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The University of Lethbridge - Faculty of Management Management 3040 – Finance Terry D. Harbottle

Chapter 1 - Key Concepts and Skills 1.1 Chapter 1 - Key Concepts and Skills Know the basic types of financial management decisions and the role of the financial manager Know the financial implications of the different forms of business organization Know the goal of financial management Understand the conflicts of interest that can arise between owners and managers Understand the various types of financial markets and financial institutions Understand current trends in Canadian financial markets

Corporate Finance and the Financial Manager 1.2 Chapter Outline Corporate Finance and the Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the Corporation Financial Markets and the Corporation Financial Institutions Trends in Financial Markets and Financial Management www: This is a good place to show the students the web site that accompanies the book, including the various features that they can access for study purposes (study guide, quizzes, web links, etc.). Click on the “web surfer” icon to go directly to the site.

Some important questions that are answered using finance 1.3 Corporate Finance Some important questions that are answered using finance What long-term investments should the firm take on? Where will we get the long-term financing to pay for the investment? How will we manage the everyday financial activities of the firm? How can we manage financial and market risk?

Financial managers try to answer some or all of these questions 1.4 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, capital expenditures and financial planning Controller – oversees taxes, cost accounting, financial accounting and data processing Video Note: This video looks at the changing role of the Chief Financial Officer (CFO) at the Fortune 500 company, Abbot Laboratories.

A Simplified Organizational Chart Board of Directors Chairman of the Board and Chief Executive Officer (CEO) President and Chief Operations Officer (COO) Vice President Marketing Vice President Finance (CFO) Vice President Production Treasurer Controller Cash Manager Credit Manager Cost Accounting Manager Tax Manager Capital Expenditures Financial Planning Financial Accounting Manager Data Processing Manager

Financial Management Decisions 1.5 Financial Management Decisions Capital budgeting What long-term investments or projects should the business take on? Capital structure How should we pay for our assets? Should we use debt or equity? Working capital management How do we manage the day-to-day finances of the firm? Risk Management Use of derivative securities

Forms of Business Organization 1.6 Forms of Business Organization Three major forms in Canada Sole proprietorship Partnership General Limited Corporation In other countries, corporations are also called joint stock companies, public limited companies and limited liability companies www: Clicking on the “web surfer” will take you to a web site that will provide a discussion about which form of business may be appropriate for an entrepreneur. The following pages will provide links to specific pages on the web site that provide additional information about the legal aspects of each form of business, as well as a discussion of the advantages and disadvantages. The address is: http://www.nolo.com/encyclopedia/sb_ency.html#Subtopic16

Sole Proprietorship Advantages Disadvantages Easiest to start 1.7 Sole Proprietorship Advantages Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income Disadvantages Unlimited liability Limited to life of owner Equity capital limited to owner’s personal wealth Difficult to sell ownership interest www: Click on the “web surfer” for more information about sole proprietorships. If you click on the “--Sole Proprietorship” link, you will be taken to an index that will provide a link to information about husband and wife sole proprietorships.

Partnership Advantages Disadvantages Two or more owners 1.8 Partnership Advantages Two or more owners More capital available Relatively easy to start Income taxed once as personal income Disadvantages Unlimited liability General partnership Limited partnership Partnership dissolves when one partner dies or wishes to sell Difficult to transfer ownership www: Click on the “web surfer” for more information about partnerships. If you click on the “—Partnerships” link, you will go to an index that provides links to additional information about limited partnerships, partnership agreements and buy-sell agreements. Note that unlimited liability applies to all partners in a general partnership and only the general partners in a limited partnership Written agreements are essential due to the unlimited liability. Limited partners cannot be involved in the business or else they may be deemed as general partners.

Corporations A corporation is a legal entity separate and distinct from its owners has many of the same rights, duties and privileges of an actual person: borrow money can own property can enter into contracts shareholders and management are usually separate in most larger corporations the shareholders elect the board of directors the board then selects the senior managers who in theory are charged with running the affairs in the interests of the shareholders

Corporation Advantages Disadvantages Limited liability Unlimited life 1.9 Corporation Advantages Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital Disadvantages Separation of ownership and management Double taxation (income is taxed at the corporate rate and then dividends are taxed at the personal rate)

Goal Of Financial Management 1.11 Goal Of Financial Management What should be the goal of a corporation? Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company’s stock? Does this mean we should do anything and everything to maximize owner wealth or ‘shareholder value’? Try and have the students discuss each of the goals above and the inherent problems of the first three goals: Maximize profit – Are we talking about long-run or short-run profits? Do we mean accounting profits or some measure of cash flow? Minimize costs – We can minimize costs today by not purchasing new equipment or delaying maintenance, but this may not be in the best interest of the firm or its owners. Maximize market share – This has been a strategy of many of the dot.com companies. They issued stock and then used it primarily for advertising to increase the number of “hits” to their web sites. Even though many of the companies have a huge market share (I.e. Amazon) they still do not have positive earnings and their owners are not happy. Maximize the current value of the company’s stock There is no short run vs. long run here. The stock price should incorporate expectations about the future of the company and consider the trade-off between short-run profits and long-run profits. The purpose of a for-profit business should be to make money for its owners. Maximizing the current stock price increases the wealth of the owners of the firm. This is analogous to maximizing owners’ equity for firms that do not have publicly traded stock. Non-profits can also follow the same principle, but their “owners” are the constituencies that they were created to help. The instructors manual provides a letter to stockholders that was written by former Coca-Cola CEO Roberto Goizueta. There is also a brief discussion of an article that appeared in Fortune magazine that discusses Coke vs. Pepsi and their different philosophies on business in the early 1990’s. Ethics Note: See the instructor’s manual for a discussion of Dow-Corning, silicone breast implants and the ethics involved with pursuing owners’ wealth at all costs.

Primary Goal of Financial Management 1.12 Primary Goal of Financial Management Three equivalent goals of financial management: Maximize shareholder wealth or ‘shareholder value’ Maximize share price Maximize firm value ….goal is to increase ‘shareholder value’

Corporation Finance The study of the relationship between business decisions and shareholder value The focus of this class then is the identification of financial/business decisions and arrangements that contribute to shareholder value (contribute favourably to value of the stock)

The Agency Problem Agency relationship Agency problem Agency costs 1.13 The Agency Problem Agency relationship Principal hires an agent to represent their interests Stockholders (principals) hire managers (agents) to run the company Agency problem Conflicts of interest can exist between the principal and the agent Agency costs Direct agency costs Indirect agency costs Video Note: This video focuses on how one company handled the tough decision to cut jobs and managed to successfully increase shareholder value. It features ABT Co. in Canada. A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyers agent and a sellers agent. A classic conflict of interest is when the agent is paid on commission, so they may be less willing to let the buyer know that a lower price might be accepted or they may elect to only show the buyer homes that are listed at the high end of the buyers price range. Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the sensor razor. Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs. Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.

The Agency Problem Agency Relationships and Management Goals potential for conflict - is their too much emphasis on corporate survival, job security and (more recently) with management wealth creation? Do managers Act in the Shareholders’ interests? They are influenced by: how they are compensated - does their compensation encourage them to make decisions that will enhance shareholder value how easily are they replaced if they do not pursue shareholder goals - control here is with the board of directors

Agency Costs Agency Costs - defined as the costs associated with the conflict of interests : Direct agency costs Indirect agency costs Impact of Agency Costs on Shareholder Wealth or Value direct - expenditures benefiting Management e.g. the unneeded corporate jet or direct - monitoring costs e.g. outside auditors indirect - lost opportunity where Management is not acting in the best interests of its shareholders e.g. costly acquisitions driven more by desire for power and prestige

Managerial compensation 1.14 Managing Managers Managerial compensation Incentives can be used to align management and stockholder interests The incentives need to be structured carefully to make sure that they achieve their goal Corporate control The threat of a takeover may result in better management Conflicts with other stakeholders (see table 1.2)

What is the role of financial markets in corporate finance? 1.16 What is the role of financial markets in corporate finance? Cash flows to and from the firm Money vs. capital markets Primary vs. secondary markets How do financial markets benefit society? Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade. Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book to see an illustration of the cash flows. The main point is that cash comes into the firm from the sale of debt and equity. The money is used to purchase assets. Those assets generate cash that is used to pay stakeholders, reinvest in additional assets, repay debtholders and pay dividends to stockholders. Students are often confused by the fact that the NASDAQ is an OTC market. Explain that the NASDAQ market site is just a convenient place for reporters to show how stocks are moving, but that trading does not actually take place there. See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ towards becoming for-profit companies and the possible impact on investors. www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites

Cash Flows to and from the Firm 1.17 Cash Flows to and from the Firm

Financial Institutions 1.18 Financial Institutions Financial institutions act as intermediaries between suppliers and users of funds Institutions earn income on services provided: Indirect finance – Earn interest on the spread between loans and deposits Direct finance – Service fees (i.e. bankers acceptance and stamping fees)

Financial Markets Financial Markets - brings buyers and sellers of debt and equity securities together How do financial markets differ? Type of securities traded/how trading is conducted and who the buyers and sellers are Money markets and capital markets money market - short term debt securities capital market - long term debt and equity

Financial Markets Continued Primary vs. secondary markets Primary Market- where the original sale of issue of a security by a government or corporation occurs public offering - underwritten by an investment dealer and registered with provincial securities commissions private placement - debt and equity sold directly to a buyer - typically life insurance companies and , pension funds Public Offering typically underwritten by the investment dealer - buys the securities from the company and then seeks to make a profit by selling them at a higher price to the public.....take on certain risks interest rate movements credit risk of the issuing company public offering can also take the form of a ‘best efforts’ deal where the dealer does not actually buy the securities but only acts as an agent and sells as much of the issue as possible but can return any unsold shares....more on this in Chapter 15 Private Placement debt and equity instruments are sold directly to pension funds, insurance companies and mutual funds (concept of matching here with need for long term funds being matched with the supply of longer terms funds) why - avoid regulartory req’ts and costs of public issues

Financial Markets Continued Secondary Market - trading of securities subsequent to the initial sale - enables the transfer of ownership auction market - TSE dealer market - ‘over the counter (OTC) ‘ How do financial markets benefit society? Auction Market physical location - Bay Street or Wall Street exchanges match buyers and sellers OTC or Dealer Market most of the buying and selling is done by the dealer (money mkt. Concept) where the dealers are again connected electronically Financial Markets and Society channel savings into investment - increases the efficiency of allocating savings among the many competing uses for this capital produce and transmit information on returns and risk - via interest rates and securities prices - both reflect supply & demand factors and risk factors transaction prices on fin. Markets continually reflect investors evaluations of market alternatives they pay for this info thru fees to analysts and other sellers of this info as well as thru the bid ask spread in transactions provide a media and a payments system moved from exchanging one commodity to accepting paper claims

Financial Markets and Society what is the benefit to society? Channel savings into investment produce and transmit information on returns and risk provide a media and a payments system enable the shifting of the timing of consumption over a life cycle enable the management of risk enable the diversification of portfolios savings - increases the efficiency of of allocating savings among the many competing uses for this capital produce and transmit info:- via interest rates and security prices - both reflect supply and demand factors and risk factors transaction prices on fin. Mkts continually reflect investors evaluations of market alternatives they pay for this via direct fees to analysts and other sellers of this info and thru the bid-ask spread in transactions media & payments system - moved from exchanging one commodity for another to accepting paper claims Shifting the timing of consumption over a life cycle borrowing and lending facilitated by fin. Mkts allows people to shift the timing of their use or consumption of lifetime incomes and wealth. managing risk various forms of insurance hedging opportunities diversification of portfolios

Trends in Financial Markets and Management 1.19 Trends in Financial Markets and Management Financial Engineering Derivative Securities Advances in Technology – i.e. E-business Deregulation Corporate Governance Reform

What are the three major forms of business organization? 1.20 Quick Quiz What are the three types of financial management decisions and what questions are they designed to answer? What are the three major forms of business organization? What is the goal of financial management? What are agency problems and why do they exist within a corporation? What is the difference between a primary market and a secondary market?

Summary 1.9 You should know: 1.21 You should know: The advantages and disadvantages between a sole proprietorship, partnership and corporation The primary goal of the firm What an agency relationship and cost are The role of financial markets