Introducing Financial Management

1. Introducing Financial Management Chapter 1 ACT3211 Financial Management

2. ACT3211 Financial Management

3. 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 company rather than an individual, but the same concepts apply to both ACT3211 Financial Management

4. Economic Participants • We can segment participants along two dimensions: • Those with “extra” money available to invest • Those with economically viable ideas ACT3211 Financial Management

5. We can set aside Types 1 and 4 • Type 1 people play no direct role in financial markets as either lenders or users of capital, but they play an indirect role by providing labor and consuming products • Type 4 people are self-funded, so they don’t need financial markets. They do use the financial tools discussed below, however. • Types 2 and 3 use financial institutions and financial markets to engage in mutually beneficial exchange • Type 2 people lend money to Type 3 people to invest in good business ideas. ACT3211 Financial Management

6. Type 1 participants are usually individual investors Type 3 participants are usually companies which may have R&D departments dedicated to developing innovative ideas Investors lend capital to businesses, who then expand, hire more employees, and create a promising future. The investor has increased wealth for the future as well. ACT3211 Financial Management

7. 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: • Retained earnings • Funds that the firm retains to support ongoing operations • Taxes • Used by the government to fund public services ACT3211 Financial Management

8. Sub-Areas of Finance • Investments • Studies the methods and techniques needed to make appropriate decisions about what kind of securities (bonds and stocks) to own • 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 back providers of capital ACT3211 Financial Management

9. Sub-Areas of Finance • Financial Institutions and Markets • Studies capital flows between investors and firms • Examines financial institutions such as banks, mutual funds, pension funds • Studies interest rates • International Finance • Applies all three of the above areas in a global setting • Examines exchange rates, political risk, international investment, risk management ACT3211 Financial Management

10. Applying Finance Theory • Future cash flows are uncertain in both size and timing • We refer to this uncertainty as risk • Assessing the value of financial assets, such as stocks and bonds, involves examining the expected cash flows from the asset and computing their risk-adjusted present value using the Time Value of Money. • These financial assets trade in financial markets, and are very likely to worth exactly what they cost. • In contrast, a firm may find real assets such as projects, to be worth more than they cost. We will learn a variety of methods to analyze such opportunities. ACT3211 Financial Management

11. The Financial Function • In most companies, the financial function is closely associated with the accounting function • Accounting generally looks backward in time to record things that have already happened • Finance generally looks ahead to the future • Making decisions based on economic analysis • Valuation ACT3211 Financial Management

12. 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 ACT3211 Financial Management

13. Finance in Other Business Functions • While the CFO and Treasurer are the most visible finance–related positions, finance permeates the entire business organization • Strategy • Day-to-day operations • Finance is used by all areas within the firm • Operations • Marketing • Human resources ACT3211 Financial Management

14. Finance in Your Personal Life • The financial concepts you learn in this course will also apply to your personal financial situation • Borrowing money • Refinancing • Investing • Retirement planning • Rise of defined contribution plans vs. defined benefit ACT3211 Financial Management

15. Business Organization • Single owners, partners, and corporations operate businesses. The advantages and disadvantages of forms of organization can be expressed through the following dimensions: • Who controls the firm • Who owns the firm • What are the owners’ risks • What access to capital exists • What are the tax ramifications ACT3211 Financial Management

16. Sole Proprietorships • The most common type of business organization in the U.S. (over 70% of businesses). There is no distinction between 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 ACT3211 Financial Management

17. General Partnerships • Involves multiple individual owners. Firm control is determined by the size of the partners’ ownership stakes. Profits are taxed at personal income tax rates. • Advantages: • Relatively easy to start • Single taxation • Disadvantages: • Partners jointly share unlimited liability • Difficult to raise large amounts of capital ACT3211 Financial Management

18. Limited Partnerships • Much like general partnerships • General partners make decisions regarding the firm and are liable for the firm’s debts • Limited partners are liable only for their investment in the firm • Can’t materially participate in the firm’s operations or they lose their ‘limited’ status ACT3211 Financial Management

19. Corporations • Corporations are legally independent entities entirely separate from their owners. The world’s largest businesses are organized as corporations. • Owners are called shareholders. They elect the board of directors, who then hire managers of the firm. • Advantages: • Limited liability for owners • Can raise large amounts of capital • Easy to transfer ownership • Disadvantages • Double taxation (corporate level and personal level) ACT3211 Financial Management

20. Hybrid Organizations To promote the growth of small businesses, the U.S. government allows for business organizations that simultaneously offer single taxation and limited liability S Corporations Limited Liability Companies (LLCs) and Partnerships (LLPs) ACT3211 Financial Management

21. Goals of the Firm • Owners perspective: Maximize shareholder wealth (stock price) • Another way of saying the same thing: maximize the value of the company • Adam Smith’s invisible hand: firms that pursue activities that maximize firm value also benefit society • Requires maximizing the present value of future cash flows, which requires that the firm do things that are generally desirable: making products that people want in an efficient way that results in increased growth, employment, and tax revenue ACT3211 Financial Management

22. 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 doesn’t reflect returns to equity holders ACT3211 Financial Management

23. What about other goals such as minimizing costs or maximizing market share or employee welfare or customer satisfaction? • These kinds of worthy goals are incorporated into the overall goal of maximizing firm value • When pursued in isolation, benign-sounding goals will result in financial distress or failure ACT3211 Financial Management

24. Agency Theory • When one party (the principal) hires another party (the agent) to work for them, this is an agency relationship and the agent is supposed to act in the principal’s best interest. • How does this apply to the firm? • The stockholders (owners) don’t manage the firm. They hire managers to operate the firm to maximize the value of their investment. • Often, the manager’s best interest does not align with shareholder goals. This is known as an agency problem. • Example: CEO buying corporate jet rather than flying commercial. ACT3211 Financial Management

25. Three approaches to minimizing this conflict of interest • Ignore it. If the amount of money is small enough such perks might add value by enhancing productivity. • Monitor the managers. • Accountants • Debt holders • Align incentives by making the managers owners • Equity stakes • Stock options • ESOPS ACT3211 Financial Management

26. Corporate Governance • The process of aligning managers’ incentives and monitoring managers • Inside monitors: the Board of Directors • Hires the CEO • Evaluates management • Designs compensation plans • Outside monitors • Auditors • Analysts • Banks • Credit rating agencies ACT3211 Financial Management

27. Ethics • Financial professionals manage other people’s money • Corporate managers • Bankers • Investment advisors • Professional associations place a strong emphasis on ethical behavior • The corporate agency relationship can create ethical dilemmas • Stealing from firms = stealing from shareholders ACT3211 Financial Management

28. Financial Markets & Intermediaries • Financial markets and financial intermediaries play an important role in facilitating 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 ACT3211 Financial Management