Principles of Managerial Finance PDF

Principles of Managerial Finance Arab World Edition Gitman, Zutter, Elali, Al Roubaie Chapter 1: The Role and Environment of Managerial Finance Lec...

Principles of Managerial Finance Arab World Edition Gitman, Zutter, Elali, Al Roubaie Chapter 1: The Role and Environment of Managerial Finance Lecturer: Dr. Ali Hamad Fetais © Pearson Education 2013 1-0  Learning Goals LG1: Define finance, its major areas and opportunities available in this field, and the legal forms of business organization. LG2: Describe the managerial finance function and its relationship to economics and accounting. LG3: Identify the primary activities of the financial manager. LG4: Explain the goal of the firm, corporate governance, the role of ethics, and the agency issue. LG5: Understand financial institutions and markets, and the role they play in managerial finance. © Pearson Education 2013 1-1  What is Finance? Finance can be defined as the art and science 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, and how they invest their savings. In a business context, finance involves the same types of decisions: how firms raise money from investors, how firms invest money in an attempt to earn a profit, and how they decide whether to reinvest profits in the business or distribute them back to investors. © Pearson Education 2013 1-2  Major Areas & Opportunities in Finance: Managerial Finance Managerial finance is concerned with the duties of the financial manager in the business firm. The financial manager actively manages the financial affairs of any type of business, whether private or public, large or small, profit-seeking or not-for-profit. They are also more involved in developing corporate strategy and improving the firm’s competitive position. © Pearson Education 2013 1-3  Legal Forms of Business Organization One of the most basic decisions that all businesses confront is how to choose a legal form of organization. The three most common legal forms of business organization are: Sole proprietorship Partnership Corporation © Pearson Education 2013 1-4  Legal Forms of Business Organization: Corporations A corporation is an entity created by law. It has the legal powers of an individual in that it can sue and be sued, make and be party to contracts, and acquire property. Stockholders are the owners of a corporation, whose ownership, or equity, is evidenced by either common stock or preferred stock. © Pearson Education 2013 1-5  Legal Forms of Business Organization: Corporations Figure 1.1 Corporate Organization © Pearson Education 2013 1-6  The Managerial Finance Function: Primary Activities of the Financial Manager Figure 1.2 Financial Activities © Pearson Education 2013 1-7  Goal of the Firm: Maximize Shareholder Wealth Decision rule for managers: only take actions that are expected to increase the share price. Figure 1.3 Share Price Maximization © Pearson Education 2013 1-8  Goal of the Firm: Maximize Shareholder Wealth Why? Because maximizing shareholder wealth properly considers cash flows, the timing of these cash flows, and the risk of these cash flows © Pearson Education 2013 1-9  Goal of the Firm: Maximize Profit? Which Investment is Preferred? Profit maximization may not lead to the highest possible share price for at least three reasons: 1. Timing is important—the receipt of funds sooner rather than later is preferred. 2. Profits do not necessarily result in cash flows available to stockholders. 3. Profit maximization fails to account for risk. © Pearson Education 2013 1-10  Goal of the Firm: What About Other Stakeholders? Stakeholders are groups such as employees, customers, suppliers, creditors, owners, and others who have a direct economic link to the firm. A firm with a stakeholder focus consciously avoids actions that would prove detrimental to stakeholders. The goal is not to maximize stakeholder well-being but to preserve it. Such a view is considered to be "socially responsible." © Pearson Education 2013 1-11  Goal of the Firm: The Role of Business Ethics Business ethics are the standards of conduct or moral judgment that apply to persons engaged in commerce. Violations of these standards in finance involve a variety of actions: “creative accounting,” earnings management, misleading financial forecasts, insider trading, fraud, excessive executive compensation, options backdating, bribery, and kickbacks. Negative publicity often leads to negative impacts on a firm. © Pearson Education 2013 1-12  Goal of the Firm: Ethics and Share Price Ethics programs seek to: – reduce litigation and judgment costs – maintain a positive corporate image – build shareholder confidence – gain the loyalty and respect of all stakeholders The expected result of such programs is to positively affect the firm’s share price. © Pearson Education 2013 1-13  Governance and Agency: Corporate Governance Corporate governance refers to the rules, processes, and laws by which companies are operated, controlled, and regulated. It defines the rights and responsibilities of the corporate participants such as the shareholders, board of directors, officers and managers, and other stakeholders, as well as the rules and procedures for making corporate decisions. The structure of corporate governance was previously described in Figure 1.1. © Pearson Education 2013 1-14  Governance and Agency: Individual versus Institutional Investors Individual investors are investors who own relatively small quantities of shares so as to meet personal investment goals. Institutional investors are investment professionals, such as banks, insurance companies, mutual funds, and pension funds, that are paid to manage and hold large quantities of securities on behalf of others. Unlike individual investors, institutional investors often monitor and directly influence a firm’s corporate governance by exerting pressure on management to perform or communicating their concerns to the firm’s board. © Pearson Education 2013 1-15  Governance and Agency: Government Regulation Government regulation generally shapes the corporate governance of all firms. During the past decade, corporate governance has received increased attention due to several high-profile corporate scandals. Recent corporate governance codes have been introduced in many countries internationally, including in the Arab region in Saudi Arabia, Bahrain, the U.A.E., Oman, and Qatar. © Pearson Education 2013 1-16  The Agency Issue: The Agency Problem Managers can be viewed as agents of the owners who have hired them. Technically, any manager who owns less than 100% of the firm’s equity is to some degree an agent of other owners. In theory, managers would agree with shareholder wealth maximization. However, managers are also concerned with their personal interests. This potential conflict of owner and personal goals is called the agency problem. © Pearson Education 2013 1-17  The Agency Issue: Resolving the Problem Market Forces such as major shareholders and the threat of a hostile takeover act to keep managers in check. Agency Costs are the costs borne by stockholders to maintain a corporate governance structure that minimizes agency problems and contributes to the maximization of shareholder wealth. © Pearson Education 2013 1-18  The Agency Issue: Resolving the Problem (cont.) Incentive plans are management compensation plans that tie management compensation to share price; one example involves the granting of stock options. A stock option is an incentive allowing managers to purchase stock at the market price set at the time of the grant. © Pearson Education 2013 1-19  The Agency Issue: Resolving the Problem (cont.) Performance plans tie management compensation to measures such as EPS growth; performance shares and/or cash bonuses are used as compensation under these plans. Recent studies have failed to find a strong relationship between CEO compensation and share price. © Pearson Education 2013 1-20  Financial Institutions & Markets: Financial Institutions Financial institutions are intermediaries that channel the savings of individuals, businesses, and governments into loans or investments. The key suppliers and demanders of funds are individuals, businesses, and governments. In general, individuals are net suppliers of funds, while businesses and governments are net demanders of funds. © Pearson Education 2013 1-21  Financial Institutions & Markets: Financial Markets Financial markets provide a forum in which suppliers of funds and demanders of funds can transact business directly. The two key financial markets are the money market and the capital market. Transactions in short term marketable securities take place in the money market, while transactions in long-term securities take place in the capital market. © Pearson Education 2013 1-22  Financial Institutions & Markets: Financial Markets (cont.) All securities are initially issued through the primary market. The primary market is the only one in which a corporation or government is directly involved in and receives the proceeds from the transaction. Once issued, securities then trade on the secondary markets such as the New York Stock Exchange or Tadawul. © Pearson Education 2013 1-23  The Money Market The money market is created by a financial relationship between suppliers and demanders of short-term funds (those having a maturity of a year or less). Most money market transactions are made in marketable securities which are short-term debt instruments such as government Treasury bills and commercial paper. © Pearson Education 2013 1-24  The Capital Market Capital markets are the markets for long-term debt and corporate stocks. The best-known stock market is the New York Stock Exchange. In the Arab world capital markets have grown rapidly in the past few years, but are relatively small. © Pearson Education 2013 1-25  The Capital Market The key capital market securities are bonds (long-term debt) and both common and preferred stock (equity). Bonds are long-term debt instruments used by businesses and government to raise large sums of money or capital. Common stock are units of ownership interest or equity in a corporation. © Pearson Education 2013 1-26