CHAPTER 6 - FE

Ethics in Financial Management

2 The Corporate Objective

3 Risk Management

4 Ethics of Bankruptcy

5 Corporate Governance
 1. OVERVIEW
▪ The ethical issues in financial management fall
into two broad categories:
✓The ethical obligations/duties of financial
managers of a corporation.
✓The ethical justification for organizing a
corporation with a certain assignment of
control (usually to shareholders) and the
designation of an objective (usually
shareholder wealth maximization).
 1. OVERVIEW
→ The former category of issues bears on the
decisions made by financial managers in
fulfilling the finance functions of a corporation,
and involves the fiduciary duties of financial
managers to a corporation and its shareholders.
→ The latter category is a matter largely for
government in establishing the laws of
corporate governance and those governing other
aspects of corporate financial conduct, such as
managing bankruptcy.
 2. THE CORPORATE OBJECTIVE
▪ A fundamental tenet of financial management
is that the objective of the corporation is
shareholder wealth maximization (SWM).
▪ Pursuing this objective means that all major
decisions in a for-profit business firm ought to
be made with the sole aim of increasing the
return from its activities to the putative owners,
the shareholders.
2.1 What Is Shareholder Wealth?
▪ Before SWM can be accepted as the objective of the
firm in either form, we need to clarify the concept.
✓First, even determining what is a share and who is
consequently a shareholder is complicated by the
existence of ordinary and preferred stock, convertible
stock, restricted stock, stock options, and other
financial instruments that may resemble stock. Thus,
shareholders are not a single, undifferentiated group,
and so speaking of their interest may not be entirely
clear.
2.1 What Is Shareholder Wealth?
✓Second, even ordinary shareholders are diverse
with different risk preferences and time
horizons, and so decisions that raise the value
of the firm for one set of shareholders might
lower it for another. Further, the interests of
shareholders are assumed to be identical with
that of the firm, and so perhaps the interest of
the firm could be substituted for shareholder
interests.
 2.1 What Is Shareholder Wealth?
▪ The interests of shareholders are often diverse
and may not be identical with that of the firm,
what precisely does it mean to pursue SWM?
▪ Possible measures of shareholder wealth are
accounting profits (earnings per share), cash
flows, and share price.
 2.1.1 Accounting profits
▪ Accounting profits, which are the net revenues
of a corporation after all costs of doing
business are subtracted from gross revenues, is
an unsatisfactory measure since it is based on
the accounting for revenue and expenses,
which may be manipulated to some extent
within generally accepted accounting
principles (GAAP).
▪ Reported profits may also be inflated by
outright fraud in violation of GAAP (Enron,
WorldCom…)
2.1.1 Accounting profits
▪ Profits also do not take account of the risk that is
taken. A smaller return with less risk may
represent greater wealth for an investor on a risk-
adjusted basis if a higher return is not com-
mensurate with the greater risk.
▪ Profits do not take account of the cost of capital,
and so a company could make profits and still be
losing money if the cost of capital is not
covered→ A remedy for this problem is use of the
concept of economic value added (EVA), which
measures only profit in excess of capital costs.
 2.1.2 Free cashflows
▪ Free cash flow, which is the actual cash
generated minus capital expenditures, is not
only a good measure of the return on investment
so far but also a fair predictor of the future
earnings that free cashflows make possible.
▪ This measure is less subject to manipulation
than is net revenue or profit.
2.1.3 Stock price
▪ The most common measure of shareholder wealth
is share price, the price of a company’s stock. In
practice, SWM often means, simply, the focus on
raising the price of the company’s stock.
▪ However, share price is influenced by many
nonfundamental factors, including investor
psychology, economic trends, and market
irrationality, all of which are beyond
management’s control.
2.1.3 Stock price
▪ Share price may be affected by the strategies of
short-term investors who have little stake in the
long-term prospects of a firm. Thus, a costly
investment in research and development may not
be valued by investors in the current market.
▪ In such a case, how can it be determined what is in
the shareholders’ interest and whose judgment of
shareholder interests should prevail. Is the current
share price really accurate and should the measure
be the current price or one expected in the future?
2.1.3 Stock price
→ For all these reasons, managing to maximize
stock price may not be an adequate guide for
pursuing SWM.
▪ To meet these problems:
✓The “blissful shareholder” model (Henry Hu)
✓The “extended balance sheet” model (Bradford
Cornell & Alan C. Shapiro)
2.2 Do Firms Seek To Maximize?
▪ It is no secret that most business firms do not seek
to maximize shareholder wealth. If all corporations
did, there would be no extravagant headquarters or
fleets of corporate jets; prices would be the highest
possible and costs the lowest.
▪ Managers are able to consume perquisites, collude
with employees and customers against the interests
of investors, and salve their consciences and gain
public approval with good works.
2.3 SWM and Social Responsibility
▪ A major concern about SWM as the objective of a
corporations is its possible implications for
practicing corporate social responsibility (CSR).
▪ Although the responsibility of a business firm to
serve social ends is much debated, corporations
typically devote some resources to philanthropy
and other worthwhile social initiatives.
▪ Given the SWM objective, what should firms do
with regard to CSR, including social costs or
externalities?
 3. RISK MANAGEMENT
▪ Managing risk is a large part of finance.
▪ This task belongs to the financial managers of
any business enterprise, whether in finance or
some other area, since all financial decisions in
business involve some attention to risk.
▪ However, risk has many sources and can be
addressed by different means, and so risk
management must be the responsibility of
people throughout any organization.
3.1 What Is Risk Management?
▪ A business firm, whether it be in finance or some
other area, must consider a wider range of risks.
✓The main types of risk have been commonly
classified as credit risk and market risk.
✓More recently, the field of risk management has
come to include the category of operational risk,
which results from events that affect a company’s
operations
✓Reputational risk, which involves damage to a
company’s brand or franchise, has also become
widely recognized.
 3.1 What Is Risk Management?
▪ For financial and nonfinancial firms alike, the
goal of enterprise risk management (ERM) is
to maximize the value of the enterprise by
shaping the firm’s risk profile.
▪ This consists of identifying all of the risks
faced by the firm, including their likelihood
and potential costs, targeting an acceptable
level of risk, developing a plan to keep risks
within the preferred limits, and carefully
monitoring the implementation of this plan.
 3.1 What Is Risk Management?
▪ There are five main responses to risks:
1. A firm may avoid a risk entirely, for example, by
not entering a certain line of business;
2. It may seek to reduce a risk by taking appropriate
action;
3. The risk may be hedged so that a lossinducing
event is offset by some gain;
4. The risk may be transferred so that it is assumed by
another party, often with compensation as in the
case of insurance policies;
5. It may be borne.
 3.1 What Is Risk Management?
▪ The main tools for implementing ERM are
financial instruments to hedge or transfer
risks, operational changes that avoid or reduce
risks, and capital reserves to prevent
insolvency in cases of loss due to risks.
 3.2 Ethical Issues In Risk Management
▪ There is no question that risk ought to be
managed, but it matters immensely which risks
are managed, by whom, with what means, and
for whose benefit.
 3.3 The Failure of Risk Management
▪ The task of risk management is to ensure that
top management knows and understands the
risks and the potential gains and makes prudent
trade offs. Moreover, mistaken judgment is not
necessarily ethical failure, and so a question
for ethics is how to determine when
incompetence becomes immorality.
▪ Critics identify four theoretical problems with
the techniques of risk management.
3.3 The Failure of Risk Management
✓First, in developing measures and models, risk
management attempts to quantify the probability of
extremely rare events that occur far out on the tails
of normal distribution curves. Risk management
also assumes that the past is a reliable guide to the
future, so that predictions can be made with models
that use historical data. In the case of extremely
rare events, however, historical data may be
unavailable or of little predictive value, and data
for even more common events may become
unreliable when circumstances change.
3.3 The Failure of Risk Management
✓Second, models assume a deterministic world that
operates according to physical laws that can be
expressed mathematically. Calculations of
probabilities are reliable only when events are the
result of an underlying causal system that may be
imperfectly understood but is still orderly.
However, economic behavior is an extremely
complex phenomenon, with far too many variables
to be accommodated in any model, and, further,
human behavior, which is being modeled, does not
follow fixed laws of physics.
 3.3 The Failure of Risk Management
✓Third, in using models, it is difficult to anticipate
the interactions among variables, which can often
result in the compounding of consequences from
small changes. This problem, which is known as
procyclicality, may result when small changes in
such factors as prices, volatility, and liquidity,
which often occur in crises, lead to vicious
feedback loops that produce large, unexpected
effects.
3.3 The Failure of Risk Management
✓Fourth, a great deal of criticism has been directed
toward value at risk as a measure. VaR utilizes
sophisticated mathematical formulas to circumvent
the need to perform an immense number of
calculations about each asset in a portfolio. Its
widespread adoption is due to the convenience of a
single dollar figure that represents the maximum
amount that a portfolio might lose in a certain
period of time with a specified degree of
probability.
 4. ETHICS OF BANKRUPTCY
▪ Bankruptcy occurs when individuals and
corporations that have insufficient assets to pay
their debt obligations are subject to laws that
provide some protection from creditors.
▪ For businesses, bankruptcy provides temporary
relief from the obligation to pay debts while they
seek to reorganize, or else it produces an orderly
liquidation of assets in which, ideally, all creditors
are treated fairly, if not made whole.
 4.1 Ethical Basis of Bankruptcy
▪ The use of bankruptcy as a management
strategy has been facilitated by a system that
enables, indeed encourages, distressed or
insolvent firms to reor ganize instead of
liquidating.
 4.1 Ethical Basis of Bankruptcy
▪ Once a firm files for bankruptcy under Chapter 11,
creditors are prevented from enforcing their claims. The
managers of the firm are left in control (unless a court
finds dishonesty, mismanagement, or incompetence),
and they are allowed a period of time (initially 120 days,
with extensions possible) to develop a reorganization
plan. A plan generally reduces the claims of creditors
and specifies how these reduced claims will be met. The
plan offered by management must be accepted by most
of the creditors whose claims are reduced. The plan must
be approved by the shareholders as well.
4.1 Ethical Basis of Bankruptcy
▪ In the event that no management plan is accepted
within the time allowed, creditors are permitted to
submit their own plans, subject to the same rules for
acceptance.
4.1 Ethical Basis of Bankruptcy
→ The financial argument for this system of
bankruptcy is that it maximizes a firm’s assets. The
underlying assumption is that insolvency often
results from uncontrollable outside forces or from
innocent management mistakes. If insolvent but
financially viable firms are given the opportunity to
reorganize, then they can return to profitability and
repay their creditors. Such an outcome is preferable,
from a financial point of view, if reorganization
instead of liquidation leads to more productive
deployment of a firm’s assets.
4.1 Ethical Basis of Bankruptcy
➢ In short, bankruptcy law forces creditors,
who have control during the bankruptcy
process, to act like a group of shareholders
with responsibility for enhancing the total
value of a firm instead of acting as individual
claimants who are concerned only with
getting their due.
 4.1 Ethical Basis of Bankruptcy
→ The ethical argument follows directly from
the financial argument → the “creditors’
bargain”.
▪ It is assumed that creditors would favor a
system that maximizes a firm’s assets and
hence its ability to repay all creditors, either
through liquidation or reorganization.
4.1 Ethical Basis of Bankruptcy
▪ Although individual creditors, especially those with
secured claims, might collect more of what they are
owed in particular cases by liquidation, the cost and
uncertainty of these alternatives make them less
attractive as a universal system, when, in other cases,
the same creditor may have unsecured claims. In
addition, liquidation eliminates jobs and has an
impact on customers, suppliers, communities, and
other stakeholder groups. Thus, easy access to
bankruptcy protection not only deploys assets more
productively-which benefits creditors-but also
enhances the welfare of society.
4.2 Use And Abuse of Bankruptcy
▪ Easy access to bankruptcy protection has resulted in
a number of controversial uses of the law that were
not envisioned by Congress in creating the modern
bankruptcy system. Consider the following:
✓Product liability suits
✓Collective bargaining agreements
✓Liabilities and obligations
 4.3 What is wrong with strategic bankruptcy?
▪ The charge that some companies are abusing the
bankruptcy system suggests some moral wrong, but
it is difficult to identify that wrong precisely.
✓One charge is that some companies are using the
bankruptcy law for purposes other than that for
which it was enacted. However, to use a law for an
unintended end is not itself morally objectionable.
✓A second charge is that bankruptcy is being used to
avoid ethical and legal obligations that result from
contractual agreements or court judgments.
 4.3 What is wrong with strategic bankruptcy?
✓A third and more promising objection to the
conduct of companies that seek bankruptcy
protection is not that claimants do not receive
what they are owed but that claimants who
receive their claims under one set of rules are
forced to fight for them again under another set
of rules.
→ Critics of the bankruptcy system argue that
bankruptcy is not always a condition that afflicts
companies but is sometimes a deliberate choice
that companies make for strategic ends.
 4.3 What is wrong with strategic bankruptcy?
▪ Strategic bankruptcy might be compared to a game of
poker in which a dealer with bad cards is allowed to stop
the game, rearrange some of the hands, perhaps take some
money off the table, and resume play with different rules.
▪ However, the poker game just described is not unfair if the
dealer’s options are understood at the beginning of play.
Under such conditions, the game is merely one of many
possible forms of poker, albeit with rather complicated
rules, and players can play their hands with the possibility
of a rule change in mind. Similarly, a bankruptcy system
that permits companies to seek bankruptcy protection for
strategic reasons is not unfair merely because of the
possibility of a change in the rules.
 4.3 What is wrong with strategic bankruptcy?
▪ It be considered unfair because the affected
parties that had not anticipated this use of the
Bankruptcy Code.
▪ <Read more in the textbook>
thaoluong@ueh.edu.vn