Corporate Finance

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Advanced Diploma in

Business Management

CORPORATE FINANCE

The Association of Business Executives

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CORPORATE FINANCE

Study Unit 1

The Context of Corporate Finance

Page

Introduction 2

A. Basic Principles of Companies 3

Types of Company 3

Regulatory Framework for Companies 4

B. Financial Objectives 6

The Prime Objective 6

Valuation of Companies 7

Shareholder Value Analysis (SVA) 8

Long-term Versus Short-term Objectives 8

Objectives of Multi-National Companies 8

Objectives of Public Sector Organisations 8

C. Corporate Governance 10

Company Stakeholders 10

Management/Shareholder Relationship and Agency Theory 15

The Cadbury Report 16

The Greenbury Report 18

Hampel Committee Report 19

The Combined Code 19

The Turnbull Report 21

Financial Services and Markets Act, 2000 and the FSA 22

The Higgs and Smith Reports 22

Other Disclosure and Behaviour Compliance Provisions 24

D. Corporate Financial Management 24

Financial Decision Making 24

Financial Functions in Organisations 25

The Role of the Finance Manager 26

Planning 28

Forecasting 29

Budgeting 29

Cash Management 30

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INTRODUCTION

Corporate finance covers a wide range of topics and functions within an organisation. The three main areas we will look at in this course relate to answers to the following questions:

 Which investments should the firm undertake?

 How, where, when and how much finance should be raised?

 How should the firm's profits be used or distributed? These questions are more commonly referred to as: (a) The investment decision

(b) The financing decision (c) The dividend decision.

In making such decisions, the firm must ensure that it achieves its objectives. Central to this first unit, then, is the issue of what the objectives of companies are. This is our first main area of study.

The prime objective is often stated as the maximisation of shareholder wealth. This would imply that companies must be run in the interests of shareholders. However, there are a range of interests involved in the way in which companies are managed. We shall examine these in the second main section of the unit and consider, in particular, the importance of the stakeholder concept and the tensions that arise from the different interests involved.

Finally, we turn to the scope of corporate financial management. We shall develop the issues of financial decision-making referred to above and consider their implications for the range of financial functions carried out in modern organisations and the roles required of the finance manager.

The modern financial manager also needs to consider two different issues:

 Risk. Some of the financial decisions made will incur little risk, for example, investing in Government backed bonds, but other areas of investment, such as investing in derivatives, will incur a lot of risk. There is a balance to be struck between the return that can be expected and the risk involved with the particular investment concerned.

 The strategic role of the modern financial manager. There is an ever increasing need in the modern business world for key staff, including the financial manager, to play a key role in the strategic vision and environment within which the business is operating. There needs to be input at all three levels of strategic involvement – ie at a strategic level for broad issues, at a business or competitor level in respect of how strategic vision can be turned into reality, and at an operational level for how the broader plans can be turned into operational success.

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A. BASIC PRINCIPLES OF COMPANIES

We shall start by reviewing two fundamental concepts relating to companies which underpin much of our studies.

Types of Company

When a company is formed, the person or people forming it decide whether its members' liability will be limited by shares. The memorandum of association (one of the documents by which the company is formed) will state:

 the amount of share capital the company will have; and

 the division of the share capital into shares of a fixed amount.

The members must agree to take some, or all, of the shares when the company is registered. The memorandum of association must show the names of the people who have agreed to take shares and the number of shares each will take. These people are called the

subscribers.

A company is a separate legal entity, which means that it may take legal action against its shareholders or vice versa. Limited liability companies have capital divided into shares. If a shareholder has paid in full for his or her shares, then liability is limited to those shares. This is the concept of limited liability.

The two main classes of limited company are public and private companies: (a) Public companies

Company legislation defines a public company as one which:

 Has an authorised share capital of at least £50,000;

 Is trading a minimum of £50,000 issued share capital

 Has a minimum membership of two (there is no maximum);

 Has a name ending with "public limited company" or plc.

Not all public companies have shares which are traded on the Stock Exchange. Those traded on the Stock Exchange are known as quoted or listed companies.

(a) Private companies

A private company can be formed by two or more persons. They are often smaller or family owned businesses. A private company:

 Can have an authorised share capital of less than £50,000, although there is no maximum to any company's authorised share capital and no minimum share capital for private limited companies.

 Cannot offer its shares for sale to the general public.

You may know of private companies which have become public companies and have started to trade on the Stock Exchange. An example was the clothing retailer Laura Ashley which started life as a family owned private company.

The amount of share capital stated in the memorandum of association is the company's "authorised" capital

 A company can increase its authorised share capital by passing an ordinary resolution (unless its articles of association require a special or extraordinary resolution). A copy of the resolution – and notice of the increase on Form 123 – must reach Companies House within 15 days of being passed.

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 A company can decrease its authorised share capital by passing an ordinary resolution to cancel shares which have not been taken or agreed to be taken by any person. Notice of the cancellation, on Form 122, must reach Companies House within one month.

Issued capital is the value of the shares issued to shareholders. This means the nominal value of the shares rather than their actual worth. The amount of issued capital cannot exceed the amount of the authorised capital.

A company need not issue all its capital at once, but a public limited company must have at least £50,000 of allotted share capital. Of this, 25% of the nominal value of each share and any premium must be paid up before it can can get a trading certificate allowing it to

commence business and borrow.

A company may increase its issued capital by allotting more shares, but only up to the maximum allowed by its authorised capital. Allotments must only be done under proper authority.

 A public company may offer shares to the general public. Share offers to the public are made in a prospectus or are accompanied by listing particulars.

 A private company is normally restricted to issuing shares to its members, to staff and their families, and to debenture holders. However, by private arrangement, the company may issue shares to anyone it chooses.

"Allotment" is the process by which people become members of a company. Subscribers to a company's memorandum agree to take shares on incorporation and the shares are regarded as "allotted" on incorporation.

Later, more people may be admitted as members of the company and be allotted shares. However, the directors must not allot shares without the authority of the existing

shareholders. The authority will either be stated in the company's articles of association or given to the directors by resolution passed at a general meeting of the company.

Regulatory Framework for Companies

The main legislation regulating companies is the Companies Act 1985 and the Companies Act 1989. The 1989 Act added to and amended the 1985 Act, but this is now being

superceded by the Companies Act 2006.

The 1985 and 1989 Acts have been changed in order to meet four key objectives:

 To enhance shareholder engagement and a long term investment culture;

 To ensure better regulation and a 'Think Small First' approach; lst

 To make it easier to set up and run a company; and

 To provide flexibility for the future.

Following the establishment of a Company Law Review Group in 1998 to consider in detail the modernisation of company law, The subsequent report of this group formed the basis of a White Paper for consultation in March 2005 and eventually the new Companies Act was passed in November 2006.

Some of the key effects resulting from the Act include the following. (a) Applying to all companies:

 A clear statement of directors' general duties clarifies the existing case law based rules

 Companies will be able to make greater use of electronic communications for communications with shareholders.

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 Directors will automatically have the option of filing a service address on the public record (rather than their private home address).

 Directors must be at least 16 years old, and all companies must have one natural person as a director – i.e. they cannot have all corporate directors.

 There will be improved rules for company names.

 Companies will no longer be required to specify their objects on incorporation.

 The articles will form the basis of the company's constitution. (a) Applying to private companies:

 There will be separate and simpler model Articles of Association for private companies.

 As part of the "think small first" agenda, there will be a separate, comprehensive code of accounting and reporting requirements for small companies.

 Private companies will not be required to have a company secretary.

 Private companies will not need to hold an annual general meeting unless they positively opt to do so.

 It will be easier for companies to take decisions by written resolutions.

 There will be simpler rules on share capital, removing provisions that are largely irrelevant to the vast majority of private companies and their creditors.

(c) Benefits to shareholders:

 There will be greater rights for nominee shareholders, including the right to receive information electronically or in hard copy if they so wish

 There will be more timely accountability to shareholders by requiring public companies to hold their AGM within 6 months of the financial year-end.

This 2006 Act is a piece of primary legislation under which number of provisions are currently being set out in secondary legislation, mainly through regulations or orders made by statutory instrument. It will not be fully implemented until October 2009, although parts of it were implementated in April 2007, October 2007 and April 2008. (Full details can be found on the Department for Business, Enterprise and Regulatory Reform (BERR) and the Companies House websites.)

The following changes came into force in April 2007:

 Removal of the maximum age limit (which was 70) for directors of PLCs

 Directors no longer need to provide details of their interests in shares or debentures of the company or its group – the result being that Companies House no longer accepts Form 325 (Location of Register of director's interests in shares) or Form 325a (Notice for inspection of a register of directors interests in shares kept in a non-legible format)

 There will no longer be a statutory annual report by the Secretary of State to Parliament (the "Companies In" report), but BERR will continue to produce the information.

 Directors are not required to disclose their interests in shares in the Directors report of the Annual Accounts for reports signed on or after 6 April 2007.

 Takeover forms have been replaced with forms that align with the clauses of the new Act – 429(4) Notice of non-assenting shareholders will become Form 980(1); 429dec Statutory Declaration relating to a Notice to non-assenting shares will become Form 980(dec); and 430A Notice to non-assenting shareholders will become Form 984.

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In addition, UK company law must also incorporate European company law directives. For example, the European Eighth Directive on company law required more direct control of auditors and therefore the Companies Act 1989 introduced the concept of supervision of auditors. There is an ever increasing amount of legislation being enacted by the EU and the following examples illustrate the many different items currently being added to existing UK legislation in place for limited companies :

 Company Disclosures – 4th_{and 7}th_{Company Law (Accounting) Directives}

 The Companies (Cross-Border Mergers) Regulations 2007

 Implementation of Directive 2006/43/EC on Statutory Audits of Annual and Consolidated Accounts (8th Company Law Directive)

 Shareholders' Rights Directive

 Simplification of Capital Maintenance Rules – 2nd_{Company Law Directive.} Companies are also regulated in other ways:

 The production of company financial statements must be prepared in accordance with UK accounting standards. These are issued by the Accounting Standards Board (ASB). Recent legal opinion has now established accounting standards as a source of law.

 Another key area of regulation for the privatised utility companies are the consumer watchdogs – for example, Oftel which regulates British Telecom.

 Case law is also a very important aspect of company regulation. Try to think of examples from your legal studies.

B. FINANCIAL OBJECTIVES

The Prime Objective

The underlying assumption of the theory of finance states that:

"the main objective of the firm is the maximisation of shareholder wealth in the long term".

In order to maximise shareholder wealth the management must maximise the value of the firm, because the legal owners of the company are the shareholders, and all surplus value after creditors and other liabilities have been met belongs to them. Thus the greater the value of the firm after liabilities, the greater the wealth of the shareholders. The value of the firm and shareholder wealth are represented by the market price of the company's shares, which is the amount a shareholder could obtain for selling his part of the business as a going concern.

It may seem to be a strange choice of major objective, but perhaps by thinking about some other likely objectives you will appreciate why the maximisation of shareholder wealth is the major objective of firms.

(a) The maximisation of company profits is often considered to be a major objective of firms. Clearly it is important, but even when there are rising profits the value of shares (and thus shareholder wealth) can fall. Can you think of how this might happen? There are several ways in which it may occur; one is when a company raises additional share capital in order to fund an investment to increase profits, but may cause earnings per share to fall (there being more shareholders to share in the profits), thus resulting in a fall in share price. Consider the following example.

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A company currently has 200,000 shares in issue and has expected profits of £50,000, thus EPS (earnings per share) are 25p. If the company issues a further 100,000 £1 shares to invest in a project which will give a 10% return on investment, then expected profits will increase by £10,000. However, there are now 300,000 shares in issue, and the EPS has fallen to 20p (£10,000 + £50,000/300,000 shares). The falling EPS causes the share price to drop, and shareholder wealth is therefore also reduced. (b) Another objective you might feel to be important is the maximisation of balance sheet

or asset values. Whilst a company's balance sheet is important to investors, you will discover from this course and your accountancy studies that balance sheets do not reflect a true and up-to-date valuation of the company and its assets, and thus cannot be relied upon to determine the worth of the company.

All of the objectives we have considered so far are financial objectives. In addition, a company will have important non-financial objectives which might include:

 Raising the skills of the workforce – perhaps through training and appraisal

 Adhering to environmental legislation – for example, by reducing pollution emissions

 The provision of a quality service to customers.

Increasing importance is now being placed on business survival. The modern market place for most businesses is becoming truly world-wide and this when, added to government and political influence and interference, presents much greater challenges than existed a few decades ago. The modern business will need to adapt and change continually to ensure that it survives, and continued growth is one of the keys to survival and one that all today's

businesses strive for.

Another area that is increasing in importance in the modern business world is social responsibility. Some businesses have adopted social responsibility as a key objective to work alongside their other main goals and objectives, and this is increasingly being seen in explicit policies in both such traditional areas as good working conditions for staff, providing a good all round product for customers and helping provide adequate and competent training for staff and the local labour force, and also in more modern areas such as reducing

environmental pollution or stopping corrupt promotional practices.

Financial and non-financial objectives are both important to a company. They may sometimes be in conflict, but often they are complementary. For example, training the workforce will increase costs initially, but should result in increased production which will generate additional profit for the company. There is also the recent example of many food manufacturers spending time and resources on the issues of obesity in respect of their products and, whilst it is very much in line with not having their profits adversely affected, it is also an serious attempt to address their social responsibilities.

Valuation of Companies

In order to achieve the main objective of maximising shareholder wealth we have to

determine exactly how we value companies and their shares. Shareholder wealth obtained from a company is measured by increases in the price of shares above the price the

shareholder paid for them (capital gains) and dividends received. You will see later that the price of a share is strongly affected by expectations of future dividends (the higher the expected dividends the higher the share price), and thus we can conclude that shareholder wealth can be maximised by maximising a company's share price.

Management should therefore set itself financial targets directly related to maximising shareholder wealth, but how can this be done?

 The price of a company's shares reflects the future earnings of the company so, in order to maximise shareholder wealth, the company must invest in those projects which give the highest value over time.

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 Increasing earnings per share and dividends per share also increases the share price, and firms should take decisions which allow a potential for maximisation of future dividends and earnings.

 By maximising profits – whilst we noted that maximising profits does not always increase shareholder wealth, in general it does and firms should aim to achieve this whilst considering the points raised above. Firms, however, should take care not to take undue risks when attempting to maximise their profits.

Shareholder Value Analysis (SVA)

SVA utilises the concept of NPV (net present value, which we shall discuss later) and argues that the value of an organisation is the net present value of its net future cash flows

discounted at its appropriate cost of capital.

SVA states that managers should concentrate on the value drivers, which are the factors which maximise shareholder value. They include:

 Growth in sales

 Profit margins

 Investment in fixed assets

 Investment in working capital

 The cost of capital

 The tax rate.

Management must identify the value drivers, cash flows and risks that result from investment options and aim to maximise value in the long term. Whilst this approach is popular in several companies (well-known examples being Disney and Pepsi) it relies on subjective judgments of cash flows in the future, and so does not have universal appeal.

Long-term Versus Short-term Objectives

Unfortunately, the Stock Market is often more concerned with short-term increases in share prices rather than the maximisation of long-term profits (short-termism) e.g. choosing the project with the higher profits in the first year rather than over the life of projects. Often companies have to trade off short-term gains (e.g. achieving an earnings figure for a financial year) against acting in the best interests of the company in the long term (e.g. investing in future training and development expenditure).

Objectives of Multi-National Companies

The objectives of multinational companies (MNC) are similar to those of other organisations but may be more complicated due to the number of differing views and requirements of the different countries they are based in.

Objectives of Public Sector Organisations

Characteristics of organisations generally considered to be within the public sector include being non-profit making, with the Government accepting full, or a degree of, responsibility for their performance and exercising some measure of control over their activities. Broadly the public sector encompasses central government departments, local authorities, the Health Service, the police, and public bodies which receive their principal financing from central and local government (e.g. the Arts Council, the Fire Service, The Sports Council), plus

nationalised industries (see below).

These bodies are statutory organisations created by Acts of Parliament. The appointment of some of the members of the organisation is a matter for the Executive. It may be that a

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minister has statutory powers to make appointments, such as in nationalised industries, or administrative power, e.g. making appointments to advisory committees.

Public sector organisations will be funded either wholly or in part by money provided by Parliament. Care must be taken, however, to distinguish between those organisations financed by Parliament and those which simply receive grant-aid to assist them with an investment programme.

There are several differences which may exist between public bodies and commercial organisations.

 Many public organisations may have monopolies in either a service or geographical area.

 Although prices may be charged for some public services, they are rarely related to profit-making objectives and sometimes fail to cover the full economic cost. In general, the public sector does not use the price mechanism to test whether the public want the services provided. Instead, the criteria applied tend to be based on the political

judgment of elected representatives under the constraints of the political mechanism of elections, pressure groups and consultative processes.

 The public sector exists to serve the community and, in the field of accounting, the stewardship of funds is often the key objective (rather than the profit motive). However, the responsibilities of the financial manager and the need to exercise good financial public relations are as important as in commercial organisations. In order to replace the profit motive as a yardstick performance measures have been developed in order to ensure that the three "Es" of efficiency, economy and effectiveness are achieved, and to protect public money. Thus, for example, in an attempt to improve the performance of central and local government departments, the Government has introduced a wide range of key performance indicators (K.P.I.'s).

Within these overall points about the public sector in general, we should also recognise a number of particular aspects and developments relating to specific types of organisation. (a) Nationalised Industries

In recent years the number of nationalised industries has been reduced due to the privatisation programme of the Conservative Governments of 1979-1997. However, there are still some large organisations remaining in this category, including the Post Office (although this may soon be privatised). The objectives of such organisations are generally social or service-led.

They are funded by borrowing from the capital markets and the Government. Whilst the maximisation of profits is not their main objective they generally have to obtain set financial targets, perhaps to maintain required subsidies at a set level or below. In general nationalised industries in the UK have been expected to aim to achieve a set rate of return (before interest and tax) on new investment programmes. The rate of return is measured by current cost operating profit as a proportion of the net

replacement cost of assets employed. Nationalised industries also have other

performance measures, including cost reductions and efficiency gains which they have to achieve.

(b) Government Departments

One major change in this area within the UK recently has been the formation of executive agencies to carry out specific functions, such as the Contributions Agency. They are expected to achieve a set level of service and are answerable to the Government for their service levels but are managed independently on business-led lines.

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(c) Private Finance Initiative (PFI)

The Private Finance Initiative (PFI) is a small, but important part of the Government's strategy for delivering high quality public services.

The Private Finance Initiative (PFI) was introduced in 1992 as a means of obtaining private finance for public sector long-term capital projects, e.g. the building of prisons, schools and hospitals. The current government is committed to developing this

approach across a wide range of public services. A new Commission on Public Private Partnerships was set up in Autumn 1999 (the Institute of Public Policy Research Commission, IPPR) to examine questions about specific forms of partnership between private sector firms and public sector organisations – for example, how can private firms involved in partnerships be made accountable to the public, and how does this accountability fit in with achieving the best value for money?

In assessing where PFI is appropriate, the Government's approach is based on its commitment to efficiency, equity and accountability and on the objectives of public sector reform. PFI is only used where it can meet these requirements and deliver clear value for money without sacrificing the terms and conditions of staff.

Where these conditions are met, PFI delivers a number of important benefits. By requiring the private sector to put its own capital at risk and to deliver clear levels of service to the public over the long term, PFI helps to deliver high quality public services and ensure that public assets are delivered on time and to budget.

(d) Not for Profit Organisations

The prime objectives of organisation such as charities are not concerned with profit-making, but with the provision of services, e.g. to offer a service such as training guide dogs for the blind, or to fund research into cancer treatments. They do, however, operate within financial constraints and must work within the funds they obtain. All not-for-profit organisations also strive, as do many commercial ones, to obtain the three Es of economy, efficiency and effectiveness.

C. CORPORATE GOVERNANCE

Shareholders are the owners of a company and it is important to remember that the

maximisation of their wealth is the prime objective of companies in the private sector. This is the underlying concept in the theoretical parts of this course. However, they are not the only groups with an interest in the company and the interplay of factors in the governance of a company is a key concept.

Company Stakeholders

Stakeholders are usually divided into two distinct categories:

 Internal stakeholders such as managers and employees, and

 External stakeholders such as shareholders, creditors and lenders.

In practice companies often have multiple objectives (both financial and non-financial) involving various stakeholder groups, which prevent the maximisation of shareholder wealth. The different stakeholder groups in an organisation were identified in 1975 by the Corporate Report (ASC) which dealt with their objectives and specific requirements from accounting information. Clearly, different users will look at the company in different ways, and the objectives of organisations have to be designed to satisfy their varying needs, with the objectives of one group often also applying to another group. The objectives of different groups may conflict, and compromises will have to be made.

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We consider the interests of some of the stakeholder groups below, but you should try to think of other points yourself.

(a) Banks and other lenders

This group includes anyone who makes a loan or other financial accommodation available to an organisation, examples being debenture-holders, finance companies, building societies and venture capitalists.

The main concern of this group is the safety of the investment; lenders expect to get their money back within an agreed period and to make a profit. In order to maintain the safety of the investment they want to ensure that the level of debt to equity does not become too high, because increases in the level of debt increase the risk of insolvency of the firm, with the firm being unable to pay the required interest payments. Short-term lenders are especially concerned with the ability and willingness (known as "corporate integrity") to repay the liability from cash generated by the business. Long-term lenders may place a restrictive trust deed or set financial guidelines, e.g. a set proportion of working capital, in order to ensure their investment remains safe. (b) Business-contact group (includes debtors and creditors)

This group includes suppliers, competitors and all other business affected by an organisation's activities. Their objectives include ensuring that the firm deals honestly, does not misuse any monopoly powers and pays its bills promptly within the terms of the trading agreement.

The group will be interested in developing long-term strategic relationships and the continuity of trading opportunity with an organisation which is financially stable with minimal administration. Customers of the organisation will be concerned with having a supplier who is reliable, and who provides a constant supply of the product (when required) of consistent quality with good, efficient service at a fair price. Customers will also be concerned with the level of service they are receiving, the value for money, and the safety of the goods they receive.

Competitors are also included in this group, and include those who may be interested in acquiring the business as well as those who are rivals in trade. The group will require as much information about the company and its finances as possible, although the company will not wish them to have such information, and secrecy may conflict with the needs of other groups.

(c) Public

The needs of the general public can take many forms, e.g. sections of the general public may wish to see a restriction on contributions to political parties, charities or social groups, or a restriction on the business activities carried out with, or in, a particular country. Another example is where local residents are interested in the amount of investment and degree of control that an entity has in their own community and its ultimate effect on their local environment. When public money assists the enterprise the public may wish to see the return in profitability, jobs and services. (d) Government

The Government (and, indeed, the public) wish to ensure that the organisation adheres to the law, pays the correct amount of taxes and other financial charges levied upon it by government bodies, and provides the statistical and other information required in order to ensure control over its (the Government's) own economic policy. The

Government will also be interested in ensuring that the organisation respects its social and environmental commitments.

Moreover, the Government has a desire to regulate some of the privatised utilities to prevent them abusing their monopoly powers. For this reason it has set up consumer

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"watchdogs", e.g. Oftel, which regulates British Telecom, to oversee such companies. The watchdogs may, amongst other things, limit price levels which can conflict with a company's desire to maximise profits.

(e) Financial analysts and advisors

This group will comment upon the progress, or otherwise, of the entity. In order to do so they will need the fullest possible information in whichever field their interest lies. Their requirements may mirror those of any of the other user groups. They will, however, have the key objective of ensuring compliance with accounting standards to provide for uniformity to the presentation of information and the easier comparison with other organisations.

(f) Employees and management

Employees will be concerned with the remuneration they receive from the company, their working conditions and security of employment. They may also be concerned with other factors such as training and career development prospects within the firm; benefits in kind such as company cars; company pension and redundancy provisions; and the potential for future expansion of jobs for themselves and their friends and families.

(g) Shareholders and investors

Shareholders and investors are obviously an important stakeholder group, being the owners of the business. In order to meet the needs of shareholders management must:

 Maximise their wealth (shown by the growth in share price and the payment of dividends).

 Achieve a specific level of earnings, earnings per share and dividends per share. Note that some shareholders prefer high dividends and some prefer capital gains (see later study unit) but the needs of the majority should be met as far as

possible.

 Stick to a preset target for operating profitability represented by either a set return on capital employed or a profit/sales ratio (also discussed later).

 Expand the business when feasible – to be a worthwhile investment, growth, level of risk, return on investment and profitability in relation to competitor businesses and other investment opportunities will be expected to be at an appropriate level.

 Maintain the security (as far as is consistent with profit-making) of the

shareholder's investment. (The risk-return trade off is discussed in more detail in a later study unit.) This includes considering the fact that shareholders have different risk preferences and thus prefer different levels of gearing.

 Satisfy the investor that the company has sufficient cash flow to accommodate its plans and avoid future potentially fatal liquidity problems.

 Give details of political, charitable or social donations in order to allow

shareholders to decide whether the convictions of the management are in line with their own views.

This is not an exhaustive list of management objectives in respect of shareholder interests and you may be able to think of several others. A company therefore has to know who its major shareholders are and what their objectives for the company are, and concentrate on achieving those objectives. Such knowledge would also help to explain recent price movements when shareholdings change hands, and might help in fighting off a takeover bid.

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Companies may have only a few shareholders (e.g. a private family company) or they may have many small shareholders (e.g. some of the privatised utilities). Advantages of having a large number of shareholders include a reduced risk of one shareholder obtaining a controlling interest; greater market activity in the firm's shares and thus the likelihood of vast price movements caused by one shareholder selling his shares is also reduced; and takeover bids are easier to frustrate. Against this, however, will be increased administration costs covering statutory requirements of information to shareholders, and it may be more difficult to meet all shareholders' conflicting objectives.

Many decisions in financial management are taken in a framework of conflicting stakeholder viewpoints. For example, consider the stakeholders and the related financial management issues involved in the following situations.

 A private company converting into a public company The stakeholders will include:

(a) Shareholders of existing private company; (b) Shareholders of new public company; (c) Employees and management.

Some of the key financial management issues will be:

(i) Who will gain a controlling interest in the new company?

(ii) Will the company be administered differently, perhaps as family owner

shareholders no longer have day to day involvement in running the company? How will it affect terms and conditions of employees?

(iii) How will the conversion affect maximisation of shareholder wealth?

 A highly geared company, such as Eurotunnel, attempting to restructure its capital finance

The stakeholders will include: (a) Debenture holders; (b) Banks and other lenders; (c) The government;

(d) Shareholders.

(i) Shareholders will be concerned about the effects of additional gearing on the company's ability to pay dividends, which may conflict with the government's objective of ensuring financial stability.

(ii) As this is a large public interest project (Eurotunnel) the government will want to see financial stability to ensure that the company can complete the project without financial collapse.

(iii) Debenture holders are concerned to ensure that the company will have sufficient cash flow to meet interest payments as they fall due.

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 A large conglomerate "spinning off" its numerous divisions by selling them, or setting them up as separate companies, e.g. Hanson

The stakeholders will include: (a) Employees and management; (b) Debtors and creditors;

(c) Shareholders.

(i) The security of jobs for employees and management in the new companies, which may conflict with the aim of shareholders to maximise wealth.

(ii) Customers (debtors) will be concerned about the quality of the product and whether the new structure will affect this.

(iii) Suppliers (creditors) will want to know the liquidity of separate companies and their ability to pay outstanding debts. Also how will outstanding debts be settled if divisions are sold?

 Japanese car-makers, such as Nissan and Honda, building new car plants in other countries

The stakeholders will include: (a) Shareholders;

(b) Employees and management; (c) Government;

(d) Public.

(i) The public may be concerned that they have no control over foreign companies setting up in their local areas, which may conflict with the aims of government in encouraging investment by overseas companies.

(ii) The government may grant development finance and incentives to incoming companies.

(iii) The shareholders of the Japanese companies will be concerned about the security of their investment overseas.

(iv) Japanese management may be concerned about different pay and conditions if they are sent to manage the overseas plants.

 A public company offering to run the UK national lottery for free rather than for profit

The stakeholders will include: (a) The government; (b) The public; (c) Shareholders; (d) Financial analysts.

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(i) The government will be concerned about the company's objectives if profit is not the obvious one.

(ii) Shareholders will want to know how this non-profit making venture will affect dividends and the value of shares. After all, their main objective is maximisation of shareholder wealth.

(iii) Financial analysts will study the possible effects on the company's value if it gains the contract to run the lottery.

(iv) The public will want to know what percentage of takings will be donated to good causes and how much will be retained by the company for administration and investment in equipment.

Management/Shareholder Relationship and Agency Theory

The skill and experience of the senior management board (and to a lesser extent its subordinate management) are important to shareholders as they are employed to manage the shareholders' investment on their behalf. There must be trust in the integrity and ability of the managers; a dynamic board of management can make a significant difference to the performance of a business and the way the market views it.

An agency relationship exists where one person (an agent) acts on the behalf of another (the principal). The management/shareholder relationship is an example of an agency relationship. Goal congruence occurs when the objectives of the agents match those of the principals. The agency problem is the conflict that arises from the separation of

management and ownership in many companies, leading to a lack of goal congruence. The financial and other rewards of managers (agents) may not be linked to the shareholders' (principals) financial return. In theory management should not be able to act contrary to the wishes of shareholders because shareholders can dismiss the managers or sell their shares. Unfortunately it is often not the case. Small shareholders frequently have little knowledge about the running of the business and little power to alter its execution; and the large institutional shareholders have often been passive and uninvolved.

However, a series of "corporate raids" in the late 1980s, when firms acquired and then asset stripped managerially-focused companies believing them to be undervalued, has led to the large institutional shareholders considering the actions of management more carefully. A number of incentive schemes have been introduced in an attempt to encourage goal congruence between management and shareholders. The most popular is the stock option scheme. This allows senior management up to a certain number of the company's shares at a fixed price at a specified time in the future. The management therefore have a financial incentive to act in ways to maximise the share price, which benefits all shareholders. However, such schemes are of doubtful benefit – management do not have to buy shares if the price has fallen; and the schemes can lead to volatility in the share price which is counter to the principle of a stable share price which many shareholders desire.

Another popular scheme involves profit-related incentives in which bonuses are based on the annual growth in earnings per share, measured against a pre-set target such as

companies in the sector. However, you will appreciate that accounting figures can easily be manipulated and can also be affected by external factors such as a change in tax rates. Such measures therefore only give a partial (and perhaps misleading) picture of

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The Cadbury Report

The Committee on the Financial Aspects of Corporate Governance (known as the Cadbury Committee, after its Chairman) was set up in May 1991 by the Financial Reporting Council (FRC), the London Stock Exchange and the accounting profession, in response to increasing public concern over the management of large companies and professional

investors' low levels of confidence in financial reporting and auditing. Concerns included lack of direction and control of organisations by the boards, a lack of true auditor independence, and an increase in litigation and damages awarded against companies. The aim of the Cadbury Committee was "to bring forward proposals to promote good financial corporate

governance, without stifling entrepreneurial drive or impairing companies' competitiveness".

"Corporate governance" was defined by the committee as "the system by which companies

are directed and controlled" and is the responsibility of the directors of the company. The

Committee intends to consider the responsibilities of each group involved in the financial reporting process including:

 The links between board, auditors and shareholders;

 The role and responsibilities of audit and the auditors;

 The need for audit committees, their functions and membership;

 The type and frequency of information required by shareholders and other parties with a financial interest;

 The role and responsibilities of executive and non-executive directors as regards the reporting of financial performance.

The heart of the Committee's recommendations was a Code of Best Practice, to be

adopted by the directors of all UK public companies, with all company directors to be guided by it. Some allowances are made for the way in which it might be implemented in different companies.

You will see later that the Cadbury Code of Best Practice has been incorporated into the Combined Code. However, the recommendations of the Cadbury Committee are so important in the development of corporate governance in the UK that we will look at them in detail.

The Code of Best Practice The major points are as follows: (a) The Board

There should be a clearly accepted division of responsibility at the head of a company ensuring a balance of power and authority. In cases where the Chief Executive is also the Chairman there should be strong independent executives on the board with their own appointed leader.

The calibre and number of non-executive directors should be such that their views carry significant weight on the board.

Boards should meet regularly and have a formal schedule of matters reserved for their decision to ensure that the direction and control of the company remain firmly in their hands, including the monitoring of the executive management.

All directors should have access to the advice and services of the company secretary, who is responsible to the board for ensuring that board procedures are followed and that applicable rules and regulations are complied with. Any question of the removal of the company secretary should be a matter for the board as a whole.

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(b) Executive Directors

Directors' total emoluments and those of the Chairman and the highest-paid UK director should be fully disclosed and split into their salary and performance-related elements, with an explanation of the basis on which performance is measured. Executive directors' pay should be subject to the recommendations of a remuneration committee made up wholly or mainly (and preferably chaired) by non-executive directors. Directors' service contracts should not, unless approved otherwise by shareholders, exceed three years.

(c) Controls and Reporting

Boards must establish effective audit committees. The chairmen of audit and

remuneration committees should be responsible for answering questions at the AGM. The board should ensure that an objective and professional relationship is maintained with the auditors. The board must explain their responsibility for preparing the

accounts next to a statement by the auditors regarding their reporting responsibilities. The Code requires that directors report on the effectiveness of the company's system of internal control, and state that the business is a going concern, with supporting assumptions or financial qualifications if necessary.

The board's duty is to present a balanced and understandable assessment of their company's position. Balance sheet information should be included with the interim report, which should be reviewed by the external auditors but need not be subject to a full audit.

(d) Shareholders

Both boards and shareholders were encouraged by the Committee to consider how to improve the effectiveness of general meetings.

(e) Auditing

The annual audit is described as "one of the cornerstones of corporate governance". Several minor recommendations were made to ensure its effectiveness and objectivity:

 Audit Effectiveness

Audit effectiveness should be increased by clarifying the respective responsibilities of directors and auditors for preparing and commenting on financial statements, and by developing audit practice in areas such as internal control, going concern, fraud and other illegal acts.

 Audit Objectivity

Both the board and auditors have a responsibility to ensure that the relationship between them is professional and objective. Audit Committees

The Committee stated that the board should establish an audit committee of at least three non-executive directors with written terms of reference which deal clearly with their authority and duties.

(f) Non-executive or Outside Directors

Non-executive directors should bring an independent judgment to bear on issues of strategy, performance and resources including key appointments and standards of conduct.

The Committee recommended that a majority of non-executive directors should be independent and free of any business or financial connection with the company (apart from their fees and shareholdings). Fees should reflect the time which they commit to the company, but they should receive no pension or share options as part of their

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service. The Code also suggested that an agreed procedure should be in place for non-executives to take independent professional advice at the company's expense. The selection of non-executive directors should be by a formal process, for a specified term, and their nomination should be a matter for the board as a whole. However, the report does not discuss the action that should be taken in the event of a non-executive director resigning or being released.

The independence of non-executives must be transparent. Fees should be such that part-time rather than full-time involvement is encouraged and, since resignation is the ultimate sanction of the non-executive director, the fees should not be so large that the non-executive is dependent upon them.

In summary, the recommendations of the Cadbury Report, as encompassed by the Code of Best Practice, were that listed companies should include in their accounts full and clear disclosure of directors' total emoluments and those of the Chairman and the highest-paid director. The disclosures should include pension contributions and stock options.

Performance-related elements, and the basis upon which performance is measured, should be shown separately.

With effect from April 1993, the Stock Exchange stated that UK-incorporated listed

companies must state in their accounts for accounting periods ending after 30 June 1993, whether they have complied with the Code throughout the accounting period in addition to the other continuing obligations. Any failure to comply must be stated, along with reasons for the non-compliance. The compliance statement must be reviewed by the auditors. Other UK companies should adopt the Code at the earliest practicable date.

In addition, from 1 January 1995 directors' statements should include the following:

(a) An acknowledgment that directors are responsible for the system of internal financial control including the main procedures established and their effectiveness.

(b) An explanation that the system can only provide a reasonable level of control.

(c) Confirmation that the directors have reviewed the effectiveness of their present internal financial control.

The Greenbury Report

The Greenbury Report, published by the Greenbury Committee in July 1995, goes beyond the Cadbury Code of Best Practice in establishing principles for determining directors' pay and disclosures on pay to be given in the annual accounts and company reports.

The Greenbury Code recommends that a remuneration committee should be established comprising solely non-executive directors – though the Chief Executive or Chairman may be asked for advice – and that this committee should determine executive directors'

remuneration. The Code also recommends that directors should have service contracts limited to one year.

Other important recommendations are:

 Public companies should publish an audited statement detailing compliance with the Greenbury Code under Stock Exchange rules.

 The remuneration committee should report to shareholders via the annual report and accounts. Full details should be included of directors' remuneration:

(i) Basic salary (ii) Benefits in kind (iii) Annual bonuses

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The majority of the Greenbury Code principles have been included in the Listing Rules of the Stock Exchange.

Hampel Committee Report

Sir Ronald Hampel was given the task of continuing the work of Sir Adrian Cadbury on corporate governance. The final report of the Hampel Committee was issued in February 1998. Sir Ronald summed up the essence of his committee's report by saying that "Good

governance requires judgment, not prescription and for that reason I believe it is in business' own interest to conform, and that it will". The main features of this report relating to

corporate governance are:

 Most non-executive directors should be independent and their independence should be identified in the annual report.

 Directors should receive appropriate training.

 The roles of chairman and chief executive should be separate.

 A senior non-executive director should be appointed to deal with shareholders' concerns. The name of the director should be identified in the annual report.

 The practice of paying non-executive directors using company shares is not recommended, although there is nothing against it in principle.

 Directors should be on contracts of one year or less.

 A remuneration committee of the board should be established, made up of independent non-executive directors. The committee should make decisions on the pay packages of executive directors and the framework of executive pay.

 Companies should include in the annual report a narrative account of how they apply broad principles and should explain their policies. Any departure from best practice should be justified in the report.

 The creation of an internal audit department is recommended.

 Directors should review the effectiveness of the company's internal controls (not just financial controls) but need only report publicly on the system rather than its

effectiveness.

The Stock Exchange has a code of practice which incorporates the recommendations of the Cadbury, Greenbury and Hampel reports (see later). The Stock Exchange will be

responsible for overseeing adherence to the code. The government has indicated that if companies do not adopt best practice, it may take action to introduce legislation on corporate governance. In particular, continuing large pay awards to directors and extensive share option schemes may prompt the government to take action.

The Combined Code

In June 1998 the London Stock Exchange published the Hampel Committee Principles of Good Governance and the Code of Practice (the Combined Code). It replaces the Cadbury and Greenbury Codes but incorporates aspects of both of them.

(a) The Principles of Good Governance

 Directors and the Board

(i) There should be an effective board to lead and control the company. (ii) Running the board and running the business are separate tasks. There

must be a clear division of responsibilities at the head of the company. No one individual should have unfettered powers.

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(iii) There should be a balance of executive and non-executive directors (NEDs) including independent NEDs. No individual or group should dominate the board.

(iv) Timely and quality information should be provided to the board. (v) There should be a formal and transparent procedure for board

appointments (usually a nomination committee of mainly NEDs). (vi) Directors should be re-elected at least every three years.

 Directors' Remuneration

(i) Remuneration should be sufficient to attract and retain the directors needed but no more than necessary. Executive directors' remuneration should be partly linked to corporate and individual performance.

(ii) There should be a formal and transparent procedure for developing

remuneration policy and individual packages, i.e. a remuneration committee of NEDs. Directors should not be involved in deciding their own

remuneration.

 Relations with Shareholders

(i) The board should encourage dialogue on objectives with institutional shareholders.

(ii) The annual general meeting (agm) should be used to communicate with private investors and encourage their participation.

 Accountability and Audit

(i) There should be a balanced, understandable assessment of the company's position and prospects.

(ii) There should be a sound system of internal control to safeguard the shareholders' investment and the company's assets.

(iii) There should be formal and transparent arrangements to apply the above two principles and maintain relationships with the auditors.

The Combined Code requires an explanation in a listed company's annual report of how these principles have been applied. A major impact of the Combined Code is that a company must review the effectiveness of all controls, not just financial controls. (b) Examples of Contents of Combined Code

 Directors

(i) The Board must comprise at least one third non-executive directors. (ii) There must be a senior independent director (not the Chairman) to whom

shareholders can raise their concerns.

(iii) A nomination committee is strongly recommended. (iv) All directors should receive training when first appointed.

 Directors' Remuneration

(i) A significant proportion of executive remuneration should be linked to corporate and individual performance.

(ii) The remuneration report should be issued in the name of the board and not just the remuneration committee.

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 Accountability and Audit

(i) Financial reporting provisions apply to all price-sensitive public reports and reports to regulators.

(ii) The definition of "internal control" covers all controls, not just financial controls.

(iii) The majority of the audit committee should be independent non-executive directors.

(iv) The audit committee should review the scope, results, cost-effectiveness, independence and objective of external audit.

(v) The company should review the need for internal audit. (c) Matters to be Reported Publicly by Companies

 How the company applies the principles

 Whether or not the company complies with detailed provisions; any exceptions must be explained

 Justify combined posts of chairman and chief executive

 Give the names of:

(i) The chairman, chief executive, senior independent director and other independent directors

(ii) The chairman and members of the nomination committee (iii) Members of the remuneration committee

(iv) Members of the audit committee

(v) Biographies of directors submitted for election or re-election

 Remuneration policy and details of the remuneration of each director

 Explain the directors' responsibility for preparing the accounts

 Whether the business is a going concern, together with the supporting assumptions or qualifications

 State that directors have reviewed the effectiveness of internal controls

The Turnbull Report

Guidance for directors on the scope, extent and nature of the review of internal controls was issued by the Institute of Chartered Accountants in England and Wales in late September 1999 in the form of the Turnbull Report – "Internal Control: Guidance for Directors of Listed Companies in the UK". This guidance has the support and endorsement of the Stock Exchange.

The Turnbull Report states that:

"A company's system of internal control has a key role in the management of

risks that are significant to the fulfilment of its business objectives".

The company's system of internal control should:

 Be embedded within its operations and not be treated as a separate exercise;

 Be able to respond to changing risks within and outside the company; and

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The Report makes it clear that the board of a company is ultimately responsible for its system of internal control. It will normally delegate to management the task of establishing,

operating and monitoring the system.

Financial Services and Markets Act, 2000 and the FSA

The Financial Services and Markets Act 2000 set out four statutory objectives, supported by a set of principles of good regulation which companies must have regard to when

discharging their functions. The objectives are:

 market confidence – maintaining confidence in the financial system

 public awareness – promoting public understanding of the financial system

 consumer protection – securing the appropriate degree of protection for consumers, and

 the reduction of financial crime – reducing the extent to which it is possible for a business to be used for a purpose connected with financial crime.

The Act also set up the Financial Services Authority (FSA), one of now a number of financial service regulators. The FSA has set out its aims under three broad headings:

 promoting efficient orderly and fair markets

 helping retail consumers achieve a fair deal

 improving companies' business capability and effectiveness. These objectives condition the way in which the FSA acts:

 providing political and public accountability – so its annual report contains an

assessment of the extent to which it has met these objectives, and scrutiny of the FSA by Parliamentary Committees may focus on the extent to which this is being achieved

 governing the way it carries out its general functions in respect of rule-making, giving advice and guidance, and determining general policy and principles – so, for example, it is under a duty to show how the draft rules it publishes relate to these statutory objectives; and

 assisting in providing legal accountability – so where it interprets the objectives wrongly, or fails to consider them, it can be challenged in the courts by judicial review.

The Higgs and Smith Reports

At the turn of the century the world markets were affected by major collapses such as

ENRON and these had an adverse impact on the profile of corporate governence. In the UK, the Government established enquiries into two areas in which failures were were seen as key to these collapses:

 the effectiveness on non-executive directors, reported on by the Higgs Report, and

 the independence of audit committees, reported on by the Smith Report. (a) The Higgs Report

The main recommendations were as follows: (i) The chairman:

 runs the board

 sets its agenda

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 ensures that the members of the board develop an understanding of the views of the major investors

 ensures that sufficient time is allowed to discuss complex or contentious issues

 takes the lead in ensuring induction training for new directors

 takes the lead in identifying development needs for directors

 ensures the performance of individuals and the board as a whole

 encourages active involvement by all members of the board

 should maintain a good working relationship with the chief executive. (ii) As members of a unitary board, all members are required to:

 Provide entrepreneurial leadership of the company within a framework of prudent and effective controls

 set the company's strategic aims

 ensure that the necessary financial and human resources are in place to meet its objectives

 review the performance of management. (iii) Non-executive directors should:

 constructively challenge and help develop strategy

 scrutinise the performance of management

 satisfy themselves on the integrity of financial information

 satisfy themselves that financial controls and the system of risk management are robust and defensible

 set the remuneration of the executive directors

 have a prime role in appointing and removing executive directors

 be independent of judgement and have an enquiring mind

 be well informed about the company and the environment in which it operates

 by visiting sites and meeting middle and senior management ensure that his/her knowledge of the company is kept up to date

 uphold the highest standards of integrity and probity

 question intelligently, debate constructively, challenge rigorously and decide dispassionately

 promote the highest standards of corporate governance

 declare any potential conflicts of interest and refrain from discussion on matters where conflict of interest may arise

 understand the views of major investors through the chairman and the senior non-executive director.

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The Smith Report

This examined the role of audit committees and gave authoritative guidance on how audit committes should be operated and run. The main recommendations were that the audit committee should: