Introduction to financial management Chapter 1

Key concepts and skills Have a good understanding of the: basic types of financial management decisions and the role of the financial manager goal of financial management financial implications of the different forms of business organisation conflicts of interest that can arise between managers and owners Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Chapter outline Finance: A quick look Business finance and the financial manager Forms of business organisation The goal of financial management The agency problem and control of the corporation Financial markets and the corporation Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

The four basic areas of finance 1. Corporate finance or business finance 2. Investments 3. Financial institutions 4. International finance Corporate finance may imply that the topics covered here are related to corporations only, but almost all the topics are much broader than that. Business finance is a little more descriptive but still too narrow to cover the basic financial ideas and principles that we discuss and are applicable across all the various areas of finance and beyond. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Investments Working with financial assets such as shares and bonds Value of financial assets, risk versus return and asset allocation Job opportunities Stockbroker Financial advisor Portfolio manager Security analyst These job opportunities in finance, like many areas in finance, share an interesting feature. They are very rewarding if done well but can be very demanding and competitive careers. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Financial institutions Companies that specialise in financial matters Banks─commercial and investment, credit unions, savings and loans Insurance companies Brokerage firms Job opportunities Job opportunities at financial institutions include loan officers in banks and analysts in insurance companies. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

International finance This is an area of specialisation within one of the areas discussed so far. Involves international aspects of corporate finance or investments or financial institutions. It may allow you to work in other countries or at least travel on a regular basis. Need to be familiar with exchange rates and political risk. Need to understand the customs of other countries and you would benefit from fluency in a foreign language. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Why study finance? Marketing Accounting Management Personal finance Budgets, marketing research, marketing financial products Accounting Dual accounting and finance function, preparation of financial statements Management Strategic thinking, job performance and profitability Personal finance Budgeting, retirement planning, university planning, day-to-day cash flow management Marketing Have to work within a budget Marketing research is often very important to financial analysts; those doing the research need to understand what information the analysts need so that they ask the right questions Marketing financial products—including entire companies through IPOs and seasoned equity offerings, as well as insurance and other basic financial products Accounting In smaller businesses, accountants often perform both the accounting and finance functions Prepare the financial statements that financial analysts rely on for information Management Business strategy—have to understand the goals of the business and how cash flow works Understand how job performance affects profitability Personal finance For many students, emphasising the personal finance issues whenever possible can make the material more relevant Decisions about 401K plans, saving for houses, cars, kids’ college, etc., can be discussed throughout the course Day-to-day decisions about consumption vs saving can also be discussed within a finance framework Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Business 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? Business finance, broadly speaking, is the study of ways to answer these questions. Emphasise that ‘business finance’ is just another name for the ‘corporate finance’ mentioned under the four basic types. Students often get confused by the terminology, especially when different terms are used to refer to the same thing. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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, credit management, capital expenditure and financial planning Accountant: oversees taxes, cost accounting, financial accounting and data processing Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

A simplified organisational chart Figure 1.1 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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? Capital budgeting: The process of planning and managing a firm’s long-term investments. Capital structure: The mixture of debt and equity maintained by the firm. Working capital: Firm’s short-term assets and liabilities. The three areas of corporate financial management—capital budgeting, capital structure and working capital management—are very broad categories. These broad areas will be discussed in detail in the chapters ahead. Provide some examples of capital budgeting decisions, such as what products or service will the firm sell, should it replace old equipment with newer, more advanced equipment, etc. Be sure to define debt and equity. Provide some examples of working capital management, such as who should the firm sell to on credit, how much inventory should it carry, when should it pay its suppliers, etc. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Forms of business organisations Three major forms in Australia and New Zealand 1. Sole proprietorship 2. Partnership General Limited 3. Corporation Sole proprietorship: A business owned by a single individual Partnership: Business owned by two or more individuals or entities Corporation: A business created as a distinct legal entity owned by one or more individuals or entities, and having many of the rights, duties and privileges of an actual person. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Sole proprietorship Copyright © 2011 McGraw-Hill Australia Pty Ltd Advantages Easiest to start Least regulated Single owner keeps all the profits Taxed once as personal income Disadvantages Limited to life of owner Equity capital limited to owner’s personal wealth Unlimited liability Difficult to sell ownership interest Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Partnership Copyright © 2011 McGraw-Hill Australia Pty Ltd 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 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Corporation Advantages Limited liability Unlimited life Separation of ownership and management Transfer of ownership is easy Easier to raise capital Disadvantages Taxation of company profits can be an issue The taxation of corporations is a significant disadvantage, being a legal person it not only pays tax but also the money paid to shareholders in the form of dividends is taxed again as income to those shareholders. For more information on business organisation visit the business section at <www.business.gov.au>. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

International corporate forms Joint stock companies Public limited companies Limited liability companies All share: public ownership limited liability Public ownership simply means ownership of a firm by a large group of unrelated individuals and/or organisations, such as institutional investors. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Goal of financial management What should be the goal of a corporation? Maximise profit? Minimise costs? Maximise market share? Maximise the current value per share of the company’s existing stock? Maximise the market value of the existing owners’ equity? It does not matter whether the business is a sole proprietorship, a partnership or a corporation. For each of these, good financial decisions increase the market value of the owners’ equity and poor financial decisions decrease it. The goal does not imply that the financial manager should take illegal or unethical actions in the hope of increasing the value of the equity in the firm. The financial manager best serves the owners of the business by identifying investment projects that add value to the firm because they are desired and valued in the free marketplace. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

The agency problem Agency relationship Agency problem Principal hires an agent to represent their interests. Shareholders (principals) hire managers (agents) to run the company. Agency problem Conflict of interest between principal and agent Management goals and agency costs Agency cost: When managers fails to take advantage of a valuable opportunity available to the firm. A common example of an agency relationship is a real estate broker—in particular if you break it down between a buyer’s agent and a seller’s 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 only to show the buyer homes that are listed at the high end of the buyer’s price range. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Do managers act in shareholders’ interests? Managerial compensation Incentives can be used to align management and shareholder interests. The incentives need to be structured carefully to make sure that they achieve their goals. Corporate control The threat of a takeover may result in better management. Other stakeholders Proxy fight: A mechanism whereby a group of unhappy shareholders solicit proxy votes to replace existing management. Stakeholders: Someone other than a shareholder or creditor who potentially has a claim on the cash flows of the firm. Incentives—discuss how incentives must be carefully structured. For example, tying bonuses to profits might encourage management to pursue short-run profits and forgo projects that require a large initial outlay. Stock options may work, but there may be an optimal level of insider ownership. Beyond that level, management may be in too much control and may not act in the best interests of all stockholders. The type of stock can also affect the effectiveness of the incentive. Corporate control—ask the students why the threat of a takeover might make managers work towards the goals of stockholders. Other groups also have a financial stake in the firm. They can provide a valuable monitoring tool, but they can also try to force the firm to do things that are not in the owners’ best interests. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Example: Work the Web The Internet provides a wealth of information about individual companies. <http://au.finance.yahoo.com/> is an excellent website. Click on the information icon to reach <http://au.finance.yahoo.com/>. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Cash flows between the firm and the financial markets Figure 1.2 Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Financial markets Cash flows to the firm Primary vs secondary markets Dealer vs auction markets Listed vs private companies Australian Securities Exchange (ASX) To learn more about the Australian Securities and Investments Commission, visit <www.asic.gov.au>. Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their textbook 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. To learn more about the stock exchange, visit <www.asx.com.au>. Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

Quick quiz What are the four basic areas of finance? 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 organisation? What is the goal of financial management? What are agency problems and why do they occur within a corporation? Copyright © 2011 McGraw-Hill Australia Pty Ltd PPTs t/a Essentials of Corporate Finance 2e by Ross et al. Slides prepared by David E. Allen and Abhay K. Singh

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