows go from ‘principal’ to ‘agent’ and show capital flowscapital flows
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.22
Other areas of agency
• Debt holders (principals) and shareholders (agents)
• Solutions: security, restrictive covenants
• Management (principles) and employees (agents)
• Solutions: executive share option plans (ESOPs), monitoring, performance-related pay (PRP)
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
Slide 1.23
Corporate governance
‘ Corporate governance is about promoting corporate fairness, transparency and accountability’ J. Wolfensohn, President (World Bank), Financial Times, June 21, 1999.
• Can be seen as attempt to solve agency problem using externally imposed regulation.
• In the UK it is administered through a series of self-regulatory codes.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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)
A 1996 PIRC report indicated widespread abuse of above.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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:
• Embodies Hampel, Cadbury and Greenbury recommendations
• Compliance is an LSE listing requirement
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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.
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 4th Edition, © Pearson Education Limited 2007
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.
• Managers still receive ‘excessive’ rewards
• The future: – US style shareholders coalitions? e.g. CalPers– statutory legislation?