1. Financial Management (Ch. 1)
04/03/06

2. Cycle of money
The primary function of finance is the moving of money from lenders to borrowers and back again. This is referred to as the cycle of money.
Institutions, such as banks, facilitate this process by acting as the intermediary between lenders and borrowers.

3. Financial management decisions
Financial management is defined as the activities that create or preserve the economic value of assets.

4. Financial management decisions
In the business context, this function is divided into three areas
Capital Budgeting – the selection of products or services in which the company will invest its funds
Capital Structure – identifying the sources and amounts of funding
Working Capital Management – ensuring that the company has cash to maintain day-to-day operations
Ex., the curious demise of Webvan

5. Forms of business organization
Sole Proprietorship
Owned and operated by a single individual
Represents about 75% of all businesses in the US (more than 80% of Oregonian businesses)
Proprietor has unlimited liability – assets of the owner can be seized by creditors if owner is in default of debt payments
Partnership
General partners operate the company and have unlimited liability
Limited partners (if involved) may participate in certain aspects of the business
Silent partners (if involved) only provide capital
Corporation
Considered a separate legal entity
Represents 80 – 90% of the business revenues

6. Organizational form differences
Prop
Partner
Corporation
Profits
Owner
General partners
Reinvested or paid out as dividends
Liability
Unlimited
Limited
Raising Capital
Limited to owner’s assets
Generally limited to partner’s assets
Can tap into public investor market by sale of stock
Life
Owner’s life
General partner’s life
going concern
Transfer of ownership
Difficult – succession issues
Easy – purchase/sale of stock
Taxation
At owner’s personal income tax rate
At partner’s personal tax rate
At corporate rate plus taxes on dividends *
Information
Publicly reported
*Jobs and Growth Tax Relief Reconciliation Act of 2003 reduces dividend taxes

7. Corporate organizational chart

8. Financial roles within a corporation
Treasurer
Financial manager responsible for capital expenditure, capital raising and short-term asset management
Controller
Responsible for corporate accounting and tax management
Larger firms may have the treasurer delegate these responsibilities to subordinates

9. Corporate departmental interactions

10. Goal of the firm
Which of the following is an appropriate goal for a firm?
Maximize sales
Maximize profits
Minimize costs
Maintain steady growth
Maximize the stock price

11. Enron’s earnings manipulation
During the fourth quarter of 2000, senior Enron and ENA accounting and commercial managers artificially increased the value of ENA's largest merchant asset, Mariner Energy Inc., by approximately $100 million to help cover an earnings shortfall facing the Company that quarter of approximately $200 million.

12. Goal of the firm
The primary goal of the financial manager is to maximize the current share price (and thus market value) of the firm for public firms and to maximize the equity value for private firms.
Share prices are based on future cash flows.

13. Owner’s wealth maximization
A firm and financial manager should:
Accept projects/make decisions that increase the firm’s stock price.
Maintain positive relationships with other stakeholders – creditors, employees, customers.
Enter into actions that are consistent with the code of ethics of the firm.

14. The agency model
(def) Principal (shareholder) hires an agent (CEO) to represent his/her interests.
The agency problem is where there is a conflict of interest between the two parties, i.e., the goals of the principal differ from that of the agent
Recent well-publicized agency problem:
Dennis Koslowski (TYCO)
GE - Welch

15. Dennis’s indulgences…
$17,100 traveling toilet box
$15,000 dog umbrella stand
$16.8 million apartment on Fifth Avenue
$3 million in renovations
$11 million in furnishings
$7 million apartment on Park Avenue for his former wife.
A $72,000 fee to Germán Frers, a yacht maker
A $6,300 sewing basket
A $6,000 shower curtain
$5,960 for two sets of sheets
A $2,900 set of coat hangers
A $2,200 gilt metal wastebasket
A $1,650 notebook
and a $445 pincushion

16. Agency problem remedies
Internal
Tie compensation to firm performance (stock price)
External
Threat of takeover

17. Top management compensation
Company/CEO Salary Other comp
??? $1 $2.48b
???* $600,000 $229m
???* $2.78m 0
*Source:

18. Time value of money sneak peak
Revisiting our day 1 example:
You have the choice of taking $1000 today or $1050 in one year.
At what interest rate (or rate of return) would you be indifferent between these two choices?
What can you conclude about these two choices at this interest rate?