CorporatefinanceEighthEditionChapter1ThefinancefunctionTwokeyconceptsRelationshipbetweenriskandreturnTimevalueofmoneyRiskandreturnRiskreferstothepossibilitythatactualreturnmaybedifferentfromexpectedreturn.Riskcanbemeasuredbystandarddeviation.Investorsrequireincreasingcompensation(return)fortakingonincreasingrisk.Returnonaninvestmentcanbemeasuredoverastandardperiodsuchas1year.Riskandreturn(continued)Shareholderreturnisannualdividend(D1)plussharepriceincrease(P1

–

P0).Relativereturninpercentagetermsis100×[(P1

–

P0)+D1]/P0.Thisiscalledtotalshareholderreturn.Futurevalues:compoundingInvest￡100nowat5%interestperyear: After1year:￡105.00(100×1.05). After2years:￡110.25(105×1.05).Thesearefuturevaluesof￡100after1and2years.Futurevaluesarefoundbycompoundinginterestforwardthroughtime.Presentvalues:discountingWhatsumofmoneyinvestednowat5%willgive￡120in2-years’time?Thiswillbe￡120/1.052=￡108.84.Thisisthepresentvalueof￡120receivedin2years,ifyourrequiredrateofreturnis5%.Dividingby1.052tofindapresentvalueiscalleddiscounting.Presentvalues:discounting(continued)Arationalinvestorwillprefer￡108.84to￡100atthecurrenttime.Discountingallowsustocompare￡120in

2-years’timewith￡100now.Notethat1/1.052=0.907.0.907isthepresentvaluefactorordiscountfactorof5%over2years(seetables).Hence￡120×0.907=￡108.84.Decision-makingareasAfinancialmanager’staskscanbedivided

intothreeareas: Financingdecisions Dividenddecisions InvestmentdecisionsKeypoint:understandtheinterrelationship

ofthesethreedecisionareasThefinancialmanagerWhoisthefinancialmanagerinreality?FinanceDirector(strategicdecision-making)CorporateTreasurer(day-to-daycashmanagement)PossiblecorporateobjectivesShareholderwealthmaximisation(SHWM)MaximisationofprofitMaximisationofsalesSurvivalSocialresponsibility Whichoneshouldacompanyfollow?ShareholderwealthmaximisationShareholderswantbothdividendsand

capitalgains.Capitalgainsreflectfuturedividends.Currentandfuturedividendsdependonfuturecashflows:TheirmagnitudeorsizeTheirtimingTheirassociatedriskLinkingNPVtoSHWMTheagencyproblemWhydoesitarise?DivergenceofownershipandcontrolManagers’goalsdifferfromshareholders’AsymmetryofinformationWhataretheconsequences?ShareholderwealthisnolongermaximisedAgencyproblemconsequencesManagerswillfollowtheirownobjectives,

i.e.increasingtheir:power;jobsecurity;payandrewards.Shareholdersneedtoensurethattheirownwealthismaximised.SignsofanagencyproblemManagersmainlyfinancecompanywithequityfinance.Managersacceptlowrisk,short-paybackinvestmentprojects.Managersdiversifybusinessoperations.Managersfollow‘petprojects’.Managersarerewardedforperformancethatis‘belowaverage’.OptimalcontractsandagencyBestsolutiontotheagencyproblemistodesignmanagerialcontractsthatminimisethesumofthefollowingcosts:FinancialcontractingcostsMonitoringcostsDivergentbehaviourcostsOption1:donothingLeavingmanagerstotheirowndevicesisproblematic:Givenhumannature,managerswillengageinsuboptimalbehaviour.Shareholdersaresatisficed

ratherthansatisfied.Doingnothingisnotreallyanoption.Option2:monitoringProblemsassociatedwithmonitoring:Costlyintermsofbothtimeandmoney.Whowillpay?Largeshareholders?Whatabout‘free-riding’smallerinvestors?Somemanagerialactionsarehardtofollow.Maydrive‘badmanagers’underground.Option3:rewardgoodbehaviourWhatdowelinkmanagerialrewardsto?Mostcommonlylinkedto:profits;shareprice(e.g.viashareoptions).Rewardingismorecommonthanmonitoring.But…tyingrewardstoprofitsmayencourageshort-termismandcreativeaccounting.Option3:rewardgoodbehaviour(continued)Therearealsoproblemsusingshareoptions:Howmanyoptionsshouldmanagersbeawarded?Atwhatsharepriceshouldmanagersbeabletoexercisetheiroptions?Managerscangetrewardedforpoorperformanceifthereisa‘bull’stockmarket.OtherareasofagencyCompaniesaremadeupofaseriesofagencyrelationships:N.B.Arrowsgofrom‘principal’to‘a(chǎn)gent’andshowcapitalflows.Otherareasofagency(continued)Debtholders(principals)andshareholders(agents)Solutions:security,restrictivecovenantsManagers(principles)andemployees(agents)Solutions:executiveshareoptionplans(ESOPs),monitoring,performance-relatedpay(PRP)CorporategovernanceCorporategovernanceisaboutpromotingcorporatefairness,transparencyandaccountability.Itcanbeseenasanattempttosolveagencyproblemusingexternallyimposedregulation.IntheUK,goodcorporategovernanceisencouragedthroughaself-regulatorycodeofbestpractice.CadburyCommittee(1992)Recommended:Avoluntarycodeofpractice:Threenon-executivedirectorsatboardlevelMaximum3-yeardurationcontractsPostsofChairmanandCEOshouldbeseparateImprovedinformationflowtoshareholdersIncreasingindependenceofauditorsGreenburyReport(1995)Recommended:One-yearrollingcontractsMoresensitivitybyremunerationcommitteesPRPandshareoptionstobephasedoutandreplacedby‘challenging’long-termincentiveplans(LTIPs)PIRCreport(1996)indicatedwidespreadabuseoftheaboveHampelReport(1998)andtheCombinedCodeStressedimportanceofa‘balancedboard’,non-executivedirectorsandtheroleofinstitutionalshareholdersCombinedCodeoverseenbytheLondonStockExchangeIntegratesHampel,CadburyandGreenburyrecommendationsComplianceisanLSElistingrequirementTurnbull,HiggsandSmithTurnbull(1999):detailedhowboardscouldmaintainsoundsystemsofinternalcontrol

(significantrisk/systemsrequired).Higgs(2003):reportdesignedtoenhancetheindependence,andhenceeffectiveness,ofnon-executivedirectors.Smith(2003):gaveauthoritativeguidanceonhowauditcommitteesshouldoperateandbestructured.Co