FIN-355 Chapter 1

Adam Smith's Theories

"Invisible Hand" guides companies to strive for profits and that hand help lead them to decisions that benefit society. Profit maximization is the right goal for businesses Free enterprise system is best for the society

Primary Tasks for CFOs

(1) Make sure accounting system provides good numbers for internal decision making and for investors (2) Ensure that the firm is financed in the proper manner (3) Evaluate the operating units to make sure they're performing in an optimal manner (4) Evaluate all proposed capital expenditures to make sure they'll increase the firm's value

How can/do we measure successful-ness of goal?

(1) ROI-EPS for short-run (2)Net Income for short-run

Modifications to Adam Smith's Theories

-Firms principal financial goal should be to maximize the wealth of its stockholders, which means maximizing the value of its stock -Free enterprise is still the best economic system for society as a while under the free enterprise framework, companies develop products and services that people want and benefit society -Some constraints are needed. Firms should not be allowed to pollute the air and water, engage in unfair employment practices, or to create monopolies that exploit customers

Areas of Finance

1) Financial aka corporate finance: How much/which type of assets to acquire, how to raise capital to purchase assets, and how to run firm to maximize value 2) Capital Markets: Relate to markets where interest rates/stock/bond money is determined. Involves Federal Reserve System and SEC 3) Investments: Decisions concerning stocks and bonds, security analysis, portfolio theory, market analysis

Three main methods a firm finances the purchase of assets

1. External equity (Shark Tank)- IPO's 2. Internal equity- Retained earnings 3. Debt

Important business trends

1. Globalization of business 2. information technology 3. business ethics 4. Balancing SH interests and interests of society

What is a firm's intrinsic value? Its current stock price? Is the stock's "true" long-run value more closely related to its intrinsic value or to its current price?

A firm's intrinsic value is an estimate of a stock's "true" value based on accurate risk and return data. It can be estimated but not measured precisely. A stock's current price is its market price the value based on perceived but possibly incorrect information as seen by the marginal investor. From these definitions, you can see that a stock's "true " long-run value is more closely related to its intrinsic value rather than its current price

Corporation

A legal entity created by a state, separate and distinct from its owners and managers, having unlimited life, easy transferability of ownership, and limited liability.

S Corp

A special designation that allows small businesses that meet qualifications to be taxed as if they were a proprietorship or a partnership rather than a corporation.

Intrinsic Value

An estimate of a stock's "true" value based on accurate risk and return data. The intrinsic value can be estimated but not measured precisely.

Enterprise Value

Asking Amount/Equity Stake (Sand Cloud from Shark Tank)

Balance Sheet Equation

Assets = Liabilities + Owner's Equity

Corporation

Corporation: A legal entity created by a state distinct from its owners and managers. Pros: Stockholders/stocks, easier to raise capital, limited liability Cons: Double taxation (CIT and PIT) and more government regulations, BOD to answer to

What Financial Management Addresses

Creating value or manage assets you've purchased to maximize its value. What assets do we buy/invest and how much money do we spend How do you raise capital to pay for these assets

Corporate governance

Establishment of rules and practices by Board of Directors to ensure that managers act in shareholder's best interests while balancing the needs of other constituencies

True or False: Managers always attempt to maximize the long- run value of their firms' stocks, or the stocks' intrinsic values. This is exactly what stockholders desire. Thus, conflicts between stockholders and managers are not possible. However, there can be conflicts between stockholders and bondholders.

False

Dodd-Frank Act

Gave SEC authority to make rules regarding shareholder's access to company proxy materials. Gave shareholders right to nominate to company's board.

LLC LLP

LLC: Hybrid of partnership and corporation LLP: Professional firm in accountancy, law, and architecture Pros: Limited liability and taxed as partnership Cons: Votes by investors for decisions

Sarbones-Oxley Act

Law passed by Congress that requires the CEO and CFO to certify that their firm's financial statements are accurate

Goal of Financial Management

Maximize shareholder value and value of the firm (long term)

Is maximizing shareholder wealth inconsistent with being socially responsible? Explain.

No. It can be sustainability as one reason why. Sand Cloud didn't pay themselves much to keep putting in the business for the long-term

Triple Bottom Line

P.P.P People-follow employer regulations, treat people well, good community business Plantet-Taking care of the environment Profit-Sustainable profit

What is a business?

Profit-seeking entity that provides goods/services that society wants or needs Organization looking to make a profit Selling something in exchange for something of value (cash) Idea?!

Proprietorship Partnership

Proprietorship- A single owner who assumes all the risks, as well as all of the profit of a business. Partnership- A small group sharing the risks and profits from operating a business Pros: You get all the control and all the money, easy and inexpensive to form, subject to few government regulations, and lower-income taxes (no corporate income tax) Cons: Unlimited personal liability, limited to life of who created it, hard to transfer ownership, and difficulty obtaining large sums of capital

Prevent managers from abuse of powers with stock

Reasonable compensation packages, firing managers that do not perform well, and the threat of hostile takeovers (happens when stock is undervalued and corporate raiders will attempt to capture firm) Award people for stock's performance over the long-run (average over time)

Business ethics

Standards of conduct or moral behavior

Should stockholder wealth maximization be thought of as a long-term or a short-term goal? For example, if one action increases a firm's stock price from a current level of $20 to $25 in 6 months and then to $30 in 5 years but another action keeps the stock at $20 for several years but then increases it to $40 in 5 years, which action would be better? Think of some specific corporate actions that have these general tendencies.

Stockholder wealth maximization is a long -run goal. Companies, and consequently the stockholders, prosper by management making decisions that will produce long-term earnings increases. Actions that are continually shortsighted often "catch up" with a firm and, as a result, it may find itself unable to compete effectively against its competitors. There has been much criticism in recent years that U.S. firms are too short-run profit -oriented. A prime example is the U.S. auto industry, which has been accused of continuing to build large "gas guzzler" automobiles because they had higher profit margins rather than retooling for smaller, more fuel-efficient models.

If a company's board of directors wants management to maximize shareholder wealth, should the CEO's compensation be set as a fixed dollar amount, or should the compensation depend on how well the firm performs? If it is to be based on performance, how should performance be measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock's intrinsic value? Which would be the better performance measure? Why?

The board of directors should set CEO compensation dependent on how well the firm performs. The compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock's performance over the long run, not the stock's price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, it is easier to measure the growth rate in reported profits than the intrinsic value, although reported profits can be manipulated through aggressive accounting procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable, compensation must be based on the stock's market price—but the price used should be an average over time rather than on a specific date.

What are the various forms of business organization? What are the advantages and disadvantages to each?

The four forms of business organization are proprietorships, partnerships, corporations, and limited liability corporations and partnerships. The advantages of the first two include the ease and low cost of formation. The advantages of corporations include limited liability, indefinite life, ease of ownership transfer, and access to capital markets. Limited liability companies and partnerships have limited liability like corporations. The disadvantages of a proprietorship are (1) difficulty in obtaining large sums of capital; (2)unlimited personal liability for business debts; and (3) limited life. The disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4)difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) setting up a corporation and filing required state and federal reports, which are complex and time-consuming. Among the disadvantages of limited liability corporations and partnerships are difficulty in raising capital and the complexity of setting them up.

stockholder wealth maximization

The primary financial goal for managers of publicly owned companies implies that decisions should be made to maximize the long-run value of the firm's common stock.

The Agency Relationship (problem)

The relationship between the principal and the agent, which the agency acts for the principal (in corps: principals are the shareholders and agents are the managers) Problem: Managers' personal goals may compete with SH wealth max. Managers could be more focuses on personal wealth maximization. Techniques to motivate managers: 1. Compensation packages designed to encourage long-term growth 2. Fire bad managers 3. threat of hostile takeovers

Equilibrium

The situation in which the actual market price equals the intrinsic value, so investors are indifferent between buying and selling a stock.

Market price

The stock value based on perceived but possibly incorrect information as seen by the marginal investor.

True or False: If a firm's board of directors wants to maximize value for its stockholders in general (as opposed to some specific stockholders), it should design an executive compensation system whose goal is to maximize the stock's intrinsic value rather than the stock's current market price.

True

True or False: In order to maximize its shareholders' value, a firm's management must attempt to maximize the stock price in the long run, or the stock's "intrinsic value."

True

True or False: The more capital a firm is likely to require, the greater the probability that it will be organized as a corporation.

True

What are some actions that stockholders can take to ensure that management's and stockholders' interest are aligned?

Useful motivational tools that will aid in aligning stockholders' and management's interests include: (1) reasonable compensation packages, (2) direct intervention by shareholders, including firing managers who don't perform well, and (3) the threat of takeover. The compensation package should be sufficient to attract and retain able managers but not go beyond what is needed. Also, compensation packages should be structured so that managers are rewarded on the basis of the stock's performance over the long run, not the stock's price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so managers will have an incentive to keep the stock price high over time. Since intrinsic value is not observable, compensation must be based on the stock's market price—but the price used should be an average over time rather than on a specific date. Stockholders can intervene directly with managers. Today, the majority of stock is owned by institutional investors and these institutional money managers have the clout to exercise considerable influence over firms' operations. First, they can talk with managers and make suggestions about how the business should be run. In effect, these institutional investors act as lobbyists for the body of stockholders. Second, any shareholder who has owned $2,000 of a company's stock for one year can sponsor a proposal that must be voted on at the annual stockholders' meeting, even if management opposes the proposal. Although shareholder-sponsored proposals are non-binding, the results of such votes are clearly heard by top management. If a firm's stock is undervalued, then corporate raiders will see it to be a bargain and will attempt to capture the firm in a hostile takeover. If the raid is successful, the target's executives will almost certainly be fired. This situation gives managers a strong incentive to take actions to maximize their stock's price

Intrinsic Value of a stock

You try to guess intrinsic value by looking at cash flows and risk. This is what you compare actual stock prices. This is what makes a good investor. It rises because the firm retains and reinvests earnings each year, increasing profits. Management should try to increase intrinsic value, it will increase max average over the long-run but maybe not at one specific point in time. Managers should also provide information so they can see prices should be raised, but not provide information to help competitors.

Marginal investor

an investor whose views determine the actual stock price

Which of the following actions would be likely to reduce potential conflicts of interest between stockholders and managers? a. A firm's compensation system is changed so that managers receive larger cash salaries but fewer long -term options to buy stock. b. The company changes the way executive stock options are handled, with all options vesting after 2 years rather than having 20% of the options awarded vest every 2 years over a 10- year period. c. The composition of the board of directors is changed from all inside directors to all outside directors, and the directors are compensated with stock rather than cash.

c. The composition of the board of directors is changed from all inside directors to all outside directors, and the directors are compensated with stock rather than cash.

Corporate raiders

individuals who target corporations for takeover because they are undervalued

All shareholders are stakeholders but not all stakeholders are shareholders

stakeholder: employees, suppliers, shareholders, loners/lenders/creditors, environment, government, and any party that has an interest in the success of a company

Hostile takeover

the acquisition of a company over the opposition of its management