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Chapter 1 An Overview of Managerial Finance

Chapter 1 An Overview of Managerial Finance. Learning Objectives. 1. Understand the general framework for financial decision making. 2. Describe the role of financial decision making in maximizing the value of the firm.

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Chapter 1 An Overview of Managerial Finance

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  1. Chapter 1 An Overview of Managerial Finance

  2. Learning Objectives 1. Understand the general framework for financial decision making. 2. Describe the role of financial decision making in maximizing the value of the firm. 3. Identify how to determine whether an investment should be made and how to finance acceptable investments. • Explain what is meant by the risk/return trade-off and how risk and return can affect management decisions. • Understand the role of financial institutions and markets and its effect on financial decisions made by the firm.

  3. Importance of Managerial Finance Maximize wealthnotprofit! Debts are paid by cashflownot income! Investment Decisionsutilize funds Financing Decisionsrequire funds

  4. The operation of a firm

  5. Forms of Business Organization Proprietorship • Advantages • Easy formation with low organizational costs • Affected by few government regulations • Income included and taxed only on proprietor’s personal tax return (i.e. only one)

  6. Forms of Business Organization Proprietorship • Drawbacks • Owner has unlimited liability (i.e. total wealth can be taken to satisfy debts) • Lacks continuity when proprietor dies • Transferring of ownership is difficult • Limited fund-raising power tends to inhibit growth

  7. Forms of Business Organization Partnership • Advantages • Fairly easy and inexpensive formation • Affected by few government regulations • Income included and taxed only on partner’s tax return

  8. Forms of Business Organization Partnership • Drawbacks • Owners have unlimited liability and may have to cover debts of other partners • Partnership is dissolved when a partner dies • Difficulty to liquidate or transfer partnership • Difficulty of raising large amounts of capital

  9. Forms of Business Organization Corporation • Advantages • Long life of firm even if owners do not have a relationship with the business • Ownership (stock) is readily transferable • Owners have limited liability which guarantees that they cannot lose more than they invested • Better access to financing

  10. Forms of Business Organization Corporation • Drawbacks • More expensive to organize than other business forms and subject to greater government regulation • Taxes are higher because of double taxation: corporate income is taxed and also dividends paid to owners are taxed

  11. Value maximized for corporations Why? • Limited Liability reduces the risk borne by investors • A firm’s current value is related to its future growth opportunities • Corporate ownership can be transferred easier than the ownership of either a proprietorship or a partnership

  12. Role of Finance in a Business Organization

  13. The Goals of the Corporation Stockholder wealth maximization • This should be the primary goal of a financial manager Incentives against are to keep stockholder returns “at reasonable level” and work for other goals such as: • pursue goals of public service activities • target employee benefits • pursue higher executive salaries • But… • Competitive forces require financial managers to opt for stockholder wealth maximization, to avoid losing their jobs

  14. The Goals of the Corporation Social Responsibility • Firms should provide a safe environment, avoid air pollution and produce safe products. Incentives against for firms to act in a socially responsible manner are: • Disadvantage in attracting funds due to extra costs incurred • Inability to compete due to higher prices of products • Constraints by capital market factors • Therefore… • Social Responsibility actions should be enforced on a mandatory rather than a voluntary basis

  15. The Goals of the Corporation Stock Price Maximization and Social Welfare • Shareholder Wealth Maximization is beneficial for the society: • Stock price maximization requires efficient, low cost plants that produce high-quality goods and services at a low cost • Stock price maximization requires the development of products that customers want and need, leading to new technology, new products and new jobs • Stock price maximization necessitates efficient service, adequate stocks and well located business establishments

  16. The Goals of the Corporation Therefore primary goal is to Maximize Shareholder Wealth

  17. Ù Ù Ù CF CF CF Asset 1 2 n = + + + L value 1 2 n + + + 1 k ) ( 1 k ) ( 1 k ) ( Decisions affecting the firm’s value • How to finance (capital structure decision) • What assets to purchase (capital budgeting decision) • Pay dividends or re-invest earnings? (dividend policy decision) Value = Current (present) value of expected cash flows (CFs) based on the return demanded by investors (k)

  18. Present Value… explained • The value of any financial contract (i.e., stock) answers the following questions: • 1. How much do I expect receipts to be (expected cash flow to the investor (i.e., dividends))? • 2. When do I receive the payments (timing/opportunity cost)? • 3. What is the chance I do not receive what I expected (risk)? • The Present Value (discounted) of cash flows received by an investor is used as the estimate of the value of a contract (i.e., shareholder wealth) • The Present Value (discounted) of a single share is the shares market price • Shareholders Wealth=Market Value of Equity=Number of shares * share price

  19. Should Earnings Per Share Be Maximized? Beware: Wealth is NOT profit! Profit maximization fails to account for differences in the level of cash flows (as opposed to profits), the timing of these cash flows, and the risk of these cash flows.

  20. Make decisions about the cash flow Beware: Accounting is NOT an economic profit! Cash flow is the actual cash generated by the firm. CF = Net Income + Depreciation or (CF = NI + DEP )

  21. Agency Relationships Stockholders versus Managers – The problem • Whenever a manager owns less than 100% of the firm’s equity, a potential agency problem exists. • In theory, managers would agree with shareholder wealth maximization. • However, managers are also concerned with their personal wealth, job security, fringe benefits, and lifestyle. • This would cause managers to act in ways that do not always benefit the firm’s shareholders.

  22. Agency Relationships Stockholders versus Managers - Solutions • Managerial compensation (in the form of performance shares, executive stock options or restricted stock grants) • But…. Recent studies have failed to find a strong relationship between CEO compensation and share price. • The threat of firing • Shareholder intervention • The threat of takeover

  23. Agency Relationships Stockholders versus Creditors • Creditors consider the riskiness of the firm • Stockholders should not act against creditors because • Creditors protect themselves through restrictions in credit agreements • Creditors may request an interest rate much higher than normal to compensate for the stockholder’s actions • Result: Stockholders may find it difficult to borrow funds in the future

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