Chapter 1 Financial Management and Financial Objectives

LEARNING OBJECTIVES
1.
2.
3.
4.
5.
6.
7.
8.
9.

Explain the nature of financial management.

Explain the purposes of financial management (raising finance, allocation of financial
resources, maintaining control over resources).
Distinguish between financial management and financial and management accounting
and explain the relationship between them.
Define and distinguish between financial strategy and financial objectives.
describe the relationship between corporate strategy, corporate objectives and financial
objectives.
Explain the features of the financial objective of shareholder wealth maximization.
Distinguish between shareholder wealth maximisation and satisficing in a scenario.
Explain the financial management in not-for-profit organization.
Explain the agency problems and describe the methods of how to reduce such problems.

Financial Mangement
and
Financial Objectives

Nature
and
Purpose

Fin. Mgt.,
Mgt. Accounting
and
Fin. Accounting

Fin. Objectives
and
Org. Strategy

Shareholders
Wealth
Maximisation

Not-for-profit
Organisations

Different
Financial
Objectives

Value for
Money

Agency
Problems

Methods to
Reduce

1.
1.1

The Nature and Purpose of Financial Management

Key concepts
(a)

(b)
(c)

Financial management can be defined as the management of the

finances of an organization in order to achieve the financial objectives of
the organization. The usual assumption in financial management for the
private sector is that the objective of the company is to maximize
shareholders wealth.
Financial management decisions cover investment decisions, financing
decisions, and dividend decisions and risk management.
Financial control the control function of the financial manager becomes
relevant for funding which has been raised. Are the various activities of the
organization meeting its objectives? Are assets being used efficiently? To
answer these questions, the financial manager may compare data on actual
performance with forecast performance.

1.2

Investment decisions, financing decisions and dividend decisions

(a)

Investment decisions
(i)
The investment decision considers the benefits of investing cash, either
in projects or in working capital, or even in high yield deposit
accounts.
(ii)

This is important to shareholders, as it will determine the cash flows

which are generated by the company and will ultimately affect the
dividends paid and the share price.
(iii) Assessing projects can be difficult as large investments are often
required which promise the possibility of returns over many years,
making the cash flows hard to estimate.
(iv) Shareholders will also be concerned to compare the risk as well as the
return between profits, as a higher risk investment should carry a
higher return to compensate.
(b)

Financing decisions
(i)
The financing decision considers the source of the finance required for
the business operations. This will be a mixture of equity and
long-term debt finance.
(ii) Companies need to balance the benefits to their shareholders debt is
a cheaper form of finance as the returns required are lower (due to

lower risk) and the debt interest is tax allowable, but excessive gearing
can increase the risk to the company, and hence the shareholders,
dramatically.
(c)

1.3

Dividend decisions
(i)
The dividend decision looks at how much of the surplus cash
generated should be paid out to the shareholders, and how much
retained for future investments.
(ii) Shareholders generally prefer a predictable, steadily rising, dividend
rather than one, which follows the fluctuations of the profits.

Examples of different types of investment decision:

Decisions internal to the
business enterprise

Decision involving
external parties

Research and development decisions

Investment in a marketing or advertising campaign

Whether to carry out a takeover or a merger

involving another business
Whether to engage in a joint venture with another
enterprise

Disinvestment decisions

1.4

Whether to undertake new projects

Whether to invest in new plant and machinery

Whether to sell off unprofitable segments of the

business
Whether to sell old or surplus plant and machinery
The sale of subsidiary companies

The statement of financial position and financial management:

Question 1
Discuss the relationship between investment decisions, dividend decisions and financing
decisions in the context of financial management, illustrating your discussion with examples
where appropriate.
(8 marks)
(ACCA F9 Financial Management June 2010 Q4(c))

2.

Financial Management, Management Accounting and Financial

Accounting

2.1

Management accounting
Financial management is mainly concerned with making decisions for the long-term
future of the company. It involves making forecasts for the future and needs much
external information (e.g. knowledge of competitors). The purpose is to make
decisions which end up achieving the objectives of the company.
Once the long term decisions have been made, they need to be implemented and
controlled. This is management accounting.

2.2

(a)

Management accounting involves making short-term decisions as to how to

implement the long-term strategy and involves the setting up of a control
system in order to measure how well objectives are being achieved in order
that corrections may be made if necessary.

(b)

It tends to be short-term, and involves both past information and forecasts for
the future.

Financial accounting
(a)

Financial accounting is the reporting to stakeholders primarily

shareholders of how the company has performed and therefore effectively
how well the financial manager and management accountant are doing their
jobs.

(b)

The financial accountant is fulfilling a legal requirement to report the

profits, and it is not their role to look for ways of performing better that is
the job of the financial manager.

(c)

The financial accountant is only looking at past information and

information internal to the company.

3.

Financial Objectives and Organizational Strategy

3.1

The financial manager needs to decide on strategies for the raising of finance, for the
investment of capital, and for the management of working capital. However, before he
can decide on these strategies he needs to identify what the objectives of the company
are.
The following diagram is the key to understanding how financial management fits into
overall business strategy.
The distinction between 'commercial' and 'financial' objectives is to emphasise that not
all objectives can be expressed in financial terms and that some objectives derive from
commercial marketplace considerations.

3.2
3.3

Question 2
The following list contains some commercial objectives/targets, some financial
objectives/targets and some strategies, all at different levels of the business. Identify which
is which.
1.
Implement a Just-In-Time (JIT) inventory system.
2.
Increase earnings per share (EPS) by 5% on prior year.
3.
Acquire a rival in a share-for-share purchase.
4.
Buy four new cutting machines for $250,000 each.
5.
Achieve returns of 15% on new manufacturing investment.
6.
Improve the ratio of current assets to current liabilities from 1.7 to 1.85.
7.
8.
9.

Reduce unsold inventory items by 12%.

Update manufacturing capacity to incorporate new technology.
Improve brand awareness within the UK.
Commercial
objectives

Financial
objectives

Strategies

Corporate level
Business level
Operational level

4.
4.1

Financial Objectives

(Jun 13)

Shareholder Wealth Maximization

(a)

(b)

(c)

Most companies are owned by shareholders and originally set up to make

money for those shareholders. The primary objective of most companies is
thus to maximise shareholder wealth. This could involve increasing the
share price and/or dividend payout.
Shareholder wealth maximisation is a fundamental principle of financial
management. You should seek to understand the different aspects of the
syllabus (e.g. finance, dividend policy, investment appraisal) within this
unifying theme.
Many other objectives are also suggested for companies including:
(i)
profit maximization
(ii) growth
(iii) market share
(iv) social responsibilities

Question 3
Identify TWO financial objectives of a listed company such as HDW Co and discuss how
each of these financial objectives is supported by the planned investment in new machinery.
(6 marks)
(ACCA F9 Financial Management June 2013 Q1(c))
4.2

Maximising and satisficing

One problem for the financial manager is to satisfy the objectives of several
stakeholders at the same time. For example, reducing wages might increase profits and
might satisfy shareholders, but would be unlikely to satisfy employees. Therefore, in
practice a distinction must be made between maximising and satisficing.
(a)
(b)

Maximising seeking the best possible outcome

Satisficing finding a merely adequate outcome.

5.

Objectives in Not-for-profit Organizations

5.1

Not-for-profit (NFP) organizations include organizations such as charities, state health

5.2

service and police force, where they are not run to make profits, but to provide a
benefit.
NFP organisations seek to provide services to the public and this requires cash income.

5.3

Maximising net cash income is therefore a key financial objective for NFP
organisations as well as listed companies. A large charity seeks to raise as much funds
as possible in order to achieve its charitable objectives, which are non-financial in
nature.
Both listed companies and NFP organisations need to control the use of cash within a

5.4

5.5

5.6

(Dec 11)

given financial period, and both types of organisations therefore use budgets. Another
key financial objective for both organisations is therefore to keep spending within
budget.
Although good financial management of these organizations is important, it is not
possible to have financial objectives of the same form as for companies. The focus
therefore for these organizations is on value for money, i.e. attempting to get the
maximum benefits for the least cost.
Value for money can be defined as getting the best possible combination of services
from the least resources, which means maximising the benefits for the lowest possible
cost.
This is usually accepted as requiring the application of economy, effectiveness and
efficiency.
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5.7

Economy is attaining the appropriate quantity and quality of inputs at lowest cost
to achieve a certain level of outputs.
For example, the economy with which a school purchases equipment can be measured
by comparing actual costs with budgets, with costs in previous years, with
government/ local authority guidelines or with amounts spent by other schools.

5.8

Effectiveness is the extent to which declared objectives/goals are met.

For example, the effectiveness of a school's objective to produce quality teaching
could be measured by the proportion of students going on to higher or further
education.

5.9

Efficiency is the relationship between inputs and outputs.

For example, the efficiency with which a school's IT laboratory is used might be
measured in terms of the proportion of the school week for which it is used.

Question 4
Compare and contrast the financial objectives of a stock exchange listed company such as Bar
Co and the financial objectives of a not-for-profit organisation such as a large charity.
(11 marks)
(ACCA F9 Financial Management December 2011 4(d))

6.

Stakeholders

6.1

Although the theoretical objective of a private sector company might be to maximize

the wealth of its owners, other individuals and groups have an interest in what a

6.2

company does and they might be able to influence its corporate objectives. Anyone
with an interest in the activities or performance of a company are stakeholders
because they have a stake or interest in what happens.
It is usual to group stakeholders into categories, with each category having its own
interests and concerns. The main categories of stakeholder group in a company are
usually the following.
Internal:
(a)
Directors
(b)
Employees
Connected:
(c)
Shareholders
(d)
Lenders
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6.3

7.

(e)

Customers

(f)
(g)

Suppliers
Labour union

External:
(h)
Government
(i)
Society as a whole
The influence of the various stakeholders results in many firms adopting non-financial
objectives in addition to financial ones. For example,
(a)
Maintaining a contented workforce
(b)
Showing respect for the environment
(c)
Providing a top quality service to customers

Agency Problem
(Dec 08, Jun 12)

7.1

Nature of agency problem

(a)

The agency problem arises because:

(i)
the objectives of managers differ from those of shareholders;
(ii) there is a divorce or separation of ownership from control in modern
companies; and
(iii) there is an asymmetry of information between shareholders and
managers which prevents shareholders being aware of most managerial
decisions.

(b)

The primary financial management objective of a company is usually

taken to be the maximisation of shareholder wealth. In practice, the
managers of a company acting as agents for the principals (the shareholders)
may act in ways which do not lead to shareholder wealth maximisation. The
failure of managers to maximise shareholder wealth is referred to as the
agency problem.

7.2

Agency conflicts are differences in the interest of a companys owners and managers.
They arise in several ways.
(a)

Moral hazard A manager has an interest in receiving benefits from his or

her position as a manager. These include all the benefits that come from status,
such as a company car, use of a company airplane, lunches, and so on.

(b)

Effort level Managers may work less hard than they would if they were the
owners of the company. The problem will exist in a large company at middle
levels of management as well as senior management level.
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(c)

(d)

(e)

Earnings retention The remuneration of directors and senior managers is

often related to the size of the company, rather than its profits. Management are
more likely to want to re-invest profits in order to make the company
bigger, rather than payout the profits as dividends.
Risk aversion Executive directors and senior managers usually earn most of
their income from the company they work for. They are therefore interested in
the stability of the company, because this will protect their job and their
future income. This means that management might be risk-averse, and
reluctant to invest in higher-risk projects.
Time horizon Shareholders concern about the long-term financial
prospects of their company, because the value of their shares depends on
expectations for the long-term future. In contrast, managers might only be
interested in the short-term. This is partly because they might receive annual
bonuses based on short-term performance, and partly because they might not
expect to be with the company for more than a few years.

7.3

Ways to reduce the agency problem in order to achieve the objective of

maximization of shareholder wealth
(Dec 08, Dec 13)
(a)

Devising a remuneration package it can be encouraged to increase or

maximize shareholder wealth by managerial reward schemes such as
performance-related pay and share option schemes. Through these
methods, the goals of shareholders and directors may increase in congruence.
Performance-related pay links part of the remuneration of directors to some
aspect of corporate performance, such as levels of profit or EPS. However, it
may have the shortcoming of focus on short-term performance while
neglecting the longer term.
Share option schemes bring the goals of shareholders and directors closer
together to the extent that directors become shareholders themselves. Share
options encourage directors to make decisions which exert an upward
pressure on share prices.
Unfortunately, a general increase in share prices can lead to directors being
rewarded for poor performance, while a general decrease in share prices can
lead to managers not being rewarded for good performance. However, share
option schemes can lead to a culture of performance improvement and so can

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bring continuing benefit to stakeholders.

(b)

Regulatory requirements can be imposed through corporate governance

codes of best practice and stock market listing regulations.
Corporate governance codes of best practice, such as UK Corporate
Governance Code, seek to reduce corporate risk and increase corporate
accountability. Responsibility is placed on directors to identify, assess
and manage risk within an organization. An independent perspective is
brought to directors decisions by appointing non-executive directors to
create a balanced board of directors, and by appointing non-executive
directors to remuneration committees and audit committees.
Stock exchange listing regulations can place obligations on directors to
manage companies in ways which support the achievement of objectives
such as the maximization of shareholder wealth. For example, listing
regulations may require companies to publish financial reports, to provide
detailed information on directorial rewards and to publish detailed reports on
corporate governance and corporate social responsibility.

7.4

Why small and medium-sized entities (SMEs) might experience less conflict between
the objectives of shareholders and directors than large listed companies.
(a)
In many cases shareholders are not different from directors, for example in
a family-owned company. Where that is the case, there is no separation
between ownership and control, there is no difference between the
objectives of shareholders and directors, and there is no asymmetry of
information. Conflict between the objectives of shareholders and directors
will therefore not arise.
(b)

The shares of SMEs are often owned by a small number of shareholders,

who may be in regular contact with the company and its directors. In these
circumstances, the possibility of conflict is very much reduced.

Question 5
At a recent board meeting of Dartig Co, a non-executive director suggested that the
companys remuneration committee should consider scrapping the companys current share
option scheme, since executive directors could be rewarded by the scheme even when they
did not perform well. A second non-executive director disagreed, saying the problem was that
even when directors acted in ways which decreased the agency problem, they might not be
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rewarded by the share option scheme if the stock market were in decline.
Required:
Explain the nature of the agency problem and discuss the use of share option schemes as a
way of reducing the agency problem in a stock-market listed company such as Dartig Co.
(8 marks)
(ACCA F9 Financial Management December 2008 Q1(e))
Question 6
Discuss the reasons why small and medium-sized entities (SMEs) might experience less
conflict between the objectives of shareholders and directors than large listed companies.
(4 marks)
(ACCA F9 Financial Management June 2012 Q3(a))
Question 7
Explain ways in which the directors of Darn Co can be encouraged to achieve the objective of
maximization of shareholder wealth.
(6 marks)
(ACCA F9 Financial Management December 2013 Q1(c))

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Multiple Choice Questions

1.

Which of the following is NOT one of the three main types of decision facing the
financing manager in a company?
A
B
C
D

2.

Dividend decision
Investment decision
Economic decision
Financing decision

Which of the following is an example of a financial objective that a company might

choose to pursue?

3.

Provision of good wages and salaries

B
C
D

Dealing honestly and fairly with customers on all occasions

Producing environmentally friendly products
Restricting the level of gearing to below a specified target level

The following statements relate to various functions within a business.

1.

The financial management function makes decisions relating to finance

2.

Financial accounts are used as a future planning tool.

Are the statements true or false?

A
B
C
D
4.

Both statements are true

Both statements are false
Statement 1 is true and statement 2 is false
Statement 2 is true and statement 1 is false.

In the context of managing performance in 'not for profit' organisations, which of the
following definitions is incorrect?
A
B
C

Value for money means providing a service in a way which is economical,

efficient and effective
Economy means doing things cheaply: not spending $2 when the same thing
can be bought for $1
Efficiency means doing things quickly: minimising the amount of time that is
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spent on a given activity

D

5.

Effectiveness means doing the right things: spending funds so as to achieve the
organisation's objectives

The agency problem is a driving force behind the growing importance attached to
sound corporate governance.
In this context, the agents are the:

6.

A
B

Customers
Shareholders

C
D

Managers
Auditors

Which of the following is a problem associated with managerial reward schemes?

A

By rewarding performance, an effective scheme creates an organisation

focused on continuous improvement
Schemes based on shares can motivate employees/managers to act in the
long-term interests of the company
Self-interested performance may be encouraged at the expense of team work

Effective schemes attract and keep the employees valuable to an organisation

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