0. © 2003 The McGraw-Hill Companies, Inc. All rights reserved.

1. The University of Lethbridge - Faculty of Management
Management 3040 – Finance
Terry D. Harbottle

2. Chapter 1 - Key Concepts and Skills
1.1
Chapter 1 - Key Concepts and Skills
Know the basic types of financial management decisions and the role of the financial manager
Know the financial implications of the different forms of business organization
Know the goal of financial management
Understand the conflicts of interest that can arise between owners and managers
Understand the various types of financial markets and financial institutions
Understand current trends in Canadian financial markets

3. Corporate Finance and the Financial Manager
1.2
Chapter Outline
Corporate Finance and the Financial Manager
Forms of Business Organization
The Goal of Financial Management
The Agency Problem and Control of the Corporation
Financial Markets and the Corporation
Financial Institutions
Trends in Financial Markets and Financial Management
www: This is a good place to show the students the web site that accompanies the book, including the various features that they can access for study purposes (study guide, quizzes, web links, etc.). Click on the “web surfer” icon to go directly to the site.

4. Some important questions that are answered using finance
1.3
Corporate 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?
How can we manage financial and market risk?

5. Financial managers try to answer some or all of these questions
1.4
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, capital expenditures and financial planning
Controller – oversees taxes, cost accounting, financial accounting and data processing
Video Note: This video looks at the changing role of the Chief Financial Officer (CFO) at the Fortune 500 company, Abbot Laboratories.

6. A Simplified Organizational Chart
Board of Directors
Chairman of the Board and
Chief Executive Officer (CEO)
President and Chief
Operations Officer (COO)
Vice President
Marketing
Vice President
Finance (CFO)
Vice President
Production
Treasurer
Controller
Cash Manager
Credit Manager
Cost Accounting
Manager
Tax Manager
Capital
Expenditures
Financial
Planning
Financial
Accounting
Manager
Data Processing
Manager

7. Financial Management Decisions
1.5
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?
Risk Management
Use of derivative securities

8. Forms of Business Organization
1.6
Forms of Business Organization
Three major forms in Canada
Sole proprietorship
Partnership
General
Limited
Corporation
In other countries, corporations are also called joint stock companies, public limited companies and limited liability companies
www: Clicking on the “web surfer” will take you to a web site that will provide a discussion about which form of business may be appropriate for an entrepreneur. The following pages will provide links to specific pages on the web site that provide additional information about the legal aspects of each form of business, as well as a discussion of the advantages and disadvantages. The address is:

9. Sole Proprietorship Advantages Disadvantages Easiest to start
1.7
Sole Proprietorship
Advantages
Easiest to start
Least regulated
Single owner keeps all the profits
Taxed once as personal income
Disadvantages
Unlimited liability
Limited to life of owner
Equity capital limited to owner’s personal wealth
Difficult to sell ownership interest
www: Click on the “web surfer” for more information about sole proprietorships. If you click on the “--Sole Proprietorship” link, you will be taken to an index that will provide a link to information about husband and wife sole proprietorships.

10. Partnership Advantages Disadvantages Two or more owners
1.8
Partnership
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
www: Click on the “web surfer” for more information about partnerships. If you click on the “—Partnerships” link, you will go to an index that provides links to additional information about limited partnerships, partnership agreements and buy-sell agreements.
Note that unlimited liability applies to all partners in a general partnership and only the general partners in a limited partnership
Written agreements are essential due to the unlimited liability.
Limited partners cannot be involved in the business or else they may be deemed as general partners.

11. Corporations
A corporation is a legal entity separate and distinct from its owners
has many of the same rights, duties and privileges of an actual person:
borrow money
can own property
can enter into contracts
shareholders and management are usually separate in most larger corporations
the shareholders elect the board of directors
the board then selects the senior managers who in theory are charged with running the affairs in the interests of the shareholders

12. Corporation Advantages Disadvantages Limited liability Unlimited life
1.9
Corporation
Advantages
Limited liability
Unlimited life
Separation of ownership and management
Transfer of ownership is easy
Easier to raise capital
Disadvantages
Separation of ownership and management
Double taxation (income is taxed at the corporate rate and then dividends are taxed at the personal rate)

13. Goal Of Financial Management
1.11
Goal Of Financial Management
What should be the goal of a corporation?
Maximize profit?
Minimize costs?
Maximize market share?
Maximize the current value of the company’s stock?
Does this mean we should do anything and everything to maximize owner wealth or ‘shareholder value’?
Try and have the students discuss each of the goals above and the inherent problems of the first three goals:
Maximize profit – Are we talking about long-run or short-run profits? Do we mean accounting profits or some measure of cash flow?
Minimize costs – We can minimize costs today by not purchasing new equipment or delaying maintenance, but this may not be in the best interest of the firm or its owners.
Maximize market share – This has been a strategy of many of the dot.com companies. They issued stock and then used it primarily for advertising to increase the number of “hits” to their web sites. Even though many of the companies have a huge market share (I.e. Amazon) they still do not have positive earnings and their owners are not happy.
Maximize the current value of the company’s stock
There is no short run vs. long run here. The stock price should incorporate expectations about the future of the company and consider the trade-off between short-run profits and long-run profits.
The purpose of a for-profit business should be to make money for its owners. Maximizing the current stock price increases the wealth of the owners of the firm.
This is analogous to maximizing owners’ equity for firms that do not have publicly traded stock.
Non-profits can also follow the same principle, but their “owners” are the constituencies that they were created to help.
The instructors manual provides a letter to stockholders that was written by former Coca-Cola CEO Roberto Goizueta. There is also a brief discussion of an article that appeared in Fortune magazine that discusses Coke vs. Pepsi and their different philosophies on business in the early 1990’s.
Ethics Note: See the instructor’s manual for a discussion of Dow-Corning, silicone breast implants and the ethics involved with pursuing owners’ wealth at all costs.

14. Primary Goal of Financial Management
1.12
Primary Goal of Financial Management
Three equivalent goals of financial management:
Maximize shareholder wealth or ‘shareholder value’
Maximize share price
Maximize firm value
….goal is to increase ‘shareholder value’

15. Corporation Finance
The study of the relationship between business decisions and shareholder value
The focus of this class then is the identification of financial/business decisions and arrangements that contribute to shareholder value (contribute favourably to value of the stock)

16. The Agency Problem Agency relationship Agency problem Agency costs
1.13
The Agency Problem
Agency relationship
Principal hires an agent to represent their interests
Stockholders (principals) hire managers (agents) to run the company
Agency problem
Conflicts of interest can exist between the principal and the agent
Agency costs
Direct agency costs
Indirect agency costs
Video Note: This video focuses on how one company handled the tough decision to cut jobs and managed to successfully increase shareholder value. It features ABT Co. in Canada.
A common example of an agency relationship is a real estate broker – in particular if you break it down between a buyers agent and a sellers 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 to only show the buyer homes that are listed at the high end of the buyers price range.
Ethics Note: The instructor’s manual provides a discussion of Gillette and the apparent agency problems that existed prior to the introduction of the sensor razor.
Direct agency costs – the purchase of something for management that can’t be justified from a risk-return standpoint, monitoring costs.
Indirect agency costs – management’s tendency to forgo risky or expensive projects that could be justified from a risk-return standpoint.

17. The Agency Problem Agency Relationships and Management Goals
potential for conflict - is their too much emphasis on corporate survival, job security and (more recently) with management wealth creation?
Do managers Act in the Shareholders’ interests? They are influenced by:
how they are compensated - does their compensation encourage them to make decisions that will enhance shareholder value
how easily are they replaced if they do not pursue shareholder goals - control here is with the board of directors

18. Agency Costs
Agency Costs - defined as the costs associated with the conflict of interests :
Direct agency costs
Indirect agency costs
Impact of Agency Costs on Shareholder Wealth or Value
direct - expenditures benefiting Management e.g. the unneeded corporate jet or
direct - monitoring costs e.g. outside auditors
indirect - lost opportunity where Management is not acting in the best interests of its shareholders e.g. costly acquisitions driven more by desire for power and prestige

19. Managerial compensation
1.14
Managing Managers
Managerial compensation
Incentives can be used to align management and stockholder interests
The incentives need to be structured carefully to make sure that they achieve their goal
Corporate control
The threat of a takeover may result in better management
Conflicts with other stakeholders (see table 1.2)

20. What is the role of financial markets in corporate finance?
1.16
What is the role of financial markets in corporate finance?
Cash flows to and from the firm
Money vs. capital markets
Primary vs. secondary markets
How do financial markets benefit society?
Video Note: This video discusses how capital is raised in financial markets and shows an open-outcry market at the Chicago Board of Trade.
Discuss the cash flows to the firm. You might have students turn to Figure 1.2 in their book 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.
See the instructor’s manual for a discussion of an October 1999 BusinessWeek article concerning the move by the NYSE and the NASDAQ towards becoming for-profit companies and the possible impact on investors.
www: Click on the NYSE and NASDAQ hyperlinks to go to their web sites

21. Cash Flows to and from the Firm
1.17
Cash Flows to and from the Firm

22. Financial Institutions
1.18
Financial Institutions
Financial institutions act as intermediaries between suppliers and users of funds
Institutions earn income on services provided:
Indirect finance – Earn interest on the spread between loans and deposits
Direct finance – Service fees (i.e. bankers acceptance and stamping fees)

23. Financial Markets
Financial Markets - brings buyers and sellers of debt and equity securities together
How do financial markets differ?
Type of securities traded/how trading is conducted and who the buyers and sellers are
Money markets and capital markets
money market - short term debt securities
capital market - long term debt and equity

24. Financial Markets Continued
Primary vs. secondary markets
Primary Market- where the original sale of issue of a security by a government or corporation occurs
public offering - underwritten by an investment dealer and registered with provincial securities commissions
private placement - debt and equity sold directly to a buyer - typically life insurance companies and , pension funds
Public Offering
typically underwritten by the investment dealer - buys the securities from the company and then seeks to make a profit by selling them at a higher price to the public.....take on certain risks
interest rate movements
credit risk of the issuing company
public offering can also take the form of a ‘best efforts’ deal where the dealer does not actually buy the securities but only acts as an agent and sells as much of the issue as possible but can return any unsold shares....more on this in Chapter 15
Private Placement
debt and equity instruments are sold directly to pension funds, insurance companies and mutual funds (concept of matching here with need for long term funds being matched with the supply of longer terms funds)
why - avoid regulartory req’ts and costs of public issues

25. Financial Markets Continued
Secondary Market - trading of securities subsequent to the initial sale - enables the transfer of ownership
auction market - TSE
dealer market - ‘over the counter (OTC) ‘
How do financial markets benefit society?
Auction Market
physical location - Bay Street or Wall Street
exchanges match buyers and sellers
OTC or Dealer Market
most of the buying and selling is done by the dealer (money mkt. Concept) where the dealers are again connected electronically
Financial Markets and Society
channel savings into investment - increases the efficiency of allocating savings among the many competing uses for this capital
produce and transmit information on returns and risk - via interest rates and securities prices - both reflect supply & demand factors and risk factors
transaction prices on fin. Markets continually reflect investors evaluations of market alternatives
they pay for this info thru fees to analysts and other sellers of this info as well as thru the bid ask spread in transactions
provide a media and a payments system
moved from exchanging one commodity to accepting paper claims

26. Financial Markets and Society
what is the benefit to society?
Channel savings into investment
produce and transmit information on returns and risk
provide a media and a payments system
enable the shifting of the timing of consumption over a life cycle
enable the management of risk
enable the diversification of portfolios
savings - increases the efficiency of of allocating savings among the many competing uses for this capital
produce and transmit info:- via interest rates and security prices - both reflect supply and demand factors and risk factors
transaction prices on fin. Mkts continually reflect investors evaluations of market alternatives
they pay for this via direct fees to analysts and other sellers of this info and thru the bid-ask spread in transactions
media & payments system - moved from exchanging one commodity for another to accepting paper claims
Shifting the timing of consumption over a life cycle
borrowing and lending facilitated by fin. Mkts allows people to shift the timing of their use or consumption of lifetime incomes and wealth.
managing risk
various forms of insurance
hedging opportunities
diversification of portfolios

27. Trends in Financial Markets and Management
1.19
Trends in Financial Markets and Management
Financial Engineering
Derivative Securities
Advances in Technology – i.e. E-business
Deregulation
Corporate Governance Reform

28. What are the three major forms of business organization?
1.20
Quick Quiz
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 organization?
What is the goal of financial management?
What are agency problems and why do they exist within a corporation?
What is the difference between a primary market and a secondary market?

29. Summary 1.9 You should know:
1.21
You should know:
The advantages and disadvantages between a sole proprietorship, partnership and corporation
The primary goal of the firm
What an agency relationship and cost are
The role of financial markets