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Chapter 1

An Overview of Financial Management

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Topics in Chapter

Basic Goal: to create shareholder value

Agency relationships: Stockholders versus managers Stockholders versus creditors

Transparency in financial reporting Market interest rates

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Why is corporate finance important to all managers?

Corporate finance provides the skills managers need to: Identify and select the corporate

strategies and individual projects that add value to their firm.

Forecast the funding requirements of their company, and devise strategies for acquiring those funds.

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What should be management’s primary objective?

The primary objective should be shareholder wealth maximization, which translates to maximizing stock price. Should firms behave ethically? YES! Do firms have any responsibilities to

society at large? YES! Shareholders are also members of society.

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Is maximizing stock price good for society, employees, and customers?

Employment growth is higher in firms that try to maximize stock price. On average, employment goes up in: firms that make managers into owners

(such as LBO firms) firms that were owned by the

government but that have been sold to private investors

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What three aspects of cash flows affect an investment’s value?

Amount of expected cash flows (bigger is better)

Timing of the cash flow stream (sooner is better)

Risk of the cash flows (less risk is better)

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Free Cash Flows (FCF)

Free cash flows are the cash flows that are: Available (or free) for distribution To all investors (stockholders and

creditors) After paying current expenses, taxes,

and making the investments necessary for growth.

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Determinants of Free Cash Flows Sales revenues

Current level Short-term growth rate in sales Long-term sustainable growth rate in

sales Operating costs (raw materials,

labor, etc.) and taxes Required investments in operations

(buildings, machines, inventory, etc.)

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What is the weighted average cost of capital (WACC)?

The weighted average cost of capital (WACC) is the average rate of return required by all of the company’s investors (stockholders and creditors)

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What factors affect the weighted average cost of capital?

Capital structure (the firm’s relative amounts of debt and equity)

Interest rates Risk of the firm Stock market investors’ overall

attitude toward risk

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What determines a firm’s value?

A firm’s value is the sum of all the future expected free cash flows when converted into today’s dollars:

Value =

FCF1 FCF2 FCF∞

(1 + WACC)1

(1 + WACC)∞

(1 + WACC)2

+ +…

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Different definitions of value? Intrinsic value

Stock valuation based on an individual’s expected free cash flows

Market value Market price is the value quoted in

the market. Based on aggregate market’s

expectations and is set by the marginal investor. Is the marginal investor’s intrinsic value.

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Fundamental value

Is the intrinsic value and analyst would calculate given complete and accurate information about a company’s expected future free cash flows and risk. Also called true intrinsic value.

Market value may not equal fundamental value over short term, but will tend towards it over the long term.

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Short-term vs. long-term price

Management can impact the market price over the short term by releasing incomplete or inaccurate information.

Over the long term the market price will tend towards the fundamental value as more information becomes available.

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An agency relationship arises whenever one or more individuals, called principals, (1) hires another individual or organization, called an agent, to perform some service and (2) then delegates decision-making authority to that agent.

What is an agency relationship?

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No agency problem would exist. A potential agency problem arises whenever the manager of a firm owns less than 100 percent of the firm’s common stock, or the firm borrows. You own 100 percent of the firm.

If you are the only employee, and only your money is invested in the business, would any agency problems exist?

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An agency relationship could exist between you and your employees if you, the principal, hired the employees to perform some service and delegated some decision-making authority to them.

Would hiring additional people create agency problems?

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If you needed additional capital to buy computer inventory or to develop software then you might end up with agency problems if the capital is acquired from outside investors.

Might acquiring capital lead to agency problems?

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Agency problems are less for secured than for unsecured debt, and different between stockholders and creditors. So it matters whether the new capital comes in the form of an unsecured bank loan, a bank loan secured by your inventory of computers, or from new stockholders.

Does the source of the capital affect agency problems?

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There are 2 potential agency conflicts:

Conflicts between stockholders and managers.

Conflicts between stockholders and creditors.

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Would expansion increase or decrease potential agency problems?

Increase. If you expanded to additional locations you could not physically be at all locations at the same time. Consequently, you would have to delegate decision-making authority to others.

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Creditors can protect themselves by (1) having the loan secured and (2) placing restrictive covenants in debt agreements. They can also charge a higher than normal interest rate to compensate for risk.

What actions might make a loan feasible?

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Structuring compensation packages to attract and retain able managers whose interests are aligned with yours.

Threat of firing. Increase “monitoring” costs by making

frequent visits to “off campus” locations.

(More…)

What actions might mitigate your agency problems if you expanded beyond your home campus?

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Would going public in an IPO increase or decrease agency problems?

By going public through an IPO, your firm would bring in new shareholders. This would increase agency problems, especially if you sell most of your stock and buy a yacht. You could minimize potential agency problems by staying on as CEO and running the company.

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A manager might inflate a firm's reported earnings or make its debt appear to be lower if he or she wanted the firm to look good temporarily. For example just prior to exercising stock options or raising more debt.

Why might you want make your financial statements look artificially good?

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If the firm is publicly traded, the stock price will probably drop once it is revealed that fraud has taken place. If private, banks may be unwilling to lend to it, and investors may be unwilling to invest more money.

What are the potential consequences of inflating earnings or hiding debt?

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“Reasonable” annual salary to meet living expenses

Cash (or stock) bonus Options to buy stock or actual shares

of stock to reward long-term performance

Tie bonus/options to EVA

What kind of compensation program might you use to minimize agency problems?

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Yes! Investors are forcing managers to focus on value maximization. Successful firms (those who maximize shareholder value) will not continue to promote individuals who lack an understanding of financial management.

Are financial management skills important to your career?

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Students who understand this focus have a major advantage in the job market. This applies both to the initial job, and the career path that follows.

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What is transparency in financial reporting?

When all market participants have reliable, accurate information about a particular company.

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What safeguards help market transparency? Public companies use GAAP rules

established by the FASB for accounting

Public companies must have their financial statements audited

These statements are made available to the investing public by the SEC

Firms must release information to everyone at the same time

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What is Sarbanes-Oxley?

An act passed in 2002 that established new regulations for auditors, corporate officers, and securities analysts.

The goal was to make it less likely that companies and securities analysts would mislead investors, and increase the penalties for doing so.

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What are the components of market interest rates?

Quoted interest rate = r = r* + IP + DRP + LP + MRPr* = real risk free rate of interestIP = inflation premiumDRP = default risk premiumLP = liquidity premiumMRP = maturity risk premium