Chapter 01

An Overview of Managerial Finance

© 2007 Thomson/South-Western

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Essentials of Chapter 1 What is finance, and why should you understand basic financial concepts? What are the different forms of business organization? What goals should firms pursue? What is the role of ethics in successful businesses? How do foreign firms differ from U.S. firms?

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What is Finance? Finance is concerned with decisions about money (Cash Flows) Finance decisions deal with how money is raised and used Everything else being equal: More value is preferred to less The sooner cash is received the more value it has Less risky assets are more valuable than riskier assets

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General Areas of Finance Financial Markets and Institutions Banks, Insurance Companies, Saving & Loans, Credit Unions etc.

Investments Stock Brokerage firms, Financial Institutions, Investment Companies, Insurance Companies etc.

Financial Services Financial Consultants, Auditing Firms etc

Managerial Finance All type of Firms making Financial Decisions concerning cash flows

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Finance in the Organizational Structure of the Firm Board of Directors

•Manage cash & Marketable Securities •Plan how the firm is financed •Manage Risk •Oversee pension fund

President (CEO)

Vice-President: Sales

Credit Manager

Vice-President: Operations (COO)

Inventory Manager

Director of Capital Budgeting

Vice-President: Finance (CFO)

Treasurer

Controller

Vice-President: Information Systems (CIO)

Financial Tax and Cost Department Accounting

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Alternative Forms of Business Organization Proprietorship Partnership Corporation

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Proprietorship Advantages: Ease of formation Subject to few government regulations No corporate income taxes

Limitations: Unlimited personal liability Limited life Transferring ownership is difficult Difficult to raise capital

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Partnership Like a proprietorship, except two or more owners A partnership has roughly the same advantages and limitations as a proprietorship

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Corporation Advantages: Unlimited life Easy transfer of ownership Limited liability Ease of raising capital

Disadvantages: Cost of set-up and report filing Double taxation

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Hybrid Forms of Business Limited Liability Partnership (LLP) Limited Liability Company (LLC) S Corporation

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Business Organized as a Corporation: Value Maximized Limited liability reduces risk increasing market value Ease of raising capital allows taking advantage of growth opportunities Ownership can be easily transferred thus investors would be willing to pay more for a corporation

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Goals of the Corporation Primary goal:stockholder wealth maximization—translates to maximizing stock price. Managerial incentives Provide valuable incentives to keep the interest of management alive and inline with stockholder wealth maximization.

Social responsibility The concept that businesses should be actively concerned with the welfare of society at large.

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Managerial Actions to Maximize Stockholder Wealth Capital Structure Decisions Decision about how much and what types of debt and equity should be used to finance the firm.

Capital Budgeting Decisions Decision as to what types of assets should be purchased to help generate future cash flows.

Dividend Policy Decisions Decisions as to how much of current earnings to pay out as dividends rather than to retain for reinvestment in the firm.

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Value of the Firm Market Factors/Considerations Economic Conditions Government Regulations and Rules Competitive Environment Firm Factors/Considerations Normal Operations (Revenues and Expenses)

Financing Policy Investing Policy Dividend Policy

(Capital Structure) (Capital Budgeting)

Investor Factors/Considerations Income/Savings Age/Lifestyle Interest Rates Risk Attitude

Net Cash Flows, CF

Rates of Return, r

N ^ CF1 CF2 CFN CFt = + +...+ = Σ 1 2 N t (1+r) (1+r) (1+r) (1+r) t =1 ^

^

^

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Factors Influenced by Managers that Affect Stock Price

Projected earnings per share Timing of earnings streams Risk of projected earnings Use of debt (capital structure) Dividend policy

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Agency Relationships An agency relationship exists whenever a principal hires an agent to act on his or her behalf. An agency problem results when the agent makes decisions that are not in the best interest of principals

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Stockholders versus Managers Managers are naturally inclined to act in their own best interests. Mechanisms to motivate managers to act in shareholder’s best interest Managerial compensation (incentives) Performance shares awarded on basis of EPS, executive stock purchased at future time at given price, restricted stock grants to employees for some time in future.

The threat of firing  Possible now due to ownership by few large institutions like pension fund, mutual funds etc like cocacola, UA.

Shareholder intervention  Big Funds now closely monitor firms and influence management decisions when ever needed.

Threat of takeover  Hostile takeovers, management is fired.

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Business Ethics Webster: “A standard of conduct and moral behavior.” Business Ethics: A company’s attitude and conduct toward its employees, customers, community, and stockholders 18

Corporate Governance The “set of rules’ that a firm follows when conducting business As a result of the Sarbanes-Oxley Act of 2002, firms are revising their corporate governance policies Good corporate governance generates higher returns to stockholders

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Forms of Business in Other Countries Non-US firms have higher concentrations of ownership Nature of relationship with financial institutions differs from U.S.

U.S. firms have a more dispersed ownership

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Multinational Corporations Five reasons firms go “international” 1. To seek new markets 2.

To seek raw materials

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To seek new technology

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To seek production efficiency

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To avoid political and regulatory hurdles

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Multinational Versus Domestic Managerial Finance

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Factors Distinguishing Domestic Firms from Multinational Firms Different currency denominations Economic and legal ramifications Language differences Cultural differences Role of governments Political risk

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Chapter 1 Essentials What is finance? Finance deals with decisions about money What are the forms of business organization? Proprietorship, partnership, corporation What goals should firms pursue? Maximize stockholder’s wealth What is the role of ethics in business? “Ethical firms” survive; “non-ethical firms” do not How do foreign firms differ from U.S. firms? Non-US firms have more concentrated ownership

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Thank you

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