Untitled Quiz

Financial Management and the Firm

• Financial management is a critical aspect of running a successful business.
• It involves planning, organizing, and controlling a company's financial resources to achieve strategic objectives.
• This study explores fundamental principles and practices of financial management.
• Students will gain knowledge for informed decisions driving growth and profitability.

Learning Objectives

• Identify the Goal of the Firm: Understand the primary objective guiding business decisions and operations, typically maximizing shareholder wealth or value.
• Understand Financial Principles: Understand core finance principles including cash flow, time value of money, risk and reward, and the role of ethics in financial decision-making.
• Describe Finance's Role in Business: Recognize the crucial function of finance in supporting a company's operations, strategy, and decision-making processes across various functional areas.

The Goal of the Firm

• The primary objective of a firm is to maximize shareholder wealth,
• This involves making well-informed strategic decisions that increase the market value of the company's stock over the long term.
• Achieving this goal requires careful financial management, effective operations, and a focus on creating value for customers and stakeholders.
• Maximizing shareholder wealth is done by effectively increasing the price of the existing common stock.
• Good decisions increase profitability and prospects thus increasing the stock price benefiting shareholders.
• Conversely poor decisions harm a firm's operations and outlook reducing the stock price thus harming shareholders.

Foundations of Finance

• Principle 1: Cash Flow Matters: The real value of a business lies in its ability to generate positive cash flows, not just accounting profits. Decisions must focus on maximizing long-term free cash flow.
• Principle 2: Time Value of Money: A dollar today is worth more than a dollar in the future due to the opportunity to invest and earn a return. Financial analysis must account for time value of money by using tools like present value & future value calculations.

Principle 1: Cash Flow Is What Matters

• Accounting profits are not equal to cash flows.
• Companies can generate accounting profits without having available cash.
• Positive cash flows can exist without necessarily reporting accounting profits
• Decisions should focus on cash flows
• Financial decisions should be based on predicted cash flow instead of simply reported earnings to demonstrate driving business value.
• Focusing on marginal cash flows (difference between projected cash flows if a project is or isn't selected) is important to demonstrate the impact on company cash position.

Principle 2: Time Value of Money

• A dollar today is worth more than a dollar in the future due to its investment and earning potential.
• Understanding timing is crucial to earning returns
• Calculating the time value of money is vital in financial analysis.

Opportunity Cost

• Opportunity cost is the cost of choosing one option over other alternatives.
• It represents the potential benefits missed from choosing a different option.
• Opportunity costs highlight trade-offs in financial decisions.
• Understanding and evaluating the gains and losses of different options is crucial in financial decisions.

Principle 3: Risk Requires a Reward

• Investors will not take on more risk unless there is a higher potential return.
• This highlights the relationship between risk and reward in investment decisions.
• Investors expect a higher rate of return on stocks compared to bank accounts due to increased risk to their investments.
• Delaying consumption (depositing in a bank) can earn interest, but there is risk.

Principle 4: Market Prices Are Generally Right

• In an efficient market, market prices accurately reflect available information.
• Stock prices often reflect expected future cash flows and are a useful tool in assessing a company's value.
• Inefficiencies can exist in the market and distort prices, leading to errors in investment decisions.

Principle 5: Conflicts of Interest Cause Agency Problems

• Separation of management and ownership creates agency problems.
• Managers may make decisions not aligned with maximizing shareholder wealth.
• Agency conflicts can be reduced through monitoring mechanisms (like annual reports), compensation schemes (like stock options), and market forces (like the threat of takeovers).
• Aligning the interests of managers and shareholders can mitigate agency problems.

The Current Global Financial Crisis

• The 2007-2008 crisis stemmed from the subprime mortgage crisis.
• High-risk mortgages, packaged as complex financial products, spread risk throughout the financial system.
• Five finance principles explain the crisis:
  • Cash flow issues- inability to make mortgage payments led to a breakdown in cash flow
  • Time value of money- distorted by short-term funding for long-term obligations
  • Risk and reward- misjudged risk and reward in subprime mortgages
  • Market prices- inflated market prices of mortgage-backed securities
  • Agency problems between institutions, regulators, and investors contributed to the crisis

Ethics & Trust in Business

• Ethical behavior involves doing the right thing, though right and wrong is subjective depending on personal preferences and beliefs.
• Ethical dilemmas arise when personal judgments clash requiring careful consideration of principles and consequences.
• Sound ethical conduct is essential for both personal and business success.
• Unethical decisions can have severe consequences.

The Role of Finance in Business

• Finance provides tools and strategies for informed decision-making, resource management, and achieving long-term growth and profitability.
• Finance professionals work with other departments to achieve overarching business goals
• Finance is critical for managing capital budgeting and investment decisions, financial reporting, and risk management.

Basic Issues in Finance

• Capital Budgeting Decisions: Assessing long-term investments alignment with firm's strategic objectives to maximize shareholder wealth. This includes evaluating costs and expected returns of potential projects.
• Capital Structure Decisions: Determining funding through debt, equity, or a combination of both to optimize the firm's risk, cost of capital, and value.
• Working Capital Decisions: Managing daily cash flows and working capital to meet short-term obligations and ensuring sufficient liquidity for operations.

Financial Tools in Decision Making

• Financial tools are applicable across various business functions including marketing, production, and personal finance.
• Understanding these tools is key to decision-making
• Adjusting financial decisions regarding time, risk, and uncertainty is often critical for sound decisions.
• Assessing financial decisions for viability and long-term sustainability is necessary for informed decisions.

The Role of the Financial Manager

• Financial managers are crucial decision-makers in ensuring financial health and success.
• Their responsibilities include capital budgeting, investment, cash flow management and financing activities.
• They need to balance various stakeholder interests (shareholders, creditors, etc) to maximize firm value.
• The role requires analyzing financial data, assessing risks, and optimizing strategies for the firm within its competitive landscape.

The Legal Forms of Business Organization

• Choosing the legal structure for a new business is crucial.
• Options include sole proprietorships, partnerships, corporations, and limited liability companies (LLCs).
• Each form has advantages and disadvantages, including, but not limited to, liability issues, taxation, control, and the ease of operation.

LLC Overview

• LLCs combine the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation.
• LLCs offer flexible management, pass-through taxation (profits and losses passed directly to owners) and limited liability (protects personal assets of owners from business liabilities).
• LLCs are relatively easy to form and maintain compared to corporations.

Sole Proprietorship

• A business owned and operated by a single individual.
• The owner has unlimited liability.
• There is no legal separation between the owner and the business.
• The sole proprietorship can be dissolved at the owner's discretion or upon the owner's death.

Partnership

• Two or more people co-own a business.
• All partners share in the firm's liabilities in general partnerships.
• Liability in limited partnerships is limited to the amount invested in the partnership.
• Limited partners do not participate in business management and their names cannot appear in the firm name.

Corporation

• A separate legal entity distinct from its owners.
• Owners (shareholders) have limited liability (only risk the amount invested in the company).
• Shareholders elect a board of directors to manage the corporation.
• Corporations can continue operating even if owners sell shares or leave the firm.

The Trade-offs: Corporate Form

• Benefits of incorporating include limited liability, ease of ownership transferability, enhanced capital raising, and unlimited lifespan.
• Disadvantages include lack of secrecy, potential delays in decision-making, greater regulation, and double taxation.

Double Taxation Example

• Corporations are often taxed twice on profits, once at the corporate tax rate, and again at the individual shareholder level by dividends.
• Dividends are subject to additional withholding tax.

S-Corporations and Limited Liability Companies (LLCs)

• S-Corporations pass income, losses, deductions, and credits directly to shareholders (avoiding double taxation).
• They are suitable for smaller businesses.
• LLCs provide the liability protection of a corporation while also offering the flexibility and tax benefits of a partnership or sole proprietorship.

Limited Liability Companies (LLCs)

• LLCs provide limited liability protection shielding personal assets of the owners..
• LLCs are taxed similar to partnerships, meaning profits and losses pass directly to owners.
• State laws regulate LLCs

Finance and the Multinational Firm: The New Role

• Finance in multinational firms is incredibly complex and crucial for success.
• Issues like foreign markets, managing various currencies, and optimizing tax strategies are major challenges.

Why Companies Go Abroad

• Increase Revenues: Companies seek new markets.
• Reduce Expenses: Businesses can access opportunities with cheaper costs globally.
• Reduce Regulations Countries may have relaxed regulations such as environmental protection standards or worker conditions.
• Increase Exposure: Expansion improves brand recognition & facilitates wider reach for potential success in global markets.

Risks/Challenges of Going Abroad

• Country Risk: Unexpected changes in government or other similar policies can greatly impact operations and profitability.
• Currency Risk: Fluctuation in Forex (foreign exchange) rates impact cost and revenue estimations.
• Cultural Risk: Cultural differences, languages and traditions can create communications breakdowns.