2 Housekeeping Attendance Roster Textbook: www.mhhe.com/rwj Narrated Power PointInteractive Key ConceptsExcel Templates!!!Key Term FlashcardsAppendix B & D *** Do It RightCopy/Laminate/NO STRAY MARKS!!!!
3 More HousekeepingSyllabusOH projectorEthics Pledge
4 Introduction to Financial Management Chapter 1Introduction to Financial Management
5 Key Concepts and Skills Know the basic types of financial management decisions and the role of the financial managerKnow the financial implications of the different forms of business organizationKnow the goal of financial managementUnderstand the conflicts of interest that can arise between owners and managers
6 Basic Areas Of Finance Corporate finance Investments Financial institutionsInternational financeEach of these topics will be discussed in more detail in the following slides.www: Several of the following slides will have hot links to a web site that provides information about different business jobs including descriptions, skills and traits, etc. The address isVideo: Advice from recent graduates on what it takes to have a career in finance.The discussion on corporate finance is deferred until later in the chapter.
7 Why Study Finance? Marketing Accounting Management Personal finance Budgets, marketing research, marketing financial productsAccountingDual accounting and finance function, preparation of financial statementsManagementStrategic thinking, job performance, profitabilityPersonal financeBudgeting, retirement planning, college planning, day-to-day cash flow issuesSince this course is generally required of all business majors, it is important to emphasize that everyone needs to have a basic understanding of financial concepts so that they can communicate effectively within an organization. This is the same reason that everyone is required to take marketing courses, management courses, etc. It is important to speak the language of business, and that includes finance.MarketingHave to work within a budgetMarketing research is often very important to financial analysts, those doing the research need to understand what information the analysts need so that they ask the right questionsMarketing financial products – including entire companies through IPOs and seasoned equity offerings, as well as insurance and other basic financial productsAccountingIn smaller businesses, accountants often perform both the accounting and finance functionsPrepare the financial statements that financial analysts rely on for informationManagementBusiness strategy – have to understand the goals of the business and how cash flow worksUnderstand how job performance affects profitabilityPersonal FinanceFor many students, emphasizing the personal finance issues whenever possible can make the material more relevantDecisions about 401K plans, saving for houses, cars, kids college, etc. can be discussed throughout the courseDay-to-day decisions about consumption vs. saving can also be discussed within a finance framework
8 Business FinanceSome important questions that are answered using financeWhat long-term investments should the firm take on?Where will we get the long-term financing to pay for the investment?How will we manage the everyday financial activities of the firm?Emphasize that “business finance” is just another name for “corporate finance” mentioned under the four basic types. Students often get confused by the terminology, especially when different terms are used to refer to the same thing.
9 Financial ManagerFinancial managers try to answer some or all of these questionsThe top financial manager within a firm is usually the Chief Financial Officer (CFO)Treasurer – oversees cash management, credit management, capital expenditures, and financial planningController – oversees taxes, cost accounting, financial accounting, and data processingVideo Note: This video looks at the changing role of the Chief Financial Officer (CFO) at the Fortune 500 company, Abbot Laboratories.
10 Capital BudgetingThe process of planning and managing a firm’s investments in fixed assets.The key concerns are the size, timing, and riskiness of future cash flows.
11 Capital StructureThe mix of debt (borrowing) and equity (ownership interest) used by the firm.What are the least expensive sources of funds?Is there an optimal mix of debt and equity?When & where should the firm raise funds?
12 Working Capital Mgt Mgt of short-term assets & liabilities. How much inventory should the firm carry?What credit policy is best?Where will the firm obtain its short-term loans?
13 Forms of Business Organization Three major forms in the united statesSole proprietorshipPartnershipGeneralLimitedCorporationS-CorpC-CorpLimited liability company - LLCwww: Clicking on the “web surfer” will take you to a web site that will provide a discussion about which form of business may be appropriate for an entrepreneur. The following pages will provide links to specific pages on the web site that provide additional information about the legal aspects of each form of business, as well as a discussion of the advantages and disadvantages. The address is:
14 Sole Proprietorship Advantages Disadvantages Easiest to start Least regulatedSingle owner keeps all the profitsTaxed once as personal incomeDisadvantagesLimited to life of ownerEquity capital limited to owner’s personal wealthUnlimited liabilityDifficult to sell ownership interestwww: Click on the “web surfer” for more information about sole proprietorships. If you click on the “--Sole Proprietorship” link, you will be taken to an index that will provide a link to information about husband and wife sole proprietorships.
15 Partnership Advantages Disadvantages Two or more owners More capital availableRelatively easy to startIncome taxed once as personal incomeDisadvantagesUnlimited liabilityGeneral partnershipLimited partnershipPartnership dissolves when one partner dies or wishes to sellDifficult to transfer ownershipwww: Click on the “web surfer” for more information about partnerships. If you click on the “—Partnerships” link, you will go to an index that provides links to additional information about limited partnerships, partnership agreements and buy-sell agreements.Note that unlimited liability applies to all partners in a general partnership but only to the general partners in a limited partnershipWritten agreements are essential due to the unlimited liability.Limited partners cannot be involved in the business or else they may be deemed general partners.
16 Corporation Advantages Disadvantages Limited liability Unlimited life Separation of ownership and managementTransfer of ownership is easyEasier to raise capitalDisadvantagesSeparation of ownership and management (agency problem)Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate) (except sub-S & LLC)www: Click on the “web surfer” to go to a page that discusses corporations. If you click on the “—Corporations” link it will take you back to an index that provides links to additional information on corporations as well as limited liability corporations.Discuss how separation of ownership and management can be both an advantage and a disadvantage:AdvantagesYou can benefit from ownership in several different businesses (diversification)You can take advantage of the expertise of others (comparative advantage)It is easier to transfer ownershipDisadvantageAgency problems if management goals and owner goals are not alignedThe instructor’s manual provides additional discussion of limited liability companies and S-corporations
17 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 ActTry to have the students discuss each of the goals above and the inherent problems of the first three goals:Maximize profit – Are we talking about long-run or short-run profits? Do we mean accounting profits or some measure of cash flow?Minimize costs – We can minimize costs today by not purchasing new equipment or delaying maintenance, but this may not be in the best interest of the firm or its owners.Maximize market share – This has been a strategy of many of the dot.com companies. They issued stock and then used it primarily for advertising to increase the number of “hits” to their web sites. Even though many of the companies may have huge market share (i.e. Amazon) that still does not guarantee positive earnings, so their owners may not be happy.Maximize the current value of the company’s stockThere is no short run vs. long run here. The stock price should incorporate expectations about the future of the company and consider the trade-off between short-run profits and long-run profits.The purpose of a for-profit business should be to make money for its owners. Maximizing the current stock price increases the wealth of the owners of the firm.This is analogous to maximizing owners’ equity for firms that do not have publicly traded stock.Not for profits can also follow the same principle, but their “owners” are the constituencies that they were created to help.The instructors manual provides a letter to stockholders that was written by former Coca-Cola CEO Roberto Goizueta. There is also a brief discussion of an article that appeared in Fortune magazine that discusses Coke vs. Pepsi and their different philosophies on business in the early 1990s.Ethics Note: See the instructor’s manual for a discussion of Dow-Corning, silicone breast implants and the ethics involved with pursuing owners’ wealth at all costs.
18 The Agency Problem Agency relationship Agency problem Principal hires an agent to represent their interestStockholders (principals) hire managers (agents) to run the companyAgency problemConflict of interest between principal and agentManagement goals and agency costsVideo Note: This video focuses on how one company handled the tough decision to cut jobs and managed to successfully increase shareholder value. It features ABT Co. in Canada.A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyer’s agent and a seller’s agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyer’s price range.Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the Sensor razor.Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint; monitoring costs.Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.
19 Managing Managers Managerial compensation Corporate control Incentives can be used to align management and stockholder interestsThe incentives need to be structured carefully to make sure that they achieve their goalCorporate controlThe threat of a takeover may result in better managementOther stakeholdersIncentives – discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forgo projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interest of all stockholders. The type of stock can also affect the effectiveness of the incentive.Corporate control – ask the students why the threat of a takeover might make managers work toward the goals of stockholders.Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interest.
21 Financial Markets Cash flows to the firm Primary vs. secondary markets Dealer vs. auction marketsListed vs. over-the-counter securitiesNYSENASDAQVideo Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade.Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders and pay dividends to stockholders.Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there.See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ toward becoming for-profit companies and the possible impact on investors.www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites
22 Quick Quiz What are the four basic areas of finance? What are the three types of financial management decisions and what questions are they designed to answer?What are the three major forms of business organization?What is the goal of financial management?What are agency problems and why do they exist within a corporation?
24 Answers to Concepts Review and Critical Thinking Questions 1. Capital budgeting (deciding on whether to expand a manufacturing plant), capital structure (deciding whether to issue new equity and use the proceeds to retire outstanding debt), and working capital management (modifying the firm’s credit collection policy with its customers).2. Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard to raise capital funds. Some advantages: simpler, less regulation, the owners are also the managers, sometimes personal tax rates are better than corporate tax rates.
25 3. The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life.4. The treasurer’s office and the controller’s office are the two primary organizational groups that report directly to the chief financial officer. The controller’s office handles cost and financial accounting, tax management, and management information systems. The treasurer’s office is responsible for cash and credit management, capital budgeting, and financial planning. Therefore, the study of corporate finance is concentrated within the functions of the treasurer’s office.5. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly traded or not).6. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm.
26 7. A primary market transaction. 8. In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to buy and sell their assets. Dealer markets like Nasdaq represent dealers operating in dispersed locales who buy and sell assets themselves, usually communicating with other dealers electronically or literally over the counter.9. Since such organizations frequently pursue social or political missions, many different goals are conceivable. One goal that is often cited is revenue minimization; i.e., providing their goods and services to society at the lowest possible cost. Another approach might be to observe that even a not-for-profit business has equity. Thus, an appropriate goal would be to maximize the value of the equity.10. An argument can be made either way. At one extreme, we could argue that in a market economy, all of these things are priced. This implies an optimal level of ethical and/or illegal behavior and the framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are non-economic phenomena and are best handled through the political process. The following is a classic (and highly relevant) thought question that illustrates this debate: “A firm has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability claims. What should the firm do?”11. The goal will be the same, but the best course of action toward that goal may require adjustments due different social, political, and economic climates.
27 12. The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this.13. We would expect agency problems to be less severe in other countries, primarily due to the relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, given an institutions’ deeper resources and experiences with their own management. The increase in institutional ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.S. corporations and a more efficient market for corporate control.
28 14. How much is too much? Who is worth more, Lee Raymond or Tiger Woods? The simplest answer is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align stockholder and management interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes argued that much of this reward is simply due to rising stock prices in general, not managerial performance. Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price increases in excess of general market increases.15. The biggest reason that a company would “go dark” is because of the increased audit costs associated with Sarbanes-Oxley compliance. A company should always do a cost-benefit analysis, and it may be the case that the costs of complying with Sarbox outweigh the benefits. Of course, the company could always be trying to hide financial issues of the company! This is also one of the costs of going dark: Investors surely believe that some companies are going dark to avoid the increased scrutiny from SarbOx. This taints other companies that go dark just to avoid compliance costs. This is similar to the lemon problem with used automobiles: Buyers tend to underpay because they know a certain percentage of used cars are lemons. So, investors will tend to pay less for the company stock than they otherwise would. It is important to note that even if the company delists, its stock is still likely traded, but on the over-the-counter market pink sheets rather than on an organized exchange. This adds another cost since the stock is likely less to be liquid now. All else the same, investors pay less for an asset with less liquidity. Overall, the cost to the company is likely a reduced market value. Whether this is good or bad for investors depends on the individual circumstances of the company. It is also important to remember that there are already many small companies that file only limited financial information already.