gsb711 lecture note 01 introduction to managerial finance

Introduction to Managerial Finance

Topic 01GSB711 – Managerial Finance

Readings:From Corporate Finance Principles and Decision-Making:

Overview of Corporate Finance: Principles and Decision-Making (Pages 1 - 6)Chapter: Goals and Governance of the firm (Page 8 – 34)

Case Study: Ethics in Finance (Pages 36 – 51)

GSB711 Managerial Finance – Topic 01 Page No. 2

• What is managerial or corporate finance?• How is (managerial / corporate) finance different from

accounting? • What are different forms of business organization?

– Forms of business organization• What are the goals of corporate firms?

– Goals / objectives of corporate firms• What are the important financial decisions that are made in

corporate firms? – Financial decisions in a corporate firm

• What is agency cost and how does it impact financial decisions?

Important Issues


What is managerial finance?

• Managerial finance is commonly known as corporate finance

• It deals with the financing decisions made in any organization on a commercial basis

• Firms (or business entities) employ real assets and other resources to produce outputs (which may be products or services)

• Finance helps firms to acquire real assets and other factors of production. This is a very limited view of finance. In reality finance function is much broader in scope where financial managers are called upon to make important decisions that relate to (i) selection of important investments; (ii) ways in which businesses can secure necessary capital; (ii) structuring of capital into equity and debt and other sources; and (iv) payout of dividends or buyback of shares.


How is (managerial / corporate) finance different from accounting?

• Accounting provides an important function in that all use of resources are clearly accounted for as per agreed upon standards. Very often the financial reports that are produced as part of accounting are historical in nature.

• Finance on the other hand relies to a great extent on markets for all financial decisions. We will clarify this more in future topics. The most important financial statement that finance relies of the 3 is the cash flow statement as the other two statements – balance sheet and income statement suffer from historical bias and accounting judgements respectively.

• Finance is therefore completely different from accounting though we rely on financial statements for important financial decisions.


Before we examine financial decisions

• We try and distinguish different forms of business organization.

• Most of the financial decision that we will be dealing in this unit are equally applicable to all forms of business or non-business organizations as long as the objective of these organizations is to create sustainable value.

• Let us look at different forms of business organisations


Forms of business organization

• Individuals or families may organize their business in such a way where there is no separation of personal and business interests – We call this form as sole proprietorship

• Partnerships on the other hand involve more than one individual (one family). Again personal and business interests are not completely separated

• These two forms have existed from time unknown. • Corporate form of business organisations (or usually known

as firms / companies) are of relatively recent phenomenon where there is a strict legal separation of personal and business interest. Limited liability is a great distinguishing factor which makes it easy to transfer ownership from individual (or institution) to another


Sole Proprietorship

• Advantages– Easiest to start– Least regulated– Single owner keeps

all the profits– Taxed once as

personal income

• Disadvantages– Limited to life of

owner– Equity capital

limited to owner’s personal wealth

– Unlimited liability– Difficult to sell

ownership interest


Partnership

• Advantages– Two or more owners– More capital

available– Relatively easy to

start– Income taxed once

as personal income

• Disadvantages– Unlimited liability

• General partnership• Limited partnership

– Partnership dissolves when one partner dies or wishes to sell

– Difficult to transfer ownership


Corporation

• Advantages– Limited liability– Unlimited life– Separation of

ownership and management

– Transfer of ownership is easy

– Easier to raise capital

• Disadvantages– Separation of

ownership and management

– Double taxation (income taxed at the corporate rate and then dividends taxed at the personal rate)


We will focus more on corporations in the remainder of the unit

• Please note the principles or frameworks we learn in this unit have wide applications beyond corporate form of organization

• As long as we are clear about the objective of a specific organization we can easily tweak the frameworks to attain these objectives


Goals / objectives of corporate firms

What should be the goal of a corporation? It is important to recognize the changing paradigm in relation to the goals or objectives

of corporate firms. The traditional view is that corporations are ‘owned’ by shareholders and that corporate firms should pursue in maximizing the wealth of shareholders.

This view has been rightly questioned in the last 3 decades or so. Corporations (companies) have assumed great control of societal resources and are

therefore responsible for the entire society Shareholders obviously are important as they provide the necessary risk capital on a

perpetual basis. Employees are very important as their lives are intertwined with that of the business

and the sustainability of the business is important for them as their reputational capital and future entitlements are often dependent on the success of businesses.

Suppliers have relationships that are important for them Lenders are important as they provide risk capital with varying time commitments.

They also provide disciplinary benefits through their monitoring of business activities. Customers satisfaction is important and very often customers have future

commitments from firms. Governments provide the necessary legal and regulatory framework and as we have

seen in the recent global financial crisis (GFC) acted as the lender of last resort.


Goals / objectives of corporate firms

◦ While we are conscious of social responsibility considerations, for corporate firms to sustain themselves in the long run, they should enhance shareholder wealth

Does this mean we should do anything and everything to maximize owner wealth?Wealth maximization occurs when firms pursue policies

that sustain economic, social and environmental interests for the entire society

Often in the short-term, opportunities may exist to make economic profits by exploiting social and environmental resources, but pursuit of these would invariably lead to sub-optimal outcomes for stakeholders in the long run and this in turn affects value or wealth maximization.


Why traditional corporate financial theory often focuses on maximizing

stock prices as opposed to firm value

• Stock price is easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently).

• If investors are rational (are they?), stock prices reflect the wisdom of decisions, short term and long term, instantaneously.

• The stock price is a real measure of stockholder wealth, since shareholders can sell their stock and receive the price now.


Maximize stock prices as the only objective function

• For stock price maximization to be the only objective in decision making, we have to assume that– The decision makers (managers) are responsive to the

owners (shareholders) of the firm– Stockholder wealth is not being increased at the

expense of bondholders and lenders to the firm; only then is stockholder wealth maximization consistent with firm value maximization.

– Markets are efficient; only then will stock prices reflect stockholder wealth.

– There are no significant social costs; only then will firms maximizing value be consistent with the welfare of all of society.


The Classical Objective Function

SHAREHOLDERS

Maximizestockholder wealth

Hire & firemanagers- Board- Annual Meeting

BONDHOLDERSLend Money

ProtectbondholderInterests

FINANCIAL MARKETS

SOCIETYManagers

Revealinformationhonestly andon time

Markets areefficient andassess effect onvalue

No Social Costs

Costs can betraced to firm


Another Way of Presenting this is...

Stockholders hire managers to run their firms for them

Managers set aside their interests and maximize stock prices

Stockholder wealth is maximized

Firm Value is maximized

Societal wealth is maximized

Because stockholders have absolute power to hire and fire managers

Because markets are efficient

Because lenders are fully protected from stockholder actions

Because there are no costs created for society

Why Stock Price Maximization Works


Financial decisions in a corporate firm

• Four major long-term decisions– Investment decision– Financing decision– Capital structure decision– Dividend decision

• Short-term financial decisions– Working capital management

• Receivables• Payables • Cash• Inventory


The Traditional Accounting Balance Sheet

Assets Liabilities

Fixed Assets

Debt

Equity

Short-term liabilities of the firm

Intangible Assets

Long Lived Real Assets

Assets which are not physical,like patents & trademarks

Current Assets

Financial InvestmentsInvestments in securities &assets of other firms

Short-lived Assets

Equity investment in firm

Debt obligations of firm

Current Liabilties

Other Liabilities Other long-term obligations

The Balance Sheet


The Financial View of the Firm

Assets Liabilities

Assets in Place Debt

Equity

Fixed Claim on cash flowsLittle or No role in managementFixed MaturityTax Deductible

Residual Claim on cash flowsSignificant Role in managementPerpetual Lives

Growth Assets

Existing InvestmentsGenerate cashflows todayIncludes long lived (fixed) and

short-lived(working capital) assets

Expected Value that will be created by future investments


Financial

Manager

Firm's

operations Investors

(1) Cash raised from investors

(1)

(2) Cash invested in firm

(2)

(3) Cash generated by operations

(3)

(4a) Cash reinvested

(4a)

(4b) Cash returned to investors

(4b)

The Role of The Financial Manager

Real assets

Investment assets


The Role of The Financial Manager

• Real Assets– Assets used to produce goods and services.

• Financial Assets– Financial claims to the income generated by the firm’s

real assets.


Who is The Financial Manager?

Chief Financial Officer

Treasurer Controller


Who is The Financial Manager?

Chief Financial Officer (CFO)◦ Oversees the treasurer and controller and sets overall

financial strategy.Treasurer

◦ Responsible for financing, cash management, and relationships with banks and other financial institutions.

Controller◦ Responsible for budgeting, accounting, and taxes.


First Principles of Corporate / Managerial Finance

• Invest in projects that yield a return greater than the minimum acceptable hurdle rate.– The hurdle rate should be higher for riskier projects and reflect the

financing mix used - owners’ funds (equity) or borrowed money (debt)– Returns on projects should be measured based on cash flows

generated and the timing of these cash flows; they should also consider both positive and negative side effects of these projects.

• Choose a financing mix that minimizes the hurdle rate and matches the assets being financed.

• If there are not enough investments that earn the hurdle rate, return the cash to shareholders.– The form of returns - dividends and stock buybacks - will depend upon

the shareholders’ characteristics.– Objective: Maximize the Value of the Firm


Some important questions that are answered using finance

– What long-term investments should the firm take on?– Where will we get the long-term financing to pay for the

investment?– How much debt a firm needs to employ?– How much dividend to pay to shareholders or how much

stock to buyback?– How will we manage the everyday financial activities of

the firm?


Agency cost

• Agency relationship– Principal hires an agent to represent his/her interest– shareholders (principals) hire managers (agents) to run

the company


The Agency Cost Problem• The interests of managers, shareholders, bondholders and

society can diverge. What is good for one group may not necessarily for another.– Managers may have other interests (job security, perks,

compensation) that they put over stockholder wealth maximization.

– Actions that make shareholders better off (increasing dividends, investing in risky projects) may make bondholders worse off.

– Actions that increase stock price may not necessarily increase stockholder wealth, if markets are not efficient or information is imperfect.

– Actions that makes firms better off may create such large social costs that they make society worse off.

• Agency costs refer to the conflicts of interest that arise between all of these different groups.


What can go wrong?SHAREHOLDERS

Managers puttheir interestsabove shareholders

Have little controlover managers

BONDHOLDERSLend Money

Bondholders canget ripped off

FINANCIAL MARKETS

SOCIETYManagers

Delay badnews or provide misleadinginformation

Markets makemistakes andcan over react

Significant Social Costs

Some costs cannot betraced to firm


I. Stockholder Interests vs. Management Interests

• Theory: The shareholders have significant control over management. The mechanisms for disciplining management are the annual meeting and the board of directors.

• Practice: Neither mechanism is as effective in disciplining management as theory posits.


The Annual Meeting as a disciplinary venue

• The power of shareholders to act at annual meetings is diluted by three factors – Most small shareholders do not go to meetings because

the cost of going to the meeting exceeds the value of their holdings.

– Incumbent management starts off with a clear advantage when it comes to the exercising of proxies. Proxies that are not voted becomes votes for incumbent management.

– For large shareholders, the path of least resistance, when confronted by managers that they do not like, is to vote with their feet.


Directors lack the expertise to ask the necessary tough questions..

• The CEO sets the agenda, chairs the meeting and controls the information.

• The search for consensus overwhelms any attempts at confrontation.


II. Shareholders' objectives vs. Bondholders' objectives

In theory: there is no conflict of interests between shareholders and bondholders.

In practice: shareholders may maximize their wealth at the expense of bondholders.◦ Increasing dividends significantly: When firms pay cash out as

dividends, lenders to the firm are hurt and shareholders may be helped. This is because the firm becomes riskier without the cash.

◦ Taking riskier projects than those agreed to at the outset: Lenders base interest rates on their perceptions of how risky a firm’s investments are. If shareholders then take on riskier investments, lenders will be hurt.

◦ Borrowing more on the same assets: If lenders do not protect themselves, a firm can borrow more money and make all existing lenders worse off.


Aligning interests

• Managerial compensation– Incentives can be used to align management and

stockholder interests– The incentives need to be structured carefully to make

sure that they achieve their goal• Corporate control

– The threat of a takeover may result in better management

• Other stakeholders


Some important questions

• What are the types of financial management decisions and what questions are they designed to answer?

• What are the three major forms of business organization?

• What is the goal of financial management?• What are agency problems and why do

they exist within a corporation?

gsb711 lecture note 01 introduction to managerial finance

Documents

corporate finance principles

overview of corporate

goals of corporate firms

important financial

corporate firmwhat

corporate rate

finance pages

business interests