ACF 261: BUSINESS FINANCE

1. ACF 261: BUSINESS FINANCE KwasiPoku Accounting and Finance KNUST School of Business College of Humanities and Social Sciences

2. Course outline: OVERVIEW OF BUSINESS FINANCEkey concepts in Business/Corporate finance financial management decisions the objectives of a business Corporate governance and the agency problem

3. 2. FINANCING A BUSINESS- SOURCES OF EXTERNAL FINANCE- SOURCES OF INTERNAL FINANCE- SHORT TERM SOURCES OF FINANCE – LONG TERM FINANCE FOR SMALL BUSINESSES

4. 3.FINANCIAL PLANNING AND PROJECTED FINANCIAL STATEMENTS- steps in developing plans- the role of projected financial statements - preparing projected financial statements- projected financial statements and risk4.FINANCIAL STATEMENT ANALYSIS AND INTERPRETATION- financial ratios defined

5. - classification of FINANCIAL RATIOS (Profitability, Efficiency, Liquidity, Gearing and Investment) - the need for comparison - bases for Comparison - key steps in financial ratio analysis - limitations of ratio analysis

6. 5.METHODS OF INVESTMENT APPRAISAL- evidence on the employment of appraisal techniques- the appraisal methods (thepayback period, discounted payback, accounting rate of return, Net Present Value (NPV), Internal Rate of Return (IRR),)

7. 6. MANAGEMENT OF WORKING CAPITAL Major elements of current assets: Management of stock Management of debtors Major elements of current liabilities Management of cash: operating cash cycle Management of trade creditors Management of bank overdrafts

8. 7.INTRODUCTION TO CAPITAL STRUCTURE DECISIONS What the debate is about The two schools of thought: - the traditionalists view the modernists view 8. INTRODUCTION TO DIVIDEND POLICY Schools of thought: - the traditionalists view - the modernists view

9. Recommended Reading1. Atrill, P. (2003). Financial Management for Non-Specialists. 3rd edition. Pearson Education Limited, Essex, U.K.2. Arnold, G. (2008). Corporate Financial Management. 4th Edition. Financial Times/ Prentice Hall/ Pearson Education. Essex, U.K.3. Brealey, R.A, Myers S.C and Allen F. (2006). Corporate Finance. 8th Edition. McGraw Hill

10. 4. Watson, D. and Head, A. (2010). Corporate Finance: principles and practice. 5th Edition. Financial Times/ Prentice Hall/ Pearson Education Limited. Essex, U.K.

11. Chapter oneOverview of Business Finance

12. Introduction • Two key concepts in corporate finance that are pivotal in helping managers to value alternative choices are the relationship between riskand return and the time value of money. • Risk and return • Return refers to the financial rewards gained as a result of making an investment. The nature of the return depends on the form of the investment.

13. Risk refers to the possibility that the actual return may be different from the expected return. The actual return may be greater than the expected return: this is usually a welcome occurrence. Time value of money The time value of money is a key concept in finance and is relevant to both companies and investors.

14. In a wider context, it is relevant to anyone expecting to pay or receive money over a period of time. Simply stated, the time value of money refers to the fact that the value of money changes over time. Imagine that your friend offers you either Ghc100 today or Ghc100 in one year’s time. Faced with this choice, you will (hopefully) prefer to take Ghc100. The question to ask yourself is why do you preferGhc100 today? There are three major factors at work here.

15. Illustration: • Imagine that your friend offers you either Ghc100 today or Ghc100 in one year’s time. Faced with this choice, you will (hopefully) prefer to take Ghc100. why? Time: • If you have the money now, you can spend it now. • Alternatively, you can invest it so that in one year’s time you will have Ghc100 plus any investment income you have earned.

16. Inflation: Ghc100 spent now will buy more goods and services than Ghc100 spent in one year’s time because inflation undermines the purchasing power of your money. Risk: if you take Ghc100 now you definitely have the money in your possession. The alternative of the promise of Ghc100 in a year’s time carries the risk that the payment may be less than Ghc100 or may not be paid at all.

17. Starting a business Three questions to answer! • What long term investments should you take on? That is what line of business should you be involved in and what sorts of buildings, machinery and equipment will you need? • Where will you get the long term financing to pay for your investment? Will you retain the profit which you make? Will you bring in other owners or will you borrow the money?

18. How will you manage your everyday financing activities such as collecting from customers and paying suppliers? (working capital management) These are not the only questions by any means but they are among the most important. Business finance, broadly speaking is the study of ways to answer these questions.

19. THE FINANCIAL MANAGER • A striking feature of large companies is that the owners (the shareholders) are usually not directly involved in making business decisions, particularly on a day to day basis. • Instead, the company employs managers to represent the owner’s interest and make decisions on their behalf.

20. KEY TASKS OF THE FINANCEFUNCTION • Financial planning-this involves developing financial projections and plans (such as cash flow statements and profit statements). • Investment project appraisal-this involves evaluating investment projects and assessing the relative merits and risk of competing proposals. • Financing decisions– this requires the identification of financing requirements and the evaluation of possible sources of finance.

21. Capital market operations-This involves an appreciation of how finance can be raised through the markets, how securities are priced and how the markets are likely to react to proposed investment and financing plan. • Financial control-this refers to the ways in which the plans are achieved. Once plans are implemented it will be necessary for managers to ensure that things go according to plan.

22. FINANCIAL MANAGEMENT DECISIONS Capital budgeting- it is a process of planning and managing a firm’s long-term investment. It concerns the first question of a firm’s long-term investments. Capital structure- it refers to the specific mixture of long term debt and equity the firm uses to finance its operations. This involves ways in which the firm obtains and manages the long term investments.

23. Working capital management: the third question concerns working capital management. This refers to a firm’s short term assets and its short term liabilities. Some questions aboutWORKING CAPITALthat must be answered are: • How much cash inventory should we keep on hand? • Should we sell on credit? If so what terms will we offer and to whom will we extend them? • How will we obtain any needed short term financing? Will we purchase on credit or will we borrow short term and pay cash?

24. THE OBJECTIVES OF A BUSINESS • The key idea underpinningmodern financial management is that, the primary objective of a business is shareholder wealth maximization, that is, to maximize the wealth of its shareholders (owners). • In a market economy the shareholders will provide funds to a business in the expectation they will receive the maximum possible increase in wealth for the level of risk which must be faced.

25. When evaluating competing investment opportunities, therefore the shareholders will weigh the returns from each investment against the potential risk involved. • The term Wealth in this context refers to the market value of the ordinary shares. • The market value of the shares will in turn reflect the future returns the shareholder will receive over time from the shares and the level of risk involved.

26. Some Possible Objectives Achieving a target market share Quite often the winning of a particular market share is set as an objective because it acts as a proxy for other, more profound objectives, such as generating the maximum returns to shareholders. Keeping employee agitation to a minimum Here, return to the organisation’s owners is kept to a minimum necessary level. All surplus resources are directed to mollifying employees.

27. Survival There are circumstances where the overriding objective becomes the survival of the firm. Severe economic or market shock may force managers to focus purely on short-term issues to ensure the continuance of the business. Creating an ever-expanding empire Some managers drive a firm forward, via organic growth or mergers, because of a desire to run an ever-larger enterprise.

28. Social ResponsibilityCompanies may be concerned with improving working conditions for employees, providing a healthy product for consumers or avoiding anti-social actions such as environmental pollution or undesirable promotional practices.

29. Profit maximization This is much more acceptable objective, although not everyone would agree that maximisation of profit should be the firm’s purpose. Long-term shareholder wealth maximization While many commentators concentrate on profit maximisation, finance experts are aware of a number of drawbacks of profit. The maximisation of the returns to shareholders in the long term is considered to be a superior goal.

30. WEALTH MAXIMISATION OR PROFIT MAXIMISATION • Wealth maximisation is not the only financial objective which a business can pursue. Profit maximization is often suggested as an alternative for a business. • Profit maximisation is different from wealth maximisation in a number of respects.

31. Measures of profit • There are different measures of profit which could be maximised, including the following: • Operating profit (i.e. net profit before interest and tax) • Net profit before tax • Net profit after tax • Net profit available to ordinary shareholders • Net profit per ordinary share etc

32. Differences in the choice of profit measure can lead to differences in decisions reached concerning a particular opportunity. • Profit maximisation is usually seen as a short term objective whereas wealth maximisation is a long term objective. • There can be conflict between long term and short term performance. It will be quite possible for example to maximise short term profits at the expense of long term profits.

33. Reducing operating expenses • Cutting research and development expenditure • Cutting staff training and development • Bringing cheaper quality material and • Cutting quality control mechanisms • These policies may all have a beneficial effect on short term profits but may undermine the long term competitiveness and performance of a business. • Whereas wealth maximisation takes risk into account, profit maximisation does not

34. Fundamental Problems With Profit Maximization The three (3) drawbacks are: Quantitative difficulties Profit maximization as a financial objective requires the definition and accurate measurement of profitand that all the factors contributing to it are known and can be taken into account. It is very doubtful that this requirement can be met on a consistent basis.

35. Timescale over which profit should be maximised The key question to ask here is ‘should profit be maximised in the long term or in the short term?’ Given that profit considers one year at a time, the focus is likely to be on short-term profit maximisation at the expense of long-term investment, putting the long-term survival of the company into doubt. No allowance for Risk It would be inappropriate to concentrate our efforts on maximising accounting profit when this objective does not consider one of the key determinants of shareholder wealth – risk.

36. How can Shareholder Wealth be Maximised? Three variables that directly affect shareholders’ wealth: The magnitude of cash flows accumulating to the company The timingof cash flows accumulating to the company The risk associated with the cash flows accumulating to the company.

37. Indicator of shareholder wealth; The major indicator of shareholder wealth is a company’s ordinary share price, since this will reflect expectations about future dividend payments as well as investor views about the long-term prospects of the company and its expected cash flows. The surrogate objective, therefore is to maximise the current market price of the company’s ordinary shares and hence to maximise the total market value of the company.

38. The link between cash flows from projects and shareholder wealth Fig. 1.1

39. From Fig. 1.1, Stage 1- accept projects with positive NPVs Stage 2- giventhat NPV is additive, the NPV of the company as a whole should equal the sum of the NPV’s of the projects the company has undertaken. Stage 3- the NPV of the company as a whole is accurately reflected by the market value of the company through its share price. Stage 4- shareholder wealth will be maximised when the market capitalisation of the company is maximised.

40. Good financial decisions that promote shareholder wealth Efficient Working Capital Management Use appropriate Capital Structure to minimize cost of capital Use NPV for potential project assessment Accept projects with positive NPVs. Adopt appropriate Dividend Policy Financial decisions risk assessment and prevention. E.g. Hedging interest and exchange rate risk

41. To maximise or to satisfy • To begin with, this as an objective implies that the needs of the shareholders are paramount. • The business can however be viewed as a coalition of various interest groups which all have a stake in the business. • The following groups may be seen as stakeholders:(Shareholders , Employees, Managers, Suppliers, Customers, The community)

42. If we accept this view of the business, the shareholders simply become one of a number of the stakeholder groups whose needs have to be satisfied. • It can be argued that, instead of seeking to maximise the returns to shareholders, the managers should try to provide each stakeholder group with a satisfactory return.

43. The term satisficing has been used to describe this particular business objective. Although this objective may sound appealing, there are practical problems associated with its use. • Problems with satisficing • In a market economy there are strong competitive forces at work which ensures that failure to maximise shareholders wealth will not be tolerated for long.

44. Apart from shareholders, there are other stakeholders within a business. Satisfying the needs of other stakeholder groups will often be consistent with the need to maximise shareholders wealth. • This kind of interdependence has led to the argument that the needs of other stakeholder groups must be viewed as constraints within which shareholders wealth should be maximised.

45. AGENCY THEORY; why does Agency exist? Agency is the theoretical relationship that exists between the owner of a company and the managers as agents they employ to run the company on their behalf. The agency problem is said to occur when managers make decisions that are not consistent with the objective of the shareholder wealth maximisation.

46. Contributing Factors to the Existence of the Agency Problem Divergence of ownership and control. Shareholders (principal) appoint managers (agent) to act on their behalf. ii. The goals of managers differ from those of shareholders (principals) iii. Information Asymmetry exists between agent and principal

47. Possible Management Goals Managers may follow their own welfare maximising goals; Growth or maximising the size of the company Increasing managerial power Creating job security Increasing managerial pay and rewards Pursuing their own social objectives or pet projects.

48. CORPORATE GOVERNANCE AND THE AGENCY PROBLEM • The issue of corporate governance has generated much debate in recent years. • Corporate governance is used to describe the ways in which businesses are directed and controlled. • The issue of corporate governance is important because in businesses of any size, the owners (i.e. the shareholders) are usually divorced from the day-to-day control of the business.

49. Professional managers are employed by the shareholders to manage the business on their behalf. • These managers may therefore be viewed as agents of the shareholders (who are principals). • Given this agent - principal relationship, it may seem safe to assume that managers will be guided by the requirements of the shareholders when making decisions.

50. In other words the wealth objective of the shareholders will become the manager’s objectives. • However in practice this does not always occur. The managermay be more concerned with pursuing their own interest such as increasing their pay and perks (e.g. expensive motor cars and so on) and improving their job security and status. • As a result, a conflictmay occur between the interest of the shareholder and the interest of the managers.