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Fundamentals of Corporate Finance Chapter 1: Corporate Finance & The Financial Manager
Lecture Contents Introduction Key concepts in corporate finance The role of the financial manager Corporate objectives How is shareholder wealth maximised? Agency theory Financial Markets Conclusion Key Terms
Introduction • I’m saving for retirement. Should I use a • bank CD, mutual fund, direct stock market investment? • I want that new car. Should I use • saved cash, lease, borrow? • I’m thinking about starting a new business • will it reward me adequately? • The company is looking to expand into telecommunications. • how should you advise the CFO? • A Latin American country has asked for major project financing • should my organization provide the funds?
What is Finance? • Finance is concerned with decisions about money • Finance decisions deal with how money is raised and used • Finance is the study of how people and businesses evaluate investments and raise capital to fund them
Three Questions Addressed by the Study of Finance: 1. What long-term investments should the firm undertake? (capital budgeting decisions) • What is the optimal firm size? • What specific assets should be acquired? • What assets (if any) should be reduced or eliminated? 2. How should the firm fund these investments? (financing decisions) • What is the best type of financing? • What is the best financing mix? • How will the funds be physically acquired? 3. How can the firm best manage its cash flows as they arise in its day-to-day operations? (working capital management decisions) Who should we sell to on credit; How much inventory should we carry; When should we pay our suppliers
Real World Examples on Financial Decisions
Financial Decisions more. . . • Dell computer expands its product line. • Gap builds additional stores. • Nike closes a production plant in Asia. • Ford borrows $3 billion. • Perot Systems issues stock valued at $3 billion.
How Financial Manager’s Decisions Affect the Balance Sheet?
Financial events affecting investors: • Nike stock declines 5% after a financial crisis occurs in Asia. • Microsoft stock declines after the court rules against the company in an antitrust case. • Lotus stock rises by 50% on news it is being acquired by IBM.
Financial events resulting from government actions: • Yields on bonds decline to Central Bank decisions. in response • Interest rates rise in response to inflationary fears. • The TRY declines as Turkish investors invest more money abroad.
So Finance & Financial Management Concerns acquisition, financing, and management of assets with some overall goal in mind.
Financial Manager • Financial managers try to answer some or all of these questions • The top financial manager within a firm is usually the Chief Financial Officer (CFO) • Treasurer – oversees cash management, credit management, capital expenditures, and financial planning • Controller – oversees taxes, cost accounting, financial accounting and data processing
Financial Manager. CFO
Cash flow between Financial Markets & Firm’s Operations (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4 a) Cash reinvested
Goal of Management Financial • What should be the goal of a corporation? • Maximize profit? • Minimize costs? • Maximize market share? • Maximize the current value of the company’s stock?
Goal of Management Financial • What should a financial manager try to maximize? • Maximizing profit? • Earnings reflect past performance, rather than current or future performance. • Ignores the timing of the profits. • Ignores cash flows. • Ignores risk.
Goal of Management Financial • What should a financial manager try to maximize? • Maximize shareholder wealth? • As measured by the market price of the firm’s stock. • A firm’s stock price reflects the timing, magnitude, and risk of the cash flows that investors expect a firm to generate over time. • Shareholders are the residual claimants of a firm.
Maximize shareholder wealth • Takes account of: current and future profits and EPS; the timing, duration, and risk of profits and EPS; dividend policy; and all other relevant factors. • Thus, share price serves as a barometer for business performance.
What Goals do some Firms have? • Associated Banc-Corp, “Creating superior shareholder value is our top priority. ” 2006 Annual Report. • Phillips, “The desire to increase shareholder value is what drives our actions. ” 2006 Annual Report. • “Fed. Ex’s main responsibility is to create shareholder value. ” Fed. Ex Corporation, SEC Form Def 14 A for the period ending 9/25/2006. • Pirelli & C. S. p. A. Milan “… the Board of Directors plays a central role in the Company’s corporate governance system; it has the power (and the duty) to direct Company business, pursuing and fulfilling its primary and ultimate objective of creating shareholder value. ” Annual Report 2006.
Goal of Financial Management Share Price Changes (during last five years as of July 5, 2019) • Google: Share price increased by nearly $530 or around 93% (from around $570 to $1, 100) wealth created. • Ford: Share price decreased by nearly $8 or around 70% (from around $17, 41 to $10, 26) wealth destroyed.
The Agency Problem • Agency relationship exists when one or more 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 the agents and the stockholders are the principal.
The Agency Problem • Agency problems arise when there is conflict of interest between the stockholders and the managers. Such problems are likely to arise more when 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 firm value.
How to Reduce Agency Problems? 1. Monitoring (Examples: Reports, Meetings, Auditors, board of directors, financial markets, bankers, credit agencies) 2. Compensation plans (Examples: Performance based bonus, salary, stock options, benefits) 3. Others (Examples: Threat of being fired, Threat of takeovers, Stock market, regulations such as SOX) The above will help to reduce agency problems/costs.
Financial Environment • Businesses interact continually with the financial markets. • Financial Markets are composed of all institutions and procedures for bringing buyers and sellers of financial instruments together. • The purpose of financial markets is to efficiently allocate savings to ultimate users.
Financial Markets • Financial assets, issued by corporations to raise money, are bought by investors in financial markets • A framework or organization in which people can buy/sell securities • Best known financial market is the stock market • Stock exchange (#NYSE) • Stockbroker is licensed to trade securities
Financial Assets • Real asset — an object that provides a service, such as a house, car, art, coin… • Financial asset — a document representing a claim to future income • Stock represents ownership interest • Bond represents a debt relationship • Investing involves buying financial assets in the hope of earning more money (a return) • Investments can be made directly or indirectly through a mutual fund • A Security is a financial asset that can be traded among investors
The Firm as an Investment Vehicle
Four Basic Principles of Finance üMoney Has a Time Value üThere is a Risk-Return Trade-off üCash Flows Are The Source of Value üMarket Prices Reflect Information
Key Terms • Agency problem • Capital budgeting • Opportunity cost • Capital structure • Corporation • Debt • Equity • Financial market • Shareholder • Shares • Stockholders • Working capital management
Work the Web Example • The Internet provides a wealth of information about individual companies • One excellent site is finance. yahoo. com • Click on the web surfer to go to the site, choose a company and see what information you can find!
Selected End of Chapter Questions-8/9 8 -What is the most important type of decision that the financial manager makes? The investment decision is the most important decision that a financial manager makes, as the manager must decide how to put the owners’ money to its best use. 9 -Why do all shareholders agree on the same goal for the financial manager? The goal of maximizing shareholder wealth is agreed upon by all shareholders because all shareholders are better off when this goal is achieved.
Selected End of Chapter Questions-10 10 -Corporate managers work for the owners of the corporation. Consequently, they should make decisions that are in the interests of the owners, rather than in their own interests. What strategies are available to shareholders to help ensure that managers are motivated to act this way? Shareholders can a. Ensure that employees are paid with company stock and/or stock options. b. Ensure that underperforming managers are fired. c. Write contracts that ensure that the interests of the managers and shareholders are closely aligned. d. Mount hostile takeovers.
Selected End of Chapter Questions-11 11 -Recall the last time you ate at an expensive restaurant where you paid the bill. Now think about the last time you ate at a similar restaurant, but your parents paid the bill. Did you order more food (or more expensive food) when your parents paid? Explain how this relates to the agency problem in corporations. When your parents pay for the meal, you benefit from the food but do not take on the cost of the food. This is similar to the agency problem in corporations, when managers can benefit from taking actions in their own personal interests using money that belongs to shareholders.
Selected End of Chapter Questions-13 13 -You are the CEO of a company and you are considering entering into an agreement to have your company buy another company. You think the price might be too high, but you will be the CEO of the combined, much larger company. You know that when the company gets bigger, your pay and prestige will increase. What is the nature of the agency conflict here and how is it related to ethical considerations? There is an ethical dilemma when the CEO of a firm has opposite incentives to those of the shareholders. In this case, you (as the CEO) potentially have an incentive to overpay for another company (which would be damaging to your shareholders) because your pay and prestige will improve.
Selected End of Chapter Questions 14/15 14 -What is the difference between a public and a private corporation? The shares of a public corporation are traded on an exchange (or “over the counter” in an electronic trading system), while the shares of a private corporation are not traded on a public exchange. 15 -What is the difference between a primary and a secondary market? A primary market is where the company sells shares of itself to investors. The secondary market is where investors can buy and/or sell the company’s shares with other investors (but not the company itself).
Selected End of Chapter Questions-18/19/20 (new edition) 18 -How are limit orders and market orders different? A limit order specifies a price at which you are willing to buy or sell. It will be executed when there is demand or supply at that price. A market order is executed immediately at the best outstanding limit order. For example, a market buy order will be immediately executed against the best limit ask price. 19 -Explain why the bid-ask spread is a transaction cost. Investors always buy at the ask and sell at the bid. Because ask prices always exceed bid prices, investors “lose” this difference. It is one of the costs of transacting. Because the market makers take the other side of the trade, they make up this difference. 20 -What are the tradeoffs in using a dark pool? Using a dark pool allows traders not to reveal their intentions because limit order books are not visible. In addition, using a dark pool allows traders to potentially trade at a better price. However, dark pools sacrifice the guarantee of immediacy because an order may not be filled.
Selected End of Chapter Questions-17 17 -The following quote on Twitter stock appeared on July 13, 2019, on Yahoo! Finance: If you wanted to buy Twitter!, what price would you pay per share? How much would you receive per share if you wanted to sell Twitter!? You would need to pay the ask price to buy Twitter! That price is $37. 84 per share. If you sold, you would receive the bid price: $37. 76 per share.
Selected End of Chapter Questions 18/21 18 -What is the financial cycle? The financial cycle describes how money flows from savers to companies and back. In the financial cycle, (1) people invest and save their money; (2) that money, through loans and stock, flows to companies that use it to fund growth through new products, generating profits and wages; and (3) the money then flows back to the savers and investors. 21 -What are some of the similarities and differences among mutual funds, pension funds, and hedge funds? Mutual, pension, and hedge funds all pool together money and invest it on behalf of the investors in the fund. They differ in terms of who invests in the fund and what the primary objective is. Mutual and pension funds are most similar except that pension funds are investing retirement savings invested through the workplace with the objective of providing retirement income for those employees. Hedge funds are only open to investments by wealthy individuals and endowments. They invest across all asset categories, usually seeking low-risk investment strategies that will generate high returns.
Selected End of Chapter Questions-8
Selected End of Chapter Questions-8