CHAPTER 1 - B&H An Overview of Financial Management Pankaj Agrrawal, Ph.D.

1. CHAPTER 1 - B&H An Overview of Financial ManagementPankaj Agrrawal, Ph.D. Career Opportunities Issues of the New Millennium Forms of Businesses Goals of the Corporation Agency Relationships

2. Better than avg. drivers, pls. stand up. Finance Concepts are Simple, the Behavioral Aspects are not… • A $ today is better than a $ tomorrow (concept of TVM) • Buy Low sell High (arbitrage – fear and greed, I say fear of losing and missing are the only motivators) • No free lunch (the world of risk and return, CAPM, APT) • Prices do not instantaneously adjust to all new information (random price path  irrationality)

3. Let’s take a 5-7 minute “Initial” Exam: PA: If you can get an asset worth $100 for $90, what’s the instant profit you just made? • If your initial investment declines by 50%, what percentage increase will bring you back to even? • If the average annual returns for the past two years has been –50% and +50%, what is the return on your investment over those two years? • If your investment has trebled in value, what is the associated percentage rise?

4. Financial Management Issues of the New Millennium • The effect of changing technology: lower costs, efficient, barriers to entry lowered • The globalization of business

5. Relevance of Finance and Globalization: • If you are a Doctor / Engineer– how does FM affect you? • For self decisions – day to day • Good business organization • If you are a Nebraska Homebuilder– how does Globalization affect you? (discuss KO) • Interest rates –global- housing demand • Local economy – wheat demand - global

6. Career Opportunities in Finance • Money and capital markets • Financial management • Investments • Financial Intermediaries: Banking • Corporate Finance: Managing the financing of corporations • Investment Management: Portfolio Management

8. Role of Finance in a Typical Business Organization

9. Responsibility of the Financial Staff • Maximize stock value by: • Forecasting and planning • Investment and financing decisions • Coordination and control • Transactions in the financial markets • Managing risk

10. Percentage of Revenue and Net Income from Overseas Operations for 10 Well-Known Corporations, 2001

11. Alternative Forms of Business Organization • Sole proprietorship • Partnership • Corporation

12. Sole proprietorships & Partnerships • Advantages • Ease of formation • Subject to few regulations • No corporate income taxes • Disadvantages • Difficult to raise capital • Unlimited liability • Limited life

13. Corporation • Advantages • Unlimited life • Easy transfer of ownership • Limited liability • Ease of raising capital • Disadvantages • Double taxation (Delaware 300k+ companies) • Cost of set-up and report filing

14. Financial Goals of the Corporation • The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price. • Do firms have any responsibilities to society (safety, pollution, antitrust- price gouging,fair hiring) at large? (DSEFX [ETF=KLD-show how to locate], SPX, VICEX – 3yrs) • Priced out of mkt • Shunned by investors • Social objectives have to be mandated – role of Govt • Is stock price maximization good or bad for society (efficient production, new technology,new jobs)? • Should firms behave ethically?

16. Is stock price maximization the same as profit maximization (Rev-Cost)? • No, despite a generally high correlation amongst stock price, EPS, and cash flow. • Current stock price relies upon current earnings, as well as future earnings and cash flow. • Some actions may cause an increase in earnings, yet cause the stock price to decrease – risk impact (and vice versa).

17. Agency relationships • An agency relationship exists whenever a principal hires an agent to act on their behalf. • Within a corporation, agency relationships exist between: • Shareholders and managers • Shareholders and creditors

18. Shareholders versus Managers • Managers are naturally inclined to act in their own best interests (ICC). • But the following factors affect managerial behavior: • Managerial compensation plans • Direct intervention by shareholders (free rider problem – Satellite Dish example) • The threat of firing • The threat of takeover (poison pills, greenmail)

19. Shareholders versus Creditors • Shareholders (through managers) could take actions to maximize stock price that are detrimental to creditors. • In the long run, such actions will raise the cost of debt and ultimately lower stock price.

20. Factors that affect stock price • Projected cash flows to shareholders • Timing of the cash flow stream • Riskiness of the cash flows

21. Basic Valuation Model • A=P(1+r)^n => 110 = 100(1+10%) ^1 yr • For 2 years CF is: 10/(1.1)+(10% of 100)/(1.1*1.1)+100/(1.21) = (11+10+100)/1.21 =>100 • Or 9.09+10/1.21+100/1.21= 9.09+8.26+82.64 =>99.99 (A $ one yr from now is more valuable than two yrs from now) • To estimate an asset’s value, one estimates the cash flow for each period t (CFt), the life of the asset (n), and the appropriate discount rate (k) • Throughout the course, we discuss how to estimate the inputs and how financial management is used to improve them and thus maximize a firm’s value.

22. Factors that Affect the Level and Riskiness of Cash Flows • Decisions made by financial managers: • Investment decisions • Financing decisions (the relative use of debt financing) • Dividend policy decisions • The external environment

23. Austrian Economic Cycle

24. HW Questions Ch 1: 1-1, 1-5, 1-6, 1-7, 1-8 and ST -1 (solutions at end of book, in Appx B)---- Read Ch 4, self review ST questions page 159