Chapter 1 The Financial Manager and the Firm

1. Chapter 1 The Financial Manager and the Firm Mgt 326 Fall 2014

2. Why Study Finance?

3. How Firms are Organized • Sole proprietorship • Easy • Most common • Partnerships • Business run by more than one owner • Limited partnership – limited liability

4. How Firms are Organized • Limited Liability Companies • All owners have limited liability • Flow through tax benefits • Set up to protect professionals in a partnership due to poor performance or misconduct by one partner. • Ex: malpractice suit.

5. How Firms are Organized • Corporations • Legally defined, artificial being, separate from its owners • Formation • Must be legally formed. • Difficult • Ownership • Shareholders are the owners. • Dividend payments are made to the shareholders at the discretion of the corporation. • Payment is proportional to the amount of shares held. • Taxation • S Corp • C Corp

6. How Firms are Organized • Corporations • Taxation • S Corp • Taxed once • All profits pass through stock holders, no tax is paid at the corporate level • C Corp • Subject to taxation separate from the owners tax obligations • In effect shareholders pay tax twice on the corporations profits • This is referred to as double taxation

7. Proprietor or Partnership Advantages- Easy to set up Owner manager make decisions Less regulated Single taxation Disadvantages Unlimited Liability Life of the business is limited to the life of the owner. Difficult to transfer ownership Hard to raise capital Corporation Advantages Liability limited to the amount invested Easy to transfer ownership Unlimited life Disadvantages Harder to set up Double Taxation Highly regulated by the Fed. Owner Manager conflicts How Firms are organized - summarized

8. Tax Implications for Corporations • Example You are a shareholder in a corporation. The corporation earns $5.00 per share before taxes. After it has paid taxes, it will distribute the rest of its earnings to you as a dividend. The dividend is income to you so you will then pay taxes on these earnings. The corporate tax rate is 40%, and your tax rate on the dividend is 15%. How much of the earnings remain after all taxes are paid?

9. What do Financial Manager’s do? • Make Investment Decisions • Weigh the cost and benefit of each investment / project • Decide whether they are good uses of the available money • Make Financing Decision • Will the manager finance the decision using additional stock or issue debt • Manage Cash Flow. • Make sure the company has enough cash to meet the day to day obligations.

10. What do Financial Manager’s do? • Goal of the financial Manager • Maximize the wealth of the stockholders. • Unambiguous objective • Easy to Measure • Public traded are perfect for this due to the large number of buyers / sellers • Forces securities to trade near their true price

11. Board of Directors President / CEO VP: Marketing VP Finance (CFO) VP: Manufacturing Controller Treasurer • Cost Accounting • Financial Accounting • Tax Management • Cash & Credit Mgmt • Inventory Management • Capital Budgeting • Planning and Forecasting The Corporate Management Team

12. The Financial System • Financial Market – General term that includes different types of markets for the creation and exchange of financial assets • Financial Institutions – Provide Financial services to the economy. Such as Business loans, stocks, and bonds • Commercial banks • Credit unions • Insurance companies • Pension funds and • Finance Companies

13. The Financial System (cont) • Financial Institutions (cont) • Invest in Financial Assets • Business loans • Stocks, and bonds. • Financial systems • Take money from those that have excess • Channel the money to others that need it

14. Investment Banks and Direct Financing • Investment banks – specialize in helping companies sell new debt or equity. • Money bank centers – large commercial anks that provide both traditional and investment banking services throughout the world. • Historically there had been a clear distinction between the two, in 1999 that ended.

15. Investment Banks and Direct Financing • Origination - preparing a security issue for sale • Underwriting - the investment banker help the company sell its new security issue • Distribution – the process of marketing and reselling the securities to investors

16. The Stock Market • The stock market provides liquidity for a company’s shares and determine the market price. • Primary Market • Issues new shares. These go to investors • Secondary Market • Shares trade between investors, with out the involvement of the corporation. • The stock market acts as a score card for management and how well of a job they are doing, based upon the stock price.

17. NYSE • Physical Location • Market Makers or Specialist • Individuals on the trading floor of a stock exchange who match buyers with sellers • They post two prices for every stock they make a market for • Bid price – • Ask price – • The Specialist will buy or sell (up to a limited amount of shares) and make the trade, even if they don’t have another customer willing to take the other side of the trade. • This way they make sure the market is liquid

18. NYSE cont • Auction Market • Licensed holders can go to the companies trading posts and directly sell or buy shares • Bid Ask Spread • Transaction cost • Small spread

19. NASDAC • National Association of Security Dealers Automated Quotation • Over the Counter (OTC) Market • The major difference between NYSE and NASDAC is that on the NYSE each stock only has one market maker • On NASDAC, stocks can and do have multiple market makers who compete with each other • Each Market maker must post bid and ask prices in the NASDAQ network where they can be viewed by all participants. • The NASDAQ system posts the best prices first and fills orders accordingly

20. Listing Standards • These are the requirements that have to be met to be traded on the exchange. • Require enough shares for liquidity. • The two exchanges compete over the listings of larger companies.

21. Efficient Market Hypotheses • Strong Form Efficiency • The market price of the security always reflects all information available • Few people believe that market prices for public securities reflect all available information • it is widely accepted that insiders have information that is not reflected in the security prices. • Thus the concept of strong form market efficiency represents the ideal case rather than the real world

22. Efficient Market Hypotheses • Semi-strong Form Efficiency • Only the public information is reflected in security prices • People with inside information are able to profit by trading on this information before it becomes public • Is a reasonable representation of the public stock markets

23. Efficient Market Hypotheses • Weak-Form Efficiency • All information is contained in past prices fo a security is reflected in current prices but thtat there is both public and private information that is not • In a weak form efficient market it would not be possible to earn abnormally high returns by looking for patterns in security prices, but would be possible to do so by trading on public or private information.

24. Financial Institutions • Banks and Credit Unions • Deposits • Loans money to people • Insurance companies • Premiums and investment earnings • Invests mostly in bond, some stocks, using the investment income to pay claims • Mutual Funds • Peoples investments (savings) • Buys stocks bonds and other financial instruments on behalf of its investors

25. Financial Institutions • Pension Funds • Retirement savings contributed through the workplace • Similar to mutual funds, except with the purpose of providing retirement income. • Hedge Funds • Investments by wealthy individuals and endowments • Invests in any kind of investment in an attempt to maximize returns.

26. Financial Institutions • Venture Capital • Investments by wealthy individuals and endowments • Invest in start up, entrepreneurial firms • Private Equity Funds • Investments by wealthy individuals and endowments • Purchases whole companies by using a small amount of equity and borrowing the rest.

27. Factors that influence stock prices • Internal Factors (ie influenced by management) • Projected Earnings Per Share • Timing of projected earnings • Riskiness of the projected earnings • Debt Policy • Dividend Policy

28. Factors that influence stock prices • External factors (ie beyond management’s control) • Antitrust laws • Environmental regulations • Product and workplace safety regulations • Federal Reserve Monetary Policy • Government Fiscal Policy • International Developments

29. What Jobs Can Finance majors pursue? • Private sector • Stock Broker • Personal Investment Counselor • Public Sector • Program Manager • Budget Analyst • Cost Analyst • Corporations and Small Businesses • Budget Analyst • Cost Analyst • Capital Manager • Program Manager

30. The Difference between Finance & Accounting • Finance • Focused on the future • Deals with uncertainty • Primarily concerned with deciding how to acquire, generate and distribute assets & capital resources • Strategic decision making

31. The Difference between Finance & Accounting • Accounting • Focused on the past • Very little uncertainty • Primarily concerned with keeping track of how assets and capital are distributed • Limited decision making

32. Real Rate of Interest • Real Rate of Interest – an interest rate determined in the absence of inflation. • Inflation is the amount by which aggregate price levels rise over time. • The real rate of interest is not observable because all economies operate with some degree of inflation. • Nominal Rate of Interest – the interest rate actually observed in the market place

33. Real Rate of Interest • Return on investment • Also known as the rate of return (RoR), interest, yield • The percent increase in the price of a financial asset • The return must be greater than the cost of funding • Formula for calculating RoR • (Sales – COGS) / COGS • (New Price – Old Price) / Old Price

34. Real Rate of Interest • Time Preference for Consumption • Most people prefer to consume goods today, versus saving for the good in the future. • Interest rates offered on financial instruments determine how much people will save • Lower interest rates people would rather consume now • Higher interest rates people would rather save

35. Real Rate of Interest • Equilibrium Condition • The rate of interest at which the supply of funds equals the demand for those funds

36. Rate of Return (cont) • In finance we are more concerned with RoR than we are Profit • Consider the 2 investments • Invest 5,000 and receive 5,500 in one year. • Invest 100,000 receive 108,000 in one year

37. Rate of Return (cont) • The second option has a higher profit, however the first option was more profitable because you got more money with respect to the amount of money invested. • Investments expressed as RoR can be compared on the same basis with out bias.

38. Agency Conflicts • Agency Problems • When managers, despite being hired as the agents of shareholders, put their own self-interest ahead of the interests of the shareholders

39. Agency Conflicts • What can be done to eliminate Agency Problems • Tie Performance to compensation • Shareholders can force a resignation • Hostile take over • Legal & Regulatory Environment • Sarbanes-Oxley – also known as the Truth in Securities Act

40. Ethics in Business • Agency Costs • Act Honestly • Deception & Fraud can have a huge & long lasting effect on stock price • Could cause bankruptcy as with Enron and WorldCom • Conflicts of Interest • Dual Function • Disclosure • Sometimes law requires one party to withdraw

41. Ethics in Business (cont) • Information Asymmetry • One party has information the other does not • Inside information illegal • Truth in Negotiations

42. Ethical Consequences • Bernard Ebbers – WorldCom • Guilty of Fraud • Sentenced to 25 yes jail time • Bernard Madoff • Pleaded guilty to 11 federal felonies – massive ponzi scheme • Sentenced to 150 years in prison – Maximum allowed