Decision Structures and Corporate Governance
We can summarise the normative objectives of strategic financial management as follows:
The determination of a maximum inflow of cash profit and hence corporate value, subject to acceptable levels of risk associated with investment opportunities, having acquired capital efficiently at minimum cost.
Investment and financial decisions can also be subdivided into two broad categories; longer term (strategic or tactical) and short-term (operational). The former may be unique, typically involving significant fixed asset expenditure but uncertain future gains. Without sophisticated periodic forecasts of required outlays and associated returns, which incorporate time value of money techniques, such as ENPV and an allowance for risk, the subsequent penalty for error can be severe; in the extreme, corporate death.
Conversely, operational decisions (the domain of working capital management) tend to be repetitious, or infinitely divisible, so much so that funds may be acquired piecemeal. Costs and returns are usually quantifiable from existing data with any weakness in forecasting easily remedied. The decision itself may not be irreversible.
However, irrespective of the time horizon, the investment and financial decision process should always involve:
- The continual search for investment opportunities.
- The selection of the most profitable opportunities, in absolute terms.
- The determination of the optimal mix of internal and external funds required to finance those opportunities.
- The establishment of a system of financial controls governing the acquisition and disposition of funds.
- The analysis of financial results as a guide to future decision-making.
Needless to say, none of these functions are independent of the other. All occupy a pivotal position in the decision making process and naturally require co-ordination at the highest level. And this is where corporate governance comes into play.
We mentioned earlier that empirical observations of agency theory reveal that management might act irresponsibly, or have different objectives. These may be sub-optimal relative to shareholders wealth maximisation, particularly if management behaviour is not monitored, or they receive inappropriate incentives (see Ang, Rebel and Lin, 2000).
To counteract corporate misgovernance a system is required whereby firms are monitored and controlled. Now termed corporate governance, it should embrace the relationships between the ordinary shareholders, Board of Directors and senior management, including the Chief Executive Officer (CEO).
In large public companies where goal congruence is a particular problem (think Enron, or the 2007-8 sub-prime mortgage and banking crisis) the Board of Directors (who are elected by the shareholders) and operate at the interface between shareholders and management is widely regarded as the key to effective corporate governance. In our ideal world, they should not only determine ethical company policies but should also act as a constraint on any managerial actions that might conflict with shareholders interests. For an international review of the theoretical and empirical research on the subject see the Journal of Financial and Quantitative Analysis 38 (2003).
The Developing Finance Function
We began our introduction with a portrait of rational, risk averse investors and the corporate environment within which they operate. However, a broader picture of the role of modern financial management can be painted through an appreciation of its historical development. Chronologically, six main features can be discerned:
- Post Modern
Traditional thinking predates the Second World War. Positive in approach, which means a concern with what is (rather than normative and what should be), the discipline was Balance Sheet dominated. Financial management was presented in the literature as merely a classification and description of long term sources of funds with instructions on how to acquire them and at what cost. Any emphasis upon the use of funds was restricted to fixed asset investment using the established techniques of payback and accounting rate of return (ARR) with their emphasis upon liquidity and profitability respectively.
Managerial techniques developed during the 1940s from an American awareness that numerous wide-ranging military, logistical techniques (mathematical, statistical and behavioral) could successfully be applied to short term financial management; notably inventory control. The traditional idea that long term finance should be used for long term investment was also reinforced by the notion that wherever possible current assets should be financed by current liabilities, with an emphasis on credit worthiness measured by the working capital ratio. Unfortunately, like financial accounting to which it looked for inspiration; financial management (strategic, or otherwise) still lacked any theoretical objective or model of investment behaviour.
Economic theory, which was normative in approach, came to the rescue. Spurred on by post-war recovery and the advent of computing, throughout the 1950s an increasing number of academics (again mostly American) began to refine and to apply the work of earlier economists and statisticians on discounted revenue theory to the corporate environment.
The initial contribution of the financial literature to financial practice was the development of capital budgeting models utilising time value of money techniques based on the discounted cash flow concept (DCF). From this arose academic suggestions that if management are to satisfy the objectives of corporate stakeholders (including the shareholders to whom they are ultimately responsible) then perhaps they should maximise the net inflow of cash funds at minimum cost.
By the 1960s, (the golden era of finance) an econometric emphasis upon investor and shareholder welfare produced competing theories of share price maximisation, optimal capital structure and the pricing of equity and debt in capital markets using partial equilibrium analysis, all of which were subjected to exhaustive empirical research.
Throughout the 1970s, rigorous analytical, linear techniques based upon investor rationality, the random behaviour of economic variables and stock market efficiency overtook the traditional approach. The managerial concept of working capital with its emphasis on solvency and liquidity at the expense of future profitability was also subject to economic analysis. As a consequence, there emerged an academic consensus that:
The normative objective of finance is represented by the maximisation of shareholders' welfare measured by share price, achievable through the maximisation of the expected net present value (ENPV) of all a company's prospective capital investments.
Since the 1970s, however, there has also been a significant awareness that the ebb and flow of finance through investor portfolios, the corporate environment and global capital markets cannot be analysed in a technical vacuum characterized by mathematics, statistics and equilibrium analysis. Efficient financial management, or so the argument goes, must relate to all the other functions within the system that it serves. Only then will it optimise the benefits that accrue to the system as a whole.
Systematic proponents, whose origins lie in management science, still emphasise the financial decisions-maker's responsibility for the maximisation of corporate value. However, their most recent work focuses upon the interaction of financial decisions with those of other business functions within imperfect markets. More specifically, it questions the economist's assumptions that investors are rational, returns are random and stock markets are efficient. All of which depend upon the instantaneous recognition of interrelated flows of information and non-financial resources, as well as cash, throughout the system.
Behavioral scientists, particularly communications theorists, have developed this approach further by suggesting that perhaps we can't maximise anything. They analyse the reaction of individuals, firms and stock market participants to the impersonal elements: cash, information and resources. Emphasis is placed upon the role of competing goals, expectations and choice (some quantitative, others qualitative) in the decision process.
Post-Modern research has really taken off since the millennium and the dot.com-techno crisis, spurred on by global financial meltdown and recession. Whilst still in its infancy, its purpose seems to provide a better understanding of how adaptive human behaviour, which may not be rational or risk-averse, determines investment, corporate and stock market performance in today's volatile, chaotic world and vice versa.
So, what of the future?
Obviously, there will be new approaches to financial management whose success will be measured by the extent to which each satisfies its stated objectives. The problem today is that history tells us that every school of academic thought (from traditionalists through to post-modernists) has failed to convince practicing financial managers that their approach is always better than another. A particular difficulty is that if their objectives are too broad they are dismissed as self evident. And if they are too specific, they fail to gain general acceptance.
Perhaps the best way foreword is a trade-off between flexibility and uniformity, whereby none of the chronological developments outlined above should be regarded as mutually exclusive. As we shall discover, a particular approach may be more appropriate for a particular decision but overall each has a role to play in contemporary financial management. So, why not focus on how the various chronological elements can be combined to provide a more eclectic (comprehensive) approach to the decision process? Moreover, an historical perspective of the developments and changes that have occurred in finance can also provide fresh insights into long established practice.
As an example, consider investors who use traditional published accounting data such as dividend per share without any reference to economic values to establish a company's performance. In one respect, their approach can be defended. As we shall see, evidence from statistical studies of share price suggests that increased dividends per share are used by companies to convey positive information concerning future profit and value. But what if the dividend signal contained in the accounts is designed by management to mislead (again think Enron)?
As behaviorists will tell you, irrespective of whether a positive signal is false, if a sufficient number of shareholders and potential investors believe it and purchase shares, then the demand for equity and hence price will rise. Systematically, the firm's total market capitalization of equity will follow suit.
Post-modernists will also point out that irrespective of whether management wish to maximise wealth, stock market participants combine periodically to create "crowd behaviour" and market sentiment without reference to any rational expectations based on actual trading fundamentals such as "real" profitability and asset values.