1. Ch 1: Introduction to Financial Management www.txstate.edu/~hy11/secure/fin3312.html Username: fin3312 Password: b0bcats

2. 2 Issues in Ch 1 Careers in finance Careers in finance Forms of business organization Forms of business organization The goal of financial management The goal of financial management The agency problem The agency problem

3. 3 Careers in Finance Corporate finance Corporate finance Investment, Money Management Investment, Money Management Banking (commercial banking, investment banking) Banking (commercial banking, investment banking) Insurance Insurance Real estate finance Real estate finance International finance International finance Derivatives (e.g., futures, options, swaps, etc) Derivatives (e.g., futures, options, swaps, etc) Risk management Risk management Financial planning and personal finance Financial planning and personal finance …….. ……..

4. 4 Forms of Business Organizations Sole proprietorship Sole proprietorship Partnership Partnership Corporation Corporation

5. Google - History On August 1998: The first funding for Google was a $100,000 contribution from Andy Bechtolsheim, co-founder of Sun Microsystems, given to a corporation which did not yet exist.Sun Microsystems On June 7, 1999: Equity funding totaling $25 million was given by rival venture capital firms Kleiner Perkins Caufield & Byers and Sequoia Capital.Kleiner Perkins Caufield & Byers Sequoia Capital In January 2004, Google hired investment bankers, Morgan Stanley and Goldman Sachs Group to arrange the IPO.Morgan StanleyGoldman Sachs Group Google's IPO took place on August 19, 2004. Google's IPO took place on August 19, 2004. –A total of 19,605,052 shares were offered at a price of $85 per share. –Of that, 14,142,135 were floated by Google and 5,462,917 by selling stockholders. –The sale raised US$1.67 billion, and gave Google a market capitalization of more than $23 billion. market capitalizationmarket capitalization –The vast majority of Google's 271 million shares remained under Google's control. –Many of Google's employees became instant paper millionaires.

6. 6 Sole Proprietorship A single individual owns all the firm’s assets directly and indirectly responsible for all its liabilities. A single individual owns all the firm’s assets directly and indirectly responsible for all its liabilities. Simplest type of business without outstanding stock offerings Simplest type of business without outstanding stock offerings easy to own and operate easy to own and operate limited ability to raise capital or access to capital market limited ability to raise capital or access to capital market difficult to transfer ownership difficult to transfer ownership difficult to measure the value of the firm objectively difficult to measure the value of the firm objectively unlimited liability unlimited liability Personal tax on profits Personal tax on profits

7. 7 Partnership Similar to a proprietorship with multiple owners Similar to a proprietorship with multiple owners general partner vs. limited partners general partner vs. limited partners limited access to capital markets limited access to capital markets Income taxed as personal income to the partners Income taxed as personal income to the partners

8. 8 Corporation Legally a “person” that is separate and distinct from its owners, the shareholders. Legally a “person” that is separate and distinct from its owners, the shareholders. –Two controlling groups: Stockholders and Managers –separation of ownership and management more difficult to start more difficult to start easier access to raising capital easier access to raising capital easy to transfer ownership easy to transfer ownership easy to measure the value of the firm objectively easy to measure the value of the firm objectively

9. 9 Corporation limited liability to investors limited liability to investors –Limited Liability: A type of liability that does not exceed the initial amount a person invested into a business entity. double taxation double taxation – A tax law that causes the same earnings to be subjected to taxation twice. A company's income is taxed initially and then the shareholders and investors are taxed on the distributions they receive from the company. taxinvestorstaxinvestors –President Bush reduce tax rates on dividend in 2002.

10. Unlimited vs. Limited Liability Business AssetPersonal Asset 10 Asset Debt + Equity $100K Bank Loan $60K Equity $40K House $200K Mortgage $170K Equity $30K

11. 11 Corporate Structure Sole Proprietorships Corporations Partnerships Unlimited Liability Personal tax on profits Limited Liability Corporate tax on profits + Personal tax on dividends

12. 12 Types of U.S. Firms There are four different types of firms in the United States. As (a) and (b) show, although the majority of U.S. firms are sole proprietorships, they generate only a small fraction of total revenue, in contrast to corporations. Source: www.bizstats.com

13. 13 Role of the Financial Manager Financial manager Firm's operations Financial markets (1) Cash raised from investors (2) Cash invested in firm (3) Cash generated by operations (4a) Cash reinvested (4b) Cash returned to investors (1)(2) (3) (4a) (4b) Financial Markets

14. 14 What should a financial manager try to maximize? Maximize profit? Maximize profit? Maximize employee, supplier, creditor, and other stakeholder wealth? Maximize employee, supplier, creditor, and other stakeholder wealth? Maximize shareholder wealth? (more important) Maximize shareholder wealth? (more important) –Shareholder wealth is measured by the market value of the firm's common stock (i.e., the price that the stock trades in the market). –Maximize the current value per share of the existing stock or to maximize the market value of the existing owners’ equity –Enron and WorldCom were very profitable in the past, but why they are almost extinct now?

15. 15 What Should Managers Maximize? Problems with Profit Maximization Problems with Profit Maximization –Profits is not Necessarily Cash Flows, or Ignores the Timing of Returns due to accrual basis accounting –Accounting profits can easily be manipulated –Ignores Risk –Focuses on Short-Term Profits Maximize Shareholder Wealth Maximize Shareholder Wealth –Focus on Maximization of Stock Price, rather than Profits –Account for Risk

16. 16 Agency problem In typical corporations, ownership can be spread over a huge number of stockholders. In typical corporations, ownership can be spread over a huge number of stockholders. Therefore, agency relationship exists when someone (the principal, or stockholders) hires another (the agent, or CEO, CFO, and other managers) to represent his or her interest. Therefore, agency relationship exists when someone (the principal, or stockholders) hires another (the agent, or CEO, CFO, and other managers) to represent his or her interest. Then, the separation of ownership and management creates agency problem, or Principal-Agent problem. Then, the separation of ownership and management creates agency problem, or Principal-Agent problem. – –Agency problem: the possibility of conflict of interest between the owners and management of a firm. Mangers won’t work for the firm’s owners unless it’s in their best interest.

17. 17 Two Key Groups in Corporation The agency problem: Mangers won’t work for the firm’s owners unless it’s in their best interest!

18. 18 How are entrenched managers harmful to shareholders? Management act in the best interest of themselves, not in the best interest of shareholders. Management act in the best interest of themselves, not in the best interest of shareholders. –Management consume perks such as lavish offices and corporate jets, excessively large staffs, and memberships at country clubs. More critically, management engages in non- value increasing activities. More critically, management engages in non- value increasing activities. –Management accepts projects (or acquisitions) to make firm larger, even if its value after the event may go down.

19. 19 CEO Stock Options Why are the corporations willing to provide stock options to CEOs? Why are the corporations willing to provide stock options to CEOs? – –The separation of ownership and management creates conflicts (or agency cost) between managers and shareholders. – –One way to mitigate conflicts is to offer stock options to mangers. – –That is, in order to reduce agency cost, managerial compensation is closely tied to share value of the firm.

20. 20 Stock Options in Compensation Plans Gives owner of option the right to buy a share of the company’s stock at a specified price (called the exercise price) even if the actual stock price is higher. Gives owner of option the right to buy a share of the company’s stock at a specified price (called the exercise price) even if the actual stock price is higher. Usually can’t exercise the option for several years (called the vesting period or the expiration). Usually can’t exercise the option for several years (called the vesting period or the expiration).

21. A Hypothetical Example of CEO Stock Option 21 $20 $50 ($50 -$20)*100,000 shares = $3 million profit!

22. CEO Pays in Corporate America 22

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25. 25 Practice Question Which one of the following is an advantage of ownership of a corporation over that of a sole proprietorship? Which one of the following is an advantage of ownership of a corporation over that of a sole proprietorship? A) The owners of a corporation have limited liability for the firm's debts. B) A corporation is the easiest form of a business to start. C) A corporation is difficult to access to capital markets. D) A corporation is less regulated than a sole proprietorship. E) The profit of a corporation is subject to double taxation.

26. Practice Question The primary goal of financial management is to maximize which one of the following for a corporation? The primary goal of financial management is to maximize which one of the following for a corporation? A.Current profits B.Market share C.Number of shares outstanding D.Market value of existing stock E.Revenue growth 26