© 2004 by Nelson, a division of Thomson Canada Limited Chapter 1: The Role and Objective of Financial Management Contemporary Financial Management

© 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  This chapter introduces the financial management process. It looks at the financial manager, the field of finance, financial decisions and their implications, and the daily questions faced by the firm’s financial management.

© 2004 by Nelson, a division of Thomson Canada Limited 3 Questions Faced in Finance  How is finance related to other fields of study?  What are financial managers’ goals and objectives?  How has the finance field evolved?  How is the finance field changing today?

© 2004 by Nelson, a division of Thomson Canada Limited 4 Forms of Business Organizations  Sole proprietorship  Partnership  Corporation

© 2004 by Nelson, a division of Thomson Canada Limited 5 Sole Proprietorship  Owned by one person  Represent 75% of all businesses, but accounts for less than 5% of dollar volume. Advantages Disadvantages Easy FormationUnlimited Liability Difficult to Raise Funds

© 2004 by Nelson, a division of Thomson Canada Limited 6 Small Business  Not the dominant firm in the industry  Tend to grow more rapidly  Lack management resources  Have a high failure rate  Shares not publicly traded  Poorly diversified  Owner/manager frequently the same

© 2004 by Nelson, a division of Thomson Canada Limited 7 Partnership  Owned by two or more persons  Classified as general or limited Advantages Disadvantages Easy FormationDifficult to Raise Funds Partnership Dissolves if Partner Dies Taxation occurs at the level of the partner, not the partnership

© 2004 by Nelson, a division of Thomson Canada Limited 8 Liability of Partners  General Partner Has unlimited liability for all obligations of the business  Limited Partner Liability limited to the partnership agreement

© 2004 by Nelson, a division of Thomson Canada Limited 9 Limited Partnerships  Must have at least one general partner who: Has unlimited liability Performs all management functions  Can have many limited partners who: Have limited liability Cannot participate in management

© 2004 by Nelson, a division of Thomson Canada Limited 10 Corporation  A distinct, legal entity of its own Advantages Disadvantages Limited Liability Permanency Ability to Raise Capital Potential for Double Taxation Some Owners Have Minimal Control

© 2004 by Nelson, a division of Thomson Canada Limited 11 Board of Directors  Shareholders elect a Board of Directors  Board of Directors appoints the officers of the company: Chairman of the board Chief executive officer (CEO) Chief operating officer (COO) President Chief financial officer (CFO) Vice president Treasurer Secretary

© 2004 by Nelson, a division of Thomson Canada Limited 12 Who Manages? Board of Directors Deals with broad policy Develops 3-5 year strategic plan Management Responsible for implementing strategic plan Makes day-to-day management decisions

© 2004 by Nelson, a division of Thomson Canada Limited 13 Shareholder Rights  Right to share in company profits (or losses)  Right to vote Some shares may be non-voting Some shares may carry multiple votes  Right to share in the residual assets at dissolution  Right to acquire new common stock (preemptive right)

© 2004 by Nelson, a division of Thomson Canada Limited 14 Priority of Corporate Securities Bonds: Debt securities often backed by the corporation’s assets. Preferred Stock: non-voting shares that often offer a fixed dividend to shareholders. Common Stock Priority

© 2004 by Nelson, a division of Thomson Canada Limited 15 Type of Organization Influenced by  Cost  Complexity  Liability  Continuity  Need for capital  Decision making  Tax considerations

© 2004 by Nelson, a division of Thomson Canada Limited 16 Shareholder Wealth Maximization  Core objective of financial managers.  Considers the timing and risk of the benefits from stock ownership  Determines that a good decision increases the price of the firm’s common stock (C/S)  Is an impersonal objective  Is concerned for social responsibility

© 2004 by Nelson, a division of Thomson Canada Limited 17 Social Responsibility  Ethical issues will constantly confront financial managers as they strive to achieve the goal of Shareholder Wealth Maximization  Managers must: Avoid personal conflicts of interest Maintain confidentiality Be objective Act fairly

© 2004 by Nelson, a division of Thomson Canada Limited 18 Agency Relationships/Problems Owners Managers Employees Management may attempt to maximize its own welfare instead of the owners’ wealth. Caused by separation of principals

© 2004 by Nelson, a division of Thomson Canada Limited 19 Job Security  Management’s decisions may be based on retaining management, rather than Shareholder Wealth Maximization Example: A decision is made to retain an existing supplier rather than select a new supplier providing higher quality and/or lower cost Why? If a change is made management will be scrutinized, but if no change is made, the issue will be ignored.

© 2004 by Nelson, a division of Thomson Canada Limited 20 Agency Costs  Costs incurred by shareholders to minimize agency problems Examples: Management incentives Monitor performance Owners protection Complex organization structures  Recent Trend: flatter organizational structures have emerged to reduce costs.

© 2004 by Nelson, a division of Thomson Canada Limited 21 Another Agency Problem Owners Creditors Caused by separation of Solution: Creditors insert protective covenants in loan agreements

© 2004 by Nelson, a division of Thomson Canada Limited 22 Examples of Protective Covenants  Limitations on Dividends Capital expenditures Asset divestitures Incurring additional debt Poison pills

© 2004 by Nelson, a division of Thomson Canada Limited 23 SWM and Profit Maximization  Shareholder Wealth Maximization is not the same as Profit Maximization Reasons: Profit maximization has no time dimension Profit is an accounting concept with many different interpretations Profit maximization ignores risk

© 2004 by Nelson, a division of Thomson Canada Limited 24 Maximizing Shareholder Wealth  To maximize shareholder wealth, the financial manager must maximize the market value of the firm’s common stock  Three factors determine the market value of common stock: Size of the firm’s cash flow Timing of the firm’s cash flow Risk of the firm’s cash flow stream

© 2004 by Nelson, a division of Thomson Canada Limited 25 Conditions Affecting Market Value Conditions in Financial Markets Factors outside of management’s control Amount, Timing & Size of Expected Cash Flows Shareholder Wealth (Market Price of the Shares) Factors within management’s control

© 2004 by Nelson, a division of Thomson Canada Limited 26 Cash Flow  Cash flows, not accounting profits, are critical to most financial analysis  Important cash flow concepts: Timing of cash inflows versus cash outflows Cash flow is not equal to operating profit.

© 2004 by Nelson, a division of Thomson Canada Limited 27 Concept of Net Present Value  The net present value (NPV) of an investment represents the contribution of the investment to the value of the firm  To maximize shareholder wealth, reject all projects with a negative NPV  NPV = PV of cash inflows - PV of cash outflows

© 2004 by Nelson, a division of Thomson Canada Limited 28 NPV Example  A firm is analyzing a new investment opportunity. It can invest $1 million today to generate free cash flows of $400,000 per year for the next three years. After three years, the project is worthless. The firm’s shareholders require a 20% return. Should they proceed?

© 2004 by Nelson, a division of Thomson Canada Limited 29 NPV Example: Intuition 0321 $1 M$400K Solution is calculated by discount each of the cash flows back to time period zero using a discount rate of 20%.

© 2004 by Nelson, a division of Thomson Canada Limited 30 NPV Example: Solution NPV Decision: Reject the project. Accepting the project will destroy significant shareholder value

© 2004 by Nelson, a division of Thomson Canada Limited 31 Major Points  Businesses may be established as proprietorships, partnerships or corporations.  Shareholders are entitled to a number of rights as owners of a corporation.  The separation between shareholders, managers and creditors give rise to agency problems which detract from a firm’s goal of shareholder wealth maximization.  Positive NPV projects enhance shareholder wealth.