SOLUTIONS MANUAL

CHAPTER
Overview of Financial
1 Management

1 Financial management knowledge is important to a firm in that the following questions would
have to be answered:

What sort of fixed assets should a firm invest in?

To answer this question, one has to be familiar with the nature of the business of the firm and the
industry it operates in, plus the plans and strategies of the firm concerned. This issue is typically
addressed under the heading of capital budgeting, which describes the process of making and
deciding on which fixed asset or business opportunity to invest in.

How shall firms raise the necessary funding to finance the capital expenditure once a decision
has been made as to the type of fixed asset or business opportunity to invest in?
This question is addressed when one looks at the long term debt and equity of a firm. One has
to consider capital structure of the firm, i.e. what shall be the proportions of debt and equity
sources of financing that a firm shall have. The finance manager would hence need to appreciate
the types of long term finance available to a firm; the respective characteristics, advantages and
disadvantages of each type of finance.

How shall a firm manage its short term operating cash flows?
A finance manager must ensure that there is adequate operating cash flows in the firm at all
times. This can be difficult as the amount and timing of operating cash flows may be uncertain.
The finance manager must be able to manage any gaps, shortages and excesses in operating cash
flows. He/she must develop the capability to manage the firm’s net working capital, comprising
current assets and current liabilities – working capital management.

Alternative answer:
Financial management involves:
(a) Raising capital to support a firm’s operations and investment programmes
(b) Managing a firm’s day-to-day cash flows (e.g. receipts from customers and payments to
suppliers; determining optimal holdings of short term assets such as cash and inventory;
developing short and medium term financial plans to ensure adequacy of financial
resources)
(c) Identifying the best projects in which to invest a firm’s resources, based on each project’s
perceived risk and expected returns
(d) Managing a firm’s exposure to risk in order to maintain the optimum risk-return trade-off
and hence, maximize shareholder value
(e) Developing corporate governance structure capable of ensuring that managers act ethically
and in shareholders’ interests

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2 The role of a finance manager may be depicted diagrammatically:

Board of Directors

Chief Executive Officer (CEO)

Other departments Chief Financial Officer (CFO) Other departments

Duties:
• Corporate Strategic & Financial
planning
• Control firm cash flow
• Determine financial policy

Treasurer Controller
Duties: Duties:
• Capital budgeting & expenditures • Financial statements
• Financial planning • Cost and management accounting
• Sourcing and raising funds • Firm taxes
• Cash management
• Credit management
• Management of foreign currencies
• Risk management

You may also discuss the role of treasurer and controller.

Furthermore, the finance manager acts as an intermediary between the firm’s operations and the
financial markets. The figure below illustrates the flow of cash from investors to the firm, the use
of the cash by the firm, the subsequent generation of cash inflows into the firm in the future, and
the final payment of returns to the investors.

Finance manager and the flow of cash into and out of a firm.

Funds from
Investment Financial
financial markets
Firm’s assets Finance markets (debt
& operations manager and equity
Returns to holders)
Cash inflows
financial markets

3 If management focuses only on the existing share price, this can lead to finance managers
emphasizing on what impacts the share price in the immediate term. Generally then, finance
managers would be concerned about immediate (short term) profits as reported by the firm. This
is dangerous as the finance managers would be looking at actions/activities that can boost the

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firm’s profits, such as cutting costs, postpone long term investment (reduce capital outlay) and
sell assets. This can lead to increase in reported profits and return on assets in the near term, and
may have an immediate impact on share price.

However, the long term negative impact would be that the firm may be giving up on profitable
investment opportunities in the future (due to postponement of investments) or that future
operational capabilities may be affected (for example, costs cutting measures that are not
sustainable are implemented).

This can result in lower sales and higher costs in the future and hence, future long term profits
can be negatively affected.

4 The goal of the firm is to maximize the wealth of shareholders, because of:
(i) Practical reason
If finance managers act in the best interest of the shareholders when making decisions, then
financial decisions can be made much more simply and quickly.
(ii) Legal reason
Firms come into being due to the contributions and risks taken on by the shareholders. Their
position is also protected given the provisions of the Companies Act, 1965. Hence, finance
managers owe some kind of allegiance to the ‘owners’ of the firm.

Alternative answer:
Maximizing shareholders’ wealth has the following advantages over other alternative goals, such
as profit maximization as wealth maximization:
(a) Uses a long run perspective of the business
(b) Takes future cash flows into account
(c) Takes risks into consideration
(d) Does not rely on accounting numbers
(e) Considers time value of money

5 Other possible goals:

• Maximize sales and/or market share
• Minimize costs
• Maximize profits
• Achieve adequate profits – this is known as ‘satisficing’ where the manager earns reasonable
profits just to ‘satisfy’ the shareholders
• Ensure continued earnings growth (with minimum % growth targets)
• Catch up and overtake competitors
• Avoid financial distress and bankruptcy
• Survive
• Limited working hours and days in a week
• Achieve high reputation for product quality and service
• Achieve good employer–employee relations
• Be environmentally friendly – do not pollute
• Be ethical

6 It is summarized that in attempting to maximize the wealth of shareholders, finance managers must
ensure that the decisions that they make maximize the market value of the existing shareholders’
stock, which in turn is equated to efforts to maximize the value of the firm. Students and lecturers
shall elaborate on this answer.

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7 There exists a Principal-Agent relationship between the shareholders and management of a firm
(Agency Relationship).

This symbolizes the separation of ownership and control. The ownership of the firm lies in the
hands of the shareholders, whereas the control (management and running of the firm, making
important strategic and operational decisions) lies in the management team of the firm, typically
the directors.

The goal of managers would be to maximize their own wealth, (maximizing their salaries, fringe
benefits, number of share options etc). Hence, the key root of the agency problem is the non-
congruence or conflict of goals of the firm and management.

8 Possible solutions include:

(i) Provisions in the Companies Act, 1965
(ii) Selling shares and threat of takeover
(iii) Information flow
(iv) Linking management remuneration to improvements to shareholder wealth
Students and lecturers to elaborate

9 This may be achieved through linking management remuneration to improvements to shareholder

wealth.
• Linking performance targets and remuneration – commission, bonuses, increments
• Granting of share options to directors and management

10 (a) Profit maximization

The classical economic view of the firm is that it should be operated in a manner that
maximises its economic profits. This is however, not the same as accounting profit. There
have been many cases in the past of firms going into liquidation shortly after declaring high
profits. There are three three fundamental problems with profit maximisation as an overall
goal of the firm.

The first problem is that there are quantitative difficulties associated with profit. Maximisation
of profit as a financial objective requires that profit be defined and measured accurately, and
that all the factors contributing to it are known and can be taken into account. However,
there are many areas in accounting where judgement is required. This creates some elements
of subjectivity and perhaps, some inconsistencies in accounting treatments between firms.

The second problem concerns the timescale over which profit should be maximised. Should
profit be maximised in the short term or the long term? Given that profit considers one year
at a time, the focus is likely to be on short-term profit maximisation at the expense of long-
term investment. This may have adverse consequences on the long-term future prospects of
the firm.

The third problem is that profit does not take account of, or make an allowance for risk. It
would be inappropriate to concentrate all efforts on maximising accounting profit when this
objective does not consider one of the key determinants of shareholder wealth. Shareholders’
dividends are paid with cash, not profit, and the timing and associated risk of dividend
payments are important factors in the determination of shareholder wealth.

(b) Sales maximisation

If a company were to pursue sales maximisation as its only overriding long-term objective,
then it is likely to reach a stage where it is overtrading (see later topics). It might also eventually

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have to go into liquidation. Maximising sales may not necessarily result in a firm being able
to maximise the profits of the firm and sales targets could be disastrous if products are not
correctly priced. Maximisation of sales can be useful as a short-term objective, though. For
example, a firm entering a new market and trying to establish sustainable market share could
follow a policy of sales maximization. However, as should be noted by students, this is merely
a short term objective.

(c) Maximisation of benefit to employees and the local community

Some organisations adopt an altruistic social purpose as a corporate objective. They may
be concerned with improving working conditions for their employees, providing a healthy
product for their customers or avoiding antisocial actions such as environmental pollution
or undesirable promotional practices. While it is important not to upset stakeholders such
as employees and the local community, social responsibility should play a supporting role
within the framework of corporate objectives rather than acting as a company’s primary
goal. Although a firm does not exist solely to please its employees, managers are aware that
having a demotivated and unhappy workforce will be detrimental to its long-term prosperity.
Equally, in the case of a local community within which a firm operates, an action group
of local residents unhappy with a factory’s environmental impact can decrease its sales by
inflicting adverse publicity on the firm
(d) Maximisation of shareholder wealth.
Financial theories often stress that a firm’s objective should be to make decisions that
maximise the value of the firm for the benefit of its owners. Since the owners of the firm
are its shareholders, the primary financial objective of finance is usually stated to be the
maximisation of shareholder wealth. Since shareholders receive their wealth through
dividends and capital gains (increases in the value of their shares), shareholder wealth will be
maximised by maximising the value of dividends and capital gains that shareholders receive
over time.

By considering ‘maximisation of shareholder wealth’ as financial objective, this then focuses

the attention of financial managers and the firm in ensuring that shareholder wealth is
maximised by maximising the purchasing power that shareholders derive through dividend
payments and capital gains over time. Attempts to maximise shareholder wealth ensures that
the following variables are taken into account, which other objectives (such as sales and
profit maximization objectives) do not take into account:
• the magnitude of cash flows accumulating to the company;
• the timing of cash flows accumulating to the company;
• the risk associated with the cash flows accumulating to the company

11 Public listed companies are often extremely complex and require a substantial investment in
equity to fund them. Hence, they often have large numbers of shareholders. Shareholders in
turn delegate control to professional managers (for example, the board of directors and finance
managers) to run the company on their behalf. The board acts as agents. Shareholders normally
play a passive role in the day-to-day management of the company. This separation of ownership
and control leads to a potential conflict of interests between managers and shareholders. This
conflict is an example of the principal-agent issue.

The agency problem results from the separation of management and the ownership of the
firm. For example, a large firm may be managed by professional managers who have little or no
ownership in the firm. Because of this separation of the decision makers and owners, managers
may make decisions that are not in line with the goal of maximization of shareholder wealth.

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They may approach work less energetically and attempt to benefit themselves in terms of salary
and perquisites at the expense of shareholders

To manage the agency problem, students may discuss the following areas (refer to text):
(a) Provisions in the Companies Act, 1965
(b) Selling shares and threat of takeover
(c) Information flow
(d) Linking management remuneration to improvements to shareholder wealth

Other comments:
In general, the main cause of agency problem is the lack of goal congruence between shareholders
and managers. There are several ways to encourage goal congruence.

The first way is for shareholders to monitor the actions of management. There are a number of
possible monitoring devices that can be used (but they incur costs in terms of both time and
money. These monitoring devices include the use of independently audited financial statements
and additional reporting requirements, the shadowing of senior managers and the use of external
analysts.

An alternative to monitoring is for shareholders to incorporate clauses into managerial

contracts which encourage goal congruence. Such clauses formalize constraints, incentives and
punishments. An optimal contract will be one which minimises the total costs associated with
agency. These agency costs include:
• financial contracting costs, such as transaction and legal costs;
• the opportunity cost of any contractual constraints;
• the cost of managers’ incentives and bonus fees;
• monitoring costs, such as the cost of reports and audits;
• the loss of wealth owing to suboptimal behaviour by the agent.

Managerial contracts for such companies may therefore include bonuses for improved
performance. Owing to the difficulties associated with monitoring managerial behaviour, such
incentives could offer a more practical way of encouraging goal congruence. The two most
common incentives offered to managers are performance-related pay (PRP) and executive share
option schemes

12 (e)

13–14 Students to follow the web-links and would need to explain the points that they have noted
from the web-links. Answers to vary.

15 Note: The share price should be RM4.00 instead of RM42.00.

(a) LOEL Retail Bhd can be said to be suffering from ‘agency problem’ owing to several issues:
• The company’s average annual share price growth over the past five years of 5% falls short
of the conglomerate sector average annual share price growth rate of 9% over the same
period. Shareholders might get the impression that the growth potential of the company
pales in comparison to the industry average and that this may be due to the management
not acting in the interest of the shareholders.
• The company directors’ average annual salary is significantly higher than the average salaries
in the conglomerate sector. The question is: are the directors of the company significantly
being overpaid? This question becomes especially so when the growth rate of the company
is lower than that of the conglomerate sector, as mentioned in the earlier point.

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• The directors of the company are employed on a five year rolling contract basis, which is
relatively longer than the typical industry practice of being on a three year rolling contract
basis and provide a better comfort for the directors of LOEL. This may mean that the
directors are only under pressure to perform in the 4th and 5th year of their period of
contract, whereas the directors of conglomerates worry over a shorter term period since
their performance would be under review earlier for the purpose of contract renewal.
• Another factor to consider may be that the directors of the company are interested in the
short term performance of the firm. The current share price is RM4.68. The directors have
been given options that allow the said directors to purchase shares at a price of RM4.00.
Directors may therefore feel that they should act and make decisions sufficiently to ensure
that the share price does not fall below the price of RM4.00. Otherwise, the directors
would not find it attractive to exercise the share option.

(b) Certain steps may be taken to address the agency problem:

(i) Align the remuneration of the directors of the company with the industry average
(ii) Reduce the contract period of employment from five years to three years. This may
keep the directors on their toes in terms of performance, as the contract of employment
would come up for renewal within a relatively shorter period (compared to the current
practice).
(iii) Set targets of performance to be met by the directors. When the targets are met or exceeded,
then the remuneration of the directors are correspondingly increased (performance
related pay).

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