Finance – An Overview

Introduction

It is a basic assumption of finance theory, taught as fact in Business Schools and advocated at the highest level by vested interests, world-wide (governments, financial institutions, corporate spin doctors, the press, media and financial web-sites) that stock markets represent a profitable long-term investment. Throughout the twentieth century, historical evidence also reveals that over any five to seven year period security prices invariably rose. This happy state of affairs was due in no small part (or so the argument goes) to the efficient allocation of resources based on an efficient interpretation of a free flow of information. But nearly a decade into the new millennium, investors in global markets are adapting to a new world order, characterised by economic recession, political and financial instability, based on a communication breakdown for which strategic financial managers are held largely responsible. The root cause has been a breakdown of agency theory and the role of corporate governance across global capital markets. Executive managers motivated by their own greed (short-term bonus, pension and share options linked to short-term, high-risk profitability) have abused the complexities of the financial system to drive up value. To make matters worse, too many companies have also flattered their reported profits by adopting creative accounting techniques to cover their losses and discourage predators, only to be found out. We live in strange times. So let us begin our series of Exercises with a critical review of the traditional market assumptions that underpin the Strategic Financial Management function and also validate its decision models. A fundamental re-examination is paramount, if companies are to regain the trust of the investment community which they serve.

Exercise 1.1: Modern Finance Theory

We began our companion text: Strategic Financial Management (SFM henceforth) with an idealised picture of shareholders as wealth maximising individuals, to whom management are ultimately responsible. We also noted the theoretical assumption that shareholders should be rational, risk-averse individuals who demand higher returns to compensate for the higher risk strategies of management. What should be (rather than what is) is termed normative theory. It represents the bedrock of modern finance. Thus, in a sophisticated mixed market economy where the ownership of a company’s investment portfolio is divorced from its control, it follows that: