Introduction To Financial Management

Chapter 1

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Topics1. The basics of corporate financial

management decisions and the role of the financial manager

2. The goal of corporate financial management

3. The financial implications of the different forms of business organizations

4. The conflicts of interest that can arise between managers and owners

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The Basics Of Corporate Financial Management Decisions Define Asset:

Examples: Cash, UPS Trucks, Buildings “Provide probable future economic benefit”

Definition of Finance: How to allocate scarce resources across

assets over time in order to earn a return What should we invest in? Should we incur debt?

How do we as individuals make investments, conduct banking activities, incur debt?

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The Basics Of Corporate Financial Management Decisions

Four basic areas of finance: Corporate finance

How corporations allocate scarce resources across assets over time

Investments Stocks and Bonds, Risk and Return

Financial institutions Banks, Exchanges, Insurance Co.

International Finance All of the above but more than one country

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Why do you need to know finance? Student Loans Credit cards Investments Retirement

Savings Banking

Careers in: Finance Accounting Marketing Sole proprietorship Security Analyst

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Why Study Finance? Marketing

Budgets, marketing research, marketing financial products

Accounting Dual accounting and finance function,

preparation of financial statements Management

Strategic thinking, job performance, profitability

Personal finance Budgeting, retirement planning, college

planning, day-to-day cash flow issues

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The Role Of The Financial Manager Business Finance Questions

1.What long-term investments should you make

Examples: equipment, buildings

2.Where will you get the long-term financing?

Profits? Equity? Debt?

3.Short-term cash management1.How will you collect from customers and

pay your bills?

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Financial Management Decisions1. Capital Budgeting

The process of planning and managing a firm’s long-term investments

Evaluating the size, timing, and risk of the future cash flows

Use NPV finance tool to decide (chapter 8)

2. Capital Structure The mixture of debt and equity

3. Working Capital The firm’s short-term assets and liabilities

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The Role Of The Financial Manager

Board of Directors

Chairman of the Board andCEO

President andCOO

VP Marketing VP FinanceCFO

VP Production

Treasurer

Cash Manager Credit Manager

Capital Expenditures

Financial Planning

Controller

Tax Manager Cash Accounting Manager

Financial Accounting

Manager

Information Systems Manager

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Forms of Business Organization

Three major forms in the united states Sole proprietorship Partnership

General Limited

Corporation S-Corp Limited liability company

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Sole Proprietorship

Advantages Easiest to start Least regulated Single owner keeps

all the profits Taxed once as

personal income

Disadvantages Limited to life of

owner Equity capital

limited to owner’s personal wealth

Unlimited liability Difficult to sell

ownership interest

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Partnership

Advantages Two or more

owners More capital

available Relatively easy to

start Income taxed once

as personal income

Disadvantages Unlimited liability

General partnership Limited partnership

Partnership dissolves when one partner dies or wishes to sell

Difficult to transfer ownership

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Corporation

Advantages Limited liability Unlimited life Separation of

ownership and management

Transfer of ownership is easy

Easier to raise capital

Disadvantages Separation of

ownership and management (agency problem)

Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate)

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Figure 1.2

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Forms of Business Organization Sole proprietorships Partnerships Corporations

Fewest in number Account for more business transactions

than the other two types combined Limited Liability Company (LLC)

Benefit of single taxation and limited liability

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Forms of Business Organization Sole Proprietorship (one person)

Easy to set up No double taxation No liability insulation to deflect outside

claims (unlimited liability) When owner dies, business ends Difficult to transfer ownership Hard to raise capital (money to invest)

Partnerships (More than one person) General partners fully liable

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Forms of Business Organization Corporations

Legal “person” separate from owners Can owe property, sue, be sued, enter into

contracts Limited Liability (owners only lose up to

investment, debt responsibility of corp.) Continuity of existence (Stock transferable –

when owner dies, corporation does not die) Separation of owner and manager

Allows continual existence, however it creates agency problem

Easier to get external financing (equity & debt) Double taxation

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Corporations Issue stock to stockholders Issue bonds to bondholders Carry out business activities for the

purpose of making profits Not-for-profit corporations carry out charitable,

educational, or other philanthropic purposes and are beyond the scope of this chapter

Distribute the profits to their owners Pay interest to bondholders Reinvests earnings to buy more assets

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The Financial Implications Of The Different Forms Of Business Organizations The corporate form is superior when it comes to

raising cash: Ease of transferring ownership

Business does not end each time stock is sold Unlimited life

When owners die, the business does not end Limited liability for business debts

Owners can only loose up to the amount they have invested

For good ideas to be implemented which in turn creates profits for owners, cash is required. Thus the business form which can raise cash more easily is more beneficial

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The Goal Of Corporate Financial Management

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The Goal Of Corporate Financial Management Presume:

The stockholders elect the BofD The BofD hire the managers The managers work for the stockholders

Goal: The financial managers have a fiduciary duty

to identify goods and services that add value to the firm because they are desired and valued in the free marketplace, which in turn increases current and future revenues, which in turn increases stock price/equity value

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The Goal Of Corporate Financial Management The goal of financial management is to

maximize the current value per share of existing stock (market value of equity) This is theoretically a good goal

Do some managers employ creative accounting so that it looks like stock value goes up?

Financial managers should not take illegal or unethical actions to increase stock value

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The Goal Of Corporate Financial Management

1. Managers commit assets in a particular direction in order to earn a return

1. Capital budgeting using NPV model (ch.9) Cash Flow is what the managers will

use to make decisions (ch.5)

2. Goal is to maximize returns at a given risk level (risk and return are considered together) (ch.11)

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The Goal Of Corporate Financial Management2. Corporation must continually get

cash to acquire assets to earn a return

1. Corporation acquires cash from financial markets through equity or debt

2. Corporation reinvests earnings (remaining amount paid to owners)

3. More assets, more sales, higher return, higher stock value (theoretically)

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The Goal Of Corporate Financial Management

3. All this is done to increase the current stock price

1. Owners’ stock value is increased2. Managers salaries should be based on

stock value and so their salaries increase (theoretically)

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Goal Of Financial Management

What should be the goal of a corporation? Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company’s

stock? Does this mean we should do anything and

everything to maximize owner wealth? Sarbanes-Oxley Act

Makes managers personally responsible for financial statements

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The Conflicts Of Interest That Can Arise Between Managers And Owners Creative accounting so that it looks like

stock value goes up? Enron:

Former Enron CFO Andrew Fastow, the alleged mastermind behind Enron's complex network of offshore partnerships and questionable accounting practices*

World Com: Former CEO, Bernard Ebbers was convicted (2005) of

fraud and conspiracy in the largest (to date) accounting scandal in U.S. history, as a result of WorldCom's false financial reporting, and subsequent 11 billion dollar loss to investors*

Andrew and Bernard were agents that were supposed to be serving the stockholders

*Wikipedia

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Agency Problem How do you get managers inside the firm

(managers have custody of assets that belong to owners) to act in the best interest of the owners? We must incur agency costs to minimize problems

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Agency Costs Direct

Pay managers based on stock value (aligns managers’ and owners’ interests)

Allow external auditor to examine the financial statements

Have internal controls over assets and accounting

Have internal auditors report to BofD Sarbanes-Oxley Act

Makes managers personally responsible for financial statements

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Agency Costs Indirect

A profitable project that is risky may benefit owners, but may put the manager’s job at risk

If manager does not take on project Cost to owner

Managers may create ways to pay themselves great deals of money (accounting or other)

Cost to owner

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Financial Markets Primary Markets

Original sale of equity or debt Corporation issues security

Secondary Markets After original sale of equity or debt You sell/buy security

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Financial Markets Secondary Markets: Dealer Markets (Over-the-counter markets

(OTC)) Dealers buy and sell for themselves

(think of car lot) Most debt is sold this way Example: NASDAQ

Auction Markets (Exchanges) Brokers and agents match buyers and sellers

(think of real estate agent) Most of the large firms’ equity is sold this way Example: NYSE

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Summary Slide

The Basics Of Corporate Financial Management Decisions

Why do you need to know finance? The Role Of The Financial Manager Financial Management Decisions Forms of Business Organization The Financial Implications Of The Different Forms Of

Business Organizations The Goal Of Corporate Financial Management The Conflicts Of Interest That Can Arise Between

Managers And Owners Agency Problem Agency Costs Financial Markets