Chapter 1: The Role of Managerial Finance PDF

CHAPTER 1 THE ROLE OF MANAGERIAL FINANCE Learning Goals (1 of 2) L G 1 Define finance and the managerial finance function. L G 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...

CHAPTER 1 THE ROLE OF MANAGERIAL FINANCE Learning Goals (1 of 2) L G 1 Define finance and the managerial finance function. L G 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. L G 3 Identify the primary activities of the financial manager. L G 4 Explain the key principles that financial managers use when making business decisions. Learning Goals (2 of 2) L G 5 Describe the legal forms of business organization. L G 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. 1.1 Finance and the Firm (1 of 10) 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 1.1 Finance and the Firm (2 of 10) What Is Finance? 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 Matter of Fact (1 of 9) 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. Matter of Fact (2 of 9) Finance Professors Aren’t Like Everyone Else 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. 1.1 Finance and the Firm (3 of 10) 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 1.1 Finance and the Firm (4 of 10) 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 Matter of Fact (3 of 9) Firms Accelerate Dividends So That Shareholders Save on Taxes One way that firms can maximize the wealth of shareholders is by thinking carefully about the taxes their shareholders must pay on dividends. In 2003, Congress lowered the tax rate on most dividends paid to shareholders to 15%. However, the legislation contained a provision by which the tax cuts would expire in 2013 unless Congress acted to renew them. With a political compromise to renew the tax cuts looking unlikely in the 2012 election year, many firms announced plans to accelerate dividend payments they had planned to make in early 2013 to late 2012. Matter of Fact (4 of 9) Firms Accelerate Dividends So That Shareholders Save on Taxes The Washington Post Company, for example, announced that in December 2012, it would pay out the entire $9.80 per share dividend that it had planned to distribute in 2013. The stock market approved, as Washington Post shares rose $5. By accelerating their dividend payments, companies such as Washington Post, Expedia, Inc., and luxury goods producer Coach, Inc., were increasing the wealth of their shareholders by helping them save taxes. Example 1.1 (1 of 2) Nick Dukakis, the financial manager of Neptune Manufacturing, a producer of marine engine components, is choosing between two investments, Rotor and Valve. The following table shows the E P S Dukakis expects each investment to earn over its three-year life. Copyright © 2022 Pearson Education, Ltd. Example 1.1 (2 of 2) If Dukakis thought he should make decisions to maximize profits, he would recommend that Neptune invest in Valve rather than Rotor because it results in higher total earnings per share over the three-year period ($3.00 E P S compared with $2.80 E P S). 1.1 Finance and the Firm (5 of 10) What Is the Goal of the Firm? 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 1.1 Finance and the Firm (6 of 10) What Is the Goal of the Firm? Maximize Stakeholders’ Welfare? Flaws in neglecting shareholder wealth maximization: Maximizing shareholder wealth does not in any way imply that managers should ignore the interests of everyone else connected to a firm To maximize shareholder value, managers must necessarily assess the long-term consequences of their actions The stakeholder perspective is intrinsically difficult to implement, and advocates of the idea that managers should consider all stakeholders’ interests do not typically indicate how managers should carry it out 1.1 Finance and the Firm (7 of 10) What Is the Goal of the Firm? Maximize Stakeholders’ Welfare? Flaws in neglecting shareholder wealth maximization: Many people misinterpret the statement that managers should maximize shareholder wealth as implying that managers should take any action, including illegal or unethical actions, that increases the stock price 1.1 Finance and the Firm (8 of 10) The Role of Business Ethics Business ethics are standards of conduct or moral judgment that apply to persons engaged in commerce The goal of such standards is to motivate business and market participants to abide by both the letter and the spirit of laws and regulations concerned with business and professional practice 1.1 Finance and the Firm (9 of 10) The Role of Business Ethics Ethical Guidelines Is the action arbitrary? Does it unfairly single out an individual or group? Does the action violate the moral or legal rights of any individual or group? Does the action conform to accepted moral standards? Are alternative actions less likely to cause harm? 1.1 Finance and the Firm (10 of 10) The Role of Business Ethics Ethics and Share Price An effective ethics program can enhance corporate value by producing positive benefits Ethical behavior is necessary for achieving the firm’s goal of owner wealth maximization 1.2 Managing the Firm (1 of 7) The Managerial Finance Function Financial Managers’ Key Decisions Investment Decisions How a company will spend money on long-term projects Financing Decisions (Capital structure decisions) How companies raise money (capital) needed for investment opportunities. The mix of funding sources that a company uses has important implications. Working Capital Decisions Decisions that refer to the management of a firm’s short-term resources Figure 1.1 Financial Activities Copyright © 2022 Pearson Education, Ltd. 1.2 Managing the Firm (2 of 7) The Managerial Finance Function Principles That Guide Managers’ Decisions Time Value of Money Tradeoff Between Return and Risk Cash Is King Competitive Financial Markets Incentives Are Important 1.2 Managing the Firm (3 of 7) The Managerial Finance Function Principal–Agent Problem A problem that arises because the owners of a firm (principals) and its managers (agents) are not the same people and the agents fail to act in the interest of the principals 1.2 Managing the Firm (4 of 7) The Managerial Finance Function Organization of the Finance Function CEO CFO Treasurer Controller Director of Investor Relations Director of Internal Audit Foreign Exchange Manager Figure 1.2 Corporate Organization Copyright © 2022 Pearson Education, Ltd. 1.2 Managing the Firm (5 of 7) The Managerial Finance Function Relationship to Economics Marginal Cost–Benefit Analysis Economic principle that states that financial decisions should be made and actions taken only when the marginal benefits exceed the marginal costs Example 1.2 (1 of 4) Justin Liter, owner of the Houston-based barbeque restaurant, Game of Bones, is contemplating an investment decision. Currently, customers who buy soft drinks fill their own orders using a dispenser that offers a choice of seven different drink flavors. For $20,000, Justin can replace his current dispenser with a new one that lets customers choose among 100 plus different soft drinks. Example 1.2 (2 of 4) Justin believes that if he purchases this new dispenser, more drink orders will pour in. Specifically, with the current dispenser, Justin’s restaurant brings in about $73,000 in net cash flow (i.e., revenue minus the cost of operating the machine and providing cups and lids) per year. With the new machine in place, Justin estimates that net soft drink cash flow will surge to $100,000 per year. If Justin buys the new dispenser, he can sell the used one to another restauranteur for $5,000. Example 1.2 (3 of 4) Applying marginal cost–benefit analysis, Justin organizes the data as follows: Net soft drink cash flow with new dispenser $100,000 Less: Cash flow with old dispenser 73,000 (1) Marginal benefit $ 27,000 Cost of new dispenser $ 20,000 Less: Proceeds from sale of old dispenser 5,000 (2) Marginal cost $ 15,000 Net benefit [(1) – (2)] $ 12,000 Because the marginal benefit of $27,000 exceeds the marginal cost of $15,000, Justin is inclined to buy the new dispenser. The firm will experience a net benefit of $12,000 as a result of this action.  Example 1.2 (4 of 4) Justin recognizes that his analysis is still incomplete because he has considered marginal costs and benefits for just one year, he has made no adjustment for the time value of money (i.e., he must pay the costs up front but the benefits come later), and he has not considered any tax implications of this decision. Still, at first glance, buying the new dispenser looks like a good decision. Copyright © 2022 Pearson Education, Ltd. 1.2 Managing the Firm (6 of 7) The Managerial Finance Function Relationship to Accounting Emphasis on Cash Flows Accrual Basis Recognizes revenue at the time of sale and recognizes expenses when they are incurred Cash Basis Recognizes revenues and expenses only with respect to actual inflows and outflows of cash Example 1.3 (1 of 2) Nassau Corporation, a small yacht dealer, sold one yacht for $1,000,000 in the calendar year just ended. Nassau originally purchased the yacht for $800,000. Although the firm paid in full for the yacht during the year, at year’s end it has yet to collect the $1,000,000 from the customer. The accounting view and the financial view of the firm’s performance during the year are given by the following income and cash flow statements, respectively. Example 1.3 (2 of 2) In an accounting sense, Nassau Corporation is profitable, but in terms of actual cash flow, it has a problem. Its lack of cash flow resulted from the uncollected accounts receivable of $1,000,000. Without adequate cash inflows to meet its obligations, the firm will not survive, regardless of its profits. Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 1.4 (1 of 2) 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: Copyright © 2022 Pearson Education, Ltd. Personal Finance Example 1.4 (2 of 2) 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. 1.2 Managing the Firm (7 of 7) The Managerial Finance Function Relationship to Accounting Decision-Making Accountants focus on collecting and presenting financial data Financial managers evaluate the accounting information and other data to influence business decisions to create value for shareholders. 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (1 of 13) Legal Forms of Business Organization Sole Proprietorships Businesses owned by one person and operated for his or her own profit Unlimited Liability The condition of a sole proprietorship, giving creditors the right to make claims against the owner’s personal assets to recover debts owed by the business 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (2 of 13) Legal Forms of Business Organization Partnerships Businesses owned by two or more people and operated for profit Articles of Partnership The written contract used to formally establish a business partnership 1.3 Organizational Forms, Taxation, and the Principal– Agent Relationship (3 of 13) Legal Forms of Business Organization Corporations Legal business entities with rights and duties similar to those of individuals but with a legal identity distinct from its owners Stockholders The owners of a corporation, whose ownership, or equity, takes the form of common stock or, less frequently, preferred stock Limited Liability A legal provision that limits stockholders’ liability for a corporation’s debt to the amount they initially invested in the firm by purchasing stock  1.3 Organizational Forms, Taxation, and the Principal– Agent Relationship (4 of 13) Legal Forms of Business Organization Corporations Stock A security that represents an ownership interest in a corporation Cash Dividends Periodic distributions of cash to the stockholders of a firm Board of Directors Group elected by the firm’s stockholders and typically responsible for approving strategic goals and plans, setting general policy, guiding corporate affairs, and approving major expenditures 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (5 of 13) Legal Forms of Business Organization Corporations President or Chief Executive Officer (CEO) Corporate official responsible for managing the firm’s day-to-day operations and carrying out the policies established by the board of directors Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization (1 of 2) Sole proprietorship Partnership Corporation Strengths Owner receives all Owners who are Owners have limited liability, and profits (and sustains all limited partners have cannot lose more than they losses) limited liability and invested Low organizational costs cannot lose more than Can achieve large size via sale of Income taxed only on 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 Table 1.1 Strengths and Weaknesses of the Common Legal Forms of Business Organization (2 of 2) Sole proprietorship Partnership Corporation 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 partners More expensive to organize than power tends to inhibit Partnership is dissolved other business forms growth when a partner dies Subject to greater government Proprietor must be jack- Difficult to liquidate or regulation of-all-trades transfer partnership Lacks secrecy because regulations Difficult to give employees require firms to disclose financial long-run career results opportunities Lacks continuity when proprietor dies Matter of Fact (5 of 9) Number of Businesses and Income Earned by Type of U.S. Firm Although sole proprietorships greatly outnumber partnerships and corporations combined, they generate the lowest level of income. In total, sole proprietorships account for almost three- quarters of the number of business establishments in operation, but they earn just 10% of all business income. Corporations, on the other hand, account for just 17% of the number of businesses, but they earn almost two-thirds of all business income. Matter of Fact (6 of 9) Sole proprietorships Partnerships Corporations Number of firms (millions) 25.3 3.4 5.8 Percentage of all firms 73% 10% 17% Percentage of all business 10% 26% 64% income Source: Overview of Approaches to Corporate Integration, Joint Committee on Taxation, United States Congress, May 17, 2016. 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (6 of 13) Business Organizational Forms and Taxation Prior to 2018 Proprietorships and partnerships taxed according to the same progressive rate structure as individual taxpayers Corporations taxed according to an alternative, mostly progressive rate structure Marginal Versus. Average Tax Rate The marginal tax rate represents the rate at which the next dollar of income is taxed while the average tax rate equals taxes paid divided by taxable income The marginal rate does not usually equal the average rate under a progressive tax rate structure 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (7 of 13) Business Organizational Forms and Taxation After 2018 (Tax Cuts and Jobs Act) Proprietorships and partnerships still taxed according to a (revised) progressive rate structure Corporations taxed at a flat rate of 21% Under a flat tax, the marginal and average tax rates are equal 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (8 of 13) Legal Forms of Business Organization Business Organizational Forms and Taxation Double Taxation A situation facing corporations in which income from the business is taxed twice—once at the business level and once at the individual level when cash is distributed to shareholders Ordinary Income Versus Capital Gains Ordinary income is income earned by a business through the sale of goods or services while capital gains is income earned by selling an asset for more than its cost Table 1.2 2020 Federal Tax Rates for Individual and Joint Taxpayers Copyright © 2022 Pearson Education, Ltd. Pre-2018 Corporate Tax Rate Schedule Copyright © 2022 Pearson Education, Ltd. Example 1.5 (1 of 2) Dan Webster is a partner in Webster Manufacturing. This year, Dan’s share of the partnership’s earnings is $80,000 before taxes. Assuming that Dan is single and has no other income, the taxes he will owe on his business income are as follows: Total tax liability = (0.10 × $9,875) + [0.12 × ($40,125 − $9,875)] + [0.22 × ($80,000 − $40,125)] = $987.50 + $3,630 + $8,772.50 = $13,390 Example 1.5 (2 of 2) A common misconception is that taxpayers can be worse off by earning extra income because that puts them in a higher tax bracket. Notice that Webster falls in the 22% income tax bracket (i.e. his business income is greater than $40,125 but less than $85,525), but the 22% rate applies only to income above $40,125. He pays 10% tax on the first $9,875 that he earns and 12% on the next $30,250 of earnings. Only the final $39,875 in earnings is subject to the 22% tax rate. Figure 1.3 Dan Webster’s Total Tax Liability, Marginal Tax Rate, and Average Tax Rate for Different Income Levels Copyright © 2022 Pearson Education, Ltd. Figure 1.4 Marginal and Average Tax Rates at Different Income Levels for an Individual Taxpayer (for Tax Year 2020) Copyright © 2022 Pearson Education, Ltd. Example 1.6 (1 of 2) Peter Strong is the sole proprietor of Argaiv Software, and from that business he earned taxable income of $300,000. Assuming that this is Peter’s only source of income and that he is single, from Table 1.2 we can see that based on Peter’s tax bracket, he faces a marginal tax rate of 35%. How much tax does Peter owe? Total tax liability = (0.10 × $9,875) + [0.12 × ($40,125 − $9,875)] + [0.22 × ($85,525 − $40,125) ] + [0.24 × ($163,300 − $85,525)] + [0.32 × ($207,350 − $163,300)] + [0.35 × ($300,000 − $207,350)] = $987.50 + $3,630+ $9,988 + $18,666 + $14,096 + $32,427.50 = $79,795 Example 1.6 (2 of 2) Now suppose that Argaiv Software is organized as a corporation rather than as a sole proprietorship. In that case, the company will pay a 21% corporate tax rate on the $300,000 in earnings. That means Argaiv will pay $63,000 (0.21 × $300,000) in taxes as a corporation and will have $237,000 in after-tax income, which it pays to Peter as a dividend. Based on his $237,000 income level, Peter will pay a 15% capital gain tax on the dividend income that he receives, plus he will pay the 3.8% net investment tax on the portion of his investment income that exceeds $200,000, so his personal tax liability will be $36,956 [(0.15 × $237,000 + 0.038 × ($237,000 − $200,000)]. Adding up the taxes paid by Argaiv Software and its owner, we can see the effect of the double taxation on corporate income. Total tax liability = $63,000 + $36,956 = $99,956 Here, the company and its owner pay a combined tax bill of $99,956, whereas the total tax bill on $300,000 of business income was just $79,795 under the sole proprietorship structure. 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (9 of 13) Legal Forms of Business Organization 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 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (10 of 13) Legal Forms of Business Organization Business Organizational Forms and Taxation Interest received by corporations is taxed as ordinary income, while dividends received get a special tax break Dividends received by the firm for stock held in other corporations are usually subject to a 50% exclusion for tax purposes The dividend exclusion in effect eliminates much of the potential tax liability from dividends received by the corporation and moderates the effect of double taxation on dividends paid by the corporation In calculating their taxes, corporations can deduct operating expenses, as well as interest expenses they pay to lenders The tax deductibility of these expenses reduces their after-tax cost Example 1.7 (1 of 2) Two corporations, Debt Co. and No-Debt Co., earned $200,000 before interest and taxes this year. During the year, Debt Co. paid $30,000 in interest. No-Debt Co. had no debt and no interest expense. How do the after-tax earnings of these firms compare? Copyright © 2022 Pearson Education, Ltd. Example 1.7 (2 of 2) Both firms face a 21% flat tax rate. Debt Co. had $30,000 more interest expense than No-Debt Co., but Debt Co.’s earnings after taxes are only $23,700 less than those of No-Debt Co. This difference is attributable to Debt Co.’s $30,000 interest expense deduction, which provides a tax savings of $6,300 (the tax bill is $35,700 for Debt Co. versus $42,000 for No-Debt Co.). The tax savings can be calculated directly by multiplying the 21% tax rate by the interest expense (0.21 × $30,000 = $6,300). Similarly, the $23,700 after-tax interest expense can be calculated directly by multiplying one minus the tax rate by the interest expense [(1 − 0.21) × $30,000 = $23,700]. 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (11 of 13) Agency Problems and Agency Costs Agency Costs Costs that shareholders bear due to managers’ pursuit of their own interests 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (12 of 13) Corporate Governance The rules, processes, and laws by which companies are operated, controlled, and regulated Internal Corporate Governance Mechanisms Stock Options Securities that allow managers to buy shares of stock at a fixed price Restricted Stock Shares of stock paid out as part of a compensation package that do not fully transfer from the company to the employee until certain conditions are met Matter of Fact (7 of 9) CEO Pay Around the World Both the amount that CEOs receive in compensation and the form their compensation takes vary greatly around the world. A recent report noted that median pay for CEO s in the United States was $14.9 million, nearly three times more than the median pay for CEO s from non-U.S. companies. British CEOs earned the second highest median pay at $10.5 million. On the European continent, German and French CEOs earned roughly half of what their British counterparts make, at $5.4 million and $4.0 million, respectively. Japanese CE Os received even less, with median pay at $1.5 million. Matter of Fact (8 of 9) C E O Pay Around the World Given these large differences in total compensation, the base salaries of C E O s were surprisingly similar. For instance, the median base salary for a U.S. C E O was $5.1 million, compared with $4.1 million for a German C E O. What, then, caused the variations in total C E O pay? These were driven mostly by differences in the use of equity based compensation. Matter of Fact (9 of 9) CEO Pay Around the World As an example, the portion of CEO pay coming in the form of stock or stock options was 60% for U.S. and U.K. firms, but in Germany and France, the fraction paid in equity totaled less than 24%. Japan was an even more dramatic outlier, with equity-based compensation accounting for just 10% of total CEO pay. Recall that the U.S. and U.K. legal systems emphasize the duty of managers to shareholders, whereas legal systems elsewhere place more emphasis on stakeholders. Those differences are reflected in equity-based CEO compensation around the world. Source: “How CEO pay differs around the globe,” Equilar.com press release, August 17, 2016. 1.3 Organizational Forms, Taxation, and the Principal–Agent Relationship (13 of 13) Corporate Governance External Corporate Governance Mechanisms Individual Versus Institutional Investors Activist Investors Investors who specialize in influencing management The Threat of Takeover Government Regulation Sarbanes-Oxley Act of 2002 An act aimed at eliminating corporate disclosure and conflict of interest problems Contains provisions concerning corporate financial disclosures and the relationships among corporations, analysts, auditors, attorneys, directors, officers, and shareholders Figure 1.5 Activists Seeking Board Representation in U.S. Companies Source: “The Activist Investing Annual Review 2020,” corpgov.law.harvard.edu Copyright © 2022 Pearson Education, Ltd. 1.4 Developing Skills for Your Career Critical Thinking Communication and Collaboration Financial Computing Skills Review of Learning Goals (1 of 8) 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 Review of Learning Goals (2 of 8) 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. Review of Learning Goals (3 of 8) 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. Review of Learning Goals (4 of 8) 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. Review of Learning Goals (5 of 8) L G 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. Review of Learning Goals (6 of 8) 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. Review of Learning Goals (7 of 8) 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. Review of Learning Goals (8 of 8) L G 6 (Cont.) 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. A firm’s corporate governance structure is intended to help ensure that managers act in the best interests of the firm’s shareholders and other stakeholders, and it is usually influenced by both internal and external factors.