Finance 3332 - Ch. 1

Corporation

A "legal person" composed of one or more actual individuals or legal entities. The owners or a corporation are called shareholders Private (closely-held) or public companies i.e. IKEA About 20% of U.S. businesses, 84% of business revenues.

Microeconomics

Financial managers apply microeconomic models of efficient decision making. In general, they should use the concept of setting marginal cost equal to marginal revenue when making long-term investment decisions and when managing working capital.

Accounting

Financial managers are primarily concerned with a firm's cash flow: - should a project be implemented? - if so, how to raise funds to finance it? Financial managers refer to accounting data when making decisions regarding, for example, current investments in working capital, future resource allocation for long-term investments, etc.

Chief Financial Officer

Head of the finance function Reports to the president or CEO Oversees the following functions: - Accounting - Treasury - Tax - Audit Responsibility for strategic planning, risk management, monitoring and trading foreign currencies, and monitoring production and inventory levels.

Mechanisms to minimize Agency Problems 2

Managerial Compensation - Properly designed compensation contracts can help to align shareholder - management conflicts - Compensation plan tied to the performance of the firm: managers will not do well unless the market value (stock price) increases. Stock options - managers have the option to buy shares of the company at a specified exercise price (idea that in the future if/when the price goes up, they would exercise the option)

Managerial Actions to Influence Value (under management control)

Managers should formulate a competitive strategy analyzing five competitive forces that can affect the market value of individual companies in an industry: - 1. The threat of new entrants - 2. The threat of substitute products - 3. The bargaining power of buyers - 4. The bargaining power of suppliers - 5. The rivalry among current competitors

Financial managers

should seek to maximize shareholder wealth

Limited Liability Company (LLC)

similar to S corporation but with less restrictions/ more flexibility in accounting requirements.

Most firms recognize

the importance of the interest of all their constituent groups, or "stakeholders", not only the shareholders: Stakeholder concerns: - Shareholders - Customers - Employees - Suppliers - Communities in which the firm operates

Debt securities

- (debt holders) receive periodic interest payments and the return of the "principal" in the future.

Agency Problems - Examples

- Managers avoid risky - but potentially profitable projects to protect their jobs: managers' own interest of job security, instead of shareholders' interest of wealth maximization. - Managers use firm's money to consume luxuries for their own benefit, wasting shareholders' wealth Agency Costs i.e.: Expenditures to monitor management's actions (audits of performance and expenses) - Expenditures to structure the organization in such a way as to minimize the incentives for management to take actions contrary to shareholder interests - Bonding expenditures to protect the owners from managerial dishonesty - The opportunity cost of lost profits arising from complex organizational structures that prevent management from making timely responses to opportunities

What should managers do to maximize shareholder wealth if not guided by profits?

- Managers should attempt to maximize the market value of the company's shares, not the accounting or book value per share (accounting concept).

Profit Maximization

- Maximizing profits is typically not the same as maximizing shareholder wealth - Profit maximization lacks a time dimension (long-term versus short-term). Which year's profits? - Offers no explicit basis for comparing long-term and short-term profits. i.e. capital expenditure decisions, which are central to the finance function, have a long-term impact on the performance of the firm. Financial managers must make trade-offs between short-run and long-run returns in conjunction with capital investment decisions. GAAP results in hundreds of definitions of profits (or earnings or income) Profit maximization ignores risk: two projects that are expected to generate identical future cash flows may have different levels of risk.

Threat of Takeovers

- Takeovers can serve as an important deterrent to shareholder - management conflict - If managers don't aim to maximize shareholder wealth, the value of the shares decrease and the company becomes a natural target for takeover by other companies - Management may then be replaced.

Partnership advantages and disadvantages

Advantages: Limited partners' liability is limited to what is specified in the agreement (owners are responsible for paying off debts etc.) Disadvantages: - Partnership dissolves when a general partner dies (must be re-formed). - Unlimited liability for general partners - Higher capacity to raise capital than sole proprietorship, but lower than corporations.

Marketing, Production, Quantitative Methods, and Human Resources Management

Areas indirectly related to the key day-to-day decisions made by financial managers. i.e. financial managers should consider the impact of new product development and promotion plans made in the marketing area b/c these plans will require capital outlays and have an impact on the firm's projected cash flows. Changes in the production process may necessitate capital expenditures, which the firm's financial managers must evaluate and then finance.

Partnership

Owned by two or more individuals (partners). i.e. Legal firms About 10% of U.S. businesses and less than 13% of business revenues in the U.S. Classified as general or limited. General partnership (23%): each partner has unlimited liability. Limited partnership: limited partners' liability is limited to what is specified in the partnership agreement. Common in real estate ventures

Treasurer

Responsibilities over acquisition and expenditure of funds, including: - Cash and marketable securities management - Capital budgeting analysis - Financial planning - Credit analysis - Investor relations - Pension fund management

Controller

Responsible for all accounting-related activities, including: - Financial accounting - Cost accounting - Taxes - Data Processing

Agency problems and costs

are incurred when: - 1. managers do not attempt to maximize firm value - 2. shareholders incur costs to monitor the managers and constrain their actions.

Not all management decisions are consistent with the goal of shareholder wealth maximization

b/c of the separation of ownership and control in corporations.

Subchapter S Corporation

companies with 100 or less shareholders, paying taxes similarly to partnerships, but preserving some benefits of a corporation (limited liability)

Determinants of Value

- Cash Flow: cash generated and paid by the firm (actual cash inflows and outflows) - Timing of Cash Flows: "A dollar today is worth more than a dollar tomorrow" - Perceived Risk of Cash Flow: "A safe dollar is worth more than a risky dollar" - an investor will require a higher rate of return for a project that is riskier.

Corporate Securities

- Claims against the assets and future earnings of the firm.

Corporation 2

Separation of Ownership and Management - Owners and managers of big corporations are different parties: more stability and flexibility. - Agency problems: managers (agents of the shareholders) may pursue their own interest, instead of the interests of shareholders.

Corporation Organization and Governance

Shareholders elect a board of directors Board of directors then elect the officers - Chairman of the board - Chief executive officer (CEO) - Chief operating officer (COO) - President - Chief financial officer (CFO) - Vice presidents - Treasurer - Secretary

Forms of Business Organization

Sole proprietorship - Owned by one person - Represent 72% of all businesses in the U.S. - Account for less than 4% of total business revenues in the U.S. - Advantage - Easy formation -Disadvantage - Unlimited liability for all debts and other obligations incurred by the firm. - Difficulty raising funds

Some critics of stock options

have argued that they tend to distort executive decisions by emphasizing short-term performance and giving them incentives to engage in accounting tricks to inflate the company's stock price. Possible solutions: Restricted stock - shares cannot be sold unless the managers remains with the company for a certain period of time Performance shares: stock grants based on the company meeting specific performance targets.

Mechanisms to minimize agency problems

- Corporate governance - Managerial compensation - Threat of takeovers

How can managers influence the magnitude, timing, and risk of expected cash flows, with the objective of maximizing shareholder wealth?

- Economic Environmental Factors (NOT under management control) - Level of economic activity (i.e. recession) - Tax rates and regulations ' - Competition, including the threat of new competitors and substitute products - Laws and government regulations - Unionization of employees - International business conditions and currency exchange rates - Bargaining power of buyers

What is a corporation?

- Legal entity, owned by its shareholders - Limited liability (of shareholders) -Private (closely-held) or public companies Separation of ownership and control: - permanence/stability to the corporation BUT... may generate agency problems

Equity securities

("shareholders" or "stockholders") are the owners of the corporation. - Common stock - residual form of ownership (the claims of common stockholders on the firm's earnings and assets are considered only after all other claims - such as those of the government, debt holders, and preferred stockholders - have been met); common stockholders have dividend rights, voting rights, etc. - Preferred stock - preferred stockholders have priority over common stockholders (but NOT over debt holders) with respect to company's earnings and assets. Are paid cash dividends before common stockholders. If a corporation enters bankruptcy, is reorganized, or is dissolved, preferred stockholders have priority over common stockholders in the distribution of the corporation's assets.

Corporate Finance- Financial Services Sector:

- Commercial Banks - Securities Brokers - Investment Banks - Mutual Funds - Pension Funds - Real Estate Companies - Insurance Companies

Corporation Advantages and Disadvantages

- Limited liability of shareholders (once stockholders have paid for their shares, they are not liable for any obligations or debts the corporation may incur. They are liable only to the extent of their investment in the shares.) - Permanency - Flexibility - Higher ability to raise capital: due to the limited liability and easy marketability of corporation's shares. Disadvantages - Agency problems due to the separation of ownership and management.

Separation of Ownership and Management

- Owners and managers of big corporations are different parties: more stability to the firm operations. - Managers may pursue their own interests, instead of the interests of shareholders. - i.e. Managers may avoid risky - but potentially profitable - projects to protect their jobs (managers' own interest of job security, instead of shareholders' interest.)

Managerial Actions to Influence Value (under management control)

- Products and services offered for sale - Production technology - Marketing and distribution network - Investment strategies - Employment policies and compensation packages for managers and other employees - Ownership form - proprietorship, partnership, or corporation - Capital structure - use of debt and equity to finance the firm - Working capital management policies - Dividend policies

Agency Problems

- The existence of a conflict of interest/objectives between management and owners (shareholders)

The Goal of Shareholder Wealth Maximization

- What is the primary goal of the (owners of a) firm? - make firm more valuable by maximizing shareholder wealth (making shareholders rich!)

Agency Relationships

- an individual or entity ("principal") hire another individual or entity to perform a service on behalf of the "principal" - i.e. Shareholders (Principal) and Managers (Agent) - Agency Problems and Costs: Managers, acting as agents for shareholders, may act in their own interests rather than maximizing shareholder wealth

Market value

- measures shareholder wealth Shareholder wealth = Number of shares outstanding * Market price per share

Shareholder wealth

- represented by the market price of a firm's common stock - objective of firm is to make the most efficient use of the firm's resources and thereby maximize the value of the firm for its owners, that is, to maximize shareholder wealth.

Shareholder wealth

- the present value of the expected future returns to the shareholders of the firm.

Present value

- the value today of some future payment or stream of payments, evaluated at an appropriate discount rate.

Agency Problems & Corporate Governance

Agency problems are mitigated by good systems of corporate governance (i.e. mechanisms used to align managers' and shareholders' interests) Corporate Governance Solutions: The Board of Directors represents the shareholders and can replace managers. - The board of directors of a corporation should have a majority independent directors. - The committee responsible for nominating members of the board of directors must be composed only of independent directors - The post of chairman of the board of directors should be split from the CEO position - All members of the audit and compensation committees must be independent directors

Macroeconomics

Financial managers should recognize and understand how, for example, monetary and fiscal policies affect the economy, the cost of funds and the availability of credit. i.e. What the economy can be expected to do in the future is a crucial factor in generating sales forecasts as well as other types of forecasts.