Chapter 1: an Overview of Financial Management
Chapter 1: An Overview of Financial Management
I.Business: functions and financial decisions
A.Primary function of firm: produce goods and/or services
B.Business finance or corporate finance = branch of finance dealing with financial decisions of firms
C.To produce goods and services, firms require capital
1.Physical capital = buildings, machinery and other intermediate inputs in production process
2.Financial capital = stocks, bonds and loans used to finance acquisition of physical capital
D.Typical financial decisions by firms: (i) strategic planning, (ii) capital budgeting, (iii) determining the firm’s capital structure, and (iv) working capital management
1.1st financial decision firm makes:
a.What business it wants to be in = strategic planning
b.Strategic planning involves evaluation of cost and benefits spread over time → financial-decision making process
2.2nd financial decision firm makes:
a.Capital budgeting process= preparing plan to acquire factories, machinery, research laboratories, showrooms, warehouses, and other long-lived assets
b.Prepare plan to train personnel who will operate this physical capital
c.Investment project = basic unit of analysis in capital budgeting
i.Identify new investment projects
ii.Evaluate competing projects
iii.Decide which projects to undertake
iv.Implement new project
3.3rd major financial decision
a.Decide how to finance new project
b.Determine capital structure = percentage of loans, bonds, common stock and preferred stock that minimizes the cost of capital
c.Cost of capital = minimum rate of return an investment project must earn in order not to diminish stockholder wealth = interest rate used to discount a project’s future cash flows in computing its present value
d.Unit of analysis is the firm as a whole
4.4th major financial decision:
a.Working capital management = day-to-day financial affairs of firm
b.Cash flow: collecting from consumers, paying bills as they come due
c.Need to finance cash-flow deficits and invest cash-flow surpluses
II.Forms of business organization
A.Three different forms of business organizations
1.Sole proprietorship = firm that has a single owner who is also the major manager of the business
2.Partnership = contractual relationship in which two or more people combine their capital, skills, and knowledge to carry on a business
3.Corporation = legal entity created by state government that has an existence separate from that of its owners
B.Relative distribution of business organizations
1.The numbers:
a.Sole proprietorships: 80% of all firms
b.Partnerships: 10% of all firms
c.Corporations: 10% of all firms
2.Dollar value of sales:
a.Corporations: 80% of all sales
b.Sole proprietorships: 13% of all sales
c.Partnerships: 7% of all sales
3.Because most successful sole proprietorships and partnerships convert to corporations, book focuses on corporations
C.Sole proprietorship
1.Advantages
a.Ease of formation: easily and inexpensively formed
b.Subject to few government regulations
c.Pays no corporate income tax
2.Disadvantages
a.Difficult to obtain large sums of capital
b.Unlimited liability = no legal distinction is made between personal and business activities or assets and liabilities
c.Limited life: limited to life of individual who created it
D.Partnership: has roughly the same advantages and disadvantages as a sole proprietorship
1.Advantages
a.Low cost and ease of formationb.Pays no corporate income tax
2.Disadvantages
a.Unlimited liabilityc.Difficulty in transferring ownership
b.Limited lifed.Difficulty in raising large amounts of capital
E.Corporation
1.Advantages
a.Unlimited life
b.Limited liability = liability of owners limited to the amount of capital they have invested in the business
c.Easy transfer of ownership
d.Ease of raising capital: sell additional shares of stock to current or new stockholders
2.Disadvantages
a.Double taxation: corporate earnings taxed at corporate tax rate, dividends taxed as income to stockholders
b.More complex and time consuming to set up. Cost of report filing.
F.Deciding upon form of organization? Firms must trade off the advantages of incorporation against disadvantages of possible higher tax disadvantage. Book argues corporate structure usually maximizes value of business. Why?
1.Limited liability → ↓ risk borne by investors. ↓ firm’s risk → ↑ firm’s value
2.Corporations attract capital more easily than unincorporated business → ↑ firm’s ability to take advantage of growth opportunities → ↑ firm’s value
3.Because corporate stock is easier to sell than interests in sole proprietorship or partnership → corporate stock is more liquid than ownership in other forms of business (Liquidity = ease of selling asset and converting it to cash at fair market value) → ↑ stock liquidity → ↑ price of stock → ↑ firm’s value
III.Stock prices and shareholder value
A.Assume management’s primary goal =maximize stockholder wealth → maximize the price of the firm’s common stock
B.Stockholder wealth = (number of shares outstanding) x (market price per share)
C.Market price of stock = present value of cash flows it provides to its owners over time
D.Factors that affect stock price
1.Projected cash flows to shareholders: ↑ cash flows → ↑ stock price
2.Timing of the cash flows: The earlier the receipt of the cash flows → ↑ stock price
3.Riskiness of cash flows: The less risky the cash flows → ↑ stock price
IV.Intrinsic values and stock prices
A.The difference between a stock’s intrinsic value and a stock’s market price
1.“True” investor return vs. “perceived” investor return and “true” risk vs. “perceived” risk
2.“True” = return and risk that most investors would expect if they had all the information that exists about the company
3.“Perceived” = what investors expect given the information that they actually have
B.Stock’s intrinsic value
1.Measure of stock’s “true value” based on estimates of the “true” investor returns and the “true” risk
2.True value based on accurate risk and return data
3.Intrinsic value can be estimated but not measured precisely
C.Stock’s market price
1.Based on marginal investor’s estimates of “perceived” investor returns and “perceived” risk
2.Based on perceived but possibly incorrect data
D.Stock prices: Disequilibrium and equilibrium values
1.Disequilibrium: in short run stock price may deviate from its intrinsic value
a.If actual market price > intrinsic value → stock overvalued
b.If actual market price < intrinsic value → stock undervalued
2.Equilibrium
a.Situation where actual market price = intrinsic value
b.Investors indifferent between buying or selling stock
3.Management should take actions designed to maximize firm’s intrinsic value, not its current price
a.Maximizing intrinsic value will maximize average price over the long run
b.Ideally managers should avoid actions that reduce intrinsic value, even if those decisions increase stock price in short run
V.Some important trends
A.Recent corporate scandals have reinforced importance of business ethics → Have spurred additional regulations and corporate oversight
B.Continued globalization of business
C.Changing information technology has profound effect on all aspects of business finance
VI.Separation of ownership and management: Common practice for owners of large firm to delegate management responsibilities to professional managers
A.Five reasons for separating management from ownership
1.Find professional managers with superior ability in running business
2.Efficient scale of business may pool resources of many households, not all who can be actively involved in managing business
3.Owners may want to diversify risk across many firms: efficient reduction of risk may not be obtained without separation of ownership and management
4.Separation of ownership and management reduces the cost of information gathering
a.Managers can gather most accurate data on firm’s production technology, cost of inputs, and demand for products
b.Owners need to relatively little about firm’s technology and the intensity at which it is being used
5.Learning curve favors separated management
a.Suppose owner wants to sell all or part of firm’s technology now or at later date. If owner was manager, new owners would have to learn technology from former owner in order to manage it efficiently. Failure to separate ownership and management reduces liquidity of assets.
b.If former owner wasn’t the manager, new owners hire existing management and work continues in place
B.Problem with separating ownership from management
1.Principal agent problem
a.Def’n: Situation arising when agents do not make the same decisions that the principals would have made if principals had the same information the agents had and were making the decisions themselves
b.Source of potential conflict of interests
2.Problems cause by incomplete information or asymmetric information
a.Owners don’t know with certainty whether managers are acting in owners’ best interests
b.Because owners have incomplete information → Managers have incentive to maximize their interests and neglect their obligations to owners
3.In those businesses where potential conflicts of interests between owners and managers can be resolved at reasonable cost → Expect to find that owners of business firms will not be managers
C.Agency relationships
1.An agency relationship arises whenever one or more individuals, called principals, hire another individual, called an agent, to perform some service and then delegate decision-making authority to that agent.
2.Within a corporation, agency relationships exists between:
a.Shareholders and managers
b.Shareholders and creditors
3.Moral hazard = agents take unobserved actions in their own behalf because it is impossible for stockholders to monitor all managerial actions. Managers are naturally inclined to act in their own best interests. Many people have argued that agents'/managers= primary goal is to maximize the size of the firm. By creating a large, rapidly growing firm, managers:
a.↑ job security because hostile takeover is less likely
b.↑ their own power, salary, and status
c.↑ opportunities for their lower- and middle-level managers
d.↑ bureaucracy
e.↑ perquisites = executive fringe benefits such as luxurious offices, executive assistants, expense accounts, limousines, corporate jets, and generous retirement plans
4.Agency costs = costs borne by stockholders to encourage managers to maximize the firm=s stock price rather than to act in their own self interest. Examples of agency costs:
a.Expenditures to monitor managerial actions such as audit costs
b.expenditures to restructure firm to ↓ undesirable managerial behavior → appoint outside investors to board of directors
c.Note agency costs have their own opportunity costs: shareholder imposed restrictions may ↓ managers= ability to take timely actions to ↑ stockholder wealth.
5.Ways to encourage managers to act in best interest of stockholders:
a.The threat of firing
b.The threat of takeover
c.Managerial compensation plans based on performance
d.Direct intervention by shareholders
6.Shareholders vs. creditors
a.Shareholders (through management) could take actions to maximize stock price that are detrimental to creditors
b.In the long run, such actions will raise the cost of debt and ultimately lower the stock price.
Chapter 1: An Overview of Financial ManagementPage 1