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Introduction To Financial Management

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Title: Introduction To Financial Management


1
Introduction To Financial Management
  • Chapter 1

2
Topics
  • The basics of corporate financial management
    decisions and the role of the financial manager
  • The goal of corporate financial management
  • The financial implications of the different forms
    of business organizations
  • The conflicts of interest that can arise between
    managers and owners

3
The Basics Of Corporate Financial Management
Decisions
  • Define Asset
  • Examples Cash, UPS Trucks, Buildings
  • Provide probable future economic benefit
  • Definition of Finance
  • How to allocate scarce resources across assets
    over time in order to earn a return
  • What should we invest in?
  • Should we incur debt?
  • How do we as individuals make investments,
    conduct banking activities, incur debt?

4
The Basics Of Corporate Financial Management
Decisions
  • Four basic areas of finance
  • Corporate finance
  • How corporations allocate scarce resources across
    assets over time
  • Investments
  • Stocks and Bonds, Risk and Return
  • Financial institutions
  • Banks, Exchanges, Insurance Co.
  • International Finance
  • All of the above but more than one country

5
Why do you need to know finance?
  • Student Loans
  • Credit cards
  • Investments
  • Retirement Savings
  • Banking
  • Careers in
  • Finance
  • Accounting
  • Marketing
  • Sole proprietorship
  • Security Analyst

6
Why Study Finance?
  • Marketing
  • Budgets, marketing research, marketing financial
    products
  • Accounting
  • Dual accounting and finance function, preparation
    of financial statements
  • Management
  • Strategic thinking, job performance,
    profitability
  • Personal finance
  • Budgeting, retirement planning, college planning,
    day-to-day cash flow issues

7
The Role Of The Financial Manager
  • Business Finance Questions
  • What long-term investments should you make
  • Examples equipment, buildings
  • Where will you get the long-term financing?
  • Profits? Equity? Debt?
  • Short-term cash management
  • How will you collect from customers and pay your
    bills?

8
Financial Management Decisions
  • Capital Budgeting
  • The process of planning and managing a firms
    long-term investments
  • Evaluating the size, timing, and risk of the
    future cash flows
  • Use NPV finance tool to decide (chapter 8)
  • Capital Structure
  • The mixture of debt and equity
  • Working Capital
  • The firms short-term assets and liabilities

9
The Role Of The Financial Manager
10
Forms of Business Organization
  • Three major forms in the united states
  • Sole proprietorship
  • Partnership
  • General
  • Limited
  • Corporation
  • S-Corp
  • Limited liability company

11
Sole Proprietorship
  • Advantages
  • Easiest to start
  • Least regulated
  • Single owner keeps all the profits
  • Taxed once as personal income
  • Disadvantages
  • Limited to life of owner
  • Equity capital limited to owners personal wealth
  • Unlimited liability
  • Difficult to sell ownership interest

12
Partnership
  • Advantages
  • Two or more owners
  • More capital available
  • Relatively easy to start
  • Income taxed once as personal income
  • Disadvantages
  • Unlimited liability
  • General partnership
  • Limited partnership
  • Partnership dissolves when one partner dies or
    wishes to sell
  • Difficult to transfer ownership

13
Corporation
  • Advantages
  • Limited liability
  • Unlimited life
  • Separation of ownership and management
  • Transfer of ownership is easy
  • Easier to raise capital
  • Disadvantages
  • Separation of ownership and management (agency
    problem)
  • Double taxation (income taxed at the corporate
    rate and then dividends taxed at personal rate)

14
Figure 1.2
15
Forms of Business Organization
  • Sole proprietorships
  • Partnerships
  • Corporations
  • Fewest in number
  • Account for more business transactions than the
    other two types combined
  • Limited Liability Company (LLC)
  • Benefit of single taxation and limited liability

16
Forms of Business Organization
  • Sole Proprietorship (one person)
  • Easy to set up
  • No double taxation
  • No liability insulation to deflect outside claims
    (unlimited liability)
  • When owner dies, business ends
  • Difficult to transfer ownership
  • Hard to raise capital (money to invest)
  • Partnerships (More than one person)
  • General partners fully liable

17
Forms of Business Organization
  • Corporations
  • Legal person separate from owners
  • Can owe property, sue, be sued, enter into
    contracts
  • Limited Liability (owners only lose up to
    investment, debt responsibility of corp.)
  • Continuity of existence (Stock transferable
    when owner dies, corporation does not die)
  • Separation of owner and manager
  • Allows continual existence, however it creates
    agency problem
  • Easier to get external financing (equity debt)
  • Double taxation

18
Corporations
  • Issue stock to stockholders
  • Issue bonds to bondholders
  • Carry out business activities for the purpose of
    making profits
  • Not-for-profit corporations carry out charitable,
    educational, or other philanthropic purposes and
    are beyond the scope of this chapter
  • Distribute the profits to their owners
  • Pay interest to bondholders
  • Reinvests earnings to buy more assets

19
Advantages of the Corporate Form
  • Limited liability
  • The corporation is responsible for its own debt
  • The stockholder can only lose up to the amount of
    his or her investment
  • Ease of raising capital
  • A corporation can issue stock to raise capital
  • A corporation can have over a million
    stockholders
  • A corporation can issue bonds to raise capital

20
Advantages of the Corporate Form
  • Ease of transferring ownership rights
  • Ownership rights in a corporation are represented
    by shares of stock
  • Stock can readily be transferred from one person
    to another without the permission of other
    stockholders
  • With partnerships, other partners have to give
    permission for changes in ownership in order for
    the business to continue

21
Advantages of the Corporate Form
  • Continuous existence
  • The length of life of a corporation is stipulated
    in its charter
  • When the charter expires, it may be renewed
  • The death, incapacity, or withdrawal of an owner
    does not affect the life of the corporation
  • No mutual agency
  • Stockholders who are not officers do not have the
    power to bind the corporation to contracts
  • Owners need not participate in management
  • The corporation is free to employ the managerial
    talent it believes can best accomplish its
    objectives

22
Disadvantages of the Corporate Form
  • Additional taxation
  • Double taxation
  • Taxation of corporate income at two separate
    points
  • First, the net income of the corporation is taxed
    because the corporation is a separate entity
  • When the net income is distributed as dividends
    to stockholders, it becomes part of the personal
    income of the individual stockholder and is taxed
    a second time
  • The corporation must pay charter fees (fees paid
    for the corporation's right to exist)

23
Disadvantages of the Corporate Form
  • Government regulation
  • States often regulate
  • The amount of net income that a corporation may
    retain
  • The extent to which it may buy back its own stock
  • The amount of real estate it may own
  • Securities And Exchange Commission (SEC) requires
    that corporations file financial statements
    quarterly and yearly
  • Sarbanes-Oxley Act

24
The Financial Implications Of The Different Forms
Of Business Organizations
  • The corporate form is superior when it comes to
    raising cash
  • Ease of transferring ownership
  • Business does not end each time stock is sold
  • Unlimited life
  • When owners die, the business does not end
  • Limited liability for business debts
  • Owners can only loose up to the amount they have
    invested
  • For good ideas to be implemented which in turn
    creates profits for owners, cash is required.
    Thus the business form which can raise cash more
    easily is more beneficial

25
Page 10 In Textbook
  • Link to
  • www.buisnessfinancemag.com
  • Is filled with ads
  • Better to go to www.Google.com and click on News

26
The Goal Of Corporate Financial Management
27
The Goal Of Corporate Financial Management
  • Presume
  • The stockholders elect the BofD
  • The BofD hire the managers
  • The managers work for the stockholders
  • Goal
  • The financial managers have a fiduciary duty to
    identify goods and services that add value to the
    firm because they are desired and valued in the
    free marketplace, which in turn increases current
    and future revenues, which in turn increases
    stock price/equity value

28
The Goal Of Corporate Financial Management
  • The goal of financial management is to maximize
    the current value per share of existing stock
    (market value of equity)
  • This is theoretically a good goal
  • Do some managers employ creative accounting so
    that it looks like stock value goes up?
  • Financial managers should not take illegal or
    unethical actions to increase stock value

29
The Goal Of Corporate Financial Management
  • Managers commit assets in a particular direction
    in order to earn a return
  • Capital budgeting using NPV model (ch.9)
  • Cash Flow is what the managers will use to make
    decisions (ch.5)
  • Goal is to maximize returns at a given risk level
    (risk and return are considered together) (ch.11)

30
The Goal Of Corporate Financial Management
  • Corporation must continually get cash to acquire
    assets to earn a return
  • Corporation acquires cash from financial markets
    through equity or debt
  • Corporation reinvests earnings (remaining amount
    paid to owners)
  • More assets, more sales, higher return, higher
    stock value (theoretically)

31
The Goal Of Corporate Financial Management
  • All this is done to increase the current stock
    price
  • Owners stock value is increased
  • Managers salaries should be based on stock value
    and so their salaries increase (theoretically)

32
Goal Of Financial Management
  • What should be the goal of a corporation?
  • Maximize profit?
  • Minimize costs?
  • Maximize market share?
  • Maximize the current value of the companys
    stock?
  • Does this mean we should do anything and
    everything to maximize owner wealth?
  • Sarbanes-Oxley Act
  • Makes managers personally responsible for
    financial statements

33
The Conflicts Of Interest That Can Arise Between
Managers And Owners
  • Creative accounting so that it looks like stock
    value goes up?
  • Enron
  • Former Enron CFO Andrew Fastow, the alleged
    mastermind behind Enron's complex network of
    offshore partnerships and questionable accounting
    practices
  • World Com
  • Former CEO, Bernard Ebbers was convicted (2005)
    of fraud and conspiracy in the largest (to date)
    accounting scandal in U.S. history, as a result
    of WorldCom's false financial reporting, and
    subsequent 11 billion dollar loss to investors
  • Andrew and Bernard were agents that were supposed
    to be serving the stockholders

Wikipedia
34
Agency Problem
  • How do you get managers inside the firm (managers
    have custody of assets that belong to owners) to
    act in the best interest of the owners?
  • We must incur agency costs to minimize problems

35
Agency Costs
  • Direct
  • Pay managers based on stock value (aligns
    managers and owners interests)
  • Allow external auditor to examine the financial
    statements
  • Have internal controls over assets and accounting
  • Have internal auditors report to BofD
  • Sarbanes-Oxley Act
  • Makes managers personally responsible for
    financial statements

36
Agency Costs
  • Indirect
  • A profitable project that is risky may benefit
    owners, but may put the managers job at risk
  • If manager does not take on project? Cost to
    owner
  • Managers may create ways to pay themselves great
    deals of money (accounting or other)
  • Cost to owner

37
Financial Markets
  • Primary Markets
  • Original sale of equity or debt
  • Corporation issues security
  • Secondary Markets
  • After original sale of equity or debt
  • You sell/buy security

38
Financial Markets
  • Secondary Markets
  • Dealer Markets (Over-the-counter markets (OTC))
  • Dealers buy and sell for themselves
  • (think of car lot)
  • Most debt is sold this way
  • Example NASDAQ
  • Auction Markets (Exchanges)
  • Brokers and agents match buyers and sellers
  • (think of real estate agent)
  • Most of the large firms equity is sold this way
  • Example NYSE

39
Summary Slide
  • The Basics Of Corporate Financial Management
    Decisions
  • Why do you need to know finance?
  • The Role Of The Financial Manager
  • Financial Management Decisions
  • Forms of Business Organization
  • The Financial Implications Of The Different Forms
    Of Business Organizations
  • The Goal Of Corporate Financial Management
  • The Conflicts Of Interest That Can Arise Between
    Managers And Owners
  • Agency Problem
  • Agency Costs
  • Financial Markets
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