1 The University of Lethbridge - Faculty of Management Management 3040 – FinanceTerry D. Harbottle
2 Chapter 1 - Key Concepts and Skills 1.1Chapter 1 - Key Concepts and SkillsKnow 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 managersUnderstand the various types of financial markets and financial institutionsUnderstand current trends in Canadian financial markets
3 Corporate Finance and the Financial Manager 1.2Chapter OutlineCorporate Finance and the Financial ManagerForms of Business OrganizationThe Goal of Financial ManagementThe Agency Problem and Control of the CorporationFinancial Markets and the CorporationFinancial InstitutionsTrends in Financial Markets and Financial Managementwww: This is a good place to show the students the web site that accompanies the book, including the various features that they can access for study purposes (study guide, quizzes, web links, etc.). Click on the “web surfer” icon to go directly to the site.
4 Some important questions that are answered using finance 1.3Corporate 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?How can we manage financial and market risk?
5 Financial managers try to answer some or all of these questions 1.4Financial 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, 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.
6 A Simplified Organizational Chart Board of DirectorsChairman of the Board andChief Executive Officer (CEO)President and ChiefOperations Officer (COO)Vice PresidentMarketingVice PresidentFinance (CFO)Vice PresidentProductionTreasurerControllerCash ManagerCredit ManagerCost AccountingManagerTax ManagerCapitalExpendituresFinancialPlanningFinancialAccountingManagerData ProcessingManager
7 Financial Management Decisions 1.5Financial Management DecisionsCapital budgetingWhat long-term investments or projects should the business take on?Capital structureHow should we pay for our assets?Should we use debt or equity?Working capital managementHow do we manage the day-to-day finances of the firm?Risk ManagementUse of derivative securities
8 Forms of Business Organization 1.6Forms of Business OrganizationThree major forms in CanadaSole proprietorshipPartnershipGeneralLimitedCorporationIn other countries, corporations are also called joint stock companies, public limited companies and limited liability companieswww: 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:
9 Sole Proprietorship Advantages Disadvantages Easiest to start 1.7Sole ProprietorshipAdvantagesEasiest to startLeast regulatedSingle owner keeps all the profitsTaxed once as personal incomeDisadvantagesUnlimited liabilityLimited to life of ownerEquity capital limited to owner’s personal wealthDifficult 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.
10 Partnership Advantages Disadvantages Two or more owners 1.8PartnershipAdvantagesTwo or more ownersMore 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 and only 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 as general partners.
11 CorporationsA corporation is a legal entity separate and distinct from its ownershas many of the same rights, duties and privileges of an actual person:borrow moneycan own propertycan enter into contractsshareholders and management are usually separate in most larger corporationsthe shareholders elect the board of directorsthe board then selects the senior managers who in theory are charged with running the affairs in the interests of the shareholders
12 Corporation Advantages Disadvantages Limited liability Unlimited life 1.9CorporationAdvantagesLimited liabilityUnlimited lifeSeparation of ownership and managementTransfer of ownership is easyEasier to raise capitalDisadvantagesSeparation of ownership and managementDouble taxation (income is taxed at the corporate rate and then dividends are taxed at the personal rate)
13 Goal Of Financial Management 1.11Goal Of Financial ManagementWhat 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 or ‘shareholder value’?Try and 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 have a huge market share (I.e. Amazon) they still do not have positive earnings and their owners are not 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.Non-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 1990’s.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.
14 Primary Goal of Financial Management 1.12Primary Goal of Financial ManagementThree equivalent goals of financial management:Maximize shareholder wealth or ‘shareholder value’Maximize share priceMaximize firm value….goal is to increase ‘shareholder value’
15 Corporation FinanceThe study of the relationship between business decisions and shareholder valueThe focus of this class then is the identification of financial/business decisions and arrangements that contribute to shareholder value (contribute favourably to value of the stock)
16 The Agency Problem Agency relationship Agency problem Agency costs 1.13The Agency ProblemAgency relationshipPrincipal hires an agent to represent their interestsStockholders (principals) hire managers (agents) to run the companyAgency problemConflicts of interest can exist between the principal and the agentAgency costsDirect agency costsIndirect 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 buyers agent and a sellers 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 buyers 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.
17 The Agency Problem Agency Relationships and Management Goals potential for conflict - is their too much emphasis on corporate survival, job security and (more recently) with management wealth creation?Do managers Act in the Shareholders’ interests? They are influenced by:how they are compensated - does their compensation encourage them to make decisions that will enhance shareholder valuehow easily are they replaced if they do not pursue shareholder goals - control here is with the board of directors
18 Agency CostsAgency Costs - defined as the costs associated with the conflict of interests :Direct agency costsIndirect agency costsImpact of Agency Costs on Shareholder Wealth or Valuedirect - expenditures benefiting Management e.g. the unneeded corporate jet ordirect - monitoring costs e.g. outside auditorsindirect - lost opportunity where Management is not acting in the best interests of its shareholders e.g. costly acquisitions driven more by desire for power and prestige
19 Managerial compensation 1.14Managing ManagersManagerial compensationIncentives 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 managementConflicts with other stakeholders (see table 1.2)
20 What is the role of financial markets in corporate finance? 1.16What is the role of financial markets in corporate finance?Cash flows to and from the firmMoney vs. capital marketsPrimary vs. secondary marketsHow do financial markets benefit society?Video 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 towards becoming for-profit companies and the possible impact on investors.www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites
21 Cash Flows to and from the Firm 1.17Cash Flows to and from the Firm
22 Financial Institutions 1.18Financial InstitutionsFinancial institutions act as intermediaries between suppliers and users of fundsInstitutions earn income on services provided:Indirect finance – Earn interest on the spread between loans and depositsDirect finance – Service fees (i.e. bankers acceptance and stamping fees)
23 Financial MarketsFinancial Markets - brings buyers and sellers of debt and equity securities togetherHow do financial markets differ?Type of securities traded/how trading is conducted and who the buyers and sellers areMoney markets and capital marketsmoney market - short term debt securitiescapital market - long term debt and equity
24 Financial Markets Continued Primary vs. secondary marketsPrimary Market- where the original sale of issue of a security by a government or corporation occurspublic offering - underwritten by an investment dealer and registered with provincial securities commissionsprivate placement - debt and equity sold directly to a buyer - typically life insurance companies and , pension fundsPublic Offeringtypically underwritten by the investment dealer - buys the securities from the company and then seeks to make a profit by selling them at a higher price to the public.....take on certain risksinterest rate movementscredit risk of the issuing companypublic offering can also take the form of a ‘best efforts’ deal where the dealer does not actually buy the securities but only acts as an agent and sells as much of the issue as possible but can return any unsold shares....more on this in Chapter 15Private Placementdebt and equity instruments are sold directly to pension funds, insurance companies and mutual funds (concept of matching here with need for long term funds being matched with the supply of longer terms funds)why - avoid regulartory req’ts and costs of public issues
25 Financial Markets Continued Secondary Market - trading of securities subsequent to the initial sale - enables the transfer of ownershipauction market - TSEdealer market - ‘over the counter (OTC) ‘How do financial markets benefit society?Auction Marketphysical location - Bay Street or Wall Streetexchanges match buyers and sellersOTC or Dealer Marketmost of the buying and selling is done by the dealer (money mkt. Concept) where the dealers are again connected electronicallyFinancial Markets and Societychannel savings into investment - increases the efficiency of allocating savings among the many competing uses for this capitalproduce and transmit information on returns and risk - via interest rates and securities prices - both reflect supply & demand factors and risk factorstransaction prices on fin. Markets continually reflect investors evaluations of market alternativesthey pay for this info thru fees to analysts and other sellers of this info as well as thru the bid ask spread in transactionsprovide a media and a payments systemmoved from exchanging one commodity to accepting paper claims
26 Financial Markets and Society what is the benefit to society?Channel savings into investmentproduce and transmit information on returns and riskprovide a media and a payments systemenable the shifting of the timing of consumption over a life cycleenable the management of riskenable the diversification of portfoliossavings - increases the efficiency of of allocating savings among the many competing uses for this capitalproduce and transmit info:- via interest rates and security prices - both reflect supply and demand factors and risk factorstransaction prices on fin. Mkts continually reflect investors evaluations of market alternativesthey pay for this via direct fees to analysts and other sellers of this info and thru the bid-ask spread in transactionsmedia & payments system - moved from exchanging one commodity for another to accepting paper claimsShifting the timing of consumption over a life cycleborrowing and lending facilitated by fin. Mkts allows people to shift the timing of their use or consumption of lifetime incomes and wealth.managing riskvarious forms of insurancehedging opportunitiesdiversification of portfolios
27 Trends in Financial Markets and Management 1.19Trends in Financial Markets and ManagementFinancial EngineeringDerivative SecuritiesAdvances in Technology – i.e. E-businessDeregulationCorporate Governance Reform
28 What are the three major forms of business organization? 1.20Quick QuizWhat 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?What is the difference between a primary market and a secondary market?
29 Summary 1.9 You should know: 1.21You should know:The advantages and disadvantages between a sole proprietorship, partnership and corporationThe primary goal of the firmWhat an agency relationship and cost areThe role of financial markets