Chapter 3 Wealth Maximization.pdf

Wealth Maximization 0 © Pearson Education 2013  Risks faced by a firm Unsuccessful product launch Core Business...

Wealth Maximization 0 © Pearson Education 2013  Risks faced by a firm Unsuccessful product launch Core Business Labour problems Risks Peculiar to a firm Cyclical demand fluctuations Material supply problems And so forth.. Exchange rate fluctuations Environmental All pervasive and affect all Interest rate fluctuations firms in an industry Risks Sudden price rise of Financial risks are a subset goods of environmental risks Shifts in government policies And so forth.. 1 What is FINANCIAL risk? Credit risk Concentration risk Interest rate risk Currency risk Market risk A situation involving exposure RISK to danger. Equity risk Commodity risk Refinancing Liquidity risk risk Financial risk refers to the Financial Risk chance that an investment's actual return will be different Legal risk FINANCIAL than expected. It basically is RISK exposure to the danger of financial loss on investments Model risk made by investors. Operational risk Political risk Valuation risk 2  Legal Forms of Business Organization: Corporations Figure 1.1 Corporate Organization © Pearson Education 2013 1-7  The Managerial Finance Function The size and importance of the managerial finance function depends on the size of the firm. In small companies, the finance function may be performed by the company president or accounting department. As the business expands, finance typically evolves into a separate department linked to the president as was previously described in Figure 1.1. © Pearson Education 2013 1-8  The Managerial Finance Function: Relationship to Economics The field of finance is closely related to economics. Financial managers must understand the economic framework and be alert to the consequences of varying levels of economic activity and changes in economic policy. They must also be able to use economic theories as guidelines for efficient business operation. © Pearson Education 2013 1-9  The Managerial Finance Function: Relationship to Economics (cont.) The primary economic principal used by financial managers is marginal cost-benefit analysis which says that financial decisions should be implemented only when added benefits exceed added costs. © Pearson Education 2013 1-10  The Managerial Finance Function: Relationship to Accounting The firm’s finance (treasurer) and accounting (controller) functions are closely-related and overlapping. In smaller firms, the financial manager generally performs both functions. © Pearson Education 2013 1-11  The Managerial Finance Function: Relationship to Accounting (cont.) One major difference in perspective and emphasis between finance and accounting is that accountants generally use the accrual method while in finance, the focus is on cash flows. The significance of this difference can be illustrated using the following simple example. © Pearson Education 2013 1-12  The Managerial Finance Function: Relationship to Accounting (cont.) The Nassima Corporation experienced the following activity last year: Sales US$100,000 (1 yacht sold, 100% still uncollected) Costs US$80,000 (all paid in full under supplier terms) Now contrast the differences in performance under the accounting method versus the cash method. © Pearson Education 2013 1-13  The Managerial Finance Function: Relationship to Accounting (cont.) INCOME STATEMENT SUMMARY ACCRUAL CASH Sales US$100,000 US$ 0 Less: Costs (80,000) (80,000) Net Profit/(Loss) US$ 20,000 US$(80,000) © Pearson Education 2013 1-14  The Managerial Finance Function: Relationship to Accounting (cont.) Finance and accounting also differ with respect to decision-making. While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily concerned with analyzing and interpreting this information for decision-making purposes. The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm. © Pearson Education 2013 1-15  The Managerial Finance Function: Primary Activities of the Financial Manager Figure 1.2 Financial Activities © Pearson Education 2013 1-16  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 1-17  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 1-18  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 1-19  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 1-20  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 1-21  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 1-22  Financial Institutions & Markets Firms that require funds from external sources can obtain them in three ways: through a bank or other financial institution through financial markets through private placements © Pearson Education 2013 1-23  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 1-24  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 1-25  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 1-26