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MBA 643 Managerial Finance Lecture 2: Theory of the Firm

MBA 643 Managerial Finance Lecture 2: Theory of the Firm. Spring 2006 Jim Hsieh. What is “Finance”?. The study of how people allocate scarce resources over time Central concept: Valuation Valuation should be forward-looking expectations or expected values vs. Accounting

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MBA 643 Managerial Finance Lecture 2: Theory of the Firm

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  1. MBA 643Managerial FinanceLecture 2: Theory of the Firm Spring 2006 Jim Hsieh

  2. What is “Finance”? • The study of how people allocate scarce resources over time • Central concept: Valuation • Valuation should be forward-looking • expectations or expected values • vs. Accounting • Costs and benefits of financial decisions: • Spread out over time • Are not known with certainty at time of decision

  3. How Do Firms Differ Institutionally?

  4. The Uniqueness of Corporation • Advantages • Unlimited life • Limited liability • Easy transfer of ownership • Ease of raising capital • Disadvantages • Double taxation • Set-up and reporting costs (Sarbanes-Oxley Act of 2002) • Agency costs

  5. A Simplified Organization Chart (Figure 1.3) Board of Directors Chairman of the Board and CEO President and Chief Operations Officer (COO) Vice President Marketing Vice President Production Vice President Finance (CFO) Treasurer Controller Cost Accounting Manager Credit Manager Tax Manager Cash Manager Financial Accounting Manager Capital Expenditures Financial Planning Data Processing Manager

  6. An Alternative (yet Better) View of the Firm • The nexus of contracts Shareholders Lessors Lessees Board of Directors Managers Suppliers Firm Employees Customers Bondholders

  7. Goal of Financial Management • Possible goals • Three equivalent goals of financial management

  8. Another View of the Firm (Figure 1.1)-- The Balance Sheet Model Total Value of Liabilities and Shareholders’ Equity Total Value of Assets Net Working Capital Current Liabilities Current Assets Long-TermDebt Fixed Assets 1. Tangible fixed assets 2. Intangible fixed assets Shareholders’Equity

  9. Another View of the Firm (cont’d) • Firm Value = Current Assets + Fixed Asset = Debt + Equity • Book value versus Market value

  10. The Role of the Financial Manager • Capital budgeting decisions • Corporate investment policy • Capital structure decisions • Corporate financing policy (debt/equity decisions) • Dividend policy • Cash holding policy • Compensation policy

  11. Agency Relationships • Q: Do managers always maximize shareholders’ wealth? • A: • Separation of ownership & control only exists in corporations • An agency relationship exists whenever a principal hires an agent to act on his/her behalf • The nexus of contract (revisited)

  12. Agency Relationships (cont’d) • Managers are naturally inclined to act in their own best interests • Agency relationship is based on the structure of contracts • For managers to maximize shareholders’ wealth, we can change the following factors to affect managerial behavior:

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