ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing
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Chapter 1: The financial management function
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There are three aspects to agency costs:
They include the costs of monitoring. A company establishes systems for
monitoring the actions and performance of management, to try to ensure that
management are acting in their best interests. An important example of
monitoring is the requirement for the directors to present an annual report and
audited accounts to the shareholders, setting out the financial performance and
financial position of the company. Preparing accounts and having them audited
has a cost.
Agency costs also include the costs to the shareholder that arise when the
managers take decisions that are not in the best interests of the shareholders (but
are in the interests of the managers themselves). For example, agency costs arise
when a company’s directors decide to acquire a new subsidiary, and pay more
for the acquisition than it is worth. The managers would gain personally from
the enhanced status of managing a larger group of companies. The cost to the
shareholders comes from the fall in share price that would result from paying
too much for the acquisition.
The third aspect of agency costs is costs that might be incurred to provide
incentives to managers to act in the best interests of the shareholders. These are
sometimes called bonding costs. The main example of bonding costs are the
costs of remuneration packages for senior executives. These costs are intended to
reduce the size of the agency problem. Directors and other senior managers
might be given incentives in the form of free shares in the company, or share
options. In addition, directors and senior managers might be paid cash bonuses
if the company achieves certain specified financial targets.
Reducing the agency problem
Jensen and Meckling argued that in order to reduce the agency problem, incentives
should be provided to management to increase their willingness to take ‘value-
maximising decisions’ – in other words, to take decisions that benefit the
shareholders by maximising the value of their shares.
Several methods of reducing the agency problem have been suggested. These
include:
Devising a remuneration package for executive directors and senior managers
that gives them an incentive to act in the best interests of the shareholders.
Fama and Jensen (1983) argued that an effective board must consist largely of
independent non-executive directors. Independent non-executive directors
have no executive role in the company and are not full-time employees. They are
able to act in the best interests of the shareholders.
Independent non-executive directors should also take the decisions where there
is (or could be) a conflict of interest between executive directors and the best
interests of the company. For example, non-executive directors should be
responsible for the remuneration packages for executive directors and other
senior managers.
These ideas for reducing the agency problem are contained in codes of corporate
governance.
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3.4 Measuring the achievement of financial objectives
Ithasbeensuggestedthatthefinancialobjectiveforacompanymightbestatedas
maximisation of shareholder wealth, or possibly in terms of profitability and
earningspershare,orgrowthinprofitsorEPS.
When a financial objective is established, actual performance should bemeasured
against the objective. In your
examination, you might be requiredto commenton
therelativesuccessorfailureofacompanytoachieveitsobjectives.Todothisyou
mightneedtocalculateoneormoresuitableperformancemeasurements.
Financial objectives are commonly measured using ratio analysis. Financial ratios
canbeusedtomakecomparisons:
Comparisons over a number of years. By looking at the ratios of a company over
a number of years, it might be possible to detect improvements or a
deterioration in the financial performance or financial position of the entity.
Ratios can therefore be used to make comparisons over time, and to identify
changes or trends
Comparisons with the similar ratios of other, similar companies for the same
period.
In some cases, perhaps, comparisons with ‘industry average’ ratios.
Return on capital employed (ROCE)
Profit-making companies should try to make a profit that is large enough in relation
to the amount of money or capital invested in the business. The most important
profitability ratio is return on capital employed or ROCE.
For a single company:
ROCE =
Profit before interest and taxation
Share capital and reserves+ Long - term debt capital
× 100%
The capital employed is the share capital and reserves, plus long-term debt capital
such as bank loans, bonds and loan stock.
Where possible, use the average capital employed during the year. This is usually
the average of the capital employed at the beginning of the year and end of the year.
Chapter 1: The financial management function
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Example
Sting Company achieved the following results in Year 1.
1
st
January Year 1
31
st
December Year 1
$
$
Share capital of $1 200,000
200,000
Share premium 100,000
100,000
Accumulated profits 500,000
600,000
Bank loans 200,000
500,000
$
Profit before taxation 210,000
Taxation 75,000
Profit after taxation 135,000
Interest charges on bank loans were $30,000. Dividend payments to shareholders
were $45,000. Sales during the year were $5,800,000.
Required
Calculate the return on capital employed for Year 1.
Answer
Capital employed at the beginning of the year = $1,000,000.
Capital employed at the end of the year = $1,400,000.
Average capital employed = [$1,000,000 + $1,400,000]/2 = $1,200,000.
Profit before interest and taxation = $210,000 + $30,000 = $240,000.
ROCE = $240,000/$1,200,000 = 0.20 or 20%.
Return on equity
Return on equity measures the return on investment that the shareholders of the
company have made. This ratio normally uses the vales in the statement of financial
position (balance sheet values) of the shareholders’ investment, rather than market
values of the shares.
ROSC =
Profit after taxation
Share capital and reserves
× 100%
The average value of shareholder capital should be used if possible. This is the
average of the shareholder capital at the beginning and the end of the year.
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Profit after taxation is used as the most suitable measure of return for the
shareholders, since this is a measure of earnings (available for payment as dividends
or for reinvestment in the business).
Example
Using the figures in the previous example:
Shareholders’ capital at the beginning of the year = $200,000 + $100,000 + $500,000 =
$800,000.
Shareholders’ capital at the end of the year= $200,000 + $100,000 + $600,000
= $900,000.
Average shareholders’ capital employed = [$800,000 + $900,000]/2 = $850,000.
Return on equity = 135,000/850,000 × 100% = 15.88%.
Note that the return on equity is not directly comparable with ROCE because ROCE
is a before-tax measure of return whereas return on equity is measured after tax.
Earnings per share and dividend per share
The earnings per share (EPS) is a measure of the profit after taxation (and preference
share dividend, if any) per equity share, during the course of a financial year. The
EPS might be:
a historical EPS, as reported in the company’s financial statements, or
a forward-looking EPS, which is the EPS that the company will expect to achieve
in the future, usually in the next financial year.
Dividend per share may be important for shareholders who are seeking income
from shares rather than capital growth. The company may have a dividend policy
which aims for steady growth of dividend per share.
Example
Using the figures in the previous example:
EPS = profit after tax/Number of ordinary shares = $135,000/200,000 = 67.5c per
share
Dividend per share = $45,000/$200,000 = 22.5c per share
Changes in share price and dividend
Financial performance can also be measured by the return provided to shareholders
over a period of time such as a financial year. The total return consists of dividend
payments plus the increase in the share price during the period (or minus the fall in
the share price).
Chapter 1: The financial management function
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This total return, often called the Total Shareholder Return or TSR, can be
expressed as a percentage of the value of the shares at the beginning of the period.
Example
At 1 January the market value of a company’s shares was $8.40 per share.
During the year dividends of 45 cents per share were paid and at 31 December the
share price was $9.00.
The share price has risen by $0.60; therefore TSR = $(0.60 + 0.45)/$8.40 = 0.125 or
12.5%.
3.5 Incentive schemes (management reward schemes)
This chapter has so far made the point that the main objective of a company should
be a financial objective, but there are different ways of stating this objective and in
measuring the extent to which the objective has been achieved.
There are different stakeholder groups with an interest in a company, and these are
likely to have conflicting interests. The main conflict of interests is the agency
problem and the different interests of shareholders and senior executive managers
and directors.
This raises the question: Can the agency problem be reduced and can managers be
persuaded to focus on returns to shareholders as the main objective of the
company? Managers may be encouraged to work in the best interests of the
company if there are remuneration incentive schemes (reward schemes) linked to
profits, earnings, share price or Total Shareholder Return.
Most, if not all, large stock market companies have remuneration schemes for their
executive directors and other senior managers, and the purpose of such schemes is
to make the personal interests of the directors and managers similar to those of the
shareholders. By achieving a financial performance that is in the interests of the
shareholders, directors and managers will also obtain personal benefits for
themselves.
Structure of a remuneration package for senior executives
The structure of a remuneration package for executive directors or senior managers
can vary, but it is usual for a remuneration package to have at least three elements.
A basic salary (with pension entitlements). Basic salaries need to be high enough
to attract and retain individuals with the required skills and talent.
Annual performance incentives, where the reward is based on achieving or
exceeding specified annual performance targets. The performance target might
be stated as profit or earnings growth, EPS growth, achieving a profit target or
achieving a target for TSR. Some managers might also have a non-financial
performance target. Some managers might have several annual performance
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targets, and there is a reward for achieving each separate target. Annual
rewards
are usually in the form of a cash bonus.
Long-term performance incentives, which are linked in some way to share price
growth or TSR over a longer period if time (in practice typically three years).
Long-term incentives are usually provided in the form of
share awards or share
options
in the company. The purpose of these awards is to give the manager a
personal incentive in trying to increase the value of the company’s shares. As a
holder of shares or share options, the manager will benefit financially from a
rising share price.
Share awards
With a share award scheme, the company purchases a quantity of its own shares
and awards these to its executive directors and other senior managers on condition
that certain ‘long-term’ financial targets are achieved, typically over a three-year
period.
Share options
A company might award share options to its executives. A share option gives its
holder the right to purchase new shares in the company on or after a specified date
in the future, typically from three years after the options have been awarded. The
right to buy new shares in the company is at a fixed price (an ‘exercise price’) that is
specified when the share options are awarded. Typically the exercise price is the
market price of the shares at the time the options are awarded. The holder of a share
option gains from any increase in the share price above the exercise price, and so
has a direct personal interest in a rising share price.
For example, a company might award share options to its chief executive officer. If
the market price of the shares at the date of the award is, say, $7.00, the CEO might
be given 500,000 share options at $7 per share, exercisable from three years after the
date of the option award. If the share price three years later is, say, $10, the CEO will
be able to buy 500,000 new shares at $7 and sell them immediately at $10, to make a
personal financial gain of $1,500,000.
Chapter 1: The financial management function
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Improving corporate governance
Approaches to corproate governance for large companies
The board of directors
Financial reporting and the external auditors: the audit committee
Directors’ remuneration
Internal control and risk management
Communication with shareholders
Stock exchange listing practices
4 Improving corporate governance
4.1 Approaches to corporate governance for large companies
A more extensive approach to reducing the agency problem and trying to ensure
that companies are managed in the best interests of shareholders is to apply rules or
guidelines of ‘best practice’ in corporate governance. Corporate governance is a
term that is used to describe the way in which a company is ‘governed’ on behalf of
its owners by the board of directors. Many countries now have codes or rules of best
corporate governance practice for large stock market companies.
There are two broad approaches to establishing ‘best practice’ in corporate
governance.
One approach is to establish a voluntary code of practice that all major stock
market companies are expected to comply with. A voluntary code is likely to
consist of general principles of good corporate governance, and some more
detailed rules or provisions.
The other approach is to legislate to impose good corporate governance
requirements on companies.
Most companies have followed the lead given by the UK from the early 1990s, and
have introduced a voluntary code of corporate governance for major stock market
companies. In the UK, this voluntary code is called the Combined Code on
Corporate Governance. (Although corporate governance in the UK is based mainly
on voluntary practice, there are some aspects of governance that are subject to
legislation and statutory requirements, particularly requirements relating to
reporting to shareholders and directors’ duties to their company).
The most notable example of a statutory approach to corporate governance is the
USA, which introduced a number of governance requirements for stock market
companies in the Sarbanes-Oxley Act 2002.
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Elements of good corporate governance
Remuneration and management reward schemes are one aspect of corporate
governance, but there are other aspects too. Measures recommended by the UK
Combined Code for achieving good corporate governance relate to:
the board of directors: the board’s responsibilities and the composition of the
board
financial reporting and the independence of the external auditors
directors’ remuneration
internal control and risk management
communications between the company and its shareholders, and the rights and
responsibilities of shareholders (particularly investment institutions such as
pension funds and insurance companies).
The provisions of the UK Combined Code are described briefly below, to give you
some idea of the nature of measures that might be taken to reduce the agency
problem and ensure as much as possible that companies are governed in the
interests of their shareholders.
4.2 The board of directors
Responsibilities of the board
The board of directors should reserve certain decisions for the board as a whole and
should not delegate these decision-making powers to the executive management.
The decisions reserved for the board would include decisions about major strategic
investments. The purpose of this requirement is to ensure that major decisions are
taken by the directors, not by executive management.
Composition of the board
To prevent the board from being dominated by a single individual, the positions of
chairman and CEO should not be held by the same individual. The chairman is
responsible for leading the board of directors and representing the company as a
figurehead, for example in communicating with the shareholders. The CEO is
responsible for leading the executive management team of the company.
To prevent the CEO (or chairman) from exerting excessive influence, the board
should include a sufficient number of independent non-executive directors (NEDs).
In large UK listed companies, at least half the board, excluding the chairman, should
be independent NEDs. The purpose if this requirement is to ensure that there are
individuals on the board of directors who do not have a conflict of interests and are
more likely to consider the best interests of the shareholders when making their
decisions.
Board committees
The board should delegate certain responsibilities to committees of the board, which
should report back to the main board. The three board committees identified by the
Chapter 1: The financial management function
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Combined Code are a nominations committee (for appointing directors), an audit
committee (to communicate with the external auditors, recommend the
appointment and annual fees of the auditors, review the need for internal audit
function, etc) and remuneration committee (to consider remuneration policy and
negotiate the remuneration of individual directors).
The audit and remuneration committees should consist entirely of independent
NEDs, to avoid undue influence in these matters by executive directors. The
nomination committee should have a majority of independent NEDs. The purpose
of board committees is to ensure that independent non-executive directors make the
decisions or recommendations on matters where executive directors are likely to
have a strong conflict of interests.
Fulfilling responsibilities as directors adequately
The Combined Code states that directors should be able to give enough of their time
to the company in order to carry out their responsibilities. However, it does not
specify any limit to the number of (non-executive) directorships any individual
should hold.
Instead, the Code states that the board as a whole, each of the board committees and
all individual directors (including the chairman) should be subject to an annual
performance review. In principle, any individual who performs badly may be asked
to resign from the board.
4.3 Financial reporting and the external auditors: the audit committee
To reduce the influence of the executive directors on the external auditors, certain
powers should be delegated by the board to the audit committee. The powers and
responsibilities of the audit committee should include the following:
Discussing the annual audit plan with the external auditors
Discussing with the external auditors any significant accounting issues that
affect the content of the annual report and accounts
Reviewing the auditors’ performance. Where this is poor, the committee may
recommend a change of auditors to the board of directors (which would then
propose a change of auditors to the shareholders)
Recommending the audit fee to the board of directors
Monitoring the independence of the external auditors from influence by the
executive directors. One way of doing this is to monitor the amount of non-audit
work carried out for the company by the auditors. The audit committee should
ensure that the audit firm does not over-rely on income from the company,
either from the audit fee or fees for non-audit work.
There has been much debate about whether there should be a compulsory rotation
of audit firms, so that companies are required to change their audit firm at least
every five or seven years. This proposal was strongly opposed by companies and
audit firms.
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An alternative suggestion is to require the rotation of key audit partners, who
should not remain as auditor for a particular company for more than a specified
number of years. There is no requirement in the Combined Code about audit
partner rotation, but the 8
th
European Union Directive requires the compulsory
rotation of key audit partners after no more than seven years.
4.4 Directors’ remuneration
The board should delegate to a remuneration committee (consisting of independent
NEDs) responsibilities for:
remuneration policy for executive directors, and
negotiating the remuneration of individual executive directors.
In the UK, quoted companies are required by law to present a directors’
remuneration report in the annual report and accounts and invite the shareholders
to approve the report at the annual general meeting of the company. The principles
of remuneration and reward schemes, described earlier, should normally be
applied.
4.5 Internal control and risk management
The board of directors must review the internal control system, and risk
management system of the company, and satisfy themselves that suitable control
systems are in place. The board should report to shareholders that they have done
so. (The responsibility for carrying out an annual review of risk management and
the internal control system may be delegated to the audit committee.)
The purpose of this requirement is to ensure that the board of directors are aware of
the significant risks to which the company (and so its shareholders) are exposed,
and are also held responsible for ensuring that adequate control and risk
management systems are in place as protection against those risks.
4.6 Communication with shareholders
The Combined Code requires the board of a company to promote good relations
and good communications with their shareholders.
In addition, institutional investors have a responsibility for maintaining a dialogue
with the company’s board of directors.
A legal requirement throughout the European Union is that companies should
prepare an annual business review, setting out the operating and financial position
of the company in easy-to-understand language.
4.7 Stock exchange listing practices
In some countries, the voluntary code of corporate governance is supported by
stock exchange requirements or requirements by the financial markets regulator.