Drake DRAKE UNIVERSITY MBA Finance 200 Financial Management Drake University Summer 2005

Drake DRAKE UNIVERSITY Fin 200 Financial Management The process by which business managers make financial decisions today that have consequences that extend through time. What is the Goal of Financial Management?

Drake DRAKE UNIVERSITY Fin 200 Goal of Financial Management Increase the value of the firm How do you measure Value?? Value should reflect the amount that all expected future cash flows generated by the firm are worth today. Possible Value measures Stock Price The Present Value of its Future Cash Flows

Drake DRAKE UNIVERSITY Fin 200 Firm Value and Stock Prices Is maximizing the value of the firm the same as maximizing the stock price? Only if we assume that management works to protect all the stakeholders in the firm

Drake DRAKE UNIVERSITY Fin 200 The Firms Stakeholders 1) Shareholders 2) Employees 3) Bondholders 4) Society

Drake DRAKE UNIVERSITY Fin 200 Management and Stockholders The Principal / Agent Problem Whenever owners (principals) hire managers (agents) to operate the firm there is a potential conflict of interest. The managers have an incentive to act in their own best interest instead of the owners (Shareholders) It is possible for stock price to increase because of managers actions without the value of the firm increasing.

Drake DRAKE UNIVERSITY Fin 200 Principal / Agent Examples Manipulation of earnings to increase the managers bonus Blocking a merger that adds value to shareholders to preserve the managers job Others?

Drake DRAKE UNIVERSITY Fin 200 Management and Stockholders Other Problems Often there is a distance between managers and shareholders that causes their interestes to not be aligned. Lack of monitoring by shareholders Lack of expertise on the board Lack of independence on the board Small ownership stake of directors Best Case Managers focus on stock price maximization and are compensated in a manner consistence with increasing shareholder value.

Drake DRAKE UNIVERSITY Fin 200 Conflicts between stockholders and bondholders Stock Price maximization may increase risk of default. For example: Undertaking a risky project that increases value if successful, but also increases possibility of default if it fails. Best Case Lenders are protected via covenants in the debt contracts and management considers both bond and stock holders in decision making.

Drake DRAKE UNIVERSITY Fin 200 Managers and Financial Markets The Information Problem Firms may intentionally mislead financial markets The Market Problem Even if information is correct, the markets may not react properly Best Case Management does not mislead the markets and the markets interpret information correctly

Drake DRAKE UNIVERSITY Fin 200 Firms and Society Management decisions may have social costs (intentional and non intentional) pollution, Johns Manville and Asbestos… Best Case Management acts in the best interest of society, and attempts to be a good “corporate citizen”.

Drake DRAKE UNIVERSITY Fin 200 Our Assumption In class we will assume that management attempts to act in the best interest of all stakeholders. Therefore, stock price maximization and firm value maximization are basically the same thing.

Drake DRAKE UNIVERSITY Fin 200 Social Welfare Does firm value maximization benefit society? The owners of the firms stock are society Stock price maximization promotes efficiency and allocation of resources Promotes growth and employment

Drake DRAKE UNIVERSITY Fin 200 Financial Management The process by which business managers make financial decisions today that have consequences that extend through time with the goal of increasing firm value.

Drake DRAKE UNIVERSITY Fin 200 Financial Decision Making 1. Capital Budgeting What projects should the firm undertake? How do the projects impact frim value? 2. Capital Structure How are the projects financed? 3. Working Capital Management How do cash flows provide for the daily operations of the firm?

Drake DRAKE UNIVERSITY Fin 200 Goal of Financial Management: A Better Definition Maximize the value of the firm as determined by: the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the firms projects and the financing mix used to fund the projects.

Drake DRAKE UNIVERSITY Fin 200 Outline of the class Part 1: Maximize the value of the firm as determined by: the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the firms projects and the financing mix used to fund the projects. Time Value of Money (Measuring PV) Applying PV to Stocks and Bonds

Drake DRAKE UNIVERSITY Fin 200 Outline Part 2 Maximize the value of the firm as determined by: the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the firms projects and the financing mix used to fund the projects. Financial Statement Analysis Estimating Cash Flows Long Term Planning

Drake DRAKE UNIVERSITY Fin 200 Outline Part 3 Maximize the value of the firm as determined by: the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the firms projects and the financing mix used to fund the projects. The relationship between Risk and Return CAPM (one approach to measuring risk and return) Cost of Capital (Based on Stock and Bond Valuation and risk and return)

Drake DRAKE UNIVERSITY Fin 200 Outline Part 4 Maximize the value of the firm as determined by: the present value of its expected cash flows, discounted back at a rate that reflects both the riskiness of the firm’s projects and the financing mix used to fund the projects. Estimating a Project’s Cash Flows (Based on Financial Statements) Capital Budgeting / Evaluating Projects using NPV (Estimates of Cash Flows, financial statement analysis, and the cost of capital)