Chapter 5 Financial Decisions Management: Commercial theory and practice.
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Introduction To Financial Management
Chapter 1
2
Topics1. The basics of corporate financial
management decisions and the role of the financial manager
2. The goal of corporate financial management
3. The financial implications of the different forms of business organizations
4. 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?
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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
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Why do you need to know finance? Student Loans Credit cards Investments Retirement
Savings Banking
Careers in: Finance Accounting Marketing Sole proprietorship Security Analyst
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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
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The Role Of The Financial Manager Business Finance Questions
1.What long-term investments should you make
Examples: equipment, buildings
2.Where will you get the long-term financing?
Profits? Equity? Debt?
3.Short-term cash management1.How will you collect from customers and
pay your bills?
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Financial Management Decisions1. Capital Budgeting
The process of planning and managing a firm’s long-term investments
Evaluating the size, timing, and risk of the future cash flows
Use NPV finance tool to decide (chapter 8)
2. Capital Structure The mixture of debt and equity
3. Working Capital The firm’s short-term assets and liabilities
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The Role Of The Financial Manager
Board of Directors
Chairman of the Board andCEO
President andCOO
VP Marketing VP FinanceCFO
VP Production
Treasurer
Cash Manager Credit Manager
Capital Expenditures
Financial Planning
Controller
Tax Manager Cash Accounting Manager
Financial Accounting
Manager
Information Systems Manager
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Forms of Business Organization
Three major forms in the united states Sole proprietorship Partnership
General Limited
Corporation S-Corp Limited liability company
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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 owner’s personal wealth
Unlimited liability Difficult to sell
ownership interest
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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
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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)
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Figure 1.2
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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
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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
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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
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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
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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
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Page 10 In Textbook Link to:www.buisnessfinancemag.comIs filled with ads…
Better to go to www.Google.com and click on News
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The Goal Of Corporate Financial Management
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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
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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
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The Goal Of Corporate Financial Management
1. Managers commit assets in a particular direction in order to earn a return
1. Capital budgeting using NPV model (ch.9) Cash Flow is what the managers will
use to make decisions (ch.5)
2. Goal is to maximize returns at a given risk level (risk and return are considered together) (ch.11)
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The Goal Of Corporate Financial Management2. Corporation must continually get
cash to acquire assets to earn a return
1. Corporation acquires cash from financial markets through equity or debt
2. Corporation reinvests earnings (remaining amount paid to owners)
3. More assets, more sales, higher return, higher stock value (theoretically)
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The Goal Of Corporate Financial Management
3. All this is done to increase the current stock price
1. Owners’ stock value is increased2. Managers salaries should be based on
stock value and so their salaries increase (theoretically)
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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 company’s
stock? Does this mean we should do anything and
everything to maximize owner wealth? Sarbanes-Oxley Act
Makes managers personally responsible for financial statements
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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
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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
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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
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Agency Costs Indirect
A profitable project that is risky may benefit owners, but may put the manager’s 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
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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
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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