Introduction
It has long been acknowledged that finance plays a vital role within the organisation, with accounting systems designed to help organisation decision-making and control, and financial techniques, such as discounted cash flow, providing tools for valuing projects and investments.
However, in recent years, it has become clear that financial strategy on its own can have a major impact on organisations. For example, choosing the right capital structure can add value, independently of production or marketing decisions. Private equity firms are able to add value simply by buying companies and restructuring their finances. Derivatives can be used to alter the risk-return profile for risks such as currency, interest rate or credit risk, to suit individual organisations' risk and return preferences. The valuation of a new issue can vary according to the state of the stock market. This book will outline the major ways in which financial strategy can add value, looking in particular at adding value through investment decisions, financing decisions and risk management decisions.
Most finance texts concentrate on either accounting or finance and fail to recognise the dilemma facing managers in practice. This is how to motivate managers and employees and measure their performance internally, at the same time ensuring that the performance is valued by external stakeholders, such as creditors and shareholders. Internal performance measures have typically been accounting-focused, whilst stock market measures have been cash-flow linked. This collection of articles will show how the traditional split between accounting – typically historic in focus – and finance – which is forward-looking – is being broken down through the use of measures such as Economic Value Added (EVA®), the balanced scorecard, and, in the public sector, measures such as Best Value.
Indeed, advances have been made in performance measurement in a number of areas. First, the traditional split between analysts concentrating on earnings and corporate financiers concentrating on cash flows had been eroded, with analysts now valuing companies using cash flows, and financiers aware of the impact of earnings announcements on share prices. Accounting regulators, both the International Accounting Standards Board, covering companies in the European Union, and the Financial Accounting Standards Board, covering companies in the United States, have been moving towards a discounted cash flow valuation of assets approach and away from the historic cost approach in an attempt to reduce the gap between financial market value and accounting book value.
Second, as globalisation of markets has taken place, the need for common accounting standards to ensure compatibility of financial reporting has been recognised, and investors are no longer so confused between, say, Japanese, German and US differences in accounting methods. Investors have become more aware, with company crises such as those experienced by Enron in the US, Royal Ahold in the Netherlands, Parmalat in Italy, Marconi in the UK, of the ability of management to be creative in their reporting of profits and assets, and regulators have moved to stamp out the worst practices. As a result of these changes, there is a trend towards a common set of international accounting standards to which firms seeking finance in international capital markets are required to adhere.
Third, the use of financial performance measures has become more widespread, particularly in the light of the massive privatisation programme, begun in the UK in the 1980s, and still continuing around the world as monopolies are dismantled and replaced by competing organisations. Newly privatised companies whose objectives and performance measures had been stated in non-financial terms are now required to report to investors, creditors and regulators who assess performance in financial terms. But this trend towards financial performance measurement has also taken place within the public sector, with public services required to compare their performance with that of equivalent private sector enterprises. The notion of value for money has become commonplace. Public sector projects are now being evaluated using private sector methodologies and sometimes financed and managed by the private sector.
Internationalisation has also widened the financial strategy debate in terms of financial objectives. The Anglo-Saxon corporate governance approach, of managers' role being to maximise shareholder value, came into conflict with the so-called Franco-German or continental European model of maximising stakeholder value, with stakeholders including managers, employees, pensioners, customers, the local community, as well as creditors and shareholders. Although Jensen and Meckling's 1976 paper on agency theory1 pointed out that, under the Anglo-Saxon model, managers may not all be trying single-mindedly to maximise shareholder value, the emphasis until recently has been how best to make sure that managers did adopt that approach, in particular through well-structured incentive schemes, typically involving share options. Also, with the dramatic rise in stock market values in the US in the 1990s, the Continental European model of corporate governance came under fire, with major companies such as Siemens introducing management incentive schemes along US lines. However, recent corporate scandals have highlighted some problems with the Anglo-Saxon model, such as the ability of management to window-dress financial performance to enhance the – short-term – value of their executive options, and how this may not be in the interests of stakeholders such as shareholders, employees and pensioners.
The traditional dominance of classical finance theories, such as Modigliani and Miller's models of optimal capital structure and dividend policy, has also been brought into question, being replaced by more considered research into why managers and investors behave in apparently non-rational ways. Part of the answer may be to do with the inadequacies of the relatively simplistic assumptions underlying these models. For example, the net present value of cash flow approach to valuing projects fails to take into account such complexities as the ability of managers to change their minds. For this, the theory of real options has been developed, where managers are deemed not just to have fixed forecast cash flows for each project, but the option to delay, abandon or alter the scale of the project, with consequent effects on their value to the firm. However, another explanation of the failure in practice of some traditional theories may be to do with behaviour. Investors may indeed be irrational, for example, buying in boom markets, and failing to sell in bear markets, instead holding on to losses in the hope the market will go back up. This is a whole new area of research into financial strategies which allows a much richer analysis of the real world.
NOTE
1. M.C. Jensen and W.H. Meckling (1976) “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure,” Journal of Financial Economics, 3(4), pp. 305–60.