CONTEMPORARY FINANCIAL MANAGEMENT

Chapter 1:

The Role and Objective of

Financial Management

INTRODUCTION

This chapter introduces the financial management process. It looks at the financial manager, the field of finance, financial decisions and their implications, and the daily questions faced by the firm’s financial management.

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QUESTIONS FACED IN FINANCE How is finance related to other fields of study?

What are financial managers’ goals and objectives?

How has the finance field evolved?

How is the finance field changing today?

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FORMS OF BUSINESS ORGANIZATIONS Sole proprietorship

Partnership

Corporation

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SOLE PROPRIETORSHIP

Owned by one person

Represent 75% of all businesses, but accounts for less than 5% of dollar volume.

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Advantages Disadvantages

Easy Formation Unlimited Liability

Difficult to Raise Funds

SMALL BUSINESS

Not the dominant firm in the industry

Tend to grow more rapidly

Lack management resources

Have a high failure rate

Shares not publicly traded

Poorly diversified

Owner/manager frequently the same6

PARTNERSHIP

Owned by two or more persons

Classified as general or limited

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Advantages Disadvantages

Easy Formation Difficult to Raise Funds

Partnership Dissolves if Partner Dies

Taxation occurs at the level of the partner, not

the partnership

LIABILITY OF PARTNERS

General PartnerHas unlimited liability for all obligations of the business

Limited PartnerLiability limited to the partnership agreement

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LIMITED PARTNERSHIPS

Must have at least one general partner who: Has unlimited liability Performs all management functions

Can have many limited partners who: Have limited liability Cannot participate in management

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CORPORATION

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A distinct, legal entity of its own

Advantages Disadvantages

Limited Liability

Permanency

Ability to Raise Capital

Potential for Double Taxation

Some Owners HaveMinimal Control

BOARD OF DIRECTORS Shareholders elect a Board of Directors

Board of Directors appoints the officers of the company:

Chairman of the board Chief executive officer (CEO) Chief operating officer (COO) President Chief financial officer (CFO) Vice president Treasurer Secretary

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WHO MANAGES?

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Board of Directors

Deals with broad policy

Develops 3-5 year strategic plan

Management

Responsible for implementing strategic plan

Makes day-to-day management decisions

SHAREHOLDER RIGHTS

Right to share in company profits (or losses)

Right to vote Some shares may be non-voting Some shares may carry multiple votes

Right to share in the residual assets at dissolution

Right to acquire new common stock (preemptive right)

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PRIORITY OF CORPORATE SECURITIES

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Bonds: Debt securities often backed by the corporation’s assets.

Preferred Stock: non-voting shares that often offer a fixed dividend to shareholders.

Common Stock

Priority

TYPE OF ORGANIZATION INFLUENCED BY

Cost

Complexity

Liability

Continuity

Need for capital

Decision making

Tax considerations 15

SHAREHOLDER WEALTH MAXIMIZATION

Core objective of financial managers.

Considers the timing and risk of the benefits from stock

ownership

Determines that a good decision increases the price of

the firm’s common stock (C/S)

Is an impersonal objective

Is concerned for social responsibility16

SOCIAL RESPONSIBILITY

Ethical issues will constantly confront financial managers as they strive to achieve the goal of Shareholder Wealth Maximization

Managers must: Avoid personal conflicts of interest Maintain confidentiality Be objective Act fairly

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AGENCY RELATIONSHIPS/PROBLEMS

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OwnersOwners ManagersEmployeesManagersEmployees

Management may attempt to maximizeits own welfare instead of the owners’ wealth.

Management may attempt to maximizeits own welfare instead of the owners’ wealth.

Caused by separation of

principals

Caused by separation of

principals

JOB SECURITY Management’s decisions may be based on retaining

management, rather than Shareholder Wealth Maximization

Example: A decision is made to retain an existing supplier rather than select a

new supplier providing higher quality and/or lower cost

Why? If a change is made management will be scrutinized, but if no change is made, the issue will be ignored.

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AGENCY COSTS Costs incurred by shareholders to minimize agency problems

Examples: Management incentives Monitor performance Owners protection Complex organization structures

Recent Trend: flatter organizational structures have emerged to reduce costs.

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ANOTHER AGENCY PROBLEM

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OwnersOwners CreditorsCreditorsCaused by separation ofCaused by

separation of

Solution:Creditors insert protective covenants in

loan agreements

Solution:Creditors insert protective covenants in

loan agreements

EXAMPLES OF PROTECTIVE COVENANTS

Limitations on

Dividends Capital expenditures Asset divestitures Incurring additional debt Poison pills

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SWM AND PROFIT MAXIMIZATION

Shareholder Wealth Maximization is not the same as Profit Maximization

Reasons: Profit maximization has no time dimension Profit is an accounting concept with many different

interpretations Profit maximization ignores risk

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MAXIMIZING SHAREHOLDER WEALTH

To maximize shareholder wealth, the financial manager must maximize the market value of the firm’s common stock

Three factors determine the market value of common stock: Size of the firm’s cash flow Timing of the firm’s cash flow Risk of the firm’s cash flow stream

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CONDITIONS AFFECTING MARKET VALUE

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Conditions in Financial

Markets

Factors outside of management’s control

Amount, Timing & Size of Expected Cash Flows

Shareholder Wealth (Market Price of the Shares)

Factors within management’s control

CASH FLOW

Cash flows, not accounting profits, are critical to most financial analysis

Important cash flow concepts: Timing of cash inflows versus cash outflows Cash flow is not equal to operating profit.

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CONCEPT OF NET PRESENT VALUE The net present value (NPV) of an investment represents the

contribution of the investment to the value of the firm

To maximize shareholder wealth, reject all projects with a negative NPV

NPV = PV of cash inflows - PV of cash outflows

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NPV EXAMPLE

A firm is analyzing a new investment opportunity. It can invest $1 million today to generate free cash flows of $400,000 per year for the next three years. After three years, the project is worthless. The firm’s shareholders require a 20% return. Should they proceed?

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NPV EXAMPLE: INTUITION

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0 321

$1 M $400K $400K $400K

Solution is calculated by discount each of the cash flows back to time period zero using a

discount rate of 20%.

NPV EXAMPLE: SOLUTION

( ) ( )

( )

÷ ÷ ÷ ÷ ÷ ÷

-t -t

Inflows Outflows

-3

NPV=PVCashInflows-PVCashOutflows

1- 1+r 1- 1+r=PMT -PMT

r r

1- 1.20=400,000 -1,000,000

0.20

=$842,5923

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NPV Decision:

Reject the project. Accepting the project will destroy significant shareholder value

MAJOR POINTS

Businesses may be established as proprietorships, partnerships or corporations.

Shareholders are entitled to a number of rights as owners of a corporation.

The separation between shareholders, managers and creditors give rise to agency problems which detract from a firm’s goal of shareholder wealth maximization.

Positive NPV projects enhance shareholder wealth.31