Lecture # 8 (Chapter 02)

Conflicts of interests: shareholders versus managers the agency problem

The problem
Although the shareholders control the business in theory, in practice the managers control it on a
day-to-day basis. It has been suggested that some businesses might pursue policies that are likely
to maximize the welfare of their managers, at the same time giving the shareholders sufficient
rewards to stop them from becoming too dissatisfied and causing discomfort to the managers,
rather than maximizing shareholders wealth. The ways in which managers might seek to
maximize their welfare include:

Paying themselves good levels of salary and perks, but not too much to alert
shareholders to whom, by law, directors salaries must be disclosed;
Providing themselves with larger empires, through merger and internal expansion, thus
increasing their opportunities for promotion and social status; and
Reducing risk through diversification, which may not benefit the shareholders, but may
well improve the managers security.

There is no reason to believe that managers consider only their own interests at the expense of
the shareholders. However, it is likely that some, possibly most, managers would consider their
own welfare when making decisions about the business. This, no doubt, can cause decisions to
be made that are sub-optimal from the shareholders viewpoint. Unfortunately, the costs of
undertaking some sort of management audit to monitor managers decisions are likely to be
considerable, making it unreasonable to attempt.
The costs to the shareholders of managers making decisions that are not in the shareholders best
interests, and/or of the shareholders monitoring the managers, are known as agency costs. This is
because managers act as agents of the shareholders in the management of the assets of the
business. Agency cost is a factor that arises in several areas of business finance. Of course,
bonuses linked to shareholder returns and directors share options, are examples of agency costs
incurred to encourage the managers to run the business in a shareholder-wealth enhancing
manner.

Short-termism
The existence of the takeover sanction may not be sufficient to cause management to be
completely selfless in its conduct of the businesss affairs, however. One area where the takeover
sanction may not be effective is where managers take too short-term a view. Although the best
interests of the shareholders may be served by an emphasis on long-term profitability, the best
interests of managers could be served by so-called short-termism. Managers may see their
careers as lasting only two or three years with a particular business before they move on to other
employment.
Their reputations may therefore depend on what happens whilst they are still with the business
rather than on the ultimate effect of their actions. Perhaps more importantly, management

remuneration may well be based on immediate profit flows. Both of these factors could promote
a tendency to concentrate on the short term.
Another factor that might encourage managerial short-termism is where managers perceive that
investors are interested only in the short term. If such a perception were correct, it would mean
that businesses whose managements failed to take decisions that would enhance short-term
profits would experience a fall in their share price.
Thus managers might promote short-term profits for one or both of two reasons:
1 It is quite common, as we have seen, for managerial remuneration to be linked to the businesss
share price: the higher the share price, the larger the bonus.
2 A weak share price might encourage a takeover of the business.
Demirag (1998) found evidence that businesses managers believe investors to be short-termists.
This supported an earlier study by the same researcher. Marston and Craven (1998) found that
there is no strong evidence that investors are in fact short-termist. These researchers also found
that, nevertheless, managers believe investors to be so. In view of these findings, it could be the
case that managers may have a tendency to favor short-term investments, in the mistaken belief
that this is what shareholders want. There is no strong evidence to support this estimation,
however.

Lecture # 9 & 10
FINANCIAL (ACCOUNTING) STATEMENTS AND THEIR INTERPRETATION
(Chapter 03)
Introduction
Most businesses that trade as limited companies are required to publish three financial statements
each year. These are:

The income statement (also known as the profit and loss account);
The balance sheet (also known as the position statement); and
The cash flow statement.

These statements provide a very valuable source of information for financial managers who work
within the business, and for investors, potential investors and their advisers. They also provide
helpful insights for others who have a relationship with the business, including customers,
employees, suppliers and the community in general.
It is likely that managers will have access to information beyond that which is made public. The
nature of the additional information and the way in which it is derived, however, are probably
very similar to the nature and derivation of published information.
The financial statements

We shall now take a look at the financial statements. These will be explained in the broadest way.
Businesses that trade as companies are required to produce the financial statements annually.
Most businesses actually produce these statements much more frequently for their own internal
purposes. The statements are often used by managers as aids to financial planning in that the data
that they contain will be based on plans and forecasts. The published statements are, of course,
based on past events.
THE INCOME STATEMENT
The income statement (or profit and loss account) is a statement that sets out a summary of the
trading events that will have affected the wealth of the business over a particular period, the
amount by which each type of event has affected wealth, and the resulting net effect on wealth.
The statement also goes on to show how any net increase in the businesss wealth over the period
has been deployed.
Wealth in this context is not restricted to cash. It is all the things that have economic value to the
business, net of such obligations that the business may have to outsiders in respect of any part of
its wealth. Things that have economic value to the business (assets) include, for example, an
office building owned by the business and the money owed to it by a customer who has bought
some of the businesss output on credit. Outside obligations would include an amount owed to a
loan notes holder. We shall now look at an example of an income statement. Jackson plc is an
imaginary manufacturing business that is listed on the London Stock Exchange.
The nature of the businesss marketing strategy is that goods are made to order so there are never
any inventories (stock) of finished goods. The form of financial statements varies from one
business to the next. The layout that is shown here is broadly in line with that which most UK
businesses use for the annual published financial statements. Individual businesses can and do
use different layouts for financial statements.
Jackson plcs income statement for the year 2008 shows that the business generated wealth
(earned revenues) of 837 million by making sales to external customers. This led directly to the
wealth being reduced (expenses incurred) in respect of meeting the cost of making those sales
revenues; also in distributing the goods sold and meeting the administrative costs of running the
business. This left the business with a net increase in wealth, as a result of operating for the year,
of 135 million. The interest that the business was under a contractual obligation to pay
accounted for a further 30 million. 27 million will be paid to the Revenue and Customs for
corporation tax, leaving an (after-tax) profit for the year of 78 million.

Lecture 11 & 12 (Chapter 03)

THE BALANCE SHEET
The balance sheet is a statement of the manner in which the business holds its wealth, how
much of its wealth it has in each category, how much of the wealth that the business controls is
committed to outsiders, and the net wealth of the business. This net wealth belongs to the
shareholders. Unlike the income statement, which summarizes the effects of various trading
events on the wealth of the business over a period, the balance sheet shows the position at a

specified point in time.

The balance sheet of Jackson plc, at the end of the year covered by the income statement that we
have just considered, is as follows:

This balance sheet tells us that the wealth of the business is 799 million. This is made up of
non-current assets of 623 million and current assets of 176 million. The business has
obligations to transfer part of this wealth to outside groups: 90 million is in respect of
obligations that relate to day-to-day trading and are likely to be short term; 300 million is in
respect of longer-term obligations not directly related to trading. The distinction between noncurrent and current assets is broadly concerned with the intended use of those assets. Non-current
assets are those that business intends to use internally to help to generate wealth, not to be sold at
a profit. Current assets are those that are acquired with the intention of turning them over in the
normal course of trading. A particular non-current asset might be sold at a profit but this would
not mean that it should have been treated as a current asset, provided that the primary reason for
buying it was for using rather than selling it. Non-current assets can be seen as the tools of the
business. Non-current assets were formerly known as fixed assets.
Depreciation recognizes that certain non-current assets are not worth as much at the end of their
life with the business as they cost at the beginning and, therefore, that some part of the businesss

wealth will be lost. This is why depreciation appears in the income statement as an expense, and
why the balance sheet value of depreciating noncurrent assets is reduced below cost. The total
amount of depreciation of a particular asset is calculated by taking its cost and deducting its
estimated disposal value at the end of its life with the business. The equity section of the
balance sheet shows how the shareholders have contributed to the businesss current wealth. This
was by a combination of shareholders specifically putting assets, normally cash, into the business
to acquire shares, and by allowing wealth generated within the business to remain there, rather
than being paid to them as dividends. These ploughed-back profits, shown under the heading
retained profit, are known as reserves. Reserves represent part of the wealth of the
shareholders just as much as dividends do. You should be clear that the 209 million of retained
profit at the end of the year is that part of the businesss end-of-year wealth that has arisen from
profits generated over the years up to 31 December 2008, to the extent that it had not been

extinguished by trading losses;

paid to the Revenue and Customs as tax; or
paid to the shareholders as dividends.

The 209 million is unlikely to be in the form of cash. As has already been pointed out, wealth
does not just mean cash. In practice the retained profit is probably in various forms plant,
inventories etc.
20 million was paid to the shareholders as a dividend during 2008. This is reflected in the cash
flow statement.
THE CASH FLOW STATEMENT
The cash flow statement is simply an analysis of the cash (including short-term, highly liquid
investments) received and paid out by the business during a period. It is arranged in such a way
that it will enable readers to derive helpful insights about the sources and uses of cash over the
period. It may seem strange that one particular asset cash is highlighted in this way when
others, for example inventories, are not. What is so special about cash? The answer to this
question is that cash tends to be at the heart of most aspects of business. A businesss ability to
prosper and survive is likely to depend on its ability to generate cash. This is not usually true for
other types of asset. This is not usually true for other types of asset. The cash flow statement of
Jackson plc is as follows:

This statement shows that the business generated a net cash inflow of 212 million from its
trading activities. That is to say that during the year the receipts of cash from sales exceeded
payments of cash to pay wages and salaries, suppliers of goods and services, and so on, by 212
million. You should be clear that this is not the same as profit. Profit is the net increase in wealth
generally as a result of trading not just cash.
The remainder of the statement shows where any other cash has come from (none in the case of
Jackson plc in 2008) and gone to. In this case, cash has been spent on paying the interest,
taxation and dividend. In addition, some cash was spent acquiring non-current assets.
Had any cash been raised through an issue of shares or loan notes, or had any cash been paid to
redeem shares or loan notes, the effect of these would have appeared under the cash flows from
financing activities heading in the statement. The net cash generated during the year was 111
million which had the effect of bringing the cash balance up from a negative (overdraft) of 86
million to a positive balance of 25 million between 1 January and 31 December 2008.