Chapter 1 An Overview of Financial Management and the Financial Environment

1. Chapter 1 An Overview of Financial Management and the Financial Environment

2. The operation of a firm

3. Forms of Business Organization Proprietorship • 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)

4. Forms of Business Organization Proprietorship • 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

5. Forms of Business Organization Partnership • Advantages • Fairly easy and inexpensive formation • Affected by few government regulations • Income included and taxed only on partner’s tax return

6. Forms of Business Organization Partnership • 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

7. Forms of Business Organization Corporation • 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

8. Forms of Business Organization Corporation • 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

9. Growing and Managing a Corporation • In addition to having products/services that attract customers, a corporation must attract investors. • Founder’s own resources and from friends, family, other private investors • Initial public offering (IPO) • Borrowing from banks, issuing bonds and additional shares • Separation of ownership and management • Agency problem • Corporate governance

10. Value maximized for corporations Why? • 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

11. Role of Finance in a Business Organization

12. 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

13. 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

14. 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

15. The Goals of the Corporation Therefore primary goal is to Maximize Shareholder Wealth

16. 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.

17. 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 )

18. Free Cash Flows (FCF) • FCF are cash flows available (or free) for distribution to all investors (stockholders and creditors). • FCF = sales revenues – operating costs – operating taxes – required investments in operating capital. • There are many ways firms can increase free cash flows.

19. Weighted Average Cost of Capital (WACC) • In addition to FCF, another factor of determining a firm’s value and its long-term stock price is WACC. • WACC is the average rate of return required by all of the company’s investors. • WACC is affected by: • capital structure (the firm’s relative amounts of debt and equity) • interest rates • risk of the firm • investors’ overall attitude toward risk

21. The capital formation process Transfer of funds Direct Transfers Securities (stocks or bonds) Borrower (Business) Saver (Investor) Euros € Indirect Transfers through an Investment Banker Securities Securities Investment Banker Saver (Investor) Borrower (Business) Euros € Euros € Indirect Transfers through a Financial Intermediary Intermediary Securities Business Securities Financial Intermediary Saver (Investor) Borrower (Business) Euros € (Loans) Euros € (Deposits)

22. Agency Relationships Stockholders versus Managers – The problem • 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.

23. The Cost of Money • Supply and demand of funds determine the cost or price of money. • What do we call the price (or cost) of debt capital? Of equity capital? • Interest rate • Cost of equity = required return = dividend yield + capital gain • Both are the rate fund users pay to fund providers.

24. Fundamental Factors That Affect the Cost of Money • Production opportunities • Time preferences for consumption • Risk • Expected inflation

25. Economic Conditions and Policies That Affect the Cost of Money • Fed policies • Budget deficits/surpluses • Business activity (recession or boom) • International trade deficits/surpluses • Country risk depending on its economic, political, and social environment • Exchange rate risk

26. What are the Financial Markets Mechanism by which those who have excess funds (investors / lenders) are brought together with those that require funds (borrowers) • Financial markets are important throughout our lives • Youngsters spend more than they earn • Working adults earn more than they consume • People on retirement use accumulated funds to compensate for their declining income

27. Types of financial markets Debt markets versus equity markets • Loans are traded in debt markets • Stocks are traded in equity markets

28. Types of financial markets Money markets versus capital markets • Securities with maturities of 1 year or less are traded in money markets • Securities with maturities of 1 year or more are traded in capital markets

29. Types of financial markets Mortgage markets versus credit markets • Debt associated with real estate is traded in mortgage markets • Consumer loans (i.e. automobiles, education, consumer appliances) are traded in consumer credit markets

30. Types of financial markets Financial markets can be… • Local, Regional, National and Global Depending on… • Coverage of securities traded • Nature of markets

31. Types of financial markets Primary markets versus secondary markets • New issues of stocks and bonds are traded in the primary markets • Previously issued securities are traded in the secondary markets

32. Types of financial markets Spot versus futures markets • Items that traded for immediate delivery • Contracts that give details about the delivery of products at some date in the future

33. The Stock Markets Physical Stock Exchanges • Characteristics • Physical locations where stock is traded (i.e. New York Stock Exchange) • Members have “seats” on the Exchanges

34. The Stock Markets Organized Investment Networks – (Over the counter - market) • Characteristics • Networks of brokers and dealers around the country linked electronically (i.e. National Association of Security Dealers Automated Quotation System) • Electronic Communications Networks (ECN), i.e. systems that transfer information to facilitate securities transactions – buy and sell orders are automatically matched