Session 1 Introduction to Finance and the Financial Environment

1. Session 1 Introduction to Finance and the Financial Environment

2. Session 1 Introduction to Finance and the Financial Environment • By the end of today’s session(s), you should be able to: • Outline the elements of the finance decision and the contribution of finance to the organisation’s objectives • Describe the financial and economic environment and its impact on the organisation • Outline possible ethical issues facing the finance manager • Adjust cash flows for the time value of money using a variety of formulae.

3. Competency Wheel Strategic Thinking & Problem Solving Communication Managing Self & Others:Leadership IT Awareness Project Management & Change Awareness Stakeholder Management Financial Reporting Management Accounting & Finance Audit & Assurance Tax & Law Strategy Ethics & Professionalism Objectivity Perceptiveness of own knowledge, values and limitations

4. Mapping • This lecture maps specifically to 1.1 on the Competency Statement

5. Exam structure • Three hour unseen paper • Two sections (A and B) • Section A is compulsory (contains 2 questions worth 20% each) • Section B has limited choice (4 out of 5 – questions are worth 15% each) • Any topic can appear in either section. • Questions can be qualitative, quantitative or a combination of both. • There is no pattern, all topics are examinable and can cross several questions. • For example, personal finance appeared as part of three questions in one of the sittings.

6. Study approach • There is a large quantity of material • Do not leave it all to the end, you will fail • Attend class, do the required reading in advance. • After class, make notes, redo the questions that were covered in class as soon as the class is over or as close to as is possible. • Read the chapter in the textbook. Make your own notes, or append additional notes to your class slides/class handouts. Highlight the key areas/points. • Do the additional suggested questions as outlined in the handouts without looking at the solution (until finished). Time yourself, do under examination conditions. • Work your way through the toolkit, applying your knowledge to the practical problems.

7. What is business finance Sometimes referred to as financial management, business finance is concerned with financial decision making within a business to achieve its financial objectives. (planning, monitoring and control)

8. Role of business finance A business finance manager works with other managers to provide relevant information which is used by the board of directors for strategic decision making.

9. Company objectives Financial objectives Objectives that have a financial outcome such as: • Equity wealth maximisation • Profit maximisation • Growth (see real world example on page 19: Sir Fred Goodwin) • Efficiencies Non-Financial objectives Objectives that have a non-financial outcome such as: • Employee welfare • Social objectives • Trade relationships and equity • Environmental policies

10. Key decision areas - influenced Business finance involves providing information to inform decision making in three key areas (primarily): • Investment decision • Finance decision • Dividend decision

11. Investment decision - explanation The investment decision involves evaluating different projects. These can be external or internal. External External investment decisions include: • Merger and • Takeover decisions (covered at CAP 2). Internal Internal investment decisions include: • New capital projects (asset replacements, etc.) • Working capital investment decisions

12. Investment decision - importance The investment decision determines the future earning potential of a company (which determines company value). The investment decision, once taken, is often costly to exit. For these reasons, it is deemed to be the most important decision facing a business finance manager.

13. Finance decision - background This involves determining the source of finance to be used by a company for funding its on-going operations and investment activity. Types: • Debt • Equity Sources: • Internal • External

14. Finance decision - types Debt and equity finance can be thought of as a company selling claims against the future revenues of the company. Debt: • Sourced as either a loan; or • As debt securities. Features of debt (in brief) Repayment of the capital amount is usually required as is interest on the amount received by a company.

15. Finance decision - types Equity: Sourced from the owners/potential owners of the company. Two sources: • Equity share capital (usually raised in the markets) • Retained earnings (internally generated) Features of equity (in brief) Repayment of capital is NOT required. A dividend can be paid, but is not mandatory.

16. Finance decision - sources Internal (all equity): • Retained earnings are dividends forgone by current equity holders. • A company can also sell assets to release capital gains when it requires finance (unrealised/unrecorded equity reserves). External (debt and equity) • Financial markets • Financial institutions

17. Dividend decision • Dividends are normally cash returns to equity holders. • As such they have an impact on the liquidity of a company. • The market likes a company to maintain a stable dividend policy. • When the market likes a company’s dividend policy they will hold the company in good esteem. • When the company changes its dividend policy and the market does not like it – company value will fall. (CAP 2)

18. Interaction between the decisions Each decision has to have regard for the other decisions. For example, if a large dividend is distributed, there will be a greater need to approach the markets for funding to undertake any investment. If the company is already highly geared – this may cause capital rationing.

19. Interaction between the decisions Modigliani and Miller’s theory: Relationship is modelled as: P + F = D + I Table to show sources and uses of cash in a company Sources Company Uses Profits (P)Dividends (D) Financing (F)Investments (I)

20. Interaction between the decisions It is argued that the interaction between the variables in the model influences company value and that the equation is constrained by various influences, such as historic performance, size, gearing, the financial environment….

21. Other influences on financial decision making • The financial environment • Human behaviour (conflicts, agency theory, corporate governance) • The Government • Globalisation (all assessed in turn)

22. The Financial Environment

23. The financial environment Two aspects which can impact on financial decision making: • The economic environment; and • The markets

24. Economic influences The economic environment encapsulates: • Inflation • Interest rate changes • Currency strength (All influence economic growth)

25. Inflation When demand for goods outstrips supply – inflation results. Suppliers can increase the price of goods without loosing sales. The goods become more expensive and the real value of money falls. Employees seek higher wages (capital maintenance) and the circle continues….

26. Inflation and business finance Inflation introduces risk into financial decision making as future cash flow streams are subject to change by unknown amounts. Where sales price is not amended to take account of inflation, or cannot be amended, then profitability will be affected. Inflation also has financing implications, as the replacement cost of assets and working capital increases.

27. Interest rate changes Interest rate changes are typically used by the government to control inflation. When inflation rises, or there is a risk of it rising, the government increases interest rates to reduce the amount of cash available, this reduces demand – holding prices down. The current situation is unique, the recession is unlike any recession that the world has encountered since the great depression in the 1930s. The reason for this is the collapse of the financial system. At present, interest rates are low. Governments are using interest rates to try to stimulate economic recovery (explain).

28. Interest rate changes & business finance When interest rates rise: • From a company perspective, the price of goods may not increase, but the cost of debt, and equity will. Therefore, the company will have to make a higher premium on each investment to satisfy its financiers and less investments will be undertaken (and vice versa). • The variability of interest rates introduces financial risk to financial decision making. • Being able to accurately predict interest rate changes – improves the quality and accuracy of the cash flows being analysed (hedging).

29. Foreign exchange rates A business finance manager has to have an awareness of the impact of foreign exchange rate movements on expected cash flows when their company imports or exports goods. Changes in exchange rates can increase or decrease the price of supplies and/or the revenues received from/to a foreign entity. Exchange rate movements can be hedged using derivative financial instruments (swaps, options, futures, forwards).

30. The markets & business finance A business finance manager also requires knowledge of the financial markets environment. • For sourcing capital (debt and equity) • For assessing reaction to dividend policy • For assessing reaction to capital structure changes • For creating an efficient market about the company’s shares (promotes confidence in a company’s share price) • For assessing how the financial environment will impact on the availability of funding (see page 34 and 38 for information on the current crises).

31. Human Behaviour Conflicts

32. Conflict between internal departments This can occur where department managers are appraised using the profitability of their section as a performance target. For example, conflict may arise between the purchasing and stores departments (bulk buying versus storage costs) or the sales and credit control department (higher sales figures versus higher bad debts). Having an appropriate appraisal system that is planned to achieve a company’s primary objective can alleviate internal conflicts.

33. Conflict between equity holders and creditors Debt holders rank in front of equity holders when it comes to yearly distributions and distributions on liquidation. Debt claims have to be met, equity claims do not. Debt claims are capped, equity claims are not. Equity holders have a vote, debt holders do not. Equity holders could pressure financial managers to distribute large amounts, affecting liquidity and the ability of the company to meet debt claims in the future.

34. Conflict between equity holders and creditors Protection for debt holders comes from: Ethical practices (covered later) Restrictive Covenants (covered later).

35. Conflict between equity holders and directors Agency theory Directors are ‘agents’ who act on behalf of their ‘principals’ the equity holders. Directors should take decisions which maximise equity holder benefit. However, in some instances, decisions which maximise equity holder wealth, may be detrimental to directors interests and sub-optimal decision making may occur. For example, putting short-term profitability in front of long-term value creation, where a bonus is pegged to profitability.

36. Management of agency theory Agency costs Costs are incurred to monitor the ‘agents’ and to align their interests with equity holders. (monitoring, bonding, residual – Jensen & Meckling, 1976) For example: • Directors’ bonuses might be aligned to long-term performance. Bonus might be share options. • Audit costs. • Corporate governance costs.

37. Corporate governance The rise of corporate governance High profile company scandals and collapses caused a shake up in corporate governance. • Robert Maxwell (Britain) • Levitt (Britain) • Polly Peck (Britain) • Barings(Britain) • Powerscreen (Ireland) • WorldCom (US) • Enron (US) • Lehman Bros (US) • RBS (Britain) • AIB (Ireland)

38. Corporate governance Reaction to scandals Reduced public confidence in auditors, financial statements, regulatory watchdogs hence the markets. LSE set up a committee under Adrian Cadbury – produced the ‘Cadbury Report’ in 1992 ‘Corporate governance is the system by which companies are directed and controlled’ (Cadbury Report, 1992)

39. Corporate gov. - Corporate Report (1992) Recommendations Detailed the composition of the board Outlined recommended responsibilities. • Meet regularly • Have control at all times • Segregation of duties – so no one director has ultimate control • Conditions to ensure independence of non-executive directors. • Establish two committees (remuneration committee; audit committee)

40. Corporate gov.- Greenbury Report (1995) Strengthened suggestions in the Cadbury Report: • All members of the remuneration committee be non-executive directors. • Annual report should have a remuneration statement

41. Corporate gov. - Hampel Report (1998) • Recommended that the role of the chief executive and Chairman be segregated. • Directors receive training on corporate governance • Directors focus their attention on creating equity holder value.

42. Corporate gov. - Combined Code 1999 All the previous codes of practices were combined to form the combined code in 1999. Updated regularly

43. Corporate gov. - Turnbull Report 1999 This report was to provide guidance on how to implement the Combined Report. It recommended a risk based approach to the establishment of internal controls and when reviewing their effectiveness.

44. Corporate gov. - continuous updating The Combined Code was updated to take account of Turnbull (1999), the Smith Report (2003) and the Flint Report (2005). The latter report suggested that there is widespread support of the recommendations in the Combined Code. US regulators recently referred to the Turnbull Report as being a good framework to adopt when reporting on a company’s internal controls.

45. Corporate gov. - continuous updating The Walker Report (2009) on banking institutions suggested that a further committee to assess risk should be established. The UK corporate governance code (2010) was published • Disclosure of compliance with the code and reasons for not complying if this was the case. • Shareholders take more responsibility for monitoring • The directors for FTSE 350 companies should be re-elected each year • More emphasis on the spirit of the code not the word of the code.

46. Business finance & ethics Some ethical issues facing a financial manager include: • Agency theory • Globalisation (child labour, low wages) • Pollution • Not abusing powerful position (payment of small suppliers) • Bribery or corruption (Countries – normal business practice) • Protection of debt holders claims • Employee welfare (health and safety, pension, etc.) • Communicating with equity holders

47. The Governments Influence

48. The Government & business finance The Government influence business finance decision making using: • Legislation (to promote ethical behaviour; to protect the public) • Taxation (Affect dividend policy, investment decisions) • Economic policy (influence interest rates, inflation, currency value, economic growth) • Grants (stimulate growth in sectors) • Encouraging share ownership (Tax incentives BES/EIS schemes)

49. Globalisation

50. Globalisation Cheaper transport costs and ease of communication across the world means that all business finance managers have to consider global resources. • For sourcing products • For sourcing labour • For sourcing capital Dealing globally has added risks which a finance manager has to be aware of.