CHAPTER 1 An Overview of Financial Management Finance VS Economics & Accounting Responsibility of CFO Three areas of Finance Goal of Corporations Intrinsic Value and Stock Price Agency Relationships

Finance VS Economics & Accounting Finance can be defined as the science and art of managing money. Finance grew out of Economics and Accounting Economics suggested that assets value is based on it’s ability to generate cash now and in the future. (cost-benefit analysis) Accountants provide information regarding the likely size of those cash flows.(accrual vs. cash, decision making)

Career Opportunities in Finance Money and capital markets (e.g. Banks, insurance companies, mutual funds) Investments (e.g. Brokerage House) Financial management

Finance Within the Organization Board of Directors Chief Executive Officer (CEO) Chief Operating Officer (COO) Marketing, Production, Human Resources, and Other Operating Departments Chief Financial Officer (CFO) Accounting, Treasury, Credit, Legal, Capital Budgeting, and Investor Relations

Responsibility of the Financial Staff Maximizing Shareholders’ Wealth by: Forecasting and planning Investment and financing decisions Transactions in the financial markets Managing risk Coordination and Control

Three areas of Finance Financial Management Corporate Finance Decisions regarding acquiring and funding for assets How to maximize firm’s value Capital Markets Markets where interest rates, prices of bonds and stocks are determined Financial institutions like banks, brokers, insurance companies are studied here Also studied are government agencies relating to fiscal and monetary policies Investments Decisions to use money to generate more. Most common types of investment is bonds and stocks Includes: Security analysis, portfolio theory, market analysis, behavioral finance.

Equation of Accounting ASSET = LIABILITIES + STOCKHOLDERS’ EQUITY

Alternative Forms of Business Organization Sole proprietorship: An unincorporated business owned by one individual Partnership: An unincorporated business owned by two or more persons. Corporation: A legal entity created by a state, separate and distinct from it’s owners and managers. Ownership is divided into several segments called shares/stocks and sold to the public, who become the shareholder.

Sole proprietorships & Partnerships Advantages Ease of formation Subject to few regulations No corporate income taxes Disadvantages Difficult to raise capital Unlimited liability Limited life

Corporation Advantages Disadvantages Unlimited life Easy transfer of ownership Limited liability Ease of raising capital Disadvantages Double taxation Cost of set-up and report filing

Goal of Corporation Because the ownership and management are separate in a corporation thus the goals of corporation are different from those of proprietorship and partnership. The primary goal for managers of publicly owned corporation implies that decisions should be made to maximize the long-run value of the firm’s shares/stocks, within some constraints.

Financial Goals of the Corporation The primary financial goal is shareholder wealth maximization, which translates to maximizing stock price. Should firms behave ethically?

Ethics in Financial Reporting Standards of conduct by which one’s actions are judged as right or wrong, honest or dishonest, fair or not fair, are Ethics. Recent financial scandals include: Enron, WorldCom, Xerox Corp. and others. Effective financial reporting depends on sound ethical behavior.

Is stock price maximization the same as profit maximization? No, despite a generally high correlation amongst stock price, EPS, and cash flow. Current stock price relies upon current earnings, as well as future earnings and cash flow. Some actions may cause an increase in earnings, yet cause the stock price to decrease (and vice versa).

Factors that affect stock price Projected cash flows to shareholders Timing of the cash flow stream Riskiness of the cash flows

Factors that Affect the Level and Riskiness of Cash Flows Decisions made by financial managers: Investment decisions Financing decisions (the relative use of debt financing) Dividend policy decisions The external environment

Intrinsic Value and Stock Price Economists’ theory of valuing an asset can be applied to stocks as well. Thus a stock’s intrinsic value is determined by it’s ability to generate cash now and in the future. Intrinsic value is an estimate of stock’s “true” value based on accurate risk and historical return data. This value is an estimate as future cash flows cannot be determined with certainty.

Intrinsic Value and Stock Price Stock Prices are seldom equal to it’s intrinsic value. The prices of stocks in the market are determined by it’s demand and supply. The investors’ demand of stocks are based on their “perceived” risk and return. “Perceived” means what the investors expect of the future.

Equilibrium The situation in which the actual market price equals the intrinsic value so investors are indifferent between buying and selling a stock.

Determinants of Intrinsic Value and Stock Price Managerial Actions, the Economic Environment, Taxes, and the Political Climate “True” investor returns (cash flows) “True” Risk “Perceived” investor returns (cash flows) “Perceived” Risk Stock’s Intrinsic Value Stock’s Market Price Market Equilibrium: Intrinsic Value = Market Price

Agency relationships Corporate Governance are the rules, processes, and laws by which companies are operated, controlled, and regulated. An agency relationship exists whenever a principal hires an agent to act on their behalf. Within a corporation, agency relationships exist between: Shareholders and managers Shareholders and creditors

Shareholders versus Managers Managers are naturally inclined to act in their own best interests. (agency problem) But the following factors affect managerial behavior: Managerial compensation plans Direct intervention by shareholders The threat of firing The threat of takeover

Shareholders versus Bondholders Stockholders are more likely to prefer riskier projects, because they receive more of the upside if the project succeeds. By contrast, bondholders receiving fixed payments 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.

Some Core Principles of Finance… The Risk-Return Trade off The time value of Money Cash – Not Profit – is our interest Efficient Capital Market