titman 01 overview

8/13/2019 Titman 01 Overview

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1.1 FINANCE:AN OVERVIEW


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What is Finance?

Finance is the study of how people andbusinesses evaluate investments and raisecapital to fund them.


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Three Questions Addressed by theStudy of Finance:

1. What long-term investments should thefirm undertake? (capital budgetingdecisions)

2. How should the firm fund theseinvestments? (capital structure decisions)

3. How can the firm best manage its cashflows as they arise in its day-to-dayoperations? (working capital managementdecisions)


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Why Study Finance?

Knowledge of financial tools is critical tomaking good decisions in both professionalworld and personal lives.

Finance is an integral part of corporateworld

How will GMs strategic decision to invest $740million to produce the Chevy Volt require theexpertise of different disciplines within thebusiness school such as marketing,management, accounting, operationsmanagement, and finance?


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Why Study Finance? (cont.)

Many personal decisions require financialknowledge (for example: buying a house,planning for retirement, leasing a car)


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1.2 THREE TYPESOF BUSINESSORGANIZATIONS


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FINC-301, Chapter 1, Russel

Business Organizational Forms

BusinessForms

Sole

Proprietorships

Partnerships

Corporations Hybrids


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Sole Proprietorship

It is a business owned by a single individualthat is entitled to all the firms profits and isresponsible for all the firms debt.

There is no separation between the businessand the owner when it comes to debts orbeing sued.

Sole proprietorships are generally financed bypersonal loans from family and friends andbusiness loans from banks.


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Sole Proprietorship (cont.)

Advantages: Easy to start No need to consult others while making decisions Taxed at the personal tax rate

Disadvantages: Personally liable for the business debts Ceases on the death of the propreitor


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Partnership

A general partnership is an associationof two or more persons who come togetheras co-owners for the purpose of operating

a business for profit.

There is no separation between thepartnership and the owners with respect todebts or being sued.


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Partnership (cont.)

Advantages: Relatively easy to start

Taxed at the personal tax rate

Access to funds from multiple sources or partners

Disadvantages: Partners jointly share unlimited liability


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Partnership (cont.)

In limited partnerships, there are twoclasses of partners: general and limited.

The general partners runs the business

and face unlimited liability for the firmsdebts, while the limited partners areonly liable on the amount invested.

One of the drawback of this form is that

it is difficult to transfer the ownership ofthe general partner.


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Corporation

Corporation is an artificial being, invisible,intangible, and existing only in thecontemplation of the law.


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Corporation (cont.)

Corporation can individually sue and besued, purchase, sell or own property, andits personnel are subject to criminal

punishment for crimes committed in thename of the corporation.


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Corporation (cont.)

Corporation is legally owned by its currentstockholders.

The Board of directors are elected by thefirms shareholders. One responsibility ofthe board of directors is to appoint thesenior management of the firm.


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Corporation (cont.)

Advantages

Liability of owners limited to invested funds

Life of corporation is not tied to the owner

Easier to transfer ownership Easier to raise Capital

Disadvantages

Greater regulation

Double taxation of dividends


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Hybrid Organizations

These organizational forms provide a crossbetween a partnership and a corporation.

Limited liability company (LLC)

combines the tax benefits of a partnership(no double taxation of earnings) andlimited liability benefit of corporation (theowners liability is limited to what they

invest).


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Hybrid Organizations (cont.)

S-type corporation provides limitedliability while allowing the business ownersto be taxed as if they were a partnership

that is, distributions back to the ownersare not taxed twice as is the case withdividends in the standard corporate form.


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How Does Finance Fit into the Firms

Organizational Structure?

In a corporation, the Chief Financial Officer(CFO) is responsible for managing thefirms financial affairs.

Figure 1-2 shows how the finance functionfits into a firms organizational chart.


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1.3 THE GOAL OFTHE FINANCIAL

MANAGER


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The Goal of the Financial Manager

The goal of the financial manager must beconsistent with the mission of thecorporation.

What is the generally accepted mission ofa corporation?


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Corporate Mission

To maximize firm value shareholders

wealth (as measured by share prices)


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Agency Considerations in CorporateFinance

Agency relationship exists when one ormore persons (known as the principal)contracts with one or more persons (the

agent) to make decisions on their behalf.

In a corporation, the managers are theagents and the stockholders are theprincipal.


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Agency Considerations in CorporateFinance (cont.)

Agency problems arise when there is conflict ofinterest between the stockholders and themanagers. Such problems are likely to arise morewhen the managers have little or no ownership in

the firm. Examples:

Not pursuing risky project for fear of losing jobs, stealing,expensive perks.

All else equal, agency problems will reduce the firmvalue.


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How to Reduce Agency Problems?

1. Monitoring

(Examples: Reports, Meetings, Auditors, board ofdirectors, financial markets, bankers, credit agencies)

2. Compensation plans

(Examples: Performance based bonus, salary, stockoptions, benefits)

3. Others

(Examples: Threat of being fired, Threat of takeovers,Stock market, regulations such as SOX)

The above will help to reduce agencyproblems/costs.


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1.4 THE FOURBASIC PRINCIPLES

OF FINANCE


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PRINCIPLE 1: Money Has a TimeValue.

A dollar received today is more valuablethan a dollar received in the future.

We can invest the dollar received today to earn

interest. Thus, in the future, you will havemore than one dollar, as you will receive theinterest on your investment plus your initialinvested dollar.


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PRINCIPLE 2: There is a Risk-ReturnTrade-off.

We only take risk when we expect to becompensated for the extra risk withadditional return.

Higher the risk, higher will be the expectedreturn.


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PRINCIPLE 3: Cash Flows Are TheSource of Value.

Profit is an accounting concept designed tomeasure a businesss performance over aninterval of time.

Cash flow is the amount of cash that canactually be taken out of the business overthis same interval.


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PRINCIPLE 4: Market Prices ReflectInformation.

Investors respond to new information by buyingand selling their investments.

The speed with which investors act and the waythat prices respond to new informationdetermines the efficiency of the market. Inefficient markets like United States, this processoccurs very quickly. As a result, it is hard to profit

from trading investments on publicly releasedinformation.


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PRINCIPLE 4: Market Prices ReflectInformation. (cont.)

Investors in capital markets will tend toreact positively to good decisions made bythe firm resulting in higher stock prices.

Stock prices will tend to decrease whenthere is bad information released on thefirm in the capital market.


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Reference:

Financial Management:Principles and ApplicationsBy Titman, Keown and Martin

titman 01 overview

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