Principles of Managerial Finance PDF

Principles of Managerial Finance Sixteenth Edition Chapter 1 Fundamental of Finance and the Financial Manager Copyright © 2022, 2019, 2015 Pearson...

Principles of Managerial Finance Sixteenth Edition Chapter 1 Fundamental of Finance and the Financial Manager Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved.  Chapter Outline Fundamental of Finance and the Financial Manager 1.1 What is Finance? 1.2 Why Study Finance? 1.3 The Financial Manager 1.4 Legal Forms of Business Organizations 1.5 The Source of Financing 1.6 Importance of Cash Flow 1.7 The Agency Problem Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. Learning Objectives Grasp the importance of financial information in both your personal and business lives Understand the important features of the four main types of firms and see why the advantages of the corporate form have led it to dominate economic activity Explain the goal of the financial manager and the reasoning behind that goal, as well as understand the three main types of decisions a financial manager makes Know how a corporation is managed and controlled, the financial manager’s place in it, and some of the ethical issues financial managers face Recognize the role that financial institutions play in the financial cycle of the economy Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.1 What is Finance? Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.1 What is Finance? What Is Finance? – Finance can be defined as the science and art of managing money – At the personal level, finance is concerned with individuals’ decisions about: ▪ how much of their earnings they spend ▪ how much they save ▪ how they invest their savings – In a business context, finance involves: ▪ how firms raise money from investors ▪ how firms invest money in an attempt to earn a profit ▪ how firms decide whether to reinvest profits in the business or distribute them back to investors – Managerial finance concerns the duties of the financial manager in a business Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.1 What is Finance? Generally, finance is the study of banking, leverage, credit, capital markets, money and investments, along with how they are used by individuals and companies To be specific, it is a term for matters regarding the management, creation, and study of money and investments. Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved.  Personal Finance Example Individuals rarely use accrual concepts. Rather, they rely mainly on cash flows to measure their financial outcomes. Generally, individuals plan, monitor, and assess their financial activities using cash flows over a given period, typically a month or a year. Ann Bach projects her cash flows during October (this year) as follows: Ann subtracts her total outflows of $4,835 from her total inflows of $4,620 and finds that her net cash flow for October will be –$215. To cover the $215 shortfall, Ann will have to either borrow $215 (putting it on a credit card is a form of borrowing) or withdraw $215 from her savings. Alternatively, she may decide to reduce her outflows in areas of discretionary spending such as clothing purchases, dining out, or those items that make up the $425 of miscellaneous expense. Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. Matter of Fact Finance Professors Aren’t Like Everyone Else Financial advisors know that many people are willing to invest in the stock market if it has been rising and are reluctant to do so if it has been falling. Such “trend- chasing” behavior often leaves investors worse off than if they had invested consistently over time. Finance theory suggests that past performance of the stock market is a very poor predictor of future performance, and therefore individuals should not base investment decisions on the market’s recent history. A survey found that at least one group of investors did not fall prey to trend chasing. When deciding whether to invest in stocks, finance professors were not influenced by the market’s recent trend, presumably because they know that past performance does not predict the future. That’s just one of the lessons in this book that can help you make better choices with your own money. Source: Hibbert, Lawrence, and Prakash, 2012, “Do finance professors invest like everyone else?” Financial Analysts Journal. Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.2 Why Study Finance? Individuals are taking charge of their personal finances with decisions such as: – When to start saving and how much to save for retirement – Whether a car loan or lease is more advantageous – Whether a particular stock is a good investment – How to evaluate the terms of a home mortgage Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.2 Why Study Finance? Corporate Finance addresses the following three questions: 1. What long-term investments should the firm engage in? 2. How can the firm raise the money for the required investments? 3. How much short-term cash flow does a company need to pay its bills? Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.3 Finance and the Firm What Is a Firm? – A firm is a business organization that sells goods or services – Firms exist because investors want access to risky investment opportunities Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. Who is responsible for the role of Finance in business? Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.4 The Financial Manager The finance manager is responsible for the day to day running of a company's finance team and are responsible for the financial health of an organization. Prepare financial statements, business activity reports, and forecasts Monitor financial details to ensure that legal requirements are met Supervise employees who do financial reporting and budgeting Review company financial reports and seek ways to reduce costs Analyze market trends to find opportunities for expansion or for acquiring other companies Help management make financial decisions Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.4 The Financial Manager Financial Manager (2) (1) Firm’s Financial Operations (4a) Markets (3) (4b) (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.4 The Financial Manager Making Investment Decisions – The financial manager must weigh the costs and benefits of each investment or project – They must decide which investments or projects qualify as good uses the money stockholders have invested in the firm Making Financing Decisions – The financial manager must decide whether to raise more money from new and existing owners by selling more shares of stock (equity) or to borrow the money instead (bonds and other debt) Managing Short-Term Cash Needs – The financial manager must ensure that the firm has enough cash on hand to meet its obligations from day to day – This job is also known as managing working capital Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.5 The Goal of Financial Manager ◼ Maximize profit? ◼ Minimize costs? ◼ Maximize market share? ◼ Maximize shareholder wealth? The Role of the Finance The Economics of an Enterprise Manager Business Enterprise is about the creation of wealth, creativity and resourcefulness To maximize the wealth of and exploiting change the shareholders Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.5 The Goal of Financial Manager What Is the Goal of the Firm? – Maximize Shareholder Wealth ▪ The primary goal of managers should be to maximize the wealth of the firm’s owners ▪ In most instances this is equivalent to maximizing the stock price – Maximize Profit? ▪ Does profit maximization lead to the highest possible share price? ▪ For at least three reasons, the answer is often no: – Timing – Cash Flows – Risk – Maximize Stakeholders’ Welfare? ▪ Some suggest a balanced consideration of the welfare of shareholders and other stakeholders – Stakeholders include employees, suppliers, customers, and even members of the local community where a firm is located Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.5 The Goal of Financial Manager The Managerial Finance Function – Organization of the Finance Function ▪ CEO – CFO Treasurer Controller Director of Investor Relations Director of Internal Audit Foreign Exchange Manager Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.5 The Goal of Financial Manager The goal of the financial manager must be consistent with the mission of the corporation, which is to maximize shareholder’s wealth by maximizing the stock price. While shareholder wealth maximization is included in Coca- Cola’s vision statement, it also includes other broader goals (such as social responsibility) that will ultimately benefit shareholders in the long-run. Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.5 The Goal of Financial Manager Coca-Cola’s Vision Statement To achieve sustainable growth, we have established a vision with clear goals for: – Profit – People – Portfolio – Partners – Planet Corporate Mission While managers have to cater to all the stakeholders (such as consumers, employees, suppliers, and community members), they need to pay particular attention to the shareholders. If managers fail to pursue shareholder wealth maximization, they will lose the support of investors and lenders. The business may cease to exist and ultimately, the managers will lose their jobs! Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. Figure 1.2 Corporate Organization Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Four Types of Firms Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Sole Proprietorship Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Sole Proprietorship Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Partnership ▪ Characteristics: ✓ At least 2 peoples, less than 100. ✓ Must be legally competent. ✓ Enter into contract to become partners. ✓ Decision making is easier with less partners Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Partnership There are two types of partnership with two kinds of owners, general partners and limited partners. Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Limited Liability Companies (LLC) Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Limited Liability Companies (LLC) In a C corporation, profits are subject to "double taxation". This means profits are taxed before being distributed to owners and taxed again when owners report their share of profits on their individual tax returns. Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Corporations – A corporation is solely responsible for its own obligations – The owners of a corporation are not liable for any obligations the corporation enters into – The corporation is not liable for any personal obligations of its owners In Malaysia, it can mean a Public limited company or Berhad (Bhd.) Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Corporations Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Corporations Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations – Business Organizational Forms and Taxation ▪ Ordinary Income – Income earned by a business through the sale of goods or services ▪ Capital Gain – Income earned by selling an asset for more than its cost – For corporations, ordinary income and capital gains are treated the same for tax purposes Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations ❖ Types of U.S. Firms There are four major types of firms in the United States. As (a) and (b) show, although the majority of U.S. revenue, in contrast to corporations. firms are sole proprietorships, they generate only a small fraction of total Source: www.irs.gov. Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.6 Legal Form of Business Organizations Characteristics of the Different Types of Firms Ownership Number of Liability for Firm’s Owners Manage Change Taxation Owners Debts the Firm Dissolves Firm Sole One Yes Yes Yes Personal Proprietorship Yes; each partner is Partnership Unlimited liable for the entire Yes Yes Personal amount Limited Liability Unlimited No Yes No* Personal Company No (but they legally Corporation Unlimited No No Double may) Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. Strengths and Weaknesses of the Common Legal Forms of Business Organization Sole proprietorship Partnership Corporation Strengths Owner receives all profits Owners who are limited Owners have limited liability, and (and sustains all losses) partners have limited cannot lose more than they invested Low organizational costs liability and cannot lose Can achieve large size via sale of Income taxed only on more than they invested. ownership (stock) proprietor’s personal tax Ability to raise funds Ownership (stock) is readily return enhanced by more transferable Independence owners Long life of firm Secrecy More available brain Can hire professional managers Ease of dissolution power and managerial Has better access to financing skill Income taxed only on partner’s personal tax return Weaknesses Owner has unlimited Owners who are general The corporation pays taxes, and liability in that personal partners have unlimited corporate income is taxed a second wealth can be taken to liability and may have to time when distributed to satisfy debts cover debts of other shareholders as a dividend Limited fund-raising power partners More expensive to organize than tends to inhibit growth Partnership is dissolved other business forms Proprietor must be jack- when a partner dies Subject to greater government of-all-trades Difficult to liquidate or regulation Difficult to give employees transfer partnership Lacks secrecy because regulations long-run career require firms to disclose financial opportunities results Lacks continuity when proprietor dies Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. Pre-2018 Corporate Tax Rate Schedule Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved. 1.7 The Source of Financing ❑ Firms may raise funds from external sources or plow back profits rather than distribute them to shareholders. ❑ Should a firm elect external financing, they may choose between debt or equity sources. Copyright © 2021 Pearson Education, Inc. All Rights Reserved 1.7 The Source of Financing ❖ Financial Institutions Entities that provide financial services, such as taking deposits, managing investments, brokering financial transactions, or making loans Copyright © 2021 Pearson Education, Inc. All Rights Reserved 1.7 The Source of Financing ❖ Financial Institutions Types of Financial Institutions – Banks and Credit Unions – Insurance Companies – Mutual Funds – Pension Funds – Hedge Funds – Venture Capital Funds – Private Equity Funds Copyright © 2021 Pearson Education, Inc. All Rights Reserved 1.8 Cash Flow Cash flows is the net amount of cash and cash-equivalents being transferred into and out of a business Cash Flow Analysis is the evaluation of a company's cash inflows and outflows from operations, financing activities, and investing activities. ❑How does a company obtain its cash? ❑Where does a company spend its cash? ❑What explains the change in the cash balance? Copyright © 2021 Pearson Education, Inc. All Rights Reserved 1.8 Cash Flow Firm Financial markets Firm issues securities (A) Retained Invests cash flows (F) in assets Short-term debt (B) Cash flow Dividends and Long-term debt Current assets from firm (C) debt payments (E) Fixed assets Equity shares Taxes (D) The cash flows from the firm Ultimately, the firm must be a must exceed the cash flows cash generating activity. from the financial markets. Government Copyright © 2021 Pearson Education, Inc. All Rights Reserved 1.8 Cash Flow Classification of Cash Flows Copyright © 2021 Pearson Education, Inc. All Rights Reserved 1.9 The Financial Cycle This figure depicts the basic financial cycle, which matches funds from savers to companies that have projects requiring funds and then returns the profits from those projects back to the savers and investors. Copyright © 2021 Pearson Education, Inc. All Rights Reserved 1.9 The Financial Cycle Financial Institutions and Their Roles in the Financial Cycle Institution Source of Money Use of Money Banks and Credit Unions Deposits (savings) Loans to people and businesses Examples: Wells Fargo, SunTrust Insurance Companies Premiums and investment earnings Invests mostly in bonds and some Examples: Liberty Mutual, Allstate stocks, using the investment income to pay claims Mutual Funds People’s investments (savings) Buys stocks, bonds, and other Examples: Vanguard, Fidelity financial instruments on behalf of its investors Pension Funds Retirement savings contributed Similar to mutual funds, except with Examples: CalPERS, REST through the workplace the purpose of providing retirement income Hedge Funds Investments by wealthy Invests in any kind of investment Examples: Bridgewater, Citadel individuals and endowments in an attempt to maximize returns Venture Capital Funds Investments by wealthy Invests in start-up, Examples: Kleiner Perkins, individuals and endowments entrepreneurial firms Sequoia Capital Private Equity Funds Investments by wealthy Purchases whole companies by Examples: TPG Capital, KKR individuals and endowments using a small amount of equity and borrowing the rest Copyright © 2021 Pearson Education, Inc. All Rights Reserved 1.10 The Agency Problem The Principal-Agent Relationship Typically, in a Corporation, there are what is called agents and principals: The Agent is the “person that acts,” whereas the Principal is the person that receives the benefits from the actions. Agency problem Conflict of interest between principal and agent – Reduced effort on the part of the agent – Excessive perks consumption – Empire building – Entrenchment – Risk avoidance Copyright © 2021 Pearson Education, Inc. All Rights Reserved 1.10 The Agency Problem The Agency Relationship In finance there are two types of Agency Relationships. Managers and Stockholders and Managers and Creditors – Principal hires an agent to represent his/her interest – Stockholders (principals) hire managers (agents) to run the company Agency Costs These are costs incurred to push agents to act in the principal’s best interest. They consist of three types of costs. – Direct contracting costs – Monitoring Costs – Loss of Principal’s wealth due to residual unresolved agency problems. Copyright © 2021 Pearson Education, Inc. All Rights Reserved 1.10 The Agency Problem How do you resolve these conflicts? Copyright © 2021 Pearson Education, Inc. All Rights Reserved  Quick Quiz What are the four major forms of business organization? What are the three main roles financial institutions play? What is the goal of financial management? What are the three basic questions Financial Managers must answer? What are the advantages and disadvantages of organizing a business as a corporation? How to reduce Agency Cost? Copyright © 2021 Pearson Education, Inc. All Rights Reserved  Review of Learning Goals LG 1 – Define finance and the managerial finance function. ▪ Finance is the science and art of how individuals and firms raise, allocate, and invest money. It affects virtually all aspects of business ▪ Managerial finance is concerned with the duties of the financial manager working in a business. Financial managers administer the financial affairs of all types of businesses: private and public, large and small, profit seeking and not for profit ▪ They perform such varied tasks as developing a financial plan or budget, extending credit to customers, evaluating proposed large expenditures, and raising money to fund the firm’s operations. LG 2 – Describe some goals that financial managers pursue, and link achievement of those objectives to the general goal of maximizing the wealth of the firm’s owners. ▪ There are many goals that firms can pursue including maximizing market share or profits. Firms might also express goals in terms of employee retention, ethics, or environmental sustainability. In finance, we say that a firm’s primary goal is to maximize the wealth of its owners who provide the capital that makes the firm’s existence possible. Maximizing the wealth of shareholders typically does not mean working against the interests of other stakeholders, but rather balancing those interests to create value for the firm in the long run Copyright © 2021 Pearson Education, Inc. All Rights Reserved Review of Learning Goals LG 3 – Identify the primary activities of the financial manager. ▪ Financial managers are primarily involved in three types of decisions. Investment decisions relate to how a company invests its capital to generate wealth for shareholders. Financing decisions relate to how a company raises the capital it needs to invest. Working capital decisions refer to the day-to-day management of a firm’s short-term resources such as cash, receivables, inventory, and payables. LG 4 – Explain the key principles that financial managers use when making business decisions. ▪ The time value of money means that money is more valuable today than in the future because of the opportunity to earn a return on money that is on hand now. Because a tradeoff exists between risk and return, managers have to consider both factors for any investment they make. ▪ Managers should also focus more on cash flow than on accounting profit. Furthermore, managers need to recognize that market prices reflect information gathered by many different investors, so the price of a company’s stock is an important signal of how the company is doing. Copyright © 2021 Pearson Education, Inc. All Rights Reserved  Review of Learning Goals LG 4 (Cont.) – Explain the key principles that financial managers use when making business decisions. ▪ Finally, although managers should act in shareholders’ interest, they do not always do so, which requires various kinds of incentives to be in place so that the interests of managers and shareholders align to the greatest extent possible. LG 5 – Describe the legal forms of business organization. ▪ These are the sole proprietorship, the partnership, and the corporation. The corporation is dominant in the sense that most large companies are corporations. A corporation’s owners are its stockholders. Stockholders expect to earn a return by receiving dividends or by realizing gains through increases in share price. LG 6 – Describe the nature of the principal–agent relationship between the owners and managers of a corporation, and explain how various corporate governance mechanisms attempt to manage agency problems. ▪ The separation of owners and managers in a corporation gives rise to the classic principal–agent relationship, in which shareholders are the principals and managers are the agents. This arrangement works well when the agent makes decisions in the principal’s best interest, but it can lead to agency problems when the interests of the principal and agent differ. Copyright © 2021 Pearson Education, Inc. All Rights Reserved Copyright This work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials. Copyright © 2022, 2019, 2015 Pearson Education, Inc. All Rights Reserved.