Introduction to Financial Management

1. Introduction to Financial Management Financial Management

2. Outline • Meaning of Financial Management • Meaning of Corporate Finance • Significance of Financial Management • Forms of Business Organization • Goal of a Firm and Corporate Form of Organization • What motivates Management to act in shareholders’ best interests?

3. Meaning of Corporate Finance • Corporate finance can be defined as a body of knowledge that deals with the following three issues: • What long-term strategic investments a firm should undertake? • What long-term strategic financing alternatives that a firm should use to raise capital to finance its long-term strategic investments? • How much short-term cash flow does a company need to ensure smooth day-to-day operations of the firm?

4. Long-term strategic investments decisions are also known as the capital budgeting decisions of the firm. • Long-terms strategic financing decisions involve a decision on mix of debt and equity financing for the company and are known as capital structure decisions. • Dividend policy decisions also fall into this category. • Management of short-term cash flows relates to working capital management.

5. Thus, we can define corporate finance as a study of the principles, policies, and institutions that shape corporate financial decisions

6. Why Financial Management is an Important? • Coordinated corporate decision-making • financial implications of virtually all business decisions and non-financial executives must know enough finance to work these implications into their own specialized analyses. • Lack of understanding of basic principles of finance may have disastrous implications for a firm.

7. Forms of Business Organization • Individual Ownership • One individual owns the business • No legal distinction between the business and the owner • All assets belong to the owner and all loans and liabilities are the responsibility of the owner • Partnership • Two or more partners own the business • Partners are jointly and severally responsible for all loans and liabilities of the firm

8. Corporate form of Organization • Shareholders own the firm • Common stockholders true owners/residual owners • Company is a separate legal entity, distinct from its owners • Shareholder cannot be sued to recover any loans/liabilities of the firm

9. Goal of Firm in a Corporate Form of Organization • Separation of ownership from management in a company form of organization • Owners (shareholders) elect the management (board of directors) • Management is in an agency relationship to shareholders • Given that management is managing the firm on behalf of the shareholders, what should be the goal of a firm? • Should it be maximization of sales revenue? • Should it be minimization of costs? • Should it be maximization of employee welfare? • Should it be maximization of society welfare? • Should it be customer satisfaction?

10. Goal of a Firm? • The overall goal should be maximization of owners’ welfare • It also means maximization of shareholder wealth • Shareholder wealth is maximized through market price per share maximization • It is also consistent with maximization of profits at a given level of risk

11. How to Ensure the Management Acts in Shareholders’ Interest? • Managerial Incentives • Performance-based Incentive Plans • Executive Stock Option Plans • Performance Shares • Direct Intervention by Shareholders • The Threat of Firing • The Threat of Hostile Takeover

12. Performance-based incentive Plans • Types of Incentive Plans • Stock Options • Performance Shares • Stock options allow management to purchase pre-designated number of shares at some time in the future at a predetermined price. • The stock options will have value only if the market price of the stock rises above the exercise price of the option. This serves as an incentive to the management to take actions that would ensure growth of stock price through comparison with competitors.

13. Performance shares are shares of stock given to executives on the basis of performance as defined by objective measures such as earnings per share, return on assets, return on equity, and so forth. Managerial performance may also be judged in a relative sense • Other methods of motivating top management: • Kodak requires its top executives to invest one to four times the base salary in Kodak shares • GM requires top executives to hold GM common stock equivalent in market value to the manager’s annual salary • Xeros, Union Carbide, and Hershey Foods also require top executives to invest in the common stock of the firm

14. Direct Intervention by Shareholders • Direct intervention more easy now with institutional ownership of shares • Shareholders being the ultimate owners can force management to act in their best interests or risk losing the job

15. Threat of Firing • Of course, shareholders can remove the existing management by voting them and with institutional investors this threat has become a reality. • American Express, Goodyear, GM, IBM, Apple have lost their CEOs at some point due to shareholders’ unhappiness

16. Threat of Hostile Takeover • Hostile takeover is a takeover of a firm against the wishes of existing management. • Hostile takeovers are most likely to occur when a firm’s stock is undervalued relative to its potential due to poor management. • RJR Nabisco was the target of hostile takeover by KKR group • IBM initial bid for Lotus Development Corporate was hostile • Can management prevent hostile takeovers? Poison Pills