Introducing Financial Management

8/6/2019 Introducing Financial Management

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ACT3211 Financial Management

Introducing Financial

ManagementChapter 1


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Chapter 1 Learning Goals

LG1: Connect finance sub-area descriptions with corporate financial tasks

LG2: Show why and how finance is at the heart of sound businessdecisions

LG3: Apply finance in your personal life

LG4: Compare and contrast the advantages and disadvantages of the

three most common business organizational forms in corporateworld

LG5: Differentiate between financial managers appropriate andinappropriate goals

LG6: Identify the firm primary agency relationship and discuss

why

agency relationships can create conflicts

LG7: Incorporate ethics into financial management

LG8: D

escribe the complex and necessary relationships among firms,

financial institutions, and financial markets


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What is Finance?

The study of valuation Stocks, bonds

Mortgage payments

Companies Projects

Business decisions

Financial Management focuses on valuing

things from the perspective of a companyrather than an individual, but the sameconcepts apply to both


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Economic Participants

We can segment participants along twodimensions:

Those with extra money available to invest

Those with economically viable ideas

No extra money Extra money

No economicallyviable business

ideas

Type 1: Nomoney and no

ideas

Type 2: Money,but no ideas

Economicallyviable businessideas

Type 3: Nomoney, but ideas

Type 4: Bothmoney and ideas


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We can set aside Types 1 and 4

Type 1 people play no direct role in financialmarkets as either lenders or users of capital, butthey play an indirect role by providing labor andconsuming products

Type 4 people are self-funded, so they dont needfinancial markets. They do use the financial tools

discussed below, however.

Types 2 and 3 use financial institutions andfinancial markets to engage in mutuallybeneficial exchange

Type 2 people lend money to Type 3 people toinvest in good business ideas.


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Type 1 participants are usuallyindividual investors

Type 3 participants are usuallycompanies which may have R&Ddepartments dedicated to developing

innovative ideas

Investors lend capital to businesses,who then expand, hire more

employees, and create a promisingfuture. The investor has increasedwealth for the future as well.


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Where Does the Cash Go?

Successful companies repay investors(plus profit) for the use of their capital.But not all the cash will return to investors

due to friction. Two sources of friction:

1. Retained earnings Funds that the firm retains to support ongoing

operations

2. Taxes Used by the government to fund public services


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Sub-Areas of Finance

1. Investments Studies the methods and techniques needed to

make appropriate decisions about what kind ofsecurities (bonds and stocks) to own

2. Financial Management Examines firm decisions

How to organize

What type of capital to raise

Which projects to fund

How much capital to retain and how to pay backproviders of capital


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Sub-Areas of Finance

3. Financial Institutions and Markets

Studies capital flows between investors and firms

Examines financial institutions such as banks,

mutual funds, pension funds Studies interest rates

4. International Finance

Applies all three of the above areas in a global

setting Examines exchange rates, political risk,

international investment, risk management


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Applying Finance Theory Future cash flows are uncertain in both size and

timing

We refer to this uncertainty as risk

Assessing the value offinancial assets, such asstocks and bonds, involves examining theexpected cash flows from the asset and

computing their risk-adjusted present value usingthe Time Value of Money.

These financial assets trade in financialmarkets, and are very likely to worth exactlywhat they cost.

In contrast, a firm may find real assets such asprojects, to be worth more than they cost. Wewill learn a variety of methods to analyze suchopportunities.


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The Financial Function

In most companies, the financial functionis closely associated with the accountingfunction

Accounting generally looks backward in time torecord things that have already happened

Finance generally looks ahead to the future

Making decisions based on economic analysis

Valuation


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The Financial Manager

Chief Financial Officer

Highest level financial officer

Controller

Oversees the accounting function

Treasurer

Responsible for managing cash, credit, financing,capital budgeting, risk management

CFO

Controller Treasurer


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Finance in Other Business Functions

While the CFO and Treasurer are the mostvisible financerelated positions, financepermeates the entire business

organization Strategy

Day-to-day operations

Finance is used by all areas within the firm

Operations Marketing

Human resources


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Finance in Your Personal Life

The financial concepts you learn in thiscourse will also apply to your personalfinancial situation

Borrowing money

Refinancing

Investing

Retirement planning

Rise of defined contribution plans vs. defined benefit


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Business Organization

Single owners, partners, and corporationsoperate businesses. The advantages anddisadvantages of forms of organization

can be expressed through the followingdimensions: Who controls the firm

Who owns the firm

What are the owners risks

What access to capital exists

What are the tax ramifications


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Sole Proprietorships

The most common type of businessorganization in the U.S. (over 70% ofbusinesses). There is no distinctionbetween the owners personal and

business assets Advantages:

Easy to start Light regulatory and paperwork burden Single taxation at the personal tax rate

Disadvantages Unlimited liability Limited access to capital


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General Partnerships

Involves multiple individual owners. Firmcontrol is determined by the size of thepartners ownership stakes. Profits are taxedat personal income tax rates.

Advantages: Relatively easy to start

Single taxation

Disadvantages: Partners jointly share unlimited liability

Difficult to raise large amounts of capital


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Limited Partnerships

Much like general partnerships

General partners make decisionsregarding the firm and are liable for the

firms debts

Limited partners are liable only for theirinvestment in the firm

Cant materially participate in the firmsoperations or they lose their limited status


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Corporations

Corporations are legally independent entitiesentirely separate from their owners. The worldslargest businesses are organized as corporations.

Owners are called shareholders. They elect theboard of directors, who then hire managers of thefirm.

Advantages: Limited liability for owners Can raise large amounts of capital Easy to transfer ownership

Disadvantages Double taxation (corporate level and personal level)


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Hybrid Organizations

To promote the growth of smallbusinesses, the U.S. government allowsfor business organizations that

simultaneously offer single taxation andlimited liability

S Corporations

Limited Liability Companies (LLCs) andPartnerships (LLPs)


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Goals of the Firm

Owners perspective: Maximizeshareholder wealth (stock price) Another way of saying the same thing:

maximize the value of the company

Adam Smiths invisible hand: firms that pursueactivities that maximize firm value also benefitsociety

Requires maximizing the present value offuture cash flows, which requires that the firmdo things that are generally desirable: makingproducts that people want in an efficient waythat results in increased growth, employment,and tax revenue


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What about Profit Maximization?

Profits are not cash flows

Which profits? This year? This quarter?

This goal ignores timing of returns This goal ignores differences in risk

between projects

This goal doesnt reflect returns to equity

holders


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What about other goals such asminimizing costs or maximizingmarket share or employee welfare or

customer satisfaction? These kinds of worthy goals are

incorporated into the overall goal ofmaximizing firm value

When pursued in isolation, benign-sounding goals will result in financialdistress or failure


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Agency Theory

When one party (the principal) hires anotherparty (the agent) to work for them, this is anagency relationship and the agent is supposedto act in the principals best interest.

How does this apply to the firm? The stockholders (owners) dont manage the firm.

They hire managers to operate the firm to maximizethe value of their investment.

Often, the managers best interest does not alignwith shareholder goals. This is known as an agencyproblem.

Example: CEO buying corporate jet rather thanflying commercial.


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Three approaches to minimizing thisconflict of interest Ignore it. If the amount of money is small

enough such perks might add value byenhancing productivity.

Monitor the managers. Accountants

Debt holders

Align incentives by making the managersowners

Equity stakes Stock options

ESOPS


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Corporate Governance

The process of aligning managers incentivesand monitoring managers

Inside monitors: the Board of Directors Hires the CEO

Evaluates management Designs compensation plans

Outside monitors Auditors Analysts Banks Credit rating agencies


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Ethics

Financial professionals manage other peoplesmoney Corporate managers

Bankers

Investment advisors

Professional associations place a strongemphasis on ethical behavior

The corporate agency relationship can create

ethical dilemmas Stealing from firms = stealing from shareholders


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Financial Markets & Intermediaries

Financial markets and financialintermediaries play an important role infacilitating the flow of capital from

investors to firms and back to investors Financial institutions acquire specialized

expertise and assets

These firms often earn very high profits

through the use of these unique characteristics

Documents

Introducing Financial Management