An Overview of Financial Management Chapter 1 An Overview of Financial Management Role of Finance Forms of Business Organization Intrinsic Values, Stock Prices, and Managerial Incentives Business Ethics Important Business Trends Conflicts Between Managers, Stockholders, and Bondholders Balancing Shareholder Value and Society Interests

What is Finance? Not too old – developed within economics – the pricing of financial assets – studies financial markets – Financial flows within firms

Modern Economics Adam Smith (1723-1790) What should firms maximize? Finance: Corporate Finance, or Financial Management What assets to acquire, how, and for how much How to raise capital & run the firm to maximize its value Capital Markets Financial Institutions Investments Security Analysis, Portfolio Theory, Market Analysis Behavioral Finance Profits? Shareholder value? Stakeholder value?

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

Forms of Business Organization Proprietorship Partnership Corporation

Proprietorships & Partnerships Advantages Ease of formation Subject to few regulations No corporate income taxes Disadvantages Difficult to raise capital Unlimited liability Limited life Often set up through LLCs/LLPs.

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

Why are corporations the most used form of business? Limited liability reduces the risks faced by investors Easier to attract capital The liquidity of the corporations’ stocks Note: A Majority of businesses operate as Proprietorships, but when based on $$ dollar value of sales, the majority of all business is conducting by Corporation

What is a stock? Ownership in the firm You expect to receive dividends + capital gains

Stock Prices & Shareholder Value The primary financial goal of management is shareholder wealth maximization, Which translates to maximizing stock price in the long run Value of any asset is present value of future cash flow Decisions are evaluated in terms of their financial consequences Stock prices change over time as conditions change and as investors obtain new information about a company’s prospects Managers recognize that being socially responsible is not inconsistent with maximizing shareholder value. Explain shareholder value and how its maximization translates into stock price maximization – How does management affect stock price? Through their investment decisions which change expectations of the firm’s future – Therefore managers should make decisions that maximize the stock price

How do those differing expectations affect the stock price?

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. Should managers maximize the stock price then or the intrinsic value? Managers could maximize the stock price easily by giving investors and the market false expectations Should managers help investors improve their estimate’s of the firm’s intrinsic value? Is it better for a firm’s actual stock price in the market to be under, over, or equal to its intrinsic value? Would your answer be the same from the standpoint of shareholders or that of the CEO of the firm?

Determinants of Intrinsic Values and Stock Prices Managerial Actions, the Economic Environment, Taxes, and the Political Climate “True” Investor Returns “True” Risk “Perceived” Investor Returns “Perceived” Risk Stock’s Intrinsic Value Stock’s Market Price Examples: Zain & Agility – over time market prices converge to intrinsic value – Different analysts come up with different intrinsic values; this is where risk exists for equity investments, if everybody knew the intrinsic value there would be no risk Market Equilibrium: Intrinsic Value = Stock Price

Undervalued Vs. Overvalued

How would you define Business Ethics? Ownership in the firm You expect to receive dividends + capital gains

Business Ethics Company’s attitude and conduct toward its employees, customers, community & stockholder High standards demand that firm treat all parties in a fair and honest manner Unethical actions can have consequences far beyond that perpetrate them Examples: Insider trading: Founder of Galleon LLC ($63.8 Millions) Accounting: Enron & Arthur Andersen Transparency: Theranos blood testing scandal Can happen in any part of the organization and at organizations of all sizes

Conflicts Between Managers & Stockholders Managers are naturally inclined to act in their own best interests which are not always the same as the interest of stockholders Examples : Disney’s former president & Tyco’s CEO’s But the following factors affect managerial behavior: Managerial compensation packages Direct intervention by shareholders The threat of firing The threat of takeover 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

Some Important Business Trends Corporate scandals have reinforced the importance of business ethics Drive additional regulations and corporate oversight. Increased globalization of business The effects of ever-improving information technology have had a profound effect on all aspects of business finance. Stockholders now have more control of corporate governance.

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.

Questions?