17 Chapter Financial Management

Learning Objectives LO 17.1 Define finance, and explain the role of financial managers. LO 17.2 Describe the parts of a financial plan and the financial planning process. LO 17.3 Outline how organizations manage their assets. LO 17.4 Compare the two major sources of funds for a business, and explain the concept of leverage. LO 17.5 Identify sources of short- term financing for business operations. LO 17.6 Discuss long-term financing options. LO 17.7 Describe mergers, acquisitions, buyouts, and divestitures.

Financial Management Finance: The business function of planning, obtaining, and managing the company’s funds to accomplish its objectives as effectively and efficiently as possible Maximizing overall worth Meeting expenses Investing in assets Increasing profits to shareholders A company’s managers must ensure that the company has enough money to perform its other tasks successfully, in both the present and the future, and that these funds are invested properly. The company must have enough funds to buy materials, equipment, and other assets; pay bills; and compensate employees. Lecture Enhancer: How does finance differ from accounting?

The Role of the Financial Manager Financial managers: The executives who develop and carry out their firm’s financial plan and decide on the most appropriate sources and uses of funds The financial department of any organization is extremely important. The growing importance of financial professionals is reflected in an expanding number of CEOs promoted from financial positions. The CFO reports directly to the CEO. The vice-president for financial management (or planning) is responsible for preparing financial forecasts and analyzing major investment decisions. The treasurer is responsible for the company’s financing activities, including cash management, tax planning, and preparation. The controller’s functions include keeping the company’s books, preparing financial statements, and conducting internal audits. Class Activity: Discuss which position is most likely to lead to becoming a chief financial officer—treasurer, vice-president for planning, or controller.

The Role of the Financial Manager Risk-return trade-off: the process of maximizing the wealth of the firm’s shareholders by striking the right balance between risk and return. Every financial manager must balance risk and return. Obtaining too much debt can be risky, while maintaining too much cash reduces the risk of meeting unexpected cash needs. Cash on hand does not earn money and could be invested to increase profitability. Lecture Enhancer: Would you invest in a friend’s business by lending money? If so, what interest rate would you charge and why?

Financial Planning Financial plan: a document that specifies the funds needed by a firm for a period of time, the timing of cash inflows and outflows, and the most appropriate sources and uses of funds Financial plans are built by answering the following questions: What funds will the firm require during the planning period? When will the firm need additional funds? Where will the firm obtain the necessary funds? Based on the forecasts of production costs, purchasing needs, plant/equipment expenses, and sales activities for a given period. The financial plan specifies the funds needed by a firm for a period of time and the timing of inflows and outflows. Most importantly, the financial plan outlines the most appropriate sources and use of funds. Operating plans are short-term financial plans that focus on no more than a year or two in the future. Strategic plans are financial plans that have a much longer time horizon, up to five or 10 years. Class Activity: Discuss why a successful financial manager needs to have a keen understanding of nonfinancial business functions in addition to strong skills in accounting and finance.

Managing Assets Sound financial management requires assets to be managed and acquired effectively and efficiently. Assets What a firm owns Use of funds To grow and prosper, firms must manage their assets effectively and efficiently. Firms must also consider what additional assets need to be purchased.

Short-Term Assets Also known as current assets Cash Marketable securities Accounts receivable Inventory It is important for financial managers to manage and balance all of the assets of a firm. Cash pays for day-to-day expenses. Most organizations try to keep a minimum cash balance so they have funds available for unexpected expenses. Marketable securities are low-risk securities that either have short maturities or can be easily sold. Accounts receivable represent the uncollected credit sales. Financial managers are responsible for the collection of these payments. For many firms, such as retailers, inventory represents the largest single asset. Lecture Enhancer: When accounts receivable increase over time, is this increase a positive or negative indicator for a business? Class Activity: Discuss how inventory values are affected by style changes, spoilage, and obsolescence.

Test Your Knowledge All of the following are short-term assets except a. inventory. b. accounts receivable. c. equipment. d. cash.

Test Your Knowledge All of the following are short-term assets except a. inventory. b. accounts receivable. c. equipment. d. cash. Answer: C

Capital Investment Analysis Long-lived assets Produce economic benefit for more than one year Substantial investments Capital investment analysis Expansion: new assets Replacement: upgrading assets Capital investment analysis is analysis of what investments need to be made and what sources of funds will pay for these investments. Financial managers must look at the goals and objectives of the organization and make investments accordingly. Class Activity: Ask students why “bricks-and-mortar” investments might be riskier than other uses of funds.

Managing International Assets Today’s firms have facilities and assets worldwide. Sales occur outside of the home country. International assets require the management of activities to reduce the financial risk of exchange rates. In an effort to reduce risk, financial managers must hedge the risk of exchange rates. Many global firms are involved in activities that reduce the risks associated with exchange rate ups and downs. Reducing the risks of exchange rate fluctuations will improve the financial performance of the firm, which can have a positive impact on its share price. Lecture Enhancer: Can a change in exchange rates ever benefit a company?

Sources of Funds and Capital Structure Debt capital consists of funds obtained through borrowing. Equity capital consists of funds provided by the firm’s owners when they reinvest their earnings, make additional contributions, liquidate assets, issue shares to the general public, or raise capital from outside investors. The capital structure is the mix of a firm’s debt and equity capital. Different companies in different industries take very different approaches to capital structure. As the company uses more debt, the risk to the company increases: the firm needs to make the interest payments on the money borrowed, regardless of the amount of cash flow coming into the company. Choosing more debt increases the fixed costs a company must pay, which makes a company more sensitive to any change in sales revenues. Debt is frequently the least costly method of raising additional financing dollars, which is why it is so frequently used. Lecture Enhancer: Which type of funds (debt or equity) offers a firm a more flexible pay arrangement? Which offers more control?

Leverage and Capital Structure Decisions Goal: increasing the rate of return on funds invested by borrowing funds Raising needed cash by borrowing allows a firm to benefit from the principle of leverage. The key is to ensure that a company’s earnings remain larger than its interest payment. Lecture Enhancer: Provide an example of a company that recently failed because of excessive leverage.

Mixing Short and Long-Term Funds Short-term funds Current liabilities Less expensive Volatile interest rates Long-term funds Long-term debt and equity Used for long-term assets Financial managers must decide the appropriate mix of short- and long-term funds. The mix of funds is a strategy to balance risk as well as meet the firm’s objectives.

Dividend Policy Dividends are periodic cash payments to shareholders. Highest dividend yielding stocks Financial managers must make decisions regarding their dividend policy. Should we pay a dividend? When should it be paid? Firms must decide if and when to pay dividends. While some companies pay large dividends, some companies do not pay them at all. Click on the link for the “Dogs of the Dow” highest yielding stocks. Lecture Enhancer: Why do you think older investors prefer to own stock in companies that provide dividend payments?

Short-Term Funding Options Trade credit Short-term loans Commercial paper Short-term funding options range. Trade credit is extended by suppliers when a firm receives goods or services. The firm agrees to pay for them at a later date. Short-term loans are a significant source of short-term financing for many businesses. Loans can be used to finance inventory and accounts receivable. Commercial paper is a short-term IOU sold by a company. Commercial paper is typically sold in multiples of $100,000 to $1 million. They usually have a maturity that ranges from 1–270 days. Although commercial paper is an attractive short-term financing option, only a small percentage of businesses can issue it. Access to the commercial paper market has traditionally been limited to large, financially strong corporations. Class Activity: Ask students why large companies are more likely to obtain favourable trade credit as compared to smaller companies. Lecture Enhancer: Why is trade credit limited to the amount of goods or services a company purchases?

Test Your Knowledge Trade credit is a source of long-term financing. a. True b. False  

Test Your Knowledge Trade credit is a source of long-term financing. a. True b. False   Answer: B

Sources of Long-Term Financing Public sale of shares and bonds Private placements Venture capitalists Private equity funds Hedge funds Unlike short-term financing, long-term financing is repaid over many years. Public sales of securities such as shares and bonds represent a major source of funds for corporations. When a small group of major investors such as pension funds and insurance companies privately invest in a company, it is called a private placement. Venture capitalists are an important source for new companies. They are business firms or groups of individuals that invest in new and growing firms in exchange for an ownership share. Private equity funds are investment companies that raise funds from wealthy individuals and institutional investors and use those funds to make investments in companies. Hedge funds are private investment companies that are available only to qualified large investors. Lecture Enhancer: What are some possible risks for a firm owner who seeks advice from a venture capital company? Lecture Enhancer: What are the risks of private equity funds?

Test Your Knowledge Why would a firm prefer to sell its bonds through private placement rather than an initial public offering? a. Firms typically receive more favorable repayment terms from private holders. b. There are more buyers for private placements than publicly traded bonds. c. It is often cheaper for the firm to sell securities privately. d. Private placements reduce the risk of default.  

Test Your Knowledge Answer: C Why would a firm prefer to sell its bonds through private placement rather than an initial public offering? a. Firms typically receive more favorable repayment terms from private holders. b. There are more buyers for private placements than publicly traded bonds. c. It is often cheaper for the firm to sell securities privately. d. Private placements reduce the risk of default.    Answer: C

Buyouts, and Divestitures Mergers, Acquisitions, Buyouts, and Divestitures Financial managers evaluate mergers, acquisitions, and other opportunities by comparing costs and benefits. Tender offer Leveraged buyouts (LBOs) Divestiture Selloff Spinoff A merger is a transaction when two firms combine. In a merger or acquisition, there is always a buyer and a seller. A tender offer is a proposal made by a firm to the target firm’s shareholders specifying a price and the form of payment. Leveraged buyouts are transactions where public shareholders are bought out and the firm reverts to private status. A divestiture is the reverse of a merger; a company sells its assets (subsidiary/facilities). In a selloff, assets are sold by one firm to another. In a spinoff, the divested assets form a new firm. Lecture Enhancer: Give an example of a recent merger. Discuss the potential benefits to both companies. Lecture Enhancer: Can you provide an example of a recent divestiture that resulted from an unsuccessful acquisition?