MAT 444 Module 1 The Role of Financial Management Example

Earnings This Quarter or Value Over Ten Years: What Financial Management Is For at a Family-Owned Fabricator

Student Name

Business Administration Program, Aspen University

MAT 444: Finance for Managers

Instructor Name

Month Day, Year

Earnings This Quarter or Value Over Ten Years: What Financial Management Is For at a Family-Owned Fabricator

Haverstock Fabrication cuts, bends and welds steel and aluminum parts for agricultural equipment makers, truck body builders and a regional maker of commercial ovens. The company was founded in Fort Wayne in 1971 and is now owned by eleven members of the founder's family, only two of whom work there. Six years ago the family hired an outside president, who has grown sales from $21 million to $28 million. This paper explains what financial management at Haverstock should aim for, where the company's current incentives work against that aim, and which decisions the finance function exists to make. Haverstock and its numbers are composites written for teaching.

The Goal of the Firm

The goal of financial management is to maximize the long-run value of the firm to its owners, which for a private company means today's value of all the cash the business will hand its owners over the years. Profit is not the same thing. Accounting profit for a quarter can be raised by spending less on maintenance, training or product development, choices that lower future cash flows by more than they save today. Profit also ignores risk and timing: two plans with the same total profit can have very different values if one delivers its cash sooner or more reliably. Value captures all three dimensions, amount, timing and risk, which is why it is the standard against which the rest of this course measures decisions.

Value and the Stakeholders

A common objection is that value maximization ignores employees, customers and the community. Jensen (2001) answered that a firm cannot be steered by many objectives at once. When managers are told to balance the interests of every stakeholder without a rule for trading them off, they have no way to judge which choice is better, and no one can hold them accountable. Jensen proposed what he called enlightened value maximization: long-run value is the single score, but a firm cannot build it while mistreating any important constituency, because underpaid workers leave, neglected customers defect and a hostile community raises costs. At Haverstock, the apprentice welding program is a good example. It costs about $180,000 a year, but it is the main source of skilled welders in a tight labor market, so cutting it raises this year's earnings while damaging long-run value.

The Agency Problem at Haverstock

Jensen and Meckling (1976) modeled a firm in which the people who supply the capital hand control to people who do not own all of it. A manager who owns little of the business keeps the full benefit of a perk or an easy decision but pays only a fraction of its cost, so self-serving choices become cheap for the manager and expensive for everyone else. Owners push back by watching the manager and by building pay and contract terms that bind the two sides together. Jensen and Meckling counted three costs: what owners spend on watching, what the manager spends to prove good faith and the value still lost after both.

At Haverstock, nine of the eleven owners are distant from daily operations and rely on the president. The president's bonus, worth up to 40% of salary, is paid each quarter on earnings before interest, taxes, depreciation and amortization measured against budget. That design rewards any action that raises the current quarter's number, whether or not it adds value.

Evidence That the Concern Is Real

Graham et al. (2005) put questions to several hundred chief financial officers, and interviewed a smaller group in depth, on the way they manage reported earnings. Most said that meeting earnings benchmarks, such as the prior year's figure or analysts' expectations, was very important. A large majority said they would give up some economic value to deliver smooth earnings, and more than half said they would delay a project with positive net present value if starting it meant missing the current quarter's target. Executives described cutting discretionary spending, such as research, advertising and maintenance, to reach a number. The survey covered managers of public companies facing analysts, but the same pressure appears wherever pay depends on a short-term figure.

Two Incidents

Haverstock's records show what the bonus design can produce. In the third quarter of last year, the president postponed a scheduled $95,000 overhaul of the large press brake, and the quarter beat budget by a narrow margin. In the following spring the machine failed, idling its line for four weeks and costing about $310,000 in lost contribution and overtime. In the same year, the apprentice program's intake was cut from eight to three. Neither choice was dishonest; both were rational responses to the incentive the owners created.

The Three Decisions

Financial management makes three kinds of decisions, each of which bears on value.

The investment decision usually matters most, because a poor asset choice cannot be fixed by clever financing. The financing decision affects the risk the owners carry and the cost of the money. Working capital decisions are smaller one at a time but frequent, and a fabricator buying steel weeks before it is paid by customers can run short of cash while profitable.

Fixing the Incentive

The family's board should replace the quarterly bonus with a plan that rewards value. The proposal has three parts. First, half the bonus will depend on cash flow return on the firm's capital, averaged over three years, so that cutting maintenance to lift one quarter does not pay. Second, the other half will depend on completing a capital plan approved by the board each year, including maintenance and training budgets that cannot be cut without board approval. Third, the president will receive phantom equity, a cash payment tied to the change in an independent appraisal of the company's value over five years. These changes lower agency costs by aligning the president's reward with the owners' wealth instead of with a single accounting figure.

Information for the Owners

The two owners who work in the business sit on the board with three family members who do not and two independent directors. The finance function should give the board what it needs to judge value: a rolling cash flow forecast, the capital plan with each project's expected return and a yearly independent valuation. Monitoring of this kind is itself an agency cost, but a small one compared with the press brake failure.

Conclusion

Financial management at Haverstock exists to raise the long-run value of the company for its owners, measured by cash flows, their timing and their risk. Jensen and Meckling explain why a hired president's interests can drift from the owners', Jensen explains why value can serve as a single objective without neglecting stakeholders and Graham, Harvey and Rajgopal show that executives do trade value for earnings. A bonus based on multi-year cash returns and a protected capital plan points the president back toward value.

References

Graham, J. R., Harvey, C. R., & Rajgopal, S. (2005). The economic implications of corporate financial reporting. Journal of Accounting and Economics, 40(1-3), 3-73. https://doi.org/10.1016/j.jacceco.2005.01.002

Jensen, M. C. (2001). Value maximization, stakeholder theory, and the corporate objective function. Journal of Applied Corporate Finance, 14(3), 8-21. https://doi.org/10.1111/j.1745-6622.2001.tb00434.x

Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305-360. https://doi.org/10.1016/0304-405X(76)90026-X