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Introduction to Managerial Finance

An Overview of Managerial FinanceBesley: Chapter 1

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Career Opportunities in Finance

Finance consists of three interrelated areas:Financial Markets & Institutions

Focus on Macroeconomic IssuesInvestments

Focus on Portfolio & Individual Securities Decision Structure

Managerial Finance“Business Finance” concerned with Managing the

Firm

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The Globalization of Business

Four factors influencing the trend toward globalization:The world has become smaller.

Advancements in transportation and communications have lowered shipping costs and expended the feasibility of international trade.

Consumer desire for low-cost; high-quality products has lowered trade barriers which have traditionally protected inefficient domestic manufacturers.

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The Globalization of Business

Four factors influencing the trend toward globalization:Firms seeking to expand into new markets to

increase unit sales find opportunities abroad.As more multinationals operate in countries

with lower costs, non-multinationals are forced to follow the trend or find other ways to compete.

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The Financial Manager’s ResponsibilityFinancial managers are responsible for making decision regarding the use of the firm’s funds. These activities include:

Forecasting & PlanningMajor investment and financing decisionCoordination and ControlDealing with the financial markets

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Alternative Forms of Business OrganizationThere are three main forms of business organization:

• Proprietorships• Partnerships• Corporations

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Proprietorship

Advantages• Easily and

inexpensively formed• Low government

regulations• Taxed at the

individual level; not corporate level

Limitations• Unlimited personal

liabilities• Limited life• Difficulty transferring

ownership• Limited access to

capital

Proprietorship: An unincorporated business owned by one individual.

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Partnership

Advantages• Easily and

inexpensively formed• Low government

regulations• Taxed at the

individual level; not corporate level

Limitations• Unlimited personal

liabilities• Limited life• Difficulty transferring

ownership• Limited access to

capital

Partnership: An unincorporated business owned by two or more individuals.

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Corporation

Advantages• Unlimited life• Easy transfer of

ownership• Limited Liability

Limitations• Double taxation of

corporate earnings• Complexity and cost

of incorporation

Corporation: A legal entity created by a state, separate and distinct from its owners and managers, having unlimited life.

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Finance in the Organizational Structure of the Firm

Board of Directors

President

Treasurer Controller

CreditManager

InventoryManager

Director of Capital

Budgeting

CostAccounting

FinancialAccounting

TaxDepartment

Vice-President: FinanceVice-President: Sales Vice-President: Manufacturing

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Goals of the Corporation

Primary Goal of Management is to maximize stockholder wealth.

Wealth maximization is measured by the value of the corporations common stock.

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Managerial Incentives to Maximize Shareholder WealthShareholder Actions/Expectations

Hire management team that will maximize wealth.

Management Team Actions

Reasonable Rates of Return/Normal Profits

Personal interests/goalsHigher SalaryEmployee

Benefits/PerksOther Interests

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Social Responsibility

Are firms responsible for the well-being of their employees, customers and communities?

Social responsibilities have associated costs which oppose wealth maximization.

Government Regulation.

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Stock Price Maximization and Social WelfareStock price maximization is good since it leads to:

Efficient operations that produce high-quality goods at low consumer prices.

Fulfilling consumer demand (society needs) with new products/services.

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Managerial Actions to Maximize Shareholder WealthManagement should focus on earnings per share (EPS) rather than total corporate profits.

XEROXCurrent Expansion*

Sh. Outstanding: 300Mil. 600Mil.Net Profit: $1,200Mil. $1,500Mil.EPS $4 $2.50

* Assume that Xerox decided to issue an additional 300million shares and invested the funds in business that produced profits of $300million.

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Managerial Actions to Maximize Shareholder WealthOther factors to consider in EPS maximization:

Timing of EarningsRiskCapital Structure

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Timing of Earnings

Project AExpected Change in EPS:

Year 1: $0.20

Year 2: $0.20

Year 3: $0.20

Year 4: $0.20

Year 5: $0.20

TOTAL: $1.00

Project BExpected Change in EPS:

Year 1: $0.00

Year 2: $0.00

Year 3: $0.00

Year 4: $0.00

Year 5: $1.25

TOTAL: $1.25

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Risk

Risk inherent in the predictability of the projected EPS.

Given two projects with equal EPS impact, a firm would choose the one with less risk.

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Capital Structure

Greater the use of Debt – Greater the threat of bankruptcy.

While debt financing increases EPS, it also increases the risk associated with those earnings.

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Dividend Policy

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

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Firm’s Stock Price

A firm’s stock price is determined by the following factors:

Projected Earnings per Share Timing of the Earnings Stream Predictability (risk) of projected earnings Use of debt Dividend Policy Market Conditions

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Agency Relationships

Agency Relationship: a relationship in which one or more people (principals) delegate certain decision making authority another (agent).

Examples of agency relationships are:Stockholders and ManagersStockholders and creditors (debtholders)

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Agency Relationships

Agency Problem: Is the potential for a conflict of interests between the shareholders (principals) and (1) the firm’s managers, or (2) creditors.

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Stockholders versus Managers

Managers are naturally inclined to act in their own best interests.

Methods of Motivating Managers:Threat of firing.Threat of hostile takeover.

Defense Mechanisms:• Poison Pill

Examples:» “Golden Parachutes”» Disney sale of large blocks of stock at low prices to “friendly”

investors.» Scott Industries’ plan to make all debt immediately payable.

• Greenmail

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Stockholders versus Managers

Methods of Motivating Managers:Management Compensation/Incentives

Performance Based Compensation packages:• Executive Stock Options

• Performance Shares

• Profit-Based Bonus’

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Stockholders versus Creditors

Creditors lend funds to the firm at rates that are based on:

The riskiness of the firm’s existing assets; Expectations concerning the riskiness of future

asset additions; The firm’s existing capital structure; and Expectations concerning future capital

structure changes.

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Stockholders versus Creditors

Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors.

In the long run, such actions will raise the cost of debt and ultimately lower stock price.

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The External Environment

External Constraints:

1. Antitrust Laws

2. Environmental Regulations

3. Product and Workplace Safety Regulations

4. Employment Practices Rules

5. Federal Reserve Policy

6. International Developments

Strategic Policy Decisions Controlled by Management

1. Types of Products and Services Produced

2. Production Methods Used

3. Relative Use of Debt Financing

4. Dividend policy

Level of Economic Activity and

Corporate Taxes

Stock Market

Conditions

Expected Profitability

Timing of Cash Flows

Degrees of Risk

Summary of Major Factors Affecting Stock Prices

Stock Price

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Business Ethics

Most executives believe that there is a positive correlation between ethics and long-run profitability because ethical behavior:

Avoids fines and legal expensesBuilds public trustAttracts business from customers who appreciate and

support its policiesAttracts and keeps employees of the highest caliber,

andSupports the economic viability of the communities in

which it operates.

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Multinational Corporations

Five principal reasons companies go “international”:

Seek new markets Seek raw materials Seek new technology Seek production efficiency Avoid political and regulatory hurdles

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Multinational versus Domestic Managerial FinanceMajor differences of multinational companies from those operating entirely within a single country:

Multiple CurrenciesEconomic and legal ramificationsLanguage DifferencesCultural DifferencesGovernmental Role/InterventionPolitical Risk