INVESTORS’ BIASES AND HERDING BEHAVIOR IN THE CRYPTOCURRENCY MARKET

Text references. Chapter 1 for the role and responsibilities of management; Chapter 3 for ethical / environmental issues; Chapter 4b for agency issues.

Top tips. There are plenty of issues in the scenario that you can address but make sure to relate your answer to part (a) to strategic financial issues. Make sure that the issues you identify are quite specific as you are required to provide potential actions that could resolve these issues.

Ethics have been identified by the examiner as being an important part of the syllabus and these are dealt with in part (b). Some of the issues can be easily identified. Others, such as the earnings management issue, are more subtle; don't worry if you haven't mentioned that one as it is only worth 2 marks.

As both parts of this question link quite closely to one another, you should carefully plan your answer to ensure that the alternatives you identify in (a) can be used to resolve the ethical issues in (b).

Easy marks. As mentioned above, there are some easy marks to be gained in part (b) by identifying some of the more obvious ethical issues in the scenario.

Examiner's comments. This question gave candidates a wide degree of latitude in identifying the strategic, financial and ethical issues faced by the company concerned. A wide variety of answers were provided by candidates.

Many candidates demonstrated skills in planning and layout. However relatively few candidates focused on the perspective of a chief financial officer which was the role they were asked to assume. The selection of issues and details of alternative courses of action were generally limited and sometimes inconsistent. Candidates should also pay attention to the simple points. For example, this company has surplus cash and the overriding question is whether there is any prospect that the cash could be used effectively through new value-adding investment. If that is not the case then the company has an ethical duty to return that cash to the shareholders.

Candidates should also note that points should not be repeated unless it is relevant to the development of new lines of argument or mentioned in the conclusion.

Marking scheme

Marks (a) Setting the scene and identifying core problem and its source 2

Principal alternatives:

Acquisition strategy 2

Reorganisation, organic growth with cost minimisation 2

Return cash to investors 2

Investment in AMT 2

Incentives for management 2

Changes to capital budgeting system 2

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(b) Identification of core ethical issues 3

Social policy and property rights arguments underpinning ethical

dimension 2

Resolution and advice 4

Note on ethics of earning management 2

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(a) Notes for the 'Agenda for Change' board paper Strategic financial issues

The company appears to have lost some of its competitive edge due to a slow-down in spending on defence-based components which are a major part of the company's business. The company has failed to invest in research and development although it has adopted a strategy of growth by acquisition. Significant problems appear to be the lack of expenditure on new investment projects and the lack of accountability of managers who sponsor poorly performing projects and whose remuneration is relatively low.

Financial position

The company's financial position appears to be strong, with low gearing and a comfortable current assets ratio, as well as an abundance of cash in hand and on deposit. However such a financial position makes the company ripe for a takeover bid.

Possible alternatives

I have identified four alternatives that could be pursued to address these strategic financial issues. These are not necessarily mutually exclusive.

(i) Acquiring research and development expertise by acquisition

As the company already has a 'growth by acquisition' strategy it could extend this to its research and development facility. As research and development growth by internal investment can take years – and time is not something that the company has – this strategy is much more viable, particularly as

the necessary cash is available. An improvement in the essential research and development facility will allow the company to develop new and improved products to appeal to more lucrative markets.

This is particularly important as the 'dominant' defence side of the business appears to be in decline.

(ii) Organic growth with cost minimisation

Given the Chairman’s comments about the likelihood of a fall in business opportunities in future years, and the strong competitive pressures currently being faced – it seems likely that the company will have to try to extract greater efficiency from its existing business units. The structural and managerial problems that are being faced suggest that the acquisitions may have created a fragmented value chain. The company needs to examine the cause of these problems – potentially there may be opportunities to close down overlapping business units and to reorganise them into larger division with fewer overlapping activities.

(iii) Returning cash to shareholders

An excess of cash can make a company vulnerable to a takeover bid. One way of avoiding this – particularly if there are few, if any, profitable investment opportunities available – is to return cash to the shareholders, either in the form of a special dividend or via a share buy-back. As there is currently a problem with ensuring the accountability of managers who are sponsoring projects, there is a risk that managers will enter into unprofitable projects just to be seen to be spending money (but at the expense of shareholder wealth). One way of avoiding such a misuse of funds would be to give the money back to the shareholders directly.

(iv) Actively pursuing the adoption of advanced manufacturing technologies

The manufacture of aerospace components requires the use of the most up to date technology. As the company has not actively pursued the use of such techniques it is placed at a competitive disadvantage and is unlikely to be operating at maximum efficiency or minimum cost. The company should be aware of the potential adverse long-term consequences of continuing to avoid the adoption of advanced technologies. To promote this the company should identify the areas where AMT offers the greatest potential and set time based targets for the introduction of this technology. Such investment should be preceded by a thorough NPV analysis to ensure that the investment is justified in terms of its potential financial returns.

(v) Motivating managers

At the moment managers' remuneration levels are poor and whilst high salary levels should not be the only motivational factor, they do help to promote the company's appreciation of its staff. Low remuneration packages have resulted in difficulties for the company in attracting a suitably qualified management team. The company could move towards rectifying this situation by offering an incentive package such as a performance shares scheme – where managers are rewarded with shares for achieving targets (the shares can then be sold after a period of time – for example 3 years). If managers know they will benefit financially from increasing shareholder wealth they are more likely to pursue only those projects with positive NPVs and keep tighter control over costs.

(vi) Changes to the capital budgeting system

At the moment managers are not being held accountable for the underperformance of projects. A system of independent post audits should help to address this. Evaluating projects after a couple of years to assess whether they are delivering the expected returns can help to identify and rectify problems that are occurring and can also generate a culture of learning from mistakes so that future projects are more likely to be successful.

There is a danger of a blame culture being created, which could lead to fewer projects being

suggested by managers – so understanding must be shown that sometimes projects will fail because the environment has changed in a way that could not have been predicted at the time that a project was being put forward.

(b) The key issues

Lack of investment opportunities

One key issue for the company is the lack of profitable investment opportunities which has led to a slow-down in earnings growth that could soon lead to an actual decline. The main reasons for this appear to be the failure to adopt advanced manufacturing technologies and lack of management accountability.

From an ethical point of view if there are no profitable investments available the company should ensure that shareholders' funds are not wasted on loss-making projects.

Environmental footprint

A second issue is the company's approach to environmental issues. It has already been fined for polluting a river – without resolution, such occurrences are likely to increase.

Earnings management

Earnings management is another key issue. There should be a close examination of the company's ratio of EBITDA to operational cash flow. A ratio that is consistently lower than that of a growing firm suggests that earnings are being hidden. This may discourage shareholders from putting pressure on management to return excess funds to them. Managers themselves may feel unable to press for higher salaries in the light of these artificially reduced earnings. Alternatively it may be an attempt to smooth earnings to enable more consistent performance indicators to be reported. If earnings are being artificially reduced then an ethical issue arises in the form of trying to deceive company stakeholders.

How can these be resolved?

(i) Return excess funds to the shareholders

The ethical issue that shareholders' funds should not be wasted can be resolved by returning the excess funds to the shareholders themselves (as suggested in alternative (ii) above). Such funds should not be used by management – regardless of how poorly they feel they are paid – to enhance their own perks. It could be argued that if money was used to improve managers' remuneration packages then this would motivate them to pursue the overriding company objective of maximising shareholders' wealth. However if funds were returned to the shareholders, they could make their own decisions as to how best to use these funds. The critical factors here are ownership of resources and the efficient use of these resources. Shareholders own the company – any surplus funds legally belong to them and they are therefore entitled to have such funds returned to them.

(ii) The use of advanced manufacturing technologies

The company has been fined for an untreated discharge into a local river. With increased focus on environmental problems and the ethical issues attached to environmental pollution the company should be avoiding such publicity at all costs.

One potential reason for the pollution could be the use of inferior manufacturing techniques. This could be resolved through active pursuit of and investment in advanced manufacturing technologies.

Not only could this serve to reduce environmental pollution it may also reduce energy consumption.

(iii) Internal audit

In order to ensure as far as possible that managers are disclosing all figures correctly, an internal audit function could be set up if it is not already in evidence. Such governance procedures improve the transparency of the reported figures and can highlight any system issues that prevent figures being reported correctly. It is a company's duty to make full and correct disclosure of its results – the existence of an effective internal audit function should help to ensure that this is the case.

(c) Possible environmental management accounting objectives (i) Eco-balance

The company should identify the raw materials it uses and outputs such as noise, to which it attributes a notional value. These outputs can then be identified as social 'costs'.

(ii) Cleaner technology

This can be used in the manufacturing process to avoid waste. The company can look at changes in waste levels as a result of adopting new technology.

(iii) Performance appraisal

This can include steps taken to reduce pollution, backed up by scientific measures of emissions.

(iv) Life cycle assessments

The total environmental impact of a product is measured, from the resources it consumes, the energy it requires in use, and how it is disposed of, if not recycled. It may be that a product's poor ecological impact (and consequent liability or poor publicity) can be traced back to one component or material, which can be replaced.

(v) Budgetary planning and control system

These can be used to develop variances analysing environmental issues.