Financial Management_CH1.pdf

Chapter 1: Introduction to Financial management Dr. Nader Naifar [email protected] 1  Chapter Outline The goal of Organization of What is Financial Financ...

Chapter 1: Introduction to Financial management Dr. Nader Naifar [email protected] 1  Chapter Outline The goal of Organization of What is Financial Financial Management? the Financial Management? Management Function The Agency The Corporate Problem and Firm Control of the Corporation Dr. Nader Naifar [email protected] 2  Key Concepts and Skills After studying Chapter 1, you should be able to: ✓Describe “financial management” in terms of the three major decision areas that confront the financial manager. ✓Identify the goal of the financial management ✓ Understand the organization of the Financial Management Function ✓Understand the potential problems arising when management of the corporation and ownership are separated. 3  1- What Is Financial Management ❑ Financial management is concerned with acquiring, financing, and managing assets with some overall goal in mind. ❑ Thus, the decision function of financial management can be broken down into three major areas: ✓Investment ✓Financing ✓ Cash Flows Management 4  1- What Is Financial Management you hire managers to buy you make an investment raw materials, and you in assets (such as machinery, land, assemble a workforce and labor…) Suppose you decide an equal amount of cash you need financing raised by financing to start a firm When you begin to sell you need Working capital items, your firm will management (such as generate cash. inventory… 5  1- What Is Financial Management Q1: What long-term Capital budgeting decision investments should the firm take on? Financial management Q2: How can the firm raise Capital structure decision addresses the following the money for the required three questions capital expenditures? How should short-term operating cash flows be Net Working capital management managed? 6  The purpose of the firm is to create value for investors, the owner. The value is reflected in the framework of the simple balance sheet model of the firm. Q3: How should short-term operating cash flows be managed? Q1: What long- Q2: How can the term investments firm raise the should the firm money for the take on? required capital expenditures? 7  1- What Is Financial Management Main Task of Financial Management: Capital budgeting: The process of planning and managing a firm’s long-term investments and fixed assets. (Example: deciding whether or not to open a new project). Capital structure: The mixture of debt and equity is maintained by the firm S-T and L-T debt and equity. Working capital management: The firm’s short-term assets and liabilities current assets and current liabilities. 8  2- The Goal of Financial Management Assuming that we restrict our discussion to for-profit businesses, the goal of financial management is to make money or add value for the owners. A more general goals: Maximize the value of the existing owners’ equity. 9  3- Organization of the Financial Management Function The treasurer is responsible for handling cash flows, The controller managing capital handles expenditure decisions, the accounting and making financial function plans 10  4- The Corporate Firm A basic problem of the firm is how to raise cash. Then the corporate form of business is the standard method for solving problems encountered in raising large amounts of cash. We consider the three basic legal forms of organizing firms: -The sole proprietorship; - The partnership; - The corporation. 11  4- The Corporate Firm 2.1. The sole proprietorship - A sole proprietorship is a business owned by one person. - The sole proprietorship is the cheapest business to form - The sole proprietorship has unlimited liability for business debts and obligations. - No distinction is made between personal and business assets. - The life of the sole proprietorship is limited by the life of the sole proprietor. 12  4- The Corporate Firm 2.2. The partnership - Any two or more people can get together and form a partnership. - Partnerships fall into two categories: (1) general partnerships and (2) limited partnerships. - In a general partnership, all partners agree to provide some fraction of the work and cash and to share the profits and losses. - In a limited partnership, some partners’ liability is limited to the amount of cash each has contributed to the partnership. (1) at least one partner be a general partner and (2) the limited partners do not participate in managing the business. 13  4- The Corporate Firm 2.3. The Corporation - The corporation is by far the most important form of business enterprise. - It is a distinct legal entity. As such, a corporation can have a name and enjoy many of the legal powers of natural persons. For example: ▪ Corporations can acquire and exchange property. ▪ Corporations can enter contracts and may sue and be sued. Starting a corporation is more complicated than starting a proprietorship or partnership. 14  4- The Corporate Firm - In its simplest form, the corporation comprises three sets of distinct interests: the shareholders (the owners), the directors, and the corporation officers (the top management). - Traditionally, the shareholders control the corporation’s direction, policies, and activities. They elect a board of directors, who in turn select top management. - The potential separation of ownership from management gives the corporation several advantages over proprietorships and partnerships: 1- Ownership can be readily transferred to new owners. 2- The corporation has unlimited life 3- The shareholders’ liability is limited to the amount invested in the ownership shares. 15 5- The Agency Problem and Control of the Corporation 5.1. The agency problem - The relationship between stockholders and management is called an agency relationship. Such a relationship exists whenever someone (the principal) hires another (the agent) to represent their interests. - In such relationships, there is a possibility of a conflict of interest between the principal and the agent. Such a conflict is called an agency problem. How management and stockholder interests might differ? 16 5- The Agency Problem and Control of the Corporation Example: Suppose a firm is considering a new investment. The new investment is expected to impact the share value favorably, but it is also a relatively risky venture. The owners of the firm will wish to take the investment (because the stock value will rise), but management may not because there is the possibility that things will turn out badly and management jobs will be lost. If management does not take the investment, then the stockholders may lose a valuable opportunity. This is one example of an agency cost. 17 5- The Agency Problem and Control of the Corporation Agency costs refer to the costs of the conflict of interest between stockholders and management. These costs can be indirect or direct. Direct costs: Costs incurred when the agent (management team) uses the company’s resources for their own benefit. Indirect costs: Costs incurred by the principal (shareholders) to prevent the agent (management team) from prioritizing him/herself over shareholder interests 18 5- The Agency Problem and Control of the Corporation 5.2. Do managers act in the stockholders’ interests? Whether managers will act in the best interests of stockholders It depends on two factors. ❑ First, how closely are management goals aligned with stockholder goals? This question relates, at least in part, to the way managers are compensated. ❑ Second, can managers be replaced if they do not pursue stockholder goals? 19 5- The Agency Problem and Control of the Corporation There are several reasons to think that management has a significant incentive to act in the interests of stockholders. ❑ Managerial Compensation: Management will frequently have a significant economic incentive to increase share value for two reasons: First, managerial compensation (financial performance in general) Second, to share value in particular (ex., managers are frequently given the option to buy the stock at a bargain (low) price). 20 5- The Agency Problem and Control of the Corporation ❑ Control of the Firm: ▪ Unhappy stockholders can replace existing management: this mechanism is called the proxy fight. - A proxy is the authority to vote someone else’ s stock. - A proxy fight develops when a group solicits proxies to replace the existing board and thereby replace existing management. ▪ Another way that management can be replaced is by a takeover. Thus, avoiding a takeover by another firm gives management another incentive to act in the stockholders ’ interests 21  Summary and Conclusions 1- Financial Management has three main areas of concern: a. Capital budgeting: What long-term investments should the firm take? b. Capital structure: Where will the firm get the long-term financing to pay for its investments? c. Working capital management: How should the firm manage its everyday financial activities? 2- The goal of financial management in a for-profit business is to make decisions that increase the value of the stock or, more generally, increase the market value of the equity. 3- The corporate form of organization is superior to other forms of raising money and transferring ownership interests, but it has the disadvantage of double taxation. 4- A large corporation may have conflicts between stockholders and management. We called these conflicts agency problems and discussed how they might be controlled and reduced. 5- The existence of financial markets enhances the advantages of the corporate form. 22  Multiple choice questions 1. Which of the following terms is defined as managing 4. A business owned by a solitary individual who has a firm's long-term investments? unlimited liability for its debt is called a: A. working capital management A. corporation B. financial allocation B. sole proprietorship. C. capital budgeting. C. general partnership D. capital structure D. limited partnership 2. Which of the following terms is a mixture of a firm's 5. A business formed by two or more individuals whom debt and equity financing? each have unlimited liability for all of the firm's A. working capital management business debts is called a: B. cash management A. corporation C. cost analysis B. sole proprietorship D. capital structure. C. general partnership. 3. Which one of the following is defined as a firm's D. limited partnership short-term assets and its short-term liabilities? 6. A business partner whose potential financial loss in A. working capital. the partnership will not exceed their investment in that B. debt partnership is called a: C. investment capital A. general partnership D. net capital B. sole proprietorship C. limited partnership. D. corporation 23  Multiple choice questions 7. A business created as a distinct legal entity and 10. Which of the following questions are addressed by treated as a legal "person" is called a: financial managers? A. corporation. I. How should a product be marketed? B. sole proprietorship II. Should customers be given 30 or 45 days to pay for C. general partnership their credit purchases? D. limited partnership III. Should the firm borrow more money? 8. Which one of the following terms is defined as a IV. Should the firm acquire new equipment? conflict of interest between the corporate shareholders A. I and IV only and the corporate managers? B. II and III only A. articles of incorporation C. I, II, and III only B. corporate breakdown D. II, III, and IV only. C. agency problem. E. I, II, III, and IV D. bylaws 11.. The controller of a corporation generally reports 9. Which of the following functions should be the directly to the: responsibility of the controller rather than the A. board of directors treasurer? B. chairman of the board A. daily cash deposit C. chief executive officer B. income tax returns. D. president C. equipment purchase analysis E. vice president of finance. D. customer credit approval 24  Multiple choice questions 12. Which of the following accounts are included in 14. Which of the following provides limited liability for working capital management? all its owners? I. accounts payable A. sole proprietorship II. accounts receivable B. partnership with only general partners III. fixed assets C. partnership with both general and limited partners IV. inventory D. Corporation. A. I and II only 15. Finance managers need to interact constantly with: B. I and III only A. marketing managers C. II and IV only B. accounting staff D. I, II, and IV only. C. management information systems staff 13. Which one of the following is a working capital D. all of the above. management decision? A. determining the amount of equipment needed to complete a job B. determining whether to pay cash for a purchase or use the credit offered by the supplier. C. determining the amount of long-term debt required to complete a project D. determining the number of shares of stock to issue to fund an acquisition 25 Recommended Reading Chapter 1: Introduction to Corporate Finance 26 27