1. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 1 of 23 Chapter 1 An Overview of Managerial Finance

2. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 2 of 23 Learning Objectives 1.Understand the general framework for financial decision making. 2.Describe the role of financial decision making in maximizing the value of the firm. 3.Identify how to determine whether an investment should be made and how to finance acceptable investments. 4.Explain what is meant by the risk/return trade-off and how risk and return can affect management decisions. 5.Understand the role of financial institutions and markets and its effect on financial decisions made by the firm.

3. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 3 of 23 Importance of Managerial Finance Maximize wealth not profit! Debts are paid by cashflow not income! Investment Decisions utilize funds Financing Decisions require funds

4. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 4 of 23 The operation of a firm

5. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 5 of 23 Forms of Business Organization Advantages –Easy formation with low organizational costs –Affected by few government regulations –Income included and taxed only on proprietor’s personal tax return (i.e. only one) Proprietorship

6. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 6 of 23 Forms of Business Organization Drawbacks –Owner has unlimited liability (i.e. total wealth can be taken to satisfy debts) –Lacks continuity when proprietor dies –Transferring of ownership is difficult –Limited fund-raising power tends to inhibit growth Proprietorship

7. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 7 of 23 Forms of Business Organization Advantages –Fairly easy and inexpensive formation –Affected by few government regulations –Income included and taxed only on partner’s tax return Partnership

8. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 8 of 23 Forms of Business Organization Drawbacks –Owners have unlimited liability and may have to cover debts of other partners –Partnership is dissolved when a partner dies –Difficulty to liquidate or transfer partnership –Difficulty of raising large amounts of capital Partnership

9. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 9 of 23 Forms of Business Organization Advantages –Long life of firm even if owners do not have a relationship with the business –Ownership (stock) is readily transferable –Owners have limited liability which guarantees that they cannot lose more than they invested –Better access to financing Corporation

10. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 10 of 23 Forms of Business Organization Drawbacks –More expensive to organize than other business forms and subject to greater government regulation –Taxes are higher because of double taxation: corporate income is taxed and also dividends paid to owners are taxed Corporation

11. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 11 of 23 Value maximized for corporations Limited Liability reduces the risk borne by investors A firm’s current value is related to its future growth opportunities Corporate ownership can be transferred easier than the ownership of either a proprietorship or a partnership Why?

12. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 12 of 23 Role of Finance in a Business Organization

13. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 13 of 23 The Goals of the Corporation Stockholder wealth maximization This should be the primary goal of a financial manager Incentives against are to keep stockholder returns “at reasonable level” and work for other goals such as: –pursue goals of public service activities –target employee benefits –pursue higher executive salaries But… –Competitive forces require financial managers to opt for stockholder wealth maximization, to avoid losing their jobs

14. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 14 of 23 The Goals of the Corporation Social Responsibility Firms should provide a safe environment, avoid air pollution and produce safe products. Incentives against for firms to act in a socially responsible manner are: –Disadvantage in attracting funds due to extra costs incurred –Inability to compete due to higher prices of products –Constraints by capital market factors Therefore… –Social Responsibility actions should be enforced on a mandatory rather than a voluntary basis

15. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 15 of 23 The Goals of the Corporation Stock Price Maximization and Social Welfare Shareholder Wealth Maximization is beneficial for the society: –Stock price maximization requires efficient, low cost plants that produce high-quality goods and services at a low cost –Stock price maximization requires the development of products that customers want and need, leading to new technology, new products and new jobs –Stock price maximization necessitates efficient service, adequate stocks and well located business establishments

16. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 16 of 23 The Goals of the Corporation Therefore primary goal is to Maximize Shareholder Wealth

17. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 17 of 23 Decisions affecting the firm’s value n n 2 2 1 1 )k1( CF )k1( )k1 ( value Asset            Value = Current (present) value of expected cash flows (CFs) based on the return demanded by investors (k) How to finance (capital structure decision) What assets to purchase (capital budgeting decision) Pay dividends or re-invest earnings? (dividend policy decision)

18. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 18 of 23 Present Value… explained The value of any financial contract (i.e., stock) answers the following questions: –1. How much do I expect receipts to be (expected cash flow to the investor (i.e., dividends))? –2. When do I receive the payments (timing/opportunity cost)? –3. What is the chance I do not receive what I expected (risk)? The Present Value (discounted) of cash flows received by an investor is used as the estimate of the value of a contract (i.e., shareholder wealth) The Present Value (discounted) of a single share is the shares market price Shareholders Wealth=Market Value of Equity=Number of shares * share price

19. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 19 of 23 Should Earnings Per Share Be Maximized? Beware: Wealth is NOT profit! Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows.

20. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 20 of 23 Make decisions about the cash flow Beware: Accounting is NOT an economic profit! Cash flow is the actual cash generated by the firm. CF = Net Income + Depreciation or (CF = NI + DEP )

21. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 21 of 23 Agency Relationships Whenever a manager owns less than 100% of the firm’s equity, a potential agency problem exists. In theory, managers would agree with shareholder wealth maximization. However, managers are also concerned with their personal wealth, job security, fringe benefits, and lifestyle. This would cause managers to act in ways that do not always benefit the firm’s shareholders. Stockholders versus Managers – The problem

22. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 22 of 23 Agency Relationships Managerial compensation (in the form of performance shares, executive stock options or restricted stock grants) –But…. Recent studies have failed to find a strong relationship between CEO compensation and share price. The threat of firing Shareholder intervention The threat of takeover Stockholders versus Managers - Solutions

23. Essentials of Managerial Finance by S. Besley & E. Brigham Slide 23 of 23 Agency Relationships Creditors consider the riskiness of the firm Stockholders should not act against creditors because –Creditors protect themselves through restrictions in credit agreements –Creditors may request an interest rate much higher than normal to compensate for the stockholder’s actions Result: Stockholders may find it difficult to borrow funds in the future Stockholders versus Creditors