Fundamentals of Corporate Finance Textbook PDF

Fundamentals of Corporate Finance Fourth Edition Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D. Chapter 1 The Financial Manager and the Firm Chapter 1: The Financial Mana...

Fundamentals of Corporate Finance Fourth Edition Robert Parrino, Ph.D.; David S. Kidwell, Ph.D.; Thomas W. Bates, Ph.D.; Stuart Gillan, Ph.D. Chapter 1 The Financial Manager and the Firm Chapter 1: The Financial Manager and the Firm Copyright ©2018 John Wiley & Sons, Inc. 2 Learning Objectives (1 of 2) 1. Identify the key financial decisions facing the financial manager of any business 2. Identify common forms of business organization in the United States and their respective strengths and weaknesses 3. Describe the typical organization of the financial function in a large corporation 4. Explain why maximizing the value of the firm’s stock is the appropriate goal for management Copyright ©2018 John Wiley & Sons, Inc. 3 Learning Objectives (2 of 2) 5. Discuss how agency conflicts affect the goal of maximizing stockholder value 6. Explain why ethics is an appropriate topic in the study of corporate finance Copyright ©2018 John Wiley & Sons, Inc. 4 The Role of the Financial Manager (1 of 5) Maximize Shareholder Wealth o Maximizing the price of a firm’s stock will maximize the value of a firm and the wealth of its shareholders/owners Stakeholders o Managers, employees, suppliers, creditors, and the government Copyright ©2018 John Wiley & Sons, Inc. 5 The Role of the Financial Manager (2 of 5) It’s All About Cash Flows o Positive residual cash flow may be paid to firm owners as dividends or invested in the firm o The larger the positive residual cash flow, the greater the value of a firm o Negative residual cash flow, over the long run, leads to bankruptcy or closing a business Copyright ©2018 John Wiley & Sons, Inc. 6 The Role of the Financial Manager (3 of 5) Exhibit 1.1 Cash Flows Between the Firm and Its Stakeholders and Owners (Stockholders) A. Making business decisions is all about cash flows, because only cash can be used to pay bills and buy new assets. Cash initially flows into the firm as a result of the sale of goods or services. These cash inflows are used in a number of ways: to pay wages and salaries, to buy supplies, to repay creditors, and to pay taxes. B. Any cash that is left over (residual cash flows) can be reinvested in the business or paid as dividends to stockholders. Copyright ©2018 John Wiley & Sons, Inc. 7 The Role of the Financial Manager (4 of 5) Three Fundamental Decisions in Financial Management o Capital Budgeting: identify which long-term assets to acquire to maximize net benefits for the firm o Financing: determine how to pay for short-term and long-term assets by finding the best combination of short-term debt, long-term debt, and equity o Working Capital: decide how to manage short-term resources and obligations by adjusting current assets and current liabilities to promote growth in cash flow Poor decisions about capital budgeting, financing, or working capital may lead to bankruptcy or business failure Copyright ©2018 John Wiley & Sons, Inc. 8 The Role of the Financial Manager (5 of 5) Exhibit 1.2 How the Financial Manager’s Decisions Affect the Balance Sheet Financial managers are concerned with three fundamental types of decisions: capital budgeting decisions, financing decisions, and working capital management decisions. Each type of decision has a direct and important effect on the firm’s balance sheet and, ultimately, the success or failure of the firm. Copyright ©2018 John Wiley & Sons, Inc. 9 Forms of Business Organization Sole proprietorships Partnerships Corporations Copyright ©2018 John Wiley & Sons, Inc. 10 Sole Proprietorship Owned by a single person who is financially responsible for the actions and obligations of the business Advantages o Easiest to create and control o Easiest to dissolve o Right to all profits Disadvantages o Owner’s personal assets at risk due to unlimited liability for firm obligations o Equity only from owner or business profit o Business income taxes as personal income o Difficult to transfer ownership Copyright ©2018 John Wiley & Sons, Inc. 11 Partnership A business owned by more than one person; one or more of them is financially responsible for the actions and obligations of the business Advantages o Limited protection of owner’s personal assets o Owner’s limited liability for firm obligations o More sources of equity o More sources of expertise Disadvantages o Shared control o Shared profit harder to dissolve Copyright ©2018 John Wiley & Sons, Inc. 12 Corporation A business owned by more than one person; none of them are financially responsible for the actions and obligations of the business. The corporation is responsible for its obligations and actions. Advantages o Protects personal assets o No shareholder liability for business o Easiest to change ownership o Greatest access to sources of funds Disadvantages o Most difficult and expensive to establish o Dilutes individual control over the firm o Overall higher taxes on income for shareholders Copyright ©2018 John Wiley & Sons, Inc. 13 Hybrid Forms of Business Organization (1 of 4) Limited Liability Partnerships (LLPs) Limited Liability Companies (LLCs) Both combine limited liability with tax advantages of a partnership Copyright ©2018 John Wiley & Sons, Inc. 14  Hybrid Forms of Business Organization (2 of 4) Exhibit 1.3 Characteristics of Different Forms of Business Organization Choosing the appropriate form of business organization is an important step in starting a business. This exhibit compares key characteristics of the most popular forms of business organization in the United States. Limited Liability Sole General Limited Partnership (L LP) Proprietorship Partnership Partnership S-Corporation C-Corporation or Company (LLC) Cost to establish Inexpensive More costly More costly More costly More costly More costly Life of entity Limited Flexible Flexible Indefinite Indefinite Flexible Control by Complete Shared Shared Depends on Depends on Shared founder over ownership ownership business decisions Access to capital Very limited Limited Less limited Less limited Excellent Less limited Copyright ©2018 John Wiley & Sons, Inc. 15 Hybrid Forms of Business Organization (3 of 4) Limited Liability Sole General Limited Partnership (L LP) Proprietorship Partnership Partnership S-Corporation C-Corporation or Company (LLC) Cost to transfer High High High High Can be low High ownership Separation of No No Yes Yes Yes Yes management and Investment Potential owner/ No No Some Potentially Potentially Some manager high high conflicts Ability to Limited Good Good Good Good Good provide incentives to attract and retain high-quality employees Copyright ©2018 John Wiley & Sons, Inc. 16 Hybrid Forms of Business Organization (4 of 4) Limited Liability Sole General Limited Partnership (L LP) Proprietorship Partnership Partnership S-Corporation C-Corporation or Company (LLC) Liability of Unlimited Unlimited Unlimited for Limited Limited Limited owners general partner Tax treatment Flow-through Flow-through Flow-through Flow-through Double tax As elected of income Tax Limited Limited Limited Limited Less limited Limited deductibility of owner benefits Copyright ©2018 John Wiley & Sons, Inc. 17 Managing the Financial Function (1 of 2) Organizational Structure o Chief Financial Officer (CFO), responsible for the quality of the financial reports received by the Chief Executive Officer (CEO) o Positions Reporting to the CFO Treasurer Risk Manager Controller Internal Auditor o External Auditor o Audit Committee o Compliance and Ethics Director Copyright ©2018 John Wiley & Sons, Inc. 18 Managing the Financial Function (2 of 2) Exhibit 1.4 Simplified Corporate Organization Chart The firm’s top finance and accounting executive is the C F O, who reports directly to the C E O. Positions that report directly to the C F O include the treasurer, risk manager, and controller. The internal auditor reports both to the C F O and to the audit committee of the board of directors. The external auditor and the compliance and ethics director also are ultimately responsible to the audit committee. Copyright ©2018 John Wiley & Sons, Inc. 19 The Goal of the Firm (1 of 2) Why not maximize market share? o Giving away goods or services for free will maximize a firm’s market share for a while, but the firm will not be able to pay its bills and stay in business Why not maximize profits? o Accounting profit differs from economic profit o Profit earned may not equal cash received Maximize the value of the firm’s stock o Future cash flows are considered o The timing of future cash flows is considered o The risks associated with having to wait to for cash flows are considered Management decisions affect cash flows and therefore stock prices Copyright ©2018 John Wiley & Sons, Inc. 20 The Goal of the Firm (2 of 2) Exhibit 1.5 Major Factors Affecting Stock Prices The firm’s stock price is affected by a number of factors, and management can control only some of them. Managers exercise little control over external conditions (blue boxes), such as the state of the general economy, although they can closely observe these conditions and make appropriate changes in strategy. Also managers make many other decisions that directly affect the firm’s expected cash flows (green boxes)—and hence the price of the firm’s stock. Copyright ©2018 John Wiley & Sons, Inc. 21 Agency Relationship An agency relationship is created when the owner (a principal) of a business hires an employee (an agent) The owner surrenders some control over the enterprise and its resources to the employee Separating ownership from control creates the potential for agency conflicts Copyright ©2018 John Wiley & Sons, Inc. 22 Agency Conflicts An agency relationship exists between stockholders (principals) and the firm’s hired management (agents) Ownership and Control o In large corporations, shared ownership among many shareholders may result in relatively little control over management o Shareholders own the corporation, but managers control the firm’s assets and may use them for their own benefit Copyright ©2018 John Wiley & Sons, Inc. 23 Agency Costs Agency Costs are costs that arise from incurring and preventing conflicts of interest between a firm’s owners and its managers These costs may reduce positive residual cash flow, stock price, and shareholder wealth Agency costs can be reduced by o Increased oversight o Aligning incentives Giving agents the right incentives to reduce agency costs o Managers tend to focus on wealth maximization when their compensation depends on stock price Copyright ©2018 John Wiley & Sons, Inc. 24 Aligning the Interests of Managers and Stockholders Board of Directors has oversight over the CEO and major capital decisions Managerial labor market provides incentives to run the company well Internal competition among managers Large stockholders also monitor managerial decisions Corporate raiders search for takeover targets Legal and regulatory constraints limit managerial behavior Copyright ©2018 John Wiley & Sons, Inc. 25 Sarbanes-Oxley and Regulatory Reform (1 of 5) Better corporate governance reduces agency costs by requiring o More effective monitoring of managers’ activities o Programs that promote appropriate behavior by managers o Penalties for executives who do not fulfill their fiduciary responsibilities Copyright ©2018 John Wiley & Sons, Inc. 26 Sarbanes-Oxley and Regulatory Reform (2 of 5) The new regulations require all public corporations to implement the following strategies: o Ensure greater board independence o Establish internal accounting controls o Establish compliance programs o Establish an ethics program o Expand the audit committee’s oversight powers Copyright ©2018 John Wiley & Sons, Inc. 27 Sarbanes-Oxley and Regulatory Reform (3 of 5) Exhibit 1.6 Corporate Governance Regulations Designed to Reduce Agency Costs These are regulatory requirements that are designed to reduce agency costs. The most important requirements resulted from the Sarbanes-Oxley Act, passed by Congress in 2002. The act was aimed at reducing agency costs, promoting ethical conduct, and improving the integrity of accounting reporting systems. Board of Directors Board has a fiduciary responsibility to represent the best interest of the firm’s owners. Majority of the board must be outside independent directors. Firm is required to have a code of ethics, which has to be approved by the board. Copyright ©2018 John Wiley & Sons, Inc. 28 Sarbanes-Oxley and Regulatory Reform (4 of 5) Firm must establish an ethics program that has a complaint hotline and a whistleblower protection provision that is approved by the board. Separation of chairperson and CEO positions is recommended. Board members can be fined or receive jail sentences if they fail to fulfill their fiduciary responsibilities. Audit Committee External auditor, internal auditor, and compliance and ethics director’s fiduciary (legal) responsibilities are to the audit committee. Audit committee approves the hiring, firing, and fees paid to external auditors. CEO and CFO must certify financial statements. All audit committee members must be outside independent directors. One member must be a financial expert. Copyright ©2018 John Wiley & Sons, Inc. 29 Sarbanes-Oxley and Regulatory Reform (5 of 5) External Auditor Lead partner must change every five years. There are limits on consulting (nonaudit) services that external auditors can provide. Sources: Sarbanes-Oxley Act, Public Accounting Reform and Investor Protection Act, and NYSE and NASDAQ new listing requirements. Copyright ©2018 John Wiley & Sons, Inc. 30 The Importance of Ethics in Business What are Ethics? o Ethics are society’s standards for judging whether an action is right or wrong o Business Ethics are society’s standards for acceptable behavior applied to business and financial markets Copyright ©2018 John Wiley & Sons, Inc. 31 Ethics in Corporate Finance (1 of 4) Examples of Ethical Conflict in Business o Agency Cost Employee’s unacceptable use of employer’s computer Conflict of Interest o Mortgage contract which a home-buyer is unlikely to fulfill but earns a mortgage broker more money– Information Asymmetry o Seller knows about prior damage to the vehicle but the potential buyer does not Copyright ©2018 John Wiley & Sons, Inc. 32 Ethics in Corporate Finance (2 of 4) Business Behavior o Regulation and market forces are not enough to maintain integrity in the marketplace o Business norms must be based on ethical beliefs, customs, and practices Ethical Behavior o It is sometimes difficult to judge whether behavior is ethical or not Was the manager too careful? Did the manager take too much risk? Consequences of Unethical Behavior o Inefficiency in the economy and costs to society o High legal and social costs o Problems such as the recent financial crisis in the U.S. Copyright ©2018 John Wiley & Sons, Inc. 33 Ethics in Corporate Finance (3 of 4) Exhibit 1.7 A Framework for the Analysis of Ethical Conflicts Dealing with ethical conflicts is an inescapable part of professional life for most people. An analytical framework can be helpful in understanding and resolving such conflicts. The first step toward ethical behavior is to recognize that you face a moral issue. In general, if your actions or decisions will cause harm to others, you are facing a moral issue. When you find yourself in this position, you might ask yourself the following questions: 1. What does the law require? When in doubt, consult the legal department. 2. What do your role-related obligations require? What is your station, and what are its duties? If you are a member of a profession, what does the code of conduct of your profession say you should do in these circumstances? 3. Are you an agent employed on behalf of another in these circumstances? If so, what are the interests and desires of the employing party? Copyright ©2018 John Wiley & Sons, Inc. 34 Ethics in Corporate Finance (4 of 4) 4. Are the interests of the stockholders materially affected? Your obligation is to represent the best interests of the firm’s owners. 5. Do you have a conflict of interest? Will full diclosure of the conflict be sufficient? If not, you must determine what interest has priority. 6. Are you abusing an information asymmetry? Is your use of the information asymmetry fair? It probably is fair if you would make the same decision if the roles of the parties were reversed or if you would publicly advocate the principle behind your decision. 7. Would you be willing to have your action and all the reasons that motivated it reported in the Wall Street Journal? Copyright ©2018 John Wiley & Sons, Inc. 35 Copyright Copyright © 2018 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein. Copyright ©2018 John Wiley & Sons, Inc. 36