Financial Management and the Firm PDF

Financial Management and the Firm Financial management is a critical aspect of running a successful business. It involves the planning, organization, and control of a company's financial resources to achieve its strategic objectives. This chapter explores the fundamental principles and practices of...

Financial Management and the Firm Financial management is a critical aspect of running a successful business. It involves the planning, organization, and control of a company's financial resources to achieve its strategic objectives. This chapter explores the fundamental principles and practices of financial management, equipping students with the knowledge to make informed decisions that drive growth and profitability. Learning Objectives Identify the Goal of the Firm Understand Financial Principles Describe Finance's Role in Business Understand the primary objective that Grasp the core principles of finance, guides the decisions and operations of a including the importance of cash flow, Recognize the critical function of finance in business organization, which is typically to time value of money, risk and reward, and supporting a company's operations, maximize shareholder wealth or value. the role of ethics and trust in financial strategy, and decision-making processes decision-making. across various functional areas. The Goal of the Firm The primary goal of a firm is to maximize the wealth of its shareholders. This involves making 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 The Goal of the Firm The primary goal of a firm is to create value for its shareholders by maximizing the price of the existing common stock. Increase Stock Price Good financial decisions that enhance the firm's performance and prospects will lead to an increase in the stock price, benefiting shareholders. Decline in Stock Price Poor financial decisions that negatively impact the firm's operations and outlook will result in a decline in the stock price, harming shareholders. Foundations of Finance The core principles that underlie financial decision-making and shape the discipline 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. Financial 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 tomorrow due to the opportunity to invest and earn a return. Financial analysis must account for the time value of money using tools like present value and future value calculations. Principle 1: Cash Flow Is What Matters Accounting Profits vs. Cash Driving Business Value Incremental Cash Flows Flows Ultimately, it is the cash flows of a When making financial decisions, it's It's important to understand that business, not its accounting profits, crucial to focus on the incremental or accounting profits are not equal to that drive the overall value of the firm. marginal cash flows - the difference cash flows. A company can generate Financial decisions must be based on between the projected cash flows if accounting profits on paper, but not projected cash flows rather than just the project is selected versus if it is not have the actual cash available. reported earnings. selected. This helps ensure decisions Conversely, a company can generate are based on the actual impact on the positive cash flows without company's cash position. necessarily reporting accounting profits. Principle 2: Time Value of Money The Time Value of Money The Importance of Timing A dollar received today is worth more than a dollar received in Receiving money sooner rather than later is advantageous the future. This is because the dollar received today can be because the sooner you receive it, the sooner you can put it to invested and earn interest, making it more valuable than the work and start earning a return on that money. This time value of same dollar received later. money concept is a fundamental principle in finance and impacts many business decisions. Opportunity Cost 1 Defining Opportunity 2 Example: Lending vs. Cost Saving Opportunity cost refers to the For instance, by lending cost of making a choice in money to a friend at zero terms of the next best percent interest, the alternative that must be opportunity cost is the 1% foregone. It represents the interest that could have been potential benefits or returns earned by depositing the that could have been gained money in a savings account by choosing the next best at a bank. option. 3 Understanding Trade-offs Opportunity cost highlights the trade-offs inherent in financial decisions. It encourages individuals and businesses to carefully weigh the potential gains and losses of different options before making a choice. Principle 3: Risk Requires a Reward Risk and Return Delayed Consumption Equity Risk Premium Investors will not take on additional When investors deposit their savings Investors expect to earn a relatively risk unless they expect to be in a bank, they are essentially higher rate of return on stocks compensated with a higher potential "delaying consumption" by not compared to a bank savings account return. This principle reflects the spending that money immediately. In because they are taking on the fundamental trade-off between risk return, they expect to earn a modest additional risk of investing in the stock and reward that drives investment rate of interest on their deposits. market. This difference in expected decisions. returns is known as the equity risk premium. Figure 1-1 Figure 1-1 illustrates the key principles of finance that form the foundation of business decision-making. These fundamental principles guide financial managers in maximizing shareholder wealth and ensuring the long-term success of the firm. The diagram highlights the interplay between cash flows, time value of money, risk and reward, and market prices - all of which are critical considerations when evaluating investment opportunities and managing a company's financial resources. Principle 4: Market Prices Are Generally Right In an efficient market, the market prices of all traded assets, However, it's important to note that there can be inefficiencies in such as stocks and bonds, fully reflect all available information at the market that may distort the market prices from the true value any instant in time. This means that stock prices are a useful of assets. These inefficiencies are often caused by behavioral indicator of the value of a firm, as price changes reflect changes biases, such as overconfidence or herd mentality, which can lead in expected future cash flows. investors to make suboptimal decisions. Principle 5: Conflicts of Interest Cause Agency Problems 1 Agency Conflict 2 Reducing Agency Conflict The separation of management and ownership Agency conflict can be in a firm creates an agency reduced through monitoring problem, where managers mechanisms like annual may make decisions that do reports, compensation not align with the goal of schemes such as stock maximizing shareholder options, and market forces wealth. like the threat of takeovers. 3 Aligning Interests By aligning the interests of managers and shareholders, the agency problem can be mitigated, ensuring that decisions are made in the best interest of the firm and its owners. The Current Global Financial Crisis The global financial crisis that began in 2007-2008 was sparked by the subprime mortgage crisis in the United States. Subprime loans were high-risk mortgages extended to borrowers with poor credit histories, often with low or no down payments. These mortgages were then securitized, meaning they were packaged into complex financial products and sold to investors, spreading the risk throughout the financial system. The crisis can be explained using the five principles of finance. Cash flow matters - the inability of subprime borrowers to make mortgage payments led to a breakdown in the cash flow needed to service the securitized debt. The time value of money was distorted by the use of short-term funding to finance long-term mortgage obligations. The risk and reward of these subprime mortgages was misjudged, leading to excessive leverage and risk-taking. The market prices of these mortgage-backed securities were inflated due to high demand. Finally, the agency problems between financial institutions, regulators, and investors exacerbated the crisis. Ethics & Trust in Business Ethical Behavior Ethical behavior is doing the right thing, but determining what the "right thing" is can be challenging as each person has their own set of values and beliefs. Ethical Dilemmas Ethical dilemmas arise when personal judgments about right and wrong come into conflict, requiring careful consideration of principles and consequences. Business Success Sound ethical standards are crucial for both business and personal success. Unethical decisions can have devastating consequences, such as the Enron scandal that destroyed shareholder wealth. The Role of Finance in Business Finance plays a critical role in the success of any business, providing the tools and strategies needed to make informed decisions, manage resources effectively, and achieve long-term growth and profitability. From capital budgeting and investment decisions to financial reporting and risk management, finance professionals are responsible for ensuring the financial health and viability of the organization. They work closely with other departments to align financial strategies with the overall business objectives, helping to drive innovation, improve operational efficiency, and create value for stakeholders. Basic Issues in Finance Capital Budgeting Decisions Capital Structure Decisions Working Capital Decisions The field of finance helps firms determine Finance also helps firms decide how to Additionally, finance plays a crucial role in which long-term investments they should fund their investments, whether through managing the firm's day-to-day cash flows undertake. This involves evaluating the debt, equity, or a combination of the two. and working capital, ensuring the business costs and expected returns of potential This capital structure decision impacts the has the necessary liquidity to fund its projects to ensure they align with the firm's risk, cost of capital, and ultimately its operations and meet short-term firm's strategic objectives and maximize value. obligations. shareholder wealth. Financial Tools in Decision Making 1 Relevant for All Areas 2 Adjusting for Time and Risk Knowledge of financial tools is relevant for decision Decisions in business involve making across all areas of an element of time and business, from marketing to uncertainty, so financial tools production, as well as for help adjust for these factors personal financial and make more informed management. choices. 3 Assessing Financial Viability Business decisions should be financially viable, and financial tools help determine the feasibility and long-term sustainability of these decisions. The Role of the Financial Manager As a key decision-maker within the organization, the financial manager plays a crucial role in ensuring the firm's financial health and success. Their responsibilities span a wide range of areas, from capital budgeting and investment decisions to managing the firm's cash flow and financing activities. Financial managers must balance the competing interests of shareholders, creditors, and other stakeholders to maximize the firm's overall value. They analyze financial data, assess risks, and develop strategies to optimize the company's financial performance and position within the market. The Legal Forms of Business Organization When starting a new business, one of the first key decisions is choosing the legal structure. The most common options include sole proprietorships, partnerships, corporations, and limited liability companies (LLCs). Each form has unique advantages and considerations that entrepreneurs must carefully evaluate. LLC Overview What is an LLC? Key Features of an LLC Benefits of an LLC A Limited Liability Company (LLC) is a Flexible management structure - The LLC structure provides business type of business structure that can be member-managed or owners with liability protection, tax combines the pass-through taxation manager-managed efficiency, and operational flexibility, of a partnership or sole proprietorship Pass-through taxation - profits and making it an attractive option for with the limited liability of a losses pass through to the owners' many small and medium-sized corporation. LLCs provide liability personal tax returns enterprises. LLCs can be an optimal protection for the business owners, choice for entrepreneurs looking to Limited liability - members are not known as members, while offering balance liability concerns with the personally liable for the flexibility in management and simplicity of a partnership or sole company's debts or obligations ownership structure. proprietorship. Easy to form and maintain compared to a corporation Sole Proprietorship Business Owned by an Individual A sole proprietorship is a business owned and operated by a single individual. The owner maintains full title to the assets and profits of the business. Unlimited Liability With a sole proprietorship, the owner has unlimited liability, meaning they are personally responsible for all debts and obligations of the business. There is no legal separation between the owner and the business. Termination of the Business A sole proprietorship can be terminated at the owner's discretion or upon the owner's death. There is no legal entity separate from the individual owner. Partnership General Partnerships Limited Partnerships In a general partnership, two or more persons come together as Limited partnerships have both general partners and limited co-owners of a business. All partners are fully responsible for the partners. General partners have unlimited liability, while limited liabilities incurred by the partnership, meaning they can be held partners' liability is restricted to the amount of capital they have personally liable for the firm's debts and obligations. invested in the partnership. Limited partners cannot participate in the management of the business, and their names cannot appear in the firm's name. Corporation Separate Legal Entity Shareholder Control Perpetual Existence A corporation is a legally separate entity The owners or shareholders of a Unlike sole proprietorships or from its owners. It can sue, be sued, corporation dictate the company's partnerships, a corporation can continue purchase, sell, and own property in its own direction and policies, often through an to operate even after a change in name, independent of the individuals who elected board of directors. Shareholders ownership through sale or inheritance. The founded or own the company. have limited liability, with their risk corporation's life is not dependent on its restricted to the amount of their individual owners. investment. The Trade-offs: Corporate Form 1 Benefits 2 Drawbacks Incorporating as a corporation offers advantages such as However, the corporate form also comes with drawbacks, limited liability, easy transfer of ownership, enhanced including lack of secrecy, potential delays in decision- ability to raise capital, and unlimited lifespan (unless the making, greater regulation, and the burden of double firm undergoes restructuring like mergers or bankruptcy). taxation on both the corporation and its shareholders. Double Taxation Example Let's consider a scenario where a company has earnings before tax of RM1,000. After the federal tax of 25% is applied, the after-tax income available for distribution to shareholders is RM750. Federal Tax After-tax Income If the company chooses to distribute the entire after-tax profits to shareholders as dividends, the shareholders will be subject to additional personal income tax, resulting in a "double taxation" scenario. Double Taxation Example 15% RM750 Dividend Tax Rate Distributed Profits RM112.50 RM362.50 Dividend Tax Total Tax In this example, when a corporation distributes its profits as dividends to shareholders, the shareholders are taxed again on those dividends. Assuming a dividend tax rate of 15%, the total tax burden becomes significant, reaching 36.25% of the original profits. S-Corporations and Limited Liability Companies (LLCs) An S-corporation (S-corp) is a type of corporation that avoids double taxation by passing corporate income, losses, deductions, and credits through to shareholders. S-corps have a limit of 100 shareholders, making them suitable for smaller businesses such as retail stores, banks, car dealerships, and movie theaters. Limited Liability Companies (LLCs) provide the liability protection of a corporation while offering the flexibility and tax benefits of a partnership or sole proprietorship. Limited Liability Companies (LLCs) Limited Liability Partnership Taxation Regulatory Considerations LLCs are a popular business structure LLCs are taxed like partnerships, The specific requirements and that provides owners with limited meaning the profits and losses pass qualifications for LLCs can vary liability protection. This means that through to the individual owners. This significantly from state to state. the personal assets of the owners are avoids the double taxation issue Entrepreneurs must carefully review shielded from the company's debts associated with corporations, where their state's LLC laws to ensure they and liabilities, giving them a layer of profits are taxed at both the business are meeting all the necessary legal legal and financial protection. and personal levels. and operational requirements. Finance and the Multinational Firm: The New Role As businesses expand globally, the role of finance in multinational firms has become increasingly complex and vital. Navigating foreign markets, managing currency risks, and optimizing tax strategies are just a few of the unique challenges faced by financial managers in multinational companies. Why Do Companies Go Abroad? Increase Revenues Reduce Expenses Reduce Regulations Increase Exposure By expanding into new Operating in other countries In some cases, companies Going global enhances a international markets, can provide access to lower may seek to operate in company's brand recognition companies can tap into costs for land, labor, capital, countries with more lax and reputation, allowing it to larger customer bases and raw materials, and taxes. This regulations, particularly in reach a wider audience and unlock additional revenue can significantly improve a areas like environmental potentially gain a streams. This global company's profitability and protection and labor competitive advantage over expansion can drive growth competitiveness on a global standards. This can reduce domestic-only rivals. and diversify a company's scale. compliance costs and income sources. overhead. Risks/Challenges of Going Abroad Country Risk Currency Risk Cultural Risk Expanding a business abroad comes with Fluctuations in exchange rates between Navigating the cultural differences in the risk of unexpected changes in the home and foreign currency can create language, traditions, and ethical standards government regulations, political significant financial risk, making it between the home and foreign country instability, and economic volatility in the challenging to accurately forecast costs can be a significant challenge. Failure to foreign market. These uncertainties can and revenues. This currency volatility must understand and adapt to these differences significantly impact operations and be carefully managed. can lead to communication breakdowns profitability. and ethical dilemmas.