Finance and The Financial Manager Chapter 1 Principles of Corporate Finance Ninth Edition Finance and The Financial Manager McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered What Is A Corporation? The Role of The Financial Manager Who Is The Financial Manager? Separation of Ownership and Management

Personal tax on profits Corporate Structure Sole Proprietorships Unlimited Liability Personal tax on profits Partnerships Limited Liability Corporate tax on profits + Personal tax on dividends Corporations

Finance Within the Organisation 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 1-4

Organizing a Business 4 4 4 4 5 4

What Is Finance? Finance is the study of managing money. At the most basic level, this involves determining where to get money and what to do with it. The Study of Markets and Institutions: Markets: The determination of interest rates, and how the market prices and distributes securities Financial institutions: Banks, the Federal Reserve (RBNZ), and finance companies increase the efficiency of financial transactions.

What Is Finance? (continued) Investments: How can dollars available today be turned into more dollars in the future? Portfolios, diversification, risk-return tradeoff Market prices Corporate Finance: Finance applied in a business setting Evaluation of Long-Term Projects Study of How to Acquire Funds Analysing Firm Performance

Financial Market Functions Source of funding Investor liquidity Risk management Source of information

Role of The Financial Manager (2) Cash invested in firm (2) (1) Cash raised from investors (1) Firm's (4a) Cash reinvested (4a) Financial Financial manager operations markets (3) Cash generated by operations (3) (4b) Cash returned to investors (4b)

Role of The Financial Manager Common Finance Terminology Real assets Financial assets / Securities Capital markets and financial markets Investment / capital budgeting Financing

Who is The Financial Manager? Chief Financial Officer Treasurer Controller

Ownership vs. Management Difference in Information Stock prices and returns Issues of shares and other securities Dividends Financing Different Objectives Managers vs. stockholders Top mgmt vs. operating mgmt Stockholders vs. banks and lenders

Should the Financial Manager Maximise Profits? Not necessarily—this may result in: 1. Short-run decision making 2. Ignoring risk 3. Ignoring the timing of cash flows

Stock Prices and Shareholder Value The primary financial goal of management is shareholder wealth maximisation, which means maximising stock price. Value of any asset is present value of the cash flow stream to owners. Most significant 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 have an obligation to behave ethically Share price depends on cash flows a “marginal” investor expects to receive Good decisions – share price increases: bad decisions oppposite effect 1-14 14

Determinants of Intrinsic (True) 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 Market Equilibrium: Intrinsic Value = Stock Price 1-15 15

Stock Prices and True Value In equilibrium, a stock’s price should equal its “true” or intrinsic value. It reflects the long-term value of the business To the extent that investor perceptions are wrong, a stock’s price in the short run may be different to its true value. Ideally, managers should avoid actions that reduce true value, even if those decisions increase the stock price in the short run. 1-16 16

Some Important Business Trends Recent corporate scandals have reinforced the importance of business ethics, and have spurred additional regulations and corporate oversight. Increased globalisation of business. The effects of ever-improving information technology have had a profound effect on all aspects of business finance. 1-17 17

Managers will not always maximise stockholders’ wealth because of: Agency Costs The financial interests of the manager may be different to those of the shareholders Costs of meeting legislative requirements aimed at protecting shareholders Social Conscience The judgements of the manager on social issues may be different to those of the shareholders

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). But the following factors affect managerial behavior: Managerial compensation (pay) packages Direct intervention by shareholders The threat of firing The threat of takeover 1-19 19

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 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. 1-20 20

Five Key Concepts of Finance Greater returns require taking greater risks Good deals disappear fast Time value of money Cash flows determine value Information is not freely available to all

Five Key Concepts of Finance Greater returns: require taking greater risks when an investor buys a risky security, the required expected return is high over the long term . the actual return over any period may be equal to the expected return, or it may be more, or it may be less.

Five Key Concepts of Finance (cont)

Five Key Concepts of Finance (cont) Good deals disappear fast (also known as the “Theory of Efficient Markets” ) As new information becomes available to investors, security prices will adjust so that the return to investors is fair If financial markets are efficient, the price of a security is an accurate estimate by the market of its true value.

Five Key Concepts of Finance (cont) 3. The value of money: depends upon when it is received A dollar received today is worth more than a dollar received in the future.

Five Key Concepts of Finance (cont) Cash flows determine value Cash flows are what investors can invest and firms can use to pay dividends Accounting earnings (or profits) are not cash – they can be manipulated, and may never be converted into cash e.g. Bad debts

Five Key Concepts of Finance (cont) Information is not freely available to all Asymmetric information is the difference in the information set held by different participants in the financial marketplace Investors may not know what the firm’s insiders know. A bank may not know what a borrower plans to do with a loan. An insurance agent may not know how well an insured person will act to protect against loss

Web Resources Web Links Click to access web sites Internet connection required www.careers-in-finance.com www.careers.wsj.com www.wageweb.com www.corpgov.net www.thecorporatelibrary.com