CHAPTER 1

Objectives

Introduction
Examination context
Topic List
1 Business and financial strategy
2 Stakeholders and their objectives
Summary and Self-test
Answers to Interactive questions
Answers to Self-test

1
 Introduction

Learning objectives Tick off

 To explain the general objectives of financial management

 To explain the roles played by different stakeholders in the financial strategy selected by a business

 To identify possible conflicts of objectives between different stakeholders

The syllabus references that relate to this chapter are 1a, b, d, e and f.

Syllabus links
The area of corporate governance is more rigorously explored in the Business and Finance and Assurance papers.
The financial strategy of a business will be strongly influenced by the business strategy chosen, hence this subject
needs to be viewed in the context of the topics explained in Business Strategy.
In terms of linkages within Financial Management, this chapter provides a backdrop against which the techniques
and topics explored in this study manual can be viewed. It inevitably makes reference to ideas and terminology that
are explored more fully in later chapters. Consequently this chapter should be returned to after studying the other
chapters in this manual.

Examination context
In the exam, candidates may be required to discuss the likely objectives of various stakeholders, and comment
upon how conflicting objectives might be reconciled.

2 Financial Management
 1 Business and financial strategy
C
H
Section overview A
P
 Strategic planning addresses the long-term direction of the business.
T
 Business strategy is concerned with how the business will achieve its objectives.
E
 Financial strategy is concerned with the financial implications of the business strategy.
R

1.1 What is strategy?

1
Most businesses will undertake some form of strategic planning (either formally or informally). Strategic
planning is concerned with the long-term direction of the business (eg which products should it sell in which
markets), and how the business will achieve its objectives, ie its business strategy (or strategies). The Business
Strategy exam deals with much of the detail relating to strategic planning and business strategy, eg how in order
for a business to achieve its objectives it must interact with its environment, its available resources (eg physical and
human assets) and its stakeholders.

1.2 Financial strategy

This is concerned with the financial aspects of the strategic planning process, so in reality they are part and parcel
of the same overall picture. This chapter examines some of the financial strategy aspects of setting objectives and
dealing with stakeholders.
Having decided on its overall direction and objectives a firm must then make more detailed supporting financial
decisions over the medium to short term. The Financial Management syllabus is concerned with three broad
categories of these financial decisions which must be made, and these are outlined below.
Other aspects of short-term decision making are dealt with in some of the other examination papers, eg budgeting
and variances are covered in the Management Information paper.

Investment
decisions

Financing Risk management

decisions decisions

Three categories of financial decisions

1.3 Investment decisions

These are concerned with how a firm decides whether, for example, to buy plant and equipment or introduce a new
product to the market.
Investment decisions were introduced in Management Information, and are taken further in Chapter 2. These are of
fundamental importance, particularly as there is a risk that things could go wrong. For example, if a firm introduces
a new product and demand for it turns out to be far less than expected then, depending on the size of the investment
made, the future of the firm could be in jeopardy. Even if it survives, it will probably have to explain itself to its
investors (eg shareholders, banks).

1.4 Financing decisions

These are concerned with such matters as how a firm should be financed – solely by equity (shares) or by a
combination of equity and debt, and in what proportions.

Objectives 3
 Financing decisions are discussed in Chapters 4 and 5 and can be fundamental to a firm's existence. In times of
recession firms that have borrowed heavily often go bankrupt because cash flows have fallen to a level insufficient
to make interest payments on debt. It is for this type of reason that a greater amount of equity finance (on which
dividend payments are discretionary) may be preferable to debt. This is discussed further in Chapter 6.

1.5 The dividend decision

An important aspect of 'financing decisions' is the 'dividend decision'; this is concerned with whether or not a firm
should pay a dividend and, if one is to be paid, how much that dividend should be.
Of particular importance here are the effects of cutting dividends – what will be the reaction of shareholders facing
a cut in their income? If the company is quoted what will this do to the share price?
These issues are discussed in Chapter 7.

1.6 Risk management decisions

These are concerned with how a business manages risk in relation to investment decisions, financing decisions and
liquidity, currency and credit decisions.
Aspects of risk and uncertainty surrounding investment appraisal are explored in Chapter 3. Financial risks such as
currency and interest rate changes have created the need for risk reduction or hedging strategies. These are
explored in Chapters 9 and 10.

1.7 Inter-relationships
There are inter-relationships between all of these decisions. Chapter 8 explores business planning, which brings
together investment and finance decisions.

Worked example: Inter-relationships

Relationship Example

A company's chosen business strategy will determine A retailing company makes a strategic decision to
the necessary investment decisions to put into place the widen its markets
required assets

Investment in new stores

The new assets trigger a demand for capital ie A new issue of debt is made
financing decisions

The ongoing implementation of the strategy causes Overseas expansion creates a need for hedging activity
cashflow demands, as well as a different risk profile
which requires risk management decisions to be taken.

1.8 Financial economics

Financial economics is covered in this Financial Management study manual as follows:
 Discounted cash flows and NPV – see chapters 2 and 3.
 Financial economic models such as CAPM and Modigliani and Miller – see chapters 3 and 6.

4 Financial Management
 2 Stakeholders and their objectives
C
H
Section overview A
P
 A stakeholder is someone who has an interest in the performance of a firm
T
 Shareholders' objective – of wealth maximisation – is the primary objective
E
 Companies have a framework of objectives, which may be in conflict with one another
R

2.1 Objective
1
In order to make the decisions noted above, what those decisions are trying to achieve must be known, ie what is
the objective? Your objective (hopefully) is to pass your Financial Management examination. However, what are
the objective(s) of a firm? This depends on the objectives of the stakeholders who make up the firm.
Stakeholders are individuals or groups who have an interest in the performance of a firm although their various
goals may not always coincide.

Interactive question 1: Stakeholder objectives [Difficulty level: Easy]

Question Fill in your answer

 Who are the main

stakeholders in a business
and what are their likely
objectives?

 How might they conflict?

 How might the conflict

be resolved?

See Answer at the end of this chapter.

Objectives 5
 2.2 Conflict and an overriding objective
Return It is generally accepted that the interests of shareholders should be put first (at least as a
starting point in the decision making process). This means aiming to take decisions which
maximise the wealth of the shareholders. Wealth is measured by the value of the firm's shares,
which reflects the net present value of any projects taken on by the firm. The share price also
takes into account the returns to the shareholders in terms of dividend payments and the risk
attached to those returns.
Risk Risk may be viewed as the likelihood of the returns being achieved. Logically, therefore, if two
firms produce the same returns but with different risks, the less risky firm will be worth more.
Stakeholders The existence of multiple stakeholders can lead to multiple objectives. These objectives may
or may not be in conflict. For example, it seems reasonable to assume that a well-motivated
workforce whose objectives of pay, security and conditions are met is consistent with a
profitable and stable future for a firm and its shareholders. On the other hand, if controlling
pollution imposes increased costs on a firm (through government legislation), then returns to
shareholders may be reduced.
Shareholders By focusing on a single objective (that of increasing shareholder wealth) clear decisions can be
made. The rest of this manual develops the decision making tools which link to this objective.
Once the basic decision is made in terms of whether or not shareholder wealth is maximised,
the complications of multiple (conflicting) objectives can be taken into account.
Satisficing The firm may then attempt to 'satisfice' – that is make decisions which allow for the (partial)
satisfaction of the stakeholder objectives but which do not fully maximise shareholder wealth.

2.3 Agency theory and managerial objectives

The relationships between the various interested parties in the firm are often described in terms of agency theory.
Agency relationships occur when one party, the principal, employs another party, the agent, to perform a task or a
set of tasks, on his behalf. In many of these principal/agent relationships conflicts of interest can exist.
Shareholders
'principal'

Directors
'agent'

Suppliers Company Customers

One of the most important of these potential conflicts is between shareholders (principals) and directors (agents).
Though both of these parties tend to have similar objectives for the firm, there can be differences. With some
firms, shareholders insist that part of the directors' remuneration is linked to the extent to which shareholders'
wealth is enhanced. For instance, directors are sometimes given long-term share option schemes. Sometimes
management audits are used to monitor the actions of the directors. These arrangements have a cost to the
shareholders, often referred to as agency costs.
Some of these agency costs will be considered in later chapters.

Interactive question 2: Conflicts between shareholders and directors

[Difficulty level: Easy]
Specific areas in which conflicts of interest might occur between directors and shareholders include the following.
 Takeovers

6 Financial Management
 C
H
 Time horizon A
P
T
E
R
 Risk
1

 Debt

For each of these, explain why the directors might pursue an agenda which is at odds with the maximisation of
shareholder wealth.
See Answer at the end of this chapter.

Practical illustrations
It has been argued that in the 1990s directors used maximising shareholder wealth (or shareholder value) as a cover
to do what they wanted. Shareholders were not concerned as rising share prices kept them happy whilst directors
profited from share option schemes. Then came major falls in world stock markets and revelations that criminal
behaviour had been used to achieve higher share prices. A dramatic example of this is Enron.
Enron was initially an energy producer, but moved onto the trading of energy and water – these commodities
can be bought, sold, and hedged just like shares and bonds. By taking risky positions in these energy
products, Enron grew to become America's seventh largest company, employing 21,000 staff in more than 40
countries.
Fortune magazine named Enron 'America's Most Innovative Company' for six consecutive years from 1996
to 2001. In one year, Ken Lay – Enron's founder and former chairman – earned $252m including stock
options.
The desire to maintain a profitable face to the outside world however resulted in the collapse of the company.
Jeffrey Skilling, Enron's former chief executive, faced 28 counts of fraud, conspiracy, insider trading and
lying to auditors for allegedly trying to fool investors into believing Enron was healthy before the firm
crashed. Skilling was jailed for 24 years.
Ken Lay had faced six counts of fraud and conspiracy for perpetuating the scheme after Skilling quit in
August 2001. Ken Lay died after being convicted.
Enron left behind $31.8bn (£18bn) of debts; its shares became worthless, and 21,000 workers around the
world lost their jobs.
Shareholders have now begun to flex their muscles and take a much more active interest in what companies and
directors are doing, eg the chairman of Royal Dutch/Shell was forced to step down. Michael Eisner of Disney was
obliged to give up his chairmanship (but not the chief executiveship) after 43% of shareholders voted against his
reappointment.

2.4 Ethical considerations

Directors/managers (and shareholders) are often faced with ethical considerations in setting objectives and making
financial decisions, for example increasing profits by using foreign child labour; polluting the environment or
using non-renewable energy because it is cheaper, or exploiting superior (inside) information. A firm's value can
depend very much on its reputation. Many, such as the major banks, spend years building trust with customers and

Objectives 7
 suppliers, establishing a name for fair dealing and financial integrity. Fraud, allegations of dishonesty or a
reputation for sharp business practice and so on can undermine years of hard work and with it, shareholder value.
Some businesses explicitly state their ethical principles in order to distinguish themselves, eg Body Shop (animal
testing), Co-op (fair trade).

8 Financial Management
Summary and Self-test C
H
A
P
T
Summary E
R

Objectives 9
 Self-test
Answer the following questions.

1 'Financial managers need only concentrate on meeting the needs of shareholders by maximising earnings per
share – no other group matters.'

Discuss. (10 marks)

2 Many decisions in financial management are taken in a framework of conflicting stakeholder viewpoints.
Identify the stakeholders and some of the financial management issues involved in the following situations:

(a) A private company converting into a public company.

(b) A highly geared company, such as Eurotunnel, attempting to restructure its capital.

(c) A large conglomerate 'spinning off' its numerous divisions by selling them, or setting them up as
separate companies (eg Hanson).

(d) Japanese car-makers, such as Nissan and Honda, building new car plants in other countries.

(10 marks)

3 Assume you are Finance Director of a large multinational company, listed on a number of international stock
markets. The company is reviewing its corporate plan. At present, the company focuses on maximising
shareholder wealth as its major goal. The Managing Director thinks this single goal is inappropriate and asks
his co-directors for their views on giving greater emphasis to the following:

(i) Cash flow generation

(ii) Profitability as measured by profits after tax and return on investment

(iii) Risk-adjusted returns to shareholders

(iv) Performance improvement in a number of areas such as concern for the environment, employees'
remuneration and quality of working conditions and customer satisfaction

Requirement

Provide the Managing Director with a report for presentation at the next board meeting which:

(a) Discusses the argument that maximisation of shareholder wealth should be the only true objective of a
firm, and

(b) Discusses the advantages and disadvantages of the MD's suggestions about alternative goals.

(10 marks)

4 A company is considering improving the methods of remuneration for its senior employees. As a member of
the executive board, you are asked to give your opinions on the following suggestions:

(a) A high basic salary with usual 'perks' such as company car, pension scheme etc but no performance-
related bonuses

(b) A lower basic salary with usual 'perks' plus a bonus related to their division's profit before tax

(c) A lower basic salary with usual 'perks' plus a share option scheme which allows senior employees to
buy a given number of shares in the company at a fixed price at the end of each financial year

Requirement
Discuss the arguments for and against each of the three options from the point of view of both the company
and its employees. Detailed comments on the taxation implications are not required.
(10 marks)
Now, go back to the Learning Objectives in the Introduction. If you are satisfied you have achieved those
objectives, please tick them off.

10 Financial Management
Answers to Interactive questions C
H
A
P
Answer to Interactive question 1 T
 Shareholders may be interested in the dividends they receive and the price of their shares (assuming they are E
quoted); R

 Managers may be interested in their salary, perks (eg office size), relative power, etc;
 Employees may be interested in their pay, security of employment, working conditions, etc; 1
 Unions tend to have the same objectives as employees;
 Government may be interested in ensuring that firms do nothing illegal, pay appropriate taxes, etc;
 Society at large may be interested, for example in ensuring that pollution levels are kept to a minimum;
 The conflicts are perhaps apparent. Shareholder returns will be compromised in the short term by allowing
other stakeholders' objectives to be achieved;
 The resolution of this conflict is typically achieved in the longer term, as motivated managers, loyal
customers etc are likely to result in a more successful company. For example, greater sales, harder working
employees, committed suppliers all contribute to higher growth, higher prices and a higher share price, hence
maximising shareholder wealth.

Answer to Interactive question 2

 Takeovers
Victim company managers often devote large amounts of time and money to 'defend' their companies against
takeover. However, research has shown that shareholders in companies that are successfully taken over often
earn large financial returns. On the other hand, managers of companies that are taken over frequently lose
their jobs! This is a common example of the conflict of interest between the two groups.
 Time horizon
Managers know that their performance is usually judged on their short-term achievements; shareholder
wealth, on the other hand, is affected by the long-term performance of the firm. Managers can frequently be
observed to be taking a short-term view of the firm which is in their own best interest but not in that of the
shareholders.
 Risk
Shareholders appraise risks by looking at the overall risk of their investment in a wide range of shares. They
do not have 'all their eggs in one basket', unlike managers whose career prospects and short-term financial
remuneration depend on the success of their individual firm.
 Debt
As managers are likely to be more cautious over risk than shareholders, they might wish to adopt lower levels
of debt than would be optimal for the shareholders.

Objectives 11
 Answers to Self-test

1 Profit maximisation
One of the principles of the market economy is that if the owners of businesses attempt to achieve maximum
profitability and earnings this will help to increase the wealth of society. As a result, it is usually assumed
that a proper objective for private sector organisations is profit maximisation. This view is substantially
correct. In general, the market economy has out-performed planned economies in most places in the world.
Two key objectives of financial managers must therefore be the effective management of shareholders'
funds and the provision of financial information which will help to increase shareholder wealth.
Problems with profit maximisation
However, profit-seeking organisations can also cause problems for society. For example, monopolists are
able to earn large returns which are disproportionate to the benefits they bring to society. The costs of
pollution fall on society rather than on the company which is causing it. A company may increase
profitability by making some of its work-force redundant but the costs of unemployed people fall on society
through the social security system.
The question that then follows is 'Should individual companies be concerned with these market
imperfections?'
Government's role
There are two opposing viewpoints. On the one hand it can be argued that companies should only be
concerned with maximisation of shareholders' wealth. It is the role of government to pick up the problems
of market imperfections (eg by breaking up monopolies, by fining polluters and by paying social security
benefits).
Stakeholder interests
An alternative viewpoint is that a company is a coalition of different stakeholder groups: shareholders,
lenders, directors, employees, customers, suppliers, government and society as a whole. The objectives of all
these groups, which are often in conflict, need to be considered by company managers when making
decisions. From this viewpoint, financial managers cannot be content with meeting the needs of shareholders
only.
Consideration of stakeholders
The truth is somewhere in between. The over-riding objective of companies is to create long-term wealth for
shareholders. However this can only be done if we consider the likely behaviour of other stakeholders. For
example, if we create extra short-term profits by cutting employee benefits or delaying payments to creditors
there are likely to be repercussions which reduce longer term shareholder wealth. Or if we fail to motivate
managers and employees adequately, the costs of the resulting inefficiencies will ultimately be borne by
shareholders.
Conclusion
In summary, the financial manager is concerned with managing the company's funds on behalf of
shareholders, and producing information which shows the likely effect of management decisions on
shareholder wealth. However management decisions will be made after also considering other stakeholder
groups and a good financial manager will be aware that financial information is only one input to the final
decision.

12 Financial Management
2 (a) A private company converting into a public company

When a private company converts into a public company, some of the existing shareholders/managers C
will sell their shares to outside investors. In addition, new shares may be issued. The dilution of H
ownership might cause loss of control by the existing management. A
P
The stakeholders involved in potential conflicts are as follows. T
E
(1) Existing shareholders/managers R
They will want to sell some of their shareholding at as high a price as possible. This may motivate
them to overstate their company's prospects. Those shareholders/managers who wish to retire from
the business may be in conflict with those who wish to stay in control – the latter may oppose the
1
conversion into a public company.

(2) New outside shareholders

Most of these will hold minority stakes in the company and will receive their rewards as
dividends only. This may put them in conflict with the existing shareholders/managers who
receive rewards as salaries as well as dividends. On conversion to a public company there should
be clear policies on dividends and directors' remuneration.

(3) Employees, including managers who are not shareholders

Part of the reason for the success of the company will be the efforts made by employees. They
may feel that they should benefit when the company goes public. One way of organising this is to
create employee share options or other bonus schemes.

(b) A highly geared company attempting to restructure its capital

The major conflict here is between shareholders and lenders. If a company is very highly geared, the
shareholders may be tempted to take very high risks. If the gamble fails, they have limited liability and
can only lose the value of their shares. If they are lucky, they may make returns many times the value of
their shares. The problem is that the shareholders are effectively gambling with money provided by
lenders, but those lenders will get no extra return to compensate for the risk.

Removal of risk

In restructuring the company, something must be done either to shift risk away from the lenders or to
reward the lenders for taking a risk.

Risk can be shifted away from lenders by taking security on previously unsecured loans or by writing
restrictive covenants into loan agreements (eg the company agrees to set a ceiling to dividend pay-outs
until gearing is reduced, or to confine its business to agreed activities).

Lenders can be compensated for taking risks by either negotiating increased interest rates or by the
issue of 'sweeteners' with the loans, such as share warrants or the issue of convertible loan stock.

Other stakeholders

Other stakeholders who will be interested in the arrangements include trade creditors (who will be
interested that loan creditors do not improve their position at the expense of themselves) and managers,
who are likely to be more risk averse than shareholders if their livelihood depends on the company's
continuing existence.
(c) A large conglomerate spinning off its divisions

Large conglomerates may sometimes have a market capitalisation which is less than the total realisable
value of the subsidiaries. This is referred to as 'conglomerate discount'. It arises because more synergy
could be found by the combination of the group's businesses with competitors than by running a
diversified group where there is no obvious benefit from remaining together.

Objectives 13
 For many years, Hanson Trust was the exception to this situation, but subsequently it decided to break
up the group.

The stakeholders involved in potential conflicts are as follows.

(1) Shareholders

They will see the chance of immediate gains in share price if subsidiaries are sold.

(2) Subsidiary company directors and employees

They may either gain opportunities (eg if their company becomes independent) or suffer the threat
of job loss (eg if their company is sold to a competitor).

(d) Japanese car makers building new car plants in other countries

The stakeholders involved in potential conflicts are as follows.

(1) The shareholders and management of the Japanese company

They will be able to gain from the combination of advanced technology with a cheaper workforce.

(2) Local employees and managers engaged by the Japanese company

They will gain enhanced skills and better work prospects.

(3) The government of the local country, representing the tax payers

The reduction in unemployment will ease the taxpayers' burden and increase the government's
popularity (provided that subsidies offered by the government do not outweigh the benefits!)

(4) Shareholders, managers and employees of local car-making firms

These will be in conflict with the other stakeholders above as existing manufacturers lose market
share.

(5) Employees of car plants based in Japan

These are likely to lose work if car-making is relocated to lower wage areas. They will need to
compete on the basis of higher efficiency.

3 REPORT
To: Managing Director
From: Finance Director
Date: 17 November 20X5
Subject: Discussion of corporate objectives
Introduction
1 This report has been drafted for use as a discussion document at the forthcoming board meeting. It deals
with the validity of continuing to operate with the single major goal of shareholder wealth
maximisation. The remaining sections of the report contain an analysis of the advantages and
disadvantages of some of the alternative objectives that have been put forward in recent discussions.
Maximisation of shareholder wealth
2 The concept that the primary financial objective of the firm is to maximise the wealth of
shareholders, by which is meant the net present value of estimated future cash flows, underpins much
of modern financial theory.
3 While the relevance of the wealth maximisation goal is under discussion, it might also be useful to
consider the way in which this type of objective is defined, since this will impact upon both parallel and
subsidiary objectives. A widely adopted approach is to seek to maximise the present value of the
projected cash flows. In this way, the objective is both made measurable and can be translated into a

14 Financial Management
 yardstick for financial decision making. It cannot be defined as a single attainable target but rather as a
criterion for the continuing allocation of the company's resources. C
4 There has been some recent debate as to whether wealth maximisation should or can be the only true H
objective, particularly in the context of the multinational company. The stakeholder view of corporate A
objectives is that many groups of people have a stake in what the company does. Each of these groups, P
which include suppliers, workers, managers, customers and governments as well as shareholders, has its T
own objectives, and this means that a compromise is required. For example, in the case of the E
multinational firm with a facility in a politically unstable third world economy, the directors may at R
times need to place the interests of the local government and economy ahead of those of its
shareholders, in part at least to ensure its own continued stability there.
Cash flow generation 1
5 The validity of cash flow generation as a major corporate objective depends on the timescale over
which performance is measured. If the business maximises the net present value of the cash flows
generated in the medium to long term, then this objective is effectively the same as that discussed
above. However, if the aim is to maximise all cash flows, then decisions are likely to be
disproportionately focused on short-term performance, and this can work against the long-term health
of the business. Defining objectives in terms of long-term cash flow generation makes the shareholder
wealth maximisation goal more clearly definable and measurable.
Profitability
6 Many companies use return on investment (ROI) targets to assess performance and control the
business. This is useful for the comparison of widely differing divisions within a diverse multinational
company, and can provide something approaching a 'level playing field' when setting targets for the
different parts of the business. It is important that the measurement techniques to be used in respect of
both profits and the asset base are very clearly defined, and that there is a clear and consistent approach
to accounting for inflation. As with the cash flow generation targets discussed above, the selection of
the time frame is also important in ensuring that the selected objectives do work for the long-term
health of the business.
Risk adjusted returns
7 It is assumed that the use of risk adjusted returns relates to the criteria used for investment appraisal,
rather than to the performance of the group as a whole. As such, risk adjusted returns cannot be used in
defining the top level major corporate goals; however they can be one way in which corporate goals
are made congruent with operating decisions. At the same time, they do provide a useful input to the
goal setting process in that they focus attention on the company's policy with regard to making risky
investments. Once the overall corporate approach to risk has been decided, this can be made effective in
operating decisions, for example by specifying the amount by which the cost of capital is to be
augmented to allow for risk in various types of investment decisions.
Performance improvement in non-financial areas
8 As discussed in the first section of this report, recent work on corporate objectives suggests that firms
should take specific account of those areas which impact only indirectly, if at all, on financial
performance. The firm has responsibilities towards many groups in addition to the shareholders,
including:
(a) Employees: to provide good working conditions and remuneration, the opportunity for personal
development, outplacement help in the event of redundancy and so on
(b) Customers: to provide a product of good and consistent quality, good service and
communication, and open and fair commercial practice
(c) The public: to ensure responsible disposal of waste products.
9 There are many other interest groups that should also be included in the discussion process. Non-
financial objectives may often work indirectly to the financial benefit of the firm in the long term, but in
the short term they do often appear to compromise the primary financial objectives.
Conclusions
10 It is very difficult to find a comprehensive and appropriate alternative primary financial objective to that
of shareholder wealth maximisation. However, achievement of this goal can be pursued, at least in
part, through the setting of specific subsidiary targets in terms of items such as return on investment

Objectives 15
 and risk adjusted returns. The establishment of non-financial objectives should also be addressed in the
context of the overall review of the corporate plan.
Signed: Finance Director
4 Factors affecting remuneration policy
(a) Cost: the extent to which the package provides value for money.
(b) Motivation: the extent to which the package motivates employees both to stay with the company and to
work to their full potential.
(c) Fiscal effects: government tax incentives may promote different types of pay. At present there are tax
benefits in offering some types of share option schemes. At times of wage control and high taxation this
can act as an incentive to make the 'perks' a more significant part of the package.
(d) Goal congruence: the extent to which the package encourages employees to work in such a way as to
achieve the objectives of the firm - perhaps to maximise rather than to satisfice.
Option (a)
In this context, Option (a) is likely to be relatively expensive with no payback to the firm in times of low
profitability. It is unlikely to encourage staff to maximise their efforts, although the extent to which it acts as
a motivator will depend on the individual psychological make-up of the employees concerned. Many staff
prefer this type of package however, since they know where they are financially. In the same way the
company is also able to budget accurately for its staff costs.
Option (b)
The costs of this scheme will be lower, though not proportionately so, during a time of low profits. The effect
on motivation will vary with the individual concerned, and will also depend on whether it is an individual or
a group performance calculation. There is a further risk that figures and performance may be manipulated
by managers in such a way as to maximise their bonus to the detriment of the overall longer term company
benefit.
Option (c)
A share option scheme (Option (c)) carries fiscal benefits in the same way as the performance related pay
above. It also minimises the cost to the firm since this is effectively borne by the existing shareholders
through the dilution of their holdings. Depending on how pricing is determined, it may assist in achieving
goal congruence. However, since the share price depends on many factors which are external to the firm, it is
possible for the scheme to operate in a way which is unrelated to the individual's performance. Thus such a
scheme is unlikely to motivate directly through links with performance. Staff will continue to obtain the
vast majority of their income from salary and perks and are thus likely to be more concerned with
maximising these elements of their income than with working to raise the share price.

16 Financial Management