b821 Block1unit1 Fundamentals of Finance

7/28/2019 b821 Block1unit1 Fundamentals of Finance

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B821 FinancialStrategyBlock1 Introduction

Unit1TheFundamentalsofFinancePreparedbytheCourseTeam

Masters


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C O N T E N T S 1 Introduction to finance 5

1.1 Why finance is important 51.2 Aims and objectives 81.3 The scope of finance: two examples 11

2 Finance, accounting and corporate governance 192.1 Information for governance 202.2 Finance and accounting 262.3 Finance and corporate governance: agency theory 30

Summary 373 Return on investment 39

3.1 Investment return unbundled 403.2 The time preference rate 433.3 Adjustment for inflation 44

Summary 484 Investment risk 51

4.1 Risk aversion 524.2 Quantifying risk 534.3 Risk factors 574.4 The NPV rule 61

Summary 635 The market context 65

5.1 Perfect and efficient markets 66Summary 71

6 Strategic analysis: porter revised and used 736.1 The Porter five forces model 736.2 Competitive strategy 766.3 The Porter model applied: De La Rue plc and

the banknote and security printing industry 776.4 Porter analysis and accounting data 79

Summary 81


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1 I N TR OD U C TI ON T O FI N A N C E 1 INTRODUCTION TO FINANCE

WH Y F I N AN C E IS I M P O R T AN T 1 . 1 Thiscourseisprimarilyconcernedwiththerelationshipbetweenanorganisationandoneofitskeyexternalstakeholdergroupstheprovidersoffinancialresources.Thisrelationship,justlikethosewithcustomers,suppliersandemployees,iscentraltothestrategicdecision-makingprocessofanyorganisation.Butwhatmakesthisrelationshipsoimportant?Andisitdifferentfromtheotherthree?The importance of finance goes back to the fact that the peopleand organisations that own the surpluswealth in the economy arenot the same oneswho put thatwealth to productive use.l Intheprivatesector,theindustrialrevolutionsofthenineteenth

andtwentiethcenturiescreatedopportunitiesforunprecedentedeconomiesofscale,butthecapitalrequiredtoexploitthese

wasfarbeyondtheresourcesofthetypicalowner-entrepreneurandhis/herimmediatecircleoffamilyandfriends.Amechanism

wasneededtoattractcapitalfrompeoplewhowerewillingtoprovidefinancialresourcestoafirmwithouthavingtoparticipateinthemanagementortorununlimitedfinancialrisks.

l In thepublic sector, governments face a constant mismatchbetween their own spending needs and the ability orwillingnessof households and businesses to finance those needs throughcurrent taxation. So governments too need a mechanism to tapthe surplus savings in the economy, borrowing during times offiscal deficit and repaying during times of surplus.

That mechanism is provided, for both the private and the publicsectors, by the financial markets. The study of finance is primarilythe study of these markets. How do they operate? How efficientlydo they operate? How do they reconcile the complementary andsometimes conflicting interests of the providers and users offinance? Can they be made more efficient?

Anotherway to appreciate the fundamental importance of financeis to consider the basic activity of any organisation as thetransformation of resources.We can see here a similarity betweenfinance and the organisations relationshipswith suppliers andemployees. Finance, like the resources of raw materials and labour,is a key input into this process of resource transformation. But isfinance just like any other resource or is it different from them? Thestatements We dont have the resources and We dont have the money are often used almost interchangeably. This implies thatmoney is not just another resource like materials and labour, butalso the key that unlocks the door to all other resources.

OU BUSINESS SCHOOL 5


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1 INTRODUCTION TO FINANCE

familiarwith other sources of financial information, commentand analysis. Here are some suggestions.l Most companieswhose shares are quoted on a stock

exchange have a section on theirwebsites (typicallycalled Investor relations or something similar)wherethey communicate information about their financialperformance and general strategy.

l Thehardcopyandonlineeditionsofthemaindailynewspapersdevotemajorsectionstobusinessandfinancialnews.Onlineeditionsalsoofferextensivearchives,makingitquiteeasytofollowacompany,anindustryorageneralthemeoveraperiodofmonthsorevenyears.TheprimaryUKnewspapersourceforfinancialnewsandcommentistheFinancialTimes(universallyknownastheFTforshort).AguidetofindingyourwayaroundtheFTispostedontheB821website.WerefertotheFTasitisavailableinlocaleditionsforEurope,Asia,theUSAandsoon,butthesameappliestootherEnglish-languagefinancialnewspapers,suchastheWallStreetJournal,andmostEuropeancountrieshavetheirownlocal-languagejournals(forexample,HandelsblattZeitunginGermany).

l The B821 coursewebsite is regularly updatedwith linksto articles and other resources of topical interest.

l Last but by no means least,you should use the facilities ofFirstClass conferencing and of tutorials or day schools totap into the experience ofyour fellow-students. In fact,you might like to use thisActivity 1.1 as a convenientice-breaker inyour own tutor group conference bycomparing notes onyour findingswith those of other students inyour group.

Whatobservationsdidyoumakeinthecourseofyourreview?Youmayhavecomeacrossreferencestosuchthingsas:l thedisposalofanoperatinguniton thegroundsof

inadequatereturnon investment;l theprospectofoperatingsynergies tobegainedfrom the

acquisitionofanotherbusiness that is, theopportunitytoforgea combinationwhere thewholewillbemorethan thesumof theparts;

l theneedtoimprovekeyfinancialperformanceindicatorssuchasprofitabilityratios(inaprofit-makingbusiness)orthecostratio(inanon-profit-makingoperation).

Whateveryourownfindingsandthoseofyourfellow-studentsmayhavebeen,youhaveprobablyidentifiedatleastonecommonfeature;theneedtosatisfytherequirementsofexternalprovidersoffinancehasfar-reachingimplicationsfortheinternalmanagementoftheorganisation.

This course includes aseparate whole-courseGlossary that will helpyou to understand thetechnicaljargon and todevelop confidence inusing it. Terms that aredefined in the Glossaryare shown inbold typewhen they first appear inthe text.



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UNIT 1 THE FUNDAMENTALS OF FINANCE

Wewill return to these ideas in the following sections, but firstweoutline the structure and aims for this unit, and in brief thosefor the course.

A IMS A ND O BJ E C T I V E S 1 . 2 Course aimsBeforewedescribethecourseaims,itisperhapsworthstatingatwhomthecourseismainlyaimed.OfcoursethegeneraltargetmarketisOUStageIImastersstudents,butweshouldbealittlemorepreciseinourdepictionoftheexpectedparticipantbaseforB821.Itwouldbedisingenuousofustobelievethatallcoursestudentsaretakingitbecauseofadeep-seatedloveoffinanceasasubject.While

wemayhopethatistrueforaminorityofthegroup,itisobviousfromaconsiderationofthesituationandfromsurveysoffinanceelectivestudentsthatthemostcommonreasonforstudyingB821isbecausefinanceisanecessaryelementofaworthwhileMBA(orequivalent)education.ThusamajorityofB821participantsarenotaccountingorfinancespecialistsintheircareers.Thisisasitshouldbe.Whilewegenuinelybelievethatthecoursewillbeinterestingandbeneficialtothosewhoarealreadyfollowingorintendtofollowafinancestreamastheircareerchoice,B821isprimarilyaimedatthosewhowillnottakeupfinanceasaspecialismbutwill,laterintheircareers,beexpectedtodebatewith,questionandcontrolthosewhodo.In

all

organisations,

be

they

private,

public

or

voluntary

sector,

the

seniormanagementbecomelegallyliableforthefinancialsituation,andsoitisincumbentuponallmembersofthatgrouptohaveortoacquiresufficientunderstandingtodebateandchallengewitheachtopicheadtheperformanceofhisorherdepartment.B821isintendedtoprovidepeopleaimingforseniormanagementlevelswhichisalmostadefinitionofanMBAstudentwiththefinancialknowledgetofulfilthisrequirementproperlyandsafely

whentheChiefFinancialOfficer(orequivalent)isunderthespotlight.Alltoooftenheorshewillhavebecomeusedto,atbest,averylightandsuperficialscrutiny,andthisdangerouslackofpeerreviewis

whatweintendtolessen(inasmallway)byprovidingB821studentcohortswiththenecessaryknowledgeandunderstandingtoproperlycommentonthestrategiesandprocessesofthefinancialspecialists.

Withtheforegoinginmind,theoverridingaimofthiscourseistogiveyouthenecessarytheoreticalgroundingandpracticalproblem-solvingskillstoidentify,analyseanddealwiththestrategicfinancialissuesarisingintheorganisationwhereyouwork.Here are the specific issues that this coursewill giveyou the skillsto tackle.l How can the financial management of an organisation best

reflect its external reporting and governance regime?l Is there an optimal balance between different sources of finance

in the capital structure of an organisation?OU BUSINESS SCHOOL 8


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l What is the bestway to decide between alternative projects orinvestments offering different returns but entailing differentlevels of risk, or to combine investments and projects into abalanced portfolio?

l How canwevalue an enterprise as awhole for acquisition orother strategic purposes?

l Whataretheprincipalfinancialrisksconfrontinganorganisation,andwhatisthebestwaytomonitorandcontrolthem?

Course objectives After successfully completing this course,you should:l have acquired a thorough understanding of the strategic

considerations determining the financial policy of organisations;l understand and be able to analyse and use company accounts

in different situations and from the standpoints of differentinterest groups;

l be able to contribute effectively to the financial decision-makingprocess ofyour own organisation; and

l have mastered the mechanics of the financial marketssufficiently to implement a specific financial strategyappropriately and cost-effectively.

Unit 1 aimsThe overall aim of this unit is to set the scene foryour moredetailed study of finance in the subsequent units. Specifically,weaim to show:l how the flow of information plays a key role in the financial

relationship between an organisation, its owners and otherexternal providers of funds;

l how risk and return are key determinants of investor decision-making;

l how the financial markets bring together the providers andusers of finance, and how market prices are determined.

Unit 1 learning outcomes Whenyou have studied this unityou should be able to:l understand and comment critically on the main features of a

system of financial reporting and corporate governance;l appreciate how an overall return on investment can be broken

down into its constituent parts for the purpose of investmentanalysis;

l explain the concept of risk in an investment context, andcomment critically on the impact of the principal risk factors ina given investment context;



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l make an informed judgement aboutwhether or towhat extenta financial market satisfies the conditions of an efficient market,and identify the main factors that could detract from thatefficiency.

Unit 1 outline This introductory section endswith two readings that givea sense of the broad scope of the subject of financial strategy.Sections 2 to 5 introduce the four key themes of the course,

which are:1 information, control and governance2 return on investment3 investment risk4 finance markets, their behaviour and uses.Finally,

Section

6

provides

preparation

for

your

study

of

financial

analysis in Block 2.Sect ion 2: Finance, account ing and corporategovernanceThis section explores the first of the four key themes of finance.l How do the providers of finance obtain the necessary

information to decidewhere to invest their savings? Once theyhave invested their money, how can they make sure thatthe users remain properlyaccountable for its use? How canthey

control

the

way

their

savings

are

used?

In particular, it:l introduces the main themes of corporate governance and maps

out the central part played by financial reporting in an efficientgovernance regime;

l describes the main conflicts of interest inherent in theseparation of ownership from management;

l explainswhy, despite the strenuous and continuing efforts bylawmakers, regulators and professional bodies, intractableproblems of accountability and control still affect theworldsmost advanced economies;

l givesyou the background and the tools to follow this processin the economy at large and to participate in it inyour ownorganisation.

Sect ion 3: Return on inves tment This section explores the second of our four themes.l What is a fair return for providers to receive for the use of

their savings?In

particular,

it:

l introduces the key concept of return as one of the twin

foundation stones of the theory and practice of investment;

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l unbundles the return on any investment into its constituentparts; the time preference rate, the allowance for inflation andthe premium for risk.

Sect ion 4: Inves tment r i sk This section explores the third of the four themes.l How do providers assess the risk of entrusting their savings to

users, and how are they rewarded for running that risk?In particular, it:l examines in detail the third component in return on

investment compensation for the element of risk;l explains how in a financial context risk is not exclusively

a negative concept but is a synonym for uncertainty or thelikelihood that thingswill turn out differently (and notnecessarilyworse) than expected;

l introduces the quantitative techniques used for identifyingfinancial risk;

l identifies the principal factors contributing to risk in the realworld of financial markets and instruments.

Sect ion 5: Themarket context This section explores the last of our four key themes.l How do the financialmarkets match providerswith users, and

howefficiently does the market determine prices?In

particular,

it:

l introduces the concepts of perfect and efficient markets;l sets out the main arguments and empirical findings connected

with the Efficient Markets Hypothesis (EMH).Sect ion 6: StrategicanalysisPorter revisedThis section is a precursor toyour study of financial analysis inBlock 2 (Units 2 and 3). It:l uses Porters five forces model to give a qualitative, strategic

overviewwithinwhichyou can better understandyourquantitative analysis of a particular company (De La Rue);

l gives an important reminder that this course is aboutstrategy aswell asfinance. The latter must always be seen in the contextof the former. Sometimes one is so engrossed in the technicalfinancial trees that one must make a conscious and continuingeffort to keep in mind the strategic wood at the same time.

T HE S C O P E O F F I N AN C E : T WO E X AM P L E S

1 . 3 Let us end this introductory sectionwith a pair of readings thatought to indicate the breadth of the subject thatyouwill bestudying in this course. It is sometimes felt that the finance



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Cleaner or not

CO2 emissions per total manufacturing value addedtCO2/$000

Raw materials Other manufacturing

Australia1974

US

Finland

Japan

Germany

France

Source: IEA

2.01.51.00.50

1973

1973

1973

1973

1973

1998

1998

1998

1998

1998

1998

BenediktvonButlerofEvolutionMarkets,agreenhouse-gasbroker,pointstoonereasonnottoworry:price.Ifafirmcannotstayunderitsgovernment-allocatedquotaforcarbonemissions(andeverysizeableEUfirmreceivedsuchaquotaearlierthisyear),thenitmustpurchasecarbonallowancesatthegoingprice.Followingtheinformalcarbonmarketalreadyunderway,pan-EUcarbontradingstartsnextyear.Afewyearsago,observesJorundBuenofPointCarbon,aEuropeancarbonconsultancy,mostexpertshadexpectedbusinessestobeconfrontedwithapriceofE2025($2531)pertonne.Inpractice,priceshavebeenalotlowerthanthatandtheyarenotexpectedtorisemuchaboveE1015pertonne.Therearetworeasonsforthis.Thefirstisthepotentialoverhangofhotair.Russiawasgivenanover-generousallowanceofcredits,topersuadeittojointhetreaty.Someworriedthatitwould,overtime,depresspricesontheEUmarket.Infact,self-interestwilldiscouragethis:theRussiansdonotwantapricecollapse.Indeed,arguesMrvonButler,theyaremorelikely,eventually,tojoinUkraineandBulgariainacarteltotrytopropupprices.Themostlikelyoutcome,reckonsDavidVictorofStanfordUniversity,is

thatoverhangofRussiancreditswillallowEUgovernmentstousethehotairasasafetyvalvetoensurethelong-termpriceofEUcarboncreditsdoesnotrisemuchaboveE10.Thesecondreasonisthat,despitealltherhetoric,theEUisdoingratherlessthanitappearsonclimate,andAmericarathermore.EuropehasalltheregulationsofKyotoinplace,butthestraitjacketonindustryisprettyloose.Whenthenationalallocationplansforcarbonwereissuedearlierthisyear,thegreenscomplainedthattheyweretoothlessandamountedtobusinessasusual.IndustryhadsuccessfullylobbiedEUgovernmentsnottohobbleitscompetitiveness.AndinAmerica,whereMrBushhasunshackledcorporationsfromKyoto,manyindustriesareconfrontingacarbonchallengenonethelessand,insomecases,makingvoluntarycuts.OneexampleisDuPont,whichhasslasheditsemissionsofgreenhousegases(whichincludegasesotherthancarbondioxide)byabreathtaking65%comparedwithits1990levels.Onereasonhasbeentogainfavourablepublicity.ButmultinationalslikeDuPontareconvincedthatcarbonconstraintsarecominganywayinAmerica,andtheywanttomakeglobalpreparations.SincetheyhaveoperationsinsideKyoto-land,manyarepursuinglow-carbonstrategiesathome,evenintheabsenceofregulation.ThereisalsoagrassrootsrebelliontakingplaceinAmerica.Manystateshave,indefianceoftheBushadministration,introducedcarbonrestrictions.StatesinNewEnglandhaveimposedcurbsoncarbonemissionsfrompowerplants,andaredevelopingacommontradingsystemforemissionswithCanadaseasternprovinces.Californiahasthenationsfirstlawlimitinggreenhouse-gasemissionsfromcars.NewYorkandothersmayadoptsimilarrules.So,KyotoneednotplaceacarbonmillstonearoundtheneckofEuropesbusinesses.Indeed,evenconcernsabout



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developingcountriesstealingacompetitive medium-sizedconsultingfirms,technologyedgemaybeoverblown.China,whichhasnoobligationsunderthetreaty,isimposingdefactoconstraintsonlocalindustrythroughseeminglyunrelatedpoliciessuchas

tough

new

fuel-efficiency

laws

for

cars.

Europeaneconomiesmightevengainsomeadvantages.AnthonyHobleyofBaker&McKenzie,anAmericanlawfirm,arguesthatBritainsearlyembraceoftheKyotoprotocolgivesitachancetodominateasectorthatbenefits:thelegalprofession.Englishlawislikelytobethemajorlegalsystemofthisnewinternationalmarket.ThefacttheUShasruledoutratifyingKyototakesNewYorklaw

out

of

the

running

for

the

time

being.

Despiteal ltherhetoric,the EUis doingratherlessthanit appearson climate,andAmericarathermore.Anothersortofedgeliesinthepan-EUtradingsystem.Itformallycovers25countries,butmaysettheglobalstandard.Already,notesMrHobley,Norway,SwitzerlandandCanadahavehadformaldiscussionsaboutlinkingtothesystem.Japan,aKyotosignatory,mayalsoannouncealinkingscheme.Mostintriguingly,rumourssuggestthatCaliforniamightunveilacarbon-tradingsysteminDecemberandittoomightbelinkedtotheEuropeanscheme.TheemergingcarbonmarketalreadyfeelsmorelikethedizzyingearlydaysofSiliconValleythanthestatecapitalismofEuropespast.JosDelbeke,oftheEuropeanCommission,certainlysoundsmorelikeafreemarketeerthanaEurocrat:Wehavecreatedanewcurrency,thecarbonallowance,butonlythemarketcansetitsprice.TheCommissionhasalreadychastisedeasternEuropeangovernmentsforover-generouscarbonallowances,whichitinsistsadduptounfairstateaid.Theemergingcarbon-emissionsindustryintheEUcountsdozensofsmalland

start-upsandthelike.Thebigaccountingfirmsarescramblingtotraincarbonaccountants,andventurecapitalispouringintocleanenergy.Londonisquickly

emerging

as

the

carbon-finance

capital.ItishometoClimateChangeCapital,thefirstmerchantbankdedicatedtocarbonissues,andtheCarbonTrust,aninnovativepublicprivatepartnershipthataimstoboostcleanenergy,inpartbyfundingpromisingtechnologiesconsideredalittletooriskyforprivatefinanciers.IfanyindustryshouldbehostiletoKyoto,thenitshouldbeenergy.Yetin1997,LordBrowne,thebossofBP,theworldssecond-largest

oil

company,

broke

ranks

and

called

foractiononglobalwarming.Hopingtoencourageamarket-friendlyapproachbytheEU,hevowedthathiscompanywouldreduceitsemissionsto10%below1990levelsby2010.HeturnedtoEnvironmentalDefence,amarket-mindedgreengroupthathelpeddesignAmericassuccessfulsulphur-dioxidetradingsystem.Together,theyimplementedacap-and-tradecarbonschemeforBPsvariousdivisionsworldwide.Theresult?Thefirmmetitstargetseightyearsaheadofschedulethroughacombinationofhigherefficiency,newtechnologyandbettermanagementofenergy.Mostimpressive,LordBrowneexplains,isthepricetag:Wevemetitatnoneteconomiccostbecausethesavingsfromreducedenergyinputsandincreasedefficiencyhaveoutweighedalltheexpenditureinvolved.Thecostsoftacklingclimatechange,heconcludes,areclearlylowerthanmanyfeared.Thisisamanageableproblem.ByembracingKyoto,theEUmightjusthavegivenitsbusinessesanedgeintheracetowardscleanenergy.(Source:TheEconomist,7October2004)Copyright#2005TheEconomistNewspaperandTheEconomistGroup.Allrightsreserved.



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The reason for including this article is that the issue of globalwarming is demonstrably as all-encompassing a topic as one couldfind, and carbon emissions are a key factor in the debate. The maineconomic system that has been introduced as a practical attempt todo something about the problem is carbon limits and their trade.The methodology, process and system for handling thisvery realpollutant isexactly that invented for futures trading,whichyouwillstudy in Block 4 (Units 79),FinancialRiskManagement.Whetherone is talking about crowns (Swedish, Norwegian or Czech) orcarbon, the trading methods are the same, and are those created bythe financial marketplace.I hopeyou found Welcome to Kyoto-land an interesting indicatorof the breadth of financial matters. Ifyou have time (and areinterested in the carbon-trading topic), read some of the otherarticles available through the B821website. Thiswill be a commonpractice in B821, i.e. the textwill often contain an article, case orexample that is backed up and reinforced by additional materialsavailable electronically. Even ifyou do not intend to read each andevery piece,you should have a look at thewebsite because theremay be a more up-to-dateversion ofwhat is in the coretext keeping theWeb current is obviously much more feasiblethan reprinting the units every time an update becomes available.

European pensionaccountingPainful Thepicture isbleak.Newaccountingstandardscouldmake itbleakerLIFE,notdeath,maybethefinalaccountingforEuropesharriedexecutives.Nextyear,thewaytheytallyassetsandliabilitiesintheircompaniespensionplansisduetochangewheninternationalaccountingstandardstakeeffectforlistedfirms.Thenewruleswillmakeit(abit)hardertopretendthatbigdeficitsdonotexist,andeasierforinvestorstocomparepension-financingacrosscompanies.Companiesarebracingthemselves.Already,defined-benefitpensionsinwhichemployeesarepromisedacertainamountuponretirementareinbigtrouble.Thestockmarketslumphashurtinvestmentreturns;meanwhile,retirees

keeplivinglongerandlowinterestrateshavepushedupthepresentvalueofliabilities.BritishAirwayspensiondeficitisaround70%ofitsmarketcapitalisation,withotherworthiessuchasRolls-RoyceandBTnotfarbehind,accordingtoJ.P.MorganChase(seechart).

Pity the pensioners

Pension funds, unfunded liabilities/deficits*as % of market capitalisation

Volkswagen

0

British Airways

DaimlerChrysler

RWE

BAE Systems

ICI

Deutsche Post

Bayer

Rolls-Royce

BT Group

20 40 60 80 100

*As at last published annual reportSources: J.P.Morgan Chase; The EconomistAs at Nov 8th



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Onthecontinent,thepictureisvaried. returns.They are now scrambling toGermanysVolkswagen,DaimlerChryslerandDeutschePostallhaveheftyunfundedliabilities.Germancompanieslookworst,becausemanyusepay-as-you-goschemes,in

which

contributions

are

paid

out

immediatelytotodayspensionersratherthan(asinBritain)invested.ThemeticulousDutchusuallyfundtheirpensionsfully.InFranceandItalythestateshouldersmuchofthepensionburden;otherFrenchschemesarepay-as-you-go.Whereasamajorityofcontinentalcompanieswithhugepensionschemesalreadyuseinternationalfinancial-reportingstandardsorsimilarAmericanones,lotsofbigBritishcompaniesareintheprocessofswitchingstandards.SothenewaccountingruleswillaffecttheBritsmost,saysJ.P.Morgan:manyarelikelytoputtheirfullpensiondeficitsontheirbalancesheetsnextyearforthefirsttime,althoughtheyalreadydiscloseenoughinformationforinvestorstodothemathsthemselves.Thenewnumbersmaybeajolt forbothinvestors andpensioners, for tworeasons.First ispension liabilities:underthenew rules, a companys futureobligationswillbe calculatedusing theyieldonhigh-quality corporatebonds.Because this isa smallernumber thanmany companiesusedbefore, thepresentvalueof theobligationswillbehigher.(Some argue that thediscount rateshouldbe lower still.)The second reason is on the asset side.Companies habitually smooth investmentreturns, on the theory that the actualfigureswould be too volatile forinvestors and analysts to bear.Underthe new rules, companieswill be able tochoose between smoothed and actual

decidewhat to do.Eventually,internationalruleswillprobablybetightenedtorequiretheactual,volatilenumbersonbalancesheets.Britainisslightlyaheadonthis,sinceitsownrulesensuremorefair-valuereporting,althoughsomeimportantrequirementswillnotapplytonon-listedcompaniesuntilnextyear.Oneweaknessofthenewrules,arguesKeithJecksofABNAmro,isthattheydonotrequirecompaniestodisclosetheamountneededtowinduptheirpensionplans.DiscontinuanceisincreasinglyanissueinBritain,wheretworecenttakeoverattemptsfailedpartlyowingtobiddersfearsofgiant,ill-talliedpensionliabilities.Evenso,thenewrulesshouldgiveamorestandardised,grimmerpictureofcompaniespensionplans.Althoughsomefirmsmaydipintoprofitstoplugnewlyexposedgaps,manymorewillcontinuethetrendofjunkingdefined-benefitschemesaltogether.LotsofFTSE100companieshaveclosedsuchschemestonewemployees,andareswitchingtodefined-contributionplans,whichmakenopromisestopensioners.MrJecksnotesthatcurrentemployeesoftencompriseonlyone-fifthofapensionschemesmembers;therestareretiredorworkingelsewhere.Pensionfinancesmaylookevenworseinsixmonths,whenBritainsactuariesproduceastudyonlongevity.Futurecentenarianswouldbewisetofindalternativewaysofsaving.(Source:TheEconomist,11November2004)Copyright#2005TheEconomistNewspaperandTheEconomistGroup.Allrightsreserved.



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TheEconomists Painful article is included for three reasons. First,it demonstrates that seemingly obscure accounting rule changes canand do have a real effect on organisations. Second, asyou moveup to the top echelons ofyour organisation, it is likely thatyou

will become involved in the management ofyour companyspension scheme (assuming there is one). Third, since pensions andpensions liabilities affect corporatevalue,youwill need to takesuch matters into accountwhen evaluating potential acquisitions ordisposals. The ideas in Blocks 2, 3 and 5 analysis,valuation andcorporate governance are all relevant to the pensions debate.

Aswith the carbon trading article,youwill find more informationand links about pension accounting (and associated topics) on theB821website. Both articles are interesting in themselves, but themain reason for including them is to show that the concepts, ideasand methods of finance have influence in a muchwider spherethan

just

its

direct,

technical

segment.

It

is

thus

important

that

managers of all specialisations have some knowledge of the subject.

An example may illustrate this.At the time ofwriting (April 2005),a High Court case has begun inwhich 15 former directors ofEquitable Life are being sued for negligence by the presentmanagement for 1.7bn. The underlying problem that eventuallyled to this high-profile (and high-cost) legal actionwas, essentially,that the Society mishandled its risk management of an annuityproduct in the early 1990s (the GuaranteedAnnuity Rate scheme).Of the 15 defendants, ninewere non-executive directors andnon-financial people such as the marketing director. They arebeing held personally liable for the results of a technical and quiteesoteric aspect of financial management. One is driven to ask:werethey providedwith the necessary information to perform theirduties? Did they have enough financial understanding toask therightquestions? Theywould not have been expected to delve intothe precise operations of the corporate treasury and its riskmanagement, but they are being held to account for ineffectualunderstanding and control of the key policies involved. If they hadstudied B821 in general, and Block 4Financial riskmanagementin particular, they might not be at risk of personal bankruptcy.

At the time of writing(April 2005) thepartnership deal betweenMG Rover and ShanghaiAutomotive fellapart sending Roverinto administration atleast partly due to futurepension liabilities and ahole in the funds assetbase.



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2 FI N A N C E, A C C O U N TI N G A N D C OR P OR A TE GOVER N A N C E 2 FINANCE, ACCOUNTING AND CORPORATE GOVERNANCE

Institutionalinvestorssometimesbehaveasif theyownedthebusiness,whereasinfacttheyare justtradersofpiecesofpaper.(Finance director of FTSE-100 company,FinancialTimes,April 1998)

We said at the beginning of this unit that this course is primarilyconcernedwith the relationship of an organisationwith one ofits key external stakeholder groups the providers of financialresources. This relationship throws up many questions, but most ofthem flow from just two main issues.l Which projects should the organisation invest in?l How should the organisation procure the finance to pay for

them?Ifwe consider these issues in a little more detail,we might comeupwith the following more specific questions.l How do the providers of finance obtain the necessary

information to decidewhere to invest their savings? Once theyhave invested their money, how can they make sure that theusers

remain

properly

accountable

for

its

use?

How

can

they

control theway their savings are used?

l What is a fair return for the providers of finance to receive forthe use of their savings?

l How do providers assess the risk of entrusting their savings tousers, and how are they rewarded for running that risk?

l How do the financialmarkets match providerswith users, andhowefficiently does the market determine prices?

The italicisedwords highlight the basic themes in the study offinance,which are:l information, accountability and controll returnl riskl markets and market efficiency.This introductory unit explores each of these fundamental themesin turn.Asyouwork through the rest of the course,you should tryto always keep them clearly inview. They drive and inform the

whole subject of finance.



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I N F O R M AT I O N F OR G O V E R N AN C E2 . 1 The first question in our list concerns information andaccountability. One of the key themes of this course is concerned

with the strategic financial decision-making of organisations, soweshould consider the accountability question mainly at a policy/organisational level. This indicates the key role of finance incorporate governance. In most cases (barring owner-entrepreneurssuch as Richard Branson), senior managers are the employees ofthe companys owners, the shareholders (thoughwewill investigatethis statement later in this section). The latter, in theory, shouldprovide oversight and governance, and so need to be provided

with information by their stewards. In general, this is provided bythe financial and business statements made by companies on aregular basis: for a small business, an annual report; for a largestock exchange-listed company, quarterly interim results.Wewillinvestigate and analyse financial numbers in detail in Block 2; here

we take an overview approach, aiming to get an initialunderstanding of the business in question, in this case Shell.Box 2.1 contains extracts from the press release that accompaniedthe release of the 2004 annual results by Royal Dutch/Shell, themajor oil company (from here on referred to as Shell, as the company itself generally does). Notice that almost all of its strategicobjectives (Outlook 2005) for the next 12 months are expressed infinancial terms. Do notworry at this stage if the exact meaning ofsome of the technical terms is unclear toyou.What matters is that

you appreciate three general points.1 The dominant role played by financial considerations in the

determination of strategic objectives and the measurement ofactual performance against those objectives.

2 Financial terminology is often employed as a shorthandwhendescribing broader strategic objectives in essence, money isused as a numericalway of keeping score as often as it ismeant as an indicator of actual cashvalue.

3 Ratios andpercentages are important in financial decisionmaking.

Itwill be helpfulwhenyou look at the Shell results to rememberthat the company had a fairly traumatic 2004 in respect of its

valuation of proven oil reserves itwas more than an occurrencethough less than a financial scandal and so the marketwasparticularly interested in these figures, and the companywas keento be reassuring about them. Do not get too caught up in the detailof the multitude of numbers, since allyou are aiming to do is getan overall impression a feel, if that is not toovague a term ofShells results and outlook. One technical point: in many placesShell use the abbreviation CCS. This is explained in one of thebullet points, but the detail is not easy to spot. CCS stands forCurrent

Cost

of

Supplies

oil

prices

are

so

variable

that

Shell

needs to state some figures not only as they actually came out



21/92

2 FINANCE, ACCOUNTING AND CORPORATE GOVERNANCE

but also based on the up-to-date price.As an example, earningsper share (given in the first bullet) is shown asE4.43 actual orE4.19 calculated on a CCS basis; for our purpose of taking anoverview, the technicalities of CCS can be passed over.

BOX2.1

SHELL: KEY FEATURES OF THE FULL YEAR 2004l Prior to restatement, on a net income basis, basic earnings per

share (EPS) for Royal Dutch for 2004 wereE4.43 ($5.50) andfor Shell Transport were 42.7p (i.e. 0.427). On a CCS basis,basic EPS for Royal Dutch 2004 wereE4.19 ($5.22) and forShell Transport EPS were 40.5p (i.e. 0.405).

l Second interim dividends have been announced ofE1.04 pershare for Royal Dutch (E1.79 for the full year, up 1.7% from2003) and of 10.7p per share for Shell Transport (16.95p for thefull year, up 7.6%).

l Record reported net income of $18,536 million was 48% higherthan 2003. Net income in 2004 included net gains of $88 million(including divestment gains partly offset by other charges),versus a net charge of $14 million in 2003.

l Full year CCS earnings (i.e. on an estimated current cost ofsupplies basis for the Oil Products segment earnings) for theyear were $17,591 million, 38% higher than 2003. Earningsreflected higher hydrocarbon realisations, strong LNG earningsand higher Downstream earnings in Oil Products and Chemicals.

lThe

return

on

average

capital

employed

(ROACE)

on

a

net

income basis was 20.1% (2003 15.5%).

...l The Group has now completed its proved reserves reviews

and internal audits for the period 2003 and earlier, and hasdetermined that it will restate approximately 1.4 billion boe[barrels of oil equivalent] of proved reserves. SEC Provedreserves at December 31, 2003, previously reported as14.35 billion boe, are estimated to be 12.95 billion boe.

l The proved Reserves Replacement Ratio (RRR) for 2004 isexpected to be in the range 4555% before year-end pricingimpact and divestments.

...l Full year cash flow from operating activities was $25.6 billion, up

18% from 2003. Fourth quarter cash flow from operations was$6.7 billion.

l The total debt ratio was 13.7%, compared to 20.9% at year-end2003; cash and cash equivalents increased by $6.5 billion to$8.5 billion and debt decreased by $5.7 billion.

l Capital investment for 2004 was $13.4 billion (excluding theminority share of Sakhalin of $1.5 billion) of which $10.0 billionwas invested in the Upstream segments.



22/92


l Gross proceeds from divestments for the full year were$7.6 billion and for the fourth quarter were $4.8 billion.

...Outlook 2005l With the adoption of quarterly dividends in 2005 and subject

to exchange rates, payment of at least $10 billion in dividendsis expected in 2005. In this transition year this results frompayment of the 2004 second interim dividend (some 60% of the2004 dividend distribution subject to exchange rates) followed bythree quarterly dividend payments on account of 2005.

l Given strong cash and debt position from 2004, the buybackprogram will be relaunched on 3 February 2005, with return ofsurplus cash to shareholders for the year 2005 in the rangeof $3 billion to $5 billion, assuming continued high oil prices.Any purchases will be made in accordance with applicableregulations and consistent with an exemption received from theSEC in connection with the Transaction whereby any purchasesof Royal Dutch shares will only occur outside the USA.

l Capital investment in the medium term is expected to be around$15 billion per annum excluding the minority share of Sakhalin.

l Guidance for gross divestment proceeds for the period 2004 to2006 is increased to a range of $12 billion to $15 billion inaggregate.

l The targeted gearing is in the 20% to 25% range, includingother commitments such as operating leases and retirementbenefits (totalling some $10 billion), and net of cash holdingsminus operational cash requirements. On this basis gearingstood at some 16% at the end of 2004.

l The production outlook for 2005 to 2006 remains 3.5 to3.8 million boe per day and for 2009 remains 3.8 to 4.0 millionboe per day.

(Source: Royal Dutch/Shell, 2005)

Much of the Shell numbers are in the form of ratios andpercentages,which measure one thing in terms of another, so theyare essentially comparative or relative. This serves to highlight akey feature of finance.

Financeisaboutrelative,notabsolute,values.Anoverridingobjectiveofthesystematicstudyoffinance istodevelopaframeworkforcomparisonwhichisatoncetheoreticallysoundandusefulinpractice.

Ifwe think in even broader terms about the influence of financeon the big picture,we can see that finance has become a keydriver

in

the

process

of

the

structural

change

that

has

come

to

dominate the landscape of both the private and the public sector.In itself change is nothing new,whether it is caused by the swingsof the economic cycle or by one-off factors such aswars, or the



23/92


transition from steam to electric power, or from a command to amarket economy.What is different about todays environment isthat the process of change has become seemingly continuous.Andfinancial drivers are at the heart of this process.l In theprivate sector, the belief that bigger is better, founded

on the principles of economy of scale and economy of scope,went largely unchallenged for manyyears. From the 1970sonwards, however, analysts and academics increasinglyquestioned this belief. Strategists such as Porter (1979) haveshown that sizeperse is neither good nor bad,with optimalsize depending on other factors such as competitive forces.They have argued that the financial interests of stakeholders arebest served by maximising long-term profitability (a relativemeasure) rather than by maximising current profit (an absolutemeasure); and by achieving the most favourable trade-offbetween profitability and risk (again, a relative, not an absolutemeasure).

In

both

cases,

the

objective

is

not

to

maximise

size

but tooptimise size for other, more appropriate, financial

variables.l During the same period, change in thepublic sector has been

dominated by the following four interrelated developments.1 Previously state-owned industries and activities have been

transferred back to the private sector on a massive scale.2 In the drive to achieve bestvalue, public-sector activities

have been subjected to private-sector financial disciplinessuch as economy,efficiency andeffectiveness.

3 The process of accounting for public-sector activity in theUK and elsewhere has been completely overhauled. The oldsystem of cash-based accounting did not make even therudimentary distinction between capital expenditure andcurrent expenditure. It has been replaced by resource-basedaccounting founded onwell-established private-sectorprinciples, including the concept of accruals and a cleardefinition of capital employed and the opportunity cost ofemploying it.

4 Since 1992, the drive to improve the provision and efficiencyof public services in the UK has led the Government toadopt a policy of introducing private-sector capital, financialdisciplines and management expertise into new areas suchas schools, hospitals and prisons. The most important formof such so-called Public Private Partnerships (PPP) is thePrivate Finance Initiative (PFI). Operating as it does on anentirely new interface between private- and public-sectoraccounting, PFI has produced awhole new set of financialrules and guidelines, changing theways managers in bothsectors identify, quantify and manage the risks, costs andbenefits of such partnerships.

So farwe have been thinking about the influence of finance onthe broad landscape. However, to keep in balance considerationsof policy and of implementation, it is important to also think about



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the subject in terms of the day-to-day operations.Activity 2.1 invitesyou to think about the impact of finance on the fine detail ofyourimmediate environment and thewayyou go aboutyour dailywork.

ACTIVITY 2.1Considerjust three aspects ofyourworking environment.1 What procedures doyou have to follow in order to get

approval for any particular course of action?2 What reporting requirements doyou have to complywith

in regard toyour regular activities?3 Which departments or central functions lay down these

procedures and reporting requirements, andwhy?Dependingon theexactnatureofyourrole (andonhowsensitiveyouare to theburdenof red tape!),your listsofprocedures

and

reporting

requirements

could

be

very

long

andvaried.Youhaveprobably identified requirementsfromseveraldepartments.For instance, thehuman resourcesdepartmentneeds regular information toensure thatstaffarepaidcorrectlyfor thehoursworked,and that thelegislationaboutemploymentconditionsandhealthandsafetyatwork isproperlyobserved.But,whateveryour role,youhaveprobablyfound that thefinancefunction inyourorganisation imposesmore,andmoredetailed,requirementsthananyotherdepartment.Thiswillbereflectedjustasmuch in theproceduresforobtainingapprovalfornewprojectsas in therulesforreporting thefinancialoutcomesofexistingactivities.

You may find it surprising that the finance function not only seemsto have the final say on major new projects, but also lays down

very detailed rules about such apparent trivia as the layout of formsfor reclaiming petty cash expenses. In particular, ifyouwork for alarge company (or for a government department),you may findthat such forms call for all sorts of information about expensecodes, cost centres and sub-centres.You may be tempted to

wonderwhether the expense of collecting all this information isworth the effort. Later in this unitwewill consider in more detailthe important link between collecting internal data and therequirement to provide intelligible information to external providersof finance. For the moment, however,we just need to identify ingeneral terms the relationship between the big picture and the finedetail between strategy and tactics because this explainsanother peculiarity of the finance function in a large organisation.There is an old saying that the first and most importantrequirement of any statement of long-term strategy is: Surviveuntil nextweek. Or, in thewords of an Indianapolis 500winner:In order to finish first,you must first finish. If an organisation does



25/92


not have enough money to pay the immediate bills, the bestlong-term financial strategy in theworldwill be of no benefit to it.But strategy is more than just surviving to the end of theweek,everyweek; strategy is more than, and different from, theaggregation of many short-term tactical moves. This much maybe familiar enough toyou.What is different about finance is thatthere is frequently a tension, or even an outright conflict, betweenlong-term strategy and the dictates of short-term survival. Thereason for this is that most major financial decisions and allinvestment decisionswithout exception involveweighing up thecertain sacrifice of immediate spending-power against uncertainfuture gains. Fromyour earlier studies, or fromyour practicalexperience,you are probably familiarwith the general debateabout the appropriate time-horizon to adopt in considerationsof strategy. Infinancial strategy, that general debate becomesa burning issue. The difference between adopting a five- anda seven-year horizon, for example, can make all the differencebetween approving and rejecting a major project.

A further difference between finance and some other functionaldisciplines is that in finance the chain of command between those

who formulate strategy and thosewho implement it on a day-today basis can bevery short or possibly even non-existent. Eveninvery large companies, the senior executives responsible forformulation of financial strategy retain a surprising degree ofinvolvement in the nitty-gritty of implementation. This iswhy inthis courseyouwill encounter an unusual amount of detail for acoursewith strategy in its title. In order to have credibility andself-confidence in dealingwith the finance function ofyourorganisation,you need to have a good grasp of the broad pictureandof thefinedetail.In almost any organisation the finance department enjoys a positionof special prominence.Whether in central government or in privateenterprise, it has unique powers to provide the money for andhence to control other departments activities; it also has to keepthe score through its responsibility for maintaining accounts andsetting and monitoring budgets. This iswhyyouwill probably findthat,whatever organisationyouwork for,you have to providemore information, more regularly, and in more detail, to thefinance department than to any other. This reliance is, though, atwo-way street. Typically, the finance department is responsible foractually raising the funds needed by the organisation the board

will set the funding strategy but itwill be implemented andoperated by the finance area and this requires the provision ofinformation to potential investors (and analysts, financial journalists,etc.).Without a regular and accurate stream of data from the rest ofthe organisation, the finance team cannot fulfil this task properly.

At best this is likely to raise the overall cost of capital; atworst itcould start to starve the business of funds for investment.



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F I N AN C E AND AC C OUNT I NG 2 . 2 Information and control are key issues in finance. Investorsneed information in order to make rational investment decisions,to track the progress of their investments, and to monitor therisks and returns of alternative investments. Users of financeneed information about the availability and cost of funds, andabout the reporting and management constraints that investorsmay impose on their freedom of action.Without an efficientflow of information, both investors and users may make baddecisions decisions that are bad for themselves, bad forthe other group and bad for the economy as awhole.The primary meanswhereby any organisation communicatesinformation to the outsideworld about its financial condition andperformance is through its accounts, as given in theAnnual Reportand other public statements. Corporate governance is the namegiven

to

the

control

mechanism

whereby

the

finance

providers

monitor and direct the activities of the managers,who put theirfunds to productive use. So there is a close three-way connectionbetween finance, accounting and corporate governance. Thepurpose of this section is to examine that relationship in moredetail.

OPTIONAL ACTIVITY 2.2Ifyou feelyour knowledge of basic accounting is rusty,youshould nowwork systematically through the introductory CDFoundations of FinancialAnalysis.Your primary objectiveis to refreshyour memory about the basics of companyorganisation, accounting and reporting.Ifyou note down any terms that are unclear,you can thencheck in the Glossary for a cross-reference to the unitwherethat subject is discussed in more detail. Put a note in therelevant unit andwhenyou have finishedyour study of thatunit, check againyour understanding of the same topic on theCD Foundations of FinancialAnalysis.

The CD is based on UK practice. Patterns of business organisation,and the financial reporting and governance systems that supportthem,vary markedly between different countries, and evenbetween countries that are close to each other geographically andin terms of economic structure and development. Some of thereasons for these differences, and the resultingvariations infinancial reporting regimes, are described elsewhere in the course.But itwould be impracticable to provide a comprehensive guide,even ifwewere to restrict it to the major economies of theworld.Our aim has been to alertyou to the types of factor producingsuch differences, and to giveyou the tools to identify and evaluatethe consequences.



27/92


Finance and accounting are often regarded as closely relateddisciplines, not only in the academic sense, but also in the sensethat they sit closely together in most organisations. In a typical largecompany, they are usually sectionswithin the same department andcome under the responsibility of the finance director.Apart fromthe obvious fact that both functions are concernedwith money,

what is the exact nature of the connection between them? Perhapsmore importantly,what is the distinction between them, and arethere even potential conflicts between their demands?The most important and revealing difference between finance andaccounting is in their diametrically opposed perspectives. Finance isprimarily about decision making, and decision making is about thefuture.All the questionswe identified in the Introduction as beingcentral to finance relate to the future.Accounting, by itsvery name,is primarily concernedwith the past. Company accounts are socalled because in them the directorsaccount to the owners fortheir past stewardship of the companys assets and operations.So much for the difference. Butwhat about the connection?Rational decisions about the future rest on analysis of the past. Thatis not to say thatwe naively extrapolate past trends indefinitely intothe future, but only thatwe look to the past for clues as to howfuture events might unfold. So one starting point possibly themost important starting point of an analysis of a companys futureprospects is an examination of its past record.There is another polarity in the finance/accounting relationship,

whichwe can appreciate better ifwe look at how these twofunctions are typically organised in a large company. So farwehave considered the backward-looking perspective of accountingand the forward-looking perspective of finance. The second polarityrelates to the difference between an inward-looking and anoutward-looking focus.The finance function in an organisation is traditionally responsiblefor two sets of tasks. The first is the area of accounting andfinancial control, the second dealswith the actual management ofthe organisations financial resources. In a medium-sized or largeenterprise, these areas might have separate heads, typically calledthe financial controller and the treasurer, each reporting to theoverall head of the finance function. The financial controller isnearly always a qualified accountant,whereas the treasurer (whomay also have an accounting background) has extensive experienceas a practitioner in the financial markets. To the naked eye,as itwere, the financial controller looks like an inside man(orwoman),whereas the treasurer certainly has the air of one

who does deals in the outsideworld. Considering their respectivefunctions in more detail,we might find some or all of the followingresponsibilities under each of the two broad headings shown inTable 2.1.



28/92


Table2.1 Responsibilities forfinance andaccounting functions Financial controller Treasurerl Preparation of external annual

accounts l Raising short- and long-termexternal fundsl Preparation of internal monthly

management accounts l Management of liquidityl Preparation of capital and

revenue budgets l Minimisation of cost of externalfundsl Tracking of budget variances l Management of cash within the

organisationl Key relationship: auditors l Management of exposure to

financial risks interest-rateand foreign exchange

lKey

relationships:

existing

and

potential providers of funds,stock-market analysts, financialpress

Toanalysetheactivityofthefinancedivisioninthesetermsisperhapsnatural inviewof thedivisionofresponsibilitiesbetweenthetwokeysub-divisionalheads.Butamoreusefulanalysiswouldcutthepackofcardstheotherway,anddivideitintointernalandexternalfunctionsasinTable2.2.Table2.2 Internal andexternal finance andaccounting functions Internal Externall Management of liquidity l Raising short- and long-term

external fundsl Management of cash within the

firm l Preparation of external annualaccountsl Preparation of internal monthly

management accounts l Minimisation of cost of externalfundsl Preparation of capital and

revenue budgets l Management of exposure tofinancial risks interest-rateand foreign exchange

l Tracking of budget variances l Key relationships: existing andpotential sources of funds,stock-market analysts, financialpress, auditors

This

analysis

highlights

more

effectively

the

dynamic

two-way

feature of the finance function. Externally, it raises finance for thefirms operations, and accounts to the providers of finance primarilythrough the publication of periodic financial statements. Internally,



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it channels funds, both from external and internal sources,to those business areas that need it, and keeps track of howeffectively those funds are used to further the firms objectives bysetting budgets, approving capital expenditure and monitoringperiodic performance against budgets. In all of this, the financefunction has an overriding responsibility to control financial riskby identifying it, quantifying it andensuring that anymeasures takento limit or eliminate it meet the rigorous requirements ofa costbenefit analysis.

ACTIVITY 2.3Try to find out how the finance function inyour ownorganisation is structured. Canyou identify similarities ordifferences between it and the general schemewe have setout?Differencesmaybedue to therelativedependenceofyourorganisationonexternalsourcesoffinance,and to therelativecomplexityof itsfinancialstructure.Ifyouworkforadivisionofa largegroup, thefinancefunctionofyourowndivisionmaybeprimarilyconcernedwith theaccountingandcontrollingfunction,whileexternalfinancialrelationshipsarehandledcentrallybyagroup treasuryfunction.

We have seen that accounts and accounting are at the heart of anyfinancial information and control system. This may take the form of:l internal accounts, designed to help management exercise more

effective control over the organisations operations;orl external accounts, published for the benefit of investors,

creditors and other interest groupswho need to control ormonitor the organisations activities.

The course devotes awhole Block (Units 2 and 3,which togethercomprise

Block

2)

to

the

analysis

and

use

of

accounts

as

a

key

aid

to financial decision making. The emphasis is on the practicalapplication of accounting information. The course does refer tosome areas of continuing controversy in accounting theory, butonlywhen necessary to an understanding of the relationshipbetween accounting and finance.



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F I N AN C E AND C O R P O R AT E G O V E R N AN C E :AG EN C Y T H E O R Y

2 . 3 Current issues in corporate reporting and accountabilitywill makemore sense ifwe first sketch the historical background and clearup a basic question about the nature of ownership.

Aswe saw in the Introduction to the course, the opportunitiesoffered by the industrial revolution created the need for amechanism to attract capital from peoplewhowerewilling to buya stake in a firmwithout having to participate in the managementor expose themselves to unlimited financial risks. This mechanism

was provided by the limited liability company. Investors subscribea fixed amount of capital,which is also the limit of their liability forlosses. If the firm fails and there are insufficient funds to pay offthe creditors, the shareholders cannot be called upon to contributemore than the capital they have committed to subscribe. Theupside is that however big the surplus might be, either in terms ofannual income or on final liquidation, the shareholders get to keepall of it subject only to tax!

Thepubliccorporation[i.e.thelimitedliabilitycompany]isasocialinventionofvasthistoricalimportance.Itsgeniusisrootedinitscapacitytospreadfinancialriskover thediversifiedportfoliosofmillionsofindividualsandinstitutionsandtoallowinvestorstocustomiserisktotheiruniquecircumstancesandpredilections.Bydiversifyingrisksthatwouldotherwisebebornebyowner-entrepreneurs,andbyfacilitatingthecreationofaliquidmarketforexchangingrisk,thepubliccorporationloweredthecostofcapital.Thesetradableclaimsoncorporateownership(commonstock)[i.e.ordinaryshares]alsoallowedtherisktobebornebyinvestorsbestabletobearit,withoutrequiringthemtomanagethecorporationstheyowned.

(Jensen,1989)The legislatorswho created the statutory framework for the limitedliability company also recognised the need for certain safeguards.If creditorswere to be denied unlimited recourse to the assets ofa companys shareholders, then they should be entitled to knowhow

likely

it

was

that

the

company

would

be

able

to

meet

its

obligations from its own resources. So therewas a clear need formandatory disclosure of a companys financial condition, for thebenefit of the business community and society at large.Butwhat about the shareholders? Towhat extent do they alsoneed protection from their own appointed agents, the directors?In order to answer this question,we need to examine morecritically the proposition that shareholders own the company.



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BOX 2.2TEST OF POSSESSIONHow do you tell whether you own an umbrella, let alonea company?Iownmyumbrella.Andcompaniesareownedbytheirshareholders.Butwhatdowemeanwhenwesaythat?Whatdoes,orcould,thewordownmeanwhenapplied,nottotherelationshipbetweenmeandmyumbrella,buttothatbetweenhundredsofthousandsofshareholdersandthecollectionofpeopleassets,brandsandcustomersthatconstitutesBritishTelecommunications(BT)?Theclassicdescriptionofthenatureofownershipwasprovided40yearsagobythedistinguishedlegaltheorist,A.M.Honor.Conceptsofownershipvaryacrosscountriesandovertime.ButHonorargued,thereisindeedasubstantialsimilarityinthepositionofonewhoownsanumbrellainEngland,France,RussiaandChina.Inallthesecountries,theownerofanumbrellamayuseit,stopothersusingit,lendit,sellit,orleaveitbywill.Nowheremayheuseittopokehisneighbourintheribsorknockoverhisvase.Honorexplainedthatownershipisneitherasinglenorasimpleconcept.Ownership,likefriendship,orobligation,hasmanycharacteristics.Ifarelationshiphassufficientlymanyofthese,itisonewecandescribeasownership:justasifananimalhasenoughelephant-likefeatures,wesaythatwhatweseeisanelephant.Honor went on to list 11 badges of ownership. Ownership typicallyconfers

the

right

to

possess,

the

right

to

use

and

the

right

to

manage. Ownership entitles you to any income that is earned, andto claim the capital value of the asset. Ownership imposes anobligation to refrain from harmful use.What you own can be seized to satisfy your unpaid debts. Ownersmay claim security against expropriation. And owners can pass onany or all of their rights to someone else. There is no time limit onthe rights of ownership. And owners have an ultimate right ofresidual control. All rights which you have not explicitly concededto someone else belong to you.That is what we mean when we say I own my umbrella. I can putit up, take it down, sell it, rent it, leave it in my will, throw it away.I can appeal to the police or the European Commission on HumanRights if a thief or the government takes my umbrella away. AndI must accept responsibility for its misuse and admit the right of mycreditors to take a lien on it.When we run through these tests, we see immediately thatshareholders own their shares in BT. All the criteria of ownershipare met. But it is not at all obvious that they own BT itself.



32/92


Their shareholding gives them no right of possession, no right ofuse. If they go to a telephone exchange, they will be turned awayat the door. They have no more right to use BT services than anyother customers. They are not responsible for BTs harmful actions,and BT assets cannot be used to satisfy their debts.Shareholders do not have the right to manage, although they dohave a largely theoretical right to appoint the people who do.They have a right to such part of the income as the directorsdeclare as dividends. They have no right to the proceeds of thesale of BT assets, except in the wholly fanciful event of theliquidation of the entire company, in which case they will get whatvalue is left, but not much.The application of another of Honors tests the right ofshareholders to contest the appropriation of the companysassets was the key issue in a leading case in corporate law,Short

v.

Treasury

Commissioners.

Their

lordships

went

on

to

say,

in unequivocal terms, shareholders are not, in the eyes of the law,part owners of the company.And the House of Lords was right. Of the 11 tests put forward byHonor, the relationship between BT and its shareholders satisfiesonly two, and these are rather minor. Three tests are satisfied inpart and six are not met at all. We could make a stronger case forasserting that BT is owned by its directors.So who does own BT? The answer is that no one does.There are many different kinds of claims, contracts and obligationsin modern economies, and only occasionally are these welldescribed by the term ownership.Characteristic Me andmy

umbrella Me andmyBT share Me andBTRight to manage 3 3 PartialRight of posession 3 3 7Right of use 3 3 7Right of income 3 3 PartialRight to capital 3 3 PartialPower to transfer 3 3 7Security from expropriation 3 3 7Must refrain from harmful use 3 3 7Can satisfy debts 3 3 7No limit of time 3 3 3Right of residual control 3 3 3



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The differences between BT and my umbrella are so wide rangingthat it is hardly likely that my relationship to them could bedescribed in the same way. We have been made victims of aninappropriate analogy.AsCharlesHandyputsit,whenwelookatthemoderncorporation,themythofownershipgetsintheway.(Source: Kay, 1997)

The Kay article makes it clear that shareholders do not own thecompany in any everyday sense of theword. In the UK andelsewhere, company legislation has been based on the premise thatshareholders are separate from, and external to, the company itself.They are a stakeholder group, albeit a special one, and their rightsand

obligations

vis--vis

the

company

and

its

managers

need

to

be

regulated just as much as those of other stakeholders such ascreditors and employees.

Apotentialforconflictbetweenshareholders(owners) and managersexistedfromtheearliestdaysofthelimitedliabilitycompany,butitremainedinthebackgroundformostofthetwentiethcenturybecauseofthemorepressingproblemscreatedbytheevenolderconflictbetweencapitalandlabour.Thesteadydeclineoforganisedlabourasastakeholderforcefromabout1980onwardswasonereasonwhytheowner/managerconflictbegantoattractwiderpublicattentionafteryearsasaprimarilyacademicconcern.It is natural to assume that the shareholders objective is tomaximisewealth in the form of dividends and capital appreciationof their shares. The interests of managers are more difficult toidentify and may be less homogenous, but aworking hypothesismight be that they seek to maximise their ownwealth and security

with the minimum of effort.The conflict of interest inherent in this situation has been dealt

with in the academic literature by agency theory.The agency relationship is defined byJensen and Meckling(1976) as:

acontractunderwhichoneormorepersons(theprincipals)engageanotherperson(theagent)toperformsomeserviceontheirbehalfwhichinvolvesdelegatingsomedecision-making authority totheagent.

Agency theory is an attempt to create a formal framework todetermine the optimal contract between principal and agent. Itassumes that both the principal and the agent are rationalindividuals seeking to maximise their own perceived self-interest.If

the

principal

can

observe

all

of

the

agent

sactivity,

or

can

determine the effects of the agents actions and the information on

which the agents decisions are based, the problem is a relativelyminor one.



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The problem becomes more complexwhenwe consider twoadditional factors that almost always apply to real-world agencyrelationships.l information asymmetry

The information available to the agent is not the same as theinformation

available

to

the

principal.

l uncertainty

The principal does not know onwhat information the agentsdecisions are based, or towhat extent the outcome of theagents activity is determined by the agents decisions and to

what extent by factors outside the agents control.These factors can create two separate problems.l adverse selection

The agent no longer makes the best decision for the principalbut makes the decisionwhichwillappear best to the principal(in the principals imperfect state of knowledge)while actuallyserving the private interests of the agent.

l moral hazard (or hidden action)An agentwho knows that his actions cannot be exactlymonitoredwill tend to act in the agents best interests,irrespective ofwhether this is optimum for the principal.

While the formal articulation of agency theory is relatively recent,the problems associatedwith the principal/agent relationship havelong been recognised. Examples abound in ancient Greek andRoman literature and (perhaps more surprisingly) in the holy booksof theJewish and Christian religions. More recently, Shakespearehad thesewords ofwisdom on the subject:

NeitheraborrowernoralenderbeForloanoftlosesbothitselfandfriend

Andborrowingdullstheedgeofhusbandry(Shakespeare,HamletAct I Scene (iii))

In this short passage he makes two telling observations,which areas topical now as theywerewhen Shakespeare penned them400years ago.l If an investment transaction between friends turns sour, the

friendship may be as much a casualty as the lost investment.l Reliance on external funds can dull the edge of husbandry, or

in otherwords a manager might be more careless in hisstewardship of others resources entrusted to him than in thecare of his ownwealth.



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ACTIVITY 2.4Consideryourownorganisationinthelightofwhatyouhavejustreadaboutpossibleconflictsbetweenmanagersandowners(shareholders)orotherexternalfinancialstakeholders.Howaresuchconflictscontrolledinthecontextofyourorganisation

ssystemofcorporategovernance?Areyouabletopositivelyidentifyinstanceswheresuchconflicthasledto

sub-optimaldecisionmakingbymanagersordirectors?The range of possible findings from this activity isverywideindeed, and mayverywell raise points thatyou feel reluctantto discusswith other students! Nevertheless,you might havefound caseswhere a particularly influential or forcefulmanager has pushed through a pet proposal that he or shewould like to see on their CV butwhose benefits for theorganisation as awhole are perhaps less obvious. Onamore

complex

level,

you

might

come

across

attempts

to

massage accounting figures in order to achieve targets thattrigger bonus payments or the issue of share options.

The drive to find practical solutions to the problems identified byagency theory has progressed simultaneously on two separatefronts. The problem of information asymmetry has been addressedby imposing ever-increasing disclosure requirements on companymanagement,while the more glaring conflicts of financial interestbetween shareholders and directors have been tackled by creatinga closer correlation between company performance (as measuredby increase in shareholdervalue) and directors remuneration.Inthelate1980sarangeofconcernsaboutthewaydirectorsmanagedpubliccompanieshademergedintheUKand,tovaryingdegrees,elsewhereintheindustrialisedworld.Thesehadtheeffectoffocusingthesustainedattentionofthebusiness,academicandregulatorycommunityoncorporategovernancetoanunprecedentedextent.Wecandefinecorporategovernanceasthesetofrulesgoverningthewaythedirectorsinteract(a)witheachotherintheeffectivemanagementof

the

company

and

(b)

with

the

shareholders

in

their

accounting

for

theirstewardshipofthecompany.The following are the main corporate governance problems to havesurfaced in the last twentyyears of the twentieth century.l Directors remunerationwas either excessive or insufficiently

linked to performance, or both.l Directorswere not generally acting in the best interests of the

company.l Directorswere effectively unaccountable to shareholders.l Somecompanyboardsweredominatedbyasingleindividualor

byasmallgroupofindividualswithinthewiderboardofdirectors.l Non-executive directors,who should act as a check on the

full-time executive directors, lacked genuine independence.OU BUSINESS SCHOOL 35


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l Private and small shareholders seemed to be powerless.l Institutional investors received private briefings and preferential

treatment.These problems have surfaced in differentways in differentcountries, so it is not surprising that the attempted solutions havealso been quitevaried.We make some brief comments now on thecontrastingways inwhich the UK and Germany have addressedthese problems. In Block 2youwill read more about how theauthorities in the US have tackled the same issues.IntheUK,theLondonStockExchangeandotherregulatorshavebeensystematicallyaddressingtheseproblemsofcorporategovernancesince1990.Thefirstcommitteetolookintotheseproblemswassetupin1991bytheStockExchange,theFinancialReportingCouncilandtheaccountancyprofessionunderthechairmanshipofaleadingindustrialist,SirAdrianCadbury.TheresultingCadburyReportmadealarge

number

of

recommendations

aimed

at

preventing

the

abuses

listedabove.Afurtherreportin1995,theGreenburyReport(namedafteritschairman,whowasalsochairmanofMarksandSpencer),concentratedonthequestionofdirectorsremuneration.In1998thetworeportswerecombinedandfine-tunedintheHampelReport,

whichledinturntothepublicationoftheCombinedCodeofgovernancein1999.(ThesefourreportscanbefoundonTheFinancialServicesAuthorityswebsitewww.fsa.gov.uk.The2003versionoftheCombinedCodeisavailablethroughtheB821website.)TheCodecoversboththetheoreticalbasisandthepracticalapplicationintwopartsentitledPrinciplesofgoodgovernanceandCodesofbestpractice

.

The cumulative effects of these committeeswork can be seen inany large listed companys published annual report,with lengthysections now devoted to the details of corporate governance and todirectors remuneration.

While the drive towards greater transparency and accountability inthe UK has been left in the hands of private-sector regulators suchas the Stock Exchange and the accountancy profession, theequivalent development in Germanywas marked in 1998 by thepassing of a new law, theGesetzzurKontrolleundTransparenzimUnternehmensbereich (Law on control and transparency inbusiness), or KonTraG for short. Thiswas a response to seriousand mounting criticisms of managers, members of supervisoryboards and auditors, and reflected the increasing pressure towardsinternational harmonisation of reporting and governance standards.Thisworkwas continuedwith the publication in 2002 of acomprehensive and partly mandatory code of best practice incorporate governance (Der Deutsche Corporate GovernanceCodex),which is available in translation on thewebsite of theGerman Ministry ofJustice (www.bmj.bund.de). Despite all this increased regulation and disclosure, serious doubtsremain about how effective they are in achieving their basicobjectives of ensuring that directors manageandareseen to



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manage their companies in accordancewith the shareholdersinterests. Huge efforts have been made to ensure that directorsown remuneration is aligned to the long-term health of thecompany rather than to the attainment of short-term goals. Butacademic and other studies continue to show that the link betweenlong-term corporate performance and directors pay is still far fromperfect. No solution hasyet been found to the basic problem that itis impossible to measure how far the performance of a companyand its share price is due to the efforts of its directors and how farto external forces beyond their control. Some companies do try tojudge directors performance using measures relative to those of agroup of peer companies, but this is notyetvery common and hasnot, so far, been empirically demonstrated to solve the problem.

Also, as the repeated corporate scandals that emerged during 2002to 2004 (for example, Enron,WorldCom and Parmalat)vividlydemonstrated, to resolve the conflict of financial interest betweenshareholders and directors by linking the latters remuneration toshareholder returns might solve one problem only by creatinganother much larger one. Through their responsibility for theaccounts of the company, the directors also have control overarguably the biggest single influence on the companys shareprice its reported performance.

ACTIVITY 2.5Use the internet to search officialwebsites and nationalnewspapers online archives for recent news stories andcommenton the evolution of corporate governance inyourown country or industry. Try to identify the general themesthatwe have described, and lookout for local or sectoraldifferences in the problems and the attempts to solve them.You have access to suitable sources (with appropriate searchfacilities) through the OU Librarys electronic provision, andthere is a link to Open Library on the B821website.This isa topicalandcontentious issue inmosteconomiesand industries.AsyouprogresswithyourstudyofB821,youwillfind ituseful towatchoutforfurtherdevelopmentsandadd

to

your

collection

of

press

cuttings

and

related

materials

from the internet.

S UM M AR Y Finance studies the relationship between the organisation and a keyexternal stakeholder group the providers of financial resources.Finance is also about money, and money has a unique triple roleas a medium of exchange, a store ofvalue and a unit of account. Ittherefore plays a pivotal part in the principal function of anyorganisation the transformation of input resources into outputs.



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Almost all major issues in finance can be reduced to just twoquestions.1 Which projects should the organisation invest in?2 How should they be financed?Four prominent themes running through finance are:1 information and control2 investment return3 investment risk4 market efficiency.In this sectionwe looked at the first of these information andcontrol extending the discussion to consider governance. Toexercise control one must have information (and be able tounderstand it), and, in practice, there is a risk of this beingproblematic because the agents (management) usually oversee theprovision

of

information

to

their

principals

(owners,

shareholders).

Agency theory gives us a modelwithwhich to understand thedynamics of this relationship,which in turn helps us to set upsystems designed to minimise any conflicts of interest.The finance function of an organisation occupies a special place inthe structure because it both controls the external procurement andinternal allocation of resources, and keeps the score settingbudgets, tracking performance against budget and reportingoutcomes to external stakeholders through its accounting. Financeis therefore a key determinant of the big picture and, at the sametime, has a close interest in the fine detail of an organisationsday-to-day activity.There are close links between finance, accounting and corporategovernance. Finance and accountingappear to have a diametricallyopposed focus because accounting is backward-lookingwhereasfinance is about decisions affecting the future. But in fact they areclosely related because accounts provide much of the basis ofhistorical data onwhich financial decisions are made.Just asfinance has an external and an internal dimension in the firm, soaccounting can have an external or an internal focus in the shapeof published financial accounts and internal management accounts.

An organisations system of corporate governance provides thebasic framework for the external providers of finance to receiveinformation about how their funds are being used, and to exercisea degree of control over the full-time managerswho are entrusted

with their stewardship. There is a potential conflict of interestbetween the providers of finance (the principals) and their agents(the managers) that is aggravated by the asymmetry of informationbetween them. Despite an ever-increasing regulatory burden ofreporting and accounting, these conflicts continue to give problemsin most of theworlds major economies.



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3R ETU R N ON I N VESTM EN T 3 RETURN ON INVESTMENT

In the introduction to this unitwe posed four of the key questionsin finance. The secondwas:l What is a fair return for the providers of finance to receive for

the use of their savings?We also said, in Section 2, that nearly all significant financialdecisions can be reduced to just two major questions.1 Which projects should the organisation invest in?2 How should the organisation procure the funds to pay for

them?In this sectionwe explore the connections between these questionsby examining in detail the idea of return on investment (ROI).

A key function of money is to enable economic decision-makingunits (firms, households and other organisations) to bring forwardor to put back their spending plans; that is, to shorten or lengthenthe period ofwaiting before incurring some planned expenditure.

A basic objective of finance theory is to understand this process;finance is therefore about the transfer ofwaiting.This section is devoted to the basic mechanics of the return oninvestment. In Section 4we shall explore the associated concept ofrisk.We shall then end these sections on return and risk byshowing how the techniques of discounted cash flow and netpresentvalue enable the investor to evaluate the risk and returncharacteristics of investments in a theoretically rigorousway.

We startwith an observation about terminology.We already said inthe units introduction that theword return has subtly differentmeanings in everyday usage and as a technical term in finance.l

Whenwe

talk

about

the

rate

of

return

(or

the

return

) on an

investment for a particular period,we are usually talking aboutaperiodicpercentage rate, not amoneyamount. Ifyou invest100 for oneyear and receive a total of 110 at the end oftheyear,wewould say that the return onyour investment is10%perannum(i.e.peryear),not10. IfaTMAorexaminationquestionasksyou tocalculateareturn,remember thatyouarenormallyworking towardsananswerexpressedaspercentperannum.

l You should assume, unless something in the context suggestsotherwise, that the return on an investment is the total returnon the investment. For instance, in the case of a share in



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a company, the total return for any period is the sum of anydividends paid during that period,plusorminus the capitalgain (or loss)arisingfrom the increase (ordecrease) in thevalueof theshare. So ifyou buy some shares for 100, and atthe end of theyear receive a dividend of 10 but can sell theshares themselves for only 98,we say that the return onyourinvestment is 8% per annum. The total amountyou can realisefromyour investment is 10 plus 98,which is just 8% morethanyou invested ayear earlier.

ACTIVITY 3.1Before studying the restof this section,you should reviseVitalStatistics, Section 4, Investment appraisal, up to the end of section 4.3.2. Make sure thatyou complete Exercises4.1 to 4.7 and checkyour results against the answers providedin the backofVitalStatistics.In the Introductionwe mentioned that thevariety of termsused in the contextof different financial transactions andmarkets can be bewilderingly large, but the number ofdifferent mathematical operations involved is really quite small.Asyouworked through the section ofVitalStatistics, didyounotice that althoughyouwere meeting all sorts of technicalfinancial terms (for example, mortgage, annuity, perpetuity)youwere nearly always performing the same mathematicaloperation? In different disguises, the basic equation forcalculating the presentvalue of a future cash flow underlaynearly allyour calculations:

CPV =

(1+r)twhere PV is the presentvalue, C is the nominal future cashflow, r is the required discount rate, and t is the number ofdiscounting periods (time) to the date of the future cash flow.

I N V E S T M E N T R E T UR N UN BUN D L E D 3 . 1 The timevalue of money is arguably the single most basic conceptin thewhole theory and practice of finance. Confrontedwith thechoice between receiving 100 today and receiving the sameamount in ayears time, nobodywould normally choose towait forayear.Without the timevalue of money, all further discussionabout investment returnswould be redundant. It is the keystone

withoutwhich thewhole structure of financewould collapse.



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ACTIVITY 3.23 RETURN ON INVESTMENT

Youwill be aware that different types of saving, investmentand borrowing carry quite different rates of return. Identify(a) two popular types of investmentor saving, and (b) twopopular forms of borrowing.What rates of return areassociatedwith each? Canyou explain the differences?Aswiththe earlier activities in this unit,you are encouraged to drawon avarie

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