Financial Management (Ch. 1) 04/03/06

Cycle of money The primary function of finance is the moving of money from lenders to borrowers and back again. This is referred to as the cycle of money. Institutions, such as banks, facilitate this process by acting as the intermediary between lenders and borrowers.

Financial management decisions Financial management is defined as the activities that create or preserve the economic value of assets.

Financial management decisions In the business context, this function is divided into three areas Capital Budgeting – the selection of products or services in which the company will invest its funds Capital Structure – identifying the sources and amounts of funding Working Capital Management – ensuring that the company has cash to maintain day-to-day operations Ex., the curious demise of Webvan

Forms of business organization Sole Proprietorship Owned and operated by a single individual Represents about 75% of all businesses in the US (more than 80% of Oregonian businesses) Proprietor has unlimited liability – assets of the owner can be seized by creditors if owner is in default of debt payments Partnership General partners operate the company and have unlimited liability Limited partners (if involved) may participate in certain aspects of the business Silent partners (if involved) only provide capital Corporation Considered a separate legal entity Represents 80 – 90% of the business revenues

Organizational form differences Prop Partner Corporation Profits Owner General partners Reinvested or paid out as dividends Liability Unlimited Limited Raising Capital Limited to owner’s assets Generally limited to partner’s assets Can tap into public investor market by sale of stock Life Owner’s life General partner’s life going concern Transfer of ownership Difficult – succession issues Easy – purchase/sale of stock Taxation At owner’s personal income tax rate At partner’s personal tax rate At corporate rate plus taxes on dividends * Information Publicly reported *Jobs and Growth Tax Relief Reconciliation Act of 2003 reduces dividend taxes

Corporate organizational chart

Financial roles within a corporation Treasurer Financial manager responsible for capital expenditure, capital raising and short-term asset management Controller Responsible for corporate accounting and tax management Larger firms may have the treasurer delegate these responsibilities to subordinates

Corporate departmental interactions

Goal of the firm Which of the following is an appropriate goal for a firm? Maximize sales Maximize profits Minimize costs Maintain steady growth Maximize the stock price

Enron’s earnings manipulation During the fourth quarter of 2000, senior Enron and ENA accounting and commercial managers artificially increased the value of ENA's largest merchant asset, Mariner Energy Inc., by approximately $100 million to help cover an earnings shortfall facing the Company that quarter of approximately $200 million.

Goal of the firm The primary goal of the financial manager is to maximize the current share price (and thus market value) of the firm for public firms and to maximize the equity value for private firms. Share prices are based on future cash flows.

Owner’s wealth maximization A firm and financial manager should: Accept projects/make decisions that increase the firm’s stock price. Maintain positive relationships with other stakeholders – creditors, employees, customers. Enter into actions that are consistent with the code of ethics of the firm.

The agency model (def) Principal (shareholder) hires an agent (CEO) to represent his/her interests. The agency problem is where there is a conflict of interest between the two parties, i.e., the goals of the principal differ from that of the agent Recent well-publicized agency problem: Dennis Koslowski (TYCO) http://money.cnn.com/2004/09/23/news/fortune500/gesec.reut/- GE - Welch

Dennis’s indulgences… $17,100 traveling toilet box $15,000 dog umbrella stand $16.8 million apartment on Fifth Avenue $3 million in renovations $11 million in furnishings $7 million apartment on Park Avenue for his former wife. A $72,000 fee to Germán Frers, a yacht maker A $6,300 sewing basket A $6,000 shower curtain $5,960 for two sets of sheets A $2,900 set of coat hangers A $2,200 gilt metal wastebasket A $1,650 notebook and a $445 pincushion

Agency problem remedies Internal Tie compensation to firm performance (stock price) External Threat of takeover

Top management compensation Company/CEO Salary Other comp ??? $1 $2.48b ???* $600,000 $229m ???* $2.78m 0 *Source: http://www.forbes.com/2005/04/20/05ceoland.html

Time value of money sneak peak Revisiting our day 1 example: You have the choice of taking $1000 today or $1050 in one year. At what interest rate (or rate of return) would you be indifferent between these two choices? What can you conclude about these two choices at this interest rate?