Chapter 1 Introduction to Financial Management Importance of

Chapter 1 Introduction to Financial Management • Importance of finance • Forms of business organizations • Intrinsic values, stock prices, and executive compensation • Business ethics • Conflicts between managers, stockholders, and bondholders Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 1

What is Finance Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 2

Areas of Finance § Corporate finance: § what assets to acquire § How to raise capital § How to run the firm to maximize value. § Capital Markets: § Relate to markets where stock and bond prices are determined. § Financial institutions. § Investments: § § Security analysis Portfolio theory Market Analysis Behavioral Finance § They are closely interconnected Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 3

Forms of Business Organization 1. Proprietorship 2. Partnership 3. Corporation 4. Limited liability companies (LLC or LLP) Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 4

Proprietorships and Partnerships § Proprietorship: An unincorporated business owned by one individual. § Partnership: An unincorporated business owned by two or more persons. § Advantages § Ease of formation § Subject to few regulations § No corporate income taxes § Disadvantages § Difficult to raise capital § Unlimited liability § Limited life Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 5

Corporation § Corporation: a legal entity created by a state, and it is separate and distinct from its owners and managers. § Advantages § § Unlimited life Easy transfer of ownership Limited liability Ease of raising capital § Disadvantages § Double taxation § Cost of setup and report filing Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 6

Limited liability companies (LLC or LLP) § Limited liability companies: a relatively new type of organization that is a hybrid between a partnership and a corporation. § They have limited liability like corporations but are taxed like partnerships. Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 7

Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 8

Why most successful businesses organize as a corporation? § Limited liability reduces the risks faced by investors § Easier to attract capital § The liquidity of the corporations’ stocks Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 9

What is a stock Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 10

Stock Prices and Shareholder Value § The primary financial goal of management is to. . maximize shareholder wealth, which translates to maximizing stock price. § How can management affect stock price? Through their investment decisions which change expectations of the firm’s future § Is maximizing shareholder value inconsistent with being socially responsible Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 11

Determinants of Intrinsic Values and Stock Prices Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 12

Stock Prices and Intrinsic Value § In equilibrium, a stock’s price should equal its “true” or intrinsic value. § Intrinsic value is a long-run concept. § To the extent that investor perceptions are incorrect, a stock’s price in the short run may deviate from its intrinsic value. § Ideally, managers should avoid actions that reduce intrinsic value, even if those decisions increase the stock price in the short run. Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 13

Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 14

§ Should managers maximize the stock price then or the intrinsic value? § Should managers help investors improve their estimate’s of the firm’s intrinsic value? Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 15

Some Important Business Trends § Increased globalization of business § Improvement in information technology § More data and better decisions § Corporate Governance Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 16

Conflicts Between Managers and Stockholders § Managers are naturally inclined to act in their own best interests (which are not always the same as the interest of stockholders). Disney’s former president severance package of $140 million after 14 months on the job Disney’s former CEO pay of $575 million Tyco’s CEO’s $1 million birthday party for his wife § But the following factors affect managerial behavior: § § Managerial compensation packages Direct intervention by shareholders The threat of firing The threat of takeover Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 17

Conflicts Between Stockholders and Bondholders § Stockholders are more likely to prefer riskier projects, because they receive more of the upside if the project succeeds. By contrast, bondholders receive fixed payments and are more interested in limiting risk. § Bondholders are particularly concerned about the use of additional debt. § Bondholders attempt to protect themselves by including covenants in bond agreements that limit the use of additional debt and constrain managers’ actions. Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 18

What did we talk about Dr. Mohammad Alkhamis Kuwait University - College of Business Administration 19